The SEC staff issued a no-action position to the Investment Adviser Association, offering relief from custody requirements as they apply to sub-advisers.

Key Takeaways

Rule 206(4)-2 under the Investment Advisers Act sets forth a number of requirements for investment advisers, including sub-advisers, in possession of client investments. These requirements include obtaining a surprise examination by an independent public accountant to verify the client funds or securities. The SEC said that it recognized that affiliated custodial relationships present higher risks than arrangements with independent custodians, but offered relief to sub-advisers when the following four conditions are met:

  • The sole basis for the sub-adviser having custody is its affiliation with the qualified custodian and the primary adviser
  • The primary adviser will comply with Rule 206(4)-2 by having a surprise exam by an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB)
  • The sub-adviser does not hold client funds itself, have authority to obtain the funds, or have authority to deduct fees from client accounts
  • The sub-adviser continues to obtain from the primary adviser or qualified custodian an annual written internal control report

Summary

A registered investment adviser with custody of client funds or securities is required by Rule 206(4)-2 of the Investment Advisers Act to take a number of steps designed to safeguard those client assets. One such step is that an adviser that has custody of client assets generally must undergo an annual surprise examination by an independent public accountant to verify the client funds and securities.

In addition, the SEC recognizes that affiliated custodial relationships present higher risks to advisory clients than where client funds or securities are maintained with an independent custodian. In this regard, where an investment adviser, or its related person, maintains client funds or securities, it must obtain or receive a written internal control report from an independent public accountant that demonstrates that it, or its related person, has established appropriate custodial controls.

Notwithstanding these concerns, staff of the Division of Investment Management said that it would not recommend enforcement action to the SEC under Section 206(4) of, and Rule 206(4)-2 under, the Investment Advisers Act. This includes a situation in which an investment adviser does not obtain a surprise examination, where it acts as a sub-adviser in an investment advisory program for which a related person qualified custodian is the primary adviser (or an affiliate of the primary adviser), and the primary adviser is responsible for complying with Rule 206(4)-2.

This position is based, in particular, on the following:

  1. The sole basis for the sub-adviser having custody is its affiliation with the qualified custodian and the primary adviser
  2. The primary adviser will comply with Rule 206(4)-2, including having client funds and securities in the investment advisory program verified by a surprise examination conducted by an independent public accountant registered with the PCAOB, pursuant to an agreement entered into by the primary adviser
  3. The sub-adviser does not (i) hold client funds or securities itself; (ii) have authority to obtain possession of clients' funds or securities; or (iii) have authority to deduct fees from clients' accounts
  4. The sub-adviser will continue to be required to obtain from the primary adviser, or qualified custodian, an annual written internal control report prepared by an independent public accountant registered with, and subject to, regular inspection by the PCAOB as required by Rule 206(4)-2(a)(6)