Investment Advisers Act of 1940 - Rule 206(4)-4(b)
Kirkpatrick & Lockhart LLP

January 28, 2004

Your letter of August 29, 2003, requests that we concur with your view that your client, Wilshire Associates, Inc. ("Wilshire"), a corporation that is dually registered with the Securities and Exchange Commission ("Commission") as an investment adviser and broker-dealer, is not required to disclose a recent disciplinary action taken against it by the New York Stock Exchange ("NYSE"), a self-regulatory organization ("SRO"), on Form ADV or pursuant to Rule 206(4)-4 under the Investment Advisers Act of 1940 ("Advisers Act"). As discussed below, we disagree that the violations underlying the Disciplinary Order are "minor rule violations" that need not be disclosed in Part 1A, Item 11.E(2) of Form ADV ("Item 11.E(2)"), and we seriously question whether you have rebutted the presumption of materiality applicable to certain SRO disciplinary proceedings set forth in Rule 206(4)-4(b).¹

On September 8, 2003, the NYSE considered a Stipulation of Facts and Consent to Penalty dated August 7, 2003, between the NYSE and Wilshire, and issued a final decision (the "Disciplinary Order"): (1) finding that Wilshire had violated certain NYSE rules; (2) censuring Wilshire; and (3) imposing a fine of $50,000.² The Disciplinary Order sanctioned Wilshire for numerous violations, including its failure to reasonably supervise and provide for appropriate supervisory procedures and controls with respect to approving and reviewing securities accounts of its employees. During the period in question, Wilshire employees maintained approximately 45 personal securities accounts at other financial institutions without Wilshire's review or approval. Our records indicate that Wilshire amended its Form ADV to disclose the Disciplinary Order on November 14, 2003.

Item 11.E(2) requires that a registered investment adviser disclose any findings by an SRO that the adviser has been involved in a violation of its rules. Item 11.E(2) excepts from disclosure violations that are designated as "'minor rule violation[s]' under a plan approved by the SEC."³ "Minor rule violation" is defined under Form ADV as a "violation of a self regulatory organization rule that has been designated as 'minor' pursuant to a plan approved by the SEC."⁴ The definition further provides that a "rule violation may be designated as 'minor' under a plan if the sanction imposed consists of a fine of $2,500 or less, and if the sanctioned person does not contest the fine."⁵

We do not agree with your argument that the violations underlying the Disciplinary Order are "minor rule violations" and therefore would not be required to be disclosed on Part 1A of Form ADV. In order to qualify for Form ADV's exception for "minor rule violations," SRO rule violations must meet all of the elements of Form ADV's definition, and must have been treated as "minor rule violations" by the SRO pursuant to a Commission-approved plan. The violations underlying the Disciplinary Order fail to meet this definition in several respects. First, the NYSE found that Wilshire violated several NYSE rules for which treatment under the NYSE's minor rule violations plan is not available.⁶ Second, even with regard to the rules violations that were eligible for "minor rule violation" treatment, the NYSE exercised its discretion under NYSE Rule 476A(e) to forego pursuing those violations as "minor" and instead opted to bring formal, adjudicated disciplinary proceedings against Wilshire.⁷ Finally, the $50,000 fine imposed by the NYSE makes Form ADV's definition of "minor rule violation" inapplicable to the violations.⁸

You also argue that the NYSE proceeding against Wilshire, which ultimately resulted in the Disciplinary Order, is "immaterial" under Rule 206(4)-4 under the Advisers Act. Rule 206(4)-4(a)(2) states that it is a fraudulent act within the meaning of Section 206(4) of the Advisers Act for a registered investment adviser to fail to disclose a "legal or disciplinary event that is material to an evaluation of the adviser's integrity or ability to meet contractual commitments to clients." Rule 206(4)-4(b) sets out certain events that are deemed to be presumptively material for the purposes of Rule 206(4)-4(a)(2).⁹ Rule 206(4)-4(b)(3)(ii) creates a rebuttable presumption of materiality with regard to SRO proceedings in which an adviser was found to have been in violation of the SRO's rules and, among other things, fined more than $2,500. The Disciplinary Order reflects the NYSE's finding of numerous rule violations and imposes a fine of $50,000. Consequently, your argument appears to be that you have rebutted the presumption of materiality under the specific facts and circumstances relating to the Disciplinary Order.

Whether a disciplinary event is material to an evaluation of an investment adviser's integrity is heavily dependent in each case upon the particular facts and circumstances presented. In general, the staff does not respond to requests for determinations as to whether a disciplinary event is material and must be disclosed to clients pursuant to Rule 206(4)-4. Consistent with this approach, we neither concur nor disagree with your view that Wilshire need not disclose the Disciplinary Order to clients under Rule 206(4)-4.

We emphasize, however, that we are not convinced that the facts and circumstances discussed in your letter would rebut the presumption of materiality under Rule 206(4)-4. Your argument appears to rest in large part on your conclusory statements that the violations underlying the Disciplinary Order "are totally unrelated to Wilshire's advisory business [and] do not implicate the Advisers Act…." You provide, however, no facts or legal analysis in support of these conclusions. For example, you fail to discuss why a dual registrant's failure to ensure that its employees periodically report information regarding their personal securities accounts would be "unrelated" to its advisory business and would not "implicate the Advisers Act."¹⁰ Under both the Advisers Act and the Investment Company Act of 1940 ("Investment Company Act"), investment advisers must make and keep accurate records relating to the maintenance of the securities accounts of certain employees, as well as those employees' personal securities transactions.¹¹ The Commission has imposed such obligations for the explicit purpose of preventing fraud.¹² Information related to employee securities transactions is of critical importance in helping an investment adviser ensure that its personnel do not use information gained in their advisory capacity to the disadvantage of its advisory clients.¹³

In addition, you generally appear to contend that the disciplinary action taken against Wilshire implicated only its broker-dealer functions, and therefore did not trigger disclosure obligations under the Advisers Act. Neither Item 11.E(2) nor Rule 206(4)-4(b)(3) is limited solely to SRO findings or actions that directly implicate a dual registrant's advisory activities. As a matter of law, Item 11.E(2) requires disclosure of all SRO findings that a registrant has violated its rules (the only exception being "minor rule violations," as discussed above), and contains no exceptions based on which employees or functions are involved in a violation. Thus, even assuming that the Disciplinary Order relates only to Wilshire's broker-dealer activities, that fact is irrelevant to Wilshire's disclosure obligations on Form ADV. With regard to Wilshire's disclosure obligations under Rule 206(4)-4(b), the Commission has stated that the distance of a person or entity involved in a disciplinary event from the advisory function may be one factor to be considered in deciding whether a presumption of materiality has been overcome. In your letter, however, you neither contend nor provide evidence to indicate that the personnel or entity involved in the violations set forth in the Disciplinary Order was distant from Wilshire's advisory activities.

Endnotes

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¹ Your letter addresses only Item 11.E(2) and Rule 206(4)-4 under the Advisers Act. In responding to your arguments, we express no views as to whether Wilshire's violations trigger other disclosure requirements.

² See New York Stock Exchange, Inc., Exchange Hearing Panel Decision 03-170 (Sep. 8, 2003) http://www.nyse.com/pdfs/03-170.pdf. The disclosure requirements of Part 1A, Item 11 of Form ADV and the presumption of materiality applicable to SRO disciplinary proceedings under Rule 206(4)-4(b)(3) generally apply to final actions by an SRO against an adviser or certain related persons. See Rules 206(4)-4(b)(3)(ii) and 206(4)-4(d)(2) under the Advisers Act. See also Item 11.E(2) and Form ADV, Glossary of Terms 12. Although your letter refers to the August 7, 2003, Stipulation of Facts and Consent to Penalty, and pre-dates the issuance of the Disciplinary Order, we are responding to your letter as if it relates specifically to the Disciplinary Order because your position appears to be that Wilshire would not be required to disclose that order.

³ See Item 11.E(2).

⁴ See Form ADV, Glossary of Terms 21. See also Securities Exchange Act Release No. 21013 (June 1, 1984) (amending Rule 19d-1 under the Securities Exchange Act of 1934 to allow SROs to submit minor rule violation plans). The NYSE submitted, and the Commission approved, a plan for handling and reporting "minor rule violations" in 1985. See Securities Exchange Act Release No. 22300 (Aug. 8, 1985) (approving the NYSE's plan, submitted pursuant to Rule 19d-1(c)(2) under the Securities Exchange Act of 1934). Pursuant to its approved plan, the NYSE has reserved discretion to treat any rule violation as "not minor in nature," and to pursue formal disciplinary proceedings in lieu of "minor rule violation" treatment. See NYSE Rule 476A(e).

⁵ See Form ADV, Glossary of Terms 21. See also Investment Advisers Act Release No. 1897 at n. 41 (Sep. 12, 2000) (adopting revised Form ADV).

⁶ For example, violations of NYSE Rules 304(b), 311(b)(1), 342(a) and 342.16-17 are not eligible for "minor" treatment under Rule 476A, the NYSE's minor rule violation plan. See NYSE Rule 476A Supplementary Material: List of Exchange Rule Violations and Fines Applicable Thereto Pursuant to Rule 476A. The Disciplinary Order sanctions Wilshire for violation of these rules. See New York Stock Exchange, Inc., Exchange Hearing Panel Decision 03-170 (Sep. 8, 2003) http://www.nyse.com/pdfs/03-170.pdf.

⁷ The NYSE may bring such proceedings "whenever it determines that any violation is not minor in nature." NYSE Rule 476A(e).

⁸ We also find unpersuasive your argument that the NYSE has historically treated violations such as Wilshire's as "minor" and that the Commission's recent amendments to Form ADV were adopted in the expectation that "historical patterns of sanctioning by the NYSE would continue to be followed." The plain text of the Form and its adopting release do not support such an interpretation. See Form ADV, Glossary of Terms 21; Investment Advisers Act Release No. 1897 at n. 41 (Sep. 12, 2000).

⁹ Rule 206(4)-4(b) is not an exclusive statement of which disciplinary events are material. See Whitaker Capital Management (pub. avail. June 7, 1990); Douglas Capital Management (pub. avail. Jan. 11, 1988). Materiality ultimately depends on the significance that a reasonable investor would place on the withheld or misrepresented information in making an investment decision, such as deciding whether to retain or continue to retain an investment adviser. See In the Matter of Sage Advisory Services LLC, et al. , Admin. Proc. File No. 3-10540, Investment Advisers Act Release No. 1954 (Jul. 27, 2001); In the Mater of Stephen L. Hunt, Esq. , Admin. Proc. File No. 3-11214, Securities Exchange Act Release No. 48330 (Aug. 13, 2003).

¹⁰ You also provide no indication that Wilshire had in place adequate policies and procedures applicable to its investment advisory business requiring that its advisory employees report their personal securities transactions.

¹¹ See Rule 204-2(a)(12)-(13) under the Advisers Act; Rules 17j-1 and 31a-1(f) under the Investment Company Act.

¹² See, e.g., Investment Advisers Act Release No. 1815 (Aug. 20, 1999) (The reporting requirements of Rule 17j-1 under the Investment Company Act are designed to prevent fraud. The purpose of Rule 204-2(a) requirements is substantially the same.).

¹³ You also argue that public disclosure of the Disciplinary Order on the NYSE's website and in Wilshire's Form BD should obviate the need for Wilshire to fulfill its disclosure obligations under the Advisers Act. There is no exception under either Form ADV or Rule 206(4)-4 excusing disclosure under those circumstances, nor does the Commission consider the passive presence of information on a website, without more, to be effective delivery of information that must be delivered to clients. See Rule 204-1(b) under the Advisers Act; Form ADV, General Instruction 4 (Form ADV must be amended promptly if information provided in response to Item 11, among others, becomes inaccurate in any way). See also Jeanco Financial, Inc. (pub. avail. Jan. 28, 1988) (disclosures required by Rule 206(4)-4 must be delivered to clients); Investment Advisers Act Release No. 1562 (May 9, 1996) at n. 21 (delivery through a website requires separate notice actually sent to clients).

Incoming Letter:

The Incoming Letter is in Acrobat format.

http://www.sec.gov/divisions/investment/noaction/lk012804.htm