Financial Planning Association
FPA Government Relations Office
Via electronic mail
September 25, 2002
Mr. Jonathan G. Katz
Re: Release No. IA-2044; File No. S7-28-02; Custody of Funds or Securities of Clients by Investment Advisers
Dear Mr. Katz:
The Financial Planning Association ("FPA")1 is pleased to submit comment to the Securities and Exchange Commission ("SEC") with respect to, and in support of, the proposed rulemaking "Custody of Funds or Securities of Clients by Investment Advisers" ("Custody Rule").
FPA members are greatly interested in promulgation of the Custody Rule, even though most do not hold direct custody. Uncertainty with respect to "constructive custody" 2 and its application to financial planners is a compliance problem that has been around for many years. Constructive custody remains an ongoing question for the many financial planners who are affiliated with SEC advisers, or with broker-dealers that are dually registered as advisers with the Commission. Moreover, in past discussions with the North American Securities Administrators Association ("NASAA") concerning state bonding requirements for advisers holding discretion or custody over client assets, a NASAA work project group deferred further action on defining custody until promulgation of a new rule by the SEC. Thus, any rule change adopted by the SEC will eventually have a significant impact on changes to the custody rules and examination policies applied by state securities administrators to small advisory firms.
As noted in the Proposing Release to the Custody Rule, custodial practices by investment advisers have changed significantly since the original Rule 206(4)-2 was adopted in 1962. The SEC and staff are to be commended for reviewing and proposing appropriate revisions to custodial practices, perhaps the most vulnerable area of investor protection. Such a review is critical, coming at a time of increased competition within the financial services industry to aggregate and manage an individual client's total assets within one firm.
Clarification of the Custody Rule is important to investment advisers, as noted earlier, with respect to the definition of custody and how it applies, or doesn't apply, to certain administrative services provided by planners to their clients. With the addition of amendments to the Custody Rule addressing this particular problem, FPA is strongly supportive and commends the Commission for its efforts to streamline and conform the Rule to changing industry practices. Our comments are made in the context of -- and we believe consistent with -- the principal public policy goal of discouraging abusive or fraudulent custody practices by providing more timely disclosure to adviser clients and regulators.
FPA comments that follow are limited to several issues of concern to financial planners: 1) absence of safe harbor for the forwarding of stock certificates by investment advisers and registered representatives; 2) additional clarification in the examples of the custody definition concerning common, custody-like situations not intended to be covered by the Rule; and 3) miscellaneous issues.
1. Forwarding of Stock Certificates by Financial Planners Acting in the Capacity of Investment Advisers and Registered Representatives.
The principal concern of financial planners with the new Custody Rule is the lack of a safe harbor for constructive custody, e.g., the activity of forwarding client securities, or stock certificates, to a third-party custodian. Many financial planners hold licenses as registered representatives and investment adviser representatives. A financial planner hoping to avoid constructive custody is treated differently under the existing Custody Rule, however, depending upon his or her regulatory affiliation as a registered representative of a broker-dealer or as an investment adviser. Registered representatives, as noted in the Proposing Release and SEC Staff Letter Powers Financial Services,3 can forward stock certificates overnight to a custodian if the broker-dealer meets certain NASD net capital requirements and the registered representative is acting in that capacity, and not as an investment adviser. With regard to investment advisers, however, the forwarding of stock certificates is frequently cited in compliance articles as a common technical violation of Rule 204(6)-2.4
A. Investment Advisers. Turning first to investment advisers, SEC staff many years ago framed the potential constructive custody issue for advisers who forwarded third-party checks or stock certificates to custodians. In SEC Staff letters Lawwill, Sena & Weller, 5 and Hayes Financial Services, Inc., 6 the SEC determined that client checks drawn to a bank or broker were ultimately the responsibility of those financial institutions, but that the adviser continued to be responsible for possession of a client's securities, even if the certificates were deposited on the same day to the client's account.
FPA believes that in the forwarding of certain stock certificates, where the ultimate authority to cash a security is the responsibility of another financial institution, or where it is virtually impossible for the adviser to illegally cash a security, such administrative activity should receive the same safe harbor consistent with the interpretation accorded to third-party check transfers.
FPA strongly supports the new safe-harbor in the Custody Rule provided to investment advisers where they are able to return client funds or stock certificates within one business day without being deemed to hold custody. However, the transit exception should be expanded to include the forwarding of stock certificates; it is the client asking for this service, not the adviser. Absent any empirical evidence of abusive practices (other than the technical violations cited in SEC examinations), FPA urges the Commission to amend the Custody Rule so that only client stock certificates and checks endorsed to the adviser, as well as cash, etc., should be returned to the client within one business day after receipt. Like third-party checks, investment advisers should be able to forward stock certificates to third-party custodians under certain conditions. In recognition of this market demand, we urge the Commission to expand the safe harbor for investment advisers to include the ability to forward to third-party custodians:
We note that the changes to the Custody Rule rely in part on the premise that most advisers should not have a constructive custody problem since broker-dealers and other "qualified custodians" that they do business with would provide monthly statements to their clients and thereby relieve advisers of the potential custody problem. This assumption is flawed, for two reasons. First, as the Proposing Release notes, an independent adviser may not be able to take advantage of the amended rule if its clients are unwilling to share confidential information with the custodian. Not only would their `celebrity' clients who desire privacy object to such information sharing; many other clients who wish to avoid cold calling, telemarketing or direct mail solicitations from the large custodial institutions also would object. Second, many of the potential "qualified custodians" that the Initial Regulatory Flexibility Analysis ("IRFA") assumes would have no additional record keeping burden - primarily broker-dealers -- would be reluctant to assume that responsibility because the proposed rule would in fact increase mailing and other administrative costs, as discussed in greater detail below. For all of these reasons, we urge the SEC to consider a one-business day transit exception for advisers to forward stock certificates to the custodian, instead of returning them to clients.
B. Registered Representatives. FPA supports the proposal to permit broker-dealers to act as qualified custodians in connection with the Custody Rule. About two-thirds of FPA members are affiliated with broker-dealers and, as registered representatives of broker-dealers, are currently able to forward client securities without triggering the Custody Rule as noted in Powers. Under the proposed Custody Rule, however, registered representatives would no longer be able to rely on that particular safe harbor. This safe harbor in the current rule, to our knowledge, has worked well with no evidence of systemic abuse.
The problem with the amended Custody Rule is that, in order for registered representatives to continue to forward securities, broker-dealer custodians would be required to provide monthly account statements to clients of the agent on all assets held in custody. This is not, as the Proposing Release suggests, currently "a matter of practice." It is true that many brokerage and advisory accounts of a broker-dealer routinely generate monthly reporting activity, such as statements on money market or income-generating positions held by the customer. However, the monthly reporting requirement in the revised Custody Rule would include, for the first time, individual ERISA and 403(b) accounts where payroll deductions are made on a monthly basis but typically reported on a quarterly basis to participants. The increased tripling of retirement account statements from four times to 12 times a year, adding up to hundreds of thousands of plan participant mailings - and particularly to those who would otherwise not receive or expect a monthly statement -- would be burdensome to the broker-dealer and probably ignored by recipients. At a minimum, the SEC should factor these additional costs into the IRFA analysis.
FPA supports two alternative ways of providing a safe harbor for financial planners acting in the capacity of a registered representative in forwarding stock certificates to third-party custodians. First, just as the new Custody Rule would allow investment advisers to rely on the old custody requirements, the new Custody Rule should also retain the existing 24-hour safe harbor for registered representatives as outlined in Powers. Second, for those broker-dealers that wish to meet the definition of "qualified custodian," the Custody Rule should exclude from the monthly reporting requirement pension assets as discussed previously.
2. Clarification of Non-Custody Activities by Investment Advisers.
Many financial planners have diversified practices that include, in addition to investment advice, wealth management, family office and trustee services that, among other activities, may raise custody issues.
FPA supports formalizing the SEC's longstanding view of adviser custody by incorporating the proposed definition of "custody" into the Rule and using examples to clarify its application. The examples provided in the proposed rule are generally helpful guidance. The first example in particular is a very clear, brief and succinct summary of the body of no-action letters related to possession or control of third-party checks. However, we urge the Commission to further clarify non-custody situations in the latter two examples of the custody definition, or at a minimum, address these issues in the Adopting Release.
A. Proposed Custody Definition Rule (c)(1)(ii); Deduction of Advisory Fees. Subparagraph (ii) states that custody includes
Investment advisers, as noted in the Proposing Release, currently rely on several SEC no-action letters to deduct advisory fees from a client's account without triggering the Custody Rule. Yet the above example and discussion in the Proposing Release,8 read literally, would suggest that the ability to directly deduct fees triggers custody. One must go to footnote 23 of the Proposing Release to find the information critical to most investment advisers, that "many advisers rely on a series of staff no-action letters to avoid application of the rule when they have authority to withdraw their advisory fees from client assets. ... We have designed the proposed rule so that these advisers would be able to comply with the rule without facing the burdens they previously sought to avoid."9 It is not clear to us where in the new Custody Rule advisers can find a discussion of alternative procedures, or whether they need to continue to rely on the old no-action letters for guidance. In either case, it would be extremely helpful to state clearly, and in the text of the Rule or final Adopting Release, that advisers can continue to withdraw fees, based on certain operating procedures, without triggering custody.
B. Proposed Custody Definition Rule (c)(1)(ii); Trustee and Partnership Activities. FPA believes that the example in proposed Rule (c)(1)(ii) of the custody definition needs additional clarification to provide guidance to the growing number of investment advisers who serve in dual capacities as trustee or executor and adviser to the trust, as well as in the combined roles of investment adviser and shareholder in partnerships. This subparagraph describes custody as including
Literal reading of this example could be easily misinterpreted if the adviser was unaware that under current SEC examination standards, certain written restrictions in the trust or pooled investment agreement that prohibit the adviser from deducting fees, or that require a countersignature from an unaffiliated person, would not be deemed custody.
To cite a recent example, a third-party custodian initially declined to grant discretion over an investment club's assets to an adviser/participant. The adviser pointed out that the club's partnership agreement specifically prohibited her from withdrawing fees or other assets from the investment pool. The agreement designated the authority of paying fees and expenses to another investment club partner who was not affiliated directly or indirectly with the adviser. Although an SEC examiner concluded such an arrangement was not deemed to be custody, the literal reading of the above example might be viewed as restricting such an activity.
In order to avoid continued uncertainty over the Custody Rule's applicability to the widely varied activities of financial planners, it is critical that the Rule add or expand upon examples where the agreement prohibits direct or indirect access to client assets in what otherwise would be deemed custody. These examples should be made up-front in the final Rule or Adopting Release, not for future review in no-action requests, or by an exhaustive review of old SEC staff letters. So in response to the question posed in the Release, whether additional examples should be added, FPA strongly encourages the SEC to provide more examples.
3. Miscellaneous Issues.
Definition of "Qualified Custodians." The Proposing Release includes as qualified custodians "the types of financial institutions that customarily provide custodial services and are regulated and examined by their regulators with respect to those services."10 However, it is not clear to us that it would include independent trust companies, which may perform those same functions, and may be regulated as federal or state-chartered banks, or by the federal Office of Thrift Supervision. In order to provide the greatest flexibility to the adviser in selecting a custodian, or to continue using the client's current custodian, we recommend that the SEC review the definition to ensure all relevant and appropriate state and federal institutions are included in the definition.
Custody by Qualified Custodian/Advisers. The Proposing Release poses the question, "Should the rule permit advisers that are qualified custodians to maintain their clients' funds and securities themselves? With affiliated qualified custodians?"11 The Release appropriately cites a new trend by independent advisers to place custody of client assets, either in arms-length business relationships, or as affiliated firms, with independent trust companies. We urge the Commission to clarify that where trust companies meet appropriate state or federal chartering requirements under banking regulations, and disclosure of conflicts of interest (as already required in Form ADV), that such affiliations be allowed.
In summary, FPA believes that the Rule warrants favorable consideration, with amendment, by the Commission. And, in connection with the inadvertent custody issue, that the Rule include a safe harbor for the routine, overnight forwarding of client stock certificates. As reflected in many of the SEC no-action requests, constructive custody situations are typically initiated by the client, not the financial planner or investment adviser. In particular, elderly clients prefer having the adviser forward the stock certificates and other relevant paperwork to the custodian or other entity on their behalf. In these situations, absent any empirical data demonstrating widespread complaints by investors with this practice, broad application of the Custody Rule will only impair the adviser's ability to provide reasonable, routine, and simple administrative services on behalf of the client.
In the interim, please do not hesitate to contact the undersigned if you have any questions or comments.
Duane R. Thompson