On May 20, 2009, the SEC issued a release proposing amendments to Rule 206(4)-2 of the Advisers Act to improve the safekeeping of client assets. The proposed rule would require a yearly "surprise exam" of investment advisers deemed to have custody of client assets, to be performed by an independent public accountant, to verify the integrity of client assets. In addition, when an adviser or an affiliate directly holds client assets, the proposed rule would require that in addition to a surprise exam, a custody control review be conducted by a PCAOB-registered and inspected accountant. The proposed rule would also require qualified custodians to deliver periodic account statements to clients of an investment adviser, or to the underlying investors in the case of advisers to pooled investment vehicles such as private equity funds and hedge funds that do not distribute annual audited financial statements to investors.

The proposed rule would apply to any SEC-registered investment adviser deemed to have custody of client assets, either directly or through an affiliate, and to those registered investment advisers with authority to access client funds, to deduct advisory fees for example. This would place 9,600 of the approximately 11,000 currently registered advisers within the scope of the proposed rule, a number that will rise dramatically if pending federal legislation requiring the registration of most investment advisers, specifically the Hedge Fund Transparency Act or the Hedge Fund Adviser Registration Act, becomes law.

The SEC is seeking comments on the proposed rule by July 28, 2009. We expect many industry participants to suggest that the rule not apply to advisers deemed to have custody solely as a result of their ability to withdraw advisory fees directly from client accounts (nearly two-thirds of all advisers subject to the proposed rule), given that such limited access to client assets is less likely to be subject to abuse and misappropriation.

Proposed Rule: Custody of Funds or Securities of Clients by Investment Advisers, SEC Rel. No. IA-2876 (May 20, 2009)

Related Client Alert: Available here (PDF)