Education and Sharing Day, U.S.A., 1994

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