The SEC has adopted amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940. The amendments modify what’s known as the Custody Rule and are designed to increase safeguards over client funds in the custody of SECregistered investment advisers.

Under the new amendments, advisers who maintain custody of client assets through an affiliated qualified custodian will now be subject to an annual surprise examination unless they can demonstrate sufficient operational independence from the custodian. In a departure from the proposed rule, the surprise examination will not apply to advisers who have custody based only on their ability to deduct advisory fees directly from a client’s account. As a result, it is expected that far fewer advisers will be subject to enhanced oversight.

Pooled investment vehicles are now subject to surprise examinations as well unless their annual audited financial statements are provided by an independent accountant registered with, and subject to regular inspection by the PCAOB. The proposed rule would have subjected pooled investment vehicles to the surprise examination without exception.

The SEC has also heightened the requirements for advisers to form a “reasonable belief” that the qualified custodian has sent account statements directly to clients by requiring advisers to conduct a “due inquiry.” The SEC did not provide a single method for satisfying this standard but rather left advisers with flexibility to determine how best to meet the requirement.

In an effort to enhance their ability to identify compliance risks associated with custody of client assets, the SEC also adopted several amendments to Part 1A and Schedule D of Form ADV requiring advisers to report more details about their custody practice.

Although the final rule is scaled back in certain respects from the proposed rule, the SEC has signaled its intentions to make custodial practices a key area of focus in response to various high profile frauds in the past year.