Securities and Exchange Commission Investment Adviser Year 2000 Reports August 10, 1998 DRAFT 8/7/98 (Riggs) August 10, 1998 Jonathan G. Katz Secretary Securities and Exchange Commission 450 Fifth Street, N.W. Stop 6-9 Washington, D.C. 20549 Re: File No. S7-20-98 -- Investment Adviser Year 2000 Reports Dear Mr. Katz: Charles Schwab & Co., Inc. ("Schwab") appreciates the opportunity to comment on the recent proposal by the Securities and Exchange Commission's ("Commission" or "SEC")* to require most investment advisers registered with the Commission to file reports about their preparations for the Year 2000 computer problem.[1] This letter is also submitted on behalf of Charles Schwab Investment Management, Inc. ("CSIM"), an investment adviser registered with the Commission that serves as adviser to the SchwabFunds, a family of investment companies also registered with the Commission. As discussed below, Schwab generally supports the Commission's proposal. Our comments are intended to enhance the Pproposal's balance between gathering meaningful information about investment advisers' Year 2000 readiness and imposing new reporting requirements on advisers at a time when their resources must be focused on their actual Year 2000 preparations. Schwab is a broker-dealer and is also an SEC registered investment adviser. Through its Schwab Institutional Services for Investment Managers enterprise, Schwab renders brokerage and related services to [over 5,300???] independent investment advisers whose clients' accounts with Schwab total [more that $128 billion???]. Schwab also operates the nation's leading mutual fund supermarket, which allows Schwab's customers to invest in over 1,527[_____???] funds from 246 fund families. Schwab is under common control with Charles Schwab Investment Management, Inc., an investment adviser registered with the Commission that serves as adviser to [the Schwab Funds???], a family of investment companies also registered with the commission. Schwab's own, limited investment advisory services are comprised primarily of impersonal advisory services rendered in connection with its related brokerage services. Schwab Supports The Commission's Efforts To Encourage Year 2000 Preparations By Investment Advisers And Investment Companies Schwab appreciatescommends the Commission's leadership in raising awareness about the critical need of all participants in the securities markets to remediate their computer systems to address the Year 2000 problem. As the market leader both in serving independent investment advisers and in makingoffering mutual funds available through a fund supermarket, Schwab commends the Commission for recognizingacknowledging in its proposal that "investment advisers play a key role in the economic life of America today."* [2] Schwab agrees that timely preparation for the Year 2000 by investment advisers and investment companies is critical to investor protection. As the Commission is aware from its Year 2000 examination of Schwab, Schwab iswe are devoting significant resources to its own Year 2000 preparations. Schwab has also undertaken efforts to increase the Year 2000 awareness of other market participants, particularly the investment advisers whom Schwab serves. and the investment companies whose shares are made available through Schwab. Schwab acknowledges the Commission's effort to take a flexible, common sense approach so that Year 2000 reporting is not unduly burdensome on affected investment advisers.* [3] Schwab strongly encourages the Commission to take a similar approach as it considers changes to its existing rules under the Investment Advisers Act of 1940 (the "Advisers Act") based on the work of the Investment Adviser Task Force in the Division of Investment Management. Schwab Strongly Supports The Commission's Proposal To Not Require Not Require Independent Public Accountant Attestation Of The Reports As proposed, advisers' reports on Form ADV-Y2K would not be required to be attested to by independent public accountants. The Commission requested comment on whether such attestation should be required. Schwab strongly supports the Commission's proposal to not require attestation. As stated in Schwab's comments on the Commission's previous proposal (now adopted) to require Year 2000 reports by broker-dealers and non-bank transfer agents,*[4] requiring independent public accountant attestation of the reports likely will impose costs out of proportion to the value of attestation to the Commission or the public. Moreover, we understand that the accounting profession has raised significant concerns about the ability of independent public accountants to attest to Year 2000 reports.[5] Schwab believes these same problems would affect an attestation requirement for advisers' reports on proposed Form ADV-Y2K and probably to a greater degree. We believe that for many advisers, the cost of engaging an independent public accountants to attest to theirits Year 2000 reports would be prohibitive. Schwab Supports The Proposed "Qualitative Average" Method For Advisers Reporting On The Year 2000 Preparedness Of Multiple Systems In its proposal, the Commission recognized that investment advisers and funds may rely on multiple systems that are at different stages of preparation for the Year 2000. As proposed, Form ADV-Y2K would require the adviser to report based on a "qualitative average" of the preparation of its multiple systems weighted by the criticality of each of the systems on which the average is based. We understand that the Commission intends this to be a flexible approach to "present the most accurate picture practicable" of the preparedness of the adviser's or fund's systems.[6] The Commission requested comment on this approach and alternatives to it. Schwab supports the "qualitative average" approach, and we believe it is more practical than available alternatives. The Commission noted that one alternative would be to require advisers to report preparedness on a system-by- system basis. As the Commission is aware, a key aspect of the Year 2000 problem is the complex interdependencies of multiple systems. An adviser's or fund's own systems have interdependencies among themselves, and they also have interdependencies with vendors' systems and those of other market participants. System-by-system reporting would not efficiently address these interdependencies. The proposed "qualitative average" approach, however, would allow reporting advisers to factor into their reports multiple system interdependencies. In addition, Schwab believes that requiring system-by-system reporting would significantly and unnecessarily increase the burden on advisers preparing the reports. an The Commission Should Provide Safe Harbor Protection For Good Faith Forward-Looking Statements In The Reports As proposed, advisers' reports on Form ADV-Y2K would be made available to the public. Schwab supports perceivemaking the reports publicly available for the reasons noted in the Commission's proposal. Nevertheless, Schwab urges the Commission to provide filing advisers a limited safe harbor from private liability for forward- looking statements contained in the reports and made with a reasonable basis and in good faith. As the Commission has recognizedhas recognized, preparation for the Year 2000 problem is among the most complicated and largest tasks ever undertaken by the securities markets and their participants.* [7] We are sure that the Commission also recognizes the extreme challenge presented by the requirement to report on preparation for a future event that is unprecedented in nature, scope and complexity. By their nature, advisers' reports on preparations for the Year 2000 problem will be forward- looking.[8] Advisers' Year 2000 compliance plans must, by nature, also be dynamic. As an adviser implements its plan, the plan itself and the adviser's preparations for the Year 2000 must continually be updated and adjusted. In addition, due to the complex interdependencies among an adviser's systems and those of third parties with whom the adviser interacts, the information will necessarily be reasonably uncertain.[9] * Inevitably, despite an adviser's good faith and best efforts, some statements in its reports on Form ADV-Y2K may prove to have been erroneous or may become erroneous after the reports are filed. While Schwab agrees that this information is important to securities market participants and the investing public, it is precisely the type of information the reasonable and good faith disclosure of which should not expose advisers to the potential for costly securities fraud litigation. Because the reports will be made public, advisers' clients and other market participants may claim to have relied on them to their detriment and seek redress against the filing advisers. We do not believe that this should be the Commission's intended purpose for the reports or making them publicly available.[10]* Thus, Schwab encourages the Commission to provide a limited safe harbor from private liability for forward-looking statements in advisers' Year 2000 reports. Such a safe harbor could be modeled after that provided to public companies under the Private Securities Litigation Reform Act of 1995.[11]* It would cover only forward-looking statements made with a reasonable basis and in good faith and accompanied by meaningful cautionary disclosure. Without the recommended safe harbor, advisers will be prudent to add disclaimers and other qualifying disclosures in explanatory notes to their answers to the questions of form ADV-Y2K.* Consistent with the Commission's experience with disclosure of this type in other contexts, we believe these disclosures would be comprised largely of boilerplate which would be counter to the otherwise simple, user- friendly, common sense format of the reports. The Commission Should Clarify Registered Investment Company Year 2000 Reporting As proposed, Form ADV-Y2K would require advisers to registered investment companies to complete Part II of the Form with respect to those funds and other funds in the same complex or family. Schwab believes that fund advisers' reports on Form ADV-Y2K will further the protection of fund investors by providing useful information about investment companies' Year 2000 readiness. Schwab suggests that the Form should be clarified to assure that the scope of the information required sufficiently covers a fund's operations, no matter who is responsible for those operations. The questions of Form ADV-Y2K Part II track closely the questions of Part I, but they relate to the fund as opposed to the adviser. The Commission's proposal acknowledges the external, third party management structure of most investment companies. In some cases, a fund's systems and the compliance plans may be under the control not of the fund or its adviser, but rather of some third party service provider, and we understand that some commentators oppose requiring advisers to report on the status of issues outside their direct control. We believe information about Year 2000 readiness is important to investors no matter what the management structure of the fund. Therefore, Schwab recommends that the Commission clarify Part II of Form ADV-Y2K to assure that the reports adequately cover the Year 2000 preparations of all fund service providers whose systems support fund operations, whatever their registration status. Schwab Generally Supports Filing Adviser Year 2000 Reports By Fax Proposed Rule 204-5 would require that reports on proposed Form ADV-Y2K be filed with the Commission exclusively by fax. Paper filings would not be accepted. Instructions to the Form would provide specified fax numbers. The Commission stated in its proposal that it assumes all advisers easily will be able to file the reports by fax. Schwab believes all filing advisers will have access to fax machines. Nevertheless, we are concerned about the potential inability of advisers to file due to problems with the SEC's fax machines. We would expect that a substantial majority of the advisers' reports would be transmitted relatively close to the applicable filing deadlines, and therefore, the Commission's fax machines could be busy, or there could be transmission errors that are not resolved before the applicable filing deadlines. Thus, despite good faith reasonable efforts, advisers could experience problems with timely filing the reports by fax. We understand that this concern is shared by other interested parties who may comment on the proposal, such as the Investment Company Institute (ICI). We support providing a safe harbor for late reports of advisers who makde timely, good faith, but unsuccessful attempts to file by fax. As an alternative, the Commission could allow advisers to choose between filing their Year 2000 reports by fax or in paper. [Finally, Schwab stronglyencouragess the Commission to allow advisers to file Form ADV-Y2K by e-mail, much as it currently allows comment letters such as this to be filed by e-mail. make E-mail a viable medium for filing SEC reports.???] Other Comments Schwab, like many other broker-dealers, is also registered with the Commission as an investment adviser. Under Rule 204-5 as proposed, Schwab would not be required to file Year 2000 reports on Form ADV-Y2K because it does not have $25 million or more in assets under management and is not an investment adviser to a registered investment company. Nevertheless, pursuant to Instruction 2 to Part I of proposed Form ADV-Y2K, CSIM (which is required to file because it does serve as investment adviser to registered investment companies) mightwould appear to be required to include information about Schwab in its reports. This is based on the assumption that, bBecause Schwab and CSIM are under common control, they wcould be deemed "investment adviser affiliates" as that term is used in Instruction 2 to Part I of proposed Form ADV-Y2K. The term "investment adviser affiliates" is not defined in Form ADV-Y2K, proposed Rule 204-5 or, to our knowledge, anywhere else in the Advisers Act or the rules thereunder. Nevertheless, from discussions with members of the staff in the Division of Investment Management, wWe understand that the term may cover SEC registered advisers that, like Schwab, would not be required to file Form ADV-Y2K but are in a control relationship with an adviser, like CSIM, that must file.*[12] We believe no useful purpose would be served by requiring CSIM to include in its reports on Form ADV-Y2K information about theSchwab's Year 2000 preparations of Schwab. Schwab's systems predominately support its business as a broker-dealer. Those systems will be the subject of Year 2000 reports Schwab is required to file under the Commission's recently adopted broker-dealer and transfer agent Year 2000 reporting requirements.* The preparation of those systems for the Year 2000 is also subject to examination by the Commission. As stated above, as an investment adviser, Schwab has no assets under management. Moreover, its investment advisory activities are entirely incidental to its business as a broker-dealer and are virtually all of an impersonal nature. Schwab's investment advisory activities are not heavily reliant upon computer systems, and the systems that support those activities are the same systems supporting Schwab's broker- dealer activities. In addition to being redundant of Schwab's broker-dealer Year 2000 reports, the inclusion of that information would cloud the picture of CSIM's Year 2000 readiness Therefore, the inclusion in CSIM's Year 2000 reports of information about the year 2000 preparations of Schwab's broker-dealer systems would serve no useful purpose andand thereby may, in fact, decrease the usability of CSIM's reports. [13] Schwab strongly recommends that the Commission clarifyrevise the instructions to Form ADV-Y2K reporting requirements for to make clear that the term "investment adviser affiliates." does not include advisers that must file broker-dealer Year 2000 reports with the Commission or that have no assets under management or that render only impersonal advisory services. At a minimum, Tthe Commission could provide in the instructions to the Form that only systems that support the adviser's or an investment adviser affiliate's business as an investment adviser are covered by the report. Systems that support an adviser's activities other than its advisory business would not be covered. The Commission could also address this issue by allowing a SEC registered investment adviser affiliate to voluntarily file its own reports on Form ADV- Y2K in lieu of including information about the affiliate in the reporting adviser's reports as otherwise required by Instruction 2 to Part I. The Commission Should Clarify Registered Investment Company Year 2000 Reporting As proposed, Form ADV-Y2K would require advisers to registered investment companies to complete Part II of the Form with respect to those funds and certain other funds in the same complex or family. The questions of Part II track fairly closely the questions of Part I, but they relate to the fund as opposed to the adviser. Although the Commission's proposal acknowledges the external, third party management structure of most investment companies, we believe that, in may cases, the fund itself will have neither the systems nor the compliance plans contemplated by the proposed wording of the questions in Part II. Therefore, Schwab recommends that the Commission clarify Part II of Form ADV-Y2K to assure that the reports cover the Year 2000 preparations of fund service providers whose systems support fund operations. We believe the following additional comments may clarify certain aspects of Form ADV-Y2K. First, the legend at the bottom of the cover page of the Form should include the word "willfully" following the words "Advisers Act" in the first line, in order for it to accurately reflect Section 207 of the Advisers Act. Second, we note that the first "check-box" of Question 1 (b) in Part I contemplates a written plan, while (d) of that question asks whether the plan is in writing. Third, with respect to Question 2 (c), (e) and (g) of Part I, we suggest that percentages of the adviser's total annual budget allocated to its Year 2000 preparations might be more meaningful than the ranges of dollar amounts of specific Year 2000 budget allocations requested by the question as proposed. Fourth, with respect to Question 5 of both Parts I and II, regarding inventories of systems, we suggest that it may be appropriate to ask advisers to identify their mission- critical systems and those of the funds they advise. This identification could be by basic system type, such as portfolio management, trading, accounting, etc. Second, the wording of Question 10(db) of Part I should be revised to ask whether any vendor of a mission-critical system has not provided assurance that it is undertaking the "steps it reasonably believes are necessary" to prepare the system for the Year 2000. Conclusion Schwab commends the Commission for its continued leadership on the Year 2000 issue. We join the Commission in recognizing the importance of investment advisers and investment companies to the American economy, and we appreciate the Commission's efforts to encourage their Year 2000 preparations by proposing a generally balanced and common sense reporting requirement. Our comments are intended to enhance the balance and practicality of advisers' Year 2000 reports. Sincerely, CHARLES SCHWAB & CO., INC. David E. Riggs Vice President and Senior Corporate Counsel [cc: Barry P. Barbash Director, Division of Investment Management???] **FOOTNOTES** [1]: SEC Release No. IA-1728; IC-23293; File No. S7-20-98 (June 30, 1998)(the "Proposing Release"). [2]: Proposing Release at p. 2. [3]: Schwab believes that completing Part I and filing Form ADV-Y2K may take many advisers longer than the two employee hours the Commission estimates. See Proposing Release, Section VI at p. 6. [4]: See Letter from W. Hardy Callcott, Vice President and Deputy General Counsel, Charles Schwab & Co., Inc., to Jonathan G. Katz, Secretary, SEC, dated April 16, 1998. See also, Reports to be Made by Certain Brokers and Dealers, SEC Release No. 34-40162; File No. S7-7-98 (July 2, 1998) (the "Broker-Dealer Release") and Year 2000 Readiness Reports to be made by Certain Transfer Agents, Release No. 34-40163; File No. S7-8-98 (July 2, 1998). [5]: See the Broker-Dealer Release at Section III.B., p.7. [6]: Proposing Release at p. 3. [7]: See Proposing Release at n. 18 citing Securities Industry Association Year 2000, available at http://www.sia.com/year_2000/index.html. [8]: Certain questions included in proposed Form ADV-Y2K call for answers that are inherently forward-looking. For example, Question 2 of Part 1 asks for information about Year 2000 budget allocations for the years 1999 and 2000. Questions 7, 8 and 9 asks for percentages of completion of various components of an advisers Year 2000 compliance plan. In light of the nature, complexity and scope of preparing for the Year 2000, advisers can only make estimates of all of the steps and tasks necessary to prepare. As preparations proceed, the number or scope of various previously identified steps or tasks will inevitably be revised. Therefore , percentages of completion of currently identified preparatory steps and tasks are also inherently forward-looking and uncertain. [9]: The Commission's recent Interpretive Release providing guidance on Year 2000 disclosure by investment advisers, among others, notes that statements of Year 2000 readiness based on reasonable reliance on third party statements and representations would be forward-looking. See Statement of the Commission Regarding Disclosure of Year 2000 Issues and Consequences by Public Companies, Investment Advisers, Investment Companies, and Municipal Issuers, SEC Release Nos. 33-7558; 34-40277; IA-1738; IC-23366; International Series Release No. 1149 (the "Interpretive Release") [10]: As the Commission discussed in the Interpretive Release, Investment advisers and investment companies have Year 2000 disclosure obligations to their advisory clients and shareholders, respectively, and potential liability attendant thereto separate from the proposed reports on Form ADV-Y2K. See Interpretive Release, Section III.D. at p. 12 [11]: See Securities Act of 1933 Section 27A and Securities Exchange Act Section 21E. [12]: Schwab is registered as an investment adviser with the Commission pursuant to Rule 203A-2 under the Advisers Act. Paragraph (c) of that Rule provides an exemption from Advisers Act Section 203A(a)'s prohibition on Commission registration for advisers controlling, controlled by, or under common control with SEC registered advisers with whom they share the same principal office and place of business. Schwab is under common control with CSIM, which is registered with the Commission, and they share the same principal office and place of business. [13]: Schwab's systems predominately support its business as a broker- dealer. Those systems will be the subject of Year 2000 reports Schwab is required to file under the Commission's recently adopted broker- dealer and transfer agent Year 2000 reporting requirements. See n. 4, above. Schwab does not conduct an investment advisory business separate from its business as a broker-dealer. The systems that support those activities also support Schwab's broker-dealer activities. Schwab has no systems that would be covered by the inclusion of its systems in CSIM's reports that will not be covered in Schwab's broker-dealer reports. 1 28291 SEC IA Y2K COMMT LTR