Alert May 19, 2009

SEC Votes to Propose Amendments to Adviser Custody Rule

At its open meeting on May 13, 2009, the SEC voted to propose amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940, as amended.  Rule 206(4)-2 imposes certain requirements on a registered adviser that has custody of client assets, or is deemed to have custody of client assets by virtue of its access to them, e.g., when the adviser has the authority to withdraw funds from a client account held by a third party custodian.  According to an SEC press release describing the Commission’s action, the proposal would make the following changes to the rule:

Surprise exam for all advisers with custody - All registered advisers with custody of client assets would have to undergo an annual “surprise exam” by an independent public accountant to verify those assets exist.

Annual SAS-70 requirement for advisers holding clients assets with an affiliated custodian - Advisers whose client assets are not held or controlled by an entity independent of the adviser would be required to retain a PCAOB-registered and inspected accountant to prepare a SAS-70 report that, among other things, would describe the controls in place at the custodian, tests the operating effectiveness of those controls, and documents the results of those tests.  The review would have to meet PCAOB standards.

Reporting requirements - An adviser would be required to disclose in public filings with the SEC, among other things, the identity of the independent public accountant that performs its “surprise exam,” and would have to amend those filings to report a change in that accountant.  The accountant would have to report the termination of its engagement with the adviser and, if applicable, any problems with the examination that led to the termination of its engagement.  An accountant would have to report to the SEC any material discrepancies found during a surprise examination.

Direct delivery of statements to clients - The proposed amendments would require all custodians holding advisory client assets to deliver custodial statements directly to advisory clients rather than through the investment adviser.  Advisers opening custody accounts for clients would have to instruct the clients to compare the account statements they receive from the custodian with those they receive from the adviser.

In remarks at the open meeting, Commissioner Paredes, who indicated that he supported the proposal, asked for comment on the following particular issues, noting that in 2003 the SEC had considered measures similar to those being proposed and chose not to adopt them:

  1. whether the surprise examination requirement should cover investment advisers with an independent qualified custodian or be targeted to instances where the investment adviser or a related person is the qualified custodian, given that non-affiliated custodians already serve as an important safeguard of client assets;
  2. whether the rules should cover investment advisers who have custody only because they withdraw fees from client accounts;
  3. the extent to which the new requirements could adversely impact competition if they are disproportionately costly and burdensome for smaller entities; and
  4. the extent to which the new rules could foster moral hazard by promoting an undue sense of security that dissuades investors from doing their own diligence.  Commissioner Paredes indicated that it was worth considering the circumstances under which active investor diligence may do more to deter and detect misconduct than certain regulatory demands.
The period for public comment on the proposal will run for sixty days from the date of the proposal’s publication in the Federal Register.  The Alert will provide additional coverage once the SEC makes the formal release describing the proposal publicly available.

At its open meeting on May 13, 2009, the SEC voted to propose amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940, as amended.  Rule 206(4)-2 imposes certain requirements on a registered adviser that has custody of client assets, or is deemed to have custody of client assets by virtue of its access to them, e.g., when the adviser has the authority to withdraw funds from a client account held by a third party custodian.  According to an SEC press release describing the Commission’s action, the proposal would make the following changes to the rule:

Surprise exam for all advisers with custody - All registered advisers with custody of client assets would have to undergo an annual “surprise exam” by an independent public accountant to verify those assets exist.

Annual SAS-70 requirement for advisers holding clients assets with an affiliated custodian - Advisers whose client assets are not held or controlled by an entity independent of the adviser would be required to retain a PCAOB-registered and inspected accountant to prepare a SAS-70 report that, among other things, would describe the controls in place at the custodian, tests the operating effectiveness of those controls, and documents the results of those tests.  The review would have to meet PCAOB standards.

Reporting requirements - An adviser would be required to disclose in public filings with the SEC, among other things, the identity of the independent public accountant that performs its “surprise exam,” and would have to amend those filings to report a change in that accountant.  The accountant would have to report the termination of its engagement with the adviser and, if applicable, any problems with the examination that led to the termination of its engagement.  An accountant would have to report to the SEC any material discrepancies found during a surprise examination.

Direct delivery of statements to clients - The proposed amendments would require all custodians holding advisory client assets to deliver custodial statements directly to advisory clients rather than through the investment adviser.  Advisers opening custody accounts for clients would have to instruct the clients to compare the account statements they receive from the custodian with those they receive from the adviser.

In remarks at the open meeting, Commissioner Paredes, who indicated that he supported the proposal, asked for comment on the following particular issues, noting that in 2003 the SEC had considered measures similar to those being proposed and chose not to adopt them:

  1. whether the surprise examination requirement should cover investment advisers with an independent qualified custodian or be targeted to instances where the investment adviser or a related person is the qualified custodian, given that non-affiliated custodians already serve as an important safeguard of client assets;
  2. whether the rules should cover investment advisers who have custody only because they withdraw fees from client accounts;
  3. the extent to which the new requirements could adversely impact competition if they are disproportionately costly and burdensome for smaller entities; and
  4. the extent to which the new rules could foster moral hazard by promoting an undue sense of security that dissuades investors from doing their own diligence.  Commissioner Paredes indicated that it was worth considering the circumstances under which active investor diligence may do more to deter and detect misconduct than certain regulatory demands.
The period for public comment on the proposal will run for sixty days from the date of the proposal’s publication in the Federal Register.  The Alert will provide additional coverage once the SEC makes the formal release describing the proposal publicly available.