Investment Advisers Act of 1940 - Section 206(3)
RESPONSE OF THE OFFICE OF CHIEF COUNSEL
Our Ref. No. 20043311129
Your letter dated August 17, 2005 requests our assurance that we would not recommend enforcement action to the Commission against Credit Suisse First Boston, LLC ("CSFB") under Section 206(3) of the Investment Advisers Act of 1940 (the "Advisers Act") if, as described more fully in your letter, CSFB uses certain prior global consent forms to provide written disclosures to and obtain written consents from its investment advisory clients ("Global Consents") regarding certain proposed principal transactions. That is, CSFB would like to use Global Consents, rather than transaction-by-transaction consents, to communicate with its clients about the purchase of certain of the clients' securities by CSFB's affiliated derivatives dealer.
You state the following: CSFB is a financial services firm registered with the Commission as both an investment adviser and a broker-dealer. In its capacity as an investment adviser, CSFB provides a volatility management program ("Program") to very high net worth clients and institutions that hold large positions in individual equity securities.1 As described below, the Program utilizes covered call options2 to either: (i) provide yield enhancement on the client's underlying stock position; or (ii) enable the client to exit the underlying stock position (or portions thereof) at specified price targets. The Program is driven by a quantitative analytical model ("Model") that calculates the probability that the underlying stock price will close above the strike price of a given covered call option.3
CSFB sets the Program's parameters based on each client's individual investment objectives, that is, whether the client seeks yield enhancement, seeks to exit a stock position, or both, as well as client-imposed investment restrictions and risk tolerance guidelines that will govern the management of the client's account. If the client's objectives include yield enhancement, CSFB seeks to create an additional stream of cash flow or a "synthetic dividend" for the client by selling a portfolio of covered call options with several strike prices and maturities.4 CSFB will also actively manage the positions by continuously monitoring the client's covered call options and seeking to buy back shorter-dated covered call options and sell longer-dated covered call options at a higher strike price when the underlying stock price is increasing and the client's covered call options positions are at risk of being exercised. If the client's objectives include exiting all or part of the client's underlying stock position, CSFB seeks to raise the client's effective selling price by selling covered call options on only a percentage of the underlying stock and actively managing the position to achieve the best risk-adjusted returns until the client's target exit level is reached.
The covered call options transactions are entered into based on the analyses provided by the Model, which projects future stock prices based on the risk-free rate of return and a comparison of implied versus historical volatility, and are not driven by the fundamental analyses of the underlying stock. The strike price, term and premium amount of individual covered call options may vary, but the type of option (i.e., a call option), the underlying type of security, the method of settlement, and other characteristics of the covered call options will be the same for each client. CSFB, on average, will enter into between four and eight covered call options transactions for each underlying stock position in any one year. The goal for each client is to establish an options portfolio for the underlying stock that is: (i) diversified across strike prices; and (ii) diversified across the maturity spectrum.
CSFB will sell an exchange-listed call option for the client when an exchange-listed call option is available that meets the client's investment objectives and fits the characteristics required by the Model. Listed call options meeting those criteria, however, are not always obtainable.5 CSFB, in those circumstances, will seek to enter into covered call options transactions for a client in the over-the-counter ("OTC") market. You represent that CSFB can construct options in the OTC market ("OTC Calls") with the precise strike prices and expiration dates that are needed to meet the economic terms specified by the Model, and can achieve broader diversification for its clients by allowing the specification of strike price and maturity on a trade-by-trade basis.
Currently, CSFB solicits bids for OTC Calls from two or more major financial services firms ("third-party dealers") on negotiated terms. The client must first establish an account with a third-party dealer before CSFB can solicit bids from that particular third-party dealer. You claim that clients are substantially inconvenienced by the burdens of establishing accounts with different third-party dealers because of the amount of OTC Calls that are effected for a client over the course of one year and the number of different third-party dealers.6 You claim that this places practical limitations on the number of accounts that a client is willing to open with different third-party dealers, which limits CSFB's ability to expand the number of third-party dealers from which it can seek more favorable bids on behalf of the client.
CSFB proposes, therefore, to have its clients sell OTC Calls to CSFB's affiliated OTC derivatives dealer ("Derivatives Affiliate"). In other words, CSFB would cause its clients to engage in certain principal transactions with the Derivatives Affiliate, as described in more detail below (the "Proposed Principal Transactions").7 Specifically, CSFB would seek bids from third-party dealers to buy a covered call option from its Derivatives Affiliate (on terms that would be identical to those of the OTC Call that the Derivatives Affiliate would purchase from CSFB's client) when an appropriate and desired covered call option is not available on the listed market. Bids would be evaluated solely based on price and the ability of the third-party dealer to execute the transaction in a timely manner.
If CSFB receives bids that it determines would meet the client's needs (i.e., that meet the parameters determined by the Model), CSFB would sell an OTC Call for the client's account to its Derivatives Affiliate on the same terms set forth in the best bid or bids received from the third-party dealer(s). In addition, CSFB would direct its Derivatives Affiliate to simultaneously sell an offsetting OTC Call to the third-party dealer(s) on terms that mirror those of the contract purchased from the client ("Mirror OTC Call").
The premium and strike price and other terms of each OTC Call purchased by the Derivatives Affiliate from a client would be identical to the terms of the Mirror OTC Call. If a third-party dealer exercised a Mirror OTC Call, the Derivatives Affiliate would in turn exercise its OTC Call with the client and obtain cash or the underlying stock from the client. You represent that Derivatives Affiliate would be able to exercise an OTC Call only upon the exercise of the Mirror OTC Call by the third-party dealer. You also represent that the Mirror OTC Calls would completely offset the Derivatives Affiliate's transactions with the clients so as to prevent the Derivatives Affiliate from profiting from the premium or strike price of any OTC Call. A client's underlying stock would secure the client's obligations under an OTC Call as well as the Derivatives Affiliate's offsetting obligations under each Mirror OTC Call.
The Derivatives Affiliate, for its services, would charge each client a standard servicing fee that would be capped at a fixed rate or amount (the "proposed fee rate").8 You represent that the proposed fee rate would be both commensurate with the work performed by the Derivatives Affiliate and compares favorably with the fees charged by other major brokerage firms for executing OTC covered call option transactions for institutional clients. The proposed fee and CSFB's Program advisory fees would be the only compensation earned by the Derivatives Affiliate or CSFB from the Proposed Principal Transactions, and you represent further that the advisory fee that a client pays to CSFB is not dependent on the number of transactions in the client's account.
Each client would consent to the Proposed Principal Transactions through a written Global Consent. The Global Consent would apprise the clients of the capacities in which CSFB and the Derivatives Affiliate would be acting and the potential conflicts of interest raised in connection with the Proposed Principal Transactions. The Global Consent would disclose the nature and maximum amount of compensation to be charged by the Derivatives Affiliate on each OTC Call (i.e., the proposed fee rate). The Global Consent would cover only the OTC Calls to be entered into within one year (or such shorter period specified by the client) of the date of the client's written consent, unless renewed by the client in writing for another year (or such shorter period specified by the client). The variables for each covered call option transaction (i.e., the strike price, premium, expiration date, quantity of shares covered, and time of the transaction, as well as the amount of the proposed fee paid to the Derivatives Affiliate) would be shown on the confirmation statement for each transaction that would be sent to the client by the Derivatives Affiliate, as promptly as possible, and in any event at or before completion of each transaction in the Program, and on the client's quarterly account statements from CSFB. In addition, a client could cancel participation in the Program upon 30 days' written notice to CSFB and may withdraw his or her Global Consent to any further Proposed Principal Transactions with the Derivatives Affiliate at any time.9
You claim that by structuring transactions in this manner, the client would have a single account, a single standardized OTC options agreement and a single collateral agreement with CSFB's Derivatives Affiliate.10 This would save clients substantial time, cost and paperwork, and would protect the confidentiality of client information.
Accordingly, you request relief from the transaction-by-transaction disclosure and consent requirements of Section 206(3) of the Advisers Act that would apply to each Proposed Principal Transaction. You believe that transaction-by-transaction disclosure and consent would undermine the Program because clients who would not be available to consent to the Proposed Principal Transactions within the short timeframes dictated by the Program would not be able to enter into the OTC Calls that would most benefit them.
Section 206(3) of the Advisers Act, in relevant part, makes it unlawful for any investment adviser, directly or indirectly, acting as principal for its own account, knowingly to sell any security to, or purchase any security from, a client without disclosing to such client in writing, before the completion of the transaction, the capacity in which the adviser is acting and obtaining the client's consent to the transaction.11 Section 206(3) is intended to address, as relevant here, the potential for self-dealing that could arise when an investment adviser acts as principal in a transaction with a client, such as through price manipulation.12 To address the potential for self-dealing, Section 206(3) requires, among other things, transaction-by-transaction disclosure to, and consent by, the client prior to the completion of each principal transaction.13
You question whether Section 206(3) would apply to the Proposed Principal Transactions because of the Mirror OTC Call, notwithstanding the fact that the Derivatives Affiliate, acting for itself, would purchase from a client an OTC Call, as well as the underlying stock upon the exercise of the option.14 You contend that the Global Consent rather than prior transaction-by-transaction disclosure and consent would address the limited conflicts of interest that may be raised by the Proposed Principal Transactions.15
You claim that the Proposed Principal Transactions would not raise the concerns regarding price manipulation by CSFB or the Derivatives Affiliate because of the Mirror OTC Calls between the Derivatives Affiliate and the third-party dealers. You represent that the Mirror OTC Calls would completely offset the Derivatives Affiliate's transactions with the clients so as to prevent the Derivatives Affiliate from profiting from the premium or strike price of any OTC Call. You contend that CSFB and the Derivatives Affiliate would have no incentive to engage in price manipulation because they could not benefit from any such manipulation.16 You claim that, in essence, any OTC Call, and any underlying stock (upon exercise), would pass through the Derivatives Affiliate's account only to facilitate a client's transactions with a third-party dealer. You contend that, consequently, the Proposed Principal Transactions should not implicate Section 206(3) because they are akin to transactions in which the Derivates Affiliate acts solely as an agent for a client.
You represent that the Global Consents would apprise the clients of the capacities in which CSFB and the Derivatives Affiliate would be acting, the proposed fee rate that the clients would pay to the Derivatives Affiliate, and any potential conflicts of interest raised in connection with the Proposed Principal Transactions.17 For instance, the Global Consents would apprise clients that the Proposed Principal Transactions may raise the concern that CSFB would cause a client to sell OTC Calls in order to generate proposed fee payments on those transactions. You note that the Global Consents, along with the confirmation statements and account statements, that CSFB will provide to each client, would allow a client to monitor the number and appropriateness of the OTC Calls that CSFB caused the client to enter into. You also contend that the clients' financial sophistication (as evidenced by the substantial amount of assets that a client must commit to the Program) would allow them to assess that information and evaluate whether or not to participate in the Program. You also note that the Global Consents are limited. That is, they would extend for only up to one year, and clients could withdraw their Global Consents at any time. You assert that, consequently, transaction-by-transaction disclosure and consent would be unnecessary, and would impede the operation of the Program for the benefit of the clients.
Based upon the facts and representations set forth in your letter, we would not recommend enforcement action to the Commission against CSFB under Section 206(3) of the Advisers Act if, as described more fully in your letter, CSFB uses the Global Consents to provide written disclosures to and obtain written consents from its clients regarding the Proposed Principal Transactions.18 Our position is based upon the facts and representations set forth in your letter, including your representations that:
This response expresses our views on enforcement action only and does not express any legal conclusions on the questions presented. Because our position is based on the facts and representations in your letter, you should note that any different facts or representations may require a different conclusion.
Kenneth C. Fang
In addition, Section 206(3) applies to certain principal or agency transactions engaged in, or effected by, a broker-dealer that controls, is controlled by, or is under common control with, a registered investment adviser. See Interpretation of Section 206(3) of the Investment Advisers Act of 1940, Investment Advisers Act Release No. 1732 (July 17, 1998) at n. 3 ("1998 Interpretive Release").
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