[Federal Register Volume 59, Number 55 (Tuesday, March 22, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-6658]


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[Federal Register: March 22, 1994]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release No. IA-1406; File No. S7-8-94]
RIN 3235-AG06

 

Suitability of Investment Advice Provided by Investment Advisers; 
Custodial Account Statements for Certain Advisory Clients

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Commission is proposing for comment new rule 206(4)-5 
under the Investment Advisers Act of 1940 (``Advisers Act'') that would 
expressly prohibit investment advisers from making unsuitable 
recommendations to clients. Proposed rule 206(4)-5 would make explicit 
advisers' suitability obligations under the Advisers Act.
    The Commission also is proposing new rule 206(4)-6 under the 
Advisers Act to prohibit registered investment advisers from exercising 
investment discretion with respect to client accounts unless they have 
a reasonable belief that the custodians of those accounts send account 
statements to the clients no less frequently than quarterly. Proposed 
rule 206(4)-6 is designed to prevent certain fraudulent practices.

DATES: Comments on the proposals should be received on or before May 
23, 1994.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G. 
Katz, Secretary, Securities and Exchange Commission, 450 5th Street, 
NW., Washington, DC 20549. All comment letters should refer to File No. 
S7-8-94. All comments received will be available for public inspection 
and copying in the Commission's Public Reference Room, 450 5th Street, 
NW., Washington, DC 20549.

FOR FURTHER INFORMATION CONTACT: W. Thomas Conner, Attorney, or Kenneth 
J. Berman, Deputy Office Chief, (202) 272-2107, Office of Disclosure 
and Investment Adviser Regulation, Division of Investment Management, 
450 5th Street, NW., Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission today 
is proposing for comment:
    (1) Rule 206(4)-5 under the Investment Advisers Act of 1940 (15 
U.S.C. 80b-1 et seq.) (``Advisers Act'') to expressly prohibit 
investment advisers from making unsuitable recommendations to clients;
    (2) Rule 206(4)-6 under the Advisers Act to prohibit investment 
advisers registered or required to be registered under the Advisers Act 
from exercising investment discretion with respect to client accounts 
unless they have a reasonable belief that the custodians of those 
accounts send account statements to the clients no less frequently than 
quarterly; and
    (3) Amendments to rule 204-2 (17 CFR 275.204-2) under the Advisers 
Act to require investment advisers subject to the recordkeeping 
requirements of the Advisers Act to maintain (i) information about 
clients obtained by the investment advisers to comply with proposed 
rule 206(4)-5, and (ii) copies of client custodial account statements 
received by the advisers.

I. Introduction

    The Commission is proposing two rules under the antifraud 
provisions of the Advisers Act.1 Rule 206(4)-5 would make express 
the fiduciary obligation of investment advisers to make only suitable 
recommendations to a client, after a reasonable inquiry into the 
client's financial situation, investment experience, and investment 
objectives. Rule 206(4)-6 would prohibit registered investment advisers 
from exercising investment discretion with respect to client accounts 
unless they have a reasonable belief that the custodians of those 
accounts send account statements to the clients no less frequently than 
quarterly.
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    \1\Section 206(4) (15 U.S.C. 80b-6(4)) makes it unlawful for any 
investment adviser, by use of the mails or any means or 
instrumentality of interstate commerce, directly or indirectly, ``to 
engage in any act, practice, or course of business which is 
fraudulent, deceptive, or manipulative.'' Section 206(4) authorizes 
the Commission to adopt rules and regulations defining the acts, 
practices, and courses of business that will be deemed fraudulent, 
deceptive, or manipulative for purposes of section 206(4), and to 
prescribe means reasonably designed to prevent such conduct. The 
Commission has adopted four rules under section 206(4): rule 206(4)-
1 (17 CFR 275.206(4)-1) (advertisements); rule 206(4)-2 (17 CFR 
275.206(4)-2) (custody or possession of funds or securities of 
advisory clients); rule 206(4)-3 (17 CFR 275.206(4)-3) (cash 
payments for client solicitations); and rule 206(4)-4 (17 CFR 
275.206(4)-4) (financial and disciplinary information that 
investment advisers must disclose to clients).
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II. Suitability of Investment Advice

    Investment advisers are fiduciaries2 who owe their clients a 
series of duties,3 one of which is the duty to provide only 
suitable investment advice. This duty is enforceable under the 
antifraud provision of the Advisers Act, section 206,4 and the 
Commission has sanctioned advisers for violating this duty.5 The 
Commission now proposes to make explicit this duty in a new rule under 
section 206(4) of the Advisers Act. The scope of proposed rule 206(4)-5 
reflects the Commission's interpretation of advisers' suitability 
obligations under the Advisers Act.6
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    \2\SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 
191, 194 (1963) (``Capital Gains'').
    \3\These duties include the duty of full disclosure of conflicts 
of interest, Capital Gains at 191-92; utmost and exclusive loyalty, 
In re Kidder, Peabody & Co., Inc., 43 SEC 911, 915 (1968) 
(``Kidder''), Investment Advisers Act Rel. No. 40 (Feb. 5, 1945) 
(staff position stating advisers' duty of loyalty requires full 
disclosure of adverse interests and client consent before purchase 
or sale of securities from clients); and the duty of best execution, 
Kidder at 915-16. See generally 2 Frankel, The Regulation of Money 
Managers 343-47 (discussing general duties of fiduciaries), ch. XIII 
(duty of loyalty), ch. XV (duty of care); Leavell, Investment Advice 
and the Fraud Rules, 65 Mich. L. Rev. 1569 (1967) (discussing legal 
controls on providing investment advice).
    \4\Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 
17 (1979) (Advisers Act's legislative history leaves no doubt that 
Congress intended to impose enforceable fiduciary obligations).
    \5\See, e.g., In re David A. King and King Capital Corp., 
Investment Advisers Act Rel. No. 1391 (Nov. 9, 1993) (investment 
adviser recommended investments in a risky pool of first, second and 
third mortgages to retirees and others of limited means); In re 
George Sein Lin, Investment Advisers Act Rel. No. 1174 (June 19, 
1989) (investment adviser with discretionary investment authority 
invested funds of clients desiring low-risk investments in uncovered 
option contracts and utilized margin brokerage accounts); In re 
Westmark Financial Services, Corp., Investment Advisers Act Rel. No. 
1117 (May 16, 1988) (financial planner recommended speculative 
equipment leasing partnerships to unsophisticated investors with 
modest incomes); In re Shearson, Hammill & Co., 42 SEC 811 (1965) 
(sections 206(1) and (2) violated when adviser recommended 
investments unsuitable to child and widow).
    \6\In addition, in formulating the proposed rule, the Commission 
has looked to interpretations of the scope of broker-dealers' 
suitability obligations under the antifraud provisions of the 
Securities Exchange Act of 1934 [15 U.S.C. 78a et seq.] (``Exchange 
Act''). The federal securities laws, as well as rules of various 
self-regulatory organizations (``SROs''), impose suitability 
requirements on broker-dealers. Under the ``shingle'' theory, a 
broker-dealer makes an implied representation to its customers that 
it will deal with them fairly and in accordance with the standards 
of the profession. Duker & Duker, 6 S.E.C. 386, 388 (1939). A 
broker-dealer that breaches this representation may violate certain 
antifraud provisions of the federal securities laws, namely, section 
17(a) of the Securities Act of 1933 [15 U.S.C. 77q(a)], sections 
10(b) and 15(c)(1) of the Exchange Act [15 U.S.C. 78j(b) and 
78o(c)(1)], and rules 10b-5 and 15c1-2 thereunder [17 CFR 240.10b-5 
and 240.15c1-2]. See, e.g., Hanly v. SEC, 415 F.2d 589 (2d Cir. 
1969); Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), 
cert. denied, 321 U.S. 786 (1943); In re Harold Grill, 41 SEC 321 
(1963). A broker making unsuitable recommendations breaches this 
representation. See, e.g., Clark v. John Lamula Investors, Inc., 583 
F.2d 594 (2d Cir. 1978) (recommended purchase of a convertible 
debenture was unsuitable for the needs of a widowed, retired 
customer, when the broker-dealer failed, among other things, to 
disclose the risks of the investment). This doctrine is incorporated 
into the rules of the SROs. National Association of Securities 
Dealers, Inc. (``NASD'') Rules of Fair Practice, art. III, Sec. 2, 
NASD Manual (CCH) 2152; New York Stock Exchange (``NYSE'') rule 
405, 2 N.Y. Stock Exch. Guide (CCH) 2405 (the ``Know Your Customer 
Rule''). See also Municipal Securities Rulemaking Board (``MSRB'') 
rule G-19, MSRB Manual (CCH) 3591; NYSE rule 472, 2 N.Y. Stock 
Exch. Guide (CCH) 2472.40(1) (``When recommending the purchase, 
sale or switch of specific securities, supporting information must 
be provided or offered.''). Broker-dealers also are required under 
SRO rules to establish and enforce written supervisory procedures 
that are reasonably designed to achieve compliance with the 
applicable securities laws and regulations, including the obligation 
of fair dealing. See, e.g., NASD Rules of Fair Practice, art. III, 
Sec. 27, NASD Manual (CCH) 2177. In addition, broker-dealers must 
comply with specialized suitability rules when recommending certain 
kinds of securities, such as penny stocks and options, or when 
offering to extend, or arrange for the extension of, credit in 
connection with inducing the purchase of a security. See, e.g., 
rules 15g-9 (17 CFR 240.15g-9) (penny stocks) and 15c2-5 (17 CFR 
240.15c2-5) (extensions of credit) under the Exchange Act; NASD 
Rules of Fair Practice, Art. III, Sec. 2, Policy of the Board of 
Governors, NASD Manual (CCH) 2152 (statement of policy concerning 
recommendations of speculative low-priced securities and 
recommendations of or accepting orders for options). Compliance with 
proposed rule 206(4)-5 would not override the obligation of an 
investment adviser that is also a broker-dealer to meet the 
requirements of these rules. Nor would a determination by a broker-
dealer under these rules that a particular investment is suitable 
relieve an investment adviser that is acting as the purchaser's 
adviser in connection with the transaction from making a suitability 
determination under proposed rule 206(4)-5 with respect to the 
investment.
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    As discussed in more detail below, rule 206(4)-5 would prohibit an 
investment adviser from providing investment advice to a client unless 
the adviser makes a reasonable inquiry into the financial situation, 
investment experience, and investment objectives of the client and 
reasonably determines that the investment advice is suitable for the 
client.7 An amendment to rule 204-2 under the Advisers Act would 
require investment advisers subject to the recordkeeping requirements 
of the Advisers Act to maintain records of the information obtained 
from clients in the required inquiry.
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    \7\A similar provision is contained in H.R. 578, the Investment 
Adviser Regulatory Enhancement and Disclosure Act of 1993, which is 
currently pending before Congress.
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1. Duty To Inquire

    Paragraph (a)(1) of rule 206(4)-5 would require an investment 
adviser, before providing any investment advice, and, as appropriate 
thereafter, to make a reasonable inquiry into the client's financial 
situation, investment experience, and investment objectives.8 The 
extent of the inquiry would turn on what is reasonable under the 
circumstances. For example, to formulate a comprehensive financial plan 
for a client, an adviser may be required to obtain extensive personal 
and financial information about the client, including current income, 
investments, assets and debts, marital status, insurance policies, and 
financial goals. This information must be updated periodically so that 
the adviser can adjust its advice to reflect changed circumstances. The 
frequency with which the information must be updated would turn on what 
is appropriate under the circumstances. Among the factors to be 
considered in determining when to update client information would be 
the passage of time since the information was last updated and whether 
the adviser is aware of events that have occurred that could render 
inaccurate or incomplete the information on which it currently bases 
its advice. For example, a change in the tax law or knowledge that the 
client has retired or experienced a change in marital status might 
trigger an obligation to make a new inquiry. Comment is requested on 
whether the proposed rule should specify the minimum frequency for 
making inquiries to update information concerning the client. For 
example, should the rule require that client information be updated no 
less frequently than annually?
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    \8\Rule 206(4)-5 would not apply to impersonal advisory 
services, and references to investment advice in this Release do not 
include impersonal advisory services. Impersonal advisory services 
would be defined in paragraph (b) of proposed rule 206(4)-5 as 
investment advisory services provided solely (1) by means of written 
material or oral statements that do not purport to meet the 
objectives or needs of specific individuals or accounts; (2) through 
the issuance of statistical information containing no expression of 
opinion as to the investment merits of a particular security; or (3) 
any combination of the foregoing services. This definition is 
derived from the definition of ``contract for impersonal advisory 
services'' in rule 204-3 under the Advisers Act [17 CFR 275.204-3]. 
Rule 204-3 requires an adviser to provide clients and prospective 
clients with a written disclosure statement or ``brochure,'' except 
when advisory services are provided in connection with a contract 
for impersonal advisory services.
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    Most advisers conduct an inquiry at an initial client meeting that 
would generally satisfy the proposed requirement.9 Clients are 
typically asked to complete questionnaires that request information 
about each client's current financial situation, financial goals, risk 
tolerance, and any other information that the adviser believes 
necessary to develop recommendations for a financial plan or specific 
investments.10 Clients typically are requested periodically to 
review the information and notify the adviser of any changes.
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    \9\See State and Federal Regulation of Financial Planners: A 
Policy Overview and Model for Reform, Prepared for the American 
Association of Retired Persons Public Policy Institute by Barbara 
L.N. Roper 2-3 (1993) (describing generally accepted standards of 
financial planning that include, among other things, meeting with a 
client at the outset of the engagement to review the client's 
personal finances, risk tolerance, and investment objectives).
    \1\0Financial Planners, Report of the Staff of the United States 
Securities and Exchange Commission to the House Committee on Energy 
and Commerce's Subcommittee on Telecommunications and Finance 8 
(February 1988).
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2. Duty To Give Only Suitable Advice

    Paragraph (a)(2) of rule 206(4)-5 would prohibit an adviser from 
giving advice to a client unless the adviser reasonably determined that 
the advice was suitable to the client's financial situation, investment 
experience, and investment objectives. A reasonable determination of an 
investment's suitability for a client would require, for example, that 
certain kinds of particularly risky investment products be recommended 
only to those clients who can and are willing to tolerate the risks and 
for whom the potential benefits justify the risks.11
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    \1\1The prohibition against providing unsuitable advice would 
apply to advice to institutional clients as well as to individual 
clients. Institutional investors have experienced significant losses 
as a result of recommendations to invest in complex financial 
products that they did not fully understand. See H.R. Rep. No. 255, 
103d Cong., 1st Sess. 30-34 (1993) (municipal governments and 
savings and loan associations experienced widespread losses in U.S. 
Treasury instruments, derivative products, futures transactions, 
options hedging, and mortgage-backed securities recommended by 
dealers). The rationale underlying the duty to make suitable 
recommendations, although developed largely in the context of 
investors who are not deemed to be ``sophisticated,'' applies also 
to those who are ordinarily considered to be ``sophisticated.'' See 
Root, Suitability--The Sophisticated Investor--and Modern Portfolio 
Management, Colum. Bus. L. Rev. 287 (1991).
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    While rule 206(4)-5 would require an investment adviser to have 
reasonably determined that each piece of its investment advice would be 
suitable for the client,12 suitability of the advice would be 
evaluated in the context of the client's portfolio.13 For example, 
an investment adviser may hedge a portfolio of U.S. government bonds 
for a client having very conservative investment objectives, in which 
case the suitability of the hedging instruments would be evaluated in 
light of their hedging function. Thus, inclusion of some risky 
investments in the portfolio of a risk-averse client may not 
necessarily be unsuitable.14
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    \1\2For an account under discretionary management, each trade 
initiated by the adviser would constitute ``advice.'' For a 
discussion of when an account is under discretionary management, see 
infra note 29.
    \1\3A similar standard is applied in determining the prudence of 
an investment made for a retirement plan under the Employee 
Retirement Income Security Act of 1974 (29 U.S.C. 1001 et seq.) (see 
29 C.F.R. 2550.404a-1(a)), and generally in determining the 
suitability of a trustee's investment decision under trust law (see 
Restatement (Second) of Trusts, Sec. 227 commentary (1959)).
    \1\4Conversely, while advice to invest in a particular security 
may be suitable to the needs of a client, advice to make the same 
investment on margin may not be.
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    Proposed rule 206(4)-5's suitability obligation includes the 
requirement that an adviser ``know his client,'' as well as the 
requirement that an adviser ``know his product.'' Lack of actual 
knowledge about the client or the investment products recommended would 
not provide a defense for an adviser unless it would be reasonable for 
the adviser not to have known the information.15 It generally 
would, for example, be reasonable for an adviser to rely on information 
provided by a client (or the client's agent) regarding the client's 
financial circumstances in response to the inquiry required by 
paragraph (a)(1) of proposed rule 206(4)-5, and an adviser should not 
be held to have given unsuitable advice if it is later shown that the 
client had misled the adviser.16 If a client refused to provide 
requested information, however, the adviser could not make assumptions 
about the client that were not reasonable.17 When no other 
information is available, the adviser may have to assume the client has 
no assets or source of income other than the assets the adviser 
manages. If the client refused to provide information upon which an 
adviser could base recommendations, the adviser would be permitted to 
rely upon trustworthy information about the client that it obtains from 
other reliable sources, such as a consultant to the client or other 
intermediary.
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    \1\5See In re Baskin Planning Consultants, Ltd., Investment 
Advisers Act Rel. No. 1297 (Dec. 19, 1991) (adviser failed 
adequately to investigate investment recommendations to clients); In 
re Alfred C. Rizzo, Investment Advisers Act Rel. No. 897 (Jan. 12, 
1984) (investment adviser lacked a reasonable basis for advice and 
could not rely on ``incredible claims'' of issuer of security); In 
re Winfield & Co., Inc., 44 SEC 810, 817-18 (1972) (investment 
adviser to investment company failed to make reasonable 
investigation before causing the company to purchase securities); In 
re Shearson, Hammill & Co., supra note 5.
    \1\6An adviser could not disregard information concerning the 
client's affairs that the adviser knows or should have known.
    \1\7In one case involving a client that turned over 
approximately $100,000 to a broker but refused to provide financial 
information, the Commission explained that the broker had a ``duty 
to proceed with caution; to make recommendations only on the basis 
of the concrete information that [the client] did supply and not on 
the basis of guesswork as to the value of other possible assets.'' 
In re Eugene J. Erdos, 47 SEC 985, 988 (1983), aff'd sub nom. Erdos 
v. Securities and Exchange Commission, 742 F.2d 507 (9th Cir. 1984). 
See also In re Gerald M. Greenberg, 40 SEC 133, 137-38 (1960), 
petition for review dismissed on motion of petitioner sub nom. 
Greenberg v. SEC, 287 F.2d 571 (10th Cir. 1960) (``clear purpose'' 
of NASD suitability rule would be defeated if it were construed as 
permitting a broker-dealer to recommend low price speculative 
securities to ``unknown'' customers ``without any knowledge of or 
attempt to obtain information concerning the customer's other 
security holdings, his financial situation, and his needs so as to 
be in a position to judge the suitability of the recommendation'' 
(citation omitted)).
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    Proposed rule 206(4)-5 would not require that knowledge of an 
affiliate of the adviser be imputed to the adviser if it would be 
unreasonable to expect the adviser to know the information. For 
example, section 204A of the Advisers Act (15 U.S.C. 80b-4a) requires 
that advisers establish, maintain, and enforce written procedures 
designed to prevent insider trading, in which case the adviser may not, 
and should not, have access to certain information about a recommended 
security that an affiliated adviser might have. Comment is requested on 
whether the proposed rule should specify standards that would establish 
a presumption that the knowledge of an affiliate would not be imputed 
to the adviser.

3. Recordkeeping

    The Commission is proposing an amendment to rule 204-2 under the 
Advisers Act to require any investment adviser subject to the 
recordkeeping requirements of the Advisers Act18 to maintain 
records of the information obtained about clients from the inquiries 
the adviser has made in complying with paragraph (a)(1) of proposed 
rule 206(4)-5.19 The proposed recordkeeping requirement would not 
require advisers to memorialize the suitability considerations 
underlying each recommendation to clients. The amendment would require 
advisers to maintain, as part of their records, completed client 
questionnaires, or any other records or documents that the advisers 
have obtained from their client inquiries. These records would assist 
the Commission in determining whether investment advisers have complied 
with rule 206(4)-5. Comment is requested on whether advisers should be 
required to document the bases upon which suitability determinations 
have been made, either in connection with each piece of investment 
advice or in the form of a list of generic investments that the adviser 
has determined are suitable for the client.
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    \1\8Rule 204-2, the general recordkeeping rule under the 
Advisers Act, applies to every investment adviser who makes use of 
the mails or of any means or instrumentality of interstate commerce 
in connection with his or its business as an investment adviser, 
other than one specifically exempted from registration pursuant to 
section 203(b) of the Advisers Act.
    \1\9Proposed paragraph (a)(17) of rule 204-2.
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III. Custodian Account Statements

    Under typical discretionary advisory arrangements, a third-party 
custodian holds client assets and sends account statements to the 
client and copies of the account statements to the client's investment 
adviser.20 These account statements provide clients with 
independent reports of account activity and are designed to permit 
clients to protect themselves against illegal or questionable conduct, 
including inappropriately high levels of trading in their accounts, 
unauthorized transactions, and unsuitable investments.21
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    \2\0Custodial arrangements are typically made with broker-
dealers and banks. Broker-dealers are required to provide account 
statements to customers. For example, the rules of the NASD, the 
NYSE, and the American Stock Exchange (``AMEX'') require member 
broker-dealers to provide account statements to customers at least 
quarterly. NASD Rules of Fair Practice, Sec. 45, art. III, NASD 
Manual (CCH)  9440; NYSE rule 409, 2 New York Stock Exchange Guide 
(CCH)  2409; AMEX rule 419, 2 American Stock Exchange Guide (CCH)  
9439. These rules, however, permit customers to direct delivery of 
statements to investment advisers holding powers of attorney over 
customer accounts. See, e.g., NYSE rule 409(b), 2 New York Stock 
Exchange Guide (CCH)  2409; AMEX rule 420(a), 2 American Stock 
Exchange Guide (CCH)  9440. Commission rules under the Exchange Act 
require a broker-dealer to send account statements to its customers 
under certain circumstances. See, e.g., rule 15g-6 [17 CFR 240.15g-
6] (monthly account statements for penny stock customers); rule 
15c3-2 [17 CFR 240.15c3-2] (quarterly statement concerning use by 
broker-dealer of funds arising out of free credit balance in 
customer's account). See also infra note 21. Commission rules under 
the Advisers Act require an investment adviser that has custody or 
possession of client funds or securities to send to clients account 
statements at least every three months. Rule 206(4)-2 under the 
Advisers Act [17 CFR 275.206(4)-2].
    \2\1Another means of permitting clients to monitor their 
accounts would be to require advisers to have a reasonable belief 
that brokers send confirmations to clients. The Commission is not 
proposing such a requirement. A broker-dealer, however, has an 
obligation under rule 10b-10 under the Exchange Act [17 CFR 240.10b-
10] to send its customers an immediate confirmation with respect to 
each transaction the broker-dealer effects. In the case of an 
account managed by a fiduciary, the customer, rather than the 
fiduciary, is considered to be the customer of the broker-dealer. 
Accordingly, under rule 10b-10, the broker-dealer must send an 
immediate confirmation to the account holder, in addition to any 
confirmation it may send to the account fiduciary; however, an 
account that has given discretionary authority in writing to its 
fiduciary may agree in writing with the broker-dealer effecting its 
trades to waive the receipt of the immediate confirmation required 
by rule 10b-10 if, among other things, the broker-dealer sends the 
discretionary account a statement no less frequently than quarterly 
containing all the information required to be disclosed on the 
immediate confirmation. The customer may not waive this quarterly 
statement. See Securities Exchange Act Rel. No. 33743 (March 9, 
1994) [59 FR 12767 (March 17, 1994)] at note 3.
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    Failure of a custodian to provide account information directly to 
clients may facilitate fraudulent transactions in client accounts, as 
illustrated in the case of Institutional Treasury Management, Inc. 
(``ITM''), a registered investment adviser, and its controlling person, 
Steven Wymer. ITM attracted clients by promising above-market returns 
through the use of sophisticated trading strategies in U.S. Government 
securities. When the strategies not only failed to produce the promised 
returns, but also began to cause substantial losses, Wymer began to 
trade client accounts aggressively, often without the clients' 
knowledge, in an attempt to recover losses. To cover additional losses, 
Wymer began to divert funds from one client account to another.22 
Total client losses as a result of the fraud amounted to approximately 
$104 million.23
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    \2\2On September 29, 1992, the Commission and the U.S. 
Attorney's Office for the Central District of California jointly 
announced a settlement of civil and criminal actions against Wymer. 
Wymer pleaded guilty to nine felony counts, including securities 
fraud, and was ordered to pay $209 million in restitution and 
prejudgment interest to his defrauded clients. Litigation Rel. No. 
13389 (Sept. 29, 1992) (concerning Securities and Exchange 
Commission v. Institutional Treasury Management, Inc., Civil Action 
No. 91-6715 MRR (C.D. Cal. Sept. 25, 1992) and United States v. 
Steven D. Wymer, No. CR 92-2-RG.) In entering his guilty plea before 
the court, Wymer described how he traded in options and other 
speculative investments for accounts with conservative investment 
objectives, and then sent false account statements to clients to 
conceal losses and misappropriation of funds. Transcript of 
Proceedings before the Honorable Richard A. Gadbois, Jr., United 
States v. Steven D. Wymer, No. CR 92-02-(A)-RG (C.D. Cal. Sept. 29, 
1992), at 25.
    \2\3See SEC v. Institutional Treasury Management, Inc., Denman & 
Company and Steven D. Wymer (Civil Action No. 91-6715 RJK) (C.D. 
Cal.) (Commission's Motion for an Order Distributing the Steven D. 
Wymer Qualified Settlement Fund, filed on Dec. 22, 1993).
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    Crucial to Wymer's fraudulent scheme was his ability to persuade 
the custodians of client accounts not to send confirmations and monthly 
statements to his clients.24 Because clients received no 
independent reports of account activities, Wymer was able to 
successfully fabricate false account statements to hide the losses, 
unauthorized transactions, and the misappropriation of client funds and 
securities.25 Other investment advisers have engaged in similar 
fraudulent schemes resulting in substantial client losses.26
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    \2\4Wymer testified before a Congressional subcommittee that he 
selected for his clients only those custodians that agreed to make 
ITM the exclusive recipient of account information. Investment 
Adviser Industry Reform, Hearing before the Subcommittee on 
Telecommunications and Finance of the House Committee on Energy and 
Commerce, 103d Cong., 1st Sess. 88-89 (1993).
    \2\5Id.
    \2\6See, e.g., In re Thomas Walter McKibbin and Equitrust, Inc., 
Investment Advisers Act Rel. No. 1165 (May 1, 1989) (adviser 
invested clients' funds in mutual funds, which sent account 
statements directly to adviser, which, in turn, sent false account 
statements to clients concealing misappropriation of funds); In re 
Robert Schwarz, Inc. and Robert G. Schwarz, Investment Advisers Act 
Rel. No. 1248 (Aug. 31, 1990) (adviser sent false account statements 
to clients concealing markups on municipal bonds purchased from 
broker-dealer, which sent confirmations of the transactions only to 
the adviser).
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    The Commission is proposing for comment new rule 206(4)-6 under the 
Advisers Act as a means reasonably necessary to prevent the type of 
fraudulent conduct in which Wymer and other advisers have 
engaged.27 Rule 206(4)-6 would prohibit an investment adviser 
registered or required to be registered under the Advisers Act from 
exercising investment discretion with respect to a client 
account28 unless it reasonably believed that the custodian of the 
account is providing account statements to the client no less 
frequently than quarterly.29 An adviser would be deemed to have a 
reasonable belief that the custodian is providing account statements if 
the adviser has received copies of client account statements indicating 
that they were sent to clients.30 Comment is requested on whether 
the ``reasonable belief'' standard in the proposed rule is appropriate 
and consistent with the duties of a fiduciary.
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    \2\7In addition, the Commission is proposing an amendment to 
rule 204-2 to require investment advisers subject to the 
recordkeeping requirements of the Advisers Act to maintain in their 
records copies of custodian account statements that are received by 
the adviser. Proposed paragraph (a)(18) of rule 204-2.
    \2\8Proposed rule 206(4)-6 would not apply to an adviser's 
exercise of investment discretion with respect to the assets of 
investment companies registered under the Investment Company Act of 
1940 (15 U.S.C. 80a-1 et seq.) (``1940 Act'') or business 
development companies. The 1940 Act regulates custodial arrangements 
with respect to these assets. Section 17(f) of the 1940 Act (15 
U.S.C. 80a-17(f)) and rules 17f-1, 17f-2, 17f-4, and 17f-5 
thereunder (17 CFR 270.17f-1, 17f-2, 17f-4, and 17f-5) and Section 
59 of the 1940 Act (15 U.S.C. 80a-58).
    \2\9For purposes of rule 206(4)-6, an investment adviser would 
be deemed to exercise investment discretion with respect to an 
account if, directly or indirectly, the investment adviser is 
authorized to determine what securities or other property are 
purchased or sold for the account, or makes decisions as to what 
securities or other property are purchased or sold by or for the 
account, even though some other person may have responsibility for 
those investment decisions. Paragraph (c)(2) of proposed rule 
206(4)-6. This definition is the same as in section 3(a)(35) of the 
Exchange Act [15 U.S.C. 78c(a)(35)].
    \3\0Paragraph (c)(4) of proposed rule 206(4)-6. The adviser 
could not rely on the copy of the account statement as a basis for 
its reasonable belief if the adviser had reason to believe that the 
account statements had not been delivered. Under the proposed rule, 
receipt of a copy of the account statement would not be the 
exclusive means by which an adviser could form a reasonable belief 
that the custodian is providing account statements to the client.
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    In some cases, a client may appoint another person to monitor his 
account and receive communications regarding the account. In such 
cases, proposed rule 206(4)-6 would permit the account statement to be 
sent to the client's designee. In order to prevent the rule from being 
circumvented, the rule would not permit the designee to be the 
custodian, the investment adviser, a person associated with the 
investment adviser, or a person under common control with the 
investment adviser.31 Investment advisers often act as general 
partners of limited partnerships that invest in various types of 
financial instruments. In these cases, the account statement could be 
sent to a designee of the partnership--another general partner, an 
accountant or an attorney--that is not associated with the 
adviser.32 Comment is requested, however, on whether the rule 
should contain specific provisions to address the delivery of account 
statements to limited partnerships. For example, should the rule 
specify that the account statement may, or should, be sent to each 
limited partner? Comment also is requested on how the proposed rule 
should address shares of open-end management investment companies, 
which might not be held by third-party custodians.
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    \3\1Paragraph (c)(1) of proposed rule 206(4)-6. The term 
``person associated with an investment adviser'' is defined in 
section 202(a)(17) of the Advisers Act [15 U.S.C. 80b-2(a)(17)] to 
mean any partner, officer, or director of the investment adviser (or 
any person performing similar functions), or any person directly or 
indirectly controlling or controlled by the adviser, including any 
employee of the adviser.
    \3\2See, e.g., GBU, Inc. (pub. avail. Apr. 22, 1993); PIMS, Inc. 
(pub. avail. Oct. 21, 1991); Bennett Management Company, Inc. (pub. 
avail. Feb. 26, 1991) (general partner not deemed to have custody of 
client assets when it is authorized to make certain draws on 
partnership funds if, before making draws, the general partner 
provides certain information concerning the draws to an independent 
representative of the partnership for review and authorization).
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    The account statement specified in proposed rule 206(4)-6 would be 
required to show all transactions occurring in the account during the 
period covered by the account statement, and the funds, securities, and 
other property in the account at the end of the period.33 The 
Commission requests comment on whether the rule should require other 
information to be provided (e.g., the value of securities positions in 
the account) to assure that clients receive sufficient information to 
monitor account activity.34
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    \3\3Paragraph (b) of proposed rule 206(4)-6.
    \3\4See, e.g., rule 15g-6(d)(2) (17 CFR 240.15g-6(d)(2)) under 
the Exchange Act (requiring market value of penny stocks, if 
determinable, to appear on account statement sent to customer that 
purchases penny stocks).
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    The Commission believes that the proposed rule reflects the 
business practices of most investment advisers and custodians under 
which an account statement showing all account transactions is 
generated by the custodian and delivered directly to the client. Copies 
of account statements are typically provided to the investment adviser, 
and the data is used by the adviser to verify the accuracy of the 
adviser's own records.
    If proposed rule 206(4)-6 is adopted, the Commission anticipates 
delaying the effective date of the rule for a sufficient period to 
permit advisers to confirm that their clients' custodians are providing 
account statements to the clients and, if they are not, to permit 
clients to direct custodians to provide them with account statements. 
An adviser that exercises investment discretion with respect to client 
accounts that cannot form a reasonable belief that the custodians of 
those accounts are sending account statements to clients could not 
continue to provide investment advice to the clients on a discretionary 
basis. Comment is requested on whether a sixty-day delay would be 
sufficient.

IV. General Request for Comments

    Any interested persons wishing to submit written comments on the 
rule proposals that are the subject of this release, suggest additional 
changes, or submit comments on other matters that might have an effect 
on the proposals described in this release, are requested to do so.

V. Summary of Initial Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis in accordance with 5 U.S.C. 603 regarding the proposed rules 
and rule amendments. The analysis notes that proposed rule 206(4)-5 
makes explicit an adviser's current obligation under the Advisers Act 
to make a reasonable inquiry into a client's financial situation, 
investment experience, and investment objectives, and, thereafter, to 
reasonably determine that investment advice is suitable for the client. 
Proposed paragraph (a)(17) of rule 204-2 would require investment 
advisers to retain for Commission inspection the client questionnaire 
or other records or documents received by the adviser in response to 
the inquiry that would be required by proposed rule 206(4)-5. The 
Commission does not have information on how many investment advisers 
that are ``small entities'' under the Advisers Act (``small advisers'') 
do not currently record this information. The Commission believes, 
however, that the costs involved in doing so would not be significant 
and would be outweighed by the benefits to clients.
    The analysis also notes that proposed rule 206(4)-6 would prohibit 
a registered investment adviser from exercising investment discretion 
with respect to client accounts unless it has a reasonable belief that 
the custodians of those accounts send account statements to the clients 
no less frequently than quarterly. The analysis notes that most 
custodians already provide account statements to clients, and in many 
cases also send copies of account statements to the clients' investment 
advisers. The Commission believes that the costs involved with sending 
these statements to clients and to advisers would not be significant, 
and would be outweighed by the benefits to clients. Proposed paragraph 
(a)(18) of rule 204-2 would require investment advisers to maintain 
copies of client custodial account statements received by the adviser. 
The Commission believes that the costs associated with retaining these 
copies would not be significant and, in any event, would be outweighed 
by the benefits to the Commission's adviser examination program.
    The analysis notes that alternatives to the proposals were 
considered, including establishing different compliance or reporting 
requirements or timetables that would take into account the resources 
available to small advisers, and the simplification of compliance and 
reporting requirements for small advisers. The Commission also 
considered the use of performance rather than design standards, and the 
exemption of small advisers from coverage of part or all of the 
proposed amendments. The Commission concluded that the alternatives 
would not be as effective as the proposals in assuring that the 
suitability standard is understood and adhered to by all advisers and 
that all discretionary clients are provided with independent reports to 
monitor account activity. A copy of the Initial Regulatory Flexibility 
Analysis may be obtained by contacting W. Thomas Conner, Office of 
Disclosure and Investment Adviser Regulation, Division of Investment 
Management, Securities and Exchange Commission, 450 5th Street, NW., 
Washington, DC 20549.

VI. Statutory Authority

    The Commission is proposing rules 206(4)-5 and 206(4)-6 under the 
authority set forth in sections 206(4) and 211(a) of the Advisers Act 
(15 U.S.C. 80b-6(4) and 80b-11(a)).
    The Commission is proposing amendments to rule 204-2 under its 
authority in sections 204 and 211(a) of the Advisers Act (15 U.S.C. 
80b-4 and 80b-11(a)).

Text of Proposed Rules and Rule Amendments

List of Subjects in 17 CFR Part 275

    Investment advisers, Fraud, Reporting and recordkeeping 
requirements.

    For the reasons set out in the preamble, title 17, chapter II of 
the Code of Federal Regulations is proposed to be amended as follows.

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

    1. The general authority for part 275 is revised to read as 
follows:

    Authority: 15 U.S.C. 80b-3, 80b-4, 80b-6(4), 80b-6A, 80b-11, 
unless otherwise noted.
* * * * *
    2. By adding paragraphs (a)(17) and (a)(18) to Sec. 275.204-2 to 
read as follows:


Sec. 275.204-2  Books and records to be maintained by investment 
advisers.

    (a) * * *
    (17) With respect to each client (other than a client to which the 
adviser provides only impersonal advisory services), completed client 
questionnaires, or other records or documents received by the 
investment adviser in response to the inquiry made by the investment 
adviser into the client's financial situation, investment experience, 
and investment objectives required by Sec. 275.206(4)-5.
    (18) With respect to each client (other than an investment company 
registered under the Investment Company Act of 1940 (15 U.S.C. 80a-1 et 
seq.) or a business development company), copies of account statements 
sent to such client by the custodian of such client's account that were 
also received by the adviser.
* * * * *
    3. By adding Sec. 275.206(4)-5 to read as follows:


Sec. 275.206(4)-5  Suitability of investment advice.

    (a) It shall constitute a fraudulent, deceptive, or manipulative 
act, practice, or course of business within the meaning of section 
206(4) of the Act (15 U.S.C. 80b-6(4)) for any investment adviser to 
provide investment advice to any client, other than in connection with 
impersonal advisory services, unless the adviser:
    (1) Before providing any investment advice, and as appropriate 
thereafter, makes a reasonable inquiry into the client's financial 
situation, investment experience, and investment objectives; and
    (2) Reasonably determines that the investment advice is suitable 
for the client.
    (b) For purposes of this section, the term impersonal advisory 
services shall mean investment advisory services provided solely:
    (1) By means of written material or oral statements that do not 
purport to meet the objectives or needs of specific individuals or 
accounts;
    (2) Through the issuance of statistical information containing no 
expression of opinion as to the investment merits of a particular 
security; or
    (3) Any combination of the foregoing services.
    4. By adding Sec. 275.206(4)-6 to read as follows:


Sec. 275.206(4)-6  Custodial account statements.

    (a) It shall constitute a fraudulent, deceptive, or manipulative 
act, practice, or course of business within the meaning of section 
206(4) of the Act (15 U.S.C. 80b-6(4)) for any investment adviser 
registered or required to be registered pursuant to section 203 of the 
Act (15 U.S.C. 80b-3) to exercise investment discretion with respect to 
a client account (other than the account of an investment company 
registered under the Investment Company Act of 1940 (15 U.S.C. 80a-1 et 
seq.) or a business development company), unless the investment adviser 
reasonably believes that the custodian of the client account is 
providing to the client or its designee an account statement described 
in paragraph (b) of this section not less frequently than once every 
three months.
    (b) The account statement required by paragraph (a) of this section 
shall show, for the period of the account statement:
    (1) All transactions occurring in the account during the period; 
and
    (2) The funds, securities, and other property in the account at the 
end of the period.
    (c) For purposes of this section:
    (1) The client's designee shall not be the custodian, the 
investment adviser, a person associated with the investment adviser, or 
a person under common control with the investment adviser;
    (2) An investment adviser exercises investment discretion with 
respect to an account if, directly or indirectly, the investment 
adviser:
    (i) Is authorized to determine what securities or other property 
shall be purchased or sold by or for the account; or
    (ii) Makes decisions as to what securities or other property shall 
be purchased or sold by or for the account even though some other 
person may have responsibility for those investment decisions;
    (3) A person (other than the client) is a custodian of a client 
account if it has custody or possession of any securities or other 
property in which the client has any beneficial interest; and
    (4) An adviser shall be deemed to have a reasonable belief that the 
custodian has provided a particular account statement to the client or 
its designee if the adviser has received a copy of such statement 
indicating that it has been sent to the client, provided that the 
adviser has no reason to believe that the account statement has not 
been delivered to the client.

    By the Commission.
    Dated: March 16, 1994.

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-6658 Filed 3-21-94; 8:45 am]
BILLING CODE 8010-01-P