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Thursday, July 29, 2010

Many RIAs Must Comply with New SEC Custody Requirements


Late last year, the U.S. Securities and Exchange Commission (SEC) amended its custody rule — Rule 206(4)-2 under the Investment Advisers Act — to help safeguard investor assets. Now it’s time for certain SEC-registered investment advisers (RIAs) to start taking steps to ensure they comply with two of its requirements.

The amendments impose substantial new obligations — which may include 1) annual surprise exams and 2) internal control reports — on RIAs that possess or have access to client funds or securities. The amendments took effect March 12, 2010, but affected RIAs generally have until later this year to begin required exams and reports.

What Does "Custody" Mean?

The amended rule defines "custody" as "holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them." It includes arrangements under which an RIA is permitted to withdraw client funds or securities held by a qualified custodian (such as a bank or broker-dealer), as well as situations where an RIA has access to client assets by virtue of the RIA’s dual role as general partner of and investment adviser to a limited partnership.

In a significant change, the amended rule provides that an RIA is deemed to have custody of client assets held directly or indirectly by an affiliate or other "related person," defined as any person directly or indirectly controlling or controlled by the RIA or under common control with the RIA.

What’s Required?

Under the amendments that went into effect March 12. 2010, RIAs with custody of client assets generally must have a reasonable basis, after due inquiry, for believing that any qualified custodian maintaining funds or securities for their clients sends the clients quarterly account statements. They also generally must provide a notice to clientsLate last year, the U.S. Securities and Exchange Commission (SEC) amended its custody rule — Rule 206(4)-2 under the Investment Advisers Act — to help safeguard investor assets. Now it’s time for certain SEC-registered investment advisers (RIAs) to start taking steps to ensure they comply with two of its requirements. — on opening an account and on future account statements — urging them to compare account statements received from the custodian with any statements received from the RIA.

Perhaps more burdensome are the requirements for surprise exams and internal control reports that affected RIAs generally must begin later this year:

1. If the RIA has custody of client assets, the RIA generally must undergo annual surprise examinations of client assets by an independent public accountant who is registered with the Public Company Accounting Oversight Board (“PCAOB”).

2. If the RIA or a related person acts as the qualified custodian, the RIA generally must obtain (or receive from the related person) an annual internal control report (such as a Type II SAS 70 report) prepared by a registered independent public accountant.

Generally, the first surprise exam must commence by December 31, 2010, or within six months after an RIA becomes subject to the custody rule (by registering with the SEC, for example). RIAs subject to the internal control report requirement must obtain the first report by September 12, 2010 (or within six months after becoming subject to the rule), and the first surprise exam must then commence within six months after the internal control report is obtained.

Additionally, RIAs subject to the surprise exam requirement must have a written agreement with the accountant requiring the accountant to 1) file Form ADV-E within 120 days after the exam commences, describing its nature and extent, 2) notify the SEC of any material discrepancies within one business day after discovering them, and 3) file Form ADV-E within four business days after its dismissal, resignation, or voluntary or involuntary removal from consideration for reappointment, explaining any problems relating to the exam that contributed to such termination.

What are the Exceptions?

Under the amended rule, the following RIAs are exempt from the surprise exam requirement:

RIAs deemed to have custody of client assets solely because they have the authority to deduct advisory fees,

RIAs to hedge funds or other pooled investment vehicles that distribute financial statements under Generally Accepted Accounting Principles — audited by an independent PCAOB-registered accountant — to investors within 120 days after the vehicle’s fiscal year end (180 days for a fund of funds) and "promptly" after completion of a liquidation audit (these RIAs are also exempt from the reasonable belief requirement regarding quarterly account statements), and

RIAs deemed to have custody of client assets solely because the qualified custodian is a related person from whom the RIA is "operationally independent."

In general, an RIA is operationally independent from a related-person custodian if the client assets aren’t exposed to the RIA’s creditors; advisory personnel have no authority over client assets; and the two entities are distinct in terms of personnel, supervision and office space.

What Do You Need to Do?

Here’s a quick recap of how the new exam and report rules might apply to you:

  • If you use an independent custodian and have the authority to deduct only advisory fees, you need not undergo surprise exams or obtain internal control reports.
  • If you use an independent custodian and have custody of client funds, you must undergo surprise exams but need not obtain internal control reports.
  • If you or a related person who’s not operationally independent acts as qualified custodian, you must undergo surprise exams and obtain internal control reports.
  • If an operationally independent related person acts as qualified custodian, you need not undergo surprise exams but you must obtain internal control reports.

Get Your Investment House in Order

The deadlines for complying with the SEC’s tough new surprise exam and internal control report requirements are rapidly approaching. RIAs should review their advisory contracts and custodial practices to determine whether they’re subject to the requirements. Those that are, will need to engage a qualified accountant to perform the necessary procedures. If you have custody of client assets, or if you or a related person acts as qualified custodian of your clients’ assets, we’d be pleased to help you comply with the new requirements.

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