At an open meeting on December 16, 2009, the Securities and Exchange Commission (SEC) unanimously approved amendments (the “Amendments”) to Rule 206(4)-2 under the Investment Advisers Act of 1940, as amended (the “Act”), which governs the custody of client assets by investment advisers registered under the Act. The Amendments, which were drafted in response to the numerous instances of fraud and misappropriation of client assets uncovered in the past year, are designed to strengthen the protections provided to customers who turn control of their assets over to investment advisers.
As adopted, the Amendments require that certain investment advisers who maintain custody over client assets be subject to annual surprise examinations conducted by independent auditors. Any material discrepancies uncovered during the examinations must be reported by the auditor to the SEC’s Office of Compliance Inspections and Examinations within one day of their discovery. In cases where client assets are held by a custodian that is not independent from the investment adviser, the Amendments also require the investment adviser to obtain a written report attesting to the controls the custodian has in place regarding the safekeeping of client assets. Such reports are to be prepared by independent accountants that are registered with, and regularly inspected by, the Public Company Accounting Oversight Board (PCAOB). Furthermore, the Amendments require all registered investment advisers with custody of client assets to have a reasonable basis for believing that the qualified custodian holding client assets delivers quarterly custodial account statements directly to clients so that the client has the ability to compare the statements they receive from their custodian with those received from the investment adviser, to ensure that there has been no misappropriation of their assets. Finally, the Amendments require that such auditors file a notice with the SEC should their service terminate explaining the reasons for their resignation or dismissal.
The Amendments differ in some respects from those originally proposed by the SEC on May 14, 2009. Specifically, the Amendments, which originally would have required all registered investment advisers that were deemed to have custody of client assets to be subject to the surprise audit requirement, now contain exceptions from that requirement in certain limited circumstances. Those circumstances include:
- Investment advisers deemed to have custody of client assets only because they have the authority to deduct advisory fees directly from client accounts. The SEC felt that such an arrangement does not present the same chance for fraud as do situations in which the investment adviser has physical custody of the assets.
- Investment advisers deemed to have custody of client assets solely as a result of an affiliate having custody of those assets. In such instances, the investment adviser could make the determination that it is operationally independent from the custodian and thus not required to be subjected to an annual surprise examination. Absent that determination, surprise audits would still be required.
- Investment advisers to pooled investment vehicles that obtain an annual financial statement audit of the pool. The auditors conducting the financial statement audits must be registered with, and inspected by, the PCAOB, and the results of the audits must be released to investors in the pool in order for the adviser to be exempt from the annual surprise audit requirement.
The text of the Amendments is not yet available. As such, the information contained in this alert is based on statements made by the commissioners and staff of the SEC at the open meeting.