SEC Proposes Changes to the Custody Rule that Go Too Far; Impose Significant Costs and Fail to Address Shortcomings in the Existing Rule

January 1, 0001


On May 20, 2009, the Securities and Exchange Commission (“SEC”) proposed (“Proposal”) amendments to the rule that requires registered investment advisers with actual or constructive custody of client funds and securities to maintain such assets with qualified custodians. As amended, Rule 206(4)-2 (“Custody Rule”) under the Investment Advisers Act of 1940 (“Advisers Act”) would impose additional burdens and controls on registered investment advisers without providing a proportionate benefit to clients. The proposed amendments are intended to target recently disclosed misappropriations of client assets by registered investment advisers and restore public confidence in the investment advisory industry and the SEC.

The Proposal would, among other things, (i) impose significant costs on investment advisers by requiring surprise examinations and internal control opinions, and (ii) incentivize banking organizations to provide discretionary advisory services through banks exempt from registration as opposed to through an affiliated registered adviser. The Proposal fails to address problems under the current Custody Rule with respect to the custody of hard-to-custody assets, such as loans, and fails to answer basic question such as the treatment of pledged assets. An overview of the Proposal and a more detailed discussion of these compliance issues is set forth below.

1.  2009 Proposed Amendments to the Custody Rule

A.  Annual Surprise Audit

Under the Proposal, all registered investment advisers with custody of client funds or securities (including advisers that are dually registered as broker-dealers and may act as qualified custodians for their client assets) would be required to engage an independent public accountant to conduct an annual surprise examination of client accounts. If the investment 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 Public Company Accounting Oversight Board (“PCAOB”).

In each case, the independent public accountant would be required to verify all of the client funds or securities of which the adviser is deemed to have custody, including funds or securities maintained with a qualified custodian as well as assets maintained by the adviser itself, such as privately offered securities[1] and mutual fund shares.[2]

In contrast to the current Custody Rule, this surprise annual examination is required whether a qualified custodian directly provides quarterly account statements to clients (as opposed to account statements delivered to clients by the adviser), or in the case of a pooled investment vehicle, the pool is audited at least annually and distributes its audited financial statements to investors within 120 days (or 180 days in the case of a fund of funds) after the end of its fiscal year.

B.  Annual Opinion from Independent Public Accountant

If an investment adviser (or a related person) is a qualified custodian and maintains custody of client funds or securities, the Proposal would require the adviser to obtain (or its related person to deliver) an annual written report as to the controls of the qualified custodian with an opinion by an independent public accountant registered with, and subject to regulation by, the PCAOB (the “Control Report”). The Control Report must be issued in accordance with PCAOB standards, and include a description of the adviser’s controls in place relating to custodial services, including the safeguarding of cash and securities held by the adviser or a related person on behalf of the adviser’s clients, and tests of operating effectiveness.

C.  Delivery of Account Statements and Notice to Clients

Under the current Custody Rule, an investment adviser that maintains client funds or securities with a separate qualified custodian has the option to send quarterly account statements to clients so long as the investment adviser undergoes an annual surprise examination. Under the Proposal, this option would be eliminated, and all registered investment advisers with custody of client assets would be required to have a “reasonable basis” for believing the qualified custodian sends an account statement, at least quarterly, to each client for whom the qualified custodian maintains funds or securities. In the case of pooled investment vehicles, the Proposal would not eliminate the exception that permits an adviser to avoid sending any quarterly account statements if audited financial statements are sent to investors in such pooled investment vehicles within 120 days of the pooled investment vehicles’ fiscal year-end (or 180 days in the case of a fund of funds). As a result, fund managers are not required to provide quarterly account statements to investors under the amendments so long as they distribute timely audited financial statements to clients.

D.  Amendments to Form ADV

The Proposal would also amend Part 1A and Schedule D of the Form ADV to require registered investment advisers to report on Schedule D all related persons that are broker-dealers, and to identify which related persons, if any, serve as qualified custodians with respect to the adviser’s clients’ assets. Item 9 of Part 1A of the Form ADV would be amended to require, among other things, advisers that have custody (directly or indirectly through related persons) of client assets 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.

2.  The Proposal Would be Costly and Fails to Address Certain Shortcomings of the Current Custody Rule

The proposed amendments create, or in certain instances fail to address, the following compliance issues.

A.  The Proposed Amendments will Impose Significant Costs on Investment Advisers without Providing a Proportionate Benefit to Clients

Prompted by the SEC’s embarrassment at missing the Madoff fraud, the Proposal goes too far. The cost of the requirement that investment advisers engage independent accountants to verify 100% of client securities positions far exceeds the risk of loss. While there may be merit in a requirement that securities are periodically verified, the objectives would be satisfied by permitting accountants to select a risk-based sample for consideration. Moreover, to the extent that client assets are reported to them on statements produced by qualified custodians that are subject to supervisory oversight of other Federal regulatory agencies, the SEC should defer to such qualified custodians’ other regulators to ensure that they properly custody client assets.

Instead of requiring all advisers to have a surprise audit conducted annually, the staff should seek to leverage existing regulatory requirements that provide protection against the loss of customer securities. For example, the surprise audit requirement provides little additional protection against the loss of customer securities over what would be provided by expanding the scope of the annual audit that private investment vehicles already are required to have to include verification of securities that are at a high risk of loss. The audit could include verifying that assets subject to custody have been appropriately custodied since acquisition and, thereby, eliminate the need for assets to be verified by surprise.

The requirement that a Control Report be obtained whenever an investment adviser or a related person acts as a qualified custodian and maintains custody of client funds or securities goes too far because the cost of obtaining the report will, in many instances, outweigh its benefit. For example, the cost of obtaining a Control Report when an adviser or a related person custody only a small percentage of client assets will exceed the benefit when the potential risk of loss is considered.

B.  The Proposed Amendments Incentivize Banking Organizations to Restructure Discretionary Advisory Services

The disproportionate costs and burdens associated with the surprise audit and the Control Report requirement are likely to incentivize banking organizations that custody assets with affiliated banks to shift discretionary investment advisory activities from registered investment advisers to the bank.[3]

C.  Hard to Custody Assets

The current Custody Rule and the Proposal assume that securities are either capable of being custodied by a custodian or will satisfy the requirements of the privately offered securities exemption. Because of the breadth of the definition of “security” under the Advisers Act, the 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[4] 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 (“Article 8”) 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.

Because bank loans and other hard to custody assets have become more common subjects of asset management, the failure of the SEC to prescribe a rational approach for the custody of such assts has become a more critical issue. The SEC needs to undertake a disciplined and legally informed assessment of this issue as part of its consideration of the Proposal.

D.  Pledged Assets

Another problem under the current Custody Rule on which the SEC is silent under the Proposal is the treatment of collateral arrangements. On examination, SEC staff has objected to collateral arrangements in which securities or funds of a debtor client have been delivered to a secured party creditor (such as under an OTC derivative). In such instances, the staff has criticized the investment adviser on the grounds that such assets must be held by a qualified custodian. We disagree with the staff’s position that the Custody Rule requires a qualified custodian to hold custody of funds or securities pledged to secure obligations of an advisory client. Such a conclusion would preclude advisory clients from incurring secured obligations or impose on them more costly means of securing such obligations, an outcome that was not discussed or contemplated by the SEC when it overhauled the Custody Rule in 2004 and that would be inconsistent with the purpose of the Custody Rule. Securities pledged by delivery of a certificated security to a secured party are not subject to the Custody Rule because, under applicable state law, such a pledge is the equivalent of a sale of the security and the pledgor receives ― in addition to the rights incidental to the obligation ― contractual rights that are not capable of being reduced to possession or control by a custodian.


[1] The current Custody Rule exempts privately offered securities from all requirements of the Custody Rule. Rule 206(4)-2(b)(2). A privately offered security is a security that is:

    1. acquired from the issuer in a transaction or chain of transactions not involving any public offering;

    2. uncertificated, and ownership thereof is recorded only on books of the issuer or its transfer agent in the name of the client; and

    3. transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

Id. The Proposal exempts privately offered securities from the requirement that client assets be maintained with a qualified custodian, but not from the other requirements, including the surprise annual examination.

[2] In the case of mutual fund shares, an investment adviser is permitted to use the mutual fund's transfer agent in lieu of a qualified custodian. Rule 206(4)-2(b)(1).

[3] Banks are excluded from the definition of “investment adviser” by Section 202(a)(11) of the Advisers Act.

[4] 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.