Summary of Comments
on Proposed Amendments to Rule 206(4)-2
Under the Investment Advisers Act of 1940 Addressing
Custody of Funds or Securities of Clients
by Investment Adviser

November 7, 2002

S7-28-02

Prepared by Jamey Basham and Vivien Liu
Division of Investment Management

Table of Contents

List of Commenters

Category and Commenters	Short Name	No.
Investment Advisers and Adviser Representatives
Allen, Archie, Jr.	Allen	11
American Realty Advisors	American Realty	18
Bank One (Banc One Securities Corporation, Banc One Investment Advisors Corporation)	Bank One	28
Charles Schwab & Co., Inc.	Charles Schwab	24
Credit Suisse Asset Management, LLC	Credit Suisse	15&48
Cullinan Associates, Inc.	Cullinan	8
Fiduciary Counselling, Inc.	FCI	27
Foreman, Arlene R.	Foreman	2
Frederic T. Kutscher Associates, Inc.	FTKA	21
Global Trends Investments	Global Trends	46
Great Northern Capital	GNC	6
Hart Advisers, Inc.	HAI	20
Ivy Assets Management Corp.	IAMC	19
Kennedy Associates Real Estate Counsel, Inc.	KAREC	14
Legg Mason, Inc.	Legg Mason	10
Mellon Financial Corporation	Mellon	22
Morgan Stanley Alternative Investments, LP Morgan Stanley AIP GP, LP	Morgan Stanley	37
Northwest Investment Consulting, Inc.	Northwest	7
OppenheimerFunds, Inc.	Oppenheimer	47
PlanMember Securities Corporation	PlanMember	4
Siguler Guff Advisers, L.L.C.	Siguler	44
T. Rowe Price Associates, Inc.	T. Rowe	30
Trade or Professional Associations
The Association of Corporate Credit Unions	ACCU	39
The Financial Planning Association	FPA	36
The Institute of International Bankers	IIB	43
The Investment Company Institute	ICI	40
The Investment Counsel Association of America	ICAA	26
National Association of Real Estate Investment Managers	NAREIM	17
The Ohio Credit Union League	OCUL	29
State Securities Administrators
North American Securities Administrators Association, Inc.	NASAA	38
Law Firms
Financial Services Practice Group of Dechert	Dechert	32
Geltner & Associates, P.C.	Geltner	5
LeBoeuf, Lamb, Greene & MacRae L.L.P.	LeBoeuf	34
McNaul Ebel Nawrot Helgren & Vance	McNaul	23
Morgan Lewis & Bockius LLP	Morgan Lewis	33
Packard and Djinis LLP	Packard	16
Seward & Kissel	S&K	42
Tannenbaum Helpern Syracuse & Hirschtritt LLP.	Tannenbaum	3
Accounting Firms
Arthur F. Bell, Jr. & Associates, L.L.C.	Arthur F. Bll	35
PricewaterhouseCoopers	PWC	41
Others
Collins, David W.	Collins	13
Corporate One FUC	Corporate One	9
Kenck, Fran	Kneck	25
National Regulatory Services	NRS	31
Pantalione, Terri	Pantalione	1
The Advisory Press, Inc.	AP	12
U.S. Central Credit Union	USCCU	45

I. General Comments

On July 18, 2002, the Securities and Exchange Commission ("the Commission") issued a release proposing amendments to rule 206(4)-2, the custody rule under the Investment Advisers Act of 1940 (the "proposed rule"). The comment period closed on Sept. 25, 2002. The Commission received forty-eight comment letters, twenty-three of which were from investment advisers, seven from trade or professional associations, one from state securities administrators, eight from law firms, two from accounting firms, and seven from credit unions and other commenters. This section summarizes the views of those commenters who expressed general views on the proposed rule.¹

Most commenters strongly endorsed the approach of the proposed rule. Commenters commended the Commission's efforts to modernize the rule,² to harmonize the rule with modern custodial practices,³ and to improve its clarity and transparency.⁴ Commenters also applauded the proposed rule for providing greater protection to investors while removing unnecessary compliance procedures.⁵ Several cited the increasing difficulty of applying the body of interpretive guidance that has grown around the rule, and expressed strong approval of the Commission's choice to replace it with a better framework instead of codifying its complexity.⁶

Advisory industry trade groups commended the Commission for providing greater clarity regarding the application and scope of the rule.⁷ The FPA pointed out that uncertainty with respect to the application of the rule had been a compliance issue for years and applauded the proposed clarification of the rule. The ICAA characterized the proposed clarification and transparency to the rule as "much needed". In addition, the ICI credited the proposed rule for eliminating confusion and inefficiencies engendered by staff's various interpretive positions under the current rule.

While an overwhelming majority of commenters expressed their strong support for, and none of the commenters raised opposition to, the overall framework of the proposed rule, commenters expressed concerns about some of the specific proposals, as described in the following sections of this summary.

II. Definition of "Custody"

The current rule does not contain a definition of "custody". The proposed rule would incorporate Form ADV's definition of "custody" into its rule text and provide examples that illustrate the application of the definition.

Commenters were generally in favor of the Commission's decision to incorporate a definition of "custody" into the proposed rule. The ICI pointed out that this approach would provide more transparency to the rule. The ICAA applauded the use of helpful examples. Commenters also requested modifications of the definition.

A. Inadvertent Receipt of Assets

The proposed rule would exclude from the definition of "custody" funds and securities that an adviser received inadvertently if the adviser returns them within one business day.⁸

1. One-Day-Return

Nine commenters objected to the proposed one-day return period.⁹ The ICAA expressed concern that the one-day-return requirement might trigger an adviser's violation of the rule if there is any unintentional delay and suggested that the rule instead require prompt return. Other commenters recommended alternatives ranging from a three-day-return to a "prompt" return.¹⁰

2. Forwarding Assets and Other Suggested Modifications

Commenters requested that the Commission permit an adviser to forward the assets to the client or the client's custodian as long as the adviser notifies the client where the assets have been sent.¹¹ Two of these commenters argued that forwarding assets to clients or clients' custodians would be more efficient than returning them to the senders.¹² Three commenters urged that the Commission permit advisers to forward stock certificates from clients to custodians, arguing that the adviser is no more able to misappropriate such stock than it could misappropriate a third party's check.¹³ One suggested that the Commission add language requiring an adviser to return or forward the assets in the same form as received and to keep record of such return or forwarding.¹⁴

B. Fee Deductions and Other Withdrawals of Funds

Under the proposed rule advisers would have custody if they have the authority to deduct fees or make other withdrawals of funds directly from clients' accounts maintained with custodians.¹⁵

1. Fee Deduction Exception

Fourteen commenters requested the Commission to exclude advisers' authority to deduct fees from the definition of "custody".¹⁶ Eight commenters, including the ICAA and ICI, recommended that the Commission permit an adviser to deduct fees and make other withdrawals from clients' custody accounts without being deemed to have custody if the adviser complies with certain safeguards set forth in the Commission's staff's no-action letters.¹⁷ Three of these commenters noted that such an exception to custody would be consistent with advisers' common assumption that an adviser complying with these safeguards is deemed not to have "custody" of clients' assets.¹⁸ The ICAA pointed out that in the absence of this exception would cause many advisers to revise their Form ADV response from "having no custody" to "having custody", which would not only confuse their clients but also have collateral consequences to advisers' contracts with their clients and third parties such as insurers. Two of the commenters shared the ICAA's concern that insurance premiums for advisers would rise absent an exception.¹⁹ Morgan Lewis expressed concerns that taking away this exception might jeopardize advisers' compliance with other laws and regulations that restrict or prohibit an adviser from having custody of client funds or securities. The ICAA recommended that, if the requested exception is not available, the Commission amend Form ADV, Part 1 to distinguish those who actually hold assets of clients and those who are "deemed" to have custody because they deduct fees or are in other similar circumstances.

2. Further Clarification of "Custody"

Five commenters requested clarification to distinguish an adviser's limited authority to move funds between a client's accounts or to a third party as specified by the client from an adviser's authority to withdraw funds for its own accounts.²⁰ One of these commenters sought additional of examples to the definition establishing that advisers do not have custody simply for giving instructions to custodians for purposes of transactions, dispositions of funds to service providers, or disbursements to clients.²¹ Another similarly recommended that the Commission include examples of "not having custody" where agreements prohibit direct or indirect access to client assets.²² Three other commenters argued that, absent these types of clarifications, the definition would result in a broader scope of "custody" than the one they understand under the current rule.²³

The ICI asked for clarification whether the proposed rule would continue to deem advisers to have custody under certain circumstances when their affiliates maintain their clients' assets and requested specification of circumstances under which advisers have custody through affiliates. One commenter requested clarification that an adviser with multiple lines of business would not be deemed to have custody if custody arises from a line of business apart from its advisory business.²⁴

III. Use of Qualified Custodians

A. Assets Maintained with Qualified Custodians

The proposed rule would require that all client assets, whether funds or securities, be maintained with qualified custodian.²⁵

Commenters supported the requirement that client funds and securities be maintained with qualified custodians.

1. Mutual Fund Shares

The ICI requested modifications to this provision so that an adviser can purchase mutual fund shares on behalf of a client from a fund that records the client's name with the fund transfer agent and sends statements directly to the client.²⁶ The ICI stated that most mutual fund shares are uncertificated securities and that the funds' transfer agents usually record clients' ownership of these fund shares through book-entry. Maintaining these fund shares with a qualified custodian would require these funds shares to be registered under the name of an intermediary that is a qualified custodian. The ICI agued that such a result is not necessary to protect investors and will increase an investor's custodian costs.

2. Certain Privately Offered Securities

Eight commenters urged the Commission to allow advisers to hold certain privately offered securities that are difficult to maintain in accounts with custodians.²⁷ Two commenters suggested narrowing the term "securities" for purposes of the rule to exclude assignments, subscription agreements, loan participations and other customized agreements that are not negotiable instruments, since they cannot be easily re-sold and their non-negotiability creates a significant impediment to their use as collateral for borrowings.²⁸ Commenters cited unnecessary costs, burden, and minimal risk for investors as reasons for calling for such modifications.²⁹

B. Assets Maintained with Foreign Qualified Custodians

The proposed rule would permit a foreign financial institution to maintain securities for which the primary market is in the country where the foreign financial institution is located, and cash and cash equivalents reasonably necessary to effect transactions in those securities.³⁰

Six commenters made suggestions with respect to this provision.³¹ The ICAA pointed out that some advisers manage US securities for non-US clients through non-US custodians and urged elimination of the "primary market" restriction on securities eligible for custody by foreign financial institutions. The ICI stated that the Commission too narrowly defined the assets permissible for custody by foreign financial institutions and expressed concerns that custodial costs for an adviser's overseas clients would increase. One international bank trade association also requested that the Commission permit a foreign qualified custodian to maintain all assets, citing principles of competitive equity as its supporting argument.³² The trade association suggested that the Commission might impose alternative protections for investors' overseas investments, such as limiting foreign qualified custodians to financial institutions that are subject to a regulatory regime governing such activities. Other commenters also favored requiring foreign custodians to be subject to a regulatory regime.³³ One commenter also recommended that if an adviser uses a foreign qualified custodian, it should disclose to its clients that their assets may not receive the same protection when held by foreign custodians.³⁴ Two commenters asked for clarification of "primary market" for those securities that traded both in the US and outside the US.³⁵

C. Definition of Qualified Custodians

Under the proposed rule qualified custodians would include banks, savings associations, broker-dealers, futures commission merchants, and under certain conditions, foreign financial institutions.³⁶

The FPA requested clarification whether independent trust companies supervised by state or federal depository institution regulators may act as qualified custodians. Four comments from credit unions and credit union trade groups urged the Commission to include in the definition of "qualified custodian" corporate credit unions regulated by the National Credit Union Administration ("NCUA").³⁷ These commenters stated that the NCUA has proposed rules to permit these credit unions to offer custodial and safekeeping services. NASAA similarly suggested inclusion of credit unions, if investigation demonstrates that credit unions are subject to regulation of custody functions on an equivalent basis with banks.

IV. Delivery of Account Statements to Clients and Alternative Procedures

The proposed rule would relieve an adviser from requirements to send clients account statements and undergo annual surprise examinations if the adviser has reasonable basis for believing that the qualified custodian sends monthly account statements directly to its advisory clients.³⁸

A. Monthly Statements from Qualified Custodians

Commenters generally responded favorably to replacing the surprise examination requirement with the account statements requirement. One investment adviser, however, expressed concerns that the requirement of monthly statements from qualified custodians would shift the administrative burden from advisers to advisory clients, who must review the statements to protect themselves.³⁹ Two commenters observed that custodians' account statements may confuse investors in pooled investment vehicles due to the lengthy listing of all transactions for the pooled investment vehicle during the period, and stressed the importance of the alternative procedures discussed in section V., below.⁴⁰ Fourteen commenters recommended modifications to the proposed delivery requirement under the rule.⁴¹

1. Frequency of Delivery

Seven commenters called for changing the frequency with which a qualified custodian delivers account statements to clients under the rule.⁴² Some of these commenters suggested that the Commission change the requirement from monthly to quarterly for accounts with no activity, pointing out that the modification would be in line with the current broker-dealer rules under the Exchange Act of 1934 (the "34 Act").⁴³ Others requested that the frequency of account statements delivery from qualified custodians should follow the regulatory requirements under the qualified custodians' respective regulatory regimes.⁴⁴

2. Account Statements Delivered to Designees

The ICI urged that the Commission permit account statements from qualified custodians to be sent to a client's designee, so long as the designee is not the custodian, the adviser, a person associated with the adviser, or a person under common control with the adviser, arguing that this approach would be a parallel to that of rule 10b-10 under the 34 Act.⁴⁵ The ICAA requested clarification that an adviser who acts as a trustee may have account statements from the qualified custodian sent to a grantor of the trust, an independent co-trustee, an attorney for the trust, or a defined beneficiary of the trust, consistent with previous staff letters.

3. Forwarding Qualified Custodians' Account Statements

One commenter asked the Commission to permit advisers to forward qualified custodians' account statements, asserting that the fact that qualified custodians prepared the account statements would provide enough protection to clients.⁴⁶ Another commenter suggested the same procedure for advisers having omnibus accounts, but stated the adviser should also disclose the fact that the account statements are not from the qualified custodians directly.⁴⁷

4. Review of Account Statements

In responding to the Commission's inquiry whether it should explicitly require advisers to review qualified custodians' account statements, three commenters stated that such explicit requirement is not necessary because it is already embedded in an adviser's fiduciary duties.⁴⁸

5. Independent Representatives

One law firm commented that the Commission should permit third party administrators to act as independent representatives, citing costs as the reason prompting the suggestion. Another commenter requested the Commission to permit an independent fund administrator to receive account statements from qualified custodians for pooled investment vehicles and produce account statements for each advisory client based on those statements.⁴⁹

B. Advisers Sending Statements and Undergoing Surprise Examinations

Under the proposed rule, an adviser would continue to be subject to the requirements of sending quarterly statements and undergoing surprise examinations if the qualified custodian does not send monthly statements.⁵⁰

1. Disclosure to Clients

NASAA asserted that if an adviser takes the option to send account statements and undertake surprise examinations, the adviser should disclose to its clients that the account statements come from the adviser rather from the qualified custodian, provide contact information of the qualified custodian for its clients to contact if they choose, and seek prior consent from the client for this option.

2. Dually Registered Advisers and Affiliated Qualified Custodians

Two commenters argued that an adviser acting as qualified custodian or using an affiliate as its qualified custodian should continue to be subject to the surprise examination requirement, with one of these commenters asserting that audit typically performed on the qualified custodian does not provide equivalent protection to the surprise examination.⁵¹ Two others, on the other hand, asserted that surprise examination is not necessary for these advisers.⁵² One of these commenters, a law firm, observed that many of its investment clients rely on the Commission's current interpretation permitting affiliates with sufficient separateness to act as their custodians. It also noted that no significant custody related abuses have resulted from dual registrants maintaining custody.⁵³ Another commenter asserted that prohibition on maintaining custody at affiliated qualified custodians would likely have the effect of causing the firm to move the investment management function of these assets out of the registered investment adviser and into the affiliate itself.⁵⁴

3. Reform of the Surprise Examination

Two commenters, including the PWC, recommended that the Commission reform the surprise examination to replace the current approach of 100% review and confirmation of client assets with the approach of sampling review and confirmation, noting that the recommended change would be more efficient and cost-effective and would provide adequate protection to the investors.⁵⁵ PWC also suggested elimination of the current requirements that examiners issue negative assurance regarding compliance, and permit examiners simply to state whether the examinee has established reasonable compliance procedures. PWC explained that the suggested change is based on a new accounting rule that prohibits accountants from providing negative assurance on compliance.

4. Filing Form ADV-E and Notification of Material Discrepancy

The proposed rule would require an independent accountant performing the annual surprise examination to file a certificate on Form ADV-E with the Commission within 30 days of the examination and to notify the Commission within one business day of finding any material discrepancies during the examination.⁵⁶

PWC wanted clarification that the 30-day period should start to run after the completion of the examination. PWC also sought further clarification of the terms of "finding" and "material discrepancies". The ICI wrote that the one business day period for the independent accountant to notify the Commission of any material discrepancies should run after the accountant has established the basis for believing there is material discrepancy, including after consulting with the adviser.

V. Exceptions

The proposed rule would provide exceptions to the rule with respect to accounts of (1) a registered investment company, or (2) a limited partnership (or another type of pooled investment vehicle) that has its transactions and assets audited annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners within 90 days after year-end.⁵⁷

Commenters generally expressed strong support for the proposed exceptions. Twelve commenters recommended modifications to the proposed exceptions.

A. Financial Statements Prepared According to US GAAP

Three commenters urged that the Commission to permit financial statements for pooled investment vehicles to be prepared according to GAAP of a jurisdiction other than the United States.⁵⁸ Dechert noted that many private funds prepare their financial statements in accordance with GAAP of a jurisdiction other than the United States because they are a fund of funds or their master funds are organized outside the United States and subject to accounting principles applicable to foreign jurisdictions. Commenters also requested that the rule be modified to permit deviation from GAAP, if such deviation is clearly disclosed to the investors and the financial statements are audited according to GAAP. Credit Suisse pointed out that many funds of funds' underlying investment funds frequently prepare their financial statements on an adjusted cost or tax basis rather than market value as required by GAAP, because they are unable to value certain illiquid investments due to the lack of a liquid funds market. Dechert observed that many private funds, in order to more equitably allocate the funds' organizational expenses among investors in the funds, choose to amortize organizational expenses over a five-year period. Such amortization, however, is a deviation from GAAP.

B. Distribution of Audited Financial Statements to Investors

Fourteen commenters made comments on this proposed requirement.⁵⁹ Commenters requested that the Commission extend the period for distributing audited financial statements from 90 days to a longer period (ranging from 120 days to 180 days) for funds of funds. Commenters asserted that the 90-day period is not realistic for funds of funds because they have to wait for the completion of the financial statements of the underlying investment funds before preparing their own financial statements. Commenters pointed out that the Commodity Futures Trading Commission permits an extension of up to 150 days for fund of funds to distribute certain financial information to their clients and that the Commission should adopt similar approach.⁶⁰

C. Application of the Exception to Other Accounts

Several commenters recommended that the Commission extend the audit exception to accounts other than those of pooled investment vehicles.⁶¹ Two commenters requested that the exception be applicable to privately negotiated separate accounts that are contractually subject to annual audit.⁶² They noted that most of the clients of separate accounts they advise are institutional or sophisticated investors and suggested that if necessary, the exception may be limited only to audited separate accounts of "qualified clients". One commenter sought clarification that the audit exception is applicable to a limited liability corporation owned by a single client.⁶³

D. Advisers That Are Broker-Dealers

The proposed rule would eliminate the current exemption for advisers that are broker-dealers.

Three commenters requested that the Commission retain the exemption for dually registered broker-dealers.⁶⁴ One of these commenters, a law firm, noted that a dually registered broker-dealer that did not comply with the monthly statement requirement would be subject to the annual surprise examination requirement, and expressed concerns that the examination would be much more restrictive than the one under broker-dealer rules.⁶⁵ Alternatively, this commenter suggested, the annual examination for dually registered broker-dealers should follow the broker-dealer rule.⁶⁶

VI. Elimination of Balance Sheet Requirement

The proposed rule would eliminate the requirement that advisers with custody send an audited balance sheet to their clients.

Five commenters supported the elimination of balance sheet requirement.⁶⁷ Three of these commenters, including the ICI, recommended elimination of the balance sheet requirement for the advisers with fee prepayments, citing the same reasons as those for eliminating the requirement for advisers with custody.⁶⁸

VII. Comments Covering Miscellaneous Topics

A. Individual Trusts

One commenter sought clarification as to how this proposed rule would affect advisers to individual trusts.⁶⁹ Another commenter recommended that the Commission provide exception to the rule to trustees of a family-related trust.⁷⁰

B. Wrap Accounts

One commenter suggested that the Commission add a provision to the rule addressing wrap accounts, noting that wrap accounts have increased greatly in number.⁷¹