Updated as of March 5, 2010
Staff Responses to Questions About the Custody Rule
The staff of the Division of Investment Management has prepared the following responses to questions about the rule 206(4)-2, the "custody rule" under the Investment Advisers Act of 1940 and expects to update from time to time our responses to additional questions. These responses represent the views of the staff of the Division of Investment Management. They are not a rule, regulation, or statement of the Securities and Exchange Commission, and the Commission has neither approved nor disapproved this information. The adopting release for the most recent amendments to the rule (dated December 30, 2009, the "Adopting Release") can be found at: http://www.sec.gov/rules/final/2009/ia-2968.pdf. These responses supersede the previously posted responses to questions regarding the 2003 amendments to the rule. The adopting release for those 2003 amendments ("2003 Release") can be found at http://www.sec.gov/rules/final/
ia-2176.htm. (Answers that are indicated as modified from the prior version related to the 2003 amendments may have been either changed or clarified without substantive change.)
I. Compliance Dates (This section I is new and posted March 5, 2010.)
Question I.1
Q: An investment adviser that currently sends account statements to its clients in lieu of those from a qualified custodian now must arrange for the account statements to be delivered directly by a qualified custodian. When must the qualified custodian send the first account statements directly to the adviser's clients?
A: The compliance date is March 12, 2010. Accordingly, qualified custodians must deliver account statements for all periods ending on or after March 12, 2010. Thus, quarterly statements ending on March 31, 2010, must be sent by qualified custodians directly to clients. The account statement need only cover the period between the compliance date and March 31, 2010 (but may of course also cover periods before March 12).
Question I.2
Q: Some investment advisers have omnibus account arrangements with qualified custodians who have no client information and thus do not deliver client statements. Advisers are converting these relationships to meet the requirements of amended rule 206(4)-2, but such conversions require obtaining new account documentation from clients and system reprogramming, which may not be feasible in time for the qualified custodian to send account statements for the period ending March 31, 2010. May these advisers have more time to complete these conversions?
A: The Division would not recommend enforcement action to the Commission if an adviser modifying an omnibus arrangement as described above complies with rule 206(4)-2(a)(3) for those accounts no later than the delivery of the account statement for the third quarter of 2010, provided that (i) the adviser sends notice to each client no later than the time of sending the account statement for the period ending March 31, 2010, clearly describing the way in which the adviser intends to change the account arrangements to comply with the amended rule and the expected timing of those changes, and (ii) the adviser undergoes a surprise examination for 2010.
Question I.3
Q: Must the surprise examination required under rule 206(4)-2(a)(4) be completed before December 31, 2010?
A: No. The surprise examination must commence on or before December 31, 2010 but does not need to be completed until 120 days after commencement. If the adviser itself maintains client assets as qualified custodian, the first surprise examination must commence no later than six months after obtaining the internal control report. For an adviser that becomes subject to the rule after the effective date, the surprise examination must commence within six months after it becomes subject to the rule. However, as a transitional matter, the Division would not recommend enforcement action to the Commission if an adviser that becomes subject to the rule after the effective date has its first surprise examination commence by the later of six months after the adviser becomes subject to the rule or December 31, 2010.
Question I.4
Q: Does the requirement that the accountant performing an annual audit on a pooled investment vehicle for purposes of compliance with the rule must be registered with and subject to regular inspection by the Public Company Accounting Oversight Board ("PCAOB") pursuant to rule 206(4)-2(b)(4)(ii) apply to the 2009 fiscal year?
A: This requirement applies to audits for fiscal years beginning on or after January 1, 2010.
Question I.5
Q: Section III.B.3. of the adopting release (transition section) indicates that for pooled investment vehicles, "[a]n investment adviser to a pooled investment vehicle may rely on the annual audit provision if the adviser (or a related person) becomes contractually obligated to obtain an audit of the financial statements of the pooled investment vehicle for fiscal years beginning on or after January 1, 2010 by an independent public accountant registered with, and subject to regular inspection by, the PCAOB." Does this mean an adviser must be a party to a written engagement letter with the auditor?
A: No. The obligation to obtain an audit may be evidenced in a partnership agreement, disclosure statement, or engagement letter with the auditor. See 2003 Release, Footnote 47.
Question I.6
Q: Under rule 206(4)-2(b)(4), an independent public accountant performing an annual audit on a pooled investment vehicle in lieu of the required annual surprise examination must be registered with, and subject to, regular inspection by the PCAOB. The effective date of the rule is March 12, 2010. If an accountant is not currently subject to regular inspection by the PCAOB, may the accountant satisfy the requirement for exemption from the surprise examination by becoming subject to regular inspection by the PCAOB before the issuance of the audit report for the pooled investment vehicle's 2010 fiscal year?
A: Yes.
Question I.7
Q: Rule 206(4)-2(a)(6) requires that an adviser or its related person that maintains client assets as a qualified custodian must obtain (or receive from the related person) a written internal control report (e.g., Type II SAS 70 report) regarding the adviser's or its related person's custodial practices. What is the compliance date for the internal control report?
A: The compliance date for obtaining an internal control report is September 12, 2010 for advisers subject to the requirement on March 12, 2010. Advisers that are newly subject to Rule 206(4)-2(a)(6) (e.g., newly maintaining, or having a related person maintaining, client assets as a qualified custodian after March 12, 2010) must obtain the internal control report within six months of becoming subject to the requirement.
Question I.8
Q: Rule 206(4)-2(a)(6) requires that an adviser or its related person that maintains client assets as a qualified custodian must obtain (or receive from the related person) a written internal control report (e.g., Type II SAS 70 report) regarding the custodial services of the qualified custodian. Does the internal control report need to address the effectiveness of controls over custodial services prior to March 12, 2010, the effective date of the amended rule?
A: No, the internal control report does not need to address the effectiveness of controls over custodial services prior to March 12, 2010, the effective date of the amended rule, even if it results in a shortened examination period for the 2010 internal control report.
Question I.9
Q: Currently, qualified custodians often obtain custody-related SAS 70 reports prepared on a regular reporting cycle. If a qualified custodian obtained a SAS 70 report in 2009 and plans to obtain a SAS 70 report in 2010, is the qualified custodian expected to alter its reporting cycle to meet (or allow its related person investment adviser to meet) the initial September 12, 2010 compliance date?
A: No, a qualified custodian that obtained a custody-related SAS 70 report in 2009 is not expected to alter its reporting cycle in 2010.
Question I.10
Q: When must advisers registered with the SEC begin using the amended Form ADV?
A: Advisers must provide responses to the additional questions in amended Form ADV in their first annual updating amendment after January 1, 2011. Advisers who file an initial Form ADV before the updated Form ADV is available in IARD may use their first annual updating amendment to provide answers to these additional questions.
Question I.11
Q: When must accountants performing the required surprise examination file Form ADV-E electronically?
A: Investment advisers will be notified as soon as the IARD system is able to accept Form ADV-E filings. Until the IARD system is upgraded to accept Form ADV-E, accountants performing surprise examinations should continue paper filing of Form ADV-E.
II. Definition of Custody; Scope of the Rule
Question II.1
Q: If an adviser inadvertently receives securities from a client, under the amended rule may the adviser forward the securities to the qualified custodian instead of returning the securities to the client?
A: No. If the adviser does not return the securities to the sender within three business days, the adviser not only has custody but has also violated the amended rule's requirement that client securities be maintained in an account with a qualified custodian.1 However, the Division would not recommend enforcement action to the Commission under certain circumstances if an adviser inadvertently receives tax refunds from tax authorities, or client settlement proceeds from administrators in connection with class action lawsuits and other legal actions, or stock certificates, dividends, or evidence of new debt from issuers in connection with class action lawsuits involving bankruptcy or business reorganization, and forwards these client assets within five business days of its receipt and maintains appropriate records. See Investment Adviser Association, SEC Staff Letter, (Sept. 20, 2007), available at http://www.sec.gov/divisions/investment/noaction/
2007/iaa092007.pdf. (Modified March 5, 2010.)
Question II.2
Q: If an employee of an advisory firm serves as a trustee to a firm client, does the firm have custody?
A: Generally, yes. The role of the supervised person as trustee is imputed to the advisory firm, thus causing the firm to have custody.
Footnote 139 of the Adopting Release explains, however, that the role of the supervised person as trustee will not be imputed to the advisory firm if the supervised person has been appointed as trustee as a result of a family or personal relationship with the grantor or beneficiary and not as a result of employment with the adviser. A similar analysis would apply where the supervised person serves as the executor to an estate as a result of a family or personal relationship with the deceased. A personal relationship developed as a result of providing advisory services to a client over many years is not the type of "personal relationship" contemplated by footnote 139. (Modified March 5, 2010.)
Question II.3
Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?
A: No. Rule 206(4)-2 applies only to clients' funds and securities. (Posted 2003.)
Question II.4
Q: Does an adviser with authority to transfer client funds or securities between two or more of a client's accounts have custody?
A: Under rule 206(4)-2(d)(2)(ii), an adviser has custody if it has the authority to withdraw client assets maintained with a qualified custodian upon the adviser's instruction to the custodian. We do not interpret the authority to withdraw assets to include the limited authority to transfer client assets between client accounts maintained at a qualified custodian if the client has authorized the adviser in writing to make such a transfer and a copy of that authorization is provided to the qualified custodian. (Posted March 5, 2010.)
III. Fee Deductions
Question III.1
Q: A client has instructed its custodian to debit the client's account for advisory fees each quarter. The custodian makes all fee calculations, based on the advisory contract. The adviser does not calculate the fee, nor does it send a bill. Does the adviser have custody?
A: No. Under these circumstances, the custodian is acting only as agent for the client, and the adviser does not have access to the client's funds. (Posted 2003.)
IV. Account Statements; Surprise Examinations
Question IV.1
Q: May account statements be delivered electronically?
A: Yes. Electronic delivery is permissible, if (1) the client has given informed consent to receiving the information electronically; (2) the client can effectively access the electronically delivered information; and (3) evidence of the delivery is received, such as an email return-receipt or other confirmation that the information was accessed. See Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information; Additional Examples under the Securities Act of 1933, Securities Exchange Act of 1934, and Investment Company Act of 1940, Release No. 33-7288 (May 9, 1996) [61 FR 24644 (May 15, 1996)]. These guidelines are available at www.sec.gov/rules/concept/33-7288.txt.
Advisers whose clients receive electronic statements from qualified custodians must still form a reasonable belief after due inquiry that the clients are receiving those statements. The adviser may satisfy this requirement by, for example, being copied on the email notifications of account statement postings sent to clients in addition to having access to client statements on the custodian's website, although this is not the exclusive means of forming that reasonable belief (footnote 21 of the Adopting Release). (Modified March 5, 2010.)
Question IV.2
Q: Can an adviser voluntarily continue to send its own quarterly account statements to clients in addition to the statements that the clients receive directly from qualified custodians?
A: Yes. If an adviser voluntarily sends account statements, it must insert a legend required under paragraph (a)(2) of the rule urging the client to compare information provided in its statements with those from the qualified custodian in account opening notices and subsequent statements sent to the client for whom the adviser opens custodial accounts with the qualified custodian. (Modified March 5, 2010.)
Question IV.3
Q: If an accounting firm regularly audits an advisory firm's books or the books of a limited partnership run by the advisory firm, can that accounting firm also be an "independent" public accountant for purposes of performing the surprise examination under the custody rule?
A: Yes, provided that the accounting firm meets the definition of "independent public accountant" in section (d)(3) of the rule. (Modified March 5, 2010.)
V. Notice to Clients
Question V.1
Q: An adviser uses three different custodians for one of its clients, and the assets are moved among them depending on the trading in the account. At any given moment, one or two of those custodians might not be holding that client's funds or securities. Must the adviser provide the client with a new notice each time the assets are moved, or can the adviser provide the client with notice at one time advising the client of all three custodians?
A: The adviser can give the client a one-time notice of all three custodians, and is not required to provide a new notice each time the assets move among the three. The purpose of the notice is to tell the client whom to contact to get his assets, if necessary, and this purpose is satisfied even if the client has to contact three custodians. (Posted 2003.)
VI. Pooled Investment Vehicles
Question VI.1
Q: Should the account statements sent to the investors be a statement of the transactions and holdings of the pool, or a statement of the investor's holdings in the shares of the pool (i.e., how many limited partnership units the investor owns)?
A: They must be a statement of the transactions and holdings of the pool. (Posted 2003.)
Question VI.2
Q: Does each limited partner need to have a separate independent representative or can one independent representative serve for all limited partners?
A: The representative can serve for all limited partners, so long as the representative is, in fact, independent and satisfies the definition in rule 206(4)-2(d)(4). (Modified March 5, 2010.)
Question VI.3
Q: To use the "audit approach" relying on rule 206(4)-2(b)(4), must the financial statements be prepared in accordance with U.S. GAAP?
A: Yes, with some exceptions. Pooled vehicles organized outside of the United States, or having a general partner or other manager with a principal place of business outside the United States, may have their financial statements prepared in accordance with accounting standards other than U.S. GAAP so long as they contain information substantially similar to statements prepared in accordance with U.S. GAAP and any material differences are reconciled. Both U.S. and non-U.S. pooled investment vehicles must be audited in accordance with U.S. Generally Accepted Auditing Standards and by an independent public account as defined in the rule. However, offshore advisers registered with the SEC are not subject to the custody rule, with respect to offshore funds See ABA Subcommittee on Private Investment Entities, SEC Staff Letter, Aug. 10, 2006 ("ABA Letter"), available at http://www.sec.gov/divisions/
investment/noaction/aba081006.pdf. The terms "offshore adviser" and "offshore fund" are defined in the ABA Letter. (Modified March 5, 2010.)
Question VI.4
Q: To use the "audit provision" allowed under rule 206(4)-2(b)(4), must the audit meet the requirements of U.S. Generally Accepted Auditing Standards?
A: Yes. If the audit does not meet U.S. GAAS requirements, the adviser cannot rely upon the "audit provision." Account statements must be delivered by the qualified custodian to each of the underlying investors of the pool or to their independent representative(s), and the adviser must undergo an annual surprise examination with respect to the assets of the pooled investment vehicle. (Modified March 5, 2010.)
Question VI.5
Q: Does a fund of funds have to meet the 120-day deadline for sending out its audited financial statements?
A: The Division has issued a letter indicating that it would not recommend enforcement action to the Commission if an adviser relying on the "audit provision" for a fund of funds distributes the audited financials to investors within180 days from the end of the fund of funds' fiscal year. A fund of funds is a pooled investment vehicle that invests 10 percent or more of its total assets in other pooled investment vehicles that are not, and are not advised by, a related person of the pool, its general partner, or its adviser. A "related person" of an adviser includes officers, partners, directors, most employees, and anyone controlled by, controlling or under common control with the adviser. See Adopting Release at footnote 45 and the ABA Letter. (Modified March 5, 2010.)
Question VI.6
Q: An adviser's client is a pooled investment vehicle that invests in a fund of funds, but the "top tier" pool is not a fund of funds as defined in the ABA Letter because it is affiliated with the fund of funds in which it invests — for example, the top tier pool is a feeder fund in a master-feeder structure where the master fund is a fund of funds. If the top tier pool wishes to rely on the "audit provision," must it distribute its audited financial statements within 120 days of its fiscal year end, or may it use the extended 180-day deadline available to the fund of funds?
A: In these circumstances, the auditors of the top tier pool, like the auditors to the fund of funds, might not be able to complete their work until the audit reports of the funds underlying the fund of funds are available. The Division would not recommend enforcement action for a violation of rule 206(4)-2 against an adviser to a top tier pool that invests 10 percent or more of its total assets in a fund of funds if the adviser distributes the top tier pool's audited financial statements within 180 days of the end of the fiscal year of the fund of funds. (Modified March 5, 2010.)
Question VI.7
Q: If a pooled investment vehicle is subject to an annual audit and its adviser is relying on the "audit provision" under rule 206(4)-2(b)(4), would the adviser be in violation of the rule if the pooled vehicle fails to distribute its audited financial statements within 120 days after the end of its fiscal year?
A: The Division would not recommend enforcement action for a violation of rule 206(4)-2 against an adviser that is relying on rule 206(4)-2(b)(4) and that reasonably believed that the pool's audited financial statements would be distributed within the 120-day deadline, but failed to have them distributed in time under certain unforeseeable circumstances. (Modified March 5, 2010.)
Question VI.8
Q: Some registered fund families have organized unregistered money market funds for investment exclusively by their registered investment companies, in compliance with rule 12d1-1 under the Investment Company Act of 1940.2 The financial statements of the unregistered money market funds are audited, but are delivered to the registered investment companies, which may be related persons of the adviser. Under rule 206(4)-2(c), sending audited financial statements solely to pooled investment vehicle investors that are themselves pooled investment vehicles and related persons of the adviser does not satisfy the financial statement delivery requirement under rule 206(4)-2(b)(4). Must the financial statements of the unregistered money market funds be delivered to each shareholder in the registered investment companies investing in the unregistered fund?
A: The Division would not recommend enforcement action to the Commission under rule 206(4)-2 if the audited financial statements of the unregistered money market funds are not delivered to the shareholders of the registered investment companies, provided that the financial statements are delivered to each registered investment company's chief compliance officer, audit committee members and the members of the board of directors who are not interested persons of the adviser. (Posted March 5, 2010.)
Question VI.9
Q: Section 206(4)-2(b)(4) provides that an adviser may comply with the rule's requirements with respect to an account of a "limited partnership (or limited liability company, or another type of pooled investment vehicle)" by delivering audited financial statements of the limited partnership to investors. In some cases such pooled investment vehicles are formed where the general partner has only a nominal capital account and there is a single limited partner. Similarly, a limited liability company may have a single member. Is there a minimum number of investors that a limited liability company or other entity must have in order to come within the meaning of section 206(4)-2(b)(4)?
A: No. (Posted March 5, 2010.)
VII. Privately Offered Securities
Question VII.1
Q: If the client is a pooled investment vehicle that does not rely on the "audit provision" under the amended custody rule, may the adviser use the exception for privately offered securities for that client?
A: No. The exception provided under paragraph (b)(2) of the rule is only available for an adviser to a pool that is audited pursuant to rule 206(4)-2(b)(4). (Modified March 5, 2010.)
Question VII.2
Q: The limited partnership an adviser manages does not undergo an annual audit, and the amended custody rule therefore requires that privately offered securities owned by the limited partnership be maintained with qualified custodians. Some of these securities, however, are recorded only on the books of their issuers that are not qualified custodians. May the adviser satisfy this requirement of rule 206(4)-2(a)(1) by keeping the subscription agreement for the security with a qualified custodian or having the custodian act as nominee for the limited partnership?
A: Yes. Under this circumstance, an adviser may satisfy the requirements of rule 206(4)-2(a)(1) by keeping the originally signed subscription agreement (instead of the security itself) with a qualified custodian or having the custodian act as nominee for the limited partnership. (Modified March 5, 2010.)
Question VII.3
Q: When does an adviser have custody when it advises a client with respect to the purchase of privately offered uncertificated securities, i.e., the securities described in paragraph (b)(2)(i) of the rule?
A: Whether an adviser has custody of client funds and securities depends upon whether the adviser directly or indirectly holds the securities or has any authority to possess them. Custody does not turn on whether the securities are maintained with a qualified custodian. Thus, an adviser that is a general partner of a limited partnership or a trustee of a trust would always have custody of such securities held by the partnership or the trust. An adviser that does not have such legal authority to obtain possession of such securities would generally not have custody, for example if the client must sign a subscription agreement to purchase a privately offered security, and the adviser has no authority to transfer or redeem those securities without client consent to the issuer. (Posted March 5, 2010.)
VIII. Independent Representatives
Question VIII.1
Q: If an adviser appoints an independent representative for a client, must the adviser obtain the client's consent?
A: The rule does not address this point. However, an adviser's fiduciary duties, client contract or limited partnership contract may require it to obtain client consent for the appointment. Appointment of a representative without consent of the client suggests that the representative may be controlled by the adviser and is not truly independent. (Posted 2003.)
Question VIII.2
Q: If an accounting firm acts as the independent auditor (or independent surprise examiner) of an adviser, may the accounting firm also act as the independent representative for the limited partners of a pooled investment vehicle run by the adviser?
A: Likely not. The accounting firm would have to meet the definition of "independent representative" set out in the rule. We note that the concept of independence for purposes of the definition of "independent representative" under the rule is distinct from the concept of independence for purposes of the Commission's auditor independence rules. (Posted 2003.)
Question VIII.3
Q: If an accounting firm acts as the independent auditor of a pooled investment vehicle, may the accounting firm also act as the independent representative for the investors in the pool?
A: Likely not. The accounting firm would have to meet the definition of "independent representative" set out in the amended custody rule. As noted in the previous question, the concept of independence for purposes of the definition of "independent representative" under the amended custody rule is distinct from the concept of independence for purposes of the Commission's auditor independence rules.
In addition, if the audited financial statements are intended to be delivered to the independent representative rather than to the investors in the pooled vehicle, then the accounting firm would be receiving its own audit results; in those circumstances, we believe that the accountant may not be able to act solely in the limited partners' interests. (Posted 2003.)
Question VIII.4
Q: If an adviser is a trustee for a client's trust, can a co trustee be the "independent representative" to receive statements for the trust?
A: The co-trustee can be the independent representative provided it meets the tests for independence set out in the rule. (Posted 2003.)
Question VIII.5
Q: Can someone who is an advisory client of an adviser act as an independent representative for other clients of that adviser?
A: Yes, if it meets the tests for independence set out in the rule. If the client relationship is a "material business relationship" (or the person has another material business relationship) with the advisory firm, the person will not meet the tests for independence. (Posted 2003.)
IX. Sub-Custodians
Question IX.1
Q: If an adviser that is a qualified custodian uses a sub-custodian (that is also a qualified custodian) to hold some book-entry securities, may the adviser send its advisory clients consolidated account statements that incorporate the sub custodian's account statements, or must the sub-custodian send separate account statements?
A: If the adviser/custodian's account includes the assets maintained with the sub custodian, the adviser/custodian can send a consolidated statement. (Posted 2003.)
X. Auditing Non-Pool Accounts
Question X.1
Q: Can an adviser use the audit approach under the rule with respect to the account of a client that is not a pooled investment vehicle (e.g., an endowment, an individual, or a pension fund)? What if the client co-invests alongside an audited private pool?
A: No. The audit approach is not available if the client is not a pooled investment vehicle; account statements must be sent to the client by a qualified custodian. The answer does not change if the client co-invests alongside an audited pool. (Modified March 5, 2010.)
XI. Balance Sheet
Question XI.1
Q: Under what circumstances must an adviser still provide an audited balance sheet to its advisory clients?
A: Although having custody no longer causes SEC-registered advisers to be subject to the balance sheet requirement, Item 14 of Form ADV Part II still requires advisers that charge prepayment of fees exceeding $500 and six or more months in advance to provide audited balance sheets to their clients. (Posted 2003.)
XII. Trustees
Question XII.1
Q: A related person of an investment adviser (e.g., an officer or director of the adviser) may act as the trustee of the participant-directed defined contribution plan established for the benefit of the adviser's employees. As trustee of the plan, the related person selects the service providers for the plan, such as an administrator and may select the investment options available under the plan, e.g., mutual funds. Must the adviser treat the assets of the plan as client assets of which it has custody?
A: The Division will not recommend enforcement action to the Commission against an investment adviser that does not treat the assets of a participant-directed defined contribution plan established for the benefit of adviser's employees as those of a client of which it has custody in these circumstances solely because a related person of the adviser is trustee which may select service providers and investment options for the plan, provided that (i) neither the investment adviser nor a related person otherwise acts as an investment adviser to the plan or any investment option available under the plan and (ii) the investment adviser and the related person trustee are, to the extend applicable, in compliance with the Employee Retirement Income Security Act of 1974 (ERISA) and rules and regulations issued thereunder with respect to the plan. (Posted March 5, 2010.)
Endnotes
http://www.sec.gov/divisions/investment/custody_faq_030510.htm
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