On May 20, 2009, the Securities and Exchange Commission (the “SEC”) released proposed amendments to Rule 206(4)-2 (the “Custody Rule”), promulgated pursuant to Section 206(4) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”).1 The following information summarizes and analyzes the existing Custody Rule, the proposed amendments to the Custody Rule (the “Amendments”), and certain related matters.

The Existing Rule

Under the current Custody Rule, investment advisers registered (or required to be registered) under the Advisers Act are required to fulfill certain obligations if such advisers are deemed to have custody of client assets. For purposes of the Custody Rule, custody includes possession of client funds or securities as well as the ability to obtain possession of client funds or securities (e.g., the ability to withdraw client funds or securities maintained with a qualified custodian or serving as the general partner of a limited partnership). If deemed to have custody of client assets, covered investment advisers must, among other obligations, maintain accounts with “qualified custodians” (e.g., registered broker-dealers) and, with certain exceptions, reasonably believe that the qualified custodian sends quarterly account statements to each advisory client. Certain privately offered securities need not be held by a qualified custodian (including privately offered securities held by a pooled investment vehicle, if the pooled investment vehicle is audited annually and audited financial statements are distributed to all investors in such pooled investment vehicle within certain specified time frames). In addition, the adviser, rather than the qualified custodian, may send quarterly account statements to clients, if the adviser also engages an independent public accountant to verify client assets in an annual surprise examination. Pooled investment vehicles subject to an annual audit that distribute audited financial statements to investors within designated time frames are exempt from the quarterly account statement distribution requirement (including the associated surprise examination if the adviser distributes the quarterly statements itself).

The Amendment

The Amendments consist of the following items:

(i) all covered investment advisers with custody of client assets (including privately offered securities) must undergo an annual surprise examination conducted by an independent public accountant pursuant to a written agreement with such independent public accountant;

(ii) all covered investment advisers that either directly or indirectly (i.e., through “related persons”) maintain control of advisory client assets as qualified custodians must undergo thorough inspections by certain independent public accountants in addition to the surprise examination;

(iii) all covered investment advisers must have a reasonable basis for believing that the qualified custodian holding client assets sends an account statement to each advisory client at least quarterly and provide investors with certain disclosure regarding such account statements; and

(iv) all covered investment advisers must make additional custody related disclosures on Part 1A of Form ADV and Schedule D thereto.

Each Amendment is discussed in more detail below.

Annual Surprise Examinations and Written Agreement

If enacted in its current form, the Amendments require all investment advisers registered (or required to be registered) under the Advisers Act that have custody of client assets (including privately offered securities) to undergo a surprise annual examination by an independent public accountant. The Amendments, however, do not alter the broad definition of “custody” contained in the existing Custody Rule. Covered investment advisers, for example, that maintain the ability to withdraw management fees from client accounts held with a qualified custodian or covered investment advisers that serve as the general partner of a limited partnership or other pooled investment vehicle (such as a hedge fund) will be subject to surprise examination under the Amendments. In addition, under the Amendments, the surprise examination is required even if a pooled investment vehicle client is otherwise subject to an annual audit by independent public accountants.

The surprise examinations confirm the existence of client assets and assess the quality of the investment adviser’s (or its related person’s) custody controls. In furtherance of the surprise examination requirement, the Amendments require all covered investment advisers to enter into a written agreement with an independent public accountant to conduct the mandatory surprise examinations. The written agreement must require the accountant to notify the SEC within one business day of finding any material discrepancies, and to submit Form ADV-E to the SEC within 120 days of the time chosen for the surprise examination. Form ADV-E describes the nature and extent of the surprise examination and the accountant’s services rendered to the investment adviser. Form ADV-E is also filed by the accountant within four business days of its resignation, dismissal, removal or other termination with respect to the applicable engagement.

Investment Advisers or Related Persons Acting as Qualified Custodian

The Amendments provide for additional custody procedures and reports if the covered investment adviser or a “related person” maintains client funds or securities as a qualified custodian in connection with advisory services. A “related person” is defined as a person directly or indirectly controlling or controlled by an investment adviser and any person under common control with the adviser, while “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. Under the Amendments, the independent public accountant engaged by any such investment adviser to perform the surprise examination must be a member registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (a “PCAOB Accountant”). In addition to the surprise examination by a PCAOB Accountant, any such investment adviser must obtain, or receive from its related person, an annual “internal control report” describing the investment adviser’s or its related person’s custody controls. Such report must include an opinion from a PCAOB Accountant addressing the nature and extent of such custody controls.

Account Statements and Notice to Investors

Pursuant to the Amendments, investment advisers registered (or required to be registered) under the Advisers Act that have custody of advisory client assets must have a reasonable basis, formed after “due inquiry,” for believing that the qualified custodian sends an account statement, at least quarterly, to each of the investment adviser’s advisory clients. Similar to the current Custody Rule, covered investment advisers to pooled investment vehicles that (i) are subject to an annual audit and an audit upon liquidation and (ii) distribute financial statements to investors within specified time frames, remain exempt from the account statement distribution requirement with respect to assets held by the pool. The Amendments, however, eliminate the ability of a covered investment adviser to send account statements directly to clients (whether or not such adviser undergoes an annual surprise examination by an independent public accountant).

In addition to requiring quarterly account statements sent from the qualified custodian to advisory clients, the Amendments require covered investment advisers to include a statement advising its advisory clients to compare any custodial statements with any statements received directly from the investment adviser. Such statement is included in the written notice to clients required by the Custody Rule and the Amendments upon opening an account with a qualified custodian.

Amendments to Form ADV

The SEC is also considering certain revisions to Form ADV that are designed to provide the SEC and investors with additional detail relating to covered investment advisers’ custody practices. They include revisions to the following:

  • Item 7 of Part 1A, which would require each covered investment adviser to disclose the name of “related person” broker-dealers and to identify whether any such persons serve as qualified custodians with respect to the adviser’s clients’ funds or securities
  • Item 9 of Part 1A, which would require each covered investment adviser that has control of advisory client funds or securities (or whose “related persons” have such control) to report the amount in U.S. dollars of advisory client assets and number of advisory clients of which it or its “related person” has custody
  • Item 9 of Part 1A, which would require covered investment advisers to disclose whether a qualified custodian sends quarterly account statements to investors in pooled investment vehicles that the investment adviser manages and whether the financial statements of the pooled investment vehicles that the adviser manages are audited
  • Item 9 of Part 1A, which would require an investment adviser to disclose whether an independent public accountant registered with the PCAOB prepares an “internal control report” with respect to the adviser’s or its “related persons’” custodial services when acting as a qualified custodian for advisory client funds or securities
  • Schedule D, which would require covered investment advisers to disclose certain information relating to the independent public accountants that perform surprise examinations or prepare control reports, if applicable

Analysis and Next Steps

The SEC has requested that comments on the Amendments be received by the SEC on or before July 28, 2009. As a result, the extent to which the Amendments will be adopted is currently unclear. If adopted in its current form, the broad definition of “custody” contained in the existing Custody Rule and the Amendments will subject almost all covered investment advisers to increased regulatory oversight by the SEC and additional costs, including the added expense of retaining an independent public accountant to conduct annual surprise examinations.

For covered investment advisers that advise pooled investment vehicles (such as hedge funds), accounting and audit costs are typically borne by the pooled investment vehicle. Although the surprise examination will be in addition to the current customary and industry standard annual audit of pooled investment vehicles, it is likely that such additional expense will be borne by the pooled investment vehicle along with other fund accounting and audit expenses. If market forces continue to tolerate passing along accounting expenses to fund clients (including the proposed surprise examination), it will place further downward pressure on returns. If covered investment advisers bear such expenses, however, whether on behalf of fund clients or managed accounts, it may lead to increased risk taking (to generate outsized performance returns to cover the additional expenses) or create upward pressure on management fees. Such additional expenses and third-party custody controls may also lead covered advisers to cut staff, although the SEC has continued to discourage any such action. In fact, covered investment advisers (particularly smaller investment advisers) may find that they need additional staff to assist and monitor third-party accountants and to ensure the diligence and disclosure requirements of the Amendments are timely met.

In addition to the cost of surprise examinations, covered investment advisers will also be subject to additional responsibilities and bear incremental costs relating to the “due inquiry” requirement with respect to qualified custodian account statements (if applicable), document retention (e.g., retention of any accountant contracts relating to the surprise examinations) and disclosure. Finally, covered investment advisers that do not utilize the services of an independent qualified custodian (i.e., either such investment adviser or a “related person” of such investment adviser maintains control of such investment adviser’s advisory clients’ assets) may wish to consider whether utilizing the services of an independent qualified custodian is more cost effective than incurring the additional regulatory costs and burdens imposed by the Amendments. At the very least, the Amendments are a clear indication from the SEC that such relationships are disfavored, if not statutorily prohibited.