PICKARD AND DJINIS LLP
ATTORNEYS AT LAW
1990 M STREET, N.W.
WASHINGTON, D.C. 20036
TELEPHONE: (202) 223-4418
March 15, 2004
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Mail Stop 6-9
Washington, D.C. 20549
Re: Commission File No. S7-04-04;
Dear Mr. Katz:
We submit these comments in connection with the above-referenced proposal regarding investment adviser codes of ethics.1 Pickard and Djinis LLP is a law firm specializing in securities regulation relating to investment advisers, broker-dealers and service providers thereto. Our investment adviser client base ranges from federally registered firms with billions of dollars of assets under management to state-regulated solo practitioners. This letter reflects the opinions of a number of our federally registered adviser clients located in the U.S. and Canada.
As a general matter, we agree that investment advisers should adopt written codes of ethics. Indeed, articulating standards of conduct for advisory personnel is a "best practice" in the investment adviser industry today. We also agree that, at a minimum, codes of ethics should set forth the general standards of behavior expected of advisory personnel, address personal trading by such individuals, and safeguard material, nonpublic information about client transactions and investment recommendations. We believe that the inclusion of any additional topics in a code of ethics should be left to the discretion of the particular adviser, since, as the Commission wisely recognizes, registered investment advisers come in many different shapes and sizes.
Notwithstanding our general support for a code of ethics requirement, we believe that certain aspects of the Commission's proposal discussed below would impose burdens on advisers that would far outweigh any potential benefits to investors. In view of the almost unprecedented spate of new regulatory requirements that have recently been adopted, we urge the Commission to be exquisitely sensitive to the effect that any additional obligations will have on the day-to-day operations of investment advisers.
Definition of "Access Person"
Under proposed Rule 204A-1, an adviser's code of ethics would have to require an adviser's "access persons" to periodically report their personal securities transactions and holdings to the firm's chief compliance officer. Such persons also would be obliged to obtain the adviser's approval before investing in an IPO or private placement. The rule would define an "access person" as any supervised person2 who has access to nonpublic information regarding clients' purchases or sales of securities or the portfolio holdings of any reportable fund,3 as well as any person who is involved in making securities recommendations to clients or who has access to such recommendations before they become public. The proposed rule would establish a presumption that all the officers, directors and partners of a firm whose primary business is rendering investment advice are access persons.
While we endorse the idea of focusing personal trading scrutiny on those who have access to the type of information that could be used to harm clients, we believe that the officer and director presumption is inconsistent with that approach. Even in companies that do nothing but render investment advice, outside directors and officers such as corporate secretaries and treasurers may have no knowledge about a firm's confidential investment recommendations and decisions or client holdings and transactions.4
We respectfully suggest that the Commission amend proposed Rule 204A-1 to remove the officer and director presumption. Instead, these individuals should be treated like any other supervised persons, and should be elevated to the status of "access persons" only if they truly have access to information they could use to clients' detriment.
As a general matter, we endorse the proposal to require access persons to report their personal securities transactions on a quarterly basis. We further applaud the idea that such reports need not be filed to the extent the adviser obtains the required information by means of trade confirmations and account statements. However, we believe that the timing and scope of the required trade reports should be modified in three respects.
First, requiring advisers to capture personal trade information within ten days after the end of the calendar quarter in which the trading occurred may preclude the adviser's reliance on brokerage statements, since such statements are sometimes not received until the middle of the month following the end of the quarter. Extending the ten day limit to twenty days would eliminate this problem without increasing the risk of harm to the adviser's clients in any material way.
Second, we recommend that the Commission do away with the requirement that access persons file reports for quarters during which they had no personal securities transactions. Although this requirement may not be burdensome in the case of an access person who maintains one or more brokerage accounts and has account statements delivered directly to the adviser, it will be extremely inconvenient in the case of an access person who neither trades nor maintains a personal securities account.5 In addition to an annual report showing that she does not hold securities, such a person would have to file four statements a year confirming that she has no personal trades. Over time, it is highly unlikely that even the most well-intentioned employee will continue to file such "nothing-to-report" reports without quarterly intervention by the already overburdened compliance staff. Furthermore, there is nothing to suggest that requiring quarterly "no-trade" reports would offer any incremental customer protection over requiring only the annual "no holdings" report. Because the benefits do not outweigh the burdens here, the "no-trade" aspect of the transaction reporting requirements should be eliminated.
The third area which we believe merits attention concerns the proposed exceptions from the reporting requirements. Under these exceptions, neither holdings nor transaction reports would be required as to securities that are direct obligations of the U.S. Government, bankers' acceptances, bank certificates of deposit, commercial paper, high-quality short-term debt instruments (including repurchase agreements), money-market funds and shares issued by other types registered open-end investment companies, other than reportable funds. Since many investment advisers are global in nature, we respectfully suggest that Canadian and perhaps certain other non-U.S. government securities be added to the list of excepted securities.
Safeguarding Non-Public Customer Information
Proposed Rule 204A-1 would require an adviser's code of ethics to include provisions reasonably designed to safeguard material nonpublic information regarding the adviser's securities recommendations, as well as client transactions and holdings. In particular, an adviser would be obliged to restrict access to confidential client information on a "need to know" basis. The Commission has indicated that such a restriction would not preclude an adviser from furnishing necessary information to outside persons who provide services to the adviser or the account.6
Although we do not object to this aspect of the proposal, we note that the safeguarding requirement raises an issue for advisers whose supervised persons are also registered as associated persons of broker-dealers.7 NASD Rule 3040 provides that any person associated with an NASD member who participates in a "private securities transaction" must provide prior written notice to the member, and the member must state in writing whether it approves or disapproves of the proposed transaction. If the member approves and the registered person is to receive selling compensation, the member must record the transaction on its books and records and supervise the transaction as though it were its own. The NASD defines "selling compensation" for purposes of this rule to include asset-based and performance-based fees in addition to commission-type compensation.8 Traditional advisory fees, therefore, are selling compensation, and traditional investment management activities may implicate the private securities transaction obligations.
Where Rule 3040 applies, the broker-dealer with whom an RR/IAR is registered must maintain complete information about transactions effected for advisory clients and enough information about those clients to confirm the suitability of those transactions, whether or not the broker-dealer actually provides any services to the advisory client.9 It would appear, therefore, that Rule 3040 is at odds with proposed Rule 204A-1. Unless a broker-dealer has been engaged to provide services to an RR/IAR's managed accounts, the broker-dealer does not need to know confidential information about those accounts.
While there may be good reasons for requiring a broker-dealer to supervise its registered persons' unregulated activities away from the firm, these reasons are not so apparent where the extracurricular activities are themselves subject to a highly developed regulatory system, as is the case where a registered representative is also associated with a registered investment adviser.10 In order to avoid placing advisers between the regulatory version of a rock and a hard place, we suggest that the Commission ask the NASD to revisit the scope of Rule 3040 to conform it to Rule 204A-1.
In addition to proposing a new code of ethics rule, the Commission has also proposed changes to the personal trade recordkeeping requirements under Rule 204-2. We commend the Commission for proposing to replace the confusing obligations currently found in 204-2(a)(12) and (13) with requirements that are simple and clear. However, we find two aspects of the recordkeeping proposal to be troublesome.
The first is the proposal to require advisers to maintain holdings and transaction reports (or confirms and account statements in lieu of transaction reports) in a searchable electronic database. Today, most investment advisers maintain personal trading records for their "advisory representatives" (the term used in the current rule) in paper format, and have devised practical ways to examine those records. Converting all these records to an electronic system would be an extremely costly and labor-intensive exercise.
Maintaining an electronic trade record database would be expensive on an ongoing basis as well. The use of a spreadsheet, as the Commission suggests for small firms,11 would likely require the adviser to rekey information from access persons' brokerage statements and confirms. Large firms who do not actively manage money may also need to resort to spreadsheets, since such firms would not have client portfolio analysis systems. Even money managers who do have such systems could find them burdensome to use for all their access persons. For one thing, not all brokers supply retail account statements and confirms in an electronic format, and those that do may use a format that is incompatible with the adviser's system. Even where brokerage statements can be downloaded into an adviser's portfolio management database, a costly manual reconciliation might still be required to ensure accuracy.12
We respectfully request that the Commission amend the proposal to give advisers the option of maintaining transactions and holdings reports in electronic or paper format. We believe that this approach will amply protect investors and will avoid imposing unwarranted burdens on advisers.
The second potentially troublesome feature of the proposed changes to the recordkeeping rule is the requirement that all acknowledgements of receipt of the code of ethics be maintained for each person "who is currently, or within the past five years, was a supervised person of the investment adviser." This language expands on Rule 204-2's general requirement that documents must be retained for at least five years from the end of the fiscal year during which the last entry was made on such record.13 By focusing on the acknowledging party's status as a supervised person at any time during the past five years, as opposed to whether the acknowledgement was made during the past five years, the proposal stands to create a logistical nightmare for advisers. For example, the adviser would be required to keep all acknowledgements from someone who was a supervised person four years ago, even if those acknowledgements date back ten years. This would effectively preclude the adviser from ever destroying acknowledgements.
In order to reduce this burden, we respectfully suggest that code of ethics acknowledgements be treated like most other records under Rule 204-2. That is, an acknowledgement should have to be retained for five years from the end of the fiscal year in which the supervised person signed it.
We applaud the Commission's ongoing efforts to safeguard the interests of investment advisers' clients, and we generally endorse the requirement that advisers adopt codes of ethics as the Commission has proposed. However, we request that the Commission amend its proposal to: (1) eliminate the presumption that all officers, directors and partners of firms whose primary business is rendering investment advice are "access persons;" (2) expand the time within which advisers must capture access persons' transaction information from ten to twenty days; (3) eliminate the requirement that access persons submit transaction reports for months in which they have not traded; (4) add Canadian and perhaps certain other non-U.S. government securities to the list of securities excepted from the transaction and holdings reporting requirements; (5) give advisers the option of maintaining transactions and holdings reports in electronic or paper format; and (6) subject code of ethics acknowledgements to the standard five-year retention calculation under Rule 204-2. We further suggest that the Commission ask the NASD to conform its Rule 3040 to the safekeeping requirements of Rule 204A-1.
We very much appreciate the opportunity to comment on these important issues.
cc: (By Hand)
Hon. William H. Donaldson
Hon. Paul S. Atkins
Hon. Roel C. Campos
Hon. Cynthia A. Glassman
Hon. Harvey J. Goldschmid