On September 25, 2003, the Securities and Exchange Commission (“SEC”) adopted final amendments to Rule 206(4)-2, the custody rule under the Investment Advisers Act of 1940, as amended (the “Custody Rule”), which requires registered investment advisers to protect client funds and securities that are in their custody. See SEC Release No. IA-2176 (http://www.sec.gov/rules/final/ia-2176.htm ).
The amendments are intended to harmonize the Custody Rule with modern custodial practices and more clearly define when an investment adviser has custody of client assets. Significantly, the amendments define “custody” to conform to the Form ADV and broaden permitted custodians by introducing a new term, “qualified custodian”, to encompass entities that regularly provide custodial services and are regulated and examined with respect to those services.
The effective date of the amended Custody Rule is November 5, 2003, however, investment advisers have until April 1, 2004 to achieve full compliance.
Definition of “Custody”
The new amendments provide that an investment adviser has “custody” when the adviser directly or indirectly holds client funds or securities or has any authority to obtain possession of them. The SEC considers an adviser to have custody, and therefore subject to the Custody Rule, in the following situations:
- Whenever an adviser has possession of client funds or securities, albeit briefly;[1]
- Whenever an adviser has the authority to withdraw funds or securities from a client’s account; and
- Whenever an adviser acts in any capacity that gives the adviser legal ownership of, or access to, the client funds or securities.[2]
Use of Qualified Custodians
The amended Custody Rule requires investment advisers with custody of client funds and securities to maintain such funds with qualified custodians. The qualified custodian must hold the funds or securities in an account either under the client’s name or under the adviser’s name as agent or trustee for its clients.
“Qualified custodians” include the types of financial institutions that clients and advisers customarily turn to for custodial services. These include banks and savings associations, registered broker-dealers and registered futures commission merchants. Foreign financial institutions that customarily hold financial assets for their customers are also considered qualified custodians, provided that the foreign financial institution keeps advisory clients’ assets in customer accounts segregated from its proprietary assets. SEC-registered advisers that are themselves qualified custodians or have affiliates that are qualified custodians may also maintain their clients’ funds and securities, so long as they are in full compliance with the provisions of the Custody Rule.
Mutual Funds and Private Issues. The amendments contain special exemptions from the qualified custodian requirement for two types of securities: mutual fund shares and private issues. The amended Custody Rule allows an investment adviser to use the mutual fund transfer agent in lieu of a qualified custodian with respect to those shares.
In addition, where a client purchases privately-offered uncertificated securities where ownership of the securities is recorded only on the books of the issuer or its transfer agent, in the name of the client, and transfer of ownership is subject to prior consent of the issuer or holders of the issuer’s outstanding securities, the SEC exempts advisers of such client accounts from maintaining the securities with a qualified custodian. If the client, however, is a limited partnership (or other pooled investment vehicle) that purchases private issues, then the adviser will only be exempt from the qualified custodian requirement if the limited partnership is audited annually and the audit results are distributed to investors.
Delivery of Account Statements to Clients
The amended Custody Rule requires that advisers with custody of client assets have a reasonable belief that qualified custodians are providing quarterly account statements directly to clients. Such account statements may be delivered either electronically or on paper. If a client does not receive account statements directly from the qualified custodian, then the adviser must continue sending quarterly account statements and the adviser will also be subject to an annual surprise examination by an independent public accountant to verify the funds and securities of that client.[3]
Should a client choose not to directly receive account statements, an independent representative may be appointed to receive account statements on its behalf. An “independent representative” is a person that (i) acts as agent for an advisory client; (ii) does not control, is not controlled by, and is not under common control with the adviser; and (iii) does not have, and has not had within the past two years a material business relationship with the adviser.
Exemptions
Advisers of registered investment companies are exempt from the provisions of the amended Custody Rule. The amendments also exempt advisers of pooled investment vehicles that are audited annually from the account statement reporting requirement and surprise audits, if the audit results are also distributed to investors.[4]
Elimination of Balance Sheet Requirement
Finally, the SEC has eliminated the requirement that advisers with custody of client assets include an audited balance sheet in disclosure statements sent to clients.
Conclusion
The amended Custody Rule imposes more stringent requirements on registered investment advisers to protect client funds and securities in the adviser’s custody.
Please do not hesitate to contact any member of our Broker-Dealer Practice Group and Funds Practice Group if we can be of assistance to you in explaining the amended Custody Rule.
[1] An adviser is not deemed to have possession where it inadvertently receives client funds or securities, so long as the adviser returns the funds or securities to the sender within three business days of receiving them. An adviser’s possession of a check drawn by the client and made payable to a third party is also not considered possession of client funds for purposes of the custody definition.
[2] A common example is when an adviser acts as both managing member and investment adviser to a limited liability company or another type of investment vehicle. Because the adviser acts for the limited liability company, it generally has apparent authority to dispose of funds or securities and therefore has custody of client assets. Pursuant to certain no-action letters issued by the SEC in the past, advisers who were affiliated with the general partners of limited partnerships, would not be deemed to have custody if the adviser engaged a third party to verify the calculation of the adviser’s fees before it was paid by the custodian. This exemption has been repealed and advisers, including those firms that have relied on these letters in the past, must comply with the amended Custody Rule.
[3] As discussed above, where advisers take legal title to the client assets they manage, account statements must be sent directly to the investors in the pool if the adviser to the pool also acts as its general partner, managing member, or in a similar capacity and has custody over client assets.
[4] Please note that the SEC has retreated from its initial proposed complete exemption of advisers of pooled investment vehicles from the Custody Rule. While such advisers are now exempt from the account statement reporting requirement, they still remain subject to the other provisions of the Custody Rule, including the requirement that funds and securities be held with a qualified custodian.