2) Whether advisory personnel have the opportunity to misappropriate clients' property.

Transcription

1 DIVISION OF INVESTMENT MANAGEMENT Crocker Investment Management Corp. File No March 15, 1978 You have requested a reconsideration of the staff position taken in Columbia Advisory Corporation, January 28, 1975, that Rule 206(4)-2 under the Investment Advisers Act of 1940 applies to a situation in which funds and securities of clients of an investment adviser are in the custody of a bank which is affiliated with the adviser through their both being wholly-owned subsidiaries of the same parent. You have requested our concurrence in your opinion that Rule 206(4)-2 does not apply to situations in which an affiliated person of a registered investment adviser has custody of funds or securities of clients of that adviser. Whether an adviser has custody or possession of clients' funds or securities when an affiliated company of the adviser holds such property, under custodial agreements with the clients, is a question of fact. The answer to this question will depend upon the following: 1) Whether clients' property in the custody of the affiliated company might be subject, under any reasonably foreseeable circumstances, to the claims of the adviser's creditors. 2) Whether advisory personnel have the opportunity to misappropriate clients' property. 3) Whether advisory personnel ever have custody or possession of or direct or indirect access to clients' property or the power to control the disposition of such property to third parties for the benefit of the advisor or its affiliated persons. 4) Whether advisory personnel and personnel of the affiliated company who have possession or custody of, or control over, or access to, advisory clients' property are under common supervision. 5) Whether advisory personnel hold any position with the custodian or share premises with the custodian and, if so, whether they have, either directly or indirectly, access to or control over clients' property. Whether Crocker Investment Management Corporation ("CIMCO") has custody of its clients' funds or securities when they are held by Crocker National Bank as custodian, is, therefore, a question which depends upon the facts. Since the pertinent facts are not stated in your letter, we express no opinion on this question and cannot advise you of what we would recommend to the Commission if CIMCO does not comply with Rule 206(4)-2.

2 Stanley B. Judd, Assistant Chief Counsel Division of Investment Management INQUIRY-1: LAW OFFICES OF MORRISON & FOERSTER ONE MARKET PLAZA SPEAR STREET TOWER SAN FRANCISCO, CALIFORNIA TELEPHONE (443) December 5, 1977 Office of Chief Counsel Division of Investment Management Securities & Exchange Commission 500 North Capitol Street Washington, D.C Re: Rule 206(4)-2 Gentlemen: We serve as legal counsel to Crocker Investment Management Corporation ("CIMCO"), a registered investment adviser under the Investment Advisers Act of CIMCO is a wholly owned subsidiary of Crocker National Corporation. CIMCO's primary activity is the investment management of employee benefit plan assets for large institutional investors. CIMCO does not offer custodial services and will not accept custody or possession of its customers' funds or securities. In several instances, however, its customers have elected to entrust custody of the securities portfolio being managed by CIMCO to Crocker National Bank ("the Bank"), which also is a wholly-owned subsidiary of Crocker National Corporation. During the course of the routine examination of CIMCO conducted by personnel from the San Francisco regional office of the Securities and Exchange Commission ("the Commission") earlier this year, a question arose as to the need for CIMCO to comply with Rule 206(4)-2 of the Investment Advisers Act of Specifically, it was the opinion of the examiner that since CIMCO and the Bank are both wholly-owned subsidiaries of the same corporation, compliance with the rule is necessary in any situation in which CIMCO acts as investment adviser for a client and the Bank serves as custodian for that client. In support of his position, the examiner referred us to certain correspondence between the Commission Staff and the Office of Chief Counsel and legal counsel to Columbia Advisory Corporation (your reference number ). In addition, he suggested that we review an August 21, 1973 interpretive opinion of the Chief Accountant to Myron J. Hubler Jr. of the American Institute of Certified Public Accountants with regard to Section 17(d) and 17(f) of the Investment Company Act of 1940.

3 After a careful review of the reference materials noted above and the applicable laws and regulations, we are unable to conclude that the position taken by the Office of the Chief Counsel in the Columbia Advisory Corporation correspondence is supported by law. For this reason, we have advised the San Francisco regional office that we intended to submit to your office this request for reconsideration of the position taken in that earlier correspondence. As an initial point, we note that under a literal reading of Rule 206(4)-2, it applies only in situations in which the investment adviser itself has custody or possession of funds or securities of its clients. There is no language in the rule which suggests that it applies in situations in which an affiliated person of the investment adviser has custody or possession of client's funds. This lack of specificity is particularly significant when one examines other regulations of the Commission that are intended to encompass affiliated persons. For example, Rule 206(3)-2, which deals with the situation in which an adviser is acting in the dual capacity of adviser and broker, explicitly states that it applies to any transaction in which the adviser "or any person controlling, controlled by, or under common control with such investment adviser" acts in a dual capacity. Similarly, the definition of "advisory representative" in Rule 204-2(a) expressly includes not only the investment adviser, but also "(i) any person in a control relationship to the investment adviser, (ii) any affiliated person of such controlling person and (iii) any affiliated person of such affiliated person." In proposed rule 204-4(d) (9), the Commission explicitly indicates its intention to encompass broker-dealers affiliated with the investment adviser by including a specific cross reference to the term "affiliated person" as defined in Section 2(a) (3) of the Investment Company Act of This comparison of the clear language of these other regulations and proposed regulations suggests quite strongly that the Commission did not intend rule 206(4)-2 to apply in situations in which an affiliated person of the Investment Adviser has custody or possession of funds or securities of the adviser's clients. If the Commission did intend to include affiliated persons within the scope of Rule 206(4)-2, it would have done so explicitly, as it has in its other rules and regulations. In this connection, we note that item 23 of Form ADV, which is intended to elicit information from applicants concerning custody and possession of their clients' securities and funds, is somewhat more broadly worded than Rule 206(4)-2. It asks whether the applicant, "or any person connected with" the applicant, has custody or possession of clients' funds. There is no definition of the phrase "person connected with" in the Investment Advisers Act or its implementing regulations. However, the Guide for Form ADV issued by the Commission after Form ADV was revised on September 1, 1968 directs applicants to answer item 23 for itself "and for associated persons as well." It thus equates the phrase "person connected with" in item 23 with the term "person associated with an investment adviser", which is defined at section 202(17) of the Investment Advisers Act of Interestingly, the definition of "person associated with an investment adviser" includes persons directly or indirectly controlling of controlled by the investment adviser, but does not include persons under common control with the investment adviser. Therefore, CIMCO and the Bank would not be defined as associated

4 persons under section 202(17). Since the Commission's own Guide for Form ADV equates the phrase "person connected with" to associated persons, it also seems reasonable to conclude that the Bank is not a "person connected with "CIMCO under the Commission's published interpretations. We believe that the above analysis demonstrates quite clearly that there is no language in the Investment Advisers Act, or in its implementing regulations issued by the Commission, to support the applicability of Rule 206(4)-2 to situations in which a bank under common control with a registered investment adviser has custody of securities of a client of the adviser. The only other support for such an extension of rule 206(4)-2 offered by the Office of Chief Counsel in the Columbia Advisory Corporation correspondence and by the Commission Staff during its examination of CIMCO is the August 21, 1973 interpretive opinion of the Office of the Chief Accountant. At the outset, we note that this correspondence deals not with Rule 206(4)-2 under the Investment Advisers Act of 1940, but rathr with Rule 17f-2 under the Investment Company Act of Therefore, the views expressed in this letter would be applicable only by analogy. Having examined Rule 17f-2 and the Chief Accountant's letter, we have concluded that they are not determinative of the issue at hand. Rule 17f-2 establishes certain specific independent verification procedures that must be followed in situations in which a registered investment company has custody or possession of securities and investments. It explicitly provides, however, that investments of a registered investment company that are in the custody of a bank are deemed to be in the custody of the investment company if there is an arrangement allowing the directors, officers, employees or agents of the investment company to withdraw such investments upon mere receipt. Thus, the rule itself contains language extending its scope beyond the situation in which the investment company itself has custody or possession. As we have noted above, Rule 206(4)-2 contains no langauge extending its scope beyond the situation in which the investment adviser itself has custody or possession of its clients funds or securities. With respect to the Chief Accountant's correspondence, we note that the letter from the American Institute of Certified Public Accountants requesting the Chief Accountant's opinion states that "a considerable number of bank-sponsored, closed-end bond funds to be registered as investment companies under the 1940 Act are presently being organized by commercial banking institutions themselves or a newly incorporated subsidiary which will act as adviser to such fund." The letter thus presumes a situation in which a commercial bank is acting as custodian and the same bank, or a subsidiary of the bank, is acting as adviser. Later in the correspondence, the AICPA letter also mentions the situation in which an affiliate of the Bank custodian is acting as adviser. The response from the Office of the Chief Accountant is much more vaguely worded with respect to affiliates and subsidiaries of the Bank custodian. In its opening paragraph, it presumes that the Bank itself is providing both investment advisory and depository services. Later, the letter states "we presently interpret the provisions of Rule 17f-2 as applying to any arrangement between and investment company and its adviser bank whereby such bank (emphasis added) provides custodian or depository services...". Nowhere in the Chief

5 Accountant's response is there any indication that this interpretation as intended to apply to situations in which it is not the bank custodian itself that serves as the adviser, but rather an affiliate of the bank custodian. Indeed, a literal reading of the Chief Accountant's letter suggests quite strongly that the interpretation applies only when the Bank itself is acting in the dual capacities of custodian and adviser. In particular, the August 21, 1973 interpretive opinion does not state that "there can be no assurance of independent scrutiny and safekeeping of clients' funds and securities by a bank where such bank is a 100% subsidiary of a parent who is also 100% owner of the investment adviser;" yet the January 28, 1975 response of Martin Lybecker on behalf of Alan Rosenblat, Chief Counsel of the Division of Investment Management Regulation, cites the Chief Accountant's opinion for this proposition. In summary, we find no legal support for the position taken by the Commission Staff in the Columbia Advisory Corporation correspondence and during its examination of CIMCO. If the Commission desires Rule 206(4)-2 to apply in situations in which an affiliated person of a registered investment adviser has custody or possession of funds or securities of clients of that adviser, the Commission clearly has the power to amend Rule 206(4)-2 to so provide. Any such amendment, of course, would have to be proposed for public comment in accordance with normal administrative law procedures. These procedures would put interested parties on notice of the Commission's intentions and would allow an opportunity for such parties to make their views known to the Commission on this question. As legal counsel to a registered investment adviser that has attempted and will continue to attempt to comply with all duly promulgated laws of Congress and regulations of the Commission applicable to its business affairs, we request a clarification from the Commission that Rule 206(4)-2, as presently in effect, does not apply to situations in which an affiliated person of the registered investment adviser has custody of funds or securities of clients of that adviser. If you require any further information or have any questions concerning this request, please contact John Kelly of our office or me. Very truly yours, Joseph E. Terraciano