National Regulatory Services
Submitted Via Email to: email@example.com
September 25, 2002
Jonathan G. Katz, Secretary
RE: Proposed Rule on Custody of Funds or Securities by Investment Advisers- File No. S7-28-02
National Regulatory Services ("NRS") appreciates the opportunity to offer comments on the recently proposed amendments to the custody rule under the Investment Advisers Act of 1940. NRS is a compliance and regulatory consulting firm based in Lakeville, Connecticut which services the needs of investment advisers and broker-dealers. NRS commends the SEC for taking the initiative to amend rule 206(4)-2 in order to accommodate modern custodial practices and reduce unnecessary compliance burdens on advisers without compromising investor protection.
As observed in the proposing release, the Commission has attempted to accommodate evolving business practices, which could not have been foreseen when the custody rule was adopted over forty years ago, by issuing an ongoing series of no-action and interpretative letters. While this effort has been undertaken with the best of intentions, the custody rule has in fact become, with the passage of time, less transparent and more challenging from a compliance and operational perspective. There are significant costs associated in complying with the current custody rule with no commensurate benefit or protection for advisory clients.
Before turning to our specific comments, we wish to offer the following as a general observation: The proposing release would have been perhaps more instructive conceptually had it clearly differentiated constructive custody (where the client has authorized the payment of advisory fees directly from the client's account by an independent custodian) from the legal authority (generally through a general power of attorney) to directly withdraw funds or securities from a client's account without the intervention of a third party. To do so would be quite beneficial in that many advisers seeking to direct debit advisory fees do not have nor intend to have authority to directly withdraw client funds or securities or to sign checks on a client's behalf. In addition, although the Commission notes that the proposed rule is intended to allow advisers to comply with the rule "without facing the burdens they previously sought to avoid," it is unclear whether an adviser could continue to rely on existing no-action authority that permits advisory fees to be paid directly from custodial accounts as an alternative to the rule as proposed.
To facilitate the reading of our specific comments below, we have incorporated text from the proposing release, which is followed by our specific bolded comments. We have slightly modified the text by breaking apart some paragraphs, deleting text and inserting formatting to accommodate the insertion of our comments.
A. Definition of Custody
Currently, we define "custody" in our instructions to Form ADV. We propose to incorporate that definition into rule 206(4)-2, provide examples that illustrate the application of the definition, and include, within the rule, a limited exception for advisers that inadvertently receive client assets.
The proposed definition 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." Accordingly, an adviser must comply with the rule when it has access to client funds and securities as well as when the adviser holds those assets. In either circumstance, clients are at risk that their assets may be lost, misused, misappropriated, or subject to the adviser's financial reverses.
We propose to include, in the definition, three examples designed to illustrate circumstances under which an adviser has custody of client assets.
The first example clarifies that an adviser has custody when it has any possession or control of client funds or securities. An adviser that holds clients' stock certificates or cash, even temporarily, puts those assets at risk of misuse or loss. We recognize, however, that an adviser may inadvertently receive client assets when a third party sends funds or securities to a client via the adviser, or when a client attempts to route funds or securities to his custodian through the adviser's office. To avoid causing an adviser to violate the rule inadvertently as a result of actions by other persons, the rule would expressly exclude inadvertent receipt by the adviser of client funds or securities, so long as the adviser returns them to the sender within one business day of receiving them.
NRS comment: While we concur that the return of client funds or securities to the sender within one business of receiving them is a sensible exclusion from inadvertent violation of the rule, we would also suggest that the example be modified to accommodate the situation of an adviser who is in receipt of stock certificates with stock powers. An adviser intent on providing customer service should not be deemed in violation of the rule provided such documents are forwarded to the custodian on the same date the adviser receives them. In the case of stock certificates with or without stock powers, the adviser should also be obligated to send to the client a letter indicating the adviser is not the custodian and cannot be in receipt of any of the client's stock certificates. Said another way: the client will be instructed to "please do not send stock certificates to us for deposit into your custodial account in the future."
We also propose to clarify that an adviser's possession of a check drawn by the client and made payable to a third party will not be considered possession of client funds for purposes of the custody definition.
NRS comment: We strongly endorse the idea of, in effect, codifying the industry's current understanding about this issue.
The client's relationship with the drawee bank should provide the client with protections comparable to the protections the proposed rule would provide.
The second example clarifies that an adviser has custody if it has the authority to withdraw funds or securities from a client's account. An adviser with power of attorney to sign checks on a client's behalf, to withdraw funds or securities from a client's account, or to dispose of client assets for any purpose other than authorized trading has access to the client's assets. Similarly, an adviser authorized to deduct advisory fees or other expenses directly from a client's account has access to, and therefore has custody of, the client funds and securities in that account.
NRS comment: These are two different items and are best addressed in separate examples.
Example two: Power of attorney over a client's account, trust, etc., amounts to actual possession (check writing privileges not withstanding).
Example three: The ability to direct debit amounts to "constructive custody." Access provided to the adviser is only after obtaining written instructions from the client via the advisory contract and limited power of attorney authorization provided by the client to the custodian.
These advisers might not have possession of client assets, but they have the authority to obtain possession.
NRS comment: We have encountered some confusion within the industry as to whether the custody rule applies to all client assets within a client's account irrespective of whether the assets are managed by the adviser. Many clients are demanding accommodation by advisers for consolidated reporting. Consequently, many clients of registered advisers have "managed and non-managed" assets held within the same custodial account. Consequently, we believe that clarification within the context of the rule may be accomplished by defining and describing any and all assets within the account whether advised or not advised by the adviser.
The last example clarifies that an adviser has custody if it is the legal owner of the client assets or has access to those assets. One common instance is a firm that acts as both general partner and investment adviser to a limited partnership. By virtue of its position as general partner, the adviser generally has authority to dispose of funds and securities in the limited partnership's account and thus has custody of client assets.
Our proposed definition of "custody" is based on our longstanding interpretation of the term currently used in the rule.
B. Use of Qualified Custodians
Rule 206(4)-2 currently requires advisers to maintain client funds with a bank, but does not require that client securities be held in a brokerage account or with any other type of financial institution. Almost all advisers that have custody of client securities maintain them in accounts with a broker or a bank, but on occasion our examiners discover an adviser keeping certificates in office files or in a safety deposit box. Such practices do not provide adequate protection for client securities, because these certificates may too easily be lost, stolen, or destroyed. We are therefore proposing to amend the rule to require that advisers maintain both 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 clients.
"Qualified custodians" under the proposed rule would include the types of financial institutions that customarily provide custodial services and are regulated and examined by their regulators with respect to those services. These would include banks, savings associations, registered broker-dealers, and registered futures commission merchants. We recognize that advisory clients often invest in securities traded on foreign exchanges and their advisers must, as a practical matter, maintain securities with financial institutions in foreign countries where the securities are traded. With respect to securities for which the primary market is in a country other than the United States, and to cash and cash equivalents reasonably necessary to effect transactions in those securities, we would treat financial institutions that customarily hold financial assets in that country and that hold the client assets in customer accounts segregated from their proprietary assets as qualified custodians.
Many advisers registered with us also would be qualified custodians under the proposed rule. These advisers could maintain their own clients' assets, subject to the account statement requirements described below and the custody rules imposed by the regulators of the advisers' custodial functions. Advisers could also maintain client assets with affiliates that are qualified custodians.
We request comment on our proposal to require client funds and securities to be maintained by a qualified custodian.
C. Delivery of Account Statements to Clients
Rule 206(4)-2 seeks to deter misuse of client assets by requiring an adviser with custody to send each client quarterly account statements, and to engage an independent public accountant to conduct an annual surprise examination of client assets in custody. Advisers have complained about the cost of annual surprise examinations and have sought to avoid them. Moreover, experience has shown that the current rule has limited deterrent effect. Advisers that intend to misuse client assets can fabricate client account statements and, because the surprise examination is performed only annually, many months may pass before the accountant has an opportunity to detect a fraud.
After reviewing the operation of the current rule and evaluating its benefits and costs, we are proposing an entirely different approach to protect advisory clients - an approach that would rely on periodic disclosure of account information by a qualified custodian rather than rely on a surprise examination. We propose to exempt advisers from the requirements to send quarterly account statements and to undergo annual surprise examinations if the qualified custodian sends monthly account statements directly to each advisory client. Qualified custodians' delivery of account statements to clients directly should provide clients with confidence that any erroneous or unauthorized transactions or withdrawals by an adviser have been reflected.
We recognize that our new approach may not work in all custodial arrangements. Some advisers do not disclose the identity of their clients to their custodians to prevent a potential competitor from having access to their clients. Others may wish to protect the privacy of certain well-known clients. To accommodate this business practice, the proposed rule would require an adviser to continue sending quarterly account statements to each client that does not receive account statements directly from the qualified custodian and to undergo an annual surprise examination to verify the funds and securities of those clients. [Emphasis added by NRS].
NRS comment: This is somewhat counterintuitive. The adviser in this instance does not have custody; the qualified custodian does. What would the surprise examination verify? We fail to understand how making the adviser subject to a surprise annual examination will protect the holdings of advisory clients. Subjecting the custodian to a surprise examination for each adviser's designated client account seems infeasible and duplicative of precious regulatory resources.
NRS is not aware of custodians who accept nominee named or private, numbered accounts (also an anti-money laundering issue), although we concede that some number of these may exist. In such cases, the qualified custodian does not know the client; the adviser is the only party that possesses the specific client information. Consequently, we recommend the custodian send the monthly statement to the adviser who is then obligated, within 24 hours of receipt, to send the statement to the actual client. We also believe advisers who provide or accept "private or numbered accounts" should disclose that there is risk to both parties when the qualified custodian cannot communicate directly with the actual client.
To enhance our ability to protect advisory clients' assets by intervening as early as possible, the proposed amendments would require notice of any material discrepancies found during the examination. The rule would require the accountant finding such discrepancies during an examination to notify our Office of Compliance Inspections and Examinations.
The proposed amendments contain a special provision requiring account statements (whether delivered by the qualified custodian or the adviser) to be sent directly to the limited partners of a limited partnership (or to their independent representative) if the adviser to the limited partnership also acts as its general partner and has custody of client assets. As general partner, the adviser generally has custody of these client assets. This special provision would avoid the adviser's being the sole recipient of account statements in its capacity as general partner of the limited partnership. Delivery of account statements to the adviser but not to the limited partners would not, of course, deter the adviser's misuse of client assets.
1. Registered Investment Companies
We propose to exempt advisers from the rule with respect to clients that are registered investment companies. Registered investment companies and their advisers must comply with the strict requirements of section 17(f) of the Investment Company Act of 1940 and the custody rules we have adopted under that section. We believe that applying rule 206(4)-2 in addition to those requirements may not increase safeguards on investment company assets.
2. Pooled Investment Vehicles
We also propose to exempt advisers from the rule with respect to client assets held in pooled investment vehicles such as limited partnerships or limited liability companies if the pooled investment vehicle:
(i) has its transactions and assets audited at least annually; and
(ii) distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) NRS comment: Does this include independent representatives? Within 90 days of the end of its fiscal year.
These investors will have established, by contract, a means to protect themselves from misuse of pool assets. Moreover, a periodic report by auditors may be more useful to them than receiving reports of the large number of transactions in pool assets.
3. Registered Broker-Dealers
We are not proposing to retain the current exemption from the rule for advisers that are also registered broker-dealers. The proposed rule would permit advisers that are also registered broker-dealers (and advisers that are also other types of qualified custodians) to hold custody of their clients' funds and securities without being subject to annual surprise examinations so long as they send monthly statements to their clients. Broker-dealers already are required to send confirmations and account statements to their customers, including those that are advisory clients. Most advisers that also are registered broker-dealers should therefore already be in compliance with the proposed rule and face no additional burdens.
E. Amendments to Part II of Form ADV
Advisers that have custody of client assets must include, in their disclosure statements ("brochures") sent to clients, a balance sheet audited by an independent public accountant. We adopted the audited balance sheet requirement, in part, to assist clients in determining whether their adviser may face financial pressure to misuse the assets entrusted to it. A balance sheet, however, may give an imperfect picture of the financial health of an advisory firm - many profitable advisers have few financial assets.
Moreover, rule 206(4)-4 now requires advisers to disclose to their clients any financial condition that is reasonably likely to impair the adviser's ability to meet its contractual commitments to its clients, a disclosure requirement that did not exist in 1979 when the audited balance sheet requirement was adopted. We believe that this current disclosure requirement is a better means to warn clients of when their assets may be at additional risk, and that clients should not have to rely for protection on reviewing balance sheet information. We are therefore proposing to eliminate the requirement that advisers with custody include a balance sheet in their client brochures.
III. General Request for Comment
The Commission requests comment on the rule amendments proposed in this Release, suggestions for additional changes to the rules and comment on other matters that might have an effect on the proposals contained in this Release. For purposes of the Small Business Regulatory Enforcement Fairness Act of 1966, the Commission also requests information regarding the potential impact of the proposed rule on the economy on an annual basis. Commentaries should provide empirical data to support their views.
We applaud this long overdue effort to clarify and modernize the custody rule. This initiative is consistent with Chairman Pitt's view that regulation should be more consistent with business practice while not compromising investor protection. The proposed simplification of "constructive custody" issues is consistent with the SEC's thinking found within no-action letters and interpretive releases.
We recommend that the final rule release clearly delineate that advisers who use qualified custodians (and these custodians send out monthly statements) in the varying contexts articulated within the rule may disclose in Form ADV, Parts 1 and II that "they do not have custody." We also strongly recommend that the release specifically articulate that it supercedes and renders moot the "history" of no-action letters and interpretative letters that industry is currently relying upon.
Should you have any comments or questions regarding our observations or comments, please do not hesitate in contacting one or more of the individuals below. For your convenience, each individual's email address is listed below.
National Regulatory Services
Peter Mafteiu, Director
Bill Cavell, Director
Rick Cortese, Vice President