SEC Issues Custody Rule Amendments
1/12/2010
On December 30, 2009, the Securities and Exchange Commission (“SEC”) issued amendments to Rule 206(4)-2 of the Investment Advisers Act of 1940 (“Custody Rule”). The amendments are effective March 12, 2010.
As mentioned in previous J.H. Cohn email alerts, the amendments are intended to safeguard client assets held by SEC-Registered Investment Advisers (“Advisers”). The following information represents a brief summary of the amendments—and certain exceptions to the amendments—issued by the SEC. The full text of the amendment can be found here.
Advisers that have custody of client assets and maintain those assets with an independent qualified custodian are required to undergo a surprise examination of client assets by an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board (“PCAOB”). As amended, an exception to this Custody Rule is advisers who are deemed to have custody of client assets solely because of their ability to deduct advisory fees from client accounts.
Further, advisers to unregistered pooled investment vehicles that are subject to annual audits by an independent public accountant that is registered with and subject to regular inspection by the PCAOB and deliver the financial statements to clients within 120 days (180 days for fund of funds) are exempt from surprise audit requirements. Upon liquidation of an unregistered pooled investment vehicle, advisers must obtain a final audit and distribute financial statements to clients promptly after completion of the audit.
Following are other, critical amendments to be cognizant of:
- An adviser required to obtain a surprise examination must enter into a written agreement with an independent public accountant and ensure the first examination occurs prior to December 31, 2010. The independent accountant must file Form ADV-E with the SEC within 120 days of the date selected for the surprise exam.
- The amendments eliminate the ability for an adviser to send quarterly statements to clients if the adviser underwent a surprise examination. Advisers are now required to have the independent custodian mail statements directly to clients. The adviser must have a reasonable belief that the qualified custodian sends account statements directly to clients after “due inquiry.” However, the SEC does not define procedures to be followed by the adviser as part of “due inquiry.”
- If an adviser elects to mail quarterly statements to clients in addition to the statements mailed by qualified custodians, the adviser must include a legend in the notice when changing qualified custodians urging clients to compare statements they receive from the adviser to statements sent by the qualified custodian.
- An adviser that maintains possession of client assets itself or with a custodian that is not “operationally independent” from the adviser must undergo a surprise examination and receive an internal control report (such as a Type II SAS 70). Both must be performed by an independent public accountant that is registered with and subject to regular inspection by the PCAOB. The SEC, however, does not specify the type of internal control report required.
- An adviser required to obtain an internal control report must obtain such report within six months of the effective date of the amendments, which is noted above.
In connection with the custody rule amendments, the SEC also issued guidance to accountants. The guidance provides direction with regard to the surprise examination and internal control report.
For more information about these amendments, please contact William Pidgeon, J.H. Cohn partner, or a member of your J.H. Cohn Financial Services team at 877-704-3500.