On April 26, 2022, the SEC’s Division of Examinations (EXAMS) issued a risk alert highlighting notable deficiencies observed by the EXAMS staff regarding investment advisers’ obligations to establish, maintain and enforce written policies and procedures to prevent the misuse of material non-public information (MNPI) as required under Section 204A of the Investment Advisers Act of 1940 (the Advisers Act) and Rule 204A-1 thereunder (the Code of Ethics Rule).
Section 204A requires all advisers, registered and unregistered, to establish, maintain and enforce written policies and procedures that, taking into consideration the nature of the adviser’s business, are reasonably designed to prevent the misuse of MNPI by the adviser and its associated persons. The risk alert noted examples of deficiencies related to Section 204A, including:
- The failure of advisers using non-traditional data sources (Alternative Data) to adopt or implement adequate policies or procedures to address the attendant risks of such use. Specifically, the alert noted advisers failing to implement processes and policies to (i) properly memorialize diligence of Alternative Data sources; (ii) sufficiently assess the terms, conditions or legal obligations associated with the collection or dissemination of Alternative Data; and (iii) consistently diligence and update procedures relating to the engagement of Alternative Data service providers.
- Advisers lacking or implementing inadequate policies and procedures to address risks associated with certain investors or key persons most likely to possess MNPI (Value-Add Investors), including identifying Value-Add Investors and tracking such investors’ relationships with potential sources of MNPI.
- Advisers lacking or failing to implement adequate policies and procedures to monitor, track and log employees’ discussions with expert network consultants who may potentially possess MNPI related to publically traded companies. EXAMS staff also noted certain advisers failing to (i) implement processes to review notes taken during expert network calls and (ii) observe trading activity of supervised persons in securities of public companies belonging to industries similar to those of companies discussed on expert network calls.
Code of Ethics Rule
Under the Code of Ethics Rule, advisers that are registered or required to be registered under the Advisers Act are required to adopt a code of ethics that sets forth, among other things, the standard(s) of business conduct expected from an adviser’s supervised persons, including requiring “access persons” to report their personal securities transactions and holdings to the adviser’s chief compliance officer or other designated persons. With respect to the Code of Ethics Rule, the alert noted a number of issues observed by the EXAMS staff, including:
- Advisers failing to (i) identify employees as access persons and implement proper supervision procedures in accordance with the Code of Ethics Rule or (ii) define “access person” in the Adviser’s code of ethics;
- Access persons failing to obtain required pre-approval for purchases of beneficial ownership in public and limited offerings and advisers failing to incorporate provisions in their codes requiring such pre-approvals to be obtained;
- Deficiencies related to required reporting of access persons’ personal securities transactions and holdings, such as (i) advisers being unable to produce evidence of supervisory review of holdings and transactions reports; (ii) access persons failing to submit holdings and transactions reports entirely or within timeframes reflected in the code (or such code failing to require submission of reports at all); and (iii) advisers failing to require access persons to include specific content in holdings and transactions reports as specified in the Code of Ethics Rule;
- Failure of advisers to provide supervised persons with a copy of the code, or, where a copy was provided, to obtain an acknowledgment of receipt from the recipient;
- Employees trading investments included on an adviser’s restricted list; and
- Advisers or their employees purchasing securities at a better price, ahead of the adviser’s clients, in contravention of the adviser’s code.
In response to this risk alert, advisers should review their policies and procedures to ensure compliance with Section 204A and the Code of Ethics Rule as well as their practices related to the acquisition and dissemination of MNPI generally.