New York, NY 10019-5389

September 25, 2002


Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609

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

Dear Mr. Katz:

We are writing in response to the request by the Securities and Exchange Commission ("Commission") for comments on proposed amendments to Rule 206(4)-2 under the Investment Advisers Act, i.e., the custody rule. Our comments are based on our own experience and observations, as well as those of our investment management clients. In general, we commend the Commission's efforts to update the rule to reflect modern custodial practices and to provide greater clarity regarding the application and scope of the rule. As described more fully below, however, we ask that the Commission reconsider certain aspects of the proposed amendments, including those with respect to (1) the proposed exemption for the accounts of limited partnerships, limited liability companies and other types of pooled investment vehicles ("Private Funds") and (2) custody by advisers and their affiliates who are "qualified custodians."

A. Private Funds

Proposed Rule 206(4)-2(b)(2) would exempt an adviser from the rule's requirements with respect to the accounts of Private Funds, provided certain conditions are met. Specifically, a Private Fund must: (1) have its transactions and assets audited at least annually and (2) distribute its audited financial statements prepared in accordance with generally accepted accounting principles to all beneficial owners within 90 days of the end to the Private Fund's fiscal year. While we generally support this exemption and expect that it will apply to most Private Funds, we believe that the 90-day deadline will effectively exclude from the scope of the exemption those Private Funds that invest their assets in securities issued by other Private Funds (i.e., "Funds of Funds"). For the reasons described below, we request that the Commission amend the proposed exemption to make it available to any Fund of Funds that meets the audit requirements and distributes its audited financial statements to its beneficial owners within 120 days of the end of the fund's fiscal year.

To illustrate our concern, we note initially that Private Funds often have the same fiscal year end, specifically, December 31. We further note that a Fund of Funds may invest its assets in another Private Fund (an "Investee Fund") that itself may be operated to conform with the proposed exemption and therefore may not provide its investors, including the Fund of Funds, with a copy of its audited financial statements until 90 days from the end of its fiscal year. The Fund of Funds will need to obtain and rely on an Investee Fund's financial statements in order to produce its own audited financial statements. Therefore, if the Fund of Funds does not receive the Investee Fund's audited financial statements until the end of the 90-day period, the Fund of Funds will not be able to meet the requirements of proposed Rule 206(4)-2(b)(2).1 We do not believe that solid policy arguments exist for excluding Funds of Funds from the ability to rely on the proposed exception. In our view, investor interests will not be materially affected if investors in a Fund of Funds agree to receive audited financial statements 30 days later than other Private Funds. Accordingly, we suggest that the Commission revise proposed rule 206(4)-2(b)(2) to permit any Fund of Funds to comply with the proposed exception if it meets the audit requirements and provides its audited financial statements to each of its investors within 120 days of the end of its fiscal year.2

The Commission also has requested comment as to whether it should require advisers relying on proposed Rule 206(4)-2(b)(2) to maintain the assets of Private Funds with a qualified custodian. We believe that most advisers to Private Funds already maintain the assets of those funds with a qualified custodian, such as a prime broker. We caution, however, that certain types of Private Funds, such as private equity funds, often do not invest in securities that can be easily maintained with a qualified custodian. For instance, a private equity fund may make a direct investment in a non-public company and obtain from the company only a signed agreement evidencing the fund's ownership interest. Maintaining the original agreement with a qualified custodian would be awkward and burdensome and would not seem to provide any additional protections to fund investors because the documentation evidencing a fund's direct investment in a non-public company is not fungible. Moreover, the evidence of ownership typically is recorded in more than one place and due to the highly negotiated nature of the transaction, disputes as to ownership interests, even absent the ability of a fund or its adviser to produce a contract, are unlikely. Thus the risk of loss, destruction or theft in these circumstances is minimal. As a result, we urge that the Commission take into consideration these special circumstances in considering whether to require Private Funds to maintain their assets with a qualified custodian in order for their advisers to rely on Rule 206(4)-2(b)(2).3

B. Advisers and Affiliates as Qualified Custodians

Under the proposed amendments to Rule 206(4)-2, the Commission would permit an adviser to maintain its own clients' assets, provided that the adviser meets the definition of a "qualified custodian," complies with the proposed new account statement requirements and adheres to the custody rules imposed by the regulator of the adviser's custody functions. We support the Commission's approach on this issue. We believe that the rules imposed by various regulators on the custody function provide adequate client protections. To that end, we note that current Rule 206(4)-2(b) exempts from the requirements of the custody rule those advisers who are dually registered as broker-dealers under Section 15 of the Exchange Act and generally meet applicable net capital requirements. We are not aware of any significant custody-related abuses that have arisen involving advisers dually registered as broker-dealers and relying on Rule 206(4)-2(b). Similarly, we would not anticipate any significant custody related abuses by advisers who otherwise meet the definition of a qualified custodian and who adhere to the custody rules imposed by the regulator of the adviser's custody functions. For similar reasons, we believe that any adviser affiliate who meets the definition of a qualified custodian should be permitted to maintain the funds and securities of an adviser's clients subject to compliance with the amended rule.4 Accordingly, we support the Commission's proposed approach.

C. Conclusion

We appreciate the Commission's consideration of our comments and we would be pleased to discuss them in greater detail with members of the Commission's staff. Please feel free to contact me at (212) 424-8542 or Ricardo Marano at (212) 424-8113.


              Terrance J. O'Malley

1 We point out that the same timing issues could arise for any Private Fund that invests a portion of its assets in securities issued by another Private Fund that also is operated to conform with proposed Rule 206(4)-2(b)(2).
2 We further suggest that the Commission provide similar relief for any Private Fund that invests any portion of its assets in securities issued by another Private Fund.
3 Similar issues arise for any Private Fund that invests in privately issued equity securities, as well as in bank debt.
4 The Commission staff has previously stated that Rule 206(4)-2 would not apply to an adviser who maintains client funds and securities with an affiliate so long as sufficient separateness exists between the adviser and its affiliate. See Crocker Investment Mgmt. Corp., SEC no-action letter (Apr. 14, 1978). Many of our investment management clients rely on this prior guidance. The proposed rule does not specifically address this prior guidance. Therefore, we ask the Commission to clarify that an adviser either (1) does not have custody of client assets if it continues to rely on the staff's prior guidance in this area or (2) can meet the requirements of the proposed amended rule if the affiliate complies with the proposed new account statement requirements and adheres to the custody rules imposed by the regulator of the adviser's custody functions.