On December 16, 2009, the Securities and Exchange Commission
(the "SEC") voted unanimously to amend
Rule 206(4)-2 (the "Custody Rule") under
the Investment Advisers Act of 1940, as amended. The amendments
approved by the SEC are intended to address recently disclosed
misappropriations of client assets by registered investment
advisers and restore public confidence in the investment advisory
industry and the SEC. We previously analyzed the SEC's proposed
amendments to the Custody Rule in an O'Melveny & Myers
Client Alert dated June 2, 2009 (Click to read "SEC Proposes Changes to the Custody Rule that Go
Too Far; Impose Significant Costs and Fail to Address Shortcomings
in the Existing Rule," a June 2009 O'Melveny Client
Alert) (the "Proposed
Amendments").
Although the SEC has not yet published the adopting release for the
Custody Rule, it appears based on the open Commission meeting on
December 16, 2009 that the following will be included in the
Custody Rule. We will update this alert once the adopting release
is available.
Surprise Annual Audit
Under the Proposed Amendments, all registered investment advisers
with custody[1] 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 have been
required to engage an independent public accountant to conduct an
annual surprise audit 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 have been performed by an independent public accountant
registered with, and subject to regular inspection by, the Public
Company Accounting Oversight Board
("PCAOB").
Based on the discussion of the amendments to the Custody Rule
during the SEC's meeting yesterday, it appears that the Custody
Rule will provide for three exceptions to the annual surprise audit
requirement, as described below:
- Exception for Advisers that Are "Operationally Independent" from Affiliated Custodian: The exact scope of this exception was not made clear during yesterday's meeting, but it appears to be an exception from the requirement to obtain a surprise audit. However, it appears that a rebuttable presumption would be imposed on the registered adviser to prove it is operationally independent from its affiliated qualified custodian.[2]
- Exception for Advisers with Limited Custody: In the event a registered investment adviser uses a third party qualified custodian and its only access to client funds and securities is the ability to deduct advisory fees, the Custody Rule may not require an annual surprise audit. However, the adopting release may identify controls and procedures related to advisory fee deduction that registered investment advisers should adopt, and the Chairman stated that review of advisory fee deduction will be a top priority during staff examinations.
- Exception for Advisers to Pooled Investment Vehicles: Advisers to pooled investment vehicles that obtain an audit of those vehicles from an independent public accountant registered, and subject to oversight by the PCAOB may not be subject to an annual surprise audit.
In addition, the SEC indicated that it will consider further
amendments to require public disclosure by registered investment
advisers regarding the use of affiliated qualified custodians and
auditors performing surprise audits so the quality of custody
arrangements and controls over client assets can be better
monitored. It appears that the SEC will also require auditors who
cease to provide services to a registered investment adviser to
engage in a "noisy withdrawal" by explaining to the SEC
the reason for the termination of the relationship. Finally, the
SEC expects to issue an interpretive release to provide guidance to
accountants on conducting surprise audits and issuing internal
controls reports.
The amendments to the Custody Rule will become effective 60 days
after their publication in the Federal Register.
Endnotes
[1] The Custody Rule defines "custody" broadly
and contemplates situations in which the adviser has only
constructive custody over client assets. An adviser has custody
over client assets (i) when it has physical possession of client
assets (e.g., the adviser holds a client's stock certificates),
(ii) through an arrangement (e.g., a power of attorney) whereby the
adviser is authorized to withdraw client assets maintained with a
qualified custodian or deduct advisory fees or other expenses from
client accounts maintained with a qualified custodian, or (iii)
through a legal capacity or relationship of the adviser or a
supervised person of the adviser (e.g., the general partner of a
partnership).
[2] The SEC Staff indicated that a qualified custodian and an
adviser would be "operationally independent" if they do
not have any overlap of personnel, office space, or
supervision.
