The SEC’s Office of Compliance Inspections and Examinations issued a National Examination Risk Alert that discusses areas of non-compliance with Rule 206(4)-2 (the “Custody Rule”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), observed by the SEC’s National Examination Program (“NEP”). Referring to the Custody Rule as “[o]ne of the most critical rules under the [Advisers Act],” the Risk Alert describes “widespread and varied non-compliance with elements of the [Custody Rule],” with approximately one-third of the examinations reviewed in preparing the Risk Alert exhibiting custody-related issues. The Risk Alert groups the custody-related deficiencies observed by the NEP into the following four categories:
- failure to recognize that an adviser has “custody” in a number of situations where an adviser or its affiliates hold or have access to client assets;
- failure to comply with elements of the Custody Rule’s “surprise examination” requirement;
- failure to comply with the Custody Rule’s “qualified custodian” requirements by, e.g., commingling proprietary and client assets in a single account; and
- failure to satisfy various requirements of the Custody Rule when an adviser elects to comply with the Rule through the preparation and distribution of audited annual financial statements for pooled investment vehicles it manages.
The Risk Alert concludes by noting that Custody Rule deficiencies noted in examinations have resulted in actions ranging from immediate remedial measures taken by advisers to referrals to the SEC’s Division of Enforcement and subsequent litigation. In conjunction with the Risk Alert, the SEC’s Office of Investor Education and Advocacy (the “OIEA”) issued an Investor Bulletin that walks through the Custody Rule’s components and urges advisory clients to consider particular elements of the Custody Rule in their diligence processes.