Company Name: Quest Advisory Corp.
Public Availability Date: Aug. 28, 1996

INQUIRY LETTER

ROSENMAN & COLIN LLP

(202) 463-4640

August 28, 1996

Securities Act of 1933

Regulation D, Rule 502(c)

Sent via Federal Express and FAX

Martin P. Dunn, Esquire

Chief Counsel

Division of Corporation Finance

Securities and Exchange Commission

450 Fifth Street, N.W., Stop 3-3

Washington, DC 20549

Re: Royce Exchange Fund

Interpretive Issues Under Rule 502(c)

Dear Mr. Dunn:

On behalf of Quest Advisory Corp. ("Quest"), we request that the staff of the Division of Corporation Finance confirm that Quest may identify prospective investors in a proposed exchange fund in the manner described below violating the ban on general solicitation set forth in Rule 502(c) of Regulation D.

1 Quest and the Fund.

Quest is a registered investment adviser whose clients consist of eleven management investment companies or separate series of such companies and other non-investment company institutional accounts which are generally managed on a pooled basis. As of June 30, 1996, Quest had approximately $2.1 billion under management.

Royce Exchange Fund (the "Fund") is being established to enable persons to have substantial holdings of equity securities with relatively large unrealized capital appreciation to diversify these investment assets into a professionally managed equity portfolio without incurring Federal capital gains tax liability. An investor may invest in the Fund by outstanding equity securities that are acceptable to Quest, which will serve as manager and investment adviser to the Fund. It is likely that the Fund will be organized as a New York limited liability company ("LLC"), in which event investors will be solicited to exchange such low-basis securities for membership interests in the LLC.

Quest has, for more than 20 years, specialized in small capitalization stock using a "value" approach. The Fund will invest primarily in small-cap and mid-cap company stocks, with the small-cap stocks generally being those of companies in which Quest has already invested for its other accounts.

The investment objective of the Fund will be long-term capital appreciation. The Funds investment portfolio will be managed in a manner designed to minimize the recognition of capital gain by the Fund and by members with respect to their contributed securities. Although the Fund will thus generally retain the securities contributed by members, it may employ a variety of investment techniques to attain the benefits of an active management approach, including hedging techniques to reduce exposure to adverse price movements and covered call option writing to supplement income and enhance total return.

Interests in the Fund will be offered pursuant to Rule 506 of Regulation D. ¹ The minimum contribution will be $500,000 or more, and each investor or each investor and his or her spouse will be required to have a net worth in excess of the lesser of $5 million or four times the value of securities invested. The investors low-basis shares will have to be suitable portfolio securities for the Fund, and the investor will be permitted to contribute only such shares to the Fund.

A major national broker-dealer will serve as placement agent for the offering of interests in the Fund. The placement agent may establish investor suitability requirements in addition to those discussed above, and will determine the total number of offerees and purchasers, subject to the limitations of Section 3(c)(1) of the Investment Company Act.

2 Pre-Offering Identification of Prospects.

Investors in the Fund will be sought from three separate and distinct groups: portfolio company-related persons, registered investment adviser clients and placement agent/subplacement agent relationships.

A Portfolio Company-Related Persons.

The most important group of investors that Quest proposes to identify, and to have qualified as prospective Fund offerees, consists of current and former directors and executive officers of, and/or pre-initial public offering security holders in, certain of its portfolio companies and members of their immediate families ("portfolio company-related persons"). Because of the nature of the Fund, i.e., an exchange fund designed to enable investors to contribute in a tax-free exchange low-basis shares as capital, Quest will necessarily be seeking portfolio company-related persons as investors in the Fund. In that effort, Quest will be addressing a narrowly delineated group of highly accredited investors who have been long-term shareholders of their respective portfolio companies.

In its capacity as an investor of its clients accounts, Quest has prior business relationships with its portfolio companies and has continuing contact with one or more executive officers at each such portfolio company. Quest will seek to identify portfolio company-related persons who might be prospective investors in the Fund only through the portfolio company officials through whom Quest maintains its contacts with the companies. It will not use any directory or other public means or any compensated intermediaries to do so. Quest believes that, although its contacts do not have any fiduciary duty requiring them to "know" portfolio company-related persons in a suitability sense, they do not have reason to know whether these individuals are likely to have at least $500,000 of low-basis stock in the particular company and the requisite minimum net worth.

Portfolio company-related persons will be considered as prospective Fund offerees only if the following prior business relationships exist:

(1) Quest will have invested client assets in the particular portfolio companys equity securities for more than one year.

(2) Quest will have known and been in contact with at least one executive officer of the particular portfolio company for more than one year through one or more company visits, analyst meetings or telephone calls.

(3) The portfolio company-related person will be a present or former executive officer or director of, and/or pre-initial public offering investor in, such company or a member of his or her immediate family, not a more distant relative or social or business acquaintance.

B Registered Investment Adviser Clients.

Quest also has prior business relationships with certain registered investment advisers, who generally are not registered as or affiliated with broker-dealers, and may also identify and have qualified as prospective Fund offerees clients of such advisers. Clients of an adviser will be considered as prospective offerees only if the following prior business relationships exist:

(1) The registered investment adviser will for more than one year have been part of Quests network of financial planners whose clients invest in shares of Quest-managed mutual funds.

(2) The registered investment adviser will manage or supervise client securities portfolios, and each such advisers portfolios will total more than $25 million.

(3) The registered investment adviser/client relationship will have existed for more than one year.

C Placement Agent Relationships.

The placement agent will seek investors with whom it or the subplacement agents appointed by it have pre-existing substantive relationships.

Quest expects to initiate its identification process by telephoning the particular portfolio company contact or registered investment adviser. Quests caller will briefly describe the principal features of the Fund, applicable investor suitability requirements and the role of the placement agent and, if the intermediary indicates interest in the Fund, will send her or him a short fact sheet covering these matters. ²

Each portfolio company contact or investment adviser, as applicable, will be requested to provide a written undertaking to distribute the fact sheet only to, and discuss the Fund only with, persons who the intermediary believes meet the Funds suitability criteria and to keep (and make available to Quest upon request) a record of each such distribution, including the name of the person who received the fact sheet and the date it was provided. Quest will not seek or permit the Fund to acquire from a portfolio company-related person with whom the placement agent or subplacement agent does not have a prior substantive relationship any securities other than those of the portfolio company.

Quest will ask its portfolio company contacts to identify to the placement agent (either directly or through Quest) the portfolio company-related persons who are believed to be eligible to receive and interested in receiving an offer, and (if known) those persons brokers. Registered investment advisers will be asked to identify to Quest the clients who they believe are eligible to receive and interested in receiving an offer, and (if known) the clients brokers.

No compensation will be paid by Quest, the placement agent or the Fund to either the portfolio company contacts or registered investment advisers who assist the Fund in the identification of offerees.

Thus, even at the pre-offering stage, prospective offerees will be identified through a linkage of pre-existing business and/or substantive relationship with the issuer. ³

3 Pre-Offering Qualification by Placement Agent.

By agreement between Quest and the placement agent, all offers to interested portfolio company-related persons who have been identified as prospects as described above will be made only by the placement agent or by the prospects brokers (if acceptable to the placement agent as subplacement agents). Before any such offer is made, the prospective offeree will be qualified by the placement or subplacement agent through questionnaires and possibly follow-up phone calls or visits. Those portfolio company-related persons determined by the placement agent to be qualified to receive an offer and who are acceptable to the placement agent will then receive the offering documents from the placement agent or a subplacement agent.

In the case of prospective offerees identified through the registered investment advisers known to Quest, the adviser will be able to make a preliminary determination, on the basis of its pre-existing substantive and business relationship with the client, as to the apparent qualification of the client as an offeree and the suitability of the investment for the client. ⁴ All clients of such advisers who are identified to Quest as prospects will be formally qualified by the placement agent or subplacement agent though questionnaires and possibly follow-up phone calls or visits, and offers will be made only by the placement agent or subplacement agent.

4 Interpretation of Rule 502(c).

Rule 502 imposes several conditions on offers and sales made pursuant to Regulation D. Rule 502(c) provides that "... neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising...." In a series of staff letters and a settled administrative proceeding from the late 1970s to the late 1980s, the staff of the Division of Corporation Finance placed a gloss on Rule 502(c) to the effect that a prior substantive relationship with the issuer or with its broker-dealer agent is almost always prerequisite to any Rule 505 or Rule 506 exemption of a non-public "offering" of securities. ⁵

We believe that identification of prospective portfolio company-related persons by Quest and its portfolio company contacts in the manner set forth above should not violate the ban on general solicitation because Quest, as an established investor in such companies, has prior business relationships with the portfolio companies and continuing contact with one or more principal executives of each. Quests portfolio company contacts are, in turn, likely to have such relationships with most of the portfolio company-related persons, who generally will have acquired their securities as actual or prospective "insiders" and not as members of the general investing public. Finally, the portfolio company-related persons will have for a year or more been investors with Quest in the portfolio company. Thus, there are triangularly linked pre-existing relationships among Quest, the portfolio company contacts with whom Quest deals, and the portfolio company-related persons themselves.

In the case of the registered investment advisers known to Quest, Quest has prior business relationships with such advisers, who have previously invested their clients funds in Quest-sponsored products. These advisers, in turn, by virtue of their Federal fiduciary duty, which entails an obligation to "know" their clients, have prior substantive and business relationships with their clients. ⁶

Because Quests ability to identify investors through the placement agent or its subplacement agents is well-settled by staff letters, our request focuses only on Quests ability to identify investors through its portfolio company contacts and registered investment adviser network, as described above. To our knowledge, the staff has never taken an interpretive position in either of these two factual contexts. We therefore request confirmation that the most far-reaching of the staffs interpretive positions, taken nearly ten years ago in different contexts, do not extend to Quests proposed course of action.

There is nothing here reminiscent of the cold-call offers to lists of persons previously unknown (in a substantive or business sense) to the offeror, as were present in In re Kenman Corporation, Sec. Exch. Act Rel. 34-21962, 32 SEC Docket (CCH) 1352 (Apr. 19, 1985). ⁷ Nor is this situation analogous to that presented in the staffs 1977 letter to Arthur M. Borden, Esq., in which it was proposed that small broker-dealers and issuers be permitted to enter into agreements (possibly involving compensation) with a variety of intermediaries (including attorneys, accountants and broker-dealers) who would provide the issuer or its placement agent with lists of prospective offerees. Unlike Quests proposal, in the Borden situation there was no required prior business relationship between the issuer or small broker-dealers and the intermediaries, no prior substantive or business relationship between such intermediaries and the ultimate offerees and no nexus between the issuer and the offerees.

The Funds situation also differs markedly from that in Webster Management Assured Return Equity Management Group Trust, pub. avail. Feb. 7, 1987, in which the issuer expressly requested that registered representatives of its placement agent be permitted to offer units in a group trust to investors with respect to whom neither the placement agent nor the issuer had any previous knowledge or relationship. The issuer had argued that, because the prospective investors were all qualified employee benefit plans, the investment decision on their behalf would be made by a sophisticated fiduciary subject to regulation under ERISA. The staff noted that, in addition to the fact that there would be no pre-existing relationship with the potential offerees, some offerees would not even be accredited, and no limitation had been proposed on the manner of contacting the offerees.

The staffs 1987 letter to Robert T. Willis, Jr., P.C. contains the statement: "You indicate that interests...would be offered... to new investors through referrals.... If interests... are offered to persons who may not have had a prior existing relationship with the issuer, we would be unable to conclude that there would be no general solicitation for purposes of Rule 502(c)." The Willis letter was factually spare, but there did not appear to be any prior relationship between referrors and referrees, nor between referrors or referrees and the issuer.

We believe that several factors make it inappropriate to apply the generic Willis statement to the Funds proposed offering, including the apparent accreditation of Quests investors by virtue of the nature of the investment (a factor which was absent in Willis); the defined universe of prospective investors in an exchange fund (i.e., holders of a substantial amount of low-basis stock in acceptable company); the risk-reducing nature of the investment (in the Funds case, the investor exchanges a concentrated position for a diversified investment); in the case of portfolio company-related persons, the triangularly linked pre-existing relationships among Quest, the portfolio company contacts and the portfolio company-related persons, in the case of clients of registered investment advisers, the advisers obligation to "know" their clients from a suitability perspective; and the relationships between the issuer and the referrors and the referrors relationship with and/or knowledge of those being referred.

Quests proposal for identification of offerees as described above is considerably less ambitious in scope than the activities of certain broker-dealers that were the subject of previous interpretive letters, and the interpretation sought here would thus not be inconsistent with such positions. E.g., Bateman Eichler, Hill Richards, Incorporated, pub. avail. Dec. 3, 1985; E.F. Hutton & Company Incorporated, pub. avail. Dec. 3, 1985. ⁸ In Bateman Eichler, each account executive of a broker-dealer was permitted to make a monthly mailing to 50 local professionals, previously unknown to the account executive, for the purpose of locating prospective offerees for subsequent offerings. After reviewing responses to the questionnaires, the executive would follow up to obtain additional personal and financial information, and only after review of such information was the offeree to be placed on the list of prospective offerees. No offering materials were to be sent for 45 days after the mailing to ensure that offers were not made with respect to programs currently offered. On this ground, the staff advised that the conduct described did not constitute an "offer" of a security.

Quests proposal differs from the Bateman Eichler situation in several important respects. First, Quest will not engage in any form of solicitation open to or directed to solicitees on an individually indiscriminate basis, but will identify prospects only from a limited and defined group of persons through a chain of prior relationships. Thus, even if an offer were deemed to occur as a result of delivery of a fact sheet, the manner of offering restrictions of Rule 502(c) would not be breached. Further, in Bateman Eichler, the initial mailing did involve a general solicitation and thus a mechanical separation of actual offers from the mailing was necessary. In contrast, interests in the Fund will not be available to any person until after formal documented prequalification of the prospective offeree, and therefore a waiting period would serve no useful purpose.

We are of the view that the offering that Quest and the Fund propose to make, in one-on-one communications between the issuer, a portfolio company executive officer or registered investment adviser known to Quest and prospects referred by such intermediaries in the manner described above, should not be deemed to "involve any public offering" or to utilize methods of "general solicitation". We request the staffs confirmation of our views on the interpretive issues herein presented.

Please contact the undersigned at (212) 751-1000 or (202) 463-4640, respectively, if you require additional information or would like to discuss these matters further.

Edward H. Fleischman, for Marybeth Sorady, for

LINKLATERS & PAINES ROSENMAN & COLIN LLP

STAFF REPLY LETTER

August 28, 1996

RESPONSE OF THE OFFICE OF CHIEF COUNSEL

DIVISION OF CORPORATION FINANCE

Re: Royce Exchange Fund (the "Fund")

Quest Advisory Corp. ("Quest")

Incoming letter dated August 9, 1996

Based on the facts presented, and without necessarily agreeing with your analysis, it is the view of the Division that the activities proposed in your letter would not involve a general solicitation within the meaning of Rule 502(c) of Regulation D. In this regard, it should be noted that the involvement of a different set or class of investors than those described in your letter might require a different conclusion.

In reaching this position, we have noted particularly (1) the nature and extent of the pre-existing relationship required between Quest and any portfolio companies whose shareholders may be solicited to invest in the Fund, between Quest and its portfolio-company contacts and between the portfolio companies and the portfolio company-related persons (as defined in your letter); and (2) the nature and extent of the pre-existing relationship required between Quest and the registered investment advisers whose clients may be solicited to invest in the Fund and between the registered investment advisers and their clients.

Because this position is based on the facts presented in your letter, it should be noted that any different facts or conditions might require a different conclusion.

Sincerely,

Cecilia D. Blye

Special Counsel

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