SEC Adopts Safe Harbor For Discretionary Investment Advisory Programs

April 28, 1997

On March 24, 1997, the Securities and Exchange Commission (the "SEC") adopted new Rule 3a-4 under the Investment Company Act of 1940 (the "Investment Company Act"). The rule provides a nonexclusive safe harbor from the definition of "investment company" for discretionary investment advisory programs, including wrap fee programs, involving large numbers of small clients. The rule provides that programs by which large numbers of clients receive the same or similar advice will not be regulated under the Investment Company Act if they meet conditions designed to ensure that participating clients receive individualized treatment. Programs that comply with the rule also are not required to register the accounts that participate as publicly offered securities under the Securities Act of 1933 (the "Securities Act"). The rule is of particular significance to investment advisors who provide similar portfolio advice and management to more than 100 clients.

The rule responds to an increase in the number of investment advisory programs that provide professional, discretionary portfolio management services to a large number of individual client accounts who invest smaller amounts than are ordinarily required for such services but more than the minimum investment for most mutual funds. These programs typically provide asset allocation advice and administrative services, as well as portfolio management services or advice regarding the selection of another investment advisor to serve as the client's portfolio manager.

In the SEC's view, a discretionary advisory program in which investors receive substantially overlapping investment advice that does not afford investors individual attention would appear to be offering a security within the meaning of the Securities Act¹. Moreover, under the Investment Company Act, any "issuer" which is engaged primarily in investing or trading in securities is an investment company. Because the term "issuer" includes any organized group of persons, the SEC believes that such a discretionary advisory program "could be considered to be an issuer because the client accounts in the program, taken together, could be considered an organized group of persons." If such a program is an issuer, it follows that by reason of such issuer's investing activities it will meet the definition of an investment company. If such an issuer has more than 100 participants, it would be required to register as an investment company under the Investment Company Act.

As a means to prevent the pooling of large numbers of small investment advisory clients into one or more investment companies, Rule 3a-4 is designed to ensure that clients participating in an investment advisory program receive individualized treatment. The sponsor of a program, or the sponsor's designee, must perform the duties specified in the rule, which defines the term "sponsor" broadly to include "any person who receives compensation for sponsoring, organizing or administering the program, or for selecting, or providing advice to clients regarding the selecting of, persons responsible for managing the client's account in the program." Thus, the rule covers sponsors of hedge funds and funds of funds, as well as fund administrators and investment advisors and may, in certain instances, include broker-dealers involved in directing clients to another "sponsor." The rule applies both to sponsors that are required to register with the SEC under the Investment Advisers Act of 1940 (the "Advisers Act") as well as to those who are not required to be registered under the Advisers Act. If a program has more than one sponsor, one person must be designated as the principal sponsor with responsibility for performing the duties set forth in the rule.

The safe harbor is subject to the satisfaction of the following conditions:

Individualized Management:

As discussed more fully below, each client's account must be managed on the basis of the client's financial situation and investment objectives and in accordance with reasonable restrictions imposed by the client. This is viewed to be a critical distinction between participation in a discretionary investment advisory program and the acquisition of securities of an investment company. In this regard, the SEC confirmed its prior advice that the use of model portfolios is not inconsistent with individualized treatment and that it is not necessary "for a portfolio manager to make separate determinations regarding the appropriateness of each transaction for each client prior to effecting the transaction."

Client Contact:

When an account is opened, the sponsor or its designee must obtain information through an in-person or telephone interview or through a questionnaire from each client concerning the client's financial situation and investment objectives, including any reasonable restrictions the client wishes to impose on the management of the client's account. As noted, the responsibility for compliance with this de facto "know your client" obligation may be delegated to a designated representative. In many instances a referring broker, for example, may be willing to act as a designee for this purpose, soliciting a prospective client's responses to a questionnaire prepared or approved by the program sponsor.

Thereafter, the sponsor or its designee must:

(i) contact the client at least annually to determine if the client's financial situation or investment objectives have changed, or whether the client then wants to impose any reasonable restrictions on management of the account or modify earlier restrictions², and

(ii) at least quarterly, the sponsor or its designee must notify the client in writing that the client should contact the sponsor or a designated person if there have been any changes in the client's financial situation or investment objectives, or if the client wants to impose or modify any reasonable restrictions on management of the account. This notice could be included as part of another mailing sent to the client (such as the quarterly account statement described below).

In addition, the sponsor and personnel of the portfolio manager who are knowledgeable about the client's account must be reasonably available to consult with the client, and clients must be provided with a procedure by which they can obtain access to the appropriate personnel. Importantly, the contact person need not be the individual primarily responsible for managing the account, but must be someone who is able to discuss and explain investment decisions made with respect to the account.³

Reasonable Restrictions:

Each client must be able to impose reasonable restrictions on the management of the account. Whether a particular restriction is reasonable would depend on an analysis of the relevant facts and circumstances. For example, the exclusion of individual stocks or stocks from a particular country would appear to be reasonable under ordinary facts and circumstances. In the adopting release for Rule 3a-4, however, the SEC noted that programs do not need to permit clients to direct the manager to purchase specific securities or types of securities⁴. The SEC also noted that the restrictions imposed by a client could be unreasonable in the aggregate, even if each restriction is reasonable when considered separately. In addition, restrictions could be unreasonable if the client changes them or imposes new restrictions with excessive frequency.

A client should be notified and given an opportunity to restate a restriction more reasonably if a particular restriction sought to be imposed by a client is deemed to be unreasonable. Only if a client is unable or unwilling to modify an unreasonable restriction, may the client be removed from the program without jeopardizing reliance on the safe harbor. Similarly, the SEC is of the view that if a prospective client wants to impose a restriction that is deemed to be unreasonable, the sponsor or portfolio manager may not refuse to accept the client without first offering the client an opportunity to modify or withdraw the restriction.

Quarterly Account Statements:

At least quarterly, each client must be given an account statement. The quarterly statement must describe:

(i) 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); and

(ii) the value of the account at both the beginning and the end of the quarter.

Client Retention of Indicia of Ownership:

Each client must retain the indicia of ownership of all securities and funds in the account, including the right to withdraw and vote securities, the right to be provided with written confirmation of each transaction and the right to proceed at law against the issuer of any securities in the client's account. These indications of ownership provisions apply only to the extent that they would apply if the securities and funds were held outside the program. Thus, for example, it is permissible for securities to be held in street name and for restrictions imposed by the terms of a retirement plan or tax law to remain in place. Although the rule does not require that each client have the right to pledge securities, the right to withdraw securities must be provided. The SEC has noted, however, that a right to pledge securities in a program account may be relevant in determining whether a program that does not or cannot rely on the safe harbor provisions of the rule is an investment company.

Under the safe harbor, clients must have the right to vote the securities in their accounts and to delegate the authority to vote securities to another person, including the portfolio manager or an other fiduciary. The client must, however, retain the right to revoke the delegation at any time. If the client retains voting authority, he or she must receive proxy materials in sufficient time to consider how to vote and to submit the proxies. The provision of the rule addressing confirmations states that a client in an investment advisory program must receive confirmations that the person executing the transaction is required to send and that the confirmations must include the information specified by the applicable law governing such content.⁵

The rule does not require a minimum account size, although the SEC stated in the adopting release that it will consider a relatively large minimum account size as evidence that individualized treatment is being provided in determining the status under the Investment Company Act of a program that does not qualify for the safe harbor. Although the SEC did not impose recordkeeping requirements⁶, it strongly recommends that sponsors adopt written policies and procedures, noting that such policies and procedures may serve to protect an adviser from liability for violating the Investment Company Act or the Securities Act.

* * * * *

The consequences of having numerous individual investment advisory accounts pooled into an investment company can be extremely severe. If there are more than 100 participants, registration under the Investment Company Act will be required and the sponsor may be subjected to sanctions for having failed to register when the total first exceeded the 100 investor threshhold. The consequences of a required registration are themselves significant (but beyond the scope of this Advisory).

Even if a discretionary investment advisory program has fewer than 100 participants similar consequences might follow. If such a program is determined to be an investment company, it may also be deemed to be integrated with one or more other investment vehicles under similar management, such as a hedge fund. The accumulation of investors that would occur should such integration be successfully asserted might cause the combined "issuer" (i.e., the program and the hedge fund) to find itself with more than 100 equity owners despite being unregistered under the Investment Company Act.

The simple, but significant, benefit of Rule 3a-4 is the avoidance of any of these consequences. Compliance with the rule should not impose any undue burdens on portfolio managers and other program sponsors and will relieve them of the risk that they are violating the law by conducting a discretionary investment advisory program.

NOTES:

Such a program could be deemed to be "an investment . . . in a common enterprise with profits to come solely from the efforts of others" and, therefore, to include all of the "Howey" test elements of the type of security known as an investment contract.
The rule does not dictate the manner in which annual contact must be made, and the SEC noted that contact in person, by telephone, by letter, or by electronic mail would all be acceptable. A sponsor that is unable to obtain client information after using all reasonable means to contact the client would not be precluded from relying on the safe harbor.
Reasonable fees may be charged for this service provided they are adequately disclosed. 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).
The adopting release also indicates that, 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, or is fundamentally inconsistent with the nature or operation of the program. Other factors that bear on whether a particular restriction is reasonable are the difficulty in complying with the restriction, the specificity of the restriction and the number of other restrictions imposed by the client. A restriction would not be unreasonable, however, simply because it placed administrative burdens on the manager, or could affect the performance of the account.
Banks that execute securities transactions for customers generally are subject to confirmation requirements under the banking laws. Broker-dealers are subject to SEC Rule 10b- 10, which permits customers to waive receipt of individual confirmations in certain circumstances. 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, but may not waive both.
In an earlier release the SEC had proposed that a sponsor be required to: "(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 SEC upon demand copies of the policies, procedures and other documents created pursuant to these policies and procedures." Among other reasons for dropping these recordkeeping requirements was the fact that with respect to programs sponsored by registered investment advisers, the recordkeeping requirements under the Advisers Act and the SEC's authority to examine registered investment advisers should be sufficient to enable the SEC to detect violations of the Investment Company Act and that most, if not all, of the records that would have been covered by the rule currently are required to be maintained under SEC Rule 204- 2 under the Advisers Act.

For more information, please contact Howard Neuman in the firm's New York office at (212)818-9200.