The SEC last week proposed amendments (the “Proposed Amendments”) to Rule 206(4)-2 under the Investment Advisers Act of 1940 (the “Advisers Act”), which imposes a number of requirements on an SEC-registered investment adviser that is deemed to have custody of its clients’ funds and securities. In general terms, the SEC views an adviser as having custody of client assets not only when the adviser has physical custody of those assets, but also when the adviser has the authority to obtain client assets, such as by deducting advisory fees from a client account, writing checks or withdrawing funds on behalf of a client, or by acting in a capacity, such as general partner of a limited partnership, that gives an adviser or its supervised person the authority to withdraw funds or securities from the limited partnership’s account. The Proposed Amendments come in the wake of a number of enforcement actions recently brought by the SEC against broker-dealers and advisers involving the misappropriation or misuse of customer assets, including the action brought against Bernard Madoff.The Proposed Amendments, if adopted, would make four principal changes to Rule 206(4)‑2.
Client Assets held by a Related Person. Currently, the SEC takes the position that when a “related person” of an adviser, for example, an affiliated broker-dealer, has access to client funds, the adviser may have custody of those funds depending on the circumstances, and the SEC staff has provided no-action guidance on the considerations relevant to determining whether or not custody ultimately exists. The Proposed Amendments would deem an investment adviser to have custody of client assets if a related person of the adviser has access to those assets, provided that the investment adviser is providing investment advisory services to the client. Under the Proposed Amendments, a related person would be any person directly or indirectly controlling, controlled by, or under common control with the investment adviser. The Proposed Amendments also would define “control” generally to mean the power to direct the management or policies of a person. The Proposed Amendments include several presumptions of control in the cases of certain officers, partners and directors, certain 25 percent shareholders of corporations, partnerships and limited liability companies, and trustees and managing agents of trusts.
Surprise Examination Requirement. The Proposed Amendments would require all registered investment advisers with custody of client assets to engage an independent public accountant to conduct an annual surprise examination of those assets. The most recent amendments to Rule 206(4)-2 adopted in 2003 generally eliminated this requirement when a qualified custodian provides statements to clients or, in the case of a pooled investment vehicle, the pool is audited annually and a copy of the auditor’s report is sent to the investors in the pool. Under the Proposed Amendments, privately offered securities that an investment adviser holds on behalf of its clients also would be subject to the surprise examination requirement, although they would continue to be excluded from the other requirements of the rule. The Proposed Amendments also would require, among other things, that the independent public accountant be a member of, and subject to regular inspection by, the Public Company Accounting Oversight Board (“PCAOB”).
Quarterly Account Statements. Rule 206(4)-2 currently requires delivery of quarterly account statements to clients when an adviser has custody of their assets, either by (a) the qualified custodian used to hold client assets or (b) the adviser itself, provided the adviser undergoes surprise audits at least annually. The Proposed Amendments would eliminate the latter option so that in all cases where an adviser has custody of client assets, the qualified custodian holding the client assets would have to deliver the quarterly statements. In addition, where the current rule requires an adviser that relies on a qualified custodian to deliver quarterly accounts statements to have a reasonable basis for believing that such delivery takes place, the Proposed Amendments would require that reasonable basis to be after due inquiry. According to the SEC’s proposing release, an investment adviser could satisfy the due inquiry standard by receiving copies of quarterly account statements from the qualified custodian or a written confirmation each quarter that the necessary account statement was sent.
Controls Report for Related Person Custodian. When an investment adviser or a related person serves as a “qualified custodian” of client assets in connection with the advisory services provided by the investment adviser, the Proposed Amendments would require the investment adviser to obtain, or receive from its related person, at least annually a report from an independent public accountant that includes an opinion on the investment adviser’s or related person’s controls relating to the custody of client assets, such as a Type II SAS 70 report. The Proposed Amendments also would require, among other things, that the independent public accountant be a member of, and subject to regular inspection by, the PCAOB.
The Proposed Amendments also would, among other things, make corresponding changes to Form ADV, and they would impose additional restrictions on when and under what circumstances the independent public accountant must file Form ADV-E relating to surprise examinations under Rule 206(4)-2.
As with the current Rule 206(4)-2, the Proposed Amendments, if adopted, only would apply to client securities and funds, and would not apply to other types of investments. Also as with the current Rule 206(4)-2, the Proposed Amendments would not require an investment adviser to comply with the rule with respect to the account of a registered investment company. Finally, the Proposed Amendments would not materially change Rule 206(4)-2’s current definition of a “qualified custodian.”
Comments on the Proposed Amendments are due to the SEC on or before July 28, 2009.