On April 26, 2022, the U.S. Securities and Exchange Commission’s (SEC) Division of Examinations (EXAMS) outlined compliance deficiencies concerning Section 204A of the Investment Advisers Act of 1940 (the Act) in a risk alert. The risk alert provides information about deficiencies commonly observed by EXAMS staff related to investment advisers’ use of material non-public information (MNPI) in investment activities. The SEC has stated that “advisers’ required procedures under section 204A usually also contain a summary of insider trading law and procedures for determining whether information has become public.” EXAMS staff previously noted deficiencies in MNPI compliance as one of the five most frequent compliance issues identified in its examinations of investment advisers.
Section 204A of the Act requires investment advisers to establish, maintain and enforce written policies and procedures to avoid the misuse of MNPI. This duty to avoid misuse of MNPI is required regardless of registration status of the investment adviser. Furthermore, Rule 204A-1 of the Act (Ethics Rule) requires registered investment advisers to adopt a “code of ethics.” The Ethics Rule requires the registered investment adviser’s “access persons”— a supervised person who has access to nonpublic information regarding clients’ purchase or sale of securities — to report personal securities transactions and holdings to a designated person (usually, the chief compliance officer).
The MNPI compliance issues observed by EXAMS staff included the following:
- Inadequate policies and procedures concerning “alternative data.” Deficiencies with managing “alternative data” — data from non-traditional sources such as social media, internet searches or emails — included not implementing reasonably designed written policies and procedures to address receipt and use of alternative data. EXAMS staff noted deficient documentation of due diligence of alternative data service providers, deficient procedures related to the collection of data including policies about actions that need to be taken if red flags are detected, and the implementation deficit of policies related to the use of alternative data.
- Issues related to handling “value-add investors.” EXAMS staff observed that many written policies and procedures did not appreciate “value-add investors” — clients or fund investors that are corporate executives or financial professional investors who are more likely to possess MNPI. The observed policies and procedures were silent on “value-add investors” or did not correctly identify or track these relationships.
- Issues related to handling “expert networks.” EXAMS staff noted shortfalls in policies and procedures guiding the adviser’s discussions with “expert networks” — groups of professionals who are paid for their specialized information and research services. Common issues included lapses in monitoring discussions with expert networks consultants including untracked, unreviewed or unmonitored communications.
The issues related to the Code of Ethics Rule included the following:
- Identifying access persons. EXAMS staff observed that advisers failed to identify “access persons” and supervise them as such or did not account for “access persons” in the adviser’s code of ethics.
- Preapproval to purchase certain investment. The general issue noted by EXAMS staff was that “access persons” were purchasing securities in IPOs and limited offerings without necessary pre-approval.
- Reporting of personal securities transactions and holdings. Unreported personal securities transactions and holdings by access persons, scarce evidence of supervisory review of holdings and transaction reports, deficits related to submission of holdings and transaction reports, and gaps in advisers’ code of ethics regarding specified content required by the Code of Ethics Rule were noted.
- Receipt & acknowledgment issues. Deficiencies related to the receipt of code of ethics or receipt of amendments to code of ethics by supervised persons were also noted.
In addition to these observations related to the Code of Ethics Rule, EXAMS staff also recommended that an adviser incorporate a “restricted list” of issuers about which the advisory firm has inside information into their code of ethics, as well as incorporating procedures to ensure investment opportunities are first offered to clients.
- Utilize this risk alert as a guide to review, and perhaps revise, their written policies and procedures regarding MNPI, as well as, their code of ethics, accordingly. For instance, investment advisers should review or implement procedures to ensure “access persons” are (i) properly identified, (ii) obtaining preapprovals and (iii) properly reporting their securities transactions and holdings.
- Special attention should be given to managing data programs including handling of “alternative data” as the amount and types of “alternative data” is growing exponentially in the industry.
- Ensure that “value-add investors” and “expert networks” are accounted for in the written policies and procedures regarding MNPI.