In 1997, the SEC adopted rule 3a-4 under the Investment Company Act of 1940 (the “Company Act”) to “provide a non-exclusive safe harbor from the definition of Investment Company for certain advisory programs. These programs typically involve separately managed accounts or “mini-accounts”, asset-allocation programs, and even wrap programs, where the investment advisor manages accounts with common investment strategies in a similar manner (e.g. model based programs). These clients that have similar investment objectives essentially receive the same investment advice and hold virtually the same securities in their account. Given the similarity of the investments, and how the investors are treated they may be considered an organized group of persons, and therefore an Issuer under the Company Act.
Under the Company Act an investment company is defined, in part, as “any issuer which is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities”1. The Company Act defines an issuer as “any person who issues or proposes to issue any security”2. The term “person” is defined as a natural person or a company3. Finally, “company” is defined, in part, as “a corporation, a partnership, an association, a joint-stock company, a trust, a fund, or any organized group of persons whether incorporated or not”.
If you follow the logic, a set of managed accounts may be considered an organized group of persons, and therefore a company. Further, if the purpose of the managed accounts is to invest in securities, the group of accounts (e.g. the company) is an issuer engaged in investing in securities. As a result, they may be an unregistered investment company.
The rule provides a non-exclusive safe harbor from the definition of an investment company provided the following conditions are met:
- Each client’s account is actually managed on the basis of the clients’ individual financial situation, investment objectives, and in accordance with reasonably imposed restrictions;
- When opening an account, the program’s sponsor/adviser obtains information from each client to be able to provide individualized investment advice to the client, including the client’s financial situation and investment objectives, and gives the client the opportunity to impose reasonable restrictions on the management of the account;
- At least annually, the sponsor/adviser contacts the client to determine whether there have been any changes to in their financial situation, their objectives, or in the restrictions they want implemented;
- At least quarterly, the sponsor/adviser must notify the client in writing to contact the sponsor/adviser with any such changes, and to provide the client with a means to make such contact;
- Each client has the ability to impose reasonable restrictions on the account’s management, including the prohibition of particular securities or types of securities from being purchased for the account;
- Individuals of the sponsor/adviser, who are knowledgeable about the account and its management, are made “reasonably available” to consult with clients;
- Each client is provided with a quarterly statement containing a description of all activity in the client’s account; and
- Each client retains indicia of ownership of securities in his or her account.
Impact on Digital Advisers (Robo-Advisers)
In February of 2017, the SEC released an IM Guidance Update that discussed the fact that robo-advisers may rely on algorithms, provide advisory services over the internet and may offer limited, if any, direct human interaction to their clients. These facts and circumstances should have advisers questioning whether they have potential issues under Rule 3a-4 under the Company Act.
In the IM Guidance Update, the SEC encouraged digital advisers, often referred to as robo advisers, to consider contacting the Staff for further guidance if it believes its organization and operation raise unique facts or circumstances not addressed by Rule 3a-4. It’s important to keep in mind that Rule 3a-4 is just a safe harbor. If you don’t follow the requirements set forth in the safe harbor, it doesn’t necessarily mean that you’re running an unregistered investment company. Rule 3a-4 was not written with the digital adviser business model in mind. Given the fact that digital advisers have been seen to set up their advisory platforms in various ways with varying levels of human interaction, it is imperative that each adviser evaluate their business model and whether the business model inadvertently poses any issues from a regulatory standpoint.
During regulatory exams, ACA has seen SEC examiners specifically ask if a digital adviser has evaluated the applicability of Rule 3a-4 as well as include certain requests in their document request lists that would contribute to the analysis of determining if an adviser has met the conditions set forth in Rule 3a-4. Additionally, ACA has seen the SEC exam staff comment in a deficiency letter that a particular adviser may be operating as an unregistered investment company given its portfolio models were standardized and clients could not impose any type of investment restrictions for their portfolios to take into account each clients’ individualized investment needs. Further, the SEC exam staff alleged the adviser did not generally communicate with its advisory clients. As a result, the SEC asked that the adviser describe how it satisfied the safe harbor or how it is exempt or excepted from the definition of investment company. ACA believes this analysis should not be prompted by a SEC exam. Instead, digital advisers should already be prepared to justify why it would not be deemed an unregistered investment company, taking into account the conditions set forth in Rule 3a-4.
Questions about the Impact of Rule 3a-4 on your Digital Advisers’ Services?
ACA can assist digital advisers in reviewing their policies and procedures surrounding their robo-advisory services and ensure they are aligned with the expectations of Rule 3a-4 under the Company Act. For more information, please contact Maureen Colligan or your ACA consultant.