National Association of Real Estate Investment Managers

September 25, 2002


Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Re: SEC File No. S7-28-02; Proposed Rule: Custody of Funds or Securities of Clients by Investment Advisers

Dear Mr. Katz:

We are submitting comments on behalf of the National Association of Real Estate Investment Managers ("NAREIM") generally supporting the goal of the Securities and Exchange Commission (the "Commission") to modernize Rule 206(4)-2 under the Investment Advisers Act of 1940, as amended ("Advisers Act").1 On July 18, 2002, the Commission proposed amendments to Rule 206(4)-2 that, if adopted, will (i) define certain relevant terms under the Rule; (ii) require Commission-registered investment advisers having custody over client funds or securities to perform functions to ensure the safekeeping of client funds and securities;2 and (iii) except specified types of accounts from the Rule's application.3

We appreciate the opportunity to comment on this proposal. This comment letter focuses solely on the proposal to except certain types of accounts from the application of the Rule and respectfully requests that the Commission consider extending a similar exception from the Rule to registered investment advisers that manage client assets under a "Separate Account" arrangement, as defined and discussed in more detail below.

I. Background on NAREIM and Its Members

NAREIM, currently in its 12th year of operation, is a trade association of institutional real estate investment companies and real estate advisory firms. NAREIM currently has 68 members, and membership is offered to any organization of real estate professionals (domestic or foreign), which, among other things, actively manages at least $200 million or more of real property investments for its own account or the accounts of clients, such as pension funds, trusts, foundations, endowments, and other institutional investors. Clients of NAREIM members may own real estate assets through so-called commingled or pooled funds that, in turn, hold assets, such as fee interests in real property, shares of real estate investment trusts, interests in limited partnerships, interests in limited liability companies, shares of title holding corporations, mortgages, loan notes, loan participations and short-term cash management instruments (e.g., cash, government securities, shares of money market funds, or certificates of deposit).

NAREIM members also may enter into individually negotiated arrangements with large institutional investors, including primarily pension and employee benefit plans that are subject to the Employment Retirement Income Security Act of 1974 ("ERISA") or similar government plans that track ERISA requirements. These types of accounts, referred to herein as "Separate Accounts," generally are managed on a discretionary or a non-discretionary basis in accordance with the client's investment objectives and criteria. Separate Accounts also may invest in real estate directly or through intermediate vehicles that, in turn, hold title to the real estate assets.

Because of considerations under ERISA and the Advisers Act, many of NAREIM's 68 members are registered with the Commission as investment advisers under the Advisers Act. In general, registered investment advisers that manage the assets of commingled funds or Separate Accounts, as noted above, may be deemed to have custody over client assets for purposes of current Rule 206(4)-2 based on Commission and staff interpretations. Additionally, in cases of commingled funds and Separate Accounts, it is customary industry practice for an independent public accountant to audit client accounts on an annual basis and in accordance with generally accepted accounting principles ("GAAP"), irrespective of the application of the Rule. Investors in commingled funds and Separate Account clients receive annual audited financial statements and generally unaudited financial statements for each quarter.

II. Comments to the Proposal

Currently, Rule 206(4)-2 applies to the custody activities of any investment adviser that is registered, or required to be registered, with the Commission regardless of the type of client whose assets are in the adviser's custody. Essentially, an adviser that has custody over any client funds or securities is subject to the rule's segregation, notice, reporting, and annual surprise audit obligations. The Commission's proposal would limit the reach of the Rule in several instances, including in cases where a registered investment adviser is deemed to have custody of the assets of a limited partnership, limited liability company, or other type of pooled investment vehicle (collectively, an "investment pool"), provided assets and transactions of the investment pool are audited by an independent public accountant at least annually and the partners, the members, or other beneficial owners of the investment pool receive within 90 days of the end of the investment pool's fiscal year financial statements prepared in accordance with GAAP.4

In support of the proposed exception, the Proposing Release noted that investors in investment pools "will have established, by contract, a means to protect themselves from misuse of pool assets." Presumably, underlying the Commission's proposal is the notion that investment pools include investors that demonstrate a level of financial and investment sophistication enabling them to protect their investments through negotiation by contract or otherwise.5 To the extent that investors in investment pools receive annual GAAP financial statements, the Proposing Release also stated, "a periodic report by auditors may be more useful to them than receiving reports of the large number of transactions in pool assets."

NAREIM supports the Commission's proposal to except investment pool accounts from the application of the Rule because of the level of protection already established by means of agreement, investor sophistication, and audited financial reporting. NAREIM, however, believes that this exception should not be limited solely to investment pools that satisfy the criteria of the proposed Rule. Because Separate Accounts and investment pools share similar fundamental characteristics relevant to the Rule's application, namely the ability to negotiate by agreement for the safeguarding of assets, investor sophistication, and audited financial reporting, NAREIM respectfully requests that the Commission consider extending the Rule's limited client exceptions to Separate Account clients. In this way, the Commission would not be limiting the compliance burden of one set of advisers (i.e., advisers to investment pools) versus another (i.e., advisers to Separate Accounts), where the types of accounts and the protections afforded the two types of accounts are virtually indistinguishable.

To alleviate any concerns the Commission may have that a registered investment adviser might try to extend the proposed exception for Separate Accounts to retail accounts or other accounts where the protection of investors might be compromised, the Commission could impose conditions on the use of the Separate Account exception. First, similar to the proposed exception for investment pools, the transactions and assets of a Separate Account client should be subject to an audit by an independent public accountant at least annually. Second, also similar to the proposed exception for investment pools, the Separate Account client must receive the audited financial statement prepared in accordance with GAAP within 90 days of the fiscal year designated for the Separate Account. Lastly, to ensure an appropriate level of sophistication, the Commission could limit use of the exception solely to Separate Accounts of institutional clients that fall within the definition of "qualified client" under Rule 205-3(d)(1) under the Advisers Act.6

NAREIM believes that an exception for Separate Account clients similar to the exception for investment pools would strike an appropriate balance in allocating the burdens imposed by the Rule and be consistent with its modernization. Additionally, it would apply regulation consistently to similar kinds of accounts.

If the Commission has any questions with this comment letter or requires any clarification, please do not hesitate to contact the undersigned at (202) 778-9324.


              C. Dirk Peterson

1 17 C.F.R. § 275.206(4)-2. We refer herein to this rule as either "Rule 206(4)-2" or the "Rule".
2 Under the proposal's safekeeping obligations, a registered investment adviser would be obligated to notify its clients of the location of the client's funds or securities and to send periodic notices identifying transactions in the client's account either directly to the client or via a "qualified custodian." A registered investment adviser that sends account statements directly to a client, not via a "qualified custodian", would be obligated under the proposal to submit to an annual surprise audit by an independent public accountant. The proposal obligates the accountant to make filings with the Commission in the event it finds certain material discrepancies in the course of its audit. We are not commenting on these aspects of the proposed amendments. Nor are we commenting on the proposed definitions under the Rule.
3 See Investment Advisers Act Release No. 2044 (July 18, 2002) ("Proposing Release").
4 The Commission also has proposed excepting client accounts of an investment company registered with the Commission pursuant to the Investment Company Act of 1940, as amended ("1940 Act"). We are not commenting on the exception for registered investment advisers whose clients are registered investment companies.
5 As the Commission is aware, interests in investment pools are offered and sold through long-standing exemptions from the Securities Act of 1933 ("Securities Act") and exclusions from the 1940 Act. The private offering exemptions under the Securities Act and the rules thereunder recognize that certain investors, such as accredited investors (as defined in Section 2(a)(15) of the Securities Act and Rule 501(a) of Regulation D) and qualified institutional buyers (as defined in Rule 144A(a)(1) under the Securities Act), have a level of business and financial sophistication enabling them to operate outside of certain protections of the Securities Act. Similarly, the 1940 Act recognizes the business and financial sophistication of so-called qualified purchasers (as defined in Section 2(a)(51) of the 1940 Act and the rules thereunder) enables them to invest in certain private investment pools outside of the regulatory protections of the 1940 Act.
6 As pertinent to an institutional client, a qualified client under Rule 205-3(d)(1) includes (i) an entity that has at least $750,000 under the management of the investment adviser immediately after entering into an agreement with the adviser; (ii) an entity that the adviser reasonably believes immediately prior to entering into a contract with the adviser has a net worth of more than $1.5 million; or (iii) an entity that the adviser reasonably believes is a qualified purchaser as defined in Section 2(a)(51)(A) of the 1940 Act (e.g., a person with discretionary authority over at least $25 million in investments) at the time the contract is entered.