SEC Adopts Amendments Imposing Significant New Requirements for Advisers with Custody of Client Assets
December 31, 2009
On December 30, 2009, the SEC published the adopting release for amendments to the custody requirements under the Investment Advisers Act of 1940 (the ”Act”). The final rules largely follow the SEC’s May 2009 proposal but contain some notable exceptions intended to address concerns raised in the comment letters.
The amendments to Rule 206(4)-2 under the Act subject registered investment advisers that have custody of client assets to significant additional requirements, including undergoing an annual surprise examination to verify client assets by an independent, PCAOB-registered public accountant, and receiving a report of internal controls relating to the custody of those assets from such an accountant. The SEC also published an interpretive release providing guidance to auditors regarding the surprise examination and internal controls report requirements.
Surprise Examination Requirement
The amendments generally require (with certain exception described below) that any registered investment adviser with “custody” (as described below) of client assets retain an independent public accountant to conduct an annual surprise examination of client assets. Previously, an adviser was not required to undergo such an annual surprise examination if the adviser had a reasonable belief that the qualified custodian (e.g., a bank or broker-dealer) provided account statements directly to clients. The amendments also expand the surprise examination requirement to apply to privately offered securities, which were previously excluded from Rule 206(4)-2 entirely.
Each independent public accountant who performs a surprise examination for an investment adviser must do so pursuant to a written agreement with the adviser. The written agreement must provide that the accountant (i) notify the SEC within one business day of discovering any material discrepancies during a surprise examination; (ii) file Form ADV-E and a certificate with the SEC describing the nature and extent of the surprise examination within 120 days of its start date; and (iii) file Form ADV-E within four business days of its dismissal, resignation, or voluntary or involuntary removal from consideration for reappointment. If the accountant has been terminated, Form ADV-E must be accompanied by a termination statement containing the date of the termination and accountant contact information, and detailing any disagreement over the scope or procedure of the examination that led to the termination.
Definition of “Custody”. Rule 206(4)-2 broadly defines “custody” as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them,” and includes (i) possession of client funds or securities, (ii) any arrangement under which an adviser is authorized or permitted to withdraw client funds or securities held by a custodian upon instruction to the custodian, and (iii) access to client funds by virtue of an adviser’s dual role as both general partner and investment adviser to a limited partnership or other such capacity.
Notably, under the amendments an adviser is deemed to have custody of any client assets held directly or indirectly by a “related person” (e.g., an affiliate) “in connection with” advisory services provided by the adviser to the client, and would accordingly be subject to the surprise examination requirement with respect to those assets. Also, when an adviser or related person serves as the qualified custodian of client assets, a PCAOB-registered accountant must conduct the surprise examination. Advisers who currently custody client assets with an affiliate or who are considering doing so should evaluate that decision in light of these additional requirements.
In response to concerns raised in numerous comment letters, the SEC added three exceptions to the surprise examination requirement:
First, advisers to pooled investment vehicles that obtain an annual independent audit by a PCAOB-registered accountant and distribute audited financial statements to investors will not be subject to the requirement.
Second, advisers deemed to have custody of client assets solely as a result of their authority to deduct fees from a client’s account will not be subject to the requirement. Rather, the adopting release includes guidance regarding enhanced compliance procedures for advisers with the authority to deduct fees. This exception is a welcome improvement over the May 2009 proposal, given the importance of fee deduction authority for large classes of advisers.
Third, in line with the SEC’s 1978 Crocker Investment Management no-action letter, an adviser is not subject to the requirement if it is (a) deemed to have custody of client assets solely because of custody by a related person and (b) “operationally independent” from the related person. An adviser is presumed not to be operationally independent from a related person unless certain conditions are met: (i) client assets in custody of the related person may not be subject to claims of the adviser’s creditors, (ii) advisory personnel may not have authority over client assets of which the related person has custody, (iii) advisory personnel and personnel of the related person who have access to client advisory assets may not be under common supervision, and (iv) advisory personnel may not hold any position with the related person or share premises with the related person.
Our Perspective: To avoid the costs and burdens involved in complying with the surprise examination requirement, advisers should consider including a provision in their new advisory contracts making it explicit that the adviser does not have authority over client assets held by a custodian. Advisers should also review their existing contracts to determine the accounts for which they may be deemed to exercise custody and consider amending those contracts. It is unfortunate that the exception for fee deduction authority did not also extend to advisers with custody solely by virtue of their role as general partners.
Internal Controls Report Requirement
If an adviser or a related person serves as the qualified custodian, then the adviser must obtain, or receive from the related person, a written “internal controls report” containing an opinion from an independent, PCAOB-registered public accountant concerning the adviser or related person’s controls related to custody of client assets. This requirement does not apply if the qualified custodian is independent.
Account Statement Requirements
All investment advisers must have a reasonable belief, after “due inquiry,” that the qualified custodian of client assets is providing quarterly account statements directly to clients. The due inquiry requirement can be satisfied in several ways, including receipt by the adviser of a copy of the account statements the custodian is providing to the adviser’s clients. Previously, an adviser could provide account statements to clients itself, rather than having the qualified custodian do so, if the advisorsubmitted to an annual surprise examination (which has now been made mandatory for all investment advisers).
Advisers to layered pooled investment vehicle may not satisfy requirements to deliver account statements and audited financial statements if all of the investors to which the statements are sent are themselves pooled investment vehicles that are related persons of the adviser. Rather, such advisers must distribute the statements to the underlying beneficial owners or treat the assets of lower tier vehicles as assets of the upper tier vehicle, which would then be within the scope of that vehicle’s financial statement audit.
Also, an adviser that opens a custodial account on a client’s behalf will be required to include in any account statements that it sends to the client a legendurging the client to compare the account statements received from the adviser with account statements the client receives from the custodian.
Our Perspective: While the exceptions to the surprise examination requirement will result in some reduction in costs as compared to the May 2009 proposal, the amendments will increase the costs of business for investment advisers, and we expect that those costs will ultimately be passed along to advisory clients. Additionally, we note that the adopting release also indicated that consideration of additional enhancements of the rules governing custody of customer assets by broker-dealers will follow.
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