The U.S. Securities and Exchange Commission (the "SEC") is currently reviewing public comments on proposed amendments to Rule 206(4)-2 (the "Custody Rule") under the Investment Advisers Act of 1940 (the "Advisers Act")1. The amendments are designed to provide additional safeguards under the Advisers Act when an adviser has custody of client funds or securities. The amendments were proposed by the SEC in response to several recent enforcement actions against investment advisers and broker-dealers alleging fraudulent conduct, including misappropriation or other misuse of investor assets.
The amendments would, among other things require registered investment advisers that have custody of client funds or securities to undergo an annual surprise examination by an independent public accountant to verify client funds and securities. In addition, unless client accounts are maintained by an independent qualified custodian (i.e., a custodian other than the adviser or a related person), the adviser or related person would be required to obtain a written report from an independent public accountant that includes an opinion regarding the qualified custodian's controls relating to custody of client assets. The proposed rules will result in the SEC receiving better information about the custodial practices of registered investment advisers.
Background Of Rule 206(4)-2
Rule 206(4)-2 regulates the custody practices of investment advisers registered under the Advisers Act. The Custody Rule requires advisers that have custody of client funds or securities to implement controls designed to protect those client assets from being lost, misused, misappropriated or subject to the advisers' financial reserves, such as insolvency. The two primary regulations of the Custody Rule are to require advisers that have custody:
- with certain limited exceptions, to maintain client funds or securities with a qualified custodian2; and
- to reasonably believe that the qualified custodian holding the assets provides account statements directly to clients, or investors in pooled investment vehicles, at least quarterly.
If the qualified custodian does not provide clients with account statements, the Custody Rule requires the adviser to deliver quarterly statements itself and engage an independent public accountant to verify the client assets in a surprise examination that must occur annually.
Surprise Examination
Under the proposed amendments, all registered investment advisers with custody of client assets would be required to engage an independent public accountant to conduct an annual surprise examination of client assets. The surprise examination would include an examination of all privately offered securities that the investment adviser holds on behalf of its clients.3 Additionally, all registered investment advisers would be required to enter into a written agreement with an independent public accountant to conduct the surprise examination requiring the accountant, among other things, to notify the SEC within one business day of finding material discrepancies, and to submit Form ADV-E to the SEC accompanied by a certificate within 120 days of the time chosen by the accountant for the surprise examination, stating that it has examined the funds and securities and describing the nature and extent of the examination.
Custody By Adviser Or Related Persons
The SEC proposed amending Rule 206(4)-2 to provide that an adviser has custody of any client securities or funds that are directly or indirectly held by a "related person" in connection with advisory services provided by the adviser to its clients.4 A "related person" would be a person directly or indirectly controlling or controlled by the adviser and any person under common control with the adviser. "Control" would be defined as the power, directly or indirectly, to direct the management or policies of a person, whether through ownership of securities, by contract or otherwise. Under the current Custody Rule, an adviser may have custody of client assets through a related person; however, there is no bright line test and the determination must be made based on a number of factors set forth in various staff interpretive letters.
Internal Control Report And PCAOB Registration And Inspection
Under the proposed Custody Rule, if an adviser or related person serves as a qualified custodian for client funds or securities, the adviser must obtain, or receive from the related person, at least on an annual basis, a written report (referred to by the SEC as an "internal control report"), which includes an opinion from an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board ("PCAOB"), with respect to the adviser's or related person's controls relating to custody of client assets. The investment adviser would be required to maintain a copy of its internal control reports for five years under the proposed rule.
Also, if the adviser or related person serves as a qualified custodian for client funds or securities, the surprise examination discussed above must by performed by an independent public accountant registered with, and subject to regular inspection by, the PCAOB, in accordance with the rules of the PCAOB.
Delivery Of Account Statement And Notice To Clients
The SEC proposed amending the Custody Rule to require registered investment advisers with custody of client funds or securities to have a reasonable basis for believing that the qualified custodian sends an account statement, at least quarterly, to each client for which the qualified custodian maintains funds or securities. This amendment would eliminate from the current Custody Rule, the option an adviser has to send reports to clients if it undergoes a surprise examination by an independent public accountant at least annually. Thus, under the amended Custody Rule, all advisers would have to have a reasonable belief that the qualified custodian delivers account statements to advisory clients or their representatives. Under the amended Custody Rule, an adviser's reasonable belief would have to be formed after "due inquiry."
Form ADV And Form ADV-E
The SEC proposed several amendments to Form ADV that are designed to provide more complete information about the custody practices of advisers registered with the SEC. The SEC also proposed amendments to the instructions of Form ADV-E.
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The SEC staff will draft the final amendments to the Custody Rule, taking into consideration the public comments submitted on the proposed amendments, and present the final rule to the SEC Commissioners for their consideration.
Footnotes
1. SEC Release No. IA-2876.
2. A qualified custodian, which is defined in Rule 206(4)-2(c)(3), includes the types of financial institutions to which clients and advisers customarily turn for custodial services, including banks, registered broker-dealers and registered fund commission merchants.
3. Privately offered securities currently are excluded from all aspects of the Custody Rule.
4. The "in connection with" limitation of the proposed rule is designed to prevent an adviser from being deemed to have custody of client assets held by a related person qualified custodian with respect to which the adviser does not provide advice.
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