Investment Counsel Association of AmericaSeptember 25, 2002 Via Electronic Filing Jonathan G. Katz
Re: Proposed Rule: Custody of Funds or Securities of Clients by Investment Advisers, File No. S7-28-02, Release No. IA-2044 Dear Mr. Katz: The Investment Counsel Association of America1 (ICAA) appreciates the opportunity to submit comments regarding the Securities and Exchange Commission's proposed amendments to Rule 206(4)-2 of the Investment Advisers Act of 1940, which governs custody of client assets.2 The Commission's proposed amendments represent a major and comprehensive revision of the current custody rule. We applaud the Commission's efforts to modernize this rule and strongly support the proposal with some suggested modifications. As the Commission notes in the proposing Release, the custody rule has not been amended since its adoption over 40 years ago. Custodial practices have changed significantly since adoption of the rule. Although the Commission has sought to clarify application of the rule through no-action letters and interpretive guidance, the abundance of these pronouncements (almost 90 no-action letters) has been a source of confusion for advisers. The proposed amendments seek to conform the rule to modern custodial practices and provide much needed clarification and transparency to the rule. The proposal also would alleviate unnecessary compliance burdens for advisers while providing workable standards and meaningful protection for advisory clients. BACKGROUND AND SUMMARY The custody rule is designed to prevent the misappropriation of client assets by investment advisers. To achieve this purpose, the rule requires advisers with custody to: (1) segregate and identify each client's securities and hold them in a reasonably safe place; (2) deposit each client's fund in bank accounts that contain only client funds and are maintained in the adviser's name as agent or trustee for the client; (3) notify the client of the place and manner in which such funds and securities are maintained at all times; (4) send the client on a quarterly basis an itemized statement showing the funds and securities in the adviser's custody; (5) at least once each year, have an independent public accountant conduct a surprise examination of all client funds and securities in the adviser's custody; and (6) send an audited balance sheet with the disclosure brochure (Part II of Form ADV) they send to their clients.3 The proposed rule amendments would eliminate many of these burdensome requirements so long as the adviser with custody maintains client funds and securities with a qualified custodian and has a reasonable basis to believe that the qualified custodian sends monthly account statements directly to their clients. Alternatively, the adviser could choose to send clients quarterly account statements and be subject to an annual surprise audit. The proposal exempts advisers from the custody rule with respect to clients that are registered investment companies or are limited partnerships or other pooled investment vehicles if the partnership is audited at least annually and the audited financial statements are delivered to limited partners. The proposed amendments would add a definition of custody to the rule and clarify certain circumstances under which an adviser has custody of client funds. Finally, the proposal would eliminate the requirement that advisers with custody include an audited balance sheet with their client brochures. DISCUSSION The ICAA strongly supports the proposal with the modifications recommended below.
1. Definition of Custody The proposed definition of custody would provide that an adviser has custody of client assets when it holds, "directly or indirectly, client funds or securities or [has] any authority to obtain possession of them." The proposal includes three examples that illustrate circumstances under which an adviser has custody of client assets. We applaud this use of helpful examples, but request certain modifications. Inadvertent Receipt of Client Funds or Securities Under the proposal, an adviser would not be considered to have custody of client funds or securities that are received by the adviser inadvertently, provided that they are returned to the sender within one day of the adviser's receipt. We believe that the requirement that the adviser return funds or securities within "one business day" is impractical given the potential for inadvertent delay. For example, due to internal delays in delivery of mail, the appropriate advisory representative may not have actual knowledge that the firm is in possession of client funds or securities within the one-day timeframe. We recommend use of the term "promptly" as a substitute for "one business day." Additionally, for client servicing reasons, we suggest that the adviser be given the opportunity to forward a client's assets to the client's designated custodian. From time to time, advisers do inadvertently receive funds or securities from clients or third parties. In many instances, clients prefer that the adviser forward their assets directly to the custodian. As an alternative to returning the assets to the client, it is more efficient and likely safer if the adviser promptly forwards the assets to the custodian with a notice to the client. Similarly, an adviser that receives funds or securities from a third party intended for a client should be able to forward the funds or securities directly to the client. This process would provide the client with adequate protections, while promoting good business practice and client relationships. Accordingly, we suggest revising the proposed Section 206(4)-2(c)(i) to read: "possession or control of client funds (but not checks drawn by clients and made payable to third parties) or securities, unless you receive them inadvertently and (a) you return them to the sender promptly upon receiving them; or (b) you promptly forward them to the client or the client's qualified custodian, provide notice to the client, and maintain a record of such notice." Deduction of Advisory Fees or Expenses The proposed definition of custody would include arrangements where the adviser is authorized to deduct its advisory fees from client accounts. In the past, these advisers have relied on a series of staff no-action letters to avoid application of the custody rule so long as they are in compliance with certain procedures.4 Compliance with these no-action letters results in the adviser "not being deemed to have custody."5 Thus, the proposed definition of custody would likely result in thousands of additional advisers being required to state they have custody of client assets.6 Although the proposal would eliminate the procedural burdens set forth in these no-action letters, an acknowledgement of custody may nevertheless have unintended collateral consequences that advisers wish to avoid. First, advisory clients may be confused by an adviser's disclosure of custody. The Commission's proposed inclusion of fee billing arrangements in the definition of custody is inconsistent with the common understanding of what it means to have custody.7 Clients may believe that the adviser has taken over some or all duties from their actual custodian or may have some type of possession that they previously did not exercise. This misunderstanding could be harmful to the advisory relationship. Second, potentially thousands of investment advisers will have to amend their Form ADV, Part 1 to indicate they have custody. These advisers will undoubtedly also have to amend Part II to explain the reason that they now have "custody" and to explain that they do not have "actual custody." Third, investment management agreements between advisers and their clients commonly include representations that the adviser does not have "custody" or is not the "custodian."8 Potentially hundreds of thousands of contracts would have to be modified to reflect the consequences of the amended custody rule. Similarly, contracts or applications among advisers and other third parties, such as insurance companies, may include representations regarding custody. Finally, acknowledgment of "custody" may have consequences under other rules, statutes, interpretations, or no-action letters or may result in increased liability or exposure. For all of these reasons, we strongly urge that the Commission except from the definition of custody situations where the adviser has authority to deduct fees directly from the client's account pursuant to the enhanced protections set forth in the proposed rule.9 In other words, if client assets are held by a qualified custodian that sends account statements directly to the client, the adviser would not be deemed to have custody of the assets. This modification would preserve the Commission's preferred framework of investor protection while mitigating the collateral consequences of the "custody" label.10 We are unaware of any abuses in this area that would dictate a different approach. We therefore suggest re-numbering proposed Section 206(4)- 2(c)(1) as (c)(1)(i), changing the references in the proposed Sections 206(4)-2(c)(1)(i), (ii), and (iii) to 206(4)-2(c)(1)(A), (B), and (C), and adding the following:
To further assure no broader implications for advisers who now must disclose that they have custody, we also request that the Commission specify more explicitly in its final rule that the definition of custody is solely for purposes of Rule 206(4)-2 and that an acknowledgement of custody for purposes of this rule shall not be imported into other laws, rules, interpretations, or contracts. 2. Use of Qualified Custodian The proposed rule requires that advisers maintain client funds and securities with a qualified custodian in an account either under the client's name or under the adviser's name as agent or trustee for its client. The term "qualified custodian" includes banks, savings associations, registered broker-dealers, and registered futures commission merchants. With respect to "securities for which the primary market is in a country other than the United States," certain financial institutions in non-U.S. countries would be treated as qualified custodians. The purpose of the "primary market" clause is not clear. We understand, for example, that some SEC-registered advisers manage U.S. securities for non-U.S. clients through non-U.S. custodians. Therefore, we request that the Commission modify the proposal to eliminate the qualifier "With respect to securities for which the primary market is in a country other than the United States, and cash and cash equivalents reasonably necessary to effect transactions in those securities." 3. Delivery of Account Statements to Clients The proposed rule would require an adviser with custody of a client's account to (a) have a reasonable belief that the custodian sends monthly account statements directly to the client or (b) send quarterly statements to the client and be subject to an annual independent surprise audit. We are concerned that the monthly reporting requirement may not be a common practice for some custodians. For example, broker-dealers may only be required to send quarterly account statements to clients when there has been no account activity.11 Additionally, there may be situations where non-U.S. custodians are not required to send monthly account statements. Moreover, as a result of increased access to account statements via the Internet and client requests to limit the abundance of paper statements, it is more likely that broker-dealers and other custodians will continue to send quarterly account statements instead of monthly statements. Finally, under both the existing and proposed custody rule, advisers with custody are required to send quarterly (not monthly) account statements to clients. We see no reason why custodians should be required to follow a different and more burdensome reporting practice. For these reasons, we suggest amending the proposed rule to permit a qualified custodian to send quarterly account statements consistent with laws, rules or other regulations applicable to banks, broker dealers and other qualified custodians. The proposal requires account statements to be sent directly to clients. The proposal provides a special rule for limited partnerships and limited liability companies that requires account statements to be sent to each limited partner or to their independent representative. Similarly, we recommend that the proposal confirm that advisers who act as trustees to client trusts may send account statements to an independent third party representative or a defined beneficiary of the trust, consistent with previous staff no-action letters.12 Accordingly, we propose adding the following provision as new Section 206(4) - 2 (a)(3)(iv): Special Rule for trust accounts. If you or an employee of the investment advisory firm serves as a trustee to a trust established by a client, the account statements required under paragraphs (a)(3)(i) or (a) (3)(ii) of this section must be sent to the representative of the trust (i.e., the grantor of the trust, the attorney for the trust if it is a testamentary trust, a co-trustee, other than an employee or officer of the investment adviser) or a defined beneficiary of the trust. 4. Exemption for Pooled Investment Vehicles The proposed rule would exempt advisers with respect to assets held in pooled investment vehicles such as limited partnerships or limited liability companies if the pooled investment vehicle: (a) has its transactions and assets audited at least annually; and (b) distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 90 days of the end of its fiscal year. We seek confirmation that the term "generally accepted accounting principles" is interpreted to mean those followed by both U.S. and non-U.S. countries. Many private funds prepare their financial statements in accordance with generally accepted accounting principles of a jurisdiction other than the United States. Advisers to non-U.S. pooled funds using generally accepted accounting principles other than U.S. GAAP should also be permitted to rely upon the exemption under the proposed rule. We are also concerned with the timing of delivery of audited financial statements for certain pooled investment vehicles that invest in other funds, commonly known as "funds of funds." Funds of funds typically cannot complete their audited financial statements until the underlying fund prepares its own audited financials. Because the underlying fund is also required to submit financials within 90 days of the end of its fiscal year, the fund of funds may not have adequate time to complete its audited financial statements within 90 days. Accordingly, we recommend that the Commission modify the rule proposal to exempt funds of funds from the custody rule if they send audited financial statements within a reasonable time after receiving financial statements from the underlying funds. 5. Elimination of the Balance Sheet Requirement We strongly support elimination of the balance sheet requirement for advisers with custody. This would significantly reduce an adviser's compliance burdens without reducing investor protections. As noted in Section II(E) of the Release, balance sheets do not necessarily reflect the financial health of the advisory firm. We agree that the requirement that advisers disclose to clients any financial condition that is reasonably likely to impair the adviser's ability to meet its contractual commitments to its clients is a more useful disclosure than the balance sheet requirement. We applaud the Commission's decision to remove this often costly and burdensome requirement. 6. Form ADV, Part 1 As discussed above, the proposed rule defines custody to include situations where the adviser deducts its advisory fees, acts as a general partner to a limited partnership, or serves as trustee for a client account. This would result in a significant number of additional investment advisory firms being required to state that they have custody in Form ADV. This statement may prove to be misleading to clients because it implies that advisers actually hold client assets. We believe that the best method for avoiding such client confusion is the narrowing of the custody definition that we propose above. However, if the Commission does not determine to so revise the definition, we urge the Commission to amend Form ADV, Part 1 to distinguish between advisers who actually hold client assets and those who have custody under other circumstances. Although the instructions to proposed Part 2 of Form ADV make this distinction, Part 2 has not been adopted, and clients and prospective clients have access only to Part 1 of Form ADV on the Investment Adviser Registration Depository website.13 Accordingly, we propose adoption of separate response items on Form ADV, Part 1 that distinguish between advisers who actually hold client assets and those who are deemed to have custody because they deduct advisory fees, act as a general partner to a limited partnership, or serve as a trustee for a client account.14 This change would eliminate confusion by investors and provide more meaningful data for the Commission and the public. * * * We appreciate the opportunity to comment on the Commission's proposed revisions to the custody rule. We commend the Commission's efforts to think creatively outside-the-box in crafting this new framework for the rule. The proposed amendments represent a significant step toward modernizing the custody rule to reflect current practices and maintain investor protection. Please do not hesitate to contact us if you require additional information. Sincerely, Karen L. Barr
cc: The Honorable Harvey L. Pitt
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