IAA Submits Supplemental Letter on Dealer Proposal

October 17, 2023

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Ms. Vanessa A. Countryman
Secretary
U.S. Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-1090

Re:      Further Definition of “As a Part of a Regular Business” in the Definition of Dealer and Government Securities Dealer (Rel. No. 34-94524; File No. S7-12-22)

Dear Ms. Countryman:

The Investment Adviser Association (IAA)^[1] appreciates the opportunity to supplement our June 2022 comment letter on the Commission’s proposal to amend the definitions of “dealer” and “government securities dealer” under the Securities Exchange Act of 1934 (Exchange Act) (Supplemental Letter).[2] We reiterate the serious concerns we raised in the IAA Initial Letter and incorporate those comments in this Supplemental Letter. We do not believe that Congress intended for any advisers acting as fiduciaries under the Investment Advisers Act of 1940 (Advisers Act) for any types of clients, including private funds, to be brought into the Exchange Act dealer regime for that fiduciary conduct. Therefore, we again strongly urge the Commission to exclude all SEC-registered investment advisers and all their discretionary clients (including private funds they manage) from any further definition of “dealer.”[3]

If, despite our significant concerns, the Commission nonetheless declines to adopt categorical exclusions for SEC-registered advisers and their discretionary clients, at a minimum the Commission should make certain changes to the proposed definition of “own account” that could lessen some of the negative – and wholly unwarranted – consequences of the Proposal. These changes are necessary to align any final rules with the Commission’s stated intent that the Proposal does not intend to capture discretionary investment management.[4]

Specifically, we recommend that:

1. The Commission revise the exclusion from the definition of “own account” in subsection (b)(2)(ii)(B) of proposed Rules 3a5-4 and 3a44-2 (we refer to this subsection as the “control provision”), so that the following types of advisory accounts would not be considered either the adviser’s or the client’s “own account” for purposes of the rules:
   1. Accounts established to develop an investment strategy intended to be offered to clients (i.e., seeded accounts);
   2. Funds established as a vehicle for a single investor, and not offered or intended to be offered to other investors (i.e., “funds of one”); and
   3. Accounts for a client that is an affiliate or subsidiary of the adviser’s managed pursuant to an arm’s-length advisory agreement.
2. 1. The Commission remove subsections (b)(2)(ii)(C) and (b)(4) of the proposed rules (we refer to these subsections as the “aggregation provision” and “parallel account structure exception,” respectively) to eliminate both (i) the inappropriate definition of “control” as meaning under discretionary management, and (ii) the inaccurate concept of aggregation of parallel account structures in the case of discretionary clients of an investment adviser. Removing these provisions would help ensure that advisory client accounts that are each managed for their own benefit by an adviser acting as a fiduciary would not be swept into the proposed dealer definition.
   2. Alternatively, the Commission substantially revise the aggregation provision and parallel account structure exception to (i) clarify use of the term “control,” (ii) exclude SMAs, and (iii) include intent.[5]
3. The Commission adopt a general anti-evasion provision to address concerns relating to potential evasion of the application of the proposed rules.

We discuss each of these recommendations and suggest modifications to the proposed rule language below.

A. The Commission should explicitly exclude certain advisory accounts from the “own account” definition even where they are “controlled” by the adviser under the control provision.

Subsection (b)(2)(ii)(B) of proposed Rules 3a5-4 and 3a44-2 excludes from the definition of “own account” an investment advisory account held in the name of the adviser’s client if the adviser does not “control” the client. Under this subsection, an adviser would control the client “as a result of the adviser’s right to vote or direct the vote of voting securities of the client, the adviser’s right to sell or direct the sale of voting securities of the client, or the adviser’s capital contributions to or rights to amounts upon dissolution of the client.”[6] As discussed in the IAA Initial Letter, we do not believe that an investment adviser managing a discretionary account of any type should be viewed as “controlling” that account for purposes of the dealer definition.

Should the Commission retain this provision, however, we have identified several situations where its application would significantly hinder advisory activities that we do not believe the Commission intended to capture. We urge the Commission, at a minimum, to exclude these types of accounts from the definition of “own account.”

First, advisers may provide seed capital to establish an investment strategy, through a private fund or otherwise, and then establish a track record of its performance for marketing purposes before offering it to investors. Depending on the investment strategy, the account could meet one or more of the proposed tests for “as a part of a regular business” under subsection (a)(1) of the proposed rules. Because it would be controlled by the adviser during its seeding period, the account would then meet the “own account” definition under the control provision as well, and be deemed to be a dealer. We do not understand the rationale for considering these types of accounts to be dealers and ask that they be excluded from the definition of “own account.”[7]

Similarly, advisers may manage SMAs for their affiliates or subsidiaries pursuant to an arm’s-length management arrangement. In these cases, the adviser manages the affiliate’s investment strategy as a fiduciary and according to the investment guidelines under the management agreement in the same way that it would manage other SMAs. For example, an insurance company affiliate of an investment adviser might engage the adviser to manage one or more specific strategies for the insurance company’s general account. Because of their corporate structure, the adviser could be deemed to control the affiliate’s account under the control provision. There is no sound basis for considering these types of accounts to be dealers and they should also be excluded from the definition of “own account.”

Finally, we ask that any fund established as a vehicle for a single investor, and not offered or intended to be offered to other investors, that is managed by an adviser acting as general partner be excluded from the definition of “own account” under the control provision. “Funds of one” are a type of SMA for which the adviser is retained to follow a specific strategy or investment guidelines by a single client who opts for a fund-of-one structure for tax or other reasons. While the adviser could theoretically be deemed to control the fund under the control provision, the adviser would typically manage the account as a fiduciary in the same way that it would manage any other SMA. We thus also recommend that these types of accounts be excluded from the definition of “own account.”

To prevent the myriad unwarranted negative consequences of treating any of these types of accounts as a dealer, we recommend that subsection (b)(2)(ii)(B) of the proposed rules be modified as follows (marked to compare to the proposed rule text):

(B)(i) With respect to an investment adviser registered under the Investment Advisers Act of 1940, an account held in the name of a client of the adviser unless the adviser controls the client as a result of the adviser’s right to vote or direct the vote of voting securities of the client, the adviser’s right to sell or direct the sale of voting securities of the client, or the adviser’s capital contributions to or rights to amounts upon dissolution of the client.;

(ii) For purposes of this subsection, an adviser will not be considered to control: (a) an advisory account established and funded by the adviser to develop an investment strategy intended to be offered to clients; (b) an account for a client that is an affiliate or subsidiary of the adviser’s managed by the adviser pursuant to an arm’s-length advisory agreement; or (c) a fund established as a vehicle for a single investor, and not offered or intended to be offered to other investors managed by the adviser;[8] or

B. The Commission should remove the aggregation provision from the proposed rules because it inappropriately sweeps all client accounts that are not managed in concert with one another into the “own account” definition.

We appreciate the Commission’s recognition that “[i]n the case of registered investment advisers that have no controlling ownership interest in an entity for which they are solely managing client assets, the trading activities of the adviser and each client are independent of each other and are not for the benefit of the adviser or any other client.”[9] The express intent of the Proposal, therefore, is to exclude discretionary management of an adviser’s client accounts from the dealer definition. We fully agree and strongly support such an exclusion.

However, we believe that the aggregation provision would lead to a contrary result, significantly undermining the Commission’s stated intent. Out of a concern that advisers might establish multiple discretionary accounts to evade application of the proposed rules,[10] the aggregation provision would sweep into the “own account” definition an adviser’s discretionary client accounts if they are “parallel account structures.”[11] Thus, advisers’ client account trading would not need to be aggregated, unless the accounts constitute a parallel account structure.

As discussed in the IAA Initial Letter, the aggregation provision is fundamentally flawed for at least two primary reasons. First, it inexplicably incorporates a definition of “control” that is different from that used in the control provision as well as from how the Release discusses control in the context of the aggregation provision. Second, the broad definition of parallel account structure would pull in unrelated client accounts that follow similar investment strategies but do not act in concert. For these reasons, we urge the Commission to remove the aggregation provision from the proposed rules.

“Control” as discretionary management.

The aggregation provision addresses “[w]ith respect to any person, an account in the name of another person that is under common control with that person solely because both persons are clients of an investment adviser registered under the Investment Advisers Act of 1940.”[12] However, as the Release itself notes, advisers do not control their clients’ accounts solely because they manage or exercise discretion over those accounts.[13] Indeed, advisers do not control these accounts unless they meet the Rule 13h-1 definition of control that has been incorporated into the proposed rules.[14]

Aggregation of accounts that constitute a parallel account structure.

Investment advisers are always fiduciaries to their clients. As the Commission has repeatedly emphasized, all investment advisers owe each of their clients independently a fiduciary duty under the Advisers Act, and that federal fiduciary duty may not be waived.[15] An adviser’s fiduciary duty requires it, at all times, to serve the best interest of its clients and not subordinate a client’s interest to its own.[16] This means that each client account, whether an SMA or a private fund, is managed exclusively for the benefit of that client and in accordance with that account’s investment guidelines.

A similar or substantially similar investment strategy may commonly be offered through a variety of vehicles in the ordinary course of an adviser’s business. For example, a substantially similar strategy may be in the best interest of several clients given their investment objectives and guidelines. Similarly, the same client may want to follow a similar strategy but prefer to invest in separate vehicles with, e.g., different terms, guidelines, and/or tax consequences. Thus, it may be common for an adviser to offer similar investment strategies in a variety of SMA formats, such as through mutual funds, ETFs, non-U.S. fund vehicles, collective investment trusts, and “funds of one,” as well as private funds, across clients or for a particular client.

Indeed, the Commission recognizes that client accounts managed by an adviser “may have similar trading strategies,” and thus “their trading activities in the aggregate could meet the proposed qualitative or quantitative standards. This would result in the application of the Proposed Rules to the activities of a registered investment adviser and those of its clients even when none of the entities is engaged in dealer activity for the economic benefit of another.”[17]

We are concerned that the parallel account structure exception to the exclusion for advisory accounts from the “own account” definition would swallow or at least substantially limit the exclusion, and thereby chill an adviser’s willingness to offer a wide range of investment vehicles to meet clients’ objectives or manage different client accounts to similar investment strategies where such strategies may be in the clients’ best interest. We strongly believe that a concern that some may attempt to evade the application of the proposed rules does not justify the broad sweep of the aggregation provision. We offer the following alternatives to the aggregation provision and parallel account structure exception, which we believe will impose a less severe constraint on an adviser’s ordinary course fiduciary management of client accounts.

Alternatives to address the IAA’s concerns.

Alternative 1: Remove aggregation provision and parallel account structure exception. For the reasons discussed above and in the IAA Initial Letter, we urge the Commission to remove the aggregation provision and the parallel account structure exception, i.e., subsections (b)(2)(ii)(C) and (b)(4) of proposed rules 3a5-4 and 3a44-2, entirely. Removing these provisions would ensure that SMAs or private funds that are each managed for their own benefit by an adviser acting as a fiduciary – and not managed in concert with one another or with other advisory accounts – would not be swept into the proposed dealer definition. In our view, this is the most straightforward way to ensure that all client accounts managed in the ordinary course by fiduciary investment advisers will not be inappropriately pulled within scope of dealer activity. The Commission’s concern relating to potential evasion of the application of the proposed rules would be better addressed with a general anti-evasion provision, as recommended below.

Alternative 2: Clarify use of the term “control” in aggregation provision and revise parallel account structure exception to exclude SMAs and include intent. To the extent the Commission does not accept our recommendation in the IAA Initial Letter – reiterated in this Supplemental Letter – to exclude all clients of advisers, including private funds, we offer a second alternative. Under this alternative, the Commission should revise the term “control” in the aggregation provision to align with the meaning of “control” in the control provision. Under this correct meaning, an adviser would generally not control an SMA under the control provision, and those accounts should thus also be removed from the parallel account structure exception. The Commission should also add an intent element to the parallel account structure exception. We offer the following alternative rule text for subsections (b)(2)(ii)(C) and (b)(4) to reflect this alternative recommendation (marked to compare to the proposed rule text):

(b)(2)(ii)(C) With respect to any person, an account in the name of another person that is under common control with that person solely because where both persons are clients of an investment adviser registered under the Investment Advisers Act of 1940 and under common control with the adviser,[18] unless those accounts constitute a parallel account structure; or

(b)(4) The term “parallel account structure” means a structure in which the same investment adviser controls one or more private funds within the meaning of subparagraph (b)(3) (each a “parallel fund”), accounts, or other pools of assets (each a ‘‘parallel managed account’’) managed by the same investment adviser and pursues substantially the same investment objective and strategy and invests side by side in substantially the same positions for these as another parallel funds, with the intent to avoid application of subparagraph (a)or parallel managed account.

C. The Commission should include a general anti-evasion provision to address its concerns relating to potential evasion of the proposed rules.

As discussed in the IAA Initial Letter, we believe that the Commission should focus on general anti-evasion principles rather than broadly imposing dealer regulation on advisers and their clients out of concern that some persons could theoretically evade regulation. If the Commission’s intent is to deter the structuring of corporate relationships or legal entities in order to avoid dealer registration, a more balanced, and in our view effective, way to achieve this goal would be to add a general anti-evasion provision that would prohibit a person from doing so. The Commission could look to Exchange Act Rule 13h-1(c)(2) as an example of a general anti-evasion provision.[19]

* * *

We appreciate the Commission’s consideration of our supplemental comments and recommendations and stand ready to provide any additional information that may be helpful. Please contact the undersigned at (202) 293-4222 if we can be of further assistance.

Respectfully Submitted,

Gail C. Bernstein
General Counsel

Monique S. Botkin
Associate General Counsel

cc:
The Honorable Gary Gensler, Chair
The Honorable Hester M. Peirce, Commissioner
The Honorable Caroline A. Crenshaw, Commissioner
The Honorable Mark T. Uyeda, Commissioner
The Honorable Jaime Lizárraga, Commissioner
Haoxiang Zhu, Director, Division of Trading and Markets
William A. Birdthistle, Director, Division of Investment Management

Exhibit A

[1] The IAA is the leading organization dedicated to advancing the interests of investment advisers. For more than 85 years, the IAA has been advocating for advisers before Congress and U.S. and global regulators, promoting best practices and providing education and resources to empower advisers to effectively serve their clients, the capital markets, and the U.S. economy. The IAA’s member firms manage more than $35 trillion in assets for a wide variety of individual and institutional clients, including pension plans, trusts, mutual funds, private funds, endowments, foundations, and corporations. For more information, please visit www.investmentadviser.org.

[2] Further Definition of “As a Part of a Regular Business” in the Definition of Dealer and Government Securities Dealer, SEC Rel. No. 34-94524, 87 Fed. Reg. 23054 (Apr. 18, 2022) (Proposal or Release) (proposing to expand Section 3(a)(5) of the Exchange Act to add Rules 3a5-4 and 3a44-2 as a further definition of “as a part of a regular business” under new qualitative and quantitative tests, respectively), available at https://www.govinfo.gov/content/pkg/FR-2022-04-18/pdf/2022-06960.pdf. See Letter from the IAA to the Commission re: Further Definition of “As a Part of a Regular Business” in the Definition of Dealer and Government Securities Dealer (June 3, 2022) (IAA Initial Letter), attached as Exhibit A and available at https://www.investmentadviser.org/wp-content/uploads/2022/06/IAA-Comment-Letter-on-Dealer-Proposal.6.3.22.pdf. Unless otherwise noted, we use the term “dealer” to cover both dealers and government securities dealers under the Exchange Act.

[3] We use the term “separately managed accounts” (SMAs) to include all accounts managed on a discretionary basis by an SEC-registered investment adviser that are not private funds.

[4] Release at 23057.

[5] We urge the Commission to accept our recommendation in B.1 to exclude all clients of advisers. We offer B.2 as an alternative should the Commission decline to do so.

[6] The proposed rules incorporate the definition of “control” as used in the SEC’s Large Trader Reporting Rule 13h-1, under which “control” means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of securities, by contract, or otherwise. Proposed Rules 3a5-4(b)(3) and 3a44-2(b)(3): “The term “control” has the same meaning as prescribed in § 240.13h-l (Rule 13h-l), under the Act.”

[7] We again call on the Commission to exclude all private funds managed by an SEC-registered investment adviser from the scope of the proposed rules, which could be accomplished by excluding these funds from the control provision. See IAA Initial Letter. At a minimum, however, we urge the Commission to exclude private funds established or managed by an adviser acting as general partner during these funds’ seeding period, as we recommend in this Supplemental Letter.

[8] Some indicia of an arm’s-length relationship might be, for example, fees that are within the range of those paid to the adviser for similar investment management services by an unaffiliated account or client; day-to-day investment management decisions made by the adviser independently of the affiliate client; and/or no common officers or directors between the adviser and the affiliated client.

[9] Release at 23075.

[10] According to the Release, this provision is designed to “address situations in which a registered investment adviser might use the proposed exclusion to avoid the application of the Proposed Rules. For example, a registered investment adviser that has a controlling ownership interest in a client could attempt to divide trading activities among several clients it controls to avoid dealer registration by any individual client whose trading activities would meet either of the Proposed Rules.” Proposal at 23075.

[11] We refer to this as the “parallel account structure exception.” A parallel account structure is defined as “a structure in which one or more private funds (each a ‘parallel fund’), accounts, or other pools of assets (each a ‘parallel managed account’) managed by the same investment adviser pursue substantially the same investment objective and strategy and invest side by side in substantially the same positions as another parallel fund or parallel managed account.”

[12] Subsection (b)(2)(ii)(C) of proposed rules 3a5-4 and 3a44-2 (emphasis added).

[13] The Release notes: “[W]e are proposing to exclude registered investment advisers from aggregating their trading activities with those of their clients when the adviser and client only have a discretionary investment management relationship (i.e., where the registered investment adviser does not control the client as a result of the adviser’s right to vote or direct the vote of voting securities of the client, the adviser’s right to sell or direct the sale of voting securities of the client, or the adviser’s capital contributions to or rights to amounts upon dissolution of the client).” Release at 23075. See also id. at 23064 (“The Commission is mindful, however, that with some clients, a registered investment adviser only exercises investment discretion over the client’s account, while with some other clients, the adviser also may control the client through an ownership interest.”).

[14] See note 6 above.

[15] See, e.g., Commission Interpretation Regarding Standard of Conduct for Investment Advisers, 84 Fed. Reg. 33669 (July 12, 2019).

[16] Id.

[17] Proposal at 23075.

[18] This change would make clear that the term “control” has the same meaning as in subsection (b)(3), i.e., the same meaning as in the Large Trader Reporting Rule.

[19] Rule 13h-1(c)(2) provides that “[u]nder no circumstances shall a person disaggregate accounts to avoid the identification requirements of this section.”