SEC Division of Examinations’ Risk Alert Concerning Notable MNPI

Authors: Greg Reymann & Jim Obuchi

On Tuesday, April 26th, the SEC’s Division of Examinations (the “Division”) issued a Risk Alert that outlined notable deficiencies observed by the Division’s staff with respect to two key compliance areas:

Section 204A of the Advisers Act of 1940, which addresses the prevention of the misuse of material non-public information (MNPI) by the adviser or any person associated with the adviser; and

Rule 204A-1 (commonly referred to as the “Code of Ethics Rule”), which requires investment advisers to adopt and maintain a Code of Ethics (“Code”) that sets forth the standard of business conduct expected from the adviser’s “supervised persons” (generally all employees, officers, directors and any persons who provide advice on behalf of the adviser and are subject to the adviser’s supervision and control). 

Highlights:

Compliance Issues Related to Section 204A

Section 204A requires advisers (registered and unregistered alike) to establish and implement written policies and procedures reasonably designed to prevent the misuse of MNPI. The Division cited three areas in which its staff observed common deficiencies to policies and procedures:

1. Where advisers used data from non-traditional sources normally used for financial analysis (which the Division termed “alternative data”), but failed to implement appropriate due diligence processes even though the alternative data may not necessarily contain any MNPI. (Examples of alternative data provided by the Division include information gathered from satellite and drone imagery, aggregate credit card transactions, social media and internet searches, geolocation data from mobile phones, and email data obtained from consumer applications and other tools.)

2. Where advisers maintained client relationships with key persons (such as corporate executives or financial professionals) or institutional investorsthat are likely to possess substantial MNPI, but the adviser did not appear to have any procedures in place to assess the risks associated with these “value-add investors”, nor any tracking in place for such client relationships.

3. Where advisers used “expert networks” (networks of professionals who provide consulting and research services in various areas) but neglected to maintain adequate policies and procedures for documenting calls with the consultants and reviewing subsequent trading activity of supervised persons in the securities of publicly traded companies discussed in the consultant calls.  

Compliance Issues Related to Rule 204A-1 (the Code of Ethics Rule)

As previously mentioned, Rule 204A-1 requires all advisers to adopt and implement a Code of Ethics (“Code”) that sets forth the adviser’s standards of business conduct and reflects its fiduciary duties. Upon receipt of the Code (or any written amendment thereto), each supervised person is required to provide written acknowledgement to the adviser. The Division’s staff found instances where the written acknowledgement was not provided, as well as other instances where the adviser’s Code was silent with respect to the written acknowledgement requirement.

Under the Code of Ethics Rule, ongoing identification of “access persons” and their securities holdings (including transactions) is required.  (“Access persons” include supervised persons who have access to NPI related to client transactions or reportable fund holdings, make or have access to client securities recommendations that are non-public, and generally include all officers, directors and partners of the adviser.) The Division outlined several areas related to the monitoring of the adviser’s access persons’ securities transactions and holdings where the adviser’s Code was deficient, required monitoring was lacking, or a combination of both:

• Access persons were not identified by the adviser in accordance with the Code, or the advisor’s Code did not provide a proper definition of “access persons”;
• Access persons had not obtained pre-approval for certain tradesin accordance with the advisor’s Code, or the appropriate “pre-approval provision” did not appear in the Code;
• Periodic holdings/transaction reports were not provided by access persons to the Chief Compliance Officer (“CCO”) as required by the adviser’s Code, or such provision was not addressed in the adviser’s Code;
• With respect to periodic holdings/transaction reports, the Codes of certain advisers did not address the specific content requirement under the Code of Ethics Rule; and
• Certain advisers were unable to produce evidence of supervisory review of the periodic holdings/transaction reports submitted by access persons. In addition, the Division noted instances where policies and procedures were not in place to address the review of the CCO’s holdings/transaction reports to be reviewed by another member – effectively allowing the CCO to conduct a self-review of his/her own holdings and transactions.

The Division referred to the SEC’s Code of Ethics Adopting Release, in which several suggested practices were provided for advisers to consider incorporating into their Codes. Two examples of such practices are:

1. Implementing and distributing a “restricted list” of issuers about which the adviser has inside information, and prohibiting any trades in those securities while they remain on the restricted list; and

2. Implementing procedures to ensure investment opportunities are first offered to clients to avoid having the adviser’s own employees purchase the securities ahead of their clients at a better price.

Final Thoughts:

This summary is intended to provide highlights of the above-referenced Risk Alert.  If your firm actively uses “alternative data” in conducting its business, has “value-add investors” as clients, or is an ongoing user of one or more expert networks, you may find additional guidance in the Risk Alert.

The Code of Ethics maintained by your firm likely already contains the required provisions under the Code of Ethics Rule; most deficiencies are a result of a lapse in documenting a certain review or approval, so it is imperative to maintain the appropriate support to your compliance personnel to ensure ongoing monitoring is maintained.

Please do not hesitate to contact Reymann Law Group, P.A. should you have any questions or wish to have me review any of your own materials that are addressed above.