By Craig Foster and Carol Dey Hibbs
The SEC amended its custody rule, effective March 12, 2010, to increase the oversight of advisers that are deemed to have custody of client assets. An adviser is deemed to have “custody” in numerous situations, such as when the adviser deducts fees from client accounts, manages a private investment fund, serves as trustee for a client, or has a general power of attorney from a client. If an adviser is deemed to have custody of client assets, a “qualified custodian,” such as a bank, trust company or broker-dealer, must maintain those assets (other than certain privately offered securities).
Under the amended Rule 206(4)-2, advisers that are deemed to have custody of client funds or securities must meet certain new requirements, some of which are described below.
1. Surprise Examination
These advisers must engage an independent public accountant to conduct an annual “surprise exam” to verify the existence of client assets subject to the adviser’s custody. The accountant will be required to contact the SEC within one business day if he or she discovers any material discrepancies.
An adviser is exempted from the surprise exam requirement if the adviser:
(a) is deemed to have custody solely because the adviser has authority to deduct advisory fees from client accounts;
(b) is deemed to have custody solely because a related person has custody of client assets, and the related person is “operationally independent” (as defined in the amended rule) from the adviser; or
(c) is the manager of a private investment fund, if the fund’s financial statements are audited and distributed to investors in the fund within 120 days of the fund’s fiscal year-end (or, for a fund of funds, within 180 days of the fund’s fiscal year-end). The audit must be done by an accounting firm registered with and subject to regular inspection by the Public Company Accounting Oversight Board (the “PCAOB”).
Required Action. Generally, advisers required to obtain a surprise exam must enter into a written agreement with an independent public accountant that provides for the first exam to take place by December 31, 2010, or, for advisers that become subject to the rule after March 12, 2010, within six months of becoming subject to the requirement.
2. Delivery of Account Statements by Custodians Directly to Clients
Under the old custody rule, advisers deemed to have custody of client assets had two options with respect to providing account statements to clients. The qualified custodian maintaining the assets could send quarterly account statements to clients or, if the adviser was subject to an annual surprise exam, the adviser itself could send quarterly account statements to clients.
The amended rule eliminates the second option and requires the qualified custodian to send account statements directly to clients. In addition, an adviser deemed to have custody of client assets must now:
(a) have a reasonable basis, after due inquiry, for believing that the qualified custodian sends, at least quarterly, account statements to each of the adviser’s clients for which the qualified custodian maintains assets; and
(b) upon opening an account with a qualified custodian on a client’s behalf, promptly notify the client in writing of the qualified custodian’s contact information. If the adviser also sends account statements to clients, such notice and account statements must include a legend that recommends that the client compare account statements received from the qualified custodian with those received from the adviser.
Required Action. Advisers deemed to have custody of client assets (including advisers that are deemed to have custody solely because they deduct fees from clients) must be in compliance with Section 2(a) and, if applicable, with Section 2(b) by March 12, 2010. The only exception is for advisers managing private investment funds where the funds’ financial statements are audited, and the financial statements are distributed to fund investors, as summarized in Section 1(c) above.
3. Internal Control Report
When the adviser or an affiliate of the adviser serves as the qualified custodian of client assets (regardless of whether a surprise exam is required), the adviser must now obtain a written report prepared by an accountant that is registered with and subject to regular inspection by the PCAOB. The report would, among other things, include an opinion as to whether the qualified custodian’s internal controls are suitably designed and operating effectively to safeguard assets in its custody.
Required Action. An adviser required to obtain an internal control report must do so by September 12, 2010, or, for an adviser that becomes subject to the rule after March 12, 2010, within six months of becoming subject to the requirement.
For further questions concerning the SEC’s new custody rule, please contact our Financial Services Practice Group.
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