Wednesday, May 27, 2009

Update: SEC Proposal to Amend Investment Advisers Custody Rule

On May 15, we reported on the SEC's proposal to amend Rule 206(4)-2 (the "Custody Rule") under the Investment Advisers Act of 1940 to require investment advisers who maintain custody of their clients' assets to subject themselves to surprise examinations. The SEC has since published the full text of the proposal (the "Proposal"), the key provisions of which are summarized below.

The most significant change for registered investment advisers would be the requirement to have any client assets for which an investment adviser has custody verified annually by an independent public accountant on an unannounced basis. This surprise examination would cover "all client funds and securities of which an adviser has custody, including those maintained with a qualified custodian and those that are not maintained with a qualified custodian, such as certain privately offered securities and mutual fund shares." The Proposal would further require an investment adviser to contract with an independent public accountant to conduct such examinations and notify the SEC within one business day of finding material discrepancies. The accountant would be required to submit Form ADV-E to the SEC within 120 days of the surprise examination, accompanied by a certificate stating that it has examined the funds and securities and describing the nature and extent of the examination. Finally, additional notification requirements are imposed upon the resignation, dismissal, removal, or other termination of the accountant's engagement by the investment adviser, together with a statement explaining any problems which may have contributed to the termination. Like the current rule, the revised Custody Rule would not apply to accounts of investment companies registered under the Investment Company Act of 1940.

The Proposal also includes heightened requirements for investment advisers who use affiliated qualified custodians. Such advisers would need to retain a member of the Public Company Accounting Oversight Board (the "PCAOB") to conduct the surprise examinations, and would also need to obtain an annual internal control report including an opinion from an independent public accountant registered with the PCAOB with respect to the adviser's or its custodian's controls relating to the custody of clients' assets.

Additional amendments envisaged by the Proposal would require that investment advisers' clients receive account statements from the custodian at least quarterly, and would revise the content of the notice advisers send to their clients upon opening a custodial account on their behalf. Finally, the SEC is also proposing amendments to Part 1A and Schedule D of Form ADV.

The SEC will be accepting comments on the Proposal until July 28, 2009.