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Vol . 13, No. 3 • March 2006

Gifts and Entertainment

Policies : Guide forReevaluating t Policies

Investment Advisersby Kurt J . Decko

ntil recently, the receipt of

gifts and entertainment by

employees ofinvestment

advisers garnered little atten-

tion from regulators and the media . With news

reports revealing bachelor parties and the like

financed by brokers, investment advisers are

reevaluating existing gifts and entertainment poli -

cies and procedures (or adopting new policies

and procedures) in heightened recognition of the

need, to minimize not only any potential conflict s

Continued on page 10

Kurt J. Decko is a member of the Investment ManagementGroup at Kirkpatrick & Lockhart Nicholson Graham LLP(K&LNG) in San Francisco, CA. The author would like tothank Richard M . Phillips, also at K&LNG, for his comments

and contributions to this article . This article is for informationalpurposes and does not contain or convey legal advice .

ASPENPUBLISHERS

Aspen Publishers

Highlights of This Issueby Stephanie A . Djinis,Editor-in-Chief, page 2

Proxies on the Internet: AHarbinger for InvestmentCompany Prospectuses

and Reports?by Michael Berenson and

Christopher D . Menconi, page 3

Anti-Money LaunderingDue Diligence Rule for

Mutual Fund sby John B. Cairns, page 20

Recent Banking Developments . . .page 25

• FDIC Amendments• Audit Engagement

Letter Requirements -• Private Banking Guidance and Other

AML Developments

Gifts and Entertainment PoliciesContinued from page 1

of interest, but also the appearance of such con-flicts with the brokers and other service provid-ers with which the adviser conducts business.Indeed, the appearance of conflicts of interest is

often, from a reputational viewpoint, as harmfulas actual conflicts of interest . The reevaluationof gifts and entertainment policies also providesadvisers the opportunity to remind employees ofthe adviser's business standards .

As there is no such thing as a "model" or "stan -dard" gifts and entertainment policy for advisers,and little directly applicable regulatory authorityon the topic, this article seeks to provide guidanceon the evaluation and implementation of an effec-tive policy. It highlights a number of provisionsand issues that investment advisers should, at aminimum, consider in reevaluating their policies.While each adviser must tailor its policy to itsparticular organization to be truly effective (withvariances depending on the size, structure andbusiness activities of the adviser and its affiliates),gifts and entertainment policies normally includeseveral common elements. Structurally, effectivepolicies contain clear and precise limitations -onemployees accepting gifts and entertainment .Generally, these limitations (the scope of whichis discussed subsequently) are broad, usually withnarrowly tailored exclusions based on specificsituations in which potential conflicts of interestwould not arise or can be effectively monitored .Just as critical as a clear and articulate policy isthe method by which the policy is implemented .In this regard, most advisers consider reportingand pre-clearance requirements as useful tools formonitoring compliance.

While the task sounds simple-forbid employ-ees from accepting certain gifts and entertainmentand check to see if they follow the policy-numer-ous complications arise in trying to impose restric -tions that are not always intuitive and can, attimes, alter established business practices . Fewinternal regulating policies (with the exception oflimitations on personal trading) potentially impactthe personal activities of employees as limitationson gifts and entertainment, particularly for trad-ing room and investment personnel, as well as, insome cases, individuals engaged in marketing theadviser's investment services and products .

In the personal trading context, employeesknow (or should know) that investing based oninside information is inherently wrong and if theydo not know this, they at least understand that

the activity could very well put them in jail . Bycontrast, how does an employee know where todraw the line on accepting gifts and entertainmentgiven the need to develop business relationshipsand the inevitable intertwining of personal andbusiness relationships? Certainly, accepting quidpro quo gifts is (or should be) obviously wrong-asare bribes. Rarely, however, is anything expresslyconditioned on the gift . What is the harm, anemployee may think, in accepting a free iPod, aninvitation to a celebrity golf tournament, or scarceSuper Bowl tickets? If a broker or other vendorhas already paid for the gift, why not take advan-tage of the opportunity as a perk of the job? Even

more blurry, what if the gift-giver is a personalfriend or member of an extended family? A mem-ber of ancillary issues also arise : When reportingthe receipt of Super Bowl tickets, is the propervalue the $100 printed on the face of the tickets orthe $2000 that can be fetched for them on eBay?Advisers are also considering whether to restrictemployees from giving gifts and entertainment toothers to the same extent as receiving or whethera different standard should apply to giving in lightof competitive pressures that may include gift-giv-ing or sponsoring entertainment as an integral partof the adviser's overall marketing activities . Theseare all valid questions for which employees needguidance, and the regulatory and media attentionfocused on gifts and entertainment policies furtherunderscore the need for clear and articulate writtenpolicies and procedures on the topic .

The Legal and Regulatory Background

Gifts and entertainment policies are no texpressly mandated by the compliance and codesof ethics rules of the Securities and ExchangeCommission (SEC) under the Investment AdvisersAct of 1940, as amended (Investment AdvisersAct), or, for investment advisers to registeredinvestment companies, under the InvestmentCompany Act of 1940, as amended (InvestmentCompany Act) .l Nonetheless, accepting giftsand entertainment can create serious conflicts ofinterest or, often just as significant, the, appear-ance of such conflicts . As noted in a speechby the then-Director of the SEC's Division ofInvestment Management in early 2005, "[t]hereis no doubt that the receipt of lavish gifts andentertainment can influence fund personnel'sactions, and even tempt fund personnel to takeactions that may not be in the best interest offund investors .112 Thus, it is with some peril thatan investment adviser relies on the absence of an

THE INVESTMENT LAWYER

10

express mandate for gifts and entertainment poli-cies to fail to adopt such policies .

Developing an effective gifts and entertainmentpolicy is particularly difficult in the absence of reg -ulatory guidance as to "best practices" in the area .Some guidance can be found from analogous pro-visions of the National Association of SecuritiesDealers, Inc. (NASD) Code of Conduct appli -

cable to NASD-member firms, including mutualfund underwriters. Notably, NASD Conduct Rule2830(1) regulates cash and non-cash compensa-tion arrangements in connection with the saleand distribution of investment company securi-ties.3 The NASD has recently issued, for com-ment, proposed interpretive material to NASDConduct Rule 3060 that restricts broker-dealersfrom improperly influencing or rewarding employ-

ees of others .4 The proposed interpretive materialspecifically addresses gifts and business entertain-ment and reflects the renewed regulatory interest

in the subject . NASD regulations provide helpfulguidance concerning the appropriate manner toconduct business and directly regulate organiza-tions with which the adviser conducts business .However, these provisions are usually not directlybinding on advisers, unless they are dually regis-tered as broker-dealers but may be applicable toany affiliated broker-dealer of the adviser .

The receipt of gifts and business entertainment byemployees of advisers to registered investment com -panies, if extremely lavish or extensive, could resultin violations of Section 17(e) under the InvestmentCompany Act, which limits the nature and extentof compensation received by affiliated persons ofregistered investment companies in connection . withthe purchase or sale of securities on behalf of suchinvestment companies.5 Even if the adviser does notprovide services to registered investment companies,the failure to disclose receipt of such compensationmay violate Section 206 of the Investment Advisers

Act6 and other antifraud provisions of the federalsecurities laws. One way to protect the adviser andits employees from potential liability involving theexchange of gifts and entertainment by the adviser'semployees is to. develop, monitor and enforce a giftsand entertainment policy. At the very least, effec-tive implementation of such a policy can insulatethe adviser from a charge of failing to supervise itsemployees . ?

The Benefits of Gifts and Entertainment

Business entertainment and gifts can and d oserve legitimate and valuable business purposes . Itmay sound like a cliche, but often business deals

are made over meals and relationships are devel-oped on the golf course. All else being equal, pur-chasers prefer to conduct business with an indi-vidual they trust and have a personal connectionwith rather than someone they barely know exceptover the phone, especially in service industries .Qualities such as responsiveness and character

are important to forming lasting and meaningfulbusiness relationships and often these qualities arejustifiably developed and evaluated away from thetrading desk and outside of the conference room .Indeed, with the proliferation of email and thegrowing impersonalization of business, the per-sonal relationships that flow from business mealsand entertainment may be of more value than inthe past. Regardless, this article does not attemptto delve into the psychological aspects of businessrelationships, but assumes that there are morethan minimal potential benefits in allowing atleast some business entertainment and gifts . Thisprinciple is similarly recognized by NASD, as theprovision of business entertainment and gifts byNASD-member firms is not prohibited outright,but is rather carefully regulated .

First Step for Evaluating a Giftsand Entertainment Policy :Talk with Employees

In order to properly develop a gifts and enter-tainment policy, the adviser should involve at theoutset, as reasonably practical, as many employeesdirectly affected by the policy as possible, especiallytrading room employees and investment personnel,i.e., those most likely to receive gifts and businessentertainment . This involvement could take theform of questionnaires, but preferably interviewsand group meetings . Only by involving affected

personnel can the adviser gauge the practicalapplication of the policy and learn about employeeconcerns, including how their every-day businesspractices would be impacted by any proposedchanges to the policy. The adviser benefits fromthe process, as it can learn how to best tailor thepolicy to its particular circumstances . To be sure,interviews and conferences will not draw out everyissue, and unanticipated issues will arise. However,to the extent issues can be anticipated and resolvedin advance (backed with the considered thought ofthe adviser's decisionmakers), the guidance will beconsiderably more valuable in applying the policyin a consistent and principled manner .

The most significant benefit accruing fromthe involvement of affected personnel is that thepolicy can be drafted so that it will actually work

11 Vol. 13, No . 3 • Match 2006

in practice. Discussions with personnel will revealto what extent employees are aware of and adhere

to existing policies (indicating whether additionalor more targeted training efforts are warranted) .It is of little or no use to enact a gifts and enter-tainment policy if it is not followed . Indeed, inmany instances it is worse for the adviser to havea policy that is ignored or thwarted in practicethan to have no policy at all .8 This is not to saythat the policy should merely codify currentpractices if they are deficient . Rather, policiesshould be drafted and behavior modified in arealistic and pragmatic manner . For example,as business entertainment invitations frequentlyarise at the last minute, requiring pre-clearanceswithout reasonable exceptions may only encour-age non-compliance . To deal with such instances,advisers should seek to develop, in conjunctionwith affected personnel, reasonable and practi-cal approaches to address common situations .Moreover, when implementing the reporting orpre-approval requirements noted subsequently,advisers often utilize, to the maximum extent pos-sible, available technologies to facilitate compli-ance with the requirements .

Specific Provisions of an Effective Giftsand Entertainment Polic y

The essential question for each adviser is whereto draw the line between appropriate and inap-propriate gifts and entertainment. Drawing sucha line is not a simple process and many factorsgo into the evaluation . Short of a bribe or theexplicit quid pro quo situation, there is a large greyarea, and it is in this area where the guidance fur-nished by an adviser's policies and procedures isinvaluable. As such, policies usually contain botha general policy statement and specific and, to theextent feasible, objective criteria for determiningwhether particular gifts or entertainment are per-missible. Examples illustrating appropriate andinappropriate conduct often help clarify expecta-tions, whether as part of the policy or in the formof an explanatory Q & A or otherwise, with themost obvious example prohibiting quid pro quo

situations. Employees should be expressly encour-aged to seek guidance whenever a questionablesituation arises, and cautioned that the appropri-ateness of gifts or business entertainment oftenwill be measured with the benefit of hindsight .Certain specific provisions and guidelines com-monly found in gifts and entertainment policiesare discussed later in this article.

Policy Statemen t

Almost universally, gifts and entertainmentpolicies begin with a discussion of the principlesbehind the policy and the general business stan-dards (at least concerning gifts and entertain-ment) the adviser expects employees to follow.Essentially, the gifts and entertainment policycommunicates to employees that they should notaccept inappropriate gifts, favors, entertainment,special accommodations, or other things of mate-rial value that could influence their decisionmakingor make them feel beholden to a person or firm .9The NASD code of business conduct is informa-tive (even if not directly binding) and many poli-cies at the outset similarly encourage employees to

strive to achieve "high standards of commercialhonor and just and equitable principles of trade,"as reflected in the NASD code .1 0

Cash

Most policies flatly prohibit accepting cashgifts or cash equivalents (checks, lottery tickets,gift cards redeemable for cash, etc .) from a client,prospective client, or any entity that does busi-

ness or seeks to do business with the adviser .11While gifts arguably can play an appropriate rolein establishing a beneficial business relationship,a cash gift raises the specter of a kickback or abribe, which would clearly be inappropriate .

Gifts

Most policies include a general restriction,subject to enumerated exceptions (discussed sub-sequently), on accepting any gift, service, or otherthing of more than de minimis value from a client,prospective client, or any entity that does businessor seeks to do business with the adviser . The clear-est policies provide (either in the policy or in relat-ed explanatory materials) examples, depending onthe nature of the adviser' s business, of acceptableor unacceptable gifts in order to better remindemployees of the breadth of the restriction (meals,event tickets, travel, lodging, golf tournaments,wine, clothing, services, charitable donations onanother's behalf, etc.) . Conceptually, a gift is anything of value that would not be includable asbusiness entertainment . 12 Tangible objects-wine,clothing, physical items-are clearly gifts . Themore difficult questions arise when entertainmentis involved, with a classic example being tickets toan event .

To quantify the general restrictions conce rn ing

THE INVESTMENT LAWYER

1 2

gifts, most policies delineate a specific de minimisvalue for acceptable gifts. The specific amount mayvary depending on the nature and location of theadviser and its clients, but several advisers (regard-less of location) use a $100 annual gift de minimis

value for all employees. The $100 annual limit isderived from NASD Conduct Rules 2830(1) and3060.13 Accordingly, absent more specific guid-ance from the SEC, the $100 standard has rapidlybecome the de facto general standard for permis-sible gifts across the financial services industries.

Related to the limitations on accepting gifts,many policies also prohibit employees from solic-iting gifts or anything of value for themselves orfor the adviser. To some extent,. a prohibition onsoliciting gifts necessarily would be subsumed byrestrictions concerning the acceptance of gifts(why would an employee ask for something thatthey would be unable to accept), but it neverthelessis appropriate to clarify that solicitation in and ofitself is not condoned . This concept is sometimesexpressed as a prohibition on using one's positionwith the adviser to obtain anything of value froma client, prospective client, or any entity that doesbusiness or seeks to do business with the adviser .

Business Entertainmen t

Although some policies apply the same stan-dards to both gifts and business entertainment,more frequently there are different limitationson business entertainment in recognition of thegreater role that business entertainment serves infostering relationships . Specific to business enter-tainment, policies often contain a restriction onaccepting extravagant, lavish, or excessive enter-tainment from a client, prospective client, or anyentity that does business or seeks to do businesswith the adviser. The value of business entertain-ment can be limited to the same value as the giftpolicy or, as is often the case, a higher amount, solong as that amount is not extravagant or excessive(the amount may be influenced by the adviser'slocation, as a meal in New York City costs morethan in most, other locations) . Business enter-tainment sometimes excludes related out-of-towntransportation and lodging expenses,14 becausesuch expenses could reasonably be categorized asgifts instead.

Business entertainment restrictions usuallyextend beyond simply prohibiting illegal activi-ties. The adviser may also restrict activities that,although not illegal, could harm the adviser'sreputation if it is learned that its employees engagein such activities. The policies that provide the best

guidance set forth specific examples of entertain-ment that the adviser considers inappropriate forit to, in effect, sanction by permitting employees toengage in the activity in connection with adviser-related business. Further detail is often providedin terms of appropriate venues, nature of events,frequency of events, and types and class of accom-modation and transportation related to the event(if determined to be business entertainment) . 15Some policies also set forth different guidelines forcharitable, educational or philanthropic events .

Business Entertainment versus Gif t

What is and what is not business entertainment,as opposed to a gift, is not always clear, but afrequently utilized distinction is whether personsfrom the firm providing the entertainment whoare relevant to the business relationship attend the

event. For example, receiving tickets to a baseballgame, which is not attended by the giver or any-one who is relevant to the business relationship,would be characterized as a gift ; whereas receivinga ticket to the same game attended by the giverwould be characterized as business entertainment .The NASD has proposed using a similar standardin the NASD Gifts and Entertainment Notice bydefining "business entertainment" 16 as providingentertainment "in which a person associated witha member accompanies and participates with suchemployee irrespective of whether any businessis conducted during, or is considered attendantto, such event ."17 A further distinction made insome policies is that for the event to qualify asbusiness entertainment there must be a businesspurpose for the event . For example, attending theopera at which the person paying for the ticketsits three aisles away and the business associatesnever speak all night might be considered a gift,whereas if the business relationship is discussed ata dinner preceding the opera a different conclu-sion could be reached . The drawback with sucha distinction is that, in practice, it would be verydifficult to monitor and enforce . Regardless ofhow the adviser determines to distinguish businessentertainment from gifts, the distinction should beclearly articulated in the policy and consistentlyapplied in practice .

Valuation Issue s

One of the trickier details of a gifts and enter-tainment policy involves the valuation of items .In this respect, effective policies contain guidanceon how to determine the value of a gift or busi-

13 Vol . 13, No. 3 o March 2006

ness entertainment, and consistently apply suchdeterminations . In many instances, value is appar-ent (tickets to a routine event have a face valueprinted on the ticket, hotel lodging is provided at aknown rate; greens fees are ascertainable) . In othersituations, however, the value may not be known(in which case it may be, justifiably, awkward foran employee to inquire as to the cost of an item)or the item may have value as a unique or hard toacquire item (Super Bowl tickets, exclusive tours,etc .) .

One useful manner to address valuation con-cerns is to provide that routine items be valued atcost, while items with unknown or special value bevalued at market rates or pursuant to good faithestimation. In the latter cases, although adminis-trative costs may increase, some mechanism oftenexists to assist the employee in making valuationestimates. For example, in conjunction with thereporting element discussed subsequently, a policymay provide for supervisory review of the basisfor any estimated valuation (in essence allowingsupervisory or compliance personnel to auditthe valuation) . Some policies provide examplesand specifically address difficult valuation issues,such as whether private air transportation should

be valued at the cost of a first class commercialticket or whether valuation of an invitation toparticipate in a celebrity golf tournament mustinclude a proportionate percentage of celebrityappearance fees. Further examples can be gleanedfrom discussions with affected personnel (derivedfrom past experiences), but whatever valuationdecisions are ultimately implemented should bedrafted as clearly as possible to guide employees(and supervisors) .

Exclusions

As illustrated, the limitations on gifts andentertainment often are broadly stated. As ageneral matter, they relate to at least some situa-tions in which there are limited or no conflicts ofinterest . In these instances, specific types of giftsand entertainment are carved out and excludedfrom the policy's requirements, often developed inconsultation with affected employees. The guidingprinciple is whether the proposed exclusion offers

the potential for abuse and whether that potentialcan be addressed in a different manner, for exam-ple, by requiring reporting .

Common examples of items that many poli-cies specifically exclude (whether from the policyas a whole or from a reporting requirement)include small promotional items with prominent

corporate logos-the risk that employees wouldforego their duties to clients for a pen would seemminimal in light of the paperwork that would begenerated to report receipt of such an item . Ameal that is necessitated by business obligationsis also sometimes excluded (for example, when anemployee spends the day conducting business ata vendor's office and has meals with the vendor'spersonnel) . Another excludable category appear-ing in some policies is the receipt of certain dis-counts or rebates from counterparties. In order toprevent abuse, however, an appropriate qualifyinglimit can be imposed (i.e., the discount or rebatemust not exceed those known to be available toclasses of other customers) .

Fam ily and Friends

Another difficult issue to resolve in formulat-ing a gifts and entertainment policy concerns thereceipt of gifts or entertainment from family orindividuals with close personal relationships . Thisissue is perhaps the most personally invasive . Whenevaluating the gifts and entertainment policy, it isnecessary to recognize that the financial servicesindustry can be a rather small world and oftenclose family (spouses/siblings), extended family orpersonal friends work for entities that do businesswith the adviser. In such instances, strict applica-tion of the policy would impose intrusive regula-tion on the exchange of gifts between family mem-bers and close personal friends (such as Christmasor wedding presents), where the exchange of thegift is a by-product of the personal relationship .Moreover, the potential conflicts of interest inher -ent in close personal relationships derive not fromthe exchange of gifts, but from the relationshipitself (in other words, the adviser's concern is thatan employee may direct trades to a best friendat a broker not because of an expensive gift, butbecause they are best friends) . Given the varietyof personal relationships, it is difficult to develophard and fast rules governing conduct basedsolely on a categorization of relationships . Thus,many advisers find it useful to primarily focus ondisclosure of the nature of the relationship andthe parties involved so that potential conflicts ofinterest can be monitored by supervisory person-nel-in many respects, the benefits of reportinghave less to do with regulating actual gifts, butfrom understanding the nature and extent of therelationship.

Policies address the issue of gifts and entertain-ment between family and friends in different ways .Some exclude, categorically, gifts and entertain-

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1 4

ment exchanged between persons in certain typesof relationships (or, conversely, make no exclu-sions at all) ; others make an exclusion conditionedon proper reporting of the gift or entertainmentor of the relationship. For example, some policiesfully exclude gifts and entertainment given andaccepted if based on personal, rather than busi-ness, motivations, but the breadth of the exclusionin such instances becomes vague and imprecise(i.e., without guidance, how is an employee sup-posed to determine and evaluate the motiva-tion for a gift ; should it matter if a friendshipdates back to pre-employment days or developedthrough working with each other ; should a line bedrawn between intimate dating -relationships andother types of relationships, etc .?) . Some policiesbroadly exclude, at least from the numerical limitsof the policy, gifts and entertainment from bothimmediate family and friends, but require thatany such items be reported nonetheless . Whilethis approach has the advantage of improving theadviser's monitoring capabilities, it may encounterresistance on the part of employees not wishing toshare personal information like the value of theirChristmas gifts.

The easiest test to administer fully excludes(both from the policy and any reporting require-ment) appropriate gifts and entertainment if basedon specific, narrow, and enumerated relationships(i.e., spouses and immediate family members) butwould not exclude non-enumerated relationships(i.e., friends and extended family) . Such a dis-tinction allows for minimal discretion in evaluat-ing the nature of relationships as an employee'simmediate family is an objective and verifiablecategorization. Further, advisers often separatelyrequire that employees report whether their spous-es or immediate family members are employed bybrokers or vendors (including the nature of suchemployment), which allows the adviser to monitorpotential conflicts of interest arising from theserelationships (knowing whether spouses spend alot on their anniversary presents adds little to theadviser's monitoring goals, but would be highlyintrusive to the employee) .

Under this approach, gifts and entertainmentprovided by persons outside of the narrow exclu-sion (i.e., anyone other than spouses and immedi-ate family) may still be excluded from the policy,but only if properly reported and evaluated .The adviser need not (although it could) requirereporting of the value of such gifts and entertain-ment, as the potential conflicts of interest of con-cern to the adviser often follow from the nature ofthe relationship itself and not the actual value of

the gift or entertainment (further, requiring valu-ations may encounter resistance and discouragereporting in the first instance) . The absence of avaluation, however, requires that the descriptionin the report contain sufficient detail to permitinformed oversight .

Accordingly, to be effective, the policy shouldspecify the factors an employee should note whenreporting gifts and entertainment, thus allowingsupervisory evaluation of the appropriateness ofthe gift or entertainment . Potential factors includethe nature and duration of the relationship andwhether the gift or entertainment was paid for bythe giver or his or her employer . The report shouldalso discuss whether the employee and the giftgiver are in positions to influence decisions at theirorganizations and, most . importantly, whether theemployee and the gift giver are in positions fromwhich they can (or actually do) conduct businesstogether (i.e., an employee's personal relationshipwith a trader at a broker used by the adviser raisesmore concerns than a similar personal relation-ship with an employee of the broker working in adepartment that the adviser has no contact with) .As it relates to the gifts and entertainment policy,if the report indicates a close personal relation-ship (a gift from a groomsman), no further actionunder the policy would be required (the relation-ship would be monitored for other conflicts ofinterest, however); whereas if the report raisesconcerns (a gift from a cousin recently employedby a vendor whom the employee may not haveseen for years), further inquiry would followand the gift or entertainment may be restrict-ed. Further, beyond the gifts and entertainmentpolicy, learning of the existence and nature ofpersonal relationships, irrespective of gift giving,allows the adviser to best monitor conflicts arisingfrom the relationship itself, albeit in a potentiallyimprecise manner (relations that do not exchangegifts would not require reporting) . Determiningthe contours of a friends and family exclusion isdifficult, but discussions with affected personnel,as discussed, can be very helpful in determiningthe extent of potential relationships and how bestto address the subject .

Implementation of a Gifts andEntertainment Policy

As noted, it is critical that any gifts and enter-tainment policy be systematically monitored forcompliance and that employees receive trainingto help them thoroughly understand the contentsand import of the policy.

15 Vol . 1 3 , No. 3 • March 2006

Reporting

Various methods are used to monitor compli-ance with the policy. The most common formof monitoring involves a reporting requirement .Many policies require reporting of all gifts andentertainment except those that are de minimis orotherwise specifically excluded (see the previousdiscussion concerning family and friends) . Otherpolicies require reporting of all gifts and enter-tainment (regardless of whether it is below the deminimis threshold set by the adviser), with onlyspecial exceptions (i.e., immediate family) . Whilereporting all such gifts and entertainment permitsthe adviser to best monitor whether limitationscontained in the policy have been exceeded, itcould burden the adviser administratively andmay be subject to frequent underreporting . Forexample, employees may forget about small giftsor occasional meals . Some policies seek a middleground by imposing a lower threshold for report-ing purposes (for example, individual items over$50), although this approach may unnecessarilyconfuse employees by substituting two thresholdsin lieu of the single, easy-to-remember $100 limit .Depending on the structure and size of the advis-er, electronic monitoring may be the only feasiblemethod of administering and monitoring the vari-ous reports, in which case specialized computersoftware may be necessary.

In addition to employee reporting, some advis-ers seek the cooperation of their brokers and othervendors to monitor compliance with the adviser'spolicy. They do this by requesting the vendorto acknowledge in writing that they will seek toassure compliance with the adviser's gifts andentertainment policy by personnel doing businesswith the adviser . In some cases, they may ask forperiodic reports and expense account items relat-ing to gifts and entertainment provided to employ-ees of the adviser. Cooperation could become evenmore extensive in the future . For example, NASDmember firms are subject to detailed recordkeep-ing requirements and, under the proposed NASDGifts and Entertainment Release, detailed recordsof business entertainment expenses would have tobe made available to customers of NASD-memberfirms.18 The adviser could use these records tocross-check records submitted by its employees.Should this proposal be adopted for brokeragepersonnel, some advisors may seek similar assis-tance from other vendors .

While a reporting requirement should, in and ofitself, act to deter some inappropriate conduct, itis critical that the reports actually be monitored.19

There is little point and, from a regulatory perspec-tive, much danger in requiring detailed reportingof gifts and entertainment if the reports are neverreviewed by qualified personnel . Regulators, inconnection with a review of an adviser's gifts andentertainment policy, would be looking to see howthe adviser uses reports generated under the policy .Moreover, a reporting requirement provides onlyevidence of red flags if an issue could have beenaverted had the reports simply been read .

Pre-Clearance

Many policies, in addition to a reporting ele-ment, require pre-clearance for certain categoriesof gifts and entertainment . For example, advisersmay find it useful (depending on the firm cultureand the resources available to implement the poli-cy) to require that gifts or business entertainmentevents exceeding a specified value (or regularity),or of a certain type (i.e., offer of travel expensesor hotel costs) receive pre-clearance from theadviser's supervisory or compliance personnel orother appropriate person. As with other aspectsof the gifts and entertainment policy, advisersgenerally weigh the costs and benefits of imple-menting a pre-clearance requirement . In orderfor the requirement to be workable, certain exclu-sions may be necessary (i.e., last-minute businessentertainment invitations and unexpected gifts) .If the policy includes a pre-clearance element, itgenerally specifies the factors to be considered ingranting clearance and the appropriate proceduresto follow (including retention of records) . It is alsoimportant to ensure consistency in the granting ofclearances throughout the adviser's organization,through the training of supervisory personnel orotherwise.

Training

A critically important aspect of an effectivegifts and entertainment program is the trainingprogram. Often, training is not specifically dis-cussed in the gifts and entertainment policy, but isprovided in connection with other aspects of theadviser's compliance program. Regular trainingconcerning the gifts and entertainment policy isimportant because some of its substantive pro-visions may not be intuitive to employees andcould directly impact their personal lives. Advisersoften find that training is valuable as a means ofreceiving feedback from employees concerningproblems with the implementation of the policy.For example, numerous questions from employees

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16

would suggest a need for greater clarity in specificareas. Further, if the same or related issues areraised by several employees, the adviser can revisitthe policy and modify it as appropriate .

Other Implementing Provisions

Implementing provisions concerning the appli-cation of the policy should be considered anddescribed as precisely as feasible . For example,reporting requirements often provide precisedetails of where and when reports should be sub-mitted. Pre-clearance elements frequently specifythe process for obtaining necessary clearances.Most policies contain provisions concerning theretention of appropriate documentation (pre-clearance forms, reports, etc .) . A documentationrequirement, if consistently implemented, encour-ages more care to be given to the granting of anyclearances, which in turn encourages greater com-pliance with the policy. Some policies outline therange of penalties that may be imposed for viola-tions of the policy. These penalties often rangefrom reprimands (a letter in the employee's file) todismissal for egregious violations . Policies some-times explicitly describe how the policy is com-municated to employees (as part of an employeehandbook, whether a signed acknowledgement isrequired, etc .) .

Finally, some gifts and entertainment policieshave explicit provisions that provide for periodicreview of the policy and modification as frequent-ly as necessary (even if the policy is not explicit,periodic reviews should be conducted as a matterof good practice) . As the SEC staff has recognizedin other compliance contexts, compliance is a fluidand dynamic process.20 It is highly likely that newand unforeseen issues will arise over time. Periodicreview allows an adviser to identify elements ofthe policy that may not be working . Fixing a poli-cy that is not working in some aspect is not neces-sarily an admission of a failed program, but ratherevidence that the adviser is working to addressnew issues and responding accordingly.

Special Considerations : Applicationof the Policy to the Giving of Giftsand Entertainment

The discussion so far has focused primarilyon limitations and restrictions advisers imposeon employees' receipt of gifts and entertainment .Indeed, the adviser's responsibilities to its clientsare most susceptible to conflicts of interest whenemployees are accepting, rather than giving, gifts

and entertainment . Nonetheless, to an increasingextent, advisers are addressing their policies toissues involved in the giving of gifts and entertain-ment . Apart from instances when the giving ofgifts and entertainment violate a client's policy orother legal constraints, giving also implicates bothbusiness and regulatory hazards, as the adviserwould not want to read media reports concerningimproper conduct by its employees or improprietyat an adviser-sponsored event . Ideally, policiesshould limit giving and receiving to the, sameextent (and some do), but this may unnecessarilyinhibit the adviser from marketing and promotingits services in a competitive marketplace.

While restrictions on giving are often differ-ent from receiving, a number of reasonable limitsare often still imposed . As a threshold, somepolicies prohibit employees from giving lavish,extravagant, or improper gifts and entertainment .In addition, some advisers prohibit employeesfrom giving gifts or entertainment in contraven-tion of the recipient's employer's policies on giftsand entertainment (if such policies exist) . Otherprovisions, as applicable to the particular adviser,prohibit giving gifts or entertainment that violateregulatory restrictions (i .e., the NASD standards,if applicable to a portion of the adviser's business)

or legal restrictions (as noted subsequently, specialrules may apply when dealing with governmentofficials in certain jurisdictions or personnel ofregulated entities) . In many respects, it is easier foradvisers to monitor compliance with giving restric-tions because employees will often seek reimburse-ment for such expenditures. Accordingly, advisersare more carefully reviewing expense accounts ofemployees engaged in marketing activities or otherentertainment-prone activities with an eye on thepropriety of such expenditures from a recipient'sperspective. . In some cases, expense account sys-tems are linked to reporting systems under thegifts and entertainment policies .

Apart from business and securities regula-tory considerations, gifts and entertainment caninvolve a risk of criminal investigations or at leastserious political scandal . Advisers doing businessin foreign countries are regulated by, among otherthings, the Foreign Corrupt Practices Act, which,broadly speaking, restricts providing gifts to cer-tain government officials .21 Other laws may applyto state, local, or federal government officials .Similarly, special rules on gifts and entertain-ment may apply when dealing with pension plansor ERISA-regulated entities . For example, theDepartment of Labor requires the reporting ofaggregate annual gifts over $250 to certain cov-

17 Vol. 13, No. 3 • March 2006

Bred persons associated with union-affiliated pen -

sion plans (Taft-Hartley plans) .22 The MunicipalSecurities Rule Making Board, which regulates thesales of 529 college savings plans, recently amend-ed its rules concerning gifts and other non-cashconsideration to more closely follow the approachof the NASD.23 Although the requirements ofthese laws and regulations are beyond the scope ofthis article, when applicable, employees should bemade aware that laws or rules in various jurisdic-tions or under other regulatory regimes may sepa-rately prohibit or limit gifts or entertainment . Insuch instances, employees are frequently trained inthe special requirements of applicable regulationsand warned that certain conduct, which wouldbe otherwise generally appropriate, may be pro-hibited simply because of the individual or entityinvolved .

Conclusion

An effective gifts and entertainment policyappropriately balances the benefits derived fromthe exchange of business entertainment and giftswith the need of the adviser to monitor and avoidconflicts of interest in fulfilling its fiduciary dutiesto clients and avoiding regulatory and other Jawenforcement issues . The elements described neednot appear in every adviser's policy, as every adviserhas different needs and risks; however any provi-sions that are included are most effective whenimplemented in a clear and consistent manner sothat they are indeed adhered to by employees . Inthe area of gifts and entertainment, it is importantto recognize that the policy can and will affectemployees personally and should be structured toaccount for this dynamic. To this end, it is impera-tive to receive and incorporate feedback fromaffected employees for the policy to be successful .This includes an active training program and theflexibility to modify, as necessary, policies that arenot working or could be enhanced in certain aspects .If implemented appropriately, in a way tailored to

the adviser's unique organization an adviser willbenefit from the strengthening of business relation-ships through gifts and business entertainment,while at the same time avoiding or minimizing regu-latory issues and the actual and potential conflictsof interest inherent in these practices.

NOTES

several issues investment advisers and investment companieswould be expected to address, at a minimum, in their compli-ance programs . The non-exclusive lists encompass broad aspectsof the business of advising and operating mutual funds, but donot reference gifts and entertainment policies and procedures .See Rel Nos. IA-2204; IC-26299, Compliance Programs ofInvestment Companies and Investment Advisers (December 17,2003) . Siri larly, Rule 204A-1 under the Investment AdvisersAct and Rule 17i-1 under the Investment Company Act, whichmandate codes of ethics for certain employees of investmentadvisers and investment companies, do not impose regulationson gifts and entertainment.

2 . See Remarks before the Mutual Fund Directors ForumFifth Annual Policy Conference : Critical Issues for InvestmentCompany Directors, by Paul E Roye, February 17, 2005, avail-able at h ttp://www.sec.gov/news/speech/SpchO2l7O5pfrhtm .

3 . NASD Conduct Rule 2830(1) provides, among other things(including a prohibition on the receipt of cash and specifiedrecord-retention requirements), that :

In connection with the sale and distribution of investmentcompany securities :

(5) No member or person associated with a member shalldirectly or indirectly accept or make payments or offers ofpayments of any non-cash compensation, except as providedin this provision . Notwithstanding the provisions of [theRule], the following non-cash compensation arrangementsare permitted :

(A)Gifts that do not exceed an annual amount per person fixedperiodically by the Association [presently $1001 and are notpreconditioned on achievement of a sales target .

(B) An occasional meal, a ticket to a sporting event or the the-ater, or comparable entertainment which is neither so frequentnor so extensive as to raise any question of propriety and is notpreconditioned on achievement of a sales target .

(C) Payment or reimbursement by offerors in connection withmeetings held by an offeror or by a member for the purposeof training or education of associated persons of a member,provided that:

(i) the record keeping requirement [of the Rule] is satisfied ;

(ii) associated persons obtain the member's prior approval toattend the meeting and attendance by a member's associatedpersons is not preconditioned by the member on the achieve-inent of a sales target or any other incentives pursuant to a non-cash compensation arrangement permitted by [the Rule] ;

(iii) the location is appropriate to the purpose of the meeting,which shall mean an office of the offeror or the member, or afacility located in the vicinity of such office, or a regional loca-tion with respect to regional meetings ;

(iv) the payment or reimbursement is not applied to the expens-es of guests of the associated person ; an d

(v) the payment or reimbursement by the offeror is not precon-ditioned by the offeror on the achievement of a sales target orany other non-cash compensation arrangement permitted by[the Rule] .

4 . See Notice to Members 06-06, NASD Requests Commenton Proposed Interpretive Material IM-3060 Addressing Giftsand Business Entertainment (January 23, 2006) (the NASD

1 . In the release mandating compliance programs for invest-ment advisers and investment companies, the SEC enumerated

THE INVESTMENT LAWYER

1 8

Gifts and Entertainment Notice) . NASD Conduct Rule 3060provides, in pertinent part, that :

(a) No member or person associated with a member shall,directly or indirectly, give or permit to be given anything ofvalue, including gratuities, in excess of one hundred dollarsper individual per year to any person, principal, proprietor,employee, agent or representative of another person wheresuch payment or gratuity is in relation to the business of theemployer of the recipient of the payment or gratuity . A gift ofany kind is considered a gratuity .

5 . Section 17(e) of the Investment Company Act provides :

It shall be unlawful for any affiliated person of a registeredinvestment company, or any affiliated person of such person-

(1) acting as agent, to accept from any source any compensa-tion (other than a regular salary or wages from such registeredcompany) for the purchase or sale of any property to or forsuch registered company or any controlled company thereof,except in the course of such person's business as an underwriteror broker ; o r

(2) acting as broker, in connection with the sale of securitiesto or by such registered company or any controlled companythereof, to receive from any source a commission, fee, or otherremuneration for effecting such transaction which exceeds (A)the usual and customary broker's commission if the sale iseffected on a securities exchange, or (B) 2 per centum of thesales price if the sale is effected in connection with a second-ary distribution of such securities, or (C) 1 per centum of thepurchase or sale price of such securities if the sale is otherwiseeffected unless the Commission shall, by rules and regulationsor order in the public interest and consistent with the protectionof investors, permit a larger commission .

6 . Section 206 of the Investment Advisers Act provides, inpertinent part :

It shall be unlawful for any investment adviser, by use of themails or any means or instrumentality of interstate commerce,directly or indirectly-

(1) to employ any device, scheme, or artifice to defraud anyclient or prospective client; (2) to engage in any transaction,practice, or course of business which operates as a fraud ordeceit upon any client or prospective client ; . . . (4) to engagein any act, practice, or course of business which is fraudulent,deceptive, or manipulative .

7 . See Section 203(e)(6) of the Investment Advisers Act, allow-ing for various penalties to be assessed against advisers for,among other things, failing reasonably to supervise, with a viewto preventing violations of the federal securities laws, personsunder their supervision, unless :

(A) There have been established procedures, and a system forapplying such procedures, which would reasonably be expectedto prevent and detect, insofar as practicable, any such violationby such other person, and

(B)Such person has reasonably discharged the duties and obli-gations incumbent upon him by reason of such procedures and

system without reasonable cause to believe that such proceduresand system were not being complied with .

8. See, e.g., Rel. No. IA-1848, In the Matter of ScudderKemper Investments, Inc. and Gary Paul Johnson (December22, 1999) .

9. The NASD Gifts and Entertainment Notice contains asimilar general standard: "when a member interacts with anemployee of a customer, the member should not do or giveanything of value to the employee that is intended to cause, orotherwise would be reasonably judged to have the likely effectof causing, such employee to act in a manner that is inconsis-tent with the best interests of the customer. "

10. See NASD Conduct Rule 2110 (Standards of CommercialHonor and Principles of Trade) .

11. NASD Conduct Rule 2830(1)(4) similarly provides that cashmay not be received in connection with the sale and distributionof securities, unless it is described in the current prospectus ofthe investment company.

12 . See also NASD Gifts and Entertainment Notice sitpra n.4 .

13. See ns.3, 4 supra.

14.The NASD, however, proposes including transportationand lodging expenses in its proposed definition of businessentertainment. See NASD Gifts and Entertainment Release .

15.See NASD Gift s and Entertainment Release .

16. "Business entertainment" is otherwise defined as "providingentertainment to an employee in the form of any social event,hospitality event, charitable event, sporting event, entertainmentevent, meal, leisure activity or event of like nature or purpose,as well as any transportation and/or lodging accompanyingor related to such activity or event, including such businessentertainment offered in connection with an educational eventor business conference. . ." See NASD Gifts and EntertainmentNotice supra n .4 .

17.See NASD Gifts and Entertainment Notice supra n.4 .

18.See NASD Conduct Rule 2830(1)(3) and the NASD Giftsand Entertainment Release.

19.The NASD would impose a similar requirement on memberfirms . See NASD Gifts and Entertainment Release.

20. See, e.g., The New Compliance Rule : An Opportunity for

Change, by Lori A . Richards, June 28, 2004, available at http:llvvvviv. sec. gov/news/Speechlspch0630041ar. htm .

21. Pub. L. 105-366, 15 U.S.C. §§ 78dd-1, et seq.

22. See generally, Form LM-10 (Employer Reports) Advisory

(November 10, 2005), available at h ttp ://www.dol.gov/esa/regs/compliancelolmsl1m10_advisory.htm, (which contains a link tofrequently asked questions concerning the noted reportingform) .

23. For a summary of these amendments, see h ttp://www.msrb.org1msrb11archive1200512005-52. asp.

19 Vol . 13, No. 3 • March 2006