On December 16, 2009, the US Securities and Exchange Commission (SEC) voted to adopt amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940 – the “Custody Rule” for registered investment advisers (RIAs).1 Based in part on approximately 1,300 comment letters received by the SEC, the SEC intends to make some significant changes from the original proposal to amend the Custody Rule.2
RIAs Using Independent Custodians with Authorization to Deduct Fees
A major change from the original proposal is that an RIA who maintains client assets with an unaffiliated “qualified custodian”3 will not be deemed to have custody (and be subject to the requirements otherwise applicable to advisers with custody described below) solely on the basis of exercising the authority to deduct advisory fees directly from clients’ accounts with the custodian. Instead, these fee-deducting RIAs will be required to implement certain compliance controls related to ensuring proper fee deductions.
Custody with Affiliated Qualified Custodians
As provided in the original proposal, every RIA that maintains custody of client assets through an affiliated qualified custodian will be subject to an annual surprise examination by an independent auditor.4 Moreover, these RIAs will be required to annually obtain an “internal control report” (commonly referred to in the United States as a SAS 70) from an independent accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (PCAOB). This internal control report would review and assess the controls put in place by the custodian.
Under the original proposal, affiliated qualified custodians under common control were deemed to be related for purposes of triggering the foregoing requirements. As a change to the original proposal, the amendments will establish a rebuttable presumption that such an affiliation creates a sufficient degree of relatedness to trigger the foregoing requirements. In other words, if an RIA can demonstrate that it is operationally independent from its affiliated custodian, it will not need to undergo the annual surprise examination.5 However, the RIA would not be exempt from the requirement to obtain an internal control report from its affiliated custodian. As explained by SEC Chair Shapiro, criteria for determining operational independence should include whether the RIA and its affiliate are distinct legal entities, and whether there is overlap between the RIA and its affiliate with respect to personnel, office space or supervision.6
RIAs to Private Funds
Under the Custody Rule, RIAs to private funds (i.e., pooled investment vehicles not required to register under the Investment Company Act of 1940) may, in lieu of providing quarterly account statements, instead annually provide audited financial statements for the private funds to all fund investors. Under the adopted amendments, these audited financial statements will now need to be provided by an independent accountant registered with, and subject to regular inspection by, the PCAOB, and the results of the independent accountant’s audit must be released to investors in the private fund. In a change from the original proposal, the annual surprise examination requirement described above will not apply to private funds that provide audited financial statements.
RIAs that use an Independent Qualified Custodian but have Authority over Client Assets
The SEC noted that some RIAs, particularly smaller RIAs, use an independent qualified custodian but nonetheless have authority over client assets because (i) they serve as trustee to a client trust, (ii) they have a power of attorney over the client’s account, or (iii) they have authority to write checks on the client’s account. Because of the control exercised by these RIAs, they would be required to undergo an annual surprise examination, as described above. In recognizing the costs the surprise examination could impose on these often smaller RIAs, the SEC explained that they are directing the SEC staff to monitor the issue and study the impact of these fees over the first year that the amendments are in place, and noted that depending on the findings, the SEC may revisit the issue in the future.
The SEC also explained that it will be issuing an interpretive release updating the guidance on surprise examinations by auditors, and will also be giving guidance on internal controls related to custody. In addition, the SEC indicated the following issues addressed in the original proposal were also approved:
- Heightened requirements for RIAs in forming their “reasonable belief” that the custodian is delivering quarterly account statements to clients; and
- A requirement, under certain circumstances, for auditors to make a so-called “noisy withdrawal” if they cease to perform examinations for an RIA. Under the original proposal, this would be accomplished through a submission to the SEC detailing the date and circumstances of the auditor’s termination by the RIA.
We will provide another Client Update when the text of the adopting release and the new interpretive releases are available. If you have questions regarding these latest developments, or the Custody Rule in general, please contact the Mayer Brown attorney with whom you normally communicate or any of the following attorneys: Michael R. Butowsky at +1 212 506 2512, Marc R. Cohen at +1 202 263 3206, Elizabeth M. Knoblock at +1 202 263 3263, Stephanie M. Monaco at +1 202 263 3379, or Jerome J. Roche at +1 202 263 3773.
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1. This Client Alert is based on the SEC’s Open Meeting held on December 16, 2009. The full text of the adopting release is not yet available.
2. Investment Advisers Act Release No. 2,876 (May 20, 2009), 74 FR 25354 (May 27, 2009), available here. For Mayer Brown’s Client Update concerning the original proposal, please click here.
3. “Qualified custodian” generally includes banks, certain broker-dealers, futures commission merchants and certain foreign financial institutions.
4. This would similarly apply to RIAs that maintain self-custody of client assets, unchanged from the original proposal. During the examination, the auditor would examine client accounts to try to determine whether there has been any misappropriation of assets. If the auditor were to find any discrepancy, it would be required to notify the SEC within one day.
5. It is currently unclear how and when the rebuttal of this presumption would be evaluated by the SEC. We surmise at this time that the SEC would raise the issue ex post facto during an examination of the RIA.
6. Notably, in discussing these operational independence issues, SEC Commissioner Casey referred to Crocker, an SEC no-action letter issued under a prior iteration of the Custody Rule. See Crocker Investment Management Corporation, SEC No-Action Letter (April 14, 1978).