February 18, 1997
VIA FEDERAL EXPRESS AND E-MAIL firstname.lastname@example.org
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: File No. S7-31-96
Dear Mr. Katz:
This comment letter is submitted in triplicate in response to Release No. IA-1601 (the "Release"). In the Release, the Securities and Exchange Commission (the "SEC") proposed for comment new rules and rule amendments ("Proposed Rules") under the Investment Advisers Act of 1940, as amended (the "Act"), to implement provisions of the Investment Advisers Supervision Coordination Act of 1996 (the "1996 Act").
As background, our firm represents approximately 275 investment advisers that manage more than 220 investment pools. These pools are exempt from registration as investment companies under the Investment Company Act of 1940, as amended ("Investment Company Act"), and their interests are held by both onshore and off-shore investors.Of the forty attorneys at our firm, ten devote substantial time to counseling investment advisers. Our practice group includes two former SEC enforcement attorneys. John P. Broadhurst of this office is a member of the American Bar Association Task Force on Hedge Funds. The views expressed in this letter, however, are those of our firm and are not being submitted on behalf of that Task Force or any of our clients.
We have the following specific comments on the Release and the Proposed Rules.
I. Proposed Form ADV-T
a. Registration Permitted or Required? The SEC should consider clarifying Instruction 6 to proposed Form ADV-T. New section 203A(c) of the Act states that the SEC may permit the registration with the SEC of any person or class of persons to which the application of section 203A(a) would be unfair, a burden on interstate commerce, or otherwise inconsistent with the purposes of section 203A. Instruction 6 to Proposed Form ADV-T, however, refers to an adviser that is not registered or required to be registered in the state in which it maintains its principal office and place of business, and to the advisers exempted from the prohibition on SEC registration by Proposed Rule 203A-2, as being required to register with the SEC regardless of the amount of assets under management. If registration with the SEC is permitted, but not required, for certain advisers, it would seem that such advisers could choose not to register with the SEC in reliance on the exemption from SEC registration provided by section 203(b)(3) of the Act. Furthermore, the concept that advisers not registered in the state where their principal offices are located are eligible, but not required, to register with the SEC is reinforced by the language of Instruction 3 to proposed Form ADV-T.
b. Use of Form ADV-T for Withdrawal From State Registration. Advisers that are currently registered with one or more states, but that will be eligible to be registered with only the SEC after April 9, 1997, will have to go through the lengthy and expensive process of withdrawing from registration with, in some cases, multiple states. We suggest that the SEC consider whether it has the authority to require, or to make available, Form ADV-T to be used to withdraw from state registration. Form ADV-T will already contain much of the required information that will serve as the basis for withdrawal from state registration, but may need to be amended by the addition of boxes to be checked or blanks for the identification of the state(s) from which withdrawal is requested.
2. Transitions Between State and SEC Registration. Proposed Rule 203A-1(b) provides for a $25,000,000 to $30,000,000 window to facilitate the transition between state and federal regulation for advisers whose assets under management fluctuate within that range. This window, however, is not large enough to accommodate, for example, a 25% increase or decrease in an adviser's assets under management resulting from a change in the market. We are concerned that market shifts in the value of portfolios could require frequent de-registration and re-registration between the SEC and the states. To avoid this "transient registration" problem, we propose a slightly different rule. The rule could provide that a state-registered adviser would have to maintain assets under management of over $30,000,000 for a six-month period before being required to register with the SEC. At that point, the adviser would be allowed a period of four to six months to register with the SEC and de-register with the state(s). Similarly, an SEC-registered adviser whose assets under management fell below $25,000,000 for a six-month period would be required to de-register with the SEC and register with the appropriate state(s). Again, a four- to six-month period would be allowed for the transition.
Even if a proposal along the lines suggested in the preceding paragraph is not implemented, we do not believe that the ninety-day grace period allowed in Proposed Rule 203A-1(c) for a transition from SEC to state registration is sufficient. In our experience, state registration can be a lengthy process. We suggest that a four- to six-month grace period would be more realistic for this purpose. We also suggest, for state-registered advisers whose assets under management grow to $30,000,000 or more, that a grace period of at least ninety days be allowed before SEC registration is mandatory for those advisers. The requirement that SEC registration be made "promptly" in this situation (see the Release in the text accompanying note 41) is not practical given the time needed to make the required calculations and amend and file the adviser's Form ADV.
3. Proposed Rule Exemptions from Prohibition from Registration with SEC.
a. Consultants. Section 203A(c) of the Act gives the SEC authority to exempt advisers from the prohibition on SEC registration if the prohibition would be "unfair, a burden on interstate commerce, or otherwise inconsistent with the purposes" of section 203A. Pursuant to that authority, Proposed Rule 203A-2(b) would exempt from the prohibition pension consultants who provide advice with respect to assets of plans having an aggregate value of at least $50,000,000. We see no reason to restrict the scope of the exemption to employee benefit plans. We propose that this exemption be extended to all consultants who choose and monitor managers of their clients' assets. Such an exemption would apply to advisers who manage family offices, funds of funds and wrap fee programs. Many of such advisers have a national or multistate practice and it would be inconsistent with the purposes of the 1996 Act for these advisers to continue to be subject to varying state registration requirements.
b. Certain Affiliated Investment Advisers. We are concerned that Proposed Rule 203A-2(c) may cast doubt on the ability of an entity affiliated with an SEC-registered investment adviser to rely on the Richard Ellis, Inc. (avail. Sept. 17, 1981) line of SEC no-action letters in not registering with the SEC. In Richard Ellis, Inc. and related no-action letters, the Division of Investment Management stated, in summary, that affiliation with an entity that is registered as an investment adviser would not constitute a violation of section 208(d) of the Act by the unregistered affiliate if the two companies exist and function independently. In determining whether the requisite independence is present, five specific factors were to be considered.
The SEC should make clear that Proposed Rule 203A-2(c) will not require an entity affiliated with an SEC-registered adviser to register with the SEC if it would not otherwise be required to do so, so long as the Richard Ellis factors are present. No policy reason would be served by now requiring registration of such affiliated entities.
We also suggest deletion of the requirement that the affiliated entities share the same principal office and place of business. As the Release states in the text accompanying note 56, affiliated advisers that share the same principal office and place of business are likely to have overlapping operations, similar books and records, and integrated compliance systems. The same can often be said, however, of affiliated advisers whose places of business are physically separate, especially as technology continues to reduce the significance of where a securities business is conducted. The rule should provide instead that affiliated advisers need only have centralized management and/or compliance systems to take advantage of this exemption. Implementation of this proposal would also require amendment of Instruction 4 to proposed Form ADV-T.
c. Reasonable Expectation of Eligibility. Proposed Rule 203A-2(d) would allow an investment adviser to register with the SEC if it is not registered or required to be registered with the SEC or any state and has a reasonable expectation that it would be eligible to register with the SEC within ninety days after the date the adviser's registration becomes effective. We agree that such an exemption is appropriate, but we have several concerns with the proposed rule.
First, a ninety-day period does not seem long enough for a newly-formed adviser to begin its business fully. We believe a time period of 180 days would be more realistic. Second, we do not understand the requirement that the adviser must not be registered or required to be registered with any state for this exemption to apply. The Release indicates that Proposed Rule 203A-2(d) was included because requiring a newly-formed adviser to register with the states, only to de-register and register with the SEC shortly thereafter, would be unfair, burdensome, and inconsistent with the purposes of section 203A. By imposing this requirement, however, if an adviser initiates its business in a state that happens to require registration immediately, the adviser is unable to take advantage of Proposed Rule For example, California does not have a de minimus exemption so a new manager generally is required to be licensed in California immediately. An adviser should be able to take advantage of Proposed Ruleregardless of whether it is at that time required to be registered with a state.
4. "Regulated or Required to be Regulated" by a State. In the Release in the text accompanying note 60, the SEC states that it proposes to interpret the phrase "regulated or required to be regulated,"as used in section 203A(a)(1) of the Act, as "registered or required to be registered." A primary goal of the 1996 Act was to separate SEC and state authority over investment advisers. That goal is not advanced by requiring an investment adviser to register with the SEC if the state in which such adviser's principal office is located regulates investment advisors and requires investment advisers to register, but provides an exemption or exception from its registration requirement for such an adviser.
If a state has an investment adviser statute, the state has asserted its right to regulate investment advisers with a principal office and principal place of business in that state, and the SEC does not need to supervise those investment advisers unless they are managing in excess of $25,000,000 and are otherwise required to register with the SEC. The state law may provide for exemptions from its registration requirements or exceptions to the definition of investment adviser, but in doing so it does not delegate responsibility for such exempted or excepted advisers to the SEC. The legislative history of the 1996 Act quoted in the Release at note 59 is consistent with this position. It provides that the SEC "will continue to supervise all advisers that are based in a state that does not register investment advisers."(emphasis added)
The Release requests comment on whether the SEC should recommend that Congress amend section 203A(a)(1) of the Act to prohibit an adviser from registering with the SEC if it has its principal office and principal place of business in a state that has enacted an investment adviser statute (regardless of whether that statute requires the adviser to register). We agree that such a recommendation should be made. We note that upon such an amendment, the SEC should consider amending Proposed Rule 203A-4. Rulea safe harbor for state-registered investment advisers, is proposed to be available only for an adviser that is actually registered with the state in which it has its principal office and place of business. We propose that it be extended to advisers who are exempt or excluded from state registration in a state that has enacted an investment adviser statute.
According to the Release in the text accompanying noteunder Sectionof the Act, the SEC will retain regulatory responsibility for advisers with a principal office and place of business in states that have not enacted investment adviser statutes. We would like the SEC to clarify, Section 203A(a)(1) of the Act does not preclude such an adviser from failing to register with the SEC in reliance on the exemption provided by Sectionof the Act.
In the Release in the text accompanying notethe SEC recognized that the 203(b)(3) exemption should still be available for an adviser with a principal office and place of business in a state that has an investment adviser statute, but that is not required to be registered under that statute. We request that the SEC clarify that the sectionexemptions will also continue to be available for advisers with their principal offices and places of business in states that have not enacted investment adviser statutes (we understand that currently there are four such states).
6. Persons Acting on Behalf of Investment Advisers. Proposed Rule 203A-3(a)(1) would define "investment adviser representative" for purposes of section 203A of the Act and the rules thereunder, as a supervised person of the investment adviser, if a substantial portion of the business of the supervised person is providing investment advice to clients who are natural persons. The Release in the text accompanying note 77 requests comment on whether to except from the definition of "investment adviser representative" supervised persons a substantial portion of whose business is providing services to natural persons who have a high net worth or meet other indicia of financial sophistication.
According to the Release in the text accompanying note 68, the legislative history of the 1996 Act suggests that Congress intended to permit state securities authorities to establish qualification standards for investment adviser representatives to protect individual, or "retail," investors. We propose that an exception be provided for supervised persons a substantial portion of whose business is providing services to natural persons who are "accredited investors," as defined in Rule 501(a) under the Securities Act of 1933, as amended. This would further the policy of allowing states to regulate supervised persons who provide advice to "retail" clients, who may need that protection. Accredited investors, who must have a high net worth to meet the requirements of Rule 501(a), should not require the same protection.
We also suggest that the SEC clarify that "client," as used in Proposed Rule 203A-3(a)(1), when applied with respect to a supervised person providing investment advice to an entity such as a limited partnership, means the entity and not natural persons who invest in the entity. This would be consistent with the SEC's position with respect to limited partnerships in Rule 203(b)(3)-1 under the Act (that the limited partnership itself, if certain conditions are met, is considered the "client" and the individual investors in the pool need not be counted separately) and with the definition of "client" in Proposed Rule 222-2(b). We suggest that the SEC provide that the comprehensive definition of "client" in Proposed Rule 222-2 also apply for purposes of Proposed Rule 203A-3(a)(1).
7. Definition of "Client". The Release in the text accompanying note 95 requests comment on the proposed definition of "client" in Proposed Rule 222-2. Preliminarily, we suggest that this definition of "client" also be applied for purposes of section 203(b)(3) of the Act. There is little guidance available regarding who is a "client" under section 203(b)(3), and the comprehensive definition of "client" in Proposed Rule 222-2 would provide much-needed clarification for that purpose. We have the following additional comments on Proposed Rule 222-2.
a. Identical Beneficial Owners. As stated in the Release at note 94, the SEC's Division of Investment Management has allowed multiple trusts with identical beneficiaries to be treated as a single client for purposes of section 203(b)(3). Rule 222-2 should also treat multiple legal entities with identical shareholders, partners, members or beneficiaries as a single client. Wealthy families frequently invest through different vehicles, such as trusts, partnerships, limited liability companies and corporations, that have identical beneficial ownership. We see no reason to regard all such vehicles as separate clients. In addition, it should be made clear that this principle should apply whether or not the beneficial owners own each entity in the same proportions.
b. No-Fee Accounts. Advisers frequently manage accounts for the benefit of members of their families and personal friends to whom they do not charge fees. We have been advised informally by the SEC's Division of Investment Management that these no-fee accounts need not be counted as clients for purposes of section 203(b)(3), but the assets of those clients should be reported in Part I of Form ADV in Items 18 and 19. Confirmation of this position in Rule 222-2 would be helpful.
c. Family Members Not Sharing Same Principal Residence. We agree with the policy of Proposed Rule 222-2(a) that multiple accounts for natural persons and their family members should be counted as one client. In certain circumstances, however, the requirement that the natural person and family members share the same principal residence may have the effect of excluding certain family relationships. For example, accounts for a person and the person's minor child residing with the other parent would not qualify as one client, while accounts for the same person and a minor child residing with that person would qualify. To avoid this inequity, we suggest the deletion of the requirement that family members share the same principal residence.
d. Rule 203(b)(3)-1. The Release in the text accompanying note 96 requests comment on whether the SEC should reconsider the requirement that limited partnership interests be regarded as securities for purposes of Rule 203(b)(3)-1. We believe that the requirement that such interests be securities is unnecessary in light of the separate requirement that the general partner or other person provide investment advice to the partnership based on the investment objectives of the limited partnership. We also suggest that Rule 203(b)(3)-1 be extended to apply to all investment pools managed by an investment adviser, such as limited liability companies and corporations, as well as limited partnerships. Investment pools may be organized in other forms than limited partnerships, but the same policies should apply.
e. Foreign Clients. The SEC has recognized that it has less interest in regulating an investment adviser with respect to its relationships with its foreign clients than its U.S. clients and that a U.S. investment adviser should not be placed at a disadvantage vis a vis foreign advisers in competing for foreign clients. For example, the Division of Investment Management has taken the position in no-action letters that foreign investment advisers must count only their U.S. clients and need not count their foreign clients in determining whether they have fewer than fifteen clients for purposes of section 203(b)(3) of the Act. Congress has also recognized this in enacting section 205(b)(5) of the Act, to provide that the prohibition on investment advisory contracts providing for compensation to an investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds of a client do not apply to an investment advisory contract with a client that is not a U.S. resident. We recommend, therefore, that the definition of "client" in Rule 222-2 exclude foreign clients of the adviser.
8. Rule 206(4)-3(a)(ii). The SEC should amend Rule 206(4)-3(a)(ii) under the Act to correct the cross-references to paragraphs (4) and (5) of Section 203(e) of the Act. The 1996 Act inserted a new paragraph (3) to section 203(e) and renumbered paragraphs (4) as (5) as paragraphs (5) and (6).
9. Performance Fee Exception. New section 205(b)(5) states that paragraph (1) of subsection (a) of section 205 does not apply to an investment advisory contract with a person who is not a resident of the United States. We suggest that the SEC clarify the application of this section to an entity organized and domiciled outside the United States, some of the beneficial owners of which are residents of the United States. We understand from unofficial sources that the SEC is considering taking the position that the performance fee prohibition, and thus Rule-3 under the Act, will continue to apply to off-shore entities that have United States investors who are not "qualified purchasers," as defined in section 3(c)(7) of the Investment Company Act.
It is unclear whether this position goes beyond the language of the statute. If the SEC takes this position, we suggest that the performance fee prohibition, and thus Rule-3, only apply if U.S. investors who are not qualified purchasers own more than 25% of the foreign entity's equity securities.
We appreciate the opportunity to comment on the Proposed Rules.
SHARTSIS, FRIESE & GINSBURG LLP