SEC Adopts. Amendments. To The Advisers Act Custody Rule SECURITIES LAW ALERT MARCH 2010

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1 MARCH 2010 SEC Adopts Amedmets To The Advisers Act Custody Rule The Securities Exchage Commissio ( SEC ) has adopted amedmets to Rule 206(4)-2 (the Custody Rule ) uder the Ivestmet Advisers Act of 1940 (the Advisers Act ). 1 I respose to several highly publicized scadals ad otable eforcemet actios i the ivestmet idustry, the SEC proposed amedmets to the Custody Rule ad related forms origially i May 2009 ad adopted such amedmets, revised per idustry commets, o December 30, The Custody Rule amedmets (the Amedmets ) are desiged to provide additioal safeguards uder the Advisers Act whe a registered ivestmet adviser has custody of cliet fuds or securities ad to provide the SEC with better iformatio about the custodial practices of ivestmet advisers. The Amedmets do ot apply to registered ivestmet compay accouts maaged by a ivestmet adviser. Curret Requiremets Uder Rule 206(4)-2, advisers geerally must: (1) maitai cliet fuds ad securities with a qualified custodia, such as a bak or registered broker-dealer; (2) provide cliets with otice of the ame ad address of such qualified custodia; ad (3) 1 See Custody of Fuds or Securites of Cliets by Ivestmet Advisers, SEC Release No. IA-2968 (December 30, 2009) ( Adoptig Release ), available at: sec.gov/rules/fial/2009/ia-2968.pdf. have a reasoable belief that cliets receive accout statemets at least quarterly. Uder a curret exemptio, the cliet accout statemets may be set by the qualified custodia or the adviser. If the adviser seds the accout statemets, the the adviser is required to egage a idepedet public accoutat at least aually to verify the cliet assets i a surprise examiatio. Advisers with custody of pooled ivestmet vehicles (i.e., a hedge fud or other private ivestmet fud) may satisfy the accout statemet delivery requiremets by obtaiig a aual audit of the ivestmet pool ad mailig it to ivestors withi 120 days of the ivestmet pool s fiscal year-ed. Expaded Defiitio of Custody uder Amedmets The Amedmets expad the defiitio of custody ad will impact ot oly a adviser with actual custody over cliet assets, but those advisers whose related persos have custody of cliet assets, i.e., costructive custody. The Amedmets will impact those advisers who are dually-registered as broker-dealers. Advisers who act as trustees or executors or have geeral authority to withdraw cliet assets from cliets accouts will be subject to the ew requiremets uder the Amedmets. Advisers to pooled ivestmet vehicles ad privately offered securities will also be impacted. Advisers 1

2 Uder the Amedmets, a related perso is defied as a perso directly or idirectly cotrollig or cotrolled by the adviser ad ay perso uder commo cotrol with the adviser. who automatically deduct advisory fees from cliet accouts will eed to comply with certai aspects of the Amedmets. Uder the Amedmets, a related perso is defied as a perso directly or idirectly cotrollig or cotrolled by the adviser ad ay perso uder commo cotrol with the adviser. 2 The Adoptig Release otes that for advisers who are part of multi-service fiacial orgaizatios, such related perso custodias may iclude broker-dealers ad baks. Prior to these Amedmets, there was o presumptio that a adviser s affiliate s custody was imputed to the adviser. Rather, the adviser was deemed to have custody oly if the affiliate held fuds or securities of the adviser s cliets uder coditios where the adviser had access to these cliet assets or securities through the affiliate. 3 A adviser whose related perso acts as a qualified custodia for cliet assets is presumed to have custody ad must report custody o its Form ADV ad must submit to a aual surprise exam, uless the adviser claims operatioal idepedece from its affiliate ad does ot otherwise have custody 2 See Ameded Custody Rule 206(4)-2(d)(2) ad (7). 3 (See Crocker Ivestmet Maagemet Corp., SEC Staff Letter (Apr. 14, 1978). The Adoptig Release (pp ) specifically states that i light of our ameded defiitio of custody, our staff is withdrawig several o-actio letters to the extet such letters are icosistet with this defiitio, icludig Crocker ad Pictet et Cie, SEC Staff Letter (Jue 22, 1980). Advisers, icludig those firms that have relied o these letters i the past, must comply with the ameded rule. See Ameded Rule 206(4)-2. over cliet assets. 4 The adviser must receive a copy of the related perso s aual iteral report. New Requiremets The Amedmets require, amog other thigs, that advisers who have custody of cliet fuds or securities: udergo a aual surprise examiatio by a idepedet public accoutat to verify cliet assets; have the qualified custodia maitaiig cliet fuds ad securities sed accout statemets directly to the advisory cliets ad form a reasoable belief based upo due iquiry that the custodia has actually doe so; ad uless cliet assets are maitaied by a idepedet custodia (i.e., a custodia that is ot the adviser itself or a related perso), obtai or receive from the related perso a report of the iteral cotrols relatig to the custody of those assets from a idepedet public accoutat that is registered with ad subject to regular ispectio by the Public Compay Accoutig Oversight Board ( PCAOB ). The Amedmets also iclude certai techical revisios to the Form ADV that require advisers to report curret iformatio about custodial relatioships as discussed below. 4 See Ameded Rule 206(4)-2(d)(5)(defiig operatioally idepedet ). Note: The adviser is required to maitai a memoradum describig its relatioship with the related perso ad the adviser s basis for its operatioally idepedet determiatio. 2

3 The SEC published a compaio Release to provide guidace to accoutats with respect to the aual surprise examiatio ad iteral cotrol report required uder the Amedmets. 5 Aual Surprise Examiatio Oe of the most commeted upo provisios of the Amedmets is the requiremet that advisers with custody over cliet assets be subject to a aual surprise examiatio by a idepedet public accoutat (or audit, if applicable, i the case of a pooled ivestmet vehicle). Commeters oted that they were ot opposed to the surprise examiatio requiremet, but that it may be burdesome ad costly for small advisers. 6 I respose to these commet letters, the SEC has oted that it will evaluate the impact of the surprise examiatio requiremet o smaller advisers ad these advisers cliets, ad followig completio of the first roud of examiatios, review the fidigs ad, if appropriate, revise the Custody Rule amedmets. 7 5 See Commissio Guidace Regardig Idepedet Public Accoutat Egagemets Performed Pursuat to Rule 206(4)-2 Uder the Ivestmet Advisers Act of 1940, Release No. IA-2969 (December 30, 2009) ( Accoutig Release ), available at: iterp/2009/ia-2969.pdf. 6 See Commets o Proposed Rule: Custody of Fuds or Securities of Cliets by Ivestmet Advisers, available at: 7 Adoptig Release at pp Privately Offered Securities The Amedmets provide that privately offered securities owed by cliets ad held i the custody of a ivestmet adviser will be subject to the same aual surprise examiatio requiremets as publiclytraded securities. The Accoutig Release provides guidace regardig procedures that a accoutat should udertake with respect to the surprise examiatio of privately offered securities. Agreemet with Idepedet Public Accoutat Advisers subject to the Amedmets are required to eter ito a writte agreemet with a idepedet public accoutat to coduct the surprise examiatio. If the qualified custodia for the cliet accout is the adviser or a related perso, a idepedet accoutat who is registered with, ad subject to regular ispectio by, the PCAOB must coduct the surprise exam ad eter ito a writte agreemet with the adviser. The writte agreemet must require the accoutat, amog other thigs, to: otify the SEC withi oe (1) busiess day of fidig ay material discrepacy durig the examiatio; submit a Form ADV-E to the SEC, accompaied by the accoutat s certificate reportig o the ature ad extet of the exam, withi 120 days of the exam; ad Advisers subject to the Amedmets are required to eter ito a writte agreemet with a idepedet public accoutat to coduct the surprise examiatio. 3

4 No exemptios are provided for advisers who have custody through trustee or executor relatioships. file a statemet regardig termiatio with its Form ADV-E withi four (4) busiess days of its resigatio or dismissal. Exemptios to Surprise Exam Requiremet Certai exemptios to the surprise exam requiremet uder the Amedmets are available for advisers: who are deemed to have custody solely because of their ability to deduct fees from cliet accouts; who advise pooled ivestmet vehicles that are subject to a aual fiacial audit by a idepedet public accoutat, ad that distribute the audited fiacial statemets prepared i accordace with geerally accepted accoutig priciples ( GAAP ) to the pool s ivestors withi 120 days of the pool s fiscal year-ed (the aual audit provisio ); ad who have custody of cliet assets solely because a related perso has custody of advisory cliets fuds or securities, provided that the adviser ad the related perso are operatioally idepedet. 8 No exemptios are provided for advisers who have custody through trustee or executor relatioships. Delivery of Accout Statemets The Amedmets require that advisory cliets must ow receive accout statemets directly from the qualified custodia. 8 See Ameded Rule 206(4)-2(d)(5). Curretly, uder a exemptio to the Custody Rule, a adviser that uderwet a aual surprise examiatio by a idepedet public accoutat, rather tha qualified custodia, was permitted to deliver accout statemets. The Amedmets elimiate this exemptio as of March 12, If a adviser chooses to cotiue to provide a cliet with a periodic accout statemet i additio to the custodia s accout statemet, such adviser must ow iclude a leged i its custody otices that the cliet should compare the accout statemets they receive from the adviser with the accout statemets from the custodia. Due Iquiry of Statemet Delivery Uder the Amedmets, a adviser must make due iquiry to form a reasoable belief that a custodia actually delivers cliet accout statemets to the adviser s cliets at least quarterly. The adviser s receipt of duplicate statemets from the qualified custodia(s) (a commo idustry practice) is oted as oe method of due iquiry, although advisers are ot limited to this practice. The SEC oted that the accessig of advisory cliet statemets via a website does ot satisfy this due iquiry requiremet i that the postig of statemets o a website oly cofirms that the statemets are available, ot that they have bee delivered. 4

5 Iteral Cotrol Report; Custody by a Related Perso Repeatedly throughout the Adoptig Release, the SEC ecourages the use of idepedet custodias but does ot require such. The Amedmets provide additioal requiremets whe a adviser or related perso serves as qualified custodia for cliet fuds or securities. As discussed above, the adviser must udergo a aual surprise examiatio ad obtai, or receive aually from its related perso, a iteral cotrol report, such as a Type II SAS 70 report, with respect to custody cotrols. The iteral cotrol report, like the surprise examiatio, must be prepared by a idepedet public accoutat that is registered with, ad subject to regular ispectio by, the PCAOB, ad must iclude a opiio from such regardig the adviser s or the related perso s cotrols to maitai custody of ad safeguard cliet assets. The Accoutig Release provides guidace for accoutats o how to verify that the cliet fuds ad securities are recociled to a custodia other tha the adviser or its related perso. Additioal Requiremets for Advisers to Pooled Ivestmet Vehicles As discussed above, a adviser to a pooled ivestmet vehicle that avails itself of the aual audit provisio is deemed to have satisfied the aual surprise examiatio requiremet. However, i the Adoptig Release, the SEC oted that because a adviser to a pooled ivestmet employig the aual audit provisio is ot required to have a reasoable belief that a qualified custodia delivers accout statemets to ivestors, the ivestors i such pooled ivestmet vehicles, i tur, do ot have the beefit of regularly receivig reports that the assets uderlyig their ivestmets are properly held. The SEC stated that it is cocered that the curret protectios of the rule may be isufficiet, ad has directed its staff to explore ways [to] remedy this potetial shortcomig while respectig the cofidetial ature of proprietary iformatio. 9 The Amedmets impose the followig additioal requiremets o advisers to pooled ivestmet vehicles. Iteral Cotrol Report Where assets are maitaied with a qualified custodia that is the adviser or a related perso of the adviser to the pool, the adviser must coduct or obtai a iteral cotrol report. Liquidatio Audit If a adviser relies o the aual audit provisio, i additio to obtaiig a aual audit, such adviser must obtai a fial audit of the pool s fiacial statemets upo liquidatio of the pool whe the liquidatio occurs prior to the pool s year ed, ad distribute the fiacial statemets to pool ivestors promptly after completio of the audit. 9 Adoptig Release, pp a adviser to a pooled ivestmet vehicle that avails itself of the aual audit provisio is deemed to have satisfied the aual surprise examiatio requiremet. 5

6 Resposes to the revised Form ADV will be required i the first aual amedmet after Jauary 1, Special Purpose Vehicles I situatios where all the ivestors i a pooled ivestmet vehicle to which accout statemets are set are pooled ivestmet vehicles that are related persos of the adviser (i.e., Special Purpose Vehicles or SPVs ), the SEC has proscribed that the ivestmet adviser could either treat the SPV as a separate cliet, i which case the adviser will have custody of the SPV s assets, or treat the SPV s assets as assets of the pooled ivestmet vehicles of which it has custody idirectly. If the adviser treats the SPV as a separate cliet, the adviser must distribute the audited fiacial statemets or accout statemets of the SPV to the beeficial owers of the pooled ivestmet vehicles. If the adviser treats the SPV s assets as assets of the pooled ivestmet vehicles of which it has custody idirectly, such assets must be cosidered withi the scope of the pooled ivestmet vehicle s fiacial statemet audit or surprise examiatio. 10 Form ADV Amedmets The Amedmets to Form ADV mirror the Amedmets to the Custody Rule. The Amedmets amed Form ADV as follows: Item 7. Advisers must report all related persos who are broker-dealers ad idetify which, if ay, serve as qualified custodias with respect to the adviser s cliets fuds or securities; 10 Id. at pp Item 9. Advisers must report: (1) the total umber of cliets ad amout of cliet assets i the adviser s (or a related perso s) custody; (2) if the adviser, or a related perso, acts as a adviser to a pooled ivestmet vehicle, whether the pool is audited ad whether the qualified custodias sed accout statemets to ivestors; (3) whether a idepedet public accoutat coducts a aual surprise examiatio; (4) whether a idepedet public accoutat prepares a iteral cotrol report for the adviser or a related perso; ad (5) whether the adviser or a related perso serves as qualified custodia for the adviser s cliets; Schedule D. Advisers must: (1) idetify ad provide certai iformatio about the accoutats that perform audits ad surprise examiatios ad that prepare iteral cotrol reports; ad (2) idetify related persos that serve as qualified custodias for cliet fuds or securities ot otherwise disclosed i Item 7; ad Sectio 7.A. of Schedule D. A adviser must report whether it has overcome the presumptio that it is ot operatioally idepedet from a related perso broker-dealer qualified custodia, ad, therefore, is ot required to obtai a surprise examiatio for the cliets assets maitaied at that custodia. Resposes to the revised Form ADV will be required i the first aual amedmet after Jauary 1, The IARD system for the upcomig March 2010 Form ADV aual updates will ot reflect these Amedmets. 6

7 Compliace Policies ad Procedures The Adoptig Release provides guidace to advisers regardig the types of policies ad procedures they should adopt to satisfy their obligatios uder Rule 206(4)-7 with respect to the Custody Rule. Such recommedatios iclude, amog other thigs, coductig backgroud ad credit checks o the adviser s employees who will have access (or could acquire access) to cliet assets, requirig the authorizatio of more tha oe employee to move fuds from cliet accouts ad to chage accout owership iformatio, limitig the umber of employees iteractig with cliet custodias ad rotatig them periodically, ad, if the adviser also serves as qualified custodia, segregatig the duties of advisory ad custodial persoel to make it difficult for ay oe perso to misuse cliet assets without beig detected. Effective Date The effective date of the Amedmets is March 12, A ivestmet adviser required to obtai a surprise examiatio must eter ito a writte agreemet with a idepedet public accoutat that provides that the first such examiatio will take place by December 31, A ivestmet adviser also required to obtai or receive a iteral cotrol report because it or a related perso maitais cliet assets as a qualified custodia must obtai or receive a iteral cotrol report withi six (6) moths of the effective date. Additioal Iformatio To discuss how the Custody Rule Amedmets impact your busiess, please cotact Bria Amery or Fraces Grabish. Fraces C. Grabish, Esq. For more iformatio about ay of the topics covered i this issue of the Securities Law Alert, please cotact: Bria F. Amery, Esq. bamery@bressler.com Fraces C. Grabish, Esq. fgrabish@bressler.com The iformatio cotaied i this Cliet Alert is for geeral iformatioal purposes oly ad is either preseted or iteded to costitute legal advice or a legal opiio as to ay particular matter. The reader should ot act o the basis of ay iformatio cotaied herei without cosultig first with his or her legal or other professioal advisor with respect to the advisability of ay specific course or actio ad the applicable law. 17 State Street New York, NY Columbia Turpike Florham Park, NJ SW 149th Aveue Miramar, FL The views preseted herei reflect the views of the idividual author(s). They do ot ecessarily reflect the views of Bressler, Amery & Ross, P.C. or ay of its other attoreys or cliets Bressler, Amery & Ross, P.C. All rights reserved. ATTORNEY ADVERTISING