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American Bar Association - Defending Liberty, Pursuing Justice

SPRING 2011

Vol. 7, No. 3

 

BUSINESS LAW

 

Custody Rules for Investment Advisors

By Amy Rigdon

On December 30, 2009, the Securities and Exchange Commission (the SEC) published its final rule amending the Custody Rule and related forms and rules. These amendments became effective March 12, 2010, and affect four main areas: (1) account statements; (2) additional surprise examinations; (3) physical custody of client assets; and (4) enhanced compliance and reporting obligations.

Who is affected? The Custody Rule applies to registered investment advisers (RIAs). In the amended Custody Rule, the definition of “custody” has been expanded to specifically include RIAs that have related persons who hold or are authorized to possess client funds or securities in connection with the advisory services provided by the RIA to its clients. This expansion is a significant departure from the SEC’s practice of not attributing custody of client assets held by a related person of an RIA if the related person was operationally separate. The term “related” means a person directly or indirectly controlling, controlled by, or under common control with the RIA. Thus, RIAs who are a part of multiservice financial organizations may have “related person” custodians that are banks and broker‐dealers. While the amended Custody Rule still applies to only RIAs, unregistered investment advisers should be aware of the rule given that they may have to register depending upon the outcome of the proposed financial reform legislation (e.g., Dodd Bill).

Changes to Custody Rule (New Requirements)

Account Statements

Under the amended Custody Rule, the qualified custodian must send account statements on a quarterly basis directly to an RIA’s clients. The RIA may send an additional account statement to its client, but the statement must include a legend asking the client to compare this statement to the one from the qualified custodian. Additionally, the RIA must form a reasonable belief that the qualified custodian is sending the account statements directly to clients. The reasonable belief must be formed after “due inquiry.” Notably, even if a client receives its quarterly accountant statements electronically from the custodian, the RIA must still form a reasonable belief after due inquiry that the clients are receiving those statements.

Neither the Custody Rule nor its adopting release prescribes a particular method to satisfy “due inquiry.” The adopting release specifically states that an RIA cannot satisfy its “due inquiry” obligation if the custodian merely makes the clients’ account statements available on its website for the clients to access.

Practice Tip: An RIA will probably satisfy its “due inquiry” if the custodian emails a link to electronically access the statement to the clients and includes the RIA as a “CC:” recipient on each email.

Annual Surprise Examination

RIAs with custody of client assets generally are subject to annual surprise examinations by independent public accountants. The amended Custody Rule includes three exceptions from this requirement. First, the requirement does not apply to RIAs that (1) maintain client funds and securities at a qualified custodian and (2) have custody solely because of the RIA’s authority to deduct advisory fees from client accounts. Be aware that this exemption does not apply if the RIA has custody for any additional reason.

Second, the surprise examination requirement is deemed fulfilled for an RIA of a private pooled investment vehicle if (1) such vehicle undergoes an annual financial statement audit by an independent public accountant who is registered with and subject to inspection by PCAOB; (2) such audited financial statements are prepared in accordance with GAAP; and (3) the audited financial statements are distributed to the fund’s investors within 120 days after the end of the fiscal year (or 180 days for fund­-of‐funds). This second exemption is significant for RIAs of hedge fund and other private funds because it allows those RIAs to not only be exempt from the surprise examination but to also be exempt from the requirement to have a custodian send quarterly annual account statements to investors. Accordingly, if an RIA of a private pooled investment vehicle complies with this annual audit exemption, the requirements to deliver quarterly account statements and undergo surprise examinations do not apply to the RIA. Please note that this exemption is available only to RIAs’ advisory services provided to clients that are pooled investment vehicles and not any advisory services provided to another type of client.

Practice Tip: Not all PCAOB‐registered accounting firms are regularly inspected by the PCAOB. You should inform your RIA clients to ensure that the engagement letter with their accountant includes a representation that the accountant is both registered and inspected by the PCAOB. Additionally, this requirement applies to audits for fiscal years beginning on or after January 1, 2010.

Third, the surprise examination requirement is waived if the RIA is deemed to have custody of client assets solely because a related person is holding the assets and the related person is “operationally independent” of the RIA. The SEC presumes that related persons are not operationally independent, which makes it difficult for RIAs to use this exemption. Nevertheless, an RIA may rebut this presumption by demonstrating that certain conditions apply to the related person. Note that the presumption cannot be rebutted if the RIA has custody for additional reasons, and in such case, the RIA would be subject to the surprise examination requirement.

Internal Control Report

If client assets are held by an RIA or a related person, the RIA must obtain, or receive from the related person, a report of the internal controls relating to the custody of those assets from an independent public accountant. This requirement exists whether or not the related person is operationally independent; however, an RIA who maintains custody of privately offered securities is not required to obtain an internal control report unless the RIA also acts as qualified custodian with respect to other client funds or securities.

The RIA must receive the first internal control report within six months of becoming subject to this requirement. For RIAs subject to the requirement as of the Custody Rule’s effective date, the deadline to obtain an internal control report was September 12, 2010. RIAs must maintain copies of these internal control reports for five years.

In the case of a private pooled investment vehicle, if the pooled vehicle’s assets are maintained with a qualified custodian that is either the adviser to the pool or a related person of the adviser, then the RIA must obtain an internal control report from the related person. This requirement applies whether or not the RIA has fulfilled the surprise examination requirement by distributing audited annual financial statements.

Recommended Compliance Policies

The adopting release recommends certain policies and practices for RIAs to comply with the new Custody Rule. In addition to those recommendations, the subcommittee discussed additional best practices. Some of those best practices for RIAs include:

  • Conduct background and credit checks on the RIA’s employees who will have access to client assets;
  • Require the authorization of two or more employees to transfer assets in and out of a client’s account;
  • Limit the number of employees who are permitted to interact with custodians regarding client assets and rotate such employees on a periodic basis;
  • If the RIA also serves as a qualified custodian for client assets, segregate the duties of its advisory personnel from those of custodian personnel to impede any one person from misusing client assets;
  • Track the status of the auditor;
  • Establish policies to track the due inquiry supporting the RIA’s belief that custodians have sent quarterly account statements to client;
  • Establish policies to document the reasons the RIA believes its related person is operationally independent;
  • Prohibit employees from becoming trustees for client assets or obtaining powers of attorney for clients to prevent the RIA from inadvertently being deemed to have custody of client assets; and
  • Most importantly, ensure that the RIA’s chief compliance officer has access to information on relevant matters so that he or she may enforce these policies and practices.

Lawyers with clients affected by the new Custody Rule should tell their clients to anticipate more detailed reporting and recordkeeping obligations in these areas. The SEC has announced that in light of these amendments Form ADV Part 1 will be amended to require RIAs to report more detailed information about their custody practices, to identify the accountants that perform audits or surprise examinations and that prepare internal reports, and to identify related persons that serve as qualified custodians. For RIAs that use a related person as its custodian, the RIA must also report whether it has determined that its related person is operationally independent and thus is not subject to the surprise examination requirement. RIAs can expect to provide these responses to the revised Form ADV in their annual amendments as of January 1, 2011.

Amy R. Rigdon is an associate in the Orlando, Florida, office of Holland & Knight. Ms. Rigdon practices in the area of corporate and securities law. Her practice includes investment management, mergers and acquisitions, general corporate law, and litigation. Specifically, her experience includes forming and providing counsel to investment advisers and onshore and offshore hedge funds. She can be reached at Amy.Rigdon@hklaw.com.

The above article is reprinted from “Custody Rules for Investment Advisors” by Amy Rigdon, published by ABA Business Law Section, Young Lawyer Committee Newsletter, March 2011. Copyright 2011© by the American Bar Association. Reprinted with permission. All rights reserved. This information or any or portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

© Copyright 2011, American Bar Association.