On May 14, 2009, the Securities and Exchange Commission (the “SEC”) announced that it would propose certain rule amendments intended to strengthen the custody controls that apply to investment advisers.
In a speech delivered at an open meeting of the SEC, SEC Chairman Mary Schapiro stated that the proposed rule amendments were a direct response to certain allegations of fraudulent activity in the investment advisory industry that have shaken investors’ confidence in the financial markets and raised concerns about the safekeeping of investors’ assets.1 The proposed rule amendments are “part of a larger package of reforms”2 increasing regulatory oversight of registered investments advisers and come shortly after the SEC’s recent announcement of its intention to request independent confirmation of investor assets from various third parties (i.e., advisory clients, third-party service providers and transaction counterparties) as part of its routine compliance examinations of investment advisers.3
The Custody Rule
Pursuant to Rule 206(4)-2 (the “Rule”), promulgated pursuant to Section 206(4) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), investment advisers registered under the Advisers Act are required to fulfill certain obligations if such advisers are deemed to have custody of client assets (e.g., if such advisers have possession of client funds or securities or if such advisers have legal capacities providing ownership of client funds or securities, such as being a general partner of a limited partnership). If deemed to have custody of client assets, investment advisers must, among other obligations, maintain accounts with “qualified custodians” (e.g., registered broker-dealers) and, with certain exceptions, send quarterly account statements (or reasonably believe that the qualified custodian sends quarterly account statements) to each advisory client.
According to the SEC’s announcement, the proposed amendments to the Rule include (i) requiring registered investment advisers to undergo an annual surprise examination conducted by an independent public accountant in order to verify the existence of client assets; (ii) promoting independent custody of client assets by requiring investment advisers that, either directly or indirectly (i.e., through affiliated entities), maintain control of client assets to undergo thorough inspections by accountants approved by the Public Company Accounting Oversight Board (such inspections would be used to both confirm the existence of client assets and assess the quality of custody controls currently being used by such investment advisers or affiliated entities); (iii) increasing reporting requirements in an effort to alert the SEC to potential adverse circumstances relating to investment advisers, including disclosure of details relating to the surprise examinations discussed above; and (iv) requiring all custodians holding client assets to deliver directly custodial statements to advisory clients rather than allowing investment advisers to send such client statements.
There are currently certain unanswered questions relating to the SEC’s proposed amendments, including the extent of an investment adviser’s custody of client assets necessary to trigger a surprise examination and the nature and extent of such surprise examinations. Once the SEC officially releases the proposed amendments to the Rule, the proposed amendments will undergo a period of public comments during which the SEC will assess the potential efficacy of the amendments and the probable costs to market participants associated with such amendments.