[Federal Register Volume 69, Number 131 (Friday, July 9, 2004)]
[Rules and Regulations]
[Pages 41696-41709]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-15585]



[[Page 41695]]

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Part III





Securities and Exchange Commission





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17 CFR Parts 270, 275, and 279



Investment Adviser Codes of Ethics; Final Rule

  Federal Register / Vol. 69, No. 131 / Friday, July 9, 2004 / Rules 
and Regulations  

[[Page 41696]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 270, 275, and 279

[Release Nos. IA-2256, IC-26492; File No. S7-04-04]
RIN 3235-AJ08


Investment Adviser Codes of Ethics

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission is adopting a new rule 
and related rule amendments under the Investment Advisers Act of 1940 
that require registered advisers to adopt codes of ethics. The codes of 
ethics must set forth standards of conduct expected of advisory 
personnel and address conflicts that arise from personal trading by 
advisory personnel. Among other things, the rule requires advisers' 
supervised persons to report their personal securities transactions, 
including transactions in any mutual fund managed by the adviser. The 
Commission is also adopting amendments to rule 17j-1 to conform certain 
provisions to the new rule. The rule and rule amendments are designed 
to promote compliance with fiduciary standards by advisers and their 
personnel.

DATES: Effective Date: August 31, 2004. Compliance Date: January 7, 
2005.

FOR FURTHER INFORMATION CONTACT: Robert L. Tuleya, Attorney-Adviser, or 
Jennifer Sawin, Assistant Director, at (202) 942-0719, Office of 
Investment Adviser Regulation, Division of Investment Management, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-0506.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission 
(``Commission'' or ``SEC'') is adopting (i) rule 204A-1 [17 CFR 
275.204A-1] under the Investment Advisers Act of 1940 [15 U.S.C. 80b] 
(``Advisers Act'' or ``Act''); (ii) amendments to rule 204-2 [17 CFR 
275.204-2] and Form ADV [17 CFR 279.1] under the Advisers Act; and 
(iii) amendments to rule 17j-1 [17 CFR 270.17j-1] under the Investment 
Company Act of 1940 [15 U.S.C. 80a] (``Company Act'').\1\
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    \1\ Unless otherwise noted, when we refer to rule 17j-1 or any 
paragraph of the rule, we are referring to 17 CFR 270.17j-1 of the 
Code of Federal Regulations in which the rule is published, and when 
we refer to rule 204-2 or any paragraph of the rule, we are 
referring to 17 CFR 275.204-2 of the Code of Federal Regulations in 
which the rule is published.
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Executive Summary

I. Background
II. Discussion
    A. Standards of Conduct and Compliance with Laws
    B. Protection of Material Nonpublic Information
    C. Personal Securities Trading
    1. Personal Trading Procedures
    2. ``Access Persons'' Subject to the Reporting Requirements
    3. Initial and Annual Holdings Reports
    4. Quarterly Transaction Reports
    5. Exceptions From Reporting Requirements
    6. Reportable Securities
    D. Initial Public Offerings and Private Placements
    E. Reporting Violations
    F. Educating Employees About the Code of Ethics
    G. Adviser Review and Enforcement
    H. Recordkeeping
    I. Amendment to Form ADV
    J. Amendments to Rule 17j-1
III. Effective Date
IV. Cost-Benefit Analysis
V. Effects on Competition, Efficiency and Capital Formation
VI. Paperwork Reduction Act
VII. Final Regulatory Flexibility Analysis
VIII. Statutory Authority
Text of Rules and Form Amendments

Executive Summary

    The Commission is adopting new rule 204A-1 under the Advisers Act 
to require registered investment advisers to adopt codes of ethics. The 
rule requires an adviser's code of ethics to set forth standards of 
conduct and require compliance with Federal securities laws. Codes of 
ethics must also address personal trading: they must require advisers' 
personnel to report their personal securities holdings and 
transactions, including those in affiliated mutual funds, and must 
require personnel to obtain pre-approval of certain investments. The 
Commission is amending the Advisers Act recordkeeping rule to require 
advisers to keep copies of their codes of ethics and records relating 
to the code. The Commission is also amending the client disclosure 
requirements under part II of Form ADV to require advisers to describe 
their codes of ethics to clients.

I. Background

    In January of this year, we proposed to require every adviser 
registered with us to adopt and enforce a written code of ethics 
applicable to its supervised persons.\2\ Our proposal was designed to 
prevent fraud by reinforcing fiduciary principles that must govern the 
conduct of advisory firms and their personnel. The proposal was part of 
a package of regulatory initiatives with which we have responded to a 
number of recent enforcement actions against advisers or their 
personnel alleging violations of their fiduciary obligations to 
clients, including mutual fund clients.\3\
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    \2\ Investment Adviser Codes of Ethics, Investment Advisers Act 
Release No. 2209 (Jan. 20, 2004) [69 FR 4040 (Jan. 27, 2004)].
    \3\ See, e.g., In the Matter of Strong Capital Management, Inc., 
Investment Advisers Act Release No. 2239 (May 20, 2004) (``Strong'') 
(adviser disclosed material nonpublic information about fund 
portfolio holdings to hedge fund, and permitted own chairman and 
hedge fund to engage in undisclosed market timing of funds managed 
by adviser); In the Matter of Massachusetts Financial Services Co., 
Investment Advisers Act Release No. 2213 (Feb. 5, 2004) (2 senior 
executives of adviser permitted undisclosed market timing in certain 
funds in the complex managed by the adviser); In the Matter of 
Alliance Capital Management, L.P., Investment Advisers Act Release 
No. 2205 (Dec. 18, 2003) (``Alliance'') (disclosure of material 
nonpublic information about certain mutual fund portfolio holdings 
permitted favored client to profit from market timing); In the 
Matter of Robert T. Littell and Wilfred Meckel, Investment Advisers 
Act Release No. 2203 (Dec. 15, 2003) (portfolio manager of hedge 
fund made misrepresentations to investors and potential investors 
concerning performance, management oversight, and risk management 
practices); In the Matter of Zion Capital Management LLC and Ricky 
A. Lang, Investment Advisers Act Release No. 2200 (Dec. 11, 2003) 
(``Zion'') (adviser favored an advisory account in which he had an 
interest, allocating profitable trades to this account while 
allocating numerous unprofitable trades to another client); In the 
Matter of George F. Fahey, Investment Advisers Act Release No. 2196 
(Nov. 24, 2003) (president of investment adviser made 
misrepresentations to clients as to risk of investment strategy and 
value of investments); In the Matter of Putnam Investment Management 
LLC, Investment Advisers Act Release No. 2192 (Nov. 13, 2003) 
(``Putnam'') (adviser failed to reasonably supervise employees who 
market timed funds managed by the adviser and failed to disclose 
their timing activities); In the Matter of Wendell D. Belden, 
Investment Advisers Act Release No. 2191 (Nov. 6, 2003) (associate 
of adviser defrauded clients by misleading them about their 
investment options and the security of their invested principal and 
by investing their money in a manner calculated to enrich himself at 
their expense); In the Matter of James Patrick Connelly, Jr., 
Investment Advisers Act Release No. 2183 (Oct. 16, 2003) (adviser's 
vice chairman permitted more than a dozen clients to market time 
certain funds in the complex managed by the adviser in exchange for 
stable investments in other funds in the complex); In the Matter of 
Marshall E. Melton and Asset Management & Research, Inc., Investment 
Advisers Act Release No. 2151 (Jul. 25, 2003) (investment adviser 
made material misrepresentations to its clients to induce them to 
invest their funds in limited liability companies controlled by 
adviser's principal).
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    Advisers' codes would be required to contain provisions reminding 
employees of their obligations to clients as well as provisions 
requiring reporting of personal securities transactions and holdings. 
In order to ensure that advisers' employees are made aware of their 
firms' standards, advisers would have to obtain (and keep) a written 
acknowledgement from each supervised person confirming that he or she 
received a copy of the code of ethics and any amendments. While the 
code of

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ethics would have to contain certain minimum provisions, our proposal 
left advisers with substantial flexibility to design individualized 
codes that would best fit the structure, size and nature of their 
advisory businesses.
    We received 44 comment letters in response to our proposal. Most 
commenters supported requiring advisers to have written codes of 
ethics, and supported the flexibility that our proposal offered. Today, 
we are adopting new rule 204A-1 with certain changes that respond to 
commenters' recommendations.

II. Discussion

A. Standards of Conduct and Compliance With Laws

    Rule 204A-1 requires each adviser's code of ethics to set forth a 
standard of business conduct that the adviser requires of all its 
supervised persons.\4\ The rule does not require the adviser to adopt a 
particular standard, but the standard chosen must reflect the adviser's 
fiduciary obligations and those of its supervised persons, and must 
require compliance with the federal securities laws.\5\
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    \4\ Rule 204A-1(a)(1).
    \5\ Rule 204A-1(a)(1) and (2).
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    This provision, which we are adopting as proposed, establishes only 
a minimum requirement. Advisers are free to set higher standards for 
their employees, such as those established by professional or trade 
groups.\6\ Of course, any other code adopted for use must meet the 
minimum requirements of the rule, or be supplemented to meet the 
minimum requirements.\7\
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    \6\ Many professional and trade organizations, such as the 
Financial Planning Association, the Association for Investment 
Management and Research, the Certified Financial Planner Board of 
Standards, the Investment Counsel Association of America, and the 
American Institute of Certified Public Accountants, have developed 
professional codes of ethics or model codes for their members' use.
    \7\ While advisers are also free to structure their codes as 
best fits their organizations, an adviser using multi-document codes 
should ensure that all parts are integrated and understandable, so 
it is clear to supervised persons that these documents constitute 
the firm's code of ethics.
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    We urge advisers to take great care and thought in preparing their 
codes of ethics, which should be more than a compliance manual. Rather, 
a code of ethics should set out ideals for ethical conduct premised on 
fundamental principals of openness, integrity, honesty and trust. A 
good code of ethics should effectively convey to employees the value 
the advisory firm places on ethical conduct, and should challenge 
employees to live up not only to the letter of the law, but also to the 
ideals of the organization.\8\
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    \8\ See joint comment letter from the Ethics Resource Center and 
Thelen Reid & Priest LLP (Apr. 6, 2004) (available from the 
Commission's public reference room in File No. S7-04-04).
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B. Protection of Material Nonpublic Information

    We proposed to require codes of ethics to prevent access to 
material nonpublic information about the adviser's securities 
recommendations, and client securities holdings and transactions by 
individuals who do not need the information to perform their duties.\9\ 
Commenters supported our objective of controlling access to information 
as a first line of defense against misuse, but noted that it may be 
impractical to segregate employees, particularly in smaller firms that 
have limited office space. We are not requiring this provision in the 
code of ethics, but remind advisers that they must maintain and enforce 
policies and procedures to prevent the misuse of material nonpublic 
information,\10\ which we believe includes misuse of material nonpublic 
information about the adviser's securities recommendations, and client 
securities holdings and transactions.\11\ Advisers' duty of care also 
requires that they safeguard this sensitive information.\12\ Advisers 
should carefully consider how to control dissemination of sensitive 
information both within their organizations and outside them.
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    \9\ Proposed rule 204A-1(a)(3).
    \10\ Section 204A [15 U.S.C. 80b-4a]. Advisers' required 
procedures under section 204A usually also contain a summary of 
insider trading law and procedures for determining whether 
information has become public. These may be distinct from the 
adviser's section 204A procedures to guard against misuse of 
material nonpublic information about client recommendations, 
trading, and holdings. Many advisers may choose to integrate their 
section 204A procedures into their codes, but they are not required 
to do so.
    \11\ See, e.g., Strong, supra note (adviser that released 
nonpublic information about fund portfolio holdings to select market 
timers violated section 204A); Alliance, supra note (adviser that 
released, to select market timers, material nonpublic information 
concerning portfolio holdings of fund managed by the adviser 
violated section 204A); Putnam, supra note (adviser whose portfolio 
manager traded on nonpublic information regarding portfolio holdings 
and transactions of fund managed by the adviser violated section 
204A).
    \12\ As we noted in our proposing release, the obligation to 
safeguard sensitive client information would not preclude the 
adviser from providing necessary information to, for example, 
persons providing services to the adviser or the account such as 
brokers, accountants, custodians, and fund transfer agents, or in 
other circumstances when the client consents. In addition, if the 
adviser has supervised persons who are also associated persons of a 
broker-dealer, self-regulatory organization rules may require the 
broker-dealer to have certain information about the adviser's client 
accounts. Two commenters noted that, under certain circumstances, 
NASD rule 3040 requires the broker-dealer to supervise its 
registered representatives' activities for advisory accounts.
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C. Personal Securities Trading

    Each adviser's code of ethics must require an adviser's ``access 
persons'' to periodically report their personal securities transactions 
and holdings to the adviser's chief compliance officer or other 
designated persons.\13\ The code of ethics must also require the 
adviser to review those reports.\14\ Reviewing these reports will allow 
advisers as well as the Commission's examination staff to identify 
improper trades or patterns of trading by access persons. The reports 
are modeled largely on those required by rule 17j-1 under the Company 
Act.\15\
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    \13\ Rule 204A-1(a)(3). We are not suggesting that the chief 
compliance officer must personally review all reports. In addition, 
we expect most advisers will designate another individual to review 
personal securities reports submitted by the chief compliance 
officer.
    \14\ Rule 204A-1(a)(3).
    \15\ Rule 17j-1 requires that fund advisers adopt written codes 
of ethics and have procedures in place to prevent their personnel 
from abusing their access to information about the fund's securities 
trading, and requires ``access persons'' to submit reports 
periodically containing information about their personal securities 
holdings and transactions. Rule 17j-1(c)(1) and (d) under the 
Investment Company Act. Most funds, and therefore most fund 
advisers, must have codes of ethics under rule 17j-1. Money market 
funds and funds that invest only in certain non-covered securities, 
however, are not required to adopt codes of ethics under rule 17j-1. 
Rule 17j-1(c)(1)(i). As of May 1, 2004, approximately 1500 advisers, 
or 18 percent of the firms registered with us, reported that they 
manage fund portfolios.
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1. Personal Trading Procedures
    As discussed in more detail below, while rule 204A-1 requires 
advisers' codes of ethics to contain provisions requiring access 
persons to report securities transactions and holdings, it does not 
require advisers to adopt many of the detailed prophylactic measures 
common to many codes.\16\ Commenters agreed with this approach, which 
we took to accommodate the vast differences among advisory firms 
registered with us and the variety of risks associated with employee 
securities transactions. Advisory firms that have already adopted codes 
of ethics, however, commonly include many of the following elements, or 
address the following issues, which we believe that all advisers should 
consider in crafting their own procedures for

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employees' personal securities trading.\17\
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    \16\ For example, pre-clearance of personal securities 
transactions, see infra note and accompanying text, is mandated to 
some degree in most advisory firms that have adopted a code of 
ethics.
    \17\ In addition to personal securities transaction procedures, 
the following is a list of other provisions that many advisers 
include in codes of ethics, and that advisers should consider when 
deciding what to include in their own codes: Limitations on 
acceptance of gifts; limitations on the circumstances under which an 
access person may serve as a director of a publicly traded company; 
detailed identification of who is considered an access person within 
the organization; and procedures for the firm and its compliance 
personnel to review periodically the code of ethics as well as to 
review reports made pursuant to it.
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     Prior written approval before access persons can place a 
personal securities transaction (``pre-clearance'').\18\
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    \18\ In some organizations, all personnel must pre-clear all 
trades with the firm's compliance personnel. In other firms, only 
access persons must pre-clear, or only certain types of transactions 
must be pre-cleared. Some advisers have begun using compliance 
software to pre-clear personal trades on an automated basis, rather 
than have compliance personnel process the requests. Pre-clearance 
procedures may also identify who has authority to approve a trade 
request, the length of time an approval is valid, and procedures for 
revoking an approval, as well as procedures for verifying post-trade 
reports or duplicate confirmations against the log of pre-clearance 
approvals.
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     Maintenance of lists of issuers of securities that the 
advisory firm is analyzing or recommending for client transactions, and 
prohibitions on personal trading in securities of those issuers.
     Maintenance of ``restricted lists'' of issuers about which 
the advisory firm has inside information, and prohibitions on any 
trading (personal or for clients) in securities of those issuers.
     ``Blackout periods'' when client securities trades are 
being placed or recommendations are being made and access persons are 
not permitted to place personal securities transactions.\19\
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    \19\ Advisers may use blackout periods to guard against 
employees trading ahead of clients or on the same day as clients' 
trades are placed. See In the Matter of Roger Honour, Investment 
Advisers Act Release No. 1527 (Sept. 29, 1995). Prohibiting personal 
trading at the same time as client trading can also serve as a 
measure to prevent employees from allocating trades in a manner that 
defrauds clients. See, e.g., In the Matter of Nicholas-Applegate 
Capital Management, Investment Advisers Act Release No. 1741 (Aug. 
12, 1998) (adviser's senior trader placed personal trades alongside 
trades for employee plan, allocating profitable trades to his 
personal account and unprofitable ones to the employee plan's 
account); SEC v. Moran, 922 F.Supp. 867 (S.D.N.Y. 1996) (advisory 
principal allocated shares to his family and personal accounts even 
though additional shares would need to be purchased for client 
accounts on the following day at higher prices). The Commission has 
previously indicated its approval of blackout periods for advisory 
personnel. See Report of the Securities and Exchange Commission on 
the Public Policy Implications of Investment Company Growth (1966) 
(``PPI Report'') at 196 (noting with approval that the staff's 1962-
63 Special Study of the Securities Markets had concluded that all 
funds and advisers should have policies precluding certain insiders 
from buying and selling securities at the same time as a fund they 
manage).
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     Reminders that investment opportunities must be offered 
first to clients before the adviser or its employees may act on them, 
and procedures to implement this principle.\20\
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    \20\ In several of our enforcement cases involving personal 
trading, advisory personnel took investment opportunities for 
themselves (or for an account in which they had an interest) instead 
of for clients, even where the investment became available only 
because of the client's other securities purchases. See In the 
Matter of Joan Conan, Investment Advisers Act Release No. 1446 
(Sept. 30, 1994); In the Matter of Kemper Financial Services, Inc., 
Investment Advisers Act Release No. 1494 (June 6, 1995).
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     Prohibitions or restrictions on ``short-swing'' trading 
and market timing.\21\
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    \21\ Advisers that prohibit short-term trading generally mandate 
disgorgement of any profits if an employee effects a short-term 
trade.
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     Requirements to trade only through certain brokers, or 
limitations on the number of brokerage accounts permitted.
     Requirements to provide the adviser with duplicate trade 
confirmations and account statements.
     Procedures for assigning new securities analyses to 
employees whose personal holdings do not present apparent conflicts of 
interest.\22\
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    \22\ Initial and annual holdings reports will facilitate an 
adviser's assessment of whether an individual's personal securities 
holdings present a conflict of interest.
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2. ``Access Persons'' Subject to the Reporting Requirements
    Under rule 204A-1, the adviser's code must require certain 
supervised persons, called ``access persons,'' to report their personal 
securities transactions and holdings.\23\ An access person is a 
supervised person who has access to nonpublic information regarding 
clients' purchase or sale of securities, is involved in making 
securities recommendations to clients or who has access to such 
recommendations that are nonpublic.\24\ A supervised person who has 
access to nonpublic information regarding the portfolio holdings of 
affiliated mutual funds is also an access person.\25\
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    \23\ Rule 204A-1(a)(3). Section 202(a)(25) of the Advisers Act 
[15 U.S.C. 80b-2(a)(25)] defines ``supervised person.'' An adviser's 
supervised persons are its partners, officers, directors (or other 
persons occupying a similar status or performing similar functions) 
and employees, as well as any other persons who provide advice on 
behalf of the adviser and are subject to the adviser's supervision 
and control.
    \24\ Rule 204A-1(e)(1).
    \25\ Id. A supervised person would not be an access person 
solely because he has nonpublic information regarding the portfolio 
holdings of a client that is not an investment company. The 
individual is unlikely to be able to exploit that information in any 
way that would benefit himself.
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    We are adopting the definition of ``access person'' as proposed. 
Some commenters suggested that we adopt a narrower definition covering 
only those employees who actually obtained nonpublic information, the 
approach rule 17j-1 takes for mutual fund advisers.\26\ Others 
suggested that all advisory employees be covered.\27\ Our approach 
takes the middle course. It treats as access persons employees who are 
in a position to exploit information about client securities 
transactions or holdings, and thus provides the adviser with a tool to 
protect its clients.
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    \26\ Rule 17j-1 includes individuals as access persons only if 
they make, participate in, or obtain information regarding, the 
purchase and sale of the fund's securities, or if their functions 
relate to the making of any recommendations for such transactions. 
Rule 17j-1(a)(1)(i), 17j-1(a)(2)(i).
    \27\ While the definition of ``access person'' under rule 204A-1 
will not require all employees to submit personal securities 
transaction reports, some firms may elect to require reporting from 
all personnel. This approach, while not required, offers certainty 
as to whether reports are required from a given individual.
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    Access persons will include portfolio management personnel and, in 
some organizations, client service representatives who communicate 
investment advice to clients. These employees have information about 
investment recommendations whose effect may not yet be felt in the 
marketplace; as such, they may be in a position to take advantage of 
their inside knowledge. Administrative, technical, and clerical 
personnel may also be access persons if their functions or duties give 
them access to nonpublic information. Organizations in which employees 
have broad responsibilities, and where information barriers are few, 
may see a larger percentage of their staff subject to the reporting 
requirements. In contrast, organizations that keep strict controls on 
sensitive information may have fewer access persons.\28\
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    \28\ As proposed, persons who are not ``supervised persons'' of 
the adviser would not be access persons. This represents a change 
from the current adviser recordkeeping rule, rule 204-2(a)(12). 
Commenters supported the change.
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    In many advisory firms, directors, officers and partners will also 
be access persons. Rule 204A-1, as proposed, contains a presumption 
that, if the firm's primary business is providing investment advice, 
then all of its directors, officers and partners are access 
persons.\29\ Commenters supported this approach rather than rule 17j-
1's special rules and revenue-based test for advisory firms ``primarily 
engaged'' in a business other than advising funds or advisory 
clients.\30\
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    \29\ Rule 204A-1(e)(1)(ii).
    \30\ Rule 17j-1(a)(1)(i)(A) and (B). See also current rule 204-
2(a)(13)(iii)(D). Today we are also adopting parallel changes to 
17j-1 to remove this revenue-based test. See infra Section II.J of 
this Release.

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3. Initial and Annual Holdings Reports
    The code of ethics must require a complete report of each access 
person's securities holdings, at the time the person becomes an access 
person and at least once a year thereafter.\31\ Commenters supported 
these reporting requirements, which are similar to those required by 
rule 17j-1.\32\ The holdings reports must be current as of a date not 
more than 45 days prior to the individual becoming an access person 
(initial report) or the date the report is submitted (annual report). 
We had proposed to require initial holdings reports to be current as of 
the date the individual becomes an access person, and annual reports to 
be current within 30 days prior to submission, but many commenters told 
us these requirements were not flexible enough to allow access persons 
to use brokerage statements as the basis of their reports.\33\
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    \31\ Rule 204A-1(b)(1).
    \32\ Rule 17j-1(d)(1)(i) and (iii). As under rule 17j-1, an 
access person can satisfy the initial or annual holdings report 
requirement by timely filing and dating a copy of a securities 
account statement listing all their securities holdings, if the 
statement provides all information required by the rule and the code 
of ethics. Similarly, if a supervised person has previously provided 
such statement to the adviser, or has previously been reporting or 
supplying brokerage confirms for all securities transactions and the 
adviser has maintained them as a composite record containing all the 
requisite information, the access person can satisfy the initial or 
annual holdings report requirement by timely confirming the accuracy 
of the statement or composite in writing. See Personal Investment 
Activities of Investment Company Personnel, Investment Company Act 
Release No. 23958 (Aug. 20, 1999) [64 FR 46821 (Aug. 27, 1999)] 
(``Rule 17j-1 1999 Adopting Release''), at n. 34. The rule would 
not, however, permit an access person to avoid filing an initial or 
annual holdings report simply because all information has been 
provided over a period of time in various transaction reports. One 
reason for requiring a holdings report is so that the adviser's 
compliance personnel and our examiners have ready access to a 
``snapshot'' of the access person's holdings and are not required to 
piece the information together from transaction reports.
    \33\ We modeled our proposal on requirements in rule 17j-1. We 
are today adopting amendments to these requirements in rule 17j-1 to 
conform them to rule 204A-1. See infra Section II.J of this Release.
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4. Quarterly Transaction Reports
    The code of ethics must require quarterly reports of all personal 
securities transactions by access persons, which are due no later than 
30 days after the close of the calendar quarter.\34\ The code of ethics 
may excuse access persons from submitting transaction reports that 
would duplicate information contained in trade confirmations or account 
statements that the adviser holds in its records, provided the adviser 
has received those confirmations or statements not later than 30 days 
after the close of the calendar quarter in which the transaction takes 
place.\35\
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    \34\ Rule 204A-1(b)(2). In response to comments, we extended the 
deadline from the 10-day deadline we had proposed, and we have made 
similar changes to rule 17j-1. See infra Section II.J of this 
Release.
    \35\ The rule does not require all of the information required 
in a transaction report to appear in the duplicate trade 
confirmation or account statement. That is, some of the required 
information could appear in the confirmation or statement, and the 
remainder could be submitted by access persons in their reports.
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    We have not adopted a requirement we proposed that would have 
required access persons that had no personal securities transactions 
during the quarter to submit a report confirming the absence of 
transactions. Commenters argued that reports confirming absence of 
transactions were unnecessary and burdensome, particularly when the 
adviser was relying on transaction records received from the access 
person's broker-dealer during the course of the quarter.
5. Exceptions From Reporting Requirements
    Rule 204A-1 permits three exceptions to personal securities 
reporting. No reports are required:
     With respect to transactions effected pursuant to an 
automatic investment plan.\36\
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    \36\ Rule 204A-1(b)(3)(ii). However, any transaction that 
overrides the pre-set schedule or allocations of the automatic 
investment plan must be included in a quarterly transaction report. 
We are also adopting a parallel exception under rule 17j-1. See 
infra Section II.J of this Release.
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     With respect to securities held in accounts over which the 
access person had no direct or indirect influence or control.\37\
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    \37\ Rule 204A-1(b)(3)(i).
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     In the case of an advisory firm that has only one access 
person, so long as the firm maintains records of the holdings and 
transactions that rule 204A-1 would otherwise require be reported.\38\
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    \38\ Rule 204A-1(d). We had proposed this exception for firms 
that have only one supervised person, because that individual would 
otherwise be required to make reports to himself; commenters 
suggested that we should extend to firms with one access person, 
because these are still essentially one-man shops. We agree that a 
sole proprietor who has a clerical assistant or bookkeeper for his 
business should still be able to use this exception so long as that 
employee is not also an access person. These small advisers would 
still be subject to the other provisions of the rule, including the 
requirements to adopt a code of ethics and safeguard material 
nonpublic client information.
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6. Reportable Securities
    Access persons must submit holdings and transaction reports for 
``reportable securities'' in which the access person has, or acquires, 
any direct or indirect beneficial ownership.\39\ An access person is 
presumed to be a beneficial owner of securities that are held by his or 
her immediate family members sharing the access person's household.\40\
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    \39\ Rule 204A-1(b)(1)(i)(A) and (b)(2)(i). Rule 204A-1 provides 
that beneficial ownership is to be interpreted in the same manner as 
for purposes of rule 16a-1(a)(2) under the Securities Exchange Act 
of 1934 in determining whether a person has beneficial ownership of 
a security for purposes of section 16 of that Act. Rule 204A-
1(e)(3). This is the same as the standard under rule 17j-1. Rule 
17j-1 1999 Adopting Release, supra note. It is also the standard 
used under our current adviser recordkeeping rule. See rule 204-
2(a)(12)(iii)(B). Rule 204A-1, again like rule 17j-1, provides that 
any required report may contain a disclaimer of beneficial ownership 
by the person making the report.
    \40\ Rule 16a-1(a)(2)(ii)(A) [17 CFR 240.16a-1(a)(2)(ii)(A)].
---------------------------------------------------------------------------

    Rule 204A-1 treats all securities \41\ as reportable securities, 
with five exceptions designed to exclude securities that appear to 
present little opportunity for the type of improper trading that the 
access person reports are designed to uncover: \42\
---------------------------------------------------------------------------

    \41\ The term ``security'' is defined in section 2(a)(18) of the 
Act. [15 U.S. 80b-2(a)(18)].
    \42\ Rule 204A-1(e)(10). No investment adviser is required to 
take advantage of these exceptions; an adviser is free to require 
its access persons to report their holdings and transactions in all 
securities, notwithstanding these exceptions.
---------------------------------------------------------------------------

     Transactions and holdings in direct obligations of the 
Government of the United States.\43\
---------------------------------------------------------------------------

    \43\ Rule 204A-1(e)(10)(i).
---------------------------------------------------------------------------

     Money market instruments--bankers' acceptances, bank 
certificates of deposit, commercial paper, repurchase agreements and 
other high quality short-term debt instruments.\44\
---------------------------------------------------------------------------

    \44\ Rule 204A-1(e)(10)(ii). We have interpreted ``high quality 
short-term debt instrument'' to mean any instrument having a 
maturity at issuance of less than 366 days and which is rated in one 
of the highest two rating categories by a Nationally Recognized 
Statistical Rating Organization, or which is unrated but is of 
comparable quality. Personal Investment Activities of Investment 
Company Personnel and Codes of Ethics of Investment Companies and 
Their Investment Advisers and Principal Underwriters, Investment 
Company Act Release No. 21341 (Sept. 8, 1995) [60 FR 47844 (Sept. 
14, 1995)] (proposing amendments to rule 17j-1) at n. 66.
---------------------------------------------------------------------------

     Shares of money market funds.\45\
---------------------------------------------------------------------------

    \45\ Rule 204A-1(e)(10)(iii).
---------------------------------------------------------------------------

     Transactions and holdings in shares of other types of 
mutual funds, unless the adviser or a control affiliate acts as the 
investment adviser or principal underwriter for the fund.\46\
---------------------------------------------------------------------------

    \46\ Rule 204A-1(e)(9) and (10)(iv). Transactions and holdings 
in shares of closed-end investment companies would be reportable 
regardless of affiliation. The exception extends only to open-end 
funds registered in the U.S.; therefore, transactions and holdings 
in offshore funds would also be reportable.
---------------------------------------------------------------------------

     Transactions in units of a unit investment trust if the 
unit investment trust is invested exclusively in unaffiliated mutual 
funds.\47\
---------------------------------------------------------------------------

    \47\ Rule 204A-1(e)(10)(v). This exception is aimed at variable 
insurance contracts that are funded by insurance company separate 
accounts organized as unit investment trusts. Such separate accounts 
typically are divided into subaccounts, each of which invests 
exclusively in shares of an underlying open-end fund. Commenters 
suggested that these investments be excepted to the same extent as 
the underlying open-end funds.


[[Page 41700]]


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The rule thus requires access persons to report shares of mutual funds 
advised by the access person's employer or an affiliate, and is 
designed to help advisers (and our examiners) identify abusive trading 
by personnel with access to information about a mutual fund's 
portfolio.\48\
---------------------------------------------------------------------------

    \48\ Portfolio managers' short-term trading in fund shares has 
been an issue in our recent enforcement actions. See, e.g., Putnam, 
supra note 3.
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D. Initial Public Offerings and Private Placements

    The code of ethics must require that access persons obtain the 
adviser's approval before investing in an initial public offering 
(``IPO'') or private placement.\49\ Most individuals rarely have the 
opportunity to invest in these types of securities; an access person's 
IPO or private placement purchase therefore raises questions as to 
whether the employee is misappropriating an investment opportunity that 
should first be offered to eligible clients, or whether a portfolio 
manager is receiving a personal benefit for directing client business 
or brokerage.\50\ Advisory firms with only one access person would not 
be required to have that access person pre-clear these investments.\51\ 
We are adopting this provision as proposed.\52\
---------------------------------------------------------------------------

    \49\ Rule 204A-1(c).
    \50\ See, e.g., In the Matter of Monetta Financial Services, 
Inc., Robert S. Bacarella, and Richard D. Russo, Investment Advisers 
Act Release No. 2136 (Jun. 9, 2003) (investment adviser to mutual 
funds improperly allocated IPO shares in which funds could have 
invested to certain access persons of the funds without adequate 
disclosure or approval); In the Matter of Ronald V. Speaker and 
Janus Capital Corporation, Investment Company Act Release No. 22461 
(Jan. 13, 1997) (portfolio manager made a profit on same day 
purchase and sale of debentures in which fund could have invested, 
and failed to disclose transactions to the fund or obtain prior 
consent of the fund); U.S. v. Ostrander, 999 F.2d 27 (2d Cir. 1993) 
(affirming conviction of portfolio manager for accepting unlawful 
compensation where she purchased privately offered warrants of a 
company whose securities she acquired for the fund).
    \51\ Rule 204A-1(d). Firms with only one access person are 
generally one-person operations. It would make little sense to 
require the individual to pre-clear investments with himself. See 
supra note 38.
    \52\ Advisers that elect to prohibit their access persons from 
investing in IPOs and private placements would not have to include 
this pre-clearance provision.
---------------------------------------------------------------------------

E. Reporting Violations

    Under rule 204A-1, each adviser's code of ethics must require 
prompt internal reporting of any violations of the code.\53\ Violations 
must be reported to the adviser's chief compliance officer. An 
investment adviser can choose to have supervised persons report 
violations to either the chief compliance officer or to other persons 
designated in the code of ethics. But an advisory firm that designates 
someone other than the chief compliance officer to receive reports of 
code violations from supervised persons must have procedures requiring 
that the chief compliance officer also receives reports periodically of 
all violations. We caution advisers, however, that it is incumbent on 
them to create an environment that encourages and protects supervised 
persons who report violations. Advisers should consider how they can 
best prevent retaliation against someone who reports a violation; many 
advisers may choose to permit anonymous reporting, others may decide 
that retaliation constitutes a further violation of the code, and still 
others may find other methods to ensure that concerned employees feel 
safe to speak freely.
---------------------------------------------------------------------------

    \53\ Rule 204A-1(a)(4). We adopted a similar provision under 
section 406 of the Sarbanes-Oxley Act. See Disclosure Required by 
Sections 406 and 407 of the Sarbanes-Oxley Act of 2002, Securities 
Act Release No. 8177 (Jan 23, 2003) [68 FR 5109 (Jan. 31, 2003)].
---------------------------------------------------------------------------

    We are not, as some commenters suggested, adopting a system of 
fines or other penalties for violations of a code of ethics, nor are we 
requiring codes of ethics to include a discussion of penalties. We 
note, however, that many advisers do so, so that employees have a 
meaningful understanding of the importance of the code and of the 
consequences of violating it.\54\
---------------------------------------------------------------------------

    \54\ Our understanding is that penalties for violations vary 
from one firm to another, and depend on the type of violation 
involved. Employees may be required to cancel trades, disgorge 
profits or sell positions at a loss, and may face internal 
reprimands, fines, or firing.
---------------------------------------------------------------------------

F. Educating Employees About the Code of Ethics

    Under rule 204A-1, an adviser's code of ethics must require the 
adviser to provide each supervised person with a copy of the code of 
ethics and any amendments.\55\ The code must also require each 
supervised person to acknowledge, in writing, his receipt of those 
copies.\56\ While some commenters opposed this requirement, most who 
addressed it were supportive. Some commenters went further, and 
recommended we mandate that advisers educate employees as to the code 
of ethics. An investment adviser's procedures for informing its 
employees about its code of ethics are critical to obtaining good 
compliance and avoiding inadvertent violations of the code. Although we 
do not believe it is necessary to require employee education as an 
element of codes of ethics, we expect most advisory firms will ensure 
that their employees have received adequate training on the principles 
and procedures of their codes. Many firms that have already implemented 
codes of ethics hold periodic orientation or training sessions with new 
and existing employees to remind them of their obligations under the 
code; others may require employees to certify that they have read and 
understood the code of ethics, and require annual recertification that 
the employee has re-read, understands and has complied with the code. 
We are not mandating any of these procedures, but they are among best 
practices for advisers.
---------------------------------------------------------------------------

    \55\ Rule 204A-1(a)(5).
    \56\ Id. These written acknowledgements may be made 
electronically.
---------------------------------------------------------------------------

G. Adviser Review and Enforcement

    Rule 204A-1 requires that advisers maintain and enforce their codes 
of ethics.\57\ We expect that the adviser's chief compliance officer, 
or persons under his authority, will have primary responsibility for 
enforcing the adviser's code of ethics.\58\ Enforcement of the code 
must include reviewing access persons' personal securities reports.\59\ 
As discussed below, we are not adopting the proposed requirement that 
records of these reports be maintained in an accessible electronic 
database. However, we question seriously whether a larger investment 
advisory firm will be able adequately to review such reports manually 
or on paper. Review of personal securities holding and transaction 
reports should include not only an assessment of whether the access 
person followed any required internal procedures, such as pre-
clearance, but should also compare the personal trading to any 
restricted lists; assess whether the access person is trading for his 
own account in the same securities he is trading for clients, and

[[Page 41701]]

if so whether the clients are receiving terms as favorable as the 
access person takes for himself; periodically analyze the access 
person's trading for patterns that may indicate abuse, including market 
timing; investigate any substantial disparities between the quality of 
performance the access person achieves for his own account and that he 
achieves for clients; and investigate any substantial disparities 
between the percentage of trades that are profitable when the access 
person trades for his own account and the percentage that are 
profitable when he places trades for clients.
---------------------------------------------------------------------------

    \57\ Rule 204A-1(a). Some firms may, in their code, reserve the 
right to waive compliance with certain of the code's provisions. Of 
course, if a code provision is required by new rule 204A-1 (or by 
rule 17j-1), the advisory firm cannot waive a supervised person's 
compliance with that provision.
    \58\ Advisers to investment companies must provide the 
investment company's board of directors with an annual report 
describing any issues arising under the code of ethics. See rule 
17j-1(c)(2)(ii). Such annual report must include a discussion of any 
material violations of the code and whether any waivers that might 
be considered important by the board were granted during the period.
    \59\ Rule 204A-1(a)(3).
---------------------------------------------------------------------------

H. Recordkeeping

    We are amending rule 204-2 under the Advisers Act to reflect new 
rule 204A-1. Because the codes of ethics will already cover personal 
securities transaction and holdings reports, we have been able to 
simplify rules 204-2(a)(12) and (13) significantly.\60\ As amended, 
rule 204-2(a)(12) requires advisers to keep copies of their code of 
ethics, records of violations of the code and actions taken as a result 
of the violations, and copies of their supervised persons' written 
acknowledgement of receipt of the code. As discussed earlier, rule 
204A-1 requires prompt internal reporting of violations of the code of 
ethics,\61\ but we are not requiring advisers to keep records of these 
whistleblower reports.\62\ Commenters have persuaded us that requiring 
these records could have a chilling effect on employees' willingness to 
report violations, particularly in smaller organizations. Rule 204-
2(a)(13), as amended, covers records of access persons' personal 
trading. It requires advisers to keep a record of the names of their 
access persons, the holdings and transaction reports made by access 
persons, and records of decisions approving access persons' acquisition 
of securities in IPOs and limited offerings.
---------------------------------------------------------------------------

    \60\ Currently, these sections lay out fairly complex 
requirements for the information that an adviser must keep regarding 
personal securities transactions of ``advisory representatives,'' 
which include the adviser's personnel, directors, officers and 
partners.
    \61\ See supra note 53.
    \62\ An adviser could, for example, record the facts and 
circumstances surrounding a violation of the code, but omit mention 
of the employee who brought the problem to the adviser's attention.
---------------------------------------------------------------------------

    We proposed, but are not requiring, records of access persons' 
personal securities reports (and duplicate brokerage confirmations or 
account statements in lieu of those reports) to be maintained 
electronically in an accessible computer database. Commenters were 
concerned that the requirement would be unduly burdensome and would 
require them to input large quantities of data manually. Although we 
are not adopting this requirement, as discussed above, we have strong 
expectations that most advisers will need to maintain these records 
electronically in order to meet their responsibilities to review these 
records and monitor compliance with their codes.
    The standard retention period required for books and records under 
rule 204-2 is five years, in an easily accessible place, the first two 
years in an appropriate office of the investment adviser.\63\ Advisers 
must maintain the records required under amended rule 204-2(a)(12) and 
(13) for this standard period, subject to special holding requirements 
for certain categories of records as specified in amended rule 204-
2(a)(12) and (13). Codes of ethics must be kept for five years after 
the last date they were in effect. Supervised person acknowledgements 
of the code must be kept for five years after the individual ceases to 
be a supervised person.\64\ Similarly, the list of access persons must 
include every person who was an access person at any time within the 
past five years, even if some of them are no longer access persons of 
the adviser.\65\
---------------------------------------------------------------------------

    \63\ Rule 204-2(e) (retention period of five years from the end 
of the fiscal year during which the last entry was made on such 
record).
    \64\ One commenter suggested that the acknowledgement be kept 
only for five years after it was made. We are not adopting this 
suggestion, because it could mean that an adviser would have no 
records of acknowledgement from long-term employees.
    \65\ In addition, records supporting decisions to approve access 
persons' acquisitions of IPOs or private placements must be retained 
for at least five years after the end of the fiscal year in which 
the approval is granted.
---------------------------------------------------------------------------

I. Amendment to Form ADV

    We are amending part II of Form ADV, as proposed, to require 
advisers to describe their codes of ethics to clients and, upon 
request, to furnish clients with a copy of the code of ethics.\66\ This 
disclosure will serve two functions: first, it will help clients 
understand the adviser's ethical culture and standards, how the adviser 
controls sensitive information and what steps it has taken to prevent 
employees from misusing their inside positions at clients' expense. 
Clients will be able to select advisers whose ethical commitment meets 
their expectations. Second, disclosure will act as sunlight, 
encouraging advisers to implement more effective procedures by exposing 
them to view, and encouraging advisers to adhere strictly to the 
procedures they disclose.\67\
---------------------------------------------------------------------------

    \66\ We are amending Item 9 of Form ADV Part II, which asks 
whether the adviser or a ``related person'' (that is, a person that 
controls the adviser, is controlled by the adviser, or is under 
common control with the adviser) participates or has an interest in 
client transactions. In April 2000, we proposed a new version of 
part 2 that called for a narrative disclosure brochure, and which 
moved this disclosure topic to Item 10.
    \67\ An investment adviser that disclosed its policies and 
procedures but then materially deviated from them may be subject to 
action under section 206 of the Advisers Act.
---------------------------------------------------------------------------

J. Amendments to Rule 17j-1

    As proposed, we are revising a provision of rule 17j-1 to state 
that no report would be required under rule 17j-1 ``to the extent 
that'' the report would duplicate information required under the 
Advisers Act recordkeeping rules.\68\ Currently, the rule contains an 
exception only if ``all of'' the information in the report would 
duplicate information required to be recorded under Advisers Act rules. 
The reports we are requiring under the Advisers Act are not identical 
to those required under rule 17j-1, and this amendment avoids 
unnecessary duplication.
---------------------------------------------------------------------------

    \68\ Rule 17j-1(d)(2)(iv).
---------------------------------------------------------------------------

    In the proposing release, we also requested comment whether, to the 
extent rule 204A-1 as adopted differed from rule 17j-1, we should make 
conforming changes to rule 17j-1. With limited exception, commenters 
addressing this issue expressed a desire to keep the rules as parallel 
as possible and suggested that rule 17j-1 be modified in some respects. 
We are persuaded that four changes should be made to rule 17j-1. First, 
rule 17j-1 as amended provides that the information in initial and 
annual holdings reports must be current as of a date no more than 45 
days prior to the individual becoming an access person under the rule 
(initial holdings report), or submitting the report (annual holdings 
report).\69\ Second, quarterly transaction reports will be due no later 
than 30 days after the close of the quarter, rather than 10 days as 
currently provided.\70\ Third, quarterly transaction reports need not 
be submitted with respect to transactions effected pursuant to an 
automatic investment plan.\71\
---------------------------------------------------------------------------

    \69\ Rule 17j-1(d)(1)(i) and (iii).
    \70\ Rule 17j-1(d)(1)(ii).
    \71\ Rule 17j-1(d)(2)(vi).
---------------------------------------------------------------------------

    Fourth, we are revising the definition of ``access person.'' \72\ 
Under the amended rule, an access person includes an advisory person of 
a fund or its investment adviser. We are eliminating the revenue-based 
test for determining whether an investment

[[Page 41702]]

adviser's primary business is advising funds and other advisory 
clients. Advisers with other primary businesses used this test to 
exclude certain of their officers, directors and general partners from 
being considered access persons under the rule. We are replacing the 
revenue-based test with the same legal presumption we are adopting in 
new rule 204A-1--that directors, officers and general partners are 
presumed to be access persons if the firm's primary business is 
investment advisory.\73\
---------------------------------------------------------------------------

    \72\ Rule 17j-1(a)(1)(i).
    \73\ In addition, the directors, officers and general partners 
of a fund are presumed to be access persons of the fund.
---------------------------------------------------------------------------

III. Effective Date

    The effective date of the new rule and amendments is August 31, 
2004. Advisers must comply with the new rule and rule amendments by 
January 7, 2005. By this compliance date, each adviser must have 
adopted its code of ethics and be prepared to maintain and enforce it. 
In addition to fundamentals such as articulating its chosen standards 
of conduct, each adviser's preparation will necessarily include 
identifying its access persons, providing a copy of the code of ethics 
to each supervised person and receiving their acknowledgement. Also by 
January 7, 2005, each adviser must have an initial holdings report from 
each access person, and must arrange for the submission of quarterly 
transaction reports. Access persons' personal securities transaction 
reports for the calendar quarter ended March 31, 2005 will be due no 
later than April 30, 2005. Until advisers begin to comply with new rule 
204A-1, the amendments to rule 204-2, and the amendments to Form ADV 
Part II, they must continue to comply with the personal securities 
transaction recordkeeping requirements of our current rule 204-2(a)(12) 
and (13).

IV. Cost-Benefit Analysis

    The Commission is sensitive to the costs and benefits resulting 
from our rules. The new rule we adopt today requires investment 
advisers to establish, maintain, and enforce codes of ethics for their 
supervised persons. These codes of ethics must establish standards of 
business conduct reflecting the fiduciary obligations of the adviser 
and its personnel and impose personal securities reporting measures 
designed to prevent access persons from abusing information about 
clients' securities transactions. We are also adopting related 
recordkeeping and client disclosure amendments under the Advisers Act 
and conforming amendments under the Company Act.\74\
---------------------------------------------------------------------------

    \74\ We are adopting amendments to rule 204-2, the recordkeeping 
rule under the Advisers Act, to address documentation of advisers' 
compliance with rule 204A-1. We are also amending Part II of Form 
ADV, which specifies certain information investment advisers must 
disclose to their clients, to require advisers to include a 
discussion of their codes of ethics and make copies available to 
clients upon request. We are adopting amendments to rule 17j-1, the 
code of ethics rule under the Company Act, to conform certain of its 
provisions to those in new rule 204A-1.
---------------------------------------------------------------------------

    In our Proposing Release, we carefully analyzed the costs and 
benefits of our proposed rule and amendments and requested comment 
regarding the costs and benefits. Most commenters supported requiring 
advisers to have written codes of ethics, although several commenters 
expressed reservations at the potential costs of the proposed 
electronic recordkeeping requirement for personal securities 
transactions. Only one commenter specifically addressed our cost-
benefit analysis.
    We are adopting the rule and amendments substantially as proposed, 
with some revisions in response to comments, including elimination of 
the proposed electronic recordkeeping requirement for personal 
securities transactions. We believe our original analyses regarding the 
benefits and costs of the rule and amendments remain accurate. Most of 
the benefits and costs under the new rule and amendments, however, are 
not quantifiable.

A. Benefits

    Codes of ethics under new rule 204A-1 should benefit advisory 
clients as well as advisory firms. The codes will impress upon 
advisers' supervised persons the significance of the fiduciary aspects 
of their professional responsibilities, formulating these into 
standards of conduct to which their employers will hold these 
individuals accountable. Codes of ethics will also be an important part 
of advisers' efforts to prevent fraudulent personal trading by their 
supervised persons. As a result, these codes increase investor 
protection by forestalling supervised persons from engaging in 
misconduct that defrauds clients. In addition, the Form ADV amendments, 
which require advisers to describe their codes of ethics to clients and 
to furnish copies to clients upon request, put clients in a better 
position to evaluate whether their advisers' codes of ethics meet their 
expectations. If a client is not confident that an advisory firm has 
taken appropriate measures to prevent its personnel from placing their 
own interests ahead of their clients' interests, the client will be 
able to seek a different adviser whose measures he approves.
    Rule 204A-1 will reinforce existing measures that require 
investment advisers to guard against employee misconduct. It goes 
beyond section 204A of the Advisers Act, which focuses on policies and 
procedures to prevent misuse of material nonpublic information by 
advisory firm personnel. Rule 204A-1 expands advisers' policies to 
address other situations in which such personnel could potentially 
benefit at the expense of firm clients. It also goes beyond Company Act 
rule 17j-1, which focuses on fraud in connection with securities held 
or to be acquired by an investment company advised by an adviser. Rule 
204A-1 expands advisers' policies to address advisory personnel's 
holdings and transactions in shares of investment companies managed by 
the adviser. Codes of ethics will also assist advisers in meeting their 
obligations under Advisers Act rule 206(4)-7 to adopt policies and 
procedures reasonably designed to prevent their supervised persons from 
violating the Advisers Act.
    Rule 204A-1 will benefit investment advisers by renewing their 
attention to their fiduciary and other legal obligations, and by 
increasing their vigilance against inappropriate behavior by employees. 
This may have the effect of diminishing the likelihood that their firms 
will be embroiled in securities violations, Commission enforcement 
actions, and private litigation. For an adviser, the potential costs 
associated with a securities law violation may consist of much more 
than merely the fines or other penalties levied by the Commission or 
civil liability. The reputation of an adviser may be significantly 
tarnished, resulting in lost clients. Advisers may be denied 
eligibility to advise funds.\75\ In addition, advisers could be 
precluded from serving in other capacities.\76\
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    \75\ Section 9(a) of the Investment Company Act [15 U.S.C. 80a-
9(a)] prohibits a person from serving as an adviser to a fund if, 
within the past 10 years, the person has been convicted of certain 
crimes or is subject to an order, judgment, or decree of a court 
prohibiting the person from serving in certain capacities with a 
fund, or prohibiting the person from engaging in certain conduct or 
practice.
    \76\ See, e.g., 29 U.S.C. 1111(a) (prohibiting a person from 
acting in various capacities for an employee benefit plan, if within 
the past 13 years, the person has been convicted of, or has been 
imprisoned as a result of, any crime described in section 9(a)(1) of 
the Investment Company Act [15 U.S.C. 80a-9(a)(1)]).
---------------------------------------------------------------------------

    Our revision of advisers' recordkeeping obligations for personal 
securities transactions will also benefit investment advisers. The 
amended rules are easier to understand than the

[[Page 41703]]

complex provisions currently contained in Advisers Act rule 204-
2(a)(12) and (13). The requirement that advisers maintain information 
about their access persons' personal securities transactions will 
enable firms to detect trading patterns that may indicate abuse.\77\ In 
addition, the requirement that each access person provide initial and 
annual holdings reports allows investment advisers to better monitor 
conflicts that may arise when an access person participates in 
investment decisions involving securities the access person holds in 
his or her portfolio, and to assess whether access persons are filing 
accurate quarterly transaction reports.
---------------------------------------------------------------------------

    \77\ Although the Commission is not adopting the proposed 
requirement that advisers maintain these records electronically, as 
previously noted we have strong expectations that most advisers will 
need to maintain these records electronically in order to meet their 
responsibilities to review these records and monitor compliance with 
their codes.
---------------------------------------------------------------------------

B. Costs

    The new rule and amendments will result in some additional costs 
for advisers. It is possible that advisers may pass these costs along 
to their clients in the form of advisory fees.\78\ Advisers, however, 
are already required to maintain various policies and procedures that 
would constitute core elements of their codes of ethics, and therefore 
many of these costs are already reflected in fees clients currently 
pay. Advisers are required, under section 204A of the Advisers Act, to 
maintain and enforce written policies and procedures reasonably 
designed to prevent the firm or its employees from misusing material 
nonpublic information. Also, the approximately 1,500 advisers who 
advise registered investment companies currently have codes of ethics 
to prevent their ``access persons'' from abusing their access to 
information about the fund's securities trading, pursuant to Company 
Act rule 17j-1.\79\ In addition, advisers are required under Advisers 
Act rule 206(4)-7 to adopt policies and procedures reasonably designed 
to prevent their supervised persons from violating the Advisers Act. 
Accordingly, we believe requiring written codes of ethics will impose 
few new costs on advisers.
---------------------------------------------------------------------------

    \78\ We understand, however, that many advisers have already 
adopted codes of ethics for their firm and their employees. We are 
unaware whether these firms charge higher advisory fees than firms 
that have not yet adopted codes of ethics.
    \79\ Based on our records of information submitted to us by 
investment advisers in Part 1 of Form ADV through December 10, 2003, 
approximately 1,500 advisers report that they manage portfolios for 
investment companies.
---------------------------------------------------------------------------

    Similarly, our rule to require access persons to report personal 
securities transactions should cause only minor cost increases. 
Advisers are already required to maintain records of their advisory 
representatives' personal securities transactions on a quarterly basis 
under Advisers Act rules 204-2(a)(12) and (13). The additional 
reporting required of access persons under our new rule--an annual 
report of securities holdings--should impose only minor additional 
costs.\80\ Because most SEC-registered investment advisers have so few 
employees, we believe the cost of these additional reports will be 
minor. As of December 2003, 49% of investment advisers registered with 
us reported that they had five or fewer non-clerical employees, and 
another 18% reported that they had only six to ten non-clerical 
employees.\81\ The majority of larger SEC-registered advisers are 
already subject to Company Act rule 17j-1 because they advise 
investment companies, and consequently obtain annual reports from their 
``access persons'' that contain virtually the same information as would 
be required under our proposals. These larger firms are also in a 
position to limit the number of supervised persons subject to the 
reporting requirements, by imposing stringent controls on who obtains 
access to client securities information.
---------------------------------------------------------------------------

    \80\ The Commission is not adopting its proposal to require 
quarterly reports indicating that no transactions were effected.
    \81\ This is based on Form ADV data (under Item 5.A of Part 1A) 
submitted to us by 8,019 SEC-registered investment advisers through 
December 9, 2003.
---------------------------------------------------------------------------

    Many commenters expressed concern regarding the cost of the 
proposed requirement that advisers maintain records of personal 
securities transactions electronically. The Commission is not adopting 
the proposed electronic recordkeeping requirement.
    One commenter stated that significant costs would result from the 
new rule's requirement that advisers review supervised persons' 
securities holdings and transaction reports to monitor them for abuses. 
The Commission recognizes that advisers will experience costs in 
conducting their review. The benefits to investors and to advisory 
firms themselves in terms of improved detection and prevention of 
abuses will, however, justify these costs. Moreover, the incremental 
cost imposed by the new rule in this regard is diminished to the extent 
that advisers should already be conducting such a review. An adviser's 
fiduciary duty of loyalty to its clients may require it to take steps 
to protect clients from such abuses by the adviser's personnel, and 
section 204A of the Advisers Act requires the adviser to enforce its 
policies and procedures designed to prevent misuse of material 
nonpublic information.
    We expect only minor cost increases from the new requirement that 
access persons obtain their advisers' approval before investing in an 
initial public offering or private placements. Our experience 
administering the same requirement under Company Act rule 17j-1 has 
been that such proposals are infrequent, even at larger advisory firms. 
We also believe that our new requirement that advisers describe their 
codes of ethics to clients in their Form ADV and provide copies on 
request will impose only minor cost increases. We expect few clients 
will request a copy of the code, and that the cost to provide it will 
be minimal.

V. Effects on Competition, Efficiency and Capital Formation

    Section 202(c) of the Advisers Act [15 U.S.C. 80b-2(c)] mandates 
that the Commission, when engaging in rulemaking that requires it to 
consider or determine whether an action is necessary or appropriate in 
the public interest, to consider, in addition to the protection of 
investors, whether the action will promote efficiency, competition, and 
capital formation.
    As discussed above, rule 204A-1 requires investment advisers to 
adopt codes of ethics applicable to their supervised persons. These 
codes of ethics must establish standards of business conduct reflecting 
the fiduciary obligations of the adviser and its personnel and impose 
personal securities reporting measures designed to prevent access 
persons from abusing their access to information about clients' 
securities transactions. We expect that the proposed rule may 
indirectly increase efficiency by forestalling supervised persons from 
engaging in misconduct that defrauds clients and harms the advisory 
firm, or by facilitating the adviser's early intervention to protect 
its clients. In addition, the existence of an industry-wide code of 
ethics requirement may enhance efficiency further by encouraging third 
parties to create new informational resources and guidance to which 
industry participants can refer in establishing and improving their 
codes.
    Since the rule applies equally to all registered advisers, we do 
not anticipate that it introduces any competitive disadvantages. We 
expect that the rule may indirectly foster capital formation by 
bolstering investor confidence. To the extent that investors know that 
advisory firms have taken measures designed to prevent their supervised 
persons from placing their interests

[[Page 41704]]

ahead of their clients' interests, clients are more likely to make 
assets available through advisers for investment in the capital 
markets.

VI. Paperwork Reduction Act

    As we discussed in the Proposing Release, the new rule and rule and 
form amendments contain ``collection of information'' requirements 
within the meaning of the Paperwork Reduction Act of 1995.\82\ These 
collections of information are mandatory. One of the collections of 
information is new. The title of this new collection is ``Rule 204A-
1,'' which the Commission submitted to the Office of Management and 
Budget (``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 
CFR 1320.11. The OMB has approved this collection under control number 
3235-0596 (expiring on March 31, 2007). The other collections of 
information take the form of amendments to currently approved 
collections titled ``Rule 204-2,'' under OMB control number 3235-0278, 
and ``Form ADV,'' under OMB control number 3235-0049. The Commission 
also has submitted the amendments to these collections to the OMB for 
review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The OMB 
has approved these collections under control numbers 3235-0278 
(expiring on July 31, 2007) and 3235-0049 (expiring on July 31, 2007), 
respectively. An agency may not conduct or sponsor, and a person is not 
required to respond to, a collection of information unless it displays 
a currently valid control number.
---------------------------------------------------------------------------

    \82\ 44 U.S.C. 3501 to 3520.
---------------------------------------------------------------------------

    The collection of information under rule 204A-1 is necessary to 
establish standards of business conduct for supervised persons of 
investment advisers and to facilitate investment advisers' efforts to 
prevent fraudulent personal trading by their supervised persons. The 
collection of information is mandatory. The respondents are investment 
advisers registered with us, and certain of their supervised persons 
who must submit reports of their personal trading activities to their 
firms. These investment advisers use the information collected to 
control and assess the personal trading activities of their supervised 
persons. Responses to the reporting requirements will be kept 
confidential to the extent each investment adviser provides 
confidentiality under its particular practices and procedures.
    The collection of information under rule 204-2 is necessary for the 
Commission staff to use in its examination and oversight program. This 
collection of information is mandatory. The respondents are investment 
advisers registered with us. Responses provided to the Commission in 
the context of its examination and oversight program are generally kept 
confidential.\83\ The records that an adviser must keep in accordance 
with rule 204-2 must generally be retained for not less than five 
years.\84\
---------------------------------------------------------------------------

    \83\ See section 210(b) of the Advisers Act [15 U.S.C. 80b-
10(b)].
    \84\ See rule 204-2(e) [17 CFR 275.204-2(e)].
---------------------------------------------------------------------------

    The collection of information under Form ADV is necessary to 
provide advisory clients and prospective clients with information about 
an adviser's code of ethics. This collection of information is 
mandatory. The respondents are investment advisers registered with us. 
Clients of these investment advisers use the information collected to 
assess measures the adviser has taken to prevent its supervised persons 
from placing their own interests ahead of the adviser's clients' 
interests. Responses to the disclosure requirements are not kept 
confidential.

A. Rule 204A-1

    Rule 204A-1 requires SEC-registered investment advisers to 
establish a written code of ethics for their supervised persons.\85\ We 
estimated in the Proposing Release that each adviser would spend six 
hours annually, on average, documenting its code of ethics, taking into 
consideration that investment advisers currently maintain policies and 
procedures that can be the basis for their code of ethics and that 
advisers to investment companies already have fully developed codes of 
ethics. Based on our estimate in the Proposing Release that 8,019 
advisers would incur the burden, the burden estimate for establishing a 
written code of ethics was 48,114 hours.\86\
---------------------------------------------------------------------------

    \85\ Rule 204A-1(a).
    \86\ 8,019 advisers x 6 hours = 48,114 total annual hours.
---------------------------------------------------------------------------

    Rule 204A-1 also requires each adviser's code of ethics to include 
provisions under which the adviser provides each supervised person with 
a copy of the code of ethics and any amendments, and obtains written 
acknowledgment of receipt from the supervised person. Based on our 
estimates that, on average, each investment adviser has 100 supervised 
persons,\87\ will hire 5 new supervised persons each year, and each 
adviser will amend their codes once every other year, that advisers 
will have to provide a copy of their codes of ethics and obtain an 
acknowledgment of receipt 55 times each year.\88\ We further estimated 
in the Proposing Release that it will take an investment adviser 0.05 
hours on average for each iteration, for an annual burden of 2.75 hours 
per adviser and a total burden of 22,052.25 hours for all advisers 
related to informing supervised persons of adviser codes of ethics.\89\
---------------------------------------------------------------------------

    \87\ This estimate is based on each adviser having on average 84 
non-clerical and 16 clerical employees.
    \88\ Over any two-year period, 100 copies of amendments in year 
1 + 10 copies of complete code for new supervised persons in year 1 
through 2 = 110 copies, divided by 2 years = 55 copies.
    \89\ 0.05 hours per copy x 55 copies per year = 2.75 hours. 2.75 
hours x 8,019 investment advisers = 22,052.25 hours total.
---------------------------------------------------------------------------

    Lastly, rule 204A-1 also requires each adviser's code of ethics to 
include provisions under which the adviser's ``access persons'' report 
their personal securities transactions and holdings to the adviser.\90\ 
To estimate the annual paperwork burden stemming from this requirement 
we relied on the following assumptions: (1) Advisers would treat all 
their non-clerical employees as access persons; (2) advisers have, on 
average, 84 non-clerical employees; \91\ (3) initial and annual 
holdings reports will take 0.7 hours on average; and (4) quarterly 
transaction reports will take 0.6 hours on average annually.\92\ Using 
these assumptions, we estimated in the Proposing Release that the total 
annual burden hours for all access persons under the proposed would be 
875,675 hours.\93\
---------------------------------------------------------------------------

    \90\ Rule 204A-1(a)(3).
    \91\ This average is based on Form ADV data that asks for the 
total number of employees. We believe this estimate overstates the 
typical number of access persons for an adviser, since the data is 
skewed significantly higher by the largest (in terms of number of 
employees) 100 advisers.
    \92\ We estimated in the Proposing Release that quarterly 
transaction reports would take 0.6 hours per access person. In a 
change from the proposed rule, the adopted rule does not require 
quarterly reports for any quarter in which the access person makes 
no security transactions. In the Proposing Release, we assumed for 
purposes of estimating access person reporting that access persons 
would typically file transaction reports indicating no transactions 
in 3 out of the 4 quarters. Thus we have reduced by half the amount 
of time allocated for access person transaction reporting, as 
discussed below.
    \93\ (0.7 hours holdings report + 0.6 hours transactions report) 
x (84 access persons x 8,019 investment advisers) = 875,675 hours.
---------------------------------------------------------------------------

    One significant amendment to rule 204A-1 that addressed commenters 
concerns materially reduces the paperwork burden on advisers. Because 
we are no longer requiring access persons to make quarterly reports 
when they do not have securities transactions, we are thus adopting 
rule 204A-1 with revised paperwork collection requirements. 
Accordingly, our estimate of the total annual burden for rule 204A-1 in 
the Proposing Release of

[[Page 41705]]

945,841.25 hours is reduced to 743,762.25 hours.\94\
---------------------------------------------------------------------------

    \94\ Eliminating these quarterly reports decreases the burden of 
quarterly transaction reporting on access persons from 0.6 hours to 
0.3 hours, or a total of 202,079 hours (0.3 hours x 84 access 
persons x 8,019 advisers = 202,079). Our revised total burden is as 
follows: 48,114 hours by advisers to record their codes of ethics + 
673,596 hours for reporting by access persons + 22,052.25 hours for 
advisers to deliver copies of codes and amendments = 743,762.25.
---------------------------------------------------------------------------

B. Rule 204-2

    In the Proposing Release, we estimated that the amendments to rule 
204-2 would result in an approximate 10% net decrease from the 
currently approved annual aggregate collection of information 
burden.\95\ Eliminating the requirement that advisers retain records 
relating to the personal securities transactions of advisory 
representatives reduces the annual average burden of the rule,\96\ 
while the new recordkeeping requirements under the amendments to rule 
204-2 add to the burden, as does the increase of 229 advisers 
registered with us.\97\
---------------------------------------------------------------------------

    \95\ Prior to the adoption of the amendments herein, the 
approved annual aggregate information collection burden was 
1,651,324.2 hours (based on 7,790 advisers) or 211.98 hours per firm 
for rule 204-2.
    \96\ In the Proposing Release we estimated that the reduction 
would be 25.2 hours per firm (0.3 hours per access person to record 
the transactions x 84 access persons per firm). This results in a 
reduction on a per firm basis to 186.78 hours (211.98 - 25.2).
    \97\ The new recordkeeping obligations under the rule include 
the maintenance of access person holding and quarterly transaction 
reports, retention of the codes of ethics, supervised person 
acknowledgments, records of the names of the firm's access persons, 
records of any violation of the codes of ethics and any action 
taken, and records of any decision under rule 204A-1 to permit an 
access person to invest in an initial public offering or private 
placement. In the Proposing Release we estimated that these new 
collections would add 5 hours on average per adviser to the annual 
hour burden of the rule. This results in a per firm annual burden 
estimate of 191.78 hours (186.78 + 5).
---------------------------------------------------------------------------

    Many commenters objected to the proposed requirement to require 
advisers to maintain access person reports electronically. The amended 
rule does not include this requirement, but this amendment does not 
change the information collection burden estimate.\98\ Our total hour 
burden estimate for the collection of information under rule 204-2 
remains 1,537,883.8 burden hours, as we estimated in our proposal.\99\
---------------------------------------------------------------------------

    \98\ In the Proposing Release, we estimated no incremental 
burden in connection with the proposed requirement for advisers to 
maintain access person reports electronically. We estimated advisory 
firms would be able to use their existing computer software, taking 
transaction data electronically from the same broker-dealers that 
advisory firms use to obtain electronic information about client 
transactions.
    \99\ 191.78 hours per adviser x 8,019 advisers = 1,537,883.8 
hours.
---------------------------------------------------------------------------

C. Form ADV

    In the proposing release, we estimated that the amendments to Form 
ADV (requiring advisers to describe their codes of ethics and furnish a 
copy upon request) would increase the annual collection burden under 
Form ADV by 6.95 hours per adviser.\100\ One trade group commenter 
recommended that we allow web site posting of the code of ethics in 
lieu of furnishing a copy upon request. We do not believe that web 
access is universal at this time so we are adopting amendments to Form 
ADV without change and, accordingly, our total burden hour estimate 
remains at 102,653 burden hours.\101\
---------------------------------------------------------------------------

    \100\ 0.25 hours preparing a description of the code of ethics + 
6.7 hours responding to requests for copies of the code of ethics 
(based on a 10% request rate by the 670 average number of clients 
per adviser and 0.1 hours for delivery).
    \101\ (0.25 hours + 6.7 hours) x 8,019 advisers = 55,732 hours. 
46,921 hours (existing total) + 55,732 hour increase = 102,653 
hours.
---------------------------------------------------------------------------

VII. Final Regulatory Flexibility Analysis

    The Commission proposed new rule 204A-1 and amendments to rule 204-
2 and Form ADV under the Advisers Act, and amendments to rule 17j-1 
under the Company Act, in a release on January 20, 2004 (``proposing 
release''). An Initial Regulatory Flexibility Analysis (``IRFA'') was 
published in the proposing release. No comments were received 
specifically on the IRFA. The Commission has prepared the following 
Final Regulatory Flexibility Analysis (``FRFA'') in accordance with 5 
U.S.C. 604, regarding rule 204A-1 and amendments to rule 204-2 and Form 
ADV under the Advisers Act and amendments to rule 17j-1 under the 
Company Act.

A. Need for the Rule and Amendments

    Sections I and II of this Release describe the background and 
reasons for the new rule and rule amendments. As we discussed in detail 
above, the rule and amendments are designed to promote compliance with 
fiduciary standards by advisers and their personnel.

B. Significant Issues Raised by Public Comment

    The Commission received 44 letters from commenters in response to 
the proposing release. Commenters supported the proposal. As discussed 
in section II of this Release, the Commission is adopting the new rule 
and rule amendments substantially as proposed with some changes to 
respond to commenters' suggestions. Commenters opposed a proposed 
requirement that advisers keep records of access persons' personal 
securities reports electronically in an accessible database, and the 
Commission is not adopting this provision of the proposal. The 
Commission specifically requested comments with respect to the IRFA, 
but did not receive any comments specifically concerning the IRFA.

C. Small Entities Subject to Rule

    The new rule and rule amendments under the Advisers Act apply to 
all advisers registered with the Commission, (and the amendments to 
rule 17j-1 apply to all investment companies) including small entities. 
In developing the new rule and amendments, we have considered their 
potential effect on small entities. Under Commission rules, for 
purposes of the Regulatory Flexibility Act, an investment adviser 
generally is a small entity if it: (i) Has assets under management 
having a total value of less than $25 million; (ii) did not have total 
assets of $5 million or more on the last day of its most recent fiscal 
year; and (iii) does not control, is not controlled by, and is not 
under common control with another investment adviser that has assets 
under management of $25 million or more, or any person (other than a 
natural person) that had $5 million or more on the last day of its most 
recent fiscal year.\102\ The Commission estimates that approximately 
570 SEC-registered investment advisers are small entities that are 
affected by the new rules and rule amendments.\103\
---------------------------------------------------------------------------

    \102\ 17 CFR 275.0-7(a).
    \103\ This estimate is based on the information submitted by 
SEC-registered advisers in part 1A of Form ADV as of May 1, 2004.
---------------------------------------------------------------------------

    For purposes of the Regulatory Flexibility Act, a registered 
investment company (``fund'') is a small business or small organization 
(collectively, ``small entity'') if the fund, together with other funds 
in the same group of related investment companies, has net assets of 
$50 million or less as of the end of its most recent fiscal year.\104\ 
The Commission estimates that approximately 204 registered investment 
companies are small entities.\105\ As discussed in section II of this 
Release, the amendments to rule 17j-1 (i) allow advisers to rely on a 
reporting exception in the rule if the adviser already maintains 
duplicate

[[Page 41706]]

information under records required by certain Advisers Act rules, (ii) 
exempt certain transactions from required reporting, and (iii) replace 
with a legal presumption a revenue-based test for the primary business 
of the adviser. Whether the amendments to rule 17j-1 affect small 
entities depends on whether the small entities rely on the reporting 
exception or use the exemption, and whether the small entity is 
primarily engaged in the business of advising investment companies or 
other advisory clients.
---------------------------------------------------------------------------

    \104\ 17 CFR 270.0-10.
    \105\ This estimate, which is current as of December 2003, is 
derived from analyzing information from Form N-SAR and various 
databases including Lipper. Some or all of these entities may 
contain multiple series or portfolios. If a registered investment 
company is a small entity, the portfolios or series it contains are 
also small entities.
---------------------------------------------------------------------------

D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

    The amendment to Form ADV imposes a new reporting requirement on 
advisers, requiring that they make an additional disclosure statement 
in their brochures describing their codes of ethics and noting that 
copies of the codes are available from the adviser upon request. 
Although new rule 204A-1 and the other rule amendments under the 
Advisers Act impose no other new reporting requirements on registered 
advisers themselves, the new rule requires advisers' codes of ethics to 
impose a new reporting requirement on advisers' access persons by 
requiring certain new personal securities holdings and transaction 
reports. One rule amendment under the Company Act exempts certain 
personal securities transactions from existing quarterly reporting 
requirements.
    The new rule and rule amendments create certain new recordkeeping 
and compliance requirements. The rule amendments impose new 
recordkeeping requirements by requiring that advisers maintain certain 
records pertaining to their codes of ethics and requirements of such 
codes (including records of personal securities holdings and 
transaction reports).\106\ The new rule imposes new compliance 
requirements by requiring that SEC-registered investment advisers adopt 
codes of ethics, obtain written acknowledgments of their supervised 
persons' receipt of copies of the code and any amendments, review 
personal securities holdings and transaction reports filed by their 
access persons, and pre-approve investments by their access persons in 
IPOs and limited offerings.
---------------------------------------------------------------------------

    \106\ These records are: copies of the codes of ethics, records 
of violations of the codes of ethics, records of personal securities 
transactions and holdings reports, records of persons subject to 
reporting under the codes of ethics, records of decisions relating 
to approvals of investments in IPOs or limited offerings, and 
records of supervised person acknowledgments of the code of ethics. 
Advisers are generally required to retain these records for five 
years.
---------------------------------------------------------------------------

    Small entities registered with the Commission as investment 
advisers are for the most part subject to these new reporting, 
recordkeeping and compliance requirements to the same extent as larger 
advisers. With regard to reporting of securities holdings and 
transactions and to pre-approvals of certain investments, however, 
certain small advisers, possibly including some that are small 
entities, are not subject to the new requirements. Additionally, we 
anticipate that most advisers will very rarely need to address 
violations to their codes of ethics and, similarly, should infrequently 
be asked by an access person to consider pre-approval of an investment 
in an IPO or limited offering. Small advisers will likely deal with 
violations or IPO and limited offering pre-approvals on an even more 
limited scale due to the smaller size of their operations. Furthermore, 
it is important to note that some of the new reporting, recordkeeping 
and compliance requirements replace, clarify or simplify existing 
requirements to which advisers, including those that are small 
entities, are already subject. To the extent that such requirements 
clarify or simplify existing requirements, the rule and amendments may 
actually alleviate reporting, recordkeeping, or compliance burdens on 
advisers, including those that are small entities.

E. Agency Action To Minimize Effect on Small Entities

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objective, 
while minimizing any significant adverse impact on small entities.\107\ 
In connection with the new rule and rule amendments, the Commission 
considered the following alternatives: (a) The establishment of 
differing compliance or reporting requirements or timetables that take 
into account the resources available to small entities; (b) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rule for such small entities; (c) the 
use of performance rather than design standards; and (d) an exemption 
from coverage of the rule, or any part thereof, for such small 
entities.
---------------------------------------------------------------------------

    \107\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    With respect to the first alternative, the Commission believes that 
the flexibility built into the rules adequately addresses different 
compliance and reporting requirements. The Commission is not 
prescribing uniform codes of ethics, but gives each adviser the 
flexibility to design its own code in light of the firm's size and 
operational structure, and the particular types of conflicts 
encountered by the firm in connection with its business and clients. 
The amendments to rule 204-2 permit the use of brokerage confirmations 
and statements in lieu of separate reports, at the firm's option.
    With respect to the second alternative, the Commission believes 
that clarification, consolidation, or simplification of the compliance 
and recordkeeping requirements under the rule for small entities 
unacceptably compromises the investor protections of the rule. Rule 
204A-1 sets out minimum requirements for advisers' codes of ethics, 
which are designed to promote compliance with fiduciary standards by 
advisers and their personnel. Eliminating some or all of these 
requirements would potentially impede achievement of that objective. 
Similarly, in establishing the categories of records to be retained 
under amendments to rule 204-2, the records described by the rule are 
necessary for the Commission to evaluate advisers' compliance with rule 
204A-1 as part of the Commission's inspection program.
    With respect to the third alternative, the Commission believes that 
the compliance and reporting requirements contained in the new rule and 
rule amendments already appropriately use performance standards instead 
of design standards. The rule enumerates few elements required for 
codes of ethics, allowing all firms, including small firms, to tailor 
the remainder of their codes of ethics to the nature and scope of their 
business. Rule 204A-1 does not specify what standard of conduct an 
adviser must require of its supervised persons, but requires only that 
the adviser articulate a standard in its code of ethics. Similarly, the 
rule does not specify which supervised persons should have access to 
nonpublic information about client recommendations, trading and 
holdings, and does not prohibit or restrict personal securities 
transactions by access persons, but requires only that access persons 
report their personal securities trading and holdings to the adviser. 
Furthermore, the recordkeeping requirements under rule 204-2 do not 
specify the means by which an adviser must keep records to demonstrate 
its compliance with the rule.
    Finally, with respect to the fourth alternative, the Commission 
notes that the rule exempts advisers with only one access person from 
personal securities reporting and pre-clearance of investments in IPOs 
and private placements. The codes of ethics are designed to promote 
advisers' fulfillment of their fiduciary duty to

[[Page 41707]]

clients and to guard against personal securities trading by advisers' 
access persons that may be contrary to clients' interests. Because the 
protections of the Advisers Act are intended to apply equally to 
clients of both large and small advisory firms, it would be 
inconsistent with the purposes of the Advisers Act to exempt small 
entities further from the rule and rule amendments or to specify 
different requirements for small entities.

VIII. Statutory Authority

    We are adopting amendments to rule 17j-1 pursuant to our authority 
set forth in sections 17(j) and 38(a) of the Investment Company Act [15 
U.S.C. 80a-17(j) and 80a-37(a)] and sections 206(4) and 211(a) of the 
Advisers Act [15 U.S.C. 80b-4 and 80b-11(a)].
    We are adopting amendments to rule 204-2 pursuant to our authority 
set forth in sections 204 and 206(4) of the Advisers Act [15 U.S.C. 
80b-4 and 80b-6(4)].
    We are adopting rule 204A-1 pursuant to our authority set forth in 
sections 202(a)(17), 204A, 206(4) and 211(a) of the Advisers Act [15 
U.S.C. 80b-2(a)(17), 80b-4a, 80b-6(4) and 80b-11(a)].
    We are adopting amendments to Form ADV under section 19(a) of the 
Securities Act of 1933 [15 U.S.C. 77s(a)], sections 23(a) and 28(e)(2) 
of the Securities Exchange Act of 1934 [15 U.S.C. 78w(a) and 
78bb(e)(2)], section 319(a) of the Trust Indenture Act of 1939 [15 
U.S.C. 77sss(a)], section 38(a) of the Investment Company Act of 1940 
[15 U.S.C. 78a-37(a)], and sections 203(c)(1), 204, and 211(a) of the 
Investment Advisers Act of 1940 [15 U.S.C. 80b-3(c)(1), 80b-4, and 80b-
11(a)].

Text of Rules and Form Amendments

List of Subjects in 17 CFR Parts 270, 275 and 279

    Investment companies, Reporting and recordkeeping requirements, 
Securities.


0
For reasons set forth in the preamble, title 17, chapter II of the Code 
of Federal Regulations is amended as follows:

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

0
1. The authority citation for part 270 continues to read in part as 
follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.
* * * * *

0
2. Section 270.17j-1 is amended by:
0
a. Revising paragraph (a)(1)(i);
0
b. Revising paragraph (a)(2)(i);
0
c. Adding new paragraph (a)(11);
0
d. Revising the introductory text of paragraphs (d)(1)(i), (d)(1)(ii), 
and (d)(1)(iii);
0
e. Revising paragraph (d)(2)(iv); and
0
f. Adding new paragraph (d)(2)(vi).
    The additions and revisions to read as follows:


Sec.  270.17j-1  Personal investment activities of investment company 
personnel.

    (a) * * *
    (1) * * *
    (i) Any Advisory Person of a Fund or of a Fund's investment 
adviser. If an investment adviser's primary business is advising Funds 
or other advisory clients, all of the investment adviser's directors, 
officers, and general partners are presumed to be Access Persons of any 
Fund advised by the investment adviser. All of a Fund's directors, 
officers, and general partners are presumed to be Access Persons of the 
Fund.
* * * * *
    (2) * * *
    (i) Any director, officer, general partner or employee of the Fund 
or investment adviser (or of any company in a control relationship to 
the Fund or investment adviser) who, in connection with his or her 
regular functions or duties, makes, participates in, or obtains 
information regarding, the purchase or sale of Covered Securities by a 
Fund, or whose functions relate to the making of any recommendations 
with respect to such purchases or sales; and
* * * * *
    (11) Automatic Investment Plan means a program in which regular 
periodic purchases (or withdrawals) are made automatically in (or from) 
investment accounts in accordance with a predetermined schedule and 
allocation. An Automatic Investment Plan includes a dividend 
reinvestment plan.
* * * * *
    (d) * * *
    (1) * * *
    (i) Initial Holdings Reports. No later than 10 days after the 
person becomes an Access Person (which information must be current as 
of a date no more than 45 days prior to the date the person becomes an 
Access Person):
* * * * *
    (ii) Quarterly Transaction Reports. No later than 30 days after the 
end of a calendar quarter, the following information:
* * * * *
    (iii) Annual Holdings Reports. Annually, the following information 
(which information must be current as of a date no more than 45 days 
before the report is submitted):
* * * * *
    (2) * * *
    (iv) An Access Person to an investment adviser need not make a 
separate report to the investment adviser under paragraph (d)(1) of 
this section to the extent the information in the report would 
duplicate information required to be recorded under Sec.  275.204-
2(a)(13) of this chapter.
* * * * *
    (vi) An Access Person need not make a quarterly transaction report 
under paragraph (d)(1)(ii) of this section with respect to transactions 
effected pursuant to an Automatic Investment Plan.

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

0
3. The general authority citation for part 275 is revised to read in 
part as follows:

    Authority: 15 U.S.C. 80b-2(a)(11)(F), 80b-2(a)(17), 80b-3, 80b-
4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless otherwise noted.

* * * * *

0
4. Section 275.204-2 is amended by revising paragraphs (a)(12), 
(a)(13), and (e)(1) to read as follows:


Sec.  275.204-2  Books and records to be maintained by investment 
advisers.

    (a) * * *
    (12)(i) A copy of the investment adviser's code of ethics adopted 
and implemented pursuant to Sec.  275.204A-1 that is in effect, or at 
any time within the past five years was in effect;
    (ii) A record of any violation of the code of ethics, and of any 
action taken as a result of the violation; and
    (iii) A record of all written acknowledgments as required by Sec.  
275.204A-1(a)(5) for each person who is currently, or within the past 
five years was, a supervised person of the investment adviser.
    (13)(i) A record of each report made by an access person as 
required by Sec.  275.204A-1(b), including any information provided 
under paragraph (b)(3)(iii) of that section in lieu of such reports;
    (ii) A record of the names of persons who are currently, or within 
the past five years were, access persons of the investment adviser; and
    (iii) A record of any decision, and the reasons supporting the 
decision, to approve the acquisition of securities by access persons 
under Sec.  275.204A-1(c), for at least five years after the end of the

[[Page 41708]]

fiscal year in which the approval is granted.
* * * * *
    (e)(1) All books and records required to be made under the 
provisions of paragraphs (a) to (c)(1)(i), inclusive, and (c)(2) of 
this section (except for books and records required to be made under 
the provisions of paragraphs (a)(11), (a)(12)(i), (a)(12)(iii), 
(a)(13)(ii), (a)(13)(iii), (a)(16), and (a)(17)(i) of this section), 
shall be maintained and preserved in an easily accessible place for a 
period of not less than five years from the end of the fiscal year 
during which the last entry was made on such record, the first two 
years in an appropriate office of the investment adviser.
* * * * *

0
5. Section 275.204A-1 is added to read as follows:


Sec.  275.204A-1  Investment adviser codes of ethics.

    (a) Adoption of code of ethics. If you are an investment adviser 
registered or required to be registered under section 203 of the Act 
(15 U.S.C. 80b-3), you must establish, maintain and enforce a written 
code of ethics that, at a minimum, includes:
    (1) A standard (or standards) of business conduct that you require 
of your supervised persons, which standard must reflect your fiduciary 
obligations and those of your supervised persons;
    (2) Provisions requiring your supervised persons to comply with 
applicable Federal securities laws;
    (3) Provisions that require all of your access persons to report, 
and you to review, their personal securities transactions and holdings 
periodically as provided below;
    (4) Provisions requiring supervised persons to report any 
violations of your code of ethics promptly to your chief compliance 
officer or, provided your chief compliance officer also receives 
reports of all violations, to other persons you designate in your code 
of ethics; and
    (5) Provisions requiring you to provide each of your supervised 
persons with a copy of your code of ethics and any amendments, and 
requiring your supervised persons to provide you with a written 
acknowledgment of their receipt of the code and any amendments.
    (b) Reporting requirements. (1) Holdings reports. The code of 
ethics must require your access persons to submit to your chief 
compliance officer or other persons you designate in your code of 
ethics a report of the access person's current securities holdings that 
meets the following requirements:
    (i) Content of holdings reports. Each holdings report must contain, 
at a minimum:
    (A) The title and type of security, and as applicable the exchange 
ticker symbol or CUSIP number, number of shares, and principal amount 
of each reportable security in which the access person has any direct 
or indirect beneficial ownership;
    (B) The name of any broker, dealer or bank with which the access 
person maintains an account in which any securities are held for the 
access person's direct or indirect benefit; and
    (C) The date the access person submits the report.
    (ii) Timing of holdings reports. Your access persons must each 
submit a holdings report:
    (A) No later than 10 days after the person becomes an access 
person, and the information must be current as of a date no more than 
45 days prior to the date the person becomes an access person.
    (B) At least once each 12-month period thereafter on a date you 
select, and the information must be current as of a date no more than 
45 days prior to the date the report was submitted.
    (2) Transaction reports. The code of ethics must require access 
persons to submit to your chief compliance officer or other persons you 
designate in your code of ethics quarterly securities transactions 
reports that meet the following requirements:
    (i) Content of transaction reports. Each transaction report must 
contain, at a minimum, the following information about each transaction 
involving a reportable security in which the access person had, or as a 
result of the transaction acquired, any direct or indirect beneficial 
ownership:
    (A) The date of the transaction, the title, and as applicable the 
exchange ticker symbol or CUSIP number, interest rate and maturity 
date, number of shares, and principal amount of each reportable 
security involved;
    (B) The nature of the transaction (i.e., purchase, sale or any 
other type of acquisition or disposition);
    (C) The price of the security at which the transaction was 
effected;
    (D) The name of the broker, dealer or bank with or through which 
the transaction was effected; and
    (E) The date the access person submits the report.
    (ii) Timing of transaction reports. Each access person must submit 
a transaction report no later than 30 days after the end of each 
calendar quarter, which report must cover, at a minimum, all 
transactions during the quarter.
    (3) Exceptions from reporting requirements. Your code of ethics 
need not require an access person to submit:
    (i) Any report with respect to securities held in accounts over 
which the access person had no direct or indirect influence or control;
    (ii) A transaction report with respect to transactions effected 
pursuant to an automatic investment plan;
    (iii) A transaction report if the report would duplicate 
information contained in broker trade confirmations or account 
statements that you hold in your records so long as you receive the 
confirmations or statements no later than 30 days after the end of the 
applicable calendar quarter.
    (c) Pre-approval of certain investments. Your code of ethics must 
require your access persons to obtain your approval before they 
directly or indirectly acquire beneficial ownership in any security in 
an initial public offering or in a limited offering.
    (d) Small advisers. If you have only one access person (i.e., 
yourself), you are not required to submit reports to yourself or to 
obtain your own approval for investments in any security in an initial 
public offering or in a limited offering, if you maintain records of 
all of your holdings and transactions that this section would otherwise 
require you to report.
    (e) Definitions. For the purpose of this section:
    (1) Access person means:
    (i) Any of your 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.
    (2) Automatic investment plan means a program in which regular 
periodic purchases (or withdrawals) are made automatically in (or from) 
investment accounts in accordance with a predetermined schedule and 
allocation. An automatic investment plan includes a dividend 
reinvestment plan.
    (3) Beneficial ownership is interpreted in the same manner as it 
would be under Sec.  240.16a-1(a)(2) of this chapter in determining 
whether a person has beneficial ownership of a security for purposes of 
section 16 of the Securities

[[Page 41709]]

Exchange Act of 1934 (15 U.S.C. 78p) and the rules and regulations 
thereunder. Any report required by paragraph (b) of this section may 
contain a statement that the report will not be construed as an 
admission that the person making the report has any direct or indirect 
beneficial ownership in the security to which the report relates.
    (4) Federal securities laws means the Securities Act of 1933 (15 
U.S.C. 77a-aa), the Securities Exchange Act of 1934 (15 U.S.C. 78a-mm), 
the Sarbanes-Oxley Act of 2002 (Pub. L. 107-204, 116 Stat. 745 (2002)), 
the Investment Company Act of 1940 (15 U.S.C. 80a), the Investment 
Advisers Act of 1940 (15 U.S.C. 80b), title V of the Gramm-Leach-Bliley 
Act (Pub. L. 106-102, 113 Stat. 1338 (1999), any rules adopted by the 
Commission under any of these statutes, the Bank Secrecy Act (31 U.S.C. 
5311-5314; 5316-5332) as it applies to funds and investment advisers, 
and any rules adopted thereunder by the Commission or the Department of 
the Treasury.
    (5) Fund means an investment company registered under the 
Investment Company Act.
    (6) Initial public offering means an offering of securities 
registered under the Securities Act of 1933 (15 U.S.C. 77a), the issuer 
of which, immediately before the registration, was not subject to the 
reporting requirements of sections 13 or 15(d) of the Securities 
Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)).
    (7) Limited offering means an offering that is exempt from 
registration under the Securities Act of 1933 pursuant to section 4(2) 
or section 4(6) (15 U.S.C. 77d(2) or 77d(6)) or pursuant to Sec. Sec.  
230.504, 230.505, or 230.506 of this chapter.
    (8) Purchase or sale of a security includes, among other things, 
the writing of an option to purchase or sell a security.
    (9) Reportable fund means:
    (i) Any fund for which you serve as an investment adviser as 
defined in section 2(a)(20) of the Investment Company Act of 1940 (15 
U.S.C. 80a-2(a)(20)) (i.e., in most cases you must be approved by the 
fund's board of directors before you can serve); or
    (ii) Any fund whose investment adviser or principal underwriter 
controls you, is controlled by you, or is under common control with 
you. For purposes of this section, control has the same meaning as it 
does in section 2(a)(9) of the Investment Company Act of 1940 (15 
U.S.C. 80a-2(a)(9)).
    (10) Reportable security means a security as defined in section 
202(a)(18) of the Act (15 U.S.C. 80b-2(a)(18)), except that it does not 
include:
    (i) Direct obligations of the Government of the United States;
    (ii) Bankers' acceptances, bank certificates of deposit, commercial 
paper and high quality short-term debt instruments, including 
repurchase agreements;
    (iii) Shares issued by money market funds;
    (iv) Shares issued by open-end funds other than reportable funds; 
and
    (v) Shares issued by unit investment trusts that are invested 
exclusively in one or more open-end funds, none of which are reportable 
funds.

PART 279--FORMS PRESCRIBED UNDER THE INVESTMENT ADVISERS ACT OF 
1940

0
6. The authority citation for Part 279 continues to read as follows:

    Authority:  The Investment Advisers Act of 1940, 15 U.S.C. 80b-
1, et seq.


0
7. Form ADV (referenced in Sec.  279.1) is amended by:
0
In part II, at the end of Item 9 add ``Describe, on Schedule F, your 
code of ethics, and state that you will provide a copy of your code of 
ethics to any client or prospective client upon request.''

    Note: The text of Form ADV does not and this amendment will not 
appear in the Code of Federal Regulations.


    Dated: July 2, 2004.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-15585 Filed 7-8-04; 8:45 am]
BILLING CODE 8010-01-P