SEC Publishes New Adviser Custody Rule

On December 30, 2009 the SEC published an adopting release (sec.gov/rules/final/2009/ia-2968.pdf) that contains amendments to Rule 206(4)-2, the investment adviser custody rule. The SEC also published an interpretive release (sec.gov/rules/interp/2009/ia-2969fr.pdf) providing guidance to auditors regarding the surprise examination and internal control report requirements. Following is a brief summary of significant provisions of the new rule, which goes into effect March 12, 2010: 

Advisers Deemed to Have Custody of Client Assets: With limited exceptions discussed below, advisers that are deemed to have custody of client assets—including advisers that serve as trustees to client accounts or general partners of limited partnerships, or advisers with check-writing authority—are required to undergo an annual surprise exam by an independent public accountant, even if client assets are held by an independent third-party custodian. The surprise exam must include all client funds and securities with respect to which the adviser is deemed to have custody, including privately offered securities and mutual fund shares. The first round of surprise exams must take place by December 31, 2010.

Advisers Deemed to Have Custody Solely Because They Have Authority to Deduct Fees: Advisers that are deemed to have custody of client assets solely because they have authority to deduct fees are not required to receive an annual surprise exam by an independent public accountant. Instead, those advisers are expected to have policies and procedures in place that address the risk that the adviser or its personnel could deduct fees to which the adviser is not entitled under the terms of the advisory contract. The adopting release provides guidance for such policies and procedures as well as guidance on policies and procedures addressing custody issues more broadly.

Advisers to Pooled Investment Vehicles: Advisers to pooled investment vehicles that are audited annually and that distribute financial statements in accordance with the rule are not required to undergo a surprise exam in addition to their regular annual audit. The annual audit, however, must be conducted by a PCAOB registered and inspected accountant. Advisers to pooled investment vehicles that are not audited annually will be subject to the surprise exam requirement. To be exempted from the surprise exam requirement, an adviser to a pooled investment vehicle must be contractually obligated to obtain an audit of the financial statements of the pooled vehicle for fiscal years beginning on or after January 1, 2010.

Advisers or Affiliates of Advisers with Physical Custody of Client Assets: All advisers that maintain custody of client assets as a qualified custodian, or with an affiliate that acts as a qualified custodian of client assets, are required to undergo an annual surprise exam and are required to obtain, or have their affiliate obtain, an internal control report from an independent public accountant, attesting to controls related to safekeeping of client assets. The accountant must be registered with and subject to inspection by the PCAOB. There is an exception to the surprise exam requirement for advisers that demonstrate that they are “operationally independent” of their affiliate. The exception applies only to the surprise exam; all advisers that have an affiliate that maintains custody of client assets as a qualified custodian will be required to obtain an internal control report from the affiliate. Advisers required to obtain or receive an internal control report must do so by September 12, 2010. Such advisers are required to have a surprise exam within six months of obtaining the internal control report.

Delivery of Account Statements: Account statements must be delivered by the qualified custodian directly to clients. The new rule eliminates the alternative that allowed an adviser to send account statements to clients if the adviser had an annual surprise exam by an independent public accountant. Instead, advisers must have a reasonable belief, after “due inquiry,” that the qualified custodian is providing quarterly account statements directly to clients. The due inquiry requirement can be satisfied in several ways, including receipt by the adviser of a copy of the account statements the custodian provides to clients. These requirements apply to all account statements sent as of March 12, 2010.

Notice to Clients: An adviser with custody of client assets that opens a custodial account on behalf of a client, and that sends account statements to clients, must send a notification to the client, including a statement urging the client to compare the account statements received from the adviser with account statements received from the custodian. This statement also must be included in every account statement the adviser sends to that client. The notices must be provided on all custodial accounts opened as of March 12, 2010.

Disclosure: The SEC adopted several amendments to the custody disclosure in Form ADV requiring detailed information about adviser custody practices. Responses to the revised Form ADV must be provided in an adviser’s first annual amendment after January 1, 2011. The IARD system apparently will not reflect the Form ADV changes in time for the 2010 round of annual amendments.

What This Means to You, Our Clients: In advance of the effective date, investment advisers who maintain client assets should consider the following:

• Identify and engage an independent accountant to perform a surprise examination by the end of the year;
• Review your current ADV disclosures for compliance with the new rules;
• Determine whether or not to continue to use an affiliated custodian;
• Review existing internal controls and prepare for an audit of those controls by an accountant registered with the PCAOB; and
• Determine how to allocate the expenses for compliance with the new requirements, including accountants’ fees for surprise examinations. 

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