Interpretive Letter to Martin Miller, Esq., Willkie Farr & Gallagher
March 16, 1999
Mr. Martin Miller, Esq.
Willkie Farr & Gallagher
787 Seventh Avenue
New York, NY 10019
Dear Mr. Miller:
I am responding to your letter of January 22, 1999, wherein you request interpretive guidance regarding the application of NASD Rule 2330(f) to an investment partnership that intends to register as a broker/dealer.
The relevant facts are as follows. You represent a client, Convexity Partners, L.P. (the "Company"). The Company is an investment partnership that plans to register as a broker/dealer to obtain better execution for its trades with other broker/dealers. The Company has a general partner and limited partners and trades only for its own account. As part of its agreement with the limited partners that have contributed capital to the Company, the Company's General Partner, Convexity Group, LLC ("General Partner"), will receive a 20% incentive fee.
The fee arrangement will be in compliance with Securities and Exchange Commission ("SEC") Rule 205-3, which currently requires such "performance fees" to be assessed only against certain" qualified clients" as defined under SEC rules.
You state that if the Company registers as a broker/dealer, the incentive fee could be construed as sharing in a customer account, which is generally prohibited under NASD Rule 2330(f). Rule 2330(f) states that "no member or person associated with a member shall share directly or indirectly in the profits or losses in any account of a customer carried by the member or any other member." However, Rule 2330 (f)(2) permits sharing in customer accounts under certain conditions that appear to be based on SEC Rule 205-3.
Effective August 20, 1998, SEC Rule 205-3 was modified by the SEC.1 The current version of NASD Rule 2330(f)(2) follows the "old" requirements of 205-3 which were more restrictive in some ways, including requiring a period of one year to elapse before such an incentive fee could be assessed. You state that the General Partner does not want to wait one before charging this incentive fee.
You have asked NASD Regulation to confirm that the provisions of Rule 2330(f) do not apply to the Company based on the language of the Rule and the specific nature of the Company's business. Rule 2330(f) prohibits sharing in the accounts of a "customer" carried by the member. You state that the Company has no "customers" and that the limited partners of the Company are the owners of the Company. You believe that owners of an NASD member firm are not considered "customers" for purposes of the NASD rules unless they otherwise have opened customer accounts with the member. You state that since the Company will merely trade its own assets and have no customers, it is not a "customer" for purposes of Rule 2330.
The staff of NASD Regulation concurs with your analysis that because the partnership registering as a broker/dealer would be trading only for its own account, it has no customers for purposes of Rule 2330(f). The phrase "customer carried by the member" in Rule 2330(f) is intended to refer to a person who utilizes the services of a broker/dealer, not a person who is registered as a broker/dealer.
I hope this letter is responsive to your inquiry. Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the Board of Directors of NASD Regulation. This letter responds only to the issues that you have raised based on the facts you have described, and does not address any other rule or interpretation of the Association, or all the possible regulatory and legal issues involved.
Robert J. Smith
Office of General Counsel
NASD Regulation, Inc.
1 The amendment to Rule 205-3 increased from $500,000 to $750,000 the mandatory level of a client's assets under management and increased the alternative net worth standard from $1 million to $ 1.5 million. The amendments reflect the effects of inflation since the rule's adoption in 1985. As before, a registered investment adviser's clients must meet one of the two standards if the client is to be charged an advisory fee based on performance of the client's account.
In addition, the amendment permits advisers to enter into performance fee contracts with "knowledgeable employees" (as defined) of the investment adviser and clients who meet the definition of "qualified purchasers" for purposes of participating in investment pools that are exempt from registration under Section 3(c)(7) of the Investment Company Act of 1940, as amended ($5 million of investments if a natural person or family company and $25 million of investments for others).
Additionally, Section 205 of the Investment Advisers Act, which is the basis for Rule 205-3, was amended by the National Securities Markets Improvement Act of 1996 to make its prohibitions on performance-based compensation inapplicable to non-U.S. clients and clients that are "3(c)(7)" companies.
The SEC eliminated the rule's provisions prescribing contractual terms and requiring specific disclosure. Thus, a client will able to agree to pay a performance fee calculated over a period of less than 12 months, which the rule in its previous form did not permit. This change materially eases compliance and avoids some of the more difficult calculations previously required by Rule 205-3.