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SEC Adopts Changes to Investment Advisers Act Custody Rule
January 5, 2010
On December 30, 2009, the Securities and Exchange Commission (the "SEC") published its final rule changes to certain custody and recordkeeping requirements under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) and related forms (the “Amendments”). The Amendments, which were modified in part from the proposal, are designed to provide additional safeguards when a registered investment adviser ("RIA") has access to client funds and/or securities. As approved by the SEC, the Amendments significantly impact the custody practices of many private investment funds and their managers by requiring, under certain circumstances, either an annual surprise exam or audit by an independent public accountant, an internal control report and a liquidation audit. The Amendments go into effect sixty days after publication in the Federal Register.
The Amendments include changes to Advisers Act Rule 206(4)-2 (the “Custody Rule”) and related changes to Advisers Act Rule 204-2 (the “Books and Records Rule”), Form ADV, and Form ADV-E that are intended to improve the SEC’s ability to oversee custody practices of RIAs. In response to comments, the SEC made several modifications from its proposed rule (see our May 22, 2009 Alert regarding the proposed rule).
Although certain exceptions may apply, for purposes of the Custody Rule, RIAs generally will be deemed to have "custody" of client assets when they have:
- possession of client funds or securities;
- arrangements authorizing the RIA to withdraw client funds or securities maintained with a third-party custodian; and
- legal capacities, such as being a general partner of a limited partnership, that gives the RIA legal ownership of, or access to, client funds or securities. Most RIAs to private investment funds usually fall into this category and are deemed to have custody of fund assets for purposes of the Custody Rule.
In its current form, the Custody Rule requires, in part, that RIAs with custody of client assets maintain those assets with a "qualified custodian" – a term that generally includes most regulated banks, broker-dealers and other financial institutions providing custodial services. The Custody Rule also requires those advisers to have a reasonable belief that the qualified custodian holding the assets provides periodic account statements to the clients. If a client does not receive account statements directly from the qualified custodian, the RIA must send quarterly account statements to that client and undergo an annual surprise examination by an independent public accountant to verify the funds and securities of that client. In lieu of providing quarterly reports to clients, RIAs to private investment funds may provide annual audited financial statements prepared in accordance with generally accepted accounting principles within 120 days (180 days in the case of a fund of funds) of the end of the fund's fiscal year. Below is a brief summary of the Amendments.
- Delivery of Account Statements to Clients — All RIAs with custody of client assets must have a reasonable belief, after “due inquiry,” that the qualified custodian delivers account statements to advisory clients or their representatives (and not through the RIA) at least quarterly. Although the SEC did not prescribe a single method for forming this reasonable belief, in the adopting release the SEC stated that this belief may be formed if the qualified custodian provides the RIA with a copy of the account statement that was delivered to the client. If the RIA or a related person is a general partner of a limited partnership (or managing member of a limited liability company, or holds a comparable position for another type of pooled investment vehicle), the account statements must be sent to each limited partner (or member or other beneficial owner). When limited partners (or members or other beneficial owners) themselves are limited partnerships (or limited liability companies, or another type of pooled investment vehicle), account statements and financial statements must be sent to the underlying limited partners (or members or other beneficial owners).
- Notices to Clients — RIAs with custody of client assets who elect to send their own account statements to clients must include in notices sent to clients upon opening custodial accounts or upon changes to their account information, a legend urging clients to compare the account statements they receive from the custodian with those they receive from the RIA. The Amendments also require such legend to be included in any subsequent statements delivered to clients after the initial notice.
- Annual Surprise Examination of Clients Assets — All RIAs with custody of client assets must obtain an annual surprise examination by an independent public accountant. Accountants conducting surprise examination of RIAs acting as qualified custodian or whose related person acts as qualified custodian, must be registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (“PCAOB”). However, unlike the proposed rule, the Amendments, as adopted, except from the surprise examination requirement RIAs with custody of client assets solely because of their authority to deduct advisory fees from client accounts. The Amendments also except from the surprise examination requirement RIAs that are (i) deemed to have custody solely as a result of certain of their related persons holding client assets, and (ii) “operationally independent” of the custodian (as such term is defined in the Amendments). In addition, the Amendments deem RIAs to pooled investment vehicles that (i) are subject to an annual financial statement audit by an independent public accountant registered with, and subject to regular inspection by, the PCAOB; and (ii) distribute the audited financial statements prepared in accordance with generally accepted accounting principles to the pool’s investors within 120 days of the pool's fiscal year end, to have satisfied the surprise examination requirement. Acknowledging concerns raised by commenters, the SEC has directed its staff to evaluate the impact of the surprise examination requirement on smaller RIAs and their clients and provide recommendations for any necessary amendments to the Custody Rule as it applies to those RIAs.
- Commission Reporting — All RIAs with custody of client assets who are subject to the surprise examination requirement must enter into a written agreement with an independent public accountant to conduct the surprise examination requiring the accountant, among other things, to notify the SEC within one business day of finding material discrepancies, and to electronically submit Form ADV-E to the SEC, via IARD, within 120 days of the examination. Form ADV-E must be accompanied by a certificate stating that the accountant has examined the funds and securities and describing the nature and extent of the examination. The written agreement must also require the independent public accountant to submit Form ADV-E to the SEC within four business days of its resignation, dismissal from, or other termination of the engagement or upon removing itself or being removed from consideration for being reappointed.
- Privately Offered Securities — Privately offered securities are now subject to the Custody Rule, including the surprise examination requirement. However, certain privately offered securities do not need to be maintained by a qualified custodian; provided that, with respect to securities held for the account of a pooled investment vehicle, the pool must be audited and the audited financial statements must be distributed within 120 days of the pool's fiscal year end.
- Custody by Adviser and its Related Persons — RIAs whose “related persons” (a person directly or indirectly controlling or controlled by the RIA and any person under common control with the adviser) hold client assets are deemed to have custody if those assets are held by the related person in connection with the advisory services provided by the RIA. If the RIA or a related person instead serves as a qualified custodian for client funds or securities, the RIA must obtain or receive from the related person no less frequently than once each calendar year a written report (“internal control report”) that demonstrates that the RIA or its related person has established appropriate custodial controls. The internal control report must be issued by an independent public accountant registered with and subject to regular inspection by the PCAOB, who must also verify that the client funds and securities are reconciled to a custodian other than the RIA or its related person. The RIA must maintain the internal control report in its records and make it available to the SEC upon request. In addition, the Amendments require RIAs whose client assets are held by a related person but do not undergo a surprise examination to make and keep a memorandum describing the relationship with the related person in connection with advisory services the RIA provides to clients and including an explanation of the RIA’s basis for determining that it has overcome the presumption that it is not operationally independent of the related person with respect to the related person’s custody of client assets. Although the SEC is not requiring the use of an independent custodian, in the adopting release the SEC stated that it is encouraging the use of custodians independent of the RIA to maintain client assets as a best practice whenever feasible.
- Liquidation Audit — RIAs to pooled investment vehicles with custody of pool assets must, in addition to obtaining an annual audit, 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.
- Compliance Policies and Procedures — In the adopting release the SEC provided guidance regarding the types of policies and procedures relating to safekeeping of client assets that RIAs should consider. In particular, the SEC stated that RIAs to pooled investment vehicles should consider whether certain compliance practices should cover investor accounts in the pool to prevent misappropriation of investor assets. The guidance set forth in the adopting release is primarily in the form of examples and the SEC expects RIAs to tailor their custody policies and procedures to fit both the size and the particular risks raised by their business model. Accordingly, RIAs should consult with their legal counsel regarding this guidance when updating their compliance programs and manuals to reflect the Amendments.
- Changes to Form ADV — Form ADV requires more detailed disclosure of an RIA's custody practices to reflect the changes to the Custody Rule, including disclosure of whether the RIA's clients' assets are subject to a surprise examination.
- Changes to Form ADV-E — Form ADV-E must be filed electronically via IARD. The surprise examination certificate must be filed within 120 days of the surprise examination date and a termination statement must be filed within 4 business days of termination.
- Changes to the Books and Records Rule — RIAs must maintain a copy of (i) the internal control report that such RIA is required to obtain or receive from its related person, and (ii) the memorandum describing the basis upon which the RIA determined that the presumption that any related person is not operationally independent has been overcome, for 5 years from the end of the fiscal year in which, as applicable, the internal control report or memorandum is finalized.
- Compliance Dates — Except as provided below, RIAs must comply with the Amendments on and after the effective date. An RIA required to obtain a surprise examination must enter into a written agreement with an independent public accountant that provides that the first examination will take place by December 31, 2010. If the RIA acts as the qualified custodian, the agreement must provide for the first surprise examination to occur no later than 6 months after obtaining the internal control report. An RIA required to obtain or receive an internal control report must obtain or receive such report within 6 months of becoming subject to the requirement. An RIA to a pooled investment vehicle may rely on the annual audit provision if the RIA (or a related person) becomes contractually obligated to obtain an audit of the financial statements of the pooled investment vehicle for fiscal years beginning on or after January 1, 2010. RIAs must provide responses to the revised Form ADV in their first annual amendment after January 1, 2011.