On May 20, 2009, the Securities and Exchange Commission (the "SEC") published its proposed changes (the "Proposed Amendments") to Rule 206(4)-2 (the "Custody Rule") promulgated under the Investment Advisers Act of 1940, as amended (the "Advisers Act"). The Proposed Amendments are designed to provide additional safeguards when a registered investment adviser ("RIA") has custody of client funds and/or securities by imposing annual surprise examinations, reporting requirements and additional disclosure obligations regarding RIA custodial practices. If approved by the SEC, the Proposed Amendments would significantly impact the custody practices of many private investment funds and their managers. The SEC has requested comment on the Proposed Amendments, which must be received on or before July 28, 2009.
The Custody Rule requires RIAs that have custody of client securities or funds to implement a set of controls to protect those client assets from being lost, misused, misappropriated or subject to the advisers' financial reverses. The Custody Rule deems an investment adviser to have "custody" of client assets if the RIA holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them. Although certain exceptions may apply, for purposes of the Custody Rule, RIA generally will be deemed to have "custody" of client assets when they have:
- possession of client funds or securities;
- arrangements authorizing the RIA to withdraw client funds or securities maintained with a third-party custodian; and
- legal capacities, such as being a general partner of a limited partnership, that gives the RIA legal ownership of, or access to, client funds or securities. Most RIAs to private investment funds usually fall into this category and are deemed to have custody of fund assets for purposes of the Custody Rule.
The Custody Rule requires, in part, that RIAs with custody of client assets maintain those assets with a "qualified custodian" – a term that generally includes most regulated banks, broker-dealers and other financial institutions providing custodial services. The Custody Rule also requires those advisers to have a reasonable belief that the qualified custodian holding the assets provides periodic account statements to the clients. If a client does not receive account statements directly from the qualified custodian, the RIA must send quarterly account statements to that client and undergo an annual surprise examination by an independent public accountant to verify the funds and securities of that client. In lieu of providing quarterly reports to clients, RIAs may provide annual audited financial statements prepared in accordance with generally accepted accounting principles within 120 days (180 days in the case of a fund of funds) of the end of the fund's fiscal year.
According to SEC Chairman Mary Schapiro, the Proposed Amendments, if adopted, would add safeguards to decrease the likelihood that an RIA could misappropriate a client's assets without SEC detection.
Below is a brief summary of certain provisions of the Proposed Amendments.
- Annual Surprise Examination of Clients Assets—All RIAs with custody of client assets must obtain an annual surprise examination regardless of whether a qualified custodian directly provides statements to clients or, in the case of a pooled investment vehicle, the pool is audited at least annually and distributes its audited financial statements to its limited partners (or other investors) within 120 days of the end of its fiscal year.
- Commission Reporting—All RIAs with custody of client assets must enter into a written agreement with an independent public accountant to conduct the surprise examination requiring the accountant, among other things, to notify the SEC within one business day of finding material discrepancies and to electronically submit Form ADV-E to the SEC, via IARD, within 120 days of the examination. Form ADV-E must be accompanied by a certificate stating that the accountant has examined the funds and securities and describing the nature and extent of the examination. The written agreement must also require the independent public accountant to submit Form ADV-E to the SEC within four business days of its resignation, dismissal from, or other termination of the engagement or upon removing itself or being removed from consideration for being reappointed.
- Custody by Adviser and its Related Persons—RIAs whose “related persons” (a person directly or indirectly controlling or controlled by the adviser and any person under common control with the adviser) hold client assets would be deemed to have custody under the Custody Rule if those assets are held by the related person in connection with the advisory services provided by the adviser. If the adviser or a related person instead serves as a qualified custodian for client funds or securities, the adviser must obtain or receive from the related person no less frequently than once each calendar year a written report (“internal control report”) which includes an opinion from an independent public accountant registered with and subject to regular inspection by the Public Company Accounting Oversight Board (“PCAOB”). The adviser would be required to maintain the internal control report in its records and make it available to the SEC upon request.
- Delivery of Account Statements and Notices to Clients—All RIAs with custody of client assets must have a reasonable belief that the qualified custodian delivers account statements to advisory clients or their representatives (and not through the RIA). Advisers relying on the qualified custodian to send account statements directly to clients must form their reasonable belief that such account statements are sent after “due inquiry.”
- Amendments to Form ADV—Form ADV would be modified to require the disclosure of the following:
- all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to the adviser’s clients’ funds or securities;
- the amount in U.S. dollars of client assets and number of clients of which it or its related person has custody and whether it or its related person serves as qualified custodian with respect to the adviser’s clients’ funds or securities;
- whether a qualified custodian sends quarterly account statements to investors in pooled investment vehicles that the adviser manages;
- whether the financial statements of the pooled investment vehicles that the adviser manages are audited;
- whether the adviser’s clients’ funds or securities are subject to a surprise examination;
- whether an independent public accountant registered with and subject to regular inspection by the PCAOB prepares an internal control report with respect to the adviser or its related persons’ custodial services when acting as a qualified custodian for advisory client funds or securities;
- the month in which the last surprise examination commenced;
- the accountants who perform audits or surprise examinations and who prepare internal control reports and information about the accountants, including address and PCAOB registration and inspection status, the type of engagement (audit, surprise examination, internal control report), and whether the accountant’s report was unqualified; and
- the name and address of any related person who serves as a qualified custodian for its clients and whether the related person qualified custodian is a bank, futures commission merchant or foreign financial institution.