Investment Advisers Act of 1940 - Section 206(4) and Rule 206(4)-2(a)(1)
RESPONSE OF THE OFFICE OF CHIEF COUNSEL
Our Ref. No. 2005428949
Your letter dated April 28, 2005 requests our assurance that we would not recommend enforcement action to the Commission under Section 206(4) of the Investment Advisers Act of 1940 (the "Advisers Act") and Rule 206(4)-2(a)(1) thereunder (the "Custody Rule") against a registered investment adviser if, as described in your letter, it is authorized to withdraw its client's funds from an account that is maintained with American Skandia Life Assurance Corporation and/or its insurance company affiliates ("American Skandia"), rather than with a qualified custodian as defined in the rule. In particular, the client would authorize the investment adviser to deduct its advisory fees from a separate account that supports the client's variable annuity contract that is issued by and maintained with American Skandia.
You state the following: American Skandia is a stock life insurance company domiciled in Connecticut with licenses in all 50 states, the District of Columbia and Puerto Rico. American Skandia's primary business involves the issuance of registered variable annuity products. American Skandia is subject to extensive regulation under state insurance laws, including strict solvency and capital adequacy requirements.
Each of American Skandia's variable annuity contracts that are at issue here are funded by one of several of American Skandia's separate accounts. Pursuant to the terms of American Skandia's variable annuity contracts, a contract holder can elect to have his or her payments to American Skandia under the contract allocated among a number of different investment options through the applicable American Skandia separate account. The investment options invest in shares of particular open-end management investment companies that are registered with the Commission under the Investment Adviser Act of 1940 (the "Company Act"). Each applicable separate account is registered with the Commission under the Company Act as a unit investment trust and, for accounting and regulatory purposes, the separate account designates a "subaccount" for each investment option. Pursuant to the variable annuity contracts, a contract holder can change his or her investment allocations among the investment options, subject to certain limitations.
Through its administrative system ("VPAS"), American Skandia registers the contract holders' ownership interests in the variable annuity contracts and units of the separate accounts. VPAS records the number of units of the separate account that are owned by each contract holder, and designates for each contract holder an account in the contract holder's name. VPAS records changes in the allocations among the investment options relating to that account, and produces the definitive record of the contract holders' interests in the investment options.
Some contract holders hire an investment adviser that is registered with the Commission to provide professional asset allocation advice concerning the allocation of their investments among the various investment options that are offered within American Skandia's variable annuity contracts. Some contract holders (i.e., investment advisers' clients) would like to allow the investment advisers to deduct their advisory fees directly from the separate account that supports the variable annuity contracts by periodically directing American Skandia to redeem units of the separate account equal in value to the advisory fees for the relevant time periods ("Direct Fee Payment Arrangements").1
You understand that, in a Direct Fee Payment Arrangement, a contract holder would authorize, in writing, the investment adviser to submit a redemption request directly into VPAS without the direct involvement of any employee of American Skandia. In addition, you understand that, if an investment adviser opens an account with American Skandia on behalf of its client (i.e., a contract holder), the adviser would disclose in writing to its client that American Skandia holds the payments that the contract holder makes under his or her variable annuity contract, and that American Skandia would record the contract holders' ownership interests in the units of the separate account that supports the variable annuity contract. American Skandia would send the contract holder a quarterly account statement that identifies the amount of funds and each security in the account at the end of the period and that sets forth all transactions in the account during that period, including payments of the advisory fees that were made to the investment adviser.
Under the Custody Rule, Direct Fee Payment Arrangements would vest an investment adviser with custody of its clients' funds and securities. You are concerned that the Custody Rule would require an independent third-party custodian to maintain custody of the contract holder's funds and securities (i.e., the variable annuity contract) and process the contract holder's advisory fee payments to the investment adviser because American Skandia does not meet the definition of a qualified custodian under the Custody Rule. Accordingly, you request relief from certain of the Custody Rule's requirements, as described below.
The Custody Rule provides that it is a fraudulent, deceptive or manipulative act, practice or course of business within the meaning of Section 206(4) of the Advisers Act2 for an investment adviser that is registered or required to be registered under the Advisers Act to have "custody" of client funds or securities unless they are maintained in accordance with the requirements of the rule. The Custody Rule is designed to protect client assets from being lost, misused, misappropriated or subject to investment advisers' financial reverses.3
Paragraph (c)(1) of the Custody Rule provides that an investment adviser has custody of client funds and securities when it holds, "directly or indirectly, client funds or securities or [has] any authority to obtain possession of them." The release adopting the Custody Rule clarifies that an investment adviser has custody if it is authorized to deduct advisory fees or other expenses directly from a client's account.4 That form of access to client funds and securities gives investment advisers an opportunity to misappropriate the funds and securities.
Paragraph (a)(1) of the Custody Rule requires an investment adviser that has custody of client funds and securities to maintain them with a "qualified custodian" as defined in paragraph (c)(3) of the rule. Paragraph (c)(3) of the Custody Rule defines qualified custodian to include, among others, certain banks, registered broker-dealers and futures commission merchants and certain foreign financial institutions. That definition does not include insurance companies.
You acknowledge that the investment advisers that enter into Direct Fee Payment Arrangements would be deemed to have custody of the contract holders' funds and securities under the Custody Rule because the advisers automatically may deduct their advisory fees by redeeming the contract holders' units of American Skandia's separate account that supports the contract holder's variable annuity contract. You acknowledge further that American Skandia is not a qualified custodian under the Custody Rule. You in essence contend, however, that, as described below, American Skandia will protect contract holders' funds and securities from misappropriation by the investment advisers in connection with the Direct Fee Payment Arrangements in a manner that is consistent with the policies underlying the rule.
In particular, you note that paragraph (b)(1) of the Custody Rule essentially provides that a registered mutual fund's transfer agent may act in lieu of a "qualified custodian"5 with respect to the shares of the mutual fund, provided that the shares are maintained in accordance with the requirements of the Custody Rule.6 The Commission determined that requiring a qualified custodian in addition to the fund transfer agent would not provide additional protection to mutual fund investors and would unnecessarily increase investors' custodian costs.7 Essentially, the Commission determined that a mutual fund transfer agent would protect a client's funds and securities from misappropriation by an investment adviser in a manner that is consistent with the policies underlying the Custody Rule.
You contend that American Skandia acts like a mutual fund transfer agent with respect to the contract holders' variable annuity contracts and units of the separate accounts8 because American Skandia registers the contract holders' ownership interests in the variable annuity contracts and units of the separate accounts. In addition, you note that, like mutual fund transfer agents with custody of client assets, American Skandia will send quarterly account statements that reflect transactions relating to the Direct Fee Payment Arrangements to its contract holders.9 You state that the only differences are that the variable annuity contracts are not organized as mutual funds, and the interests in the variable annuity contracts and separate accounts are recorded on the books of the insurance company (through VPAS) and not on the books of a transfer agent.10 You contend, in sum, that American Skandia will protect contract holders' funds and securities from misappropriation by the investment advisers in connection with the Direct Fee Payment Arrangements to the same extent as a mutual fund transfer agent protects client funds and securities from misappropriation by investment advisers in connection with similar arrangements.
Based upon the facts and representations contained in your letter, we would not recommend that the Commission take enforcement action under Section 206(4) of the Advisers Act and Rule 206(4)-2(a)(1) thereunder against a registered investment adviser if it is authorized to withdraw its client's funds from an account that is maintained with American Skandia, rather than a qualified custodian as defined in the rule. Our response does not provide relief from any other provision of the Custody Rule that would apply to the Direct Fee Payment Arrangements, for instance, the requirement in paragraph (a)(1) of the Custody Rule regarding the account that the qualified custodian maintains for each client.11 This conclusion is based on all of the facts and representations set forth in your letter. You should note that any different facts or representations might require a different conclusion. Further, this response expresses our position only with respect to enforcement action, and does not express any legal conclusion on the issues presented.
[A]t times, a client or adviser may purchase shares of a mutual fund directly from the fund's transfer agent rather than through another intermediary such as a broker-dealer. In these cases, the mutual fund's transfer agent maintains the securities of the client on the mutual fund's books. The adviser, however, may also have custody because, for example, the adviser has check-writing or fee-deduction authority over the assets. The amended rule allows an adviser to use the mutual fund transfer agent in lieu of a qualified custodian with respect to those shares. (citations omitted).
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