SEC Proposes New Custody Rule for RIAs Requiring Annual Surprise Audits

May 16, 2009

During an open meeting yesterday, the U.S. Securities and Exchange Commission (“SEC”) proposed amendments to Rule 206(4)-2 which, according to the SEC, are designed to increase protections for investors who entrust their funds and securities to registered investment advisers.

The proposed changes would require all federally registered investment advisers that have custody, as defined under Rule 206(4)-2, to undergo annual surprise examinations. The surprise examinations would have to be conducted by independent accounting firms for the purpose of verifying the safety and location of client assets.

Under the proposed amendments to the custody rule, registered investment advisers that use an affiliated qualified custodian will need to undergo an additional custody control review, known as a Statement on Auditing Standards (“SAS”) No. 70 Type II report, conducted by an accounting firm registered and inspected by the Public Company Accounting Oversight Board (“PCAOB”). By requiring a SAS 70 Type 2 report prepared by a PCAOB accounting firm for federally registered investment advisers that use affiliated qualified custodians, the SEC is attempting to encourage registered investment advisers to use independent qualified custodians.

Unfortunately, the SEC has yet to publish the proposed rule and interperative release, but it is expected to be available on the SEC website soon. Once it is available, the proposal will have a 60 day public comment period before the final rule is voted on by the SEC commissioners.

Based on comments by SEC commissioners during the open meeting, it does not appear that the SEC will change the definition of custody, which is defined under Rule 206(4)-2 as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. Custody includes the following:

(i) Possession of client funds or securities, (but not of checks drawn by clients and made payable to third parties,) unless you receive them inadvertently and you return them to the sender promptly but in any case within three business days of receiving them;

(ii) Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and

(iii) Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities.

Some of the more common types of investment adviser custody observed by RIA Compliance Consultants, Inc. include investment advisers or their associated persons serving as trustee to a client, having full power of attorney on an account, accepting stock certificates from a client to forward to the qualified custodian, providing bill paying services, and deducting fees directly from client accounts.

The surprise audit requirement appears to be far-reaching as it would apply to all investment advisory accounts of which the investment advisor has any form of custody, including the ability to deduct advisory fees directly from the accounts. What is not clear at this point is the applicability of the rule when a client of a federally registered investment adviser has a third-party deduct advisory fees on behalf of the investment adviser and client. This could include another investment advisor, a broker/dealer or other administrator. It is also not clear if the previous SEC no-action letters in place before the SEC made changes to Rule 206(4)-2 in 2004 will be reinstated. According to those SEC no-action letters, a registered investment adviser could avoid the surprise examination requirement by (1) receiving the client’s written authorization to deduct fees; (2) deliver a written invoice to the client prior to fees being deducted; and (3) confirming the actual fee deducted is listed on the client’s account statement delivered from the qualified custodian. Hopefully, the proposed rule release will clarify this issue further, but early indication is that all federally registered investment advisers that deduct advisory fees will be subject to the surprise audit requirement.

Another issue that is seems unclear is a federally registered investment adviser’s authority to disburse funds from a client’s account directly to a client or directly to another account owned by a client. While the ability to disburse funds from an account to a third-party is clearly a form of custody under SEC rules, the ability to disburse funds to the client is often not as clear. Hopefully, the SEC will comment on this issue in the proposed rule release.

The proposed changes to the custody rule would no longer allow a federally registered investment advisor to send client statements in lieu of account statements prepared by the qualified custodian. It appears that proposed rule will require the qualified custodian to send account statements directly to underlying clients. This raises a question for registered investment advisers that maintain client accounts in omnibus accounts. How will such registered investment advisers comply with the rule? Hopefully, the SEC rule release will comment on the logistical issues concerning the use of omnibus accounts.

As part of the proposed rule, federally registered investment advisers will be required to disclose their accounting firms on Form ADV Part 1. Materials findings from the audits will need to be reported to the SEC. Accounting firms will need to report the termination of their agreement with an investment advisor directly to the SEC and report, if applicable, any problems with the examination that led to the termination of its engagement.

Once the SEC releases the actual text of the proposed amendments to SEC Rule 206(4)-6, RIA Compliance Consultants will host a webinar on this topic. Please stay tuned for more developments concerning the proposed custody rule and the registration information for our webinar.

Posted by Bryan Hill
Labels: Custody, SAS 70 Audit Report