CHARLES SCHWAB & CO., INC.
101 Montgomery Street
San Francisco, California
415-627-7000
Member SIPC/NYSE
September 25, 2002
Via U.S. Mail and Electronic Filing
Mr. Jonathan G. Katz
Secretary
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:
Charles Schwab & Co., Inc. ("Schwab")1 appreciates the opportunity to comment on the Securities and Exchange Commission's recent proposal to amend Rule 206(4)-2 (the "Rule") of the Investment Advisers Act of 1940 ("Advisers Act"). The Rule regulates advisers who have custody of client assets.2
Schwab Supports the Commission's Efforts to Modernize and Clarify the Custody Rule
Schwab supports the proposal subject to our comments in this letter. We believe the proposal represents a significant step toward modernizing investment adviser regulation. Given the importance of advice to the investing public and the related growth in the number of investment advisers and the assets entrusted to them3, this modernization effort is badly needed. Schwab's experience serving advisers has shown us that the application of and compliance with the existing custody rule are not easily understood and are frequently out of step with common arrangements among advisers, their clients and custodians. We applaud the Commission's intent to clarify the rule, make it more transparent, and conform it to modern custodial practices. Our comments are consistent with those goals and are intended to further clarify the Rule's coverage and requirements.
Schwab generally agrees with many of the comments on the proposal we understand are being submitted by certain securities industry groups and other commenters. Many of Schwab's independent investment adviser clients are members of the Investment Counsel Association of America ("ICAA"), and Schwab generally agrees with the comments submitted by the ICAA. Schwab's affiliate, Charles Schwab Investment Management, Inc., is an investment adviser registered with the Commission and a member of the Investment Company Institute ("ICI"), and Schwab generally agrees with the overall comments submitted by the ICI. We believe that the thrust of these groups' comments is consistent with our recommendations, which are as follows:
The Definition of "Custody" Should Reflect Current Widespread Practices Consistent With No-Action Letters
We believe that defining "custody" in the Rule and providing examples of when an advisor will be deemed to have custody can enhance advisors' compliance by reducing confusion about when the Rule applies. The proposed definition and the accompanying examples, however, do not reflect the longstanding no-action positions of the Commission's staff that certain widespread practices are not custody when conditions are satisfied that protect against the adviser's misappropriation of client assets. These common arrangements include (1) advisers who deduct advisory fees from client accounts; (2) advisers who serve as general partners of limited partnerships (or managing members of limited liability companies); and (3) advisers with personnel that act as trustees of client trusts. Reversing the treatment of these arrangements will unduly burden advisers, for example, by requiring amendment of their ADVs and agreements with clients). The treatment of these arrangements as constructive custody may also have unintended adverse consequences, such as triggering increases in advisers' insurance premiums. At the same time, the treatment of these arrangements as constructive custody under the Rule will not enhance investor protection. Accordingly, Schwab opposes inclusion of these arrangements in the Rule's definition of custody.
The Definition of "Custody" Should Not Include the Adviser's Authority to Instruct the Custodian to Disburse Assets to the Client.
We also recommend clarifying the definition of custody to exclude the common arrangement under which an adviser has the authority to instruct the custodian to disburse funds or securities from a client account directly to the client at its address of record with the custodian or to another of the client's accounts of like registration. These arrangements allow advisers to act as agent for their client in managing the client's cash and budgeting through, for example, periodic distributions of income to the client. Because the assets are disbursed by the custodian to the client, not to the adviser or third parties (except, in some cases, pursuant to the client's standing letter of authorization), this arrangement does not present the risk of misappropriation the Rule is designed to protect against.
The Broker-Dealer Exemption from the Rule Should Be Retained
The Rule currently specifically exempts advisers who are also broker-dealers in compliance with the net capital rule. This exemption is based on the rigorous financial responsibility rules that, like the custody Rule, protect against misappropriation or loss of customer assets in firm's control. Like the reversing the traditional treatment of common fee deduction, partnership and trust arrangements discussed above, elimination of the broker-dealer exemption will unduly burden many dual registrant advisers and could result in other unintended consequences without increasing investor protection. Therefore, Schwab recommends that the Commission revise the proposal to retain the broker-dealer exemption.
The Frequency of Custodians' Account Statements Should Conform to the Custodians' Regulatory Requirements
The proposal would permit an adviser with custody of client assets to avoid the cost and other burdens of the Rule's surprise audit requirements if the qualified custodian sends monthly account statements directly to the advisers clients. This frequency would be required even if the custodian's applicable regulatory obligation allowed for less frequent statements (quarterly statements, for example, when there has been no activity in the account). In addition to being inconsistent with qualified custodians' client reporting obligations, this monthly requirement is inconsistent with the proposal's requirement of only quarterly statements when the adviser, rather than the qualified custodian, sends them. Moreover, the proposed monthly statement requirement would not enhance investor protection in the case where a quarterly statement would be permitted under regulations applicable to the qualified custodian because there has been no activity in the account. Thus, Schwab recommends that the frequency of account statements from the qualified custodian be determined by the custodian's regulatory requirements.
Schwab also recommends that the Commission clarify, for purposes of statements delivered by the qualified custodian to the advisor's clients, that statements delivered to the account holder of record (provided the account holder is not the adviser) pursuant to a broker-dealer's obligations under Rule 10b-10 of the Securities Exchange Act of 1934 would meet the requirement of the custody Rule to deliver statements to the adviser's "client." By requesting this clarification, we intend to eliminate any argument that the adviser's "client" is a person or persons other than the account holder (for example, beneficiaries of a trust).
Other Comments
Schwab supports the proposed elimination of the requirement that advisers with custody include their audited balance sheet in Part II of their ADV. We believe the rationale supporting this proposal (better disclosure of adviser financial difficulties under Rule 206(4)-4) also supports eliminating the balance sheet requirement for advisers who require the prepayment of more than $500 in fees per client and six or more months in advance.
Conclusion
Schwab commends the Commission and its staff for this effort to modernize investment adviser regulation, and we support the proposal subject to our comments above. If you have questions about this letter, please contact the undersigned at 415-636-5015 or at david.riggs@schwab.com.
Sincerely,
CHARLES SCHWAB & CO., INC.
David Riggs
Vice President and
Associate General Counsel
cc: Paul F. Roye
Robert E. Plaze
___________________________
| 1 | Schwab is registered with the Commission as both a broker-dealer and an investment adviser. Through its Schwab Institutional division, Schwab renders brokerage, custody, back office and related services to approximately 5,800 independent investment advisers whose clients' accounts with Schwab total approximately $215 billion, making it the leading provider of these services to independent advisers.
| | 2 | Investment Advisers Act Release No. IA-2044 (July 18, 2002) (the "Proposing Release").
| | 3 | See, e.g., Investment Adviser Year 2000 Reports, SEC Release No. IA-1728; IC-23293; File No. S7-20-98 (June 30, 1998) ("Investment advisers play a key role in the economic life of America today.")
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