By: Jaqueline M. Hummel, IACCP®, AIFA®
Managing Director
Hardin Compliance Consulting LLC

The SEC recently came out with guidance under Rule 204A-1 of the Advisers Act, which requires registered investment advisers to establish, maintain and enforce a written code of ethics. This rule mandates that employees of an investment adviser, and others with nonpublic information regarding the adviser’s securities transactions, report their personal securities holdings and transactions.

This new guidance addresses the definition of “control”, and requires advisory firms to perform due diligence in situations where an individual required to report under the code of ethics (“access person”) asserts that he or she does not have any control over an account. Generally, if an access person has no control over an account, the account and any activity within that account would not have to be reported under the adviser’s code of ethics. In its release, the SEC says that a general certification regarding a lack of control is not enough. The SEC staff provides sample questions for firms to ask to determine whether an access person truly has control over an account.  The staff further recommends requesting holdings and/or transaction reports with respect to those accounts on a sample basis. Like many compliance procedures, this approach follows that Russian proverb beloved by former President Ronald Reagan, “Trust, but verify.”

Compliance officers probably receive more questions and push back regarding this rule than any other under the Advisers Act. Many people find the requirement to disclose personal securities holdings, accounts and transactions an invasion of privacy. The disclosure and monitoring of personal trading activity, however, is essential to fulfilling an adviser’s fiduciary duty to its clients.  It’s part of the price of doing business.

Many access persons understandably want to avoid or limit the amount of reporting they are required to provide under the firm’s code of ethics, in part because they do not want to disclose to others their financial situation and in part because they do not want to fill out the paperwork. For example, an access person may tell the compliance staff that the broker has discretion over his or her securities account, and he or she does not provide any input with respect to the trading activity. Therefore, the access person argues, no reporting is required. Prior to this guidance being provided, the compliance staff may have requested a general certification from the access person stating that he or she did not exercise any control or influence over the account, without requesting any further verification of his claim.

This new guidance, however, gives compliance officers specific instructions and provides them with a directive to seek more information on these types of accounts.  The guidance states:

The staff believes that the fact that an access person provides a trustee with management authority over a trust for which he or she is grantor or beneficiary, or providing a third- party manager discretionary investment authority over his or her personal account, by itself, is insufficient for an adviser to reasonably believe that the access person had no direct or indirect influence or control over the trust or account for purposes of relying on the reporting exception.

Simply put, even though an access person may not have exercised discretion over an account, the access person may still have the power to exercise discretion by directing the trustee or third- party manager to make certain purchases or sales. The SEC wants advisers to perform additional due diligence to confirm that the access person has no direct or indirect influence or control over the account.

The staff makes the following suggestions:

• Request information about a trustee or third-party manager’s relationship to the access person (i.e., independent professional versus friend or relative; unaffiliated versus affiliated firm);
• Require more detailed, periodic certifications by access persons and their trustees or discretionary third-party managers regarding the access persons’ influence or control over trusts or accounts;
• Include a clear definition of “no direct or indirect influence or control” in the firm’s code of ethics that the adviser consistently applies to all access persons, and include that definition in the certification; and
• Require periodic reports on holdings and/or transactions made in the trust or discretionary account to identify transactions that would have been prohibited pursuant to the adviser’s code of ethics, absent reliance on the reporting exception.

It may also be appropriate to ask for a copy of the investment management agreement governing the account to verify whether the access person has any authority to direct trading activity.

The staff also recommends that the certifications specifically address whether the access person suggested, directed or consulted with the trustee or third-party discretionary manager to make any particular purchases or sales of securities.