Investment advisers generally understand that safeguarding

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1 Frequent Compliance Issues under the SEC s Custody Rule under the Investment Advisers Act * By Edwin C. Laurenson Investment advisers generally understand that safeguarding client assets entrusted to their care is one of their most important duties. In order to assure that they do so, the SEC s custody rule (the Custody Rule or the Rule ) 1 under the Investment Advisers Act of 1940 (the Advisers Act or the Act ) which was revised in 2009 in the wake of the Madoff scandal 2 imposes detailed requirements governing the manner in which an SEC-registered investment adviser must hold client assets and related obligations. The SEC examination staff closely inspects a registered adviser s compliance with the Custody Rule s requirements in the Staff s periodic compliance examinations and may engage in special custody examinations if reason is found to do so. Drawing on a National Exam Program Risk Alert issued by the SEC s Office of Compliance, Inspections and Examinations earlier this year (the OCIE Alert or the Alert ), 3 this article discusses failures that the SEC examination staff and others have identified in registered advisers compliance with the Custody Rule and measures that advisers may wish to consider to provide assurance that violations of the Rule will not occur. 4 Edwin (Ted) C. Laurenson is a partner at the New York City office of McDermott Will & Emery LLP.** What is custody under the Custody Rule, and how must client assets be held? The OCIE Alert notes that some registered advisers apparently did not understand the breadth of the Custody Rule s definition of custody and, as a consequence, did not take steps to comply with the Rule s provisions when they should have. In ordinary parlance a person is considered to have custody if he holds an asset in his possession. However, physical custody has little to do with the determination of whether an adviser has custody for purposes of the Rule. In fact, with one narrow exception recently announced by the SEC Staff, the Custody Rule forbids a registered investment adviser to hold physical custody of client funds or securities. 5 Instead, the rule s definition of custody primarily keys off the power of an adviser or its related persons to control the disposition of client assets for the potential benefit of the adviser or its related persons , Edwin C. Laurenson PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY SEPTEMBER OCTOBER

2 Thus, while custody for purposes of the Custody Rule does not arise from mere possession of the power to buy and sell securities for a client pursuant to a grant of discretionary investment management authority, 7 custody is deemed present for purposes of the rule when the adviser or one of its related persons (i.e., a natural person or entity controlled, controlled by or under common control with the same adviser) 8 has the direct or indirect authority (regardless of whether exercise of that authority would be improper) to obtain possession of client funds or securities in connection with the adviser s provision of investment advisory services. The OCIE Alert The SEC examination staff closely inspects a registered adviser s compliance with the Custody Rule s requirements in the Staff s periodic compliance examinations and may engage in special custody examinations if reason is found to do so. notes that the SEC Staff had observed failures by advisers to realize that they were deemed to have custody in the following circumstances: The adviser s personnel or a related person serve as trustee or have been granted power of attorney for client accounts. 9 The adviser (1) provides bill-paying services for clients and, therefore, is authorized to withdraw funds or securities from the client s account, (2) manages portfolios by directly accessing online accounts using clients personal usernames and passwords without restrictions and, therefore, has the ability to withdraw funds and securities from the clients accounts or (3) has signatory and check writing authority for client accounts. 10 If it wants to avoid the attribution of custody on these bases, an adviser must rigorously assure that the power of attorney or other instrument or arrangement that grants the adviser authority to execute transactions on the client s behalf grants no more than trading authority or the ability to transfer client assets between the client s custodial accounts. In the case of a power of attorney or similar instrument (such as a standing instruction ), that is best accomplished by including wording that specifically disclaims other powers. The adviser received checks made out to clients and failed to return them promptly to the sender. 11 The adviser or one of its affiliates serves as the general partner of a limited partnership or holds a comparable position for a different type of pooled investment vehicle (such as by serving as the manager or managing member of a limited liability company or as the trustee of a business trust). 12 The adviser has physical possession of client assets, such as securities certificates. Registered advisers should note that, in this connection, they are almost never permitted to hold client securities certificates in their own possession. If an adviser possesses the kind of power over client assets that gives rise to custody under the Rule, with strictly limited exceptions (described below), the Rule requires that all client funds and securities assets be held at a qualified custodian. 13 If an adviser does not possess that kind of power, it would generally not make sense for the adviser to engage in practices that would otherwise give rise to custody under the Rule because doing so would subject the adviser to the Rule s requirements when those requirements would not otherwise apply. For practical purposes, the interaction of these principles means that at least when a registered adviser has discretionary trading authority over a client s account or effects transactions for a client upon the client s instruction, the client s securities will almost always be held in a segregated account at a bank or savings association, broker or futures commission merchant that has the ability to act as a qualified custodian regardless of whether the adviser has custody under the Custody Rule. 14 When the adviser does not have the kind of authority that gives rise to custody under the Rule, this is true because an adviser with discretionary trading authority or execution authority must be able to give instructions (pursuant to a power of attorney or other standing instructions ) to the person holding the client s funds or securities to effect transactions on the client s behalf. To be sure, if the adviser does not have custody for purposes of the Rule, the person holding the client funds or securities that are subject to the adviser s discretionary or transaction execution authority need not comply with the Rule s technical defi nition of qualifi ed custodian. However, for practical purposes that person will almost 18 SEPTEMBER OCTOBER 2013 PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY

3 always need to hold securities for the adviser s client in book entry form in order to be able to use modern settlement procedures and will need to be either a qualifying bank or savings association, a broker-dealer or a futures commission merchant. Because U.S. banks and savings associations, brokers and futures commission merchants are subject to regulatory requirements that impose obligations to segregate client securities from the holding institution s proprietary assets, client securities held in the United States will almost always be held in a separate account that is segregated from the custodian s own assets. On the other hand, if custody under the Custody Rule is not present and the client elects to hold funds or securities outside the United States, there can be a genuine difference in the way the assets and funds are held from the manner in which they must be held if the Rule applies. If custody under the Rule is present, the adviser must see to it that a foreign qualified custodian keeps the advisory clients assets in customer accounts segregated from [the qualified custodian s] proprietary assets. Because not all foreign regulatory authorities require the segregation of client securities, a registered adviser with mere trading or execution authority, but not custody under the Rule, need not assure that client securities held with an offshore bank or broker are segregated by the custodian from its proprietary assets; rather, that is up to client. In addition, while an adviser with custody can always hold power over client funds held in a properly designated, qualifying U.S. bank or savings association account, 15 the Custody Rule by its terms does not allow an adviser with custody to have power over client funds that are held in a non-u.s. bank account 16 whereas a client operates under no such restriction when the client s adviser does not have custody for purposes of the Rule. The Custody Rule s requirement that a qualified custodian hold the client s assets when custody is present under the Rule is subject to two strictly limited exceptions, one of which was recently modified by the SEC Staff. First, the qualified custodian for mutual fund shares (i.e., shares of open-end investment companies registered under the Investment Company Act of 1940, including registered money market funds 17 ) may be the mutual fund s transfer agent. Second, the Rule provides that an adviser is not required to arrange for a qualified custodian to hold uncertificated, privately offered securities that are transferable only with the permission of the issuer of the securities. In August of this year the Staff modified a previous position to permit the investment manager of a pooled investment vehicle to hold certificates for privately offered securities that are transferable only with the permission of the issuer, subject to specified conditions. 18 In the case of a pooled investment vehicle, an adviser with custody over the vehicle s assets must also employ the audit approach (discussed below) in order for the adviser to be permitted to hold the vehicle s privately offered securities in its own custody rather than in the custody of a qualified custodian. 19 Importantly, even if an adviser with custody under the Rule can rely upon these alternative methods for holding client securities with respect to all client securities under the adviser s control, 20 the adviser would still have custody and need to comply with the Custody Rule s other requirements even though the adviser would not need to retain a qualified custodian to hold the securities. Compliance Issues When Custody is Present The OCIE Alert reports that the SEC Staff had observed a number of failures to comply with the Custody Rule s requirements when an adviser properly recognized that it has custody under the Rule: Although the Custody Rule permits client assets held at a qualified custodian to be held in the adviser s name as agent or trustee for its clients, it does not permit an adviser to commingle its own proprietary assets and assets of its employees with client assets in that kind of account. The OCIE Alert found that some advisers failed to honor the agent/trustee designation requirement and others engaged in improper commingling. Registered advisers with custody should note in this connection that even though the Custody Rule does not by its terms forbid commingling the assets of multiple clients in a single custodial account established by the adviser as agent or trustee, doing so in effect requires the establishment of subaccounts for each client. Except when the adviser s client is a pooled investment vehicle and the audit approach is used, the Rule requires an adviser holding custody to have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of [the adviser s] clients for which [the qualified custodian] maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY SEPTEMBER OCTOBER

4 and setting forth all transactions in the account during that period. 21 In order for the custodian to perform this function without revealing the assets and transactions of one client to other clients, the custodian must have an adequate basis for determining which assets and transactions relate to which client. That would be difficult (or impossible) to arrange if client assets were commingled and could implicate privacy concerns under regulations that apply to the custodian. In With one narrow exception the Custody Rule forbids a registered investment adviser to hold physical custody of client funds or securities. addition, if the adviser has custody because the client has granted the adviser authority to write checks or otherwise disburse funds to third parties on the client s behalf, it is difficult (or impossible) to see how it could be appropriate to do so out of a custodial account that the adviser holds in its own name for the benefit of multiple clients. Therefore, we believe that for practical purposes an adviser holding multiple clients assets in a properly established account at a qualified custodian must arrange for the custodian to establish a subaccount for each client indeed, we believe that the establishment of subaccounts under such circumstances should be required by qualified custodians. As a result, it is not clear that any efficiency advantage would be conferred by the adviser s establishment of a single account, with multiple subaccounts, as opposed to a separate account for each client. Relatedly, the OCIE Alert notes that some advisers did not have a reasonable basis, after due inquiry, for believing that a client s qualified custodian was sending quarterly account statements to the client (or the client independent representative 22 ). 23 In its 2009 Amending Release, which imposed the custodian-provided-statement requirement, the SEC did not generally specify what kind of due inquiry is necessary to provide an adviser with a reasonable basis for believing that the custodian sends the required statement. The 2009 Amending Release does indicate, however, that the adviser s receipt of a duplicate copy of custodian statements will generally meet the standard, whereas the adviser s merely checking on the online availability of the statement on the custodian s website would not. 24 Advisers should also make it a standard practice when they meet with their clients to inquire as to the clients receipt of custodian statements. Where the adviser opened a custodial account on behalf of a client and sent account statements to the client, the OCIE Alert notes that the statements sent by some advisers failed to include the required notification urging clients to compare the account statements from the custodian with those from the adviser. 25 Because the Rule requires that qualified custodians account statements be sent only quarterly (although many custodians send statements monthly), an adviser with custody that sends its own statements to clients on a more frequent basis may report asset values or holdings that diverge from the values or holdings shown in the custodian s report. This should not be problematic so long as the statement sent by the adviser is accurate as of its date. Rather than being held by the custodian directly, the OCIE Alert notes that some advisers improperly placed securities certificates in a safe deposit box controlled by the adviser at a local bank. 26 Although the Custody Rule generally imposes a requirement that a registered adviser with custody undergo an annual surprise examination by an independent public accountant, 27 the OCIE Alert reports that the Staff found evidence suggesting that examinations were not being conducted on a surprise basis (for example, exams were conducted at the same time each year). In order to comply with the surprise requirement, the accountant should select a time that varies each year without notice to the adviser. In addition, the Alert notes that some examining accountants did not, as required, file a Form ADV-E reporting audit results to the SEC within 120 days after the date of the exam chosen by the accountant. While the Custody Rule specifies that an adviser with custody must insist upon a provision in the adviser s agreement with an examining accountant requiring the accountant to file a Form ADV-E with the SEC within the specified period, 28 the Rule does not require the adviser to assure that the accountant actually complies with that contractual obligation. Nevertheless, we believe that a registered adviser is well-advised to insist on obtaining evidence of the required filing by the accountant, if for no other reason than to show the SEC Staff that the adviser is eager to demonstrate full compliance with the Rule. 20 SEPTEMBER OCTOBER 2013 PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY

5 Pooled Investment Vehicle Issues In addition to observing in the OCIE Alert that some advisers failed to recognize that they had custody when the adviser or a related person served as the general partner, manager or managing member of a pooled investment vehicle, the SEC Staff noted a number of other compliance deficiencies under the Rule by advisers that manage vehicles of that kind. Importantly, several of the Rule s requirements that apply to non-pooled-investmentvehicle advisers that are deemed to have custody do not apply to a pooled vehicle manager with custody of the vehicle s assets if the vehicle is audited annually, and upon liquidation, by an independent public accountant registered with, and subject to inspection by, the Public Company Accounting Oversight Board (the PCAOB ) and the audit report is provided to the vehicle s investors or their independent representatives within a specified period. 29 The OCIE Alert refers to this is exception as the audit approach. 30 The OCIE Alert flags the following issues in connection with the use of the audit approach: The accountant that conducted the financial statement audit was not, as required by the Custody Rule, independent under the SEC s Regulation S-X 31 or was not registered with, and subject to inspection by, the PCAOB. Advisers that do not use the audit approach either because they are pooled investment vehicle managers with custodial powers but elect not to use it or because they do not manage pooled investment vehicles should note that the independence requirement also applies to advisers that instead arrange for a surprise audit. However, in that case the accountant performing the examination need not be registered with, and subject to inspection by, the PCAOB unless the adviser or one of its related persons serves as the qualified custodian. 32 The audited financial statements were not prepared in accordance with U.S. generally accepted accounting principles ( GAAP ) (e.g., organizational expenses were improperly amortized rather than expensed as incurred, resulting in a qualified audit opinion; financial statements were prepared on a federal income tax basis; the adviser could not substantiate fair valuations and the accountant therefore could not issue an unqualified opinion on the financial statements). In the case of offshore pooled investment vehicles managed by a registered adviser with its principal office and place of business in the United States, the Staff has indicated that it is permissible to have the vehicle s accounting statements prepared in accordance with another accounting regime, such as international financial reporting standards, but only if material differences are reconciled with GAAP in financial statements sent to U.S. investors. 33 The OCIE Alert indicates that some advisers have not seen to it that the required reconciliation was provided. Relatedly, the OCIE Alert notes that some accountants conducting an audit of such an offshore pooled investment vehicle at times did not comply with U.S. generally accepted auditing standards ( GAAS ). Counterintuitively, while a lapse of this kind would appear to be attributable to the accountants rather than the adviser, in the Staff s view the lapse would disqualify the adviser from relying on the audit approach. 34 Therefore, advisers who retain non-u.s. accountants to audit offshore pooled investment vehicles in compliance with the audit approach would be well advised to obtain the accountants assurance that they will comply with GAAS in performing the audit. 35 The adviser failed to demonstrate that the audited financial statements were distributed to all pooled investment vehicle investors. Rather, it appeared that in many instances the statements were only made available upon request. The audited financial statements were not sent to investors within 120 days of the pooled investment vehicles fiscal year ends (or 180 days for fund of funds). 36 Advisers should note that although the Staff Responses indicate that a failure to distribute pooled investment vehicle financial statements within the required periods will not necessarily preclude reliance upon the audit approach if the adviser reasonably believed that the deadline would be met and the failure is attributable to certain unforeseeable circumstances, 37 neither the SEC nor the Staff has defined what those circumstances are. Therefore, it behooves an adviser relying on the audit approach to cooperate willingly in the audit and impress the need to meet the applicable deadline upon the investment vehicle s accountant. A final audit was not performed on liquidated pooled investment vehicles. The adviser requested (and apparently received) investor approval to waive the annual financial audit of a pooled investment vehicle but did not arrange instead to undergo a surprise examination. Therefore, since the Custody Rule requires a pooled investment vehicle adviser with custody to use one of the two approaches and does not permit investor waiver, the adviser violated the Rule. PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY SEPTEMBER OCTOBER

6 While the OCIE Alert specifically mentions the applicability of the surprise examination requirement when the full requirements of the audit approach are not met only in the context of a pooled investment vehicle adviser s failure to see to it that the vehicle was audited, any of the failures to comply with the audit approach noted above can give rise to a requirement to arrange for a surprise examination. Also, although not mentioned in the OCIE Alert, it is worth noting that, in addition to arranging to undergo a surprise examination, a pooled investment vehicle adviser that does not comply with the audit approach must (1) assure that the vehicle s qualified custodian sends quarterly statements to the vehicle s investors 38 and (2) comply with the Custody Rule requirement that any account statement sent by the adviser to the vehicle s investors contain a statement urging the [investors] to compare the account statements from the custodian with those from the adviser. 39 * * * As the issues discussed in this article demonstrate, proper compliance with the Custody Rule requires close attention both to the Rule s wording and related SEC releases and SEC Staff interpretations. SEC registered advisers should be sure to consult qualified compliance professionals to assure that they meet the requirements of this important provision. ENDNOTES * This article is intended only as a general discussion of the issues treated in it. It should not be regarded as legal advice. The author would be pleased to provide additional details or advice about specific situations. ** Edwin C. Laurenson has decades of experience advising U.S. and international investment advisers and managers and public and private investment funds on all aspects of U.S. securities regulation, including compliance with the Investment Advisers Act of 1940, the Investment Company Act of 1940, the Securities Act of 1933 and the Securities Exchange Act of 1934, and the establishment and offering of interests in investment funds of all kinds (including related areas of partnership, limited liability company and corporate law). Ted is a graduate of Amherst College and Yale Law School. 1 Rule 206(4)-2 under the Advisers Act. 2 Advisers Act Release No (December 30, 2009) (cited in this article as the 2009 Amending Release ). At the same time the SEC published an interpretive release for independent public accountants providing direction with respect to the independent verification and internal control reports required by amended Rule 206(4)-2, Advisers Act Release No (December 30, 2009). The amendments adopted in the 2009 Amending Release were proposed in Advisers Act Release No (May 20, 2009). 3 Office of Compliance, Inspections and Examinations, Significant Deficiencies Involving Adviser Custody and Safety of Client Assets, National Exam Program Risk Alert, Vol. 3, Issue 1 (March 4, 2013). 4 This article makes no attempt to comprehensively describe the Custody Rule s requirements or its interpretation. To achieve a full understanding of the Rule, registered advisers should consult qualified compliance professionals. 5 The Custody Rule does not apply to client assets that are not funds or securities. See Staff Responses to Questions About the Custody Rule (most recently updated December 13, 2011) (the Staff Responses ) at question II.3 (available at divisions/investment/custody_faq_ htm). The Custody Rule does, however, apply to a registered adviser s custody of funds or securities even if the advisory relationship is uncompensated (Staff Responses at question II.9). Under the Custody Rule swap transaction collateral must also be held at a qualified custodian pursuant to arrangements that meet all applicable requirements (Staff Responses at question II.10). 6 The definition of custody (in paragraph (d)(2) of the Custody Rule) is as follows: Custody means holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. You have custody if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services you provide to clients. Custody includes: (i) Possession of client funds or securities (but not of checks drawn by clients and made payable to third parties) unless you receive them inadvertently and you return them to the sender promptly but in any case within three business days of receiving them; (ii) Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and (iii) Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities. 7 See Advisers Act Release No (September 25, 2003) (the 2003 Amending Release ) at notes 5 and 10. The 2009 Amending Release did not change the Custody Rule s definition of custody. An adviser is not deemed to have custody as a result of having been granted the power to transfer assets between accounts at the qualified custodians holding client assets or to instruct a qualified custodian to distribute assets to the client pursuant to authority granted by the client (Staff Responses at questions II.4-6). 8 Custody Rule paragraph (d)(7). Control is defined paragraph (d)(1) as follows: Control means the power, directly or indirectly, to direct the management or policies of a person, whether through ownership of securities, by contract, or otherwise. Control includes: (i) Each of your firm s officers, partners, or directors exercising executive responsibility (or persons having similar status or functions) is presumed to control your firm; (ii) A person is presumed to control a corporation if the person: (A) Directly or indirectly has the right to vote 25 percent or more of a class of the corporation s voting securities; or (B) Has the power to sell or direct the sale of 25 percent or more of a class of the corporation s voting securities; (iii) A person is presumed to control a partnership if the person has the right to receive upon dissolution, or has contributed, 25 percent or more of the capital of the partnership; (iv) A person is presumed to control a limited liability company if the person: (A) Directly or indirectly has the right to vote 25 percent or more of a class of the interests of the limited liability company; (B) Has the right to receive upon dissolution, or has contributed, 25 percent or more of the capital of the limited liability company; or (C) Is an elected manager of the limited liability company; or (v) A person is presumed to control a trust if the person 22 SEPTEMBER OCTOBER 2013 PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY

7 is a trustee or managing agent of the trust. 9 The SEC Staff has stated that it will not recommend enforcement action against an adviser under the Custody Rule if, without compliance with the Custody Rule, a related person of the adviser serves as trustee of a participant-directed defined contribution pension plan for the adviser s employees but (i) neither the adviser nor one of its related persons otherwise acts as an investment adviser to the plan or any investment option under the plan and (ii) the adviser and the related person trustee are, to the extent applicable, in compliance with the Employee Retirement Income Security Act of 1974 and related rules and regulations with respect to the plan (Staff Responses at question XII.1). An adviser is not deemed to have custody of client assets by virtue of providing investment advisory or management services to a related natural person with respect to assets that are both legally and beneficially owned by that person and over which that person holds power of disposition (Staff Reponses at question II.7) or to a supervised person who is appointed a trustee or executor solely as a result of personal or family connections (but not as a result of a personal relationship deriving from the provision of advisory services to a client) (2009 Amending Release at note 139 and Staff Responses at question II.2). The Staff Responses to questions XII.2 and 3 discuss circumstances in which an adviser may not be deemed to have custody when the adviser or one of its related persons serves as a co-trustee. 10 A registered adviser s power to withdraw funds from a client s account for this purpose could also give rise to a need to comply with the SEC s identity theft red flags rules. See Identity Theft Red Flags Rules, Release Nos , IA-3582, IC (April 10, 2013) (promulgated jointly with the Commodity Futures Trading Commission). 11 This restriction does not apply to checks drawn by a client and made payable to a third party. The SEC Staff has taken the position that it will not recommend enforcement action if an adviser inadvertently receives tax refunds, class action settlement proceeds, dividends and certain other items and forwards them to the client within five business days, subject to the requirement that the adviser maintains appropriate records. See Staff Responses at question II Most pooled investment vehicles with advisers subject to the Custody Rule are private investment companies that qualify for one of the private investment company exemptions from investment company status under the Investment Company Act of 1940 (sections 3(c)(1) or 3(c)(7) of the Investment Company Act); however, in some case other Investment Company Act exemptions apply. In the case of hedge funds, private equity funds and venture capital funds, either the adviser/manager or one of its affiliates almost always serves as the general partner (or manager or managing member) of the fund, thereby conferring custody under the Rule. In the case of certain other pooled investment vehicles, such as structured collateralized loan obligation and collateralized debt obligation funds, it is less likely that the vehicle s investment adviser will possess the kind of power that gives rise to custody under the Rule; however, in every such case counsel must rigorously examine the documentation that confers powers upon the adviser to determine whether it gives rise to custody under the Rule. No explicit SEC guidance is available with regard to whether a registered adviser is deemed to have custody when a control person of the adviser or one of its employees serves as a director or officer of a pooled investment vehicle organized as a corporation. However, in our experience SEC examiners have taken the position that custody exists in those circumstances, at least when the director or officer appears to have a control relationship with the vehicle. Although investment companies and business development companies registered as such under the Investment Company Act are also, of course, pooled investment vehicles, Custody Rule paragraph (b)(5) provides that an adviser is not required to comply with the Custody Rule with respect to entities of that kind because the Investment Company Act and SEC rules under it impose their own rigorous custody requirements. 13 The term qualified custodian is defined in Custody Rule paragraph (d)(6). Under this definition a qualified custodian is either a U.S. commercial bank or savings association that has deposits insured by the FDIC, a U.S. registered broker-dealer or futures commission merchant holding client assets in customer accounts subject to the rules of the SEC or the Commodity Futures Trading Commission applicable to such accounts or a foreign financial institution that customarily holds financial assets for its customer and keeps the adviser s clients assets in customer accounts that are segregated from the custodian s proprietary assets. 14 If custody under the Rule is not present and the advisory relationship is both nondiscretionary and does not involve the adviser s execution of transactions on the client s behalf, the client can, of course, hold its assets any way it wants to. 15 Although the Custody Rule requires that a U.S. bank or savings association acting as a qualified custodian be insured by the FDIC, almost all U.S. deposit-taking banks and savings associations (albeit not credit unions) are so insured (and, in any event, the FDICinsurance qualification can be easily checked). It should be noted in this connection that the obligation of a bank to its depositors constitutes a debtor-creditor relationship under which the assets backing the bank s obligations are not segregated from the bank s proprietary assets. 16 While there is no written SEC Staff position that permits a registered adviser with custody to hold client assets in a properly designated non-u.s. bank account, in oral consultations relating to a private investment fund a member of the Staff advised the author that use of a non-u.s. bank account (established for administrative purposes at a non-u.s. bank that was an affiliate of the private fund s administrator) could be permissible if the adviser/manager (1) determined that holding funds in such an account was in the best interests of the private fund and (2) engaged in an appropriate investigation of the soundness of the bank in question. Because this is not a written position, however, it is not clear that it should be relied upon. 17 Custody Rule paragraph (b)(1). Note, however, that this exception does not apply in the case of a privately offered money market fund that is not registered under the Investment Company Act of 1940 (cf. Staff Responses at question VI.10). If a mutual fund s transfer agent is a related person of the investment adviser, the transfer agent must comply with the Rule s internal control report and surprise examination requirements (or, in the case of a pooled investment vehicle, the annual audit requirements that must be met if the audit approach is used (discussed further below)) (Staff Responses at question XV.1). 18 Privately Offered Securities Under the Investment Advisers Act Custody Rule, IM Guidance Update No (August 2013). In addition to meeting the audit approach requirement discussed below, the conditions stated in the Guidance Update are that (1) the certificate can only be used to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer; (2) ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client; (3) the certificate contains a legend restricting transfer; and (4) the certificate must be appropriately safeguarded by the adviser and can be replaced upon loss or destruction. The Staff had previously refused to extend the kinds of privately offered, restricted transfer securities that could be held by an adviser to certificated securities, on the grounds that the SEC itself had explicitly considered and rejected that possibility. See Response C.2 in ABA Subcommittee on Private Investment Entities (December 8, 2005). Although it does not refer to that previous position, the Guidance Update indicates that the rationale for the change largely lies in the verification procedures that a pooled investment vehicle s independent accountant must apply in connection with the audit approach, which was inserted into the Custody Rule by the 2009 amendments. In a footnote, the Guidance Update also noted that (1) securities that are evidenced by ISDA master agreements that cannot be assigned or transferred without the consent of the counterparty are privately offered securities under privately offered, restricted transfer securities exception and, therefore, are eligible for relief with regard to the custody of related certificates (if such a certificate exists), as well as when there is no related certificate, and (2), as stated in the PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY SEPTEMBER OCTOBER

8 2003 Amending Release, partnership agreements, subscription agreements and LLC agreements are not certificates under the Custody Rule and, therefore, privately offered, restricted transfer securities evidenced by that kind of documentation need not be held by a qualified custodian if the relevant conditions (including compliance with the audit approach in the case of a pooled investment vehicle) are met. Separately, if the adviser s client is not a pooled investment vehicle over which the adviser or one of its related persons has powers that confer custody as defined in the Custody Rule, the adviser may not have custody of a privately offered security if the client must sign the subscription agreement for that security and the adviser has no authority to transfer or redeem the security without client consent (Staff Responses at question VII.3). 19 Custody Rule paragraph (b)(2); Staff Responses at question VII.1. If the audit approach is not available to an adviser to a pooled investment vehicle with the result that the vehicle s adviser must arrange to hold privately offered, restricted transfer securities at a qualified custodian the adviser may satisfy the holding requirement with respect to an uncertificated security by arranging for the applicable subscription agreement to be held by a qualified custodian or for a qualified custodian to serve as the vehicle s nominee (Staff Responses at question VII.2). 20 While it would be unusual for this to be the case with respect to most advisees, a private equity or venture capital fund could hold only privately offered securities and, perhaps, money market fund investments, all of which would qualify for the exceptions described above. Note, however, that if such a fund subsequently came to hold securities that would not qualify for those exemptions (as a result, for instance, of an IPO by one of the fund s portfolio companies or the sale or merger of a portfolio company in which the consideration received by the fund consisted of public company stock), the fund s investment manager would then need to engage a qualified custodian to hold those fund securities. 21 Custody Rule paragraph (a)(3). 22 Custody Rule paragraph (a)(7). The term independent representative is defined in Custody Rule paragraph (d)(4). See Staff Responses at questions IV.4 and VIII.1-5 for answers to questions relating to independent representatives. 23 Note that, as discussed below, this requirement does not apply to pooled investment vehicles and their investors if the vehicle s adviser sees to it that the vehicle complies with the audit approach Amending Release at notes Custody Rule paragraph (a)(2). 26 As the SEC has explained, because client funds and securities must be held on behalf of the client by the qualified custodian so that the qualified custodian can provide account information to the clients, keeping stock certificates in the adviser s bank safe deposit box, for example, would not satisfy the requirements of the Rule. See the 2003 Amending Release at note Custody Rule paragraph (a)(4). The surprise audit requirement does not apply (1) in the case of a pooled investment vehicle if the adviser complies with the audit approach discussed below (Custody Rule paragraph b(4)) or (2) when an adviser has custody only because it has the right to requisition payments of the adviser s agreed fees from the client s qualified custodian (Custody Rule paragraph (b)(3)). 28 Custody Rule paragraph (a)(4)(i). The agreement must also require that (1) if the examining accountant finds material discrepancies in the course of the surprise examination, the accountant will inform the SEC of the discrepancies within one business day (Custody Rule paragraph (a)(4)(ii)), and (2) if the accountant resigns, is dismissed or either is removed from or removes itself from reappointment, the accountant will file a statement with the SEC on Form ADV-E within four business days, giving the date of the relevant event and containing an explanation of any problems relating to examination scope or procedure that contributed to the accountant s dismissal or removal (Custody Rule paragraph (a)(4)(iii)). 29 Custody Rule paragraph (b)(4). See below for a discussion of the period within which reports must be provided. 30 Registered pooled investment vehicle managers are not required to use the audit approach, but must comply with the Custody Rule s otherwise applicable requirements if they elect not to do so CFR part Custody Rule paragraphs (a)(4) and (a)(6). 33 Staff Responses at question VI.5. In accordance with previous guidance, that Staff Response also affirms that an offshore registered adviser is not subject to the Custody Rule in relation to an offshore pooled investment vehicle, even if that vehicle has U.S. investors. 34 Staff Responses at question VI This assurance should be straightforwardly forthcoming in view of the fact that an accountant retained in connection with an adviser s use of the audit approach must be registered with, and subject to examination by, the PCAOB. 36 Custody Rule paragraph (b)(4), which establishes the audit approach, specifies only the 120-day period. The 180-day period for funds of funds is an SEC Staff position. In addition, the Staff has taken the position that a pooled investment vehicle that invests 10 percent or more of its assets in funds of funds can provide financial statements within 260 days without jeopardizing the fund adviser s reliance on the audit approach. Staff Responses at questions VI.7, VI.8A and VI.8B. 37 Staff Responses at question VI Custody Rule paragraphs (a)(5). Custody Rule paragraph (c) requires that account statements and audited financial statements must be sent to investors in a related vehicle if, as in a master-feeder structure, the investor s interest is held through other vehicles in which investors invest. The account statements sent with respect to such a pooled investment vehicle must relate to the assets of the vehicle as a whole, not a slice of those assets attributable to a particular investor s interest in the vehicle, and should provide investors with information necessary to respond to accountant confirmation requests with regard to deposits and withdrawals (Staff Responses at questions VI.2 and 3). In the absence of the availability of the audit approach, Custody Rule paragraph (a)(2) also requires the adviser to notify its client of the identity of the qualified custodian that holds the client s assets. Because, in the case of a pooled investment vehicle, the adviser s client is the vehicle and not its investors, this notification requirement is presumably automatically met i.e., since the adviser or one of its affiliates controls the vehicle, the adviser would in effect be giving notice to itself, and the requirement in Custody Rule paragraph (a)(5) that account statements be sent to a pooled investment vehicle s investors when the audit approach is not used does not by its terms require the adviser to notify the vehicle s investors of the identity of the vehicle s qualified custodian. In any case, pooled investment vehicle private placement memoranda customarily name the vehicle s custodian. Clearly, however, if the audit approach is not used or not available, a pooled investment vehicle s adviser must see to that the vehicle s investors know the identity of the vehicle s custodian since the investors will be receiving quarterly statements from the custodian. 39 Custody Rule paragraph (a)(2). This article is reprinted with permission from Practical Compliance and Risk Management for the Securities Industry, a professional journal published by Wolters Kluwer Financial Services, Inc. This article may not be further re-published without permission from Wolters Kluwer Financial Services, Inc. For more information on this journal or to order a subscription to Practical Compliance and Risk Management for the Securities Industry, go to pcrmj.com or call SEPTEMBER OCTOBER 2013 PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY