Morgan Stanley Alternative Investments, LP
September 25, 2002
Jonathan G. Katz
Re: File No. S7-28-02
Proposed Amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940
Dear Mr. Katz:
We are writing on behalf of Morgan Stanley Alternative Investments, LP ("MSAIP") and Morgan Stanley AIP GP, LP ("MSAIPGP"), each an investment adviser registered with the Securities and Exchange Commission (the "Commission"), (collectively, the "Advisers"1) in response to your request for comments in connection with the proposed amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940, as amended.
Specifically, in connection with the exemption for pooled investment vehicles under proposed Rule 206(4)-2(b)(2), we are requesting that the Commission increase the period within which a pooled investment vehicle must distribute its audited financial statements to limited partners (or other beneficial owners) from 90 days to 180 days of the end of its fiscal year. The increase in the period would enable the Advisers to rely on the exemption by providing the Advisers sufficient time to prepare the pooled investment vehicles' audited financial statements after receiving the audited financial statements from the underlying funds in which the pooled investment vehicles invest.2
1. Rule 206(4)-2
Currently, Rule 206(4)-2 requires each investment adviser that has custody of client assets to deposit client funds in bank accounts and to segregate and identify client securities and hold them
in safekeeping. The Rule also requires the adviser to send quarterly account statements to each client whose assets are in the adviser's custody and to have an independent public accountant conduct an annual surprise examination of the custodied assets.
A firm that acts as both a general partner and an investment adviser to a limited partnership is deemed to have custody of client assets.3 By virtue of its position as general partner, the adviser generally has authority to dispose of funds and securities in the limited partnership's account and thus has custody of those assets.4 Advisers that also act as general partners have avoided application of Rule 206(4)-2 to their activities by relying on no-action and interpretive letters such as Bennett Management Co., SEC Staff Letter (February 26, 1990) and PIMS Inc., SEC Staff Letter (October 21, 1991).5
2. Proposed Amendments to Rule 206(4)-2
The proposed Rule would require advisers that have custody to maintain client funds and securities with a broker-dealer, bank or other qualified custodian.6 If the qualified custodian sends monthly account statements directly to an adviser's clients, the adviser would be relieved of sending its own account statements and undergoing an annual surprise examination, as is the case under the current Rule. As an alternative to having the custodian send monthly account statements directly to an adviser's clients, the adviser can elect to continue sending quarterly account statements to each client that does not receive account statements directly from the qualified custodian and to undergo an annual surprise examination.
The proposed amendments would exempt advisers from the custody rule with respect to clients that are limited partnerships or other pooled investment vehicles if the pooled investment vehicle (i) has its transactions and assets audited at least annually; and (ii) distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or beneficial owners) within 90 days of the end of its fiscal year.
3. The Advisers
Under both Rule 206(4)-2 and the proposed amendments to the Rule, the Advisers have custody of client assets. In their capacity as general partners of the pooled investment vehicles they manage, the Advisers have authority to direct the custodian to convert partnership assets to cash and remit that cash to the Advisers and their affiliates for payment of expenses. Thus, the Advisers must currently either comply with Rule 206(4)-2 or follow the procedures stated in one of the available no-action letters discussed above.
The proposed amendments would make available a complete exemption from the requirements of the amended Rule or, alternatively, from the requirements of the available no-action letters provided the Advisers can provide audited financial statements for the pooled investment vehicles within 90 days of the end of the pooled investment vehicles' fiscal years.
In its Executive Summary to the proposed Rule, the Commission asked for comment on its understanding that the exemption would apply to most limited partnerships, limited liability companies and other pooled investment vehicles. In addition, the Commission requested comments on quantifying the costs advisers incur in connection with the alternative procedures under the staff no-action or interpretive letters in lieu of complying with the annual surprise examination requirement, how many advisers incur such costs, and the reduction in costs that would be available to the Advisers under the amended Rule.
We are proposing that the Commission expand the time frame for preparing and distributing audited financial statements for pooled investment vehicles from 90 days to 180 days to enable the Advisers to rely on the exemption from the proposed amendments.
As noted earlier, the Advisers invest in other pooled investment vehicles. Many of these vehicles will rely on the 90 day deadline in providing their audited financial statements to the Advisers' pooled investment vehicles. As a result, the Advisers may not receive audited financial statements in time to complete the audited financial statements of their pooled investment vehicles within the 90 day deadline.
Moreover, some of the underlying funds in which the Advisers' funds invest are not required to prepare audited financials as frequently as registered funds. For example, some of the underlying funds are commodity pools subject to CFTC regulation. CFTC rules recognize that commodity pools that invest in collective investment vehicles may not be able to obtain information necessary to prepare audited financials within 90 days of the end of the commodity pool's fiscal year. As a result, commodity pool operators can have as long as 150 days of the end of their fiscal year to prepare audited financials.
In the Advisers' experience, financials from these types of funds are typically not received until toward the end of the 150 day period. Thus, any delays are generally based on a commodity pool's reliance on an extension authorized under CFTC rules. Since the Advisers need additional time after they receive audited financials from funds in which they invest to prepare the financials for the pooled investment vehicles they manage, the Advisers believe they need 180 days to prepare and distribute audited financial statements in order to rely on the amended Rule.
Please also note that pooled investment vehicles invest in funds of funds that are exempt from registration under the securities laws. These funds of funds are not statutorily required to deliver audited financial statements by a prescribed date. Instead, the funds of funds' governing documents, such as limited partnership agreements and participation or subscription agreements, establish the time by which the funds of funds must provide audited financial statements to investors. As a result there is a possiblity that investors in funds of funds may not receive audited financial statements from some funds of funds in enough time to prepare their audited financials within the 180 day time period. Thus, we are also requesting that the amended Rule permit pooled investment vehicles to provide their audited financials as soon as practicable after receiving the audited financials from the funds of funds pursuant to the terms of the governing documents.
An expansion of the time frame would give the Advisers adequate time to prepare and distribute the pooled investment vehicles' audited financials after receiving audited financials from the underlying funds without diminishing the protection the proposed Rule is intended to provide. Moreover, the Advisers would be placed at a competitive disadvantage if they could not rely on the exception under the amended Rule merely because they could not comply with this technical requirement.
The Advisers' ability to rely on the proposed exemption (if modified as proposed) would result in savings of cost and time associated with complying with the proposed Rule or with the procedures set forth in the available no-action letters. 7 For example, in complying with the proposed Rule, the Advisers would incur the expense of having a custodian distribute monthly account statements to the Advisers' clients. Moreover, under the no-action letters, the Advisers would need to engage an independent representative to review and authorize the Advisers' withdrawal of funds from the pooled investment vehicles' accounts and to have a custodian to send quarterly account statements to the independent representative. If the Advisers were unable to rely on the proposed exemption, they would incur an expenditure of time and money merely due to not being able to meet a technical requirement of the amended rule. An extension of the time frame to 180 days would easily eliminate this disadvantage.
Finally, as the Commission noted in its Executive Summary, limited partners who are investors establish by contract (e.g., limited partnership agreements and participation or subscription agreements which set forth the rights and responsibilities of limited partners and general partners) a means to protect themselves from the misuse of pooled investment vehicle assets. Thus, a periodic report by auditors may be more useful to investors than receiving monthly reports of the number of transactions in the pooled investment vehicle.
Thank you for your consideration of these comments concerning the proposed amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940.
Please do not hesitate to call me at (212) 762-5260 if you have any questions.
Sincerely, A. Thomas Smith, III