Dec. 30, 2009 -- On December 30, 2009, the SEC adopted the long-awaited amendments to the “Custody Rule” - Rule 206(4)-2 of the Investment Adviser Act of 1940 (the “Rule"). The amendments seek to strengthen custodial controls in several ways, as summarized below.
Independent Accountant’s Verification of Assets
One significant amendment to the Rule requires advisers who have custody of client assets to undergo an annual surprise examination by an independent public accountant to verify client assets. If the adviser or a related person* is also the qualified custodian, this accountant must be registered with, and subject to regular inspections by, the Public Company Accounting Oversight Board (PCAOB).
This annual surprise examination requirement does not apply to advisers who are deemed to have custody solely because of their authority to deduct fees from client account assets. Nor does this requirement apply to an adviser to a pooled investment vehicle that is subject to an annual financial statement audit by an independent public accountant, so long as the audited financial statements are distributed to the pool’s investors within 120 days of the end of the pooled investment vehicle’s fiscal year-end and the audit is conducted by an accountant registered with the PCAOB.
Advisers who are subject to the surprise annual examination must enter into a written agreement with an accountant that provides for the first examination to take place by December 31, 2010, or, for advisers who become subject to the Rule after the effective date, within six months of obtaining custody.
Internal Control Report
Another significant amendment requires an adviser who is also acting as the qualified custodian to obtain a report of the internal controls relating to the custody of client assets from an independent public accountant registered with the PCAOB. This report is typically known as a Type II SAS 70 report, and the adviser must obtain such a report no less frequently than once each calendar year. This provision does not apply if the assets are held with an independent custodian.
The report must include an opinion from the accountant regarding whether the adviser’s internal controls are suitably designed to meet control objectives relating to custodial services. The accountant must also verify that assets are reconciled to a custodian other than the adviser or a related person acting as custodian.
Advisers who are subject to this provision are required to obtain the internal control report within six months of becoming subject to the Rule. Please note that an adviser obtaining an internal control report need not undergo a surprise examination (above) until six months after obtaining the internal control report.
Other Rule Provisions
The amendments did not change the requirement that all assets must be maintained by a qualified custodian. Common qualified custodians are banks with deposits insured by FDIC and registered broker-dealers. Advisers must also continue to send their clients a Notice if the adviser opens the account with a qualified custodian on the client’s behalf. This Notice must provide the client with the custodian’s name, address and manner in which the assets are maintained.
However, the amendments did change the statement delivery obligations and expanded the Notice requirements. The Rule no longer provides advisers the option of sending statements in lieu of the custodian’s statements; rather, advisers must have a reasonable basis for believing the qualified custodian is sending each of its clients an account statement at least quarterly. If an adviser sends its clients account statements in addition to the custodial statements, the Notice mentioned above (and any subsequent account statement) must include a legend that urges the client to compare account statements from the custodian with those from the adviser.
Advisers to pooled investment vehicles are not subject to the Notice and statement delivery requirements, if they distribute their audited financials, prepared by an accountant registered with the PCAOB, within 120 days of the end of its fiscal year to all limited partners.
The Rule will be effective on March 12, 2010. Please contact Vista360 if you have any questions relating to the new Custody Rule and how it may affect you.
You can view the SEC’s Final Rule here.
* The Rule defines “related person” as any person, directly or indirectly, controlling or controlled by the adviser, and any person that is under common control with the adviser.