The following is a brief overview of the proposed amendments to the Investment Advisers Act.

 

On May 20, the SEC proposed amendments to Rule 206-4(2) under the Investment Advisers Act of 1940 ("Advisers Act"), commonly known as the “Custody Rule.”

According to the SEC, the proposed measures are intended to ensure that investment advisers who have “custody” of clients’ funds and securities are handling those assets properly. In some recent SEC enforcement actions, firms and principals have been charged with misusing clients’ money and covering up their illicit activities by distributing false account statements showing non-existent funds.

If adopted, the following three changes would be made to the Advisers Act:

1) “Surprise Exams”
One proposed amendment would require all registered investment advisers with custody of client assets to undergo an annual “surprise exam” by an independent public accountant to verify those assets exist, regardless of whether a qualified custodian directly provides statements to clients. A pooled investment vehicle must also undergo a surprise exam, even if the pool is audited at least annually and distributes its audited financial statements to limited partners within 120 days of the end of its fiscal year.  Included in the definition of custody would be advisers deemed to have custody as a result of serving as the general partner to a pooled investment vehicle or due to their ability to deduct advisory fees directly from client accounts.

This is a change to the 2003 amendment that eliminated the need for annual surprise examinations if certain criteria were met. 

2) Internal Control Reports
The second proposed amendment would apply to investment advisers that also serve as the qualified custodian for client assets. In such cases, the investment adviser will be required to obtain a written internal control report—prepared by a PCAOB-registered and inspected accountant—that, among other things, describes the controls in place, tests the operating effectiveness of those controls, and provides the results of those tests. This review would have to meet PCAOB standards and would be required to be performed on at least an annual basis. Such report on the description of controls placed in operation and tests of operating effectiveness is commonly referred to as a “Type II SAS 70 Report” (Statement on Auditing Standards No. 70, “Reports on the Processing of Transactions by Service Organizations.”)

3) Custodial Statements
Under the current rules, advisers satisfy their obligation of mailing account statements by either having the qualified custodian deliver account statements directly to an adviser’s clients or by sending the statements out themselves, assuming they also obtain an annual surprise exam from an independent public accountant. The proposed amendments would eliminate the option for the adviser to satisfy delivery of account statements by directly mailing them and relying on a surprise exam. Thus, the custodian holding advisory client assets would be required to directly deliver custodial statements to advisory clients rather than through the investment adviser. In addition, the adviser would be required to instruct those clients to compare account statements they receive from the custodian with those received from the adviser. These additional safeguards would make it more difficult for an adviser to prepare false account statements, and more likely that clients would find discrepancies. The proposal would retain the exemption for advisers to limited partnerships that send annual audited financial statements to limited partners within 120 days of their year end.

Reporting Requirements
The proposed measures also would include reporting requirements designed to alert the SEC staff and investors to potential problems at an adviser, and provide the Commission with important information for risk assessment purposes. An adviser would be required to disclose in public filings with the Commission, among other things, the identity of the independent public accountant that performs its “surprise exam,” and to amend its filings to report if it changes accountants. The accountant would have to report the termination of its engagement with the adviser and, if applicable, any problems with the examination that led to the termination of its engagement. If the accountants found any material discrepancies during the surprise examination, they would have to report them to the Commission. The independent public accountant would also be required to file Form ADV-E within 120 days of the date selected for the surprise exam.

The proposed amendments do not comment on whether or not the same accounting firm that conducts annual audits of a registered investment adviser can also provide the above-mentioned services.

Public Comment
The SEC is seeking public comment on these proposed measures through July 28, 2009. J.H. Cohn will continue to keep you updated on developments related to these proposals.