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86-31 Request for Comments on a Proposed Amendment to Article III, Section 19(f) of the NASD Rules of Fair Practice

TO: All NASD Members and Other Interested Persons

LAST DATE FOR COMMENT: MAY 25, 1986

The Board of Governors of the National Association of Securities Dealers, Inc. (NASD), is seeking comments on a proposed amendment to Article III, Section 19(f) of the NASD Rules of Fair Practice, which would, under certain circumstances, allow performance-type fees. 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 proposed amendment was recommended to the Board of Governors by the National Business Conduct Committee (NBCC) pursuant to a study of the issue by a subcommittee of the NBCC dealing with investment advisory-related issues.

BACKGROUND

This matter was considered by the Board of Governors in view of the recent promulgation by the Securities and Exchange Commission (SEC) of Rule 205-3 under the Investment Advisers Act of 1940 (Advisers Act). The NASD staff has, in the past, occasionally taken no-action positions with respect to certain performance-type fees in circumstances where a customer has entered into an agreement with a member or persons associated with a member and the facts indicate that the investment is relatively large; the number of investors is limited; there is evidence of the investors' sophistication; and that the agreement could be reasonably considered to be entered into by virtue of arm's-length negotiation.

The recent adoption of SEC Rule 205-3 under the Advisers Act marks the codification of the SEC staff's position since 1975, that under certain factual circumstances, the prohibitions of Section 205(1) of the Advisers Act against performance-type fees may not be necessary or appropriate in the public interest. Rule 205-3 applies similar, although more specific, standards to those utilized by the NASD with respect to Section 19(f) no-action requests.

PROPOSED AMENDMENT

The proposed amendment to Section 19(f) generally parallels the SEC rule and would allow sharing in the profits or losses in customer accounts when the following conditions are met:

  • The person seeking such compensation obtains written authorization from the member carrying the account;
  • The customer's net worth is not less than $1 million, or the minimum amount invested in the account is not less than $500,000;
  • The customer understands the method of compensation and its risks, and the arrangement has been set forth in a written agreement between the customer and the member;
  • The arrangement represents an arm's-length agreement between the parties;
  • The formula takes into account profits and losses over a period of at least one year; and
  • The member has disclosed all material aspects of the compensation agreement and any conflicts of interest that may result from the compensation formula.

The text of the proposed amendment is attached.

Members are cautioned that while the proposed amendment, to some degree, parallels SEC Rule 205-3, the adoption of this rule would not in any way alter the registration obligations which may exist for a member or person associated with a member under the Advisers Act.

* * * * *

The NASD encourages all members and other interested persons to comment on this proposed amendment. Comments should be directed to:

Mr. James M. Cangiano
Secretary
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C.20006

Comments must be received no later than May 25, 1986. Comments received by the indicated date will be considered by the NBCC and the NASD Board of Governors. If the proposed amendment is approved by the Board, it will then be submitted to the membership for a vote. If approved by the membership, the amendment must be filed with and approved by the Securities and Exchange Commission before becoming effective.

Questions concerning this notice may be directed to either Dennis C. Hensley, Vice President and Deputy General Counsel, or T. Grant Callery, Assistant General Counsel, NASD Office of the General Counsel, at (202) 728-8285.

Sincerely,

Frank J. Wilson
Executive Vice President
Legal and Compliance

Attachment

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

Note: New language underscored.

Sharing in accounts; extent permissible

(f)
(l)
(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; 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 share in the profits or losses in an account or otherwise receive compensation based on such profits or losses if all of the following conditions are satisfied;
(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 of not less than $1,000,000, or the minimum amount invested in the account is not less than $500,000;
(C) The customer is able to understand the proposed method of compensation and its risks;
(D) The compensation arrangement is set forth in a written agreement executed by the customer and the member;
(E) 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 any potential conflicts of interest which may result from the compensation formula.

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