Code of Ethics for an Investment Adviser

With the upcoming requirement that advisers to many private investment funds must register with the SEC, I figured it was time to look at some of the requirements that registration will impose.

Section 204A of the Investment Advisers Act requires registered investment advisers to

“establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such investment adviser’s business, to prevent the misuse … of material, nonpublic information by such investment adviser or any person associated with such investment adviser.”

It also requires the SEC to adopt “adopt rules or regulations to require specific policies or procedures reasonably designed to prevent misuse.” That leads to the issuance of  Rule 204A-1 under the Investment Advisers Act of 1940

Rule 204A-1 has three key elements: Adoption, Reporting, IPOs.

The adoption element lays out what needs to be in the advisers code of ethics:

  1. A standard of business conduct that you require which reflect the fiduciary obligations;
  2. Provisions requiring your supervised persons to comply with applicable federal securities laws;
  3. Provisions that require all of your access persons to report, and you to review, their personal securities transactions and holdings periodically;
  4. Provisions requiring supervised persons to report any violations of your code of ethics promptly; and
  5. Provisions requiring you to provide each of your supervised persons with a copy of your code of ethics and any amendments, and requiring your supervised persons to provide you with a written acknowledgment of their receipt of the code and any amendments.

Number five requires the standard delivery of the code and signature that they received the code. The prompt reporting is also standard for a code of conduct, as is the compliance with laws.

The fiduciary obligations may be a surprise for the advisers to private investment funds. Fund managers typically structure the funds as limited partnerships. The enabling statute impose a fiduciary duty on the general partner of a limited partnership, which for a private fund will be the investment adviser affiliate. Delaware limited partnership law allows a general partner to reduce its fiduciary obligations, but still must retain the implied contractual covenant of good faith and fair dealing. (see 17 Del Code §17-1101)

On the other hand, Section 206 of the Investment Advisers Act imposes fiduciary duties on investment advisers, regardless of whether or not they are registered with the SEC. This is a different body of law defining the obligations of an investment adviser as opposed to the general partner of a limited partnership.

The fiduciary obligation in 206 make its a violation to

  • employ any device, scheme, or artifice to defraud any client or prospective client;
  • engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;
  • engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative;

Those are your conventional anti-fraud provisions. There is one more violation and it gets the most attention:

“Acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.”

The key here is that is a violation to if you don’t disclose the conflict prior to completion of the transaction.

Fora private fund, you will need to take a look at Rule 206(4)-8 because it lays out some additional fraud prohibitions for investment advisers to private investment funds.

If you run a private fund and don’t have written code of  ethics, it’s time to start thinking about putting one in place. Here are some examples of investment adviser code of ethics:

If you don’t have a code of conduct and are looking for a starting point. Those three are worth taking a look at. There are plenty of others out there and findable with an internet search.

Also keep in mind that you will have to revisit your code next year. Rule 206(4)-7 requires an annual review of your code of ethics.

Sources:

  • Section 204A of the Investment Adviser Act
  • Rule 204A-1 – Investment Adviser Code of Ethics
  • Investment Adviser Code of Ethics Rule by Shearman and Sterling
  • Section 206 of the Investment Advisers Act
  • Rule 206(4)-7
  • Rule 206(4)-8

It Will be up to the SEC to Define Venture Capital

With the financial reform bill set to eliminate the 15 client rule exemption for registration under the Investment Advisers Act, the only remaining exemption for fund companies with over $150 million in assets under management will be for venture capital. The Congressional conference decided to not include the Senate’s exemption for private equity.

The bill would leave it up to the Securities and Exchange Commission to define “venture capital.” So what do you think that definition will be?

Wikipedia provides a nice overview, but lacks much in the way of a definition for regulators.

Venture capital is provided as seed funding to early-stage, high-potential, growth companies and more often after the seed funding round as growth funding round in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company. Venture capital investments are generally made in cash in exchange for shares in the invested company.

Next I turned to a trade group’s definition of venture capital. So I went to the website for the National Venture Capital Association. I had a hard time finding a comprehensive definition. Although I’m sure that they are working on some proposals for the SEC. Here are some tidbits:

Venture capitalists invest mostly in young, private companies that have great potential for innovation and growth.

Venture capitalists are long-term investors who take a very active role in their portfolio companies. When a venture capitalist makes an investment he/she does not expect a return on that investment for 7-10 years, on average.

Venture capital is a subset of the larger private equity asset class. The private equity asset class includes venture capital, buyouts, and mezzanine investment activity. Venture capital focuses on investing in private, young, fast growing companies. Buyout and mezzanine investing focuses on investing in more mature companies. Venture capitalists also invest cash for equity. Other private equity investors tend to use debt as part of their transactions.

Venture capital is more like a different business model for investing than a legally definable industry. Since the SEC is going to come up with a definition, that means that there will be a legal definition.

That also means that the SEC definition will most likely affect the types of investments by venture capital firms, the nature of their capital investment, and the exit strategy from their investments.

Here are some guesses:

  • Prohibition or limitation on holding debt
  • Limitation on holding preferred shares
  • Restricted to holding common shares in operating companies
  • Prohibitions or limitations on holding publicly-traded securities
  • Limitations on holding shares in companies that have debt obligations
  • Restrictions on the type of operating companies they can invest in

They are just guesses. But the industry should be very worried about the eventual definition. The SEC has expressed a desire to regulate all private investment funds so I would expect their eventual definition to be very narrow.

I’m sure that the venture capital industry views the exemption as a victory. But the exemption could end up being a heavy weight around their necks. They may need to change their operating approach and investing style to stay within the boundaries of the definition and the exemption.

In the end, it may just be easier to register and regain the flexibility for a wider variety of investment approaches.

Sources:

You can get the “Trust Me, I’m a Venture Capitalist” hat at Cafe Press.

Compliance Bits and Pieces for June 18

Here are some recent stories that I found interesting:

Who Does Your Chief Compliance Officer Report To? by Thomas Fox in a guest post on The FCPA Blog

Should a CCO report to a company’s Board of Directors, or an appropriate Board committee such as an Audit Committee or Compliance Committee? Or can a CCO report to a company’s General Counsel (GC) but have access to the Board of Directors for periodic, but no less than annual, reporting? Is there any specific guidance from the Foreign Corrupt Practices Act (FCPA) or any of its U.S. government interpretations such as the U.S. Sentencing Guidelines? Is one approach more preferable than the other?

The Ethics of Perception vs. Reality by Kathleen Edmond, Best Buy’s Chief Ethics Officer

Is it OK for our employees to engage company vendors in private contracts unrelated to their work on behalf of Best Buy? Why or why not?

Why Congressional Insider Trading is so Profitable in ProfessorBainbridge.com

In my paper, The Stop Trading on Congressional Knowledge Act, I explained that a 2004 study of the results of stock trading by United States Senators during the 1990s found that that senators on average beat the market by 12% a year. In sharp contrast, U.S. households on average underperformed the market by 1.4% a year and even corporate insiders on average beat the market by only about 6% a year during that period. A reasonable inference is that some Senators had access to – and were using – material nonpublic information about the companies in whose stock they trade.

Congressman attacks student videographer on public street by Carlos Miller in Photography is Not a Crime

Bob Etheridge, a Democratic Congressman from North Carolina was walking down the street in Washington DC when he was asked a simple question by a student videographer “Do you fully support the Obama agenda?” The Congressman got irate and began demanding “who are you? who are you?” He then took a swing at the student before grabbing his wrist.

BP: Still not as evil as Goldman Sachs by Felix Salmon

Supreme Court Rules on the Privacy of Text Messages

Sort of.

The Supreme Court issued its ruling in Ontario v. Quon regarding a police chief reviewing the content of a police officer’s text messages with consent or a warrant. Many commenters hoped that the Court would issue a broad statement on an employee’s privacy rights in this age of cloud computing and web 2.0.

The Court chose to rule on very narrow grounds and not address the electronic privacy issue:

“A broad holding concerning employees’ privacy expectations vis-à-vis employer-provided technological equipment might have implications for future cases that cannot be predicted. It is preferable to dispose of this case on narrower grounds.”

The Justices were hesitant to jump into the battle about electronic privacy:

“The Court must proceed with care when considering the whole concept of privacy expectations in communications made on electronic equipment owned by a government employer. The judiciary risks error by elaborating too fully on the Fourth Amendment implications of emerging technology before its role in society has become clear.

…

Prudence counsels caution before the facts in the instant case are used to establish far-reaching premises that define the existence, and extent, of privacy expectations enjoyed by employees when using employer-provided communication devices. Rapid changes in the dynamics of communication and information transmission are evident not just in the technology itself but in what society accepts as proper behavior.”

Instead, the Justices looked narrowly as the special situation of the government as an employer.  Since its the government, the Fourth Amendment’s protection against warrantless searches comes into play. (This is not applicable for a private employer.)  The standard  is that

“when conducted for a “non-investigatory, work-related purpos[e]”or for the “investigatio[n] of work-related misconduct,” a government employer’s warrantless search is reasonable if it is “‘justified at its inception’” and if “‘the measures adopted are reasonably related to the objectives of thesearch and not excessively intrusive in light of’” the circumstances giving rise to the search.”

Even if a government employee could assume some level of privacy in their messages, it would not have been reasonable for them to conclude that his messages were in all circumstances immune from scrutiny by the government employer.

Sources:

Regulation of Advisers to Private Funds

One of the differences between the Senate and House financial reform bills is how they treat advisers to private equity funds. The Senate bill has an exemption for private equity and venture capital. The House bill only has an exemption for venture capital. Since I work for a private equity firm, I am very focused on how this gets resolved.

In reconciling the two bills at the conference, they removed the Senate exemption for private equity: Title IV as passed by the Senate conferees. They also agreed to the house provision creating an exemption from SEC registration for private fund advisers with less than $150 million dollars in assets under management. Those advisers will need to register and comply with state registration instead.

That means private equity fund advisers with more than $150 million in assets under management will need to register with the SEC as investment advisers and will be subject to the rules governing investment advisers.

The bill has not been passed yet, but it seems unlikely that they will be going back to further revise this section of the bill. There are much more contentious provisions that legislators still need to deal with.

Compliance and Humor

At the Compliance Week 2010 Conference I was surprised to discover that the improv comedy group, Second City, had dived into the world of compliance and ethics awareness. They debuted three of their awareness videos during the conference keynotes. They are now available on their Real Biz Shorts website:

The big question is whether humor is appropriate for ethics and compliance?

Second City has a response in their FAQ:

“Well we believe that this programming is too important to be delivered in a way that doesn’t connect with employees. And humor is a great tool to address tough subjects and break the ice, allowing people to dialogue about the issues they face. In the comedy business there is a saying, “things are only funny when they’re true.” Humor for humor’s sake doesn’t work in ethics and compliance, but humor as a way to get to truth is invaluable.”

Tom Yorton, the CEO of Second City Communications, stated four things that comedy pros can teach compliance professionals in an article in the May issue of Compliance Week: Winning Your Audience.

  • Humor Gets to the Truth
  • Dialogues Beat Monologues
  • Foster Open Communication
  • Say It, and Say It Again

Check out the videos if you’re feeling down at your compliance job and need a chuckle. If this sounds interesting, they also offer a free demo with four other high-quality videos.

Now if I could just be funnier…..

Enterprise 2.0, Policies and Compliance

Mike Gotta asked me to join him on a panel about the policy and compliance issues at the Enterprise 2.0 Conference in Boston. This was my fifth Enterprise 2.0 conference: 2007, 2008, 2009, 2009 San Francisco.

That the audience was interested in compliance and regulatory issues is an indication of the industry maturing.

“Policy formation, governance and risk management programs are a critical requirement as organizations assess implications to the enterprise (e.g., identity assurance, data loss, compliance, e-Discovery, security), arising from internal and external use of social networking and social media. This panel of social media and Enterprise 2.0 practitioners will discuss real-life approaches that address management concerns.”

The panel consisted of:

  • Mike Gotta, Principal Analyst, Gartner
  • Bruce Galinsky, IT Director, Global Insurance Company
  • Abha Kumar, Principal, Information Technology, Vanguard
  • Doug Cornelius, Chief Compliance Officer, Beacon Capital Partners LLC
  • Alice Wang, Director, Gartner Inc.

I took the opportunity in my introduction to set the stage for the view of most compliance and in house lawyers:

“I’m the “NO” guy in your organization and most likely the person to bring your enterprise 2.0 or web 2.0 project to a grinding halt. People in my position do not want to hear about being social. I don’t care what you had for lunch or what your kids did last night. I don’t want to endanger the multi-million dollar value of this company so that you can play with Facebook inside the office. “Now get out of my office before I sic my flying monkeys on you.”

We were unsure when planning the session whether the audience would be interested in issues related to external or internal policies. Overwhelmingly, the audience voted for a focus on internal.

One of the initial questions was whether you even need a policy. We were largely in agreement that you may not need a new separate policy. However, I pointed out, your compliance/legal department is going to want one.

Largely, the risks with enterprise 2.0 are not new risks. The big difference is that the bad stuff is now findable. Most of evangelists proclaim the benefit of finding the good stuff you need to do your job better and to encourage innovation. The downside is exposing the bad stuff and opening the enterprise up to liability.

We eventually got to the point in the discussion about if you let personal issue community to form internally. Should you allow an employee to set up a wiki or discussion forum on religious, race or political issues?  Generally it will take some action to create a new community on the enterprise 2.0 platform. Undoubtedly, there will be some need to control the creation of communities and therefore a need for a policy.

There was some discussion about content, control of the content and fixing mistakes. Personally, I have less concern about that. You need to encourage the team to keep the information current and correct. If someone is operating with the wrong information it is better you know about it and can fix the problem. The alternative is not knowing about the problem because it lives in an email silo, allowing the bad information to continue uncorrected.

When trying to draft a policy it is very useful to look to external policies for ideas and approaches. My social media policies database is a good place to start looking for precedents.  The public web 2.0 industry is well ahead of the slower enterprise 2.0 industry.

Some other issues:

  • FTC and the disclosure of “Material Connection”  (see FTC and Bloggers.)
  • EU Data Privacy
  • Records Management
  • Discovery and Law suits
  • First Amendment
  • Human Resources Issues
    • Labor relations
    • Recommendations
    • Overtime
    • Retiree and alumni involvement
  • Hiring Discrimination
  • Off-Duty activities
  • Company IP, logos and trademarks
  • Monitoring – if you have a policy you need to enforce it.

Each company has a different set of issues they are worried about. Each company also has a unique corporate culture. So there is no right way to drafting a policy. You really need to pick and chose finding the different elements that will work in your enterprise.

Are Facebook and MySpace Messages Subject to Discovery?

In the recent case of Crispin v. Audigier, a California judge ruled that Facebook and MySpace messages that aren’t publicly available are protected information under the Stored Communications Act, and therefore can’t be subpoenaed for use in civil litigation.

Buckley Crispin sued clothing maker Christian Audigier for copyright infringement, alleging that Audigier used his artistic material outside the scope of a license agreement. Audigier issued a subpoena to Facebook, MySpace, and two other third parties seeking communications by Crispin about Audigier.

Crispin’s lawyers argued that such communications fell under the Stored Communications Act, which prevents providers of communication services from divulging private communications to certain entities and individuals. A magistrate judge rejected the argument and found that Facebook and MySpace were not Electronic Communications Services and therefore not subject to the protections of the Stored Communications Act. Because the magistrate judge thought the websites’ messaging services are used solely for public display, he found that they did not meet this definition.

Judge Morrow of the US District Court for the Central District of California disagreed and laid out some thoughts about the use of the sites and how they relate to civil litigation. (Law enforcement can always use a warrant to get the information, assuming it is related to a crime.)

The Judge noted that the Stored Communications Act distinguishes between a remote computing service and an electronic communications service.

“electronic communication service” means any service which provides to users thereof the ability to send or receive wire or electronic communications (18 U.S.C. § 2510(15)) With certain enumerated exceptions, the Stored Communications Act prohibits an electronic communication service provider from “knowingly divulg[ing] to any person or entity the contents of a communication while in electronic storage by that service.” (18 U.S.C. §§ 2702(a)(1), (b))

“remote computing service” means the provision to the public of computer storage or processing services by means of an electronic communications system (18 U.S.C. § 2711(2)) The Stored Communications Act prohibits an remote computing service provider from “knowingly divulg[ing] to any person or entity the contents of any communication which is carried or maintained on that service.” (18 U.S.C. §§ 2702(a)(2)).

In the end, the decision about whether a particular message is subject to disclosure is dependent on security settings. Different messages in Facebook and MySpace (and other web 2.0 sites) will be subject to different standards.

The judge found that webmail and private messages are inherently private and quashed the subpoena for those messages. With respect to the subpoenas seeking Facebook wall postings and MySpace comments, the decision will be dependent on the person’s privacy settings and the extent of access allowed. If the general public had access to plaintiff’s Facebook wall and MySpace comments then presumably they are subject to discovery in civil litigation.

The Stored Communications Act was passed as part of the Electronic Communications Privacy Act in 1986. This was obviously well before the development of the current internet applications and technology. Courts, including the one in this Crispin case, have found that the application of this nearly 25-year-old statute presents challenges in application to the current use of the internet.

As Facebook changes the privacy settings in its platform, those changes will affect the discoverability of messages in civil litigation.

Sources:

School Official Disciplined for Misuse of LexisNexis

The Massachusetts State Ethics Commission fined Mark Rivera, the former Lawrence School Department Urban Affairs Liaison and Special Assistant to the School Superintendent, for misuse of his access rights to LexisNexis.

The Lawrence School Department purchased access to the LexisNexis database so Rivera could obtain contact information for parents no longer living in the district, and contact parents and students regarding attendance issues. However, Rivera misused his School Department access to conduct “hundreds of searches of non-public information on individuals, including state and local elected officials, professional athletes and Hollywood celebrities….”

Massachusetts General Law chapter 268a §23(b)(2) prohibits a public official from using their official position to “to secure for himself or others unwarranted privileges or exemptions which are of substantial value and which are not properly available to similarly situated individuals.”

Rivera used his official position to gain access to the database for private purposes.

Running database checks on Lawrence police Chief John Romero, David Ortiz, Johnny Damon, Michael Chiklis and Hugh Laurie cost Rivera $5,000.

This is not the only trouble for Rivera. He was also indicted on seven counts of larceny and was forced to resign in April. His boss, suspended Lawrence Superintendent Wilfredo Laboy, was recently indicted for fraud, embezzlement and possession of alcohol on school premises.

The Lawrence Public Schools system is among the poorest districts in Massachusetts. Almost 83 percent of its student body is classified as economically disadvantage.

Sources:

Why Is It Called a “Wells Notice”?

sec-seal

In 1972, SEC Chairman William J. Casey appointed a committee to review and evaluate the Commission’s enforcement policies and practices. Chairman Casey appointed John A. Wells, a lawyer at Royall, Koegel & Wells in New York, to the committee. He also added and former SEC Chairmen Manny Cohen and Ralph Demmler.  Chairman Casey asked Jack Wells to be the Chairman of the Committee specifically because he was not a securities lawyer,

Thus began what is now knows as the Wells Committee.

The Committee started its work in January 1972, and published a report with forty-three recommendations for the Commission in June of 1972. Of the 43 recommendation in the report, recommendation 7:

“The conduct of an investigation should remain with in the control of the Commission; where circumstances permit, however, the Commission should as a general practice give a party against whom the staff proposes to recommend proceedings an opportunity to present his own version of the facts by affidavit or testimony under oath.”

They further elaborated in the report:

“We recommend that, except where the nature of the case precludes, a prospective defendant or respondent should be notified of the substance of the staff’s charges and probable recommendation in advance of the submission of the staff memorandum to the Commission and be accorded an opportunity to submit a written statement to the staff which would be forwarded to the Commission together with the staff memorandum.”

The “Wells submissions” operate as a last chance for respondents to persuade the SEC staff that an enforcement recommendation is not warranted. If that fails, the Wells submissions are submitted to the Commission, along with a staff recommendation memorandum, so the Commission will have both sides of the story when it considers a recommendation for enforcement.

Who Came up With the Idea?

Former SEC Commissioner Paul S. Atkins gives credit for the concept to former Chairman Hamer Budge:

“In 1970, just months before Chairman Budge left the SEC, the Commission issued a memo to the all division directors and office heads regarding procedures to be followed in enforcement proceedings. The memo had two significant components: (1) it required the staff to get Commission approval before engaging in settlement discussions, and (2) it required the staff to provide a summary of the defendant’s arguments in a recommendation memo sent to the Commission. The latter requirement became a subject of study by the Wells Committee….”

The Wells Committee observed that “[a]s a practical matter, only experienced practitioners who are aware of the opportunity to present their client’s side of the case have made use of [such] procedures.”

Is a Wells Notice Required?

The recommendations of the Wells Committee were met with mixed responses. The Commission apparently felt hamstrung by the mandatory-sounding nature of the phrase “except where the nature of the case precludes.” They did not formally adopt the proposal. In SEC Release No. 5310 the Commission found that it would not be “in the public interest” to adopt a formal rule and instead should give notice on a strictly informal basis. The Commission “cannot place itself in a position where, as a result of the establishment of formal procedural requirements, it would lose its ability to respond to violative activities in a timely fashion.”

What’s in a Wells Notice?

From the SEC Division of Enforcement Enforcement Manual:

  • identify the specific charges the staff is considering recommending to the Commission
  • accord the recipient of the Wells notice the opportunity to provide a voluntary statement, in writing or on videotape, arguing why the Commission should not bring an action against them or bringing any facts to the Commission’s attention in connection with its consideration of this matter
  • set reasonable limitations on the length of any submission made by the recipient (typically, written submissions should be limited to 40 pages, not including exhibits, and video submissions should not exceed 12 minutes), as well as the time period allowed for the recipients to submit a voluntary statement in response to the Wells notice
  • advise the recipient that any submission should be addressed to the appropriate Assistant Director
  • inform the recipient that any Wells submission may be used by the Commission in any action or proceeding that it brings and may be discoverable by third parties in accordance with applicable law
  • attach a copy of the Wells Release, Securities Act Release No. 5310
  • attach a copy of the SEC’s Form 1662 (“Supplemental Information for Persons Requested to Supply Information Voluntarily or Directed to Supply Information Pursuant to a Commission Subpoena”)

Sources: