pdf

SEC Adopts Amendments to Custody Rule

January 1, 0001

 

On December 16, 2009, the Securities and Exchange Commission (“SEC”) voted to adopt significant changes to Rule 206(4)-2 (“Custody Rule”) under the Investment Advisers Act of 1940, as amended (“Advisers Act”).[1] As revised, the Custody Rule generally requires advisers registered with the SEC: (i) to maintain client funds and securities with a qualified custodian; (ii) to have the qualified custodian send account statements directly to advisory clients;, (iii) to undergo an annual surprise examination by an independent public accountant to verify client assets; and (iv) unless client assets are maintained by an independent custodian (a custodian that is not the adviser itself or a related person), to obtain a report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board (“PCAOB”). The SEC also made related amendments to the Form ADV and to the books and records requirements that apply to advisers.

Set forth below is an overview of the revised Custody Rule and suggested steps that advisers should consider taking to ensure compliance with its requirements.

Client Funds and Securities Must be Maintained With a Qualified Custodian

The revised Custody Rule continues to require that client funds and securities be maintained by a qualified custodian: (i) in a separate account for each client under that client’s name; or (ii) in accounts that contain only the adviser’s clients’ funds and securities, under the adviser’s name as agent or trustee for the clients. This requirement does not apply to “privately offered securities,” which are defined as 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; and
  • transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

Notice to Clients of Accounts Maintained with Qualified Custodians

The revised Custody Rule continues to require advisers to notify each client in writing of the name and address of each qualified custodian that maintains an account for the client’s benefit and to indicate whether the account is in the client’s name or the name of the adviser for the benefit of the client (“Qualified Custodian Notice”). Notice of any changes to this information also must be provided.

The revised Custody Rule provides an exception to the Qualified Custodian Notice requirement for advisers to private funds (i.e., limited partnerships or limited liability companies or other types of pooled investment vehicles). This exception is available to advisers only with respect to their private fund clients if the beneficial owners are provided audited financial statements annually (the “Annual Audit Exception”). In order for an adviser to rely upon the Annual Audit Exception, the adviser must ensure that its private fund clients are audited at least annually and distribute their audited financial statements prepared in accordance with Generally Accepted Accounting Principles (“GAAP”) to all beneficial owners within 120 days of the end of the fund’s fiscal year (or 180 days in the case of a fund of funds). The independent public accountant conducting the audit must be registered with, and subject to regular inspection by, the PCAOB. In addition, the private fund must be audited upon liquidation of the fund and audited financial statements prepared in accordance with GAAP must be provided to all beneficial owners promptly after completion of the liquidation audit.

Delivery of Account Statements and Notice to Clients

Advisers are required to have a reasonable basis, after “due inquiry,” for believing that the qualified custodian sends an account statement, at least quarterly, to each client for whom the qualified custodian maintains funds or securities.[2] Advisers that comply with the Annual Audit Exception are not required to have a reasonable basis for believing that statements are provided to private fund clients and investors in those funds.

Advisers that provide account statements to clients and that are required to provide Qualified Custodian Notices must include in the notice and any subsequent account statements sent to the client, a statement urging the client to compare the account statements from the custodian with those from the adviser.

Annual Surprise Examination of Client Assets

Advisers with custody of client assets must undergo an annual surprise examination and verification of those assets by an independent accountant.[3] In each case, the independent public accountant would be required to verify the client funds or securities of which the adviser is deemed to have custody. The SEC provided guidance in a separate release as to how accountants should conduct surprise examinations.[4] In addition, the SEC revised the Custody Rule to require that surprise examinations cover privately offered securities and mutual fund shares.

The accountant performing the surprise examination must notify the SEC by filing Form ADV-E:
  • Within 120 days after completing a surprise examination describing the nature and extent of the examination;
  • Within 1 business day of finding any material discrepancies during the course of the examination; and
  • Within 4 business days upon resignation or dismissal, or other termination of the engagement with the adviser (notice to include a statement specifying the date of resignation or dismissal and an explanation of any problems relating to examination scope or procedures that contributed to such resignation or dismissal).

In those instances where an adviser is deemed to have custody solely because a related person serves as the qualified custodian, but the adviser is otherwise operationally independent[5] of the custodian, the adviser is not required to obtain a surprise examination. The requirement to have a surprise examination also does not apply to registered advisers who have custody of client assets solely because of their authority to deduct advisory fees from client accounts. In addition, advisers to private funds are not required to undergo a surprise examination with respect to their private fund clients provided that they satisfy the requirements for the Annual Audit Exception. However, advisers to private funds and separate accounts are required to have a surprise examination with respect to their separate accounts.

The SEC amended the books and records requirements[6] for advisers to require advisers to maintain a memorandum describing the relationship with the related person custodian and the basis for determining that the related person is operationally independent of the adviser.

Adviser or Related Person Serves as Qualified Custodian

The revised Custody Rule requires that when the adviser or a related person acts as the qualified custodian for client funds and securities, the adviser must annually obtain, or receive from the related person, an internal control report (“Internal Control Report”). The Internal Control Report must be prepared by an independent public accountant registered with, and subject to regular inspection by the PCAOB, and include an opinion as to whether the custodian has controls that are suitably designed and are operating effectively to, among other things, safeguard client funds and securities.

Delivery of Account Statements and Audited Financial Statements to Related Persons

Advisers are prohibited from using layers of private funds to avoid delivery of quarterly account statements or annual audited financial statements to beneficial owners. Sending an account statement or audited financial statement solely to beneficial owners that themselves are private funds and related persons of the adviser will not satisfy the Custody Rule.

Compliance Policies and Procedures

The SEC has provided guidance with respect to certain policies and procedures that registered advisers with custody of client assets should consider adopting as part of their compliance programs. Several of the SEC’s recommendations would require the adviser to:
  • Conduct background checks and credit checks on employees who have access to client assets;
  • Require the authorization of more than one employee before the movement of assets within, and withdrawals or transfers from, a client account;
  • Limit the number of employees who are permitted to interact with custodians with respect to client assets and rotate them on a periodic basis; and
  • If the adviser also serves as a qualified custodian for client assets, segregate the duties of its advisory personnel from those of the custodial personnel to make it difficult for any one person to misuse client assets without being detected.

Amendments to Form ADV

The SEC amended Part 1A and Schedule D of Form ADV to require registered advisers with custody of client assets to report more detailed information about their custody practices. Specifically, registered advisers are required to disclose all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds or securities, and to report whether the adviser has determined that it is operationally independent from a related person custodian. Advisers are also required to provide additional information about their custodial practices and report the amount of client assets and the number of clients for which they or a related person have custody. Finally, advisers are required to identify and provide certain information about the accountants that perform annual financial statement audits or surprise examinations and/or prepare Internal Control Reports.

Effective Date

Registered advisers must comply with the revised Custody Rule by March 12, 2010, except as described below:
  • Surprise Examination: Advisers required to obtain a surprise examination 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 Custody Rule after the effective date, within six months of becoming subject to the requirement. For advisers that have a related person custodian for client funds or securities, the surprise examination must be completed within six months of receiving the Internal Control Report.
  • Internal Control Reports: An adviser required to obtain an Internal Control Report because it or a related person maintains client assets as a qualified custodian must obtain such report within six months of becoming subject to the requirement.
  • Annual Audits of Limited Partnerships: An adviser to a private fund may rely on the Annual Audit Exception if the adviser (or a related person) becomes contractually obligated to obtain an audit of the financial statements of the private fund for fiscal years beginning on or after January 1, 2010 by an independent public accountant registered with, and subject to regular inspection by, the PCAOB.
  • Form ADV: Registered advisers must provide responses to the revised Form ADV in their first annual amendment after January 1, 2011.

The Revised Custody Rule Does Not Address How Advisers are to Custody Hard to Custody Assets

The revised Custody Rule assumes that securities can be custodied by a custodian or will satisfy the requirements of the privately offered securities exemption. However, because of the breadth of the definition of “security” under the Advisers Act, the revised Custody Rule includes many assets that are not “securities” for common law purposes and are difficult to maintain in custody. By way of example, bank loans may constitute “securities” for purposes of the Custody Rule, but do not constitute “securities” for common law purposes and may not satisfy the third prong of the privately offered security exemption (that any transfer require the consent of the issuer).

In the distant past, bank loans constituted an instrument represented by a note that had independent legal significance. It was possible to transfer the loan by delivery of the note, properly endorsed. In most cases, modern bank loans represent contractual rights. Even if represented by an instrument, the instrument has no independent legal significance, and the obligations under the loan can only be transferred on the books of the agent under the applicable credit agreement. Requiring investment advisers to lodge the credit agreement or any note with a custodian[7] is ineffective to limit the investment adviser’s ability to transfer the bank loan.

In current custody practice, a bank loan could be registered in the name of a custodian that is a securities intermediary (as defined in Article 8 of the Uniform Commercial Code which is in effect in virtually all states) and held by credit to a properly constituted securities account. In many cases, however, bank loans represent bilateral obligations and embody a commitment or other executory obligations on the part of the holder. In such cases, many securities intermediaries are unwilling to be designated as the registered holder of the bank loan because that status entails a corollary obligation to perform the lender’s duties under the terms of the bank loan.

Steps Advisers Should Consider Taking to Ensure Compliance with the Revised Custody Rule

While a number of provisions of the revised Custody Rule have extended effective dates, advisers should consider taking the following steps to ensure compliance with the rule:
  • Determine whether the surprise examination and the Internal Control Report will apply and, if so, identify and retain an independent public accountant;
  • Determine whether the adviser and any related person custodian are operationally independent and prepare the memorandum documenting the basis for such conclusion;
  • Review and, if necessary, revise supervisory procedures to ensure that they are sufficient to ensure compliance with the requirements of the revised Custody Rule;
  • Review all client accounts to ensure that they are in the name of the client or are in the name of the adviser as agent or trustee;
  • Review all client securities to ensure that they are either held by a qualified custodian or satisfy the requirements of the privately offered securities exemption; and
  • Consider depositing with a qualified custodian a copy of the contract or other documents related to those securities that are not capable of being held by a qualified custodian and do not satisfy the exemption for privately offered securities.



[1] See Custody of Funds or Securities of Clients by Investment Advisers, Investment Advisers Act Release No. 2968, (December 30, 2009).

[2] The SEC noted that this can be accomplished by having the qualified custodian provide the adviser with a copy of the account statement that was delivered to the client or by having the custodian confirm in writing each quarter that it has sent account statements to the adviser’s clients.

[3] If the adviser or a related person (e.g., an affiliate of the adviser) maintains client assets as a qualified custodian, the surprise audit would have to be performed by an independent public accountant registered with, and subject to regular inspection by, the PCAOB.

[4] See Commission Guidance Regarding Independent Public Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the Investment Advisers Act of 1940, Investment Advisers Act Release No. 2969 (December 30, 2009).

[5] A related person is presumed not to be operationally independent unless each of the following conditions are met and no other circumstances can reasonably be expected to compromise the operational independence of the related person: (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 of or possession of, or direct or indirect access to client assets of which the related person has custody, or the power to control the disposition of such client assets to third parties for the benefit of the adviser or its related person, or otherwise have the opportunity to misappropriate such client assets; (iii) advisory personnel and personnel of the related person who have access to advisory client assets are not under common supervision; and (iv) advisory personnel do not hold any position with the related person or share premises with the related person.

[6] 17 CFR §275.204-2 (2009).

[7] Based on past discussions with the SEC staff and from guidance provided in a Q&A published by the staff, we understand that for assets that can’t be custodied by a qualified custodian and don’t satisfy the privately offered securities exemption, a copy of the contract or other document must be deposited with a qualified custodian. See Q&A VII.2, Staff Responses to Questions About Amended Custody Rule, available at http://www.sec.gov/divisions/investment/custody_faq.htm. The SEC did not address whether the previously issued Q&As will continue to apply to the revised Custody Rule.