Safe Harbor Rule 3a-4: Investment Advisory Programs

One of the key differences between an investment company and a registered investment advisor (RIA) is that advisers are in the business of providing investment advice to others, while an investment company is primarily engaged in the business of investing in securities themselves. Although advisors invest in securities on behalf clients, they do it on an individualized basis unlike investment companies that invest on behalf of clients on a collective basis. If any of a firm’s investment advisory programs are determined to be an investment company thenit will be regulated under the Investment Company Act of 1940 and must comply with more stringent requirements.

The Investment Company Act of 1940 requires, among other things, that firms establish a board of directors, and 75% of those members must be independent or not affiliated with the fund’s activities.  The Securities Exchange Commission’s Rule 3a-4, provides a safe-harbor to exclude investment advisory programs that have similarly-managed accounts from being deemed an investment company.  To fall within the safe harbor provided by the SEC, an investment advisory program must meet the following six requirements:

  1. Individual Management & Reasonable Restrictions. Each client’s account must be managed on the basis of the client’s specific financial situation and investment objectives, and in accordance with any reasonable investment restrictions imposed by the client. The client should be receiving individualized treatment.
  2. Collection of Client Information. The Firm must obtain sufficient client information at the account opening to enable it to provide individualized advice. This information must be obtained before or at the time the Firm places the client in the program. The Firm must also give the client the opportunity to impose reasonable restrictions at account opening.
  3. Annual Client Contact. The Firm, sponsor, or other designated person must contact the client at least annually to determine whether there have been any changes in the client’s financial situation or investment objectives, and whether the client wants to change existing, or impose new, investment restrictions.
  4. Quarterly Notices. Written notices must be delivered to clients at least quarterly. In these quarterly notices, the Firm and/or the sponsor must notify the client in writing to contact the Firm and/or the sponsor if there have been any changes in the client’s financial situation or investment objectives, or if the client wishes to modify existing, or impose new, restrictions. These written notices to the clients must identify the means through which the client should contact the sponsor or the Firm. This quarterly notification requirement is in addition to the requirement to contact the client on an annual basis.
  5. Customer Reporting. Account statements must be delivered to clients at least quarterly. The account statements must identify all activity in the client’s account for the preceding quarter, including all fees and expenses charged to the account. This can be combined with quarterly notices. In practice, the notice is often printed on the account statement.
  6. Portfolio Manager Availability. The client must have the ability to consult with the program’s sponsor or the investment manager concerning his or her account. The sponsor or investment adviser must be reasonably available to address a client’s questions and concerns.
  7. Securities Ownership. Clients must retain certain rights of securities ownership. This ownership criteria requires that the client:
  • Have the right to withdraw the securities or funds in his or her account;
  • Have the right to vote the securities in his or her account, or to delegate that authority;
  • Be provided timely written trade confirmations or other notifications of each securities transaction, as well as all other documents required by law; and
  • Have the right to take direct legal action against an issuer of a security in his account and not be obligated to join with the investment adviser or any client to pursue such action.

 

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