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SEC highlights investment adviser MNPI compliance issues

Insight 31 May 2022

SEC highlights investment adviser MNPI compliance issues

On April 26, 2022, the Securities and Exchange Commission’s (“SEC”) Division of Examinations (“EXAMS”) issued a Risk Alert highlighting deficiencies observed by staff in their examinations of investment advisers associated with their policies, procedures and controls around the creation, receipt and use of potential material non-public information (“MNPI”).

Section 204A of the Investment Advisers Act of 1940 (the “Advisers Act”) requires all investment advisers, registered and unregistered, to establish, maintain and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI. Relatedly, Rule 204A-1 (the “Code of Ethics Rule”) requires registered investment advisers to adopt a code of ethics that includes standards of business conduct and requires certain personnel of an investment adviser to report and the adviser to review their personal securities transactions and holdings periodically and to obtain pre-approval of certain investments.

Deficiencies related to Section 204A and the Code of Ethics Rule have been among those most commonly observed by EXAMS. The Risk Alert should serve as a further reminder of the importance of adhering consistently to policies and procedures and maintaining appropriate documentation to demonstrate compliance with such policies and procedures.

EXAMS observed the following deficiencies associated with policies, procedures and controls around MNPI:

Alternative data:  Alternative data used without adopting or implementing reasonably designed written policies and procedures to address the potential risk of receipt and use of MNPI through alternative data sources. For example:

  • Failure to adequately document or consistently follow diligence processes and instead engaged in inconsistent diligence of alternative data providers
  • Lack of policies and procedures that addressed the terms, conditions or legal obligations related to the collection and provision of the data, including when advisers became aware of red flags about the sources of alternative data
  • Inconsistent implementation of policies and procedures related to alternative data service providers

Value-add investors: Lack of adequate policies and procedures regarding investors who are more likely to possess MNPI, including officers or directors of a public company, principals or portfolio managers at an asset management firm, and investment bankers.

Expert networks: Insufficient implementation of adequate policies and procedures regarding an investment adviser’s discussions with expert network consultants who may be related to publicly traded companies or have access to MNPI, including:

  • Tracking and logging calls with expert network consultants
  • Reviewing detailed notes from expert network calls
  • Reviewing relevant trading activity of supervised persons in the securities of publicly traded companies that are in similar industries as those discussed during calls with experts

EXAMS observed the following deficiencies associated with the Code of Ethics Rule:

Identification of access persons: Failure to identify and supervise certain employees as access persons in accordance with the Code of Ethics Rule. Additionally, EXAMS staff noted adviser codes that failed to define “access person” or accurately reflect which employees are considered access persons.

Pre-approval for certain investments: Certain access persons purchased beneficial ownership in initial public offerings and limited offerings without obtaining pre-approval. Additionally, EXAMS staff observed advisers that did not include a provision in their code of ethics requiring access persons to obtain pre-approval before directly or indirectly acquiring interest in an initial public offering or limited offering.

Personal securities transactions and holdings: Deficiencies related to the required reporting of access persons’ personal securities transactions and holdings, including:

  • Inadequate evidence of supervisory review of holdings and transaction reports
  • Failure to have policies and procedures in place to assign the Chief Compliance Officer’s reporting to another officer or member of the investment adviser
  • Failures by access persons to submit the holdings and/or transaction reports because the adviser’s code of ethics did not include a provision requiring access persons to submit reports, or the reports were not submitted within the timeframes outlined in the Code of Ethics Rule
  • Code of ethics did not require access persons to include the specified content set out by the Code of Ethics Rule in their transaction and holdings reports, including investments in private placements

Written acknowledgment of receipt of code: Supervised persons were not provided with a copy of the code of ethics or required to provide written acknowledgment of their receipt of the code or any amendments. Additionally, code of conduct did not contain provisions to reflect the written acknowledgment requirement of Rule 204A-1(a)(5).

Trading investments on restricted list: Advisers should consider incorporating provisions into their code of ethics to include “restricted lists” of issuers about which the adviser has inside information and prohibit any trading in securities of those issuers while they remain on the restricted list.

Allocation of investment opportunities: Advisers should consider incorporating policies and procedures regarding the allocation of investment opportunities (e.g., where the investment adviser or its employees purchased securities at a better price, ahead of the adviser’s clients in contravention of the adviser’s code).

What actions are required?

Investment advisers should consider assessing whether MNPI provisions apply and review their firm’s policies and procedures to ensure adequate language is included and make adjustments as required. Emphasis should be placed on incorporating or updating procedures on value add investors to ensure they discuss how the adviser monitors communications with value add investors and demonstrate the testing and monitoring and follow-up actions if requested.

Recently, Sanne’s regulatory compliance team worked with an investment adviser to help construct an alternative vendor questionnaire. They advised the adviser to treat an alternative data service provider similarly to a strategic vendor (e.g., broker dealer, custodian, etc.). Questions included:

  • Does the adviser have agreements in place that allow them to distribute the data?
  • Are sources compensated for the data?
  • Does the firm conduct diligence on third-party data providers? If so, how?
  • How may the adviser use the data?
  • Does the data contain any material non-public information?
  • Are any portions of websites accessed not available to the general public?
  • Does the adviser perform MNPI training? If so, how frequently?
  • Who is responsible for administering the compliance program?
  • Does the data provided include any executable code or other potential malware?
  • Describe how you conduct web scraping.
  • Does the adviser have insurance to protect against covered indemnities?
  • Does the data provided include any executable code or other potential malware?

For additional information, or to discuss any of the topics highlighted above, please get in touch with Daryoush, Paul or Michael directly.

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Regulatory Overview
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Daryoush Niknejad General Counsel, North America - Dallas
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Paul Séjournant Director, Product Development - United Kingdom
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Michael Barakat Assistant Director - Dallas
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