Yesterday, the U.S. Securities and Exchange Commission (SEC) unanimously approved amendments to Rule 206(4)-2 (the Custody Rule) and related forms and rules under the Investment Advisers Act of 1940. The SEC has yet to announce the effective date of the amendments.
Surprise Exam. As expected, the amendments will provide that, subject to certain exceptions, investment advisers that have custody of client assets will be required to submit to an annual surprise examination by an independent public accountant.
Deduction of Advisory Fees. The amendments state that an investment adviser that merely deducts advisory fees from its client accounts is not required to submit to an annual surprise examination by an independent public accountant.
Affiliated Custody. The amendments revise the amendments to the Custody Rule that were proposed by the SEC earlier this year (the Proposal) with respect to affiliated custody. Under the Proposal, there would have been a provision applying to all advisers that maintain assets or utilize an affiliated custodian. Under the Proposal, such advisers would have been subject to the following additional requirements: (1) a surprise exam by an independent public accountant that is registered with and subject to examination by the Public Company Accounting Oversight Board (PCAOB); and (2) a written control report from an independent public accountant that includes an opinion regarding the custodian’s controls relating to custody of client assets.
The amendments relax these requirements by providing for a rebuttable presumption that an affiliated custodian is not independent of the investment adviser. Based upon the discussion at yesterday’s open meeting, it appears that the factors to be considered in rebutting the presumption will be stricter than the previous test established via the Crocker Investment Management Corp. no-action letter (pub. avail. Apr. 14, 1978).
In the event that an investment adviser is successful in rebutting the presumption of its affiliated custodian’s lack of independence, it must only obtain an internal control report. Otherwise, the investment adviser must submit to an annual surprise examination of client assets by an independent public accountant in addition to obtaining an internal control report. In either circumstance, the accountant that conducts the annual surprise examination and/or the internal control report must be an independent public accountant registered with the PCAOB.
Other Changes. The SEC also announced adoption of several other proposed amendments. Among them were: (1) a requirement that clients receive account statements directly from their custodians, and that investment advisers have a reasonable basis for believing that their custodians are sending the account statements to clients; and (2) an exemption from annual surprise examinations for pooled investment vehicles, which are already required to submit to financial statement audits by independent auditors registered with the PCAOB.