September 20, 2002
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, D.C. 20549-0609
Re: Proposed Rule: Custody of Funds or Securities of Clients by Investment Advisers; File No. S7-28-02
Dear Mr. Katz:
We respectfully submit this letter on behalf of our client, Credit Suisse Asset Management, LLC, in response to a request for comment by the Securities and Exchange Commission (the "Commission") on the proposed amendment of Rule 206(4)-2 (the "Custody Rule" or "Rule") under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), relating to custody of funds or securities of clients by investment advisers.1 The proposal would modernize the Custody Rule by clarifying circumstances under which an adviser has custody and would modify Advisers Act requirements for investment advisers maintaining custody of client assets, subject to exceptions for investment companies registered under the Investment Company Act of 1940, as amended, and pooled investment vehicles ("Investment Funds")2annually distributing audited financial statements prepared in accordance with generally accepted accounting principles ("GAAP") to investors within 90 days of fiscal year end.
We applaud the Commission's goal of modernizing the Custody Rule and seeking to enhance protections for investment advisory clients while reducing burdens on advisers deemed to have custody of client assets. In particular, we commend the Commission and its staff (the "Staff") for recognizing the need to provide an alternative to the proposed requirements of the amended Rule for Investment Funds. Consistent with the Commission's goal, we offer the following comments to the Proposing Release relating to the proposed exception in the Rule for Investment Funds.
As proposed, the amended Rule would require that an Investment Fund have its transactions and assets audited at least annually and distribute its audited financial statements prepared in accordance with GAAP to all limited partners (or members or other beneficial owners) within 90 days of the end of its fiscal year in order to take advantage of the exception from the Rule's requirements.3We concur with the statement in the Proposing Release that investors in Investment Funds will have established, by contract, a means to protect themselves from misuse of pooled assets and therefore require less protection than other types of investment advisory clients.4 Indeed, we submit that these contractual provisions should obviate the need for annual inspections whether or not audited financials are ultimately required to be delivered to Investment Fund investors.
However, to the extent that the Commission considers delivery of audited financial statements a useful protection for Investment Fund investors, we believe that the proposed Rule amendments should contain further specific exceptions for Investment Funds that cannot deliver financial statements prepared in accordance with GAAP due to their investment in other Investment Funds. So-called "Funds of Funds" have become increasingly popular in recent years. A Fund of Funds' financial statements are necessarily dependent on the nature and timing of the financial statements received from the underlying Investment Funds in which it invests. These factors are largely within the control of the underlying Investment Funds.
Nature of financial statements from underlying Investment Funds. In order for a Fund of Fund's audited financial statements to be considered to have been prepared in accordance with GAAP, all of its underlying Investment Funds' financials must have been prepared in accordance with GAAP. Although many underlying Investment Funds invested in by Funds of Funds of which we are aware deliver audited financial statements annually, frequently these statements are prepared on an adjusted cost or tax basis because the Investment Funds are unable to value certain illiquid investments due to the lack of a liquid market. Consequently, the Funds of Funds can only prepare their audited financial statements on an adjusted cost or tax basis. The principal difference between both these accounting treatments and GAAP is that, due to the lack of information regarding certain of the investments in underlying Investment Funds, such investments are reflected at cost rather than at fair value as required by GAAP. Such statements, if audited, while not prepared in accordance with GAAP, utilize generally accepted auditing standards and are reviewed and opined upon by independent accountants and show the cash position of the Fund of Funds. We believe that such statements, prepared in accordance with recognized and accepted accounting methods, provide appropriate, useful and significant information and disclosure to Fund of Funds investors, although perhaps different than that which would be provided by statements prepared in accordance with GAAP. We recommend that Funds of Funds be permitted to deliver audited financial statements without reference to GAAP or, in the alternative, be permitted to be prepared on an income tax basis or reflecting its underlying investments on an adjusted cost basis.
Timing of receipt of financial statements from underlying Investment Funds. A Fund of Funds must receive audited financial statements from all of its underlying Investment Funds in order to prepare its own statements for distribution to investors. As a result, a Fund of Funds generally cannot realistically be expected to deliver audited financial statements to its investors within the 90 day period proposed in the Proposing Release. We believe that the most important requirement is delivery of financial statements meeting the required standard on an annual basis. We recommend that a Fund of Funds be required to deliver such financial statements as soon as reasonably practicable.5 Alternatively, we suggest that delivery be required within 90 days after receipt of all necessary financial data from underlying Investment Funds.
We believe that it is essential for Funds of Funds to be able to fall within the exception provided in the proposed amended Rule in the Proposing Release.6 If Funds of Funds are not able to fall within the exception, as the Rule is currently proposed they would be required to (1) provide that the Funds of Funds' custodians, if any, deliver monthly account statements to their investors or (2) send quarterly account statements to investors and, more significantly, undergo an annual surprise audit. Whatever benefits there may be from delivery of audited GAAP financials in a shorter period of time (or, if the exception cannot be met, sending frequent account statements and undergoing an annual surprise audit) do not outweigh the increased burden on the adviser or the increased costs to the Funds of Funds (and ultimately their investors). We note that in light of the often illiquid and restricted nature of the investments of Funds of Funds, the potential for misuse of client assets is much more limited than may be the case for other types of investment advisory clients. In addition, such account statements are not as meaningful for Fund of Funds investors as they may be for other types of investment advisory clients, as they would only contain information relating to underlying Investment Fund interests rather than being reflective of securities or other beneficial holdings. It should also be noted that Fund of Funds investors are usually financially sophisticated persons meeting certain financial qualifications under federal law.
We believe that allowing Funds of Funds to deliver audited financial statements within a reasonable period of time following receipt of all necessary financial data from underlying Investment Funds will provide Fund of Funds investors sufficient information about their investments in a reasonable time period consistent with the Commission's goal.
We believe that it is essential that Funds of Funds be able to fall within the exception for Investment Funds provided in the proposed amended Rule, and we respectfully request that the Commission consider expanding the proposed exception to specifically address the concerns of Funds of Funds.
We hope that the Commission will find these comments helpful, and we would be pleased to discuss these matters with members of the Staff at their convenience. Please feel free to contact Hillel Bennett at 212.806.6014 or Janna Manes at 212.806.6141 if the Staff would like to discuss any of these points in further detail.
Very truly yours,
STROOCK & STROOCK & LAVAN LLP
1 Release No. IA-2044 (the "Proposing Release").
2 Referred to in the Proposing Release in the text of the proposed amended Rule as "[a] limited partnership (or limited liability company, or another type of pooled investment vehicle)."
3 Rule 206(4)-2(b)(2) in the text of the amended Rule in the Proposing Release.
4 See text following footnote 49 in the Proposing Release.
5 An Investment Fund is under pressure to deliver tax information to its investors and has no incentive to delay delivery of financial statements.
6 As proposed to be amended, Rule 206(4)-2(b)(2).