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The Advisers Act Custody Rule

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1 The Advisers Act Custody Rule
Presentation at the FIRMA 2011 National Risk Management Training Conference April 18, 2011 Kenneth J. Berman Gregory J. Lyons

2 The Custody Rule In general, Rule 206(4)-2 under the Investment Advisers Act of 1940 (the “Custody Rule”) requires a registered investment adviser who has “custody” of client funds and securities to satisfy three major requirements: The Qualified Custodian Requirement: Client funds and securities must be maintained with a “Qualified Custodian”. The Surprise Examination Requirement: The adviser must subject itself to a surprise examination at least once during a calendar year by an independent accountant. The Account Statement Requirement: The adviser must have a “reasonable belief” that the Qualified Custodian delivers account statements to clients on a quarterly basis. There is an Annual Audit Exception for pooled investment vehicles.

3 Who does it apply to? Investment advisers registered with the SEC under the Advisers Act. Does not apply to Non-U.S. registered investment advisers with respect to their non-U.S. clients; Investment advisers registered with the state (and not the SEC); and Any adviser with respect to its clients which are registered investment companies (e.g., mutual funds).

4 What is “Custody”?

5 Definition of “Custody”
“Custody” means “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” Related Person Custody: An adviser has “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 the adviser provides to clients. “Related Person” means any person, directly or indirectly, controlling or controlled by the adviser, and any person that is under common control with the adviser.

6 Examples of Custody Any arrangement under which the adviser (or a Related Person) is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the adviser’s (or a Related Person’s) instruction to the custodian. For example: A general power of attorney; or The authority to make withdrawals from client accounts to pay advisory fees (“Fee Deduction Authority”). Any capacity that gives the adviser (or a Related Person), or one of its supervised persons, legal ownership of or access to client funds or securities. For example: The general partner of a limited partnership; or The trustee of a trust.

7 Authority to Transfer Custody does not include the limited authority to transfer a client’s assets between the client’s accounts maintained at one or more Qualified Custodians if the client has authorized the adviser in writing to make such transfers and a copy of that authorization is provided to the Qualified Custodians, specifying the client accounts maintained with Qualified Custodians.

8 Qualified Custodian Requirement

9 Qualified Custodian Requirement
Client funds and securities must be maintained with a “Qualified Custodian”. “Qualified Custodians” are banks, registered broker-dealers, registered futures commission merchants or foreign financial institutions that customarily hold financial assets for their customers.

10 Related Custodian: Internal Control Report
Related Custodian: The adviser or one of its Related Persons may serve as a Qualified Custodian if it falls within the definition of “Qualified Custodian”. Internal Control Report: The adviser must receive from the custodian, at least annually, a written report prepared by a PCAOB Registered Accountant with respect to the custodian’s internal controls. Opinion of the Accountant: The internal control report must include an opinion of the accountant as to whether: The controls have been placed in operation as of a specific date; and The controls are suitably designed and are operating effectively to meet control objectives relating to custodial services during the year.

11 Qualified Custodian Requirement: Exceptions
Mutual Fund Shares: Securities issued by an open-end investment company (i.e., a mutual fund) may use the investment company’s transfer agent in lieu of a Qualified Custodian. Privately Offered Securities: A “Privately Offered Security” need not be maintained with a Qualified Custodian, unless it is owned by a pooled investment vehicle that does not satisfy the Annual Audit Exception. A “Privately Offered Security” is a security: Acquired from the issuer in a transaction or chain of transactions not involving any public offering; 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.

12 Surprise Examination Requirement

13 Surprise Examination Requirement
In general, an investment adviser that has custody of client assets is subject to a surprise examination at least once during a calendar year by an independent accountant at a time chosen by the accountant without prior notice. Exception for Fee Deduction Authority: An adviser that is deemed to have custody solely because it has the Fee Deduction Authority is not subject to the Surprise Examination Requirement. Exception for Operationally Independent Related Persons: An adviser that is deemed to have custody solely because a Related Person has custody is not subject to the Surprise Examination Requirement if the Related Person is “operationally independent.” Where a Related Custodian is used, the independent accountant must be a PCAOB Registered Accountant.

14 Operationally Independent
The Custody Rule establishes a presumption that a Related Person is not operationally independent unless: Client assets in the custody of the Related Person are not subject to claims of the adviser’s creditors; Advisory personnel do not have access to client assets (or other opportunity for misappropriation of client assets); Advisory personnel and personnel of the Related Person who have access to advisory client assets are not under common supervision; Advisory personnel do not hold any position with the Related Person or share premises with the Related Person; and No other circumstances can reasonably be expected to compromise the operational independence of the Related Person.

15 Guidance for Accountants
The SEC has also released guidance for the accountants performing the examinations which require that the examination is a compliance examination to be conducted in accordance with American Institute of Certified Public Accountants’ (“AICPA”) attestation standards. AICPA has released its own guidance include an illustrative surprise examination report. The SEC brought a recent enforcement action against an accounting firm who failed to conduct the surprise examinations in accordance with the professional standards set forth by AICPA.

16 Account Statement Requirement

17 Account Statement Requirement
Reasonable Belief: An investment adviser that has custody of client assets must have a “reasonable belief” that the Qualified Custodian delivers account statements to clients on a quarterly basis. Due Inquiry: The adviser’s “reasonable belief” may be formed only after “due inquiry.” The Adopting Release suggests that one way to form the reasonable belief is to receive copies of the account statements from the Qualified Custodian (or to be copied on any electronic delivery). Electronic delivery is allowed if the client has given informed consent; the client can effectively access the information; and evidence of the delivery is received.

18 Independent Representatives
A client may designate an “independent representative” to receive the notices and account statements required by the Custody Rule. An independent representative is a person that: acts as agent for an advisory client (including in the case of a pooled investment vehicle, for the investors) and by law or contract is obliged to act in the best interest of the advisory client or the investors; is not a Related Person of the adviser; and does not have, and has not had within the past two years, a material business relationship with the adviser.

19 Pooled Investment Vehicles

20 Pooled Investment Vehicles: Using Annual Audit Approach
Annual Audit: The pooled investment vehicle must be audited annually by an independent PCAOB Registered Accountant. Distribution of Financial Statements: The audited financial statements must be delivered to the pool’s investors within 120 days (or 180 days and, in certain circumstances, 260 days in the case of fund of funds) of the fiscal year-end. Liquidation Audit: The pooled investment vehicle must obtain an audit upon liquidation when the liquidation occurs prior to the fiscal year-end. Privately Offered Securities do not need to be maintained with a Qualified Custodian. The adviser does not need to satisfy either the Surprise Examination Requirement or the Account Statement Requirement.

21 Pooled Investment Vehicles: Not Using Annual Audit Approach
The adviser must satisfy the Surprise Examination Requirement. The adviser must satisfy the Account Statement Requirement. Privately Offered Securities must be maintained with a Qualified Custodian and would be covered by the surprise examination.

22 Pooled Investment Vehicles: With or Without the Annual Audit Exception
Internal Controls Report: The adviser would have to obtain, or receive from the Related Custodian, an internal controls report if the assets of the pooled investment vehicle are held by the investment adviser or a Related Custodian. Account Statement Delivery: The Account Statement Requirement is only considered satisfied if the account statements (or financial statements) are ultimately delivered to persons other than pooled investment vehicles who are Related Persons.

23 Pooled Investment Vehicles: SPVs
The Adopting Release provides the investment adviser with two options for dealing with SPVs. Separate Client Approach: The adviser may treat the SPV as a separate client, in which case the adviser will be deemed to have custody of the SPV’s assets. Under this approach, the adviser could either subject the SPV to a surprise examination or distribute audited financial statements of the SPV to the beneficial owners of the main fund. Consolidated Audit Approach: The adviser may treat the SPV’s assets as assets of the main fund. Under this approach, the assets of the SPV must be considered within the scope of the main fund’s financial statement audit or the Surprise Examination.

24 Responsibilities of a Qualified Custodian

25 What does a Qualified Custodian need to do?
Client Accounts: A Qualified Custodian must maintain the clients’ funds and securities either: In a separate account for each client under that client’s name; or In accounts that contain only clients’ funds and securities, under the adviser’s name as agent or trustee for the clients. Confirm Transfer. Confirm client authorizations for transfers, specifying the client accounts maintained with Qualified Custodians. Internal Control Report: A Related Custodian must provide an internal control report to the investment adviser. Surprise Examination: A Qualified Custodian may be required to subject itself to “surprise examinations” by an accountant.

26 What does a Qualified Custodian need to do? (2)
Account Statements: A Qualified Custodian must provide the adviser’s clients with quarterly account statements. The account statement should identify the amount of funds and each security in the account at the end of the period and set forth all transactions in the account during that period. Electronic delivery may be possible if the Qualified Custodian receives informed consent from the client and evidence of delivery. Generally, the Qualified Custodian will provide the adviser with a copy of the account statement that was delivered to the client.

27 When is a PCAOB Registered Accountant Required?
A PCAOB Registered Accountant is required for An audit of an investment vehicle relying on the Annual Audit Exemption; A surprise examination with respect to assets held with a Related Custodian; or An internal control report.

28 Scenarios

29 Scenarios Here are some questions to consider when considering different scenarios: What are the client’s assets? Are they client assets? Follow the flows; does anyone have custody at any point? Why does the adviser have custody? Is it due to Fee Deduction Authority? If a Related Person has custody, is it in connection with the advisory services being provided? Is the Related Person operationally independent? Is the client a pooled investment vehicle? Does the advisory structure include SPVs or other legal entities set up for other purposes?

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