The Securities and Exchange Commission (“SEC” or the “Commission”) has amended Rule 206(4)-2 under the Investment Advisers Act of 1940 (the “Custody Rule”) to impose new requirements on SEC-registered investment advisers, including annual “surprise examinations” to verify client assets and "internal control reports" with respect to the safekeeping of assets. The new amendments will not make any significant changes for advisers to pooled investment vehicles that timely deliver annual audited financial statements to their investors and that do not hold assets as a qualified custodian themselves or through a related person. In adopting the amendments, the SEC provided new guidance for registered investment advisers regarding custody policies and procedures and made amendments to Form ADV requiring additional disclosure about custody practices. The effective date of the amendments is March 12, 2010. All registered investment advisers should review their custody arrangements to determine the applicability of the new amendments and should update their custody policies and procedures and Form ADV disclosures as appropriate.
The new amendments to the Custody Rule are the result of a review commenced by the SEC in the wake of the Madoff scandal and several other high-profile Ponzi schemes involving misappropriation of customer assets held by fiduciaries and their affiliates. The SEC proposed amendments to the Custody Rule on May 20, 2009, and received over 1,300 comment letters in response. After making several modifications to the proposed amendments, on December 16, 2009, the Commission voted to adopt the amendments, and the final rule (the “Amended Rule”) was set forth in an adopting release dated December 30, 2009 (the “Adopting Release”).
The Amended Rule effects three significant changes:
- Surprise Examinations. With certain exceptions, SEC-registered advisers will be required to undergo a “surprise examination” by an independent public accountant to verify client assets on an annual basis. This requirement does not apply: (a) in the case of pooled investment vehicles whose financial statements are annually audited by an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (“PCAOB”) and are timely delivered to investors (the “Pooled Vehicle Annual Audit Exception”); (b) in the case of advisers who are deemed to have custody only because of their ability to deduct fees from the client’s account; and (c) in the case of advisers who are deemed to have custody only because a related person has custody, where the adviser and the related person are “operationally independent.” With respect to a managed account, an adviser must consider the specific terms in its managed account agreement to determine whether the adviser has custody of the managed account’s funds or securities and whether the adviser will be subject to the surprise examination requirements under the Amended Rule.
- Internal Control Reports. Where the SEC-registered adviser or certain related persons1 maintain client assets as a “qualified custodian,”2 the adviser must obtain, on an annual basis, an “internal control report” (such as a Type II SAS 70 report) from an independent public accountant, registered with, and subject to regular inspection by, the PCAOB, as to the suitability and effectiveness of the adviser’s custody controls.
- New Policies and Procedures. The Adopting Release provides specific guidance regarding the types of internal controls that advisers should consider implementing with respect to the safekeeping of client assets. Examples include controls over the movement of client assets, testing the effectiveness of the firm’s controls over the safekeeping of client assets, and particular attention to the deduction of advisory fees directly from client accounts.
Under the Amended Rule, SEC-registered advisers still must have a qualified custodian maintain client funds and securities in a separate account for each client under the client’s name or in accounts that contain only client funds and securities under the adviser’s name as agent or trustee for the client. The Amended Rule also retains an exception for certain private securities (“Privately Offered Securities”) that does not require such securities to be maintained by a qualified custodian because the limited transferability of Privately Offered Securities makes them less likely to be subject to the risk of misappropriation.
Where the Pooled Vehicle Annual Audit Exception does not apply, advisers are still required to (1) provide notices to clients, including a new requirement that advisers include a notice in any client account statements the adviser sends to clients urging the client to compare the account statements from the custodian with those from the adviser; and (2) have a reasonable basis, after due inquiry, for believing that the qualified custodian sends quarterly account statements to the clients for which it maintains funds or securities. The latter requirement typically will be satisfied if the qualified custodian provides the adviser with a copy of the account statements that were delivered to the clients.3 It is important to note that these two requirements will apply even with respect to Privately Offered Securities and even where the adviser only is deemed to have custody because of the ability to deduct fees. The following chart presents a high-level overview of the Rule’s requirements and certain common exceptions or exclusions from those requirements. It is intended to highlight key issues and not to provide a complete analysis of the Rule’s requirements.
Please click here to view table.
II. Surprise Examination
Under the Amended Rule, except as discussed below, SEC-registered advisers that maintain custody of client funds or securities are required to engage an independent public accountant to conduct an annual surprise examination to verify client assets.4 A registered investment adviser is deemed to have custody of the funds or securities in an account, and will be subject to the Custody Rule, where:
- the adviser has possession of client funds or securities (but not of checks drawn by clients and made payable to third parties) unless the adviser receives them inadvertently and returns them to the sender promptly but in any case within three business days of receiving them;5
- the adviser has entered into an arrangement (including a general power of attorney) under which the adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the adviser’s instruction to the custodian;6 or
- the adviser acts in any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position, or trustee of a trust) that gives the adviser or the adviser’s supervised person legal ownership of, or access to, client funds or securities.7
Generally, SEC-registered advisers to hedge funds and other pooled investment vehicles will be deemed to have custody but will be able to rely on an exception to the surprise examination requirement (see below). Where a surprise examination is required, important new guidance from the SEC Staff provides that the verification can be performed on a sampling basis and need not cover 100% of the assets.8 “For a sample of client accounts, the accountant should obtain records of the purchases, sales, contributions, withdrawals and any other debits or credits to each selected client’s account occurring since the date of the last examination.”9 The procedures should normally include confirmation from the qualified custodians, confirmation from the clients and reconciliation of confirmations received and other evidence of the adviser’s records.10
The accountant conducting the surprise examination must include Privately Offered Securities in its examination.11 Under the prior rule, Privately Offered Securities were completely exempted from the rule’s requirements, provided that for pooled investment vehicles, the annual financial statements were timely delivered to investors.12 Under the Amended Rule, Privately Offered Securities are still exempt from the requirement that a qualified custodian maintain the securities; however, the requirements related to notice (Rule 206(4)-2(a)(2)), account statements (Rule 206(4)-2(a)(3)) and surprise examination (Rule 206(4)-2(a)(4)) will apply to Privately Offered Securities, unless those requirements are satisfied by the Pooled Vehicle Annual Audit Exception. (For a discussion on how this may affect managed accounts, please see below.)
The accountant conducting a surprise examination is required to notify the SEC staff within one day of finding any material discrepancies including misappropriation of funds or securities.13 A “material discrepancy” means material non-compliance with either Rule 206(4)-2 (the Custody Rule) or Rule 204-2(b) (the books and records rule applicable to advisers with custody).14 The accountant also is required to file with the SEC Form ADV-E, describing the nature and extent of the examination, within 120 days of the selected examination date.15 The SEC will maintain files of the information on Form ADV-E and will make the information publicly available.16 A termination statement must be filed by an accountant within four business days of its resignation, dismissal or removal,17 and such statement will also be made publicly available.18
A. Exceptions to Surprise Examination Requirement
1. Pooled Investment Vehicles
For many advisers to pooled investment vehicles, the new amendments to the Custody Rule will not significantly change the adviser’s obligations. The surprise examination requirement will be deemed satisfied if: (1) the pooled vehicle is audited annually by an independent public accountant registered with, and subject to regular inspection by, the PCAOB;19 (2) financial statements are delivered to investors in the pooled investment vehicle within 120 days of its fiscal year-end;20 and (3) in the event of a liquidation, advisers to pooled investment vehicles obtain a final liquidation audit of the pool’s financial statements in accordance with generally accepted accounting principles and distribute it to investors promptly after completion of the audit.21 While the Amended Rule does not state that funds of hedge funds have 180 days to deliver audited financial statements, as is currently the case, the Adopting Release indicates that investment advisers may rely on previous SEC guidance to the same effect.22
The Amended Rule contains a new provision preventing an adviser from using “layers” of pooled vehicles to avoid reporting requirements. If all of the investors in the pool are themselves pooled investment vehicles that are related persons of the adviser, the delivery of financial statements to the pooled vehicles would be insufficient. Accordingly, where an adviser establishes or controls special purpose vehicles (“SPVs”) for certain investments by pooled investment vehicles managed by the adviser, either: (1) the SPVs themselves are audited and the financial statements provided to the beneficial owners of the pooled investment vehicles; or (2) the adviser treats the SPVs’ assets as assets of the pooled investment vehicles, in which case the adviser would be required to take the SPVs’ assets into consideration when performing the pooled investment vehicles’ audits or surprise examinations.23 The Adopting Release does not address whether the Pooled Vehicle Annual Audit Exception would apply to a single investor fund.
Advisers to pooled investment vehicles also are exempted from the requirement to provide notice to clients when accounts with qualified custodians are opened or changed, and are exempted from the new requirement to send clients a statement urging them to compare the account statements from the custodian with those of the adviser pursuant to Rule 206(4)-2(a)(2). Nor are they required to have a reasonable basis, after due inquiry, to believe that the qualified custodian sends account statements to clients, at least quarterly, under Rule 206(4)-2(a)(3).24 Because investors in pooled vehicles will therefore not regularly receive reports confirming the assets underlying their investments, the SEC expressed concern that the Rule’s protections are insufficient and has directed its staff to explore ways to address this concern without requiring that advisers to pooled vehicles disclose confidential information (for example, a list of investors in the pool) to all of the custodians that hold pooled vehicle assets (which would occur if the Rule required custodians to send statements directly to investors in pooled vehicles).25
2. Advisers Who Have Custody Solely Because of Authority to Deduct Fees
The surprise examination requirement of the Amended Rule does not apply if an adviser has custody solely because it has the authority to make withdrawals from client accounts to pay advisory fees.26 The SEC acknowledged that requiring a surprise examination of assets would not indicate whether fees were calculated and deducted properly.27 The Adopting Release contains ways to mitigate the risks associated with fee deductions in the section discussing compliance policies and procedures (see below).28
3. Custody By An “Operationally Independent” Related Person
SEC-registered advisers deemed to have custody solely because a related person has custody will not be subject to the surprise examination requirement where the adviser and the related person are “operationally independent.”29 The SEC has established a presumption that the adviser is not operationally independent from a related person custodian. This presumption can be rebutted if the adviser establishes that: (i) client assets in the custody of the related person are not subject to claims of the adviser’s creditors; (ii) advisory personnel do not have custody or possession of, direct or indirect access to, or the opportunity to misappropriate, client assets held by the related person; and (iii) the adviser and the related person do not have any overlapping personnel, office space or supervision.30 By way of illustration, the SEC indicated that a related person that shared management personnel with the adviser, including an owner that was actively involved in the management of the two firms, would not be considered operationally independent.31
The Amended Rule requires an adviser whose client assets are held by a related person but does not undergo a surprise examination to make and keep a memorandum describing its relationship with the related person and to include an explanation of the adviser’s basis for determining it has overcome the presumption that it is not operationally independent of the related person.32 Pursuant to amended Rule 204-2, this memorandum must be maintained in the adviser’s books and records for five years from the end of the fiscal year in which it is finalized.
B. Applicability to Managed Accounts
As noted above with respect to the definition of “custody” under the Amended Rule, an adviser is deemed to have custody where, among other things, the adviser is permitted to withdraw client funds or securities or acts in a capacity such as general partner, managing member or trustee. Accordingly, an adviser to a managed account must consider the specific terms of the managed account agreement to determine whether the adviser has custody of the managed account’s funds or securities and whether the adviser will be subject to the surprise examination requirements under the Amended Rule. For example, if a managed account is established in the client’s name at the custodian and the adviser only has trading authority, then the adviser would not be deemed to have custody.
Importantly, advisers that maintain custody of Privately Offered Securities for managed accounts (or have their related person maintain custody of Privately Offered Securities for such managed accounts) are subject to the surprise examination requirements of the Amended Rule with respect to such Privately Offered Securities.33 The SEC declined to provide additional guidance on exactly what constitutes a Privately Offered Security, other than to indicate that the Amended Rule retains the definition of Privately Offered Securities which are securities that are:
- acquired from the issuer in a transaction or chain of transactions not involving any public offering;
- uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and
- transferable only with the prior consent of the issuer or holders of the outstanding securities of the issuer.34
III. Internal Control Report
Where an SEC-registered adviser or a related person maintains client assets and serves as qualified custodian, the adviser must obtain, or receive from its related person, an annual internal, written report regarding custody controls (the “internal control report”), which includes an opinion from an independent public accountant registered with, and subject to regular inspection by, the PCAOB.35 Related person custodians may include broker-dealers and banks that are part of the same “multi-service financial organization” as the adviser.36 The internal control report is required in addition to the surprise examination and regardless of whether an adviser may be exempt from the surprise examination requirement. For instance, an adviser to pooled investment vehicles that maintains client assets as a qualified custodian will be deemed to have complied with the surprise examination requirement (if the adviser satisfies the Pooled Vehicle Audit Exception) but still must obtain an internal control report.37
The independent public accountant must prepare an internal control report (such as a Type II SAS-70 report) giving an opinion as to the suitability and effectiveness of the adviser’s (or related person’s) custody controls.38 The internal control report is intended to demonstrate that the adviser (or its related person) has established appropriate custody policies and procedures, maintains controls relating to its custodial services and the safeguarding of client assets, tests the operating effectiveness of those controls and provides the results of those tests.39 The Commission has adopted amendments to Advisers Act Rule 204-2 requiring the internal control report to be maintained in the adviser’s books and records for five years from the end of the fiscal year in which it is finalized.40
IV. Commission Guidance Regarding Policies and Procedures
Under the Advisers Act “Compliance Rule” (Rule 206(4)-7), registered advisers with custody of client assets must adopt custody controls that are “reasonably designed to prevent misappropriation or misuse of client assets, develop systems or procedures to assure prompt detection of any misuse, and take appropriate action if any misuse does occur.”41 In the Adopting Release, the SEC provides specific guidance regarding the types of policies and procedures advisers should consider relating to the safekeeping of client assets. The SEC encourages investment advisers to consider amending their written policies and procedures to include:
- conducting background and credit checks on employees who have, or could acquire, access to client assets (funds or securities) to determine if it would be appropriate for those employees to have such access;
- requiring the authorization of more than one employee to move assets within, and withdraw or transfer from, a client account, as well as make changes to ownership information;
- limiting the number of employees who are permitted to interact with custodians and rotating them on a periodic basis;
- if also serving as a qualified custodian, segregating the duties of advisory personnel from those of custodial personnel;
- developing policies regarding the ability of individual employees to acquire custody, because their custody will be attributable to the adviser, which will thereby acquire responsibility for those assets under the rule. Advisers that permit employees to serve in a capacity where the adviser acquires custody should implement policies where their employees’ custodial practices conform to the adviser’s policies and the adviser’s Chief Compliance Officer has sufficient information to enforce such policies; and
- reporting any problems immediately to the attention of the adviser’s Chief Compliance Officer or other management personnel.42
The SEC also suggests advisers periodically test the effectiveness of their policies and procedures by, for example, testing the reconciliation of account statements as reported by qualified custodians and comparing, on a sample basis, client addresses obtained from the clients’ qualified custodians to which the custodian sends client statements, with client addresses maintained by the adviser, to look for inconsistencies or patterns that suggest manipulation or misappropriation.43
Advisers that have custody as a result of their authority to deduct fees directly from client accounts should have policies that address the risk that the adviser or its personnel could deduct fees to which the adviser is not entitled under the terms of the advisory contract and which may constitute fraud under the Advisers Act. Such policies should: (i) consider how and when clients will be billed; (ii) be reasonably designed to ensure the calculation of assets under management, on which the fee is billed, is accurate; and (iii) be reasonably designed to ensure that clients are billed accurately. The SEC suggests the following policies as examples such advisers should consider:
- periodic testing on a sample basis of fee calculations to determine their accuracy;
- testing the overall reasonableness of the amount of fees deducted from all client accounts for a period of time based on the adviser’s aggregate assets under management; and
- segregating duties between those personnel responsible for: (1) processing billing invoices; (2) reviewing the invoices for accuracy; and (3) reconciling those invoices with deposits of advisory fees by the custodians into the adviser’s proprietary bank account.44
The SEC acknowledges in the Adopting Release that compliance programs will vary for different advisers based on the size of the adviser and the risks raised by the adviser’s business.45
One noteworthy suggestion by the SEC is that advisers to pooled vehicles consider applying custody control procedures to investor accounts within the pool, to protect against an employee misappropriating investor assets by processing false investor withdrawals.46
V. Form ADV Amendments Regarding Custody
The SEC adopted several amendments to Form ADV for investment advisers to report more detailed information about custody practices. This information will be included in the first annual ADV amendment after Jan. 1, 2011. These provisions are intended to provide the SEC staff with more insight into the custody practices of advisers and to better equip them to respond to potential concerns.
- Part 1A, Item 7 will require disclosure of all related persons who are broker-dealers and identification of those broker-dealers that are qualified custodians. On Section 7.A. of Schedule D the adviser will be required to report whether it has determined that it has overcome the presumption that it is not operationally independent from a related person broker-dealer that is its qualified custodian, and, as a result, is not required to obtain a surprise examination.
- Part 1A, Item 9 currently requires the adviser to disclose whether it or a related person has custody of client assets. When the Form ADV is updated, this Item will require disclosure of: (i) the amount of the custodied assets as well as the number of clients for whose accounts the adviser or its related person has custody; (ii) if the adviser or related person acts as adviser to a pooled investment vehicle, whether the pool is audited and whether the qualified custodian sends account statements to investors; (iii) whether an independent public accountant conducts a surprise examination; (iv) whether an independent public accountant prepares an internal control report; and (v) whether the adviser or a related person serves as qualified custodian.
- When the Form is updated, investment advisers to pooled investment vehicles that distribute audited financial statements will be required to check Item 9.C.(2) and indicate on Schedule D, Section 9.C.: (i) the name of the accountant; (ii) the location of the accountant’s office responsible for the audit; (iii) confirm that the accountant is registered with, and subject to regular inspection by, the PCAOB; (iv) confirm that the accountant is engaged to audit a pooled investment vehicle and, if applicable, prepare an internal control report; and (v) confirm that the audit (and the internal control report, if applicable) contains an unqualified opinion.
- In addition to the above new disclosures, Schedule D has been amended so that, in the future, advisers will have to provide information about related persons that serve as qualified custodians that have not been otherwise reported in Item 7. This information will include the qualified custodian’s name, the address of the office responsible for custody of client assets, and whether the qualified custodian is a bank, broker-dealer (that has not already been disclosed in Section 7.A. of Schedule D), futures commission merchant or foreign financial institution. Finally, Section 9.D. of Schedule D will require an adviser to report whether it has determined that it has overcome the presumption that it is not operationally independent from a related person qualified custodian and, as a result, is not required to obtain a surprise examination.
As described above, Form ADV-E has been amended and is now required to be filed after a surprise examinations and upon resignation or dismissal of the accountant.
VI. Timing and Effectiveness of the Amended Rules
The amendments to the Advisers Act Rules 206(4)-2, 204-2, Forms ADV and ADV-E will become effective on March 12, 2010.
Upon the effective date, SEC-registered advisers that have custody of client assets, other than advisers to pooled investment vehicles utilizing the Pooled Vehicle Annual Audit Exception, as described above, must: (1) promptly upon opening a custodial account, send a notification to the client, including a legend urging the client to compare account statements the client receives from the custodian with account statements received from the adviser; and (2) have a reasonable belief that a qualified custodian sends account statements directly to clients at least quarterly.47
An adviser that is subject to the surprise examination requirement must enter into a written agreement with an independent public accountant that provides that the first examination will take place by December 31, 2010 or, for advisers that become subject to the rule after the effective date, within six months of becoming subject to the requirement.48 If the adviser maintains client assets as a qualified custodian, however, the agreement with the independent public accountant must indicate the first surprise examination will occur no later than six months after obtaining the internal control report.49 If applicable, advisers must obtain internal control reports within six months of becoming subject to the requirement. An adviser obtaining an internal control report because such adviser (rather than a related person) also serves as qualified custodian of its clients’ assets need not undergo a surprise examination until six months after obtaining the internal control report.50
Advisers to pooled investment vehicles may rely on the annual audit provision if the adviser is contractually obligated to obtain the audit by an independent public accountant registered with, and subject to inspection by, the PCAOB, of the financial statements of the pooled investment vehicle for fiscal years beginning on or after January 1, 2010.51
Responses to the revised Form ADV must be provided by advisers in their first annual amendment after January 1, 2011.52 Accountants will file ADV-E forms in paper format until electronic filing becomes available. The SEC anticipates that the amended Forms ADV and ADV-E will be available online in the fourth quarter of 2010.
The new amendments to the Custody Rule impose significant new requirements. However, for many hedge fund managers there may be little change from their current practice. Registered investment advisers should create an inventory of all of the accounts they manage, the categories of assets held in these accounts and the custodians that hold these assets. Advisers should then evaluate:
(1) whether they have “custody” under the Custody Rule;
(2) whether they can satisfy the surprise examination requirement by qualifying for the Pooled Vehicle Annual Audit Exception;
(3) whether they can satisfy the surprise examination requirement by qualifying for the exception for advisers only deemed to have custody because they deduct fees;
(4) whether they advise managed accounts holding Privately Offered Securities that would be subject to the surprise examination requirement; and
(5) whether they or a related person hold securities as a qualified custodian, making them subject to the internal control report requirement.
In addition, advisers should consider whether their custody-related policies and procedures should be updated and whether Form ADV needs to be amended.
The text of the Amended Rule is below, and the Adopting Release can be accessed using this link: http://edocket.access.gpo.gov/2010/pdf/2010-18.pdf. The Accounting Release can be accessed using this link: http://edocket.access.gpo.gov/2010/pdf/2010-19.pdf