• SEC Staff Recommends Code of Ethics Reporting of Transactions in Exchange Traded Funds
  • January 17, 2006
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • On November 30, 2005, the staff of the Securities and Exchange Commission (SEC) recommended that investment advisers and investment companies require the reporting of all transactions in "Exchange Traded Funds" or "ETFs" by reporting persons under such firms' codes of ethics. The recommendation was issued in the SEC staff's response letter denying a no-action request from an investment adviser with respect to code of ethics reporting of transactions in securities of "exchange traded funds" issued by unit investment trusts. The request sought to treat shares of ETFs issued by unit investment trusts (UITs) as securities that are not "reportable" securities under codes of ethics required by Rule 204A-1 under the Investment Advisers Act of 1940, and Rule 17j-1 under the Investment Company Act of 1940 (the "Rules").

    Most ETFs are issued by open-end investment companies. Shares issued by open-end investment companies, unlike those issued by UITs, are explicitly excluded from the definition of a "reportable" security under the Rules. Because ETFs are generally considered a single type of security, regardless of an open-end company or a UIT issued them, confusion may result over whether transactions in ETFs are reportable under an adviser's code. For example, iShares, issued by an open-end investment company, are required to be reported under the Rules, while SPDRs, issued by a UIT, are not.

    In denying the no-action request, the SEC cited the need to monitor personal trading of reporting persons for "potential misconduct that could arise through their relationships with broker-dealers ( e.g., obtaining favorable commission rates on their personal securities transactions in return for directing client brokerage to the broker-dealers)." Importantly, the SEC noted that this potential misconduct could arise in all transactions in ETFs because they are exchange traded. In accordance with these potential conflicts of interest, the SEC recommended that all ETF transactions be subject to code of ethics reporting requirements for investment advisers and investment companies.

    Compliance Tickler

    Whether or not an investment adviser or investment company heeds the SEC staff's recommendation, the beginning of the new year is an excellent time for compliance personnel to review code of ethics reporting requirements. In conducting such a review, pay attention to any violations that occurred throughout the prior year, particularly recurring violations. Often, transactions are not reported because codes of ethics do not clearly describe reportable securities or transactions. (For instance, reporting of trading in ETFs issued by UITs).

    If changes to a code of ethics required by the Rules is required, keep in mind the following regulatory requirements:

    • Investment advisers should also review and, if necessary, revise, Part II of their Form ADV to ensure it conforms with the amended code.
    • Rule 17j-1 under the Investment Company Act of 1940 requires that any material change to a code of ethics of an investment company or of an investment adviser of such company is required to be approved by the investment company's board within six months of the change.
    • Amended codes should be included as exhibits to the investment company's next registration statement or post-effective amendment to its registration statement.