Page - 111 - in Austrian Law Journal, Volume 1/2015

ALJ 1/2015 Observations on Judicial Approaches to Discerning Investment Adviser Status 111 $ 1 million investment threshold to be eligible for the success fee-is a contingent financial incentive, an investment threshold incentive not designed to deliver a payment but only to qualify the adviser for a potential payment (the success fee). Vernazza’s holding that a contingent financial incentive is an economic benefit provides support for viewing an investment adviser’s unrealized investment performance fee84 as an economic benefit that would satisfy the compensation element. Similarly, the case of SEC v. Tandem Management, Inc. supports this economic benefit approach.85 In this enforcement action, the court held that an investment adviser violated, among other provi- sions, § 207 by failing to disclose on its Form ADV certain “soft dollar” arrangements. Under § 28(e)86 of the Exchange Act, soft dollar arrangements between investment advisers and broker-dealers permit the adviser to place securities trades on behalf of investment adviser clients with the broker- dealer at a commission rate higher than the lowest rate available, if the broker-dealer is providing the adviser with certain investment research or other permissible “soft dollar” benefits.87 As is typi- cal with most brokerage arrangements, the investment adviser client, not the investment adviser, pays for the brokerage commission on trades placed on the client’s own behalf. Here, the court found that the adviser engaged in several undisclosed fraudulent schemes to profit from abusing its soft dollar arrangements. These included permitting a broker-dealer to charge investment advis- er clients excessively high brokerage commissions in return for investment research and then re- quiring the broker-dealer to kick back half of the excessive brokerage commission to the adviser. Tandem Management’s holding that undisclosed kickbacks of client commission brokerage payments constitute an economic benefit supports Ogale’s holding that misappropriated client funds are an economic benefit that meets the compensation element. The client of Tandem Management paid an excessively higher brokerage commission, more than the amount permitted under a disclosed soft dollar arrangement. The amount of the commission paid in excess of the disclosed soft dollar ar- 84 Under certain terms and conditions, see, e.g., § 205, Investment Advisory Contracts, 15 U.S.C. § 80b-5, and Rule 205-3, Exemption from the Compensation Prohibition of Section 205(a)(1) for Investment Advisers, 17 C.F.R. § 275.5-3, an investment adviser may charge a client an investment performance fee, which, essentially, is based on amount of gains, if any, resulting from the adviser’s investment advice. If the investment advice achieves adequate in- vestment gains to trigger payment by the client of the investment performance fee, the investment performance fee is “realized.” If the investment adviser fails to achieve adequate gains to trigger the payment by the client of the investment performance fee, it is “unrealized.” When an investment performance fee is “unrealized” the cli- ent does not pay the adviser an investment performance fee. It remains “unrealized” until the investment advice creates an adequate gain. Courts have not resolved whether an unrealized investment performance fee satisfies the compensation element. See Fife v. SEC, 311 F.3d. 1, 11 (1st Cir. 2002) (a Commission enforcement action where the court held, without explanation, that the compensation element was met, in part by finding that the adviser “understood” he would be compensated by receiving a percentage of investment profits “if successful, pursuant to a formula to be agreed upon at a later time.”) (italics in original); but see U.S. v. Regensberg, 635 F. Supp. 2d 306 (S.D.N.Y. 2009), aff’d 381 F. App’x 60 (2d Cir. 2010) (a criminal appeal, the district court held, without explanation, that a contractual right to receive a contingent performance fee without actually meeting the condi- tions to receive the fee, did not constitute compensation under § 202(a)(11)). 85 2001 WL 1488218 (S.D.N.Y. 2001). 86 Effect on Existing Law, 15 U.S.C. § 78bb(e). 87 See, e.g., Amendments to Form ADV, Investment Advisers Act Release No. 3060 (July 28, 2010) n.126, 75 FR 49234 (Aug. 12, 2010) (adopting rule release) (“Under Section 28(e) [of the Exchange Act], a person who exercises in- vestment discretion over a client account has not acted unlawfully or breached a fiduciary duty solely by causing the account to pay more than the lowest commission rate available, so long as that person determines in good faith that the commission amount is reasonable in relation to the value of the brokerage and research services provided. […] Section 28(e) […] provides a limited ‘safe harbor’ for [investment] advisers with discretionary authority in connection with their receipt of soft dollar benefits. […] Advisers must disclose their receipt of soft dollar bene- fits to clients, regardless of whether the benefits fall inside or outside of the safe harbor.”); see also Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Ex- change Act Release No. 23170 (Apr. 23, 1986), 51 FR 16004 (Apr. 30, 1986).