On December 30, 2009, the U.S. Securities and Exchange Commission (the “SEC”) published a release adopting certain amendments to the custody and recordkeeping rules applicable to registered investment advisers under the U.S. Investment Advisers Act of 1940 ( the “Advisers Act”) and related forms (the “Release”).1 The amendments are designed to provide additional safeguards under the Advisers Act when a registered investment adviser has custody of client assets and to encourage the use of independent custodians. The Release is also intended to provide the SEC and the public with better information about the custodial practices of registered investment advisers.
Newly amended Rule 206(4)-2 under the Advisers Act (the “Amended Rule”) requires a registered investment adviser that has “custody” 2 of client assets to, among other things:
- undergo an annual surprise examination by an independent public accountant to verify client assets (subject to certain enumerated exceptions, including an exception for an investment fund that provides annual audited financial statements as more fully described below);
- have a reasonable basis after due inquiry, for believing that the “qualified custodian” maintaining client assets sends account statements directly to the advisory clients; and
- unless client assets are maintained by an independent custodian (i.e., a custodian that is not the investment adviser itself or a related person of the investment adviser), obtain, or receive from its related person, an annual report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board (the “PCAOB”).
Special Rules and Exceptions Applicable to Investment Funds. The Amended Rule provides special rules for registered investment advisers to pooled investment vehicles such as limited partnerships, limited liability companies and other similar investment vehicles, including private investment funds. These rules are summarized below.
- Annual Audit Provision. Under the Amended Rule,3 an investment adviser shall be deemed to have complied with the annual surprise examination requirement with respect to an investment fund that is subject to an audit: (i) at least annually and distributes its audited financial statements, prepared in accordance with generally accepted accounting principles (“GAAP”), to all of the fund’s investors within 120 days of the fund’s fiscal year-end (or within 180 days for funds of funds); (ii) conducted by an independent public accountant4 that is registered with, and subject to regular inspection by, the PCAOB5 as of the commencement of the professional engagement period and as of each calendar year-end; and (iii) upon liquidation of the fund and distributes its audited financial statements, prepared in accordance with GAAP, to all of the fund’s investors promptly after the completion of such audit (the “Annual Audit Provision”).6 An investment adviser may rely on the Annual Audit Provision with respect to an investment fund if the adviser becomes contractually obligated to obtain an audit of the financial statements of the investment fund for fiscal years beginning on or after January 2010. Although very unlikely, if an investment fund does not distribute audited financial statements to its investors as described above, the investment adviser must comply with the annual surprise examination requirement7 and must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement of the investment fund to its investors.8
- Internal Control Report. Under existing Rule 206(4)-2(a)(1), a registered investment adviser that has “custody”9 of client assets (with certain limited exceptions) must maintain such client assets with a “qualified custodian” 10 in either a separate account for each client under that client’s name, or alternatively, in accounts that contain only the adviser’s clients’ funds and securities, under the adviser’s name as agent or trustee for the clients. The Amended Rule establishes an additional requirement where an investment fund’s assets are maintained with a qualified custodian that is either the investment adviser to the fund or a related person11, 12of the investment adviser.13 In these circumstances, the investment adviser must obtain, or receive from its related person, no less frequently than once each calendar year, a written, internal control report prepared by an independent public accountant.14 The accountant issuing the internal control report must be registered with, and subject to regular inspection as of the commencement of the engagement period, and as each calendar year-end, by, the PCAOB. The objective of the examination supporting the internal control report is to obtain reasonable assurance that the qualified custodian’s controls have been place in operation as of a specific date and are suitably designed and are operating effectively to meet control objectives related to custody of funds and securities during a specific period. The internal control report must include an opinion from an independent public accountant with respect to the investment adviser’s or related person’s controls relating to custody of client assets. The SEC does not require a specific type of internal control report to be provided as long as the objectives are addressed in the report.15 The report should address the controls related to the areas of 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 securities to depositories and other unaffiliated custodians and client reporting. The report should also describe the nature, timing, extent and results of the procedures performed to verify that funds and securities are reconciled to depositories and other unaffiliated custodians. Investment advisers subject to this requirement must obtain or receive an internal control report within six months of becoming subject to the requirement. The investment adviser must maintain the internal control report in its records for five years from the end of the fiscal year in which the report is finalized and make it available to the SEC staff upon request.16
- Delivery to Related Persons; Look-Through Provisions. The Amended Rule contains a provision intended to preclude investment advisers from using layers of pooled investment vehicles to avoid meaningful application of the protections of the custody rules.17 Importantly, sending an account statement or distributing audited financial statements will not satisfy the requirements of the Amended Rule “if such account statements or financial statements are sent solely to limited partners (or members or other beneficial owners) that themselves are limited partnerships (or limited liability companies, or another type of pooled investment vehicle) and are your related persons”. The Release specifically addresses the use of special purpose vehicles (“SPVs”) by investment advisers to facilitate investments in certain securities by one or more investment funds that the advisers manage. SPVs are typically controlled by the investment adviser or its related persons who often serve as general partners of limited partnerships or persons who hold comparable positions for another type of pooled investment vehicle. To comply with the Amended Rule, the investment adviser must either: (i) treat the SPV as a separate client, in which case, the SPV itself must have annual audited financial statements and deliver the statements to the beneficial owners of the investment funds participating in the SPV; or (ii) treat the assets of the SPV as assets of the investment funds of which it has custody indirectly, in which case, the annual audited financial statements of each investment fund participating in the SPV must look through the SPV to audit each such participating fund’s share of assets of the SPV.
- Delivery of Account Statements and Notice to Client. The Release also amends certain portions of the custody rules applicable to notices and account statements that are delivered to advisory clients. Under Amended Rule 206(4)-2(a)(2), investment advisers are required to: (i) notify their clients promptly upon opening a custodial account on their behalf and when there are changes to the information required in that notification; and (ii) include a legend in the notice, and in any subsequent account statement, urging clients to compare the account statement they receive from the custodian with those they receive from the adviser. Additionally, under Amended Rule 206(4)-2(a)(3), an investment adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of the adviser’s clients for which it maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions in the account during the period. Importantly, under Rule 206(4)- 2(b)(4), investment advisers to investment funds that utilize the Annual Audit Provision are not required to comply with either of these requirements. In its Release, the SEC voiced concern, stating, “As a consequence, investors in pooled investment vehicles do not have the benefit of regularly receiving reports that the assets underlying their investments are properly held. We are therefore concerned that the current protections of the rule may be insufficient, and we have directed our staff to explore ways in which we could remedy this potential shortcoming while respecting the confidential nature of proprietary information.”
Amendments to Form ADV. The SEC adopted several amendments to Form ADV that will require investment advisers to report to the SEC more detailed information about their custody practices in their registration form and to update the information.18 Investment advisers must provide responses to the revised Form ADV in their first annual amendment after January 1, 2011.
Compliance Policies and Procedures. Registered investment advisers that advise investment funds may need to update their custody arrangements and/or compliance policies to satisfy the requirements of the Amended Rule. The Release provides guidance with respect to policies and procedures relating to the safekeeping of client assets that investment advisers should consider when updating their compliance manuals.19
Effective Date. Except as otherwise provided above in the relevant portions of this memorandum, the Amended Rule will become effective 60 days after its publication in the Federal Register (with the earliest possible effective date being March 1, 2010).