June 28, 2016

Custody Rule Update: SEC Independence Rules – What SEC-Registered and State Registered Investment Advisers Should Know

By Christina Catalina, Partner, Alternative Investment Group

Custody Rule Update: SEC Independence Rules – What SEC-Registered and State Registered Investment Advisers Should Know

How the SEC auditor independence rules are triggered

Rule 206(4)-2 of the Investment Advisers Act of 1940 (the Act), or the Custody Rule, requires registered investment advisers who have “custody” of client assets to take steps to guard against the misuse or misappropriation of the clients’ funds and securities. These steps include requiring registered investment advisers to maintain all securities at a qualified custodian and be subject to surprise examinations. The surprise examinations are required to be conducted by a firm that is registered with the Public Company Accounting Oversight Board (PCAOB) and must be conducted under the independence requirements of the SEC. 

An investment adviser is deemed to have custody of clients’ funds and securities by virtue of being a general partner or managing member of a pooled investment vehicle (“PIV”).  PIV’s managed by advisers are generally considered “Non-Issuer Entities” when the securities issued by such PIV’s are not registered with the SEC and such entity is not required to file with the SEC. 

An investment adviser may comply with the surprise examination requirement through the use of what is commonly referred to as the “audit provision” for PIV’s managed by the adviser. Under the audit provision, the adviser must have (1) the PIV audited annually by an independent public accountant registered with, and subject to inspection by, the PCAOB; (2)  the audited financial statements must be distributed to the investors within 120 days of the PIV’s fiscal year end (funds of funds are subject to different deadlines); (3) The auditor must be independent under SEC Regulation S-X (see discussion below); and (4) The financial statements must be presented in accordance with US GAAP (or IFRS with a reconciliation to US GAAP), and the audit must be conducted under US auditing standards.

If an adviser avails itself of the audit provision, then it does not need to comply with the notice and account statement delivery obligations of the Custody Rule, and the adviser is considered to have satisfied the surprise examination requirement of the Custody Rule. It is important to know that a liquidation audit must also be conducted, subject to same conditions, should the PIV terminate. Failure to receive a final termination audit would be a violation of the Custody Rule requirements. Investment advisers should remember that the audit provision imposes an annual audit obligation. Therefore, a separate audit is required for partial-year stub periods (e.g., for new fund launches on a date other than January 1) in order to rely on the audit provision. As noted above, this can be a critical item for private fund managers to remember when launching new vehicles.

Why SEC level independence must be followed before registration as an investment adviser

Any audit or examination report that is used to satisfy the custody rule will oblige the auditor to be qualified and independent under the SEC independence rules; in accordance with Rule 2-01 of Regulation S-X, Qualifications of Accountants. These rules indicate that an auditor must be independent during the “audit and professional engagement periods.” Thus, even if an adviser were to register on April 30, 2015, the audit period will commence on January 1, 2015, assuming a December 31 fiscal year-end. This is an important aspect of the SEC independence rules for advisers. Many advisers may not know that certain SEC rules require compliance prior to their actual SEC registration date.  Both the accountant and the adviser are mutually responsible for ensuring that SEC independence is maintained.

What are the SEC auditor independence considerations?  The CAQ and AICPA Issue a Joint Member Alert Highlighting Independence Rules:

“Independence is a cornerstone of audit quality,” said Center of Audit Quality (CAQ) Executive Director Cindy Fornelli. “This alert is an important reminder for firms to review the applicable rules and regulations, and to revisit their organization’s policies on this critical issue, as needed.”

“While we often associate the independence rules with the audits of issuers, auditors should be aware of the application of those rules to certain non-issuer audit engagements” said AICPA President and CEO Barry C. Melancon, CPA, CGMA. “This alert is intended to give practitioners an overview of which rules are – and are not – applicable in the course of these engagements.”

This alert serves as a follow-up to the independence guidance provided in the CAQ and AICPA’s original joint alert. On November 19, 2014, the CAQ and AICPA jointly issued a member alert (Alert#2014-11) that summarizes the SEC’s and PCAOB’s independence rules for audit firms that perform audit and attestation engagements for certain non-issuers, including (1) SEC-registered broker-dealers and (2) SEC- or state-registered private funds, investment advisers, or related-party custodians for whom an engagement is subject to the requirements of the Custody Rule. 

Topics discussed in the alert include the following:

  • Applicability of SEC’s and PCAOB’s independence rules.
  • Prohibition of certain bookkeeping and financial statement preparation services under the independence rules.
  • Other engagements that are subject to the SEC’s or PCAOB’s independence rules (i.e., engagements that are not subject to the custody rule.)

This alert was issued in response to clarify certain discussion points including prohibition on financial statement preparation that the SEC made specific mention of in a speech presented by its staff at the PCAOB Forum on Auditing Smaller Broker-Dealers (May 28, 2014).  The SEC staff indicated that auditors should not, among other things, provide typing and word processing services, or financial statement templates that are not publicly available to the audit client as these would be considered prohibited financial statement preparation services. Therefore, it is important to note that if an adviser requests such services from their auditor, this SEC level independence would not be maintained and therefore, the PIV would not be able to take advantage of the audit provision. 

Since many advisers take advantage of the audit provision for the PIV’s they manage, it is important to recognize that their PIV’s auditor not only needs to be registered with and inspected by the PCAOB, but also that the audits are subject to these very strict SEC independence rules.  It is therefore important that the adviser is aware of these independence considerations.  One of the focus items in this CAQ alert (launch link below), describes the SEC prohibition on financial statement preparation services (which was clarified to include financial statement production services).

This alert stated that audit firms are encouraged to review their policies and procedures as it relates to the SEC prohibition on financial statement preparation services (which may include financial statement production services) and to remind their audit engagement teams on engagements that are the subject of this alert that the activities described above are the responsibility of client management. The responsibility of the independent auditor is to express an opinion on the financial statements.

Further considerations of the SEC Independence Rules for SEC-registered and State registered investment advisers described in the Alert

If you are engaging an auditor in order to comply with the Custody Rule, the Custody Rule requires that such auditor should be independent in accordance with the provisions of SEC Rule 2-01(b) and (c), except those rules that apply only to engagements for “issuers”.

It should also be noted that certain states have adopted the requirement to comply with the SEC custody rule, thereby also requiring the auditors to comply with the SEC independence rules. As a result, when an auditor is performing engagements for investment advisers not registered with the SEC but solely with a particular state(s), the auditor may need to apply the SEC independence rules.
The Alert set forth a reminder that the non-audit services prohibitions in SEC Rule 2-01(c)(4) cover certain services that are prohibited outright (“categorically” prohibited), as well as other services that are prohibited unless they are not subject to audit (or “conditionally” prohibited).

The categorically prohibited services covered in the SEC rule are as follows:

  • Management functions
  • Human resources
  • Broker-dealer, investment advisor, or investment banking services
  • Legal services
  • Expert services unrelated to the audit

The conditionally prohibited services covered in the SEC rule are as follows:

  • Bookkeeping or other services related to the accounting records or financial statements of the audit client
  • Financial information systems design and implementation
  • Appraisal or valuation services, fairness opinions, or contribution-in-kind reports
  • Actuarial services
  • Internal audit outsourcing services

How should SEC-registered and State registered investment advisers apply the SEC’s independence rules?

The SEC’s independence rules apply not only to the audited entity complying with the custody rule but also to each of the entity’s affiliates. Since investment advisers frequently engage multiple public accounting firms to provide non-audit services, careful review is required to avoid an unintentional taint of an auditor’s independence under this more restrictive rule. 

In determining whether an auditor is independent, the SEC will consider all relevant circumstances, including all relationships between the auditor and the audit client. 

The SEC’s principles of independence for auditor’s services are based on the following basic principles, violations of which would impair the auditor’s independence:

  • A relationship or  provision of a service between an auditor and the audit client creates a mutual or conflicting interest
  • An auditor cannot function in the role of management
  • An auditor cannot audit his or her own work
  • An auditor cannot serve in an advocacy role for his or her client

The auditor for an investment adviser relying on the audit provision to comply with the Custody Rule must maintain SEC independence for the following entities:

  • The audited PIV
  • The general partner (GP) or sponsor of the PIV
  • The RIA of the PIV
  • All entities controlling the RIA of the PIV
  • All entities controlling the GP of the PIV
  • All other PIV’s advised by the RIA
  • All other PIV’s  in which the GP holds the GP interest
  • All portfolio investee companies controlled by the PIV
  • All portfolio companies over which the PIV has significant influence, unless the portfolio company is immaterial to the PIV
  • All entities under common control with the PIV including, but not limited to, other PIV’s and their controlled portfolio investee companies in the complex
  • Significant influence investors in the PIV, if the investment is material to the investor

Certain PIV’s (such as private equity funds) often use holding companies to facilitate acquisition of investments. The holding company may be owned by one or more funds and investors considered under common control of the fund adviser. In such cases there may be investors outside the common control group, e.g., minority shareholders in the holding company. The presence of external, third-party investors may have a significant impact on the application of the Custody Rule. (When a holding company is included anywhere in a private equity structure, the adviser should discuss internally and with their SEC counsel to determine if an entity must comply with the custody rule requirements. The advisor should also include the entity’s auditor in the discussions, as compliance with the custody rule also means compliance with SEC independence rules.) It should also be noted that auditors must comply with the SEC’s independence rules with respect to the  portfolio companies of the PIV and its affiliates.  

Non-audit services

There are certain services that an auditor may be able to provide to an adviser that is not relying on the Audit Provision.  Under the independence standards of the American Institute of Certified Public Accountants (AICPA), the auditor can provide certain services that would be prohibited under the SEC independence rules. An investment adviser that is now required to register with the SEC must be sure it fully understands the nature of any non-audit service the accounting firm may be providing to the audited entity or its affiliates. Prohibited services have to cease before the beginning of the audit and professional engagement periods (which may begin before the date that SEC registration occurs).  The following are some common non-audit services requested by advisers:


Comparison of Audit Independence Rules for Non-audit Services

(Note: PCAOB independence rules do not apply to engagements conducted pursuant to the Custody Rule)


SEC Registered PIVs and its portfolio companies  & other downstream affiliates

Non-registered PIVs, Affiliates of the PIV, including its non-registered portfolio companies and downstream affiliates

Non-registered PIVs, Affiliates of the PIV, including its non-registered portfolio companies & downstream affiliates

Affiliates of the PIV including its non-registered portfolio companies not audited by the firm














No (2)

Yes (1)



Yes (4)

Yes (3)



Yes (6)

Yes (5)


  1. Approve all account classifications
  2. Provide source documents to the auditor so that the auditor can prepare journal entries
  3. Take responsibility for the results of the member’s services (e.g., financial statements)
  4. Establish and maintain controls over the auditor’s bookkeeping activities
  1. Financial statement preparation services provided to the audit client (PIV) such as typing and word processing services, or financial statement templates that are not publicly available to the audit client as these would be considered prohibited financial statement preparation services (which may include financial statement production services).
  1. Designate competent management to oversee the internal audit function
  2. Determine the scope, risk, and frequency of internal audit activities
  3. Evaluate the findings and results of internal audit activities
  4. Evaluate the adequacy of the audit procedures performed and related findings
  1. Designate competent management to oversee the valuation
  2. Evaluate the assumptions and methodologies used, its findings and the results of the valuation
  3. Evaluate and accept responsibility for the results of the valuation performed and related findings

Final application and considerations

How the adviser should apply the custody rule to a specific structure is a complex question. Compliance with the custody rule requirements is a legal question that should be discussed and determined for each entity with help from legal counsel. Compliance with the custody rules also means compliance with the SEC independence rules for the entity’s auditor, which could have consequences for affiliates of the entity within the fund complex and on non-audit services provided by the auditor.  The current regulatory landscape requires advisors to have a robust understanding of these complex rules and programs in place to comply with them. If you have questions on the Custody Rules and auditor independence, contact legal counsel or a Marcum professional.

Related Industry

Alternative Investments