Attachment to Letter on Web-Based Investment Programs, September 2000
July 12, 2000
To: Division of Investment Management
Securities and Exchange Commission
From: Investment Company Institute
We are submitting this memorandum in order to present our view that the investment product being provided by the broker-dealer Folio
We believe that the Program is issuing, offering, and selling securities that are separate from the underlying securities in investors’ portfolios. These securities derive from the pooling of investors’ assets in the odd lot trade bunching and matching features of the Program, in the investment management involved in rebalancing investors’ "Folios," and in the investment expertise built into "Ready-to-go" Folios. Thus, investors in the Program and Folios are purchasing investment contracts from Folio
The Program and Folios also are investment companies under the 1940 Act because they are issuers of securities that are primarily engaged in the business of investing, reinvesting, and trading in securities and because they share many of the essential features of investment companies. Furthermore, the policies underlying the 1933 and 1940 Acts—especially the anti-self-dealing, compensation limitation, independent director oversight, advertising, and disclosure provisions—argue for regulation of the Program and the Folios under these Acts. Finally, these investor protection concerns are heightened because the basic characteristics of Folio
The Program allows investors to acquire "Folios"—baskets or portfolios of stocks that the investor initially purchases in a single transaction. A Folio can include from one to fifty different stocks, chosen from a list of 2,500 stocks. Each stock carries a percentage weight that determines its proportion of a particular Folio. Investors make initial and subsequent purchases of dollar amounts of a Folio, not of a given number of shares of individual stocks. Should changes in market valuation alter the actual weighting of their holdings, investors also have the option to "rebalance" the Folio to the chosen weighting. After an investor clicks the "rebalance" button on his or her screen, Folio
Using the Program, investors can devise a Folio from scratch, or they can choose from a number of "Ready-to-go" Folios created by Folio
Folios deliver many of the benefits of stocks and mutual funds, and eliminate many of the disadvantages. With just a few mouse clicks, you can:
Create a diversified portfolio of stocks,
Buy stocks in dollar amounts or fractional shares,
Enjoy the benefits of Folios no matter how much—or how little—you have to invest,
Know exactly what you own at all times,
Rebalance your stock portfolio quickly and easily,
Manage holdings as much or as little as you want,
Avoid the hidden fees and annual tax bill of mutual funds,
Maintain total control over when you buy and sell, controlling your taxes to maximize your after-tax returns, and
Tailor your Folios to a risk level you find comfortable.
The major theme of Folio
"As you probably know by now, with Folios, you can easily create a diversified portfolio of stocks. In fact, with just a few mouse clicks, you can get instant diversification with a couple dozen stocks.
It is not clear how Folio
"With Folios, you can buy many stocks in one transaction and in any dollar amount you want. There is no minimum investment amount--you can invest $100 or $10,000. If you have $10,000, you can simply choose to invest $200 in each of 50 stocks. Or you can specify exactly how much (in dollars, not shares) of each stock you want to own.This is possible because our system allows you to own partial shares, like three and one-third shares of Microsoft. That lets you think about your stocks in dollar values, which many people find more intuitive than thinking in terms of shares."
The Program values the odd lots and fractional shares making up each Folio as if they were participation interests in whole lots of securities. Folio
We do not select stocks based on a subjective analysis or a feeling that the company may be more profitable or may grow faster in the future than its peers. For instance, we don't pick stocks because we think the company's management is talented or the company is developing the next hot consumer product."
This web page indicates that Ready-to-go Folios are designed to appeal to investors who want to rely upon the portfolio-designing prowess of others. Folio
The specific criteria used to select Ready-to-go Folios appear to vary considerably with the type of Folio. Nonetheless, it is apparent that Folio
"With Folios, you can also diversify your stock holdings in ways that best match the level of risk you feel comfortable with. We offer several "Ready-to-Go" Folios containing stocks based on their beta. Beta measures how closely a stock or Folio has followed the volatility of the Standard and Poor's 500 Index, which many regard as a good approximation of the overall stock market. Understanding beta will help you diversify in a way that is tailored to your needs."
This passage implies that Folio
"While Folios and stock mutual funds share some of the same benefits, they are completely different investment products. For many investors, the differences could prove profound.
Folios provide many of the same benefits [as mutual funds]. They can provide instant portfolio diversification. And they also let people invest in them using modest dollar amounts, not shares."
The website also draws favorable contrasts between direct ownership of shares (Folios) and indirect ownership (mutual funds), between individual and professional portfolio management, and between fixed annual fees and percentage fees. Folio investors will retain most indicia of ownership of the individual stocks in their Folios. They will receive dividends and distributions and, according to Folio
One can own up to three Folios for a flat fee of $295 a year, or $85 per quarter. Each additional Folio is $95 per year, or $30 per quarter. Folio
is offering and will be selling separate securities that should be registered under the 1933 Act.
Whether the business plan of Folio
is offering investment contracts, which are securities as a matter of law.
Section 2(a)(1) of the 1933 Act defines "security" to include investment contracts, which the seminal Howey opinion defines using a four-element test: "An investment contract . . . means a contract, transaction, or scheme whereby a person  invests his money  in a common enterprise and  is led to expect profits  solely from the efforts of the promoter or a third party . . . ."4 The Program clearly meets the first and third elements. Whether it meets the second and fourth poses closer questions.
Generally all courts agree that the common enterprise prong of the Howey test is satisfied when there is a pooling of interests of several investors, a pooling known as "horizontal commonality." Courts disagree, however, on whether "vertical commonality"—one promoter and one investor involved in a common enterprise—alone suffices. The Ninth Circuit has adopted a more restricted vertical approach under which a common enterprise exists where "the fortunes of the investor are interwoven with and dependent upon the efforts and success  of those seeking the investment or  of third parties."5
The Program satisfies both the horizontal and vertical commonality tests, for two reasons. First, Folio investors will be relying on the Investment Management Services of Folio
Second, as noted, the typical investor’s interest in a Folio will consist largely, if not entirely, of odd lots and of fractional shares.6 The transaction costs (commissions and/or markups and markdowns) of executing individual purchase and sales orders of odd lots and fractional shares are cost-prohibitive for the typical investor. Thus, through the Odd Lot Trading Service, Folio
Furthermore, the success or failure of each Folio as an investment will be linked not only to the investment management but also to the trading, marketing and technological efforts and success of Folio
The fourth element of the Howey test is that the investor must expect profits to be derived "solely from the efforts of a promoter or a third party." In applying the test, lower federal courts have rejected a literal interpretation of the word "solely." Ten circuits have adopted a more liberal and flexible interpretation, simply requiring proof that "the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise."8 As a result, many courts have found an investment constituted a security, even when the investor was required to participate to some extent, provided his efforts were not the undeniably significant ones.9
The Program satisfies the "efforts of others" element of the Howey test for two broad reasons. First, as noted above, Folio
Moreover, while the investor’s choice of an investing strategy through a Ready-to-go Folio is significant, it involves no more than does the choice of a mutual fund. In both cases, the most difficult investment decisions lie in devising the portfolio that effectuates the strategy. A conservative portfolio weighted toward utility stocks will perform differently than one weighted toward industrial blue chips, and a technology portfolio weighted toward Microsoft, Intel and Cisco will perform differently than one made up of Internet startups. And, however active many Internet investors are, surely many will also prefer the ease and convenience of choosing a Ready-to-go Folio and leaving its composition completely or mostly untouched. Many also will not be knowledgeable or sophisticated enough to customize their Folios in any meaningful way. Courts have found that, even where an investor has the right to control the management of his or her investment, if the investor shows practical dependence or an inability to exercise meaningful powers of control or to find others to manage the investment, he or she is relying upon the efforts of others.11 Thus, Folio
In the Gary Plastic case,12 the Second Circuit applied the Howey test to facts similar in significant ways to those presented by the Program. In Gary Plastic, Merrill Lynch had marketed and sold $100,000 bank certificates of deposit (or "jumbo CDs") on representations that the CDs were negotiable (due to regulatory changes), insured, and liquid. Merrill Lynch screened daily a group of banks, claiming that it had regularly reviewed and monitored each bank and that they were obtaining competitive yields for their customers. Merrill Lynch also claimed that it would maintain a secondary market for the CDs that would enable investors to sell the CDs back to Merrill Lynch at prevailing market rates without penalties. Plaintiffs sued Merrill Lynch under the antifraud provisions of the federal securities laws, claiming that the interest rates on the jumbo CDs were in fact lower than those the banks were offering other customers and that Merrill Lynch had taken the difference as a commission without disclosing this fact to plaintiffs. The district court dismissed the action on summary judgment, holding that the jumbo CDs were not securities and not subject to the securities laws.
The Second Circuit reversed on appeal, finding that Merrill Lynch was offering and selling securities that met the Howey test.13 The court held that the program met the "common enterprise" and the "efforts of others" prongs of the test because investors in the jumbo CDs relied on the "efforts, knowledge and skill" as well as the "financial stability" of Merrill Lynch, and because their investments depended on Merrill Lynch’s "managerial and financial expertise." The court emphasized two reasons for these conclusions. First, investors depended on the secondary market that Merrill Lynch created for liquidity and capital appreciation. The court noted that, if Merrill Lynch were to become insolvent or failed to maintain the promised secondary market, an investor would have difficulty liquidating a CD, which might cost the investor capital appreciation if prevailing interest rates were to drop. Second, the investor relied on Merrill Lynch’s maintaining the program and its marketing efforts, because the success of the secondary market hinged on Merrill Lynch’s success in finding new buyers of CDs and developing strong working relationships with issuing banks. The court concluded:
Here investors are buying something more than individual certificates of deposit. They are buying an opportunity to participate in the CD Program and its secondary market. And, they are paying for the security of knowing that they may liquidate at a moment’s notice free from concern as to loss of income or capital, while awaiting for FDIC or FSLIC insurance proceeds.
Folio investors will be in a similar position to investors in Merrill Lynch’s jumbo CD program. They will be buying something more than a portfolio of individual stocks. They will be buying an opportunity to participate in the Program and the Odd Lot Trading Service, which makes purchasing, managing, and selling Folios economically feasible. If Folio
2. The program and folios warrant registration as securities under the 1933 Act as a matter of policy.
There are compelling policy reasons for the Program and Ready-to-go Folios to be registered as separate securities under the 1933 Act. As noted above, the fortunes of Folio investors to a significant extent will be dependent upon the efforts of Folio
Compliance with the requirements of the 1933 Act would not appear to impose unreasonable burdens on Folio
B. The program and folios are investment companies under the 1940 Act.
1. The program and folios meet the definition of "investment company" under the 1940 Act.
The Program and Ready-to-go Folios are investment companies under Section 3(a)(1) of the 1940 Act if they are issuers of securities which are engaged, or propose to engage, (1) primarily in the business of investing, reinvesting, or trading in securities, or (2) in the business of investing, reinvesting, owning, holding, or trading in securities, and own or propose to acquire investment securities having a value exceeding 40 percent of the value of its total assets (exclusive of government securities and cash items) on an unconsolidated basis. The Program only offers equity portfolio securities, all of which are investment securities under this provision. If the Program or Ready-to-go Folios were investment companies within the statutory definition, they would be regulated and required to register under the 1940 Act.
The Program and Ready-to-go Folios are issuers of securities. The definition of "issuer" includes any organized group of persons, whether or not incorporated, that issues or proposes to issue a security.14 The Program and Ready-to-go Folios also are engaged primarily in the business of investing, reinvesting, or trading in securities. Thus, they meet the Section 3(a)(1) definition of an investment company, and should be subject to regulation and registration under the 1940 Act unless they qualify for a statutory or regulatory exemption.
The Program can be distinguished from the Piette & Assoc. LTD interpretive letter.15 Piette was an investment adviser that planned to aggregate contemporaneous buy or sell orders of clients for securities in a joint trading account at a broker in order to obtain lower commission costs. In the letter, the SEC staff took the position that the joint account was not an investment company. Piette was merely providing this service incidentally to existing advisory clients as a cheaper way to execute trades. In sharp contrast, Folio
Finally, the Program and the Ready-to-go Folios do not qualify for the rule 3a-4 "mini-account" exemption. Rule 3a-4 provides a non-exclusive safe harbor from the definition of investment company and from 1933 Act registration for programs under which investment advisory services are provided on a discretionary basis to a large number of advisory clients having relatively small amounts to invest. As an initial matter, the Program does not provide advisory services on a discretionary basis. Moreover, the conditions to the safe harbor are designed to ensure that clients in a program relying on the rule receive a particular sort of individualized treatment, including receiving sufficient attention from the adviser to their financial situations and investment objectives and retaining the ability to place investment restrictions on the management of their accounts.
The Program as presently designed would not provide sufficient individualized attention to investors in Folios to meet the conditions or the policy objectives of Rule 3a-4. Rule 3a-4 contemplates that a program would provide individualized attention in the form of human interaction rather than the Internet interface. For instance, one condition requires that personnel who are knowledgeable about the account and its management be reasonably available to the client. The rule also contemplates that a qualifying program would actively reach out to clients for updates about their financial situations and investment objectives. The web page medium, however much it invites interaction, still requires that the client take the initiative in making contact.
Furthermore, the Program and Folios share many of the essential characteristics of investment companies. Like investment companies, the Program and the Folios offer smaller investors the benefits of portfolio diversification through participation interests in round lots of shares. Like mutual funds and UITs, the Program and Folios offer investors the ability to liquidate or redeem their interests at market prices for round lots as of certain specified pricing times during each day. Like UIT investors, investors in Ready-to-go Folios who do not significantly customize will be relying on the built-in investment expertise of the investment professionals who put together the portfolio. Like mutual fund investors, Folio investors will be relying upon the investment and trading management of investment professionals in keeping their portfolios balanced (or "rebalanced"). Like investment company investors’ holdings, Folio investors’ holdings will, in real economic terms, be indirect. Without the Program and the Odd Lot Trading Service to liquidate and rebalance Folios, Folio investors’ holdings would be worth significantly less than market price. Folio
Thus, the Program and the Ready-to-go Folios are investment companies under the 1940 Act. Folio
2. There are compelling policy reasons that warrant regulation of the program and folios under the 1940 Act.
There are compelling policy reasons to require that the Program, Ready-to-go Folios, and any similar products that might be offered by sponsors other than Folio
The Odd Lot Trading Service of the Program or similar programs might also pose conflicts of interest. This feature results in a large number of market orders of odd lots and fractional shares that need be executed only periodically. Absent 1940 Act regulation, a broker-dealer could abuse this discretion by executing these orders from its inventory when the timing best suited it. For instance, if it knew that other, larger trades in the same securities were pending execution, it might front-run those trades using the clients’ market orders. It would be difficult for a client to discern or establish a failure to obtain best execution because of the indeterminacy of the timing of the order and because the broker could claim that it was difficult to execute an odd or fractional order. The anti-self-dealing provisions of the 1940 Act as well as those of the Investment Advisers Act are also designed to prevent these types of abuses.
The 1940 Act also regulates advisory and distribution charges. The current fee of $295 would be 295 basis points of a $10,000 investment. This fee is higher than most mutual fund expense ratios. Furthermore, absent 1940 Act regulation, there would be no constraints on raising the annual fee significantly in the future. For the reasons noted above, investors in programs such as those offered by Folio
Each of the conflicts of interest described above is inherent in the structure of the Program. While it appears that Folio
The advertising restrictions applicable to mutual funds also appear necessary and appropriate for offerings such as the Ready-to-go Folios. Absent those restrictions, Folio
Regulation and registration under the 1940 Act would not appear to impose unreasonable burdens on the Program. Although the Program and the Ready-to-go Folios are not identical to traditional investment companies in all respects, other novel investment vehicles — notably variable insurance products — have adapted to the regulatory pattern, and so could the Program. The requirements of the 1940 Act might be altered through such narrowly-tailored exemptions as are necessary for the Program’s operations and fully consistent with the investor protections ensured by the Act. Nonetheless, the burdens of compliance with the 1940 Act are borne by the rest of the investment company industry, and only if Folio
C. Investor protection concerns are heightened because the characteristicsof Folio
and the program can be readily replicated by a wide range of promoters seeking to tap the public investment market.
There is little to prevent financial dot.coms and other firms from adopting the methods embedded in the Program, repackaging them, and promoting them as their own. One prominent analyst has stated that the "folio concept is a pretty big idea that’s going to stick in some form."18 Indeed, two firms have already announced plans to provide substantially similar programs later this year. The details available concerning one, Netfolio.com, are more complete, and its similarity to Folio
Two other new web-based broker-dealers—BuyandHold.com and Sharebuilder.com—are offering investment products that share key features with Folio
It is not our purpose here to analyze these other programs. Rather, their examples illustrate how easily other firms can replicate Folio
2 Patrick McGeehan, The Unmutual Fund, New York Times, May 18, 2000, at C1.
3 The central insight of modern portfolio theory is that the risk and reward characteristics of an investor’s entire portfolio, and not those of the individual investments contained within, determine expected investment performance.
4 SEC v. W.J. Howey, Co., 328 U.S. 293, 298-299 (1946).
5 SEC v. Glenn W. Turner Enter., Inc., 474 F.2d 476, 482 n.7 (9th Cir. 1973), cert. denied, 414 U.S. 821 (1973). The Commission has endorsed this approach. See Union Home Loans, Sec. Ex. Act Rel. 19,346, 26 SEC Dock. 1346, 1348 (1982). See also Loss and Seligman, Securities Regulation, vol. II 996.
6 Consider a Folio worth $50,000 with 50 stocks equally weighted. Each holding will be worth $1,000. If a stock is bought at $30, the holding will consist of 33-1/3 shares. If the stock is bought at $80 a share, the holding will consist of 12-1/2 shares.
8 SEC v. Glenn W. Turner Enter., Inc., 474 F.2d at 482.
9 While the U.S. Supreme Court expressly reserved judgment on whether the term "solely" should be interpreted literally, it deleted the term in its restated formulation of the test: "The touchstone is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others." United Hous. Found., Inc. v. Forman, 421 U.S. 837, 852 n.16 (1975).
10 Commission’s Statement to Builders and Sellers of Condominiums of their Obligations under the Securities Act, Sec. Act Rel. 5347 (Jan. 18, 1973).
11 See, e.g., Hocking v. Dubois, 885 F.2d 1449, 1460 (9th Cir. en banc, 1989), cert. denied, 494 U.S. 78 (1990) (condominium unit can be a security); SEC v. Aqua-Sonic Products Corp., 687 F.2d 577, 582-584 (2d Cir. 1982) (Friendly, J.) (dental product franchise is a security where franchisees did not have experience marketing dental supplies); Williamson v. Tucker, 645 F.2d 404, 424-25 (5th Cir. 1981) (general partnership or joint venture interest can be a security). Williamson enumerates and Hocking cites factors for determining an investor’s de facto dependence. Among these factors are "(2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or (3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers." 645 F.2d at 424.
12 Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith., Inc., 756 F.2d 230 (2d Cir. 1985).
13 756 F.2d at 240.
14 1940 Act Section 2(a)(22) defines "issuer" to include any person who issues any security. Under Section 2(a)(28), a "person" includes a company, and under Section 2(a)(8) a "company" includes any organized group of persons, whether incorporated or not.
15 Piette & Assoc. LTD (pub. avail. Sept. 17, 1981). See also Owen T. Wilkinson & Associates, Inc. (pub. avail. Dec. 30, 1987).
16 On the same grounds, one can readily distinguish the line of no-action letters addressing issuer-sponsored odd lot buy-back and round-up programs. See, e.g., John Hancock Mutual Life Insurance Company (pub. avail. Nov. 1, 1999); NCR Corporation (pub. avail. Mar. 12, 1997); U.S. West, Inc. (pub. avail. Feb. 22, 1996); Disston Associates, Inc. (pub. avail. Apr. 25, 1988). In these letters, the staff of the Divisions of Corporation Finance and Market Regulation granted no-action relief from the Securities Act registration and broker-dealer registration provisions for programs in which issuers or their agents, generally in connection with extraordinary transactions such as an asset spinoff or an insurance company demutualization, offered to buy back or round up to whole lots existing shareholders’ odd lot holdings. In none of these cases did the sponsor of the program publicly offer it to prospective investors as a long-term investment vehicle involving the purchase, management, and sale of odd lots, let alone of diversified portfolios of securities.
17 Merrill Lynch, Pierce, Fenner & Smith (pub. avail. Sept. 3, 1999).
18 Patrick McGeehan, The Unmutual Fund, New York Times, May 18, 2000, at C1 (quoting John Rekenthaler, research director for Morningstar, Inc.).
19 See Michael Santoli, Buggy Whip Funds? Former Industry Insider Sees a New, New Thing Supplanting Mutuals, Barron’s, June 26, 2000. See also Netfolio’s website at . The demonstration on the website bears a remarkable resemblance to Folio
20 See, e.g., Borzou Daragahi, Buying Stock a Little at a Time, Money, May 2000, at 140; Ilana Polyak, New Sites Let You Put Spare Change into Stocks, TheStreet.com, March 30, 2000.
21 BuyandHold charges $20 to open an account and $2.99 per trade. Sharebuilder charges $5 per purchase, which drops to $2 for recurring monthly purchases, and $19.95 per sale, which it executes in real-time rather than in periodic batches. Sharebuilder does not charge an initial fee.
22 BuyandHold claims to have about 40,000 clients.