The Industry Speaks and the SEC Listens

2009 was a year of turmoil in the financial markets and the economy in general. With abuses and fraud making headlines and regulators being partly blamed for the economic issues, individuals in the financial community seem to be awaiting a wave of regulatory self-protective backlash consisting of potentially unnecessary, and ultimately, ineffective regulations.

Among the anticipated regulatory changes was a revision of Rule 206(4)-2, (the custody rule) of the Investment Advisers Act of 1940. Last changed in 2004, some feared that the revised rule would be overly restrictive and costly for many investment advisers. The revisions were being considered in reaction to, among other things, certain advisers creating false client statements listing non-existent securities and other assets, the best known being Inmate No. 61727-054 currently residing at the luxurious Butner Federal Correctional Complex. The industry reacted to the custody proposal released last year, and to its credit, the Securities and Exchange Commission ("SEC") came out with a better, more thoughtful, final rule than the proposal initially offered. The revised rule leaves the landscape largely unchanged for the majority of advisers. It does include some material changes applicable to advisers (and affiliates) with direct custody of client funds and/or securities. Most SEC registered investment advisers either do not have custody of client funds or securities or only have custody to the extent that the adviser is authorized to deduct advisory fees directly from a client's custodial account. Under the revised rule, the actions required of these types of advisers effectively do not change although some disclosure and notification will be required on advisers' statements to clients.

The amended rule will impact those advisers who have more direct forms of custody (or custody through affiliates), such as ability to withdraw funds beyond advisory fees or who actually have physical custody of client funds and/or securities. The new provisions that affect advisers with more direct forms of custody come in the form of two types of reviews. Depending on the form of custody, relationship with the custodian, and potential type of risk for abuse of client assets, an adviser may be subject to one or both of these reviews.

The first type is an annual surprise examination that would require an independent accounting firm to verify the existence of client assets. Variations of this surprise examination have been in place in past versions of the custody rule along with a requirement to report suspected discrepancies to the SEC, as also required by the revised rule.

The second type of review is a custody controls review which entails preparation, by an accountant registered with, and subject to examination by, the Public Company Accounting Oversight Board ("PCAOB"), of a written internal control report that describes the controls in place at the custodian, the testing related to the effectiveness of those controls, and results of those tests. These reports may be in the form of, or may be similar to, SAS 70 reports.

How to determine what the new custody rule means for your firm

  • If your adviser self custodies or has custody through an affiliated custodian, the adviser will have to undergo both the annual surprise exam and the review by a PCAOB-registered accountant.
  • If your adviser is affiliated with a custodian that is operationally independent and the adviser and custodian "operate as distinct entities with no overlap of personnel, office space or common supervision, the adviser would not be subject to the surprise exam, but would have to undergo an expensive SAS-70 review.
  • If your adviser has the ability to withdraw funds from client accounts, but an independent custodian holds custody, the adviser would not be subject to a SAS-70 review, but would have to undergo the annual surprise exam.

Advisers to private funds, which needless to say have received a great deal of attention from the regulatory community and press over the last few years, will be required to engage accountants that are PCAOB-registered to conduct audits of the private funds and to distribute financial statements to investors in the fund. If an adviser to a private pooled fund uses special purpose vehicles ("SPVs"), the underlying beneficial investors are to receive financial statements rather than the SPV. In lieu of disseminating financial statements to investors, a surprise audit may be conducted of the SPV, and the adviser must have a reasonable basis to believe that investors are receiving statements regarding the pool from the qualified custodian. If the adviser to the pool, or a related person of the adviser, serves as custodian to the pool, an internal control review, as described above, would have to be conducted and a report issued as a result of the review. The amended rule also requires a final termination audit for private funds, and dissemination of the resulting financial statements to fund investors, when a fund is being liquidated.

As with any New Year and with new developments, uncertainty as to how they will actually play out is invariably a part of the consideration of those who face them. Some may question whether the costs of complying with these new requirements under the custody rule are too high, especially in conjunction with other regulations instituted during the last decade and those that may be instituted within the next year. Others may question the potential for effectiveness of these revised rules designed to prevent, curtail and catch certain types of abuses and fraud. If surprise examinations have been a component of the rule in the past, will instituting a variation on the same theme result in prevention and discovery of abuses of custodial authority, or will those abusing that authority find creative ways to avoid compliance and detection as they have in the past? Do these amended regulations only address some of the symptoms and overt signs of abuse without amputating or cauterizing the causes of the problems? Given that this amended rule significantly impacts a relatively small, yet high-risk, population of advisers, perhaps it is intended, as is noted in the adopting release for the rule, to be only a facet of a larger program, including changes in regulatory examination techniques and monitoring, that will look at a firm in its entirety, from its culture of compliance to its handling of client assets, in order to ascertain the likelihood or actuality of abuses occurring. These questions and doubts remain as we enter a new year.

Nonetheless, all advisers should review their custody relationships and determine what enhancements need to be made to training, internal procedures, and ADV disclosure, as a result of these recent related rule amendments. We look forward to 2010 hoping that the year to come will bring more stability than we have seen in the past few years. We can hope that those who remain in our industry have high ethical standards and that we can enjoy a more prosperous economy and stable financial system. As 2008 and 2009 were not the end of the world, let us not enter 2010 whimpering with fear but rather with a bang of expectation for a renewed future. Happy New Year!


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