After commencing a host of recent enforcement actions against investment advisers and brokerdealers involved in misappropriating investor assets, on May 20, 2009, the SEC proposed revisions to Rule 206(4)-2 of the Investment Advisers Act of 1940 (the “Custody Rule”). IA Rel. No. 2876, 74 F.R. 25354 (May 27, 2009). The proposed amendments are intended to better safeguard client funds held by investment advisers.
Summary of Proposed Changes
The following are the highlights of the amendments being proposed:
- All advisers deemed to have custody of client funds and securities (including hedge fund managers that serve as the hedge fund’s general partner and advisers that have custody solely because they have authority to withdraw advisory fees from client accounts) must submit to an annual surprise examination by an independent public accountant, and where the adviser or a related person serves as the qualified custodian, the accountant must be registered with the Public Company Account Oversight Board (“PCAOB”). Privately-offered securities held in clients’ accounts would also become subject to the surprise examination.
- Where an adviser or a related person to the adviser (such as a broker-dealer or bank that is under common control with the adviser) serves as a qualified custodian for client funds or securities, the adviser must obtain, or receive from the related person, at least annually, an internal control report that includes an opinion from a PCAOB-registered independent public accountant with respect to the adviser’s or the related person’s controls relating to custody of assets.
- Advisers must enter into a written agreement with the accounting firm conducting the surprise examination that requires the accounting firm to notify the SEC within one business day of finding material discrepancies, to submit Form ADV-E to the SEC within 120 days after commencing a surprise examination and to submit Form ADV-E within four business days after its resignation or dismissal from, or other termination of, the examination engagement (Form ADV-E will be required to be submitted electronically through the IARD system).
The release makes clear that the SEC staff will withdraw the Crocker Investment Management Corp. no-action letter (April 4, 1978) if the proposed amendment is adopted.2 The proposed rule would automatically impute custody if a related person acts as a qualified custodian for the adviser’s clients’ assets.
The proposal would also (i) eliminate advisers’ option to deliver quarterly account transaction reports directly to clients and (ii) require advisers to conduct “due inquiry” to form the basis of a reasonable belief that reports are sent by the qualified custodian to the adviser’s clients. The SEC states that the provision of reports directly to clients by the qualified custodian would better assure their integrity.
Advisers that act as general partners to pooled investment vehicles would continue to be excepted from the requirement to have a qualified custodian send account statements to limited partners only if the pool is audited annually, distributes audited financial statements to the limited partners within 120 days of fiscal year end and upon liquidation distributes audited financial statements to the limited partners promptly after the audit’s completion. Even though such advisers are exempt from the requirement to have qualified custodians and to send account statements to the limited partners, they would still be required to undergo an annual surprise examination.
Advisers are currently required to give notice to clients upon opening a custodial account on the client’s behalf. The proposed rule would require advisers to include in this notice a statement urging clients to compare their account statements from the custodian with those from the adviser.
Form ADV Amendments
In addition, the proposed rule would require amendments to Form ADV designed to provide the SEC and the public with greater information on how advisers are maintaining client funds. Specifically, (1) Item 7 of Part 1A will be modified to require an adviser to report all related persons who are brokerdealers and identify those serving as qualified custodians with respect to the adviser’s clients’ assets (currently, this is an optional disclosure item) and (2) Item 9 of Part 1A will require advisers and related persons with custody of client assets to report the amount of assets and number of clients for which they have custody and the month in which the last surprise examination commenced. Schedule D of Form ADV would include additional items requiring identification of accountants that perform audits, surprise examinations, and internal control reports and of related persons that serve as qualified custodians. Comments on the proposal must be received by July 28, 2009.