Investment Adviser Alert
February 2010
Authors: Irwin M. Latner, Patrick D. Sweeney
In the wake of the recent frauds and scandals in the investment management industry, the SEC has amended its custody rule (Rule 206(4)-2) under the Investment Advisers Act of 1940. The new rules apply to all investment advisers (including hedge fund managers) who are registered with the SEC. These rules are intended to encourage the use of independent custodians and to deter fraudulent conduct and misuse of assets by advisers with control over client assets.
Definition of Custody. In general, an adviser is deemed to have custody of client assets if the adviser has physical custody, has authority to obtain client funds or securities (e.g., by deducting advisory fees from client accounts), has legal ownership or access to client funds or securities, or if client funds or securities are held by a related person.
Delivery of Account Statements by Custodian. The custody rules currently require most advisers with custody to maintain client assets with a qualified custodian (generally a bank or broker dealer). The new rules eliminate certain exemptions from this requirement and require that all advisers have a reasonable belief after "due inquiry" that the qualified custodian delivers a quarterly account statement to each client. While the SEC did not prescribe any specific method for advisers to satisfy the due inquiry requirement, the SEC did note that the qualified custodian would meet the requirement if they provide the adviser with copies of the account statements delivered to clients. The rules permit advisers to send out their own account statements to clients in addition to those sent by the custodian, provided that the adviser must include a cautionary legend urging clients to compare the adviser's statements with those they receive from the custodian.
Annual Surprise Examination of Client Assets. Subject to certain exceptions, the new rules require advisers with custody of client assets to undergo an annual surprise examination by an independent public accountant. An adviser with custody of client funds solely by virtue of its authority to deduct advisory fees from client accounts is excluded from the surprise examination requirement. The SEC was persuaded to modify the initial rule proposal in this regard after weighing the benefits of imposing a surprise examination requirement to protect against improper fee deductions against the costs of such a requirement, and after considering the impact of its recommendations that advisers adopt certain compliance controls to promote accurate billing practices.
Although the new rules do not require an adviser to maintain privately offered securities with a custodian, an adviser that maintains custody of the securities would be required to retain an accountant to perform an annual surprise examination regarding the securities.
In the adopting release, the SEC recommended that advisers with custody of client assets consider adopting a number of suggested compliance policies and procedures intended to safeguard client assets from conversion or inappropriate use by advisory personnel. Advisers should consider amending their compliance manuals accordingly.
Reporting Requirements for Accountants. The rules require advisers subject to the surprise examination requirement to enter into a written agreement with an independent public accountant that provides that the first examination must be conducted within six months of the adviser becoming subject to the custody rule, and annually thereafter at irregular times chosen by the accountant without notice to the adviser.
The rules require the accountants to file a Form ADV-E together with the accountant's certificate with the SEC within 120 days after the surprise examination confirming the occurrence of the examination and describing its nature and extent. In addition, the rules require the accountant to (i) notify the SEC within one business day of finding any material discrepancy during the course of the examination, and (ii) file a notice and a Form ADV-E with the SEC within four business days of the accountant's removal or termination describing the circumstances surrounding the termination, including any problems relating to examination scope or procedure.
In adopting this "noisy withdrawal" requirement, the SEC rejected industry comments that the accountant termination filings should remain private and affirmed its belief that disclosure of termination, even for innocuous reasons, would be beneficial to the public and to the SEC staff. Nevertheless, there remains uncertainty in the industry as to the impact of the noisy withdrawal requirement on the relationship between advisers and their accounting firms, and whether advisers with legitimate reasons for switching accounting firms would be able to counter the negative perception associated with the accountant's public filing of a termination statement.
In response to several comments, the SEC issued a companion release to provide updated guidance to accountants on the applicable standards and procedures for conducting the surprise examination, as well as for the internal control report discussed below.
Custody by Adviser or Related Person. The new rules expand the definition of custody to include funds and securities held directly or indirectly by a "related person" of the adviser. Notably, the SEC moved away from its earlier position pursuant to which it did not deem an adviser to have custody if the related person was operationally separate. Instead, the SEC provided a limited exception under the new rules to the surprise examination requirement in circumstances in which an adviser is deemed to have custody solely because its related person holds client assets and the related person is operationally independent of the adviser.
Where an adviser has custody of client funds or securities, the adviser must obtain, or receive from its related person, an annual internal control report, such as a Type II SAS 70 Report. This report must contain an opinion from an independent public accountant registered with the Public Company Accounting and Oversight Board ("PCAOB") with respect to the adviser's or related person's internal controls regarding the safeguarding of client funds and securities. The SEC adopted this requirement in view of recent enforcement actions involving alleged misappropriation of client assets where advisers or related persons maintained custody. There is currently no existing regulatory requirement applicable to investment advisers or other qualified custodians focusing on internal control risks arising in an affiliated custody context.
Limited Impact on Fund Managers. The new rules should have limited impact on private investment fund managers. Unlike the SEC's initial proposals, the final rules exempt managers of pooled investment vehicles, such as hedge funds and private equity funds, from the annual surprise examination requirement and the qualified custodian reporting requirement, provided that the fund (i) is subject to an annual financial statement audit prepared in accordance with GAAP by an independent public accountant registered with, and subject to regular inspection by the PCAOB, and (ii) distributes its audited financial statements to its investors within 120 days of the fund's fiscal year-end (180 days in the case of funds of funds). In addition, the rules clarify the previously uncertain issue of liquidation audits. Under the new rules, a fund relying on the annual audit provisions must obtain a final audit upon liquidation of the fund when the liquidation occurs prior to the fund's fiscal year-end, and upon completion must promptly distribute the audited statements to its investors.
Since most hedge funds already undergo annual audits with PCAOB-registered accounting firms, the new rules should have limited impact on most hedge fund mangers.
The rules would require a fund manager that relies on the annual audit exception to undergo a surprise examination with respect to non-fund assets (e.g., managed accounts) of which it has custody or with respect to fund assets for which it does not meet the audit exception requirements (e.g., an audit not performed by a PCAOB-registered firm or not delivered to investors within the required time period). Fund managers might wish to review and/or modify the expense provisions of the fund's governing documents to ensure that the fund bears the expense of any surprise examinations required by the new rules.
Master Feeder or Layered Fund Structures. The rules clarify that in a master feeder or other layered fund structure managed by a common investment manager or one of its affiliates that is deemed to have custody of each vehicle's assets, the audited financial statement delivery requirement is satisfied only by sending the audited statements of each vehicle to underlying investors or by sending the underlying investors a single set of audited statements covering the combined assets of the master and feeder funds (which we understand is the current industry practice).
Uncertainty with Respect to Offshore Funds. There is some uncertainty as to whether the rules would deem an investment manager of an offshore fund with all or a majority of independent directors and an administrator that controls disbursements to have custody of the fund's securities by virtue of having "legal ownership of or access to client funds or securities" or as a result of being "authorized or permitted to withdraw client funds or securities maintained with a custodian." The rules refer to the deemed custody of a "general partner of a limited partnership, managing member of a limited liability company or comparable position for another type of pooled investment vehicle," and thus leave room for debate as to whether an investment manager to an offshore fund company that is structured to avoid the above elements of custody and control meets this definition.
With these tighter custody rules, the SEC is attempting to prevent the abuses that were reflected in a series of recent enforcement cases against investment advisers and to promote the independent custody of client assets.
The new custody rules will become effective March 12, 2010.
If you have any questions about the new custody rules, please do not hesitate to contact Irwin Latner at (212) 592-1558 or ilatner@herrick.com, or Pat Sweeney at (212) 592-1547 or psweeney@herrick.com.
Copyright © 2010 Herrick, Feinstein LLP. Investment Adviser Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.
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