[Federal Register Volume 59, Number 55 (Tuesday, March 22, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 94-6658]
[[Page Unknown]]
[Federal Register: March 22, 1994]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release No. IA-1406; File No. S7-8-94]
RIN 3235-AG06
Suitability of Investment Advice Provided by Investment Advisers;
Custodial Account Statements for Certain Advisory Clients
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Commission is proposing for comment new rule 206(4)-5
under the Investment Advisers Act of 1940 (``Advisers Act'') that would
expressly prohibit investment advisers from making unsuitable
recommendations to clients. Proposed rule 206(4)-5 would make explicit
advisers' suitability obligations under the Advisers Act.
The Commission also is proposing new rule 206(4)-6 under the
Advisers Act to prohibit registered investment advisers from exercising
investment discretion with respect to client accounts unless they have
a reasonable belief that the custodians of those accounts send account
statements to the clients no less frequently than quarterly. Proposed
rule 206(4)-6 is designed to prevent certain fraudulent practices.
DATES: Comments on the proposals should be received on or before May
23, 1994.
ADDRESSES: Comments should be submitted in triplicate to Jonathan G.
Katz, Secretary, Securities and Exchange Commission, 450 5th Street,
NW., Washington, DC 20549. All comment letters should refer to File No.
S7-8-94. All comments received will be available for public inspection
and copying in the Commission's Public Reference Room, 450 5th Street,
NW., Washington, DC 20549.
FOR FURTHER INFORMATION CONTACT: W. Thomas Conner, Attorney, or Kenneth
J. Berman, Deputy Office Chief, (202) 272-2107, Office of Disclosure
and Investment Adviser Regulation, Division of Investment Management,
450 5th Street, NW., Washington, DC 20549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission today
is proposing for comment:
(1) Rule 206(4)-5 under the Investment Advisers Act of 1940 (15
U.S.C. 80b-1 et seq.) (``Advisers Act'') to expressly prohibit
investment advisers from making unsuitable recommendations to clients;
(2) Rule 206(4)-6 under the Advisers Act to prohibit investment
advisers registered or required to be registered under the Advisers Act
from exercising investment discretion with respect to client accounts
unless they have a reasonable belief that the custodians of those
accounts send account statements to the clients no less frequently than
quarterly; and
(3) Amendments to rule 204-2 (17 CFR 275.204-2) under the Advisers
Act to require investment advisers subject to the recordkeeping
requirements of the Advisers Act to maintain (i) information about
clients obtained by the investment advisers to comply with proposed
rule 206(4)-5, and (ii) copies of client custodial account statements
received by the advisers.
I. Introduction
The Commission is proposing two rules under the antifraud
provisions of the Advisers Act.1 Rule 206(4)-5 would make express
the fiduciary obligation of investment advisers to make only suitable
recommendations to a client, after a reasonable inquiry into the
client's financial situation, investment experience, and investment
objectives. Rule 206(4)-6 would prohibit registered investment advisers
from exercising investment discretion with respect to client accounts
unless they have a reasonable belief that the custodians of those
accounts send account statements to the clients no less frequently than
quarterly.
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\1\Section 206(4) (15 U.S.C. 80b-6(4)) makes it unlawful for any
investment adviser, by use of the mails or any means or
instrumentality of interstate commerce, directly or indirectly, ``to
engage in any act, practice, or course of business which is
fraudulent, deceptive, or manipulative.'' Section 206(4) authorizes
the Commission to adopt rules and regulations defining the acts,
practices, and courses of business that will be deemed fraudulent,
deceptive, or manipulative for purposes of section 206(4), and to
prescribe means reasonably designed to prevent such conduct. The
Commission has adopted four rules under section 206(4): rule 206(4)-
1 (17 CFR 275.206(4)-1) (advertisements); rule 206(4)-2 (17 CFR
275.206(4)-2) (custody or possession of funds or securities of
advisory clients); rule 206(4)-3 (17 CFR 275.206(4)-3) (cash
payments for client solicitations); and rule 206(4)-4 (17 CFR
275.206(4)-4) (financial and disciplinary information that
investment advisers must disclose to clients).
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II. Suitability of Investment Advice
Investment advisers are fiduciaries2 who owe their clients a
series of duties,3 one of which is the duty to provide only
suitable investment advice. This duty is enforceable under the
antifraud provision of the Advisers Act, section 206,4 and the
Commission has sanctioned advisers for violating this duty.5 The
Commission now proposes to make explicit this duty in a new rule under
section 206(4) of the Advisers Act. The scope of proposed rule 206(4)-5
reflects the Commission's interpretation of advisers' suitability
obligations under the Advisers Act.6
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\2\SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180,
191, 194 (1963) (``Capital Gains'').
\3\These duties include the duty of full disclosure of conflicts
of interest, Capital Gains at 191-92; utmost and exclusive loyalty,
In re Kidder, Peabody & Co., Inc., 43 SEC 911, 915 (1968)
(``Kidder''), Investment Advisers Act Rel. No. 40 (Feb. 5, 1945)
(staff position stating advisers' duty of loyalty requires full
disclosure of adverse interests and client consent before purchase
or sale of securities from clients); and the duty of best execution,
Kidder at 915-16. See generally 2 Frankel, The Regulation of Money
Managers 343-47 (discussing general duties of fiduciaries), ch. XIII
(duty of loyalty), ch. XV (duty of care); Leavell, Investment Advice
and the Fraud Rules, 65 Mich. L. Rev. 1569 (1967) (discussing legal
controls on providing investment advice).
\4\Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11,
17 (1979) (Advisers Act's legislative history leaves no doubt that
Congress intended to impose enforceable fiduciary obligations).
\5\See, e.g., In re David A. King and King Capital Corp.,
Investment Advisers Act Rel. No. 1391 (Nov. 9, 1993) (investment
adviser recommended investments in a risky pool of first, second and
third mortgages to retirees and others of limited means); In re
George Sein Lin, Investment Advisers Act Rel. No. 1174 (June 19,
1989) (investment adviser with discretionary investment authority
invested funds of clients desiring low-risk investments in uncovered
option contracts and utilized margin brokerage accounts); In re
Westmark Financial Services, Corp., Investment Advisers Act Rel. No.
1117 (May 16, 1988) (financial planner recommended speculative
equipment leasing partnerships to unsophisticated investors with
modest incomes); In re Shearson, Hammill & Co., 42 SEC 811 (1965)
(sections 206(1) and (2) violated when adviser recommended
investments unsuitable to child and widow).
\6\In addition, in formulating the proposed rule, the Commission
has looked to interpretations of the scope of broker-dealers'
suitability obligations under the antifraud provisions of the
Securities Exchange Act of 1934 [15 U.S.C. 78a et seq.] (``Exchange
Act''). The federal securities laws, as well as rules of various
self-regulatory organizations (``SROs''), impose suitability
requirements on broker-dealers. Under the ``shingle'' theory, a
broker-dealer makes an implied representation to its customers that
it will deal with them fairly and in accordance with the standards
of the profession. Duker & Duker, 6 S.E.C. 386, 388 (1939). A
broker-dealer that breaches this representation may violate certain
antifraud provisions of the federal securities laws, namely, section
17(a) of the Securities Act of 1933 [15 U.S.C. 77q(a)], sections
10(b) and 15(c)(1) of the Exchange Act [15 U.S.C. 78j(b) and
78o(c)(1)], and rules 10b-5 and 15c1-2 thereunder [17 CFR 240.10b-5
and 240.15c1-2]. See, e.g., Hanly v. SEC, 415 F.2d 589 (2d Cir.
1969); Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943),
cert. denied, 321 U.S. 786 (1943); In re Harold Grill, 41 SEC 321
(1963). A broker making unsuitable recommendations breaches this
representation. See, e.g., Clark v. John Lamula Investors, Inc., 583
F.2d 594 (2d Cir. 1978) (recommended purchase of a convertible
debenture was unsuitable for the needs of a widowed, retired
customer, when the broker-dealer failed, among other things, to
disclose the risks of the investment). This doctrine is incorporated
into the rules of the SROs. National Association of Securities
Dealers, Inc. (``NASD'') Rules of Fair Practice, art. III, Sec. 2,
NASD Manual (CCH) 2152; New York Stock Exchange (``NYSE'') rule
405, 2 N.Y. Stock Exch. Guide (CCH) 2405 (the ``Know Your Customer
Rule''). See also Municipal Securities Rulemaking Board (``MSRB'')
rule G-19, MSRB Manual (CCH) 3591; NYSE rule 472, 2 N.Y. Stock
Exch. Guide (CCH) 2472.40(1) (``When recommending the purchase,
sale or switch of specific securities, supporting information must
be provided or offered.''). Broker-dealers also are required under
SRO rules to establish and enforce written supervisory procedures
that are reasonably designed to achieve compliance with the
applicable securities laws and regulations, including the obligation
of fair dealing. See, e.g., NASD Rules of Fair Practice, art. III,
Sec. 27, NASD Manual (CCH) 2177. In addition, broker-dealers must
comply with specialized suitability rules when recommending certain
kinds of securities, such as penny stocks and options, or when
offering to extend, or arrange for the extension of, credit in
connection with inducing the purchase of a security. See, e.g.,
rules 15g-9 (17 CFR 240.15g-9) (penny stocks) and 15c2-5 (17 CFR
240.15c2-5) (extensions of credit) under the Exchange Act; NASD
Rules of Fair Practice, Art. III, Sec. 2, Policy of the Board of
Governors, NASD Manual (CCH) 2152 (statement of policy concerning
recommendations of speculative low-priced securities and
recommendations of or accepting orders for options). Compliance with
proposed rule 206(4)-5 would not override the obligation of an
investment adviser that is also a broker-dealer to meet the
requirements of these rules. Nor would a determination by a broker-
dealer under these rules that a particular investment is suitable
relieve an investment adviser that is acting as the purchaser's
adviser in connection with the transaction from making a suitability
determination under proposed rule 206(4)-5 with respect to the
investment.
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As discussed in more detail below, rule 206(4)-5 would prohibit an
investment adviser from providing investment advice to a client unless
the adviser makes a reasonable inquiry into the financial situation,
investment experience, and investment objectives of the client and
reasonably determines that the investment advice is suitable for the
client.7 An amendment to rule 204-2 under the Advisers Act would
require investment advisers subject to the recordkeeping requirements
of the Advisers Act to maintain records of the information obtained
from clients in the required inquiry.
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\7\A similar provision is contained in H.R. 578, the Investment
Adviser Regulatory Enhancement and Disclosure Act of 1993, which is
currently pending before Congress.
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1. Duty To Inquire
Paragraph (a)(1) of rule 206(4)-5 would require an investment
adviser, before providing any investment advice, and, as appropriate
thereafter, to make a reasonable inquiry into the client's financial
situation, investment experience, and investment objectives.8 The
extent of the inquiry would turn on what is reasonable under the
circumstances. For example, to formulate a comprehensive financial plan
for a client, an adviser may be required to obtain extensive personal
and financial information about the client, including current income,
investments, assets and debts, marital status, insurance policies, and
financial goals. This information must be updated periodically so that
the adviser can adjust its advice to reflect changed circumstances. The
frequency with which the information must be updated would turn on what
is appropriate under the circumstances. Among the factors to be
considered in determining when to update client information would be
the passage of time since the information was last updated and whether
the adviser is aware of events that have occurred that could render
inaccurate or incomplete the information on which it currently bases
its advice. For example, a change in the tax law or knowledge that the
client has retired or experienced a change in marital status might
trigger an obligation to make a new inquiry. Comment is requested on
whether the proposed rule should specify the minimum frequency for
making inquiries to update information concerning the client. For
example, should the rule require that client information be updated no
less frequently than annually?
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\8\Rule 206(4)-5 would not apply to impersonal advisory
services, and references to investment advice in this Release do not
include impersonal advisory services. Impersonal advisory services
would be defined in paragraph (b) of proposed rule 206(4)-5 as
investment advisory services provided solely (1) by means of written
material or oral statements that do not purport to meet the
objectives or needs of specific individuals or accounts; (2) through
the issuance of statistical information containing no expression of
opinion as to the investment merits of a particular security; or (3)
any combination of the foregoing services. This definition is
derived from the definition of ``contract for impersonal advisory
services'' in rule 204-3 under the Advisers Act [17 CFR 275.204-3].
Rule 204-3 requires an adviser to provide clients and prospective
clients with a written disclosure statement or ``brochure,'' except
when advisory services are provided in connection with a contract
for impersonal advisory services.
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Most advisers conduct an inquiry at an initial client meeting that
would generally satisfy the proposed requirement.9 Clients are
typically asked to complete questionnaires that request information
about each client's current financial situation, financial goals, risk
tolerance, and any other information that the adviser believes
necessary to develop recommendations for a financial plan or specific
investments.10 Clients typically are requested periodically to
review the information and notify the adviser of any changes.
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\9\See State and Federal Regulation of Financial Planners: A
Policy Overview and Model for Reform, Prepared for the American
Association of Retired Persons Public Policy Institute by Barbara
L.N. Roper 2-3 (1993) (describing generally accepted standards of
financial planning that include, among other things, meeting with a
client at the outset of the engagement to review the client's
personal finances, risk tolerance, and investment objectives).
\1\0Financial Planners, Report of the Staff of the United States
Securities and Exchange Commission to the House Committee on Energy
and Commerce's Subcommittee on Telecommunications and Finance 8
(February 1988).
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2. Duty To Give Only Suitable Advice
Paragraph (a)(2) of rule 206(4)-5 would prohibit an adviser from
giving advice to a client unless the adviser reasonably determined that
the advice was suitable to the client's financial situation, investment
experience, and investment objectives. A reasonable determination of an
investment's suitability for a client would require, for example, that
certain kinds of particularly risky investment products be recommended
only to those clients who can and are willing to tolerate the risks and
for whom the potential benefits justify the risks.11
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\1\1The prohibition against providing unsuitable advice would
apply to advice to institutional clients as well as to individual
clients. Institutional investors have experienced significant losses
as a result of recommendations to invest in complex financial
products that they did not fully understand. See H.R. Rep. No. 255,
103d Cong., 1st Sess. 30-34 (1993) (municipal governments and
savings and loan associations experienced widespread losses in U.S.
Treasury instruments, derivative products, futures transactions,
options hedging, and mortgage-backed securities recommended by
dealers). The rationale underlying the duty to make suitable
recommendations, although developed largely in the context of
investors who are not deemed to be ``sophisticated,'' applies also
to those who are ordinarily considered to be ``sophisticated.'' See
Root, Suitability--The Sophisticated Investor--and Modern Portfolio
Management, Colum. Bus. L. Rev. 287 (1991).
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While rule 206(4)-5 would require an investment adviser to have
reasonably determined that each piece of its investment advice would be
suitable for the client,12 suitability of the advice would be
evaluated in the context of the client's portfolio.13 For example,
an investment adviser may hedge a portfolio of U.S. government bonds
for a client having very conservative investment objectives, in which
case the suitability of the hedging instruments would be evaluated in
light of their hedging function. Thus, inclusion of some risky
investments in the portfolio of a risk-averse client may not
necessarily be unsuitable.14
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\1\2For an account under discretionary management, each trade
initiated by the adviser would constitute ``advice.'' For a
discussion of when an account is under discretionary management, see
infra note 29.
\1\3A similar standard is applied in determining the prudence of
an investment made for a retirement plan under the Employee
Retirement Income Security Act of 1974 (29 U.S.C. 1001 et seq.) (see
29 C.F.R. 2550.404a-1(a)), and generally in determining the
suitability of a trustee's investment decision under trust law (see
Restatement (Second) of Trusts, Sec. 227 commentary (1959)).
\1\4Conversely, while advice to invest in a particular security
may be suitable to the needs of a client, advice to make the same
investment on margin may not be.
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Proposed rule 206(4)-5's suitability obligation includes the
requirement that an adviser ``know his client,'' as well as the
requirement that an adviser ``know his product.'' Lack of actual
knowledge about the client or the investment products recommended would
not provide a defense for an adviser unless it would be reasonable for
the adviser not to have known the information.15 It generally
would, for example, be reasonable for an adviser to rely on information
provided by a client (or the client's agent) regarding the client's
financial circumstances in response to the inquiry required by
paragraph (a)(1) of proposed rule 206(4)-5, and an adviser should not
be held to have given unsuitable advice if it is later shown that the
client had misled the adviser.16 If a client refused to provide
requested information, however, the adviser could not make assumptions
about the client that were not reasonable.17 When no other
information is available, the adviser may have to assume the client has
no assets or source of income other than the assets the adviser
manages. If the client refused to provide information upon which an
adviser could base recommendations, the adviser would be permitted to
rely upon trustworthy information about the client that it obtains from
other reliable sources, such as a consultant to the client or other
intermediary.
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\1\5See In re Baskin Planning Consultants, Ltd., Investment
Advisers Act Rel. No. 1297 (Dec. 19, 1991) (adviser failed
adequately to investigate investment recommendations to clients); In
re Alfred C. Rizzo, Investment Advisers Act Rel. No. 897 (Jan. 12,
1984) (investment adviser lacked a reasonable basis for advice and
could not rely on ``incredible claims'' of issuer of security); In
re Winfield & Co., Inc., 44 SEC 810, 817-18 (1972) (investment
adviser to investment company failed to make reasonable
investigation before causing the company to purchase securities); In
re Shearson, Hammill & Co., supra note 5.
\1\6An adviser could not disregard information concerning the
client's affairs that the adviser knows or should have known.
\1\7In one case involving a client that turned over
approximately $100,000 to a broker but refused to provide financial
information, the Commission explained that the broker had a ``duty
to proceed with caution; to make recommendations only on the basis
of the concrete information that [the client] did supply and not on
the basis of guesswork as to the value of other possible assets.''
In re Eugene J. Erdos, 47 SEC 985, 988 (1983), aff'd sub nom. Erdos
v. Securities and Exchange Commission, 742 F.2d 507 (9th Cir. 1984).
See also In re Gerald M. Greenberg, 40 SEC 133, 137-38 (1960),
petition for review dismissed on motion of petitioner sub nom.
Greenberg v. SEC, 287 F.2d 571 (10th Cir. 1960) (``clear purpose''
of NASD suitability rule would be defeated if it were construed as
permitting a broker-dealer to recommend low price speculative
securities to ``unknown'' customers ``without any knowledge of or
attempt to obtain information concerning the customer's other
security holdings, his financial situation, and his needs so as to
be in a position to judge the suitability of the recommendation''
(citation omitted)).
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Proposed rule 206(4)-5 would not require that knowledge of an
affiliate of the adviser be imputed to the adviser if it would be
unreasonable to expect the adviser to know the information. For
example, section 204A of the Advisers Act (15 U.S.C. 80b-4a) requires
that advisers establish, maintain, and enforce written procedures
designed to prevent insider trading, in which case the adviser may not,
and should not, have access to certain information about a recommended
security that an affiliated adviser might have. Comment is requested on
whether the proposed rule should specify standards that would establish
a presumption that the knowledge of an affiliate would not be imputed
to the adviser.
3. Recordkeeping
The Commission is proposing an amendment to rule 204-2 under the
Advisers Act to require any investment adviser subject to the
recordkeeping requirements of the Advisers Act18 to maintain
records of the information obtained about clients from the inquiries
the adviser has made in complying with paragraph (a)(1) of proposed
rule 206(4)-5.19 The proposed recordkeeping requirement would not
require advisers to memorialize the suitability considerations
underlying each recommendation to clients. The amendment would require
advisers to maintain, as part of their records, completed client
questionnaires, or any other records or documents that the advisers
have obtained from their client inquiries. These records would assist
the Commission in determining whether investment advisers have complied
with rule 206(4)-5. Comment is requested on whether advisers should be
required to document the bases upon which suitability determinations
have been made, either in connection with each piece of investment
advice or in the form of a list of generic investments that the adviser
has determined are suitable for the client.
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\1\8Rule 204-2, the general recordkeeping rule under the
Advisers Act, applies to every investment adviser who makes use of
the mails or of any means or instrumentality of interstate commerce
in connection with his or its business as an investment adviser,
other than one specifically exempted from registration pursuant to
section 203(b) of the Advisers Act.
\1\9Proposed paragraph (a)(17) of rule 204-2.
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III. Custodian Account Statements
Under typical discretionary advisory arrangements, a third-party
custodian holds client assets and sends account statements to the
client and copies of the account statements to the client's investment
adviser.20 These account statements provide clients with
independent reports of account activity and are designed to permit
clients to protect themselves against illegal or questionable conduct,
including inappropriately high levels of trading in their accounts,
unauthorized transactions, and unsuitable investments.21
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\2\0Custodial arrangements are typically made with broker-
dealers and banks. Broker-dealers are required to provide account
statements to customers. For example, the rules of the NASD, the
NYSE, and the American Stock Exchange (``AMEX'') require member
broker-dealers to provide account statements to customers at least
quarterly. NASD Rules of Fair Practice, Sec. 45, art. III, NASD
Manual (CCH) 9440; NYSE rule 409, 2 New York Stock Exchange Guide
(CCH) 2409; AMEX rule 419, 2 American Stock Exchange Guide (CCH)
9439. These rules, however, permit customers to direct delivery of
statements to investment advisers holding powers of attorney over
customer accounts. See, e.g., NYSE rule 409(b), 2 New York Stock
Exchange Guide (CCH) 2409; AMEX rule 420(a), 2 American Stock
Exchange Guide (CCH) 9440. Commission rules under the Exchange Act
require a broker-dealer to send account statements to its customers
under certain circumstances. See, e.g., rule 15g-6 [17 CFR 240.15g-
6] (monthly account statements for penny stock customers); rule
15c3-2 [17 CFR 240.15c3-2] (quarterly statement concerning use by
broker-dealer of funds arising out of free credit balance in
customer's account). See also infra note 21. Commission rules under
the Advisers Act require an investment adviser that has custody or
possession of client funds or securities to send to clients account
statements at least every three months. Rule 206(4)-2 under the
Advisers Act [17 CFR 275.206(4)-2].
\2\1Another means of permitting clients to monitor their
accounts would be to require advisers to have a reasonable belief
that brokers send confirmations to clients. The Commission is not
proposing such a requirement. A broker-dealer, however, has an
obligation under rule 10b-10 under the Exchange Act [17 CFR 240.10b-
10] to send its customers an immediate confirmation with respect to
each transaction the broker-dealer effects. In the case of an
account managed by a fiduciary, the customer, rather than the
fiduciary, is considered to be the customer of the broker-dealer.
Accordingly, under rule 10b-10, the broker-dealer must send an
immediate confirmation to the account holder, in addition to any
confirmation it may send to the account fiduciary; however, an
account that has given discretionary authority in writing to its
fiduciary may agree in writing with the broker-dealer effecting its
trades to waive the receipt of the immediate confirmation required
by rule 10b-10 if, among other things, the broker-dealer sends the
discretionary account a statement no less frequently than quarterly
containing all the information required to be disclosed on the
immediate confirmation. The customer may not waive this quarterly
statement. See Securities Exchange Act Rel. No. 33743 (March 9,
1994) [59 FR 12767 (March 17, 1994)] at note 3.
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Failure of a custodian to provide account information directly to
clients may facilitate fraudulent transactions in client accounts, as
illustrated in the case of Institutional Treasury Management, Inc.
(``ITM''), a registered investment adviser, and its controlling person,
Steven Wymer. ITM attracted clients by promising above-market returns
through the use of sophisticated trading strategies in U.S. Government
securities. When the strategies not only failed to produce the promised
returns, but also began to cause substantial losses, Wymer began to
trade client accounts aggressively, often without the clients'
knowledge, in an attempt to recover losses. To cover additional losses,
Wymer began to divert funds from one client account to another.22
Total client losses as a result of the fraud amounted to approximately
$104 million.23
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\2\2On September 29, 1992, the Commission and the U.S.
Attorney's Office for the Central District of California jointly
announced a settlement of civil and criminal actions against Wymer.
Wymer pleaded guilty to nine felony counts, including securities
fraud, and was ordered to pay $209 million in restitution and
prejudgment interest to his defrauded clients. Litigation Rel. No.
13389 (Sept. 29, 1992) (concerning Securities and Exchange
Commission v. Institutional Treasury Management, Inc., Civil Action
No. 91-6715 MRR (C.D. Cal. Sept. 25, 1992) and United States v.
Steven D. Wymer, No. CR 92-2-RG.) In entering his guilty plea before
the court, Wymer described how he traded in options and other
speculative investments for accounts with conservative investment
objectives, and then sent false account statements to clients to
conceal losses and misappropriation of funds. Transcript of
Proceedings before the Honorable Richard A. Gadbois, Jr., United
States v. Steven D. Wymer, No. CR 92-02-(A)-RG (C.D. Cal. Sept. 29,
1992), at 25.
\2\3See SEC v. Institutional Treasury Management, Inc., Denman &
Company and Steven D. Wymer (Civil Action No. 91-6715 RJK) (C.D.
Cal.) (Commission's Motion for an Order Distributing the Steven D.
Wymer Qualified Settlement Fund, filed on Dec. 22, 1993).
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Crucial to Wymer's fraudulent scheme was his ability to persuade
the custodians of client accounts not to send confirmations and monthly
statements to his clients.24 Because clients received no
independent reports of account activities, Wymer was able to
successfully fabricate false account statements to hide the losses,
unauthorized transactions, and the misappropriation of client funds and
securities.25 Other investment advisers have engaged in similar
fraudulent schemes resulting in substantial client losses.26
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\2\4Wymer testified before a Congressional subcommittee that he
selected for his clients only those custodians that agreed to make
ITM the exclusive recipient of account information. Investment
Adviser Industry Reform, Hearing before the Subcommittee on
Telecommunications and Finance of the House Committee on Energy and
Commerce, 103d Cong., 1st Sess. 88-89 (1993).
\2\5Id.
\2\6See, e.g., In re Thomas Walter McKibbin and Equitrust, Inc.,
Investment Advisers Act Rel. No. 1165 (May 1, 1989) (adviser
invested clients' funds in mutual funds, which sent account
statements directly to adviser, which, in turn, sent false account
statements to clients concealing misappropriation of funds); In re
Robert Schwarz, Inc. and Robert G. Schwarz, Investment Advisers Act
Rel. No. 1248 (Aug. 31, 1990) (adviser sent false account statements
to clients concealing markups on municipal bonds purchased from
broker-dealer, which sent confirmations of the transactions only to
the adviser).
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The Commission is proposing for comment new rule 206(4)-6 under the
Advisers Act as a means reasonably necessary to prevent the type of
fraudulent conduct in which Wymer and other advisers have
engaged.27 Rule 206(4)-6 would prohibit an investment adviser
registered or required to be registered under the Advisers Act from
exercising investment discretion with respect to a client
account28 unless it reasonably believed that the custodian of the
account is providing account statements to the client no less
frequently than quarterly.29 An adviser would be deemed to have a
reasonable belief that the custodian is providing account statements if
the adviser has received copies of client account statements indicating
that they were sent to clients.30 Comment is requested on whether
the ``reasonable belief'' standard in the proposed rule is appropriate
and consistent with the duties of a fiduciary.
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\2\7In addition, the Commission is proposing an amendment to
rule 204-2 to require investment advisers subject to the
recordkeeping requirements of the Advisers Act to maintain in their
records copies of custodian account statements that are received by
the adviser. Proposed paragraph (a)(18) of rule 204-2.
\2\8Proposed rule 206(4)-6 would not apply to an adviser's
exercise of investment discretion with respect to the assets of
investment companies registered under the Investment Company Act of
1940 (15 U.S.C. 80a-1 et seq.) (``1940 Act'') or business
development companies. The 1940 Act regulates custodial arrangements
with respect to these assets. Section 17(f) of the 1940 Act (15
U.S.C. 80a-17(f)) and rules 17f-1, 17f-2, 17f-4, and 17f-5
thereunder (17 CFR 270.17f-1, 17f-2, 17f-4, and 17f-5) and Section
59 of the 1940 Act (15 U.S.C. 80a-58).
\2\9For purposes of rule 206(4)-6, an investment adviser would
be deemed to exercise investment discretion with respect to an
account if, directly or indirectly, the investment adviser is
authorized to determine what securities or other property are
purchased or sold for the account, or makes decisions as to what
securities or other property are purchased or sold by or for the
account, even though some other person may have responsibility for
those investment decisions. Paragraph (c)(2) of proposed rule
206(4)-6. This definition is the same as in section 3(a)(35) of the
Exchange Act [15 U.S.C. 78c(a)(35)].
\3\0Paragraph (c)(4) of proposed rule 206(4)-6. The adviser
could not rely on the copy of the account statement as a basis for
its reasonable belief if the adviser had reason to believe that the
account statements had not been delivered. Under the proposed rule,
receipt of a copy of the account statement would not be the
exclusive means by which an adviser could form a reasonable belief
that the custodian is providing account statements to the client.
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In some cases, a client may appoint another person to monitor his
account and receive communications regarding the account. In such
cases, proposed rule 206(4)-6 would permit the account statement to be
sent to the client's designee. In order to prevent the rule from being
circumvented, the rule would not permit the designee to be the
custodian, the investment adviser, a person associated with the
investment adviser, or a person under common control with the
investment adviser.31 Investment advisers often act as general
partners of limited partnerships that invest in various types of
financial instruments. In these cases, the account statement could be
sent to a designee of the partnership--another general partner, an
accountant or an attorney--that is not associated with the
adviser.32 Comment is requested, however, on whether the rule
should contain specific provisions to address the delivery of account
statements to limited partnerships. For example, should the rule
specify that the account statement may, or should, be sent to each
limited partner? Comment also is requested on how the proposed rule
should address shares of open-end management investment companies,
which might not be held by third-party custodians.
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\3\1Paragraph (c)(1) of proposed rule 206(4)-6. The term
``person associated with an investment adviser'' is defined in
section 202(a)(17) of the Advisers Act [15 U.S.C. 80b-2(a)(17)] to
mean any partner, officer, or director of the investment adviser (or
any person performing similar functions), or any person directly or
indirectly controlling or controlled by the adviser, including any
employee of the adviser.
\3\2See, e.g., GBU, Inc. (pub. avail. Apr. 22, 1993); PIMS, Inc.
(pub. avail. Oct. 21, 1991); Bennett Management Company, Inc. (pub.
avail. Feb. 26, 1991) (general partner not deemed to have custody of
client assets when it is authorized to make certain draws on
partnership funds if, before making draws, the general partner
provides certain information concerning the draws to an independent
representative of the partnership for review and authorization).
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The account statement specified in proposed rule 206(4)-6 would be
required to show all transactions occurring in the account during the
period covered by the account statement, and the funds, securities, and
other property in the account at the end of the period.33 The
Commission requests comment on whether the rule should require other
information to be provided (e.g., the value of securities positions in
the account) to assure that clients receive sufficient information to
monitor account activity.34
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\3\3Paragraph (b) of proposed rule 206(4)-6.
\3\4See, e.g., rule 15g-6(d)(2) (17 CFR 240.15g-6(d)(2)) under
the Exchange Act (requiring market value of penny stocks, if
determinable, to appear on account statement sent to customer that
purchases penny stocks).
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The Commission believes that the proposed rule reflects the
business practices of most investment advisers and custodians under
which an account statement showing all account transactions is
generated by the custodian and delivered directly to the client. Copies
of account statements are typically provided to the investment adviser,
and the data is used by the adviser to verify the accuracy of the
adviser's own records.
If proposed rule 206(4)-6 is adopted, the Commission anticipates
delaying the effective date of the rule for a sufficient period to
permit advisers to confirm that their clients' custodians are providing
account statements to the clients and, if they are not, to permit
clients to direct custodians to provide them with account statements.
An adviser that exercises investment discretion with respect to client
accounts that cannot form a reasonable belief that the custodians of
those accounts are sending account statements to clients could not
continue to provide investment advice to the clients on a discretionary
basis. Comment is requested on whether a sixty-day delay would be
sufficient.
IV. General Request for Comments
Any interested persons wishing to submit written comments on the
rule proposals that are the subject of this release, suggest additional
changes, or submit comments on other matters that might have an effect
on the proposals described in this release, are requested to do so.
V. Summary of Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis in accordance with 5 U.S.C. 603 regarding the proposed rules
and rule amendments. The analysis notes that proposed rule 206(4)-5
makes explicit an adviser's current obligation under the Advisers Act
to make a reasonable inquiry into a client's financial situation,
investment experience, and investment objectives, and, thereafter, to
reasonably determine that investment advice is suitable for the client.
Proposed paragraph (a)(17) of rule 204-2 would require investment
advisers to retain for Commission inspection the client questionnaire
or other records or documents received by the adviser in response to
the inquiry that would be required by proposed rule 206(4)-5. The
Commission does not have information on how many investment advisers
that are ``small entities'' under the Advisers Act (``small advisers'')
do not currently record this information. The Commission believes,
however, that the costs involved in doing so would not be significant
and would be outweighed by the benefits to clients.
The analysis also notes that proposed rule 206(4)-6 would prohibit
a registered investment adviser from exercising investment discretion
with respect to client accounts unless it has a reasonable belief that
the custodians of those accounts send account statements to the clients
no less frequently than quarterly. The analysis notes that most
custodians already provide account statements to clients, and in many
cases also send copies of account statements to the clients' investment
advisers. The Commission believes that the costs involved with sending
these statements to clients and to advisers would not be significant,
and would be outweighed by the benefits to clients. Proposed paragraph
(a)(18) of rule 204-2 would require investment advisers to maintain
copies of client custodial account statements received by the adviser.
The Commission believes that the costs associated with retaining these
copies would not be significant and, in any event, would be outweighed
by the benefits to the Commission's adviser examination program.
The analysis notes that alternatives to the proposals were
considered, including establishing different compliance or reporting
requirements or timetables that would take into account the resources
available to small advisers, and the simplification of compliance and
reporting requirements for small advisers. The Commission also
considered the use of performance rather than design standards, and the
exemption of small advisers from coverage of part or all of the
proposed amendments. The Commission concluded that the alternatives
would not be as effective as the proposals in assuring that the
suitability standard is understood and adhered to by all advisers and
that all discretionary clients are provided with independent reports to
monitor account activity. A copy of the Initial Regulatory Flexibility
Analysis may be obtained by contacting W. Thomas Conner, Office of
Disclosure and Investment Adviser Regulation, Division of Investment
Management, Securities and Exchange Commission, 450 5th Street, NW.,
Washington, DC 20549.
VI. Statutory Authority
The Commission is proposing rules 206(4)-5 and 206(4)-6 under the
authority set forth in sections 206(4) and 211(a) of the Advisers Act
(15 U.S.C. 80b-6(4) and 80b-11(a)).
The Commission is proposing amendments to rule 204-2 under its
authority in sections 204 and 211(a) of the Advisers Act (15 U.S.C.
80b-4 and 80b-11(a)).
Text of Proposed Rules and Rule Amendments
List of Subjects in 17 CFR Part 275
Investment advisers, Fraud, Reporting and recordkeeping
requirements.
For the reasons set out in the preamble, title 17, chapter II of
the Code of Federal Regulations is proposed to be amended as follows.
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
1. The general authority for part 275 is revised to read as
follows:
Authority: 15 U.S.C. 80b-3, 80b-4, 80b-6(4), 80b-6A, 80b-11,
unless otherwise noted.
* * * * *
2. By adding paragraphs (a)(17) and (a)(18) to Sec. 275.204-2 to
read as follows:
Sec. 275.204-2 Books and records to be maintained by investment
advisers.
(a) * * *
(17) With respect to each client (other than a client to which the
adviser provides only impersonal advisory services), completed client
questionnaires, or other records or documents received by the
investment adviser in response to the inquiry made by the investment
adviser into the client's financial situation, investment experience,
and investment objectives required by Sec. 275.206(4)-5.
(18) With respect to each client (other than an investment company
registered under the Investment Company Act of 1940 (15 U.S.C. 80a-1 et
seq.) or a business development company), copies of account statements
sent to such client by the custodian of such client's account that were
also received by the adviser.
* * * * *
3. By adding Sec. 275.206(4)-5 to read as follows:
Sec. 275.206(4)-5 Suitability of investment advice.
(a) It shall constitute 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 any investment adviser to
provide investment advice to any client, other than in connection with
impersonal advisory services, unless the adviser:
(1) Before providing any investment advice, and as appropriate
thereafter, makes a reasonable inquiry into the client's financial
situation, investment experience, and investment objectives; and
(2) Reasonably determines that the investment advice is suitable
for the client.
(b) For purposes of this section, the term impersonal advisory
services shall mean investment advisory services provided solely:
(1) By means of written material or oral statements that do not
purport to meet the objectives or needs of specific individuals or
accounts;
(2) Through the issuance of statistical information containing no
expression of opinion as to the investment merits of a particular
security; or
(3) Any combination of the foregoing services.
4. By adding Sec. 275.206(4)-6 to read as follows:
Sec. 275.206(4)-6 Custodial account statements.
(a) It shall constitute 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 any investment adviser
registered or required to be registered pursuant to section 203 of the
Act (15 U.S.C. 80b-3) to exercise investment discretion with respect to
a client account (other than the account of an investment company
registered under the Investment Company Act of 1940 (15 U.S.C. 80a-1 et
seq.) or a business development company), unless the investment adviser
reasonably believes that the custodian of the client account is
providing to the client or its designee an account statement described
in paragraph (b) of this section not less frequently than once every
three months.
(b) The account statement required by paragraph (a) of this section
shall show, for the period of the account statement:
(1) All transactions occurring in the account during the period;
and
(2) The funds, securities, and other property in the account at the
end of the period.
(c) For purposes of this section:
(1) The client's designee shall not be the custodian, the
investment adviser, a person associated with the investment adviser, or
a person under common control with the investment adviser;
(2) An investment adviser exercises investment discretion with
respect to an account if, directly or indirectly, the investment
adviser:
(i) Is authorized to determine what securities or other property
shall be purchased or sold by or for the account; or
(ii) Makes decisions as to what securities or other property shall
be purchased or sold by or for the account even though some other
person may have responsibility for those investment decisions;
(3) A person (other than the client) is a custodian of a client
account if it has custody or possession of any securities or other
property in which the client has any beneficial interest; and
(4) An adviser shall be deemed to have a reasonable belief that the
custodian has provided a particular account statement to the client or
its designee if the adviser has received a copy of such statement
indicating that it has been sent to the client, provided that the
adviser has no reason to believe that the account statement has not
been delivered to the client.
By the Commission.
Dated: March 16, 1994.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-6658 Filed 3-21-94; 8:45 am]
BILLING CODE 8010-01-P