In December 2010, the Securities and Exchange Commission extended an interim final rule regulating an investment adviser’s principal transactions with its clients. The SEC extended Rule 206(3)-3T until December 31, 2012.1
The SEC initially adopted Rule 206(3)-3T as an interim rule in 2007 in order to provide an alternative means for investment advisers registered as broker-dealers to satisfy the requirements of Section 206(3) of the Advisers Act of 1940 (“Advisers Act”) when they act in a principal capacity in transactions with certain of their advisory clients. We previously discussed the rule and proposed amendments to the rule in our January 12, 2010 and December 14, 2010 editions of “Structured Thoughts,”2 and have included a summary of the rule below.
The SEC extended the sunset of Rule 206(3)-3T in anticipation of the publication of its staff’s Study on Investment Advisers and Broker-Dealers, including the standard of care that should apply to them. The Study, published in January 2011, recommended, among other things, that a uniform fiduciary standard should apply to both brokerdealers and investment advisers that provide personalized investment advice about securities to retail customers, no less stringent than the standard currently applied to investment advisers. Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) mandated the Study.3
The SEC stated in the Adopting Release that “firms’ compliance with the substantive provisions of rule 206(3)-3T provides sufficient protection to advisory clients to warrant the rule’s continued operation while we conduct the study mandated by section 913 of Title IX of the Dodd-Frank Act and consider more broadly the regulatory requirements applicable to broker-dealers and investment advisers.”4 The SEC also noted that, as part of its broader consideration of regulatory requirements applicable to broker-dealers and investment advisers, it “intend[s] to carefully consider principal trading by advisers, including whether Rule 206(3)-3T should be substantively modified, supplanted, or permitted to expire.”5
As a key feature of its determination, the SEC noted that in connection with its examination of brokers’ activities under the rule, its staff did not identify any cases of “dumping” securities into accounts covered by the rule.6 (However, the SEC did note that the staff had encountered a variety of compliance issues of concern,7 and was taking a variety of actions to address them, including referrals to its Division of Enforcement for possible enforcement action if warranted).
Section 206(3) of the Advisers Act provides that an investment adviser acting as principal for its own account cannot (1) sell any security to, or purchase any security from, a client, or (2) act as a broker-dealer for a person other than the client, effect any sale or purchase of any security for the account of the client, without (a) disclosing to the client in writing, prior to the completion of the transaction, the capacity in which it is acting, and (b) obtaining the client’s consent for the transaction, unless the investment adviser is not acting as such in connection with the transaction. The SEC adopted Rule 206(3)-3T in order to provide limited relief to investment advisers that are dually registered as broker-dealers (“Dual Registrants”) from the principal trading restriction under Section 206(3). The rule enables fee-based brokerage customers to convert their accounts to fee-based accounts subject to the Advisers Act or to commission-based brokerage accounts.
Background of Rule 206(3)-3T
Under Section 206(3) of the Advisers Act, Dual Registrants must provide written notice and obtain client consent on a transaction-by-transaction basis when trading as a principal with a client. Rule 206(3)-3T provides Dual Registrants with an alternative means to comply with Section 206(3), while still requiring transaction-by-transaction disclosure. Specifically, the Rule permits a Dual Registrant to engage in principal transactions with a nondiscretionary advisory client, subject to the following conditions:
- Blanket Written Notice and Revocable Consent. The Rule requires the Dual Registrant to provide the client with a blanket written prospective notice and obtain the client’s blanket written revocable prospective consent with respect to principal transactions.
- Eligible Securities. The Rule applies to any principal trade that does not involve (1) a security issued by the Dual Registrant (or by an affiliate of the Dual Registrant) or (2) a transaction in which the Dual Registrant (or an affiliate of the Dual Registrant) acts as underwriter, other than offerings of non-convertible investment grade debt securities.8
- Trade-by-Trade Disclosure/Client Consent. The Rule requires that the Dual Registrant, prior to the completion of each principal transaction, must (1) inform the client that the Dual Registrant is acting as principal for its own account with respect to the transaction and (2) obtain consent from the client for the transaction. The trade-by-trade disclosure and consent may be written or oral.
- Confirmation Disclosure. The Rule requires that the confirmation provided to the client under Rule 10b-10 of the Exchange Act, at or before completion of the transaction, indicate in plain English that (1) the Dual Registrant disclosed to the client prior to the execution of the transaction that it may act in a principal capacity in connection with the transaction, (2) the client authorized the transaction and (3) the Dual Registrant sold the security to or purchased the security from the client for its own account.
- Annual Report. The Rule requires that the Dual Registrant provide the client with a list of all principal trades that were executed in the client’s account during the prior year, including the dates and prices of the transactions.
Investment advisers that trade in securities issued by, or underwritten by, affiliates, should be mindful that these securities are not eligible securities (as discussed above) and therefore, the investment adviser must obtain consent for each transaction on a trade-by-trade basis. The Rule does not relieve any investment adviser of its fiduciary obligations under the Advisers Act or other applicable provisions of federal law. The SEC will continue to study how the rule is being used in connection with its work under the Dodd-Frank Act.
Section 913(g) of the Dodd-Frank Act requires that the standard of conduct applicable to broker-dealers should be “no less stringent” than that required by Sections 206(1) and (2) of the Advisers Act. Conspicuously omitted from this congressional mandate is a reference to Section 206(3) of the Advisers Act, apparently reflecting a congressional intent not to mandate the application of that provision to broker-dealers that provide personalized investment advice about securities to retail investors.
The SEC’s staff in the IA/BD report, however, concluded that principal trades by broker-dealers “raise the same potential conflicts of interest as such trades by investment advisers and thus implicate the duty of loyalty included in the uniform fiduciary standard” mandated by Section 913(g) of the Dodd-Frank Act. Accordingly, the staff recommended that the SEC address through guidance or rulemaking how broker-dealers would fulfill the uniform fiduciary standard when engaging in principal trades, especially trades involving fixed income securities, including municipal bonds.9 When the SEC considers whether to extend Rule 203(3)-3T beyond 2012, it is likely to embrace the staff’s recommendations.