On May 14, 2009, the U.S. Securities and Exchange Commission (SEC) held an open meeting (the Open Meeting) to determine whether to propose amendments to Rule 206(4)-2 (the Custody Rule) and related forms and rules (the Proposed Amendments) under the Investment Advisers Act of 1940 (the Advisers Act). The SEC voted unanimously in favor of the Proposed Amendments and published the release concerning the amendments on May 20, 2009 (the Release).1 The comment period on the Proposed Amendments runs until July 28, 2009.
This Legal Alert discusses the key provisions of the Proposed Amendments and the implications thereof and provides insight from the Open Meeting. The Proposed Amendments would amend the Custody Rule to require the following:
- Mandatory annual surprise examinations by an independent public accountant for investment advisers that have legal custody of client funds or securities;
- A written internal control report from an independent public accountant registered with and subject to oversight by the Public Company Accounting Oversight Board (PCAOB) for advisers that maintain, or have a related person maintain, custody of client funds or securities;
- Enhanced account statement delivery and notice requirements; and
- More disclosure of custody practices on Form ADV, Part I.
Each new requirement is briefly discussed below.
Annual Surprise Examinations
The Proposed Amendments would require all registered investment advisers with custody of client funds or securities (together, client assets) to engage an independent public accountant2 to conduct an annual surprise examination of client assets. Since the Custody Rule defines “custody” to include any registered adviser with authority or permission to withdraw client funds or securities maintained with a custodian upon instruction to the custodian, all registered advisers with the ability to obtain their advisory fees upon instruction to the custodian would be subject to the annual surprise examination requirement. In another change, the Proposed Amendments would make privately offered securities held by advisers on behalf of their clients subject to the surprise examination requirement.
Under the Proposed Amendments, all registered advisers that have custody of client assets would be required to undergo an annual surprise examination regardless of whether a qualified custodian directly provides statements to clients. During the Open Meeting, the SEC staff (the staff) noted that the proposed changes would force approximately 6,000 investment advisers to be subject to annual surprise examinations. This prompted SEC Commissioners Kathleen Casey and Troy Paredes to question whether this aspect of the Proposed Amendments was too broad.
The Release asks for comment on whether the Custody Rule should except from the surprise examination requirement advisers that have custody of client assets solely as a result of their authority to withdraw advisory fees from client accounts. The Release also solicits comment as to whether there are alternatives to the surprise examination that might provide similar protections. In addition, the Release requests comment of whether the Custody Rule should except advisers from the surprise examination requirement with respect to client assets held in pooled vehicles that are audited at least annually.
Written Agreement With an Independent Public Accountant
The Proposed Amendments would require each adviser subject to the surprise exam requirement to enter into a written agreement with an independent public accountant to conduct the examination. Among other things, the agreement would have to require the accountant to: (1) notify the SEC within one business day of finding any material discrepancy; (2) submit a Form ADV-E to the SEC accompanied by a certificate stating that it has examined the client assets and describing the nature and extent of the examination, within 120 days of the time chosen by the accountant for the examination; and (3) file a Form ADV-E within four business days of the accountant’s resignation, dismissal from or other termination of the engagement, or upon removing itself or being removed from consideration for being reappointed, accompanied by a statement explaining any reasons for the termination related to the examination scope or procedure that contributed to the resignation, dismissal, removal or other termination. Form ADV-E would be filed by advisers on the Investment Adviser Registration Depository and be publicly available via the Investment Adviser Public Disclosure system.
Requirement to Obtain Internal Control Report
The Proposed Amendments would provide that an adviser has custody of client assets that are directly or indirectly held by a “related person” in connection with advisory services provided by the adviser.3 The Proposed Amendments would define a “related person” as a person directly or indirectly controlling, controlled by or under common control with an adviser, and would adopt the definition of “control” in Glossary of Form ADV. If the Proposed Amendments are adopted, the staff would withdraw the seminal Crocker Investment Management Corp. no-action letter (pub. avail. Apr. 14, 1978) that has long provided guidance as to when an adviser has indirect custody of client assets because it, or its personnel, has access to such assets through a related person.
Investment advisers that maintain, or use a related person to maintain, custody of client assets would be required to obtain an “internal control report” that includes an opinion with respect to the adviser’s or related person’s controls relating to custody of client assets from an independent public accountant registered with and subject to regular inspection by the PCAOB. Such reports could take the form of an “SAS 70 Type II Report” conducted in accordance with PCAOB standards. The internal control report would contain, among other things, a description of the relevant controls, the control objectives and related controls and the independent public accountant’s tests of operating effectiveness that were performed and the results of those tests. The adviser would have to maintain the report in its records and make it available to the staff upon request. Moreover, the Proposed Amendments would require an adviser that does not use an independent custodian to maintain client assets to obtain its yearly surprise examination from an independent public accountant registered and subject to regular inspection by the PCAOB.4
During the Open Meeting, the staff noted that these provisions are intended to encourage advisers to use independent qualified custodians. The staff noted that it considered, but ultimately rejected, mandating the use of independent custodians by all advisers. The Release explicitly seeks comment on whether, as an alternative to the Proposed Amendments, the SEC should amend the Custody Rule to require independent qualified custodians to hold client assets. The Release also asks commenters to discuss the practical aspects of requiring advisers that have custody to maintain client assets with independent qualified custodians, such as the impact on wrap fee programs.
Account Statement Delivery and Notice Requirements
The Proposed Amendments would require a registered adviser with custody of its client assets to have a reasonable basis for believing that the adviser’s qualified custodian sends a quarterly (or more frequent) account statement to the adviser’s clients. Currently, an adviser has the option of directly sending account statements to clients, provided the adviser undergoes a surprise yearly examination by an independent public accountant. Thus, this practice would no longer be permitted.
The Proposed Amendments would also require advisers to form their reasonable belief that the qualified custodian sends account statements after “due inquiry.” The Release offers some guidance about what practices would constitute “due inquiry.” For example, the custodian could provide the adviser with a copy of the account statement that was delivered to the client. Alternatively, the custodian could confirm, in writing, each quarter that it has sent account statements to the adviser’s clients.
The Proposed Amendments would also introduce a notice requirement. Specifically, advisers would have to include a statement in the notice sent to clients upon opening custodial accounts on their behalf urging them to compare the account statements they receive from the custodian with those they receive from the adviser.
Related Form ADV Amendments
The Proposed Amendments would make certain changes to Form ADV. Item 7 would require advisers to report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to the adviser’s clients’ assets. Item 9 would require advisers that have custody of client assets, or whose related persons have custody of client assets, to provide certain information about their custodial practices. Among other things, advisers that serve as, or have related persons serve as, qualified custodians would have to disclose this practice. Advisers would also have to disclose whether they are subject to a surprise examination and whether an independent public accountant registered with and subject to inspection by the PCAOB prepares an internal control report. Advisers subject to the surprise examination requirement would have to report the month in which the last examination commenced. Finally, Schedule D would require information about the independent accountant that conducts the surprise examination and that prepares internal control reports, including whether the accountant’s reports were unqualified.