SEC Registration – What it Means to Have Custody and How to Comply
By Zachary Rosenberg, Esq., Associate, Jacko Law Group, PC Compliance Consultant, Core Compliance & Legal Services, Inc.
Now that the U.S. Securities and Exchange Commission (“SEC”) has officially announced the registration deadline of March 30, 2012 for private fund advisers to register with the SEC, firms should take note of the various regulatory requirements that apply to SEC-registered advisers. As more and more firms are swept under the regulatory oversight of the SEC, understanding the complexities of the applicable rules and regulations is critical to developing an effective compliance program. At or near the top of the list of important SEC rules (both in terms of regulatory focus and complexity) is Rule 206(4)-2 of the Investment Advisers Act of 1940 (the “Advisers Act”) commonly referred to as the “Custody Rule.”
Adopted under Section 206 of the Advisers Act, the general antifraud provision applicable to investment advisers, the Custody Rule sets forth the obligations of advisers with respect to safeguarding client funds and securities over which the adviser has custody. Ultimately, the Rule’s objective is to provide specific guidelines and requirements in order to protect client assets from loss or misappropriation. The Custody Rule applies to all SEC-registered investment advisers, including previously unregistered advisers to hedge funds and other private funds, which are required to register under the Dodd-Frank Act and the recently adopted SEC regulations promulgated thereunder. Accordingly, it is vital that firms have an adequate understanding of the circumstances that will give rise to custody and the various requirements imposed on advisers deemed to have custody. This article will discuss the circumstances under which an adviser will be deemed to have custody of client funds or securities, the obligations imposed on advisers with custody (and the available exemptions from such requirements), and recommended best practices with respect to complying with the Custody Rule.
Definition of “Custody”
Under the Custody Rule, an adviser is deemed to have custody of client funds or securities if the adviser, directly or indirectly, holds client funds or securities or has any authority to obtain possession of them, including situations in which a related person holds or has authority to obtain possession of client funds or securities in connection with advisory services provided to clients. This includes actual possession of client funds or securities, and arrangements whereby an adviser has authority to withdraw client funds or securities from a client account, including the authority to withdraw investment management fees, as well as arrangements whereby an adviser or its supervised person has legal ownership of or access to client funds or securities (e.g., serving as general partner or managing member to a pooled investment vehicle or as trustee of a trust). Thus, advisers who agree to serve as trustee or co-trustee for a client’s IRA account or trust, either as a convenience to clients or because it is required by law or the trust document, would be deemed to have custody and would be subject to the requirements of the Custody Rule.
Qualified Custodian Requirement
Generally, advisers deemed to have custody must maintain client funds and securities with a qualified custodian (such as a bank, registered broker-dealer, or similar financial institution) in a separate account for each client under that client's name or in accounts containing only client funds and securities, under the adviser’s name as agent or trustee. This requirement does not apply to certain privately offered securities that: (i) are acquired from the issuer in a transaction not involving any public offering; (ii) are uncertificated and ownership of such securities is recorded only on the books of the issuer or its transfer agent; and (iii) are subject to transfer restrictions requiring prior consent of the issuer or other holders of the securities. These would include securities acquired under Regulation D, such as private equity investments, hedge fund interests, and investments in real estate limited partnerships or LLCs.
Importantly, advisers must have a reasonable belief, after due inquiry, that the qualified custodian sends a statement directly to each client at least quarterly, identifying the amount of funds and securities in the account and setting forth all transactions that occurred in the account during the period. Advisers can meet this “reasonable belief after due inquiry” standard, for example, by receiving duplicate statements from the qualified custodian or otherwise confirming that the custodian actually delivers statements directly to clients. Advisers are permitted to send their own account statements to clients in addition to the quarterly custodial statements, but all such statements sent directly from the adviser must include a conspicuous legend that urges clients to compare the adviser’s statements to those provided by the custodian.
Annual Surprise Examination
In order to provide “another set of eyes” on client assets, the Custody Rule requires all advisers with custody to obtain an annual surprise examination by an independent public accountant to verify the client funds and securities over which the adviser has custody, and ensure proper safeguarding and protection of such assets. This requirement is intended to deter fraudulent conduct and help identify problems that may not otherwise come to clients’ attention. Additionally, privately offered securities over which an adviser has custody are also subject to verification as part of the annual surprise examination, even though such securities are not required to be maintained by a qualified custodian. Where an adviser or a related person acts as qualified custodian for client funds or securities in connection with advisory services provided to clients (i.e. where an adviser is dually registered as a broker-dealer or has an affiliated broker-dealer) the annual surprise examination must be performed by an independent public accountant registered with, and subject to regular examination by, the Public Company Accounting Oversight Board (“PCAOB”) in accordance with its rules.
Notably, advisers to limited partnerships, LLCs, or similar pooled investment vehicles will be deemed to have complied with the surprise examination requirement if: (i) the fund is subject to annual audit by an independent public accountant registered with and subject to regular examination by the PCAOB in accordance with its rules; (ii) the audited financial statements are prepared in accordance with generally accepted accounting practices (“GAAP”) and are distributed to all investors within 120 days after the end of each fiscal year (180 days for funds of funds); and (iii) upon liquidation of the fund, the audited financial statements prepared in accordance with GAAP are distributed to investors promptly after completion of the final liquidation audit. If the pooled investment vehicle is not subject to an annual audit, or if financial statements are not prepared in accordance with GAAP, the exceptions provided by this paragraph would not be available. As a consequence, the adviser would be required to obtain an annual surprise examination with respect to the pool's assets and maintain the pool’s funds and securities (including privately offered securities) with a qualified custodian that sends quarterly account statements to each investor in the pool.
There are exceptions from the independent verification by surprise examination requirement. For example, no surprise examination is required for advisers who have custody solely as a result of having the authority to deduct advisory fees directly from client accounts. Additionally, advisers with custody solely because a related person holds or has authority to obtain possession of client funds or securities are not required to obtain an independent verification by surprise examination if the related person is “operationally independent” of the adviser. Note, however, that a related person is presumed not to be operationally independent of the adviser unless: (i) the assets in the custody of the related person are not subject to claims of the adviser's creditors; (ii) advisory personnel do not have possession of, access to, or the opportunity to misappropriate client assets held by the related person; (iii) advisory personnel are not under common supervision with personnel of the related person who have access to advisory client assets; (iv) advisory personnel do not hold any position with the related person or share premises with the related person; and (v) no other circumstances exist that could compromise the operational independence of the related person.
Internal Control Report
Concerned with increased risks posed by affiliated custodial arrangements, the SEC considered, but stopped short of, requiring the use of independent custodians. Although the SEC encourages the use of independent custodians wherever feasible, the Custody Rule permits the use of related person custodians, so long as certain additional safeguards are used. For example, advisers that maintain client assets with a custodian that is under common control with the adviser must obtain from the related person custodian, no less than annually, a written internal control report demonstrating the custodial controls of the affiliated custodian. The report must include an opinion from an independent public accountant registered with and subject to annual inspection by the PCAOB, that sets forth whether appropriate custodial controls have been established, whether they are operating effectively, and verifies that the funds and securities are reconciled to other un-affiliated custodians or depositories, such as the Depository Trust Corporation.
Recommendations and Best Practices
Under Rule 206(4)-7 of the Advisers Act (the “Compliance Program Rule”) SEC registered investment advisers are required to adopt and maintain written compliance policies and procedures that are reasonably designed to prevent violations of the Advisers Act and the rules adopted thereunder. With respect to Custody, the SEC has stated that the Compliance Program Rule requires advisers to adopt and implement policies and procedures relating to the safekeeping of client funds and securities in order to prevent the misappropriation or misuse of such assets, and to develop procedures to ensure prompt detection of any potential misuse, and take appropriate action if any misuse occurs.
As a result of the approaching registration of previously unregistered advisers to private funds, and due to the increasing focus on custody by the regulators, all advisers should review, and if necessary, revise their written compliance policies and procedures with respect to custody. Such procedures will vary based on the nature and extent of each adviser’s custody arrangements, but in any event should be reasonably designed to prevent violations of the Custody Rule. For example, firms should consider, among other practices, conducting background checks on employees, requiring the authorization of more than one employee before assets are moved within or from a client account as well as before making changes to account ownership information, limiting the number of employees who are permitted to interact with custodians regarding client assets, segregating the duties of advisory personnel from custodial personnel (if applicable), restricting or limiting employees from obtaining access to or authority over client assets, and periodically testing the effectiveness of procedures.
For additional information on the Custody Rule and its implications, please visit this link.
Zachary Rosenberg is an Associate at Jacko Law Group, PC and a Compliance Consultant at Core Compliance & Legal Services, Inc. He provides legal counsel and compliance consultation services to investment advisers, hedge funds, and broker-dealers in all matters relating to formation, registration, and ongoing compliance. Mr. Rosenberg graduated magna cum laude from California Western School of Law, where he served as Executive Editor of the Law Review/International Law Journal. He is admitted to practice law in California and Massachusetts.