[Federal Register Volume 62, Number 61 (Monday, March 31, 1997)]
[Rules and Regulations]
[Pages 15098-15110]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-8075]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 270 and 274
[Release No. IC-22579; IA-1623; S7-24-95]
RIN 3235-AG07
Status of Investment Advisory Programs Under the Investment
Company Act of 1940
AGENCY: Securities and Exchange Commission.
[[Page 15099]]
ACTION: Final rule.
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SUMMARY: The Commission is adopting rule 3a-4 under the Investment
Company Act of 1940 to provide a nonexclusive safe harbor from the
definition of investment company for certain programs under which
investment advisory services are provided on a discretionary basis to a
large number of advisory clients having relatively small amounts to
invest. An investment advisory program that is organized and operated
in accordance with the rule's provisions is not required to register as
an investment company under the Investment Company Act of 1940, or to
comply with the Act's requirements. In addition, such a program is not
subject to the registration requirement under section 5 of the
Securities Act of 1933.
EFFECTIVE DATE: March 31, 1997.
FOR FURTHER INFORMATION CONTACT: Rochelle Kauffman Plesset, Senior
Counsel, (202) 942-0660, Office of Chief Counsel, Division of
Investment Management, 450 Fifth Street, N.W., Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission
(``Commission'') is adopting rule 3a-4 under the Investment Company Act
of 1940 [15 U.S.C. 80a-1, et seq.] (``Investment Company Act''). Rule
3a-4 provides a nonexclusive safe harbor from the definition of
investment company for certain programs under which investment advisory
services are provided to advisory clients (``investment advisory
programs'').
Table of Contents
Executive Summary
I. Background
II. Discussion
A. Preliminary Matters
B. Definitions
1. The Sponsor
2. Investment Advisory Program
C. Provisions Designed to Ensure that Each Client Receives
Individualized Treatment
1. Individualized Management of Client Accounts
2. Initial and Ongoing Client Contact
3. Reasonable Management Restrictions
4. Quarterly Account Statements
5. Minimum Account Size
D. Client Retention of Ownership of Securities
1. Ability to Withdraw and Pledge Securities
2. Right to Vote Securities and Receive Certain Documents as
Securityholders
3. Right to Receive Trade Confirmations
4. Legal Rights as Securityholders
E. Policies and Procedures and Form N-3a4
F. Investment Advisers Act Issues Raised by Investment Advisory
Programs
III. Cost/Benefit Analysis
IV. Paperwork Reduction Act
V. Final Regulatory Flexibility Analysis
VI. Effective Date
VII. Statutory Authority
Text of Rule
Executive Summary
The Commission is adopting rule
3a-4 under the Investment Company Act to provide a nonexclusive safe
harbor from the definition of investment company for certain investment
advisory programs. These programs typically are designed by investment
advisers or other money managers seeking to provide the same or similar
professional portfolio management services on a discretionary basis to
a large number of advisory clients having relatively small amounts to
invest. Under rule 3a-4, any investment advisory program organized and
operated in accordance with the rule's provisions is deemed not to be
an investment company within the meaning of the Investment Company Act.
In addition, a preliminary note to rule 3a-4 states that there is no
registration requirement under section 5 of the Securities Act of 1933
(``Securities Act'') 1 with respect to investment advisory
programs that are organized and operated in compliance with the
provisions of the rule.
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\1\ 15 U.S.C. 77a, et seq.
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The rule provides that: (i) each client's account must be managed
on the basis of the client's financial situation and investment
objectives, and in accordance with any reasonable restrictions imposed
by the client on the management of the account; (ii) the sponsor of the
program must obtain sufficient information from each client to be able
to provide individualized investment advice to the client; (iii) the
sponsor and portfolio manager must be reasonably available to consult
with each client; (iv) each client must have the ability to impose
reasonable restrictions on the management of the client's account; (v)
each client must be provided with a quarterly account statement
containing a description of all activity in the client's account; and
(vi) each client must retain certain indicia of ownership of all
securities and funds in the account. The rule is intended to be a
nonexclusive safe harbor; a program that is not organized and operated
in a manner consistent with the rule does not necessarily meet the
Investment Company Act's definition of investment company. The rule, as
adopted, does not include provisions regarding written policies and
procedures, the maintenance of records, or the filing of a form with
the Commission that were proposed for comment in 1995.
I. Background
In recent years, the number of investment advisory programs that
are designed to provide professional portfolio management services on a
discretionary basis to a large number of clients has increased greatly.
These programs historically have been offered typically to clients who
are investing amounts of money less than the minimum investments for
individual accounts otherwise required by participating investment
advisers, but significantly more than the minimum account sizes of most
mutual funds.
These investment advisory programs typically are organized and
administered by a sponsor, which provides, or arranges for the
provision of, asset allocation advice and administrative
services.2 In some programs, the sponsor or its employees also
provide portfolio management services, including the selection of
particular securities, to the program's clients. In other programs, the
sponsor selects, or provides advice to clients regarding the selection
of, another investment adviser (which may or may not be affiliated with
the sponsor) to act as the client's portfolio manager.3 In these
programs, the sponsor generally is responsible for the ongoing
monitoring of the management of the account by the manager or managers
selected. The sponsor, rather than the portfolio manager, often serves
as the primary contact for the client in connection with the
program.4 Sponsors and portfolio managers usually meet the
definition of ``investment adviser'' under the Investment Advisers Act
of 1940
[[Page 15100]]
(``Advisers Act''),5 and may be required to register under that
Act.6 Included among investment advisory programs developed in the
recent past are those commonly referred to as ``wrap fee programs.'' In
a wrap fee program, the client typically is provided with portfolio
management, execution of transactions, asset allocation, and
administrative services for a single fee based on the size of the
account.7 At year-end 1995, assets in wrap fee programs totaled
approximately $101.6 billion, an increase of over 30 percent in one
year.8
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\2\ The sponsor often is a money management firm, a broker-
dealer, a mutual fund adviser or, in some instances, a bank. See,
e.g., Wall Street Preferred Money Managers, Inc. (pub. avail. Apr.
10, 1992) (broker-dealer); United Missouri Bank of Kansas City, n.a.
(pub. avail. May 11, 1990, as modified Jan. 23, 1995) (bank);
Strategic Advisers Inc. (pub. avail. Dec. 13, 1988) (mutual fund
adviser). The sponsor or one of its affiliates also may execute some
or all of the transactions for client accounts.
\3\ More than one portfolio manager may manage the client's
assets, depending on the program, the client's investment
objectives, and the size of the client's account. See, e.g.,
Rauscher Pierce Refsnes, Inc. (pub. avail. Apr. 10, 1992); Wall
Street Preferred Money Managers, Inc., supra note 2; Westfield
Consultants Group (pub. avail. Dec. 13, 1991).
\4\ Some investment advisory programs, however, are marketed by
the sponsor through unaffiliated investment advisers, such as
financial planners. In some of these programs, the unaffiliated
investment adviser, rather than the sponsor, may serve as the
primary contact for its clients that participate in the program.
See, e.g., Westfield Consultants Group, supra note 3.
\5\ 15 U.S.C. 80b-1, et seq. Section 202(a)(11) of the Advisers
Act (15 U.S.C. 80b-2(a)(11)) defines ``investment adviser'' as ``any
person who, for compensation, engages in the business of advising
others, either directly or through publications or writings, as to
the value of securities or as to the advisability of investing in,
purchasing, or selling securities, or who, for compensation and as
part of a regular business, issues or promulgates analyses or
reports concerning securities * * *.'' A bank generally is excepted
from the definition of investment adviser under Section
202(a)(11)(A) of the Advisers Act. A broker-dealer that sponsors an
investment advisory program generally cannot rely on the broker-
dealer exception from the definition of investment adviser in
Section 202(a)(11)(C) of the Advisers Act. See, e.g., Status of
Investment Advisory Programs under the Investment Company Act,
Investment Company Act Release No. 21260 (July 27, 1995), 60 FR
39574 (Aug. 2, 1995) (``July Release''); National Regulatory
Services, Inc. (pub. avail. Dec. 2, 1992).
\6\ The National Securities Markets Improvement Act of 1996
(Pub. L. No. 104-290) amended the Advisers Act to provide that
certain investment advisers will be subject primarily to the
supervision of the Commission, while other advisers will be subject
primarily to state regulation. Effective April 9, 1997, if an
investment adviser is regulated or required to be regulated as an
investment adviser in the state in which it maintains its principal
office and place of business, it may not register with the
Commission unless (1) it has assets under management of $25 million
or more, or (2) it advises a registered investment company. Proposed
rules published for comment by the Commission would reallocate
regulatory responsibilities for investment advisers between the
Commission and the states. Rules Implementing Amendments to the
Investment Advisers Act of 1940, Investment Advisers Act Release No.
1601 (Dec. 18, 1996), 61 FR 68480 (Dec. 27, 1996).
\7\ See paragraph (g)(4) of rule 204-3 under the Advisers Act
(17 CFR 275.204-3(g)(4)) (defining wrap fee program for purposes of
wrap fee brochure requirement).
\8\ Cerulli Associates, Inc. and Lipper Analytical Services,
Inc., The Cerulli-Lipper Analytical Report: State of the Wrap
Account Industry 5 (1996). These figures include assets in mutual
fund wrap programs, also called mutual fund asset allocation
programs. Unlike traditional wrap fee programs, mutual fund wrap
programs contemplate that a client's assets are allocated only among
specified mutual funds. Assets in mutual fund wrap programs
represented 19% of total assets in wrap fee programs at year-end
1995. Id. at 7.
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Under wrap fee and other investment advisory programs, a client's
account typically is managed on a discretionary basis in accordance
with pre-selected investment objectives. Clients with similar
investment objectives often receive the same investment advice and may
hold the same or substantially the same securities in their accounts.
In light of this similarity of management, some of these investment
advisory programs may meet the definition of investment company under
the Investment Company Act, and may be issuing securities for purposes
of the Securities Act.9
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\9\ For a detailed discussion of why an investment advisory
program may meet the definition of investment company and may be
deemed to be issuing securities, see July Release, supra note 5, at
Section I. See also In the Matter of Clarke Lanzen Skalla Investment
Firm, Inc., Investment Company Act Release No. 21140 (June 16,
1995); SEC v. First National City Bank, Litigation Release No. 4534
[1969-1970 Transfer Binder] Fed. Sec. L. Rep. (CCH) para. 92,592
(Feb. 6, 1970).
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In 1980, the Commission sought to address certain issues presented
by investment advisory programs by proposing rule 3a-4 under the
Investment Company Act, which would have provided a safe harbor from
the definition of investment company for investment advisory programs
operating in the manner described in the rule.10 Commenters
generally opposed the proposed rule, and it was never adopted.11
After this proposal, however, the Commission's Division of Investment
Management (``Division'') received numerous requests for assurance that
it would not recommend enforcement action with respect to investment
advisory programs if they operated without registering under the
Investment Company Act. In response to these requests, the staff issued
a series of no-action letters describing investment advisory programs
that would not be deemed investment companies for purposes of the
Investment Company Act.12 Many, if not most, of the programs
described in the no-action letters met the terms specified in the
proposed rule.
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\10\ Individualized Investment Management Services, Investment
Company Act Release No. 11391 (Oct. 10, 1980), 45 FR 69479 (Oct. 21,
1980) (``1980 Release''). The 1980 Release also stated that the
Commission's Division of Corporation Finance had indicated that if
rule 3a-4 were adopted, that Division would not recommend that the
Commission take enforcement action if interests in an investment
advisory program operated in accordance with the proposed rule's
requirements were not registered under the Securities Act. Id. at
n.15.
\11\ See July Release, supra note 5, at n.20 and accompanying
text.
\12\ See, e.g., Benson White & Company (pub. avail. June 14,
1995); Wall Street Preferred Money Managers, Inc., supra note 2;
Rauscher Pierce Refsnes, Inc., supra note 3; Westfield Consultants
Group, supra note 3; WestAmerican Investment Company (pub. avail.
Nov. 26, 1991); Rushmore Investment Advisers, Ltd. (pub. avail. Feb.
1, 1991); Qualivest Capital Management, Inc. (pub. avail. July 30,
1990); United Missouri Bank of Kansas City, n.a., supra note 2;
Manning & Napier Advisors, Inc. (pub. avail. Apr. 24, 1990);
Jeffries & Company (pub. avail. June 16, 1989); Strategic Advisers,
Inc., supra note 2; Scudder Fund Management Service (pub. avail.
Aug. 17, 1988); Shearson/American Express, Inc. (pub. avail. July
13, 1983); Paley & Ganz, Inc. (pub. avail. Dec. 6, 1982).
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On July 27, 1995, the Commission proposed for comment a revised
version of rule 3a-4 (``revised proposed rule 3a-4'' or ``revised
proposed rule,'' proposed for comment in the ``July Release'').13
The objective of the revised proposed rule was to clarify the
Commission's views regarding the status of investment advisory programs
under the federal securities laws by describing certain basic
attributes of an investment advisory program that differ from those of
an investment company that is required to register under the Investment
Company Act.14 The revised proposed rule was based largely on the
provisions of the rule as originally proposed, as modified and
explained in the subsequent no-action letters, but also required the
creation and maintenance of certain documents and records. Like the
original proposal, revised proposed rule 3a-4 would have provided a
nonexclusive safe harbor from the definition of investment company for
investment advisory programs that are organized and operated in the
manner described in the rule.15
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\13\ July Release, supra note 5.
\14\ July Release, supra note 5, at Section I.
\15\ The Note to the revised proposed rule stated that interests
in investment advisory programs organized and operated in compliance
with the rule would not be required to be registered under the
Securities Act. See July Release, supra note 5, at n.26 and
accompanying text; Note to revised proposed rule 3a-4.
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The Commission received comments on the revised proposed rule from
28 commenters, including three law firms, eight professional and trade
associations, and 17 financial firms (i.e., brokers, banks, investment
advisers and others).16 Commenters generally expressed support for
the Commission's goal of providing a nonexclusive safe harbor from the
definition of investment company for certain investment advisory
programs. A number of commenters, however, raised concerns about
particular aspects of the rule. Many of these comments are discussed in
more detail below.17
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\16\ The comment letters and a summary of the comments prepared
by the Commission staff are included in File No. S7-24-95.
\17\ See infra Section II.E.
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II. Discussion
The Commission is adopting rule 3a-4 under the Investment Company
Act. Like the proposed and revised proposed rules, rule 3a-4 provides a
nonexclusive safe harbor from the definition of investment company for
investment advisory programs that are organized
[[Page 15101]]
and operated in the manner described in the rule. The rule's provisions
have the effect of ensuring that clients in a program relying on the
rule receive individualized treatment, including the opportunity to
place investment restrictions on the management of their accounts and
the right to receive disclosure documents in connection with securities
held in their accounts. Moreover, if an advisory program were operated
by an investment adviser registered under the Advisers Act, clients of
the program would receive the protections of that Act. The safe harbor
thus is designed to provide an exemption for certain investment
advisory programs without undermining the protection of investors who
participate in those programs.
A. Preliminary Matters
Several commenters supporting the goals underlying rule 3a-4 asked
the Commission to clarify the scope of the rule. Two commenters, for
example, asked the Commission to clarify that investment advisory
programs that contemplate advisers not having investment discretion
over their clients' assets generally do not need the safe harbor to
avoid investment company status. The Commission notes that rule 3a-4 is
intended to provide a safe harbor for discretionary investment advisory
programs. A nondiscretionary program (i.e., one in which the investor
has the authority to accept or reject each recommendation to purchase
or sell a security made by the portfolio manager, and exercises
judgment with respect to such recommendations), generally will not meet
the definition of investment company under the Investment Company Act
or issue securities that are required to be registered under Section 5
of the Securities Act, regardless of whether the program is operated in
accordance with the provisions of rule 3a-4.18
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\18\ Whether a program is nondiscretionary is inherently a
factual determination. A program designated as ``nondiscretionary''
in which the client follows each and every recommendation of the
adviser may raise a question whether the program in fact is
nondiscretionary.
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One commenter asked the Commission to clarify that a program's
failure to operate in a manner consistent with every provision of the
rule would not preclude the program from relying on the safe harbor.
The rule sets forth circumstances under which an investment advisory
program will not be considered an investment company, and a program
that is not organized and operated in accordance with the rule's
provisions cannot rely on the safe harbor. The safe harbor provided by
the rule, however, is designed to be nonexclusive. Failure to operate
in the manner described in rule 3a-4 does not necessarily indicate that
a program is an investment company. Whether a program that operates
outside of rule 3a-4 is an investment company is a factual
determination and depends on whether the program is an issuer of
securities under the Investment Company Act and the Securities
Act.19
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\19\ In the July Release, the Commission noted that an
investment advisory program could be considered to be an issuer
because the client accounts in the program, taken together, could be
considered to be an organized group of persons. See July Release,
supra note 5, at nn.11-15 and accompanying text; see also Advisory
Committee on Investment Management Services for Individual
Investors: Small Account Investment Management Services at 23 (Jan.
1973). (``An investment service which is operated on a discretionary
basis and does not afford investors individual attention would
appear to be offering an investment contract or security, if
substantially the same investment advice is given to all clients or
to discernible groups of clients. * * *'')
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Commenters suggested that, rather than addressing the status of
investment advisory programs under the Securities Act in a note to rule
3a-4, the rule itself should provide that interests in the programs do
not constitute ``securities'' within the meaning of the Securities
Act.20 While the Commission has not revised the rule in this
regard, it has revised the Note so that it does not imply that
investment advisory programs organized and operated in accordance with
the rule may result in the issuance of securities under the Securities
Act.21
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\20\ In letters issued by the Division of Investment Management
granting no-action assurances to investment advisory programs, the
Division of Corporation Finance also gave assurances that it would
not recommend enforcement action to the Commission if the requestor
relied on an opinion of counsel stating that interests in the
investment advisory program were not ``securities'' within the
meaning of the Securities Act. See, e.g., Morgan Keegan & Company,
Inc., supra note 12; Westfield Consultants Group, supra note 3;
Rauscher Pierce Refsnes, Inc., supra note 3.
\21\ The Note to rule 3a-4 states, in part, that there is no
registration requirement under section 5 of the Securities Act with
respect to programs that are organized and operated in the manner
described in the rule.
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The Commission noted in the July Release that the adoption of rule
3a-4 would not affect the status of no-action letters previously issued
by the Division with respect to investment advisory programs.
Therefore, investment advisory programs operated in a manner consistent
with those letters would continue not to be required to register under
the Investment Company Act, and interests in the programs would not be
required to be registered as securities under the Securities Act. The
Commission also stated in the July Release that the Division, as a
general matter, would not consider requests for no-action or exemptive
relief with respect to programs that do not rely on the rule.22 In
making this statement, the Commission sought to indicate that in the
future, the staff ordinarily will not respond to no-action requests or
support applications for exemptive relief regarding investment advisory
programs that are similar to those programs that have been the subject
of the no-action letters issued by the Division, but that are not
operated in accordance with all the provisions of rule 3a-4. The staff,
however, will in the future consider requests raising interpretive
issues under rule 3a-4, and will continue to entertain no-action
requests with respect to programs that raise unique or novel
issues.23
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\22\ July Release, supra note 5, at n.27.
\23\ The staff previously has indicated that it will no longer
entertain requests for no-action relief regarding investment
advisory programs unless they present novel or unusual issues. See,
e.g., Wall Street Preferred Money Managers, Inc., supra note 2.
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B. Definitions
1. The Sponsor
A number of the terms of the revised proposed rule provided that
the ``sponsor'' of a program or another person designated by the
sponsor must perform the duties and responsibilities set forth in the
rule. Under paragraph (b) of revised proposed rule 3a-4, ``sponsor''
would have been defined as any person who receives compensation for
sponsoring, organizing or administering the program, or for selecting,
or providing advice to clients regarding the selection of, persons
responsible for managing the client's account in the program. Revised
proposed rule 3a-4 would have provided that, if a program had more than
one sponsor, one person would need to be designated as the principal
sponsor, and that person would be responsible for carrying out the
sponsor's duties and responsibilities under the rule.24 The July
Release noted that this definition and approach was the same as that
used in paragraph (f) of rule 204-3 under the Advisers Act, which sets
forth a separate brochure requirement for sponsors of wrap fee
programs.25
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\24\ July Release, supra note 5, at Section II.A.1.
\25\ The sponsor of an investment advisory program usually is an
investment adviser under Section 202(a)(11) of the Advisers Act, and
may be required to register under the Act. See July Release, supra
note 5, at nn.5-8 and accompanying text and note 6 of this Release.
Nonetheless, the rule is available to any investment advisory
program, regardless of whether the sponsor is excepted from the
definition of investment adviser (e.g., a bank), or is required to
be registered under the Act.
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[[Page 15102]]
Some commenters were critical of the broad scope of the proposed
definition of sponsor, noting that a program could have multiple
sponsors under the definition, and asserting that the existence of
multiple sponsors would serve no purpose in assuring that clients in a
program receive individualized management services or that the program
operates in the manner specified in the rule. One commenter suggested
that the definition should be modified to reach only the manager that
sponsors the program and participates in the management of the client's
investment portfolio (or selects another person designated to perform
such management services). The Commission notes that the structure of
programs may vary widely, and that the broad definition of the term
sponsor is intended to anticipate such variations and to provide
persons involved in a program with the flexibility to designate the
person in the best position to fulfill the rule's provisions. The
Commission thus has determined to adopt the definition as proposed in
order to preserve this flexibility.26
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\26\ Paragraph (b) of rule 3a-4, as adopted.
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2. Investment Advisory Program
The safe harbor described in revised proposed rule 3a-4 would have
been available to a ``program under which investment advisory services
are provided to clients.'' The revised proposed rule, however, did not
specifically define the term ``program.'' Certain commenters requested
that the Commission provide further guidance as to what constitutes a
program. The Commission notes that the use of the term ``program'' in
the rule is intended to describe the types of advisory services that
potentially could be subject to the Investment Company Act and the
Securities Act. The Commission does not believe that it is necessary or
advisable to include a definition of program in the rule, because such
a definition could result inadvertently in the exclusion from the scope
of the rule of an entity that otherwise would be entitled to rely on
it.
C. Provisions Designed To Ensure That Each Client Receives
Individualized Treatment
Revised proposed rule 3a-4 contained four provisions relating to
the individualized treatment received by clients in investment advisory
programs covered by the rule. The July Release stated that these
provisions were based on the terms of rule 3a-4 as originally proposed,
as those provisions were applied in the no-action letters.27 The
rule as adopted includes these four provisions, with certain
modifications discussed below.
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\27\ July Release, supra note 5, at Section II.A.2.
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1. Individualized Management of Client Accounts
Paragraph (a)(1) of the revised proposed rule provided that a
client's account must be managed on the basis of the client's financial
situation, investment objectives and instructions. The July Release
noted that this provision was designed to delineate a key difference
between clients of investment advisers and investors in investment
companies. A client of an investment adviser typically is provided with
individualized advice that is based on the client's financial situation
and investment objectives. In contrast, the investment adviser of an
investment company need not consider the individual needs of the
company's shareholders when making investment decisions, and thus has
no obligation to ensure that each security purchased for the company's
portfolio is an appropriate investment for each shareholder.28 The
Commission is adopting paragraph (a)(1) without substantive
modification.29
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\28\ July Release, supra note 5, at Section II.A.2.i.
\29\ As noted above, paragraph (a)(1) of the revised proposed
rule provided that a client's account must be managed on the basis
of the client's financial situation, investment objectives and
instructions (emphasis added). The Commission has determined that
individualized treatment does not require that the client be
entitled to give instructions to the adviser with respect to the
management of the account other than those reasonable restrictions
referenced in paragraph (a)(3). Therefore, the Commission has
clarified the rule text by replacing the word ``instructions'' with
the word ``restrictions.'' Nonetheless, the rule contemplates that a
client's investment objective will be formulated with appropriate
input from the client regarding the client's financial goals and
risk tolerance.
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In the July Release, the Commission noted that clients of an
investment advisory program with similar investment objectives may hold
substantially the same securities in their accounts in accordance with
a portfolio manager's model, and that this does not necessarily
indicate that clients in the program have not received individualized
treatment for purposes of the rule.30 The Commission is
reaffirming this position in connection with the adopted rule.31
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\30\ July Release, supra note 5, at n.34 and accompanying text.
\31\ As indicated in the July Release, this position is
consistent with no-action letters issued concerning programs that
allocate client assets in accordance with computerized investment
models. July Release, supra note 5, at n.34 and accompanying text;
see, e.g., Qualivest Capital Management Inc., supra note 12 (sponsor
proposed to use computerized investment allocation model to allocate
client assets among money managers).
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The Commission also stated in the July Release that it would not be
necessary under the rule for a portfolio manager to make separate
determinations regarding the appropriateness of each transaction for
each client prior to effecting the transaction. One commenter
supporting the Commission's position with respect to model portfolios
nonetheless urged the Commission to require the sponsor or program
manager specifically to evaluate the suitability of each transaction
for each client. This commenter maintained that, without such
individualized determinations, clients of an investment advisory
program would not receive individualized advice.
Investment advisers under the Advisers Act owe their clients the
duty to provide only suitable investment advice, whether or not the
advice is provided to clients through an investment advisory
program.32 To fulfill this suitability obligation, an investment
adviser must make a reasonable determination that the investment advice
provided is suitable for the client based on the client's financial
situation and investment objectives. The adviser's use of a model to
manage client accounts would not alter this obligation in any way.
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\32\ See Suitability of Investment Advice Provided by Investment
Advisers: Custodial Account Statements for Certain Advisory Clients,
Investment Advisers Act Release No. 1406 (Mar. 16, 1994), 59 FR
13464 (Mar. 22, 1994) at nn.2-5 and accompanying text (``Investment
advisers are fiduciaries who owe their clients a series of duties,
one of which is the duty to provide only suitable investment advice.
This duty is enforceable under the antifraud provisions of the
Advisers Act, section 206, and the Commission has sanctioned
advisers for violating this duty.'').
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2. Initial and Ongoing Client Contact
Paragraph (a)(2) of revised proposed rule 3a-4 reflects the view
that providing individualized investment advice contemplates an adviser
having sufficient contact with a client to elicit the information
necessary to provide the advice. In particular, under paragraph (a)(2),
a program relying on the rule must provide that the sponsor or a person
designated by the sponsor (``designated person'') contact and solicit
information from the client. Such a program also must provide for the
sponsor and the portfolio manager to be reasonably available to consult
with the client concerning the management of the client's account.
Under paragraph (a)(2) of the revised proposed rule, an advisory
program intended to qualify for the safe harbor
[[Page 15103]]
set out in the rule would have needed to require that the sponsor or a
designated person: (1) obtain information from the client concerning
the client's financial situation and investment objectives (including
any restrictions that the client may wish to impose regarding the
management of the account) at the time the client opens the account;
33 (2) contact the client at least annually to determine whether
there have been any changes in the client's financial situation or
investment objectives, or whether the client wishes to impose any
reasonable restrictions on the management of the account or modify an
existing restriction in a reasonable manner; and (3) notify the client
in writing at least quarterly that the sponsor or designated person
should be contacted if there have been any changes in the client's
financial situation or investment objectives, or if the client wishes
to impose or modify any restrictions on the management of the account.
The Commission is adopting these three provisions as proposed, with
minor modifications to clarify their meaning.34
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\33\ A sponsor or designated person seeking to rely on the rule
as adopted could obtain this information through interviews (either
in person or by telephone) and/or through questionnaires that
clients must complete and return prior to the opening of the
account. This position is consistent with no-action letters
previously issued by the staff. See, e.g., Rauscher Pierce Refsnes,
Inc., supra note 3 (prospective client will be interviewed over the
telephone); Manning & Napier Advisors, Inc., supra note 12
(prospective client initially submits written questionnaire and
later is interviewed by telephone).
\34\ Paragraphs (a)(2)(i), (a)(2)(ii) and (a)(2)(iii) of rule
3a-4, as adopted.
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In the July Release, the Commission noted that the provision
regarding annual client contact was designed to ensure that sponsors
have current information about clients in the program, which, in the
Commission's view, is critical to the provision of individually
tailored advice.35 Like the revised proposed rule, the rule as
adopted does not dictate the manner in which a sponsor contacts its
clients annually.36 Contact can be made, for example, in person,
by telephone, or by letter or electronic mail that includes a
questionnaire requesting the client to provide or update relevant
information.37
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\35\ July Release, supra note 5, at Section II.A.2.ii.
\36\ Paragraph (a)(2)(ii) of rule 3a-4, as adopted. One
commenter asked whether the rule permits a sponsor or designated
person to contact a client by electronic mail. Under appropriate
circumstances, an electronic mail message requesting information
from clients in the program would constitute annual client contact
within the meaning of rule 3a-4. See Use of Electronic Media by
Broker-Dealers, Transfer Agents, and Investment Advisers for
Delivery of Information; Additional Examples under the Securities
Act of 1933, Securities Exchange Act of 1934, and Investment Company
Act of 1940, Securities Exchange Act Release No. 37182 (May 9,
1996), 61 FR 24644 (May 15, 1996) (interpretive release in which the
Commission, among other things, provided general guidance to
investment advisers that contemplate using electronic media to
fulfill their disclosure obligations under the Advisers Act).
\37\ This provision of the rule contemplates a reasonable
attempt by the sponsor or designated person to reach and obtain
information from the client. A sponsor or designated person that is
unable to obtain information from a client after pursuing all
reasonable means to contact the client would not be precluded from
relying on the safe harbor.
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The rule, as adopted, provides that the sponsor or a designated
person seeking to rely on the rule must notify the client in writing at
least quarterly that the sponsor or designated person should be
contacted if there have been any changes in the client's financial
situation or investment objectives, or if the client wishes to impose
or modify restrictions concerning the management of the account.38
This provision contemplates only that notice will be given to an
investor, while the annual contact provision described above
contemplates that the sponsor (or the designated person) will actively
attempt to contact the client to obtain information in order to be
covered by the rule.39
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\38\ Paragraph (a)(2)(iii) of rule 3a-4, as adopted. This notice
could be included as part of or with another mailing sent to the
client. For example, the notification could be included as part of
the quarterly account statement described in paragraph (a)(4) of the
rule. For a discussion of the provisions of rule 3a-4 stating that
quarterly account statements must be sent to investment advisory
clients, see infra Section II.C.4.
\39\ For this reason, the Commission disagrees with those
commenters who asserted that the annual contact and quarterly
notification provisions are duplicative.
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In the July Release, the Commission noted that, if the sponsor did
not provide the portfolio manager with information obtained from the
client, the manager might be unable to manage the client's account on
the basis of the client's financial situation and investment objectives
and in accordance with any reasonable restrictions imposed by the
client. The Commission requested comment whether the rule should state
explicitly that the sponsor or designated person must convey to the
portfolio manager the information obtained from the client.40 Some
commenters stated that the rule should contain an explicit provision to
that effect, while others suggested that such a provision was
unnecessary. It would appear unlikely that the provision of paragraph
(a)(1) providing that the account be managed based on the client's
financial situation and investment objectives and in accordance with
reasonable restrictions imposed by the client could be satisfied if the
sponsor failed to transmit the client's financial information to the
portfolio manager. The Commission therefore has determined not to
include in rule 3a-4 an explicit requirement that the information must
be provided to the portfolio manager.
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\40\ July Release, supra note 5, at Section II.A.2.ii.
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Paragraph (a)(2) of the revised proposed rule would have provided
that the sponsor and persons authorized to make investment decisions
for the client's account be reasonably available to consult with the
client concerning the management of the account. In the July Release,
the Commission indicated that this provision contemplated a client's
having reasonable access to the sponsor and the portfolio manager to
ask questions or to seek additional information about the investment
advisory program or the client's account.41 The Commission
recognizes that a program's sponsor may serve as the primary contact
for clients in the program, and that direct client contact with the
portfolio manager may not occur until after the sponsor and others have
attempted to address the client's questions or concerns. Nonetheless,
in the Commission's view, a program seeking to rely on the rule must
provide a procedure by which each client has reasonable access to
personnel of the manager who are knowledgeable about the management of
the client's account, as necessary to respond to the client's
inquiry.42 Therefore, the Commission is adopting this provision of
the revised proposed rule with the modification discussed below.
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\41\ Id.
\42\ This view is reflected in staff no-action letters. See,
e.g., Rauscher Pierce Refsnes, Inc., supra note 3 (the portfolio
manager, when necessary, will be available to discuss more complex
questions regarding the client's account); Westfield Consultants
Group, supra note 3 (client will be furnished the name and direct
telephone number of manager, who will be reasonably available during
business hours). In one no-action request, a representation was made
that the client would be able to contact his or her financial
planner or the portfolio manager to obtain information or assistance
during normal business hours, but the client might be charged hourly
fees whenever the client requested that certain investment officers
of the portfolio manager answer specific questions regarding
investment strategies with respect to the client's account. Manning
& Napier Advisors, Inc., supra note 12. Rule 3a-4 does not preclude
a sponsor from charging reasonable fees for this or other services.
However, such fees must be adequately disclosed to the client. See
Item 7(f) of Schedule H of Form ADV (requiring disclosure of any
fees in addition to the wrap fee that a client in a wrap fee program
may pay).
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Several commenters suggested that the rule should permit delegation
of the client consultation responsibilities to an employee of the
advisory firm managing the client's account who is
[[Page 15104]]
knowledgeable about investment and other matters relevant to the
account. The rule has been revised to state that ``the sponsor and
personnel of the manager of the client's account who are knowledgeable
about the account and its management'' must be reasonably available to
the client for consultation.43 In accordance with this provision,
the contact person need not be the individual primarily responsible for
managing the account, but must be sufficiently knowledgeable to discuss
and explain investment decisions that were made.
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\43\ Paragraph (a)(2)(iv) of rule 3a-4, as adopted.
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3. Reasonable Management Restrictions
The Commission stated in the July Release that the ability of a
client in an investment advisory program to place reasonable
restrictions on the management of his or her account is a critical
factor in determining whether individualized treatment is provided
under the program.44 Paragraph (a)(3) of the revised proposed
rule, therefore, would have provided that a program relying on the rule
must include a requirement that each client have the ability to impose
reasonable restrictions on the management of his or her account. Such
restrictions were described to include, for example, prohibitions with
respect to the purchase of particular securities or types of
securities. This provision of the rule is being adopted as reproposed,
except that language has been added to the provision to clarify that a
program relying on rule 3a-4 need not provide clients with the right to
direct the manager to purchase specific securities or types of
securities.45
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\44\ July Release, supra note 5, at Section II.A.2.iii.
\45\ Paragraph (a)(3) of rule 3a-4, as adopted.
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Some of the commenters addressing this aspect of the proposal asked
the Commission to provide additional guidance as to what constitutes a
reasonable management restriction. As noted in the July Release,
whether a particular restriction would be reasonable depends on an
analysis of the relevant facts and circumstances.46 In general, a
restriction would be unreasonable if it is clearly inconsistent with
the portfolio manager's stated investment strategy or philosophy or the
client's stated investment objective,47 or is fundamentally
inconsistent with the nature or operation of the program.48 Other
factors that bear on whether a particular restriction is reasonable are
the difficulty in complying with the restriction,49 the
specificity of the restriction and the number of other restrictions
imposed by the client.50 A restriction would not be unreasonable,
however, simply because it placed administrative burdens on the
manager, or could affect the performance of the account.
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\46\ July Release, supra note 5, at Section II.A.2.iii.
\47\ July Release, supra note 5, at Section II.A.2.iii. The
exclusion of individual stocks or stocks from a particular country,
for example, would appear to be a reasonable restriction under
ordinary facts and circumstances. A general restriction on the
purchase of the securities of foreign issuers may be unreasonable,
however, if the manager's investment strategy is to invest
exclusively or primarily in foreign securities. Under those
circumstances, it may be necessary for the client and the sponsor to
reassess the choice of manager or the client's investment objective
or strategy.
\48\ July Release, supra note 5, at Section II.A.2.iii. While
rule 3a-4 generally contemplates that clients in mutual fund asset
allocation programs should have the ability to exclude specific
funds from their accounts, under some circumstances a restriction on
the purchase of a fund included in the program may be inconsistent
with the operation of the program. This could be the case, for
example, when there is only a single fund with a specified
investment objective available in the program, and that fund plays a
necessary role in the overall investment strategy determined to be
appropriate for the client. See Benson White & Company, supra note
12 (program under which client assets are allocated among four
mutual funds based upon the client's age need not give clients the
opportunity to place restrictions on the purchase of any of the
funds).
\49\ In the context of a mutual fund asset allocation program,
for example, compliance with restrictions based on the securities
held by a fund in which program assets are invested (i.e., a
restriction that would require a manager to monitor the fund's
portfolio securities) may be so burdensome as to be unreasonable.
\50\ The restrictions that a client seeks to impose on his or
her account could be unreasonable when considered in the aggregate,
even though each restriction may be reasonable when considered
separately, or if the client alters them or imposes new restrictions
with excessive frequency. Paragraph (a)(2)(iii) of the rule, which
contemplates that a sponsor notify each client at least quarterly to
contact the sponsor if the client wishes to modify restrictions
concerning the management of the account, is not intended to imply
that it necessarily would be reasonable for a client to change his
or her investment restrictions on a quarterly basis.
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The Commission stated in the July Release that if the sponsor or
portfolio manager of a program concluded that a particular restriction
sought to be imposed by a client was unreasonable, the client should be
notified and given an opportunity to restate the restriction more
reasonably. The Commission also noted that if a client was unable or
unwilling to modify an unreasonable restriction, then the client could
be removed from the program without jeopardizing reliance on the safe
harbor.51 The Commission is also of the view that if a sponsor or
portfolio manager is informed in advance that a client wants to impose
a restriction the sponsor or portfolio manager deems unreasonable, and
the client refuses to modify the restriction, then the sponsor or
portfolio manager may refuse to accept the client. The Commission,
however, does not agree with the suggestion of some commenters that a
sponsor or portfolio manager should be permitted to refuse to accept a
client without giving the client an opportunity to modify or withdraw
the restriction.
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\51\ July Release, supra note 5, at Section II.A.2.iii.
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4. Quarterly Account Statements
Paragraph (a)(4) of the revised proposed rule stated that each
client in a program covered by the rule must be provided quarterly with
a statement describing all activity in the client's account during the
preceding quarter, including all transactions made on behalf of the
account, all contributions and withdrawals made by the client, and all
fees and expenses charged to the account. The statement also would have
included the value of the account at both the beginning and end of the
quarter. Some commenters asserted that the rule should not specify the
contents of quarterly statements. The Commission is not persuaded by
this argument. This provision, which is consistent with several no-
action letters that had specified the contents of the quarterly
reports,52 reflects the view that a key element of individualized
advisory services is an individualized report about a client's account.
The Commission therefore is adopting this provision substantially as
proposed, with one modification clarifying that statements may be sent
more often than quarterly.53
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\52\ See Westfield Consultants Group, supra note 3 (quarterly
statements will contain a review and analysis of client account);
Strategic Advisers, Inc., supra note 2 (quarterly statements will
contain a description of investments).
\53\ Paragraph (a)(4) of rule 3a-4, as adopted.
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5. Minimum Account Size
The revised proposed rule would not have specified a minimum size
for client accounts in a program.54 While the Commission
acknowledged in the July Release that providing individualized advice
to a large number of relatively small accounts may be so costly and
time-consuming as to render individualized treatment impracticable, it
noted that the provisions of the revised proposed rule should be
sufficient to ensure individualized treatment, and that innovations in
computer technology may allow portfolio managers to render
individualized treatment to relatively small accounts on a cost-
effective
[[Page 15105]]
basis.55 Nonetheless, the Commission requested comment whether the
rule should include a provision specifying a minimum account size.
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\54\ The Division has granted no-action relief to investment
advisory programs with varying minimum account sizes. See, e.g.,
Qualivest Capital Management, Inc., supra note 12 ($5 million); Wall
Street Preferred Money Managers, Inc., supra note 2 ($100,000);
Strategic Advisers, Inc., supra note 2 ($50,000).
\55\ July Release, supra note 5, at Section II.A.2.v.
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All but one of the commenters responding to the request for comment
opposed the inclusion of a minimum account size provision in rule 3a-4.
These commenters asserted that the sponsor and the portfolio manager
are in the best position to determine the appropriate minimum account
size for a program based upon the nature of the program. The Commission
has concluded that a particular account size is not a necessary element
to ensure that clients are provided with individualized investment
management services. The Commission recognizes, however, that the
smaller the minimum account size of an investment advisory program, the
more likely that clients would not have the ability to demand and
receive individualized treatment in the program. In assessing the
status under the Investment Company Act of a program that does not
qualify for the safe harbor under rule 3a-4, therefore, the Commission
will consider a relatively large minimum account size as evidence that
individualized treatment is being provided to clients of the program.
D. Client Retention of Ownership of Securities
Under paragraph (a)(5) of the revised proposed rule, a program
covered by the rule would have been characterized by each client
retaining certain specified indicia of ownership of all securities and
funds in that client's account.56 The Commission stated in the
July Release that the indicia of ownership specified in revised
proposed rule 3a-4 are those that provide clients with the ability to
act as owners of the securities in their accounts.57
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\56\ Rule 3a-4, as originally proposed, would have provided that
clients maintain to the extent reasonably practicable all indicia of
ownership of the funds in their accounts, and specified certain
requisite attributes of ownership. 1980 Release, supra note 10;
paragraph (c) of rule 3a-4 as originally proposed.
\57\ Like the revised proposed rule, rule 3a-4 as adopted does
not provide that the client be the record owner of the securities
held in its account. The Division has taken the position that an
investment advisory program would not be deemed to be an investment
company solely because securities of clients participating in the
program are held in nominee or street name. United Missouri Bank of
Kansas City, n.a., supra note 2 (investment company securities held
in nominee name). See, e.g., Manning & Napier Advisors, Inc., supra
note 12 (non-investment company securities held in nominee name).
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A number of commenters addressing this aspect of the revised
proposed rule noted circumstances in which the client's ability to
exercise ownership rights over securities in his or her account could
be restricted for reasons external to the program. One commenter
pointed out, for example, that the assets in the account of a self-
directed retirement plan may be subject to restrictions imposed by the
terms of the plan or by federal tax law.58 These commenters were
concerned that such restrictions may preclude the program from relying
on the safe harbor.
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\58\ This commenter suggested that providing the right to pledge
securities in the account of a retirement plan could cause the plan
to lose its status as a qualified plan under the Internal Revenue
Code. In general, a qualified plan must provide that benefits under
the plan may not be anticipated, assigned, alienated, or subject to
attachment, garnishment, levy, execution, or other legal process.
See Internal Revenue Code (``IRC'') Section 401(a)(13) [26 U.S.C.
401(a)(13)]; Treas. Reg. Sec. 1.401(a)-13 (as amended by T.D. 8219,
53 FR 31837 (Aug. 22, 1988)). In addition, the IRC imposes an
additional tax of 10% on early distributions from a qualified
retirement plan. See IRC Section 72(t)(1) [26 U.S.C. 72(t)(1)].
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Paragraph (a)(5) of rule 3a-4 contemplates only that the program
does not impose additional restrictions or limitations on client
ownership of securities held in program accounts, and that a client's
participation in the program will not alter his or her ability to
exercise the ownership rights enumerated in the rule.59 The
language of the rule has been modified to clarify this standard.60
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\59\ Similarly, paragraph (a)(5) would not prohibit a client
from being charged reasonable fees for services in connection with
the ownership of securities held in the program, provided such fees
could be charged if the client held the securities outside the
program. Of course, all fees must be permissible under applicable
state and federal law and must be adequately disclosed. See Item 7
of Schedule H of Form ADV.
\60\ Paragraph (a)(5) of rule 3a-4, as adopted. The rule's text
also has been changed to clarify that the rule provides for the
retention of only the rights of ownership specified in the rule. Of
course, nothing in the rule is intended to prevent clients from
retaining other rights of ownership, if permitted by the program.
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1. Ability to Withdraw and Pledge Securities
The revised proposed rule would have provided that clients be able
to withdraw securities or cash from their accounts. In addition,
revised proposed rule 3a-4 also would have specified that clients be
able to pledge the securities in their accounts. The July Release
stated that investment advisory programs relying on the safe harbor
could require a client to withdraw securities from his or her account
before using them as collateral.61
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\61\ July Release, supra note 5, at Section II.A.3.i.
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A number of commenters maintained that the retention by clients of
the right to pledge securities should be eliminated from the final
rule. One of these commenters asserted that, because clients may be
forced to withdraw their securities before pledging them, the provision
of the revised proposed rule regarding the right to pledge securities
is unnecessary if the client has the right to withdraw them. The
Commission agrees, and has modified the rule text to remove this
provision.62
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\62\ The Commission regards a client's ability to pledge
securities in his or her account directly without first withdrawing
them as an additional attribute of the client's ownership of the
securities. While the absence of a right to pledge would not cause a
program to fall outside of rule 3a-4, a client's right to pledge
securities may be relevant to determining whether a program that is
not relying on the safe harbor would be considered to be an
investment company.
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2. Right to Vote Securities and Receive Certain Documents as
Securityholders
The revised proposed rule would have provided that the client have
the right to vote the securities in his or her account. This provision
would have permitted clients to delegate the authority to vote
securities to another person, such as the portfolio manager or other
fiduciary, so long as the client retained the right to revoke the
delegation at any time. The Commission indicated that the right to vote
proxies implied that the client would receive proxy materials in
sufficient time to permit the client to consider how to vote and to
submit the proxies.63 The Commission is clarifying that, if a
client delegates voting rights to another person, the proxies, proxy
materials, and, if applicable, annual reports, need be furnished only
to the party exercising the delegated voting authority.64
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\63\ July Release, supra note 5, at Section II.A.3.ii.
\64\ See infra Section II.D.3. Rule 3a-4, as adopted, is in no
way intended to indicate the instances under which a client's right
to vote proxies may be delegated to another person. Whether the
right can be delegated depends on applicable state and federal law.
An employee benefit plan subject to the Employee Retirement Income
Security Act of 1974 (``ERISA''), for example, may provide that the
plan's named fiduciary may delegate asset management, including the
authority to vote proxies, to an ``investment manager'' for the
plan, as that term is defined in Section 3(38) of ERISA. See, e.g.,
Sections 402-405 of ERISA [29 U.S.C. Secs. 1102-1105]; Letter from
Alan D. Lebowitz, Deputy Assistant Secretary for Program Operations,
U.S. Department of Labor, to Robert A.G. Monks, Institutional
Shareholder Services, Inc. (Jan. 23, 1990), 1990 ERISA LEXIS 66.
Certain provisions of the federal securities laws also contemplate
that clients can delegate their right to vote proxies. Under the
Commission's proxy rules, the term ``beneficial owner,'' the person
who must receive proxy materials, includes an investment adviser
that has the power to vote, or to direct the voting of, a security
pursuant to an agreement with the client. See Securities Exchange
Act Rule 14b-2(a)(2) [17 CFR Sec. 240.14b-2]. Rules adopted by the
New York Stock Exchange (``NYSE''), the National Association of
Securities Dealers, Inc. (``NASD'') and the American Stock Exchange,
Inc. (``AMEX'') permit a securityholder to designate a registered
investment adviser who has discretion over the management of the
client's account to receive and vote proxies on his or her behalf.
See NYSE Guide, Rules of Board, Rules 450, 451, 452 and 465; NASD
Conduct Rules, Rule 2260; AMEX Rules 575, 576, 577 and 585.
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[[Page 15106]]
Revised proposed rule 3a-4 contemplated that the client (or the
client's agent) would be provided with documents that the client (or
agent) would have received had the same securities been owned by the
client outside the program. These documents may include prospectuses,
periodic shareholder reports, proxy materials, and any other
information and disclosure required by applicable laws or regulations.
Some commenters suggested that clients be permitted to waive
receipt of the documents generally required to be provided to
securityholders, as they could have waived receipt of immediate
confirmations under the revised proposed rule.65 Rule 3a-4 does
not limit a client's right to waive receipt of these documents. Nor
does rule 3a-4 prohibit a client from making an informed designation of
another person, including a financial planner or registered broker-
dealer, to receive such documents on the client's behalf.66
Whether a client in an investment advisory program may waive receipt of
documents or designate another person to receive documents depends upon
whether the client would have been able to do so under applicable
federal or state law if the securities were owned directly.
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\65\ See infra Section II.D.3.
\66\ In the revised proposed rule, the paragraph regarding
receipt of documents specifically referred to receipt by the
client's agent. Paragraph (a)(5)(iv) of revised proposed rule 3a-4;
July Release, supra note 5, at Section II.A.3.iii. In connection
with modifying the rule text to effect the changes discussed above,
supra Section II.D, the reference to the client's agent has been
deleted as a conforming change. These changes in the rule text are
not intended to indicate that a client in an investment advisory
program may not designate another person to receive documents that
must be provided to securityholders by law.
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3. Right to Receive Trade Confirmations
The revised proposed rule contained a provision under which a
client would have the right to receive in a timely manner confirmations
of securities transactions of the type required by rule 10b-10 under
the Securities Exchange Act of 1934.67 Two commenters objected to
the provision of the rule that the confirmations be ``of the type
required by rule 10b-10.'' These commenters asserted that this
provision was burdensome, particularly with respect to banks and trust
companies that are not subject to rule 10b-10. The Commission has
decided that the confirmation provision, like the other indicia of
ownership specified in the rule, should apply only to the extent that
the client would have a right to receive confirmations from the person
executing the transaction if he or she traded the securities through
that person outside the program. Therefore, the Commission has revised
the provision of the rule addressing confirmations to delete the
reference to rule 10b-10. As revised, this provision would state that a
client in an investment advisory program must receive confirmations
that the person executing the transaction is required to send under the
laws regulating that person's activities. This provision of the rule
also provides that the confirmations must include the information
specified by the applicable law governing such content.68
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\67\ 17 CFR 240.10b-10.
\68\ Paragraph (a)(6) of rule 3a-4, as adopted. Banks that
execute securities transactions for customers generally are subject
to confirmation requirements under the banking laws. See, e.g., 12
CFR 12.4-12.5 (Office of the Comptroller of the Currency (``OCC'')
confirmation requirements for national banks). The OCC recently
proposed amendments to these rules that would make their
confirmation requirements more closely reflect the requirements of
rule 10b-10. OCC, Recordkeeping and Confirmation Requirements for
Securities Transactions (Dec. 7, 1995), 60 FR 66517 (Dec. 22, 1995).
In addition, the Federal Deposit Insurance Corporation (``FDIC'')
recently considered when and how to amend its regulations governing
recordkeeping and confirmation requirements for securities
transactions by state nonmember banks (12 CFR part 344). FDIC,
Recordkeeping and Confirmation Requirements for Securities
Transactions (May 14, 1996), 61 FR 26135 (May 24, 1996).
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As discussed in the July Release, rule 10b-10 permits customers of
registered broker-dealers to waive receipt of individual confirmations
in certain circumstances.69 A client in an investment advisory
program whose transactions are executed by a registered broker-dealer
effectively has the option to receive either individual confirmations
for each transaction or periodic statements, delivered no less
frequently than quarterly, that include the information required by
rule 10b-10 with respect to all transactions that occurred within the
period covered by the statement.70 Two commenters suggested that
the Commission clarify that an entity that is not required to be
registered with the Commission as a broker-dealer could rely on the
safe harbor if it sent quarterly statements to clients who waived their
rights to receive individual confirmations. As discussed above, the
confirmation provision in rule 3a-4 applies only to the extent that the
client would have a right to receive confirmations if he or she traded
the securities outside the program. A client's ability to waive receipt
of confirmations will not be altered because securities are held in a
program account. Whether a client whose transactions are not executed
by a registered broker-dealer may waive receipt of confirmations or
other transaction notifications must be determined by reference to the
laws that govern the relationship.71
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\69\ July Release, supra note 5, at n.60 and accompanying text,
citing Securities Exchange Act Release No. 34962 (Nov. 10, 1994), 59
FR 59612 (Nov. 17, 1994) (``Exchange Act Release 34962'').
\70\ Although a client may waive his or her right to receive the
immediate confirmation, the client may not waive his or her right to
receive the periodic statement. Exchange Act Release 34962, supra
note 68, at nn.34-36 and accompanying text.
\71\ One commenter observed that a person executing transactions
on behalf of a client whose shares are held in nominee name may not
know the identity of the client, and asked the Commission to clarify
how a program relying on the safe harbor could comply with the
confirmation provision with respect to such a client. In the case of
transactions effected by a registered broker-dealer, the Division of
Market Regulation has expressed the view that a good faith effort
should be made in these circumstances to obtain the information
necessary to send the confirmation required by rule 10b-10 directly
to the client. If these efforts are not successful, then the
confirmation should be sent, in accordance with certain procedures,
to the client's custodian or a fiduciary authorized to manage the
account. See Letter from Catherine McGuire, Chief Counsel, Division
of Market Regulation, U.S. Securities and Exchange Commission, to
George P. Miller, Vice President and Associate General Counsel,
Public Securities Association (Sept. 29, 1995).
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4. Legal Rights as Securityholders
Revised proposed rule 3a-4 would have provided that the client
retain the right to proceed directly against an issuer of securities in
a client's account without joining any other person involved in the
program. The July Release indicated that underlying this provision
(which was based on representations made in several no-action letters)
72 was the view that a key element of providing individualized
advisory services is that a client have the same rights as a person
holding the securities outside an investment advisory program.
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\72\ See, e.g., Westfield Consultants Group, supra note 3;
Manning & Napier Advisors, Inc., supra note 12; Jeffries & Company,
supra note 12; Rauscher Pierce Refsnes, Inc., supra note 3.
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Certain commenters suggested that this provision of the revised
proposed rule may be problematic with respect to client securities that
are held in nominee or street name, or by a trustee. These commenters
stated that the nominee or trustee might be considered an indispensable
party in any action against the issuer, and that nominal joinder of the
nominee or trustee might be required. These comments have been
addressed by the revision discussed above regarding restrictions on the
exercise of ownership rights that are
[[Page 15107]]
external to the program.73 Otherwise, the Commission is adopting
this provision as proposed.74
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\73\ See supra Section II.D.
\74\ Paragraph (a)(5)(iv) of rule 3a-4, as adopted.
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E. Policies and Procedures and Form N-3a4
Paragraph (a)(6) of revised proposed rule 3a-4 contemplated the
establishment by a program's sponsor of written procedures and
agreements governing the operation of the program, and the maintenance
of records relating to the program. Paragraph (a)(6) would have
provided that the sponsor must: (1) Establish and effect written
policies and procedures that are reasonably designed to ensure that
each of the provisions of the rule are implemented; (2) maintain and
preserve all written policies, procedures and certain other documents
relating to the program for specified periods of time; (3) enter into
written agreements with other persons that the sponsor designates to
retain records pertaining to the program; and (4) furnish to the
Commission upon demand copies of the policies, procedures and other
documents created pursuant to these policies and procedures. Paragraph
(a)(7) of the revised proposed rule would have provided that the
sponsor of an investment advisory program intending to rely on the safe
harbor file Form N-3a4 with the Commission.
In the July Release, the Commission specifically requested comment
whether any of the provisions under paragraph (a)(6) of the rule could
be ``eliminated, consolidated, or otherwise made less burdensome
without compromising investor protection.'' 75 Most commenters
addressing this aspect of the revised proposed rule viewed the
provisions as unnecessary, unduly burdensome, irrelevant to determining
whether an investment advisory program is an investment company under
the Investment Company Act, or as an improper attempt by the Commission
to regulate entities--principally banks--that are excepted from the
definition of investment adviser under the Advisers Act. A few
commenters also suggested that provisions setting forth written
policies and procedures would discourage sponsors from relying on the
safe harbor. For similar reasons, most commenters also opposed any
filing provision under the rule.
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\75\ July Release, supra note 5, at Section II.A.4.
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Although the Commission does not agree with many of the comments
pertaining to the proposed recordkeeping and other operational
provisions, the Commission has reevaluated these provisions and
determined not to adopt them for a number of reasons. First, the
Commission agrees that compliance with these types of formal procedural
provisions generally should not be determinative of an entity's status
under the Investment Company Act. As one commenter noted, none of the
other rules under the Investment Company Act exempting certain entities
from investment company regulation contain similar procedural
provisions.76
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\76\ See rule 3a-1 (certain prima facie investment companies);
rule 3a-2 (transient investment companies); rule 3a-3 (certain
investment companies owned by companies that are not investment
companies); rule 3a-5 (exemption for subsidiaries organized to
finance the operations of domestic or foreign companies); rule 3a-6
(foreign banks and foreign insurance companies); and rule 3a-7
(issuers of asset-backed securities).
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Second, with respect to programs sponsored by registered investment
advisers, the recordkeeping requirements under the Advisers Act and the
Commission's authority to examine registered investment advisers should
be sufficient to enable the Commission to detect violations of the
Investment Company Act. Most, if not all, of the records that would
have been covered by the revised proposed rule currently are required
to be maintained under rule 204-2 under the Advisers Act.77
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\77\ For instance, paragraph (a)(7) of rule 204-2 [17 CFR
275.204-2(a)(7)] generally requires a registered adviser to maintain
originals of all written communications received and copies of all
written communication sent by the adviser relating to the adviser's
advice or recommendations. Under section 204 of the Advisers Act,
records maintained under rule 204-2 must be made available to
Commission examiners.
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With respect to those investment advisory programs sponsored by
banks that are not subject to the Advisers Act, the Commission staff
intends to consult and work closely with the relevant banking agencies
so that these programs will be subject to oversight designed to
determine whether the programs are being operated as unregistered
investment companies. Further, to the extent these programs include
registered investment companies as investment vehicles for their
clients, or that registered investment advisers serve as subadvisers in
a program sponsored by a bank, the Commission will have access to
certain records relating to the programs through its authority to
examine such registered entities.
Despite its determination not to include in rule 3a-4 a provision
pertaining to written policies and procedures, the Commission continues
to believe that it is important for the sponsor of an investment
advisory program to monitor the program's compliance with the rule.
Each person relying on rule 3a-4 is responsible for demonstrating its
compliance with the rule's provisions. A sponsor that establishes and
implements written policies and procedures designed to ensure adherence
to the provisions of rule 3a-4 would greatly reduce the chance that the
program will fail to operate in the manner specified in the rule.
Moreover, the implementation of such procedures by an investment
adviser may serve to protect the adviser in certain instances from
liability for violating, or aiding and abetting violations of, the
Investment Company Act and/or the Securities Act, or failing to
supervise a person under the adviser's supervision who violates those
Acts.78 The Commission, therefore, strongly recommends that a
sponsor of an advisory program seeking to rely on rule 3a-4 establish
and implement written policies and procedures, and a system for
applying such procedures, that are reasonably designed to ensure that
the program operates in the manner contemplated by the rule.
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\78\ Section 203(e)(5) of the Advisers Act [15 U.S.C. 80b-
3(e)(5)] provides that no person will be deemed to have failed to
supervise another person subject to his or her supervision if: (1)
the person has established procedures that would reasonably be
expected to prevent or detect the other person's violation, and a
system for applying such procedures; and (2) the supervisor
reasonably discharged his or her duties under the procedures and
system and did not have reasonable cause to believe that such
procedures were not being complied with.
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The Commission also believes that it would be advisable for a
person seeking to rely on rule 3a-4 to maintain the records necessary
to evidence compliance with the rule, even if the person is not subject
to rule 204-2 under the Advisers Act or certain of the records are not
required by that rule. As noted above, a person seeking to rely on rule
3a-4 must be able to establish compliance with each of the rule's
provisions. Compliance with many of these provisions, including those
relating to client contact, the delivery of documents to clients, and
the opportunity of clients to place reasonable restrictions on the
management of their accounts, would be difficult, if not impossible, to
demonstrate without contemporaneous recordkeeping.
F. Investment Advisers Act Issues Raised by Investment Advisory
Programs
The Commission noted in the July Release that wrap fee and other
investment advisory programs raise, in addition to the Investment
Company
[[Page 15108]]
Act issues addressed in the release, a number of issues under the
Advisers Act. The Commission requested comment on certain of these
issues and indicated the possible publication of an interpretive
release that would address them. 79 The Commission received few
comments in response to this request, and the comments that were
received suggested that investment advisory programs did not raise
unique issues under the Advisers Act, but simply presented issues under
the Act in a specific factual context. The Commission, therefore, has
decided not to publish an interpretive release at this time. The staff
of the Division will entertain requests for no-action or interpretive
guidance with respect to the application of the Advisers Act in the
context of investment advisory programs.
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\79\ July Release, supra note 5, at Section II.C.
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III. Cost/Benefit Analysis
Rule 3a-4 under the Investment Company Act provides a nonexclusive
safe harbor from the definition of investment company for investment
advisory programs. Programs that are organized and operated in the
manner described in the rule are not required to register under the
Investment Company Act or to comply with the Act's substantive
provisions. The rule is intended to provide guidance to persons
operating investment advisory programs regarding the status of these
programs under the Investment Company Act, and help to ensure that such
programs do not operate as investment companies without clients of the
programs benefitting from the Act's protections.
The Commission anticipates that the cost of compliance with rule
3a-4 will be small. In addition, the Commission does not believe that
compliance with any of the provisions will be unduly burdensome.
Furthermore, because the rule is based principally on long-standing
staff positions, the Commission believes that it will not substantially
alter current industry practice or the costs associated therewith.
Section 2(c) of the Investment Company Act provides that whenever
the Commission is engaged in rulemaking under the Investment Company
Act and is required to consider or determine whether an action is
consistent with the public interest, the Commission also must consider,
in addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation. The Commission
has considered rule 3a-4 in light of these standards and believes that,
by removing uncertainty with respect to the status of certain
investment advisory programs under the Investment Company Act, the rule
is consistent with the public interest, and will promote efficiency and
the competition among sponsors of such programs. In addition, the rule
will have no adverse effect on capital formation, nor be unduly
burdensome to those sponsors wishing to comply with the rule.
IV. Paperwork Reduction Act
An investment advisory program structured to take advantage of the
safe harbor contained in rule 3a-4 will provide for each client in the
program receiving a statement quarterly describing all activities in
the client's account during the preceding quarter. Such a provision
constitutes a ``collection of information'' requirement within the
meaning of the Paperwork Reduction Act of 1995 (44 U.S.C. 3501, et
seq.), 80 because providing the quarterly statements is necessary
to meet the provisions of the safe harbor. An agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information without display of a valid OMB control number. Accordingly,
the Commission submitted the revised proposed rule to the Office of
Management and Budget (``OMB'') pursuant to 44 U.S.C. 3507 and received
approval of the rule's ``collection of information'' requirement (OMB
control number 3235-0459). Because the collection of information
requires disclosure to third parties (the client accountholders),
assurance of confidentiality is not an issue.
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\80\ See supra Section II.C.4.
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As noted above, the Commission has determined not to adopt the
other collection of information requirements it proposed, including the
establishment of written procedures and agreements governing the
operation of the program, the maintenance of records relating to the
program, and the filing of Form N-3a4 with the Commission.81 Due
to this decision, as well as a revision to the Commission's estimate of
the amount of assets presently in investment advisory programs, the
Commission has revised its estimate of the paperwork burden. The total
aggregate estimated annual reporting burden associated with the rule's
requirements has been reduced by 152,724.5 hours. The potential
respondents are the approximately 53 sponsors of investment advisory
programs. The Commission now estimates that there are 1,016,000 clients
of investment advisory programs, and the reporting burden imposed by
rule 3a-4 is one hour per client, for a total aggregate annual
reporting burden of 1,016,000 hours. On average, the annual reporting
burden for each respondent is estimated to be 19,169.8 hours. The
Commission notes that many sponsors already may provide quarterly
statements to clients and the burden under paragraph (a)(4) of rule 3a-
4 is likely to be less for such sponsors.
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\81\ See supra Section II.E.
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V. Final Regulatory Flexibility Analysis
A summary of the Initial Regulatory Flexibility Analysis regarding
revised proposed rule 3a-4 was published in the July Release. No
comments were received on the Initial Regulatory Flexibility Analysis,
and no comments were received with respect to the effect of the rule on
small entities. The Commission has prepared a Final Regulatory
Flexibility Analysis in accordance with 5 U.S.C. 604 regarding rule 3a-
4.
The analysis states that the rule is intended to provide a
nonexclusive safe harbor from the definition of investment company for
certain programs under which investment advisory services are provided
to clients. The analysis notes that the objective of rule 3a-4 is to
help ensure that investment advisory programs do not operate as de
facto investment companies by clarifying the Commission's views
regarding the status of investment advisory programs under the federal
securities laws. The conditions of the rule are designed to describe
certain basic attributes that can differentiate an investment advisory
program from an investment company. As discussed more fully in the
analysis, because the rule is a nonexclusive safe harbor, no entity,
either large or small, is required to operate in accordance with its
terms, and notes that a program that is a small entity and that does
not operate in the manner contemplated by the rule is not presumed to
be an investment company.
As discussed in the analysis, the Commission estimates that of the
53 sponsors offering investment advisory programs in 1995,
approximately 6 programs met the Commission's definition of small
entity for purposes of the Investment Company Act (i.e., an investment
company with net assets of $50 million or less as of its most recent
fiscal year [17 CFR 270.0-10]).
The analysis states that the rule does not impose any reporting or
recordkeeping requirements with the exception of one condition which
requires programs relying on the rule to furnish its clients a
statement, at least quarterly, describing activity in the client's
account. This condition reflects representations in several no-action
[[Page 15109]]
letters and is consistent with industry practice. In addition, the
analysis notes that the Commission has attempted to minimize the rule's
burden on all persons, not just small entities, particularly by
eliminating provisions included in the Revised Proposed Rule relating
to the creation and maintenance of books and records to facilitate and
support a program's reliance on the rule, and to the filing of a form
with the Commission. The analysis also notes that alternatives for
providing different means of compliance for small entities were
considered, but that the rule is crafted in a manner designed to permit
program sponsors considerable flexibility as to how they comply with
the safe harbor's conditions. Furthermore, the analysis states that
exempting small entities from the conditions of the rule would be
inconsistent with the Commission's statutory authority to protect
investors. Cost/benefit information reflected in the ``Cost/Benefit
Analysis'' section of this Release also is reflected in the analysis.
A copy of the Final Regulatory Flexibility Analysis may be obtained
by contacting Rochelle Kauffman Plesset, Securities and Exchange
Commission, 450 Fifth Street, N.W., Mail Stop 10-6, Washington, D.C.
20549.
VI. Effective Date
Rule 3a-4 is effective upon publication in the Federal Register.
Pursuant to 5 U.S.C. 553(d)(1), immediate effectiveness is appropriate
because rule 3a-4 is purely exemptive in nature. It provides a
nonexclusive safe harbor from the definition of investment company for
certain programs under which investment advisory services are provided
to advisory clients. Under the rule, programs that are organized and
operated in the manner described in the rule are not required to
register under the Investment Company Act or to comply with the Act's
requirements. The benefits of the rule should be available at the
earliest possible time.
VII. Statutory Authority
The Commission is adopting rule 3a-4 pursuant to the authority set
forth in sections 6(c) and 38(a) of the Investment Company Act [15
U.S.C. 80a-6(c), -37(a)].
Text of Rule
List of Subjects in 17 CFR Parts 270 and 274
Investment companies, Reporting and recordkeeping requirements,
Securities.
For the reasons set out 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
1. The authority citation for Part 270 continues to read, in part,
as follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-37, 80a-39 unless
otherwise noted;
* * * * *
2. By adding Sec. 270.3a-4 to read as follows:
Sec. 270.3a-4 Status of investment advisory programs.
Note: This section is a nonexclusive safe harbor from the
definition of investment company for programs that provide
discretionary investment advisory services to clients. There is no
registration requirement under section 5 of the Securities Act of
1933 [15 U.S.C. 77e] with respect to programs that are organized and
operated in the manner described in Sec. 270.3a-4. The section is
not intended, however, to create any presumption about a program
that is not organized and operated in the manner contemplated by the
section.
(a) Any program under which discretionary investment advisory
services are provided to clients that has the following characteristics
will not be deemed to be an investment company within the meaning of
the Act [15 U.S.C. 80a, et seq.]:
(1) Each client's account in the program is managed on the basis of
the client's financial situation and investment objectives and in
accordance with any reasonable restrictions imposed by the client on
the management of the account.
(2)(i) At the opening of the account, the sponsor or another person
designated by the sponsor obtains information from the client regarding
the client's financial situation and investment objectives, and gives
the client the opportunity to impose reasonable restrictions on the
management of the account;
(ii) At least annually, the sponsor or another person designated by
the sponsor contacts the client to determine whether there have been
any changes in the client's financial situation or investment
objectives, and whether the client wishes to impose any reasonable
restrictions on the management of the account or reasonably modify
existing restrictions;
(iii) At least quarterly, the sponsor or another person designated
by the sponsor notifies the client in writing to contact the sponsor or
such other person if there have been any changes in the client's
financial situation or investment objectives, or if the client wishes
to impose any reasonable restrictions on the management of the client's
account or reasonably modify existing restrictions, and provides the
client with a means through which such contact may be made; and
(iv) The sponsor and personnel of the manager of the client's
account who are knowledgeable about the account and its management are
reasonably available to the client for consultation.
(3) Each client has the ability to impose reasonable restrictions
on the management of the client's account, including the designation of
particular securities or types of securities that should not be
purchased for the account, or that should be sold if held in the
account; Provided, however, that nothing in this section requires that
a client have the ability to require that particular securities or
types of securities be purchased for the account.
(4) The sponsor or person designated by the sponsor provides each
client with a statement, at least quarterly, containing a description
of all activity in the client's account during the preceding period,
including all transactions made on behalf of the account, all
contributions and withdrawals made by the client, all fees and expenses
charged to the account, and the value of the account at the beginning
and end of the period.
(5) Each client retains, with respect to all securities and funds
in the account, to the same extent as if the client held the securities
and funds outside the program, the right to:
(i) Withdraw securities or cash;
(ii) Vote securities, or delegate the authority to vote securities
to another person;
(iii) Be provided in a timely manner with a written confirmation or
other notification of each securities transaction, and all other
documents required by law to be provided to security holders; and
(iv) Proceed directly as a security holder against the issuer of
any security in the client's account and not be obligated to join any
person involved in the operation of the program, or any other client of
the program, as a condition precedent to initiating such proceeding.
(b) As used in this section, the term sponsor refers to any person
who receives compensation for sponsoring, organizing or administering
the program, or for selecting, or providing advice to clients regarding
the selection of, persons responsible for managing the client's account
in the program. If a program has more than one sponsor, one person
shall be designated the principal sponsor, and such person shall be
[[Page 15110]]
considered the sponsor of the program under this section.
By the Commission.
Dated: March 24, 1997.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-8075 Filed 3-28-97; 8:45 am]
BILLING CODE 8010-01-P
