Clarification of NASD Notice to Members 96-33: application of Rule 3040 to registered representatives of a distributor who also are employed by investment advisers to manage the portfolios of investment companies.
August 4, 1997
I am responding to your January 7, 1997 letter to Daniel M. Sibears and your May 9, 1997 letter to me regarding the application of NASD Rule 3040 to a person associated with an NASD member who engages in a "private securities transaction" on behalf of a registered investment company with respect to which the associated person or the registered investment adviser that employs such person serves as investment adviser.
NASD Rule 3040 (formerly, Article III, Section 40 of the NASD Rules of Fair Practice) 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. Where the associated person has received or may receive selling compensation, the member must respond to the notice in writing indicating whether it approves or disapproves the person’s participation in the proposed transaction. If the member approves the transaction, the member must record the transaction in its books and records and supervise the associated person’s participation in the transaction as if the transaction were executed by the member firm. The purpose of Rule 3040 is to ensure that a member firm adequately supervises and pays attention to the suitability and due diligence responsibilities of its associated persons.
"Selling compensation" is defined in the Rule as any compensation paid directly or indirectly from whatever source in connection with or as a result of the purchase or sale of a security, including, though not limited to: commissions; finder’s fees; securities or rights to acquire securities; rights of participation in profits, tax benefits, or dissolution proceeds, as a general partner or otherwise; or expense reimbursements. Notice to Members 85-84, which announced the approval of Rule 3040, and Notice to Members 91-32 state that the definition of selling compensation is deliberately broad in scope, is not restricted to the examples listed in the definition, and is meant to include any item of value received or to be received, directly or indirectly, in connection with the execution of a securities transaction. Only transactions executed on the customer’s behalf without any form of compensation would be subject to the "transactions not for compensation" provisions of Rule 3040. See Notice to Members 94-44.
We understand the pertinent facts to be the following: The letter seeks advice about individuals who are both registered representatives of broker/dealers and portfolio managers employed by investment advisers to investment companies ("RR/IAs") and who are conducting investment advisory activities away from the NASD member firm with which they are associated. The RR/IAs are registered as representatives of broker/dealers that distribute the shares of investment companies ("Distributors"). The RR/IAs are registered because they may not be able to rely in all circumstances on the "safe harbor" from broker/dealer registration provided under Securities and Exchange Commission Rule 3a4-1 when they participate in sales of the investment companies’ securities. These RR/IAs typically take only the Series 6 examination (Limited Representative--Investment and Variable Products). The Distributors often are limited purpose broker/dealers that, consistent with their restriction agreements with the NASD, are limited to underwriting and retailing mutual fund shares. In addition, the principals of these Distributors may have passed only the Series 6 and 26 examinations, limiting them to supervising trades in investment company shares and variable products. Absent unusual circumstances, no compensation is paid to the RR/IAs by the Distributors.
The RR/IAs also are employed by investment advisers to manage the portfolios of investment companies. The RR/IAs are responsible for deciding what securities should be bought and sold for the investment companies’ portfolios and for placing trades with executing brokers. In most cases, the securities transactions on behalf of the investment company are entered with a brokerage firm other than the one with which the RR/IAs are associated. The RR/IAs may purchase or sell ordinary equity or debt securities for the portfolios of the investment companies. The RR/IAs are compensated by their registered investment adviser employers based on the size of the accounts they manage. An RR/IA who is a general or limited partner of an investment adviser formed as a general or limited partnership will receive an allocation of profits and losses in accordance with the RR/IA’s partnership interest. Where the employing investment adviser is a corporation, RR/IAs may be compensated on a salary basis, but also may participate in bonus programs based upon the profitability of the investment adviser. These bonus programs can take a multitude of forms and may include payments of cash, stock options, and/or securities of the employing investment adviser.
You have acknowledged in your letter that the RR/IAs who make investment decisions regarding the portfolios of their investment company customers and enter securities orders on behalf of these customers with a brokerage firm other than the firm with which they are registered are engaging in private securities transactions. Accordingly, this letter addresses only whether the RR/IAs must comply with the "transactions for compensation" provision or the "transactions not for compensation" provision of Rule 3040.
As explained in Notices to Members 96-33 and 94-44, which clarified the application of Rule 3040 to RR/IAs, an RR/IA who receives any type of compensation from a person other than the member firm with which he or she is associated for participating in the execution of private securities transactions on behalf of a customer are subject to the full "transactions for compensation" provisions of Rule 3040. This would be the case whether the compensation paid to the RR/IA is transaction-related, commission-type compensation; asset-based or performance-based management fees; or hourly, yearly, or per-plan fees, as long as the compensation paid includes execution services of the RR/IA. As stated in Notice to Members 91-32, only transactions executed on the customer’s behalf without any form of compensation would be subject to the "transactions not for compensation" provision of Rule 3040.
Based on the foregoing analysis, it is the opinion of the staff that the referenced activities must be performed in compliance with "transactions for compensation" provisions 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 Board of Directors of NASD Regulation, Inc. This letter responds only to the issues you have raised based on the facts as you have described them in your letter, and does not necessarily address any other rule or interpretation of the NASD or all the possible regulatory and legal issues involved.
Very truly yours,
Mary N. Revell