October 2, 2007
SEC Adopts Temporary Rule Regarding Principal Trades with
Certain Advisory Clients
In light of the recent court decision vacating Rule 202(a)(11)-1 under the Investment Advisers Act of 1940 (the
Advisers Act)1, the SEC has adopted temporary Rule 206(3)-3T (Temporary Rule) to establish an alternative
method for investment advisers who are dually registered with the SEC as both advisers and broker-dealers to
meet the requirements of the Advisers Act when they act in a principal capacity in transactions with certain of their
advisory clients. The Temporary Rule is effective September 30, 2007 and will expire on December 31, 2009,
absent further action by the SEC.
General Background
Rule 202(a)(11)-1, as previously adopted by the SEC, provided, among other things, that fee-based brokerage
accounts were not advisory accounts and thus, not subject to the Advisers Act.2 As a result of the court decision
vacating Rule 202(a)(11)-1, broker-dealers offering fee-based brokerage accounts, and those resulting client
relationships, became subject to the Advisers Act – meaning that those broker-dealers would need to register
under the Advisers Act and comply with its provisions (unless the client account changed to a transaction-based
fee arrangement). In response to SEC concerns about the implications of the rule reversal, the effectiveness of
the court decision vacating Rule 202(a)(11)-1 was stayed until October 1, 2007. Prompted by the court decision,
the SEC engaged in discussions with industry participants. The SEC learned that the most significant impediment
to broker-dealers who are also registered as investment advisers under the Advisers Act (adviser/broker-dealers)
to continue to offer fee-based accounts were the provisions of Section 206(3) of the Advisers Act. In particular,
the provisions requiring written disclosure of an adviser’s principal capacity before completion of the securities
transaction were seen as troublesome. In part, Section 206(3) makes it unlawful for any investment adviser,
directly or indirectly
…acting as principal for his own account, knowingly to sell any security to or purchase any security from a
client . . . , without disclosing to such client in writing before the completion of such transaction the
capacity in which he is acting and obtaining the consent of the client to such transaction.
As noted in the release adopting the Temporary Rule (Adopting Release), the SEC believes that the Temporary
Rule will allow for the continuation of fee-based accounts in a manner that “protects investors’ choice – fee-based
brokerage customers would be able to choose an account that offers a similar set of services (including access to
the same securities) that were available to them in fee-based brokerage accounts – and avoids disruption to, and
confusion among, investors who may wish to access and sell securities only available through a firm acting in a
principal capacity and who, as a result, may no longer be offered any fee-based account.”
1
Financial Planning Association v. Securities and Exchange Commission, No. 04-1242 (DC Circuit, March 30,
2007).
2
A fee-based account pays a fee based on the amount of assets in the account (an asset-based fee) rather
than a traditional brokerage account where the customer pays a commission for each transaction.
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Overview of Temporary Rule 206(3)-3T
Rule 206(3)-3T permits a dually registered adviser/broker-dealer, with respect to non-discretionary advisory
accounts, to comply with Advisers Act Section 206(3) by, among other things:
ƒ
Providing written prospective disclosure regarding the conflicts arising from principal trades;
ƒ
Obtaining written, revocable consent from the client prospectively authorizing the adviser to enter into
principal transactions;
ƒ
Making certain disclosures, either orally or in writing, and obtaining the client’s consent before each
principal transactions;
ƒ
Sending to the client confirmation statements with particular disclosure - the capacity in which the adviser
has acted; that the adviser informed the client that it may act in a principal capacity; and that the client
authorized the transaction; and
ƒ
Delivering to the client an annual report itemizing the principal transactions.
It is important to the note that the Temporary Rule does not relieve an adviser/broker-dealer from (i) its obligations
to act in the best interests of each client, including fulfilling the duty with respect to the best price and execution
for a transaction and (ii) fiduciary obligations otherwise imposed by the Advisers Act and other federal laws.
A.
Advisory Account Must Be a Brokerage Account
The Temporary Rule is only available to an investment adviser who also is registered with the SEC as a brokerdealer. Each account for which the investment adviser relies on the Temporary Rule must be a brokerage account
subject to the Securities Exchange Act of 1934 (Exchange Act). This means that an adviser who is not a
registered broker-dealer would not be able to rely on the Temporary Rule, even if the adviser causes a client to
enter into a principal transaction with a control person that is a registered broker-dealer.
B.
Non-Discretionary Accounts
The Temporary Rule applies to principal trades only with respect to non-discretionary accounts, including those
accounts that were originally established as fee-based brokerage accounts. The Adopting Release makes it clear
the availability of the Temporary Rule to discretionary accounts would be inconsistent with the other requirements
of the Temporary Rule (as discussed below) that require the adviser/broker-dealer to obtain prior consent for each
principal transaction.
C.
Ineligible Securities
The Temporary Rule is not available for principal trades of securities for which the adviser/broker-dealer, or a
person who controls, is controlled by, or is under common control with the adviser/broker-dealer is the issuer or is
an underwriter of the security (other than with respect to non-convertible investment-grade debt securities). The
Temporary Rule is unavailable for principal transactions in traditional equity or debt offerings of the
adviser/broker-dealer or a control person of the adviser/broker-dealer, and for non-discretionary placement by an
adviser/broker-dealer of proprietary structured products. The Adopting Release notes the SEC’s concern that the
sale of securities issued or underwritten by the adviser/broker-dealer or its control persons present many conflicts
of interest.
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D.
Written Prospective Consent Following Written Disclosure
Under the Temporary Rule, an adviser/broker-dealer may, only after having secured a client’s written, revocable
consent prospectively, sell any security to or purchase any security as principal from the client. The consent can
be obtained only after the adviser/broker-dealer provides the client with written disclosure about (i) the
circumstances under which the adviser/broker-dealer may engage in principal transactions with the client; (ii) the
nature and significance of the conflicts the adviser/broker-dealer has with its clients’ interests as a result of the
principal transactions; and (iii) how the adviser/broker-dealer addresses those conflicts. The written disclosure
and request for prospective consent must include a conspicuous, plain English statement clarifying that the
consent may be revoked at any time. The SEC noted in the Adopting Release that it anticipated that the consent
would be obtained by the adviser/broker-dealer at the time an account is established.
E.
Trade-by-Trade Consent Following Disclosure
The Temporary Rule requires that before each principal transaction, the adviser/broker-dealer must (i) inform the
client in writing or orally of the capacity in which the adviser/broker-dealer may act with respect to the particular
transaction and (ii) obtain written or oral consent from the client for the adviser/broker-dealer to act as principal for
its own account with respect to each such transaction. Because in many instances, an adviser/broker-dealer will
not know whether a particular transaction will be effected on a principal basis, the Temporary Rule allows an
adviser/broker-dealer to disclose that it may act in a principal capacity. The Adopting Release also notes the
SEC’s belief that the obligation to make oral disclosure will not impose a significant burden on an adviser/brokerdealer prior to entering into a principal transaction.
F.
Written Confirmation
Under the Temporary Rule, an adviser/broker-dealer must send each client with whom it effects a principal trade
a written confirmation at or before the completion of the transaction. The confirmation must include a
conspicuous, plain English statement informing the client that (i) the adviser/broker-dealer disclosed to the client
prior to the execution of the transaction that the adviser may act in a principal capacity in connection with the
transaction, (ii) the client authorized the transaction, and (iii) the adviser/broker-dealer sold the security to or
bought the security from the client for its own account. This disclosure must be included in the confirmation
statement (as otherwise required by Rule 10b-10 under the Exchange Act) that is sent to the client. The Adopting
Release makes clear that the trade-by-trade confirmation is designed to ensure that clients are given a written
notice and reminder of each transaction that the adviser/broker-dealer effects on a principal basis, and that
conflicts of interest are inherent in such transactions.
G.
Annual Statement
Under the Temporary Rule, the adviser/broker-dealer must deliver to each client, no less frequently than once a
year, written disclosure containing a list of all principal transactions that were executed in the account, including
the date and price of such transactions. As noted in the Adopting Release, the annual summary statement is
designed to ensure that clients receive a periodic record of the principal trading activity in their accounts and are
afforded an opportunity to assess the frequency with which their adviser/broker-dealer engages in such trades. As
with the written disclosure and request for consent, the annual statement must include a conspicuous, plain
English statement that the adviser/broker-dealer client’s written prospective consent may be revoked at any time.
Request for Comment
The Adopting Release requests comments no later than November 30, 2007 on various aspects of the Temporary
Rule. The full text of the Adopting Release is available online at http://www.sec.gov/rules/final.shtml. If you are
interested in commenting on any aspect of the Adopting Release, we are available to assist you with the
preparation and submission of your comment letter.
3
For further information, please contact Cameron Avery 312-807-4302, Kevin Bettsteller 312-807-4442, Paul Dykstra
312-781-6029, Jennifer Esquibel 312-807-4262, Alan Goldberg 312-807-4227, Elizabeth H. Hudson 312-807-4376, Anna
Paglia 312-781-7163, Alicia Perla 312-807-4318, Andrew Pfau 312-807-4386, Paulita Pike 312-781-6027, Eric Purple 202955-7081, Bruce Rosenblum 202-955-7087, Donald Weiss 312-807-4303, Gwendolyn A. Williamson 202-955-7059, or Stacy
Winick 202-955-7040 of Bell, Boyd & Lloyd’s Investment Management and Financial Markets Group or visit our Web site at
www.bellboyd.com.
This publication has been prepared by the Investment Management and Financial Markets Group of Bell, Boyd & Lloyd for
clients and friends of the firm and is for information only. It is not a substitute for legal advice or individual analysis of a
particular legal matter. Readers should not act without seeking professional legal counsel. Transmission and receipt of this
publication does not create an attorney-client relationship.
© 2007 Bell, Boyd & Lloyd LLP All Rights Reserved
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