[Federal Register Volume 68, Number 190 (Wednesday, October 1, 2003)]
[Rules and Regulations]
[Pages 56692-56701]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-24813]



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Part III





Securities and Exchange Commission





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17 CFR Parts 275 and 279



Custody of Funds or Securities of Clients by Investment Advisers; Final 
Rule

  Federal Register / Vol. 68, No. 190 / Wednesday, October 1, 2003 / 
Rules and Regulations  

[[Page 56692]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 275 and 279

[Release No. IA-2176; 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: Final rule.

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SUMMARY: The Commission is adopting amendments to the custody rule 
under the Investment Advisers Act of 1940. The amendments modernize the 
rule by conforming the rule to modern custodial practices and requiring 
advisers that have custody of client funds or securities to maintain 
those assets with broker-dealers, banks, or other qualified custodians. 
The amended rule also provides a definition of ``custody'' and 
illustrates circumstances under which an adviser has custody of client 
funds or securities. The amendments are designed to enhance protections 
for client assets while reducing burdens on advisers that have custody 
of client assets.

DATES: Effective Date: November 5, 2003. Compliance Date: April 1, 
2004.

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 
Street, NW., Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to 
rule 206(4)-2 (17 CFR 275.206(4)-2) \1\ under the Investment Advisers 
Act of 1940 (15 U.S.C. 80b) (the ``Advisers Act'' or ``Act'') and to 
Part 1A, Item 9 and Part II, Item 14 of Form ADV (17 CFR 279.1).
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    \1\ 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 Form ADV
III. Effective Date
IV. Consideration of Promotion of Efficiency, Competition, and 
Capital Formation
V. Cost-Benefit Analysis
VI. Paperwork Reduction Act
VII. Final Regulatory Flexibility Analysis
VIII. Statutory Authority
Text of Rule

Executive Summary

    The Commission is amending rule 206(4)-2, the custody rule under 
the Advisers Act, to reflect modern custodial practices and clarify 
circumstances under which an adviser has custody of client assets. The 
amendments 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 account statements 
directly to an adviser's clients, the adviser is relieved from sending 
its own account statements and from undergoing an annual surprise 
examination. The amendments also add a definition of ``custody'' to the 
rule and illustrate circumstances under which an adviser has custody of 
client funds or securities. Finally, the amendments remove the Form ADV 
requirement that advisers with custody include an audited balance sheet 
in their disclosure brochure to clients.

I. Background

    Rule 206(4)-2 regulates the custody practices of advisers 
registered under the Advisers Act. The rule requires advisers that have 
custody of client securities or funds to implement a set of controls 
designed to protect those client assets from being lost, misused, 
misappropriated or subject to the advisers' financial reverses.
    Last year we proposed comprehensive amendments to rule 206(4)-2. 
Our proposal was 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.\2\ We received 49 comment letters in response to our proposed 
rule. Commenters strongly supported the approach of the proposal. One 
noted that our proposal would replace ``highly detailed compliance 
requirements with an overall regulatory framework in order to achieve 
greater accountability and transparency of transactions in client 
accounts.'' \3\ We are adopting the amendments to rule 206(4)-2 with 
certain changes that respond to commenters' recommendations.
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    \2\ Custody of Funds or Securities of Clients by Investment 
Advisers, Investment Advisers Release No. 2044 (July 18, 2002) [67 
FR 48579 (July 25, 2002)] (``Proposing Release'').
    \3\ See Summary of Comments prepared by our staff, available in 
our Public Reference Room in File No. S7-28-02, and on our Web site 
at http://www.sec.gov/rules/extra/s72802csumm.htm.
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II. Discussion

A. Definition of Custody

    We have added to the rule a definition of the term ``custody.'' An 
adviser has custody of client assets, and therefore must comply with 
the rule, when it holds, ``directly or indirectly, client funds or 
securities or [has] any authority to obtain possession of them.''\4\ We 
provide three examples designed to illustrate circumstances under which 
an adviser has custody of client funds or securities. Commenters agreed 
that the examples will be helpful to advisers.
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    \4\ Amended rule 206(4)-2(c)(1). One commenter asked whether an 
adviser with multiple lines of business within the same corporation 
or other business entity has ``custody'' if its non-advisory 
business gives the adviser or its personnel authority to obtain 
customers' funds or securities. For example, an adviser might 
provide investment advice and also offer, separately, a bill-paying 
service through which the adviser's employees gain signatory power 
over a customer's checking account. If the customer is not an 
advisory client of the adviser, the adviser does not have custody of 
``client funds and securities.'' If, however, the customer is also 
an advisory client, the adviser has access to a client's assets, and 
therefore has custody, even though that access arises through a 
separate line of business.
    The same access could also arise through an affiliate of the 
adviser. An adviser may, for example, have custody if its affiliate 
holds funds or securities of the adviser's clients under 
circumstances in which the adviser or its personnel have access to 
those client assets through the affiliate. Our staff previously has 
expressed similar views in Crocker Investment Management Corp., SEC 
Staff Letter (Apr. 14, 1978).
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    The first example clarifies that an adviser has custody when it has 
possession of client funds or securities, even briefly.\5\ An adviser 
that holds clients' stock certificates or cash, even temporarily, puts 
those assets at risk of misuse or loss. The amendments, however, 
expressly exclude inadvertent receipt by the adviser of client funds or 
securities, so long as the adviser returns them to the sender within 
three business days of receiving them.\6\ The rule does not permit 
advisers to forward

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clients' funds and securities without having ``custody,'' although 
advisers may certainly assist clients in such matters.\7\ In addition, 
the amendments clarify that an adviser's possession of a check drawn by 
the client and made payable to a third party is not possession of 
client funds for purposes of the custody definition.\8\
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    \5\ Amended rule 206(4)-2(c)(1)(i). In our proposed rule, our 
first example of custody referred to ``possession or control'' of 
client funds or securities, but commenters suggested that the term 
``control'' improperly suggested that an adviser that merely has 
trading authority over a client's securities account has custody for 
purposes of the rule. See infra note. We believe that the definition 
and other examples make it clear that an adviser has custody when it 
can control client funds or securities for purposes other than 
authorized trading, and that the word ``control'' is therefore not 
needed in the first example.
    \6\ We had proposed requiring the adviser to return the funds 
and securities in one day, but commenters suggested that a longer 
period was needed to reduce inadvertent violations of the rule.
    \7\ We understand that some advisers meet with clients to 
prepare or compile documents, including stock certificates, for 
forwarding to a custodian or third party. Nothing in the amended 
rule suggests that preparing these documents with a client gives the 
adviser ``custody.''
    \8\ Checks payable to an adviser for payment of advisory 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.
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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.\9\ 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 funds or securities for any purpose 
other than authorized trading has access to the client's assets.\10\ 
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.\11\ 
These advisers might not have possession of client assets, but they 
have the authority to obtain possession.
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    \9\ Amended rule 206(4)-2(c)(1)(ii).
    \10\ An adviser's authority to issue instructions to a broker-
dealer or a custodian to effect or to settle trades does not 
constitute ``custody.'' Clients' custodians are generally under 
instructions to transfer funds (or securities) out of a client's 
account only upon corresponding transfer of securities (or funds) 
into the account. This ``delivery versus payment'' arrangement 
minimizes the risk that an adviser could withdraw or misappropriate 
the funds or securities in its client's custodial account.
    \11\ Some commenters asked whether they could, instead of 
complying with the amended rule, continue following procedures 
established under certain no-action letters, 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 Advisers Inc., SEC Staff Letter (Apr. 4, 1997). 
The staff is withdrawing those letters. Advisers, including those 
firms that have relied on these letters in the past, must comply 
with the amended rule.
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    Several commenters suggested that we change the definition of 
``custody'' to exclude advisers' access to client funds through fee 
deductions. We are not adopting this suggestion. Removing this form of 
custody from the definition would mean that clients would not receive 
the quarterly account statements that are required under the rule, and 
which are needed so that clients may confirm that the adviser has not 
improperly withdrawn amounts in excess of its fees.\12\ We are, 
however, amending Form ADV so advisers that have custody only because 
they deduct fees will not need to amend their registration 
statements.\13\
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    \12\ See Section II.C. of this Release. We note, however, that 
rule 206(4)-2 defines ``custody'' broadly in order to serve the 
remedial purposes of the rule, and to ensure that advisory clients 
receive timely reports on transactions in their assets and thus can 
take action to protect themselves in the event of an adviser's 
misuse of their funds. Consequently, an adviser that has ``custody'' 
for purposes of rule 206(4)-2 may not necessarily have custody for 
other purposes.
    \13\ See Section II.E of this Release.
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    The last example clarifies that an adviser has custody if it acts 
in any capacity that gives the adviser legal ownership of, or access 
to, the client funds or securities.\14\ One common instance is a firm 
that acts as both general partner and investment adviser to a limited 
partnership.\15\ By virtue of its position as general partner, the 
adviser generally has authority to dispose of funds and securities in 
the limited partnership's account and thus has custody of client 
assets.\16\
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    \14\ Amended rule 206(4)-2(c)(1)(iii).
    \15\ 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. A firm may also have custody when 
a supervised person fills one of these roles, such as when a 
portfolio manager serves as trustee of a client trust. E.g., In the 
Matter of Gofen and Glossberg, Inc., Investment Advisers Act Release 
No. 1400 (Jan. 11, 1994). We understand that supervised persons may, 
on occasion, engage the advisory firm to advise an estate, 
conservatorship or personal trust for which the supervised person 
serves as executor, conservator or trustee. We would not view the 
adviser to have custody of the funds or securities of the estate, 
conservatorship, or trust solely because the supervised person has 
been appointed in these capacities as a result of family or personal 
relationship with the decedent, beneficiary or grantor (and not a 
result of employment with the adviser).
    The amended rule contains a limited exception from the rule for 
client accounts that are limited partnerships subject to an annual 
audit. See infra Section II.D.2 of this Release. Some commenters 
asked whether they could, instead of complying with the amended 
rule, continue following procedures established under certain no-
action letters, e.g., Bennett Management Co., SEC Staff Letter (Feb. 
26, 1990); PIMS, Inc., SEC Staff Letter (Oct. 21, 1991); Canyon 
Management Co., SEC Staff Letter (Oct. 15, 1991); Pacific 
Management, Ltd., SEC Staff Letter (Oct. 29, 1991); Lee Capital 
Management, SEC Staff Letter (Oct. 29, 1991); Eichler Magnin, Inc., 
SEC Staff Letter (Nov. 4, 1991); GBU, Inc., SEC Staff Letter (Apr. 
22, 1993). The staff is withdrawing those letters. Advisers, 
including those firms that have relied on these letters in the past, 
must comply with the amended rule.
    \16\ Investment advisers that also act as general partners for 
real estate partnerships in which their advisory clients are limited 
partners requested clarification about the rule's application to 
such partnerships. In such circumstances, the rule does not apply to 
the assets of the real estate partnership unless the partnership is 
an advisory client of the investment adviser.
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B. Use of Qualified Custodians

    We are adopting, as proposed, a requirement that advisers with 
custody of client funds and securities maintain them with qualified 
custodians.\17\ The qualified custodian must hold the funds or 
securities in an account either under the client's name or under the 
adviser's name as agent or trustee for its clients.\18\
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    \17\ Amended rule 206(4)-2(a)(1). The amended rule does not 
prohibit an adviser from using more than one qualified custodian to 
hold funds and securities of a client.
    \18\ Under the amendments, client funds and securities must be 
held on behalf of the client by the qualified custodian so that the 
qualified custodian can provide account information to the clients. 
Keeping stock certificates in the adviser's bank safe deposit box, 
for example, would not satisfy the requirements of the rule.
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    ``Qualified custodians'' under the amended rule include the types 
of financial institutions that clients and advisers customarily turn to 
for custodial services. These include banks and savings associations 
\19\ and registered broker-dealers.\20\ In order to allow advisers that 
also offer futures advice to comply with Commodity Futures Trading 
Commission rules, ``qualified custodians'' also include registered 
futures commission merchants.\21\ Finally, ``qualified custodians'' 
include foreign financial

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institutions that customarily hold financial assets for their 
customers, provided that the foreign financial institution keeps 
advisory clients' assets in customer accounts segregated from its 
proprietary assets.\22\
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    \19\ Amended rule 206(4)-2(c)(3)(i). 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. A ``savings 
association'' is a financial institution 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).
    \20\ Amended rule 206(4)-2(c)(3)(ii). ``Qualified custodian'' 
includes 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.
    \21\ Amended rule 206(4)-2(c)(3)(iii). 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'' includes 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 also be subject to CFTC 
rules; CFTC rules require that ``customer funds'' be custodied with 
a futures commission merchant. See rule 4.30 (17 CFR 4.30) under the 
Commodity Exchange Act. See also Commodity Futures Modernization Act 
(Pub. L. 106-554, 114 Stat. 2763 (2000)) (security futures are both 
securities and futures). The rule also allows advisers to maintain 
client securities with a futures commission merchant to the extent 
the securities are incidental to client futures transactions.
    \22\ Amended rule 206(4)-2(c)(3)(iv). We proposed to include 
foreign financial institutions only for securities whose primary 
trading market was in the country where the custodian was located. 
Some commenters urged that we permit foreign custodians to be used 
more broadly, arguing that some advisers, and some clients, 
especially those residing overseas, may at times have reason to use 
a foreign firm as a custodian or may have existing relationships 
with foreign institutions. We are modifying the rule from the 
proposal to avoid disrupting these existing practices. Where an 
adviser selects a foreign financial institution to hold clients' 
assets, we believe the adviser's fiduciary obligations require it 
either to have a reasonable basis for believing that the foreign 
institution will provide a level of safety for client assets similar 
to that which would be provided by a ``qualified custodian'' in the 
United States or to fully disclose to clients any material risks 
attendant to maintaining the assets with the foreign custodian.
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    Many advisers registered with us are themselves qualified 
custodians under the amended rule.\23\ These advisers may maintain 
their own clients' funds and securities, subject to the account 
statement requirements described below and the custody rules imposed by 
the regulators of the advisers' custodial functions. Advisers may also 
maintain client assets with affiliates that are qualified custodians.
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    \23\ For example, Form ADVs submitted by SEC-registered advisers 
indicate that as of May 16, 2002, 647 advisers were broker-dealers 
registered with us under section 15 of the Exchange Act (15 U.S.C. 
78o) and 77 advisers were banks (or separately identifiable 
departments or divisions of banks).
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    The amended rule contains special provisions for two types of 
securities: mutual fund shares and private issues. Commenters noted 
that, at times, a client or adviser may purchase shares of a mutual 
fund directly from the fund's transfer agent rather than through 
another intermediary such as a broker-dealer. In these cases, the 
mutual fund's transfer agent maintains the securities for the client on 
the mutual fund's books. The adviser, however, may also have custody 
because, for example, the adviser has check-writing or fee-deduction 
authority over the assets.\24\ The amended rule allows an adviser to 
use the mutual fund transfer agent in lieu of a qualified custodian 
with respect to those shares.\25\
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    \24\ Commenters were concerned that without an exception, an 
advisory client or adviser would have to use a qualified custodian 
in addition to the mutual fund transfer agent.
    \25\ See amended rule 206(4)-2(b)(1). The fund transfer agent 
must fulfill all aspects of the role of a qualified custodian under 
the rule, including sending statements directly to the client, or 
the adviser will be subject to annual surprise examinations. See 
discussions in Section II.C. of this Release.
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    Commenters also pointed out that, on occasion, a client may 
purchase privately-offered securities and that maintaining certain of 
these assets in accounts with qualified custodians poses difficulties 
because the client's ownership of the security is recorded only on the 
books of the issuer. The client may receive copies of subscription or 
partnership agreements that are not maintained with a custodian.\26\ 
The amendments except advisers from the rule with respect to privately-
offered uncertificated securities in their clients' accounts, if 
ownership of the securities is recorded only on the books of the issuer 
or its transfer agent, in the name of the client, and transfer of 
ownership is subject to prior consent of the issuer or holders of the 
issuer's outstanding securities.\27\ These impediments to 
transferability provide some external safeguards against the kinds of 
abuse the rule seeks to prevent. These safeguards, however, may be 
ineffective in the case of limited partnerships (or other pooled 
investment vehicles). Because the private securities are held in the 
name of the limited partnership and the adviser acts for the 
partnership, the adviser has apparent authority to arrange transfers 
that would be recognized by the issuer of the securities. Accordingly, 
an adviser may use the exception for private securities with respect to 
the account of a limited partnership only if the limited partnership is 
audited annually, and the audited financial statements are distributed, 
as described in amended rule 206(4)-2(b)(3).\28\
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    \26\ Commenters specifically mentioned clients' investments in 
limited partnerships, where clients receive only a copy of the 
partnership agreement as evidence of their investment. Commenters 
also mentioned assignment agreements for debt or equity interests in 
a private company, or other types of customized agreements. See our 
staff's summary of comments posted on our web site at www.sec.gov/rules/extra/s72802csumm.htm.
    \27\ For example, in many privately-offered limited partnerships 
transfer of a limited partnership interest must be approved by a 
majority or some other percentage of the other limited partners. The 
rule does not require a specific number or percentage of the other 
security holders that must approve the transfer; applicable 
partnership law or the limited partnership agreement would set that 
standard.
    \28\ See Section II.D.2 of this Release. Otherwise, an adviser 
to a limited partnership (or other types of pooled investment 
vehicles) will still be required to maintain custody of privately-
offered securities in accordance with the requirements of the rule.
    Some privately-offered securities may be difficult to value. 
Account statements that must be delivered to a client under the rule 
must report the amount of the client's securities, but the rule does 
not require those statements to include a valuation of the 
securities.
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C. Delivery of Account Statements to Clients

    Rule 206(4)-2, as amended, requires that advisers with custody of 
clients' funds or securities have a reasonable belief that the 
qualified custodian holding the assets provides periodic account 
statements to those clients.\29\ A number of commenters asserted that 
some custodial accounts are on quarterly rather than monthly reporting 
cycles and that moving to a monthly cycle would increase expenses 
substantially. In response to these comments, the amended rule requires 
quarterly account statements rather than the monthly statements we 
proposed. This provision, which requires qualified custodians to 
deliver account statements directly to advisory clients (and not 
through the adviser), is designed to assure the integrity of those 
account statements and permit clients to identify any erroneous or 
unauthorized transactions or withdrawals by an adviser.\30\
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    \29\ Amended rule 206(4)-2(a)(3)(i). An adviser could form this 
reasonable belief if, for example, the qualified custodian provides 
the adviser with a copy of the account statement that was delivered 
to the client.
    Account statements may be delivered electronically as well as on 
paper. Electronic delivery must comply with the Commission's 
interpretive guidelines on delivering documents electronically. See 
Use of Electronic Media by Broker-Dealers, Transfer Agents, and 
Investment Advisers for Delivery of Information; Additional Examples 
under the Securities Act of 1933, Securities Exchange Act of 1934, 
and Investment Company Act of 1940, Release No. 33-7288 (May 9, 
1996) [61 FR 24644 (May 15, 1996)]. The guidelines are available at 
www.sec.gov/rules/concept/33-7288.txt. See also New York Stock 
Exchange's June 13, 1997 Information Memo (No. 97-32) entitled 
``Electronic Delivery of Information to Customers by Members and 
Member Organizations.''
    \30\ We understand qualified custodians sometimes use service 
providers to deliver account statements. The amended rule does not 
prohibit a qualified custodian from doing so, as long as the 
statements are not routed through the adviser.
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    As we discussed in the Proposing Release, we recognize that there 
may be circumstances in which an adviser would need to continue using 
the approach of the current rule.\31\ Accordingly, if a client does not 
receive account statements directly from the qualified custodian, the 
adviser must continue sending quarterly account statements to that 
client and to undergo an annual surprise examination by an independent 
public accountant \32\ to verify the funds and securities of that 
client.\33\ The amendments require the

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accountant to notify our Office of Compliance Inspections and 
Examinations within one business day of finding any material 
discrepancies during an examination.\34\
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    \31\ See Section II.C. of the Proposing Release.
    \32\ Article 2 of Regulation S-X sets forth Commission standards 
for the independence of accountants. 17 CFR 210.2-01.
    \33\ Amended rule 206(4)-2(a)(3)(ii). If qualified custodians 
deliver account statements directly to some, but not all, of an 
adviser's clients (or with respect to some, but not all, of a 
client's funds and securities), the adviser's quarterly statements 
and the scope of the surprise examination could cover only the 
client funds and securities for which custodial statements are not 
delivered directly. The accountant must ensure, however, that all 
client funds and securities either are covered by statements sent 
directly from the qualified custodian or are covered by the surprise 
examination.
    The accountant should perform the examination in accordance with 
U.S. Generally Accepted Auditing or Attestation Standards, except 
that the accountant must verify or substantiate all client funds and 
securities covered by the examination. The examination should 
include confirmation of all cash and securities held by custodians, 
including a physical examination of securities if applicable, and 
reconciliation of all such cash and securities to the books and 
records of client accounts maintained by the adviser, as well as 
confirmation of such information with the adviser's clients. See 
American Institute of Certified Public Accountants, Audit and 
Accounting Guide: Audits of Investment Companies Sec.  11.12 (2002); 
Statement of the Commission Describing Nature of Examination 
Required to be Made of All Funds and Securities Held by an 
Investment Adviser and the Content of Related Accountant's 
Certificate, Investment Advisers Act Release No. 201 (May 26, 1966) 
(31 FR 7821). The examination must be performed at a time chosen by 
the accountant without prior notice or announcement to the adviser, 
and the timing of the examination must be irregular from year to 
year, so that the adviser will be unaware of the date on which it 
will take place.
    The accountant must file a certificate on Form ADV-E with the 
Commission within 30 days after the completion of the examination. 
We would expect that, ordinarily, an accountant should be able to 
complete its examination and file Form ADV-E within 90 to 120 days 
of commencing the examination.
    \34\ Amended rule 206(4)-2(a)(3)(ii)(C). The independent 
accountant may first take reasonable steps to establish the basis 
for believing a material discrepancy exists. The obligation to 
notify the Commission arises once the accountant has a basis for 
believing there is a material discrepancy. Ordinarily, an accountant 
should be able to determine promptly whether it has a basis for 
believing there is a material discrepancy.
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    We understand that some clients may not wish to receive custodial 
reports. Under rule 206(4)-2, as amended, clients can choose to have an 
independent representative receive account statements on their 
behalf.\35\ An ``independent representative'' is a person that (i) acts 
as agent for an advisory client and by law or contract is obligated to 
act in the best interest of the advisory client; (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.\36\
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    \35\ Our proposed amendments permitted the use of independent 
representatives only for investors in pooled investment vehicles. In 
response to the suggestions of several commenters, we have decided 
to permit all advisory clients to designate independent 
representatives under the rule.
    \36\ Amended rule 206(4)-2(c)(2).
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    The rule requires that account statements be delivered to clients. 
Advisers that take legal title to the client assets they manage, such 
as advisers that also serve as general partner to investment pools, 
have asked how they should apply this provision. Because this arises 
most often in connection with pooled investment vehicles, rule 206(4)-
2, as amended, contains a special provision clarifying that account 
statements (whether delivered by the qualified custodian or the 
adviser) must be sent directly to the investors in the pool if the 
adviser to the pool also acts as its general partner, managing member, 
or in a similar capacity and has custody of client funds or 
securities.\37\ Delivery of account statements to the adviser but not 
to the limited partners would not deter the adviser's misuse of client 
assets.\38\
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    \37\ Amended rule 206(4)-2(a)(3)(iii). These account statements 
may be sent to the investors' independent representative(s) under 
amended rule 206(4)-2(a)(4). However, as discussed below in more 
detail, the amendments provide an exemption from amended rule 
206(4)-2(a)(3) for advisers with respect to pooled investment 
vehicles that are audited annually. See discussions in Section 
II.D.2 of this Release.
    \38\ Registered advisers that provide their advisory services 
through trusts must also ensure that account statements are 
delivered to their clients. Where an adviser acts as trustee for its 
client's trust, the investment advisory agreement often takes the 
form of a trust instrument. These advisers are acting in a capacity 
that gives them legal ownership of the client assets and thus have 
custody. In many cases, the advisory client is also the trust 
grantor and beneficiary. In other circumstances, the adviser may 
need to have quarterly statements delivered to an independent 
representative who may be a co-trustee, lead beneficiary, trust 
attorney, executor, or, in the case of court-supervised trusts, the 
court.
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D. Exemptions

1. Registered Investment Companies
    Advisers need not comply with the rule with respect to clients that 
are registered investment companies.\39\ 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.\40\
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    \39\ Rule 206(4)-2(b)(4).
    \40\ 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)
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2. Pooled Investment Vehicles
    Advisers need not comply with the reporting requirements of the 
rule with respect to pooled investment vehicles, such as limited 
partnerships or limited liability companies, if the pooled investment 
vehicle (i) is 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 120 days of the end of its fiscal 
year.\41\ We had proposed a complete exemption for audited pools, but 
have decided to exempt them only from the reporting requirement and to 
retain application of the other provisions of the rule, including the 
requirement that funds and securities be held with a qualified 
custodian; these requirements provide meaningful protections to 
investors in these pools for which an annual audit provides an 
insufficient substitute.
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    \41\ Amended rule 206(4)-2(b)(3). We are aware that a small 
percentage of advisers subject to the rule advise foreign pooled 
investment vehicles that prepare their financial statements in 
accordance with International Accounting Standards or some 
comprehensive body of accounting standards other than U.S. Generally 
Accepted Accounting Principles (``U.S. GAAP''). An adviser may use 
such financial statements to qualify for this exception with respect 
to pools that have a place of organization outside the U.S. or a 
general partner or other manager with a principal place of business 
outside the U.S., if such financial statements contain information 
that is substantially similar to financial statements prepared in 
accordance with U.S. GAAP and contain a footnote reconciling any 
material variations between such comprehensive body of accounting 
standards and U.S. GAAP. To ensure such material variations are 
adequately described, the financial statements should discuss and 
quantify them in the manner described in Item 17 of Form 20-F (17 
CFR 249.220f) (except that the financial statements need not provide 
reconciliation to Regulation S-X as required of issuers under Form 
20-F). For both U.S. and foreign pooled investment vehicles, the 
rule provides that ``audit'' has the meaning under section 2(d) of 
Article 1 of Regulation S-X (17 CFR 210.1-02(d)), and pooled 
investment vehicles' financial statements must be audited in 
accordance with U.S. Generally Accepted Auditing Standards.
    We proposed to require distribution of the audited financial 
statements within 90 days, but have extended that period to 120 days 
so that funds of funds will have enough time to complete their 
financial statements. Funds of funds, as pointed out by commenters, 
usually wait for the completion of the financial statements of the 
underlying investment funds before confirming their own data and 
finalizing their own financial statements.
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3. Registered Broker-Dealers
    The amendments eliminate the exemption from the rule for advisers 
that are also registered broker-dealers, which are qualified custodians 
under the rule and for which the exemption is unnecessary.

E. Amendments to Form ADV

    We are revising an instruction to Item 9 of Part 1A of Form ADV, 
which asks whether the adviser has custody of client funds or 
securities. A large number of advisers registered with us deduct their 
fees directly from client accounts and therefore have custody, but 
currently answer ``no'' to Item 9 in

[[Page 56696]]

reliance on no-action letters issued by our staff.\42\ Commenters 
requested that we modify Item 9 to avoid requiring these advisers to 
amend their Form ADVs in this respect. The new instruction specifies 
that advisers that have custody only because they deduct fees may 
answer ``no'' to Item 9.\43\ It will be some number of months before 
the NASD, which operates the IARD for us, completes reprogramming the 
IARD to implement this change to Item 9. In the interim, advisers 
registered with the Commission that have custody only because they 
deduct fees should answer ``no'' to Item 9 of current Form ADV.
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    \42\ We are, as indicated earlier, withdrawing those staff 
letters. See supra note 11.
    \43\ The revised instruction applies only with respect to an 
adviser's registration with us, and does not affect advisers 
registered or registering with the states. We note, also, that 
advisers registering with one or more states must respond separately 
to Part 1B of Form ADV, which specifically asks whether the adviser 
deducts fees from its clients' accounts.
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    Finally, we are eliminating the requirement that advisers with 
custody of client assets include an audited balance sheet in their 
disclosure statements (``brochures'') sent to clients.\44\ Commenters 
agreed that the requirement is no longer necessary due to the adoption 
of rule 206(4)-4, which requires every adviser to disclose to its 
clients any financial condition that is reasonably likely to impair the 
adviser's ability to meet its contractual commitments to its 
clients.\45\
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    \44\ Part II, Item 14 of Form ADV.
    \45\ 17 CFR 275.206(4)-4. See also Section II.E. of the 
Proposing Release.
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III. Effective Date

    The effective date of the amendments is November 5, 2003. Advisers 
must comply with the amended rule by April 1, 2004. By this compliance 
date, an adviser with custody of clients' funds and securities must 
ensure that those assets are kept in accounts with qualified 
custodians. Also by this date, the adviser must have established its 
reasonable belief that the qualified custodians send quarterly account 
statements directly to the clients or to their independent 
representatives, or as an alternative, follow the requirements of 
sending quarterly statements and undergoing an annual surprise 
examination.\46\ In addition, by this date, advisers to limited 
partnerships that are not currently subject to annual audits must 
ensure that those partnerships have become obligated to undergo annual 
audits if the adviser intends to rely on the exception in paragraph 
(b)(3) of the amended rule.\47\
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    \46\ Until the compliance date, advisers may rely on SEC staff 
letters for exemption from the surprise examination. See SEC staff 
letters listed in supra notes 11 & 15.
    \47\ Amended rule 206(4)-2(b)(3). Advisers to limited 
partnerships that are currently subject to annual audits may rely on 
this exception immediately upon the rule's effective date. The rule 
requires that the limited partnership be subject to an annual audit, 
but does not specify the means by which that binding commitment must 
be made. In most cases, we expect that the limited partnership 
agreement itself will require that the partnership be audited 
annually. In other cases, the adviser may evidence the commitment 
through an ongoing letter of engagement with an independent public 
accountant, or may use its disclosure statement to commit to the 
investors that the audit will be performed annually.
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IV. Consideration of Promotion of Efficiency, Competition, and Capital 
Formation

    Section 202(c) of the Advisers Act requires the Commission, when 
engaging in rulemaking that requires it to consider or determine 
whether an action is necessary or appropriate in the public interest, 
to consider, in addition to the protection of investors, whether the 
action will promote efficiency, competition, and capital formation.\48\
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    \48\ 15 U.S.C. 80b-2(c). We are adopting amendments to Form ADV 
under sections 203(c)(1) and 204 of the Advisers Act. These sections 
authorize the Commission to prescribe rules as necessary or 
appropriate in the public interest or for the protection of 
investors.
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    The amendments eliminate unnecessary burdens and thus may permit 
advisers to operate more efficiently. Because they apply equally to all 
advisers registered with us, we do not anticipate that they create any 
competitive disadvantages. We do not expect them to have an effect on 
capital formation or the capital markets.

V. Cost-benefit Analysis

A. Background

    The Commission is sensitive to the costs and benefits resulting 
from its rules. The amendments we adopt today are designed to harmonize 
the custody rule with current custodial practices, enhance the 
protections afforded to advisory clients' assets, and reduce advisers' 
compliance burden. The amended rule requires advisers with custody of 
client funds and securities to maintain those funds and securities with 
broker-dealers, banks, or other ``qualified custodians.'' The amended 
rule relieves advisers from sending clients quarterly account 
statements and undergoing an annual surprise examination if qualified 
custodians send account statements directly to the clients at least 
quarterly. The amended rule also defines ``custody,'' incorporating a 
definition already used in Form ADV, and illustrates common 
circumstances under which an adviser has custody. Finally, the 
amendments make two custody-related changes to Form ADV.
    In our Proposing Release, we carefully analyzed the costs and 
benefits of our proposed amendments and requested comment regarding the 
costs and benefits to individual advisers and to the industry as a 
whole. We estimated based on advisers' filings with us that 867 
advisers registered with us (approximately 11 percent) have custody of 
clients' assets, that 156 of these firms were broker-dealers (123) or 
banks (33), that would keep custody of their own clients' assets and, 
in their capacity as qualified custodians, send account statements to 
those clients,\49\ and that in 95 percent of the remaining advisers 
with custody \50\ qualified custodians would send account statements to 
99 percent of clients and the adviser would prepare account statements 
for the remaining 1 percent of clients.\51\ We estimated that the 
remaining 36 advisory firms \52\ would prepare their own statements for 
all clients.\53\ Commenters strongly favored the amendments and agreed 
that they would ease the regulatory burden on advisers and increase 
investor protections.\54\ We did not, however, receive specific 
comments on our cost benefit analyses.
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    \49\ Registered broker-dealers or banks are ``qualified 
custodians'' under the amended rule and may custody their own 
clients' funds and securities.
    \50\ 867-156 = 711 advisers. 95 percent of 711 advisers = 675 
advisers.
    \51\ We based this estimate on our experience examining 
investment advisers. We estimated that SEC-registered investment 
advisers have a mean of 670 clients each. Thus, this group of 
advisers would be preparing their own statements for an aggregate 
group of 4,725 clients (670 mean clients per adviser x 1% = 7 
clients per adviser x 675 advisers = 4,725 clients).
    \52\ 867-156 -675 = 36.
    \53\ We estimated that these 36 advisers would have 24,120 
clients in the aggregate (36 x 670 = 24,120).
    \54\ See Summary of Comments prepared by our staff, available in 
our Public Reference Room in File No. S7-28-02, and on our Web site 
at www.sec.gov/rules/extra/s72802csumm.htm.
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    We are adopting the amendments substantially as proposed, with some 
revisions in response to comments. We believe our original analyses 
regarding the benefits and costs of the amendments remain accurate. 
Most of the benefits and costs under the amended rule, however, are not 
quantifiable.

B. Benefits

    Improved protection for advisory clients. The amended rule requires 
advisers to maintain clients' securities, as well as clients' funds, 
with qualified custodians. Although most advisers

[[Page 56697]]

with custody already maintain their clients' securities with banks or 
broker-dealers as a matter of practice, the rule has not previously 
required it. Including this requirement in the rule will ensure that 
all advisers with custody provide this protection to their clients.
    Under the amended rule, when qualified custodians send quarterly 
account statements directly to advisory clients, the adviser is no 
longer required to send its own quarterly statements and to undergo an 
annual surprise examination.\55\ Receiving quarterly account statements 
directly from the qualified custodians will enable advisory clients to 
identify questionable transactions early and allow them to move more 
swiftly than relying on an annual surprise examination. Many commenters 
commended this new approach.
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    \55\ We proposed that qualified custodians send account 
statements to clients monthly. A number of commenters asserted that 
some custodial accounts are on quarterly rather than monthly 
reporting cycles and that moving to a monthly cycle would increase 
expenses substantially. In response to these comments, the amended 
rule requires quarterly account statements rather than the monthly 
statements we proposed.
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    For the small group of advisers that cannot use the new approach 
and therefore must continue to undergo an annual surprise 
examination,\56\ the amended rule requires the independent public 
accountant conducting the examination to advise the Commission of any 
material discrepancies it discovers in the examination. The Commission 
will therefore be able to act promptly to prevent further losses 
resulting from the adviser's malfeasance.
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    \56\ As we discussed on our Proposing Release, based on 
information collected from Form ADVs, 867 advisers registered with 
the Commission--approximately 11%--report having custody. Of these, 
156 are ``qualified custodians'' that may custody their own clients' 
assets; we expect these 156 firms will all send quarterly custodial 
account statements to their clients and thus will be exempt from 
annual surprise examinations. Of the remaining 711 SEC-registered 
advisers with custody, we expect 675 (95%) will have qualified 
custodians deliver account statements directly to 99% of their 
clients, and will need to send statements and undergo annual 
surprise examinations only with respect to the remaining 1%. We 
expect the remaining 36 advisers will continue to be subject to the 
annual surprise examination requirement with respect to all of their 
clients.
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    Remove unnecessary regulatory requirements. Commenters generally 
agreed that the new compliance requirements would reduce their 
compliance burden. The compliance requirements under the amended rule 
focus on investment advisers ascertaining whether qualified custodians 
are sending quarterly account statements to each of the advisers' 
clients. This sets forth a much simpler and less expensive compliance 
procedure for the adviser than sending its own quarterly account 
statements and undergoing an annual surprise examination.\57\ As 
discussed above, we expect most advisers will have qualified custodians 
send clients' account statements directly. The amendments also 
eliminate the costs of complying with staff no-action letters that set 
out alternative procedures to the annual surprise examination; advisers 
previously relying on these letters must now comply with the revised 
rule. We did not receive comments on our estimates or on quantifying 
these cost reductions.\58\
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    \57\ In the Proposing Release, we estimated that approximately 
744 advisers (those that report having custody but are not 
registered broker-dealers) were required to undergo annual surprise 
examinations under the current rule, and that on average, an adviser 
spends approximately 335 hours (0.5 hours per client for an average 
of 670 clients) and pays $8,000 annually in fees to an independent 
public accountant in connection with undergoing the examination. We 
also estimated that under the amended rule, only 36 advisers will 
continue to incur these full costs of an annual surprise examination 
with respect to all their clients; we estimated that another 675 
advisers will incur these costs only with respect to one percent of 
their clients, spending approximately 3.5 hours and paying $1,000 
annually in fees in connection with the annual surprise examination.
    \58\ The Commission does not collect information on the number 
of advisers that currently do not comply with the custody rule in 
reliance on SEC staff no-action letters, but that will be subject to 
the revised rule.
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    The amendments 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.\59\ Eliminating the balance sheet requirement will 
reduce advisers' compliance burden.\60\ The amendments also revise the 
instruction to Item 9 of Part 1A of Form ADV, so that SEC-registered 
advisers that have custody solely because they deduct their advisory 
fees from clients' assets need not report custody for purposes of Part 
1A. These advisers currently rely on our staff's no-action letters to 
report that they do not have custody; they commented that requiring 
them to change their response to Item 9 would confuse their 
clients.\61\ This revision avoids requiring these advisers to amend 
their registration statements.\62\
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    \59\ This change will not, however, impair client protections. A 
balance sheet may give an imperfect picture of the financial health 
of an advisory firm, because many advisers, including very 
profitable firms, have few financial assets. Moreover, rule 206(4)-
4, which did not exist when the balance sheet requirement was 
adopted, requires every adviser to disclose any financial condition 
that is likely to impair its ability to meet its contractual 
commitments to its clients; this disclosure is more useful to 
clients than a balance sheet.
    \60\ 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. See infra note and accompanying text.
    \61\ Because those staff no-action letters are being withdrawn, 
these advisers must now comply with the amended custody rule.
    \62\ We have been advised by groups representing advisers 
registered with us that perhaps as many as 90% of SEC-registered 
advisers deduct fees from their clients' accounts.
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    Improved clarity and transparency of the rule. The amendments will 
improve the clarity and transparency of the rule by adding a definition 
of ``custody'' to the rule and 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. 
Commenters generally responded favorably to the insertion of the 
definition and examples.

C. Costs

    The amendments require that all client funds or securities be 
maintained with qualified custodians. This requirement may impose costs 
on the advisers that currently have physical possession of client 
assets. We estimated in the Proposing Release that the additional cost 
of this requirement, if any, would be minimal because most advisers 
already maintain client assets with banks or broker-dealers.\63\ Many 
commenters confirmed that their custody arose through their access to 
their clients' funds or securities, not through any physical possession 
of them, and this requirement would not impose additional costs on 
them.
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    \63\ In our Proposing Release, we estimated 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.
---------------------------------------------------------------------------

    In addition, the amendments exempt advisers with custody from the 
costs of undergoing annual surprise examinations and sending account 
statements only when qualified custodians send account statements 
directly to the advisers' clients at least quarterly. This condition 
may impose costs on a small number of advisers that do not already have 
qualified custodians deliver account statements directly to the 
advisers' clients.\64\ These advisers

[[Page 56698]]

will have to arrange for qualified custodians to deliver account 
statements directly to their advisory clients, and the qualified 
custodians may pass any new costs on to the advisers. These costs are 
necessary for the protection of advisory clients and we estimated in 
the Proposing Release that they should be no greater, at an aggregate 
level, than the costs incurred under the current account statement 
delivery requirement. We received no specific comments on these 
assumption and estimates, and we believe they remain accurate.
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    \64\ In the Proposing Release, we have estimated that most 
qualified custodians are delivering account statements to advisers' 
clients and that less than 1% of advisory clients (excluding 
investors in pooled investment vehicles) do not receive account 
statements directly from custodians. Many commenters indicated that 
their custodians do deliver account statements to their clients 
directly.
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VI. Paperwork Reduction Act

    As set forth in the Proposing Release, the amendments contain 
several ``collection of information'' requirements within the meaning 
of the Paperwork Reduction Act of 1995.\65\ 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 Commission 
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 collection of information for the rule and the form has 
been approved by OMB under control numbers 3235-0241 and 3235-0049, 
respectively (both expire on September 30, 2005). 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.
---------------------------------------------------------------------------

    \65\ 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.

A. Rule 206(4)-2

    We are adopting the amendments substantially as proposed. The 
amendments require advisers with client funds and securities to 
maintain those funds and securities in custodial accounts with banks, 
broker-dealers, or other ``qualified custodians.'' The amendments 
exempt advisers with custody of client assets from the current 
requirements of sending their clients quarterly account statements and 
undergoing an annual surprise examination if qualified custodians send 
account statements directly to the advisory clients at least 
quarterly.\66\ The amendments exempt advisers from the rule with 
respect to accounts of registered investment companies, and exempt 
advisers from the reporting requirement with respect to pooled 
investment vehicles that are audited annually and have the audit 
results distributed to their investors.\67\ We received no comments on 
the collection of information burden of the amendments.
---------------------------------------------------------------------------

    \66\ We proposed that qualified custodians send account 
statements to clients monthly. A number of commenters noted that 
some custodial accounts are on quarterly rather than monthly 
reporting cycles and that moving to a monthly cycle would increase 
expenses. In response to these comments, the amended rule requires 
only quarterly account statements. This revision will not affect our 
original estimate of information collection burden, which was based 
on an assumption that the amendments would not result in any change 
in qualified custodians' reporting cycles.
    \67\ We had proposed a complete exemption for advisers to 
audited pooled investment vehicles, but are adopting an exemption 
from the account statement delivery requirements only. Exempting 
audited investment pools from the account statement delivery 
requirement will eliminate both the adviser's burden of sending 
account statements and its burden in undergoing an annual surprise 
examination. This modification does not affect estimate of the 
information collection burden.
---------------------------------------------------------------------------

    We estimated in our Proposing Release that the amendments would 
generally reduce the paperwork burden for advisers. We estimated the 
aggregate burden under the current rule at 1,246,200 hours, and the 
aggregate cost under the current rule at $5,952,000, assuming that an 
adviser would pay an independent public accountant $8,000 to conduct an 
annual surprise examination.
    For purposes of calculating the burden hours under the amendments, 
we estimated in the Proposing Release that (i) of the 867 advisers 
reporting that they had custody of clients' assets, 156 would be fully 
exempted from the requirements of sending quarterly advisory account 
statements and undergoing an annual surprise examination,\68\ (ii) 95 
percent (675 advisers) of the remaining 711 advisers would be eligible 
for the exemption from these two requirements with respect to 99 
percent of their clients, and (iii) 5 percent (36 advisers) of the 
remaining 711 advisers would continue to be subject to both 
requirements with respect to all of their clients. Assuming an average 
of 670 clients per adviser registered with us, we estimated that the 
aggregate annual burden that advisers would face under the amended rule 
would be 72,113 hours rather than the estimated 1,246,200 hours under 
the current rule.\69\
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    \68\ Advisers that are registered broker-dealers (123 firms) or 
banks (33 firms) will be ``qualified custodians'' under the amended 
rule and may keep custody of their own (and other advisers') 
clients' assets. We understand that broker-dealers and banks 
generally send account statements at least quarterly. These advisers 
will therefore be in compliance with the amended rule without 
incurring any additional burden under the rule.
    \69\ The 675 advisers facing this burden with respect to 1% of 
their clients will spend 2.5 hours per client for 7 clients 
annually. 675 advisers x 7 clients x 2.5 hours = 11,812.5 hours. The 
36 advisers facing this burden with respect to all of their clients 
will spend 2.5 hours per client for 670 clients annually. 36 
advisers x 670 clients x 2.5 hours = 60,300 hours. 11,812.5 hours + 
60,300 hours = a total hour burden of 72,112.5 (rounded to 72,113) 
hours annually for all advisers in the aggregate.
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    We further estimated in the Proposing Release that (i) the 
aggregate cost for accounting fees for the annual surprise examination 
would be $288,000 for the 36 advisers who would be subject to the 
collection of information for all of their clients; \70\ and (ii) the 
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. The aggregate cost 
for information collection burden under the amended rule would 
therefore be $963,000 rather than the estimated $5,952,000 under the 
current rule.\71\ We received no comments on these estimates and 
assumptions.
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    \70\ These 36 advisers would be subject to a surprise 
examination. Based on our experience examining investment advisers, 
we estimated that each surprise examination would cost $8,000. 36 
advisers x $8,000 = $288,000.
    \71\ $288,000 + $675,000 = $963,000.
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    As stated above, we are adopting the amendments substantially as 
proposed. Accordingly, our estimate of the annual aggregate burden of 
collection for the amended rule remains 72,113 hours and our estimate 
of the aggregate cost remains $963,000. This collection of information 
is mandatory, and responses are not kept confidential.

B. Form ADV

    The amended rule eliminates 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.\72\ This will reduce paperwork burden for

[[Page 56699]]

advisers that have custody of client assets.
---------------------------------------------------------------------------

    \72\ See supra Section II.E. of this Release.
---------------------------------------------------------------------------

    In the Proposing Release, we estimated the current aggregate annual 
cost of this requirement at $11,460,000.\73\ For purposes of 
calculating this cost under the amendments, we estimated the 580 
advisers that are paying accountants' fees to comply with the balance 
sheet requirement under the current rule would no longer incur these 
costs. Therefore, we estimated in the Proposing Release that the number 
of advisers subject to this requirement would be reduced to 184, and 
the aggregate annual cost of this requirement would be reduced to 
$2,760,000, for an average annual cost for each adviser registered with 
us of $364.\74\
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    \73\ We estimated that each adviser that needed an audited 
balance sheet in order to comply with the requirement paid 
approximately $15,000 on average in accounting fees. 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 have estimated 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. $15,000 in fees x (184 advisers with advance 
fees + 580 additional advisers with custody) = $11,460,000.
    \74\ (184 x $15,000) / 7,583 = $364.
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    Commenters generally supported the elimination of the balance sheet 
requirement, but made no specific comment on our estimated numbers. We 
are adopting this amendment as proposed. These estimated numbers 
therefore remain the same.
    We are also adding an instruction to Item 9 of Part 1A of Form ADV, 
which asks whether the adviser has custody of clients' funds or 
securities. Many advisers registered with us deduct fees from clients' 
accounts but currently answer ``no'' to Item 9 in reliance on no-action 
letters issued by our staff. The new instruction would permit advisers 
that have custody solely because they deduct fees to continue answering 
``no'' to Item 9. Consequently, the new instruction does not affect the 
collection of information burden of Form ADV.
    This collection of information is mandatory, and responses are not 
kept confidential.

VII. Final Regulatory Flexibility Analysis

    The Commission proposed amendments to rule 206(4)-2, the custody 
rule under the Advisers Act, in a release issued on July 18, 2002 
(``Proposing Release'').\75\ An initial Regulatory Flexibility Analysis 
(``IRFA'') was published in the Proposing Release. No comments were 
received on the IRFA. The Commission has prepared the following Final 
Regulatory Flexibility Analysis (``FRFA'') regarding amendments to rule 
206(4)-2 and Form ADV, in accordance with 5 U.S.C. 604.
---------------------------------------------------------------------------

    \75\ Custody of Funds or Securities of Clients by Investment 
Advisers, Investment Advisers Release No. 2044 (July 18, 2002) [67 
FR 48579 (July 25, 2002)].
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A. Need for the Amendments

    We are adopting the amendments substantially as proposed. The 
amendments are necessary to harmonize the advisers' custody 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 require advisers to maintain client funds 
and securities with broker-dealers, banks, or other ``qualified 
custodians.'' If the qualified custodian sends account statements 
directly to an adviser's clients at least quarterly, the adviser will 
be relieved from sending its own account statements and from undergoing 
an annual surprise examination of those clients' accounts. The 
amendments exempt advisers from the rule with respect to clients that 
are registered investment companies and exempt advisers to limited 
partnerships (or other types of pooled investment vehicles) from the 
account statement delivery requirement if the limited partnerships are 
subject to annual audit and distribute the audit results to their 
limited partners.
    The amendments 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 (and their counsel) will no longer need to refer to external 
materials such as staff no-action letters for these examples. Finally, 
the amendments 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. Significant Issues Raised by Public Comment

    The Commission received 49 letters from commenters in response to 
the Proposing Release.\76\ Commenters strongly supported the proposal. 
As discussed in Section II of this Release, above, the Commission is 
adopting the amendments substantially as proposed with some changes to 
respond to commenters' suggestions. The Commission specifically 
requested comment with respect to the IRFA, but did not receive any 
comments concerning the IRFA.
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    \76\ See Summary of Comments prepared by our staff, available in 
our Public Reference Room in File No. S7-28-02, and on our Web site 
at http://www.sec.gov/rules/extra/s72802csumm.htm.
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C. Small Entities Subject to Rule

    In developing the amendments, we have considered their potential 
effect on small entities. 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.\77\ The Commission estimates that 
approximately 28 SEC-registered investment advisers that have custody 
of client assets are small entities.\78\
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    \77\ 17 CFR 275.0-7(a).
    \78\ This estimate is based on the information provided 
submitted by SEC-registered advisers in Form ADV, Part 1A [17 CFR 
279.1] as of May 2002.
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D. Projected Reporting, Record-keeping, and Other Compliance 
Requirements

    The amended rule imposes no new reporting and record-keeping 
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 
amendments will not materially increase the effort necessary on the 
advisers' behalf to comply with the Commission's rules. To the 
contrary, the 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

[[Page 56700]]

annual surprise examination.\79\ In addition, we are amending 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 the advisers' compliance costs. We are also 
amending Form ADV to add an instruction to Item 9 of Part 1A; this 
instruction permits SEC-registered advisers that have custody only 
because they deduct their fees from their clients' assets to continue 
responding ``no'' to Item 9.\80\
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    \79\ Under the amended rule, an adviser will not be required to 
send quarterly account statements or undergo a surprise examination 
with respect to accounts for which a qualified custodian sends 
account statements directly to clients at least quarterly.
    \80\ These advisers, in reliance on no-action letters issued by 
the Commission's staff, have responded ``no'' to Item 9 and have not 
been required to comply with the custody rule. The letters are being 
withdrawn and these advisers must now comply with the revised rule.
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E. Agency Action To Minimize Effect on Small Entities

    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 amended 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 amendments is to decrease regulatory 
burdens on advisers. Small advisers, as well as large ones, will 
benefit from the amended rule. Moreover, the 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 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 
amended 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.

VIII. Statutory Authority

    We are adopting 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 adopting amendments to 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)].

List of Subjects in 17 CFR Parts 275 and 279

    Reporting and recordkeeping requirements, Securities.

Text of Rule

0
For the reasons set out in the preamble, Title 17, Chapter II of the 
Code of Federal Regulations is amended as follows:

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

0
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.
* * * * *

0
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.
    (3) Account statements to clients.--(i) By qualified custodian. You 
have a reasonable basis for believing that the qualified custodian 
sends an account statement, at least quarterly, to each of your clients 
for which it maintains funds or securities, 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 for whom you have custody of funds or securities, 
identifying the amount of funds and of each security of which you have 
custody at the end of the period and setting forth all transactions 
during that period;
    (B) An independent public accountant verifies all of those funds 
and securities by actual examination at least once during each calendar 
year at a time that is chosen by the accountant without prior notice or 
announcement to you and that is irregular from year to year, and files 
a certificate on Form ADV-E (17 CFR 279.8) with the Commission within 
30 days after the completion of 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; and
    (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).
    (4) Independent representatives. A client may designate an 
independent representative to receive, on his behalf,

[[Page 56701]]

notices and account statements as required under paragraphs (a)(2) and 
(a)(3) of this section.
    (a) Exceptions.--(1) Shares of mutual funds. With respect to shares 
of an open-end company as defined in section 5(a)(1) of the Investment 
Company Act of 1940 (15 U.S.C. 80a-5(a)(1)) (``mutual fund''), you may 
use the mutual fund's transfer agent in lieu of a qualified custodian 
for purposes of complying with paragraph (a) of this section;
    (2) Certain privately offered securities. (i) You are not required 
to comply with this section with respect to securities that are:
    (A) Acquired from the issuer in a transaction or chain of 
transactions not involving any public offering;
    (B) Uncertificated, and ownership thereof is recorded only on books 
of the issuer or its transfer agent in the name of the client; and
    (C) Transferable only with prior consent of the issuer or holders 
of the outstanding securities of the issuer.
    (ii) Notwithstanding paragraph (b)(2)(i) of this section, the 
provisions of this paragraph (b)(2) are available with respect to 
securities held for the account of a limited partnership (or limited 
liability company, or other type of pooled investment vehicle) only if 
the limited partnership is audited, and the audited financial 
statements are distributed, as described in paragraph (b)(3) of this 
section.
    (3) Limited partnerships subject to annual audit. You are not 
required to comply with paragraph (a)(3) of this section with respect 
to the account of a limited partnership (or limited liability company, 
or another type of pooled investment vehicle) that is subject to audit 
(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 120 days of the end of its fiscal year; and
    (4) Registered investment companies. You are not required to comply 
with this section (17 CFR 275.206(4)-2) with respect to the account of 
an investment company registered under the Investment Company Act of 
1940 (15 U.S.C. 80a-1 to 80a-64).
    (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 of client funds or securities, (but not of checks 
drawn by clients and made payable to third parties,) unless you receive 
them inadvertently and you return them to the sender promptly but in 
any case within three business days 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
    (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 or your supervised person legal 
ownership of or access to client funds or securities.
    (2) Independent representative means a person that:
    (i) Acts as agent for an advisory client, including in the case of 
a pooled investment vehicle, 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 advisory 
client or 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)) or 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);
    (ii) 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;
    (iii) 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, but only with respect to clients' funds 
and security futures, or other securities incidental to transactions in 
contracts for the purchase or sale of a commodity for future delivery 
and options thereon; and
    (iv) A foreign financial institution that customarily holds 
financial assets for its customers, provided that the foreign financial 
institution keeps the advisory clients' assets in customer accounts 
segregated from its proprietary assets.

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

0
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.

0
4. Form ADV (referenced in Sec.  279.1) is amended by:
0
a. In Part 1A, Item 9, revising the introductory text to add, after the 
first sentence, ``If you are registering or registered with the SEC and 
you deduct your advisory fees directly from your clients' accounts but 
you do not otherwise have custody of your clients' funds or securities, 
you may answer ``no'' to Item 9A.(1) and 9A.(2).''; and
0
b. In Part II, Item 14, adding ``(unless applicant is registered or 
registering only with the Securities and Exchange Commission),'' after 
the words ``client funds or securities''.

    Note: The text of Form ADV does not and this amendment will not 
appear in the Code of Federal Regulations.


    Dated: September 25, 2003.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-24813 Filed 9-30-03; 8:45 am]
BILLING CODE 8010-01-P