Committee on Securities
March 15, 2004
Via email to firstname.lastname@example.org
RE: File No. S7-04-04
Dear Secretary Katz:
This letter expresses to the Securities and Exchange Commission (the "Commission" or "SEC") the comments of the Committee on Securities of the Business Law Section of the Maryland State Bar Association (the "Committee") with respect to the rules proposed in Release Nos. IA-2209, IC-26337 (the "Release"), Proposed Rule: Investment Adviser Code of Ethics (the "Proposal").
In general, we support the rule and its intent to promote compliance with fiduciary standards by advisers and their personnel.
We would like to bring to your attention several items addressed in the proposed rule and how they may impact smaller advisers, particularly advisers that do not represent registered investment companies.
Protection of Material Nonpublic Information
As you are aware, the personnel or access persons of many smaller advisers are also registered representatives of firms registered with the Commission as broker-dealers. In some cases, these broker-dealers are affiliated with the adviser firm and in others the broker-dealer and the adviser are unrelated. Where the adviser and broker-dealer are affiliated, their operations may be integrated with one another or they may operate essentially separate types of businesses (e.g., broker-dealer acting as placement agent for private offerings and adviser providing advice on mutual fund investments).
We believe that particular unintended consequences may result in circumstances where the personnel of an adviser are also registered representatives of a broker-dealer. We believe that these unintended consequences may be exacerbated by the Proposal (or at the very least the Proposal illustrates the unintended consequences).
Under NASD rule 3040, if a registered representative wants to engage in "private securities transactions," the registered representative must give prior notice to his or her employing broker-dealer and must state whether he or she will receive "selling compensation." If the registered representative will receive "selling compensation," the registered representative must obtain the approval of the broker-dealer. If the registered representative does not obtain the approval, he or she may not engage in the transaction. If the registered representative obtains the approval, the broker-dealer must record the transaction on its books and must "supervise" the registered representative's participation in the transaction.
In two notices to members on this rule (NASD Notice to Members 94-44 and 96-33), the NASD has interpreted "private securities transactions" to include providing advice as an investment adviser and has interpreted "selling compensation" to include the receipt of fees based upon assets under management.1
According to the NASD Notice to Members 96-33, where selling compensation is to be received, NASD Rule 3040 requires the broker-dealer to maintain specific records regarding the transactions and must have supervisory procedures in place to prevent and/or detect misconduct that could violate the federal securities laws and NASD rules.
The Proposal requires advisers to adopt a code of ethics to "prevent access to material nonpublic information about [the adviser's] securities recommendations and the [adviser's] clients' securities holdings and transactions, by persons who do not need such information to perform their duties." The Proposal indicates that the information may be shared with persons providing services to the adviser or the account - e.g., brokers.
It would appear that the NASD requirement that the employing broker-dealer record on its books all private securities transactions of its registered representatives would cause the adviser to violate its confidentiality obligations to its clients. To the client, such a broker-dealer does not have any "duties" that need to be performed. This would be particularly acute where the trades for the client's account will not be effected by the "supervising" broker-dealer.
In fact, requiring adviser personnel to reveal all independent trading activity for managed accounts to their employing broker-dealer could (or perhaps are likely to) inhibit efforts by the adviser to obtain best execution as such disclosure might lead the adviser personnel to feel pressured (whether warranted or not) to effect all trades through the employing broker-dealer. The fact that the adviser personnel may feel or believe that there is such pressure is contra to the adviser's obligation of undivided loyalty to its clients, which the proposed code of ethics is designed to enhance.2
The Proposal indicates that the Commission believes that there are no rules that duplicate or conflict with the proposed rules. However, as described above, it appears that a conflict does exist.
Initial Public Offerings and Private Placements
In the Release, the Commission asked whether the rule should prohibit access persons from making these types of investments (IPOs and private placements) for their personal accounts. The proposed rule and rule amendments are designed to promote compliance with fiduciary standards by advisers and their personnel. We do not believe that an outright ban on access persons investing in IPOs and private placements is necessarily the best way to accomplish this objective.
Advisers should be permitted to have the flexibility to adopt a code appropriate for their businesses. As a fiduciary, an adviser should be responsible to adopt and implement policies and procedures reasonably necessary to ensure compliance with its fiduciary obligations arising from its specific business activities. Advisers will have varying conflicts of interest due to the nature of their advisory business as well as their affiliations. In some cases, advisory firms may not have affiliations with broker-dealers that act as placement agent for private offerings or public underwritings or the advisory firm may not invest client assets in such investments due to its investment style and strategy. In other cases, these investment opportunities become available to access persons for reasons other than the individual's position with the adviser. Whether an outright ban on IPOs and private placements is appropriate will depend on the business activities of the adviser.
We believe that an outright ban may unfairly deny advisory employees of investment opportunities instances where no material conflict of interest exists. If an adviser has procedures reasonably designed to monitor for conflicts of interests specific to its business activities, then these investments should be permitted.
We believe that the proposed requirement that an adviser maintain the records of access persons' personal securities reports "electronically in an accessible computer database" may unduly burden smaller firms. There are costs involved in keying all information into a spreadsheet, as the Proposal suggests, as well as maintaining the records in accordance with the electronic storage requirements contained in Rule 204-2(g). We would suggest that a numeric limitation be placed on the number of access persons an adviser must have before the records must be retained in electronic form. (Of course, these smaller advisers could elect to keep the records in electronic form). In light of the potentially broad meaning of the term "access person," we would suggest that advisers with more than 50 "access persons" must retain the records electronically.
Very truly yours,
Ad-Hoc Subcommittee on SEC Comment
By: Hillel Tendler, Chair,