Registered Adviser Custody Rules

Transcription

1 SEC Adopts Final Rules and Issues Guidance to Safeguard the Custody of Client Assets by Investment Advisers SUMMARY The SEC has adopted and published amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940 which, once effective, will require: Annual Surprise Examination. Registered investment advisers that have custody of client assets either directly or through a related person must undergo an annual surprise examination by an independent public accountant to verify such assets, with exceptions for: (i) advisers which have custody of the assets solely as a consequence of their authority to deduct advisory fees from client accounts, (ii) advisers to pooled investment vehicles which distribute annual audited financial statements to the pool s investors, prepared in accordance with GAAP by an independent public accountant that is PCAOB-registered and (iii) advisers which are deemed to have custody solely because a related person who is operationally independent of the adviser holds the assets or has any authority to obtain possession of them in connection with services provided by the adviser; Internal Control Report. In the case of client accounts maintained by the adviser or a related person acting as a qualified custodian (as opposed to an independent qualified custodian), the rules require an annual report from an independent public accountant that is PCAOB-registered that (i) includes an opinion regarding each custodian s controls relating to custody of client assets and (ii) verifies that the client assets are reconciled to a custodian (e.g., The Depository Trust Company) other than the adviser or a related person; and Custodian Account Statement Delivery. Registered investment advisers that have or are deemed to have custody of client assets must have a reasonable belief that the qualified custodian sends account statements directly to clients, including to investors in a pooled investment vehicle, with a single exception for funds audited annually by a PCAOB-registered accountant and for which those audited financial statements are delivered to investors. In addition to amending Rule 206(4)-2, the SEC also adopted related changes to (i) Forms ADV and ADV-E to require registered advisers to report additional information in respect of their custodial practices and (ii) Rule under the Advisers Act to require an adviser which is not required to undergo a New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 surprise examination in connection with a related person in accordance with the operationally independent exception to produce a memorandum that describes the relationship with the related person in connection with the adviser s services to clients and includes an explanation of the adviser s basis for determining that operational independence is satisfied. The SEC also published a companion release to provide guidance for accountants with respect to the surprise examination and internal control report requirements under amended Rule 206(4)-2. The amendments and interpretive guidance are effective on March 12, 2010, although special compliance dates apply for certain provisions. BACKGROUND On May 20, 2009, the SEC issued proposed rules (the Proposed Rules ) 1 to amend Rule 206(4)-2 of the Investment Advisers Act of 1940 as part of its ongoing effort to implement regulatory reforms designed to provide additional protections for adviser and broker-dealer clients and their assets in light of recent allegations of fraudulent conduct, including the misappropriation or other misuse of investor assets, by investment advisers and broker-dealers. Among other things, the Proposed Rules would have: 2 required all registered investment advisers with custody of client funds or securities to engage an independent public accountant to conduct an annual surprise examination of those client assets; created an obligation (effected through a written agreement between an adviser and an accountant) that any independent public accountant conducting a surprise examination: (i) notify the SEC within one business day of finding a material discrepancy, (ii) submit a Form ADV-E to the SEC accompanied by a certificate within 120 days of the surprise examination, stating that it has examined the funds and securities and describing the nature and extent of the examination and (iii) submit a Form ADV-E within four business days of its resignation, dismissal, removal or removal from consideration for being reappointed, accompanied by a statement including (among others) an explanation of any problems relating to examination scope or procedure that contributed to the event; deemed that an adviser always has custody of any client securities or funds that are directly or indirectly held by a related person in connection with advisory services provided by the adviser to its clients; required, in the case of client accounts maintained by the adviser or a related person acting as a qualified custodian (as opposed to being maintained by an independent qualified custodian), a report from an independent public accountant registered with and inspected by the PCAOB that potentially required a Type II SAS 70 report and would include an opinion regarding the custodian s controls relating to custody of client assets; 1 2 Proposed Rules: Custody of Funds or Securities of Clients by Investment Advisers, Release No. IA (May 20, 2009), available at The Proposed Rules are described more fully in the S&C Publication, The SEC Proposes Rule Amendments Intended to Safeguard the Custody of Client Assets by Investment Advisers, dated May 26, 2009, available at -2-

3 subject to a limited exception for pooled investment vehicles that provided audited financial statements to its investors, required that all registered advisers with custody of client assets have a reasonable belief that a qualified custodian sends an account statement, at least quarterly, to each client for which the qualified custodian maintains assets; required advisers to pooled investment vehicles that distribute the pool s audited financial statements to investors under the annual audit provision of Rule 206(4)-2 to, in addition to the annual audit, obtain a final audit upon liquidation of the pool and distribute the financial statements to pool investors promptly thereafter; and modified Form ADV to provide more complete information about custody practices of registered advisers and provide the SEC with additional data for the purpose of identifying and assessing compliance risks. After receiving more than 1,300 public comments on the Proposed Rules, the SEC published final rules (the Final Rules ) 3 substantially similar to these proposals, but with some important additions and modifications made in response to concerns raised in the comment letters. The significant differences between the Proposed Rules and the Final Rules are summarized below. FINAL RULES Limited Exceptions Added to the Requirement that Advisers Undergo an Annual Surprise Examination by an Independent Public Accountant Under the Proposed Rules, all registered investment advisers with custody of client funds or securities were required to undergo an annual surprise examination by an independent public accountant to verify client assets. The Final Rules limit the scope of the surprise examination in certain circumstances where the SEC concluded that the additional protections provided to advisory clients were outweighed by the burdens. First, a surprise examination is not required where the adviser has custody of the client s assets solely as a consequence of the adviser s authority to deduct fees from the client s account. In reaching this conclusion, the SEC noted that the risk that an adviser s inappropriate fee deduction would go unnoticed was lessened by the account statement delivery requirement. In addition, advisers to pooled investment vehicles will be deemed to comply with the annual surprise examination requirement by obtaining an audit of the pool and delivering the audited financial statements to pool investors within 120 days of the pool s fiscal year-end. That audit, however, must be conducted by an accounting firm registered with, and subject to regular inspection by, the PCAOB. Finally, the surprise examination requirement does not apply in circumstances where the adviser is deemed to have custody solely as a result of certain of its related persons holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them, in connection with 3 Final Rules: Custody of Funds or Securities of Clients by Investment Advisers, Release No. IA (December 30, 2009), available at (the Release ). -3-

4 services provided by the adviser so long as the related person is operationally independent of the adviser. A related person is presumed not to be operationally independent, but that presumption can be overcome if each of the following conditions is met and no other circumstances can reasonably be expected to compromise the operational independence of the related person: client assets in the custody of the related person are not subject to claims of the adviser s creditors; the adviser s personnel do not have custody or possession of, or direct or indirect access to, client assets of which the related person has custody, or the power to control the disposition of such client assets to third parties for the benefit of the adviser or its related persons, or otherwise have the opportunity to misappropriate such client assets; the adviser s personnel and the custodian s personnel who have access to client assets are not under common supervision; and the adviser s personnel do not hold any position, or share premises, with the custodian. 4 Delivery of Statements to Related Persons The Final Rules add a new provision to Rule 206(4)-2 that addresses special issues presented by a pooled investment vehicle that holds investments through other vehicles. In the Release, the SEC noted that advisers to pooled investment vehicles sometimes use special purpose vehicles (SPVs) to facilitate investments in certain securities by one or more pooled investment vehicles that the advisers manage, which are often established or controlled by the investment adviser or its related persons. The SEC expressed concern that a literal application of the rule could result in account statements and financial statements designed to permit investors to protect their interests being sent to the adviser itself, rather than to the parties the rule was designed to protect. Accordingly, the Final Rules provide that the act of sending an account statement or distributing audited financial statements to investors in a pooled investment vehicle will not meet the requirements of the rule if all of the investors in such pooled investment vehicle are themselves pooled investment vehicles that are related persons of the adviser. According to the SEC, the adviser may choose one of two compliance options: either (i) treat the SPV as a separate client, in which case the adviser will have custody of the SPV s assets or (ii) treat the SPV s assets as assets of the pooled investment vehicle, of which it has custody indirectly. If the adviser treats the SPV as a separate client, the adviser must comply, with respect to the assets of the SPV, with the audited financial statement distribution or account statement and surprise examination requirements. If the adviser complies by distributing audited financials, distribution must be made to the beneficial owners of the pooled investment vehicles. If the adviser instead treats the SPV s assets as assets of the pooled 4 Amended Rule 206(4)-2(d)(5). In connection with this exception, the SEC has also modified Rule to require registered advisers to make and keep a memorandum describing the relationship with the related person in connection with the relevant advisory services and to include an explanation of the adviser s basis for determining that it has overcome the presumption that it is not operationally independent of the related person with respect to the related person s custody of client assets. -4-

5 investment vehicles of which it has custody indirectly, the SPV is effectively disregarded and such assets must be considered within the scope of the pooled investment vehicle s financial statement audit or surprise examination. Guidance for Accountants In a companion release to the Final Rules, the SEC published updated guidance for accountants (the Accounting Guidance ) 5 that addresses both the surprise examination and internal control report requirements under amended Rule 206(4)-2, as well as the relationship between the two. The Accounting Guidance revises guidance first published in 1966 and, among other things, discusses the relevant auditing and attestation standards that apply to these engagements and updates the SEC s requirements as to the nature and extent of the accountant s procedures when conducting the surprise examination. The Accounting Guidance states that the objective of the surprise examination is to to verify that client funds and securities of which an investment adviser has custody are held by a qualified custodian in a separate account for each client under that client s name, or in accounts that contain only clients funds and securities, under the investment adviser s name as agent or trustee for the clients. 6 With respect to each period examined and for a sample of client accounts (including accounts closed during the period or that have a zero balance as of the examination date), the accountant should obtain records of the purchases, sales, contributions, withdrawals and any other debits or credits to each selected client s account occurring since the date of the last examination. The accountant s procedures to meet the objective of the examination should normally include, but are not limited to, the following with respect to each selected client account: confirmation with the qualified custodian(s) of client funds and securities as of the date of the examination and that the client s funds and securities are held in either a separate account under the client s name or in accounts under the name of the investment adviser as agent or trustee for clients; confirmation with the client of funds and securities held in the account as of the date of the examination and contributions and withdrawals of funds and securities to and from the account since the date of the last examination (where confirmation replies are not received, the accountant should perform alternative procedures); and reconciliation of confirmations received and other evidence obtained to the investment adviser s records. 5 6 Commission Guidance Regarding Independent Public Accountant Engagements, Release No. IA (December 30, 2009), available at The surprise examination is to be conducted in accordance with AT Section 601, Compliance Attestation, under the standards of the American Institute of Certified Public Accountants ( AT 601 ). -5-

6 The Accounting Guidance also establishes the procedures accountants should take with respect to privately offered securities, which are generally exempt from the requirement that a qualified custodian maintaining assets on an adviser s behalf keep those assets either: (i) in a separate account for each client under that client s name or (ii) in accounts that contain only client assets, under the adviser s name as agent or trustee for the clients. 7 In the surprise examination, the accountant s procedures with respect to privately offered securities should include confirmation with the issuer of or counterparty to such security, or, where replies are not received, alternative procedures. The Accounting Guidance also makes clear that the accountant could use sampling and select privately offered securities for testing, but need not test each privately offered security so held. An internal control report is designed to obtain reasonable assurance that the qualified custodian s controls have been placed in operation as of a specific date, and are suitably designed and are operating effectively to meet control objectives related to custody of funds and securities during the period specified. In a change from the Proposed Rules, the Accounting Guidance and the Final Rules require the independent public accountant to verify that funds and securities are reconciled to a custodian other than the adviser or its related person (e.g., The Depository Trust Company). To satisfy this requirement, the accountant should either directly confirm (on a test basis) with each unaffiliated custodian or perform other procedures designed to verify that the data used in reconciliations performed by the qualified custodian is obtained from unaffiliated custodians and is unaltered. The internal control report should address control objectives and associated controls related to various areas of the custodian s services, including client account setup and maintenance, authorization and processing of client transactions, security maintenance and setup, processing of income and corporate action transactions, reconciliation of funds and securities to depositories and other unaffiliated custodians, and client reporting. To address each of these areas, the Accounting Guidance lists the following control objectives: 7 documentation for the opening and modification of client accounts is received, authenticated, and established completely, accurately and timely on the applicable system; client transactions, including contributions and withdrawals, are authorized and processed in a complete, accurate and timely manner; trades are properly authorized, settled, and recorded completely, accurately and timely in the client account; new securities and changes to securities are authorized and established in a complete, accurate and timely manner; Privately offered securities are defined as securities, acquired from an issuer outside of a public offering, that are uncertificated (and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client) and transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer. -6-

7 securities income and corporate action transactions are processed to client accounts in a complete, accurate and timely manner; physical securities are safeguarded from loss or misappropriation; cash and security positions are reconciled completely, accurately and on a timely basis between the custodian and depositories; and account statements reflecting cash and security positions are provided to clients in a complete, accurate and timely manner. Finally, both the Accounting Guidance and the Release provide two important clarifications. First, the Final Rule does not require a specific type of internal control report so long as the objectives set forth in the rule are addressed. Language in the release accompanying the Proposed Rules referred specifically to a Type II SAS 70 Report, and could be interpreted to mean that such a report would have been required in all cases. The Accounting Guidance states that while a Type II SAS 70 Report would suffice, so would a report issued in connection with an examination of internal control conducted in accordance with AT 601 and possibly other procedures, provided that the objectives set forth in the Accounting Guidance are otherwise met. Second, the Accounting Guidance defines the term material discrepancy (for purposes of determining what the accountants must disclose to the SEC in the context of the surprise examination) as referring to material non-compliance with the provisions of either Rule 206(4)-2 or Rule 204-2(b) under the Advisers Act. Requirement to Include a Cautionary Legend Clarified Existing Rule 206(4)-2 requires advisers to notify clients promptly upon opening an account with a qualified custodian on the client s behalf, and when there are changes to the information required in that notification. As proposed, amended Rule 206(4)-2 will now require advisers to include a legend in the notice urging clients to compare the account statements they receive from the adviser with those they receive from the custodian. In response to comment letters it received, the SEC modified this provision to make clear that the cautionary legend is only required if the adviser elects to send its own statements to clients. As proposed, however, all qualified custodians are still required to deliver quarterly statements to clients without exception regardless of whether the adviser sends a separate statement. IMPLICATIONS While the Final Rules contain a number of positive changes from the Proposed Rules, the SEC has not yet addressed a number of concerns raised by commenters. In addition, the Release identified certain areas where the SEC would consider taking additional action in the future. Prominent examples of open issues include the following: The SEC retained an exemption to the custodian account statement delivery requirement for an adviser to a pooled investment vehicle that distributes audited financial statements to its investors in accordance with the rule. Nevertheless, the SEC expressed concern that the current protections of the rule may be insufficient for these investors since they do not have the benefit of regularly -7-

8 receiving reports that the assets underlying their investments are properly held. Accordingly, the SEC has directed its Staff to explore ways to remedy this potential shortcoming while respecting the confidential nature of proprietary information. The SEC eliminated, as proposed, an alternative to the requirement that an adviser have a reasonable basis for believing that its qualified custodian sends an account statement, at least quarterly, to each client for an adviser that (i) itself sends quarterly statements to clients and (ii) undergoes an annual surprise examination by an independent public accountant. While a number of commenters objected to the elimination of this alternative on the basis of privacy concerns, the SEC ultimately concluded that the protections provided by direct delivery of account statements by custodians are of substantially greater value than the privacy and confidentiality concerns and that any such concerns can be addressed by having the adviser enter into confidentiality agreements with the custodian. In connection with the Proposed Rules, the SEC had requested comment on whether the accountant performing the surprise examination would be required to perform testing on the valuation of securities, including privately offered securities. The SEC did not include this requirement in the Final Rules, agreeing with commenters who argued that although valuation is a very important issue closely related to client assets, it covers an area that goes beyond custody. A number of commenters, including Sullivan & Cromwell LLP, suggested that amended Rule 206(4)-2 clarify that the new custody requirements do not apply to Participating Affiliates or U.S. registered investment advisers operating outside the United States at a minimum to the extent they are servicing non-u.s. clients. This suggestion was made on the basis that long-standing SEC administrative interpretations and no-action positions have indicated that U.S. registered advisers may extend the scope of their advisory services to U.S. clients through access to their non-u.s. operations by way of Participating Affiliates or non-u.s. affiliates which are registered under the Advisers Act for the purpose of serving U.S. clients without substantial prejudice to conducting their non-u.s. businesses for non-u.s. clients in accordance with otherwise applicable law. Commenters raised concerns that the Proposed Rules could impose substantial costs on Participating Affiliates or non-u.s. affiliates, especially if they are required to obtain Type II SAS 70 Reports. The SEC did not incorporate this suggestion. While the SEC chose not to exempt smaller advisers from the surprise examination requirement, the Staff has been directed to evaluate the impact of this requirement on smaller advisers that have the authority to obtain possession of client funds or securities and whose client assets are maintained by an independent qualified custodian, as well as on these advisers clients. Following the completion of the first round of surprise examinations, the Staff will also conduct a review of the rule as it relates to smaller advisers and make recommendations for amendments necessary to improve the effectiveness of the rule as it applies to these advisers, or address unnecessary burdens on them. The Release, after citing the requirement that registered investment advisers adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act, suggested that advisers with custody of client assets give "appropriate attention" to the "elevated risks" of accepting custody when designing and implementing compliance policies. The Release also suggested a number of specific procedures for advisers to consider. Registered advisers may wish to review their compliance procedures against the suggestions set forth in the Release. -8-

9 EFFECTIVENESS AND COMPLIANCE The Final Rules and the Accounting Guidance are effective on March 12, specific provisions are as follows: Compliance dates for A registered adviser required to undergo a surprise examination as of March 12, 2010 must enter into a written agreement with a qualified accountant providing that the first examination must take place by December 31, Any adviser that becomes subject to the requirement after March 12, 2010 must enter into an agreement providing that the examination take place within six months of the adviser becoming subject to the rule. However, if the adviser maintains client assets as a qualified custodian, the first surprise examination must occur no later than six months after obtaining the internal control report, and if the adviser also has related persons serving as qualified custodians, no later than six months after receiving the last internal control report it is required to receive. This is because the SEC believes that investors would be better served if the first round of surprise examinations is conducted with the benefit of internal control reports. If a registered adviser is required to obtain or receive an internal control report because it or a related person maintains client assets as a qualified custodian, it must obtain or receive the internal control report within six months of becoming subject to the requirement. An adviser to a pooled investment vehicle may rely on the annual audit exception to the surprise examination requirement 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 that is PCAOB-registered. Registered advisers are required to provide responses to the revised Form ADV in their first annual amendment after January 1, * * * 8 9 The rules do not contain an implementation schedule or compliance date for advisers that previously relied on the alternative delivery requirement for statements to clients. Thus, any pooled investment vehicle that does not deliver audited financial statements to investors in accordance with the Final Rules presumably will have to comply with the reasonable belief standard regarding direct custodian delivery of account statements as of March 12, 2010 or arrange for a PCAOB-registered accountant to perform a year-end audit on the vehicle. Accountants performing surprise examinations should make their required filings on Form ADV-E manually on paper filings until the SEC s Investment Adviser Registration Depository ( IARD ) is upgraded to accept this form electronically. Copyright Sullivan & Cromwell LLP

10 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance and corporate transactions, significant litigation and corporate investigations, and complex regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the U.S., including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish ( ; rishj@sullcrom.com) or Alison Alifano ( ; alifanoa@sullcrom.com) in our New York office. CONTACTS New York John E. Baumgardner, Jr baumgardnerj@sullcrom.com Donald R. Crawshaw crawshawd@sullcrom.com William G. Farrar farrarw@sullcrom.com Richard R. Howe hower@sullcrom.com Fredrick Wertheim wertheimf@sullcrom.com Washington, D.C. Eric J. Kadel, Jr kadelej@sullcrom.com Paul J. McElroy mcelroyp@sullcrom.com Andrew R. Bernstein bernsteina@sullcrom.com DC_LAN01: