The Securities and Exchange Commission staff conducts compliance examinations of federally registered investment advisors to identify deficiencies and weaknesses in compliance and supervisory controls. Recent examinations have provided insight into deficiencies in several areas such as Code of Ethics, Proxy Voting, Valuation and Liquidity in High Yield Municipal Bond Funds and Soft Dollar Practices. In particular, each area examined uncovered its own unique issues which are briefly outlined below.
How can we help you to mitigate any potential issues in an examination? Below are some helpful tips for consideration.
Code of Ethics
Some issues uncovered in the SEC’s Code of Ethics examinations including:
- “Access persons” were not following policies and procedures when trading in either their own personal account or the firm’s proprietary account;
- The monitoring of this trading was not being performed by the compliance personal; and
- The firm’s policies and procedures were not complete in accordance with the Investment Advisors Act of 1940, Rule 204A-1.
Tips for preventing violations of your Code of Ethics:
- Be sure your policies and procedures identify who your “access people” are, keeping in mind that an “access person” is any of your supervised persons who have access to non-public information regarding client transactions or holdings, make securities recommendations to clients or have access to such recommendations, and, for most advisers, all officers, directors and partners;
- Review your Code of Ethics and internal practices to determine if your access persons are following your written Code of Ethics policy and procedures;
- Be sure your Code of Ethics addresses conflicts of interest concerning trading in personal and proprietary accounts;
- Maintain your restricted lists and watch lists so that they are accurate and current;
- Utilizing time-stamped order tickets will help monitor the trading activity of access persons;
- Make sure your Code of Ethics addresses all the requirements of Rule 204A-1 under the Investment Advisors Act of 1940. For example,
- Are your access persons reporting their personal securities transactions to your Chief Compliance Officer or designated person each quarter? Is this being done timely? How is this being documented? The easiest way to answer these questions this is to receive duplicate statements from your access persons for their personal account.
- Have all your access persons submitted a complete report of the securities that they hold in their personal account at the time they first become an access person, and then at least once each year thereafter? Your Code of Ethics must also require that your access persons obtain your approval prior to investing in initial public offerings or private placements or other limited offerings, including pooled investment vehicles (except if your firm has only one access person);
- Designate another individual to review the Chief Compliance Officer’s personal securities transactions reports;
- Ensure your Code of Ethics is reasonably designed to prevent the misuse of material non-public information. In creating your Code, it is important that you think about the employees who have access to your firm’s non-public information and where it is stored (i.e. computer systems/file cabinets) and evaluate if this information appropriately protected from misuse; and
- Provide each of your access persons with a copy of your Code of Ethics (and any amendments that you subsequently make to it), and also obtain a written acknowledgement from the access person that he/she has received it. This should be done initially when the access person is hired, and every year thereafter.
Proxy Voting
Similar to the Code of Ethics violations mentioned above, the SEC found proxy voting policies and procedures were either not followed or contained inaccurate information.
Tips for preventing violations of your Proxy Voting:
As outlined in Rule 206(4)-6 under the Investment Advisers Act of 1940, if you have voting authority over proxies for clients’ securities, you must adopt policies and procedures reasonably designed to ensure that you:
- Vote proxies in the best interests of clients;
- Disclose information to clients about your policies and procedures; and
- Describe to clients how they may obtain information about how you voted their proxies.
In accordance with Rule 204-2 under the Investment Advisers Act of 1940, if you vote proxies on behalf of your clients, you must also retain the following records:
- Your proxy voting policies and procedures;
- The proxy statements you received regarding your client’s securities;
- Records of the votes you cast on behalf of your clients;
- Records of client requests for proxy voting information; and
- Any documents that you prepared that were material to making a decision as to how to vote or that memorialized the basis for your decision
Valuation and Liquidity Issues in High Yield Municipal Bond Funds
The SEC’s examiners uncovered several issues in the areas of portfolio composition, risk disclosures not reported, reliance on third party pricing services as “independent” values and poor records retention.
Tips for preventing violations of your valuation policies:
- Conduct a periodic review of the illiquid investments, and document your review.
- Take into consideration factors such as the company’s operating results, and financial condition when you review the illiquid security.
- Consult with an independent auditor with respect to the valuation of the illiquid securities.
- Maintain adequate documentation to support valuations regarding factors considered in determining fair valuation, the date on which the price was changed and the basis for adjusting or not adjusting the valuation of the company’s securities.
Soft Dollar Practices
Soft Dollar practices examined by the SEC determined that most investment advisors had policies in place to describe both the products and services received through soft dollar arrangements with broker-dealers. Further, most advisors disclosed that they had an “informal” commission “target” with the broker-dealers who provide them with third-party or proprietary research services. These “targets” were not obligations for investment advisors but just as a guide for the firm. Most advisors documented their best execution efforts. Advisors typically conducted their periodic execution quality reviews in an effort to document consistency with their compliance policies and procedures.
As a fiduciary, you are required to act in the best interests of your advisory clients, and to seek to obtain the best price and execution for their securities transactions. The term “best execution” means seeking the best price for a security in the marketplace as well as ensuring that, in executing client transactions, clients do not incur unnecessary brokerage costs and charges. You are not obligated to obtain the lowest possible commission cost, but rather, you should determine whether the transaction represents the best qualitative execution for your clients. In addition, whenever trading may create a conflicting interest between you and your clients, you have an obligation, before engaging in the activity, to obtain the informed consent from your clients after providing full and fair disclosure of all material facts.
When selecting a broker-dealer, you should consider the full range and quality of the services offered by the broker-dealer, including the value of the research provided, the execution capability, the commission rate charged, the broker-dealer’s financial responsibility, and its responsiveness to you. To seek to ensure that you are obtaining the best execution for your clients’ securities trades, you must periodically evaluate the execution performance of the broker-dealers you use to execute clients’ transactions.
The SEC found soft dollars products and services outside Section 28(e) safe harbor that were not disclosed. Such as:
- Internet domain fees
- Wireless services for a Blackberry
- Telecommunications and computer equipment
Tips for preventing violations of your soft dollar practices:
- Maintain reports of soft dollar arrangements and transactions
- Reconcile commissions on a periodic basis
- Review mixed-use product allocation
Receive approval from the Chief Compliance Officer, in advance, for specific products and services acquired with soft dollars.
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