On May 14, 2009, the Securities and Exchange Commission (SEC) proposed amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), which governs the custody of client assets by investment advisers registered under the Advisers Act. Drafted in response to the growing number of enforcement actions related to the theft, misappropriation and other misuses of client assets that have shaken investor confidence, the proposed amendments are designed to enhance the controls that apply to the more than 9,600 SEC-registered investment advisers deemed to have custody of client assets, either because they have physical control over the assets directly or through an affiliate, or because they have the authority to withdraw their clients’ funds.
Specifically, the proposed amendments would require that all registered investment advisers with custody of client assets engage an independent public account to conduct an annual surprise examination of client assets. Additionally, when an adviser or an affiliate, rather than an independent qualified custodian, maintains client assets, the proposed amendments would require the adviser or affiliate to obtain, at least annually, a written report from an independent public accountant that includes an opinion regarding the qualified custodian’s controls relating to custody of client assets. Finally, the proposed amendments would also require that all custodians holding advisory client assets deliver custodial statements directly to advisory clients, rather than through the investment adviser, and that advisers opening custody accounts for clients instruct those clients to compare account statements they receive from the custodian with those received from the adviser.
Comments on the proposed amendments must be received by the SEC on or before July 28, 2009.
Annual Surprise Examination of Client Assets
The proposed amendments would require all registered investment advisers who have control of client assets to engage an independent public accountant to conduct annual on-site surprise examinations of such investment advisers to verify client assets. The accountants conducting these surprise examinations would have to report to the SEC’s Office of Compliance Inspections and Examinations, within one day, any inconsistencies they may uncover during their examinations. The accountant would also be required to file with the SEC, within 120 days of the time chosen by the accountant for the surprise examination (rather than within 30 days of the completion of the examination, as currently required under the rule), a Form ADV-E and a certificate that states that the accountant has examined the assets and details the nature and extent of such examination. In addition, the accountant would also have to submit a Form ADV-E to the SEC within four business days of its resignation from, or dismissal by, the investment adviser. Along with the Form ADV-E, the accountant would also be required to provide a termination statement to the SEC detailing the accountant’s contact information, the date of resignation or dismissal and an explanation of any problems that may have contributed to the resignation or dismissal.
The proposed amendments extend the requirement of a surprise examination to apply to registered investment advisers who hold privately offered securities on behalf of their clients. Privately offered securities are currently exempt from all requirements of the custody rules.
Custody by the Adviser and Its Related Persons
The proposed amendments would amend Rule 206(4)-2 to provide that an adviser is deemed to have custody of any client securities or funds that are directly or indirectly held by a “related person” in connection with advisory services provided by the adviser to its clients. A “related person” would be a person directly or indirectly controlling or controlled by the adviser and any person under common control with the adviser. For purposes of this definition, “control” is defined as the power, directly or indirectly, to direct the management or policies of a person, whether through ownership of securities, by contract or otherwise. In cases in which the custodian is not independent from the investment adviser (i.e., the investment adviser itself or a “related person” of the investment adviser acts as custodian), the proposed amendments would require the adviser to obtain, or receive from the related person acting as custodian, a written report that includes an opinion from an independent, reputable public accountant who is registered with, and inspected by, the Public Company Accounting Oversight Board (PCAOB) on at least an annual basis, describing the custody controls in place and the effectiveness thereof (“Type II SAS 70 Reports”). These examinations would be required to be conducted, and the Type II SAS 70 Reports would be required to be prepared, in accordance with PCAOB standards. The PCAOB is a private, nonprofit corporation created by the Sarbanes-Oxley Act of 2002 to oversee the auditors of public companies and to protect investors and the public interest by promoting informative, fair and independent audit reports. It consists of five members who are appointed by the SEC and is headquartered in Washington, D.C., with regional office locations across the United States.
Delivery of Account Statements and Notice to Clients
The proposed amendments would require registered advisers with custody of client funds or securities to have a reasonable basis for believing that the qualified custodian delivers custodial statements, at least quarterly, directly to each advisory client for whom the qualified custodian maintains funds or securities. The current rule permits investment advisers to send custodial statements to clients, provided that the investment adviser undergoes an annual surprise examination by an independent public accountant. The proposed amendments would eliminate this option, making it mandatory that all custodial statements be sent directly to clients by the custodian. This mandate is aimed at making it harder for investment advisers to create false account statements, reducing the likelihood that client assets are placed at risk and allowing clients the opportunity to compare the statements they receive from the custodian with those they receive from the investment adviser. The proposed amendments also require investment advisers who open custodial accounts on behalf of their clients to send notices to those clients encouraging them to compare any account statements they receive from the custodian with any they may receive from the investment adviser.
Amendments to Form ADV
The SEC proposal also contains several amendments to Part 1A and Schedule D of Form ADV that are designed to provide the SEC with more complete information about the custody practices of advisers, as well as additional information for risk assessment purposes. Among other things, the amendments would require advisers to disclose the identity of the independent public accountant that performs its “surprise exam,” as well as any information related to the termination of, or any changes to, the engagement of the accountant or the engagement of a new accountant.
For the full text of the proposed rule, please visit http://www.sec.gov/rules/proposed/2009/ia-2876.pdf.