On March 4, 2013, the SEC released a risk alert in connection with Rule 206(4)-2, also known as the “Custody Rule,” issued under the Investment Advisers Act of 1940. Several of the issues outlined by the SEC specifically target advisers to pooled investment vehicles, such as advisers to private equity or hedge funds. The SEC identified other issues applicable to all investment advisers, in addition to those advising pooled investment vehicles.

Background

The SEC implemented the Custody Rule as a way to provide additional safeguards to investors against theft or misappropriation when investment advisers have “custody” of client funds or securities. An investment adviser has custody of client funds or securities when the adviser (1) holds client funds directly or indirectly; or (2) has authority to obtain possession of such funds or securities, such as having a power of attorney from the client to sign checks on the client’s behalf. Additionally, having the ability to dispose of client assets also constitutes custody for purposes of the Custody Rule.

Requirements

An investment adviser with custody of client assets must maintain client funds and securities with a qualified custodian, such as a bank, registered broker-dealer, futures commission merchant, or certain foreign entities, and must provide certain information to the client, such as the name and address of the custodian. The investment adviser must then have reasonable certainty that the custodian is sending regular account statements to the client, which can be used by the clients to verify the information received from the adviser about the assets within the adviser’s custody. Further, the investment adviser must enter into an agreement with an independent accounting firm to perform a surprise annual audit. Finally, where the client is a pooled investment vehicle, such as a limited partnership or limited liability company, the adviser must ensure that the account statements required to be sent to the client are also provided to the limited partners or members of the pooled investment vehicle.

Risks Discovered by the SEC

Advisers to pooled investment vehicles often rely on the “audit approach” to comply with the Custody Rule. However, this approach often results in the following deficiencies under the Custody Rule by advisers:

  1. The auditor was not independent within the meaning of Regulation S-X or registered with the PCAOB and subject to PCAOB inspection
  2. The audited financials are not prepared in accordance with the Generally Accepted Accounting Principles
  3. The adviser could not demonstrate that all audited financials were distributed to ALL investors in the fund, or that such financials were sent to investors within 120 days following the close of the fund’s fiscal year
  4. No final audit was performed at liquidation of the pooled investment vehicle

Failure by Advisers to Recognize They Have Custody

  1. The SEC identified the following situations in which advisers often fail to recognize that they have custody of client funds or assets within the meaning of the Custody Rule:
  2. The adviser personnel or a related person serve as the trustee, or have been granted a power of attorney for client accounts
  3. The adviser engages in bill-paying services in connection with the client
  4. The adviser performs its management services by using the client’s personal account user names and passwords to access accounts holding the client’s assets
  5. The adviser acts as the general partner, or other similar position such as a manager of an LLC, of a pooled investment vehicle
  6. The adviser has physical possession of the client’s security certificates or other assets
  7. The adviser has check-writing authority over a client’s account or otherwise receives checks issued to the client and fails to promptly return such checks to sender.

Advisers also were failing to meet the surprise exam requirements by failing to file Form ADV-E within 120 days of the exam being performed. In addition, the SEC has found that the exam was not being performed on a surprise basis.

In addition to the above problems, the SEC also found that the advisers were found not in compliance with the “qualified custodian” requirements of the Custody Rule. For instance, some advisers failed to have their position as custodian or trustee for the client clearly notated on the account. Others commingled property of clients, employees, and the adviser itself in one account. Still others did not have a basis to believe that the qualified custodian was sending account statements to clients.

Conclusion

Advisers should periodically review their internal controls and processes to make sure that they are in compliance with their obligations under the Advisers Act, including the Custody Rule.

Advisers would be well advised to contact their legal and accounting representative for assistance with any such review.