United States: SEC Adopts Final Rule On Advisers Custody

Lawrence Cohen, Esq. Of Counsel.
Stark & Stark, a Professional Corporation (Offices in Lawrenceville and Cherry Hill, NJ and Philadelphia, PA)

Overview. In a development with consequences for both investment advisers and broker/dealers, on September 25, 2003, the SEC adopted amendments to Rule 206(4)-2, the "Custody Rule," under the Investment Advisers Act of 1940 ("Advisers Act"). The rule provides that advisers with custody of client securities or funds are required to implement controls to protect those client assets from being lost, misused, misappropriated, or otherwise subject to the adviser's financial problems. The amended rule is effective November 5, 2003 and the deadline for compliance is August 1, 2004.

Custody Defined. The amendments add a simple definition of "custody": when an adviser holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them. Three examples are provided. First, an adviser has custody when it has possession of client funds or securities, even only briefly. However, the inadvertent receipt by the adviser of client funds or securities is expressly excluded, provided that the adviser returns them to the sender within 3 business days. Further, an adviser's possession of a check drawn by the client and made payable to a third party is not deemed to be possession of client funds.

In the second example, an adviser has custody if it has the authority to withdraw funds or securities from a client's account (e.g., power of attorney). Specifically, an adviser authorized to deduct fees or other expenses directly from a client's account has access to, and therefore has custody of, the client's funds and securities in that account. The third example clarifies that an adviser has custody if it acts in any capacity that gives the adviser legal ownership of or access to the client's funds or securities. For example, a firm that acts as both a general partner and an investment adviser to a limited partnership has custody.

Qualified Custodians. The SEC's amendments require advisers that have custody over client assets to maintain them with a broker/dealer, bank or other "qualified custodian" (including savings associations, futures commission merchants, and foreign financial institutions that customarily hold financial assets for their customers). If the qualified custodian sends account statements directly to an adviser's clients, the adviser is excused from sending the account statements itself. The adviser is also relieved from undergoing an annual surprise exam.

The qualified custodian must hold the funds or securities in an account either under the client's name or under the adviser's name as agent or trustee for its clients. An SEC-registered adviser is also a qualified custodian under the amended rule and may maintain its own client's funds and securities subject to the account statement requirements and the custody rules imposed by the regulators of the adviser's custodial functions.

With respect to mutual fund shares, an adviser may use the transfer agent in lieu of a qualified custodian with respect to those shares. Privately offered, uncertificated securities held in their clients' accounts are excepted from the rule if the ownership of such private securities is recorded only on the books of the issuer or its transfer agent in the name of the client and the transfer of ownership is subject to the prior consent of the issuer or holders of the issuer's outstanding securities. In the case of limited partnerships or other collective investment vehicles, the exception would apply only if the limited partnership or other fund is audited annually and the audited financial statements are distributed as described in the rule. The rule requires that account statements be delivered to clients on quarterly basis. Qualified custodians are required to deliver account statements directly to advisory clients and not through the adviser to ensure the integrity of the accounts statements and permit the clients to identify any erroneous or unauthorized transactions or withdrawals by an adviser. The rule carves out certain categories of clients. For example, advisers need not comply with the rule with respect to registered investment companies, pooled investment vehicles that are audited at least annual and distribute their audited financial statements to all limited partners within 120 days of the fiscal year end, and registered broker/dealers which are qualified custodians under the rule.

As a result of this new rule, the Form ADV (Item 9 of Part 1A) will be amended. Further, the requirement that advisers with custody of client assets include an audited balance sheet in their disclosure statements (Schedule F, Part II) is no longer necessary. As mentioned earlier, the amendments are effective November 5, 2003 but advisers are given until April 1, 2004 to comply.