On December 30, 2009, the SEC adopted amendments to the custody and recordkeeping rules under the Investment Advisers Act of 1940 (the “Advisers Act”) and related forms. The amendments are designed to strengthen the prior custodial controls imposed by Rule 206(4)-2.
When an adviser or its related person serves as a qualified custodian for client assets, the new rules require that the adviser undergo an annual surprise examination and obtain, or receive from its related person, an internal control report with respect to custody controls, both of which must be performed or prepared by an independent public accountant that is registered with, and subject to regular inspection by, the PCAOB. This annual surprise examination will likely result in significant increased costs for many registered investment advisers.
New Rule 206(4)-2(a) provides that it is a fraudulent practice for a registered investment adviser to have custody of client funds or securities unless:
- Qualified Custodian. A qualified custodian maintains those funds or securities in a separate account for each client or in accounts that contain only clients’ funds and securities under the adviser’s name as agent or trustee for the clients.
- Notice to Clients. The adviser notifies the client of the qualified custodian and the manner in which the funds or securities are maintained promptly when the account is opened. If the adviser sends account statements to a client, it must include a statement urging the client to compare account statements of the custodian and the adviser. The purpose of this amendment is to ensure advisory clients will receive a statement from the qualified custodian that they can compare with any statements they receive from their adviser to determine whether account transactions are proper.
- Account Statements to Clients. The adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of the adviser’s clients for which the custodian maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions during the period.
- Independent Verification. The client funds and securities for which the adviser has custody are verified by actual surprise examination annually by an independent public accountant pursuant to a written agreement between the adviser and the accountant. The written agreement must require the accountant to file a certificate stating it has performed the examination, notify the SEC of discrepancies, and notify the SEC of any termination of the engagement and any problems that contributed to the termination. The purpose of this rule is to provide “another set of eyes” on client assets and an additional set of protections against asset misappropriation. Additionally, this rule is expected to deter fraudulent conduct by investment advisers.
Rule 206(4)-2(a)(6) provides that if an adviser maintains (or has custody because a related person maintains) client funds or securities as a qualified custodian in connection with advisory services the adviser provides to clients, the following rules apply:
- The independent public accountant retained to perform the independent verification must be registered and subject to regular inspection by the PCAOB.
- The adviser must obtain or receive from its related person at least once per calendar year a written report that includes an opinion from the independent public accountant regarding controls related to custody of client assets. The purpose of this rule is deter fraud given the fact that related person custody arrangements can present higher risks to advisory clients than maintaining assets with an independent custodian.