On March 4, 2013, the staff of the SEC’s Office of Compliance Inspections and Examinations issued a National Examination Risk Alert (the “Alert”) focused on significant deficiencies observed by the SEC’s National Examination Program (the “NEP”) staff related to compliance with the custody requirements of Rule 206(4)-2 (the “Custody Rule”) under the Advisers Act. According to the Alert, approximately onethird of recent examinations conducted by the NEP staff containing significant deficiencies included custody-related issues.
The Custody Rule requires an SEC-registered investment adviser with custody of client assets to take specific measures to safeguard such assets from loss, theft or misappropriation. These measures include, subject to certain exceptions, maintaining client assets with a “qualified custodian” that the investment adviser has a reasonable basis to believe provides account statements directly to the investment adviser’s clients, notifying the client of certain information about the “qualified custodian” that maintains client assets and undergoing an annual surprise examination by an independent public accountant to verify client assets. If the qualified custodian is a related party to the investment adviser (or the investment adviser itself serves as the qualified custodian), then the annual surprise examination must be conducted by an independent accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (the “PCAOB”), and the investment adviser must obtain a report on the internal controls relating to the custody of client assets from the accountant at least annually. In addition, if an investment adviser to pooled investment vehicles distributes audited financial statements to investors at least annually (the so-called “audit approach”), it does not have to comply with certain notice and account statement delivery requirements of the Custody Rule nor does it have to undergo a surprise examination. For more information on the Custody Rule, please see the January 7, 2010 Investment Management Regulatory Update and the April 6, 2010 Investment Management Regulatory Update.
According to the Alert, the significant deficiencies observed by the NEP staff during examinations can be grouped into the following four categories:
Failure by Advisers to Recognize They Have Custody. The Alert stated that recent examinations have revealed that some investment advisers have failed to recognize that they had custody of client assets and were therefore not complying with the requirements of the Custody Rule. The Risk alert identified specific fact patterns that were common, including situations in which (i) an investment adviser’s personnel served as trustee or were granted power of attorney for client accounts, (ii) an investment adviser had authorization to withdraw funds from clients’ accounts (e.g., through bill-paying services or through having access to clients’ online accounts), (iii) the investment adviser served as the general partner (or comparable position) to a fund, (iv) an investment adviser had physical possession of client assets (such as stock certificates) and (v) the investment adviser had check writing authority for client accounts or received clients’ checks but failed to promptly return them to the sender.
Surprise Exam Requirement. According to the Alert, the NEP staff observed that investment advisers were not filing the required Form ADV-E within 120 days after the date of the exam (as required by Rule 206(4)-2(a)(4)(i) under the Advisers Act) and/or such examinations were not being conducted on a surprise basis (e.g., exams were being conducted at the same time each year such that investment advisers could predict when the exam would occur).
Qualified Custodian Requirements. The Custody Rule requires that advisers maintain client assets with a “qualified custodian” for which the adviser has a reasonable basis to believe provides account statements directly to the adviser’s clients. According to the Alert, the NEP staff has observed that certain investment advisers are holding client assets in accounts bearing the investment adviser’s name and not in their capacity as agent or trustee for the client. The Alert also stated that certain investment advisers were commingling proprietary assets with client assets, were maintaining client assets in a safe deposit box controlled by the investment adviser or the investment adviser did not have a reasonable basis for believing, after due inquiry, that a qualified custodian was sending quarterly account statements to clients.
In addition, the Alert noted that, although the Custody Rule does not require an investment adviser that opens a custodial account on the client’s behalf to send account statements to the client separate and compare the account statements from the qualified custodian with those from the investment adviser.
Audit Approach Issues. As discussed above, investment advisers to pooled investment vehicles can avoid certain obligations imposed on them by the Custody Rule if such advisers rely on the audit approach and deliver audited financial statements to their investors at least annually. According to the Alert, the NEP staff observed that certain investment advisers had failed to utilize an auditor that was independent and registered with the PCAOB, failed to ensure audited financial statements were prepared in accordance with generally accepted accounting principles or failed to distribute audited financial statements to all investors within the required time period (i.e., within 120 days of the fiscal year end for private funds and 180 days for fund of funds).