SEC Adopts Amendments to Investment Adviser Custody RuleJanuary 18, 2010
The SEC has amended Rule 206(4)-2 under the Investment Advisers Act of 1940, the custody rule for registered investment advisers, in order to provide additional safeguards when an adviser has custody of client assets and to encourage the use of independent custodians. The SEC originally proposed amendments to the custody rule in May 2009 in light of recent fraud cases involving advisers. New requirements of the final rule include the following:
- The definition of "custody" has been expanded to provide that an adviser has custody of client assets that are directly or indirectly held by an adviser's "related person" (i.e., any person controlling, controlled by or under common control with the adviser).
- Advisers with custody of client assets (other than those with custody solely by reason of their authority to deduct advisory fees from client accounts) must engage an independent public accountant to conduct annual surprise examinations of client assets. The accountant must promptly report any material discrepancies found during an examination to the SEC and submit Form ADV-E regarding the examination within 120 days.
- Advisers with custody of client assets must include a legend urging the client to compare the statements received from the custodian with those received from the adviser on (1) notices sent to clients regarding the opening of custodial accounts on their behalf and (2) any subsequent account statements sent by the adviser to clients.
- Account statements must be sent directly by a qualified custodian to clients on a quarterly basis, and the adviser must have a reasonable belief after "due inquiry" that statements are being sent (this eliminates the option under the previous rule that permitted the adviser to send account statements if certain conditions were met).
- The adviser must obtain an annual internal control report issued by an independent public accountant registered with and examined by the Public Company Accounting Oversight Board ("PCAOB-Registered Accountant"), such as a Type II SAS 70 report, if the adviser or a related person maintains custody of client assets as the qualified custodian.
- Part 1A and Schedule D of Form ADV have been amended to require identification of client custodians and information about accountants.
Applicability to Different Types of Advisers
Advisers with custody solely due to fee deductions.
Unlike the proposed rule, the final rule does not require an adviser to obtain annual surprise examinations if it has custody of client assets solely as a consequence of its authority to deduct advisory fees from client accounts. These advisers, however, are still subject to the other new requirements, including the new legend on account statements, direct delivery of account statements by the qualified custodian to the client, additional disclosures on Form ADV and, if the adviser or a related person acts as the qualified custodian, obtaining annual internal control reports issued by a PCAOB-Registered Accountant.
Advisers to private funds.
- The final rule does not require an adviser to a pooled investment vehicle (a "private fund") to obtain annual surprise examinations, or to ensure that account statements are delivered by the custodian, if the private fund is audited by a PCAOB-Registered Accountant and audited financial statements are delivered to fund investors within 120 days of the private fund's fiscal year end.
- Advisers to private funds with affiliated custodians must obtain annual internal control reports.
- Upon liquidation of the private fund, the adviser must obtain an audit and deliver the audited financial statements to fund investors.
- Due to the common use of special purpose vehicles to invest in private funds, in order to ensure that the audited financial statements reach the actual investors, the rule's delivery requirements will not be satisfied if the audited financial statements are sent to limited partners that are themselves limited partnerships or related persons of the adviser.
Advisers with affiliated custodians.
The final rule does not require use of an independent qualified custodian, although it is encouraged. As a modification to the proposed rule, the final rule does not require an adviser or related person that acts as the qualified custodian to obtain annual surprise examinations if the adviser has custody of client assets solely as a result of a related person holding client assets and the related person is "operationally independent," as defined in the rule, from the adviser.
If an adviser with affiliated custody does not meet the limited exception to the surprise examination requirement in the case of "operationally independent" related persons described above, the examination must be conducted by a PCAOB-Registered Accountant. In addition to the other new requirements, the adviser must also obtain annual internal control reports issued by a PCAOB-Registered Accountant.
Additionally, pursuant to amendments to Rule 204-2 under the Investment Advisers Act, the books and records rule, an adviser must maintain for five years (1) a memorandum describing the basis upon which the adviser determined that a related person is "operationally independent" from the adviser and (2) any internal control reports issued by a PCAOB-Registered Accountant.
- The annual surprise examinations of client assets must include examination of privately offered securities.
- The SEC maintained the previous exception for mutual fund shares, whereby an adviser may use the mutual fund's transfer agent in lieu of a qualified custodian.
- The SEC has also published a companion release to provide guidance to accountants relating to surprise examinations and internal control reports.
The effective date of the new rule is March 12, 2010.
Account Statements. By March 12, 2010, an adviser with custody of client assets must:
- Upon the opening of a custodial account on behalf of a client, promptly send a notice to the client with a legend urging them to compare the statements it will receive from the qualified custodian to those from the adviser.
- Include the legend on any account statements that the adviser subsequently sends to its clients (for example, if the adviser sends its own statements in addition to the statements from the custodian).
- Have a reasonable belief after due inquiry that a qualified custodian sends account statements directly to clients at least quarterly. "Due inquiry" could be established if the custodian provides the adviser with a duplicate copy of the account statements delivered to clients. Advisers to private funds would not need to meet this requirement if the fund's audited financial statements are delivered to investors.
Surprise Examinations. For an adviser required to obtain annual surprise examinations, the adviser must enter into a written agreement with an independent public accountant providing that the first examination will occur by December 31, 2010, or for an adviser that becomes subject to the final rule after March 12, 2010, within six months of becoming subject to the requirement. If the adviser is also required to obtain an internal control report because it or a related person maintains client assets as a qualified custodian, the surprise examination must take place no later than six months after obtaining the internal control report.
Internal Control Reports. For an adviser required to obtain an internal control report because it or a related person maintains client assets as a qualified custodian, the internal control report must be obtained or received within six months of becoming subject to the requirement.
Audits of Private Funds. An adviser to a private fund may rely on the annual audit exception to the surprise examination requirement if the adviser or a related person becomes contractually obligated to obtain an audit of the financial statements of the fund for fiscal years beginning on or after January 1, 2010.
Form ADV. An adviser must provide responses to the revised Form ADV Part 1A and Schedule D in the first annual amendment filed after January 1, 2011.
Advisers should take the following steps to comply with the new rule, related SEC guidance and best practices:
- Review current custody arrangements to determine which requirements are applicable and to ensure that client assets are maintained with a qualified custodian. For example, advisers with custody due to trustee or power of attorney relationships will now be required to obtain a surprise examination, among other requirements.
- Review the terms of custodial contracts to ensure that the custodian satisfies the account statement delivery requirements, by delivering duplicate copies or by other means, and that appropriate confidentiality provisions are included.
- Discuss the new requirements with the firm's auditors and, if necessary, enter into an agreement for a surprise examination with a PCAOB-Registered Accountant.
- Review existing disclosure about custody arrangements in Form ADV Part II and consider adding new disclosure, such as the account statement legend.
- Prepare new Form ADV Part 1A disclosure.
- Review compliance policies and procedures to bolster safeguards of client assets. For example, advisers with custody solely due to their authority to deduct advisory fees from client accounts could add procedures to periodically test the accuracy of fee calculations. Additional guidance for compliance programs is provided in the SEC's adopting release available on the SEC's website.
Please do not hesitate to contact a member of Godfrey & Kahn's Investment Management Practice Group if you have any questions regarding the new amendments to the custody rule or your compliance program.