SEC Amends Rules On Adviser Custody

Jan 27 2010 | 12:09pm ET

By Lawrence Cohen --  On Jan. 4, 2010, the final amendments to Securities and Exchange Commission (“SEC”) Rule 206(4)-2 (the “Custody Rule”) and Rule 204-2 under the Investment Advisers Act  of 1940 (the “Advisers Act”), and SEC Forms ADV and ADV-E were posted on the SEC web site. These amendments were first proposed in May 2009, largely in response to the Madoff scandal and other investment-related frauds.  They seek to strengthen controls over the custody of client assets by SEC-registered investment advisers (“RIAs”), encourage the use of independent custodians, and improve the ability of the SEC to oversee the custody practices of RIAs.  In addition, the SEC published a companion release to provide guidance for accountants with respect to the surprise examination and internal control reports required under the Custody Rule.

The Custody Rule currently requires RIAs that have custody of client funds or securities, with certain limited exceptions, to use a “qualified custodian.”  The RIA must have a reasonable basis for believing that the qualified custodian sends an account statement, at least quarterly, to each client for which it maintains funds or securities.  This requirement ensures that clients will receive a statement from the custodian that can be compared with statements or other information they receive from their RIA, allowing clients to determine whether account transactions, including deductions to pay advisory fees, are proper. 

As an alternative to the requirement that a custodian must deliver quarterly statements, the Custody Rule allowed an RIA to send quarterly account statements if it underwent an annual surprise examination by an independent public accountant.  The SEC eliminated this alternative, stating that “direct delivery of account statements by qualified custodians will provide greater assurance of the integrity of account statements received by clients.”

Paragraph (a)(3) of the Custody Rule was amended to allow RIAs flexibility in determining, after “due inquiry,” whether the qualified custodian actually sends its account statements directly to clients — no single method for forming this belief is prescribed.

Notification & Legend.  The Custody Rule requires RIAs to notify their clients promptly upon opening a custodial account on their behalf and when there are changes to the information required in that notification.  If the RIA elects to send its own account statements to clients, the amendments require the RIA to include a legend in the notice, as well as in any subsequent statements it delivers to clients after the initial notice, urging its clients to compare the account statements they receive from the custodian with those they receive from the RIA.

Surprise Examination.  Despite opposition expressed by many commenters, and subject to certain exceptions noted below, the amendments require RIAs with custody of client assets to obtain a surprise examination (or an audit, if applicable in the case of a pooled investment vehicle) of client assets by an independent public accountant.  The SEC believes that the surprise examination will deter fraudulent conduct and protect clients, even where client assets are maintained by an independent qualified custodian. 

One exception to the surprise examination requirement applies when the RIA has custody of client assets solely because of its authority to deduct advisory fees from client accounts.  Another exception is available to RIAs to a pooled investment vehicle that is subject to an annual financial statement audit by an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (“PCAOB”), and that distributes the audited financial statements prepared in accordance with GAAP.

The amendments will no longer permit the accountant conducting the annual verification of client assets to forego examining certain privately offered securities.  As a result, RIAs that maintain custody of privately offered securities on behalf of clients will be subject to the surprise examination requirement.  The Accounting Release provides guidance as to the procedures that an accountant should undertake with respect to the surprise examination of privately offered securities.

Smaller RIAs.  The SEC was sensitive to the impact of this requirement impact of the surprise examination requirement on smaller RIAs that are authorized to obtain possession of client funds or securities and whose client assets are maintained by an independent qualified custodian.  Once the first round of surprise examinations are completed, the SEC directed the staff to evaluate the requirement and produce recommendations for amendments to improve the effectiveness of the rule or address unnecessary burdens upon smaller RIAs.

Fund Advisers.  The amendments have a particular impact upon RIAs to pooled investment vehicles, such as mutual funds, hedge funds, and private equity funds.  RIAs to such funds that distribute the fund’s audited financial statements to investors under the Custody Rule’s annual audit provision must, in addition to obtaining an annual audit, obtain a final audit of the fund’s financial statements upon liquidation of the fund and distribute the financial statements to fund investors promptly after the completion of the audit.  As described herein,

  • Such an RIA may be deemed to comply with the surprise verification requirements of the rule by obtaining an audit of the fund and delivering the audited financial statements to fund investors within 120 days of the fund’s fiscal year-end;
  • The audit must be conducted by an accounting firm registered with, and subject to regular inspection by, the PCAOB; and
  • If the fund does not distribute audited financial statements to its investors, the RIA must obtain an annual surprise examination and must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement of the fund to its investors.

A new provision in Rule 206(4)-2 precludes RIAs from using layers of pooled investment vehicles to skirt the Custody Rule.  Specifically, the SEC added paragraph (c), which provides that sending an account statement or distributing audited financial statements will not meet the requirements of the Custody Rule if all of the fund investors to which the statements are sent are themselves pooled investment vehicles that are related persons of the RIA.

If a person is an RIA to a fund that uses special purpose vehicles (SPVs) to facilitate investments in certain securities, the RIA could either treat the SPV as a separate client (in which case the RIA will have custody of the SPV’s assets) or treat the SPV’s assets as assets of the funds of which it has custody indirectly.  If the RIA treats the SPV as a separate client, the Custody Rule requires the RIA to comply separately with its audited financial statement distribution or account statement and surprise examination requirements (e.g., distribute audited financial statements of the SPV pursuant to the requirements of the Custody Rule).  Accordingly, RIAs should distribute the audited financial statements or account statements of the SPV to the beneficial owners of the fund.  If, however, the RIA treats the SPV’s assets as assets of the fund of which the RIA has custody indirectly, such assets must be considered within the scope of the fund’s financial statement audit or surprise examination.

The Custody Rule requires that the accounting firm that performs the surprise examination verify “privately offered” securities, as defined in the Custody Rule, along with other cash and securities, held by a fund that is not subject to a financial statement audit.  Regardless of whether an RIA to a pooled investment vehicle obtains a surprise examination or satisfies that requirement by obtaining an audit, if the fund’s assets are maintained with a qualified custodian that is either the RIA to the pool or a related person of the RIA, the RIA to the pool would have to obtain, or receive from the related person, an internal control report.  Finally, the rule requires RIAs to pools complying with the rule by distributing audited financial statements to investors to also obtain an audit upon liquidation of the pool when the liquidation occurs prior to the fund’s fiscal year-end.

Written Agreement With Accounting Firm.  Each RIA subject to the surprise examination requirement must enter into a written agreement with the independent public accountant that will conduct the examination.  The agreement must require the accountant, among other things, to notify the SEC within one business day of finding any material discrepancy during the course of the examination and, within 120 days of the time chosen by the accountant for the surprise examination, to submit Form ADV-E to the SEC, accompanied by the accountant’s certificate stating that the accountant has examined the funds and securities and describing the nature and extent of the examination.  The agreement also must provide that, upon the accountant’s resignation or dismissal, it will file, within four business days, a Form ADV-E with a statement regarding the termination.  The SEC believes it is important that these termination statements should be available to the public, to permit clients and prospective clients to assess the reasons for the termination of an accountant’s engagement or its failure to be reappointed.

Internal Control Report.  The amendments impose additional requirements when advisory client assets are maintained by the RIA itself or by a related person, rather than with an independent qualified custodian.  In addition to the surprise examination discussed above, when an RIA or its related person serves as a qualified custodian for advisory client funds or securities under the rule, the RIA obtain, or receive from its related person, no less frequently than once each calendar year, a written report, which includes an opinion from an independent public accountant with respect to the RIA’s or related person’s controls relating to custody of client assets (“internal control report”), such as a Type II SAS 70 report.  The amended rule also requires, in these circumstances, that the accountant issuing the internal control report, as well as the accountant performing the surprise examination, be registered with, and subject to regular inspection by, the PCAOB.

The elements of the required internal control report are set forth in the Accounting Release.  The report must include the accountant’s opinion as to whether the qualified custodian’s internal controls have been placed in operation as of a specific date, and are suitably designed, and are operating effectively to meet control objectives related to custodial services, including the safeguarding of funds and securities of advisory clients during the year.  In order for the accountant to be able to form this opinion, the internal control report should address control objectives and associated controls related to the areas of client account setup and maintenance, authorization and processing of client transactions, security maintenance and setup, processing of income and corporate action transactions, reconciliation of funds and security positions to depositories and other unaffiliated custodians, and client reporting.  The independent public accountant preparing the report must verify that the client funds and securities are reconciled to a custodian other than the RIA or its related person. 

Related Persons.  The amendments provide that an RIA has custody of any client securities or funds that are directly or indirectly held by a “related person” in connection with advisory services provided by the RIA to its clients.  A related person is defined by the rule as a person directly or indirectly controlling or controlled by the RIA and any person under common control with the RIA.  A limited exception from the surprise examination requirements is provided where the RIA is deemed to have custody solely as a result of a related person having custody.  The exception is available to an RIA that is (i) deemed to have custody solely as a result of certain of its related persons holding client assets, and (ii) “operationally independent” of the custodian.  A related person that holds, or has authority to obtain possession of, client assets would be presumed not to be operationally independent of the RIA unless the RIA can meet the Rule’s conditions, which are similar to the factors used to evaluate whether an RIA has custody of client funds and securities indirectly under the Rule as a consequence of the custody of a related person, and no other circumstances exist that can reasonably be expected to compromise the operational independence of the related person. 

An RIA whose client assets are held by a related person but does not undergo a surprise examination is required to make and keep a memorandum describing the relationship with the related person in connection with advisory services the RIA provides to clients and including an explanation of the RIA’s basis for determining that it has overcome the presumption that it is not operationally independent of the related person with respect to the related person’s custody of client assets

Compliance Efforts.  Advisers with custody of client assets should consider the value of instituting the following policies and procedures as part of their compliance programs:

  • conducting background and credit checks on employees of the investment RIA who will have access (or could acquire access) to client assets to determine whether it would be appropriate for those employees to have such access;
  • requiring the authorization of more than one employee before the movement of assets within, and withdrawals or transfers from, a client’s account, as well as before changes to account ownership information;
  • limiting the number of employees who are permitted to interact with custodians with respect to client assets and rotating them on a periodic basis; and
  • if the RIA also serves as a qualified custodian for client assets, segregating the duties of its advisory personnel from those of custodial personnel to make it difficult for any one person to misuse client assets without being detected.

Advisers that have custody as a result of their authority to deduct advisory fees directly from client accounts held at a qualified custodian should have policies and procedures in place that address the risk that the RIA or its personnel could deduct fees to which the RIA is not entitled under the terms of the advisory contract, which would violate the contract and which may constitute fraud under the Advisers Act.  The SEC release included examples of policies and procedures for such an RIA:

  • periodic testing on a sample basis of fee calculations for client accounts to determine their accuracy;
  • testing of the overall reasonableness of the amount of fees deducted from all client accounts for a period of time based on the RIA’s aggregate assets under management; and
  • segregating duties between those personnel responsible for processing billing invoices or listings of fees due from clients that are provided to and used by custodians to deduct fees from clients’ accounts and those personnel responsible for reviewing the invoices and listings for accuracy, as well as the employees responsible for reconciling those invoices and listings with deposits of advisory fees by the custodians into the RIA’s proprietary bank account to confirm that accurate fee amounts were deducted.

Books and Records Rule.  Amendments to Rule 204-2 (“Books and Records Rule”) require an RIA to maintain a copy of (i) the internal control report that such RIA is required to obtain or receive from its related person, pursuant to paragraph (a)(6) of the amended Custody Rule, and (ii) the memorandum describing the basis upon which the RIA determined that the presumption that any related person is not operationally independent, pursuant to paragraph (a)(5) of the amended Custody Rule, has been overcome, for five years from the end of the fiscal year in which, as applicable, the internal control report or memorandum is finalized.

Amendments to SEC Forms.  Several amendments were made to Part 1A and Schedule D of Form ADV. The amendments require registered RIAs to report more detailed information about their custody practices in their registration form and to update the information.

Amendments have been made to the instructions to Form ADV-E.  The form instructions now require that the form and the accompanying accountant’s examination certificate be filed electronically with the Commission through the IARD system.  Advisers will, however, continue to file form ADV on paper until the IARD system begins accepting electronic filings of Form ADV-E, which should occur sometime in late 2010.  Other amendments conform the Form ADV-E instructions to address (i) the surprise examination certificate that must be filed within 120 days of the time chosen by the accountant for the surprise examination, and (ii) the termination statement to be filed by an accountant within four business days of its resignation, dismissal, or removal.

Effective Dates.  Registered RIAs must comply with these amendments on and after March 12, 2010, except as described below. 

An RIA required to obtain a surprise examination must enter into a written agreement with an independent public accountant stating that the examination will take place by December 31, 2010 or, for RIAs that become subject to the rule after the effective date, within six months of becoming subject to the requirement.  If the RIA itself maintains client assets as a qualified custodian, however, the agreement must provide for the first surprise examination to occur no later than six months after obtaining the internal control report.

Also, an RIA that is required to obtain or receive an internal control report because it (or a related person) maintains client assets as a qualified custodian must receive an internal control report within six months of its becoming subject to the requirement.

An RIA to a pooled investment vehicle may rely on the annual audit provision if the RIA (or a related person) becomes contractually obligated to obtain an audit of the financial statements of the pooled investment vehicle for fiscal years beginning on or after January 1, 2010 by an independent public accountant registered with, and subject to regular inspection by, the PCAOB.

RIAs must provide responses to the Form ADV in their first annual amendment after January 1, 2011.  Until the on-line IARD system is upgraded to accept Form ADV-E, accountants that perform surprise examinations should continue to make Form ADV-E filings on paper.

Lawrence Cohen is a director in the corporate department at law firm Gibbons P.C.  As a former legal officer and compliance director of mutual fund groups, he brings practical experience to the regulation and registration of public investment companies and the formation and operation of private investment companies.

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