Advisers Should Evaluate Compliance with Custody Rule Following SEC Risk Alert and Investor Bulletin

March 7, 2013


On March 4, 2013, the Securities and Exchange Commission (“SEC”) issued a Risk Alert and Investor Bulletin related to custody of client funds and securities by investment advisers. In the Risk Alert, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) identifies common deficiencies observed during examinations and reminds advisers of their obligations[1]. In the Investor Bulletin, the SEC’s Office of Investor Education and Advocacy (“OIEA”) instructs investors to discuss custody issues with their advisers and conduct their own due diligence[2]. In this Client Alert, we discuss the requirements of the Custody Rule and summarize the OCIE and OIEA bulletins.

The Custody Rule

Rule 206(4)-2 (the “Custody Rule”) under the Investment Advisers Act of 1940 (“Advisers Act”) requires registered investment advisers who have “custody” of client assets to take specific measures to protect those assets. An adviser has custody if the adviser holds or has the authority to obtain possession of client funds or securities. With limited exceptions, advisers with custody must satisfy the following requirements under the Custody Rule:

  • Maintain client funds and securities with a “qualified custodian” and notify clients of the custodial arrangement. Advisers that have custody of client funds or securities must maintain such client assets with a qualified custodian in a separate account for each client under the client’s name, or in an account containing only client funds and securities in the adviser’s name as agent or trustee for the clients. Advisers must notify clients upon engaging a qualified custodian and inform them of any changes in the qualified custodian’s information.
  • Have a reasonable basis for believing the client receives quarterly account statements. The adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of the adviser’s clients for which it maintains funds or securities. Quarterly account statements must include all transactions from the account during the applicable period.
  • Undergo an annual surprise examination. Client funds and securities for which the adviser has custody must be verified at least once during each calendar year by an independent public accountant, pursuant to a written agreement between the adviser and the accountant, and conducted on a surprise basis (“surprise examination”).
  • Satisfy enhanced requirements if the qualified custodian is related to the adviser. If the adviser or a related person serves as the qualified custodian, the adviser must satisfy the heightened requirements of the rule related to the annual surprise examination and the additional requirement that the adviser obtain an annual report of internal controls relating to custody of client assets.

Advisers that manage private funds or other pooled investment vehicles may rely on the “audit exemption” in the Custody Rule in lieu of satisfying the requirements described above. Pursuant to the exemption, an adviser is deemed to comply with the surprise examination requirement and exempt from the notification and quarterly statement requirements with respect to the funds and securities of pooled investment vehicles provided: (i) the adviser obtains GAAP compliant audits of the pooled investment vehicles on an annual basis and distributes the audited financials to investors in the pooled vehicles within 120 days of the end of the pooled vehicle’s fiscal year (180 days for funds of funds); and (ii) obtains an audit upon liquidation of a pool and distributes the audited financial statements promptly after the completion of the audit.

OCIE Risk Alert

OCIE’s Risk Alert describes commonly observed deficiencies in compliance with the Custody Rule and suggests registered investment advisers reassess their policies and procedures. The Risk Alert identifies four categories of custody-related deficiencies as follows:

  • Advisers did not recognize that they had “custody” for purposes of the Custody Rule;
  • Advisers did not fully satisfy the surprise examination requirements;
  • Advisers did not comply fully with the qualified custodian provision; and
  • Advisers relied on the audit exemption in connection with the assets of pooled investment vehicles managed by the advisers but did not satisfy all conditions of the exemption.

Advisers Did Not Recognize That They Had “Custody”

The OCIE Risk Alert notes that advisers often did not realize the following circumstances cause them to have custody under the Custody Rule:

  • The adviser serves as the general partner of a limited partnership or holds a comparable position for a different type of pooled investment vehicle;
  • Advisory personnel manage portfolios without restrictions by directly accessing client accounts online using the clients’ login information;
  • Advisory personnel have power of attorney over a client’s account;
  • The adviser provides bill-paying services for clients and is authorized to withdraw funds or securities from the client’s account;
  • The adviser or a related person has signatory and check writing authority for client accounts;
  • The adviser or advisory personnel receives checks made out to clients and fails to promptly return to sender; and
  • The adviser has physical possession of a client’s securities certificates or other assets.

In assessing whether or not they have custody for purposes of the Custody Rule, advisers should identify if any advisory personnel have the ability to access client funds or securities. Such access, other than for authorized trading, generally constitutes custody even where the adviser or its associated persons do not have actual possession.

Advisers Did Not Fully Satisfy The Surprise Examination Requirements

Examiners identified the following deficiencies related to surprise examinations:

Surprise examinations were not a “surprise” because they occurred around the same time each year; and

The accountants performing the surprise examinations did not timely file a Form ADV-E.

Advisers Did Not Comply Fully With The Qualified Custodian Provision

The Risk Alert identifies the following deficiencies in compliance with the qualified custodian provision of the Custody Rule:

  • Advisers did not comply with an exception to the qualified custodian requirement for privately offered securities where the advisers held the certificates of securities in safe deposit boxes controlled by the adviser;[3]
  • The custodial account was in the adviser’s name as principal rather than as agent or trustee for the client;
  • Advisers comingled proprietary, employee, and client assets;
  • Advisers that opened custodial accounts for clients but separately sent their own statements to clients failed to include a legend in the statements urging clients to compare the advisers’ statements to those sent by the custodians; and
  • Advisers had no reasonable basis for believing that qualified custodians were sending quarterly account statements to clients.

Advisers Did Not Fully Satisfy the Audit Exemption Requirements

OCIE’s Risk Alert notes that examiners identified lapses in compliance with the audit exemption by advisers to private funds or other pooled investment vehicles. The Risk Alert identifies the following deficiencies observed during SEC examinations:

  • The audited financial statements were not prepared in accordance with GAAP because: (i) organizational expenses of the fund were amortized rather than expensed as incurred; (ii) they were prepared on a federal income tax basis; (iii) the accountant could not issue an unqualified opinion on the financial statements because the adviser could not substantiate fair valuations;
  • The accountant that conducted the audit was not “independent” under Regulation S-X;
  • The auditor was not registered with and subject to inspection by the PCAOB;
  • Advisers could not demonstrate that the audited financial statements were distributed to all fund investors and, in some instances, appeared to make the statements “available upon request” rather than distributing them; and
  • The audited financial statements were not sent to investors within 120 days of the private funds’ fiscal year ends (or 180 days for fund of funds).

Fully satisfying the conditions of the audit exemption is particularly important where advisers custody privately offered securities owned by funds. The Custody Rule provides that privately offered securities do not have to be maintained by a qualified custodian and may be maintained by advisers. However, this exception is only available with respect to privately offered securities owned by private funds or other pooled investment vehicles if the adviser fully complies with the audit exemption.

OIEA Investor Bulletin

The OIEA Investor Bulletin provides investors with an overview of the Custody Rule and notes that even though the Custody Rule provides enhanced protections to investors, it is not a substitute for oversight and monitoring by investors. OIEA recommends that investors inquire about custody arrangements and whose name is on the account. Investors should also ensure they receive account statements from a qualified custodian at least quarterly, and that such statements are identical to those provided by the investment adviser.

O’Melveny & Myers is available to advise registered investment advisers and exempt reporting advisers on their compliance obligations with respect to the Advisers Act. In particular, we are able to review and identify any concerns with an adviser’s compliance with the Custody Rule. For questions or additional information regarding such regulatory obligations, please contact Heather Traeger at (202) 383-5232, Kris Easter at (202) 383-5364, or Matthew Cohen at (202) 383-5179.

[1] A copy of the Risk Alert can be found at http://www.sec.gov/about/offices/ocie/custody-risk-alert.pdf
[2] The Investor Bulletin can be found at http://www.sec.gov/investor/alerts/bulletincustody.htm
[3] The Custody Rule contains a narrow exception from the qualified custodian requirement for certain privately offered securities. These securities are defined as privately offered securities that are acquired from an issuer in a private offering and are uncertificated; ownership is recorded only on the books of the issuer or its transfer agent in the name of the client; and transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Heather Traeger, an O'Melveny partner licensed to practice law in the District of Columbia and Texas, Kris Easter, an O'Melveny counsel licensed to practice law in Texas, and Matthew Cohen, an O'Melveny associate licensed to practice law in the District of Columbia and California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

Portions of this communication may contain attorney advertising. Prior results do not guarantee a similar outcome. Please direct all inquiries regarding New York's Rules of Professional Conduct to O’Melveny & Myers LLP, Times Square Tower, 7 Times Square, New York, NY, 10036, Phone:+1-212-326-2000. © 2013 O'Melveny & Myers LLP. All Rights Reserved.