SEC Proposes Changes in Investment Adviser Custody Rules; Adopts Changes in Fund Merger Regulations; Proposes Exemptions for Standardized Options; Adopts Changes to Privacy Act Systems of Records

FOR IMMEDIATE RELEASE
2002-107

Washington, D.C., July 17, 2002 -- The Commission today proposed changes to Rule 206(4)-2, the custody rule under the Investment Advisers Act, to enhance protections afforded to advisory clients' assets, harmonize the rule with current custodial practices, and clarify when advisers have custody. SEC regulations concerning mergers of affiliated investment companies were changed to permit a greater range of fund mergers that are consistent with the protection of fund investors. The Commission also proposed exemptions for standardized options that would ensure comparable regulatory treatment of standardized options and security futures products and noticed clarification of a Privacy Act system of records.

Proposed Changes in Investment Adviser Custody Rules

The Commission voted to propose amendments to Rule 206(4)-2, the custody rule under the Investment Advisers Act. The proposed amendments are designed to enhance protections afforded to advisory clients' assets, harmonize the rule with current custodial practices, and clarify when advisers have custody.

Maintaining Client Assets with Qualified Custodians. The proposed amendments would require advisers with custody to maintain client funds and client securities in accounts with "qualified custodians" — banks, savings associations, brokers, futures commission merchants and certain foreign financial institutions. The current custody rule requires an adviser that has custody of client assets to segregate and safekeep client securities and to deposit client funds in bank accounts. The proposed change is designed to prevent advisers from, for example, keeping clients' stock certificates in their office files.

Client Account Statements. Under the proposed amendments, qualified custodians must (subject to one exception) deliver monthly account statements directly to the adviser's clients to permit clients to determine whether there has been any improper trading in the account. This requirement replaces the current requirement that the adviser itself send quarterly account statements to its clients and have an independent public accountant conduct an annual surprise examination of the client funds and securities in the adviser's custody. The new requirement addresses concerns raised by several enforcement cases in which advisers have fabricated account statements, and is designed to better deter fraud.

In some circumstances, advisers do not provide client information to qualified custodians to permit the custodians to deliver account statements. Under the proposed amendments, these advisers would continue to deliver quarterly account statements and undergo surprise examinations by independent accountants, who would now be required to report any irregularities in the advisory accounts to the Commission.

Exemption for Certain Clients. Under the proposal, advisers would not be subject to the custody rule with respect to clients that either are registered investment companies (which are subject to their own custody requirements under the Investment Company Act) or limited partnerships that undergo an annual audit and distribute the results to limited partners.

Definition of "Custody." The proposed amendments would define "custody" as holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. This largely incorporates the definition of "custody" from Form ADV (the investment adviser registration form). The proposed amendments would give advisers additional guidance through several illustrations. The current rule does not define "custody."

The Commission requests that comments on the proposed amendments, including relevant data on costs and benefits of the amendments or any alternatives to the amendments, be submitted within sixty days of the date the proposals are published in the Federal Register.

Mergers of Affiliated Investment Companies

The SEC adopted amendments to Rule 17a-8 under the Investment Company Act. Rule 17a-8 allows affiliated registered investment companies (funds) to merge without obtaining a specific exemptive order from the Commission. The amendments are designed to expand the rule to permit a greater range of fund mergers that are consistent with the protection of fund investors.

Expanded Scope for Mergers Between Funds. Rule 17a-8 currently permits affiliated funds to merge only if they are affiliated by reason of having common advisers, officers, or directors. The amendments will permit all affiliated funds to merge under the rule, regardless of the reasons for the funds' affiliation.

Mergers of Funds and Certain Unregistered Entities. Rule 17a-8 currently provides relief only for mergers between funds. The amendments will permit mergers between funds and bank common trust funds, bank collective trust funds, or unregistered insurance company separate accounts to occur under the rule. Funds relying on this relief must comply with conditions regarding the valuation of assets to be conveyed by the unregistered entity.

Board Findings. Consistent with the current rule, the amended rule will rely heavily on the scrutiny of fund directors, including independent directors, to determine whether the merger is in the best interests of the fund and its shareholders. The amended rule will require that the directors request and evaluate any information reasonably necessary to their determinations, and consider and give appropriate weight to all pertinent factors.

Shareholder Voting. The amended rule will require that the acquired fund have the merger approved by a majority vote of its shareholders in circumstances where the merger would result in a change that, in a context other than a merger, would require a shareholder vote under the Investment Company Act.

Recordkeeping. The amended rule also will require each surviving fund to preserve written records documenting the merger and its terms.

The relief provided by the rule amendments will accommodate the growing numbers of mergers that currently do not fit within Rule 17a-8, and that therefore need to proceed under what have become routine Commission orders.

Standardized Options Exemptions

The Commission proposed exemptions for most standardized options from provisions of the Securities Act of 1933 and from the registration requirements of the Securities Exchange Act of 1934. The proposals would ensure comparable regulatory treatment of standardized options and security futures products. Comments on the proposed exemption should be submitted within thirty days of the date of their publication in the Federal Register.

System of Records Clarification

The Commission will amend the Privacy Act System of Records for Enforcement Files (SEC-42) to clarify that disclosures may be made in connection with debt collection activities, including disclosures to credit reporting bureaus, to update statutory and regulatory references and addresses of system administrators, and to append a statement regarding previously published Privacy Act exemptions claimed for the system.

Note: The Commission will issue the releases on these topics in the near future.