Morgan, Lewis & Bockius LLP
1111 Pennsylvania Avenue, NW
Washington, DC 20004
Tel: 202.739.3000
Fax: 202.739.3001
www.morganlewis.com

Steven W. Stone
Partner
(202) 739-5453
sstone@morganlewis.com

September 25, 2002

VIA E-MAIL (rule-comments@sec.gov)

Jonathan G. Katz
Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549

Re: Custody of Funds or Securities of Clients by Investment Advisers, Release No. IA-2044; File No. S7-28-02; RIN 3235-AH 26

Dear Mr. Katz,

Thank you for giving us the opportunity to comment on the Commission's proposal to amend Rule 206(4)-2 of the Investment Advisers Act of 1940 ("Advisers Act") regarding custody of funds or securities of clients by investment advisers.

We agree with the overall goals of the proposed amendments - to amend Rule 206(4)-2 to reflect modern custodial practices and to clarify the circumstances under which an adviser has custody of client assets and, thus, must comply with the rule. Specifically, we commend the Commission and its staff for cutting through the accumulated no-action guidance of the past forty years and, instead of merely codifying that guidance, carving a new paradigm that, with the exceptions discussed below, makes sense in today's world. While the proposed amendments go far in reaching the Commission's goal, as currently written they would impose significant burdens on investment advisers and broker-dealers - particularly those also registered as advisers - in matters unrelated to investor protection. We urge the Commission to address these burdens when adopting the proposed amendments.

As discussed below, we believe that the current broker-dealer exemption from the custody rule should be preserved, that any requirement relating to the sending of account statements by qualified custodians should defer to existing Commission and self-regulatory organization requirements in the area, that the ninety-day period for delivery of audited statements should be extended for certain pooled investment vehicles, and that the Commission should provide clarification of certain issues under the proposed amendments. We address each of these points in turn below.

1. The Broker-Dealer Exemption Should Be Preserved.

In the release proposing the custody rule amendments (the "Proposing Release"),¹ the Commission proposes to eliminate the current exemption from Rule 206(4)-2 for advisers that are also broker-dealers registered with the Commission. That exemption, as it currently stands, exempts from the custody rule advisers that are also registered broker-dealers if they are subject to and in compliance with the net capital requirements under Rule 15c3-1 under the Securities Exchange Act of 1934 (the "Exchange Act"). As discussed below, we believe the elimination of the broker-dealer exemption is unwarranted and will result in substantial burdens for broker-dealers with no corresponding benefits to investor protection.

The Commission adopted the custody rule in 1962 to protect clients from the insolvency of an adviser and the misappropriation of client assets held by an adviser. The rule was necessary, in part, because the Advisers Act does not require advisers to adhere to any specified standards of financial responsibility. Implicit in the broker-dealer exemption was the idea that the financial responsibility rules of the Commission and the self-regulatory organizations serve as appropriate substitutes for the custody rule.

The rationale that prompted the Commission to adopt the broker-dealer exemption forty years ago is even stronger today. When the custody rule was adopted, the Commission had yet to adopt the customer protection rule, Exchange Act Rule 15c3-3, the principal rule protecting customer funds and securities held by broker-dealers. Accordingly, the custody rule contains no cross reference to the customer protection rule and refers only to the Commission's net capital rule for broker-dealers, Exchange Act Rule 15c3-1. Rule 15c3-1, while imposing strict minimum financial requirements on broker-dealers to ensure their ability to meet obligations, does not establish reserve or segregation requirements for customer assets held by broker-dealers. Nevertheless, the Commission still determined when it adopted the custody rule that broker-dealers should be exempted from the rule. The broker-dealer exemption makes even more sense in view of the extensive financial responsibility rules to which broker-dealers are now subject - rules that, in the words of a former Chief Counsel to the Division of Investment Management, are "generally far more rigorous than, the custody rule. Requiring broker-dealers to comply with the custody rule would add an unnecessary layer of compliance procedures."²

The very premise of the Commission's new approach of requiring client funds and securities to be held in the custody of qualified custodians, including broker-dealers, is recognition of the soundness of the financial responsibility rules governing such qualified custodians. Indeed, we are not aware, nor does the Proposing Release set forth any record, of investor protection problems that have arisen as a result of the custody of client assets by broker-dealers under this exemption. While we commend the Commission for considering new paradigms and adapting its rules to reflect the realities of industry practice, we urge the Commission to consider the unnecessary burdens that would be imposed upon broker-dealers in the event this exemption were withdrawn.

Unless a dually registered broker-dealer met the monthly statement requirement of the proposed amendments (which, as discussed below, surpasses what is required under existing Commission and self-regulatory organization rules), they would be subject to annual surprise examinations that are not just unnecessary and inappropriate given the Commission's financial responsibility rules applicable to broker-dealers, but that are also far more onerous than the audits required by the Commission under those financial responsibility rules. Under the Commission's Accounting Series Release No. 103 (May 26, 1966), the Commission stated that, when conducting an examination of funds and securities held by an adviser, an independent public accountant must "make a physical examination of securities and obtain confirmation as appropriate; should obtain confirmation of funds on deposit in banks; and should reconcile the physical count and confirmations to the books and records. These books and records should be verified by adequate examination of the security records and transactions since the last examination and by obtaining from clients written confirmation of the funds and securities in the clients' accounts as of the date of the physical examination." This sort of 100%, client-by-client examination goes far beyond the corresponding requirements in the broker-dealer area, which employ testing and are designed to confirm that internal controls are in place and working.

The Commission's guidance on the audit requirements of broker-dealers has long dispensed with the kind of a comprehensive, 100% examination called for in Accounting Series Release No. 103, instead allowing independent auditors to base their opinion on a review of the internal controls for safeguarding customer funds and securities.³ For example, rather than conduct an actual securities count as required under the Advisers Act custody rule, an independent auditor normally accounts for securities in a broker-dealer's physical possession (as required by Exchange Act Rule 17a-13) by observing and testing the broker-dealer's procedures.⁴ Similarly, for customer account positions and balances, an independent auditor may employ sampling techniques, especially if there are many customer accounts.⁵ The kind of examination called for under the custody rule would, as applied to broker-dealers, be tremendously burdensome and expensive even though there has been no indication on the record that the Commission's audit standards for broker-dealers should not suffice for purposes of the custody rule as well. We note in this regard that the Proposing Release's discussion of the impact of this aspect of the proposed amendments bears no mention of these burdens. At the very least, if the Commission chooses to eliminate the broker-dealer exemption, we would encourage the Commission to further amend the rule to make clear the examinations required to be conducted by independent auditors should, as applied to broker-dealers, be the same as under Rule 17a-5(g).

While we encourage the Commission to retain the broker-dealer exemption within the custody rule, we believe that the exemption does need to be amended to reference Exchange Act Rule 15c3-3, the customer protection rule, instead of Rule 15c3-1, the net capital rule.

2. The Frequency of Account Statements Should Defer to Existing Commission and Self-Regulatory Requirements.

The Commission proposes to exempt advisers from the requirement to send quarterly account statements and to undergo annual surprise examinations if the qualified custodian holding customer funds and securities sends monthly account statements directly to each advisory client. Similarly, the proposed rule would permit advisers that are also registered broker-dealers to hold custody of their clients' funds and securities without being subject to annual surprise examinations so long as they send monthly account statements to their clients. We believe the proposed amendment should instead require that account statements be sent by the qualified custodian quarterly or more frequently as may be required by the laws, rules or regulations to which the qualified custodian is subject. In other words, the proposed amendments to the custody rule should, in the case of broker-dealers, defer to existing Commission and self-regulatory organization requirements relating to account statements.

The various qualified custodians recognized under the proposed amendment are not uniformly required to send monthly statements. In this regard, broker-dealers are permitted to send customers quarterly account statements in various circumstances under the Commission's rules and the rules of the self-regulatory organizations.⁶ The Proposing Release notes this fact, stating that broker-dealers "are generally required to provide customers with . . . account statements at least quarterly."⁷ Notwithstanding the requirement to send account statements quarterly, the Proposing Release assumes that broker-dealers send account statements to customers monthly "as a matter of practice."⁸ The Proposing Release nevertheless provides no further information or explanation on the factual basis for this assumption, and we submit that account statement practices among broker-dealers are far from uniform especially when one considers the diversity of firms and range of services and programs they provide. Moreover, as clients have gained greater access to account information electronically through the Internet, many broker-dealers have begun rethinking the frequency with which they send customer account statements and have sought - or are now planning - to move from monthly to quarterly account statements where permitted. In many cases, this is in response to customer requests to reduce the flurry of paperwork they receive. Accordingly, we believe the Proposing Release's statement that "most advisers that are also registered broker-dealers should therefore already be in compliance with the proposed rule and face no additional burdens"⁹ is at best an exaggeration, and suspect it is based on anecdotal information borne from a limited sampling of firms.

Beyond industry practices, there is no suggestion in the Proposing Release that the timing of account statements by broker-dealers is too infrequent so as to raise investor protection concerns. Moreover, the proposed rule's insistence on monthly statements by broker-dealers and other qualified custodians runs counter to the proposed rule's own approach to the sending of account statements by advisers. Under paragraph (a)(4) of the proposed rule, an adviser with custody must, among other things, send each client a quarterly account statement unless the adviser has a reasonable basis to believe that the qualified custodian is sending monthly account statements. While we believe the use of quarterly account statements for this purpose is appropriate - and has been appropriate under the custody rule since its adoption in 1962 - the Proposing Release sets forth no explanation for this incongruous approach or for the justifications warranting the Commission's effectively overriding its own rules, and those rules of the self-regulatory organizations the Commission has previously approved, that in various circumstances require only quarterly account statements.

To require more frequent account statements - particularly in the absence of any apparent or explained justification - would be costly and burdensome for qualified custodians, that might be forced (given system constraints) either to send monthly account statements to all customers or to go through the often cumbersome process of reprogramming their systems to send monthly account statements selectively to clients of advisers. Given the Proposing Release's questionable assumptions that broker-dealers send monthly account statements "as a matter of practice" and "already should be in compliance with the proposed rule and face no additional burdens," we would urge the Commission to reconsider the burdens of this aspect of the proposed amendment and to undertake a more detailed cost benefit analysis.

Finally, the requirement that qualified custodians send account statements more frequently than they are legally required may result in advisers themselves becoming subject to the more onerous provisions of the rule, a result that the Commission has sought to avoid. As noted above, under the proposed amendments, an adviser may forego the obligation to send quarterly account statements and to undergo annual surprise examinations if it has "a reasonable basis for believing that the qualified custodian sends" the requisite monthly account statement. If the qualified custodian hired by a single client chooses not to send account statements more frequently than they are legally required, the adviser will be forced to comply with the quarterly statement and annual audit requirements under the proposed amendments. Moreover, given that qualified custodians may in many contexts provide quarterly statements, it is unclear on what basis (other than by requesting duplicate copies of statements) an adviser could have a reasonable belief that the qualified custodian is sending monthly statements.

3. The Commission Should Provide Further Clarification of What Constitutes "Funds and Securities"

The Commission has provided helpful guidance in the Proposing Release on what constitutes "funds and securities" that must be maintained in the custody of a qualified custodian. For example, the Proposing Release and the proposed amendments reflect the position 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. We encourage the Commission to provide further guidance in this area, including in the following instances in which we believe an adviser should not be deemed to have custody of client funds or securities:

• An adviser holds mutual fund applications, subscription agreements (e.g., for private placements) or other similar documents that evidence the purchase of an uncertificated security, where record ownership of the client's interest is reflected on the books and records of the issuer or its transfer agent; and

• An adviser holds swap agreements, loan participations and similar customized agreements that are not negotiable instruments, but rather are simply contracts.

4. The Commission Should Preserve its Long Standing Interpretation that, in Appropriate Circumstances, Automatic Payment of Advisory Fees is not Deemed Custody.

The proposed rule would deem an adviser to have custody of client funds and securities if the adviser is authorized to deduct advisory fees or other expenses directly from the client's account. This position runs counter with a line of interpretations spanning three decades.¹⁰ Specifically, in Release 1000, the staff stated the position - which has oft been repeated - that an adviser "will not be deemed to have custody . . . if (1) the client provides written authorization permitting the adviser's fees to be paid directly from the client's account held by an independent custodian, (2) the adviser sends to the client and the custodian at the same time, a bill showing the amount of the fee, the value of the client's assets on which the fee was based, and the specified manner in which the adviser's fee was calculated, and (3) the custodian agrees to send to the client a statement, at least quarterly, indicating all amounts dispersed from the account including the amount of advisory fees paid directly to the adviser." (Emphasis added.)

Although the Proposing Release indicates that the Commission has designed the proposed rule so an adviser could comply with the amended rule without facing the "burdens they previously sought to avoid,"¹¹ the matter is not so simple. Thousands of advisers that are paid in this manner and in accordance with the Commission staff's interpretation currently indicate they do not have custody on their Form ADVs. Advisory contracts frequently prohibit an adviser from having custody of client funds or securities. Changing these Form ADV responses and amending client agreements could potentially be both burdensome and confusing to clients and yet produce no investor protection benefits. Moreover, the position that such arrangements involve custody may generate concerns under other laws or regulations that restrict or prohibit an adviser from having custody of client funds or securities in a more traditional sense.¹² Accordingly, we would encourage the Commission to amend the proposed rules so as to provide, in paragraph (c)(1)(ii), that an adviser shall not be deemed to have custody insofar as the adviser complies with the enumerated requirements of the staff's longstanding interpretation, discussed above.

We would also encourage the Commission to add a preferatory note making clear that custody under the rule should not be deemed or create a presumption of custody under any other law, rule or regulation.

5. The Commission Should Extend the Proposed 90-Day Period for Delivery of Audited Statements for Certain Pooled Investment Vehicles

With respect to assets held in pooled investment vehicles such as limited partnerships and limited liability companies, the proposed amendments establish an exemption for advisers deemed to have custody. Such advisers are not required to comply with the rule, if the pooled investment vehicle has its transactions and assets audited 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.

Requiring a fund-of-funds to distribute its audited financials to investors within 90 days of the end of its fiscal year would impose a hardship potentially overlooked or not fully appreciated by the Commission. In the fund-of-funds context, the adviser to the fund generally places significant reliance on the independent audit reports prepared with respect to the funds in which it invests (the "Underlying Funds") in preparing the fund's own audited financials. Consequently, because Underlying Funds would generally not be required to distribute to the fund-of-funds audited financial statement until 90 days following the end of their fiscal years, the funds-of-funds would not have adequate time to prepare and distribute their own audited financials. To address this potential gap, the Commission should adopt the approach taken by the CFTC for the preparation of annual reports by fund-of-funds commodity pools. Recent revisions to CFTC Regulation 4.22(f), made in light of the CFTC's recognition of this precise issue, permit a commodity pool operator ("CPO") to file a claim for an automatic extension of time to file the pool's annual report where the pool is invested in other collective investment vehicles, and the CPO's independent accountant cannot obtain the information necessary to comply with the rule in a timely manner.¹³ Taking this approach would promote regulatory consistency and efficiency and avoid what, we believe, would be an unintended consequence of making it virtually impossible for a fund-of-funds to meet the requirements specified under this exemption to the account statement and "surprise audit" provisions.

6. The Definition Of Custody Should Be Clarified.

The definition of custody includes any arrangement (including a general power of attorney) under which an adviser is "authorized or permitted to withdraw client funds or securities maintained with a custodian upon [the adviser's] instruction to the custodian." The literal wording of the definition could be read to include instances where an adviser withdraws funds or securities from a client account in the course of a transaction for the client, a result we doubt the Commission intended. In addition, it would be helpful if the Commission would provide guidance regarding the duration of custody - that is, if an adviser has custody for one instant such that it would be subject to the quarterly account statement and examination requirements, for how long does the adviser have to comply with the custody rule?

Conclusion

Thank you for giving us the opportunity to comment on the Commission's proposal to amend Rule 206(4)-2 of the Advisers Act regarding custody of funds or securities of clients by investment advisers. Notwithstanding our overall support for the stated goals, the proposed amendments, as they stand now, are likely to impose significant burdens on advisers, broker-dealers and other qualified custodians. We believe, however, that with the suggested modifications, the proposed amendments could go a long way toward updating the custody rule in a way that makes sense given industry practices and investor protection considerations.

Very truly yours,

Steven W. Stone

cc: The Hon. Harvey L. Pitt, Chairman
The Hon. Cynthia A. Glassman, Commissioner
The Hon. Harvey J. Goldschmid, Commissioner
The Hon. Paul S. Atkins, Commissioner
The Hon. Roel C. Campos, Commissioner
Paul F. Roye, Director, Division of Investment Management
Robert E. Plaze, Associate Director, Division of Investment Management
Jennifer L. Sawin, Assistant Director, Division of Investment Management
Vivien Liu, Senior Counsel, Division of Investment Management

___________________________

1	Custody of Funds or Securities of Clients by Investment Advisers, Advisers Act Release 2044 (July 18, 2002).
2	See Thomas S. Harman & Lanae Holbrook, Custody Rules for Investment Advisers, Investment Lawyer (July 1994).
3	See Exchange Act Rule 17a-5(g).
4	See AICPA, Audit Guide: Brokers and Dealers in Securities (1999), at 146-47.
5	See id. at 148.
6	See, e.g., Exchange Act Rules 10b-16 & 15c3-2; NASD Conduct Rules 2340 & 2860; NYSE Rules 409 & 730.
7	Proposing Release at n. 47.
8	Id.
9	See Proposing Release at text accompanying n. 52.
10	See Investment Counsel Association of America, Inc. (available July 9, 1982); see also Staff Interpretations of Certain Investment Adviser Disclosure and Reporting Requirements, Advisers Act Release 1000 (December 3, 1985) ("Release 1000").
11	See Proposing Release at n. 23.
12	See, e.g., Employee Retirement Income Security Act of 1974 § 403; Department of Labor Regulation § 2550.403a-1.
13	See CFTC Letter to CPOs regarding 2001 Annual Reports for Commodity Pools (February 1, 2002); CFTC Regulation 4.22(f)(2).