The fund director is responsible for the trust and respect between the board acting on behalf of fund shareholders and the manager and its various advisers. This mutual trust is needed if a fund is to be efficient, effective and profitable for its investors. The code of ethics is one manifestation of this trust.
The panel drew a clear distinction between ethical behavior and the code of ethics. Ethical behavior is a much broader concept and is determined by respect for the law, social norms and the standard of behavior expected in a particular industry. The code of ethics is more precise in its construction and application, clearly delineating what is not acceptable in the trading environment of a mutual fund, its manager, sub-advisers and distributor.

The SEC has amended the rule that requires funds to adopt codes of ethics. The amendments make explicit a board's responsibility to approve the fund's code and monitor compliance with the code's provisions. The amended rule also requires funds to disclose certain information about their codes in the Statement of Additional Information part of the Prospectus from March 1, 2000. Before this disclosure of the code was optional. The Panel agreed that the SEC's intent is to spotlight trading practices so that fund directors are even more diligent in their oversight. The risk in not taking the code of ethics seriously is very substantial as the reputation of the manager, as well as the brand value of the fund family, can be permanently tarnished by negative publicity which even a series of seemingly insignificant violations can cause.

The Panel divided the code of ethics topic into four parts:

1. Creating the Code: determining what's in, what's out.
2. Building a Monitoring Process: setting up a data gathering and reporting structure.
3. Enforcing the Code: differentiating between a major and minor infractions, ensuring appropriateness in the assessment of sanctions, balancing the rights of employees with the protection of fund investors.
4. Living with the Code: applying the code to themselves, understanding the impact of the code's requirements.

The Panel agreed that the SEC is placing great importance on the code of ethics as a way of ensuring that the fund board takes a strong role in the supervision of trading practices that are fair to the fund investor. The Panel also agreed that the enforcement of the code may be made more difficult by the advent of online trading houses, such as E*Trade, Datek and AmeriTrade. Because online firms may not forward trading confirmations to third parties (such as to compliance personnel at the adviser), an important mechanism for monitoring compliance with the code of ethics may not be available. As a result (and as in the case generally with compliance with the code), if a portfolio manager does not complete the required pre-clearance and subsequent trade notification, his or her employer, and subsequently the board, will be hard pressed to find out.

Creating the Code

The objective of the code is to ensure that the manager and others who have privileged information or authority place the interests of fund shareholders first and always ahead of their own personal interests.

The fund manager must affirm that no violations, other than those disclosed to the directors, have occurred. Of course the primary focus of their representation is their own employees. However, as a result of the SEC's newly amended rule, most boards have broadened the enquiry to all sub-advisers and the fund's distributor. There are practical problems with asking an unrelated third party, such as a sub-adviser, to conform all of the requirements of its code to that of the manager. Historically, the ICI tried to set a common standard in its May 1994 Report on Personal Investing; however so many different interests are embraced under the new SEC rule and enforcing a single common standard is becoming impractical.

The code will typically only apply to a limited group of people, typically designated as "access persons". This group includes anyone with access to knowledge of the trading intentions or practices of the fund family on which they work or have association. The receptionist is not typically an access person, although he or she may become one if they overhear or handle sensitive documents. The Panel was divided about whether or not the directors themselves are access persons. Typically, the directors do not have current knowledge of the trading pattern or intention of the fund or complex and learn of fund investment activity only after investment decisions have been made. However, as one Panel Member pointed out, active trading by the fund directors does not pass the "60-Minute" test, referring to CBS Sunday night news show.

The code of ethics will typically:

Impose personal trading restrictions, such as the process for obtaining pre-clearance of personal trades and the documentation required. These provisions will typically forbid making a profit on short term trading of any security and on trading within a blackout period before and after a fund trade.
Specify the terms of pre-clearance, such as with whom to pre-clear, how often reports have to be filed, to whom purchase and sale confirmations have to be sent. The pre-clearance period is typically just one day.
Forbid front running, to prevent an access person from trading ahead of the fund, thereby benefiting from a subsequent fund investment that raises the security's price.
Address the fund and manager's position on ownership of preferential IPO rights. Some fund groups allow access persons to invest in IPOs for their own account; some do not. The ones that forbid it believe that a portfolio manager might be perceived to have received these preferred rights as a result of brokerage placed with the IPO underwriter. The ones that allow it believe that a portfolio manager should be able to own any position which is not within the scope of fund's investment objective. This is one of the hardest aspects of a fund's code of ethics to apply to a sub-adviser.

Additional matters that may or may not be considered by fund management and the board in drafting code of ethics provisions include:

Limiting ownership of post-placement IPOs. Some fund families forbid IPO ownership for 30 or 60 days of the offering. This is done to avoid the appearance of trading on knowledge of how the market will react to an initial price run up.
Banning personal trading by access persons. Certain members of the financial price and a very small number of fund families believe that all access persons should be banned from personal trading at all. This Panel was concerned that this policy might have a competitive impact on the manager's ability to hire and retain capable investment professionals.
Prohibiting corporate directorships. Some fund families forbid access persons from holding directorships in publicly traded or private companies on the grounds that an access person might learn about information that may comprise his or her responsibilities in either capacity.
An example of code of ethics disclosure is provided in Table 1:

Building a Monitoring Process

The process for monitoring a code of ethics is unfortunately complex and cumbersome. However its importance cannot be overstated. The Panel estimates that over 90% of all code violations result from improper documentation or late filings. Since the SEC or a strike suit lawyer might use such violations as a basis for more significant allegations, the Panel felt that robust enforcement of all provisions of the code must not be overlooked. Outside consultants are often retained to test the monitoring process, set violation criteria and to ensure that the process of internal control works.

The Panel was quite concerned about the capacity of the employees who have to review the detailed documents associated with enforcing the code of ethics. These employees are typically housed in the compliance or legal departments. While they are generally well supervised and managed, the Panel worried that the complex nature and volume of securities trading may lead to inadvertent lapses in the code's administration. Very few firms have automated the process for administering the code..

While most trades by access persons have to be pre-cleared, some fund families allow a carve out from the code of ethics for the purchase and sale of (1) U.S. treasury bonds, (2) mutual funds, (3) index based products, and (4) large cap widely traded stocks. One Panel member thought that the pre-clearance and subsequent reporting process is so burdensome, that access persons should be required to put their assets in a blind managed account, so as to avoid all possible appearances of conflict.

The Panel had a lively debate about application of a military academy style code of honor by which any employee is required to report any violation by a colleague. Most fund families require anyone with knowledge of a code of ethics breach to report it, although the Panel questioned whether these requirements are effectively enforced Many complexes, like public companies, have "hot lines" in which breaches of ethical behavior, usually discrimination, can be confidentially reported to the Human Resources Department

Enforcing the Code

The Panel felt that the most important aspect of enforcing the code from the directors' point of view was not to inadvertently interfere with the authority of the management company. Primarily it is the manager's responsibility to enforce the code against its employees. Interference by the directors has the potential for micro-managing the business and undermining the manager's ultimate responsibility to enforce the code's requirements.

The Panel was concerned that minor infractions are properly differentiated from major violations. This is particularly important because the unwieldy and complex process for pre-clearing and reporting trades can lead to inadvertent violations. At the same time, inadvertent violations can accumulate and lead to the termination of a successful portfolio manager whom the directors deem important to the interests of the fund shareholders. Table 2 provides a series of scenarios depicting violations of increasing severity:

Throughout the process the management company has to be concerned about the legal rights of the employee. The Panel was concerned that allegations about conduct should be handled discretely and carefully. Counsel will almost certainly represent an employee who is accused of a serious code of ethics violation. Any overzealous persecution will undoubtedly be met with a vigorous defense. The Panel was concerned that publicity about the rebuttal might become just as damaging to the interests of fund investors as the original allegations. As a result, the Panel felt that the quarterly or annual report of code violations should not contain names. Neither should the Board minutes.

Living with the Code

The Panel recommended that a mutual fund director should ask a series of questions about the fund's code of ethics as a form of check list ... and as evidence that they have diligently fulfilled their responsibilities (Table 3)

Fund directors have an overriding legal and fiduciary duty to look after the interests of the fund shareholders. By definition, directors must avoid conflicts of interest and must, at all times, have the long-term interests of the shareholders in mind. Some of the Panel felt that these overriding considerations, combined with the fact that independent directors rarely have access to knowledge of specific trades, obviated the need for them to be covered by the code of ethics.

Having to pre-clear all of his or her own trades is very burdensome and could deter a qualified individual from serving as a mutual fund director. This may be a particularly important consideration given the recent focus on the expertise and capability of independent directors.

The Panel concluded that the mutual fund directors' job, above all else, is to fairly represent the interests of the shareholders. To do this requires that they are credible, honorable and steadfast in their duties; the code of ethics is a manifestation of the trust placed in the directors by the shareholders and in the management company by the directors. Any breach erodes the very foundation of trust that is the cornerstone of the fund industry.