SEC Division of Investment Management staff letter: Gardner Russo & Gardner

Investment Advisers Act of 1940 - Section 206(3) Gardner Russo & Gardner

June 7, 2006

RESPONSE OF THE OFFICE OF CHIEF COUNSEL DIVISION OF INVESTMENT MANAGEMENT

Our Ref. No. 2005518927 Gardner Russo & Gardner File No. 801-41357

Your letter dated May 3, 2005 (as supplemented by your letter dated June 6, 2006) requests that we concur with your view that, for purposes of section 206(3) of the Investment Advisers Act of 1940 (the "Advisers Act"), Gardner Russo & Gardner ("GRG"), an investment adviser, would not be acting as principal for its own account with respect to the transactions involving the Private Funds (as defined below).

BACKGROUND

You state that, pursuant to discretionary investment management agreements, GRG, a general partnership, acts as investment manager to various client accounts (the "Accounts"), including two private investment funds, Semper Vic Partners, L.P. ("Semper Vic") and Semper Vic Partners (QP), L.P. ("Semper Vic QP," together with Semper Vic, the "Private Funds"). A general partner (the "Partner") of GRG 1 is the sole general partner and portfolio manager of each Private Fund. The Partner has a 6.237% ownership interest in Semper Vic and a 1.4405% ownership interest in Semper Vic QP. Neither GRG nor any employee of GRG (other than the Partner) has an ownership interest in the Private Funds. 2

GRG from time to time finds that, due to timing of capital flows into and out of the Accounts, it is disposing of a particular security for one Account that it is acquiring for another. GRG would like to cross the trades of a Private Fund with another Account and/or Private Fund (the "Proposed Transactions") to, among other things, reduce transaction costs. 3 You are generally concerned, however, that GRG, because of the Partner's ownership interest in each Private Fund, may be acting as principal for its own account, thereby subjecting the Proposed Transactions to the transaction by transaction notice and consent requirements of section 206(3) of the Advisers Act.

ANALYSIS

Section 206(3) of the Advisers Act, in relevant part, makes it unlawful for any investment adviser, directly or indirectly, acting as principal for its 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 the transaction, the capacity in which the adviser is acting and obtaining the client's consent to the transaction. 4 Section 206(3) is intended to address the potential for self dealing that could arise when an investment adviser acts as principal in transactions with clients, such as through price manipulation or the dumping of unwanted securities into client accounts. 5 To address this potential for self dealing, section 206(3) requires, among other things, transaction by transaction disclosure to, and consent by, the client prior to the completion of each principal transaction. 6

You question whether section 206(3) would apply to the Proposed Transactions in light of the Partner's ownership interest in each Private Fund. You cite to an enforcement proceeding, in which the Commission alleged and found that an investment adviser of a registered investment company violated section 206(3) and that Robert Gintel, the adviser's sole owner, aided and abetted and caused the adviser's violation of section 206(3). The Commission found that Mr. Gintel effected certain cross transactions between the investment company, of which Mr. Gintel owned approximately 34%, and other accounts advised by the adviser without disclosing the capacity in which the adviser was acting and obtaining the consent of the clients to such transactions. 7 The Commission found that the investment adviser violated section 206(3) because of Mr. Gintel's "substantial ownership stake" in the fund and relationship to the adviser.

You generally contend, however, that the Partner's ownership interest in each Private Fund should not cause the Proposed Transactions to implicate section 206(3). You also suggest that a Proposed Transaction would not implicate section 206(3) unless the Partner owns 25% or more of a Private Fund. We assume that you are concerned about whether section 206(3) would apply if the Partner's ownership interests in the Private Funds increase.

Recently, we addressed the application of section 206(3) to certain transactions involving principal accounts in which investment advisers have interests in the Letter to the American Bar Association, dated December 8, 2005 (the "ABA Letter"). 8 As we stated in the ABA Letter, whether section 206(3) applies to transactions involving client accounts and accounts in which an investment adviser and/or its personnel have ownership interests depends upon all of the facts and circumstances. Significant factors include the relationship of the personnel to the investment adviser, as well as the extent of the ownership interest of the investment adviser and/or its personnel in the account.

You state that the Partner is a general partner of, and controls, GRG. For purposes of section 206(3), we would deem the ownership interest of a controlling person of an investment adviser to be the ownership interest of that adviser. 9 Consequently, the investment adviser may be acting "as principal for his own account" for purposes of section 206(3) in effecting transactions involving the account, depending on the extent of the controlling person(s) and investment adviser's aggregate ownership interest in the account (as discussed below).

The extent of the ownership interest at issue is also relevant to whether the Proposed Transactions implicate section 206(3). We believe that section 206(3) would apply to a cross transaction between a client account and an account of which the investment adviser and/or a controlling person, in the aggregate, own(s) more than 25%. 10 In contrast, we believe that section 206(3) would not apply to a cross transaction between a client account and an account of which the investment adviser and/or its controlling persons, in the aggregate, own 25% or less. 11

We note that ownership interests of an investment adviser and/or its controlling persons of 25% or less of an account may present the opportunity for significant conflicts of interest between an investment adviser and its clients, creating incentives to overreach and treat unfairly the clients with which the account engages in transactions. Cross transactions involving such an account may implicate sections 206(1) and (2) of the Advisers Act, which were designed to address such conflicts of interest. These sections impose a federal fiduciary duty on an investment adviser with respect to its clients and a duty of full and fair disclosure of all material facts. 12 Those provisions may require an investment adviser to disclose information about transactions effected by the adviser involving any account in which the adviser and/or its controlling persons have an ownership interest, regardless of whether section 206(3) also applies. 13 An investment adviser, therefore, should consider monitoring the ownership interests of the adviser, and/or its controlling persons, in accounts advised by the adviser, and the terms of the transactions involving those accounts. 14

In conclusion, you essentially contend that the Partner's 6.237% ownership interest in Semper Vic and 1.4405% ownership interest in Semper Vic QP should not cause the Proposed Transactions to implicate section 206(3). We agree. Our conclusion is based on the foregoing facts and representations, in particular the representation that neither GRG nor any employee of GRG (other than the Partner) has an ownership interest in the Private Funds. Any different facts or representations may require a different conclusion. 15 Further, section 206(3) would apply to the Proposed Transactions if the Partner (who is a controlling person of GRG), along with GRG and any other controlling person of GRG, were to own, in the aggregate, more than 25% of a Private Fund.

John L. Sullivan Senior Counsel

Endnotes

1 You state that the Partner controls GRG (as "control" is defined in section 202(a)(12) of the Advisers Act: "[T]he power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company."). A person may control a company through a variety of means, including stock ownership. See generally In the Matter of Investors Mutual, Inc., et al., Investment Company Act Release No. 4595 (May 11, 1966) (Commission determination as to whether a person or group of persons are in control (as defined in section 2(a)(9) of the Investment Company Act of 1940) of an investment company's adviser and company controlling such adviser. The definition of control under section 2(a)(9) is identical to the definition of control under section 202(a)(12) of the Advisers Act, but for the inclusion of certain presumptions.).

2 Telephone conversation between John L. Sullivan of the staff and Anne D. Gardner of GRG on January 13, 2006.

3 You represent that GRG will not receive additional compensation for effecting the Proposed Transactions.

4 Section 206(3) also makes it unlawful for any investment adviser acting as broker for a person other than its client knowingly to effect any sale or purchase of any security for the account of such client without providing disclosure and obtaining consent consistent with the requirements of the section. You do not ask, and we take no position regarding, whether transactions among the Accounts, including the Private Funds, would implicate that provision. See generally Interpretation of Section 206(3) of the Investment Advisers Act of 1940, Advisers Act Release No. 1732 (July 17, 1998).

5 See Investment Trusts and Investment Companies: Hearings on S. 3580 Before the Subcomm. of the Comm. on Banking and Currency, 76th Cong., 3d Sess. 320-22 (1940).

6 See Opinion of Director of Trading and Exchange Division, Advisers Act Release No. 40 (Feb. 5, 1945) ("[T]he requirements of written disclosure and of consent contained in [section 206(3)] 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."). The Commission has instituted enforcement actions against investment advisers for violating section 206(3) when they entered into principal transactions with their clients using only prior blanket disclosures and consents. See In the Matter of Stephens, Inc., Advisers Act Release No. 1666 (Sept. 16, 1997); In the Matter of Clariden Asset Management (New York) Inc., Advisers Act Release No. 1504 (July 10, 1995).

7 In the Matter of Gintel Asset Management, et al. , Advisers Act Release No. 2079 (Nov. 8, 2002). See also SEC v. Beacon Hill Asset Management, LLC, et al. , Litigation Release No. 18950 (Oct. 28, 2004) (Commission alleged that an unregistered investment adviser violated section 206(3) and that the adviser's four principals aided and abetted the adviser's violation of section 206(3) when the principals caused securities in an account in which three of the four principals were the only investors to be sold to, and purchased from, a hedge fund client of the adviser without disclosing the capacity in which the adviser was acting and obtaining the consent of the client to such transactions).

8 Specifically, we addressed the application of section 206(3) of the Advisers Act to unregistered pooled investment vehicles.

9 The Commission has deemed ownership interests of controlling persons of an investment adviser to be ownership interests of the adviser for purposes of section 206(3) of the Advisers Act. See note 7, supra. You do not ask, and we take no position regarding, whether section 206(3) applies to cross trades between client accounts when non controlling personnel of an adviser have ownership interests in the accounts.

10 In some cases, it may be appropriate to aggregate the ownership interest in the account of a family member of a controlling person ( e.g. , a spouse or a dependent child) with the ownership interest of the controlling person and/or investment adviser.

11 GRG is, of course, free to set more stringent standards for itself and its employees than those suggested in this letter. For example, GRG may choose to provide written disclosure to its clients, before the completion of the transaction, of the capacity in which GRG is acting and obtain the consent of its clients, even when GRG and/or a controlling person of GRG own(s) 25% or less of that account.

12 See Securities and Exchange Commission v. Capital Gains Research Bureau, Inc., et al. , 375 U.S. 180, 196-97 (1963).

13 See ABA Letter at text accompanying note 32.

14 See, e.g. , rule 206(4)-7 under the Advisers Act, which generally provides, among other things, that an investment adviser must adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and the rules thereunder; section 203(e)(6) of the Advisers Act, which provides that procedures reasonably designed to detect and prevent violations of the federal securities laws can serve as a defense against a charge that an investment adviser has failed to reasonably supervise its advisory personnel who have, for instance, violated the antifraud provisions of the Advisers Act. We suggest that compliance personnel of an investment adviser consider, to the extent practicable, interests of an adviser and/or its controlling persons in accounts, in addition to direct economic interests, that may create incentives to favor one account over another (e.g., economic interests of family members, and persons with social and/or business relationships with the adviser and/or its controlling persons).

15 This letter confirms the conclusion that the staff provided orally on January 13, 2006 to Anne D. Gardner of GRG.

Incoming Letters

The Incoming Letters are in Acrobat format:

May 3, 2005 letter

June 6, 2006 letter

GARDNERRUSSO & GARDNER 223 EAST CHESTNUT STREET LANCASTER, PA 17602 INVESTMENT ADVISOR TELEPHONE (717) ass- 138s EUGENE H. GARDNER FAX (7 17) 399-3170 THOMAS A. RUSSO EUGENE H. GARDNER, JR. BRIAN J. TATE May 3,2005 Douglas J. Scheidt, Esq. Advisers Ac tl20 G(3) Chief Counsel Division of hvestrnent Management Securities and Exchange Commission 450 Fifth Street, N.W. Washngton, D.C. 20549-0506 Re: Investment Advisers Act of 1940, as amended, Section 206(3) Dear Mr. Scheidt, We respectfully request that the Division of Investment Management advise us that it will not recommend enforcement action if Gardner Russo & Gardner crosses trades among accounts that it manages in the manner described below.
I. Facts
Gardner Russo & Gardner ("GRG") is registered as an investment adviser with the U.S. Securities and Exchange Commission (the "Commission") and, pursuant to discretionary investment management agreements, acts as investment manager to various client accounts (the "Accounts"), including two private investment funds, Semper Vic Partners, L.P. ("Semper Vic") and Semper Vic Partners (QP), L.P. ("Semper Vic QP", and collectively with Semper Vic, the "Funds"). A partner and portfolio manager of GRG (the "Partner") is the general partner of each Fund. The Partner has a 6.23 7% ownership interest in Seinper Vic and a 1.4405% ownershp interest in Semper Vic QP to further align his interests with the Funds' investors. Due to the timing of capital inflows and outflows into and out of Accounts, GRG froin time to time finds that it is disposing of a particular security for one Account that it is attempting to acquire for another. GRG believes that it is often beneficial for all clients affected to be able to cross such trades to reduce transaction costs and to minimize the impact to the market for those securities. GRG would like to effect trades (the "Transactions") between Accounts, including the Funds, without obtaining the consent of its clients and of each of the Funds (i.e. either each investor in each Fund or a representative of the investors) prior to each Transaction. GRG will not receive additional compensation for effecting the Transactions. I1. Issue Is a registered investment adviser required to treat a trade between a client account and an account for which the adviser acts as the discretionary manager and in which a partner and portfolio manager of the adviser has an ownership interest (including as a general partner of the account) as a principal trade under
Section 206(3) of the Investment Advisers Act of 1940, as amended (the "Advisers Act")?

111. Legal Analysis
     Section 206(3) of the Advisers Act specifically prohibits an adviser "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." Section 206(3) imposes a prior disclosure and consent requirement on any adviser that acts as principal in a transaction with a client. Principal transactions pose the potential for conflicts between the interests of the adviser and the client and create the potential for advisers to engage in self-dealing.' The Commission has addressed this recently in Gintel Asset Management Inc., Investment Advisers Act Release No. 2079, 2002 WL 31499839 (November 8, 2002). In that administrative action, Robert Gintel owned a majority of the investment adviser and 34% of a fund that engaged in transactions with Mr. Gintel's other clients. The Commission stated that the transactions in question were principal transactions specifically because Gintel "held a substantial ownership stake" in the adviser and the fund.2 The Commission concluded that the adviser had violated Section 206(3) of the Advisers Act because it had never given advance notice nor obtained consent fi-om clients involved in the transactions and "'Gintel owned over 30 percent" of the Fund. Having investment discretion over an account either through an investment management agreement or through the holding of a general partnership interest is not a "substantial ownership stake" and should not give rise to characterizing an account as a principal account. We believe that without the partner, the portfolio manager or adviser having a "substantial ownership stake" in the economics of an account, the conflicts and opportunity for self-dealing that gave rise to Section 206(3) do not exist. Further, treating the transaction as a principal transaction would hamper the fair treatment of the account by requiring burdensome consent procedures to be in place, which might result in the account being unable to participate in certain advantageous cross trading opportunities due to difficulties in obtaining such consents in a timely fashion. While the Commission has not articulated exactly what percentage ownership interest in an account is a "substantial ownership stake" resulting in a principal transaction, the Commission's articulation of "over a 30 percent" interest in an account as a "substantial ownershtp stake" in Gintel would suggest that a "control" position by the adviser is necessary for the transaction to be deemed a principal transacti0n.l Both Section 2(a)(9) of the Investment Company Act of 1940, as amended (the "Company Act") and
     Section 202(a)(12) of the Advisers Act define control as "the power to exercise a controlling influence
     over the management or policies of a company.. ." "Section 2(a)(9) of the Company Act creates a presumption of control if a person owns 25% or more of a company's voting se~urities."~ The Advisers Act does not contain a corresponding provision. However, an analogy can be made with respect to the "assignment of investment advisory contracts." Section 202(a)(l) of the Advisers Act states that an assignment has occurred if there is a transfer of a controlling block of the assignor's outstanding voting securities. The Commission has repeatedly found that there was no change of control/assignrnent where less than 25% of an assignor's outstanding voting securities were acquired either directly or indirectly by any one This would seem to indicate that the adviser (and its principals) would need to own at ' See Investment Advisers Act Release No. 1732, 1998 SEC Lexis 1483 (July 17, 1998).

• See Gintel Asset Management, Inc., Investment Advisers Act Release No. 2079,2002 WL 31499839 (November 8,2002).
  see Lemke, Thomas P. and Lins, Gerald T., Regulation of Investment Advisers (Thornson West 2004), at 2:90 and 2:91 (articulating a "control" test for an account to be considered a principal account citing Gintel). 'See Dean Witter, Discover & Co.1993 SEC No-Action Letter, Lexis 225 (February 8, 1993). See Central Corporate Report Services, Inc. 198 1 SEC No-Action Letter, Lexis 3217 (March 9, 198 1); See Zusich Insurance Company, Scudder Keniper Investments, Inc. 1998 SEC No-Action Letter, Lexis 8 11 (August 3 1, 1998 ).

least 25% of an account in order for the adviser to control such account, and for transactions involving the account to be deemed principal transactions. The Commission found in Strong/Corneliuson Capital Management, Inc., Investment Advisers Act Release No. 1425, 1994 SEC Lexis 2100 (July 12, 1994), that the respondents violated section 206(1) and (2) of the Advisers Act because they effected trades between an offshore fund in which they had a significant ownershp interest (between 18 and 25%) and other advisory clients to which they provided investment advice. The Commission found that the respondents violated sections 206(1) and (2) because and they failed to disclose in Item 9, Part 11of their Form ADV that, they had a significant interest in the offshore fund? Notably, the Commission did not allege violations of Section 206(3) for these holdings. . Conclusion Provided that appropriate disclosure is made in the Part 11of its Form ADV and to clients, GRG believes that the Transactions do not require client consent under Section 206(3) of the Advisers Act merely because the Partner is the general partner of each Fund and holds an insignificant interest in such Funds. A general partner without a substantial economic stake in a partnership is no different than an adviser effecting transactions on behalf of its clients in separate account subject to an investment management agreement that grants the adviser investment discretion. We believe that in order for the Transactions to require client consent, GRG (together with the Partner and any other affiliates) must own 25% or more of an account that is engaging in a trade with another Account. We respectfully request that the Commission confilm that it will not recommend enforcement action if GRG effects the Transactions among the Accounts, including the Funds, without obtaining the prior consent of affected clients assuming the facts provided in this letter or otherwise complying with Section 206(3) of the Advisers Act. If you have any questions, please do not hesitate to call us at (717)299-1385. Sincerely, A Anne D. Gardner Chief Compliance Officer Thomas A. Russo Partner and Portfolio Manager See StrongIComeliuso~~ Capital Management, Inc., Investment Advisers Act Release No. 1425.

GARDNEWRUSSO tk GAWDNEW 223 EAST CHESTNUT STREET LANCASTER, PA 17602 IMVESTB/IEI\IITADVlSOR TELEPHONE (717)299-1 385 EUGENE H. GARDNER FAX (7 17) 399-3 170 THOMAS A. RUSSO EUGENE H. GARDNER, JR. BRIAN J. TATE June 6,2006 Douglas J. Scheidt, Esq. Associate Director and Chief Counsel Division of Investment Management United States Securities and Exchange Commission 100 F Street, NE Washington, DC 20549-5030 Dear Mr. Scheidt, By this letter we would like to clarify certain portions of our May 3, 2005 letter requesting your attention to Section 206(3) of the Advisers Act as it applies to certain of the Transactions involving the ~unds.' In that letter, we are essentially asking the Division of Investment Management (the "Division") to concur with our view that, for purposes of Section 206(3) of the Advisers Act, GRG would not be acting as principal for its own account with respect to transactions involving the Private Funds. We would like to clarify that GRG is a general partnership and that the Partner is a general partner of GRG. The Partner is also the sole general partner and portfolio manager of each Fund. In addition, the Partner controls GRG (as "control" is defined in section 202(a)(12) of the Advisers Act). We would further like to clarify that GKG from time to time finds that, due to timing of capital flows into and out of the Accounts under its management, it is disposing of a particular security for one Account that it is acquiring for another. GRG would like to cross the trades of a Fund with another Account andlor Fund to, among other things, reduce transactions costs. Pursuant to the final point in our May 3, 2005 letter and our discussions with the Division's staff, we also formally request that the Division indicate how much of a Fund the Partner may own before
Section 206(3) applies to the Transactions involving the Funds.
Once again, we thank the Division for its careful review of this matter.
Sincerely,
19
L4"fi y$&
Anne D, Gardner
Chief Compliance Officer
Defined terns in this letter have the same meaning as the defined terms in our May 3,2005 letter.