In response to recent fraudulent activity involving investment advisers and affiliated custodians, including the well publicized scheme engaged in by convicted adviser Bernard Madoff, on May 14, 2009, the Securities Exchange Commission (the “SEC”) voted unanimously to propose changes to Rule 206(4)-21 promulgated under the Investment Advisers Act of 1940, as amended. Rule 206(4)-2, the socalled “custody rule,” regulates the custody practices of registered investment advisers. The amendments are designed to make it more difficult for investment advisers to lose, misuse or misappropriate client funds by, among other things, expanding the use of surprise examinations, requiring advisers with actual custody of client assets to file internal control reports, and requiring all custodians to directly deliver account statements to clients. If approved by the SEC, the proposed amendments would impact the approximately 9,600 investment advisers registered with the SEC that have direct or indirect custody of client assets.

Hundreds of comments on the proposal have already been received by the SEC. The comment period ends July 28.


The custody rule was originally adopted in 1962 and substantially revised in 2003. Originally, the rule required advisers with custody of client assets to undergo an annual surprise examination by an independent accountant. In the years following the adoption of the custody rule, the SEC developed a substantial amount of guidance creating an expansive definition of “custody” coupled with numerous complicated exceptions contained in no action letters. The 2003 amendments were substantially about simplifying the rule and formalizing the SEC guidance by building it into the rule. Those amendments also eliminated the annual surprise examination in cases where “qualified custodians” delivered account statements directly to clients. See our October 1, 2003 FUNDamentalsTM Investment Management Client Alert.

The current custody rule requires investment advisers with custody of client assets to implement certain controls to protect client assets from loss, misuse or misappropriation. While most investment advisers do not maintain physical custody of client funds or securities, many are deemed to have custody of client assets by virtue of their authority to obtain client funds—such as by deducting advisory fees directly from client accounts, withdrawing funds on a client’s behalf, or acting in a capacity that gives the adviser the authority to withdraw funds, for example where the general partner of a limited partnership has authority to withdraw funds from the limited partnership’s account. Furthermore, an investment adviser may be deemed to have custody because the client’s funds are held by a custodian that is affiliated with the investment adviser. If an investment adviser is deemed to have custody, then the adviser must maintain client funds and securities with a qualified custodian. Qualified custodians include the types of financial institutions customarily engaged by clients and advisers for custodial services, including banks, registered brokerdealers, and registered futures commission merchants. The adviser must either have a reasonable belief that the custodian delivers account statements directly to clients, or must deliver account statements itself. If the adviser chooses to deliver account statements directly to the client, the adviser must engage an independent public accountant to perform annual surprise examinations in order to verify client assets.

Proposed Amendments

The proposed amendments would broaden the investor protections outlined above by, among other things, significantly increasing the applicability of surprise examinations, requiring all advisers with custody to ensure that account statements are sent by custodians, and requiring detailed internal control reports by advisers or their related persons who maintain physical custody of client funds or securities.

1. Surprise Examinations

As noted above, the current rule only requires surprise examinations of investment advisers that do not have a reasonable belief that their clients receive account statements directly from a qualified custodian. The SEC now proposes that all investment advisers, including pooled investment vehicles2, with custody of client funds or securities undergo annual surprise examinations of client assets by an independent public accountant registered with and inspected by the Public Company Accounting Oversight Board (“PCAOB”). Note that not all independent public accountants are registered with the PCAOB. Today, such registration is primarily required for auditors of public companies and brokerdealers. Accountants that do not have these types of clients may elect not be registered with the PCAOB.

Advisers would be required to enter into a written agreement with the independent public accountant requiring the accountant to

  • Notify the SEC within one business day of finding any material discrepancies,
  • Within 120 days of the surprise examination, submit to the SEC Form ADV-E and a certificate stating that the examination has taken place and summarizing the nature and extent of the examination, and
  • Submit Form ADV-E within four business days of its resignation, dismissal, termination or failure to be reappointed, along with a “termination statement” providing further information regarding the termination.

Finally, privately offered securities held by an adviser on a client’s behalf are currently entirely excluded from the custody rule. With this amendment, the SEC proposes making these privately offered securities subject to the surprise examination.

2. Custody by Advisers and Related Persons

The proposed amendments would do away with the multi-factor analysis currently used to determine whether an adviser has indirect control of client assets. Instead, if a related person of the adviser holds client assets in connection with the advisory services provided by the adviser, the proposed rule would simply deem that adviser to have custody. A “related person” includes all advisory affiliates and any person or entity under common control with the adviser.

Where the adviser or a related person serves as custodian for client funds or securities, the adviser or related person must obtain and file internal control reports annually. The internal control report—commonly known as a SAS-70 Report—must include an opinion from an independent accountant registered with and inspected by the PCAOB. In addition, the internal control report must contain a description of the controls, the objectives and related controls, and the independent public accountant’s tests of operating effectiveness, along with the results of those tests. The proposed amendments would require an adviser to maintain in its records a copy of the internal control report for five years.

3. Delivery of Account Statements

The proposed amendments would remove the exception by which an adviser could send statements directly to clients, so long as that adviser underwent an annual surprise examination. Instead, the proposed rule would require all advisers with custody of client funds to have a reasonable belief after “due inquiry” that the qualified custodian sends account statements to clients at least quarterly—effectively requiring all qualified custodians to send account statements directly to clients. In addition, the SEC proposes to amend the notice which advisers must send to clients upon the opening of a custodian account by requiring advisers to provide language in the notice urging clients to compare custodian account statements with adviser account statements.

Note that the proposed amendment would not eliminate the statement delivery exception for private pooled investment vehicles that undergo annual audits, the reports of which are timely distributed to investors.

4. Other Amendments

Liquidation Audit – As noted above, the proposed amendments would not change the current rule that allows advisers with custody of assets of private pooled investment vehicles an exemption from the account statement delivery provisions so long as the pooled vehicles are subject to annual audits and the reports of those audits are timely delivered to investors. The proposed amendments, however, would clarify the availability of the annual audit exception to pooled investment vehicles that liquidate and make final distributions other than at year end.

Amendments to Form ADV – Finally, the proposed amendments would amend Form ADV to require the adviser to provide more information regarding its custody practices.


According to the SEC, the surprise examination will cause all advisers registered with the SEC to incur an accounting fee, on average, of $8,100 each. The SEC notes that the accounting fees for surprise examinations would likely be much lower for small advisers, as most small advisers would have less than 6 accounts subject to the surprise examination.  

The internal control report required of advisers or related persons serving as qualified custodians, on the other hand, is significantly more expensive. The SEC estimates that, on average, each SAS 70 internal control report generated would cost approximately $250,000 per year. The SEC estimates that 372 investment advisers would be required to generate internal control reports.

Next Steps

While the proposal was adopted unanimously, several commissioners raised concerns about the methods, fairness and cost of the amendments as currently proposed. The SEC has requested comments on the proposed rule changes and has solicited input from the public on specific issues such as available alternatives, the reasonableness of cost burdens and the effectiveness of the proposed rules in protecting investors. While hundreds of comments have already been submitted, it is not too late to submit additional comments. Comments on the proposed rule changes are due by July 28, 2009.3