SEC Adopts New Custody Rules For Investment Advisers
The SEC has adopted its much-anticipated final rule relating to custody by investment advisers. The final rule omits the "pop quiz," or surprise audit proposal, contained in the proposed rule for advisers who have custody solely by virtue of having the ability to deduct advisory fees. The Commission stated in the adopting release that it received more than 1,300 comment letters on the proposal, most of them relating to the pop quiz proposal.
One of the stated reasons the pop quiz proposal was not adopted was that the accountant conducting the audit would be required to verify the accuracy of fees paid rather than the existence and amount of client assets. The Commission implied that such a fee justification audit would be difficult to conduct, but cited no supporting evidence for that conclusion. The principal reason for abandonment of the pop quiz seems to be that the "magnitude of risk" of an adviser overcharging a client did not justify the additional cost of the audit.
As finally adopted, however, the rule imposes some new requirements that should decrease the possibility of fraud in advisory accounts. First, the rule eliminates one of the few exceptions to the rule requiring that the "qualified custodian," or financial institution with actual custody, send at least quarterly account statements directly to the client. The result of this is that virtually all advisers whose clients' funds are with qualified custodians will receive statements from the independent qualified custodian. In addition, the new rule requires the adviser to include a legend in the notice urging clients to compare the account statements they receive from the qualified custodian with those they receive from the adviser, if any.
For those advisers who have actual custody, or who have custody by any reason other than merely the ability to deduct fees, the new rule requires the adviser to enter into an agreement with a PCOAB-certified accountant to conduct a surprise audit of client assets. The agreement must require the accountant, among other things, to notify the Commission within one business day of finding any material discrepancy during the course of the examination, and to submit Form ADV-E to the Commission accompanied by the accountant’s certificate within 120 days.
A separate amendment renders an adviser to a pooled investment vehicle subject to the audit requirement. A pooled investment vehicles complies with the surprise verification requirements of the rule by obtaining an audit of the pool and delivering the audited financial statements to pool investors within 120 days of the pool’s fiscal year-end.
In a companion release, the Commission provided updated guidance for accountants that addresses the surprise examination.
The Commission also amended the existing rule to provide that an adviser has custody if a related person or entity is the qualified custodian. Such an adviser is exempt from the surprise audit requirement, however, if it can prove it is operationally independent of the related entity.
Finally, the SEC issued recommended procedure to be adopted to prevent fraud relating to client assets, including:
● conducting background and credit checks on employees of the investment adviser who will have access (or could acquire access) to client assets to determine whether it would be appropriate for those employees to have such access;
● requiring the authorization of more than one employee before the movement of assets within, and withdrawals or transfers from, a client’s account, as well as before changes to account ownership information; and
● limiting the number of employees who are permitted to interact with custodians with respect to client assets and rotating them on a periodic basis.
Page Perry LLC's compliance and regulatory section has experience in assisting and advising investment advisers with respect to their regulatory obligations, and in designing supervisory procedures that are compliant with current regulations.
