RIA Compliance and Practice Management Blog

RIA Code of Ethics: Detecting and Addressing Unethical Employee Trading Practices

Posted by RIA in a Box

Jul 7, 2021 3:30:54 PM

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In this post, we discuss the compliance requirements and ethical standards related to employee trading for registered investment adviser (“RIA”) firms. SEC Rule 204A-1 (the "Code of Ethics Rule") under the Advisers Act describes at length, how RIA firms can meet regulatory requirements for this particular topic. Specifically, we discuss the illegal practice of front-running and how RIA firms can do their due diligence to detect and address potential trade violations. 


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What is Front-Running?

Front-running is the illegal and unethical act that occurs when someone uses non-public market knowledge, often from client trade requests, to make trades based on that advanced knowledge for their own personal gain, and with the expectation that the security price will change in their favor.

For example, an advisor receives a large stock purchase request from their client, then the advisor uses that information and expectation that the stock price will go up, to purchase the same stock prior to completing their client’s request. The stock price rises after the client’s purchase is completed, and the advisor benefits financially from these nefarious actions.

Front-running can also occur when someone buys or sells securities based on non-public information discovered from inside their firm, whether it is a direct client or not. For instance, over lunch, an advisor learns his colleague will be selling a large number of shares of a particular stock for her clients. The advisor decides to use that information to quickly sell his own shares with the expectation that the price will go down soon.

Why does your firm need to do its due diligence?

Per the SEC Rule 204A-1 under the Advisers Act, all RIA firms are required to set a Code of Ethics, addressing matters such as personal trading. Advisors must report their personal securities holdings and transactions, including those in affiliated mutual funds, to the firm’s chief compliance officer (“CCO”).

Not only is the act of front-running illegal, but it also creates a conflict of interest between the advisor and client. The advisor is putting his or her own interests before the client for personal gain. It’s important to note that the CCO is ultimately responsible for reviewing employee transaction reports and enforcing the code of ethics.

How does your firm do due diligence?

In regards to Rule 204A-1, the SEC staff states the following with respect to responsibilities of the CCO or authorized supervisor for advisor reviews and enforcement:

“assess whether the access person is trading for his own account in the same securities he is trading for clients, and 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”

Firms must put procedures in place to identify front-running violations and to carefully document the actions taken following any potential violation is detected. The CCO or supervised person should complete regular reviews to compare employee transactions with the entire firm’s client transactions.

How can software make it easier to identify front-running?

Firms can simplify the process of identifying potential front running violations with employee trade monitoring software. The right employee trade monitoring software will have the capability to auto-flag any of the employee’s personal trades that could be deemed a potential front-running violation. All actions taken in the employee trade monitoring software should be automatically logged, therefore simplifying the compliance documentation process.

From an efficiency standpoint, it is also beneficial to the firm if the employee trade monitoring software can automatically sync transactions through third party integrations or easily upload lists of transactions.

Schedule an Employee Trade Monitoring Demo Today!

Topics: RIA Operations, RIA Compliance, RIA Technology

RIA in a Box LLC is not a law firm, investment advisory firm, or CPA firm. RIA in a Box LLC does not provide legal advice or opinions to any party or client. You should always consult your relevant regulatory authorities or legal counsel if applicable.

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