SEC Issues Risk Alert on MNPI and Code of Ethics Compliance Issues
On April 26, 2022, the Securities Exchange and Commission (“SEC”) Division of Examinations (“the Division”) released a risk alert pertaining to notable deficiencies the staff observed related to Section 204A of the Investments Advisers Act of 1940 (the “Advisers Act”). Specifically, the deficiencies noted were related to Rule 204A-1 (the “Code of Ethics Rule”) regarding investments advisers' written policies and procedures concerning material non-public information (“MNPI”). The cited deficiencies were identified across numerous examinations of investment advisers nationally. In the alert, the Division noted that deficiencies related to the Code of Ethics Rule have been some of the most commonly noted deficiencies in exams.
Given the broad nature of advisory business, investment advisers are required under the Advisers Act to maintain and enforce written policies and procedures that are reasonably designed to account for numerous conflicts of interest and regulatory requirements. Among those, investment advisers are expected to have policies and procedures in place to account for and prevent the misuse of MNPI.
Below are some of the examples provide by the Division where investment advisers fell short of meeting their obligations to maintain appropriate policies and procedures under Rule 204A:
Alternative Data: Alternative data refers to many different types of information that is becoming increasingly more common in financial analysis. Some examples include drone footage of retailer parking lots, social media and internet search data, and geolocation data from consumer mobile phones. While utilizing alternative data does not necessarily mean that one would be in receipt of MNPI, the fact is it very well could be. The Division noted that in exams where investment advisers were utilizing alternative data gathering there were three common concerns:
Very little in the way of formalizing a process for access persons to adhere to in terms of performing due diligence on the alternative data sources.
Very little to nothing in place from a policies and procedures standpoint regarding the assessment of the various terms, conditions and any legal obligations related to the collection or dissemination of alternative data.
Lack of consistency in adhering to written policies and procedures
Value Add Investors: This refers to clients or investors that are corporate executives or professional financial investors. By and large, the noted deficiencies were either a lack of policies and procedures regarding MNPI risks or a lack of awareness and process on identifying and tracking relationships that were potential sources of MNPI.
Expert Networks: Similar to Value Add Investors, the lack of adequately implemented policies and procedures concerning MNPI as it relates to the use of and relationships with industry professionals that provide specialized information and research services was the key finding
On a more granular level, the Division noted more specific deficiencies as it relates to the Code of Ethics Rule 204A-1:
Identification of Access Persons: The Division noted in their findings that investment advisers had not properly identified nor supervised certain employees as access persons, with compliance policies and procedures documents either not defining or inaccurately defining an access person.
Initial Public Offerings (“IPO”) and Limited Offerings: Another common deficiency identified was related to access persons purchasing a beneficial interest in an IPO or Limited Offering without the requisite pre-approval to do so. The Code of Ethics Rule requires pre-approval for any adviser access person to obtain prior approval from the firm's Chief Compliance Officer (“CCO”) before acquiring any interest in an IPO or limited offering. Often in the exams noted, there was no mention of this requirement in the Adviser Code of Ethics.
Personal Securities Transaction and Holdings: Access persons of an investment adviser are required to disclose and provide annual holdings reports for all investment accounts in which they hold a direct or indirect beneficial interest in. Additionally, the CCO must review these accounts and their transaction report to ensure compliance with any internal policies and procedures that would limit what an access person could acquire an interest in. The Division noted the following deficiencies regarding personal securities transactions and holdings:
Advisers could not produce evidence of supervisory review of holdings and transaction reports.
The CCO was allowed to self-review their holdings and transaction report instead of delegating that responsibility.
A complete lack of reports being submitted by access persons of their holdings/transactions
In some instances, the adviser’s code of ethics did not include any language requiring this of their access persons
The full scope of what is required to be reported (i.e., including private placements) was not outlined in the advisers code of ethics and, therefore, these holdings were not disclosed or reviewed.
Amendments: Lastly, the Division noted instances where supervised persons were either not provided a written copy of the adviser’s code of ethics or they, the supervised person(s), provided no written acknowledgment of their receipt and understanding of their duties and responsibilities under the advisers code of ethics. Specifically, this was the case in instances where amendments were made and finalized to the advisers code of ethics.
It is critical that all access and supervised persons of any investment adviser are aware of what is both expected and required of them as employees of the adviser. This is specifically why the Code of Ethics rule exists. However, it is the responsibility of the CCO to ensure that their firm’s policies and procedures are as thorough and involved as they need to be to meet the various complexities that may exist. As it relates to MNPI and what you can do to ensure you are meeting what is expected of you, we encourage you to review your client files, make sure you are aware of any clients that are executives of publicly traded companies are noted and that you consider implementing a restricted securities list to account for instances where intentional or inadvertent receipt of MNPI is not acted upon. Also, review your current code of ethics with an eye paid towards what has been noted by the Division. And lastly, as the age-old adage says, if you say you are doing something…do it. The Division will consistently be looking to ensure that advisers are adhering to what their stated policies and procedures are saying they do.
For more information from the Division, you can read the full release here.
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