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Investment Advisers Act of 1940 – Section 206(4) and
Rule 206(4)-2
April 25, 2016
Response of the Division of Investment Management
IM Ref. No.: 20164261627
Robert C. Grohowski
General Counsel
Investment Adviser Association
1050 17th Street, NW
Suite 725
Washington, DC 20036-5514
Dear Mr. Grohowski:
We request that you share with your members the following letter concerning the independent verification required by Rule 206(4)-2 under the Investment Advisers Act of 1940 (“Advisers Act”). As you know, a registered investment adviser with custody of client funds or securities is required by Rule 206(4)-2 to take a number of steps designed to safeguard those client assets.[1] One such step is that an adviser that has custody of client assets generally must undergo an annual surprise examination by an independent public accountant to verify the client funds and securities.[2] In addition, the United States Securities and Exchange Commission (“Commission”) recognizes that affiliated custodial relationships present higher risks to advisory clients than where client funds or securities are maintained with an independent custodian.[3] In this regard, where an investment adviser, or its related person, maintains client funds or securities, it must obtain or receive a written internal control report from an independent public accountant that demonstrates that it, or its related person, has established appropriate custodial controls.[4]
Notwithstanding these concerns, staff of the Division of Investment Management would not recommend enforcement action to the Commission under Section 206(4) of, and Rule 206(4)-2 under, the Advisers Act if an investment adviser does not obtain a surprise examination where it acts as a sub-adviser in an investment advisory program for which a related person qualified custodian is the primary adviser (or an affiliate of the primary adviser), and the primary adviser is responsible for complying with Rule 206(4)-2. Our position is based, in particular, on the following:
(1) the sole basis for the sub-adviser having custody is its affiliation with the qualified custodian and the primary adviser;
(2) the primary adviser will comply with Rule 206(4)-2, including by having client funds and securities in the investment advisory program verified by a surprise examination conducted by an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”) pursuant to an agreement entered into by the primary adviser;
(3) the sub-adviser does not (i) hold client funds or securities itself; (ii) have authority to obtain possession of clients’ funds or securities; or (iii) have authority to deduct fees from clients’ accounts; and
(4) the sub-adviser will continue to be required to obtain from the primary adviser or qualified custodian annually a written internal control report prepared by an independent public accountant registered with and subject to regular inspection by the PCAOB as required by Rule 206(4)-2(a)(6).
We hope that this letter will clarify our views on the application of Rule 206(4)-2 for you and your members. Please share this letter with your members.
Very truly yours,
Aaron T. Gilbride
Senior Counsel
Chief Counsel’s Office
[1] Rule 206(4)-2(d)(2). Custody means “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” An adviser has custody if a “related person” has custody of client funds or securities in connection with advisory services the adviser provides to clients. Custody includes any capacity that gives an adviser or its supervised person legal ownership of or access to client funds or securities (such as acting as general partner or trustee of a pooled investment vehicle). Rule 206(4)-2(d)(7) defines “related person” as “any person, directly or indirectly, controlling or controlled by you, and any person that is under common control with you.”
[2] Rule 206(4)-2(a)(4). Rule 206(4)-2(b)(6) provides an exception from the surprise examination requirement where, among other things, a related person is “operationally independent” of the adviser. Under Rule 206(4)-2(d)(5), a related person is presumed not to be operationally independent unless each of the following conditions is met and no other circumstances can reasonably be expected to compromise the operational independence of the related person: (i) client assets in the custody of the related person are not subject to claims of the adviser’s creditors; (ii) advisory personnel do not have custody or possession of, or direct or indirect access to client assets of which the related person has custody, or the power to control the disposition of such client assets to third parties for the benefit of the adviser or its related persons, or otherwise have the opportunity to misappropriate such client assets; (iii) advisory personnel and personnel of the related person who have access to advisory client assets are not under common supervision; and (iv) advisory personnel do not hold any position with the related person or share premises with the related person.
[3] See, e.g., Custody of Funds or Securities of Clients by Investment Advisers, Investment Advisers Act Release No. 2968 (Dec. 30, 2009), 75 Fed. Reg. 1456, 1464 (Jan. 11, 2010).
http://www.sec.gov/divisions/investment/noaction/2016/investment-adviser-association-042516-206(4).htm
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