SEC’s Division of Examinations Issues Risk Alert Regarding MNPI and Code of Ethics Compliance

On April 26, 2022, the U.S. Securities and Exchange Commission’s (“SEC”) Division of Examinations (“EXAMS”) issued a risk alert concerning deficiencies related to Section 204A of the Investment Advisers Act of 1940 (“Advisers Act”) regarding: 1) the protection of material non-public information (“MNPI”) related to the use of alternative data, value-add investors, and expert networks; and 2) compliance with Rule 204A-1 (the “Code of Ethics Rule”), which requires, among other things, the adoption of standard(s) of business conduct expected from the adviser’s “supervised persons” (e.g., employees, officers, partners, directors and other persons who provide advice on behalf of the adviser and are subject to the adviser’s supervision and control) (“Code of Ethics”). 

The deficiencies observed by EXAMS were as follows:

1. Compliance Issues Related to MNPI

Section 204A of the Advisers Act requires all registered and unregistered investment advisers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the misuse of MNPI by the adviser or any person associated with the adviser.

a. Alternative Data. EXAMS observed advisers did not sufficiently adopt or implement policies and procedures to detect and mitigate MNPI risks associated with data provided by alternative data^[1] (“alt data”) providers. Based on EXAMS’ observations, investment advisers who engage alt data providers should:

a. Memorialize the diligence processes for alt data providers (and not rely on ad hoc or inconsistent processes);

b. Adopt and implement policies and procedures regarding the evaluation of the terms, conditions, and legal obligations related to the collection of data and the identification of red flags about the sources of such alternative data;

c. Consistently follow the alt data policies and procedures (including for all sources of alt data);

d. Refresh the due diligence, either after a certain period of time or based on changes in the underlying data collection practices; and

e. Document compliance with such policies and procedures.

b. Value-Add Investors.^[2] EXAMS observed that advisers either did not have, or insufficiently implemented existing policies and procedures regarding investors who are likely to possess MNPI, including officers or directors at a public company, principals or portfolio managers at asset management firms, and investment bankers. EXAMS noted that among the deficiencies included advisers that, as a corollary to having sufficient policies and procedures regarding such value-add investors, did not correctly identify, as a threshold matter, all of the value-add investors, or track their relationships with potential sources of MNPI. 

c. Expert Networks.^[3] EXAMS observed advisers either did not have, or insufficiently implemented existing policies and procedures regarding expert network personnel who likely have access to MNPI, including documenting and reviewing correspondences with such personnel, and reviewing relevant trading activity of supervised persons in the securities of publicly traded companies that are in similar industries as those discussed during such correspondences.

2. Compliance Issues Related to Code of Ethics

The Code of Ethics Rule requires the. The Code of Ethics Rule also requires certain supervised persons, called “access persons,” to report their personal securities transactions and holdings to the adviser’s chief compliance officer (“CCO”) or other designated persons. 

a. Identification of Access Persons. EXAMS observed advisers did not identify and supervise access persons in accordance with the Code of Ethics Rule, including defining access persons in their Code of Ethics policies.

b. Pre-Approval for Certain Investments. EXAMS observed that advisers’ access persons that invested in IPOs and limited offerings did not obtain pre-approval prior to making such investments (and certain advisers did not have codes requiring them to do so).

c. Personal Securities Holdings and Transactions. EXAMS observed advisers failed to provide sufficient evidence of:

a. Review of initial/annual holdings and quarterly transactions reports. EXAMS observed that advisers did not maintain evidence of the review of such reports. In addition, in case of the CCO’s such reports, advisers failed to have policies and procedures to assign such reports to another member of the advisers, and instead, permitted the CCO to self-review his/her such reports.

b. Submission of holdings and transaction reports. EXAMS observed that advisers failed to provide sufficient evidence that its access persons submitted such reports, and/or that such reports were submitted timely, as required by the Code of Ethics Rule.

c. Required content of holdings and transaction reports. EXAMS observed that holdings and transaction reports failed to include required content as required by the Code of Ethics Rule, including investments in private placements.

d. Written Acknowledgment of Receipt of Advisers’ Code of Ethics Policies. EXAMS observed advisers failed to provide sufficient evidence of its supervised persons having been provided with a copy of the Code of Ethics policies by way of written acknowledgements and/or including in its code of ethics policies provisions to reflect the written acknowledgment requirement of Rule 204A-1(a)(5).

e. Suggested Policies. EXAMS, in conjunction with the Code of Ethics Adopting Release,^[4] suggested that advisers consider including in their Code of Ethics policies and procedures related to:

a. Trading certain investments about which the adviser has inside information and to include such investments in restricted lists; and

b. Allocation of investment opportunities, where opportunities are first offered to an adviser’s clients before the adviser or its employees may execute on such investments.

3. Takeaways

a. If your firm utilizes alt data providers, (i) adopt and implement formal policies and procedures regarding the due diligence of such providers, including with respect to MNPI and other issues, (ii) maintain documentation showing compliance with such policies and procedures and (iii) refresh the due diligence performed during the onboarding process on an ongoing basis, based on the facts and circumstances; 

b. If your firm has value-add investors, adopt and implement policies and procedures to identify such investors and the potential MNPI risks associated with such investors;

c. If your firm utilizes expert networks, adopt and implement policies relating to their use (particularly relating to the potential sharing of MNPI) and document and review interactions with expert network personnel;

d. With respect to the Code of Ethics, (i) identify all “access persons” who will be subject to the personal securities transactions, (ii) make sure your Code of Ethics complies with the minimum requirements in the rule relating to pre-clearance of initial public offerings and private placements and the reporting of securities transactions and holdings, (iii) maintain evidence of compliance and of the review of the pre-clearance and transaction and holdings reports and receipt of written acknowledgement of receipt of the Code of Ethics, (iv) make sure someone other than the CCO is reviewing the CCO’s transaction and holdings reports, and (v) consider including policies beyond those required by the Code of Ethics, including use of restricted lists and with respect to allocation of investment opportunities.

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^[1]“Alternative data” refers to many different types of information increasingly used in financial analysis, beyond traditional financial statements, company filings, and press releases. Alternative data does not necessarily contain MNPI. Examples of “alternative data” include information gleaned from satellite and drone imagery of crop fields and retailers’ parking lots, analyses of aggregate credit card transactions, social media and internet search data, geolocation data from consumers’ mobile phones, and email data obtained from apps and tools that consumers may utilize.
^[2]“Value-add investor” refers to clients or fund investors that are corporate executives or financial professional investors who may have MNPI.
^[3]“Expert network” refers to a group of professionals who are paid for their specialized information and research services.
^[4]Investment Adviser Codes of Ethics, Investment Advisers Act Release No. 2256 (July 2, 2004) (“Code of Ethics Adopting Release”).