Investment Adviser Workshop: the New Form ADV Part 2, New Rules, and the IA Switch

The SEC’s 2010 Custody Rule: Changes and New Requirements Sheila Thomas Examiner

Custody Rules Purpose Prevent loss, misuse, and misappropriation Prevent loss, misuse, and misappropriation of clients’ assets of clients’ assets Encourage the use of an independent Encourage the use of an independent custodian custodian Additional Requirements for: Additional Requirements for: Advisers with Custody or Advisers with Custody or Whose Related Person has Custody Whose Related Person has Custody

Custody Rules Utah incorporated by reference the Utah incorporated by reference the SEC custody rules SEC custody rules Utah Uniform Securities Act (3) Utah Uniform Securities Act (3) Utah Administrative Rule R g(E)(15) Utah Administrative Rule R g(E)(15) SEC custody rules adopted in 2003 SEC custody rules adopted in 2003 Amended in 2009, became effective Amended in 2009, became effective March 12, 2010 March 12, 2010 What Did Not Change

Custody Rules Annual Surprise Examinations Annual Surprise Examinations (independent verification) (independent verification) Internal Control Reports Internal Control Reports Client / Custodial Statements Client / Custodial Statements What is New

Custody Rules CUSTODY: Adviser or its related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them. Definition

Custody Rules Direct Custody Possession of client funds or securities Possession of client funds or securities Permission to withdraw client funds or Permission to withdraw client funds or securities upon Adviser’s instruction (including securities upon Adviser’s instruction (including a general power of attorney) a general power of attorney) Legal ownership capacity or access to client Legal ownership capacity or access to client funds or securities (GP of limited partnership, funds or securities (GP of limited partnership, managing member of LLC, equivalent position managing member of LLC, equivalent position pooled investment vehicles, trustee of trust) pooled investment vehicles, trustee of trust)

Custody Rules Indirect Custody Advisers that receive client checks Advisers that receive client checks written to a third party but fail to written to a third party but fail to forward to the third party in a timely forward to the third party in a timely fashion. fashion. Limited power of authority to transfer Limited power of authority to transfer funds or securities funds or securities Direct Deduction of Advisory Fees Direct Deduction of Advisory Fees

Custody Rules RELATED PERSON: Any person, directly or indirectly, controlling or controlled by IA, and any person that is under common control with the IA (may include banks and broker-dealers). Definition

Custody Rules CONTROL: The power to directly or indirectly The power to directly or indirectly control, manage or set policies of the IA control, manage or set policies of the IA Officers, partners, directors, LLC Officers, partners, directors, LLC manager, trustee, managing agent, other manager, trustee, managing agent, other persons with management control persons with management control Presumption control – ownership > 25% Presumption control – ownership > 25% Definition

Custody Rules QUALIFIED CUSTODIAN (QC): Bank, savings association, registered broker- Bank, savings association, registered broker- dealer, registered futures commission merchant dealer, registered futures commission merchant QC maintains client funds and securities QC maintains client funds and securities (i)in a separate account for each client under such client's name; or (ii)in accounts that contain only client funds and securities, under the IA’s name as agent or trustee for the clients Definition

Custody Rules SCOPE OF THE EXAM “…verify clients funds and securities of which an adviser has custody, including those maintained with a qualified custodian and those that are not required to be maintained with a qualified custodian, such as privately offered securities and mutual fund shares.” Footnote: 36 SEC Custody Rule Adopting Release IA Annual Surprise Exam

Custody Rules Annual Surprise Exam If the adviser or related person has custody: Independent verification of client funds and Independent verification of client funds and securities by actual examination securities by actual examination At least once during each calendar year At least once during each calendar year Exam date chosen by accountant Exam date chosen by accountant Unannounced with no advance notice Unannounced with no advance notice Irregular from year to year Irregular from year to year

Custody Rules Advisers must enter into a written contract Independent Auditor Independent Auditor PCAOB registration - Public Company PCAOB registration - Public Company Accounting Oversight Board Accounting Oversight Board Subject to PCAOB review Subject to PCAOB review Contract must state the exam will start by Contract must state the exam will start by December 31, 2010, or 6 months after December 31, 2010, or 6 months after becoming subject to requirement becoming subject to requirement Engagement

Custody Rules Financial statements U.S. GAAP/ Audit Financial statements U.S. GAAP/ Audit conducted pursuant to U.S. GAAS conducted pursuant to U.S. GAAS Auditor must agree to inform Utah within one Auditor must agree to inform Utah within one business day of discovery of a material business day of discovery of a material discrepancy discrepancy Auditor must file within four business days a Auditor must file within four business days a statement regarding the auditor’s termination statement regarding the auditor’s termination along with a hard copy of the Form ADV-E along with a hard copy of the Form ADV-E Engagement

Custody Rules Website: pcaobus.org Website: pcaobus.org PDF list PDF list Searchable database Searchable database Export Excel list Export Excel list Finding an Auditor

Custody Rules Internal Control Report If the adviser has custody or adviser’s related person has custody (is a qualified custodian), then the independent auditor performing the surprise exam must be engaged to prepare a written internal control report of the related person QC

Custody Rules Auditor’s Opinion states whether: Auditor’s Opinion states whether: Controls have been placed in operation Controls have been placed in operation as of a specific date as of a specific date Controls are suitably designed Controls are suitably designed Controls are operating effectively to meet Controls are operating effectively to meet control objectives of custodial services, control objectives of custodial services, including safeguarding of client funds including safeguarding of client funds Internal Control Report

Custody Rules Independent auditor must verify funds Independent auditor must verify funds and securities are reconciled to a and securities are reconciled to a custodian other than the Adviser or their custodian other than the Adviser or their related person related person Independent auditor is PCAOB registered Independent auditor is PCAOB registered Report within 6 months of becoming Report within 6 months of becoming subject to the rule and annually thereafter subject to the rule and annually thereafter Internal Control Report

Custody Rules Custodial ConditionsSurprise Examination Internal Control Report Fee Deduction Only NO “Enhanced” Custody, but QC ≠ Related Person and No Common Ownership YESNO “Enhanced” Custody and QC = Related/Affiliated or Has Common Ownership YES Physical Custody YES Pooled Investment Vehicles (PIVs) or other types of investment funds Since these can be organized in many ways, each model will need to be evaluated independently. Please contact the Division to discuss the requirements for these funds. Summary

Custody Rules Initial Notice to Clients Initial Notice to Clients Account opened with QC, prompt, written notification Account opened with QC, prompt, written notification to clients to clients QC name, address, & how funds/securities are QC name, address, & how funds/securities are maintained maintained Prompt written notification of any changes Prompt written notification of any changes If Adviser sends his own statements in addition to If Adviser sends his own statements in addition to QC, notification must urge clients to compare QC, notification must urge clients to compare adviser’s statements to QC adviser’s statements to QC QC Statements

Custody Rules Advisers must have a reasonable basis, after Advisers must have a reasonable basis, after due inquiry, for believing the qualified custodian due inquiry, for believing the qualified custodian sends at least quarterly statements to clients sends at least quarterly statements to clients Statements sent directly from a QC to client Statements sent directly from a QC to client Statements must identify the amount of funds and Statements must identify the amount of funds and securities held for client and all transactions in the securities held for client and all transactions in the account during the period account during the period Insufficient to merely confirm that statements are Insufficient to merely confirm that statements are available to client available to client QC Statements

Custody Rules Auditor’s surprise examination agreement Auditor’s surprise examination agreement Auditor’s signed & finalized report Auditor’s signed & finalized report Internal control report Internal control report QC account opening notices QC account opening notices QC client statement due inquiry workpapers QC client statement due inquiry workpapers Keep 5 years Keep 5 years Books and Records

Custody Rules Adopt and implement written policies and procedures reasonably designed to prevent violations and provide for supervision of IA’s representatives. Policies and Procedures

Custody Rules SURPRISE EXAM CPA engagement letter (written agreement) CPA engagement letter (written agreement) on or before December 31, 2010 on or before December 31, 2010 Exam complete and auditor certification with Exam complete and auditor certification with 120 days after the exam begins 120 days after the exam begins Exam must be within 6 months of becoming Exam must be within 6 months of becoming subject to the rule subject to the rule Compliance Dates (SEC)

Custody Rules INTERNAL CONTROL REPORT 6 Months after Effective Date 6 Months after Effective Date (Sept 2010) (Sept 2010) 6 months after becoming subject 6 months after becoming subject to the rule to the rule Compliance Dates (SEC)

Custody Rules POOLED INVESTMENT VEHICLE AUDITS Non fund of funds: “reasonable belief” that audited financials will be distributed to investors within 120 days of the pool’s FYE Fund of funds: 180 days after pool’s FYE ADV: new disclosures must be in the first annual amendment filed after Jan. 1, Compliance Dates (SEC)

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