[Federal Register Volume 67, Number 143 (Thursday, July 25, 2002)]
[Proposed Rules]
[Pages 48579-48592]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-18698]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 275 and 279

[Release No. IA-2044; File No. S7-28-02]
RIN 3235-AH 26


Custody of Funds or Securities of Clients by Investment Advisers

AGENCY: Securities and Exchange Commission (the ``Commission'').

ACTION: Proposed rule.

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SUMMARY: The Commission is proposing amendments to the custody rule 
under the Investment Advisers Act of 1940. The proposed amendments 
would modernize the rule by, among other things, requiring advisers 
that have custody of client assets to maintain those assets with 
broker-dealers, banks, or other qualified custodians. The amendments 
also would clarify circumstances under which an adviser has custody of 
client assets. The amendments are designed to conform the rule to 
modern custodial practices and enhance protections for client assets 
while reducing burdens on advisers that have custody of client assets.

DATES: Comments must be received on or before September 25, 2002.

ADDRESSES: To help us process and review your comments more 
efficiently, comments should be sent by one method only.
    Comments should be submitted in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, 
Washington, D.C. 20549-0609. Comments may also be submitted 
electronically at the following E-mail address: [email protected].

[[Page 48580]]

All comment letters should refer to File No. S7-28-02; this file number 
should be included on the subject line if E-mail is used. Comment 
letters will be available for public inspection and copying in the 
Commission's Public Reference Room, 450 Fifth Street, NW, Washington, 
D.C. 20549. Electronically submitted comment letters also will be 
posted on the Commission's Internet web site (http://www.sec.gov).\1\*COM019*
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    \1\ We do not edit personal or identifying information, such as 
names or E-mail addresses, from electronic submissions. Submit only 
information you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: Vivien Liu, Senior Counsel, or 
Jennifer L. Sawin, Assistant Director, at 202-942-0719 or 
[email protected], Office of Investment Adviser Regulation, Division of 
Investment Management, Securities and Exchange Commission, 450 Fifth 
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Street, NW, Washington, D.C. 20549-0506.

SUPPLEMENTARY INFORMATION: The Commission is requesting public comment 
on the proposed amendments to rule 206(4)-2 [17 CFR 275.206(4)-2] \2\ 
under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (the 
``Advisers Act'' or ``Act'') and to Part II, Item 14 of Form ADV [17 
CFR 279.1].
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    \2\ Unless otherwise noted, when we refer to rule 206(4)-2 or 
any paragraph of the rule, we are referring to 17 CFR 275.206(4)-2 
of the Code of Federal Regulations in which the rule is published.
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Table of Contents

Executive Summary

I. Background
II. Discussion
    A. Definition of Custody
    B. Use of Qualified Custodians
    C. Delivery of Account Statements to Clients
    D. Exemptions
    1. Registered Investment Companies
    2. Pooled Investment Vehicles
    3. Registered Broker-Dealers
    E. Amendments to Part II of Form ADV
III. General Request for Comment
IV. Cost-Benefit Analysis
V. Paperwork Reduction Act
VI. Initial Regulatory Flexibility Analysis
VII. Statutory Authority
Text of Proposed Rule

Executive Summary

    Rule 206(4)-2 under the Advisers Act requires each investment 
adviser that has custody of client funds or securities 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.
    The Commission is proposing to amend rule 206(4)-2 to reflect 
modern custodial practices and clarify circumstances under which an 
adviser has custody of client assets and thus must comply with the 
rule. The amendments would require advisers that have custody to 
maintain client funds and securities with a broker-dealer, bank or 
other ``qualified custodian.'' If the qualified custodian sends monthly 
account statements directly to an adviser's clients, the adviser would 
be relieved from sending its own account statements and undergoing an 
annual surprise examination. The proposed amendments would exempt 
advisers from the custody rule with respect to clients that are 
registered investment companies or are limited partnerships or other 
pooled investment vehicles that are subject to annual audit by an 
independent public accountant. The proposed amendments would also add a 
definition of ``custody'' to the rule and illustrate circumstances 
under which an adviser has custody of client assets. Finally, the 
proposed amendments would remove the requirement in Form ADV that 
advisers with custody include an audited balance sheet in their 
disclosure brochure to clients.

I. Background

    Rule 206(4)-2 requires advisers to protect the assets that their 
clients have entrusted to their custody. We adopted the rule in 1962, 
shortly after Congress amended the Advisers Act to give us rulemaking 
and inspection authority under the Act's anti-fraud provisions.\3\ A 
key factor prompting us to ask Congress for this authority was concern 
about the custodial practices of advisers and the safety of client 
assets.\4\
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    \3\ Amendments to the Advisers Act (Pub. L. 86-750, 86th Cong., 
2nd Sess., 74 Stat. 885, 1960) (amending sections 206(4) and 204 of 
the Advisers Act); Adoption of Rule 206(4)-2 under the Investment 
Advisers Act of 1940, Investment Advisers Act Release No. 123 (Feb. 
27, 1962) [27 FR 2149 (Mar. 6, 1962)].
    \4\ See Securities Act Amendments, 1959: Hearings Before House 
Committee on Interstate and Foreign Commerce, 86th Cong., 107 (1959) 
(statement of Edward Gadsby, Chairman of the Securities and Exchange 
Commission). See also Securities and Exchange Commission, Protection 
of Clients' Securities and Funds in Custody of Investment Advisers: 
Report on Embezzlement of Clients' Securities and Recommendations 
for Amending the Investment Advisers Act of 1940 (1945) (describing 
various frauds involving advisers' embezzlement of client assets and 
recommending the Commission be given authority to regulate advisers' 
custodial practices); Investment Advisers Act Release No. 39 (Jan. 
31, 1945).
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    Rule 206(4)-2 applies to advisers that are registered with the 
Commission and that have custody of client funds or securities.\5\ 
Under the rule, the adviser must deposit client funds in bank accounts 
that contain only client funds, and must segregate and identify client 
securities and hold them in a reasonably safe place.\6\ Immediately 
after accepting custody of a client's funds or securities, the adviser 
must notify the client of where and how they will be maintained.\7\7 
Each quarter, the adviser must send clients account statements, and at 
least once each year, the adviser must have an independent public 
accountant conduct a surprise examination of all client funds and 
securities in the adviser's custody.\8\
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    \5\ As of June 2002, 867 advisers (approximately 11% of the 
7,583 investment advisers registered with the Commission) reported 
on their Form ADV that they had custody of client funds or 
securities.
    \6\ Rule 206(4)-2(a)(1) and (2).
    \7\ Rule 206(4)-2(a)(3).
    \8\ Rule 206(4)-2(a)(4) and (5).
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    We have not amended rule 206(4)-2 substantively since we adopted it 
over forty years ago.\9\ Since then, custodial practices have changed 
and, as a result, portions of the rule have become outdated or 
inconsistent with modern custodial practices.\10\ Advisers' business 
practices also have evolved, increasing the likelihood that advisers 
may obtain custody of client assets in circumstances that we may not 
have anticipated in 1962.\11\ Our staff has attempted to

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accommodate these evolving business practices, and to reduce 
unnecessary compliance burdens on advisers, by issuing numerous no-
action and interpretive letters and releases that helped to clarify the 
operation of the rule.\12\ Many underlying issues remain, however, that 
can be resolved only through amendments to the rule. In addition, the 
accumulated guidance in these no-action and interpretive letters, while 
helpful to advisers, has diminished the transparency of the rule's 
requirements because an adviser seeking to understand the rule must 
review a large body of letters in addition to the rule itself.
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    \9\ Rule 206(4)-2 has been amended twice. In 1989, we amended 
the rule to require accountants conducting surprise examinations to 
include Form ADV-E [17 CFR 279.8] as a cover page when filing 
examination certificates with us. See Forms for Filing by 
Accountants, Investment Advisers Act Release No. 1181 (July 26, 
1989) [54 FR 32048 (Aug. 4, 1989)]. In 1997, as part of implementing 
Title III of the National Securities Markets Improvement Act of 1996 
(Pub. L. 104-290, 110 Stat. 3428), we amended the rule so that it 
applies only to advisers registered (or required to be registered) 
with us. See Rules Implementing Amendments to the Investment 
Advisers Act of 1940, Investment Advisers Act Release No. 1633 (May 
15, 1997) [62 FR 28112 (May 22, 1997)].
    \10\ For example, the rule requires an adviser to segregate, 
identify and safe-keep client securities. See rule 206(4)-2(a)(1). 
This requirement assumes that securities are held in physical 
certificates. Most securities are now, however, held through book-
entry in custodians' accounts with securities depositories. See 
Custody of Investment Company Assets with a Securities Depository, 
Investment Company Act Release No. 25266 (Nov. 15, 2001) [66 FR 
58412 (Nov. 21, 2001)] at n.7 and accompanying text. See also James 
Rogers, Policy Perspectives on Revised UCC Article 8, 43 UCLA L. 
Rev. 1431 (1996).
    \11\ For example, many firms today have (as general partners) 
formed limited partnerships through which they provide advisory 
services (as investment advisers). Form ADVs submitted by advisers 
registered with us show that as of May 16, 2002, 2560 advisers act 
(or have related persons that act) as general partners to limited 
partnerships or as managing members to limited liability companies. 
Advisers that serve as both general partner and adviser generally 
have custody over the assets of the limited partnerships. See infra 
Section II. A of this Release.
    \12\ Our Division of Investment Management has issued 
approximately 90 no-action and interpretive letters, and one 
interpretive release, under the rule. See Investment Advisers; 
Uniform Registration, Disclosure, and Reporting Requirements; Staff 
Interpretation, Investment Advisers Act Release No. 1000 (Dec. 3, 
1985) [50 FR 49835 (Dec. 5, 1985)].
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    Today, as part of our ongoing effort to review and modernize 
federal securities law, we are proposing comprehensive amendments to 
rule 206(4)-2 under the Advisers Act. The amendments, which we describe 
in more detail below, are designed to enhance the protections afforded 
to advisory clients' assets, harmonize the rule with current custodial 
practices, and clarify circumstances under which advisers have custody 
of client assets.

II. Discussion

A. Definition of Custody

    Currently, we define ``custody'' in our instructions to Form 
ADV.\13\ We propose to incorporate that definition into rule 206(4)-2, 
provide examples that illustrate the application of the definition, and 
include, within the rule, a limited exception for advisers that 
inadvertently receive client assets.
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    \13\ Advisers use Form ADV to register with us. We amended 
instructions to Form ADV in 1985 to, among other things, explain 
that an adviser has custody if it directly or indirectly holds 
client funds or securities, has any authority to obtain possession 
of them, or has the ability to appropriate them. See Glossary of 
Terms, Form ADV; Uniform Investment Adviser Registration Application 
Form, Investment Advisers Act Release No. 991 (Oct. 15, 1985) [50 FR 
42903 (Oct. 23, 1985)].
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    The proposed definition would provide that an adviser has custody 
of client assets when it holds, ``directly or indirectly, client funds 
or securities or [has] any authority to obtain possession of them.'' 
\14\ Accordingly, an adviser must comply with the rule when it has 
access to client funds and securities as well as when the adviser holds 
those assets. In either circumstance, clients are at risk that their 
assets may be lost, misused, misappropriated, or subject to the 
adviser's financial reverses.\15\
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    \14\ Proposed rule 206(4)-2(c)(1).
    \15\ See Proposal to Adopt Rule 206(4)-2 under the Investment 
Advisers Act of 1940, Investment Advisers Act Release No. 122 (Nov. 
6, 1961) [26 FR 10607 (Nov. 10, 1961) (the custody rule was designed 
to require investment advisers to maintain client funds and 
securities ``in such a way that they will be insulated from and not 
be jeopardized by any unlawful activities or financial reverses, 
including insolvency, of the investment adviser.''). See also supra 
note 3.
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    We propose to include, in the definition, three examples designed 
to illustrate circumstances under which an adviser has custody of 
client assets.\16\ The first example clarifies that an adviser has 
custody when it has any possession or control of client funds or 
securities.\17\ An adviser that holds clients' stock certificates or 
cash, even temporarily, puts those assets at risk of misuse or loss. We 
recognize, however, that an adviser may inadvertently receive client 
assets when a third party sends funds or securities to a client via the 
adviser, or when a client attempts to route funds or securities to his 
custodian through the adviser's office. To avoid causing an adviser to 
violate the rule inadvertently as a result of actions by other persons, 
the rule would expressly exclude inadvertent receipt by the adviser of 
client funds or securities, so long as the adviser returns them to the 
sender within one business day of receiving them.\18\ We also propose 
to clarify that an adviser's possession of a check drawn by the client 
and made payable to a third party will not be considered possession of 
client funds for purposes of the custody definition.\19\ The client's 
relationship with the drawee bank should provide the client with 
protections comparable to the protections the proposed rule would 
provide.\20\
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    \16\ While these examples represent some of the most common 
circumstances, there are other circumstances in which an adviser may 
have custody of client assets. An adviser may, for example, have 
custody if its affiliate holds assets of the adviser's clients and 
the adviser either controls the affiliate's operations or has access 
to the client assets through the affiliate. See section 208(d) of 
the Advisers Act [15 U.S.C. 80b-8(d)] (adviser may not, indirectly 
or through or by any other person, do any act or thing that would be 
unlawful for the adviser to do directly). Our staff previously has 
expressed similar views. See Crocker Investment Management Corp., 
SEC Staff Letter (Apr. 14, 1978); Ryder Stilwell Investment 
Advisers, SEC Staff Letter (Nov. 22, 1988); Baker, Jongewaard & 
Levenson Financial Planning Group, Inc., SEC Staff Letter (Feb. 24, 
1989); Penn Davis McFarland, Inc., SEC Staff Letter (Apr. 2, 1990).
    \17\ Proposed rule 206(4)-2(c)(1)(i).
    \18\ Our staff has issued no-action letters agreeing not to 
recommend enforcement action to the Commission if an adviser failed 
to comply with rule 206(4)-2 in such circumstances. See Hayes 
Financial Services, Inc., SEC Staff Letter (Apr. 2, 1991).
    \19\ Checks payable to an adviser for payment of advisory fees 
or similar fees due to the adviser also do not represent client 
funds within the meaning of the custody rule and therefore advisers 
would not have custody as a result of receiving those checks. An 
adviser would, however, have custody of client funds if it holds a 
check drawn by the client and made payable to the adviser with 
instructions to pass the funds through to a custodian or to a third 
party.
    \20\ The client's relationship with the drawee bank provides the 
client with periodic statements and other sources of information 
regarding the disposition of the check.
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    The second example clarifies that an adviser has custody if it has 
the authority to withdraw funds or securities from a client's 
account.\21\ An adviser with power of attorney to sign checks on a 
client's behalf, to withdraw funds or securities from a client's 
account, or to dispose of client assets for any purpose other than 
authorized trading has access to the client's assets.\22\ Similarly, an 
adviser authorized to deduct advisory fees or other expenses directly 
from a client's account has access to, and therefore has custody of, 
the client funds and securities in that account.\23\ These advisers 
might not have possession of client assets, but they have the authority 
to obtain possession.
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    \21\ Proposed rule 206(4)-2(c)(1)(ii).
    \22\ See Glossary of Terms, Form ADV (entry for Custody states 
that an advisory ``firm has custody, for example, if it has a 
general power of attorney over a client's account or signatory power 
over a client's checking account''). The Commission staff also has 
interpreted the rule in this manner in several letters. See, e.g., 
Eugene Kaufman Inc., SEC Staff Letter (Jan. 7, 1982); Howard J. 
Gordon Investments, SEC Staff Letter (Dec. 1, 1982); Baldwin 
Brothers Inc., SEC Staff Letter (Sept. 1, 1989); and Baker, 
Jongewaard & Levenson Financial Planning Group Inc., SEC Staff 
Letter (Feb. 24, 1989).
    \23\ We understand many advisers rely on a series of staff no-
action letters to avoid application of the rule when they have 
authority to withdraw their advisory fees from client assets (and, 
in the case of general partners, withdraw capital from the 
partnerships) that are otherwise held by an independent custodian. 
See, e.g., Investment Counsel Association of America, Inc., SEC 
Staff Letter (June 9, 1982); John B. Kennedy, SEC Staff Letter (June 
5, 1996); and Securities America Advisors Inc., SEC Staff Letter 
(Apr. 4, 1997). The no-action assurances in these letters are 
conditioned on the advisers' use of alternative procedures to 
protect client assets, including an independent custodian's periodic 
delivery, to the clients, of information about the withdrawals. We 
have designed the proposed rule so that these advisers would be able 
to comply with the rule without facing the burdens they previously 
sought to avoid. See infra Sections II. B and II. C of this Release.
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    The last example clarifies that an adviser has custody if it is the 
legal owner of the client assets or has access to those assets.\24\ One 
common instance is a firm that acts as both general partner and 
investment adviser to a limited partnership.\25\ By virtue of its 
position

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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 client assets.\26\
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    \24\ Proposed rule 206(4)-2(c)(1)(iii).
    \25\ This example applies equally to an adviser that acts as 
both managing member and investment adviser of a limited liability 
company or another type of investment vehicle, or as both trustee 
and investment adviser of a trust.
    \26\ Advisers that also act as general partners have, in the 
past, avoided application of rule 206(4)-2 to their activities by 
relying on staff no-action and interpretive letters. See, e.g., 
Bennett Management Co., SEC Staff Letter (Feb. 26, 1990); Canyon 
Management Company, SEC Staff Letter (Oct. 15, 1991); PIMS Inc., SEC 
Staff Letter (Oct. 21, 1991). The no-action assurances in these 
letters are conditioned on, among other things, an independent 
representative reviewing and authorizing the adviser's withdrawals 
of funds from the partnership accounts and on custodians sending 
quarterly account statements to the independent representative. 
Under the proposed rule, an adviser would not be subject to an 
annual surprise examination if the qualified custodian sends monthly 
account statements directly to the limited partners or to their 
independent representative--a requirement similar to the procedures 
that these advisers already follow under the staff letters. See 
infra Section II. C of this Release. Moreover, under our proposal, 
the custody rule would not apply to advisers with respect to limited 
partnerships that are audited annually. See infra Section II. D. 2 
of this Release.
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    Our proposed definition of ``custody'' is based on our longstanding 
interpretation of the term currently used in the rule.
     Should we revise the definition in any way?
     The proposed rule would continue to interpret ``custody'' 
broadly to include advisers' access to client funds and securities. 
Does that definition continue to work well to protect client assets?
     Advisers that withdraw their fees from clients' accounts 
and rely on staff letters to avoid application of the custody rule send 
clients invoices detailing how those fees were calculated. Should our 
rules require advisers that deduct fees from clients' accounts to send 
such invoices to those clients?
     Will the examples be helpful? Are there additional 
examples we should add?

B. Use of Qualified Custodians

    Rule 206(4)-2 currently requires advisers to maintain client funds 
with a bank, but does not require that client securities be held in a 
brokerage account or with any other type of financial institution.\27\ 
Almost all advisers that have custody of client securities maintain 
them in accounts with a broker or a bank, but on occasion our examiners 
discover an adviser keeping certificates in office files or in a safety 
deposit box. Such practices do not provide adequate protection for 
client securities, because these certificates may too easily be lost, 
stolen, or destroyed.\28\ We are therefore proposing to amend the rule 
to require that advisers maintain both client funds and securities with 
a qualified custodian in an account either under the client's name or 
under the adviser's name as agent or trustee for its clients.\29\
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    \27\ Instead, the rule currently requires that client securities 
be held in a reasonably safe place. See rule 206(4)-2(a)(1) and (2).
    \28\ For discussions of risks in keeping securities 
certificates, see Uniform Commercial Code, Revised Article 8, 
Prefatory Note at I.C.; Randall D. Guynn, Modernizing Securities 
Ownership, Transfer and Pledging Laws 21 (Capital Markets Forum, 
International Bar Association 1996).
    \29\ Proposed rule 206(4)-2(a)(1). Under the proposed rule, 
client funds and securities would have to be maintained in a 
custodial account so that the qualified custodian can provide 
account information to the clients. Keeping securities certificates 
in a bank safety deposit box, for example, would not satisfy the 
requirements of the proposed rule.
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    ``Qualified custodians'' under the proposed rule would include the 
types of financial institutions that customarily provide custodial 
services and are regulated and examined by their regulators with 
respect to those services.\30\ These would include banks,\31\ savings 
associations,\32\ registered broker-dealers,\33\ and registered futures 
commission merchants.\34\ We recognize that advisory clients often 
invest in securities traded on foreign exchanges and their advisers 
must, as a practical matter, maintain securities with financial 
institutions in foreign countries where the securities are traded.\35\ 
With respect to securities for which the primary market is in a country 
other than the United States, and to cash and cash equivalents 
reasonably necessary to effect transactions in those securities, we 
would treat financial institutions that customarily hold financial 
assets in that country and that hold the client assets in customer 
accounts segregated from their proprietary assets as qualified 
custodians.
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    \30\ Regulatory agencies or self-regulatory organizations 
require (either by rule or by supervisory policy) these financial 
institutions to carry fidelity bonds to cover possible losses caused 
by their employees' fraudulent activities. See, e.g., New York Stock 
Exchange (``NYSE'') rule 319, 2 New York Stock Exchange Guide (CCH) 
para. 2319; National Association of Securities Dealers (``NASD'') 
rule 3020, NASD Manual (CCH) 4836; 12 CFR 7.2013 (national banks); 
12 CFR 563.190 (savings associations); 12 U.S.C. 1828(e) and Federal 
Deposit Insurance Corporation Manual of Examination Policies, 
Section 4.4 (insured state nonmember banks); 3-1555 Federal Reserve 
Regulatory Service (Feb. 28, 1962) and Federal Reserve Board 
Commercial Bank Examination Manual, Section 4040.1 (insured state 
member banks).
    We are not proposing to require advisers to look beyond the 
``primary'' custodian to determine whether the client assets are 
maintained with a qualified custodian. As a result, our proposed 
definition of ``qualified custodian'' does not include clearing 
agencies or securities depositories because they usually hold or 
process funds and securities transmitted from primary custodians. 
Compare section 17(f)(2) of the Investment Company Act of 1940 
(``Investment Company Act'') [15 U.S.C. 80a-17(f)(2)] and rules 17f-
4 and 17f-7 [17 CFR 270.17f-4 and 17f-7] under the Investment 
Company Act.
    \31\ A ``bank'' under section 202(a)(2) of the Advisers Act [15 
U.S.C. 80b-202(a)(2)] includes national banks, members of the 
Federal Reserve System, and other banks and trust companies having 
similar authority to national banks and supervised by state or 
federal banking agencies.
    \32\ ``Qualified custodian'' would include any ``savings 
association'' as defined in section 3(b)(1) of the Federal Deposit 
Insurance Act [12 U.S.C. 1813(b)(1)] and insured and supervised by 
the Federal Deposit Insurance Corporation under the Federal Deposit 
Insurance Act [12 U.S.C. 1811].
    \33\ ``Qualified custodian'' would include any broker-dealer 
that is registered with and regulated by us under the Securities 
Exchange Act of 1934 (the ``Exchange Act''), holding the client 
assets in customer accounts.
    \34\ Futures commission merchants are registered with the 
Commodity Futures Trading Commission (``CFTC'') under section 4f(a) 
of the Commodity Exchange Act [7 U.S.C. 6f(a)] and regulated by the 
CFTC. ``Qualified custodian'' would include a registered futures 
commission merchant holding the client assets in customer accounts. 
Registered investment advisers that also provide clients with advice 
about futures, including ``security futures,'' may be required by 
CFTC rules to maintain custody of those clients' funds and security 
futures with a futures commission merchant. See rule 4.30 [17 CFR 
4.30] under the Commodity Exchange Act. See also the Commodity 
Futures Modernization Act (Pub. L. 106-554, 114 Stat. 2763 (2000)) 
(security futures are both securities and futures).
    \35\ See Exemption for Custody of Investment Company Assets 
Outside the United States, Investment Company Act Release No. 14132 
(Sept. 7, 1984) [49 FR 36080 (Sept. 14, 1984)] (prohibiting foreign 
financial institutions from acting as qualified custodians for 
securities purchased on a foreign stock exchange would cause 
``inconvenience and expense associated with moving the securities 
away [from] their primary market'').
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    Many advisers registered with us also would be qualified custodians 
under the proposed rule.\36\ These advisers could maintain their own 
clients' assets, subject to the account statement requirements 
described below and the custody rules imposed by the regulators of the 
advisers' custodial functions. Advisers could also maintain client 
assets with affiliates that are qualified custodians.
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    \36\ For example, Form ADVs submitted by SEC-registered advisers 
indicate that as of May 16, 2002, 647 advisers are broker-dealers 
registered with us under section 15 of the Exchange Act [15 U.S.C. 
78o] and 77 advisers are banks (or separately identifiable 
departments or divisions of banks).
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    We request comment on our proposal to require client funds and 
securities to be maintained by a qualified custodian.
     Should we require that all client funds and securities be 
maintained with qualified custodians?
     Are there other financial institutions that should be 
included as qualified custodians?
     Is our proposal with respect to foreign qualified 
custodians too broad--

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should we limit them to entities regulated by a foreign financial 
regulatory authority? Alternatively, is the proposal too narrow--how 
many advisory clients would need to have a foreign custodian hold funds 
or securities other than those permitted under the proposed amendments?
     Should the rule permit advisers that are qualified 
custodians to maintain their clients' funds and securities themselves? 
With affiliated qualified custodians?

C. Delivery of Account Statements to Clients

    Rule 206(4)-2 seeks to deter misuse of client assets by requiring 
an adviser with custody to send each client quarterly account 
statements,\37\ and to engage an independent public accountant to 
conduct an annual surprise examination of client assets in custody.\38\ 
Advisers have complained about the cost of annual surprise examinations 
and have sought to avoid them.\39\ Moreover, experience has shown that 
the current rule has limited deterrent effect. Advisers that intend to 
misuse client assets can fabricate client account statements \40\ and, 
because the surprise examination is performed only annually, many 
months may pass before the accountant has an opportunity to detect a 
fraud.
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    \37\ Rule 206(4)-2(a)(4). This requirement is applicable to 
advisers with respect to each client whose assets are in the 
advisers' custody.
    \38\ Rule 206(4)-2(a)(5).
    \39\ See Baldwin Brothers, Inc., SEC Staff Letter (Apr. 22, 
1985). See also staff letters listed in notes 23 and 26 supra.
    \40\ See, e.g., In the Matter of Vector Index Advisors, Inc. and 
Steven H. Adler, Investment Advisers Act Release No. 1996 (Nov. 15, 
2001) (adviser sent clients false account statements to hide its 
fraudulent activities). See also Securities and Exchange Commission 
v. RCS Financial Services, Inc., (N.D. Ohio) Civil Action No. 98 CV 
1047, Litigation Release No. 15748 (May 19, 1998); In the Matter of 
Robert Pierce and Carrie L. Williams Pierce, Investment Advisers Act 
Release No. 1620 (Mar. 17, 1997); Securities and Exchange Commission 
v. Teresa V. Fernandez, (S.D.N.Y.) 96 Civ. 8702 (JES), Litigation 
Release No. 15159 (Nov. 19, 1996); United States v. Steven D. Wymer, 
Criminal Action No. 92-2-RG (C.D. Cal), Litigation Release No. 13635 
(May 12, 1993); In re Thomas Walter McKibbin and Equitrust, Inc., 
Investment Advisers Act Release No. 1165 (May 1, 1989).
    Steven D. Wymer, an investment adviser, testified before a 
Congressional subcommittee that his ability to misuse client assets 
was dependent upon custodians making him the exclusive recipient of 
account statements. He was thus able to deliver fabricated 
statements to clients to hide unauthorized transactions and losses. 
See 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).
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    After reviewing the operation of the current rule and evaluating 
its benefits and costs, we are proposing an entirely different approach 
to protect advisory clients--an approach that would rely on periodic 
disclosure of account information by a qualified custodian rather than 
rely on a surprise examination. We propose to exempt advisers from the 
requirements to send quarterly account statements and to undergo annual 
surprise examinations if the qualified custodian sends monthly account 
statements directly to each advisory client.\41\ Qualified custodians' 
delivery of account statements to clients directly should provide 
clients with confidence that any erroneous or unauthorized transactions 
or withdrawals by an adviser have been reflected.
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    \41\ Proposed rule 206(4)-2(a)(3). To avoid the situation in 
which an adviser would be violating the rule as a result of a 
qualified custodian's failure to deliver an account statement to a 
client, the rule would require the adviser to have a ``reasonable 
belief'' that the custodian is delivering the required account 
statements. An adviser could form a reasonable belief under the 
proposed rule if, for example, the qualified custodian provides the 
adviser with a copy of the account statement that was delivered to 
the client.
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    We recognize that our new approach may not work in all custodial 
arrangements. Some advisers do not disclose the identity of their 
clients to their custodians to prevent a potential competitor from 
having access to their clients. Others may wish to protect the privacy 
of certain well-known clients. To accommodate this business practice, 
the proposed rule would require an adviser 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 to verify the funds and securities of 
those clients.\42\ To enhance our ability to protect advisory clients' 
assets by intervening as early as possible, the proposed amendments 
would require notice of any material discrepancies found during the 
examination. The rule would require the accountant finding such 
discrepancies during an examination to notify our Office of Compliance 
Inspections and Examinations.\43\
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    \42\ Proposed rule 206(4)-2(a)(3)(ii). Our proposal in this 
regard has no effect on a qualified custodian's other legal 
obligations with respect to its customers.
    \43\ Proposed rule 206(4)-2(a)(3)(ii)(C). Our rules under the 
Exchange Act impose a similar requirement. See rule 17a-5(h)(2) [17 
CFR 240.17a-5(h)(2)] (requiring an auditor, upon finding any 
material inadequacies in the audited broker-dealer's accounting 
system or procedures for safeguarding securities, to notify the 
broker-dealer, and requiring the broker-dealer to notify us within 
24 hours of receiving the notice from the auditor).
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    The proposed amendments contain a special provision requiring 
account statements (whether delivered by the qualified custodian or the 
adviser) to be sent directly to the limited partners of a limited 
partnership (or to their independent representative) if the adviser to 
the limited partnership also acts as its general partner and has 
custody of client assets.\44\ As general partner, the adviser generally 
has custody of these client assets.\45\ This special provision would 
avoid the adviser's being the sole recipient of account statements in 
its capacity as general partner of the limited partnership.\46\ 
Delivery of account statements to the adviser but not to the limited 
partners would not, of course, deter the adviser's misuse of client 
assets.
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    \44\ Proposed rule 206(4)-2(a)(3)(iii). The provision would also 
apply to advisers with respect to other pooled investment vehicles, 
including limited liability companies where the adviser also acts as 
the managing member of the limited liability company. Account 
statements must be sent directly to the limited liability company 
members or to their independent representative(s). Limited 
partnerships and other investment vehicles often engage an 
independent representative to receive account statements and monitor 
the status of assets in custody on behalf of all the limited 
partners.
    For purposes of the rule, an ``independent representative'' 
would be a person that (i) acts as agent for investors in a pooled 
investment vehicle and by law or contract is obligated to act in the 
best interest of the investors; (ii) does not control, is not 
controlled by, and is not under common control with the adviser; and 
(iii) does not have, and has not had within the past two years a 
material business relationship with the adviser. See proposed rule 
206(4)-2(c)(2).
    \45\ See supra discussions of ``custody'' under Section II. A of 
this Release.
    \46\ As discussed below in more detail, the custody rule, 
including proposed rule 206(4)-2(a)(3)(iii), would not apply to 
advisers with respect to pooled investment vehicles that are audited 
annually. See proposed rule 206(4)-2(b)(2).
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     We request comments on our proposal to rely on account 
statements delivered to clients by qualified custodians instead of 
relying on investment advisers sending account statements and 
undergoing annual surprise examinations. Would the proposal afford 
equivalent protection to clients? Should the rule expressly require 
advisers to review the custodian's statement and identify any 
discrepancies?
     Should advisers that are acting as their clients' 
qualified custodians or that are using affiliated qualified custodians 
continue to be subject to annual surprise examinations?
     We understand that many, perhaps most, qualified 
custodians already send account statements directly to customers as a 
matter of practice, and therefore the effect of our proposal would be 
to eliminate the cost of annual surprise examinations for many advisers 
without imposing additional burdens.

[[Page 48584]]

We request comment on our understanding and expectations.
     We propose to require monthly account statements from 
qualified custodians so that clients may identify any irregularities 
earlier. We understand that most qualified custodians send monthly 
account statements to clients as a matter of practice.\47\ We request 
comment on this understanding.
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    \47\ Broker-dealers that are members of the NASD, the NYSE or 
the American Stock Exchange (AMEX) are generally required to provide 
customers with immediate confirmations and account statements at 
least quarterly. While NYSE rules permit a member to send account 
statements to, for example, the investment adviser if the adviser 
holds power of attorney over the customer's account, such delivery 
would not satisfy the requirement under (a)(3)(i) of the proposed 
rule (account statements to clients by qualified custodian). See 
NASD Rules IM-2340, NASD Manual (CCH) 4292; NYSE rule 409, 2 New 
York Stock Exchange Guide (CCH) para. 2409; AMEX rule 419, 2 
American Stock Exchange Guide (CCH) para. 9439. Banks effecting a 
purchase or sale of securities for a customer are required to 
provide immediate confirmations under regulations of the Office of 
the Comptroller of the Currency, the Board of Governors of the 
Federal Reserve System, and the Federal Deposit Insurance 
Corporation, subject to limited exceptions. These regulations permit 
banks and their customers to agree upon account statements at least 
quarterly in lieu of immediate confirmations for certain types of 
customer accounts, such as agency accounts for which the bank 
exercises investment discretion. 12 CFR 12.4, 12.5, 208.34, 344.5, 
344.6 (2001). While these regulations generally require account 
statements to be sent quarterly, we understand that broker-dealers 
and banks send account statements to customers monthly as a matter 
of practice.
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     The proposed rule would permit independent representatives 
to receive account statements from qualified custodians on behalf of 
investors in limited partnerships and other pooled investment vehicles. 
Are there any other types of clients that need independent 
representatives to receive account statements on their behalf?
     We also request comment on our proposal to require 
advisers with custody to continue sending quarterly account statements 
to clients and to continue undergoing annual surprise examinations if 
the qualified custodian does not send account statements directly to 
the adviser's clients. We understand that most custodians do send 
statements directly--is there a need for this alternative procedure? 
Should we require these advisers to obtain their clients' informed 
consent prior to using this alternative procedure? If not, should we 
require advisers that use this alternative procedure to disclose, to 
clients, the risks involved in receiving account statements quarterly 
from the adviser itself rather than monthly from a qualified custodian, 
or to make other disclosures?
     Should we require additional safeguards to deter misuse of 
clients' assets by advisers that send account statements to clients 
themselves--for example, should we require these advisers to send their 
statements to clients monthly rather than quarterly? Should the rule 
require surprise examinations to be conducted more often than annually? 
Are there other requirements or procedures that would further protect 
these advisers' clients' assets?

D. Exemptions

1. Registered Investment Companies
    We propose to exempt advisers from the rule with respect to clients 
that are registered investment companies. Registered investment 
companies and their advisers must comply with the strict requirements 
of section 17(f) of the Investment Company Act of 1940 and the custody 
rules we have adopted under that section.\48\ We believe that applying 
rule 206(4)-2 in addition to those requirements may not increase 
safeguards on investment company assets.
---------------------------------------------------------------------------

    \48\ 15 U.S.C. 80a-17(f) and rules 17f-1 through 17f-7 under the 
Investment Company Act of 1940 [17 CFR 270.17f-1 through 17 CFR 
270.17f-7].
---------------------------------------------------------------------------

2. Pooled Investment Vehicles
    We also propose to exempt advisers from the rule with respect to 
client assets held in pooled investment vehicles such as limited 
partnerships or limited liability companies 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 members or other beneficial owners) within 90 days of the 
end of its fiscal year.\49\ These investors will have established, by 
contract, a means to protect themselves from misuse of pool assets. 
Moreover, a periodic report by auditors may be more useful to them than 
receiving reports of the large number of transactions in pool assets.
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    \49\ See proposed rule 206(4)-2(b)(2). For purposes of this 
clause, ``audit'' has the meaning under section 2(d) of Article 1 of 
Regulation S-X [17 CFR 210.1-02(d)].
    We are not proposing to require that any pooled investment 
vehicle undergo an annual audit. We understand, however, that many 
hedge funds and other pooled accounts do undergo an annual audit, 
and we believe requiring an adviser to comply with the requirements 
of proposed rule 206(4)-2 for those accounts may be unnecessary.
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     We request comment on our proposal to exempt advisers from 
the rule with respect to pooled investment vehicles that are subject to 
an annual audit. Should the rule expressly require the adviser to 
maintain the assets of the pooled vehicle with a qualified custodian?
     We understand that this exemption would apply to most 
limited partnerships, limited liability companies and other pooled 
investment vehicles, and thus would eliminate a great number of issues 
and concerns that have arisen under the current rule and that have been 
addressed in numerous staff no-action or interpretive letters.\50\ We 
ask for comment on this understanding.
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    \50\ As discussed earlier, advisers should no longer find it 
necessary to rely on these staff letters. See supra note 26.
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3. Registered Broker-Dealers
    We are not proposing to retain the current exemption from the rule 
for advisers that are also registered broker-dealers.\51\ The proposed 
rule would permit advisers that are also registered broker-dealers (and 
advisers that are also other types of qualified custodians) to hold 
custody of their clients' funds and securities without being subject to 
annual surprise examinations so long as they send monthly statements to 
their clients. Broker-dealers already are required to send 
confirmations and account statements to their customers, including 
those that are advisory clients.\52\ Most advisers that also are 
registered broker-dealers should therefore already be in compliance 
with the proposed rule and face no additional burdens.
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    \51\ Rule 206(4)-2(b) exempts advisers that are also broker-
dealers from the custody rule if they are subject to and in 
compliance with the net capital requirement under rule 15c3-1 [17 
CFR 240.15c3-1] under the Exchange Act.
    \52\ See supra note 47.
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E. Amendments to Part II of Form ADV

    Advisers that have custody of client assets must include, in their 
disclosure statements (``brochures'') sent to clients, a balance sheet 
audited by an independent public accountant.\53\ We adopted the audited 
balance sheet requirement, in part, to assist clients in determining 
whether their adviser may face financial pressure to misuse the assets 
entrusted to it.\54\ A balance sheet, however, may give an imperfect 
picture of the financial health of an advisory firm--many profitable 
advisers have few financial assets. Moreover, rule 206(4)-4 \55\ now 
requires advisers to disclose to their clients any financial condition 
that

[[Page 48585]]

is reasonably likely to impair the adviser's ability to meet its 
contractual commitments to its clients, a disclosure requirement that 
did not exist in 1979 when the audited balance sheet requirement was 
adopted.\56\ We believe that this current disclosure requirement is a 
better means to warn clients of when their assets may be at additional 
risk, and that clients should not have to rely for protection on 
reviewing balance sheet information. We are therefore proposing to 
eliminate the requirement that advisers with custody include a balance 
sheet in their client brochures.
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    \53\ Part II, Item 14 of Form ADV.
    \54\ See Investment Adviser Requirements Concerning Disclosure, 
recordkeeping, Applications for Registration and Annual Filings, 
Investment Advisers Act Release No. 664 (Jan. 30, 1979) [44 FR 7870 
(Feb. 7, 1979)] (adopting Part II of Form ADV, including the 
requirement to include an audited balance sheet).
    \55\ 17 CFR 275.206(4)-4.
    \56\ Financial and Disciplinary Information that Investment 
Advisers Must Disclose to Clients, Investment Advisers Act Release 
No. 1083 (Sept. 25, 1987) [52 FR 36915 (Oct., 2, 1987)] (adopting 
rule 206(4)-4, which requires disclosure of an adviser's precarious 
financial condition).
---------------------------------------------------------------------------

     We request comment on this proposal. Have advisory clients 
found the balance sheet useful in evaluating the risks to their assets 
in advisers' custody? Should we retain the requirement?

III. General Request for Comment

    The Commission requests comment on the rule amendments proposed in 
this Release, suggestions for additional changes to the rules and 
comment on other matters that might have an effect on the proposals 
contained in this Release. For purposes of the Small Business 
Regulatory Enforcement Fairness Act of 1966, the Commission also 
requests information regarding the potential impact of the proposed 
rule on the economy on an annual basis. Commenters should provide 
empirical data to support their views.

IV. Cost-Benefit Analysis

    The Commission is sensitive to the costs and benefits resulting 
from its rules. Rule 206(4)-2 seeks to protect clients' assets in the 
custody of advisers from misuse or misappropriation, by requiring 
advisers to send each client quarterly account statements and to have 
independent public accountants conduct annual surprise examinations of 
the custodied assets. In the 40 years since we adopted the rule, 
custody practices in the securities markets have changed, and some 
provisions of the rule have become outdated. In addition, advisers have 
complained about the cost of annual surprise examinations. Moreover, 
experience has shown that the current rule has limited deterrent effect 
on investment advisers determined to misuse client assets. Our proposed 
amendments to the rule would require advisers to maintain clients' 
assets with qualified custodians and excuse advisers from annual 
surprise examinations if the qualified custodians send monthly account 
statements to the clients directly.
    We believe the vast majority of advisers already maintain their 
clients' assets with qualified custodians who prepare monthly account 
statements. These amendments will enhance the protections afforded to 
clients' assets while at the same time reducing advisers' compliance 
burden. We have identified certain costs and benefits that may result 
from the proposed rule amendments. We request comment on the costs and 
benefits of the proposed rule amendments, and encourage commenters to 
identify, discuss, analyze, and supply relevant data regarding these or 
any additional costs and benefits.

A. Background

    Our rules currently require advisers with custody of client assets 
to deposit client funds in bank accounts that contain only client 
funds, and to segregate and identify client securities and hold them in 
a reasonably safe place.\57\ Each quarter, these advisers must send 
clients account statements, and at least once each year, these advisers 
must have an independent public accountant conduct a surprise 
examination of all the client funds and securities in the advisers' 
custody.\58\ In addition, advisers with custody of client funds or 
securities must include an audited balance sheet with the disclosure 
brochure they send to their clients.
---------------------------------------------------------------------------

    \57\ Rule 206(4)-2(a)(1) and (2).
    \58\ Rule 206(4)-2(a)(4) and (5).
---------------------------------------------------------------------------

    Rule 206(4)-2 has not been substantively amended since its adoption 
over 40 years ago. The proposed amendments would make several changes 
to the existing rule, to modernize it to reflect developments in 
securities market custody practices. First, advisers with custody of 
client funds and securities would be required to maintain those assets 
in accounts with qualified custodians, such as a broker or a bank.\59\ 
Under the current rule, advisers are required to maintain clients' 
funds in a bank, but they are not required to maintain clients' 
securities with a qualified custodian. Second, if the qualified 
custodian sends monthly account statements directly to the advisory 
clients, the adviser would not be required to send account statements. 
The current rule requires advisers to send each client a quarterly 
account statement itemizing the funds and securities in the advisers' 
custody and all transactions for the account. Third, if the qualified 
custodian sends monthly account statements directly to the advisory 
clients, the adviser would not be required undergo an annual surprise 
examination. Under the current rule, advisers with custody must have an 
independent public accountant conduct an annual verification of the 
accuracy of account statements provided to the adviser's clients. 
Fourth, for any advisers subject to the annual surprise examination 
requirement, their independent public accountants would be required to 
notify the Commission of any material discrepancies that they uncover 
in the examination. The current rule does not require any such notice. 
Fifth, we would eliminate the current requirement that advisers with 
custody include an audited balance sheet with their disclosure 
brochures.
---------------------------------------------------------------------------

    \59\ Under proposed rule 206(4)-2(c)(3), a qualified custodian 
could be a bank, a savings association, a broker-dealer, a futures 
commission merchant, or in certain instances a foreign custodial 
institution.
---------------------------------------------------------------------------

    In addition, the proposed amendments would add new provisions to 
the custody rule to enhance its transparency and reflect advisers' 
business practices. First, the proposed amendments insert a definition 
of ``custody'' into the rule (based on the definition currently used in 
Form ADV) together with examples to illustrate circumstances under 
which an adviser has custody.\60\ Second, a special provision would 
require account statements to be sent directly to the limited partners 
(or beneficial owners in other types of pooled investment vehicles) if 
the adviser also serves as the general partner of the limited 
partnership and has custody (or holds a managing position in other 
types of pooled investment vehicles and has custody). Third, we would 
exempt client assets held in a limited partnership or other pooled 
investment vehicle from the requirements of the rule if the partnership 
is audited at least annually and the audited financial statements are 
delivered to limited partners.
---------------------------------------------------------------------------

    \60\ Proposed rule 206(4)-2(c)(1) would provide that an adviser 
has custody of client assets when it holds, ``directly or 
indirectly, client funds or securities or [has] any authority to 
obtain possession of them.'' The examples, based on longstanding 
interpretation of the term currently used in the rule, address 
situations involving advisers' possession or control of clients' 
funds or securities, the authority to withdraw funds or securities 
from clients' accounts, or access to clients' funds or securities by 
virtue of the advisers' legal capacity.
---------------------------------------------------------------------------

    Based on advisers' filings with us, we estimate that a relatively 
small portion of investment advisers registered with us--approximately 
11 percent--have custody of clients' assets.\61\ Of the 867

[[Page 48586]]

advisers who currently report having custody, many also report that 
they are broker-dealers (123) or banks (33).\62\ Advisers that are also 
registered broker-dealers or banks would be ``qualified custodians'' 
under the proposed rule and may keep custody of their own clients' 
assets. We expect that all 156 of these advisers \63\ would, in their 
capacity as qualified custodians, send monthly account statements to 
their advisory clients. Of the remaining 711 advisers that report 
having custody,\64\ we estimate that 95 percent of them (675 advisers) 
\65\ would arrange to have qualified custodians send monthly account 
statements to 99 percent of their clients, and would prepare their own 
statements for 1 percent of their clients.\66\ We expect that the 
remaining 36 advisers \67\ would prepare their own statements for all 
of their clients.\68\
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    \61\ See infra note 80 and accompanying text (867 SEC-registered 
advisers report having custody, but this may under-represent the 
number of advisers who actually have custody).
    \62\ See infra note 82 and accompanying text.
    \63\ 123 + 33 = 156.
    \64\ 867-123--33 = 711.
    \65\ 711  x  0.95 = 675.
    \66\ We base this estimate on our experience examining 
investment advisers. As we discuss, infra note 90 and accompanying 
text, we estimate that SEC-registered investment advisers have a 
mean of 670 clients each. Thus, we estimate that this group of 
advisers would be preparing their own statements for an aggregate 
group of 4,725 clients (670 mean clients per adviser  x  0.01 = 7 
clients per adviser  x  675 advisers = 4,725 clients).
    \67\ 867-123-33-675 = 36.
    \68\ We estimate that these 36 advisers would have 24,120 
clients in the aggregate (36  x  670 = 24,120). See supra note 66.
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B. Benefits

    Improved protection for advisory clients. We have designed the 
proposed amendments to offer greater protection for advisory clients. 
As discussed above, the proposed amendments would exempt advisers from 
the requirements to send each client account statements and to undergo 
an annual surprise examination of the client's account if a qualified 
custodian sends monthly account statements directly to the advisory 
client. We expect that, as a result, most advisers will have qualified 
custodians deliver account statements directly to advisory clients, 
rather than pay the costs of annual surprise examinations. Clients' 
early identification of questionable transactions upon receipt of an 
accurate account statement from a qualified custodian on a monthly 
basis, rather than an annual surprise examination that may not occur 
for many months, should allow clients to move more swiftly and to 
reduce their assets' exposure to malfeasance by advisers. Similarly, we 
anticipate that the special provision for providing account statements 
for limited partnerships and other pooled investment vehicles should 
provide investors (or their independent representatives) the 
opportunity to identify any erroneous or unauthorized transactions or 
withdrawals by the partnership's adviser.
    As discussed above, we expect that nearly all of the clients of 
advisory firms that currently have custody of their clients' assets 
will receive monthly statements from qualified custodians under the 
rule.\69\ The potential benefit to each client is not, however, 
quantifiable. We also infer that most of these clients already receive 
monthly statements from qualified custodians, as a result of voluntary 
practices by their advisers. The potential benefit of having this 
practice institutionalized in a regulation is also not quantifiable.
---------------------------------------------------------------------------

    \69\ See supra notes 61-68 and accompanying text.
---------------------------------------------------------------------------

    In addition, as discussed above, we estimate that a few advisers 
will not avail themselves of the option to have qualified custodians 
send monthly account statements to some or all of their clients, and 
that approximately 28,845 clients will continue to be protected 
primarily by annual surprise examinations of these advisers as a 
result.\70\ The proposed amendments would require independent public 
accountants conducting these examinations to advise the Commission of 
any material discrepancies they discover in the examination. This will 
enhance the safety of these clients' assets, because the Commission 
will be able to act promptly and preempt further losses resulting from 
malfeasance by the adviser. The potential benefit to clients in this 
regard is not quantifiable.
---------------------------------------------------------------------------

    \70\ See supra notes 66 and 68. We estimate the aggregate number 
of clients at 28,845 (4,725 + 24,120).
---------------------------------------------------------------------------

    The rule will also provide greater protection for advisory clients 
by requiring advisers to maintain clients' securities with a qualified 
custodian. Based on our examination experience, it is rare for an 
adviser to retain physical custody of any particular client's 
securities. Thus, advisory clients are already receiving this benefit 
as a matter of practice in most instances. The potential benefit of 
having this practice institutionalized in a regulation is not 
quantifiable.
    Remove unnecessary regulatory requirements. We estimate that 
approximately 744 advisers are currently required to undergo annual 
surprise examinations.\71\ The Commission staff has estimated, in 
connection with Paperwork Reduction Act analyses, that on average, an 
adviser spends approximately 335 hours and pays an additional $8,000 
annually in connection with undergoing annual surprise examinations 
under the existing rule.\72\ The proposed amendments to rule 206(4)-2 
would provide these advisers with the opportunity to avoid the costs of 
these annual surprise examinations. As discussed above, we estimate 
that only 36 advisers will continue to incur the costs of an annual 
surprise examination with respect to all their clients, and another 675 
will only incur these costs with respect to one percent of their 
clients.\73\ The new compliance requirements under the amended rule 
206(4)-2 would focus on investment advisers ascertaining whether 
qualified custodians are sending monthly account statements to each of 
the adviser's clients. This sets forth a much simpler and less 
expensive compliance procedure.
---------------------------------------------------------------------------

    \71\ As we discuss at notes 61-68 supra and accompanying text, 
867 advisers report having custody. Of these, 123 report that they 
are also broker-dealers. Broker-dealers are exempt from the current 
rule. 867-123 = 744 non-exempt advisers with custody.
    \72\ This estimate is based on the estimate that an adviser (i) 
spends 0.5 hours per client in connection with the annual surprise 
examination, (ii) has an average of 670 clients (0.5 x 670 = 335), 
and (iii) pays $8,000 in fees to an independent public accountant. 
See infra notes 87-88 and accompanying text.
    \73\ These 675 advisers would benefit from reducing the hours 
and other costs they spend on surprise examinations. As discussed 
below, infra notes 90 and 93, each of these 675 advisers would spend 
approximately 3.5 hours and pay $1,000 annually in connection with 
undergoing annual surprise examinations under the proposed rule.
---------------------------------------------------------------------------

    We request comment on our estimates of the number of advisers that 
would avail themselves of the opportunity to avoid the time and costs 
of an annual surprise examination under the rule. We also request 
comments quantifying the reduction in costs that would be obtained 
through the new compliance procedure.
    In addition, for other advisers who have custody but rely on 
procedures set out in staff no-action letters in lieu of complying with 
the annual surprise examination requirement, the proposed amendments 
would eliminate the cost of compliance with the procedures set forth in 
those letters. The number of advisers who have custody but rely on 
procedures set out in staff no-action letters in lieu of complying with 
the annual surprise examination requirement is difficult to 
estimate.\74\ We request comments quantifying the costs advisers incur 
in connection with the alternative procedures under the staff no-action 
letters, how many

[[Page 48587]]

advisers incur such costs, and the reduction in costs that would be 
obtained through the new compliance procedure.
---------------------------------------------------------------------------

    \74\ See infra note 80 and accompanying text.
---------------------------------------------------------------------------

    The proposed amendments would also eliminate the requirement set 
forth in Form ADV that advisers with custody must include, in their 
disclosure brochures sent to clients, a balance sheet prepared and 
audited by an independent public accountant. The elimination of this 
balance sheet requirement would reduce advisers' compliance burden. The 
Commission staff has estimated, in connection with Paperwork Reduction 
Act analyses, that an adviser not otherwise required to prepare audited 
financial statements presently spends approximately $15,000 annually to 
comply with this requirement, and that approximately 580 advisers with 
custody are currently incurring these costs.\75\ We request comment on 
our estimate of these costs and the number of advisers who would be 
relieved from these costs as a result of the proposed amendments.
---------------------------------------------------------------------------

    \75\ See infra note 96 and accompanying text. pp
---------------------------------------------------------------------------

    We do not anticipate that eliminating the balance sheet requirement 
will reduce protections to clients. Many profitable advisers have few 
financial assets, and a balance sheet may give an imperfect picture of 
the financial health of an advisory firm. Moreover, some clients may 
not have experience in interpreting the financial information presented 
in a balance sheet. Finally, rule 206(4)-4 \76\ now requires advisers 
to disclose to their clients any financial condition that is reasonably 
likely to impair the adviser's ability to meet its contractual 
commitments to its clients, and this disclosure is likely to be more 
useful to clients than a balance sheet; accordingly, we do not expect 
any reduction in investor protection to result from the proposed 
change.
---------------------------------------------------------------------------

    \76\ 17 CFR 275.206(4)-4. When we adopted the balance sheet 
requirement in 1979, rule 206(4)-4 was not in existence. See supra 
note 54.
---------------------------------------------------------------------------

    Improved clarity and transparency of the rule. We anticipate that 
investment advisers will find it easier to understand and to comply 
with the rule as a result of the proposed amendments, and that this 
increased transparency may result in cost savings for advisers. We 
adopted rule 206(4)-2 in 1962 and the rule was designed to operate in 
the securities markets of that time. The proposed amendments would 
improve the clarity and transparency of the rule by inserting a 
definition of ``custody'' into the rule and by incorporating current 
custodial practices into our requirements. The definition of 
``custody'' is based on the definition that has been used in the 
instructions to Form ADV since 1985, but our proposed amendments make 
the definition easier to use by providing examples of the custodial 
situations most likely to be encountered by an adviser in today's 
securities markets. Advisers will benefit from this transparency 
because they (or their counsel) will no longer need to refer to other 
materials such as staff no-action letters for these examples. 
Similarly, advisers relying on certain procedures set out in staff no-
action letters discussed above, as an alternative to the annual 
surprise examination requirement, will no longer need to refer to this 
body of letters. We request comment on the costs advisers currently 
incur in this regard, such as attorneys' fees, and on the likely 
savings advisers would experience under the proposed amendments to the 
rule.

C. Costs

    The proposed amendments would require that all client funds or 
securities be maintained with a qualified custodian. This requirement 
may impose costs on advisers that are not already maintaining clients' 
securities in accounts with qualified custodians. Based on our 
experience in examining advisers' operations, however, we estimate that 
no more than 1 percent of advisers with custody keep any clients' 
securities in places other than accounts with qualified custodians, and 
even these advisers maintain almost all of their clients' assets with 
qualified custodians. We estimate that the additional cost of this 
requirement, if any, would therefore be minimal.
    In addition, while the proposed amendments would exempt most 
advisers that have custody from the costs of undergoing annual surprise 
examinations and sending account statements, that exemption would be 
conditioned on qualified custodians sending monthly account statements 
directly to the advisers' clients. This condition may impose costs on 
some advisers. Our understanding is that, in most instances, qualified 
custodians are already delivering monthly account statements to 
advisers' clients as a matter of practice.\77\ However, qualified 
custodians that are not delivering account statements directly to 
clients and that would have to do so at the request of advisers may 
pass on the new costs to advisers. These costs are necessary for the 
protection of advisory clients and we estimate that they should be no 
greater, at an aggregate level, than the costs incurred under the 
current account statement delivery requirement. Moreover, an investment 
adviser has the option to continue under the old approach,\78\ in the 
unlikely event that the costs are greater. We request comments 
quantifying the costs that advisers would incur under either approach.
---------------------------------------------------------------------------

    \77\ Based on our experience in examining advisers, we estimate 
that less than 1% of advisory clients (excluding investors in pooled 
investment vehicles) do not receive account statements directly from 
custodians.
    \78\ Proposed rule 206(4)-2(a)(3)(ii).
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D. Request for Comment

     The Commission requests comments on the potential costs 
and benefits identified in this release, as well as any other costs or 
benefits that may result from the proposals.
     We encourage comments to identify, discuss, analyze, and 
supply relevant data regarding these or additional costs and benefits.

V. Paperwork Reduction Act

    The proposed amendments contain several ``collection of 
information'' requirements within the meaning of the Paperwork 
Reduction Act of 1995,\79\ and the Commission has submitted the 
amendments to the Office of Management and Budget (``OMB'') for review 
in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The titles for 
the collections of information are ``Rule 206(4)-2, Custody of Funds or 
Securities of Clients by Investment Advisers'' and ``Form ADV, 
Financial Information'' under the Advisers Act. The rule and the form 
contain currently approved collection of information numbers under OMB 
control numbers 3235-0241 and 3235-0049, respectively. An agency may 
not conduct or sponsor, and a person is not required to respond to, a 
collection of information unless it displays a currently valid control 
number.
---------------------------------------------------------------------------

    \79\ 44 U.S.C. 3501 to 3520.
---------------------------------------------------------------------------

    The collections of information under rule 206(4)-2 are necessary to 
ensure that clients' funds and securities in the custody of advisers 
are safeguarded, and information contained in the collections is used 
by staff of the Commission in its enforcement, regulatory, and 
examination programs. The respondents are investment advisers 
registered with us that have custody of clients' funds or securities. 
The collections of information under Form ADV are necessary for use by 
staff of the Commission in its examination and oversight program. The 
respondents are investment advisers seeking to register with the 
Commission or to update their registration. Responses provided to the 
Commission are not kept confidential.

[[Page 48588]]

A. Rule 206(4)-2

    According to our records, 867 out of the 7,583 advisers registered 
with the Commission have custody of client funds or securities.\80\ 
These records also show that 123 advisers registered with us that 
report having custody are also registered broker-dealers exempted from 
the current rule. The proposed amendments would remove this exemption, 
but these advisers should be in compliance with the proposed rule 
without facing additional burdens.\81\
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    \80\ Based on information filed through the IARD system as of 
June 2002, 867 advisers registered with us report on their Form ADVs 
that they have custody. There may be additional advisers registered 
with us that would be deemed to have custody under the proposed 
revised rule but that are relying on staff letters (see supra notes 
23 and 26) to avoid application of the current rule to their 
advisory business, and therefore do not report on their Form ADV 
that they have custody.
    \81\ Advisers that are also registered broker-dealers would be 
``qualified custodians'' under the proposed rule and may keep 
custody of their own (and other advisers') clients' assets. Broker-
dealer rules already require these firms to send account statements 
to their customers and we understand that broker-dealers generally 
send customers monthly account statements, as a matter of practice. 
Therefore these advisers should not be subject to the annual 
surprise examination requirement. See supra note 47.
---------------------------------------------------------------------------

    The current rule requires advisers registered with us that have 
custody of clients' assets to send account statements to those clients 
at least quarterly and to undergo an annual surprise examination to 
verify the custodied assets. The proposed amendments would exempt 
advisers from these two requirements if qualified custodians send 
monthly account statements directly to the advisory clients. As 
discussed in detail below, we estimate that of the 867 advisers that 
reported to have custody of client assets, 156 would be fully exempted 
from these two requirements, 675 would be exempted from the 
requirements with respect to 99 percent of their clients and 36 would 
remain subject to both requirements with respect to all of their 
clients.
    We estimate that advisers that are registered broker-dealers (123 
firms) or banks (33 firms) would be exempt from these two requirements 
with respect to all of their clients.\82\ We further estimate, based on 
our experience in examining advisers, that 95 percent of the other 711 
advisers that have custody would use this exemption with respect to 
approximately 99 percent of their clients; these 675 advisers \83\ 
would still be required to send account statements and undergo an 
annual surprise examination with respect to 1 percent of their clients; 
and 36 advisers would still be subject to these requirements with 
respect to all of their clients.
---------------------------------------------------------------------------

    \82\ As noted earlier, 123 advisers registered with us that 
report having custody are also broker-dealers. Another 33 advisers 
registered with us that report having custody also report that they 
are actively engaged in business as a bank. As is the case for 
broker-dealers, banks would be qualified custodians under the rule 
and may keep custody of their own (and other advisers') clients' 
assets. See supra note 81. In addition, many of these 33 advisers 
that are banks may also use the exemption provided under proposed 
rule 206(4)-2(b)(1) (exempting advisers from the custody rule with 
respect to any client that is a registered investment company). 
Section 202(a)(11)(A) of the Advisers Act [15 U.S.C. 80b-
2(a)(11)(A)] excludes banks from the definition of ``investment 
adviser'' except to the extent they advise a registered investment 
company, and many of these banks may therefore have only registered 
investment companies as their advisory clients.
    \83\ 0.95  x  711 = 675.
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    In addition, the proposed amendments would further reduce burdens 
by exempting all advisers from the custody rule with respect to their 
clients that are investment companies or audited limited 
partnerships.\84\
---------------------------------------------------------------------------

    \84\ See supra Section II. D. of this Release.
---------------------------------------------------------------------------

    The above analysis shows that the proposed amendments would 
generally reduce the paperwork burden for advisers. The currently 
approved annual aggregate burden of collection of information under 
rule 206(4)-2 is 21,625 hours. This approved annual aggregate burden 
was based on estimates that (i) 173 advisers were subject to the rule, 
(ii) the advisers had, on average, 50 clients each, and (iii) each of 
these advisers spent an average of 2.5 hours annually in responses with 
respect to each client. \85\ In addition, the approved annual burden 
includes an aggregate cost estimate of $692,000. This cost was based on 
an estimate that an adviser would pay an independent public accountant 
$4,000 to conduct the annual surprise examination. \86\
---------------------------------------------------------------------------

    \85\ The approved burden was based on an estimated 173 advisers 
that are subject to the custody rule (a total of 628 advisers with 
custody minus 455 broker-dealers exempted from the custody rule). 
The approved burden was also based on an estimate that these 173 
advisers responded, on average, 5 times annually (4 times to prepare 
quarterly account statements and 1 time to respond to the annual 
surprise examination requirement) with respect to each of their 50 
clients at an average of 0.5 hours per response, thus spending an 
estimated 2.5 hours per client annually. The total burden for each 
adviser was therefore estimated to be 125 hours annually (50 clients 
 x  2.5 hours = 125 hours) and the annual aggregate burden for all 
advisers was estimated to be 21,625 hours (173 advisers  x  125 
hours = 21,625 hours).
    \86\ 173 advisers  x  $4,000 accounting fees = $692,000.
---------------------------------------------------------------------------

    Updating those prior calculations based on current information from 
advisers registered with us, however, we would now estimate that (i) 
744 advisers are subject to the existing rule, and (ii) advisers 
registered with us have, on average, 670 clients each. We would 
continue to estimate that the burden on each adviser is 2.5 hours 
annually for each client. These current data would increase the annual 
aggregate burden under the current rule to 1,246,200 hours. \87\ In 
addition, we would now estimate the cost an adviser would incur in 
obtaining an annual surprise examination in the form of accounting fees 
would be $8,000, and these current data would increase the aggregate 
cost estimate to $5,952,000. \88\
---------------------------------------------------------------------------

    \87\ 744 advisers x 670 clients  x  2.5 hours annually per 
adviser per client = 1,246,200 hours.
    \88\ 744 advisers  x  $8,000 accounting fees = $5,952,000.
---------------------------------------------------------------------------

    As stated above, however, for purposes of estimating the burden 
hours under the proposed amendments, we now estimate that the number of 
advisers subject to the collections of information with respect to all 
of their clients for whom they have custody would decrease to 36 (5 
percent of the 711 advisers that have custody and are not broker-
dealers or banks), and a further 675 advisers (711 advisers  x  95 
percent) would be subject to these burdens with respect to only 1 
percent of their clients. \89\ Assuming an average of 670 clients per 
adviser registered with us, the aggregate annual burden that advisers 
would face under the proposed amendments would decrease to 72,113 
hours. \90\ In addition, the proposed amendments would require an 
independent public accountant to notify our Office of Compliance 
Inspections and Examinations upon finding any material discrepancy 
during the course of conducting an annual surprise examination of the 
client funds and securities in an adviser's custody. Of the 711 annual 
surprise examinations that would occur under the proposed

[[Page 48589]]

amended rule, we anticipate that not more than 1 examination per year 
would yield a material discrepancy, and that the burden on an 
accountant in providing notice to the Commission would be no more than 
0.5 hours. This new requirement would not increase the total annual 
aggregate burden under the proposed amendments. \91\
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    \89\ As discussed earlier, 867 advisers registered with us 
currently report having custody of clients' funds or securities. We 
estimate that 123 broker-dealers and 33 banks will not be required 
to send quarterly account statements or undergo an annual surprise 
examination under the rule as proposed to be revised. We further 
estimate that, of the remaining 711 advisers that have custody, 95% 
(675 advisers) will use qualified custodians to deliver account 
statements to 99% of their clients, leaving an average of 7 clients 
per adviser for whom the adviser must send account statements and 
undergo an annual examination. The other 5% of advisers with custody 
(36 advisers) would be subject to the collections of information 
under the rule with respect to all of their clients (an average of 
670 clients per adviser).
    \90\ 675 advisers would have 5 responses with respect to each of 
7 clients annually for an average of 35 annual responses per 
adviser, or an aggregate of 23,625 annual responses. An additional 
36 advisers would have 5 responses with respect to each of 670 
clients annually for an average of 3,350 annual responses per 
adviser, or an aggregate of 120,600 annual responses. 23,625 + 
120,600 = 144,225 total annual responses under the proposed rule. 
Each response is assumed to take approximately 0.5 hours, for a 
total hour burden of 72,112.5 (rounded to 72,113) hours annually for 
all advisers in the aggregate.
    \91\ As noted, supra note 90, the total hour burden is estimated 
at 72,112.5, rounded up to 72,113 hours. Adding 0.5 hours brings the 
total to 72,113, leaving the rounded number unchanged.
---------------------------------------------------------------------------

    The aggregate cost estimate for accounting fees for the annual 
surprise examination would be $288,000 for the 36 advisers who will be 
subject to the collection of information for all of their clients. \92\ 
We estimate that accounting fees for the 675 advisers who would be 
subject to the collection of information for 1 percent of their clients 
would decrease to $1,000 per adviser, for an aggregate of $675,000. 
\93\ As a result, the aggregate cost estimate would decrease to 
$963,000. \94\
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    \92\ 36 advisers  x  $8,000 accounting fees = $288,000.
    \93\ 675 advisers  x  $1,000 accounting fees = $675,000.
    \94\ $288,000 + $675,000 = $963,000.
---------------------------------------------------------------------------

    We believe, however, that using the average of 670 clients per 
adviser affected by the rule may overstate the burden significantly. 
The 670 number is a mean, but a few large advisers represent a 
significant portion of the total client base, so the typical number of 
clients for advisers registered with us should be much smaller.

B. Form ADV, Part II, Item 14

    We propose to eliminate the requirement set forth in Part II, Item 
14 of Form ADV that an adviser with custody must include in its 
brochure a balance sheet audited by an independent public 
accountant.\95\ This would reduce paperwork burden for advisers that 
have custody of client assets. We would continue to require an adviser 
to provide an audited balance sheet if the adviser requires prepayment 
of advisory fees of more than $500 per client and more than six months 
in advance.
---------------------------------------------------------------------------

    \95\ See supra Section II. E. of this Release.
---------------------------------------------------------------------------

    In the currently approved annual aggregate burden of collection of 
information, we inadvertently failed to include an estimate of the cost 
advisers incur to pay their independent public accountants to prepare 
audited balance sheets. We estimate that the current aggregate annual 
cost of this requirement for advisers registered with us is 
$11,460,000. This aggregate is based on our estimate that (i) each 
adviser who must obtain an audited balance sheet in order to comply 
with the requirement pays approximately $15,000 on average in 
accounting fees, (ii) 184 advisers incur these costs under the advance 
fees provision, and (iii) 580 additional advisers incur these costs 
under the custody provision.\96\
---------------------------------------------------------------------------

    \96\ $15,000 fees  x  (184 advisers with advance fees + 580 
additional advisers with custody) = $11,460,000. According to our 
records, 184 advisers registered with us require prepayment of fees, 
and 887 advisers registered with us provide an audited balance sheet 
to their clients under Part II, Item 14 of Form ADV. (Because 
advisers are not presently required to file Part II of ADV with the 
Commission, the 887 figure is from data collected before January 1, 
2001.) Since 867 advisers report having custody of their clients' 
assets, and this number of advisers combined with those who require 
prepayment of fees exceeds the 887 providing balance sheets by 164, 
we estimate that 164 of the advisers with custody also require 
prepayment of fees. Of the 703 advisers providing balance sheets 
because of the custody provision (867 advisers with custody -164 
also requiring prepayment of fees = 703), 123 are also broker-
dealers that are required to maintain audited financial statements 
under other rules, and only the remaining 580 advisers incur 
accountants' fees to comply with the balance sheet requirement under 
the custody provision.
---------------------------------------------------------------------------

    For purposes of calculating this cost estimate under the proposed 
amendments, the 580 advisers that we estimate are currently incurring 
accountants' fees to comply with the balance sheet requirement under 
the custody provision will no longer incur these costs. Therefore, we 
estimate that the number of advisers subject to this requirement will 
be reduced to 184, and the aggregate annual cost of this requirement 
will be reduced to $2,760,000, for an average annual cost for each 
adviser registered with us of $364.\97\
---------------------------------------------------------------------------

    \97\ (184  x  $15,000)/7,583 = $364.
---------------------------------------------------------------------------

C. Request for Comment

    We request comment whether these estimates are reasonable. Any 
information received by the Commission related to the proposed rule 
amendments would not be kept confidential. Pursuant to 44 U.S.C. 
3506(c)(2)(B), the Commission solicits comments to:
     Evaluate whether the proposed collections of information 
are necessary for the proper performance of the functions of the 
Commission, including whether the information will have practical 
utility;
     Evaluate the accuracy of the Commission's estimate of the 
burden of the proposed collections of information;
     Determine whether there are ways to enhance the quality, 
utility, and clarity of the information to be collected; and
     Determine whether there are ways to minimize the burden of 
the collections of information on those who are to respond, including 
through the use of automated collection techniques or other forms of 
information technology.
    Persons wishing to submit comments on the collection of information 
requirements should direct them to the Office of Management and Budget, 
Attention: Desk Officer for the Securities and Exchange Commission, 
Office of Information and Regulatory Affairs, Room 3208, Washington, DC 
20503, and also should send a copy to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW, Washington, 
DC 20549-0609 with reference to File No. S7-28-02. OMB is required to 
make a decision concerning the collections of information between 30 
and 60 days after publication, so a comment to OMB is best assured of 
having its full effect if OMB receives the comment within 30 days after 
publication of this release. Requests for materials submitted to OMB by 
the Commission with regard to these collections of information should 
be in writing, refer to File No. S7-28-02, and be submitted to the 
Securities and Exchange Commission, Records Management, Office of 
Filings and Information Services, 450 Fifth Street, NW, Washington, DC 
20549.

VI. Initial Regulatory Flexibility Analysis

    The Commission has prepared the following Initial Regulatory 
Flexibility Analysis (``IRFA'') regarding proposed rule 206(4)-2 in 
accordance with section 3(a) of the Regulatory Flexibility Act.\98\
---------------------------------------------------------------------------

    \98\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

A. Reasons for Proposed Action

    Rule 206(4)-2 seeks to protect clients' assets in the custody of 
advisers by requiring advisers to deposit client funds in bank accounts 
and to segregate and identify client securities and hold them in 
safekeeping. The rule also protects custodied assets by requiring 
advisers to send each client quarterly account statements and to have 
an independent public accountant conduct an annual surprise examination 
of the custodied assets. We have not amended the rule substantively 
since we adopted it over 40 years ago. Since then, custodial practices 
have changed and, as a result, portions of the rule have become 
outdated or inconsistent with modern custodial practices. Advisers' 
business practices have also evolved, increasing the likelihood that 
advisers may obtain custody of client assets in circumstances that we 
may not have anticipated in 1962.

[[Page 48590]]

    As part of our ongoing effort to review and modernize federal 
securities law, we are proposing comprehensive amendments to rule 
206(4)-2. These amendments are designed to harmonize the rule with 
current custodial practices, enhance the protections afforded to client 
assets, and clarify circumstances under which advisers have custody of 
client assets. The amendments would require advisers to maintain client 
funds and securities with a broker-dealer, bank, or other ``qualified 
custodian.'' If the qualified custodian sends monthly account 
statements directly to an adviser's clients, the adviser would be 
relieved from sending its own account statements and from undergoing an 
annual surprise examination of those clients' accounts. The proposed 
amendments would exempt advisers from the rule with respect to clients 
that are registered investment companies, as well as with respect to 
limited partnerships and other pooled investment vehicles that are 
subject to annual audit by an independent public accountant.
    The proposed amendments would add a definition of ``custody'' to 
the rule and illustrate the circumstances under which an adviser has 
custody of client assets. Advisers will benefit from this transparency 
because they (or their counsel) will no longer need to refer to other 
materials such as staff no-action letters for these examples. Finally, 
the proposed amendments would eliminate the requirement in Form ADV 
that advisers with custody include an audited balance sheet in their 
disclosure brochures to clients; other disclosures now provide clients 
with information that is likely to be more helpful to them in this 
regard.

B. Objectives and Legal Basis

    The objectives of the proposed amendments to rule 206(4)-2 are 
threefold. First, the amendments would enhance the protections afforded 
to client assets. The proposed amendments would exempt advisers from 
the requirements to send each client account statements and to undergo 
annual surprise examinations of the client's account if the qualified 
custodian sends account statements directly to the advisory client 
monthly. Qualified custodians' delivery of account statements directly 
to clients should provide clients with confidence that any erroneous or 
unauthorized transactions by an adviser have been reflected. We believe 
nearly all advisers already maintain their clients' assets with 
qualified custodians, and will avail themselves of the option to avoid 
the costs of preparing statements and surprise examinations by electing 
to have the qualified custodian send account statements directly to the 
client.
    Second, the amendments would harmonize the rule with current 
custodial practices. For example, the requirement under the current 
rule for advisers to segregate, identify, and safe-keep client 
securities assumes that securities are held as physical certificates. 
Now that most securities are held in book-entry form, the proposed 
amendments' requirement to maintain the securities with a qualified 
custodian would better reflect modern market practices.
    Third, the amendments clarify circumstances under which advisers 
have custody of client assets, by providing a definition of custody 
that includes examples illustrating application of the definition. 
Advisers will benefit from this transparency because they (or their 
counsel) will no longer need to refer to other materials such as staff 
no-action letters for these examples.
    The Commission is proposing to amend rule 206(4)-2 pursuant to 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)]. Section 206(4) gives us authority 
to issue rules designed to prevent fraudulent, deceptive, or 
manipulative acts or practices. Section 211 gives us authority to 
clarify, by rule, persons and matters within our jurisdiction and to 
prescribe different requirements for different classes of persons, as 
necessary or appropriate to the exercise of our authority under the 
Act.

C. Small Entities Subject to Rule

    Under Commission rules, for the purposes of the Advisers Act and 
the Regulatory Flexibility Act, an investment adviser generally is a 
small entity if it: (i) Has assets under management having a total 
value of less than $25 million; (ii) did not have total assets of $5 
million or more on the last day of its most recent fiscal year; and 
(iii) does not control, is not controlled by, and is not under common 
control with another investment adviser that has assets under 
management of $25 million or more, or any person (other than a natural 
person) that had $5 million or more on the last day of its most recent 
fiscal year.\99\ The Commission estimates that as of May 21, 2002 
approximately 28 SEC-registered investment advisers that have custody 
of client assets were small entities.\100\
---------------------------------------------------------------------------

    \99\ 17 CFR 275.0-7(a).
    \100\ This estimate is based on the information provided 
submitted by SEC-registered advisers in Form ADV, Part 1A [17 CFR 
279.1].
---------------------------------------------------------------------------

D. Reporting, Recordkeeping, and Other Compliance Requirements

    The proposed rule would impose no new reporting and recordkeeping 
requirements. In addition, we believe that most advisers that maintain 
custody of client assets, including advisers that are small entities, 
already maintain these assets with qualified custodians. Therefore, the 
proposed amendments would not materially increase the effort necessary 
on advisers' behalf to comply with the Commission's rules. To the 
contrary, the proposed amendments provide advisers with the opportunity 
to eliminate costs they incur complying with the present rule's 
requirements to send account statements to clients and undergo an 
annual surprise examination.\101\ In addition, we are proposing to 
amend Form ADV to eliminate the requirement that an adviser with 
custody of client assets provide its clients with a copy of its audited 
balance sheet, thereby further reducing advisers' compliance costs.
---------------------------------------------------------------------------

    \101\ Under the proposed amendments, an adviser would not be 
required to send quarterly account statements or undergo a surprise 
examination with respect to accounts for which a qualified custodian 
that sends monthly account statements directly to clients.
---------------------------------------------------------------------------

E. Duplicative, Overlapping, or Conflicting Federal Rules

    The Commission believes that there are no rules that duplicate, 
overlap, or conflict with the proposed rule.

F. Significant Alternatives

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objective, 
while minimizing any significant adverse impact on small entities. In 
connection with the proposed rule, the Commission considered the 
following alternatives: (a) The establishment of differing compliance 
or reporting requirements or timetables that take into account the 
resources available to small entities; (b) the clarification, 
consolidation, or simplification of compliance and reporting 
requirements under the rule for such small entities; (c) the use of 
performance rather than design standards; and (d) an exemption from 
coverage of the rule, or any part thereof, for such small entities.
    The overall impact of the proposed amendments is to decrease 
regulatory burdens on advisers, and small advisers, as well as large 
ones, will benefit from

[[Page 48591]]

the proposed rule. Moreover, the proposed amendments achieve the rule's 
objectives through alternatives that are already consistent in large 
part with advisers' current custodial practices. Therefore, the 
potential impact of the amendments on small entities should not be 
significant. For these reasons, alternatives to the proposed 
amendments, such as differing compliance or reporting requirements, 
simplification of compliance and reporting requirements, or the use of 
performance rather than design standards, are unlikely to minimize any 
impact that the proposed rule may have on small entities. Regarding 
exemption from coverage of the rule amendments, or any part thereof, 
for small entities, such an exemption would deprive small entities of 
the burden relief provided by the amendments. Moreover, since the 
protections of the Advisers Act are intended to apply equally to 
clients of both large and small advisory firms, it would be 
inconsistent with the purposes of the Act to specify different 
requirements for small entities or to establish different compliance or 
reporting requirements for small entities with regard to this 
requirement.

G. Solicitation of Comments

    We encourage written comments on matters discussed in this IRFA. In 
particular, the Commission seeks comment on:
     The number of small entities that would be affected by the 
proposed rule; and
     Whether the effect of the proposed rule on small entities 
would be economically significant.
    Commenters are asked to describe the nature of any effect and 
provide empirical data supporting the extent of the effect.

VII. Statutory Authority

    We are proposing amendments to rule 206(4)-2 pursuant to our 
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)].
    We are proposing amendments to Part II of Form ADV pursuant to the 
authority set forth in sections 203(c)(1), 204, and 211(a) of the 
Advisers Act [15 U.S.C. 80b-3(c)(1), 80b-4 and 80b-11(a)].

Text of Proposed Rule

    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 authority citation for Part 275 continues to read in part as 
follows:

    Authority: 15 U.S.C. 80b-2(a)(11)(F), 80b-2(a)(17), 80b-3, 80b-
4, 80b-6(4), 80b-6a, 80b-11, unless otherwise noted.
* * * * *
    2. Section 275.206(4)-2 is revised to read as follows:


Sec. 275.206(4)-2  Custody of funds or securities of clients by 
investment advisers.

    (a) Safekeeping required. If you are an investment adviser 
registered or required to be registered under Section 203 of the Act 
(15 U.S.C. 80b-3), it is 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 you to have custody of client funds or 
securities unless:
    (1) Qualified custodian. A qualified custodian maintains those 
funds and securities:
    (i) In a separate account for each client under that client's name; 
or
    (ii) In accounts that contain only your clients' funds and 
securities, under your name as agent or trustee for the clients;
    (2) Notice to clients. If you open an account with a qualified 
custodian on your client's behalf, either under the client's name or 
under your name as agent, you notify the client in writing of the 
qualified custodian's name, address, and the manner in which the funds 
or securities are maintained, promptly when the account is opened and 
following any changes to this information; and
    (3) Account statements to clients. (i) By qualified custodian. You 
have a reasonable basis for believing that the qualified custodian 
sends, to each of your clients for which it maintains funds or 
securities, a monthly account statement, identifying the amount of 
funds and of each security in the account at the end of the period and 
setting forth all transactions in the account during that period; or
    (ii) By adviser. (A) You send a quarterly account statement to each 
of your clients whose funds or securities are maintained with a 
qualified custodian, identifying the amount of funds and of each 
security in the account at the end of the period and setting forth all 
transactions in the account during that period;
    (B) An independent public accountant verifies all of those funds 
and securities by actual examination at least once each calendar year 
at a time chosen by the accountant without prior notice to you, and 
files a certificate on Form ADV-E (17 CFR 279.8) with the Commission 
within 30 days after the examination, stating that it has examined the 
funds and securities and describing the nature and extent of the 
examination; and
    (C) The independent public accountant, upon finding any material 
discrepancies during the course of the examination, notifies the 
Commission within one business day of the finding, by means of a 
facsimile transmission or electronic mail, followed by first class 
mail, directed to the attention of the Director of the Office of 
Compliance Inspections and Examinations.
    (iii) Special rule for limited partnerships and limited liability 
companies. If you are a general partner of a limited partnership (or 
managing member of a limited liability company, or hold a comparable 
position for another type of pooled investment vehicle), the account 
statements required under paragraphs (a)(3)(i) or (a)(3)(ii) of this 
section must be sent to each limited partner (or member or other 
beneficial owner), or to their independent representative.
    (b) Exceptions. You are not required to comply with this section 
(17 CFR 275.206(4)-2) with respect to the account of:
    (1) An investment company registered under the Investment Company 
Act of 1940 (15 U.S.C. 80a-1 to 80a-64); or
    (2) A limited partnership (or limited liability company, or another 
type of pooled investment vehicle) that has its transactions and assets 
audited (as defined in Section 2(d) of Article 1 of Regulation S-X (17 
CFR 210.1-02(d)) at least annually and distributes its audited 
financial statements prepared in accordance with generally accepted 
accounting principles to all limited partners (or members or other 
beneficial owners) within 90 days of the end of its fiscal year.
    (c) Definitions. For the purposes of this section:
    (1) Custody means holding, directly or indirectly, client funds or 
securities, or having any authority to obtain possession of them. 
Custody includes:
    (i) Possession or control of client funds (but not of checks drawn 
by clients and made payable to third parties) or securities, unless you 
receive them inadvertently and you return them to the sender within one 
business day of receiving them;
    (ii) Any arrangement (including a general power of attorney) under 
which you are authorized or permitted to withdraw client funds or 
securities maintained with a custodian upon your instruction to the 
custodian; and

[[Page 48592]]

    (iii) Any capacity (such as general partner of a limited 
partnership, managing member of a limited liability company or a 
comparable position for another type of pooled investment vehicle, or 
trustee of a trust) that gives you legal ownership of or access to 
client funds or securities.
    (2) Independent representative means a person that:
    (i) Acts as agent for limited partners of a limited partnership (or 
members of a limited liability company, or other beneficial owners of 
another type of pooled investment vehicle) and by law or contract is 
obliged to act in the best interest of the limited partners (or 
members, or other beneficial owners);
    (ii) Does not control, is not controlled by, and is not under 
common control with you; and
    (iii) Does not have, and has not had within the past two years, a 
material business relationship with you.
    (3) Qualified custodian means:
    (i) A bank as defined in section 202(a)(2) of the Advisers Act (15 
U.S.C. 80b-2(a)(2));
    (ii) A savings association as defined in section 3(b)(1) of the 
Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has deposits 
insured by the Federal Deposit Insurance Corporation under the Federal 
Deposit Insurance Act (12 U.S.C. 1811);
    (iii) A broker-dealer registered under section 15(b)(1) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78o(b)(1)), holding the 
client assets in customer accounts;
    (iv) A futures commission merchant registered under section 4f(a) 
of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client 
assets in customer accounts; and
    (v) With respect to securities for which the primary market is in a 
country other than the United States, and cash and cash equivalents 
reasonably necessary to effect transactions in those securities, a 
financial institution that customarily holds financial assets in that 
country and that holds the client assets in customer accounts 
segregated from its proprietary assets.

PART 279--FORMS PRESCRIBED UNDER THE INVESTMENT ADVISERS ACT OF 
1940

    3. The authority citation for Part 279 continues to read as 
follows:

    Authority: The Investment Advisers Act of 1940, 15 U.S.C. 80b-1, 
et seq., unless otherwise noted.

    4. By amending Item 14 of Part II of Form ADV (referenced in 
Sec. 279.1) by adding ``(unless applicant is registered or registering 
only with the Securities and Exchange Commission),'' after the words 
``client funds or securities''.

    Dated: July 18, 2002.
    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-18698 Filed 7-24-02; 8:45 am]
BILLING CODE 8010-01-U