Monthly Archives: September 2011

Rule 3a-4: Are Your Model Portfolios Really Investment Companies?

In 1997, the SEC adopted Rule 3a-4 of the Investment Company Act of 1940 (the “Rule”) which provides a non-exclusive safe harbor to exclude certain similarly-managed accounts, such as model portfolios, from the definition of an investment company (e.g., a mutual fund).  

In short, the Rule requires that each client receive individualized investment treatment. The conditions that must be met in order to fall under Rule’s safe harbor are as follows:

  • Each client’s account must be managed on the basis of the client’s financial situation and investment objectives and any reasonable investment restrictions the client may impose;
  • The investment adviser must obtain sufficient client information to be able to provide individualized investment advice to the client;
  • The investment adviser and/or the portfolio manager must be reasonably available to consult with the client;
  • Each client must be able to impose reasonable investment restrictions on the management of the account;
  • Each client must receive a quarterly statement with a description of all account activity; and
  • Each client must retain certain indicia of ownership of the securities and funds in the account (e.g., the ability to withdraw securities, vote securities, etc.).

In addition, the Rule requires that investment advisers provide quarterly written reminders to notify the adviser of any changes in the client’s financial situation, and also make an annual effort to update the client’s information.

Investment advisers who make use of model portfolios or other similar investment strategies and wish to take advantage of the Rule’s safe harbor should review their compliance programs to help ensure conformance with the Rule’s requirements for the safe harbor.

For additional information please contact Brent Cunningham, Associate by email at brent.cunningham@jackolg.com  or by phone at (619) 298-2880.

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Department of Labor to Re-Propose Definition of “Fiduciary”

As discussed in a previous Jacko Law Group, PC Legal Risk Management Tip, in October of last year the Department of Labor (the “DOL”) published a proposed rule that would amend the definition of “fiduciary”, and would significantly expand the categories of persons who would be deemed to be fiduciaries subject to the Employee Retirement Income Security Act of 1974 (“ERISA”). On Monday, however, the DOL announced that it will re-propose the rule, and stated that this decision was in part a response to requests from the public, including members of Congress and the financial services industry, that the DOL allow an opportunity for more input on the proposed rule. 

Some members of the financial services industry expressed concern that the originally proposed rule would limit service providers’ ability to provide advice to retirement plans.  For instance, The Securities Industry and Financial Markets Association (“SIFMA”) stated that the originally proposed rule would ultimately harm investors by raising the cost of saving and would cause retirement plan service providers difficulty in receiving fees or commissions.  To that end, in drafting the re-proposed rule the DOL will look to address concerns about the impact of the new definition on the current fee practices of brokers and advisers, and clarify the continued applicability of exemptions that have long been in existence that allow brokers to receive commissions in connection with mutual funds, stocks and insurance products.

The re-proposed rule is expected to be issued in early 2012.

For additional information please contact Brent Cunningham, Associate by email at brent.cunningham@jackolg.com  or by phone at (619) 298-2880.

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Investment Advisers May Soon Have A SRO – And FINRA Wants To Be It

Recently, Congressmen Spencer Bachus, Chairman of the House Financial Services Committee, circulated a draft bill entitled The Investment Adviser Oversight Act of 2011 (the “Bill”). If introduced and passed, the Bill will amend the Investment Advisers Act of 1940 to require both federal and state-registered investment advisers to become a member of a national investment adviser association (“NIAA”).  Among other things, the Bill provides for the NIAA to implement rules designed to prevent fraudulent and manipulative acts, protect investors, and outlines how the NIAA may apply to register as the overseer of investment advisory industry. Importantly, the Bill also lists exemptions for investment advisers with assets of 90% or more attributable to the following types of clients from having to become a member of the NIAA:

  • Investment companies registered under the Investment Company Act of 1940 (e.g., mutual funds);
  • Non-U.S. persons;
  • Clients that in the aggregate own not less than $25 million in investments;
  • Funds organized for charitable or religious purposes;
  • Pension or profit sharing plans;
  • Private funds (including hedge funds and private equity funds relying on an exemption under Sections 3(c)(1) or 3(c)(7) of the Investment Company Act); and
  • Venture capital funds.

Some observers believe that the Bill was drafted specifically with an eye toward FINRA expanding its role to include examining and overseeing investment advisers.  To this end, during a congressional hearing relating to the Bill held on September 13, 2011, FINRA asserted to Congress that it is well equipped to become the NIAA.   In his testimony before the House Committee on Financial Services, Richard Ketchum, FINRA’s Chairman and CEO, stated that FINRA is “uniquely positioned”  to help with the regulation of investment advisers.  Last week, various members from the Commission indicated at compliance conferences that we will likely know the result of this proposal before the end of 2011.

For more information, please contact Brent Cunningham, Associate, at (619) 298-2880 or at brent.cunningham@jackolg.com.

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SEC No-Action Letter Provides Further Guidance for Private Fund Solicitors

As discussed in a previous blog posting, investment advisers must comply with Rule 206(4)-3 (the “Rule”) of the Investment Advisers Act of 1940 when using solicitors.  Notably, in July 2008, the SEC issued a no-action letter (the “Letter”) which provided additional guidance to Rule 206(4)-3’s applicability.  In this Letter, the SEC stated that Rule 206(4)-3 generally does not apply to a RIA’s cash payment to a person solely to compensate that person for soliciting investors or prospective investors for, or referring investors or prospective investors to, a private fund managed by the adviser.  In support of this interpretation, the SEC noted that: 

  1. Neither the Rule’s Proposing Release nor the Adopting Release contained any statement directly or indirectly suggesting that it would apply to RIAs’ cash payments to others solely to compensate them for soliciting investors for investment pools managed by the advisers;
  2. The Rule is designed so as to clearly apply to solicitations and referrals in which the solicited or referred persons might ultimately enter into investment advisory contracts with the investment adviser, yet private fund investors do not typically enter into investment advisory contracts with the investment advisers of the pools; and
  3. The Rule’s use of the terms “client” and “prospective client,” rather than “investor” or “prospective investor,” also strongly suggests that the Rule was intended to apply to solicitations and referrals in which the solicited or referred persons might ultimately enter into investment advisory contracts with the investment adviser.

Whether a RIA’s cash payment to a person is being made solely to compensate that person for soliciting investors for an investment pool managed by the adviser will depend upon all surrounding facts and circumstances.   For example, the Rule would not appear to apply to a RIA’s cash payment to a person for referring other persons to the adviser where the adviser manages only investment pools and is not seeking to enter into advisory relationships with other persons. In contrast, the Rule would appear to apply if the adviser manages or seeks to manage investment pools and individual accounts, is seeking to enter into investment advisory relationships with other persons, and the adviser’s cash payment, under the adviser’s arrangement with the referring person, compensates the referring person for referring the other persons as prospective advisory clients.

For more information, please contact Brent Cunningham, Associate, at (619) 298-2880 or at brent.cunningham@jackolg.com.

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Rare East Coast Earthquake Serves as a Reminder to Review Business Continuity Plans

The 5.8 magnitude earthquake that shook large portions of the eastern seaboard on August 23rd should serve as a useful reminder to registered investment advisers and broker-dealers to review and update their business continuity plans.

While not explicitly stated in Rule 206(4)-7 of the Investment Advisers Act of 1940, SEC registered investment advisers are nevertheless required to maintain business continuity and succession plans.  This is true because Rule 206(4)-7’s adopting release stated that the SEC believes “an adviser’s fiduciary obligation to its clients includes the obligation to take steps to protect the clients’ interests from being placed at risk as a result of the adviser’s inability to provide advisory services after, for example, a natural disaster or, in the case of some smaller firms, the death of the owner or key personnel.”  Moreover, the SEC has explicitly stated that, at a minimum, it expects an adviser’s policies and procedures manual to contain a business continuity plan. 

FINRA Rule 4370, places a similar requirement for its member firms to implement a written business continuity plan. To that end, registered investment advisers and broker-dealers should implement a written business continuity plan which addresses (at a minimum) the following areas:

  • Data back-up and recovery (both hard copy and electronic);
  • Mission critical systems;
  • Financial and operational assessments;
  • Alternate communications between customers and the member;
  • Alternate communications between the member and its employer;
  • Alternate physical location of the employees;
  • Critical business constituent, bank and counter-party impact;
  • Regulatory reporting;
  • Communications with regulators; and
  • Assuring customers will have prompt access to their funds/securities in the event the member is unable to continue business.

For more information, please contact Brent Cunningham, Associate Attorney at Jacko Law Group, PC at (619) 298-2880 or at brent.cunningham@jackolg.com

 

 

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