Notice To Members 88-55

Correction to Notice to Members 88-55

Published Date:

SUGGESTED ROUTING*

Senior Management
Legal & Compliance
Operations

*These are suggested departments only. Others may be appropriate for your firm.

EXECUTIVE SUMMARY

The Securities and Exchange Commission (SEC) recently approved amendments to Article III, Section 19(f) of the NASD Rules of Fair Practice governing sharing in customer accounts by members and by persons associated with members.

The amendment will permit performance-based fees under certain circumstances. The text of the amendment follows this notice.

BACKGROUND

The SEC recently approved amendments to Article III, Section 19(f) of the NASD Rules of Fair Practice (see SEC Release No. 34-25736, dated May 23, 1988) that would allow performance-based fees under certain circumstances. Section 19(f) generally prohibits members or persons associated with members from sharing in the profits or losses in customer accounts other than in direct proportion to the amount invested. The amendments would permit performance-based compensation under circumstances similar to those enumerated in Rule 205-3 of the Investment Advisers Act of 1940.

EXPLANATION OF AMENDMENTS

The amendments will allow members or persons associated with members to receive compensation based on a share of profits or gains in an account when:

1. Written authorization is obtained from the member carrying the client's account.
2. The customer meets stated minimum net-worth or account investment-size requirements.
3. There is a reasonable belief that the customer understands the compensation method and its risks.
4. The arrangement is in writing.
5. The agreement was reached through "arm's length" negotiation.
6. The arrangement takes into account both gains and losses over at least a one-year period.
7. The member has disclosed all material information relating to the arrangement.

Members are cautioned, however, that it is the position of the SEC's Division of Investment Management that compensation received by a member or person associated with a member under this rule would constitute "special compensation" for purposes of the exception to the definition of "investment adviser" in Section 202(a)(ll)(C) of the Investment Advisers Act of 1940. This would limit the availability of the broker-dealer exemption from investment adviser registration. In addition, any member or person associated with a member required to be registered under the Advisers Act, or state law, who receives compensation based on a share of profits or capital appreciation of a customer's account must comply with Section 205(1) and Rule 205-3 under the Advisers Act, which set forth the terms upon which such compensation may be received or applicable state law with respect to such compensation. (See SEC Release 34-24355, dated April 16,1987.)

The NASD rule, while not identical to Rule 205-3 under the Advisers Act, uses the same basic criteria as that rule. However, Rule 205-3 in some respects imposes requirements that go beyond those of amended Section 19(f). Firms and persons associated with members who are in compliance with the current provisions of Rule 205-3 would also generally be in compliance with the provisions of Section 19(f). Questions about this notice can be directed to T. Grant Callery, NASD Associate General Counsel, at (202) 728-8285.

PROPOSED AMENDMENTS TO ARTICLE III, SECTION 19(f) OF THE NASD RULES OF FAIR PRACTICE

(New language underlined; deleted language in brackets.)

Customers' Securities or Funds

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•
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Sharing in accounts; extent permissible

(f)
(1)
(A) Except as provided in Subsection (f)(2) 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 [unless]; provided, however, that a member or person associated with a member may share in the profits or losses in such an account if (i) such member or person associated with a member obtains prior written authorization from the member carrying the account; and (ii) the member or person associated with a member shares in the profits or losses in the account only in direct proportion to the financial contributions made to such account by either the member or person associated with a member.
(B) Exempt from the direct proportionate share limitation of subsection (f)(l)(A)(ii) are accounts of the immediate family of such member or person associated with a member. For purposes of this section, the term "immediate family" shall include parents, mother-in-law or father-in-law, husband or wife, children or any relative to whose support the member or person associated with a member otherwise contributes directly or indirectly.
(2) Notwithstanding the prohibition of subsection (f)(l), a member or person associated with a member may receive compensation based on a share in profits or gains in an account if all of the following conditions are satisfied:1
(A) The member or person associated with a member seeking such compensation obtains prior written authorization from the member carrying the account;
(B) The customer has at the time the account is opened either a net worth which the member or person associated with a member reasonably believes to be not less than $100,000, or the minimum amount invested in the account is not less than $500,000;
(C) The member or person associated with a member reasonably believes the customer is able to understand the proposed method of compensation and its risks prior to entering into the arrangement;
(D) The compensation arrangement is set forth in a written agreement executed by the customer and the member;
(E) The member or person associated with a member reasonably believes, immediately prior to entering into the arrangement, that the agreement represents an arm's-length arrangement between the parties;
(F) The compensation formula takes into account both gains and losses realized or accrued in the account over a period of at least one year; and
(G) The member has disclosed to the customer all material information relating to the arrangement including the method of compensation and potential conflicts of interest which may result from the compensation formula.

1 It is the position of the Division of Investment Management of the Securities and Exchange Commission that compensation received by a member or person associated with a member under this rule would constitute "special compensation" for purposes of the exception to the definition of "investment advisor" in Section 202(a)(ll)(Q of the Investment Advisers Act of 1940 (Advisers Act). Any member or person associated with a member, required to be registered under the Advisers Act, or state law, who receives compensation based on a share of profits or capital appreciation of a customer's account must comply with Section 205(1) and Rule 205-3 under the Advisers Act, or applicable state law, with respect to such compensation. (SEC Release 34-24355, 52 Fed. Reg. 13778, April 24,1987).