Investment Company Notebook

Practical insight and analysis on the accounting, audit and tax issues impacting investment companies.

Adviser Custody Rule Update- What You Need to Know About the SEC's Recent Risk Alert

It has been more than two years since the Securities and Exchange Commission (“SEC”) adopted amendments to Rule 206(4)-2 of the Investment Advisers Act of 1940 (the “Custody Rule”). While the initial response to the amendments from advisors and broker-dealers was mixed (See our previous post Initial Response to the Revised Custody Rule), it is imperative for advisors to ensure they are in compliance. On March 4, 2013, the SEC issued a Risk Alert and Investor Bulletin regarding the Adviser Custody Rule. The alert was issued in response to recent SEC examinations conducted as part of a National Examination Program that uncovered custody-related issues in around one-third of the advisors examined.

In the Risk Alert, the SEC summarized the key provisions of the Custody Rule. Among the requirements highlighted were:

  • Assets must held by a “qualified custodian” in a segregated account (separate from firm and/or employee assets)
  • Account statements must be sent at least quarterly to clients by the qualified custodian
  • Annual surprise examinations must be conducted by an independent public accountant of advisors that have custody of client assets
  • Annual report on internal control by a PCAOB inspected independent public accountant must be filed for advisors in which a related party acts as the qualified custodian

The SEC categorized the custody-related issues noted into four broad categories: 1) Failure to recognize having “custody” as defined under the “custody rule” 2) Failure to comply with “surprise exam” requirements 3) Failure to comply with the “qualified custodian” requirements and 4) Failure to comply with the audit approach (pooled investment vehicles).

Failure to recognize having custody as defined under the Custody Rule. Advisors that have the ability to withdraw client assets are deemed to have custody. This includes providing bill paying services, having online access or ability to write checks from client accounts, and being granted power of attorney for client accounts through their role as trustee.

Failure to comply with “surprise exam” requirements. Form ADV-E must be filed with the SEC within 120 days after the date of the examination. Likewise, evidence must exist that the exam is being conducted on a surprise basis (i.e. not the same time every year).

Failure to comply with “qualified custodian” requirements. Client assets must be held in a separate account and cannot be commingled with firm and/or employee assets. The account cannot solely be in the name of the advisor, but rather in the name of the advisor as agent or trustee for the client. If the advisor sends account statements to the client, the advisor must notify clients to compare such statements to those received directly from the custodian.

Failure to comply with audit approach for pooled investment vehicles. The financial statements of the pooled investment vehicle must prepared in accordance with GAAP and must be audited by a public accountant that is independent from the investment vehicle and subject to PCAOB inspection. The advisor must demonstrate that the financial statements are distributed to all investors, not just available “upon request.”

The findings of recent examinations have resulted in a variety of measures taken by advisors, including revising their written compliance procedures, changing their client relationships, and devoting additional resources to custody-related issues. As noted in BBD’s previous blog post on this subject, advisors who are deemed to have custody of assets as a result of their capacity as trustee have considered ceasing such relationships due to the additional cost of surprise examinations. Regardless of the current or future relationships advisors have with respect to their clients, it is important to consistently ensure compliance with the various requirements of the revised Custody Rule.