Personal Securities Trade Reporting for Private Equity Firms: A Round Peg in A Square Hole

In 2004 the SEC has adopted Rule 204A-1 (the “Rule”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The Rule requires each adviser’s “Access Person”1< to report their securities holdings when they become access persons and at least once a year thereafter. The Rule also requires Access Persons to submit quarterly reports of all personal securities transactions or to submit duplicate trade confirmations or account statements. An adviser’s CCO also is required to review trade reports against the firm’s restricted list and pre-approve trade requests. In 2012 Dodd-Frank required large private funds, including private equity funds, to register with the SEC and comply with the Advisers Act.

The applicability of the Rule to private equity funds has been like trying to fit a square peg into a round hole. The Rule is intended to enable CCOs to review employee trades to ensure that employees are not trading on material non-public information (MNPI) or in other words, engaging in insider trading. Non-public information is information that is not available to members of the general investing public. Non-public information is deemed material if a reasonable investor would likely consider it important in making an investment decision to buy, hold or sell securities. Firms that trade public equities generally have much greater access to MNPI and are therefore at much greater risk of insider trading.

On the other hand, private companies do not report to the public and, therefore, all information about a private company is non-public information. Because there is never an opportunity to trade on information before it reaches the general public, the opportunity for insider trading of private company stock is non-existent. We recognize that there are limited instances where MNPI about a publicly traded company is learned in discussions with management or past employees of a private company or an industry expert and there is an opportunity for Access Persons to trade in the public company stock based on the MNPI. These instances are rare, and any information learned in this context should certainly be properly controlled.

Firms that invest in public equities have vastly different risk profiles related to insider trading than firms that invest in privately held companies. Despite the relatively low risk of insider trading associated with private equity fund managers, the Rule requires private equity firms to comply with the same onerous compliance requirements as firms that invest in public equities. Requiring Access Persons to report every trade on a quarterly basis and requiring the CCO to review and pre-approve the personal trades of all Access Persons is an administrative burden on private equity firms, particularly smaller firms, that is not justified by the low risk of insider trading. The Rule has been such a bone of contention for private equity firms that when an SEC Commissioner at NSCP’s recent National Compliance Conference offered to take questions I seized the opportunity to raise this issue.

I queried: As registered investment advisors, private equity firms have been required to comply with the Code of Ethics Rule and report all securities transactions every quarter despite the fact that they invest in private companies and have very little risk of insider trading. This one-size-fits-all approach results in undue burden on private equity firms. Is the SEC considering ways to apply a more risk-based approach to the application of the personal trade reporting requirements?

Her Response: The SEC is reviewing all of its regulations in light of their application to private funds and will be assessing the modifications that may need to be made. I can’t give you a specific time frame, but this issue is definitely one that is being considered. [This is not a verbatim response]

I was pleased with the response as was the rest of the attendees many of whom thanked me for asking the question and shared their frustrations with the personal trade reporting requirement. It appears that all should soon be good in the PE world as it relates to personal trade reporting. More to come.

1 An “access person” is a supervised person who has access to nonpublic information regarding any clients’ purchase or sale of securities, and who is involved in making securities recommendations to clients or has access to such recommendations that are nonpublic.

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