Due to recent events, including a number of enforcement actions brought by the U.S. Securities and Exchange Commission (SEC) alleging fraudulent conduct by investment advisers involving the misappropriation or misuse of investor assets, on May 20, 2009, the SEC issued a release proposing certain amendments to Rule 206(4)-2 (the “Custody Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”).
Under the Custody Rule, subject to certain exceptions, registered investment advisers who have “custody” (which is defined very broadly by the Custody Rule and includes, for example, the power to direct payment of fees) over their clients’ assets must maintain those assets with a “qualified custodian” (also defined by the Custody Rule) and such advisers must have a reasonable belief that the qualified custodian is providing the underlying clients with quarterly account statements. The following are some of the more significant changes proposed by the SEC to the Custody Rule:
- Subject to very limited exceptions, every registered investment adviser deemed to have custody of client assets will be required to engage an independent public accountant to conduct an examination to verify the existence of all such client assets (including privately offered securities) at least once each calendar year (even if an independent custodian serves as the qualified custodian of such assets), and for investment advisers that act as the qualified custodian, the independent public accountant must be PCAOB-registered.
- The examinations mentioned above must be “surprise” examinations, conducted at a time chosen by the accountant and without prior notice to the investment adviser.
- Each independent public accountant that conducts such an examination must:
- file a certificate on with the SEC within 120 days of the beginning of an examination, discussing the nature and extent of the examination;
- notify the SEC of a material discrepancy within one business day of its discovery; and
- notify the SEC within four business days of the accountant’s resignation, dismissal from, or other termination of the engagement (including if the accountant removes itself from consideration for reappointment).
- If the investment adviser acts as the qualified custodian for client assets, the adviser must receive an annual internal control report concerning the adviser’s internal controls from a PCAOB-registered independent public accountant, maintain such report for five years, and provide the report to the SEC upon request.
- All advisers would need to have a reasonable belief, after due inquiry, that each qualified custodian of client assets is sending such clients quarterly account statements, and this requirement could not be overcome by the adviser delivering such quarterly statements to the clients.
- The delivery of quarterly account statements to clients must be made directly by the qualified custodian, rather than through the adviser.
The foregoing list is not exhaustive of all the changes to the Custody Rule proposed by the SEC, and the release contains related proposed changes to Forms ADV and ADV-E, as well as additional changes in the custody-related obligations of registered investment advisers.
The SEC has requested public comment on and has asked questions related to the proposed changes to the Custody Rule. Specifically, the SEC has asked whether or not advisers or their related persons should be prevented from serving as qualified custodians and require that all client assets be maintained by independent custodians. The SEC has also requested public comment and input on whether or not Rule 206(4)-7 under the Advisers Act (regarding investment adviser compliance policies and procedures) should be amended instead of or in conjunction with the amendments to the Custody Rule. All comments must be received by the SEC on or before July 28, 2009.