Investment Company Notebook

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

Initial Response to the Revised Custody Rule

Effective March 12, 2010, the Securities and Exchange Commission (“SEC”) adopted amendments to Rule 206(4)-2 of the Investment Advisors Act of 1940 (the “Custody Rule”). These amendments are designed to provide additional safeguards when a registered advisor is deemed to have custody of client funds or securities by requiring the advisor to undergo an annual surprise examination by an independent public accountant who is subject to regular inspection by the Public Company Accounting Oversight Board. The annual surprise examination procedures are designed to verify that client funds and securities, of which an investment advisor has custody, are held by a qualified custodian and either in a separate account for each client or under the advisor’s name as agent or trustee for the client.

While considering the amendments to the Custody Rule, the SEC received more than 1,300 comment letters on the proposed amendments. The majority of these letters were from investment advisors, broker-dealers, banks and their trade organizations. While the feedback, in general, expressed support for the protection provided to the advisory clients under the proposed amendments, advisors also raised concerns about the high costs of the surprise examination. Many of the advisors asserted that the costs could drive smaller advisors out of business, or, with respect to advisors who serve as a trustee on a limited basis, to cease to provide such services to their clients. As part of the amendment/comment process, the SEC estimated that the cost of the surprise examination for advisors would range from $10,000 to $125,000, depending on factors such as the number of client accounts subject to examination, the number of custodians used, etc.

As noted above, the amendments to the Custody Rule were designed to strengthen controls over the custody of client assets by registered investment advisors and to encourage the use of independent custodians. Through interaction with investment advisors of various sizes, we have found the amended rule appears to be operating as intended, albeit through different scenarios:

  • For investment advisors with significant assets and management structures requiring them to have surprise examinations performed- the procedures serve to verify and provide comfort to clients that there is proper custody and segregation of their assets.
  • For some smaller investment advisors, which may be deemed to have custody of assets under management because of their role as trustee or as a result of having power of attorney allowing them to withdrawal assets; the custody rules have forced them to re-consider their current client relationship and perhaps pull out of situations where they could be deemed to have custody. For example, an advisor might have a handful of clients for which they serve as trustee and do not receive a fee for such service. In this scenario, it is difficult from a business perspective to justify the cost of the having the surprise examination. Through the amended rules, the SEC has forced the hand of the advisor to remove itself from a situation where it has the ability to withdraw a client’s assets unilaterally.

The SEC continues to respond to various questions surrounding the amended Custody Rule.