June 13, 2000
Jonathan G. Katz
Secretary, Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. S7-10-00
Dear Mr. Katz:
We are writing to comment on proposed Rule 204-3(d) and proposed Instruction 3 to Part 2A of the new Form ADV proposed in Investment Advisers Act Release No. 1862 (April 5, 2000) (the "Release"). This portion of the Commission's proposal would require registered investment advisers to treat investors in certain unregistered investment funds as clients so as to be obligated to deliver to such investors a proposed plain English narrative brochure and supplements thereto. While we heartily concur with the Commission's overall objective of making the brochure requirement more effective and more readable, we believe it is not necessary or appropriate in the public interest or for the protection of investors to impose a separate brochure delivery requirement for investors in private funds. Further, since investors in these types of investment funds should not be viewed as clients of the investment advisers for any purpose under the Investment Advisers Act, we believe that any disclosure requirement the Commission determines is appropriate should be grounded on a different rationale. A new Rule under Section 206(4) could, for example, state simply that any offering materials furnished to investors in a fund should reflect the information about the adviser and its relationship to the fund that is material to investors.
Registered Advisers Should not be Required to Provide a Separate Brochure to Investors in Funds Managed by Them.
In the Release the Commission identifies several flaws in the existing client disclosure regime that its brochure proposal is designed to address (text after note 107). These flaws include primarily various ways in which the information provided is either overly broad or not sufficiently geared to the client's situation. However, by imposing a separate brochure delivery requirement to investors in private funds, the Commission would, we believe, be compounding these problems for such investors.
Most of the information in a typical investment adviser's general brochure would not be relevant to a prospective or current investor in a private fund managed by the adviser. A prospective investor in a risk arbitrage fund would, for example, have no interest in the various types of advice the adviser provides to its clients or how the adviser tailors advice for its clients, the adviser's wrap fee programs, its fee schedule, the types of clients the adviser markets to, how accounts are reviewed and so forth. In addition, several mandated disclosures are inappropriate for investment funds. For example, it is not true that investors will incur brokerage fees, that an investor may obtain a refund if it redeems its investment, that an investor can purchase products (i.e., the fund) recommended by the adviser through other brokers or that an investor may place any limitation on the fund's investments.
Conversely, most of the information about an adviser that is potentially material to an investor in a particular private fund managed by that adviser is already being provided to investors through the fund's offering materials. Private funds that are offered to any unaccredited investors must provide disclosure comparable to the analog Commission form, which would generally be Form N-2 under the Investment Company Act of 1940. See Rule 502(b)(2)(A) under the Securities Act of 1933. Form N-2 requires disclosure of everything the Commission believes is pertinent to investors in a closed-end fund about the adviser and its practices with respect to the fund. Although private funds marketed solely to accredited investors are not obligated to provide any particular form of disclosure to potential investors, it is the uniform practice in the industry to provide an offering document (except occasionally in offerings to a very limited number of highly sophisticated investors who are actively negotiating the terms of the fund with the adviser). These offering documents, because of Rule 10b-5 concerns and with reference to Rule 502(b)(2)(A) under the Securities Act, provide disclosure regarding the adviser and its practices that in most cases actually goes beyond what would be required by Form N-2. These offering documents typically provide detailed information about the team that will manage the fund, the fund's investment practices and techniques, risk factors, portfolio execution practices, soft dollar practices, the circumstances in which agency cross, principal co-investment and other potential conflict transactions may occur, costs and expenses and fees and pertinent performance information.
The Commission is not yet formally required by Section 225 of the Graham-Leach-Bliley Act (to be codified as Section 202(c) of the Investment Advisers Act) to consider whether its proposed brochure requirement will promote efficiency, competition and capital formation. However, we believe that the Commission should currently consider these values in its rulemaking activities since they are explicitly stated in the legislation as additional aspects of the existing public interest standard rather than a new or different standard. If the Commission does so, we believe that it will find the application of the brochure requirements to investors in private funds to be unsupportable because such a requirement will promote inefficiency, make it more difficult for registered investment advisers who manage private funds to compete and impede the capital formation process.
Given the substantial compliance with the pertinent and material aspects of the proposed brochure requirement in private fund offering materials, requiring delivery of a separate brochure to investors in private funds would be an inefficient use of time and resources. Many registered investment advisers manage several private funds, many of which, under Section 3(c)(7) of the Investment Company Act of 1940, have hundreds of investors. A separate brochure delivery requirement would force them to deliver thousands of copies of largely irrelevant or duplicative information at substantial expense.
Requiring delivery of a separate brochure to investors in private funds would also be anticompetitive in relation to the requirements that would apply to registered funds and to private funds managed by unregistered advisers. There is no difference between registered funds and private funds that we are aware of that would justify treating them differently in this regard. While most registered funds have a board of directors or the equivalent that presumably can question and monitor the adviser's practices, many private funds organized as limited liability companies or business trusts also have boards and many private funds have advisory boards on which major investors often have representation. Further, investors in private funds have the right to obtain additional information regarding the adviser and historically have exercised their bargaining power to at least the same extent as have the boards of directors of registered funds. More importantly, registered and unregistered funds have the same materiality standard regarding disclosure to investors in their offering materials. A board of directors cannot serve to reduce the level of information about the adviser that is material to investors. Since the same standard applies, investors in either type of fund should receive the pertinent information whether or not the fund has a board of directors. Finally, under Section 206(4) of the Investment Advisers Act, which is one of the bases for the brochure delivery requirement (See Part VI of the Release), there is no difference between unregistered funds managed by registered advisers and unregistered funds managed by unregistered advisers. The Commission's rulemaking efforts should treat these two classes of advisers in the same manner for these purposes.
We believe that investors in private funds generally receive appropriate information regarding the funds' advisers and their practices. We are not aware that the Commission has found to the contrary and we question whether it is appropriate to impose additional regulatory burdens if none are needed. If after further review the Commission nonetheless determines that additional regulation is necessary and appropriate in the public interest, we respectfully submit that the proposed "clarification" that brochure delivery requirements apply to investors in private funds (text at note 117 of the Release) is not an appropriate solution and that a more appropriate solution is readily available. As to the Commission's proposed "clarification," we believe that there is no basis for concluding that investors in private funds are clients of an adviser for any purpose if they do not receive advice based on their individual situations and that the Commission should instead take the opportunity to clarify that such investors are not clients, thereby clearing up confusion in this area. We discuss this matter in detail in the following section. As to an appropriate method of assuring that investors receive appropriate information about the advisers of their funds, we would suggest that any action by the Commission be through a Rule under Section 206(4) of the Investment Advisers Act that would state simply that it would be fraudulent, deceptive or manipulative if any offering materials furnished to prospective investors in any investment fund client with respect to which an investment adviser has discretionary authority do not reflect the information about the investment adviser and its related persons and their relationships with the fund that would be material to such prospective investors.
By applying to all investment advisers, whether registered or not, such a Rule would be even-handed in its application. By focusing on the information that is material to prospective investors in a particular fund, it would avoid the necessity of providing extraneous information. By requiring that the information be in the offering materials, it would avoid unnecessary duplication and parallel the disclosure regime for registered funds.
The Commission's proposed revision to Rule 204-3 would technically apply only to registered advisers that also serve as a general partner, managing member or trustee of a limited partnership, limited liability company or trust. This formulation would apparently not apply the brochure delivery requirement if an affiliate of the investment adviser were the general partner, manager or trustee and the adviser acted by contract to provide investment advice only or if the advisee were a corporation. On the other hand, the Commission's formulation could apply to persons acting as trustees of finance subsidiaries and asset backed finance companies, which are often organized as trusts or limited liability companies. By applying to all investment advisers but only where they exercise discretion with respect to an investment fund, our suggested alternative would provide coverage that would be more evenly applicable to the world of unregistered funds. Once again, however, we do not mean to suggest that any additional regulation is required, only that there are preferable alternatives if the Commission ultimately determines further regulation is appropriate.
As a separate note, we would urge the Commission to revise its reference in general instruction 2 to Part 2A of the ADV to electronic delivery requirements to include the most recent release on this subject (SEC Rel No. 33-7856 (4/28/00)). This would make it clearer than does the 1996 release cited in the proposal that an adviser may make delivery by posting its brochure on its website with appropriate disclosure in the advisory contract or marketing material reflecting the website location and the availability of the brochure.
Investors in a Private Fund are not Clients of the Fund's Investment Adviser
In the Release (text at note 117) the Commission appears to take the position that investors in a private fund are clients of the fund's investment adviser for purposes of Rule 204-3's brochure delivery requirement. In note 117 the Commission explains its understanding that a contrary position has been taken by some advisers based on Rule 203(b)(3)-1(a)(2)'s provision that only the fund is the client for purposes of determining whether the adviser has the minimum number of clients necessary to mandate registration. The Commission goes on to state that this conclusion would result in no brochure being delivered, which would undermine the remedial purposes of the Investment Advisers Act and concludes by citing Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 1977) ("Abrahamson"), for the proposition that the anti-fraud provisions of the Investment Advisers Act apply to investors in private funds.
We believe, contrary to the Commission's statements, that (1) advisers do not deliver brochures to investors in their private funds because such investors are not clients under the Investment Advisers Act without regard to Rule 203(b)(3)-1(a)(2); (2) as discussed above, it is not necessary to turn investors into clients to have them obtain the information about the fund's adviser that is pertinent to their investment decision; (3) turning investors into clients would lead to numerous significant problems under the Investment Advisers Act which would inevitably be used by the plaintiffs' bar to prove violations by the advisers of registered investment companies as well since there is no rational basis for making private investors clients without also making public investors clients; and (4) the Abrahamson case was wrongly decided and should have no precedential bearing.
1. Investors are not Clients. The Investment Advisers Act defines an investment adviser as any person who (i) for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities or (ii) who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities. The Act does not define the term "client;" however, such term plainly has a correlative meaning as the recipient of the investment advice. Although it may fairly be concluded that a private investment fund is the recipient of investment advice from its investment adviser, such advice is not provided in any manner to those who invest in the fund. They are, like shareholders of registered mutual funds, simply passive holders of a security that entitles them to their pro rata economic share, along with all the other investors, of the benefits or detriments resulting from the advice provided by the investment adviser to the fund. In this regard it does not matter whether there are 50 investors, 5,000 investors or 500,000 investors. None of them receive any advice from the adviser and all of them share pro rata in the benefits and detriments of the advice the adviser provides to the fund. There are privately offered unregistered funds organized as partnerships, limited liability companies and business trusts with hundreds of equity investors and there are privately offered registered funds organized in precisely the same forms with fewer than 50 equity investors. There does not appear to be any basis on which to conclude that investors in the private fund are clients while investors in the registered fund are not. The only potential difference between the two funds aside from registration is that, in some cases, the unregistered fund will not have a board of directors whereas the registered fund will in all cases. However, the presence or absence of a board of directors has no bearing on whether investment advice is being provided to the investors. Abrahamson, the only decision, whether judicial or administrative, that appears to find that investors are clients, did not base its finding on either of these differences-without-meaning. Rather, the Abrahamson court appears to have based its conclusion on the fact that the adviser received compensation and that reports were provided on which investors must have relied in deciding whether to maintain their investment in the fund. Not only does this fail to provide a basis for treating investors in private funds differently from investors in registered funds, it also fails to establish any of the elements of an advisory relationship.
The Abrahamson court was apparently trying to seize on the element of the definition of investment adviser referring to the promulgation of analyses or reports concerning securities for compensation as part of a regular business. However, a report stating that the fund held specific amounts of specific securities on a specific date or, as in the Abrahamson case, a report comparing fund performance to an index cannot rationally be viewed as "analyses or reports concerning securities" within the meaning of the Act. First of all, such reports are properly regarded as reports by the fund, not the adviser, that are part of the duty of any entity to report to its owners. Second, the statutory phrase "analyses or reports concerning securities" implies that some assistance or advice regarding the recipient's potential investment decisions about third party securities is intended, whereas the typical portfolio report focuses solely on the merits of the issuer's securities that the investor has already purchased. In this regard such a report is no different than the annual and quarterly reports by management of an industrial company. Such managers also receive compensation, also provide reports to investors about the company's securities and also expect that investors will rely on those reports. Yet such reports are properly not considered "analyses and reports concerning securities" under the Advisers Act. The reports by registered and unregistered investment companies are no different. To date, no one has suggested that the periodic reports to shareholders of registered mutual funds are "analyses or reports concerning securities" by the funds' advisers for compensation within the meaning of the Investment Advisers Act. However, that would be the ineluctable and very problematic conclusion that would have to be drawn from the Commission's proposal since there is no other basis for finding a client relationship and no basis on which to distinguish registered from unregistered funds.
2. It is not Necessary to Treat Investors as Clients
As discussed in the first part of this comment letter, investors in private funds are adequately served at present by the offering materials that are and always have been the appropriate mode of disclosure to investors under the federal securities laws. If the Commission should decide that they are not adequately served, there are (as discussed earlier) adequate tools ready at hand to satisfy the Investment Advisers Act's remedial purposes without turning investors into clients.
In addition, there are numerous other laws in place to protect investors in private funds. For example, Regulation D under the Securities Act mandates disclosure requirements that apply with respect to non-accredited investors, as discussed above. In addition, the Exchange Act contains broker-dealer registration requirements which apply to the offering and sale of interests in private funds by intermediaries, and the NASD rules regulate suitability and impose fair dealing standards for these intermediaries. Further, the Investment Advisers Act anti-fraud provisions apply to managers of funds, whether the managers are registered or not. In addition, general partners of private funds owe state law fiduciary duties to their limited partners and state law also provides for derivative actions. Either of these state law bases would have provided an adequate remedy for the plaintiffs in Abrahamson without requiring the court to stretch the meaning of client into meaninglessness. It is also important to note that investors in private funds are almost entirely accredited investors, qualified purchasers under Section 2(a)(51) of the Investment Company Act or qualified institutional buyers under Rule 144A of the Securities Act, who do not need the same level of protection as unaccredited retail investors in registered funds .
3. Client Status Would Cause Numerous Problems
Providing investors in private funds with the status of clients has numerous inappropriate corollary effects. Among them, funds (whether private or registered) would no longer be able to engage in agency cross transactions without getting the approval of each and every investor in the fund and revocation of approval by a single investor would void the approval granted by all other investors. The Staff has never taken this position in the examination process; rather, it has required disclosure to investors and the ability of a majority of investors to terminate blanket authority. A contrary view would disregard the difference between a fund and individual clients. Similarly, a fund could not engage in principal transactions without the consent of each investor, whereas the Staff's position in examinations and in the interpretive release discussing what constitutes valid consent (SEC Rel. No. IA- 1732, 7/17/98) has been to permit authorization either by a majority of investors or by an independent third party appointed for that purpose. The Commission's orders under Section 17(a) permitting funds to acquire money market securities from affiliated dealers would, for example, be insufficient since they were not granted under the Investment Advisers Act and the affiliates never obtained consent from the millions of "clients"invested in their mutual funds.
Another undesirable effect of treating investors as clients is that a third party would need to have a cash solicitation agreement with the adviser rather than be a registered broker-dealer in order to receive compensation from a registered adviser in connection with effectuating sales of interests in a registered or unregistered fund. There are in fact a series of no-action letters that suggest such a result. See, e.g., Stein, Roe & Farnham (6/29/90) and Dechert Price & Rhoads (12/4/90). However, these letters logically would require advisers and third party registered broker-dealers to comply with the cash solicitation rule requirements with respect to many of the popular mutual fund "no transaction fee" programs, which would impose an immense and unwarranted compliance burden on the mutual fund industry. Furthermore, these letters have led many purveyors of private funds and -- we have been informed -- registered funds to conclude that they are not required to register as broker-dealers in order to receive such compensation if they utilize cash solicitation agreements.
In the Stein, Roe letter, for example, the Staff stated the definition of "solicitor" (any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser) and then concluded that a third party registered adviser that invested its clients' funds in a mutual fund and received compensation from the mutual fund's investment adviser for doing so would be indirectly soliciting clients for the mutual fund adviser. The only reason given by the staff for this conclusion was that, as shareholders of a mutual fund, the third party adviser's clients would be subject to the advisory fee charged by the mutual fund adviser to the mutual fund and therefore would be indirect clients of the mutual fund adviser.
This analysis is flawed in several respects. First of all, the definition of solicitor does not cover "indirect clients" but only "indirect solicitation" of actual clients. Indeed, the concept of an indirect client does not appear anywhere in the Investment Advisers Act, as the definition of "investment adviser" makes clear. Second, the suggestion that the payment of an advisory fee by a fund for advice to the fund is sufficient to make an investor in that fund an actual client of the adviser ignores the plain words of the definition of an investment adviser. Third, the only other basis for finding a client relationship, which the Staff did not assert, would be the furnishing of reports as asserted by the Abrahamson court, which is also plainly incorrect. Finally, broker-dealer registration would be adequate to provide suggested disclosures.
In Dechert Price the Staff backed off from its legal argument, saying only that, while the cash solicitation rule might not explicitly apply to the situation in the Stein, Roe letter, that situation raised the same potential for abuse that the cash solicitation rule was designed to prevent and with respect to which the Staff accordingly was unwilling to grant no-action relief. We agree that investment advisers who invest their clients' funds in mutual funds should disclose to those clients any sources of compensation they receive from third parties in connection with or as a result of their decision. However, this would appear to us to be a requirement under Section 206 without regard to the cash solicitation rule, which is a much blunter tool designed for a different purpose. It would be preferable for the Staff to state that it would not grant no-action relief in these types of circumstances unless proper disclosure was provided to the clients rather than to impose all of the paraphernalia of the cash solicitation rule (separate agreements, deliveries of brochures and written acknowledgments) designed for the traditional solicitation of an advisory relationship. The Staff has, in fact, often taken this sort of more finely tuned position in recent years. See, e.g., Charles Schwab & Co. Inc. (8/6/92) (payments by advisers or distributors in no transaction fee context) and Merrill Lynch Asset Management (4/28/97) (implementation of safeguards of private placements to affiliated mutual funds). At the same time the Staff should take the opportunity to clarify that the receipt of compensation from third parties for effectuating sales of securities (such as mutual funds and private funds) satisfies the definition of broker in the Securities Exchange Act of 1934 and that persons engaging in such activities as part of a business must register as a broker.
4. Abrahamson was Wrongly Decided
Abrahamson, the only case suggesting that private fund investors are clients, is plainly wrong. Its primary holding was overruled by the Supreme Court and it has never been cited by any court for the proposition that investors are clients. In Abrahamson, the plaintiffs, who were limited partners in an investment partnership, brought claims for damages against the general partner, alleging losses resulting from fraud on the part of defendants. One of the plaintiffs' claims was based on the antifraud provision of Section 206 of the Investment Advisers Act. In order to consider that claim, the court needed to find, among other things, that the plaintiffs were entitled to invoke Section 206 and that there is an implied private right of action for damages under the Investment Advisers Act. The court made both findings and ultimately held that plaintiffs had alleged compensable damages under Section 206 of the Advisers Act. Two years later, in Transamerica Mortgage Advisors, Inc. et al v. Lewis, the Supreme Court overruled the decision in Abrahamson with regard to the implied private right of action under Section 206. 444 U.S. 11 (Nov. 13, 1979). The court's other finding, that the investors were partners, is equally suspect.
Although the Abrahamson court explicitly recognized that the plaintiffs were only entitled to protection under Section 206 if they were clients of the investment adviser (id. at 878) and therefore the court necessarily found that they were clients, the court barely discusses what it was that made them clients. It would appear that the court simply disregarded the existence of the partnership, for it states in the course of deciding a different point, that the general partner was an investment adviser, (1) that the general partner received substantial compensation for managing the limited partners' investments, (2) that it provided monthly reports to the limited partners consisting of a brief comparison of performance to the S&P 500 index and a statement of the partnership's investment policy and (3) that limited partners necessarily relied heavily on these reports in determining whether to redeem their interests. The court's first statement is inaccurate since the general partner received compensation solely from the partnership and solely for managing the partnership's assets. The second statement is likely to be equally wrong since the reports were undoubtedly furnished on behalf of the partnership. The third statement, while correct, has no bearing on whether the investors were clients of the adviser rather than investors in a partnership.
This distinction that the Abrahamson court failed to draw is actually of critical importance. Each of the court's three statements could be made with equal force -- in fact would have to be made with equal force -- in respect of every registered mutual fund. Although the Transamerica court eliminated private causes of actions for damages under the Investment Advisers Act, it left standing the remedy of rescission. Application of a rescission remedy for violations of the Investment Advisers Act by the advisers of registered mutual funds would lead to potentially large amounts of class action litigation against such advisers. We believe that the Abrahamson court's "analysis" has not been applied to registered mutual funds only because, as discussed earlier, such "analysis" is completely wrong. We would urge the Commission not to resurrect a wrongly decided case that has never been cited favorably by any court for the proposition in question. In that regard we would also note that the Commission itself in its two amicus curiae briefs in the Abrahamson litigation (February 2, 1976 and May 19, 1977) went no further than to argue that the general partner was an investment adviser and was careful not to argue that investors in the partnership were clients of the general partner.
In summary, a determination that an investor in a fund is a client would necessarily apply to any entity, including registered mutual funds, and is not an appropriate or helpful approach under the Investment Advisers Act to address the concerns of the Commission. Consequently, we would urge the Commission either to take no action or to adopt the equally effective and far less problematic disclosure requirements suggested in this letter.
Thank you for considering our comments. If you have any questions please do not hesitate to call Yaffa R. Cheslow at (212) 735-3902, Philip H. Harris at (212) 735-3805 or myself at (212) 735-2790.
Very truly yours,
Richard T. Prins