Investment Advisers Act of 1940 – Section 206(3)

In your letter dated April 14, 2016, you request assurance that the staff of the Division of Investment Management would not recommend enforcement action to the Securities and Exchange Commission under Section 206(3) of the Investment Advisers Act of 1940 (the “Advisers Act”) if the Advisers (as defined below) and their affiliates that are registered with the Commission as broker-dealers (“broker-dealer affiliates”) purchase fractional shares from certain advisory client accounts in the manner described in your letter.

Background

You state that J.P. Morgan Securities LLC and certain of its affiliates are registered with the Commission as investment advisers (collectively, the “Advisers”) and that the Advisers exercise investment discretion over various client accounts through which client assets are invested in securities. You state that advisory clients who hold exchange-traded equity securities in their accounts may sometimes receive interests that represent the right to receive the value of a fraction of a share (“fractional shares”).[1] You state further that such fractional shares are not issued by the issuer but rather are account entries meant to represent the portion of a whole share (held by a broker or another party) that an accountholder would be entitled to (including ongoing appreciation and depreciation) if ‎‎fractional shares could be traded in the marketplace.‎[2]

You propose that, if an Adviser determines to sell out of a client position consisting of whole shares and fractional shares, the Adviser or a broker-dealer affiliate would purchase the fractional shares from the client on the same day and at the same price as the whole shares are sold. Alternatively, if the whole shares are transferred out of the client’s account as a result of an event other than a sale, the Adviser or its broker-dealer affiliate would purchase the fractional shares from the client at that day’s market closing price.[3] You state that, because fractional shares cannot be sold in the open market, there are limited, if any, alternatives to your proposed approach.

Analysis

Section 206(3) of the Advisers Act makes it unlawful for any investment adviser, directly or indirectly:

acting as principal for his own account, knowingly to sell any security to or purchase any security from a client... without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.

If the Adviser to a client, or another Adviser or broker-dealer affiliate that controls, is controlled by, or is under common control with that Adviser, purchases a fractional share as described above, such purchase could be considered to violate Section 206(3) unless the Adviser complies with that Section’s disclosure and consent requirements. [4]

Section 206(3) is intended to address the potential for self-dealing that can arise when an investment adviser acts as principal in a transaction with a client, such as through price manipulation.[5] In adopting Section 206(3), Congress chose not to prohibit advisers from engaging in principal transactions entirely but rather to impose disclosure and consent requirements. You state that the purchase of fractional shares as described in your letter does not present the price manipulation risk that Section 206(3) was designed to address because such purchases would be made at the market price for the corresponding whole shares. For this reason, you conclude that complying with the disclosure and consent requirements of Section 206(3) for these purchases would place a disproportionate burden on the Advisers and their clients.[6]

Conclusion

Based on the facts presented, we would not recommend enforcement action to the Commission under Section 206(3) of the Advisers Act if the Advisers and their broker-dealer affiliates purchase fractional shares from clients in the manner described in your letter.[7] In particular, our position is based on your representations that:

• The value of the fractional shares would be immaterial (i) with respect to each applicable client and (ii) with respect to the Advisers and their broker-dealer affiliates.[8]
• In connection with a sale of the corresponding whole shares, the Adviser or its broker-dealer affiliate will purchase fractional shares on the same day and at same price as the whole shares. In connection with an event other than a sale, the Adviser or its broker-dealer affiliate will purchase fractional shares at that day’s market closing price.
• Neither the Advisers nor their broker-dealer affiliates will receive any commission or other compensation in connection with the purchase of fractional shares.
• Because the purchase of fractional shares will always be connected to the ordinary course sale or transfer of the related whole shares held in the client’s account, the Advisers will not separately determine the timing of the principal transaction.
• The Adviser will disclose to clients in advance the practice of purchasing fractional shares either in a separate disclosure document, the advisory agreement or the Adviser’s Form ADV. Such purchases will also be reflected on the clients' trade confirmation and account statements, and will be identified as principal trades.

Any different facts or representations may require a different conclusion. This response expresses our position on enforcement action only and does not represent any legal conclusion on the issue presented.

David J. Marcinkus
Branch Chief

Incoming Letter

The Incoming Letter is in Acrobat format.

http://www.sec.gov/divisions/investment/noaction/2016/jpmorgan-041416-206(3).htm