Applicability of Rule 3040 to investment advisory activities of an individual who is dually registered as a registered representative and a registered investment advisor.


November 4, 2002

 

Donna B. Lawson
V.P./Chief Compliance Officer
First Allied Securities, Inc.
525 B Street, 17th Floor
San Diego, California 92101

 

RE: Application of NASD Rule 3040 to Investment Advisory Services of an RR/RIA

 

Dear Ms. Lawson:

 

Mr. David Anderson, at the District No. 2 office, has directed your letter of August 2, 2002, to this office. In that letter you request a written interpretation from NASD concerning the application of NASD Rule 3040 to investment advisory services provided by a registered representative affiliated with First Allied Securities, Inc. ("First Allied"), who is also an independent registered investment adviser registered with the Securities and Exchange Commission (hereafter referred to as "RR/RIA").

 

You state that the RR/RIA wishes to offer his advisory services to accounts held at First Allied's clearing firms, accounts held with product sponsors (such as mutual funds), and accounts held at unaffiliated broker/dealers. You state that in most instances, the RR/RIA will be making the recommendations and directing the investments within the accounts. You state that an opportunity may arise in which the RR/RIA and/or an affiliate of the independent RIA, a non-securities registered person who is not associated with First Allied (referred to as "IAR") may call in trades for execution to an unaffiliated broker/dealer that is holding accounts that the RR/RIA is managing, or direct trades through an unaffiliated broker acting as broker of record.

 

You ask whether any of the following six scenarios would constitute "participation in the execution of a securities trade," thereby triggering the record-keeping and supervision requirements of Rule 3040. Scenarios 4, 5, and 6 also involve an IAR. You describe the following scenarios:

 

  1. RR/RIA calls the order directly into the trading desk of an unaffiliated broker/dealer for which the account is custodied.
  2. Same as scenario 1, but the order is entered online in a trading system maintained by the unaffiliated broker/dealer for which the account is custodied.
  3. Same as scenarios 1 and 2, except the RR/RIA hands-off a list of the securities transactions for an account maintained at an unaffiliated broker/dealer to the broker who in turn calls or enters the orders into his/her broker/dealer for execution.
  4. The IAR calls the order directly into the trading desk of an unaffiliated broker/dealer for which the account is custodied.
  5. Same as scenario 4, but the order is entered online in a trading system maintained by the unaffiliated broker/dealer for which the account is custodied.
  6. Same as scenarios 4 and 5, except the IAR hands-off a list of the securities transactions for an account maintained at an unaffiliated broker/dealer to the broker who in turn calls or enters the orders into his/her broker/dealer for execution.

You ask whether certain scenarios would constitute the RR/RIA's participation in the execution of the transactions, thereby triggering a supervisory obligation by First Allied under Rule 3040.

 

Rule 3040

 

Rule 3040 provides that any person associated with a member who participates in a private securities transaction must, prior to participating in the transaction, provide written notice to the member with which he or she is associated. The required notice must describe the transaction, the associated person's role, and state whether the associated person has received or may receive selling compensation. If the person has received or may receive selling compensation in connection with the private securities transaction, the member must respond to the notice in writing indicating whether it approves or disapproves the proposed transaction. If the member approves, it must record the transaction in its books and records and supervise the registered person's participation in the transaction as if it were the member's own. If the associated person will not receive any selling compensation, the firm must acknowledge the written notice and may also require the person to adhere to specified conditions in connection with his or her participation in the transaction.

 

Applicability of Rule 3040 to Investment Advisory Activities of Registered Persons

 

Notice to Members 94-44 provides guidance regarding the applicability of Rule 3040 (previously Article III, Section 40 of the NASD Rules of Fair Practice) to the investment advisory activities of registered persons. The Notice states that an RR/RIA "participates in the execution of a transaction" for purposes of Rule 3040 when his or her participation "goes beyond a mere recommendation," e.g., when an RR/RIA "enters an order on behalf of the customer for particular securities transactions either with a brokerage firm other than the member they are registered with, directly with a mutual fund, or with any other entity, including another adviser, and receives any compensation for the overall advisory services."

 

Excluded from Rule 3040 coverage are arrangements under which the account is "handed off" to unaffiliated third-party advisers that make all the investment decisions. Other arrangements that would not be subject to Rule 3040 include: situations in which the customer executes the securities transactions independently through another broker/dealer or directly with a fund or other entity based on specific recommendations of the dually registered person; timing services where the service makes the investment decision; the utilization of unaffiliated third-party advisers where the RR/RIA does not participate in investment decisions for the client; and the creation of a financial plan.

 

Thus, determining whether an RR/RIA has "participated in the execution of a transaction" for purposes of Rule 3040 is not dependent upon whether a third party is interposed between the RR/RIA and the trading desk of the broker/dealer that ultimately enters the order. Rather, "participation" occurs when the RR/RIA is involved in directing the execution of transactions that he or she has recommended. If the RR/RIA is merely making recommendations to his or her customers, and the customers are independently executing the transactions through another broker/dealer or directly with a fund or other entity, the RR/RIA would likely not be "participating" in the execution of those transactions.

 

Assuming that the RR/RIA is making the recommendations and directing the investments within the accounts as you state in your letter, each of the scenarios you present would require compliance with the requirements of Rule 3040. In scenarios 1 and 2, the RR/RIA would be participating in the execution of transactions because he or she is calling orders directly into a trading desk or entering orders into an online trading system. With respect to scenarios 3 through 6, the RR/RIA would be participating in the execution of transactions because the RR/RIA is directing the execution of his or her recommended trades, albeit through a third-party. Under any scenario, an RR/RIA who participates in the execution of a transaction through an IAR who is associated with the RR/RIA's firm will trigger the reporting and supervision requirements of Rule 3040.

 

. I hope this letter is responsive to your inquiry. Please note that the opinions expressed in this letter are staff opinions only and have not been reviewed or endorsed by the NASD Board of Governors. This letter responds only to the issue you have raised and does not necessarily address any other NASD rule or interpretation or all the possible regulatory and legal issues involved.

 

Very truly yours,

 

Shirley H. Weiss

cc: Lani Woltmann, Director, District 2 (Los Angeles)