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U.S. Securities and Exchange Commission

Investment Advisers Act - Section 205(a)(1) and Rule 206(4)-1(a)(4)

Trainer, Wortham & Co.
Froley, Revy Investment Co.
Starbuck, Tisdale & Assoc.

December 6, 2004

RESPONSE OF THE OFFICE OF CHIEF COUNSEL
DIVISION OF INVESTMENT MANAGEMENT
Our Ref. No. 200310161413

Our Ref. No. 20043171112
Trainer, Wortham & Co. Froley, Revy Investment Co. Starbuck, Tisdale & Assoc.
File Nos. 801-56293, 801-10672, 801-2800

In your letters dated March 12, 2004 and March 30, 2004, you request our assurance that we would not recommend enforcement action to the Commission against Trainer, Wortham & Company, Froley, Revy Investment Company, or Starbuck, Tisdale & Associates (together, the "Advisers") under Section 205(a)(1) of the Investment Advisers Act of 1940 (the "Advisers Act") if the Advisers provide certain new advisory clients with a satisfaction guarantee, as described below. You also request relief under Section 206(4) of the Advisers Act and Rule 206(4)-1(a)(4) thereunder concerning the Advisers' marketing of the satisfaction guarantee.

I. FACTS

You state that the Advisers, each of which is a subsidiary of First Republic Bank, are investment advisers that are registered with the Commission under the Advisers Act. You state that the Advisers are considering providing a money-back satisfaction guarantee to certain new clients of the Advisers that would entitle those clients to a full refund of all advisory fees that they paid to the Adviser within the first twelve months of establishing their accounts with the Advisers (the "proposed satisfaction guarantee"). You state that the proposed satisfaction guarantee would allow those clients to obtain a refund of advisory fees for any reason, including unhappiness with the Advisers, unhappiness with the Advisers' investment performance, or dissatisfaction with the Advisers' responsiveness or the quality of service provided by the Advisers. You state that the proposed satisfaction guarantee would entitle a client to have his or her advisory fees returned upon his or her request at any time during the initial twelve-month period after opening an account with the Advisers.1 You assert that all refunds would be granted without condition or obligation.

You state that the proposed satisfaction guarantee would not be available in all circumstances. You state that the proposed satisfaction guarantee would be available only to new clients; current clients of the Advisers would not be eligible to participate. You state that the proposed satisfaction guarantee would not be available through all sales channels.2 You also note that new clients referred by unaffiliated third-party solicitors would not be eligible for the proposed satisfaction guarantee, although new clients that were referred by affiliated parties would be eligible. You indicate, however, that the proposed satisfaction guarantee would be equally available to all similarly situated new clients who met the criteria of the program.

You state that the terms of the proposed satisfaction guarantee would be set forth in the written advisory contracts of participating new clients. You state that the terms of the proposed satisfaction guarantee would also be included in the fee schedule that each Adviser provides in Part II of its Form ADV, and in the brochure that it provides to prospective clients pursuant to Rule 204-3 under the Advisers Act.3 You state that the Advisers may also provide their prospective clients with a printed description of the proposed satisfaction guarantee during face-to-face meetings, or as part of a direct mail campaign. You state that, in particular, this disclosure will describe in detail the terms of the fee refund, identify which categories of new clients would be entitled to participate in the proposed satisfaction guarantee, and would disclose that the proposed satisfaction guarantee would permit the client to demand a refund of advisory fees for any reason.4

You state that the Advisers anticipate that any clients who receive a return of advisory fees pursuant to the proposed satisfaction guarantee will either terminate their accounts, or remove a substantial portion of their assets from their accounts. You further state that the Advisers intend to make such a termination or removal a condition to the receipt of fees that are refunded under the proposed satisfaction guarantee. You state that the Advisers may waive this condition, provided they were clearly at fault, but were nonetheless able to retain the client's business. You indicate, however, that such a waiver will not occur in situations where the client was simply not satisfied with investment performance. You note that the Advisers do not impose account termination or transfer fees or charges on terminating clients.5 Finally, you note that the advisory fees to be paid under contracts between the Advisers and the clients participating in the proposed satisfaction guarantee program will not otherwise be based upon the investment performance of the clients' advisory accounts, and that the Advisers will not have any other understandings with any client participating in the program regarding a fee refund based upon investment performance. In particular, you state that the Advisers will not have any explicit, or tacit, understandings or agreements with their participating clients regarding a maximum, minimum, or other target level of investment performance for those clients' investment accounts.6

You express concern that the proposed satisfaction guarantee might violate Section 205(a)(1) of the Advisers Act, which generally prohibits the use of performance fees, and request our assurances that we would not recommend enforcement action to the Commission against the Advisers pursuant to that section. You also express concern that your offer of the proposed satisfaction guarantee might violate Section 206(4) of the Advisers Act and Rule 206(4)-1(a)(4) thereunder, and request our assurances that we would not recommend enforcement action to the Commission against the Advisers under that section and rule.

II. ANALYSIS

Section 205(a)(1) of the Advisers Act provides that, unless exempt from registration under Section 203(b), no investment adviser shall use any means or instrumentality of interstate commerce, directly or indirectly, to enter into an advisory contract that provides for "compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client" (a "performance fee.") Section 205(a)(1) is designed, among other things, to eliminate "profit sharing contracts [that] are nothing more than 'heads I win, tails you lose' arrangements,"7 and that "encourage advisers to take undue risks with the funds of clients,"8 to speculate, or to overtrade.9

We have taken the position that Section 205(a)(1)'s prohibition of investment advisory contracts that contain performance fees extends to investment advisory contracts that provide for "contingent fees."10 A contingent fee is "an advisory fee [that] will be waived or refunded, in whole or in part, if a client's account does not meet a specified level of performance" or that is contingent on the investment performance of the funds of advisory clients.11 A contingent fee provides an investment adviser with an incentive to take undue risks, speculate or engage in over-trading because the adviser knows that it will not receive any, or will receive reduced, compensation for its work when the performance of the client's funds has not reached the agreed-upon level.

You argue that the proposed satisfaction guarantee is not a contingent fee because the guarantee would allow a fee refund if the client were dissatisfied for any reason, and would not be limited to a refund due to dissatisfaction with investment performance.12 We do not agree. The proposed satisfaction guarantee would make the Advisers' receipt of fees contingent, at least in part, on performance because a client could obtain a refund due to the unsatisfactory performance of its account. The fact that a client could also obtain a refund for reasons unrelated to performance does not diminish the ability to obtain a refund due to performance.

The proposed satisfaction guarantee, however, is structured in a manner that would greatly reduce any incentive on the part of the Advisers to take undue risks, speculate, or overtrade. In particular, the proposed satisfaction guarantee will not feature any specific, agreed-upon level of performance that must be achieved in order for an Adviser to receive a fee.13 As a result, the Advisers' compensation for providing the advisory services would not increase with an increase in the investment performance of the client's funds, or decrease with a decrease in the investment performance of the client's funds. In addition, we believe that policy considerations support the use of the proposed satisfaction guarantee in that the guarantee could serve to encourage the Advisers to develop a strong culture of client service and responsiveness.

Based upon the facts and representations that are set forth in your letter, and the December 3, 2004 Telephone Call, we would not recommend enforcement action to the Commission against the Advisers under Section 205(a)(1) of the Advisers Act, if the Advisers provide certain new advisory clients with the proposed satisfaction guarantee.14 Our position is based particularly on your representations that:

  • Participating clients will be entitled to a refund of the advisory fees that they have paid to the Advisers for any reason;
     
  • The Advisers will not have any explicit, or tacit, understandings or agreements with the participating clients regarding a maximum, minimum, or other target level of investment performance for those clients' investment accounts; and
     
  • The proposed satisfaction guarantee will be available only for the initial twelve-month period of the advisory relationship.
     

Because our position is based on all of the facts and representations made in your letters and in the December 3, 2004 Telephone Call, you should note that any different facts or circumstances might require a different conclusion.15 Further, this response expresses our position only with respect to enforcement action, and does not express any legal conclusion on the issues presented.

You also request our assurances that we would not recommend enforcement action to the Commission under Section 206(4) of the Advisers Act, and Rule 206(4)-1(a)(4) thereunder, if the Advisers advertise the availability of the proposed satisfaction guarantee. Section 206(4) and Rule 206(4)-1(a)(4) together generally prohibit an investment adviser from using an advertisement that states that an advisory service is provided free, unless that service is, in fact, free. You have not explained how the proposed satisfaction guarantee would implicate the rule (e.g., whether advertisement of the proposed satisfaction guarantee would state that any service would be furnished for free, or whether the Advisers would, in fact, furnish any service for free within the meaning of the rule.) Consequently, we decline to respond to this portion of your request. Please also note that the staff does not review specific advertisements as a matter of policy.16

Your request for confidential treatment under the Commission's Rule 81 (17 C.F.R. 200.81) is granted until thirty days from the date of the issuance of this response.

Eric S. Purple
Senior Counsel


Endnotes

It is possible that, over time, an advisory relationship could create an expectation of return on behalf of the client that would affect an adviser's behavior. For example, if a client enjoys percentage returns that fall within a consistent range, his or her adviser might conclude that its continued service is dependent upon its ability to deliver similar results in the future. This belief could, in turn, provide the adviser with an incentive to take undue risks, speculate, or overtrade in order to continue to achieve that performance. You represent that the proposed satisfaction guarantee will be available only for the initial twelve-month period of the advisory relationship.


Incoming Letter

VIA HAND DELIVERY

March 12, 2004

Linda Schneider, Esq.
Office of Chief Counsel
Division of Investment Management
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Re:

No-Action Request under Section 205(a)(1) and Rule 206(4)-1(a)(4) of the Investment Advisers Act of 1940

Dear Ms. Schneider:

We represent First Republic Bank and its wholly-owned investment adviser subsidiaries Trainer, Wortham & Company, Froley, Revy Investment Company, and Starbuck, Tisdale & Associates ("Advisers"), which are registered with the Commission under the Investment Advisers Act of 1940 ("Advisers Act"). We respectfully submit this inquiry and request for no-action relief to the staff of the Division of Investment Management ("Staff") on behalf of our clients concerning the applicability of Section 205(a)(1) [15 U.S.C. 80b-5(a)(1)] and Rule 206(4)-1(a)(4) [17 C.F.R. 275.206(4) 1(a)(4)] under the Advisers Act. Specifically, we respectfully request that you advise us that the Division of Investment Management will not recommend enforcement action under Section 205(a)(1) or Rule 206(4) 1(a)(4) if the Advisers provide certain new advisory clients with a satisfaction guarantee in the form of a right to receive a full refund of all advisory fees without obligation within the first twelve months of new account establishment if, for any reason or no reason at all, the client is not satisfied with the Advisers' services.

I. Background

The Advisers are registered under the Advisers Act and manage an aggregate total of approximately $8.4 billion in assets in equity, convertible securities, and balanced and fixed income accounts.

The following proposal is currently under consideration. The Advisers would provide a money-back satisfaction guarantee for certain new advisory clients whereby the client would be entitled to a full refund of all advisory fees within the first twelve months of account establishment if the client is not satisfied with the Advisers' services for any reason. Thus, for example, if a new client were dissatisfied with the Adviser's responsiveness or service quality, or simply unhappy with the Adviser, the client would be entitled to have his or her advisory fees returned upon request at the end of the initial twelve-month period. Existing clients would not be offered the satisfaction guarantee, and the offer may be available for a limited time only. In addition, the satisfaction guarantee would not be offered through all channels (for example, it likely would not be made available to clients of a third-party wrap program in which an Adviser is a portfolio manager; and it might be made available only to clients who are referred by an affiliate of the Adviser). The proposed offer would provide the Adviser's services for free without any condition or obligation within the first twelve months if the client were dissatisfied with the Adviser's services.

The terms of the satisfaction guarantee would be included in the fee schedule as set forth in the relevant Adviser's Form ADV Part II. Specifically, Part II of the Adviser's Form ADV would describe in detail the fee refund terms, identify which categories of clients would be entitled to this offer, and explain that the satisfaction guarantee is in no way based on investment performance. All similarly-situated clients offered this money-back satisfaction guarantee would receive the same terms and conditions. This offer would be available for a limited time. Pre-existing clients and clients of third-party solicitors would not be eligible for the offer.

II. Legal Analysis

Paragraph (a)(1) of Section 205 provides that no registered investment adviser shall enter into or renew any investment advisory contract that "provides for compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client." The Staff has previously interpreted this section to prohibit investment advisers from entering into contingent advisory fee arrangements under which fees are waived or refunded if a client's account does not meet a specified level of performance.1 In addition, paragraph (a)(4) of Rule 206(4)-1 provides that no registered investment adviser shall publish, circulate, or distribute any advertisement containing "any statement to the effect that any report, analysis, or other service will be furnished free or without charge, unless such report, analysis or other service actually is or will be furnished entirely free and without any condition or obligation, directly or indirectly."

We believe that the Advisers' proposed fee refund offer, where the refund offer is not contingent on investment performance, is in compliance with Section 205(a)(1) and Rule 206(4)-1(a)(4) of the Advisers Act. The proposed offer would comply with Section 205(a)(1) because it would allow a fee refund if the new client were dissatisfied for any reason, and would not be limited to dissatisfaction based on investment performance.

The Staff has previously issued no-action relief where an advisory client terminated the investment advisory contract and sought a refund of advisory fees because of poor performance by the advisor.2 The contract did not make advisory fees contingent on investment performance. In that letter, the Staff noted that the Advisers Act prohibits agreements whereby fees are refunded if a client's account does not meet a specified level of performance. The Staff emphasized, however, that the Advisers Act does not prohibit a voluntary refund of advisory fees by the investment adviser where the investment advisory contract does not in any manner base advisory fees on investment performance or provide a fee refund related to investment performance. We believe that our clients' proposed fee refund offer would be consistent with the type of voluntary fee refund that received exemptive relief from the Staff in this letter.

Rule 206(4)-1(a)(4) does not prohibit offers of refunds or free services-instead it requires that if free services are offered, the investment adviser must live up to its offer. The offer would clearly state that a dissatisfied client who qualifies for the offer is entitled to a full refund of advisory fees without any condition or obligation during the initial twelve-month period, and the Advisers understand that all new qualifying clients who state they are dissatisfied must be provided a full refund of advisory fees in accordance with the terms of the written offer. Accordingly, if the Advisers make the promised refunds upon the request of qualifying clients who are dissatisfied, the offer and refund would be consistent with Rule 206(4)-1(a)(4).

III. Conclusion

For the reasons stated above, we believe that the Advisers' proposed "satisfaction guarantee" fee refund offer is consistent with the requirements of Section 205(a)(1) and Rule 206(4) 1(a)(4) of the Advisers Act. Consequently, we respectfully request that the Staff advise us that it will not recommend enforcement action under Section 205(a)(1) or Rule 206(4)-1(a)(4) of the Advisers Act if the Advisers offer to qualifying new clients who are dissatisfied with the Advisers' services the contractual right to a full refund of advisory fees within the first twelve months of new account establishment.

We respectfully request that the Staff accord this letter confidential treatment for 120 days from the date of the response by the Staff pursuant to 17 C.F.R. 200.81(b). We request this specified period of confidential treatment because the proposed "satisfaction guarantee" fee refund offer is a confidential business plan that our client is considering.

Please call me at (202) 942-5745 if you have any questions or require further information.

Sincerely,

David F. Freeman, Jr.


Endnotes


Incoming Letter 2

March 30, 2004

VIA E-MAIL and HAND DELIVERY

Eric S. Purple, Esquire
Division of Investment Management
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0504

Re: No-Action Letter Request of First Republic Bank et al.

Further to our letter of March 12, 2004 requesting the Staff take a no-action position with respect to a proposed "satisfaction guarantee" fee return offer, our client has requested that we provide the Staff with the following additional information about its proposed program.

The offer would be made through one-on-one presentations and solicitations and possibly direct mail to clients of First Republic Bank, but would not be referenced in an advertising campaign conducted by the print or broadcast media. First Republic Bank currently anticipates that its subsidiaries Trainer, Wortham & Company, and Starbuck, Tisdale & Associates will offer the satisfaction guarantee/fee rebate program to all of their new advisory customers who open investment advisory accounts during the period in which the program is being offered, other than persons referred by unaffiliated solicitors under a Rule 206(4)-3 arrangement. The participating investment advisors may also exclude certain categories of institutional clients, such as pension funds. Moreover, if the requirements of ERISA or the Internal Revenue Code significantly interfere with offering the program to IRA and similar accounts, the participating advisers may exclude such categories of accounts from the offer. We do not currently anticipate that Froley Revy Investment Company will offer the program to its customers, although in the future it might choose to do so.

During the periods in which the offer is available, all new clients of the participating investment advisers who meet the criteria of the offer would receive the satisfaction guarantee/money back offer. In other words, it would not be offered only to a favored few or narrowly targeted groups of customers. All similarly-situated new customers of a participating investment adviser would get the same satisfaction guarantee during the period in which it is offered.

The terms of the offer would be set forth in the written advisory contracts of new customers who are eligible for and accept the offer (most likely the terms would be included in the fee schedule that forms a part of the customer's written advisory contract). A printed description of the offering might be used, either to give out to customers in person, or to mail to potential customers. The terms of the offer would also be included in Form ADV Part II of each of the investment advisers that participates in the program during the periods in which the program is in effect.

Our client anticipates that any customer who receives a return of their advisory fees under the satisfaction guarantee will either terminate their account at the investment adviser or remove a substantial part of the assets from the management by the investment adviser. The participating investment advisers plan to make this a condition to receipt of the return of fees to its customers under the satisfaction guarantee (with possible exceptions for situations in which the investment adviser is clearly at fault and is nonetheless able to retain the customer; however this exception will not be invoked in situations where the customer is simply unhappy about investment performance).

The investment advisers involved do not impose termination or transfer fees or charges on terminating clients. It is possible that the custodian broker-dealers or banks that hold custody of each client's account might charge transfer fees if the customer also closes a custody account, but that is between the client and the custodian, and closure of the custodial account is independent of termination of the advisory relationship with First Republic Bank's subsidiary investment advisers (each customer has its own custodial contract and the custodians generally are banks and broker-dealers that are not affiliated with First Republic Bank).

We respectfully request 120-day confidential treatment of this letter pursuant to Rule 200.81(b).

Please contact me at 202/942-5745 if you have any questions or require additional information.

Respectfully submitted,

David F. Freeman, Jr.


http://www.sec.gov/divisions/investment/noaction/trainer120604.htm


Modified: 01/10/2002