SEC Issues Final Amendments to Investment Advisers´ Custody Rule

Prior to the release of the amended rule, a registered investment adviser could have custody of client funds and securities in one of two ways: (1) actual custody or (2) so-called "constructive custody." A registered adviser that had either actual custody or constructive custody over client funds or securities was, among other things, required to include the adviser’s balance sheet in Part II of its Form ADV and to submit to an annual surprise audit by an independent public accountant.

Under the SEC’s view, "constructive custody" existed, for example, where an adviser of a managed account had the authority to deduct its fees directly from such account. The SEC also took that view that the general partner or managing member of a hedge fund had constructive custody over the funds and securities of such fund because it generally had the right to act on behalf of the fund in its discretion (including withdrawing assets from the fund’s accounts).

Most advisers did not want to comply with the cumbersome "surprise audit" requirement, so they actively sought ways to avoid having actual or "constructive custody." The SEC provided some relief, in the form of "no action" letters, to both "traditional" investment advisers and hedge fund managers.

In the case of "traditional" registered investment advisers that had authority to deduct their fees directly from the accounts they managed, the SEC took the position that such advisers could avoid the constructive custody that would otherwise arise from that authority by simultaneously sending an invoice for their fees both to the client and the client’s custodian detailing the fee being charged to the client and how the fee was calculated.

In the case of registered investment advisers that managed hedge funds, the SEC took the position that such advisers could avoid the constructive custody that would otherwise rise from their status as general partners or managing members of such funds by instructing the custodian of the fund’s assets not to release any of such fund’s assets to the adviser or any of its affiliates without a letter of instruction from an independent certified public accountant or attorney.

Under the amended Custody Rule, a registered investment adviser that has "custody" (see discussion below) of client funds or securities must comply with three basic requirements:

• the investment adviser must maintain its clients’ assets with a "qualified custodian" (see discussion below), either in separate accounts maintained under the respective names of such clients or in an "omnibus" account holding only client assets maintained under the investment adviser’s name as agent or trustee for its clients;

• the investment adviser must notify each of its clients (or, at the client’s direction, the client’s "independent representative"¹ ) in writing of the account arrangements described in the bullet point above, including the name and address of the qualified custodian and the manner in which the assets are held (this written notification must be given promptly when an account is opened and following any changes in such information); and

• the investment adviser must have a reasonable basis for believing that the qualified custodian will send an account statement directly to each client (or, at the client’s direction, to the client’s "independent representative") no less frequently than quarterly that identifies the amount of funds and of each security in the client’s account as of the end of such period and that sets forth all of the transactions in such account during such period.

Alternatively, an investment adviser (as opposed to the custodian) may send such quarterly statements to each of its clients (or, upon the client’s direction, its "independent representative") if the investment adviser is subject to a surprise audit by an independent public accountant no less frequently than annually, and the accountant complies with certain reporting obligations with respect to such audit.

For registered investment advisers that manage hedge funds, the requirement to deliver notices and account statements to clients is interpreted by the SEC to mean that such notices and accountant statements must be sent to investors in the fund. However, if the fund is subject to audit by an independent public accountant at least annually and the hedge fund provides copies of the fund’s audited financial statements prepared in accordance with generally accepted accounting principals consistently applied to its investors within 120 days of the end of the fund’s fiscal year, then the manager of the fund is not required to comply with the requirement to deliver notices and account statements to the fund’s investors. (Of course, the manager must still comply with the other applicable provisions of the Custody Rule, such as holding the fund’s assets with a "qualified custodian.")

For a registered investment adviser that invests its clients’ assets in hedge funds or that manages a fund-of-funds (a hedge fund that invest in other hedge funds), complying with the requirement that a client’s or the fund-of-fund’s assets be held with a qualified custodian is problematic because these assets are generally not held directly with qualified custodians. The SEC recognized this situation and provided in the amended Custody Rule that, in the case of a registered investment adviser that invests client assets in certain privately offered securities, it is not necessary to hold such securities with a "qualified custodian" provided that such securities are (i) acquired from the issuer in a transaction or chain of transactions that does not involve a public offering, (ii) uncertificated, with ownership being recorded only on the books of the issuer or its transfer agent in the name of the client and (iii) transferable only with the prior consent of the issuer or the holders of the outstanding securities of the issuer. However, the SEC does require a fund-of-funds to be subject to the annual audit requirement described above in order to rely on this exemption from holding client assets that are privately offered securities with a qualified custodian.

The amended Custody Rule defines "custody" to mean "holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them." Thus, the amended rule encompasses both actual and constructive custody (just as the pre-amendment rule did, though the pre-amendment rule did not contain a formal definition of custody). The definition includes several examples of what is and is not custody. For instance, possession of client funds or securities (not including checks payable to third parties) constitutes custody unless the adviser received such funds or securities inadvertently and such funds or securities are returned promptly but in any case within three days of receiving such funds or securities. The carve out for third party checks allows an investment adviser to accept a check payable to the custodian selected by its client and to forward such check to the custodian without having custody of client funds.

Any arrangement (including a general power of attorney) under which a registered investment adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian on the adviser’s instructions also constitutes custody of client funds. For example, a registered investment adviser that, in addition to providing investment advisory services to a client, provides a bill paying service whereby the adviser writes checks under its own authority to pay bills from the client’s account has custody of client assets. Finally, a registered investment adviser acting in any capacity that gives the adviser or its supervised persons legal ownership or access to client funds or securities (such as acting as a general partner of a limited partnership or a managing member of a limited liability company) has custody of client funds.

One of the requirements for registered investment advisers that have custody of client assets is that such assets be maintained with a "qualified custodian." This change reflects the fact that most investment advisers maintained client assets with qualified custodians even before the amended rule was proposed.

A "qualified custodian" is any of the following: (i) a bank as defined in Section 202(a)(2) of the Advisers Act or a savings association as defined in Section 3(b)(1) of the Federal Deposit Insurance Act that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act; (ii) a broker-dealer registered under Section 15(b)(1) of the Securities Exchange Act of 1934 holding client assets in customer accounts; (iii) a futures commission merchant registered under Section 4f(a) of the Commodity Exchange Act holding client assets in customer accounts, but only with respect to clients’ funds and security futures or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon; or (iv) a foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer accounts segregated from its proprietary assets.

Additionally, with respect to client assets that are invested in shares of an open-ended registered investment company (commonly referred to as a mutual fund), the mutual fund’s transfer agent is as a qualified custodian with respect to such shares.