Institute of International Bankers

September 25, 2002

By E-mail

Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609

Re:  Proposed Rule: Custody of Funds or Securities of Clients by Investment Advisers
Release No. IA-2044; File No. S7-28-02

Dear Mr. Katz:

The Institute of International Bankers (the "Institute") appreciates the opportunity to comment on the Proposed Rule on Custody of Funds or Securities of Clients by Investment Advisers (the "proposed Custody Rule").1 The Institute supports the Commission's plans to modernize the Custody Rule's requirements "to reflect modern custodial practices." Specifically, we are writing to comment on the application of the proposed definition of qualified custodian ("QC") to international banks.

    A. Background

Rule 206(4)-2 (the "current Custody Rule") under the Investment Advisers Act of 1940 (the "Advisers Act") permits a registered investment adviser ("RIA") to maintain custody of client securities with any entity, including international banks and their U.S. branches and agencies, subject only to the restriction that the entity have procedures to safeguard the securities. With respect to client cash, the current Custody Rule permits RIAs to maintain custody of such cash only in one or more "bank accounts" that contain only clients' funds, maintained in the RIA's name as agent or trustee for its clients. Such bank accounts may be maintained with U.S. banks including U.S. branches and agencies of international banks, but not with non-U.S. offices or subsidiaries of international banks.

The proposed Custody Rule provides more specific guidance on eligibility of custodians including the use of custodians outside the United States. It provides that both client securities and cash may only be maintained with QCs. The proposed definition of QC includes, among other things, any bank as defined in the Advisers Act, any SEC-registered broker-dealer and "[w]ith 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, any financial institution that customarily holds financial assets in that country and that holds the client assets in customer accounts segregated from its proprietary assets."

Under the proposed definitions, U.S. financial institutions, including U.S. branches and agencies of international banks, generally would qualify without restriction. However, the non-U.S. offices of international banks and the non-U.S. subsidiaries of international banks that customarily hold financial assets in their home country and that hold client assets in segregated accounts would qualify to act only in a restricted custodial capacity. With respect to securities, a non-U.S. financial institution would be limited to keeping in custody only those securities for which the primary market is the country where the institution is located. With respect to cash and cash equivalents, a non-U.S. financial institution would be limited to keeping in custody the amounts reasonably necessary to effect transactions in its home-country securities and it would not be permitted to maintain custody of additional cash or equivalents (even if denominated in the local currency).

    B. Request for Expansion of Proposed QC Definition

The Institute appreciates the inclusion of non-U.S. financial institutions as QCs under the proposed Custody Rule. We understand that one of the objectives in establishing the definition of QC, and including in that definition certain non-U.S. financial institutions, is to recognize the current practice and need of RIAs to maintain custody of client cash and securities overseas. This objective is particularly appropriate given the growing global character of the investment advisory business and the growing interest of U.S. investors in investing in foreign securities and currencies. In light of the evolution of modern custodial practices since the current Custody Rule was promulgated over 40 years ago, we believe it is appropriate to adopt a broad QC definition.

Accordingly, we recommend that the Commission not limit the scope of the custodial services that non-U.S. financial institutions are permitted to offer. Specifically, we recommend that with respect to non-U.S. financial institutions that otherwise meet the requirements of the Proposed Custody Rule, the Commission drop the prefatory language that limits their custodial function to first, only the securities of their home countries and second, only the cash and cash equivalents necessary to effect transactions in those securities. Thus, an eligible non-U.S. financial institution would be permitted to act as the custodian for all of an RIA's client assets, both cash and securities from the financial institution's home country and any other countries, including the United States. Our recommendation is based on the following considerations. A draft of our proposed change to the regulation is attached.

First, a broader definition is fully consistent with the purposes and objective of the rule in recognizing the globalization of the securities markets. It is not clear why any limitation should be imposed on the scope of a custodian's services with respect to securities or cash and cash equivalents. If a foreign custodian meets the standards to be a custodian in its home country, on what basis should it be precluded from acting as a custodian for securities in other countries or from selecting sub-custodians in those countries? Similarly, a non-U.S. QC - like a U.S. QC - should be permitted to maintain cash and cash equivalents that may be necessary for other purposes in addition to the purchase of securities, including meeting the investment objectives of the RIA's clients, such as maintaining a cash or cash-equivalent allocation or holding foreign currencies.

Second, a broader definition is consistent with principles of competitive equity between U.S. and non-U.S. financial institutions. U.S. banks and other U.S. financial institutions that meet the QC test qualify as global custodians for all types of securities and cash. To limit the extent to which non-U.S. financial institutions could act as global custodians imposes a significant competitive disadvantage.

Moreover, an RIA subject to the proposed Custody Rule that purchases for its customers' accounts a variety of securities for which the primary markets are other countries or advises its clients to maintain cash including various non-U.S. currencies as part of their portfolio may have little practical incentive to use non-U.S. financial institutions under the proposed restrictions. Either the RIA can contract with a QC in the United States and rely on that QC's network of non-U.S. custodians for securities and cash to be kept in custody abroad, or the RIA can develop its own network of foreign QCs, one in each country in which it purchases or intends to purchase securities. The RIA cannot use a foreign QC as its "primary" custodian (i.e., the custodian with which the RIA contracts directly and that the RIA is not required to look beyond) and rely on that QC's network of non-U.S. sub-custodians.

Of the two choices - hiring a U.S. QC or developing its own network of foreign QCs - the latter would be unduly costly for most RIAs, effectively limiting them to U.S. QCs. Some foreign clients of U.S.-domiciled RIAs may prefer to have their assets kept in custody abroad at a particular primary custodian in a foreign jurisdiction, e.g., in their home country. To foster competitive equality and more fully serve the needs of advisory clients, non-U.S. QCs should enjoy the same flexibility as their U.S. counterparts, rather than being restricted to acting as custodian only with respect to their home-country securities and cash and cash equivalents necessary to effect transactions in such securities.

Leveling the playing field between U.S. and non-U.S. QCs will not result in additional risk to advisory clients. Under the proposed Custody Rule, securities generally will be kept in custody physically in the country of their primary market, regardless of whether the RIA (1) forms a direct and primary custodial relationship with a U.S. QC that in turn relies on a network of foreign custodians, or (2) relies directly on any number of foreign QCs meeting the definition in the proposed Custody Rule. Consequently, liberalizing the definition of QC in the proposed Custody Rule to permit foreign QCs to act as primary custodians would not affect the ultimate custodial location of securities abroad. Nor, for similar reasons, would it generally affect where cash denominated in any particular currency is kept in sub-custody. Indeed, it could present less risk to clients if an RIA were permitted to choose a single foreign QC as its primary custodian responsible for sub-custodial arrangements in other jurisdictions, rather than be forced to establish numerous relationships with multiple foreign QCs about which it may not be in a position to obtain substantial information. In this regard, an RIA should be permitted to benefit from the expertise of a foreign primary custodian in selecting local sub-custodians, rather than having to make such choices itself based on comparatively less experience. Moreover, the RIA itself will continue to be subject to SEC supervision and examination, including with respect to its custody role.

Third, the Institute's recommended approach is consistent with the approach taken by the Commission in Rules 17f-5 and 17f-7 under the Investment Company Act of 1940 (the "Company Act"). Rule 17f-5 permits an "Eligible Foreign Custodian" to act as custodian for "any investments (including foreign currencies) for which the primary market is outside of the United States, and such cash and cash equivalents as are reasonably necessary to effect the [f]und's transactions in such investments," provided that fund's custody manager determines that the assets kept in custody will be subject to reasonable care. Thus, the Commission has acknowledged in Rule 17f-5 that "foreign currencies" are treated as "investments" that may be kept in custody with an Eligible Foreign Custodian, thereby allowing non-U.S. custodians to maintain cash other than U.S. dollars in unlimited quantities regardless of whether the currency is reasonably necessary to effect securities transactions. Rule 17f-7 under the Company Act reflects the same approach: a fund's "primary custodian" includes a qualified foreign bank (such as an international bank) that contracts directly with the fund to maintain the fund's assets outside of the United States. The primary custodian's role under Rule 17f-7 is not confined to maintaining custody only of securities marketed primarily in its home country. In sum, in the context of the Company Act, the Commission has not concluded that a foreign custodian should be limited to the securities listed in the country of its domicile or in the amount or type of foreign currencies it can hold. Affording foreign QCs under the Advisers Act parallel breadth in their custodial functions - provided that the RIA fulfills its duty to its clients under the Advisers Act in selecting an appropriate custodian for its clients' assets - would be similarly appropriate.

Finally, if the Commission has a concern about the adequacy of the regulation of foreign custodians with respect to removing the limitations of the proposed definition, it could consider alternative eligibility criteria for those non-U.S. QCs that would be permitted to provide broader custodial services. For example, the broader role of primary custodian for non-U.S. financial institutions could be limited to international banks and their subsidiaries to the extent that the international bank is subject to comprehensive supervision on a consolidated basis ("CCS") by its home country, or limited to those foreign custodians that are regulated "as such," i.e., as a custodian, by the regulatory authorities of the foreign jurisdiction.

* * *

In conclusion, we respectfully request that the Commission modify the proposed definition of QC as set forth in the attached draft regulatory language. Please do not hesitate to contact the undersigned if we can provide further information or assistance.

Yours very truly,

Lawrence R. Uhlick

Executive Director and

General Counsel

1 The Institute of International Bankers represents internationally headquartered financial institutions from over 40 countries that engage in banking, securities and/or insurance activities in the United States. The U.S. operations of international banks play an important role in the U.S. financial markets and economy, holding over $3 trillion in banking and financial affiliate assets and employing over 120,000 U.S. citizens and residents.

PROPOSED SECTION 275.206(4)-2(c)(3)(v) (showing deletions in strikethrough and revisions in italics):

(v) 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, a A financial institution that customarily holds financial assets in that a country other than the United States and that holds the client assets in customer accounts segregated from its proprietary assets.