On Dec. 30, 2009, the Securities and Exchange Commission published amendments to Rule 206-4(2) under the Investment Advisers Act of 1940, commonly known as the “Custody Rule.” The amendments impose significant additional requirements for registered investment advisers deemed to have custody of client funds or securities. According to the adopting release, the Commission adopted the amendments to the Custody Rule to fulfill its mandate of investor protection and to incentivize the “best practice” of utilizing independent custodians for custody of client funds and securities. The amended Custody Rule (the “Amended Rule”) will become effective March 12, 2010.
I. Brief Summary
The Amended Rule imposes additional safeguards relating to a registered investment adviser (an “RIA”) that has custody of clients’ funds or securities, including new examination and disclosure requirements, as follows:
• In general, an RIA that has custody of client assets and maintains those assets with an independent qualified custodian must undergo an annual surprise examination to verify client assets performed by an independent public accountant.
• An RIA that has custody of client assets and maintains those assets itself or with a qualified custodian that is not “operationally independent” from the RIA must undergo 2 annual examinations: a surprise examination to verify client assets and an examination of the RIA’s internal custody controls. Each examination must be performed by an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board (the “PCAOB”) as of the commencement of the engagement period and as of each calendar year-end (a “PCAOB Accountant”).
• An RIA that has custody of client assets and maintains such assets with an affiliated qualified custodian that is “operationally independent” from the RIA must obtain (or receive from the affiliated qualified custodian) a written report attesting to the adequacy of the RIA’s (or the affiliated qualified custodian’s) internal custody controls by a PCAOB Accountant, but is not required to have an annual surprise examination.
• An RIA that has custody solely by having the ability to deduct the RIA’s advisory fees (and not other amounts) from client accounts is not required to undergo any examination.
• An RIA that advises pooled investment vehicles and maintains custody of the assets of such pools with an independent qualified custodian may comply with the Amended Rule by having the pool audited by a PCAOB Accountant and by distributing annual audited financial statements (prepared in accordance with GAAP) to investors in the pool within 120 days of the end of each fiscal year of the pool (or, in the case of “funds of funds,” within 180 days of the end of such fund’s fiscal year). If the RIA meets these requirements, it is not required to undergo any examination.
• An RIA is no longer able to comply with the Custody Rule by providing clients with internally generated quarterly account statements.
In connection with the amendments to the Custody Rule, the Commission published amendments to (i) Rule 204-2 (commonly known as the “Recordkeeping Rule”) to account for certain new records required to be kept by RIAs; (ii) Form ADV to require disclosure of the RIA’s custody practices; and (iii) Form ADV-E to require filings to be made by the accountants conducting the surprise examination. In addition, the Commission published guidance for RIAs to assist in complying with the Amended Rule and for accountants regarding the surprise examinations and internal control reports required by the Amended Rule.
A link to the full text of the release of the Amended Rule can be found at http://www.sec.gov/rules/final/2009/ia-2968.pdf
II. Custody Rule Requirements
Under the Amended Rule, an RIA will generally have custody of client assets when the RIA holds or has possession of those assets or has the authority to obtain possession of the assets (i.e., by deducting advisory fees or withdrawing funds on behalf of a client). In addition, an RIA has custody of a client’s assets where, by acting in a certain capacity (such as a general partner of a limited partnership or a manager of a limited liability company), the RIA or one of its supervised persons has the authority to transfer assets in the account to itself. Further, an RIA will have custody of any client assets that are directly or indirectly held by a “related person” in connection with the services provided by the RIA. A related person is a person directly or indirectly controlling or controlled by the RIA or a person under common control with the RIA.
If an RIA has custody of client assets, the RIA is required to implement controls designed to protect client assets from being lost, misused, misappropriated or subject to the RIA’s financial reverses. The Amended Rule contains three primary obligations: the placement of client assets with a “qualified custodian,” the delivery to clients of certain account statements by the qualified custodian, and examination requirements to verify the assets held with the custodian and/or the internal custody controls of the RIA.
A. Qualified Custodian
An RIA that has custody of client assets is required, subject to certain limited exceptions, to place the assets with a qualified custodian, which includes, among others, banks and registered broker-dealers. The qualified custodian must maintain the assets in a separate account for each client (in that client’s name) or in accounts that contain only client assets. Under the Amended Rule, shares of open-end mutual funds are generally not required to be kept with a qualified custodian.
Once the custodial account is established on behalf of the client, the RIA must provide details regarding the custodial arrangement to the client in a notice. Promptly upon opening a custodial account on a client’s behalf, and following any changes to the custodial account information, the RIA must notify the client of the custodian’s name, address and manner in which the assets are maintained. If the RIA also sends its own account statements to clients, the notice must include a statement urging clients to compare the account statements received by the custodian with the statements received from the RIA. This legend must also be included in any account statements that the RIA sends to the client after the account is opened.
B. Delivery of Account Statements
The Amended Rule imposes a number of obligations with respect to the delivery of account statements to clients. All RIAs with custody of client assets are required to conduct a “due inquiry” in order to establish a reasonable basis for believing that the qualified custodian sends account statements to each client no less frequently than quarterly. The receipt by the RIA of the account statements sent to each client, or the receipt of a written confirmation from the custodian that the account statements were sent to each client, will satisfy the due inquiry requirement. However, merely accessing the custodian’s account statements via a website will not satisfy the due inquiry requirement (since, in the Commission’s view, this would only establish that the account statements were available to, rather than sent to, clients).
RIAs cannot comply with the Amended Rule by providing clients with internally generated quarterly account statements and undergoing a surprise exam by an independent public accountant at least annually.
RIAs with custody of the assets of private pooled investment vehicles are exempt from the requirement to have a qualified custodian distribute periodic account statements if the pooled investment vehicle is audited annually by a PCAOB Accountant and sends copies of the pool’s audited financial statements to investors in such pool within 120 days of the end of the pool’s fiscal year (180 days for funds of funds).
The Amended Rule does not apply to assets held by registered investment companies, such as mutual funds, closed-end investment companies or exchange-traded funds (ETFs).
C. Annual Surprise Examination Requirement
The Amended Rule generally requires RIAs with custody of client assets to undergo an annual surprise examination by an independent public accountant. If an RIA maintains custody itself or with a custodian who is a “related person” to such RIA, then (i) the annual surprise examination must be conducted by a PCAOB Accountant and (ii) in some cases, the RIA is also required to procure an internal custody controls report (see Section D).
• All RIAs with custody of client assets must enter into a written agreement with an independent public accountant requiring, among other things, that:
• for RIAs currently subject to the Custody Rule, the first examination will occur prior to December 31, 2010;
• for RIAs that become subject to the Amended Rule after the Effective Date, the first examination will occur within 6 months of the RIA becoming subject to the Amended Rule (for instance, upon registering with the SEC); provided, that if an RIA also maintains custody as a qualified custodian, the agreement must provide for the first examination to occur no later than 6 months after obtaining the internal control report (see Section D);
• the accountant will submit Form ADV-E and a certificate of accounting within 120 days of the time chosen by the accountant for the examination, stating that the accountant has examined the assets of the RIA’s clients and describing the nature of the examination;
• the accountant will notify the Commission within 1 business day of finding any material discrepancies during the course of the examination; and
• the accountant will submit Form ADV-E to the SEC within 4 business days of its resignation, dismissal, termination of its engagement or upon being removed or removing itself from consideration from reappointment, accompanied by a “termination statement”. The termination statement is required to include, among other things, the date of resignation, dismissal, removal or other termination; the name, address and contact information of the accountant; and an explanation of any problems relating to the scope or procedure of the examination leading to the resignation, dismissal, removal or other termination of the accountant.
• The surprise examination must be conducted at a time that is “irregular from year to year.”
• Privately offered securities and shares of open-end mutual funds over which an RIA has custody on behalf of its clients must be verified (these securities were not covered by the existing Custody Rule). However, these securities are not required to be maintained with a qualified custodian.
• The surprise examination does not need to include testing of valuation.
The examination requirement does not apply to RIAs that are deemed to have custody solely as a result of having authority to withdraw advisory fees from client accounts. In addition, the examination requirement does not apply to RIAs of pooled investment vehicles that are audited annually by a PCAOB Accountant and that distribute annual audited financial statements to the pool’s investors within 120 days of the end of the pool’s fiscal year (180 days for funds of funds).
Following the first year of surprise examinations, the Commission will conduct a review of the surprise examination requirement in order to assess the effects of such requirement on smaller RIAs and those RIAs that have custody but utilize independent custodians.
D. Custody by an RIA or its Related Persons
The Amended Rule eliminates the factors currently used under the existing Custody Rule to determine whether an RIA has custody through related persons. Instead, the Amended Rule provides that an RIA will have custody of any client assets that are directly or indirectly held by a “related person” in connection with the advisory services provided by the RIA. A related person is a person directly or indirectly controlling or controlled by the RIA or a person under common control with the RIA.
The Amended Rule imposes additional requirements when client assets are maintained by an RIA itself or by a related person rather than with an independent qualified custodian. First, the annual surprise examination discussed in Section C above must be conducted by a PCAOB Accountant. Note that the use of an independent accountant that is registered with the PCAOB but not subject to regular inspection does not satisfy the rule’s requirements.
In addition, subject to the exception discussed below, the RIA must obtain (or receive from its related person) a written report from a PCAOB Accountant with respect to such RIA’s or related person’s custody controls of client assets. The internal control report must be obtained no less frequently than once each calendar year, and is in addition to the requirement to undergo an annual surprise examination, if applicable. The internal control report must include:
• an opinion from the PCAOB Accountant with respect to the RIA’s or the related person’s internal controls relating to the custody of client assets, including tests of operating effectiveness (for example a “Type II SAS 70 Report” or other similar report) conducted in accordance with PCAOB standards;
• a description of the relevant controls and the objectives of such controls; and
• the PCAOB Accountant’s tests of operating effectiveness that were performed, and the results of such tests.
In addition, the PCAOB Accountant must verify that client assets are reconciled to a custodian other than the RIA or its related person. The Amended Rule does not address whether the PCAOB Accountant providing the “internal control report” can be the same accountant that conducts the surprise examination, but it does not expressly require the use of a different accountant.
The Amended Rule provides that an RIA is not required to undergo an annual surprise examination if the RIA is deemed to have custody of client assets solely as a result of a related person which is “operationally independent” from the RIA having custody of such assets. (Note, however, that the RIA is still required to obtain the internal control report.)
Under the Amended Rule, a related person is operationally independent from the RIA if: (i) client assets in the custody of the related person are not subject to claims of the RIA’s creditors; (ii) advisory personnel do not have custody or possession of, or direct or indirect access to, assets of which the related person has custody; (iii) advisory personnel do not have the power to control the disposition of such client assets to third parties for the benefit of the adviser or its related persons, (iv) advisory personnel do not otherwise have the opportunity to misappropriate client assets; (v) advisory personnel and personnel of the related person who have access to advisory client assets are not under common supervision; and (vi) advisory personnel do not hold any position with the related person or share premises with the related person. The Commission stated that it would not consider a related person that shared management persons with the RIA to be operationally independent, even if no other circumstances exist that can reasonably be expected to compromise the operational independence of the related person. The adopting release also makes clear that an RIA that has custody as a result of conditions other than a related person having custody cannot rely on the exception above, and the RIA would have to undergo both an annual surprise examination and obtain the internal control report.
An RIA required to obtain (or receive) an internal control report because it or a related person maintains client assets as a qualified custodian must obtain (or receive) such internal control report within 6 months of becoming subject to the requirement. As noted above, an RIA obtaining an internal control report because it (rather than a related person) also serves as a qualified custodian (i.e., a broker-dealer) need not undergo a surprise examination until 6 months after obtaining the internal control report.
E. Pooled Investment Vehicles
The Amended Rule’s application to RIAs that serve as advisers to pooled investment vehicles (e.g., hedge funds, private equity funds and venture capital funds) has changed in several respects from the proposed amendments. Under the Amended Rule, RIAs that serve as advisers to pooled investment vehicles are deemed to comply with the surprise examination requirement with respect to the assets of such pooled investment vehicles by having an audit of the pool conducted by a PCAOB Accountant (in accordance with GAAP) and by delivering the audited financial statements to pool investors within 120 days of the pool’s fiscal year-end (180 days for funds of funds).
The Amended Rule, however, does impose additional requirements on RIAs that serve as advisers to pooled investment vehicles. First, such RIAs must procure an audit upon liquidation of such pooled investment vehicles and distribute audited financial statements to investors in such vehicles promptly upon completion of the liquidation audit. Second, the liquidation audits of such pooled investment vehicles must be conducted by a PCAOB Accountant.
If the pooled investment vehicle does not timely distribute audited financial statements to its investors, the RIA must undergo an annual surprise examination and must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement of the pooled investment vehicle to its investors at least quarterly in order to comply with the Amended Rule. If the RIA is subject to the annual surprise examination requirement, the Amended Rule requires such examination to verify privately offered securities held by the pool.
If an RIA serves as adviser to a pooled investment vehicle that utilizes a special purpose vehicle (an “SPV”) to hold certain assets, the RIA may satisfy the Amended Rule by: (i) treating the SPV as a separate client; or (ii) treating the SPV’s assets as assets of the pooled investment vehicle. If the RIA chooses the first option, the RIA must be subject to an annual surprise examination with respect to the SPV or distribute audited financial statements of the SPV to the beneficial owners of the pooled investment vehicle (as described above). If, on the other hand, the RIA treats the SPV’s assets as assets of the pooled investment vehicle, such assets must be considered within the scope of the pooled investment vehicle’s financial statement audit or surprise examination.
It is important to note that an RIA that maintains custody of a pooled investment vehicle’s assets itself or with a related person of the RIA must obtain (or receive from the related person, if such related person is operationally independent) an annual internal control report, regardless of whether the RIA obtains a surprise examination or meets the audit requirements above. In addition, an RIA that serves as an adviser to pooled investment vehicles must undergo an annual surprise examination of non-pooled investment vehicle assets of which it has custody.
Despite these new obligations, the Commission expressed concern that the Amended Rule may not provide sufficient protection to investors in pooled investment vehicles, since these investors will not generally receive reports detailing assets of the vehicle. The Commission stated that it will continue to seek out methods to alleviate this concern, while also balancing the confidentiality concerns of advisers to pooled investment vehicles.
F. Amendments to Form ADV and Form ADV-E
The Amended Rule requires additional information about the RIA’s custody practices be included in Part I of the RIA’s Form ADV. RIAs must respond to the revised Form ADV in their first annual amendment after January 1, 2011. Specifically, an RIA must:
• identify all related persons that are broker-dealers, banks or futures commission merchants and identify which, if any, serve as qualified custodians for the RIA’s clients;
• disclose whether it or any of its related persons serves as a qualified custodian of the RIA’s clients, and the dollar amount of client assets over which it or any of its related persons have custody;
• report: (i) whether a qualified custodian sends quarterly account statements to investors in pooled investment vehicles managed by the RIA; (ii) whether the financial statements of such pooled investment vehicles are audited; (iii) whether the assets of the RIA’s clients are subject to a surprise examination; and (iv) whether an independent public accountant prepares an internal control report with respect to the RIA or its related persons’ custodial services;
• report the month in which the last examination commenced; and
• identify the accountant(s) that perform audits or surprise examinations and that prepare internal control reports, provide information about the accountants (including address and PCAOB registration and inspection status), indicate the type of engagement (audit, surprise examination, internal control report) and indicate whether the accountant’s report was unqualified.
Form ADV-E has been amended to require that the accountant file: (i) the surprise examination certificate discussed above within 120 days of the time chosen by such accountant for the surprise examination and (ii) the termination statement discussed above within 4 business days of its resignation, dismissal or removal.
G. Dual Registered RIAs/Broker-Dealers
The Amended Rule applies to RIAs that are also registered as broker-dealers (“Dual Registered Entities”). Specifically:
• Dual Registered Entities are subject to the surprise examination requirement.
• Although registered broker-dealers are currently required to file a notice with the SEC within 15 business days of the dismissal or resignation of their auditors, the termination statement discussed above is required to be filed within 4 business days of the accountant’s resignation, dismissal, removal or other termination.
• The RIA will not be deemed to have custody of client assets held by a related broker-dealer with respect to which the RIA does not provide investment advice.
H. Changes to Rule 204-2
The Commission has adopted amendments to the Recordkeeping Rule, pursuant to which RIAs are required to maintain a copy of: (i) the internal control report that the RIA is required to obtain or receive from its related person; and (ii) a memorandum describing the basis upon which the RIA determined that a related person with custody of clients assets is operationally independent, in each case, for 5 years from the end of the fiscal year in which such internal control report or memorandum is finalized. In addition, the Commission stated in the adopting release that RIAs must retain a copy of the written agreement with the accountant relating to the surprise examination as part of its existing recordkeeping requirements.
I. Compliance Guidance
The Commission issued guidance regarding policies and procedures that should be adopted by RIAs in order to comply with the Amended Rule. Specifically RIAs should:
• conduct background and credit checks on employees who will have access to client assets to determine whether such access is appropriate;
• require the authorization of more than one employee before executing a transaction involving a client’s account, as well as before changing account ownership information;
• limit the number of employees who are permitted to interact with custodians, and rotate them on a periodic basis;
• periodically test the effectiveness of custody controls; and
• if the RIA also serves as a qualified custodian for client assets, segregate the duties of its advisory personnel from those of custodial personnel.
The Commission also recommended that RIAs that are deemed to have custody solely as a result of the ability to directly withdraw advisory fees from client accounts:
• periodically test fee calculations for client accounts to assess their accuracy;
• test the overall reasonableness of the amount of fees deducted from client accounts for a period of time based on the RIA’s assets under management; and
• segregate duties between those personnel responsible for processing billing invoices and those personnel responsible for reviewing the invoices, as well as the employees responsible for reconciling those invoices with deposits of advisory fees by the custodians into the RIA’s bank account.
J. Guidance to Accountants
In connection with the Amended Rule, the Commission published guidance to accountants regarding the conduct of the surprise examination and internal control report. According to the Commission, the objective of the surprise examination is to verify that client assets of which an RIA has custody are held by a qualified custodian in a separate account for each client under that client’s name, or in accounts that contain only clients’ assets, under the RIA’s name as agent or trustee for the clients. The accountant should obtain from the RIA records that detail client assets of which the RIA has custody and the identification of the qualified custodian(s) of those assets. For a sample of client accounts, the accountant should obtain records of the purchases, sales, contributions, withdrawals and any other debits or credits to each selected account occurring since the date of the last examination. The procedures used to conduct the examination should normally include:
• confirmation with the qualified custodian(s) of client assets as of the date of the examination;
• confirmation that the client’s assets are held in either a separate account under the client’s name or in accounts under the name of the investment adviser as agent or trustee for clients;
• confirmation with the client of assets held in the account as of the date of the examination and contributions and withdrawals of assets to and from the account since the date of the last examination (where confirmation replies are not received, the accountant should perform alternative procedures); and
• reconciliation of confirmations received and other evidence obtained to the RIA’s records.
In addition, the accountant’s internal control report should identify the control objectives included within the scope of the examination and include the accountant’s opinion as to whether controls have been placed in operation and are suitably designed and effective to meet the identified objectives. The report should describe the nature, timing, extent and results of the accountant’s procedures performed to verify that assets are reconciled to depositories and other unaffiliated custodians. The internal control report should address control objectives and associated controls related to the areas of client account setup and maintenance; authorization and processing of client transactions, security maintenance and setup; processing of income and transactions; reconciliation of assets to unaffiliated custodians; and client reporting. Control objectives addressing these areas should include whether:
• documentation for the opening and modification of client accounts is received, authenticated and established completely, accurately and timely;
• client transactions are authorized and processed in a complete, accurate and timely manner;
• trades are properly authorized, settled and recorded completely, accurately and timely in the client account;
• new securities and changes to securities are authorized and established in a complete, accurate and timely manner;
• securities income and corporate transactions are processed to client accounts in a complete, accurate and timely manner;
• physical securities are safeguarded from loss or misappropriation;
• cash and security positions are reconciled completely, accurately and on a timely basis between the custodian and depositories; and
• account statements reflecting cash and security positions are provided to clients in a complete, accurate and timely manner.
The accountant can rely on its own relevant audit work performed for the RIA for other purposes in preparing the internal control report.
A link to the full text of the release of the guidance can be found at http://www.sec.gov/rules/interp/2009/ia-2969.pdf
For additional information concerning this alert, please contact the following lawyers:
Amy Kroll, Partner, Broker-Dealer Group
amy.kroll@bingham.com, 202.373.6118
David Boch, Partner, Broker-Dealer Group
david.boch@bingham.com, 617.951.8485
Steven W. Hansen, Partner, Broker-Dealer
steven.hansen@bingham.com, 617-951-8538
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
roger.joseph@bingham.com, 617.951.8247
Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
edwin.smith@bingham.com, 617.951.8615
This article was originally published by Bingham McCutchen LLP.