Gregory J. Nowak, Esquire, Partner at Pepper Hamilton LLP, contributed the following piece.
Many investment advisers to private funds were required to register as registered investment advisers (“RIAs”) under the Investment Advisers Act of 1940, as amended (“Advisers Act”) by The Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203, H.R. 4173; commonly referred to as “Dodd-Frank”). Dodd-Frank was signed into federal law by President Barack Obama on July 21, 2010 effective in 2010.
As part of the adviser registration process, RIAs are required to develop a Code of Ethics and various policies and procedures, and to maintain certain books and records, pursuant to Investment Advisers Act, and rules thereunder, specifically Rule 204 2 and Rule 204A 1.
The industry received an important reminder of the applicability of these rules in a recent administrative enforcement action against Federated Global Investment Management Corp. (“FGIMC”), issued on May 27, 2016. In this administrative cease and desist proceeding, the SEC alleged that the respondent had failed to identify a longtime consultant as an “Access Person” under the RIA’s Code of Ethics and Policies and Procedures.
The RIA’s Code of Ethics was properly drafted: it required “Access Persons” to report personal securities holdings and pre-clear personal trades, it prohibited Access Persons from trading securities that the person knows or should know are being purchased or sold or are being considered for purchase or sale by the funds managed by the Adviser, it prohibited research analysts from purchasing or selling securities for which there was an open “buy” or “sell” order and from purchasing or selling a security within seven days before or after a trade in that security by the funds managed by the RIA. Investment personnel were also prohibited from trading a security within seven days after one or more of the funds had open buy or sell orders and/or had purchased or sold that security. Finally, Access Persons were required to disclose conflicts of interest and were prohibited from serving on outside boards of directors without first obtaining written approval from a committee consisting of the chief compliance officer, the general counsel, the chief audit executive and the chief risk officer of the RIA. Because the consultant was not properly designated as an Access Person, certain proscribed activities were allowed to occur.
The SEC found that during the relevant period, the RIA had failed to maintain written policies or procedures to enable the RIA’s compliance department to identify whether particular consultants — who were not employees — should nevertheless be designated as Access Persons. In the case at hand, the SEC found that while the individual consultant was working for the RIA, he was also a member of the boards of directors of a number of publicly traded biotechnology companies and possessed material nonpublic information regarding those companies. The funds held and traded the securities of four of the biotech companies of which the consultant was a board member. At times, the consultant had access to nonpublic information regarding the funds managed by the RIA including some of the fund holdings and opinions of investment management personnel regarding securities that the funds held or were considering purchasing in addition to the consultant’s own recommendations for the funds. Finally, at times the consultant purchased and sold in his personal brokerage accounts the securities of the same pharmaceutical and biotechnology companies that the funds held sometimes in close proximity to the trades by the funds.
The thesis of the government’s case was that had the consultant been properly classified as an “Access Person,” none of these issues would have unfolded simply because the very robust compliance policies and procedures that the RIA already had in place would have caught the conflict and stopped it. Note, there were no allegations that there were in fact any misappropriations of material non-public information.
The RIA in this particular case was subject to a cease and desist order from the SEC, was censured, and was required to pay a $1.5 million fine to the Securities Exchange Commission for transfer to the U.S. Treasury.
Why advisers would classify certain individuals as consultants — as opposed to employees — is an open question, usually determined with reference to applicable tax and labor laws. Also, state wage and hour laws play a significant role in determining whether a company would prefer a worker to be treated as an employee or as a consultant/independent contractor. Employees generally must be included as participants in various pension and benefit plans, whereas consultants generally are not. These business considerations put a significant amount of pressure on the determination of whether an individual is a consultant or an employee for general business purposes. Now, added to that mix, is this recent SEC action against an RIA that effectively says such labels are irrelevant for purposes of determining who is an “Access Person.” Rather, the RIA must engage in a “function analysis”: is the person in question properly characterized as an “Access Person” and therefore subject to the fully panoply of the policies and procedures and Code of Ethics of the Adviser based on what they do and the information they have access to, not just the title assigned to the worker.
This result is similar to the result reached by broker dealers under the FINRA “registered representative” test. It doesn’t matter whether one is an employee or a consultant. If they are a registered representative of the broker dealer, that person is subject to the full supervision and written supervisory procedures of the broker-dealer. The Access Person designation in the RIA context is similar to, though not quite as far-reaching as, the registered representative designation (there are licensure requirements for registered representatives that may or may not be applicable for Access Persons, for example).
It is imperative that RIAs, exempt reporting advisers and state-registered advisers do a thorough self-examination to determine whether their treatment of consultants is appropriate under the applicable employment laws. But it is equally important for the RIAs to determine if the correct workers – regardless of employee or consultant label — have been designated as Access Persons. This recent enforcement action by the SEC shows that there are consequences under the federal securities laws to whoever is deemed to meet that definition. The RIA must do a function-based analysis, and include in the Access Person ambit anyone who meets the functional definition regardless of their status as an employee or consultant for tax or labor law purposes.
Pursuant to Investment Advisers Act Rule 204A 1(e)(1), the term “Access Person” means:
“[i] any of your [i.e., the RIA’s] supervised persons:
(A) Who has access to nonpublic information regarding any clients’ purchase or sale of securities, or nonpublic information regarding the portfolio holdings of any reportable fund, or
(B) Who is involved in making securities recommendations to clients, or who has access to such recommendations that are nonpublic.
[ii] If providing investment advice is your primary business, all of your directors, officers and partners are presumed to be Access Persons.”
There is a strong incentive for managers of funds to try to slice this determination very finely in order to avoid having to maintain brokerage records and to otherwise administer a large Access Person complement. This administrative proceeding reminds us that such efforts are often for naught.
It is imperative that the chief compliance officer of an RIA review the RIAs policies and procedures to make certain that the Code of Ethics and policies and procedures are up to date and contain a definition of “Access Person” that is consistent with Rule 204A-1 and the SEC’s interpretations of that rule. The chief compliance officer should know how many “consultants” are employed by the firm and whether those consultants are properly designated as Access Persons (or not) based upon the regulatory definition. If such consultants are involved in making securities recommendations to clients or if they have access to such recommendations that are nonpublic, such consultants are Access Persons. In the alternative, if they have access to nonpublic information regarding any clients’ purchase or sale of securities or nonpublic information regarding the portfolio holdings of any reportable funds, then they are Access Persons.
The firm’s responsibilities with respect to all Access Persons should be laid out with specificity in both the Code of Ethics and the relevant policies and procedures of the firm. If such duties are not defined, then the Adviser should modify the policies and procedures to bring them up to spec.
Finally, in the case at hand, the adviser had taken significant remedial steps including, once it recognized the issue, terminating the consulting agreement with the consultant prior to notification by the Commission staff of any investigation into the matter, conducting an independent review of the RIA’s use of the consultant and trading by the funds and the securities of companies of which the consultant served as a board member, and adopting policies and procedures that allowed for the RIA to determine whether third-party consultants used by the RIA had access to or were in possession of material, nonpublic information. The SEC still found that the RIA had “willfully violated Section 204A of the Advisers Act” and also found that, given the fact that the RIA utilized third-party consultants in connection with its work – researching and analyzing securities in order to make investment decisions — the Adviser’s written policies and procedures were not reasonably designed to prevent the misuse of material, nonpublic information with respect to outside consultants, including the consultant in question. FGIMC for its part did not admit or deny wrongdoing in agreeing to pay the civil penalty and accept the censure and the cease and desist order, all of this despite the remedial action taken by the RIA and the fact that such actions were taken before it had been notified by the Commission staff of any investigation. Policing the activities of employees and consultants who are Access Persons, including reviewing their personal trading statements as required by the Code of Ethics of every RIA, cannot be gainsaid or minimized.