North American Securities Administrators Association, Inc.
September 25, 2002
Jonathan G. Katz, Secretary
Re: File No. S7-28-02, Proposal Rule on Custody of Funds or Securities of Clients by Investment Advisers
Dear Mr. Katz:
The North American Securities Administrators Association, Inc. (NASAA)1 appreciates the opportunity to comment on Release No. IA-2044, File No. S7-28-02, "Custody of Funds or Securities of Clients by Investment Advisers."
NASAA commends the Commission for proposing this rule, which is an important step in clarifying custody issues that heretofore have been dealt with in diverse opinions. Codification of the positions in those opinions will greatly aid advisers in understanding and complying with the regulations. We also appreciate the dialogue that has occurred between Commission staff and the staff of NASAA members on issues surrounding custody. Although they only apply to SEC-registered advisers, the proposal will serve as an important guide to state officials in their efforts to promote uniformity of regulation.
Throughout this comment letter, we will focus on questions posed by the Commission in the Release by highlighting your questions in italics immediately prior to our response.
Definition of Custody
The central provision of the proposed rule is Section 206(4)-2(c)(1) which would define custody in pertinent part to mean "holding, directly or indirectly, client funds or securities or having any authority to obtain possession of them." Custody would include not only direct possession and control, but also arrangements where an adviser could obtain or withdraw client funds through legal ownership of, or access to, client resources, such as through service as a general partner or in a similar position.
Should [the Commission] revise the definition [of custody] in any way?
NASAA is generally pleased with the new definition, which follows in part the definition in the current Form ADV Part II. We particularly note that the proposed definition uses the term "the authority to obtain possession" rather than Form ADV's "the ability to appropriate" client funds or securities. This is consistent with a model rule endorsed by NASAA in 1999. However, there is no discussion in the commentary accompanying the proposed rule as to why the change to "authority to obtain possession" was made. We recommend additional commentary clarifying that the remaining two parts of the definition address circumstances where an adviser misappropriates client resources without any express authority.
From previous discussions with Commission staff concerning temporary custody, our understanding is that the Commission considers whether or not the sending of funds or securities to the adviser was based on prior discussions or arrangement. A prior arrangement would be categorized as "transit" custody and an unexpected receipt would be categorized as "inadvertent" custody. Subsection (c)(1)(i) of the proposed rule provides that it is not custody if an adviser receives unexpected client funds or securities and returns them to the sender within one business day of receipt. We recommend that this subsection also include a requirement to send the item back (or forward it, as we suggest in the next paragraph of this letter) in the same form as received by the adviser. For example, an adviser could receive a cashier's check payable to the adviser and instead of returning the same check, could deposit it and the next day send back a regular check drawn on the adviser's bank account. This could result in a float that would benefit the adviser rather than the client. There should also be a specific reminder that the adviser must adhere to applicable books and records rules and make a record of receipt of such items, including their description and when they were sent back to the sender. Without such a record, it would be impossible to review for compliance with the rule.
The Commission also may want to consider the approach taken in a NASAA model rule that permits an adviser to forward misdirected funds or securities to a third party (such as a mutual fund or custodian) instead of the sender if certain conditions are met. Sending these assets on to the proper ultimate destination better serves the client by reducing the delay. If assets are returned to the client, the client must then resend them to the proper location. This could delay effecting a client's objective for a week or more. As an alternative to returning the assets to the client, the rule should permit the adviser to forward them to the appropriate third party if: a) receipt of the item by the proper party is time-sensitive, b) the assets are forwarded within one business day, c) the adviser keeps a record that includes a description of the asset, when and from whom it was received, and when and to whom it was delivered, and d) the adviser sends a notice to the client stating that the client should not have sent the asset to the adviser and that future items should be sent directly to the third party.
Should [the Commission's] rules require advisers that deduct fees from clients' accounts to send such invoices to those clients?
NASAA feels it is extremely important to investor protection that clients be provided with information on how fees deducted directly from accounts are calculated. This information should include the value of the assets, the applicable time period, and the formula used for the calculation. Often, several related accounts are combined for fee purposes. Differing rates are charged but the payment is deducted from one account. Typically, custodian statements merely show the date and total amount paid and perhaps a notation of the adviser's name or a notation such as "advisory fees." Continuing the invoice requirement will ensure this information is forwarded to clients. In addition, an invoice or statement should be sent to the client simultaneously with the instruction sent to the custodian to deduct fees so as to provide early notice to the client. Waiting for even a monthly statement from a custodian could hinder a client's ability to detect a problem.
Will the examples be helpful? Are there additional examples we should add?
NASAA is pleased that the Commission has addressed inadvertent and transit custody in the definition. Clarification through examples of the effect of these specialized types of custody will be a significant help to both advisers and regulators. We recommend that in section 206(4)-2(c)(1)(i), the Commission clarify the parenthetical phrase about transit custody by adding an example such as "...(but not of checks drawn by clients and made payable to third parties, such as direct mutual fund investments)... ." The rule also should reiterate books and records rule requirements that a record of all receipts and deliveries be maintained which would include items returned to clients or third parties, regardless of the custody treatment.
Proposed section 206(4)-2(a)(1) would require that advisers maintain funds and securities with a qualified custodian. Qualified custodians are defined in proposed section 206(4)-2(c)(3) to include banks, savings associations, broker-dealers, futures commission merchants, and certain foreign financial institutions
Should [the Commission] require that all client funds and securities be maintained with qualified custodians?
NASAA supports advisers using entities other than the adviser itself to hold client funds and securities. We do have concerns that there may be situations where obtaining an unaffiliated custodian would pose potential difficulties, such as an adviser not affiliated with a broker-dealer that does not do a lot of trading. Any exceptions to using a qualified custodian should be clearly and narrowly defined to provide the best investor protections.
Should the term " foreign financial institution" be defined or qualified?
"Qualified custodian" as defined in proposed section 206(4)-2(c)(3) includes the term "certain foreign financial institutions." However these entities do not appear to be defined in the proposed section. In the absence of a specific definition or qualifications for a "foreign financial institution" that is acting as a qualified custodian, we are concerned with the inability of regulators to examine and obtain documents held by financial institutions that are protected by foreign bank secrecy laws. Obtaining documents from foreign financial institutions for routine examination in other regulatory areas is nearly impossible unless there is an associated enforcement action, and even pursuant to an enforcement action the process is time consuming, costly and burdensome.
Are there other financial institutions that should be included as qualified custodians?
Over the last decade, credit unions have grown from small, narrowly focused cooperatives to large, sophisticated financial institutions. If investigation demonstrates that regulation by the NCUA is the functional equivalent of banking regulation by the FDIC and OCC, and comparable investor safeguards exist, the Commission may wish to consider adding NCUA-regulated credit unions to the list of qualified custodians. Similar consideration could be given to state chartered institutions that provide comparable controls and protections.
Is [the Commission's] proposal with respect to foreign qualified custodians too broad...too narrow...?
While NASAA is not in a position to comment on foreign financial services regulation, we are concerned that foreign custodians that hold client funds and securities may not be subject to the same regulatory safeguards as may be expected of the designated qualified custodians in the United States. Therefore, we recommend that if a foreign custodian is used for any reason, a disclosure must be made to clients that their assets may not receive the same protections when held by foreign custodians that they would receive from their U.S. counterparts.
Should the rule permit advisers that are qualified custodians to maintain their clients' funds and securities themselves? With affiliated qualified custodians?
NASAA is aware that there may still be some instances where it may be burdensome for the adviser to obtain the services of a qualified custodian, though this is more likely in the case of small, state-registered advisers that offer private securities to their clients, rather than SEC-registered advisers. In any event, the best investor protection may result from allowing only the narrowest of exemptions to the qualified custodian requirement. If the Commission does determine that an adviser may, under certain conditions, act as its own custodian, either directly or indirectly through an affiliated entity, NASAA recommends that the status quo remain in force with regard to the adviser's compliance with disclosure, record-keeping and audit requirements. This will provide both investors and regulators with some degree of assurance that advisers and their affiliates are not engaged in hiding any transactions or discrepancies from customers. By complying with the custody requirements, advisers and their affiliates will not be able to circumvent or diminish existing investor protections.
Account Statement Delivery
Current Rule 206(4)-2 requires an adviser with custody to send each client quarterly account statements, and to engage an independent public accountant to conduct an annual surprise audit. Proposed Rule 206(4)-2(a)(3) would relieve advisers from both sending their own account statements, and undergoing the annual surprise examination, if client assets are maintained by qualified custodians who send monthly statements directly to the advisers' clients.
Would the proposal [to rely on account statements delivered to clients by qualified custodians instead of ... the adviser] afford equivalent protection to clients? Should the rule expressly require advisers to review the custodian's statement and identify any discrepancies?
Requiring statements to be delivered by qualified custodians will increase investor protection by giving responsibility for the creation and dissemination of statements showing all activity for a client's account to someone other than the adviser. There will be less opportunity to "adjust" asset values or hide transactions that take place during the statement period. If the adviser also sends a statement, the client can compare the two and question any discrepancies immediately. It seems prudent that the adviser will reconcile its records with those of the custodian inasmuch as the adviser has an ethical obligation to verify that all information regarding a client's portfolio is accurate. Perhaps an admonition in the accompanying comments would be sufficient to alert advisers to their reconciliation obligation.
Should advisers that are acting as their clients' qualified custodians or that are using affiliated qualified custodians continue to be subject to annual surprise examinations?
If an adviser is acting as the custodian, or if it is using an affiliated entity as the custodian, NASAA strongly believes it should continue to be subject to the surprise audit requirement, as well as the special disclosure and record-keeping requirements of the current rule. States have seen instances of an adviser setting up its own affiliated entity to act as a custodian, where the adviser or its officers manage both entities. There is, in effect, only a paper wall separating the advisory and custodial functions. That situation provides too great an opportunity for unethical activity. While an adviser affiliate may be an institution already subject to an audit requirement, the custody function may be only a small part of the institution's business and therefore not be given as close scrutiny as it would during a more focused audit. Requiring the adviser to continue to be subject to the conditions of the existing rule puts no greater burden on the adviser and maintains the investor protections the rule was originally designed to provide. The desire to avoid additional record-keeping burdens may actually convince hesitant advisers to use a custodian.
[The Commission] also request[s] comment on[its] proposal to require advisers with custody to continue sending quarterly account statements to clients and to continue undergoing annual surprise examinations if the qualified custodian does not send account statements directly to the adviser's clients. ... Is there a need for this alternative procedure? Should [the Commission] require these advisers to obtain their clients' informed consent prior to using this alternative procedure? If not, should [the Commission] require advisers that use this alternative procedure to disclose, to clients, the risks involved in receiving account statements quarterly from the adviser itself rather than monthly from a qualified custodian, or to make other disclosures?
If the assets are held by a qualified custodian rather than the adviser, the custodian should be required to send monthly statements regardless of whether the adviser also wishes to send statements. Statements issued by non-adviser custodians increase investor protection by having an independent third party create and disburse monthly account statements, thus preventing any misrepresentation or tampering by an adviser. If the Commission decides to retain the option for an adviser to send statements in lieu of third party custodian statements, then the adviser should disclose that the adviser or adviser affiliate - not an independent third party - has created the statements, and provide the client with the identity and contact information for the custodian, so the client can request a statement at any time. A customer opt-in requirement should be required in instances of adviser or adviser-affiliate statements.
In the instance where the adviser does not disclose the client's identity to the custodian, thereby not making it possible for the custodian to send statements, the adviser should be required to send statements monthly rather than quarterly.
Should [the Commission] require additional safeguards to deter misuse of clients' assets by advisers that send account statements to clients themselves? Should the rule require surprise examinations to be conducted more often than annually? Are there other requirements or procedures that would further protect these advisers' clients' assets?
Because an adviser sending its own statements has greater opportunity to manipulate the data, such advisers should at a minimum be held to the same standard as an institutional custodian by requiring the adviser to also provide statements monthly rather than quarterly. This will provide better investor protection by permitting clients to review their accounts more frequently, giving clients more timely notice if fees are deducted, and placing the same standard for dissemination of information on the adviser, regardless of how the funds and securities are held.
Section 206(4)-2(b) would except from application of the rule investment companies registered under the 1940 Act and client assets held in pooled investment vehicles such as limited partnerships. In the latter case, there would have to be an audit at least annually, with audited financial statements distributed to investors.
NASAA wishes to call to the Commission's attention another situation that arises from time to time, especially with smaller advisers. That is the case of an adviser becoming the trustee of a family-related trust. The Commission issued an opinion letter in 1986 (Ref. No. 86-300-CC) regarding advisers who act as trustees to trusts for close relatives. This Bondoux letter set forth specific provisions that must be met in order to avoid having to comply with the audit and record-keeping provisions of the custody rule. NASAA recommends that such a provision should be included in the Commission's revised rule. A suggested draft of such language, prepared by the NASAA Investment Adviser Model Rules Project Group, is as follows:
Recommend new exception, section 206(4)-2(b)(3) -
(b)(3) A beneficial trust for which you act as trustee if all of the following conditions are met for each trust:
(i) The beneficial owner of the trust is a parent, a grandparent, a spouse, a sibling, a child or a grandchild of the adviser.
(ii) For each account under paragraph (i) you comply with all of the following:
(A) You provide a written statement to each beneficial owner of the account setting forth a description of the requirements of subsection (a) and the reasons why you will not be complying with the rule requirements.
(B) You obtain from each beneficial owner a signed statement acknowledging the receipt of the written statement required under subparagraph (A)
(C) You maintain a copy of both the written statement required under subparagraph (A) and the signed acknowledgement required under subparagraph (B) from each beneficial owner, until the account is closed or you relinquish trusteeship.
Form ADV, Part II, Item 14
For SEC-registered advisers only, the Commission proposes to eliminate the requirement that a balance sheet audited by an independent CPA be included on Form ADV Part II, Schedule G. The balance sheet requirement would be continued, however, if the adviser required pre-payment of advisory fees of more than $500 per client and more than six months in advance. The balance sheet requirement would not be eliminated for state-registered advisers.
Have advisory clients found the balance sheet useful in evaluating the risks to their assets in advisers' custody? Should [the Commission] retain the [Schedule G balance sheet] requirement?
Even though the Commission feels that other disclosure requirements would provide better notification of the potential financial conditions that a client should consider before entrusting custody to an adviser, NASAA would at least recommend a prominent addition to the wording of Question 14 on ADV Part II to the effect that the client can receive a copy of the adviser's latest balance sheet - either audited or at least certified by an officer of the adviser - upon request and in a timely fashion. It should also make it absolutely clear that state advisers still need to include the balance sheet if either condition in Question 14 is answered in the affirmative.
NASAA appreciates the Commission's consideration of these views.