Interpretive Letter to Name Not Public
August 5, 1994
Your June 9, 1994, letter directed to Brian Hobbs has been forwarded to us for response. You requested that the staff provide an opinion as to the application of Article III, Section 40 of the NASD Rules of Fair Practice to the activities of persons registered with [Broker/dealer] and also associated with [Investment Advisor].
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 is associated. The NASD member firm must advise the individual in writing as to whether it approves or disapproves of the person's participation in a transaction in which the associated person has received or may receive selling compensation. If the member approves the transaction, the transaction must be recorded on the member firm's books and records, and the member firm must supervise the associated person's participation as if the transaction were executed by the member firm.
We understand the pertinent facts to be the following: [Investment Advisor] is an independent registered investment adviser. Two of managing directors, [Person 1] and [Person 2], are registered representatives with [Broker/dealer] ("dually registered persons" or "RR/RIAs"). The third managing director [Person 3], is not a registered representative. Each of the three managing directors of [Investment Advisor] is an investment adviser representative with [Investment Advisor].
[Investment Advisor] manages accounts for its clients using no-load mutual funds, 401(k) no-load investment options, and some variable annuity no-load investment options. [Investment Advisor]'s investment management services provide security selection and portfolio management involving buy/sell transactions and [Person 1] and [Person 2] have been granted a limited power-of-attorney to execute certain transactions. [Investment Advisor] receives asset-based fees for its investment management services. Although [Investment Advisor]'s existing Management Service Agreement stipulates that clients are responsible for paying transaction costs, [Investment Advisor] practice has been to pay transaction costs for its clients.
Pursuant to Management Service Agreement [Investment Advisor] has complete authority and discretion as the manager of a client's account to make initial and subsequent purchases (including the reinvestment of all dividends or distributions received from the investment in a client's account), and sales of the investments that [Investment Advisor] believes to be consistent with the investment strategy selected by a client. Portfolio changes for [Investment Advisor] clients are based upon a consensus of an investment committee. This investment committee consists of [Person 1], [Person 2], and [Person 3]. Trade instructions for portfolio changes are prepared by a [Investment Advisor] staff associate and then given to [Investment Advisor]'s traders for implementation. Trades are uploaded through [Investment Advisor]'s computer interface to its custodian.
Inasmuch as [Person 1] and [Person 2] have discretionary trading authority, determine portfolio changes in their capacity as members of the investment committee, and trade instructions are prepared by [Investment Advisor] and given to [Investment Advisor]'s traders for implementation, [Person 1] and [Person 2] are "participating in the execution of a trade" on behalf of their clients. In accordance with Article III, Section 40, if compensation is received for a transaction in which a RR/RIA has participated, the transaction is subject to the full "for compensation" provisions of Article III, Section 40.
Your letter suggests that [Investment Advisor] does not receive selling compensation for executing transactions on behalf of its clients as required by Section 40, because [Investment Advisor] clients do not pay a transaction fee; rather, asset-based fees are charged by [Investment Advisor] for its investment management services. As explained in Notice to Members 94-44 which clarified the application of Section 40 to RR/RIAs, transactions executed on behalf of a customer in which the RR/RIA has participated in the execution are subject to the full "for compensation" provisions of Section 40. This would be the case whether the fees paid to the RR/RIA are transaction-related, commission-type; compensation, asset-based management fees, hourly, yearly, or per-plan fees, as long as the fees paid include execution services of the RR/RIA.
Based on the foregoing analysis, it is the opinion of the staff that the referenced activities must be performed in compliance with the provisions of Article III, Section 40 of the Rules of Fair Practice.
Very truly yours,
Daniel M. Sibears