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News April 11, 2005 Issue

And Still More Compliance Challenges of Proprietary Accounts

Several IM Insight readers offered excellent follow-up points to the article "Compliance Challenges of Proprietary Accounts" in the March 28 issue:

Crossing the line — Part 1. Caroline Schaefer, associate general counsel of the ICAA (soon to be the Investment Adviser Association) noted that there are issues to be considered when a pooled vehicle is close to crossing the 25 percent proprietary threshold (or whatever percentage the firm chooses as the dividing line between non-proprietary and proprietary money). When "approaching the line," advisers should consider whether to prohibit additional employee investments so as to maintain the pool’s status as a non-proprietary account. If a decision is made to allow the pool to cross the line (or if it happens inadvertently), investors in the pool should, at a minimum, be told that the treatment of the pool as a proprietary account under the firm’s code of ethics may result in disadvantages (for example, the pool will be subject to restrictions under the firm’s code of ethics, or may trade at the "back of the bus").

Crossing the line — Part 2: The joy of ERISA. If the pool is subject to ERISA, there are other issues to consider. For example: Does an adviser’s conservative approach of putting an ERISA/proprietary pool at the back of the bus violate the exclusive benefit rule? (More on the ERISA angle in next week’s IM Insight.)

In the family way . . . ICAA general counsel Karen Barr noted that some advisers grapple with the treatment of family accounts managed by the firm. On one hand, she said, a family account that has an advisory relationship with the firm is a "full-fledged" client, regardless of whether the account pays the adviser full fees, discounted fees, or no fees at all. "The family member has entrusted the firm to manage his/her money," said Barr. "If the adviser agrees to manage their money, even pro bono, it still has a duty to [the family member]."

Although it may be a full-fledged client, a family account still may be covered under the firm’s code of ethics and potentially be disadvantaged vis a vis other clients. For example, if the family member is an immediate relative that shares an employee’s residence, the account would be subject to any blackout period or short-term trading ban in the firm’s code. That might be a hard pill for the relative/client to swallow, particularly if he pays the firm’s regular advisory fee.

And, of course, some firms may choose to subject a broader category of family members to the firm’s code of ethics, picking up those that aren’t technically access persons (such as a parent who does not share the same residence). If those relatives pay fees, being subjected to the code may be even more difficult to swallow.

What to do? The more conservative approach, said Barr, is to fully disclose to the relative/client that the account will be subject to all relevant provisions of the code, explain how that could potentially disadvantage the account, and obtain client consent. Alternately, she said, firms could consider granting an exception from certain "best practice" aspects of the code (but not, of course, the legal requirements). In other words, an adviser might consider excepting fee-paying family accounts from their code’s blackout requirements, but still require those accounts to preclear IPOs and limited opportunity securities. Barr advised that if an adviser does choose to provide such an exception, the family account’s trading should be monitored quite closely to ensure that the account is not receiving unlawful favored treatment. Such monitoring should be well documented, she said, as OCIE staff is sure to scrutinize these accounts and any exceptions to the code. And, of course, when evaluating this as an option, consider the "distance" of the relative in terms of geography and lineage. A firm may choose to except the account of an employee’s brother-in-law on the West Coast, but not the account of an employee’s spouse, for example.

Don’t forget the Reg. D sophistication test. When allowing employees to invest in a 3(c)(1) fund, don’t assume that just because the 3(c)(7) "qualified purchaser" standard doesn’t apply, you can let any old employee invest in the fund.

Adviser Compliance Associates managing partner Rob Stype pointed out that Reg. D Rule 506, which is relied on by many hedge funds, contains a sophistication standard for non-accredited investors. To invest in a 3(c)(1) fund that relies on Rule 506, employees that are not otherwise Reg. D accredited investors must have "such knowledge and experience in financial and business matters" that they are capable of evaluating the merits and risks of the investment. So: make sure to consider the financial savviness of your IT staff, marketers, and clerical workers before allowing them in your 3(c)(1) fund — as well as anyone else whose job may not automatically qualify them as having the requisite financial knowledge and experience.

Do you have to worry about the "knowledgeable employee" standard under ICA Rule 3c-5? Not unless you are close to blowing through the 100-person limit in 3(c)(1) and need to rely on Rule 3c-5 (among other things, Rule 3c-5 states that knowledgeable employees — a tougher standard than Reg. D’s sophistication test — don’t have to be counted towards the 100 person 3(c)(1) limit).

Last, but not least: there’s another reason to think twice before allowing employees who are non-accredited investors into a 3(c)(1) fund: allowing any non-accrediteds (employee or not) into a 3(c)(1) triggers potentially burdensome reporting requirements.

But they SAID we could do it! One law firm partner suggested that proprietary accounts do not necessarily have to be backed out of bunched orders that receive partial fills. He noted that the SMC Capital no-action letter itself indicated that a proprietary account could participate in a partially-filled trade. That’s true, but other lawyers point out that the facts in SMC dealt with the situation where the proprietary accounts actually were pools of client and proprietary investments, rather than individual proprietary accounts.

Required reading. For more on the challenges of proprietary accounts, here’s a rather illustrative SEC enforcement case: Gintel Asset Management (Nov. 8, 2002).

Skin in the game does help — and here’s proof. Check out a recent academic study: "Does Skin in the Game Matter? Director Incentives and Governance in the Mutual Fund Industry." The study found that the more directors owned of the funds they governed, the better the funds performed.