September 25, 2002

Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth St., N.W.
Washington, DC 20549-0609

Re: Release IA-2044; File No. S7-28-02

Dear Mr. Katz:

We are pleased to provide comments on the Commission's proposed amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940, which governs the custody of client assets by registered investment advisers. As the Commission noted in its proposing release, this is the first significant amendment of the Rule since its adoption some 40 years ago. As the current Rule, and later SEC staff interpretations, require investment advisers to employ independent accountants in various roles to fulfill its requirements, we have had substantial involvement with the Rule's application. We agree that it has become increasingly difficult to apply the Rule over time, not only because of the continuing evolution of both the investment management industry and custody practices since its adoption, but also because such a substantial body of interpretive guidance has developed outside of the direct Rule that it is increasingly likely that an adviser (or accountant) may fall into non-compliance simply by not being aware of all of the interpretive nuances. Indeed, our Firm's investment management accounting and auditing specialists report that application of Rule 206(4)-2 is one of the most frequent areas of technical consultation by engagement teams. The proposal replaces, to a significant degree, highly detailed compliance requirements with an overall regulatory framework in order to achieve greater accountability and transparency of transactions in client accounts, consistent with the general concepts embedded in the Sarbanes-Oxley Act passed shortly after the proposal's release. Accordingly, we believe that the proposal will accomplish much of the Commission's objective of clarifying and updating the Rule's application, and promote both consistent application and compliance by investment advisers.

In considering the application of the revised Rule to many of our typical investment advisory clients, we have, however, identified several areas where we believe that either the full benefits of the revised Rule may not be achieved, highly detailed requirements may not have been fully updated, or situations exist in practice which may not have been considered by the Commission in its proposals. The following represent our observations and suggestions for further enhancement to the Rule to meet the Commission's goals. In these observations, we also address certain of the matters upon which the Commission requested comment in its proposing release.

  1. Our clients frequently have had difficulty over the years in identifying whether "securities" exist triggering the self-custody and examination provisions of Rule 206(4)-2. Under the Advisers Act definition in Section 202(a)(18), the word "securities" has been interpreted by counsel to include, for self-custody and examination purposes, many financial instruments which are either not negotiable or only negotiable after obtaining additional legal documentation, such as assignments, and cannot be redeemed at the holder's option either for cash or negotiable securities. Examples of such instruments include equities and debt of privately-held companies and many limited partnership interests. In these cases, however, the instruments appear to carry virtually none of the risks of misuse the Rule was intended to address, since they could not be re-sold and their non-negotiability creates a significant impediment to their use as collateral for borrowings. Accordingly, we believe that non-negotiable securities should specifically be excluded from the Rule's application. This exclusion would have the particular benefit of substantially reducing, or even eliminating, the burden of the Rule's application to investment managers who are general partners of limited partnerships specializing in venture capital or other private equity investments where securities acquired typically are non-negotiable. This could be addressed by adding a definition of "securities" to the Rule along the following lines:
    ` "Securities" has the meaning of "Security" as stated in Rule 2 (a) (18) of the Act, except that, for purposes of this Rule, securities that are not negotiable and cannot be redeemed for cash or negotiable securities at the option of the holder are excluded.'

  2. Under the Rule as revised, an investment manager is able to eliminate the requirement for an annual examination of "funds and securities" by an independent accountant at a time chosen without prior notice (a "surprise examination") if it cedes responsibility for custody of both "funds and securities" to a qualified custodian. If it does not do so, the requirement to issue quarterly statements to clients and arrange for an annual surprise examination remains. As the Commission notes in one of its proposed examples, a common finding of "custody" results solely from an adviser having the power to arrange disbursements (i.e., "holding the checkbook") for clients, even if all securities may have been placed with a "qualified custodian". For many high-net-worth clients, an integral part of the adviser's service - from which the client often derives significant value - is the client's ability to contact adviser personnel directly to arrange for, and process, such disbursements. As a practical matter, in such situations the adviser will be unable to delegate authority to "approve" disbursements to a "qualified custodian" and thereby will be considered to retain custody. Under the revised Rule, the adviser will have no choice but to continue with surprise examinations, not only of the funds over which it has unsupervised access, but also the securities over which it has supervised access.

    We believe that advisers who have custody solely by reason of having disbursement power over cash should be able to derive some benefit from the revised Rule. Accordingly, we recommend that the Commission provide for a reduced scope of application of the revised Rule, if a "qualified custodian" provides the required monthly statements of securities held in custody to the client, but the adviser has discretionary authority over the disbursement of cash. Under this recommendation, an adviser would be exempt from the reporting and surprise examination requirements of the Rule with respect to securities, but, with respect to cash, the adviser would be required to:

      a) provide to the client no less frequently than quarterly, a statement of cash activity, including, with respect to disbursements, at a minimum, the date, amount, and payee of each disbursement and

      b) arrange for an accountant's surprise examination of the cash accounts at least once each calendar year. The accountant's examination would include, at a minimum, tests of all reconciliations of bank statements to cash balances appearing on the quarterly reports and, on a sample basis, tests of the items listed on the quarterly statements for completeness and accuracy of description and adequacy of supporting documentation. As discussed in Item 3a below, we believe that confirmations of client accounts should either be reduced or eliminated.

  3. If surprise examinations of funds and securities continue to be required, even in limited circumstances, we believe it essential that ASR 103 (FRP 404.01.b), which outlines the Commission's rules for performance of these examinations, be updated. ASR 103 was issued in 1966 and, similar to Rule 206(4)-2 itself, no longer recognizes current securities depositary, banking, or auditing practice. In particular, we request the Commission address the following aspects of ASR 103:

    1. ASR 103 includes a requirement to "[obtain] from clients written confirmation of the funds and securities in the clients' accounts as of the date of the physical examination." Under Rule 206(4)-2(a)(5), this has typically resulted in positive confirmation of every active client's account. The requirement for positive confirmations from all active clients is extremely time-consuming and demanding of both accountant and adviser personnel, in both the preparation of confirmations and the follow-up of responses, particularly as major investment advisers may now manage 1,000 or more individual client accounts. Further, we believe it to be largely ineffective. In our experience, common response rates are only 30-50% of confirmations mailed. This low response rate leaves the accountant with no greater audit assurance about a majority of accounts than if confirmations had not been mailed. We believe the confirmation requirement achieves disappointing results for three principal reasons:

      1. Many clients have turned over their financial management affairs to advisers because they either do not have the time to be, or do not want to be, involved in the day-to-day supervision of their investments. Accordingly, they may only have limited knowledge of the contents of their investment account at any given time and as such are not in a position to provide a fully informed confirmation. (Some confirmations may ultimately be delivered to an attorney or other representative for review, from whom the accountant may receive a response.)

      2. Much of the knowledge that clients may have about their investment account, particularly when the adviser has discretionary trading authority, is based on adviser-supplied information, not their own independent understanding. In effect, clients are being asked to confirm the accuracy not of the contents of their accounts, but of the information about their accounts provided them by the adviser - an inherently circular process that may limit clients' willingness to respond.

      3. Because clients typically receive statements on a calendar-quarter basis, the mailing of confirmations different from the regular reporting and mailing schedule means that clients likely have not seen all the transactions making up their current account balances. The only way to compensate for this absence of information is to include a statement of transactions from the last quarterly statement to the date of the count, significantly expanding the length of the confirmation. This places additional demands on adviser personnel to develop these special statements and on the clients receiving the confirmations to thoroughly review them. The alternative is to schedule examinations close to, or coincident with, a quarterly mailing date, which significantly impairs the ability to examine accounts on a "surprise" basis.

      While the poor response rates could support an argument that almost any confirmation requirement fails a cost-benefit test as an examination procedure, we recognize the importance of having some direct contact with an advisor's clients during an examination. We believe that reducing the current 100% positive confirmation requirement would be a cost-effective alternative that provides adequate protection. We recommend that the revised Rule permit independent accountants to confirm annually on a positive basis a randomly selected sample of client accounts (based on the lesser of a minimum percentage of accounts or a statistically determined sample size) as of the quarterly statement date closest to the date of the surprise count. If the examination date is not the quarterly statement date, the accountants would also be required to test, on a sample basis, transactions in the accounts between the two dates. Permitting the confirmation procedure to conform to a regular statement mailing would, we believe, improve both client familiarity with balances being confirmed and their responsiveness to the confirmation request. Further, by requiring a random sample, advisory personnel would be unable to determine which clients would be subject to confirmation and thus could not easily take steps to conceal a misappropriation. While another alternative would be to perform a 100% confirmation on a negative basis, we do not recommend this alternative in light of current apparent investor inattentiveness to the more demanding positive confirmations.

    2. Item (d) of the requirements of the accountant's report in ASR 103 states that the accountant should state "whether, in connection with the examination, anything came to the accountant's attention which caused him to believe that the investment adviser had not been complying with paragraphs (a)(3) and (a)(4) of Rule 206(4)-2 during the period since the prior examination date." (Paragraph (a)(3) refers to written notification by the adviser to the client at the time the account is accepted of the place and manner in which funds and securities are to be maintained, while paragraph (a)(4) refers to the requirement to mail statements to clients on a quarterly basis.) While this reporting practice was acceptable at the time ASR 103 was issued, AICPA Statement of Standards on Attestation Engagements No. 10 (AT 601.07) now prohibits accountants from providing negative assurance on compliance. While for the past several years accountants have revised their procedures to enable them to render an affirmative report on compliance with these provisions in order to meet both current AICPA standards and the Commission's requirements, we request the Commission to review these reporting requirements in their entirety. We believe these requirements are unnecessary and should be eliminated. The adviser must specifically state in Form ADV, Part 1B, Item 2 whether it sends quarterly account statements to clients for whom the adviser is able to directly withdraw fees. In addition, the Commission, by originally requesting only the provision of negative assurance, did not consider this aspect critical enough as to require an accountant to provide positive assurance. If the Commission concludes that this should remain an element of the examination, we recommend that the report requirements be revised to permit accountants to provide attestation assurance on whether the client has established and is following procedures to permit compliance with these requirements, rather than opining that the required notifications and mailings occurred.

  4. We support the elimination of the requirement for an adviser that has custody of client assets to include an audited balance sheet in its Form ADV filing. We agree with the Commission's conclusion that an audited balance sheet as of a single point in time provides little information to enable a prospective client to judge the financial condition of an adviser and, by implication, the risk that the adviser may misappropriate client assets.

  5. We believe that the Commission should revisit its plan to continue the use of an "independent representative" to receive quarterly account statements for, and to monitor disbursements by, an investment partnership considered to have custody of client assets. This position was, as the Commission acknowledges, a creation of past Staff no-action letters. Certain of these letters suggested that an attorney or accountant could fulfill this role. In responding to a no-action request, however, the Staff concluded that the adviser's independent accountant could not serve as the "independent representative" ("approving" disbursements to the adviser) without being considered part of the adviser's internal control system, and thus jeopardizing the accountant's independence with respect to that client.1 We are aware of few attorneys who have taken on this responsibility, as they typically consider the review of disbursements a task more appropriately undertaken by an accountant. Accordingly, the "independent representative" role has often been assumed by an accountant with no other responsibilities with respect to the partnership, a practice which is cumbersome and adds cost with arguably marginal benefit.

    Based on our experience, we believe that a large majority of investment partnerships issue audited annual financial statements. This alone will reduce the number of "independent representatives" required under the revised Rule. However, if the Commission believes that pre-review of disbursements is necessary for those partnerships that do not issue audited annual financial statements, we suggest the "independent representative" requirement be revised to permit the independent accountants who are engaged to perform the annual surprise examination of funds and securities to test the disbursement request. The result of this procedure would be the issuance of an agreed-upon procedures report in conformity with Statement of Standards for Attestation Engagements (SSAE) No. 10, section 201, documenting the tests performed. These reports, or a summary2 thereof, could be filed as part of the Form ADV-E that contains the report on the annual securities examination. The issuance of such a report under attestation standards does not conflict with an accountant's independence and should not raise the concerns expressed previously by the Staff, while eliminating many of the inefficiencies of current practice. We believe this practice will achieve much of the Commission's intent and actually facilitate the annual examination by permitting the accountant to inspect, on an ongoing basis, those transactions which are considered to present the greatest risk.

  6. In the proposal, the Commission specifically requested comment on whether the Rule should permit advisers that are qualified custodians to maintain their clients' funds and securities themselves, or with affiliated qualified custodians, without requiring annual surprise examinations. We have observed that some advisers maintain custody with a qualified custodian, but only in omnibus form for all advised accounts, with the detailed record of individual clients' holdings being maintained by the adviser. An adviser currently maintaining investments in omnibus form would not be permitted to take advantage of the revised Rule unless it converts to individual-account custody, at potentially substantial additional cost. This practice does not appear to have been considered by the Staff in its analysis of the revised Rule.

    If the adviser (or its affiliate) maintains omnibus custody solely for its advised clients and is not otherwise a qualified custodian, we believe the conclusion is inescapable that this form of self-custody should remain subject to the surprise examination requirements of Rule 206(4)-2, because of the inherent risks involved in the pooling of multiple clients' assets in a common custody account. However, we do not believe a surprise examination should be required of advisers who either are, or are affiliates of, qualified custodians and maintain the assets with that custodian, provided that the qualified custodian's custody operations are subject to periodic examination by an appropriate federal or state regulatory agency, or the custodian engages an independent accountant to perform an annual examination of the internal controls over its custody operations. When the funds and securities are in the hands of a qualified custodian engaging in commercial custody operations separate from its advisory services, they are indistinguishable from, and subject to the same controls as, any other funds and securities entrusted by clients to the custodian, and thus are not subject to any greater risk of misuse than any other asset the custodian maintains.3 We also believe that a surprise examination should not be required when funds and securities are in the possession of an affiliated broker/dealer subject to Rules 15c3-1, 15c3-3, and 17a-13 under the Securities Exchange Act of 1934. The requirements of these Rules, including requirements for count procedures and annual independent accountants' reports thereon, appear to adequately address the risk of misuse.

  7. We note that the proposed exemption of investment partnerships from securities examination requirements only applies if annual audited financial statements are delivered within 90 days after the end of the partnership's fiscal year. We believe this exemption will have little effect on many partnerships that are subject to similar CFTC filing requirements. Similarly, it may not affect other partnerships that provide audited financial statements together with Form K-1 tax returns to their partners. However, certain classes of partnerships may be adversely affected, including:

    1. Partnerships which invest in other partnerships (i.e., "funds of funds"), where the annual audit is often completed after the partnership has received audited year-end financial statements (often with capital account statements) from its investees, so that a 90-day deadline is for all practical purposes unachievable;

    2. Private equity or venture capital partnerships that similarly may await the receipt of audited financial statements from their investees in order to finalize security valuations.

    Further, some partnership agreements have specifically included later issuance deadlines, such as 120 days after the end of the fiscal year.

    The exclusion of non-negotiable securities from the Rule as we discuss in Item 1 likely would reduce the number of funds affected by a 90-day issuance requirement, but would create compliance difficulties for those unable to avail themselves of an exclusion. Accordingly, we recommend that the Commission include in the final Rule an extension of the 90-day issuance deadline when the receipt of financial statements from an unaffiliated investee is integral to the determination of the value of a material portfolio investment. In such cases, we recommend that the issuance deadline be a specified number of days (e.g, 30 or 45) after the latest date of the receipt of financial statements from all material unaffiliated investees.

  8. Proposed Rule 206(4)-2(a)(3)(ii)(B) requires filing of the report on the surprise examination of securities "within 30 days after the examination". It is not clear whether this statement requires filing of the report within 30 days after the day selected for the surprise examination or the completion of fieldwork. As a practical matter, to the extent securities must be confirmed with custodians, and particularly if confirmation of client accounts is still required, it would be impossible to complete the examination within 30 days after the date of the surprise examination, since no confirmations could be mailed in advance. We recommend that this phrase be clarified to read, "within 30 days after completion of fieldwork".

  9. Proposed Rule 206(4)-2(a)(3)(ii)(C) requires reporting by the accountant of the "finding" of any "material discrepancy" to the Commission within one business day of the finding. The terms "finding" and "material discrepancy" are not defined elsewhere and may be subject to inconsistent interpretation. For example, material differences between recorded and examined amounts of funds or securities may initially be identified, but when investigated may be found to have appropriate explanations (e.g., entry of a transaction to the incorrect account). Without guidance, the proposed wording would appear to require reporting to the Commission before even a routine investigation occurs. We request that the Commission clarify the meaning of these terms to reflect what we believe to be their intent - the finding that actual funds or securities confirmed or inspected materially differ from those reported to be in client accounts. If the Commission's intention is to require reporting similar to that required by Section 10A of the Securities Exchange Act and Rule 10A-1 thereunder, the wording in this Rule should more closely track the language of Rule 10A-1.

Finally, we note that the proposal does not indicate any prospective effective date of a final Rule. We encourage the Commission to act on a final Rule quickly. As we are reaching the end of calendar year 2002, planning and execution of securities examinations and, especially, calendar year-end balance sheet audits, under the current Rule either are, or will soon be, undertaken, and it would be unfortunate if this work was made unnecessary upon issuance of a final revised Rule. Further, as we believe the revised Rule will significantly reduce regulatory burdens, we also encourage the Commission to allow advisers to adopt it as soon as possible. We do not believe it should be necessary for advisers who either can quickly achieve, or already are, in compliance with the proposed Rule to remain subject during a transition period to securities examination and financial statement audit requirements that the Commission itself has rescinded as no longer necessary for the protection of investors.

We are pleased to have had the opportunity to comment on this proposal, and we look forward to final Commission action in the near future. If you have any questions regarding the contents of this letter, please contact Richard Grueter at (617) 439-7414.

Very truly yours,

PricewaterhouseCoopers LLP

1 MacDade Abbott LLP (September 19, 1996).
2 We believe summarization may be preferable to avoid the potential release of proprietary information about fee rates or calculation methods. The actual agreed-upon procedures reports would be delivered to the adviser and available for periodic inspection by the Staff.
3 We believe this same principle holds for many assets maintained by investment companies with affiliated banks that are subject to Rule 17f-2 under the Investment Company Act of 1940. These investment companies are currently subject to three examinations annually, of which two must be unannounced. We respectfully urge the Commission to review and propose changes to Rule 17f-2 not only, as here, to reflect current custody practices, but also in consideration of the impact of the current Rule on bank-sponsored investment companies - a class of investment company that did not exist when the current Rule was adopted.