Custody of Funds or Securities of Clients by Investment Advisers
A Small Entity Compliance Guide1
On December 30, 2009, the Securities and Exchange Commission adopted amendments to the custody rule for investment adviser client funds or securities, rule 206(4)-2 under the Investment Advisers Act of 1940. The amendments are designed to provide additional client safeguards under the Advisers Act when a registered adviser has custody of client funds or securities ("client assets"). The amended custody rule, among other things, requires:
In conjunction with the amendments to the custody rule, the Commission also adopted amendments to the adviser's books and records rule (rule 204-2 under the Advisers Act), the registration form for advisers (Form ADV), and the cover sheet for accountant certificates reporting the results of surprise examinations (Form ADV-E). The rules and forms as amended operate the same for all investment advisers, regardless of their size.
A. Delivery of Account Statements and Notices to Client
The custody rule requires an adviser that has custody of client assets to maintain those assets with a "qualified custodian" such as a bank, broker-dealer, or futures commission merchant, and to have a reasonable basis for believing the custodian sends quarterly account statements directly to the clients. The amendments removed an alternative that permitted an adviser to send its own account statements to clients instead of those from the qualified custodian as long as the adviser underwent an annual surprise examination. The amendments also revised the adviser's obligation to have a reasonable basis for believing the custodian sends statements with the addition of a requirement that the reasonable basis be formed after "due inquiry." As a result, under the amended custody rule, advisers that have custody of client assets must have a reasonable basis for believing, after due inquiry, that the qualified custodian sends quarterly account statements directly to each of their clients whose assets are held with the qualified custodian.
In addition to statements, the custody rule requires advisers to notify their clients promptly upon opening custodial accounts on their behalf and when there are changes to the information required in that notification. Under the amended rule, if an adviser opens an account on behalf of a client and provides its own account statements to the client, the adviser must include a legend in the notice, and subsequent account statements, that urges the client to compare the account statements he or she receives from the qualified custodian with those from the adviser.
B. Annual Surprise Examination of Client Assets
Investment advisers that have custody of client assets are subject to an annual surprise examination of those assets by an independent public accountant under the amended custody rule, unless the adviser has custody solely because of its authority to deduct advisory fees from client accounts or it is an adviser to a pooled investment vehicle that is subject to an annual financial statement audit by an independent public accountant registered with, and subject to regular inspection by, the PCAOB and that distributes the audited financial statements to investors in the pool.
Written agreement and reporting
The revised custody rule also requires each adviser that must obtain a surprise examination to enter into a written agreement with the independent public accountant that will conduct the surprise examination. The agreement must contain provisions that require the accountant to notify the Commission within one business day of finding any material discrepancy during the course of the examination, to submit Form ADV-E to the Commission accompanied by the accountant's certificate within 120 days of the time chosen by the accountant for the surprise examination, which must state that the accountant has examined the client assets and describe the nature and extent of the examination. The written agreement also must provide that, upon resignation or dismissal, the accountant submit within four business days a statement regarding the termination along with Form ADV-E. Form ADV-E and accompanying certificates or termination statements are filed on paper pursuant to the instructions on Form ADV-E until the Internet-based Investment Adviser Registration Depository (IARD) accepts electronic filing of Form ADV-E.
C. Pooled Investment Vehicles
Under the custody rule, an adviser to a pooled investment vehicle that is subject to an annual audit by an independent public accountant registered with, and subject to regular inspection by the PCAOB and distributes the audited financial statements to each investor in the pool within 120 days after the pool's fiscal year end is deemed to have satisfied the requirement to obtain an annual surprise examination. Advisers to pooled investment vehicles that are not subject to the audit as described above must obtain an annual surprise examination under the amended custody rule.
The amended rule requires that advisers to pooled investment vehicles that are subject to the audit as described above that liquidate prior to a fiscal year end to obtain a final audit of the pool's financial statements upon liquidation of the pool and distribute the financial statements to pool investors promptly after the completion of the audit.
D. Definition of Custody
An adviser has custody if it holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them. The amendments to the rule revised the definition of "custody" under the rule to specifically include in the definition of custody arrangements where an adviser's related person has custody of client assets in connection with advisory services the adviser provides to clients. For example, if an affiliated broker-dealer of an investment adviser maintains custody of client assets as qualified custodian in connection with advisory services the investment adviser would have custody of those client assets.
E. Adviser or Related Person Qualified Custodians
When an adviser or its related person serves as a qualified custodian for client assets, the adviser must obtain, or receive from its related person, no less frequently than once each calendar year, a written report, which includes an opinion from an independent public accountant with respect to the adviser's or related person's controls relating to custody of client assets ("internal control report"), such as a Type II SAS 70 report. The internal control report is in addition to the obligation to obtain annual surprise examination, which is required under the amendments unless the adviser is deemed to have custody solely as a result of its related person having custody and the adviser is "operationally independent" of the custodian as defined in the rule. The amendments to the rule also require, in these circumstances, that the accountant issuing the internal control report, as well as the accountant performing the surprise examination, be registered with, and subject to regular inspection by the PCAOB. Related persons under the rule are persons that are directly or indirectly controlled by the adviser, control the adviser or are under common control with the adviser.
F. Delivery to Related Persons of Pooled Investment Vehicles
In order to preclude advisers from using layers of pooled investment vehicles to avoid meaningful application of the protections of the rule, the amendments to the custody rule added a new provision, which provides that sending an account statement or distributing audited financial statements will not meet the requirements of the rule if all of the investors in a pooled investment vehicle to which the statements are sent are themselves pooled investment vehicles that are related persons of the adviser.
G. Privately Offered Securities
As a result of the amendments, advisers are no longer excepted from the entire custody rule with respect to privately offered securities that client's own. As a result, the accountants performing surprise examinations must also examine privately offered securities that the adviser has custody of.
H. Guidance for Accountants
In a companion release, the Commission updated its interpretive guidance for independent public accountants that addresses the surprise examination and the internal control report required under the custody rule. The guidance addresses the relevant auditing and attestation standards that apply to these engagements, and, among other things, the nature and extent of the accountant's procedures with respect to the surprise examination.
The adopting release for amendments to the custody rule can be found on the Commission's website at http://www.sec.gov/rules/final/2009/ia-2968.pdf. The Commission's release adopting the interpretive guidance for accountants can be found on the Commission's website at http://www.sec.gov/rules/interp/2009/ia-2969.pdf.
Contacting the SEC
The Commission's Division of Investment Management is happy to assist small companies with questions regarding the amendments to the custody and related rules under the Advisers Act. The Division's Office of Investment Adviser Regulation answers questions submitted by e-mail and telephone. You can contact the Office of Investment Adviser Regulation at (202) 551-6787 or by sending an e-mail to IArules@sec.gov.
1 This guide was prepared by the staff of the U.S. Securities and Exchange Commission as a "small entity compliance guide" under Section 212 of the Small Business Regulatory Enforcement Fairness Act of 1996, as amended. The guide summarizes and explains rules adopted by the SEC, but is not a substitute for any rule itself. Only the rule itself can provide complete and definitive information regarding its requirements