On December 30, 2009, the Securities and Exchange Commission (SEC) issued an adopting release for amendments (the “Amendments”) to the custody requirements under the Investment Advisers Act of 1940 (the “Advisers Act”). The Amendments are aimed at strengthening the controls over the custody of client assets by registered investment advisers and encouraging the use of independent custodians to “help deter fraudulent conduct, and increase the likelihood that fraudulent conduct will be detected earlier so that client losses will be minimized.” The Amendments include changes to Rule 206(4)-2 under the Advisers Act, as well as related changes to Rule 204-2, Form ADV and Form ADV-E. The specific provisions of the Amendments, which go into effect 60 days after publication in the Federal Register, are discussed below.
Under Rule 206(4)-2, an adviser is deemed to have custody if (1) it is in possession of client funds or securities; (2) it has the authority to withdraw funds or securities maintained with a third party custodian, such as by deducting advisory fees from the client’s account; and (3) it serves in any capacity, such as being a general partner of a limited partnership, managing member of a limited liability company or similar position, that gives the adviser legal ownership of, or access to, client funds or securities. Under the amendments, an adviser is deemed to have custody when a “related person” of the adviser holds, directly or indirectly, client funds or securities, or has the authority to obtain possession of them in connection with the advisory services the adviser provides its client. The Amendments define a “related person” as “a person directly or indirectly controlling or controlled by the adviser and any person under common control with the adviser.”
Delivery of Account Statements
Under Rule 206(4)-2, as currently in effect, advisers are generally required to maintain client funds with a qualified custodian, such as a bank, registered broker-dealer or registered futures commission merchant. The adviser must reasonably believe that such qualified custodian sends account statements directly to each client, on at least a quarterly basis. Rule 206(4)-2 also gives advisers the option of sending out account statements themselves (rather than having the custodian send them) if the adviser is subject to an annual surprise verification of client assets by an independent public accountant. The Amendments eliminate this option, requiring direct delivery of account statements by the qualified custodian. The Amendments retain the requirement that an adviser reasonably believes that a qualified custodian sends account statements directly to clients and add that such reasonable belief must be formed by the adviser after “due inquiry.” The Amendments do not prescribe any single method for forming this belief, thus giving advisers flexibility in determining how to best meet this requirement. One example provided in the adopting release is receipt by the adviser of a copy of the account statements the custodian is providing to the adviser’s clients.
In the case of pooled investment vehicles, unless otherwise exempt, the adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement of the pooled investment vehicle to each of its investors. If all of the investors in a pooled investment vehicle to which statements are sent are themselves pooled investment vehicles that are related persons of the adviser, the adviser must treat each such pooled investment vehicle investor as a separate client, in which case it must distribute statements to the beneficial owners of those vehicles.
Notice to Client
Currently, Rule 206(4)-2(a)(2) requires an adviser to notify its clients immediately when the adviser opens a custodial account on behalf of its client or when there are any changes to the custodial account information. If an adviser chooses to send its own statements to clients in addition to that provided by the qualified custodian, the Amendments require the adviser to include a legend in any such notice that encourages clients to compare the account statements they receive from the adviser with those they receive from the qualified custodian.
Annual Surprise Examination of Client Assets
The Amendments require registered advisers who are deemed to have custody of client assets (with limited exceptions as discussed below) to undergo an annual surprise examination of those assets by an independent public accountant. Each adviser that is subject to this surprise examination requirement must enter into a written agreement with an independent public accountant, specifying that the accountant must (1) notify the SEC, within one business day, of the discovery of any material discrepancy during the course of the examination; (2) submit a Form ADV-E to the SEC, along with the accountant’s certificate, within 120 days of the time chosen by the accountant for the surprise examination, detailing the nature and extent of the examination; and (3) upon resignation or dismissal of the accountant, file a statement regarding the termination, along with the Form ADV-E, within four business days of the resignation or dismissal.
Under the Amendments, accountants will no longer be permitted to forgo examining certain privately offered securities during the course of their annual verification of client assets. Therefore, advisers that maintain custody of privately offered securities on behalf of their clients will now be subject to the annual surprise examination requirement.
In addition to the final rule release issued on December 30, 2009, the SEC also issued a companion interpretive release that provides updated guidance for accountants conducting surprise examinations. The full text of this release can be found at http://www.sec.gov/rules/interp/2009/ia-2969.pdf.
Exception for Advisers Deemed to Have Custody Solely Because of Their Authority to Deduct Fees
The Amendments contain an exception from the surprise examination requirement for advisers who are deemed to have custody of client assets solely because they have the ability to deduct advisory fees from client accounts. In such instances, the greatest risk that clients face is the deduction of incorrect fees from their account. Because a surprise examination only verifies assets, and not the accuracy of fees paid, the SEC determined that subjecting these advisers to surprise examinations would do little to protect clients.
Exception for Pooled Investment Vehicles That Are Subject to Annual Financial Statement Audits
The Amendments also contain an exception from the surprise examination requirement for pooled investment vehicles that are subject to annual financial statement audits. An adviser to a pooled investment vehicle that is subject to an annual financial statement audit by an independent public accountant registered with, and inspected by, the Public Company Accounting Oversight Board (PCAOB), and that distributes the audited financial statements to the pool’s investors, will be deemed to have complied with the annual surprise examination requirement. If all of the investors in a pooled investment vehicle to which statements are sent are themselves pooled investment vehicles that are related persons of the adviser, the adviser must either treat each of these underlying pooled investment vehicles as a separate client, in which case it must distribute statements to the beneficial owners of the underlying pooled investment vehicle, or treat the assets of the underlying pooled investment vehicle as assets of the pooled investment vehicles of which it has indirect custody, in which case such assets must be considered within the scope of the pooled investment vehicle’s financial statement audit or surprise examination.
It is noteworthy that an adviser to a pooled investment vehicle who satisfies the annual surprise examination requirement by undergoing an annual financial statement audit is not required to have a reasonable belief that a qualified custodian delivers account statements directly to investors. The SEC has noted its concern that such investors are not receiving the full protections afforded to those investors that receive statements directly from custodians, and is exploring ways to remedy this shortcoming while respecting the confidential nature of proprietary information.
The Amendments also require that advisers to pooled investment vehicles who satisfy the surprise examination requirement by undergoing annual financial statement audits and distributing the results of those audits to the pool’s investors must also obtain a final audit of the pool’s financial statement upon liquidation of the pool. The results of this final audit must be distributed to the pool’s investors as soon as the audit is complete.
Exception for Advisers Deemed to Have Custody Solely through Related Persons That Are Operationally Independent
The Amendments contain a limited exception from the surprise examination requirement for advisers who are deemed to have custody of client assets solely as a result of a related person having custody of the assets. In order to avail itself of this exception, an adviser must (1) be deemed to have custody solely as a result of certain of its related persons holding client assets and (2) be “operationally independent” of the custodian. Any related person holding, or having the authority to hold, client assets is presumed not to be operationally independent of the adviser unless the adviser can meet the conditions laid out in Rule 206(4)-2,1 and no other circumstances exist that could reasonably compromise the operational independence of the related person.
While an adviser that is able to overcome the presumption that it is not operationally independent is excused from the annual surprise examination requirement, such an adviser would still be required to comply with other provisions of Rule 206(4)-2, including the requirements to notify the client where assets are maintained, form a reasonable belief after due inquiry that a qualified custodian sends account statements directly to the client and obtain an internal control report from a related person that is a qualified custodian as described below.
Custody by Advisers or Related Persons – Internal Control Reports
In addition to the requirement for annual surprise examinations, the Amendments also require advisers who themselves maintain custody of client assets or who maintain custody of client assets through a related person to obtain, on at least an annual basis, an internal control report from an accountant who is registered with, and inspected by, the PCAOB. The report must be maintained by the adviser and made available to the SEC staff upon request.
The internal control report must include the accountant’s opinion as to whether the custodian’s internal controls (1) have been in place as of a specific date, (2) are suitably designed and (3) are operating effectively to safeguard client funds. The report should address controls in place related to client account setup and maintenance, authorization and processing of client transactions, security maintenance and setup, processing of income and corporate action transactions, reconciliation of funds and security positions to depositories and other unaffiliated custodians and client reporting. Finally, the accountant preparing the report is required to verify that client assets are reconciled to a custodian other than the adviser or its related person.
Compliance Policies and Procedures
The final rule release contains guidance regarding the types of policies and procedures that advisers are required to have in place under Rule 206(4)-7, which requires advisers maintaining custody of client assets to “adopt controls over access to client assets that are reasonably designed to prevent misappropriation or misuse of client assets, develop systems or procedures to assure prompt detection of any misuse, and take appropriate action if any misuse does occur.” Included in the policies and procedures suggested in the release are the following:
- conducting background and credit checks on employees of the investment adviser who will have, or could acquire, access to client assets to determine whether it would be appropriate for those employees to have such access;
- requiring the authorization of more than one employee before the movement of assets within, and withdrawals or transfers from, a client’s account, as well as before changes to account ownership information;
- limiting the number of employees who are permitted to interact with custodians with respect to client assets and rotating them on a periodic basis;
- if the adviser also serves as a qualified custodian for client assets, segregating the duties of its advisory personnel from those of custodial personnel to make it difficult for any one person to misuse client assets without being detected;
- requiring that any problems be immediately brought to the attention of the management of the adviser; and
- developing procedures whereby the chief compliance officer of the adviser periodically tests the effectiveness of the firm’s controls over safekeeping of client assets.
Additionally, advisers that are deemed to have custody of client of assets due to their ability to deduct fees should have policies and procedures in place to address the risk that incorrect fee amounts may be deducted. Such policies and procedures should (1) take into account how and when clients will be billed, (2) be reasonably designed to ensure that the amount of assets under management on which the fee is billed is accurate and has been reconciled with the assets under management reflected on statements of the client’s qualified custodian and (3) be reasonably designed to ensure that clients are billed accurately in accordance with the terms of their advisory contracts.
Amendments to Form ADV
Under the Amendments, an adviser will now be required to report on its Form ADV (1) all related persons who are broker-dealers and which, if any, act as qualified custodians for the adviser’s client’s assets; (2) the total number of clients for whom it or a related person has custody of assets and the total value of those assets; (3) whether an independent public accountant conducts an annual surprise examination of client assets and prepares an internal control report; (4) whether it has made a determination that it is excused from the surprise examination requirement because it has overcome the presumption that is it not operationally independent from a related person broker-dealer qualified custodian; and (5) whether any pooled investment vehicles it advises are audited, and whether the qualified custodians of those pooled investment vehicles send account statements to pool investors.
Under the Amendments, advisers must maintain copies of both their internal control reports and their memoranda describing the basis upon which they determined that the presumption that any related person is not operationally independent has been overcome, if any, for five years from the end of the fiscal year in which the report or memorandum was finalized.
The Amendments are effective 60 days after their publication in the Federal Register. Advisers required to undergo surprise examinations must enter into written agreements with an independent public accountant to ensure that the first such examination is conducted by December 31, 2010. Advisers required to obtain an internal control report must do so within six months of the effective date of the Amendments. Registered advisers must begin using the revised Form ADV in their first annual amendment after January 1, 2011. The full text of the final rule release is available at http://www.sec.gov/rules/final/2009/ia-2968.pdf.