Does the SEC’s new Internal Control Report Requirement Impact your Investment Adviser Firm or Introducing Broker/Dealer?

March 21, 2010

Reading time : 6 minutes

Internal Control Report

Earlier this month, new requirements under SEC Rule 206(4)-2 of the Investment Advisers Act of 1940 went into effect. The most stringent (and expensive) of these requirements is the new internal control report rule. Investment advisers or their related persons that serve as qualified custodian for investment advisory client funds or securities must annually obtain, or receive from its related person, a written internal control report. The internal control report must include an opinion with respect to the investment adviser’s or the related person’s controls relating to custody of client assets. The internal control report must be issued by an independent public accountant who is registered with and subject to regular inspection by the Public Company Accounting Oversight Board (PCAOB). The investment adviser must maintain the internal control report in its records and make the report available to the SEC staff upon request. The independent public accountant preparing the internal control report must verify that the client funds and securities are reconciled to a custodian other than the adviser or its related person.

Operationally Independent

In addition to the internal control reports, investment advisers with custody of client funds and securities must attain an annual surprise examination verifying the location of client funds and securities. When an investment adviser uses a related person qualified custodian, the investment adviser can avoid the surprise verification examination if it can prove the investment adviser is operationally independent from the related person qualified custodian. However, proving operationally independent may prove difficult. According to the new SEC rule, a related person that holds or has authority to obtain possession of advisory client assets is presumed not to be operationally independent of the investment adviser unless the following conditions are met and no other circumstances can reasonably be expected to compromise the operational independence of the related person: (i) client assets in the custody of the related person are not subject to claims of the adviser’s creditors; (ii) advisory personnel do not have custody or possession of, or direct or indirect access to client assets of which the related person has custody, or the power to control the disposition of such client assets to third parties for the benefit of the adviser or its related persons, or otherwise have the opportunity to misappropriate such client assets; (iii) advisory personnel and personnel of the related person who have access to advisory client assets are not under common supervision; and (iv) advisory personnel do not hold any position with the related person or share premises with the related person. The SEC has specifically commented that it would not consider a related person that shares management persons with the investment adviser, including an owner that was actively involved in the management of the two firms, to be operationally independent.

Introducing Broker/Dealer

In light of the new SEC rule, many investment advisers are analyzing the new requirement’s impact in their operations as a dually registered introducing broker/dealer or their related person introducing broker/dealer. Based on our understanding of the procedures and functions performed by introducing broker/dealers, most introducing broker/dealers have custody of advisory client assets and securities thus they are subject to the surprise verification examination. In addition, introducing broker/dealers must analyze their operations to determine if they perform functions requiring an internal control report. Recently, the SEC provided guidance on the applicability of the new custody rule on introducing broker/dealers. The following questions and answers have been posted on the SEC’s Division of Investment Management website and should be examined by all introducing broker/dealers affiliated with or registered as investment advisers.

Question XIV.1

Q: An investment adviser may also act as an introducing broker or have a related person acting as an introducing broker for its clients. Introducing brokers may have a variety of different relationships with a carrying broker with respect to matters such as the handling of customer funds and securities and sending customer account statements. In some cases, an introducing broker may maintain some client funds or securities, on a temporary and/or on-going basis (e.g., introducing brokers subject to paragraph (a)(2)(iv) of Rule 15c3-1 under the Securities Exchange Act of 1934). Is the introducing broker subject to the internal control report requirement in these circumstances?

A: Yes. An internal control report is required whenever an adviser or its related person is acting as a qualified custodian for client assets. (Posted March 10, 2010)

Question XIV.2

Q: If an introducing broker that is also an adviser or an adviser’s related person is not acting as a qualified custodian under the rule for funds or securities of the adviser’s clients, is the introducing broker subject to the internal control report requirement?

A: No. We would not consider an introducing broker to be acting as a qualified custodian under the rule if all client funds and securities are maintained with a carrying broker (which is not a related person of the adviser). Such an introducing broker must not receive client funds or securities other than checks drawn by clients and made payable to third parties such as the carrying broker. (Posted March 10, 2010)

Question XIV.3

Q: Does an adviser that meets the conditions above in Question XIV. 2 have custody of client funds or securities?

A: It depends. An adviser or its related person may have custody of client funds and securities without maintaining those funds or securities as qualified custodian for purposes of paragraph (a)(6) of the rule. For example, if the adviser or its related person has authority to withdraw client funds or securities maintained by the carrying broker, the adviser has custody of those assets. In that case, the adviser would be subject to all the applicable requirements of the rule, including the surprise examination requirement under paragraph (a)(4) of the rule. (Posted March 10, 2010)

This Thursday, March 25, RIA Compliance Consultants will be hosting our second webinar on the new SEC custody rule for federally registered investment advisers. The webinar will begin at 12:00 p.m. Central and will focus specifically on how the SEC’s rule applies to pooled invest vehicles and investment advisers operating a qualified custodian and/or introducing broker-dealer. Click here to register.

Posted by Bryan Hill
Labels: Custody, Webinar