[Federal Register: September 28, 2007 (Volume 72, Number 188)]
[Rules and Regulations]
[Page 55022-55042]
[DOCID:fr28se07-6]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release No. IA-2653; File No. S7-23-07]
RIN 3235-AJ96

Temporary Rule Regarding Principal Trades With Certain Advisory
Clients

AGENCY: Securities and Exchange Commission.

ACTION: Interim final temporary rule; request for comments.

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SUMMARY: The Commission is adopting a temporary rule under the
Investment Advisers Act of 1940 that establishes an alternative means
for investment advisers who are registered with the Commission as
broker-dealers to meet the requirements of section 206(3) of the
Advisers Act when they act in a principal capacity in transactions with
certain of their advisory clients. The Commission is adopting the
temporary rule on an interim final basis as part of its response to a
recent court decision invalidating a rule under the Advisers Act, which
provided that fee-based brokerage accounts were not advisory accounts
and were thus not subject to the Advisers Act. As a result of the
Court's decision, which takes effect on October 1, fee-based brokerage
customers must decide whether they will convert their accounts to fee-
based accounts that are subject to the Advisers Act or to commission-
based brokerage accounts. We are adopting the temporary rule to enable
investors to make an informed choice between those accounts and to
continue to have access to certain securities held in the principal
accounts of certain advisory firms while remaining protected from
certain conflicts of interest. The temporary rule will expire and no
longer be effective on December 31, 2009.

DATES: Effective Date: September 30, 2007, except for 17 CFR
275.206(3)-3T will be effective from September 30, 2007 until December
31, 2009.
    Comment Date: Comments on the interim final rule should be received
on or before November 30, 2007.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/final.shtml.
); or     Send an e-mail to<EMAIL_ADDRESS>Please include

File Number S7-23-07 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov
). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.

All submissions should refer to File Number S7-23-07. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/final.shtml). Comments are

also available for public inspection and copying in the Commission's
Public Reference Room, 100 F Street, NE., Washington, DC 20549, on
official business days between the hours of 10 a.m. and 3 p.m. All
comments received will be posted without change; we do not edit
personal identifying information from submissions. You should submit
only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: David W. Blass, Assistant Director,
Daniel S. Kahl, Branch Chief, or Matthew N. Goldin, Attorney-Adviser,
at<PHONE_NUMBER> or<EMAIL_ADDRESS>Office of Investment Adviser
Regulation, Division of Investment Management, U.S. Securities and
Exchange Commission, 100 F Street, NE., Washington, DC 20549-5041.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission
(``Commission'') is adopting temporary rule 206(3)-3T [17 CFR
275.206(3)-3T] under the Investment Advisers Act of 1940 [15 U.S.C.
80b] as an interim final rule.
    We are soliciting comments on all aspects of the rule. We will
carefully consider the comments that we receive and respond to them in
a subsequent release.

I. Background

A. The FPA Decision

    On March 30, 2007, the Court of Appeals for the District of
Columbia Circuit (the ``Court''), in Financial Planning Association v.
SEC (``FPA decision''), vacated rule 202(a)(11)-1 under the Investment
Advisers Act of 1940 (``Advisers Act'' or ``Act'').\1\ Rule 202(a)(11)-
1 provided, among other things, that fee-based brokerage accounts were
not advisory accounts and were thus not subject to the Advisers Act.\2\
As a consequence of the FPA decision, broker-dealers offering fee-based
brokerage accounts became subject to the Advisers Act with respect to
those accounts, and the client relationship became fully subject to the
Advisers Act. Broker-dealers would need to register as investment
advisers, if they had not done so already, act as fiduciaries with
respect to those clients, disclose all potential material conflicts of
interest, and otherwise fully comply with the Advisers Act, including
the Act's restrictions on principal trading.
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    \1\ 482 F.3d 481 (D.C. Cir. 2007).
    \2\ Fee-based brokerage accounts are similar to traditional
full-service brokerage accounts, which provide a package of
services, including execution, incidental investment advice, and
custody. The primary difference between the two types of accounts is
that a customer in a fee-based brokerage account pays a fee based
upon the amount of assets on account (an asset-based fee) and a
customer in a traditional full-service brokerage account pays a
commission (or a mark-up or mark-down) for each transaction.
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    We filed a motion with the Court on May 17, 2007 requesting that
the Court temporarily withhold the issuance of its mandate and thereby
stay the effectiveness of the FPA decision.\3\ We estimated at the time
that customers of broker-dealers held $300 billion in one million fee-
based brokerage accounts.\4\ We sought the stay to protect the
interests of those customers and to provide sufficient time for them
and their brokers to discuss, make, and implement informed decisions
about the assets in the affected accounts. We also informed the Court
that we would use

the period of the stay to consider whether further rulemaking or
interpretations were necessary regarding the application of the Act to
fee-based brokerage accounts and other issues arising from the Court's
decision. On June 27, 2007, the Court granted our motion and stayed the
issuance of its mandate until October 1, 2007.\5\
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    \3\ May 17, 2007, Motion for the Stay of Mandate, in FPA v. SEC.
    \4\ Id.
    \5\ See June 27, 2007, Order of the U.S. Court of Appeals for
the District of Columbia Circuit, in FPA v. SEC.
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B. Section 206(3) of the Advisers Act and the Issue of Principal
Trading

    We and our staff received several letters regarding the FPA
decision and about particular consequences to customers who hold fee-
based brokerage accounts.\6\ Our staff followed up with, and has been
engaged in an ongoing dialogue with, representatives of investors,
financial planners, and broker-dealers regarding the implications of
the FPA decision. During that process, firms that offered fee-based
brokerage accounts informed us that, unless the Commission acts before
October 1, 2007, one group of fee-based brokerage customers is
particularly likely to be harmed by the consequences of the FPA
decision: Customers who depend both on access to principal transactions
with their brokerage firms and on the protections associated with a
fee-based (rather than transaction-based) compensation structure. Firms
explained that section 206(3) of the Advisers Act, the principal
trading provision, poses a significant practical impediment to
continuing to meet the needs of those customers.
    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.'' \7\ Section 206(3) requires an adviser entering into a
principal transaction with a client to satisfy these disclosure and
consent requirements on a transaction-by-transaction basis.\8\ An
adviser may provide the written disclosure to a client and obtain the
client's consent at or prior to the completion of the transaction.\9\
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    \6\ See, e.g., Letter from Barbara Roper, Director of Investor
Protection, Consumer Federation of America, et al., to Christopher
Cox, Chairman, U.S. Securities and Exchange Commission, dated April
24, 2007; E-mail from Timothy J. Sagehorn, Senior Vice President--
Investments, UBS Financial Services Inc., to Christopher Cox,
Chairman, U.S. Securities and Exchange Commission, dated May 15,
2007; Letter from Kurt Schacht, Managing Director, CFA Institute
Centre for Financial Market Integrity, to Christopher Cox, Chairman,
U.S. Securities and Exchange Commission, dated May 23, 2007; Letter
from Joseph P. Borg, President, North American Securities
Administrators Association, Inc., to Christopher Cox, Chairman, U.S.
Securities and Exchange Commission, dated June 18, 2007; Letter from
Daniel P. Tully, Chairman Emeritus, Merrill Lynch & Co., Inc., to
Christopher Cox, Chairman, U.S. Securities and Exchange Commission,
dated June 21, 2007; Letter, with Exhibit, from Ira D. Hammerman,
Senior Managing Director and General Counsel, Securities Industry
and Financial Markets Association, to Robert E. Plaze, Associate
Director, Division of Investment Management, U.S. Securities and
Exchange Commission, and Catherine McGuire, Chief Counsel, Division
of Market Regulation, U.S. Securities and Exchange Commission, dated
June 27, 2007 (``SIFMA Letter''); Letter from Raymond A. ``Chip''
Mason, Chairman and CEO, Legg Mason, Inc., to Christopher Cox,
Chairman, U.S. Securities and Exchange Commission, dated July 10,
2007; Letter from Robert J. McCann, Vice Chairman and President--
Global Private Client, Merrill Lynch, to Christopher Cox, Chairman,
U.S. Securities and Exchange Commission, dated July 11, 2007; Letter
from Samuel L. Hayes, III, Jacob Schiff Professor of Investment
Banking Emeritus, Harvard Business School, to Christopher Cox,
Chairman, U.S. Securities and Exchange Commission, dated July 12,
2007; Letter from Duane Thompson, Managing Director, Washington
Office, Financial Planning Association, to Robert E. Plaze,
Associate Director, Division of Investment Management, U.S.
Securities and Exchange Commission, dated July 27, 2007 (``FPA
Letter''); Letter from Richard Bellmer, Chair, and Ellen Turf, CEO,
National Association of Personal Financial Advisors, to Robert E.
Plaze, Associate Director, Division of Investment Management, U.S.
Securities and Exchange Commission, dated August 14, 2007 (``NAPFA
Letter''); Letter from Congressman Dennis Moore, et al., to
Christopher Cox, Chairman, U.S. Securities and Exchange Commission,
dated July 13, 2007; and Letter from Congressman Spencer Bachus,
Ranking Member, Committee on Financial Services, to Christopher Cox,
Chairman, U.S. Securities and Exchange Commission, dated July 10,
2007. Each of these letters is available at: http://www.sec.gov/comments/s7-23-07
.

    \7\ 15 U.S.C. 80b-6(3). Section 206(3) also addresses ``agency
cross transactions,'' imposing the same procedural requirements
regarding prior disclosure and consent on those transactions as it
imposes on principal transactions. Agency cross transactions are
transactions for which an investment adviser provides advice and the
adviser, or a person controlling, controlled by, or under common
control with the adviser, acts as a broker for that advisory client
and for the person on the other side of the transaction. See Method
for Compliance with Section 206(3) of the Investment Advisers Act of
1940 with Respect to Certain Transactions, Investment Advisers Act
Release No. 557 (Dec. 2, 1976) [41 FR 53808] (``Rule 206(3)-2
Proposing Release'').
    \8\ See Commission Interpretation of Section 206(3) of the
Investment Advisers Act of 1940, Investment Advisers Act Release No.
1732 (July 17, 1998) [63 FR 39505 (July 23, 1998)] (``Section 206(3)
Release'') (``[A]n adviser may comply with Section 206(3) either by
obtaining client consent prior to execution of a principal or agency
transaction, or after execution but prior to settlement of the
transaction.''). See also Investment Advisers Act Release No. 40
(Jan. 5, 1945) [11 FR 10997] (``[T]he requirements of written
disclosure and of consent contained in this clause must be satisfied
before the completion of each separate transaction. A blanket
disclosure and consent in a general agreement between investment
adviser and client would not suffice.'').
    \9\ Section 206(3) Release (``Implicit in the phrase `before the
completion of such transaction' is the recognition that a securities
transaction involves various stages before it is `complete.' The
phrase completion of such transaction' on its face would appear to
be the point at which all aspects of a securities transaction have
come to an end. That ending point of a transaction is when the
actual exchange of securities and payment occurs, which is known as
`settlement.''').
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    During our discussions, firms informed our staff that the written
disclosure and the client consent requirements of section 206(3) act as
an operational barrier to their ability to engage in principal trades
with their clients. Firms that are registered both as broker-dealers
and investment advisers generally do not offer principal trading to
current advisory clients (or do so on a very limited basis), and the
rule vacated in the FPA decision had allowed broker-dealers to offer
fee-based accounts without complying with the Advisers Act, including
the requirements of section 206(3). Most informed us that they plan to
discontinue fee-based brokerage accounts as a result of the FPA
decision because of the application of the Advisers Act. They also
informed us of their view that, unless they are provided an exemption
from, or an alternative means of complying with, section 206(3) of the
Advisers Act, they would be unable to provide the same range of
services to those fee-based brokerage customers who elect to become
advisory clients and would expect few to elect to do so.\10\
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    \10\ The firms explained that they plan to consult with their
customers and obtain customers' consent to convert the fee-based
accounts to one or more other types of accounts already operating on
pre-existing business platforms. We understand that in most cases
customers will be able to choose among different types of brokerage
accounts, paying commissions for securities, and advisory accounts,
paying asset-based fees. Firms indicated to us that, if we provide
an alternative means of complying with section 206(3), they believe
a significant number of their fee-based brokerage customers will
elect to convert their accounts to non-discretionary advisory
accounts. Those accounts operate in many respects like fee-based
brokerage accounts, but fiduciary duties apply to the adviser, and
the other obligations of the Advisers Act also apply. Firms offering
these accounts provide investment advice, but clients retain
decision making authority over their investment selections.
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    Several broker-dealers and the Securities Industry and Financial
Markets Association (``SIFMA'') contended that providing written
disclosure before completion of each securities transaction, as
required by section 206(3) of the Advisers Act, makes it not feasible
for an adviser to offer customers principal transactions for several
reasons. Firms explained that there are timing and mechanical

impediments to complying with section 206(3)'s written disclosure
requirement. SIFMA explained that, for example, the combination of
rapid electronic trading systems and the limited availability of many
of the securities traded in principal markets means that an adviser may
be unable to provide written disclosure and obtain consent in
sufficient time to obtain such securities at the best price or, in some
cases, at all.\11\ Similarly, SIFMA contended that trade-by-trade
written disclosure prior to execution is not practicable because
``discussions between investment advisers and non-discretionary clients
about a trade or strategy may occur before a particular transaction is
effected, but at the time that discussion occurs the representative may
not know whether the transaction will be effected on an agency or a
principal basis.''\12\
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    \11\ SIFMA Letter, at 21 (``Many fixed income securities,
including municipal securities, that have limited availability are
quoted, purchased and sold quickly through electronic communications
networks utilized by bond dealers. * * * In today's principal
markets, investment advisers do not necessarily have `sufficient
opportunity to secure the client's specific prior consent' and
provide trade-by-trade disclosure, and opportunities to achieve best
execution may be lost if the adviser does not act immediately on
current market prices.'') (quoting Rule 206(3)-2 Proposing Release).
    \12\ Id.
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    Firms also explained that they engage in thousands--in many cases,
tens of thousands--of principal trades a day and that, due to the sheer
volume of transactions, providing a written notice to all the clients
with whom they conduct trades in a principal capacity may only be done
using automated systems.\13\ One such automated system is the system
broker-dealers use to provide customers with transaction-specific
written notifications, or trade confirmations, that include the
information required by rule 10b-10 under the Exchange Act.\14\ Under
rule 10b-10, a broker-dealer must disclose on its confirmation if it
acts as principal for its own account with respect to a
transaction.\15\ However, confirmations are provided to customers too
late to satisfy the requirements of section 206(3). This is because
trade confirmations are sent, rather than delivered, at completion of a
transaction and much of the information required to be disclosed by
rule 10b-10 may only be available at completion of a transaction, not
before. Thus, even if firms were to rely on the Commission's 1998
interpretation of section 206(3), under which disclosure and consent
may be obtained after execution but before settlement of a
transaction,\16\ no automated system currently exists that could ensure
compliance.\17\
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    \13\ Firms asserted that, while possible, providing written
notifications by fax or email prior to a transaction is impractical.
Clients may not have ready access to either at the time they wish to
conduct a trade and delaying the trade in order to provide the
written notification likely would not be in the client's best
interest, in particular as market prices may change rapidly.
    \14\ 17 CFR 240.10b-10. Rule 10b-10 under the Exchange Act
requires a broker-dealer, at or before completion of a transaction,
to give or send to its customer a written confirmation containing
specified information about the transaction.
    \15\ Rule 10b-10(a)(2) under the Exchange Act [17 CFR 240.10b-
10(a)(2)].
    \16\ See Section 206(3) Release.
    \17\ It may be possible for firms to upgrade their confirmation
delivery systems to provide an additional written disclosure that
satisfies the content and chronological requirements of section
206(3) of the Act. Based on our experience with changes to
confirmation delivery systems (largely in response to our changes to
Exchange Act rule 10b-10), any such upgrade could take years to
accomplish and would not be available by October 1, 2007, the date
the FPA decision becomes effective. Furthermore, even if an
automated system were developed to provide those written disclosures
at or before completion of the transaction, no such automated system
exists to obtain the required consent from advisory clients. We also
are mindful of the burdens associated with such a system change.
SIFMA has submitted to us that ``[t]rade confirmation production
systems are among the most expensive and most difficult to alter
anywhere in the brokerage industry, because of the mass nature of
confirmations, the sensitive and private nature of the information,
and the extremely short deadlines for their production and
mailing.'' Letter from Ira D. Hammerman, Senior Vice President and
General Counsel, Securities Industry and Financial Markets
Association, to Jonathan G. Katz, Secretary, U.S. Securities and
Exchange Commission, U.S. Securities and Exchange Commission, dated
April 4, 2005, available at: http://www.sec.gov/rules/proposed/s70604/ihammerman040405.pdf
.

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    Additionally, even if an automated system existed to enable the
disclosure and consent after execution of a trade but before its
completion in satisfaction of section 206(3), firms indicated that they
would be unlikely to trade on such a basis. The firms explained that
they do not seek post-execution consent because allowing a client until
settlement to consent to a trade that has already been executed creates
too great a risk that intervening market changes or other factors could
lead a client to withhold consent to the disadvantage of the firm.
    Access to securities held in a firm's principal accounts is
important to many investors. We believe, based on our discussions with
industry representatives and others throughout the transition process,
that many customers may wish to access the securities inventory of a
diversified broker-dealer through their non-discretionary advisory
accounts.\18\ For example, the Financial Planning Association (``FPA'')
noted that principal trades in a fiduciary relationship could be
beneficial to investors, stating:
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    \18\ We have previously expressed our view that some principal
trades may serve clients' best interests. See Section 206(3)
Release.

    Depending on the circumstances, clients may benefit from
principal trades, but only in the context of a fiduciary
relationship with the best interests of the client being paramount.
In favorable circumstances, advisers may obtain access to a broader
range of investment opportunities, better trade execution, and more
favorable transaction prices for the securities being bought or sold
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than would otherwise be available.\19\

    \19\ FPA Letter, at 3.
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    As a result of the FPA decision, customers must elect on or before
October 1, 2007, to convert their fee-based brokerage accounts to
advisory accounts or to traditional commission-based brokerage
accounts. Several firms emphasized to our staff that the inability of a
client to access certain securities held in the firm's principal
accounts--particularly municipal securities and other fixed income
securities that they contend have limited availability and are dealt
through a firm's account using electronic communications networks--may
be a determinative factor in whether the client selects (or the firm
makes available) a non-discretionary advisory account to replace the
client's fee-based brokerage account. As discussed in this Release,
many firms informed us that, because of the practical difficulties with
complying with the trade-by-trade written disclosure requirements of
section 206(3) discussed above, they simply refrain from engaging in
principal trading with their advisory clients. Accordingly, customers
who wish to access firms' principal inventories may, as a practical
matter, have no choice but to open a traditional brokerage account in
which they will pay transaction-based compensation, rather than convert
their fee-based brokerage account to an advisory account.
    While we do not agree with SIFMA that an exemption from section
206(3) of the Act in its entirety is appropriate, we do believe that
there may be substantial benefits to many of the investors holding an
estimated $300 billion in approximately one million fee-based brokerage
accounts if their accounts are converted to advisory accounts instead
of traditional brokerage accounts.\20\ Those investors will continue to
be able

to avoid transaction-based compensation and the incentives such a
compensation arrangement creates for a broker-dealer, a reason they may
have initially opened fee-based brokerage accounts.\21\ They also will
enjoy, as the Court pointed out in the FPA decision, the protections of
the ``federal fiduciary standard [that] govern[s] the conduct of
investment advisers.'' \22\
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    \20\ SIFMA asserted that firms should be exempt entirely from
section 206(3) of the Act in order to ``preserve the [fee-based
brokerage] client's ability to access certain securities that are
best--or only--available through trades with the adviser or an
affiliate of the adviser.'' SIFMA Letter, at 3. SIFMA further
requested that we provide broker-dealers an exemption from all of
the provisions of the Advisers Act with respect to their fee-based
brokerage accounts. We are not adopting such a broad exemption.
    \21\ A brokerage industry committee formed in 1994 at the
suggestion of then-Commission Chairman Arthur Levitt concluded that
fee-based compensation would better align the interests of broker-
dealers and their customers and allow registered representatives to
focus on what the committee described as their most important role--
providing investment advice to individual customers, not generating
transaction revenues. See Report of the Committee on Compensation
Practices (Tully Report) (Apr. 10, 1995). We already have sought and
received public comment on the potential benefits to investors of
fee-based accounts, see Certain Broker-Dealers Deemed Not to be
Investment Advisers, Investment Advisers Act Release No. 2376 (Apr.
12, 2005) [70 FR 20424 (Apr. 19, 2005]; Certain Broker-Dealers
Deemed Not to be Investment Advisers, Investment Advisers Act
Release No. 2340 (Jan. 6, 2005) [70 FR 2716 (Jan. 14, 2005)]; and
Certain Broker-Dealers Deemed Not to be Investment Advisers,
Investment Advisers Act Release No. 1845 (Nov. 4, 1999) [64 FR 61226
(Nov. 10, 1999)].
    \22\ FPA decision, at 16, citing Transamerica Mortgage Advisors
Inc. v. Lewis, 444 U.S. 11, 17 (1979).
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    To address the concerns described above and to protect the
interests of customers who previously held fee-based brokerage
accounts, we are adopting a temporary rule, on an interim final basis,
that provides an alternative method for advisers who also are
registered as broker-dealers to comply with section 206(3) of the Act.
We believe this rule both protects investors' choice--fee-based
brokerage customers would be able to choose an account that offers a
similar set of services (including access to the same securities) that
were available to them in fee-based brokerage accounts--and avoids
disruption to, and confusion among, investors who may wish to access
and sell securities only available through a firm acting in a principal
capacity and who, as a result, may no longer be offered any fee-based
account. We believe the temporary rule will allow fee-based brokerage
customers to maintain their existing relationships with, and receive
roughly the same services from, their broker-dealers. We believe
further that making the rule temporary allows us an opportunity to
observe how those firms use the alternative means of compliance
provided by the rule, and whether those firms serve their clients' best
interests.

II. Discussion

A. Overview of Temporary Rule 206(3)-3T

    Congress intended section 206(3) of the Advisers Act to address
concerns that an adviser might engage in principal transactions to
benefit itself or its affiliates, rather than the client.\23\ In
particular, Congress appears to have been concerned that advisers might
use advisory accounts to ``dump'' unmarketable securities or those the
advisers fear may decline in value.\24\ Congress chose not to prohibit
advisers from engaging in principal and agency transactions, but rather
to prescribe a means by which an adviser must disclose and obtain the
consent of its client to the conflicts of interest involved. Congress's
concerns were and continue to be significant. Self-dealing by
investment advisers involves serious conflicts of interest and a
substantial risk that the proprietary interests of the adviser will
prevail over those of its clients.\25\
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    \23\ See Investment Trusts and Investment Companies: Hearings on
S. 3580 Before the Subcomm. of the Comm. on Banking and Currency,
76th Cong., 3d Sess. 320 (1940) (statement of David Schenker, Chief
Counsel, Securities and Exchange Commission Investment Trust Study)
(``Senate Hearings''). As noted above, section 206(3) also addresses
agency cross transactions, which raise similar concerns regarding an
adviser engaging in transactions to benefit itself or its
affiliates, as well as the concern that an adviser may be subject to
divided loyalties.
    \24\ See Senate Hearings at 322 (``[i]f a fellow feels he has a
sour issue and finds a client to whom he can sell it, then that is
not right. * * *'') (statement of David Schenker, Chief Counsel,
Securities and Exchange Commission Investment Trust Study).
    \25\ As we have stated before ``where an investment adviser
effects a transaction as principal with his advisory account client,
the terms of the transaction are necessarily not established by
arm's-length negotiation. Instead, the investment adviser is in a
position to set, or to exert influence potentially affecting, the
terms by which he participates in such trade. The pressures of self-
interest which may be present in such principal transactions may
require the prophylaxis of the disclosures [required by section
206(3)].'' Rule 206(3)-2 Proposing Release.
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    In light of these concerns and the important protections provided
by section 206(3) of the Advisers Act, rule 206(3)-3T provides advisers
an alternative means to comply with the requirements of that section
that is consistent with the purposes, and our prior interpretations, of
the section. The temporary rule continues to provide the protection of
transaction-by-transaction disclosure and consent, subject to several
conditions.\26\ Specifically, temporary rule 206(3)-3T permits an
adviser, with respect to a non-discretionary advisory account, to
comply with section 206(3) of the Advisers Act by, among other things:
(i) Providing written prospective disclosure regarding the conflicts
arising from principal trades; (ii) obtaining written, revocable
consent from the client prospectively authorizing the adviser to enter
into principal transactions; (iii) making certain disclosures, either
orally or in writing, and obtaining the client's consent before each
principal transaction; (iv) sending to the client confirmation
statements disclosing the capacity in which the adviser has acted and
disclosing that the adviser informed the client that it may act in a
principal capacity and that the client authorized the transaction; and
(v) delivering to the client an annual report itemizing the principal
transactions. The rule also requires that the investment adviser be
registered as a broker-dealer under section 15 of the Exchange Act and
that each account for which the adviser relies on this rule be a
brokerage account subject to the Exchange Act, and the rules
thereunder, and the rules of the self-regulatory organization(s) of
which it is a member.\27\
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    \26\ We similarly provided, in a rule of analogous scope and
structure to rule 206(3)-3T, an alternative means of compliance with
the disclosure and consent requirements of section 206(3) relating
to ``agency cross transactions.'' See rule 206(3)-2 under the
Advisers Act.
    \27\ See Section II.B.7 of this Release.
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    These conditions, discussed below, are designed to prevent
overreaching by advisers by requiring an adviser to disclose to the
client the conflicts of interest involved in these transactions, inform
the client of the circumstances in which the adviser may effect a trade
on a principal basis, and provide the client with meaningful
opportunities to refuse to consent to a particular transaction or
revoke the prospective general consent to these transactions. We note
that we have previously stated that ``Section 206(3) should be read
together with Sections 206(1) and (2) to require the adviser to
disclose facts necessary to alert the client to the adviser's potential
conflicts of interest in a principal or agency transaction.'' \28\ We
request comment generally on the need for the rule and its potential
impact on clients of the advisers. Will the advantages described above
that we believe accompany rule 206(3)-3T be beneficial to investors?
Have we struck an appropriate balance between investor choice and
investor protection? Does the alternative means of compliance

contained in rule 206(3)-3T provide all the necessary investor
protections? \29\
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    \28\ Section 206(3) Release. For a further discussion, see
Section II.B.8 of this Release.
    \29\ In this regard, see NAPFA Letter (``express[ing] its strong
reservations regarding the possible grant of principal trading
relief'').
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B. Section-by-Section Description of Rule 206(3)-3T

    Rule 206(3)-3T deems an investment adviser to be in compliance with
the provisions of section 206(3) of the Advisers Act when the adviser,
or a person controlling, controlled by, or under common control with
the investment adviser, acting as principal for its own account, sells
to or purchases from an advisory client any security, provided that
certain conditions discussed below are met. The scope and structure of
the rule are similar to our rule 206(3)-2 under the Advisers Act,
which, as noted above, provides an alternative means of complying with
the limitations on ``agency cross transactions,'' also contained in
section 206(3).
    We have applied section 206(3) not only to principal transactions
engaged in or effected by an adviser, but also to certain situations in
which an adviser causes a client to enter into a principal transaction
that is effected by a broker-dealer that controls, is controlled by, or
is under common control with the adviser.\30\ Accordingly, rule 206(3)-
3T would be available if the adviser acts as principal by causing the
client to engage in a transaction with a broker-dealer that is an
affiliate of the adviser--that is, a broker-dealer that controls, is
controlled by, or is under common control with the investment adviser.
---------------------------------------------------------------------------

    \30\ See Section 206(3) Release at n. 3.
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1. Non-Discretionary Accounts
    Rule 206(3)-3T applies to principal trades with respect to accounts
over which the client has not granted ``investment discretion, except
investment discretion granted by the advisory client on a temporary or
limited basis.'' \31\ Availability of the rule to discretionary
accounts would be inconsistent with the requirement of the rule,
discussed below, that the adviser obtains consent (which may be oral
consent) from the client for each principal transaction.\32\ In
addition, we are of the view that the risk of relaxing the procedural
requirements of section 206(3) of the Advisers Act when a client has
ceded substantial, if not complete, control over the account raises
significant risks that the client will not be, or is not in a position
to be, sufficiently involved in the management of the account to
protect himself or herself from overreaching by the adviser.
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    \31\ Rule 206(3)-3T(a)(1). For purposes of the rule, the term
``investment discretion'' has the same meaning as in section
3(a)(35) of the Exchange Act [15 U.S.C. 78c(a)(35)], except that it
excludes investment discretion granted by a customer on a temporary
or limited basis. Section 3(a)(35) of the Exchange Act provides that
a person exercises ''investment discretion'' with respect to an
account if, directly or indirectly, such person: (A) Is authorized
to determine what securities or other property shall be purchased or
sold by or for the account; (B) makes decisions as to what
securities or other property shall be purchased or sold by or for
the account even though some other person may have responsibility
for such investment decisions; or (C) otherwise exercises such
influence with respect to the purchase and sale of securities or
other property by or for the account as the Commission, by rule,
determines, in the public interest or for the protection of
investors, should be subject to the operation of the provisions of
this title and rules and regulations thereunder.
    We would view a broker-dealer's discretion to be temporary or
limited within the meaning of rule 206(3)-3T(a)(1) when the broker-
dealer is given discretion: (i) As to the price at which or the time
to execute an order given by a customer for the purchase or sale of
a definite amount or quantity of a specified security; (ii) on an
isolated or infrequent basis, to purchase or sell a security or type
of security when a customer is unavailable for a limited period of
time not to exceed a few months; (iii) as to cash management, such
as to exchange a position in a money market fund for another money
market fund or cash equivalent; (iv) to purchase or sell securities
to satisfy margin requirements; (v) to sell specific bonds and
purchase similar bonds in order to permit a customer to take a tax
loss on the original position; (vi) to purchase a bond with a
specified credit rating and maturity; and (vii) to purchase or sell
a security or type of security limited by specific parameters
established by the customer.
    \32\ Rule 206(3)-3T(a)(4). See Section II.B.4 of this Release.
---------------------------------------------------------------------------

    The rule would apply to all non-discretionary advisory accounts,
not only those that were originally established as fee-based brokerage
accounts.\33\ As noted above, some portion of the customers converting
fee-based brokerage accounts into advisory accounts will be converting
those accounts into non-discretionary accounts offered by the same
firm. We understand from our discussions with broker-dealers that
maintaining principal trading distinctions between advisory accounts
that were once fee-based brokerage accounts and those that were not
would be very difficult. Trade execution routing for investment
advisory programs often is derived through unified programs or
electronic codes allowing or prohibiting certain kinds of trades
uniformly for all accounts that are of the same type. As such, limiting
relief to accounts that were formerly in fee-based brokerage programs
would make the requested relief impractical for firms and would neither
serve the best interests of clients (because the effect would be to
limit their ability to continue to access the inventory of securities
held by their brokerage firm) nor be administratively feasible to firms
affected by the Court's ruling with respect to the transition and
ongoing servicing of these and other accounts subject to the Advisers
Act. We accordingly determined not to limit the availability of the
temporary rule only to those non-discretionary advisory accounts that
were fee-based brokerage accounts.
---------------------------------------------------------------------------

    \33\ We have not extended the rule to advisory accounts that are
held only at investment advisers, as opposed to firms that are both
investment advisers and registered broker-dealers. See Section
II.B.7 of this Release.
---------------------------------------------------------------------------

    We welcome comment on this aspect of our interim final rule. Are we
correct that the potential for abuse through self-dealing is less in
non-discretionary accounts, where clients may be better able to protect
themselves and monitor trading activity, than in accounts where clients
have granted discretion and may not be in a position to protect
themselves sufficiently? Should we further limit the availability of
the rule so that it is only available for transactions with wealthy or
sophisticated clients who, for other purposes under the Act, we have
presumed are capable of protecting themselves? For example, should it
apply only with respect to transactions with a ``qualified client'' as
defined in Advisers Act rule 205-3?
    Should we limit the relief provided by the rule to accounts that
originally were fee-based brokerage accounts? Do the operational
burdens and complexities identified by the broker-dealers support
application of the rule to all non-discretionary advisory accounts?
2. Issuer and Underwriter Limitations
    Rule 206(3)-3T is not available for principal trades of securities
if the investment adviser or a person who controls, is controlled by,
or is under common control with the adviser (``control person'') is the
issuer or is an underwriter of the security.\34\ The rule includes one
exception--an adviser may rely on the rule for trades in which the
adviser or a control person is an underwriter of non-convertible
investment-grade debt securities.
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    \34\ Rule 206(3)-3T(a)(2). The term ``underwriter'' is defined
in section 202(a)(20) of the Advisers Act to mean ``any person who
has purchased from an issuer with a view to, or sells for an issuer
in connection with, the distribution of any security, or
participates or has a direct or indirect participation in any such
undertaking, or participates or has a participation in the direct or
indirect underwriting of any such undertaking; but such term shall
not include a person whose interest is limited to a commission from
an underwriter or dealer not in excess of the usual and customary
distributor's or seller's commission.''
---------------------------------------------------------------------------

    One benefit an investor may gain by establishing a brokerage
account with a

large broker-dealer is the ability to obtain access to potentially
profitable public offerings of securities. These securities are
typically purchased by the broker-dealer participating in the
underwriting as part of its allotment of the offering and then sold to
customers in principal transactions. As noted above, many broker-
dealers have not made such offerings available to advisory clients
because of the requirements of section 206(3).
    A broker-dealer participating in an underwriting typically has a
substantial economic interest in the success of the underwriting, which
might be different from the interests of investors. When a broker-
dealer acts as an underwriter with respect to a security, it is
compensated precisely for the service of distributing that
security.\35\ A successful distribution not only offers the possibility
of a concession on the securities (the spread between the underwriter's
purchase price from the issuer and the public offering price), but also
often an over-allotment option, and potentially future business
(whether as an underwriter, lender, adviser or otherwise) with the
issuer. The incentives may bias the advice being provided or lead the
adviser to exert undue influence on its client's decision to invest in
the offering or the terms of that investment. As such, the broker-
dealer's incentives to ``dump'' securities it is underwriting are
greater for sales by a broker-dealer acting as an underwriter than for
sales by a broker-dealer not acting as an underwriter of other
securities from its inventory.
---------------------------------------------------------------------------

    \35\ The act of underwriting is purchasing ``with a view to * *
* the distribution of any security.'' Section 202(a)(20) of the
Advisers Act [17 CFR 275.202(a)(20)].
---------------------------------------------------------------------------

    A broker-dealer acting as an issuer has similar, if not greater,
proprietary interests that are likely to adversely affect the
objectivity of its advice. We therefore are of the view that an
investment adviser who (or whose affiliate) is the issuer or
underwriter of a security has such a significant conflict of interest
as to make such a transaction, with one exception, an inappropriate
subject of the relief we are providing today.
    We have, however, provided an exception for principal transactions
in non-convertible investment grade debt securities underwritten by the
adviser or a person who controls, is controlled by, or is under common
control with the adviser.\36\ Non-convertible investment grade debt
securities may be less risky and therefore less likely to be ``dumped''
on clients. Also, it may be easier for clients to identify whether the
price they are being quoted for a non-convertible investment grade debt
security is fair given the relative comparability, and the significant
size, of the non-convertible investment grade debt markets.
---------------------------------------------------------------------------

    \36\ ``Investment grade debt securities'' are defined in the
rule to mean any non-convertible debt security that is rated in one
of the four highest rating categories of at least two nationally
recognized statistical rating organizations (as defined in section
3(a)(62) of the Exchange Act [15 U.S.C. 78c(a)(62)]). Rule 206(3)-
3T(c).
---------------------------------------------------------------------------

    Moreover, as the staff has discussed the effects of the FPA
decision with broker-dealers, those broker-dealers have asserted that
it is in the interest of investors to permit them to conduct principal
trades with their advisory clients involving these securities, even
where they or their affiliates are underwriters. Those firms argue that
clients may face difficulties and higher costs in obtaining these debt
instruments, particularly municipal bonds, through an advisory account
if the adviser is not permitted to rely on the interim final rule's
alternative means of complying with section 206(3).
    The limitation on issuer transactions makes the rule unavailable
for principal transactions in traditional equity or debt offerings of
the investment adviser or a control person of the adviser. It also
makes the rule unavailable in connection with--and thus requires
compliance with section 206(3)'s trade-by-trade written disclosure
requirements before--non-discretionary placement by an adviser of a
proprietary structured product, such as a structured note, with an
advisory client.\37\ We request comment on whether we should consider
expanding the availability of the rule to apply to structured products,
and if so, on what terms.
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    \37\ There is no uniform definition of what constitutes a
structured product and the term is not defined in the temporary
rule. Structured products include, among other things,
securitizations of pools of assets, such as asset-backed securities
which are supported by a discrete pool of financial assets (e.g.,
mortgages or other receivables). See generally Securities Act
Release No. 8518 (Dec. 22, 2004) [70 FR 1506 (Jan. 7, 2005)]. The
Financial Industry Regulatory Authority, Inc. (``FINRA''), the self-
regulatory organization that oversees broker-dealers, defines
structured products as ``securities derived from or based on a
single security, a basket of securities, an index, a commodity, a
debt issuance and/or a foreign currency.'' FINRA Notice to Members
05-59 (Sept. 2005). FINRA has notified its members that they should
consider only recommending structured products to customers who have
been approved for options trading. Id. at 4. See also FINRA Notice
to Members 03-71 (Nov. 2003) (expressing concern that investors,
particularly retail investors, may not fully understand the risks
associated with non-conventional investments--such as structured
securities--and cautioning members to ensure that their sales
conduct procedures fully and accurately address any of the special
circumstances presented by the sale of these products).
---------------------------------------------------------------------------

    We also request comment on our exclusion for securities issued or
underwritten by the adviser or its control persons. Do commenters agree
with our assessment of the risks to clients and our interpretation of
the purposes of section 206(3)? Should we consider making the rule
available for principal transactions in all securities (including those
issued or subject to an underwriting by the adviser or a control
person) in light of the clients' interest in obtaining access to public
offerings? Alternatively, is there an approach we might take that could
distinguish types of underwriting arrangements that do not present
unacceptable risks of conflicts for the adviser? In this regard, we
request comment on the one exception we have provided for non-
convertible investment grade debt securities. Is the exception
appropriate under the circumstances? Are there other circumstances in
which an adviser should be able to rely on the rule when it (or a
control person) is an issuer or underwriter of securities in certain
circumstances?
3. Written Prospective Consent Following Written Disclosure
    An adviser may rely on rule 206(3)-3T only after having secured its
client's written, revocable consent prospectively authorizing the
adviser directly or indirectly acting as principal for its own account,
to sell any security to or purchase any security from such client.\38\
The consent must be obtained only after the adviser provides the client
with written disclosure about: (i) The circumstances under which the
investment adviser may engage in principal transactions with the
client; (ii) the nature and significance of the conflicts the
investment adviser has with its clients' interests as a result of those
transactions; and (iii) how the investment adviser addresses those
conflicts.\39\ We anticipate that this consent normally would be
obtained by the adviser when the client establishes the advisory
account.\40\
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    \38\ Rule 206(3)-3T(a)(3).
    \39\ The FPA recommended a similar condition. See FPA Letter, at
3.
    \40\ No additional disclosure regarding the principal capacity
in which the adviser may be acting need be made pursuant to rule
206(3)-3T(a)(3) at the time of the transaction, provided the
disclosure required by paragraph (a)(3) of the rule has been made
and is correct in all material respects.
---------------------------------------------------------------------------

    Rule 206(3)-3T is not exclusive. An adviser would still be able to
effect principal trades with a client who either never grants the
prospective consent required under paragraph (a)(3) of the rule 206(3)-
3T, or subsequently revokes

that consent after having granted it, so long as the adviser complies
with the terms of section 206(3) of the Act.
    Will the disclosure required by paragraph (a)(3) be meaningful for
clients in understanding the conflicts and risks inherent in principal
trading by a fiduciary counterparty? Are there alternative approaches
that we could adopt to make the prospective disclosures more meaningful
to clients? Should we require disclosure to be prominent or,
alternatively, require disclosure in a separately executed document to
assure that the client has separately given attention to the request
for consent?
    With each written disclosure, confirmation, and request for written
prospective consent, the investment adviser must include a conspicuous,
plain English statement clarifying that the prospective general consent
may be revoked at any time.\41\ Thus, the client must be able to revoke
his or her prospective consent at any time, thereby preventing an
adviser from relying on rule 206(3)-3T with respect to that account
going forward.\42\ Do these provisions adequately ensure that client
consent is voluntary? Will advisers make a client's consent a condition
to participation in non-discretionary advisory accounts they offer? If
so, should we add a provision to the rule to address this issue, such
as prohibiting advisers from doing so?
---------------------------------------------------------------------------

    \41\ Rule 206(3)-3T(a)(8). The FPA recommended a similar
condition. See FPA Letter, at 4.
    \42\ The right to revoke prospective consent is not intended to
allow a client to rescind, after execution but prior to settlement,
a particular trade to which the client provided specific consent
prior to execution.
---------------------------------------------------------------------------

    The written prospective consent need only be executed once. Should
we require that the client's consent be renewed periodically? What
benefit would be gained by such a provision in light of the client's
right to revoke his or her consent at any time?
4. Trade-by-Trade Consent Following Disclosure
    The temporary rule requires an investment adviser, before the
execution of each principal transaction, to: (i) Inform the client of
the capacity in which the adviser may act with respect to the
transaction; and (ii) obtain consent from the client for the investment
adviser to act as principal for its own account with respect to each
such transaction.\43\ The trade-by-trade disclosure and consent may be
written or oral. Although representatives of the brokerage industry
have requested that we eliminate the requirement for transaction-by-
transaction disclosure and consent,\44\ we have determined that such
disclosure and consent continues to be important to alert clients to
the potential for conflicted advice they may be receiving on individual
transactions. In light of the conflicts inherent in these transactions,
generally notifying the client that a transaction may be effected on a
principal basis close in time to the carrying out of such a trade is
appropriate.
---------------------------------------------------------------------------

    \43\ Rule 206(3)-3T(a)(4).
    \44\ SIFMA Letter, at 3.
---------------------------------------------------------------------------

    Given the frequency and speed of trading in some advisory accounts
as well as the increasing complexity of securities products available
in the marketplace, trade-by-trade disclosure and consent, even if
oral, might be a more effective protection against misunderstanding by
advisory clients of the nature of a transaction and the conflicts
inherent in it as well as a meaningful safeguard for investment
advisers seeking to comply with their fiduciary obligations. We
understand, however, that in many instances the adviser may not know
whether a particular transaction will be effected on a principal basis.
Accordingly, the rule permits advisers to disclose to clients that they
``may'' act in a principal capacity with respect to the transaction.
    We do not believe the obligation to make oral disclosure will
impose a significant burden on investment advisers of non-discretionary
accounts who must, in most cases, obtain consent for each transaction
regardless of whether the transaction will be done on a principal
basis.\45\ We are interested in learning from investors whether this
consent requirement is informative and helpful. We also are interested
in learning from advisers whether they intend to document receipt of
the oral consent and, if so, whether they will be able to do so
efficiently.
---------------------------------------------------------------------------

    \45\ See rule 206(3)-3T(a)(1) (limiting the availability of the
rule to accounts over which the adviser does not exercise
discretionary authority).
---------------------------------------------------------------------------

    We request comment regarding whether investment advisers find
useful the flexibility to provide oral instead of written disclosure on
a trade-by-trade basis. Or, will advisers instead view the relief as
unworkable?
5. Written Confirmation
    The investment adviser must send to each client with which it
effects a principal trade pursuant to rule 206(3)-3T a written
confirmation, at or before the completion of the transaction.\46\ In
addition to the other information required to be in a confirmation by
Exchange Act rule 10b-10,\47\ the confirmation must include a
conspicuous, plain English statement informing the advisory client that
the adviser disclosed to the client prior to the execution of the
transaction that the adviser may act in a principal capacity in
connection with the transaction, that the client authorized the
transaction, and that the adviser sold the security to or bought the
security from the client for its own account.\48\ An investment adviser
need not send a duplicate confirmation. An adviser may satisfy its
obligations under paragraph (a)(5) by including, or causing an
affiliated broker-dealer to include, the additional required disclosure
on a confirmation otherwise sent to the client with respect to a
particular principal transaction.
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    \46\ For a discussion of the meaning of ``completion'' of the
transaction, see Section 206(3) Release. The temporary rule does not
permit advisers to deliver confirmations using the alternative
periodic reporting provisions of rule 10b-10(b) under the Exchange
Act.
    \47\ 17 CFR 240.10b-10.
    \48\ Rule 206(3)-3T(a)(5).
---------------------------------------------------------------------------

    The requirement to provide a trade-by-trade confirmation is
designed to ensure that clients are given a written notice and reminder
of each transaction that the investment adviser effects on a principal
basis and that conflicts of interest are inherent in such
transactions.\49\ We request comment on our written confirmation
condition. Is there additional information that should be included in
the confirmation? Are there circumstances in which commenters believe
it is appropriate for us to permit investment advisers to rely on rule
206(3)-3T and also deliver confirmations to clients pursuant to the
alternative periodic reporting provisions of rule 10b-10(b)?
---------------------------------------------------------------------------

    \49\ Rule 206(3)-2 under the Advisers Act, our agency cross
transaction rule, requires similar confirmation disclosure.
---------------------------------------------------------------------------

6. Annual Summary Statement
    The investment adviser must deliver to each client, no less
frequently than once a year, written disclosure containing a list of
all transactions that were executed in the account in reliance on rule
206(3)-3T, including the date and price of such transactions.\50\ The
annual summary statement is designed to ensure that clients receive a
periodic record of the principal trading activity in their accounts and
are afforded an opportunity to assess the frequency with which their
adviser engages in such trades. As with each other disclosure required
pursuant to rule 206(3)-3T, to be able to rely on the rule the
investment adviser must include a

conspicuous, plain English statement that its client's written
prospective consent may be revoked at any time.\51\
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    \50\ Rule 206(3)-3T(a)(6). Rule 206(3)-2(a)(3) contains a
similar annual report requirement with respect to agency cross
transactions. In addition, the FPA recommended a similar condition.
See FPA Letter, at 4.
    \51\ Rule 206(3)-3T(a)(8).
---------------------------------------------------------------------------

    We request comment generally on this aspect of the interim final
rule. Should a summary statement be provided more or less frequently
than annually? Is there additional information that we should require
to be included in each summary statement? For example, we are not
requiring advisers to disclose in an annual statement the total amount
of all commissions or other remuneration they receive in connection
with transactions with respect to which they are relying on this rule.
Although that disclosure is required with respect to agency cross
transactions pursuant to rule 206(3)-2(a)(3), we are concerned that
disclosure of such amounts for principal trades may not accurately
reflect the actual economic benefit to the adviser with respect to
those trades or the consequence to the client for consenting to those
trades. Are our concerns justified? Commenters are invited to submit
suggestions for possible enhancements to the disclosures in annual
statements that could enhance the disclosure to clients of the
significance of their consenting to principal trades.
7. Advisory Account Must Be a Brokerage Account
    Rule 206(3)-3T is only available to an investment adviser that also
is registered with us as a broker-dealer. Each account for which the
investment adviser relies on this section must be a brokerage account
subject to the Exchange Act, the rules thereunder, and the rules of
applicable self-regulatory organizations (e.g., FINRA).\52\ The rule
therefore requires that the protections of both the Advisers Act and
the Exchange Act apply when advisers enter into principal transactions
with clients in reliance on the rule.
---------------------------------------------------------------------------

    \52\ Rule 206(3)-3T(a)(7).
---------------------------------------------------------------------------

    The temporary rule permits, subject to compliance with the rule's
conditions, an adviser that also is registered as a broker-dealer to
execute a principal trade directly (out of its own account) or
indirectly (out of an account of another person who is a control person
of the adviser). Because we have decided to apply the rule only to
advisers who also are registered as broker-dealers, an adviser who is
not also a registered broker-dealer would be unable to rely on rule
206(3)-3T if it causes a client to enter into a principal trade with a
control person, even if that control person is a registered broker-
dealer.
    Our decision not to extend the rule to advisory accounts that are
held only at investment advisers, as opposed to entities that are both
investment advisers and broker dealers, is based on several
considerations. First, firms that are both broker-dealers and
investment advisers and their employees must comply with the
comprehensive set of Commission and self-regulatory organization sales
practice and best execution rules that apply to the relationship
between a broker-dealer and its customer in addition to the fiduciary
duties an adviser owes a client. We believe that it is important to
maintain the application of the laws and rules regarding broker-dealers
to these accounts.\53\ Second, as a practical matter, advisory clients
most frequently need and desire principal trading services from firms
that are dually registered as an adviser and a broker-dealer because
they generally carry large inventories of securities. Providing a
variation in the method of complying with section 206(3) of the
Advisers Act for advisers that also are registered as broker-dealers
thus addresses a large category of the situations in which clients are
likely to benefit from access to the inventory of the adviser/broker-
dealer without sacrificing pricing or other sales practice protections.
---------------------------------------------------------------------------

    \53\ We note that fee-based brokerage accounts have been subject
to Commission and self-regulatory organization sales practice and
best execution rules since their inception.
---------------------------------------------------------------------------

    We request comment on this aspect of the interim final rule. What
will be the benefit to customers of maintaining the sales practice
rules of self-regulatory organizations? What will be the impact of the
rule on advisers that are not themselves registered as broker-dealers?
Would they choose to register as a broker-dealer in order to take
advantage of the new rule? Are there particular requirements of broker-
dealer regulation that are clearly duplicative or clearly inapplicable
to the regulation of investment advisers and so are unnecessary in this
context?
8. Other Obligations Unaffected
    Rule 206(3)-3T(b) clarifies that the temporary rule does not
relieve in any way an investment adviser from its obligation to act in
the best interests of each of its advisory clients, including
fulfilling the duty with respect to the best price and execution for a
particular transaction.\54\ Compliance with rule 206(3)-3T also does
not relieve an investment adviser from its fiduciary obligation imposed
by sections 206(1) or (2) of the Advisers Act or by other applicable
provisions of federal law.\55\
---------------------------------------------------------------------------

    \54\ Rule 206(3)-2(e) contains a similar provision.
    \55\ Section 206(3) Release. See also SIFMA Memo at Exhibit page
23 (noting that, in connection with any relief provided under
section 206(3), ``[t]he adviser will continue to act in the best
interests of the client, including a duty to provide best execution,
and will be required to meet all disclosure obligations imposed by
Sections 206(1) and (2) of the Advisers Act and by other applicable
provisions of the federal securities laws and rules of SROs'');
section 406 of the Employee Retirement Income Security Act of 1974
(``ERISA'') (describing ``prohibited transactions'' of fiduciaries
subject to ERISA); section 4975(c)(1) of the Internal Revenue Code
(the ``Code'') (describing ``prohibited transactions'' of
fiduciaries governed by the Code).
---------------------------------------------------------------------------

    We note specifically that an adviser engaging in principal
transactions is subject to rule 206(4)-7, which, among other things,
requires an investment adviser registered with us to adopt and
implement written policies and procedures reasonably designed to
prevent violations of the Advisers Act (and the rules thereunder) by
the adviser or any of its supervised persons.\56\ Thus, an adviser
relying on rule 206(3)-3T as an alternative means of complying with
section 206(3) must have adopted and implemented written policies and
procedures reasonably designed to comply with the requirements of the
rule. In addition, rule 204-2,\57\ as well as Exchange Act rules 17a-3
\58\ and 17a-4,\59\ requires the adviser to make, keep, and retain
records relating to the principal trades the adviser effects.
---------------------------------------------------------------------------

    \56\ Rule 206(4)-7(a) [17 CFR 275.206(4)-7(a)].
    \57\ 17 CFR 275.204-2.
    \58\ 17 CFR 240.17a-3.
    \59\ 17 CFR 240.17a-4.
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9. Limited Duration of Relief
    Rule 206(3)-3T(d) contains a sunset provision. Absent further
action by the Commission, the temporary rule will expire on December
31, 2009, which is about 27 months from its effective date.\60\ Setting
a termination date for the rule will necessitate further Commission
action no later than the end of that period if the Commission intends
to continue the same or similar relief.
---------------------------------------------------------------------------

    \60\ The FPA recommended a similar condition See FPA Letter, at
2.
---------------------------------------------------------------------------

    We believe limiting the duration of the rule will give us an
opportunity to observe how firms comply with their disclosure
obligations under the rule, and whether, when they conduct principal
trades with their clients, they put their clients' interests first. A
significantly shorter period than the one we have established, however,
may have disadvantaged former fee-based brokerage customers because of
the uncertainty about the continuation of access through their advisory
accounts to the securities in the inventory of their

brokerage firm. Those customers also could have faced renewed
disruption and confusion if the rule on principal trades were abolished
or substantially modified in the short term. Similarly, broker-dealers
would have faced the same uncertainty about the continuation of the
rule, which could have caused some broker-dealers to decide not to make
the necessary expenditures and investments to offer advisory accounts
with access to principal trades.
    We request comment on whether the 27-month time frame is
appropriate. We also welcome comment on any other aspects of the rule
that commenters believe should be modified.
10. Other Matters
    This rulemaking action must be: (i) Necessary or appropriate in the
public interest; (ii) consistent with the protection of investors; and
(iii) consistent with the purposes fairly intended by the policy and
provisions of the Advisers Act.\61\ We also need to consider the effect
of the rule on competition, efficiency, and capital formation, which we
address below in Section VII of this Release. For the reasons described
in this Release, we believe that the rule is necessary or appropriate
in the public interest and consistent with the protection of investors.
We also believe that the temporary rule is consistent with the purposes
fairly intended by the policy and provisions of the Advisers Act.
---------------------------------------------------------------------------

    \61\ See 15 U.S.C. 80b-6a.
---------------------------------------------------------------------------

    In the FPA decision, the Court described the purposes of the Act,
emphasizing that the ``overall statutory scheme of the [Advisers Act]
addresses the problems identified to Congress in two principal ways:
First, by establishing a federal fiduciary standard to govern the
conduct of investment advisers, broadly defined, * * * and second, by
requiring full disclosure of all conflicts of interest.'' \62\ The
Congressional intent was to eliminate or expose all conflicts of
interest that might incline an investment adviser, consciously or
unconsciously, to render advice that was not disinterested.\63\ The
Court further noted that Congress's purpose in enacting the Advisers
Act was to establish fiduciary standards and require full disclosure of
all conflicts of interests of investment advisers.\64\
---------------------------------------------------------------------------

    \62\ FPA decision, at 490.
    \63\ Id.
    \64\ Id.
---------------------------------------------------------------------------

    The temporary rule adopted today meets those purposes and adheres
closely to the text of section 206(3), which reflects the basic
conflict disclosure purposes of the Act. That section provides that an
adviser, before engaging in a principal trade with an advisory client,
must disclose to the client in writing before completion of the
transaction the capacity in which the adviser is acting and must obtain
the consent of the client to the transaction. As we have stated before,
``[i]n adopting Section 206(3), Congress recognized the potential for
[abuses such as price manipulation or the placing of unwanted
securities into client accounts], but did not prohibit advisers
entirely from engaging in all principal and agency transactions with
clients. Rather, Congress chose to address these particular conflicts
of interest by imposing a disclosure and client consent requirement in
Section 206(3) of the Advisers Act.'' \65\
---------------------------------------------------------------------------

    \65\ Section 206(3) Release at text accompanying note 5.
---------------------------------------------------------------------------

    The temporary rule complies with Congressional intent. It provides
an alternative procedural means of complying with section 206(3) that
retains transaction-by-transaction disclosure and consent (as required
by section 206(3) of the Act), but adds additional investor protections
measures by requiring an adviser:
     At the outset of the relationship with the client, to
disclose in writing the circumstances under which the investment
adviser directly or indirectly may engage in principal transactions,
the nature and significance of conflicts with its client's interests as
a result of the transactions, and how the investment adviser addresses
those conflicts;
     To obtain prospective written consent of the client in
response to that initial disclosure;
     Before each transaction, to inform the advisory client,
orally or in writing, that the adviser may act in a principal capacity
with respect to the transaction and to obtain the consent from the
advisory client, orally or in writing, for the transaction;
     To send to the client, at or before completion of the
transaction, a written trade confirmation that, in addition to the
information required by rule 10b-10 under the Exchange Act, discloses
that the adviser informed the client prior to the execution of the
transaction that the adviser may be acting in a principal capacity in
connection with the transaction, that the client authorized the
transaction, and that the adviser sold the security to, or bought the
security from, the client for its own account;
     To send to the advisory client an annual statement listing
each principal transaction during the preceding year and the date and
price of each such transaction; and
     To acknowledge explicitly in each required disclosure the
right of the client to revoke his or her prospective consent at any
time.

We believe that these transaction-specific steps, taken together,
fulfill the Congressional purpose behind section 206(3) of the Act.
    Another significant protection is that, as we discuss in Section
II.B.7 above, to benefit from the rule, the investment adviser must
also be a broker-dealer registered with us. Therefore, the firm must
comply with the comprehensive set of Commission and self-regulatory
organization sales practice and best execution rules that apply to the
relationship between a broker-dealer and customer in addition to the
fiduciary duties an adviser owes a client.
    We further believe that the temporary nature of the rule will give
us an opportunity to observe how firms comply with their obligations,
and whether, when they conduct principal trades with their clients,
they put their clients' interests first. The rule therefore employs a
range of features to achieve the transaction-by-transaction conflict
disclosure and consent purposes and policies of the Advisers Act. The
rule additionally enables the adviser to discharge its fiduciary duties
by bolstering them with broker-dealer responsibilities.
11. Effective Date
    This temporary rule takes effect on September 30, 2007. For several
reasons, including those discussed above, we have acted on an interim
final basis.
    In the time since the FPA decision, the Commission staff has had
numerous communications with affected customers, broker-dealers, and
investment advisers about areas in which Commission action or relief
might be required to protect the interests of investors as a result of
the Court's decision. One area of significance identified as our
deliberative process continued was the area of principal trades. Under
the rule vacated in the FPA decision, principal trades in fee-based
brokerage accounts were not subject to section 206(3) of the Act.
Through the process of discussions with interested parties, it was
brought to our attention that a large number of fee-based brokerage
customers favor having the choice of advisory accounts with access to
the inventory of a diversified broker-dealer and that for certain
customers the access to such securities--many of which would otherwise
be unavailable--was a critical

component of their investment strategy. We also learned that, as
discussed above, the traditional method for complying with the
principal trading restrictions on an adviser in section 206(3)--written
disclosure and consent before completion of each securities
transaction--made it not feasible for an adviser to engage in principal
trading with its clients. The Commission received requests for
principal trading relief from firms and the staff engaged in
discussions with representatives of investors, financial planners, and
broker-dealers about the terms of relief, considered their specific
comments, and took those comments into account in developing the
temporary rule we are adopting today.
    Because of the FPA decision and the October 1, 2007 expiration of
the stay of the issuance of the Court's mandate to vacate the former
rule, investors with fee-based brokerage accounts must now consider
whether they should convert their accounts to advisory accounts or to
traditional commission-based brokerage accounts. It is not possible for
those customers to make a meaningful, well-informed decision if they do
not know what services will be offered in advisory accounts. For
example, it would be critical to a customer who invests primarily in
fixed income securities (which generally are traded by firms on a
principal basis) to know whether he or she could continue to access a
firm's inventory of those securities (or sell those securities to the
firm) in an advisory account. But firms informed us that they would not
permit that kind of trading without a rule that is effective and that
provides an alternative means of complying with section 206(3) of the
Act. Until we could publish a rule for comment, receive and analyze
those comments, and adopt a final rule, that customer would be left
with the choice between a traditional brokerage account without the
ability to pay a fee based on assets--presumably the customer's
preferred manner of payment--or a fee-based advisory account without
the ability to invest in fixed income products.
    Changing accounts and methods of payments can be highly disruptive
and confusing to many investors, requiring a series of communications
between the investor and one or more firms about the options available
to give the investor the information he or she needs to make informed
decisions about the services available in each type of account. We
believe that it serves such investors' interests best to adopt the rule
on an interim final basis, which permits them to continue the same kind
of account, with similar services, that they had when they were fee-
based brokerage customers.
    We are aware that, as a result of the FPA decision, the process for
converting as many as one million fee-based brokerage accounts to non-
discretionary advisory or other accounts requires a great deal of time
and imposes significant conversion costs on firms. For example, in
order to comply with the October 1 deadline, those firms needed to
draft or revise agreements, policies, and other documents, hire and
train employees, and make changes to data and recordkeeping, order
entry, billing, and other systems. The firms offering fee-based
brokerage accounts urged us to reduce the burdens that apply to them by
adopting a rule that is effective on or before October 1 and that
permits an alternative method of complying with section 206(3) of the
Act (or, alternatively, to exempt them from section 206(3) altogether).
They informed us that this would simplify the process of communicating
with their customers and reduce investor confusion. This is mostly
because the services and manner of payments would be substantially
similar in non-discretionary advisory accounts as they were in fee-
based brokerage accounts--the firms would not have to explain why the
services a customer has become accustomed to are changing, or why the
manner of payment is changing.
    The firms also were concerned that, without a rule that is
effective by the date the FPA decision takes effect, fee-based
brokerage customers may elect (or the firm may recommend) a commission-
based brokerage account in order to have access to their firm's
inventory of securities, then elect an advisory account only after a
rule subject to notice and comment is finalized. This type of serial
account change is costly to firms for the same reasons it is costly for
them to convert accounts pursuant to the FPA decision. Moreover, such
switching of account types can be confusing to customers if it is the
firm that is recommending the changes.
    Those factors led to this rule and similarly explain why the rule
needs to be available at the same time the broker-dealers complete the
transition from fee-based brokerage to advisory or other accounts.
Otherwise, the risk of disrupting services to the investors, depriving
them of the choice of an advisory account with a broker-dealer, and
confusing them with a series of changes to the services available to
them would have been substantial. Obtaining a further postponement of
the stay of the mandate to allow advance notice and comment rulemaking
did not appear feasible. For these reasons, issuance of an immediately
effective rule is necessary to ameliorate the likely harm to investors.
    Furthermore, we emphasize that we are requesting comments on the
rule and will carefully consider and respond to them in a subsequent
release. Moreover, this is a temporary rule. Setting a 27-month
termination date for the rule will necessitate further Commission
action no later than the end of that period if the Commission intends
to continue the same or similar relief. The sunset provision will
result in the Commission assessing the operation of the rule and
intervening developments, as well as public comment letters, and
considering whether to continue the rule with or without modification
or not at all.
    A significantly shorter period than the 27-month period we have
established could have disadvantaged investors. They would have faced
uncertainty about the continuation of having access through their
advisory accounts to the securities in the inventory of their brokerage
firm and could have faced renewed disruption and confusion if the rule
on principal trades were abolished or substantially modified in the
short term. Similarly, broker-dealers would have faced the same
uncertainty about the continuation of the rule, which could have caused
some broker-dealers to decide not to make the necessary expenditures
and investments to offer advisory accounts with access to principal
trades.
    As a result, the Commission finds that it has good cause to have
the rule take effect on September 30, 2007, and that notice and public
procedure in advance of the effectiveness of the rule are
impracticable, unnecessary, and contrary to the public interest. In
addition, the rule in part has interpretive aspects and is a rule that
recognizes an exemption and relieves a restriction.

III. Request for Comments

    The Commission is requesting comments from all members of the
public during the next 60 days. We will carefully consider the comments
that we receive and respond to them in a subsequent release.
    In addition, we are awaiting a report being prepared by RAND
Corporation comparing how the different regulatory systems that apply
to broker-dealers and advisers affect investors (the ``RAND Study'').
As we have previously announced, the Commission commissioned a study
comparing the levels of protection afforded customers of broker-dealers
and investment

advisers under the federal securities laws.\66\ The Commission will
have another opportunity to assess the operation and terms of the rule
when it receives the results of the RAND Study comparing how the
different regulatory systems that apply to broker-dealers and advisers
affect investors. The RAND Study is expected to be delivered to the
Commission no later than December 2007, several months ahead of
schedule. The results of the RAND Study are expected to provide an
important empirical foundation for the Commission to consider what
action to take to improve the way investment advisers and broker-
dealers provide financial services to customers. One option then
available to the Commission will be making the RAND Study results
available to the public and seeking comments on them and their bearing
on the terms of this rule.
---------------------------------------------------------------------------

    \66\ Commission Seeks Time for Investors and Brokers to Respond
to Court Decision on Fee-Based Accounts, SEC Press Release No. 2007-
95 (May 14, 2007).
---------------------------------------------------------------------------

IV. Transition Guidance
    We are today providing guidance to assist broker-dealers who have
offered fee-based brokerage accounts and are seeking the consent of
their clients to convert those accounts to advisory accounts and meet
the requirements of this rule by October 1, 2007.

A. Client Consent

    Broker-dealers have asked whether they must, before October 1,
2007, obtain written consent from each of their fee-based brokerage
customers to enter into an advisory agreement that meets the
requirements of the Advisers Act, in particular section 205 of the Act.
Broker-dealers have informed us that, as a practical matter, it is not
feasible for them to do so and, if written consent is required, many
fee-based brokerage customers will experience interrupted service or
will be placed in traditional commission-based brokerage accounts,
which may not be best for them.
    Interim final rule 206(3)-3T(a)(3) requires an adviser wishing to
rely on the rule's alternative means for complying with section 206(3)
of the Act to obtain a written prospective consent from each client
authorizing the investment adviser to engage in principal transactions
with the client. We understand that it likely will be impossible for
advisers to obtain these written consents from fee-based brokerage
customers who convert their accounts to non-discretionary advisory
accounts prior to October 1, 2007. To make the alternative means
provided in the interim final rule useful immediately upon its
effective date to those customers, we will not object if an adviser
obtains the required written consent no later than January 1, 2008 from
each fee-based customer who converts his or her account to a non-
discretionary advisory account. During this transitional period,
investment advisers must comply with the other conditions of rule
206(3)-3T, including the condition in paragraph (a)(4) of the rule,
which requires that the adviser make certain disclosures and obtain
client consent before effecting a principal trade with the client. They
also must provide a client with the written disclosure required by
paragraph (a)(3) of the temporary rule prior to effecting the first
trade with that client in reliance on this rule.

B. Client Brochures

    Advisers Act rule 204-3 requires an investment adviser to furnish
its advisory clients with a disclosure statement, or brochure,
containing at least the information required to be in Part II of Form
ADV at the time of, or prior to, entering into an advisory
contract.\67\ In light of the time constraints firms face in complying
with the October 1st deadline, we will not object if, with respect to
the fee-based brokerage customers that convert to non-discretionary
advisory accounts, advisers deliver this statement no later than
January 1, 2008.
---------------------------------------------------------------------------

    \67\ The Advisers Act does not specify any means by which a
client must execute a new advisory contract or agree to changes in
an existing one. For purposes of transitioning clients from fee-
based brokerage accounts, advisers presumably must look to the terms
of the contracts they have in place, as well as applicable contract
law, to determine the manner in which they need to enter into new
contract or amend existing contracts in order to come into
compliance with the Act.
---------------------------------------------------------------------------

V. Paperwork Reduction Act

A. Background

    Rule 206(3)-3T contains ``collection of information'' requirements
within the meaning of the Paperwork Reduction Act of 1995.\68\ The
collection of information is new. We submitted these requirements to
the Office of Management and Budget (``OMB'') for review in accordance
with 44 U.S.C. 3507(j) and 5 CFR 1320.13. Separately, we have submitted
the collection of information to OMB for review and approval in
accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The OMB has
approved the collection of information on an emergency basis with an
expiration date of March 31, 2008. An agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information unless it displays a currently valid OMB control number.
The title for the collection of information is: ``Temporary rule for
principal trades with certain advisory clients, rule 206(3)-3T'' and
the OMB control number for the collection of information is 3235-0630.
---------------------------------------------------------------------------

    \68\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    Rule 206(3)-3T provides an alternative method for investment
advisers that are registered with us as broker-dealers to meet the
requirements of section 206(3) when they act in a principal capacity
with respect to transactions with certain of their advisory clients. In
the absence of this rule, an adviser must provide a written disclosure
and obtain consent for each transaction in which the adviser acts in a
principal capacity. Rule 206(3)-3T permits an adviser, with respect to
a non-discretionary advisory account, to comply with section 206(3) by:
(i) Making certain written disclosures; (ii) obtaining written,
revocable consent from the client prospectively authorizing the adviser
to enter into principal trades; (iii) making oral or written disclosure
that the adviser may act in a principal capacity and obtaining the
client's consent orally or in writing prior to the execution of each
principal transaction; (iv) sending to the client confirmation
statements disclosing the capacity in which the adviser has acted and
indicating that the adviser disclosed to the client that it may act in
a principal capacity and that the client authorized the transaction;
and (v) delivering to the client an annual report itemizing the
principal transactions.

B. Collections of Information and Associated Burdens

    Under rule 206(3)-3T, there are four distinct collection burdens.
Our estimate of the burden of each of the collections reflects the fact
that the alternative means of compliance provided by the rule is
substantially similar to the approach advisers currently employ to
comply with the disclosure and consent obligations of section 206(3) of
the Advisers Act and the approach that broker-dealers employ to comply
with the confirmation requirements of rule 10b-10 under the Exchange
Act. Thus, as discussed below, we estimate that rule 206(3)-3T will
impose only small additional burdens.
    Providing the information required by rule 206(3)-3T is necessary
to obtain the benefit of the alternative means of complying with
section 206(3) of the Advisers Act. The rule contains two types of
collections of information: Information provided by an adviser to its
advisory clients and information

collected from advisory clients by an adviser. With respect to each
type of collection, the information would be maintained by the adviser.
Under Advisers Act rule 204-2(e), an adviser must preserve for five
years the records required by the collection of information pursuant to
rule 206(3)-3T. Although the rule does not call for any of the
information collected to be provided to us, to the extent advisers
include any of the information required by the rule in a filing, such
as Form ADV, the information will not be kept confidential. The
collection of information delivered by investment advisers pursuant to
rule 206(3)-3T would be provided to clients and also would be
maintained by investment advisers. The collection of information
delivered by clients to advisers would be subject to the
confidentiality strictures that govern those relationships, and we
would expect them to be confidential communications.
Collections of Information
    Prospective Disclosure and Consent: Pursuant to paragraph (a)(3) of
the rule, an investment adviser must provide written, prospective
disclosure to the client explaining: (i) The circumstances under which
the investment adviser directly or indirectly may engage in principal
transactions; (ii) the nature and significance of conflicts with its
client's interests as a result of the transactions; and (iii) how the
investment adviser addresses those conflicts. Pursuant to paragraph
(a)(8) of the rule, the written, prospective disclosure must include a
conspicuous, plain English statement that a client's written,
prospective consent may be revoked without penalty at any time by
written notice to the investment adviser from the client. And, for the
adviser to be able to rely on rule 206(3)-3T with respect to an
account, the client must have executed a written, revocable consent
after receiving such written, prospective disclosure.
    The first part of this collection of information involves the
preparation and distribution of a written disclosure statement, which
we anticipate will be largely uniform for clients in non-discretionary
advisory accounts with a particular firm. This collection of
information is necessary to explain to investors how their interests
might be different from the interests of their investment adviser when
the adviser engages in principal trades with them. It is designed to
provide investors with sufficient information to be able to decide
whether to consent to such trades.
    We anticipate that the cost of this collection will mostly be borne
upfront as advisers develop and deliver the required disclosure. This
will require drafting and distributing the required disclosure to
clients with respect to the accounts for which the investment adviser
seeks to rely on the rule.\69\ Once the disclosure has been developed
and is integrated into materials provided upon opening a non-
discretionary advisory account, the ongoing burden will be minimal.
---------------------------------------------------------------------------

    \69\ We note that disclosure about the conflicts of interest for
an adviser that engages in principal trades already is required to
be disclosed by investment advisers in Form ADV. See Item 8 of Part
1A of Form ADV; Item 9 of Part II of Form ADV; Item 7(l) of Schedule
H to Part II of Form ADV.
---------------------------------------------------------------------------

    We estimate that the average burden for drafting the required
prospective disclosure for each eligible adviser, taking into account
both those advisers that previously engaged in principal trades with
their non-discretionary advisory clients, will be approximately 5 hours
on average. We expect that some advisers, particularly the large
financial services firms, may take significantly longer to draft the
required disclosure because they may have more principal trading
practices, and potentially more conflicts, to describe.\70\ Other
advisers may take significantly less time and some eligible advisers
may choose not to rely on rule 206(3)-3T. Further, we expect the
drafting burden will be uniform with respect to each eligible adviser
regardless of how many individual non-discretionary advisory accounts
that adviser administers or seeks to engage with in principal trading.
As of August 1, 2007, there were 634 advisers that were eligible to
rely on the temporary rule (i.e., also registered as broker-dealers),
395 of which indicate that they have non-discretionary advisory
accounts.\71\ We estimate that 90 percent of those 395 advisers, or a
total of 356 of those advisers, will rely on this rule.\72\ Of the 239
eligible advisers that do not currently provide non-discretionary
advisory services, we estimate that 10 percent of these advisers, or 24
advisers, will create non-discretionary advisory programs and rely on
the alternative means of compliance provided by this rule.\73\ Thus,
the total number of advisers we anticipate will rely on the rule is
380.\74\ Accordingly, we estimate that the total drafting burden for
the prospective disclosure statement for the estimated 380 advisers
that will rely on the rule will be 1,900 hours.\75\
---------------------------------------------------------------------------

    \70\ The opportunities to engage in principal trades with
advisory clients will vary greatly among eligible investment
advisers. We believe many of these advisers are registered as
broker-dealers for limited purposes and do not engage in market-
making activities or otherwise carry extensive inventories of
securities. These firms likely would limit their principal trading
operations significantly. For example, they may choose to engage
only in riskless principal trades, which may pose limited conflicts
of interest resulting in brief disclosures. Investment advisers with
large inventories of securities and multi-faceted operations,
however, likely will have much more extensive disclosure.
    \71\ IARD data as of August 1, 2007, for Items 6.A(1) and
5.F(2)(e) of Part 1A of Form ADV.
    \72\ We anticipate that most dually-registered advisers will
make use of the rule to engage in, at a minimum, riskless principal
transactions to limit the need for these advisers to process trades
for their advisory clients with other broker-dealers. We estimate
that 10% of these firms will determine that the costs involved to
comply with the rule are too significant in relation to the benefits
that the adviser, and their clients, will enjoy.
    \73\ We estimate that 10% of the dually-registered advisers that
do not currently have non-discretionary advisory programs will
create them due to a combination of market forces and the ability to
enter into principal trades more efficiently as a result of the
rule. We base this estimate on discussions with industry
representatives.
    \74\ 356 dually-registered advisers that currently have non-
discretionary advisory account programs + 24 dually-registered
advisers that do not currently have non-discretionary advisory
programs, but we expect will initiate them = 380 eligible advisers
that will have non-discretionary advisory programs.
    \75\ 5 hours per adviser x 380 eligible advisers that will rely
on the rule = 1,900 total hours.
---------------------------------------------------------------------------

    The prospective disclosure will need to be distributed to all
clients who have non-discretionary advisory accounts for which an
adviser seeks to rely on rule 206(3)-3T. Registration data indicates
that there are approximately 3,270,000 existing non-discretionary
advisory accounts held with eligible advisers.\76\ Discussions with
eligible advisers indicate that approximately: (i) 90 percent of these
non-discretionary advisory accounts administered by them, or 2,943,000
accounts, are in programs to which the rule will not apply, such as
mutual fund asset allocation programs; and (ii) 40 percent of the
remaining 327,000 non-discretionary advisory accounts administered by
them, or 130,800 accounts, are retirement accounts, and thus unlikely
to participate in principal trading,\77\ leaving 196,200 existing non-
retirement non-discretionary advisory accounts administered by eligible
advisers.\78\
---------------------------------------------------------------------------

    \76\ IARD data as of August 1, 2007, for Item 5.F(2)(e) of Part
1A of Form ADV.
    \77\ We have based this estimate on discussions with industry
representatives. The Code and ERISA impose restrictions on certain
types of transactions involving certain retirement accounts. We do
not take a position on whether the Code or ERISA limits the
availability of rule 206(3)-3T.
    \78\ 3,270,000 existing non-discretionary advisory accounts
among eligible advisers-2,943,000 accounts in wrap fee and other
programs to which the rule will not apply-130,800 retirement
accounts = 196,200 non-retirement, non-discretionary advisory
accounts among eligible advisers.

---------------------------------------------------------------------------

    As noted in Section I.B of this Release and confirmed by
discussions with several firms, we anticipate that most fee-based
brokerage accounts will be converted to non-discretionary advisory
accounts. For purposes of our analysis, we have assumed that all of the
estimated 1 million fee-based brokerage accounts will be converted to
non-discretionary advisory accounts.\79\ Of those accounts, we estimate
that substantially all of them are held at investment advisers that
also are registered as broker-dealers.\80\ Discussion with broker-
dealers that have fee-based brokerage programs have informed us that
approximately 40 percent of the existing fee-based brokerage accounts
are retirement accounts, and are unlikely to engage in principal
trading. We anticipate that all eligible advisers that are converting
fee-based brokerage accounts to non-discretionary advisory accounts
will conduct principal trading in reliance on the rule. Thus, we
estimate that eligible investment advisers will distribute the
prospective disclosure to approximately 600,000 former fee-based
brokerage customers. When aggregated with the 196,200 existing non-
retirement, non-discretionary advisory accounts we believe likely will
receive the prospective disclosure, we estimate the total number of
accounts for which clients will receive prospective disclosure to be
796,200.\81\
---------------------------------------------------------------------------

    \79\ This assumption may result in the estimated paperwork
burdens and costs of proposed rule 206(3)-3T being overstated.
    \80\ Industry representatives have informed us that
substantially all fee-based brokerage accounts are held with twelve
broker-dealers, all of which also are registered as investment
advisers according to IARD data as of August 1, 2007.
    \81\ 196,200 existing non-retirement, non-discretionary advisory
accounts we estimate are likely to receive prospective disclosures +
600,000 fee-based brokerage accounts we estimate will be converted
to non-discretionary advisory accounts = 796,200 total accounts we
expect to receive the prospective disclosure addressed in paragraph
(a)(3) of rule 206(3)-3T.
---------------------------------------------------------------------------

    We estimate that the burden for administering the distribution of
the prospective disclosure will be approximately 0.1 hours (six
minutes) for every account. Based on the discussion above, we estimate
that the prospective disclosure will be distributed to a total of
approximately 796,200 eligible existing non-discretionary advisory
accounts and eligible former fee-based brokerage accounts. We estimate
the total hour burden under paragraph (a)(3) of rule 206(3)-3T for
distribution of the prospective written disclosure to be 79,620
hours.\82\
---------------------------------------------------------------------------

    \82\ 0.1 hours (six minutes) per account x 796,200 accounts =
79,620 hours.
---------------------------------------------------------------------------

    We estimate an average one-time cost of preparation of the
prospective disclosure to include outside legal fees for approximately
three hours of review to total $1,200 per eligible adviser on
average,\83\ for a total of $456,000.\84\ As we discuss above, advisers
that rely on the rule will face widely varying numbers and severity of
conflicts of interest with their clients. We believe that those
advisers that engage in riskless principal trading, are unlikely to
seek outside legal services in drafting the prospective disclosure. On
the other hand, advisers with more significant conflicts are likely to
engage outside legal services to assist in preparation of the
prospective written disclosure. We also estimate a one-time average
cost for printing and physical distribution of the various disclosure
documents, including a disclosure and consent form and, if necessary, a
revised account agreement, to be approximately $1.50 per account,\85\
for a total of $1,194,300.\86\
---------------------------------------------------------------------------

    \83\ Outside legal fees are in addition to the projected 5 hour
per adviser burden discussed in note 75 and accompanying text.
    \84\ $400 per hour for legal services x 3 hours per adviser x
380 eligible advisers that we expect to rely on the rule = $456,000.
The hourly cost estimate is based on our consultation with advisers
and law firms who regularly assist them in compliance matters.
    \85\ This estimate is based on discussions with firms. It
represents our estimate of the average cost for printing and
distribution, which we expect will include distribution of hard
copies for approximately 85% of accounts and distribution of
electronic copies for approximately 15% of accounts.
    \86\ $1.50 per account x 796,200 accounts = $1,194,300.
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    The second part of this burden is that the adviser must receive
from each client an executed written, revocable consent prospectively
authorizing the investment adviser, or a broker-dealer affiliate of the
adviser, to act as principal for its own account, to sell any security
to or purchase any security from the advisory client. This collection
of information is necessary to verify that a client has provided the
required prospective consent. It is designed to ensure that advisers
that wish to engage in principal trades with their clients in reliance
on the rule inform their clients that they have a right not to consent
to such transactions.
    Compliance with this part of the temporary rule will require
advisers to collect executed written, prospective consent from advisory
clients. We anticipate that the bulk of the burden of this collection
will be borne upfront. We expect that the consent solicitation for
existing non-discretionary advisory accounts and fee-based brokerage
accounts being converted to non-discretionary advisory accounts will be
integrated into the prospective written disclosure. For new clients, we
anticipate that the consent solicitation provision will be included in
the account agreement signed by a client upon opening a non-
discretionary advisory account. Once the consent solicitation has been
integrated into the account-opening paperwork, the ongoing burden will
be minimal.
    We believe that the burden and costs to advisers of soliciting
consent is included in the burdens and costs of drafting and
distributing the notices described above. This is because we expect the
consent solicitation to be integrated into the firm's prospective
written disclosure. We estimate an average burden per accountholder of
0.05 hours (three minutes) in connection with reviewing the consent
solicitation, asking questions, providing consent, and, for those that
so wish, revoking that consent at a later date. Assuming that there are
796,200 accountholders who receive prospective disclosure and a
prospective consent solicitation we estimate a total burden of 39,810
hours on accountholders for reviewing and/or returning consents.\87\ We
further estimate that 90 percent of these accountholders, or 716,580
accountholders, will execute and return the consent.\88\
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    \87\ 0.05 hours (three minutes) per accountholder x 796,200
accountholders executing and returning the consent = 39,810 total
burden hours on accountholders with respect to returning consents.
    \88\ 796,200 eligible accountholders x 90 percent = 716,580
accountholders who will return their prospective consents. We refer
herein to these 716,580 accountholders who return their consents,
and whose advisers are therefore eligible to rely on the rule with
respect to them, as ``eligible accountholders.''
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    Finally, we estimate that the burden of updating the disclosure,
maintaining records on prospective consents provided, and processing
consent revocations and prospective consents granted subsequent to the
initial solicitation will be approximately 100 hours per eligible
adviser per year. We estimate that the total burden for all advisers to
keep prospective consent information up to date will be 38,000
hours.\89\
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    \89\ 100 hours per eligible adviser x 380 eligible advisers that
will rely on the rule = a total burden of 38,000 hours for updating
disclosure, maintaining records, and processing new consents and
revocations.
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    Trade-By-Trade Disclosure and Consent: Pursuant to paragraph (a)(4)
of the rule, an investment adviser, prior to the execution of each
principal

transaction, must inform the advisory client, orally or in writing, of
the capacity in which it may act with respect to such transaction. Also
pursuant to paragraph (a)(4) of the rule, an investment adviser, prior
to the execution of each principal transaction, must obtain oral or
written consent from the advisory client to act as principal for its
own account with respect to such transaction. This collection of
information is necessary to alert an advisory client that a specific
trade may be executed as principal and provide the client with the
opportunity to withhold its authorization for the trade to be executed
on a principal basis.
    We note that section 206(3) of the Advisers Act requires written
trade-by-trade disclosure in connection with principal trades. We
believe that complying with this part of rule 206(3)-3T provides an
alternative method of compliance that is likely to be less costly than
compliance with section 206(3) in many situations. However, to the
extent that advisers are not currently engaging in principal trades
with non-discretionary advisory accountholders (and thus are not
preparing and providing written disclosure regarding conflicts of
interest associated with principal trading in particular securities),
advisers electing to rely on the rule will need to begin to prepare
such disclosure and communicate it to clients. Based on discussions
with industry and their experience with fee-based brokerage accounts
and existing non-discretionary advisory programs, we estimate
conservatively that non-discretionary advisory accountholders at
eligible advisers engage in an average of approximately 50 trades per
year and that, for purposes of this analysis, all those trades are
principal trades for which the investment adviser seeks to rely on rule
206(3)-3T.\90\ We estimate, based on our discussions with broker-
dealers, a burden of 0.0083 hours (approximately 30 seconds) per trade
on average for preparation and communication of the requisite
disclosure to a client, and for the client to consent, for an estimated
total burden of approximately 297,381 hours per year.\91\
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    \90\ These assumptions may result in the estimated paperwork
burdens and costs of proposed rule 206(3)-3T being overstated.
    \91\ 50 trades per account per year x 716,580 accountholders
that will provide prospective consent and therefore enable their
advisers to rely on the rule with respect to them x 0.0083 hours
(approximately 30 seconds) per trade for disclosure = a burden of
297,381 hours per year.
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    Trade-By-Trade Confirmations: Pursuant to paragraph (a)(5) of the
rule, an investment adviser must deliver to its client a written
confirmation at or before completion of each principal transaction that
includes, in addition to the information required by rule 10b-10 under
the Exchange Act [17 CFR 240.10b-10], a conspicuous, plain English
statement that the investment adviser: (i) Informed the advisory client
that it may be acting in a principal capacity in connection with the
transaction and the client authorized the transaction; and (ii) owned
the security sold to the advisory client (or bought the security from
the client for its own account). Pursuant to paragraph (a)(8) of the
rule, each confirmation must include a conspicuous, plain English
statement that the written, prospective consent described above may be
revoked without penalty at any time by written notice to the investment
adviser from the client. This collection of information is necessary to
ensure that an advisory client is reminded that a particular trade was
made on a principal basis and is given the opportunity to revoke
prospective consent to such trades.
    The majority of the information required in this collection of
information is already required to be assembled and communicated to
clients pursuant to requirements under the Exchange Act. As such, we do
not believe that there will be an ongoing hour burden associated with
this requirement. We estimate a one-time cost burden for reprogramming
computer systems that generate confirmations to ensure that all the
information required for purposes of paragraphs (a)(5) and (a)(8) of
rule 206(3)-3T is included in such confirmations of $20,000 per
eligible adviser for a total of $7,600,000.\92\
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    \92\ $20,000 to program system generating confirmations per
adviser x 380 eligible advisers that will rely on the rule =
$7,600,000 total programming costs for confirmations. Our estimate
for the cost to program the confirmation system was derived from
discussions with broker-dealers.
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    Principal Transactions Report: Pursuant to paragraph (a)(6) of the
rule, the investment adviser must deliver to each client, no less
frequently than annually, written disclosure containing a list of all
transactions that were executed in the account in reliance upon the
rule, and the date and price of such transactions. This report will
require a collection of information that should already be available to
the adviser or its broker-dealer affiliate executing the client's
transactions. Pursuant to paragraph (a)(8) of the rule, each principal
transactions report must include a conspicuous, plain English statement
that the written, prospective consent described above may be revoked
without penalty at any time by written notice to the investment adviser
from the client. This collection of information is necessary to ensure
that clients receive a periodic record of the principal trading
activity in their accounts and are afforded an opportunity to assess
the frequency with which their adviser engages in such trades.
    We estimate that other than the actual aggregation and delivery of
this statement, the burden of this collection will not be substantial
because the information required to be contained in the statement is
already maintained by investment advisers and/or broker-dealers
executing trades for their clients. Advisers and broker-dealers already
send periodic or annual statements to clients.\93\ Thus, to comply,
advisers will need to add information they already maintain to
documents they already prepare and send. We expect that there will be a
one-time burden associated with this requirement relating to
programming computer systems to generate the report, aggregating
information that is already available and maintained by advisers or
their broker-dealer affiliates. We estimate this burden to be on
average approximately 5 hours per eligible firm for a total of 1,900
hours.\94\ We also estimate that in addition to the hour burden, firms
may have costs associated with retaining outside professionals to
assist in programming. We estimate these costs to average $10,000 per
adviser for a total upfront cost of $3,800,000.\95\ Once

computer systems enable these reports to be generated electronically,
we estimate that the average ongoing burden of generating the reports
and delivering them to clients will be 0.05 hours (three minutes) per
eligible non-discretionary advisory account, or a total of 35,829 hours
per year.\96\
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    \93\ For example, investment advisers that are qualified
custodians for purposes of rule 206(4)-2 under the Advisers Act and
that maintain custody of their advisory clients' assets must, at a
minimum, send quarterly account statements to their clients pursuant
to rule 206(4)-2(a)(3).
    \94\ 5 hours per eligible adviser for programming relating to
the principal trade report x 380 advisers = a total programming
burden relating to the principal trade report of 1,900 hours.
Advisers that use proprietary systems will likely devote
considerably more time to programming reports. However, these
advisers are also likely to have already programmed systems to meet
the requirements of rule 206(3)-2(a)(3), which contains a similar
annual report requirement with respect to agency cross transactions.
Other advisers may be using commercial software to track and report
trades in accounts. These software packages should take little time
for an adviser to implement, and consequently should impose
significantly less than a 5 hour burden.
    \95\ $10,000 for retaining outside professionals to assist in
programming in connection with the principal transactions report per
adviser x 380 advisers = $3,800,000 in outside programming costs in
connection with the principal transactions report. We based our
outside programming cost estimate on a rate of $250 per hour for 40
hours of programming consultant time. We anticipate that the
advisers that rely on commercial software solutions, many of which
will be components to trading software they already have acquired,
will not have to retain outside programming consultants.
    \96\ 0.05 hours (three minutes) per eligible accountholder to
generate and deliver reports x 716,580 eligible accountholder =
35,829 hours total burden for generating and delivering reports to
accountholders. Because, as we note above, the information required
by the rule will be added to documents advisers already send to
clients, we estimate that there is no added cost associated with
delivering the reports to clients (e.g., postage costs).
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C. Summary of Estimated Paperwork Burden

    For purposes of the Paperwork Reduction Act, we estimate an annual
incremental increase in the burden for investment advisers and their
affiliated broker-dealers to comply with the alternative means for
compliance with section 206(3) of the Advisers Act contained in rule
206(3)-3T. As discussed above, our estimates reflect the fact that the
alternative means of compliance is similar to the approach advisers
currently employ to comply with the disclosure and consent obligations
of section 206(3) of the Advisers Act and also is similar to the
approach broker-dealers employ to comply with certain of the
requirements of rule 10b-10 under the Exchange Act.
    Some amount of training of personnel on compliance with the rule
and developing, acquiring, installing, and using technology and systems
for the purpose of collecting, validating and verifying information may
be necessary. In addition, as discussed above, some amount of time,
effort and expense may be required in connection with processing and
maintaining information. We estimate that the total amount of costs,
including capital and start-up costs, for compliance with the rule is
approximately $13,050,300.\97\ We estimate that the hour burden will be
494,440 hours.\98\
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    \97\ $456,000 for outside professional fees associated with
preparation of the prospective disclosure + $1,194,300 for printing
and physical distribution costs associated with the prospective
disclosure + $7,600,000 for programming costs for outside
professionals for rendering trade confirmations compliant with the
rule + $3,800,000 for programming costs for outside professionals to
create principal trading reports = a total of $13,050,300.
    \98\ 1,900 hours for drafting prospective disclosure + 79,620
hours for administering distribution of prospective disclosure to
accountholders + 39,810 hours for review by accountholders of the
consent solicitation and returning consents + 38,000 hours for
advisers maintaining and updating consent information + 297,381
hours for preparation and communication of trade-by-trade disclosure
and consent + 1,900 hours for programming to create principal
trading reports + 35,829 hours for ongoing generation of principal
trading reports = a total of 494,440 hours.
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D. Request for Comment

    We invite comment on each of these estimates and the underlying
assumptions. Pursuant to 44 U.S.C. 3506(c)(2)(B), we request comment
with respect to the collections described in this section of this
Release in order to: (i) Evaluate whether the collections of
information are necessary for the proper performance of our functions,
including whether the information will have practical utility; (ii)
evaluate the accuracy of our estimate of the burden of the collections
of information; (iii) determine whether there are ways to enhance the
quality, utility, and clarity of the information to be collected; and
(iv) evaluate whether there are ways to minimize the burden of the
collections of information on those who respond, including through the
use of automated collection techniques or other forms of information
technology.\99\
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    \99\ Comments are requested pursuant to 44 U.S.C. 3506(c)(2)(B).
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    Persons submitting comments on the collection of information
requirements should direct the comments to the Office of Management and
Budget, Attention: Desk Officer for the Securities and Exchange
Commission, Office of Information and Regulatory Affairs, Washington,
DC 20503, and should send a copy to Nancy M. Morris, Secretary,
Securities and Exchange Commission, 100 F Street, NE., Washington, DC
20549-1090, with reference to File No. S7-23-07. Requests for materials
submitted to OMB by the Commission with regard to these collections of
information should be in writing, refer to File No. S7-23-07, and be
submitted to the Securities and Exchange Commission, Records
Management, Office of Filings and Information Services, Washington, DC
20549. The OMB is required to make a decision concerning the collection
of information between 30 and 60 days after publication of this
release. Consequently, a comment to OMB is assured of having its full
effect if OMB receives it within 30 days of publication.

VI. Cost-Benefit Analysis

A. Background

    We are adopting, as an interim final temporary rule, rule 206(3)-3T
under the Advisers Act, which provides an alternative means for
investment advisers that are registered with us as broker-dealers to
meet the requirements of section 206(3) when they act in a principal
capacity with respect to transactions with certain of their advisory
clients. We are adopting this rule as part of our response to a recent
court decision invalidating rule 202(a)(11)-1, which provided that fee-
based brokerage accounts were not advisory accounts and were thus not
subject to the Advisers Act. As a result of the court's decision, these