United States: A Compilation Of Non-Enforcement Actions

Non-Enforcement Matters

SEC Revises Its Custody Rule

The SEC's Custody Rule (Rule 206(4)-2) was recently revised by the SEC* to target the abuses cited in the Madoff Ponzi scheme and other frauds.

The revisions to the Custody Rule (Rule), which are summarized below and effective March 12, 2010, will affect a significant number of registered investment advisers (RIAs), including those who manage private funds. Although the Rule is directly applicable only to those investment advisers registered with the SEC under the Investment Advisers Act of 1940, investment advisers registered under state securities laws also will be subject to these requirements, as many of the state securities laws require a state-registered investment adviser to comply with the SEC's Rule.

The Rule governs the RIA's custody of client funds and securities. The Rule applies if the RIA holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them. Accordingly, having custody includes the obvious and not so obvious situations. An RIA will have custody for, among other things, if the RIA maintains the client's checkbook, if it has the authority to deduct its fees directly from the client's account, if it is the general partner or manager of a private fund in which it has legal ownership or access to the fund's cash or securities, if it or one of its associated persons is a trustee for a client's account, or if an affiliate has custody of client assets. The SEC staff has historically applied an expansive interpretation of when an RIA, directly or indirectly, has custody of client funds or securities.

The Rule requires that the client funds or securities be held by a "Qualified Custodian" (which term includes a bank or registered broker-dealer). The Rule requires the RIA to have reasonable belief that the Qualified Custodian has sent account statements, on at least a quarterly basis, to the clients. The option under the prior Rule for the RIA to send clients the required account statements instead of the Qualified Custodian is no longer available. The reasonable belief requirement can be met by having the RIA receive a copy of the client account statements that were sent by the Qualified Custodian. The SEC has determined that the reasonable belief requirement could not be met by the RIA merely confirming that the account statements were on the Qualified Custodian's Web site. The RIA is required to notify its clients in writing if the client's funds and securities are maintained at a Qualified Custodian and changes in such arrangement. In addition, if the RIA also sends out statements to clients (billing statements, for example), it is required to remind clients on at least an annual basis to compare the RIA's statements with those received by the client from the Qualified Custodian.

The revised Rule requires RIAs that have custody of client funds or securities to have a "surprise examination" conducted during each calendar year by an independent accountant registered and supervised by the Public Company Accounting Oversight Board (PCAOB). The purpose of the surprise examination is to verify that client funds and securities under the custody of the RIA are held by a Qualified Custodian in the manner required under the Rule.

The surprise examination is not required under certain limited exceptions (such as when the RIA's only custody of client funds or securities is tied to its authority to deduct its fees directly from the client's account, or if the Qualified Custodian that is the RIA or is a related person of the RIA can be shown to be "operational independent" of the RIA, or if the RIA provides advice to "a private fund" when an audit of the financial statements of the fund is provided to each fund investor within 120 days of the fund's fiscal year-end). Within 120 days following the surprise examination, the accountant is required to file Form ADV-E with the SEC that serves to report the results of the accountant's examination. Immediate notice is required to be filed with the SEC if the accountant finds any "material discrepancies" during the examination, and notice within four business days of its resignation or dismissal from the engagement and for certain other listed events.

For an RIA that serves as the Qualified Custodian or utilizes a related person to be the Qualified Custodian, an additional requirement is imposed. In such cases, the RIA is required to obtain from the related Qualified Custody, at least annually, an internal control report prepared by an independent accountant registered and supervised by the PCAOB with respect to the Qualified Custodian's internal controls. The required report is commonly referred to as a Type II SAS 70 report. An examination of internal controls conducted in accordance with AT Section 601, Compliance Attestation under the standards of the American Institute of Certified Public Accountants (AICPA) would be a suitable substitute for the Type II SAS 70 report.

The SEC in its companion release to the revised Rule provides guidance to independent accountants with respect to both the surprise examination and internal control report examination requirements.* The SEC also has adopted amendments to Form ADV that are intended to provide more information about the RIA's custody and its practices.

For those RIAs who provide investment advisory services to a private fund, the Rule's requirements are met if the fund's financial statements are audited by a PCAOB-registered accountant, a copy of the statements are provided to each of the fund's investors within 120 days after the fund's fiscal year-end, and a final audit of the fund is conducted when the fund is liquidated at a time other than the end of its fiscal year.

All RIAs with custody will need to review and revise their written policies and procedures to ensure that they are reasonably designed to prevent violations of the revised Rule.

RIAs are expected to be in compliance with the revised Rule by March 12, 2010. For those RIAs subject to the surprise examination requirement due to the revised Rule, they must enter into a written agreement with a PCAOB-registered and supervised accountant to conduct the first examination by no later than December 31, 2010. For those RIAs subject to the internal control report requirement, the surprise examination need not be conducted until six months after the RIA receives the internal control report. The first internal control report must be received by the RIA by no later than September 12, 2010.

RIAs who rely on the private fund audit exception to the surprise examination requirement must enter into a written agreement with an independent PCAOB-registered and supervised accountant to conduct the first audit of the fund for the fiscal year beginning on or after January 1, 2010. Amendments to Form ADV with respect to items pertaining to the applicable provisions of the Rule are required to be filed in the RIA's annual amendment filed after January 1, 2011.

Mutual Fund Investors Fail in Efforts to Prove Excessive Fees Were Charged
The U.S. District Court for the Central District of California (In Re American Mutual Funds Fee Litigation, C.D. Cal. Case No. CV 04-5593, 12/28/09) recently ruled for the defendants against the plaintiff, mutual fund investors, with respect to claims that American Funds violated the provisions of Section 36(b) of the Investment Company Act of 1940 by imposing excessive fees. The Court applied the standards in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2nd Cir. 1982), which concluded that a violation of Section 36(b) arises from an advisory fee that is "so disproportionately large that is bears no reasonable relationship to the services rendered and could not be the product of arm's-length bargaining." The Court commented that "this standard establishes a very low threshold of the registered mutual fund company and a very high hurdle for a plaintiff."

The question of what is an excessive fee for purposes of Section 36(b) of the Investment Company Act of 1940 is currently being considered by the U.S. Supreme Court in Jones v. Harris Associates L.P., U.S. No. 08-586. In that case, a divided U.S. Court of Appeals for the Seventh Circuit rejected the Gartenberg standard ruling that marketplace competition should govern.

In this case, the plaintiffs were investors in one or more of eight American Funds. The investment adviser to the funds received management fees, an affiliate broker-dealer received distribution and marketing fees, and the funds also received 12b-1 fees from investors that were paid out as a method of compensating broker-dealer distributors and for providing certain other administrative services to investors.

In effect, the Court determined that the plaintiffs failed to prove that all of the fees received by the investment adviser and its related parties "were so disproportionate to the services rendered such that the fees could not have been the product of arms-length bargaining." Accordingly, the Court ruled that plaintiffs did not meet the Gartenberg standard.

SEC Announced Efforts to Deter and Detect Madoff-Type Frauds
In response to severe criticism from investors and politicians, the SEC has undertaken steps to help reduce the chances that frauds such as the Madoff Ponzi scheme will not occur or go undetected in the future. Those steps include:

Restructuring of the SEC's Enforcement Division: With the appointment of a new Enforcement Director, the SEC has restructured this division to better focus on cases that are likely to have a significant impact. This restructuring is intended to help reduce bureaucracy and speed up the enforcement process by removing a layer of management. Specialized units will be included to concentrate in focused areas and help detect patterns, trends, and motives. Finally, streamlined internal processes will be implemented to make the investigative process more efficient.

Encouraging Insiders' Cooperation: The SEC is working on agreements to encourage the cooperation of individuals who are on the "inside" of companies engaged in fraudulent activity. These agreements will purportedly provide that insiders who offer truthful evidence and agree to cooperate and testify would be eligible for a possible reduction in sanctions. Such agreements would be expected to provide the SEC with witnesses and key information in enabling the agency to build stronger cases more quickly.

Conducting Risk-Based Examinations of Financial Firms: The SEC has instructed its examiners to conduct a "sweep" of certain firms to determine that the clients' assets in fact exist. Such firms include advisers whose clients' assets are held with an affiliate; hedge funds that seem to have unrealistic returns; firms that use an unknown auditor or no auditor at all; firms with a regulatory history; and broker-dealers that sell an affiliate's hedge fund.

Recruiting Staff With Enhanced Experience in Detecting Fraud: The SEC is in the process of expanding its staff to include persons with diverse skill sets to expand its knowledgebase and improve its ability to assess risk, conduct examinations, detect and investigate wrongdoing, and focus the SEC's priorities. The specialized personnel will include new staffers for the examination unit who have experience in trading, operations, portfolio management, options, compliance, valuation, new instruments and portfolio strategies, and forensic accounting, and those with expertise in current financial products and techniques.

Improving Internal Controls: Both the SEC's examination unit and Enforcement Division has implemented a periodic review program to help ensure that important issues are thoroughly resolved in a timely manner and that no investigation falls through the cracks.

Seeking More Funding: The SEC has been asking Congress for additional funding to hire more examiners to conduct on-site examinations and more enforcement staff to bring more enforcement cases.

Integrating Broker-Dealer and Investment Adviser Examinations: The SEC has instituted certain measures to integrate its broker-dealer and investment adviser examination programs. It is expected that a team of examiners, taken from both the broker-dealer and investment management units, will together examine selected firms.

*See SEC Release no. IA-2968 for a copy of the revised Custody Rule and commentary on same; the release can be found on the SEC Web site at http://www.sec.gov/rules/final/2009/ia-2968.pdf.

*See SEC Release No. IA-2968 for interpretative guidance for independent accountants, available at http://www.sec.gov/rules/interp/2009/ia-2969.pdf.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions