A U.S. Securities and Exchange Commission (SEC) no-action letter issued on April 25, 2016 provides relief from the annual surprise audit requirement of the “Custody Rule” for a registered investment adviser (RIA) participating in an investment advisory program where one or more affiliates act as primary adviser and qualified custodian to clients in the program.
In the no-action letter to the Investment Adviser Association (IAA), the staff of the SEC's Division of Investment Management (Staff) provides guidance concerning the independent verification requirement set forth in Rule 206(4)-2 under the Investment Advisers Act of 1940 (Custody Rule).1 Under the IAA No-Action Letter, to the extent that (among other things) the sub-adviser is deemed to have custody solely by virtue of its affiliate serving as qualified custodian, and the affiliated primary adviser complies with the Custody Rule’s relevant requirements, the sub-adviser is not required to undergo a separate surprise examination.
Background: The Custody Rule
The Custody Rule generally regulates an RIA with respect to circumstances where the RIA or its affiliate has custody, possession or an ability to obtain client funds and securities.2 The Custody Rule was designed to protect client assets against loss, misuse and misappropriation and to ensure that client assets “will be insulated from and not be jeopardized by financial reverses, including insolvency,” of an RIA.3
An RIA is deemed to have “custody” of client assets if it holds client funds or securities “directly or indirectly” or if it has “any authority to obtain possession of them.”4 This would include circumstances where client assets are directly or indirectly held by a “related person” as qualified custodian in connection with advisory services provided by the adviser to its clients.5 The SEC has noted that while these advisers might not have actual, physical possession of client assets, they still have the authority to obtain possession.
In most cases, RIAs having custody of client funds or securities must:
- maintain client assets with a qualified custodian, in the manner described in the Custody Rule;6
- notify clients, in writing, of the identity of the qualified custodian when a custody account is opened on the client’s behalf or when changes are made;
- obtain reasonable belief that the qualified custodian is providing quarterly account statements to clients showing all holdings and transactions in the relevant account;
- undergo surprise verification by an independent public accountant on an annual basis;7 and
- receive or obtain from the qualified custodian a written report of the internal controls relating to custody of client assets from an independent public accountant on an annual basis, if those assets are maintained by a qualified custodian that is a related person or the RIA itself.
Applicability of the Custody Rule to Sub-Advisers
Although the Custody Rule does not require the use of independent qualified custodians, the IAA No-Action Letter “recognizes that affiliated custodial relationships present higher risks to advisory clients than where client funds or securities are maintained with an independent custodian.” Certain investment advisory programs involve a primary adviser/sponsor that is, or is a related person of, the qualified custodian (e.g., wrap fee programs). Such programs may make use of sub-advisers that are affiliated with the primary adviser/sponsor.
Under the current regulatory regime, such sub-advisers would be deemed to have custody of client assets if the primary adviser/sponsor, as a related person to the sub-adviser, is or is affiliated with the sub-adviser. As such, both the sub-adviser and the primary adviser/sponsor would be subject to the Custody Rule requirements set forth above, including submitting to surprise examinations by, and obtaining written internal control reports from, an independent public accounting firm.
Relief Granted by the IAA No-Action Letter
The IAA No-Action Letter provides welcome relief from duplicative surprise examinations of both the sub-adviser and the primary adviser/sponsor. The Staff confirmed that it would not recommend enforcement action to the SEC if the sub-adviser does not itself obtain a surprise audit examination where the primary adviser/sponsor complies with the Custody Rule requirements. The IAA No-Action Letter states:
[The Staff’s] position is based, in particular, on the following:
- the sole basis for the sub-adviser having custody is its affiliation with the qualified custodian and the primary adviser [or sponsor];
- the primary adviser [or sponsor] will comply with [the Custody Rule], including by having client funds and securities in the investment advisory program verified by a surprise examination conducted by an independent public accountant registered with the Public Company Accounting Oversight Board (‘PCAOB’) pursuant to an agreement entered into by the primary adviser [or sponsor];
- 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; and
- the sub-adviser will continue to be required to obtain from the primary adviser [or sponsor] or qualified custodian annually a written internal control report prepared by an independent public accountant registered with and subject to regular inspection by the PCAOB, as required by [the Custody Rule].
While surprise examinations by an independent auditor provide useful protections from custodial risks, the IAA No-Action Letter seems to recognize that any incremental benefit to duplicative surprise examinations relating to the same program accounts is outweighed by the related costs. However, in light of recent SEC enforcement actions against RIAs for Custody Rule violations, including the failure to conduct an adequate surprise examination,8 RIAs seeking to rely on the IAA No-Action Letter should ensure that they meet all of the required conditions.