SEC Flags Deficiencies In Investment Adviser MNPI Compliance Practices

On April 26, 2022, the SEC's Division of Examinations ("EXAMS") issued a risk alert flagging certain notable deficiencies that it has observed related to advisers' potential misuse of material non-public information (MNPI) in the areas of:

alternative data ("alt data"),¹
• value-add investors,² and
• expert networks.³

The risk alert also addressed deficiencies in advisers' codes of ethics concerning personal securities transactions by a firm's access persons.⁴

Investment advisers-both registered and unregistered-should take stock and be mindful of all potential points of access they have to MNPI. The SEC will be looking closely at policies and practices concerning:

Due diligence surrounding providers of alt data.
• Identifying and tracking relationships with clients and corporate executives or financial professional investors who may have MNPI.
• Tracking and logging expert network calls and reviewing trading of supervised persons.
• Trading investments on a firm's restricted list.
• Ensuring that clients are appropriately allocated investment opportunities, before the adviser or its employees may act on them.

Section 204A and MNPI

The risk alert focused on compliance issues related to Section 204A of the Investment Advisers Act of 1940 ("Section 204A"), which requires all investment advisers, registered and unregistered, to establish, maintain, and enforce written policies and procedures (WPP) that are reasonably designed to prevent the misuse of MNPI.

The risk alert put a spotlight on three areas where EXAMS staff observed deficient adviser compliance with Section 204A:

1. Alt data. EXAMS observed that some advisers failed to adopt or implement WPP that address the potential risk of receipt and use of MNPI through non-traditional, alt data sources, despite the fact that many advisers use data from these sources. The risk alert states that advisers may be engaging in ad hoc and inconsistent diligence of alt data providers. EXAMS also noted that advisers lacked WPP on assessing the terms, conditions, or legal obligations related to the collection or provision of the data, including when advisers become aware of red flags regarding the sources of alt data. Notably, EXAMS specifically identified "advisers . . . not apply[ing] their due diligence process to all sources of alternative data" as an example of advisers not consistently implementing their WPP.⁵
2. Value-add investors. EXAMS observed that some advisers fail to implement adequate WPP regarding MNPI risks posed by any "value-add" investors. The risk alert suggests that MNPI policies and procedures should include not only how a firm will identify any value-add investors, but also procedures for tracking the firm's relationship with such individuals.
3. Expert networks. EXAMS observed that some advisers failed to implement adequate WPP regarding their discussions with expert network consultants who may be related to publicly traded companies or have access to MNPI. The risk alert suggests that firms should not only track and log communications with expert networks and review detailed call notes, but also review relevant trading of their supervised persons to ensure no misuse of MNPI.

Codes of Ethics

The risk alert also raised six issues related to registered adviser compliance with Rule 204A-1 (the "Code of Ethics Rule") promulgated under the Investment Advisers Act:

1. Identification of access persons. The staff noted that some advisers' codes of ethics did not define "access persons" accurately or did not identify some employees as access persons.
2. Access persons did not obtain required pre-approval for certain investments. The staff noted that some advisers' codes of ethics do not require access persons to obtain pre-approval before acquiring interests in initial public offerings or private offerings, as required by the Code of Ethics Rule.
3. Personal securities transactions and holdings. Namely:
   1. Review of holdings and transaction reports. The staff stated that certain advisers did not have procedures in place to ensure that any personal securities trading by the firm's chief compliance officer (CCO) is reviewed by another member of the firm's staff, effectively enabling a CCO to review and approve her own trades.
   2. Failure to submit holdings and transaction reports.
   3. Inadequate content of holdings and transaction reports.
4. Failure to obtain from supervised persons written acknowledgment of receipt of the code of ethics and any amendments thereto.
5. Trading investments on restricted list by employees.
6. Allocation of investment opportunities. The staff observed situations where the adviser or its employees purchased securities at a better price, ahead of the adviser's clients, in contravention of an adviser's code.

In light of the risk alert, investment advisers should carefully review their WPP and consider whether they are reasonably designed to prevent the misuse of MNPI and allow for appropriate oversight of personal securities trading by the firm's access persons.

Footnotes

1 "Alternative data" refers to the different sources of information that are increasingly being used in financial analysis, outside of traditional sources such as financial statements, filings, and press releases.  Examples 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 internet-use tracking data.

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 "Access person" is defined in Advisers Act Rule 204A-1(e)(1) and for most advisers includes all officers, directors, and partners.

5 Although no investment advisers were charged in the SEC's recent enforcement action against App Annie, Inc., the SEC's first action charging an alt data provider with securities fraud is worth a read for all compliance personnel. See In re App Annie Inc. and Bertrand Schmitt, AP File No. 3-20549 (Sept. 14, 2021), available at https://www.sec.gov/litigation/admin/2021/34-92975.pdf.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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Ms Jina Choi
Morrison & Foerster LLP
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