Madoff with the Custody Rule:  The SEC’s Continuing Reaction to the Ponzi Proliferation

Swiftly following disclosure of Bernie Madoff’s fraud and several other Ponzi schemes, the Securities and Exchange Commission (the “SEC”) signaled that it was reviewing the investment adviser “Custody Rule,” Rule 206(4)-2 under the Investment Advisers Act of 1940 (the “Act”).  As early as this February, SEC staff let it be known that the need to strengthen the custody and audit requirements for regulated firms was under consideration, and on May 20th, the SEC announced that it was proposing rule changes that would, as Chairman Schaprio announced, “strengthen the custody controls that apply to investment advisers.” The release announcing the proposed rule changes, “Custody of Funds or Securities of Clients by Investment Advisers” (the “Release”), [1] stated that the changes are meant to provide “additional safeguards… when an adviser has custody of client funds or securities” by, among other things, expanding examination requirements and increasing the depth of reports following examinations.  Form ADV would also undergo amendments as a result of changes proposed in the Release.

The Custody Rule generally requires a registered investment adviser that has custody of client funds or securities (a “Custodial Adviser”) to (i) deposit and maintain both client funds and client securities with “qualified custodians,” [2] (ii) segregate and identify all client securities, (iii) send quarterly statements to clients whose assets are in the adviser’s custody, and (iv) have an independent public accountant conduct an annual surprise examination of those assets to verify the accuracy of client account statements and notify the SEC within one day of any material discrepancies uncovered during any surprise examination.  In addition to the element of surprise for this audit, the accountant must report its findings to the SEC on Form ADV-E within thirty (30) days after it is completed.  However, the obligation of a Custodial Adviser to send each of its clients a quarterly account statement and to undergo an annual surprise examination can be avoided if the qualified custodian sends quarterly account statements directly to the adviser’s clients, including each investor in an investment limited partnership, investment limited liability company or other type of pooled investment vehicle (all of which are referred to in this Advisory as “hedge funds”). 

In addition, the SEC generally takes the position that if an investment adviser or an affiliate or a supervised person of an investment adviser serves as the general partner of, or otherwise holds a managing position in a hedge fund, that investment adviser is a Custodial Adviser because it or its affiliate or supervised person has ownership of or access to (and thereby authority over) the hedge fund’s assets.  Nevertheless, such an adviser is generally exempt from the quarterly account statement and surprise examination provisions of the Custody Rule with respect to a hedge fund’s assets if the hedge fund is audited at least annually in accordance with U.S. generally accepted auditing standards, has its audited financial statements prepared in accordance with generally accepted accounting principles, and distributes its audited financial statements to all its investors within one hundred twenty (120) days (for a fund of funds, within one hundred eighty (180) days) of the end of its fiscal year. 

The most significant changes proposed in the Release are those that relate to the annual surprise examination.  The proposed rule changes would require that “all registered investment advisers with custody of client assets engage an independent public accountant to conduct an annual surprise examination of client assets,” even if the Custodial Adviser’s clients receive quarterly account statements directly from a qualified custodian and its hedge fund investors receive timely auditor’s financial statements.  The engagement would have to be pursuant to a written agreement with the accountant for the performance of the annual surprise examination.  Currently, fewer than 200 investment advisory firms undergo surprise examinations.  This proposal, however, is anticipated to require more than 9,000 additional investment advisers to undergo these examinations because an adviser that is authorized to deduct its fees from client accounts is deemed to be a Custodial Adviser with respect to each such account. [3]

The Release specifies that an “independent public accountant”—not currently defined in the Custody Rule—is one “that meets the standards for independence described in rule 2-01(b) and (c) of Regulation S-X.” The proposed rule changes would also change the reporting requirement so that the accountant would have to notify the SEC within one (1) business day if it finds material discrepancies, and would have to report any changes in its engagement within four (4) days but would have 120 (rather than only thirty) days of the time chosen by the accountant for the examination to submit its certified findings.

The proposed rule changes would also eliminate an adviser’s ability to send reports directly to clients by requiring that qualified custodians deliver account statements directly to clients and would amend account establishment procedures to require investment advisers to notify clients of the need to compare account statements from custodians with those from their advisers as a means to reinforce client awareness of custodian-provided statements and the wisdom of timely review.  The proposed rule changes would also require the Custodial Adviser to have a reasonable belief “after ‘due inquiry’” that its advisory clients or their representatives actually receive accountant statements from the qualified custodian.  “Due inquiry” could be satisfied by the adviser’s joint receipt of the statements or some confirmation of delivery via facsimile or email from the qualified custodian given contemporaneously with the delivery or otherwise making specific reference to the quarters covered. 

The proposals do retain the exemption from the quarterly statement delivery requirement for hedge funds and permit statements to be delivered directly by Custodial Advisers to hedge fund investors, so long as the hedge fund is audited at least annually in accordance with U.S. generally accepted auditing standards, has its audited financial statements prepared in accordance with generally accepted accounting principles, and distributes its audited financial statements to all its investors within the appropriate time period. [4] Nevertheless, Custodial Advisers to hedge funds would become subject to the annual surprise examination in order to insure that all funds or securities receive annual scrutiny.

The Release also proposes changes in the assets to be examined, so that privately offered securities [5] are no longer excluded from treatment under the Custody Rule.  The independent public accountant conducting the annual surprise examination would be required independently to verify all client funds and securities of which an adviser has custody, including those maintained with a qualified custodian and those that are not maintained with a qualified custodian, such as certain privately offered securities and mutual fund shares.  The SEC recognizes that such assets might not generally be held by qualified custodians, and is requesting special comment on whether a surprise examination of them is feasible.

Under the proposal, registered investment advisers would retain the option to retain direct custodial control over client assets or to use an independent third party to act as a custodian.  However, to discourage investment advisers from retaining custody of client funds or securities, investment advisers retaining custody would become subject to additional obligations that would expand the scope of the annual surprise examination and impose qualification requirements on independent public accountants.  These obligations would include:

- Retention of an independent public accountant registered with and inspected by the Public Company Accounting Oversight Board (“PCAOB”) [6] to perform an annual custody control examination;

- Annual preparation by the PCAOB-registered independent public accountant of a written “internal control report” (a Type II SAS 70 report [7] would be sufficient) performed in accordance with PCAOB standards, which includes the accountant’s PCAOB-appropriate opinion with respect to and a description of, among other things, controls [8] placed in operation relating to the adviser’s or its related person’s custodial services, including the safeguarding of cash and securities held by either the adviser or a related person on behalf of the adviser’s clients, and tests of operating effectiveness; and

- Retention of that report by the adviser in its records for five (5) years and production of it to the SEC upon request.

As a possible alternative to these custody control requirements, the SEC has requested special comment on whether they “should simply amend rule 206(4)-2 to require that an independent qualified custodian hold client assets.” The SEC is mindful that this might unduly affect the business of broker-dealers, who are otherwise permitted to act as custodians and advisers (and are already subject to significant oversight and regulation [9]), or might result in unreasonable costs for small advisory clients.

Along with the surprise examination changes, another significant proposal relates to extension of “custody” to client assets held directly or indirectly “by a ‘related person’ in connection with advisory services provided by the adviser to its clients.” The proposed rule changes would define “control”, “custody” and “related person”, respectively, to reflect treatment currently found only in SEC staff interpretations.  The proposals would insure that the Custody Rule applies to client assets not held with an independent custodian, whether with the adviser itself or indirectly through a related person, even if the related person is not controlled by the adviser.

In tandem with these changes to the Custody Rule, the Release proposes amendments to Form ADV.  Part 1A of the Form would be changed to require an adviser to report the following and to confirm compliance with the amended rule:

- The identities of all related persons who are broker-dealers and which, if any, are qualified custodians with respect to the adviser’s clients’ assets (in Item 7);

- The U.S. dollar amount of client assets of which, and the number of clients over whose assets, the adviser or any related person has custody, and whether either is a qualified custodian of those assets (in Item 9);

- If the adviser is Custodial Advisor, if a qualified custodian sends quarterly account statements to investors in pooled investment vehicles the adviser manages, if the financial statements of such pooled investment vehicles are audited, if the adviser’s clients’ assets are subject to a surprise examination, and if a PCAOB-registered independent public accountant prepares an internal control report with respect to the adviser or its related persons’ custodial services (in Item 9); and

- For an advisor subject to surprise annual examination, the month in which the last examination started (in Item 9).

Schedule D of Form ADV would be amended so that responses to Items 7 and 9, as changed, could be reflected in detail. Advisers would be expected to identify (a) the accountants performing audits or examinations and preparing reports, provide basic identifying and PCAOB status information about them and indicate if the report was unqualified; and (b) related persons who are qualified custodians, provide basic identifying information about them and indicate if the related person qualified custodian is a bank, futures commission merchant or foreign financial institution.

The Release puts form to Chairman Schapiro’s earlier position that the “use of third-parties to hold client assets, verify the existence of client assets, or assess the custody controls employed by the adviser or an affiliated custodian will provide a critical, independent layer of protection for advisory clients.” Nevertheless, the SEC seeks significant input as to whether the proposals will result in better investor protections sufficient to justify the costs and inefficiencies which the proposal may create.  Given that the proposals in the Release are perceived as “part of a larger package of reforms,” that assessment might in part be dependent upon the SEC’s treatment of its examination and risk-assessment processes and improvements the SEC implements in its enforcement program and ability to handle complaints and tips.

Comments on the proposed rule changes must be submitted to the SEC no later than July 28, 2009.

[1] Release No. IA-2876, RIN 3235-AK32 (May 20, 2009).

[2] “Qualified custodians” include institutions that are examined by regulators with respect to custodial services and that are required to maintain fidelity bonds to cover possible losses caused by employee dishonesty such as banks, savings associations, registered broker-dealers, registered futures commission merchants with respect to futures and with respect to securities held by the futures commission merchant incidental to client futures transactions and, under certain circumstances, foreign financial institutions that customarily hold financial assets for their customers and agree to hold advisory client assets in customer accounts segregated from their proprietary assets.  Registered investment advisers that are banks or broker-dealers are themselves qualified custodians and permitted to maintain custody of their own clients’ assets, subject to the quarterly account statement delivery requirements of the Custody Rule. Advisers can also maintain client assets with affiliates that are qualified custodians.

[3] Several industry groups have announced their intention to oppose final adoption of the proposed rule changes, in particular to the application of the rule changes to investment advisers that are Custodial Advisers solely by reason of the fact that they are authorized to deduct their fees from client accounts.

[4] The Release provides that a hedge fund that liquidates and makes final distributions other that at year end would also be entitled to this exemption, provided its final audit was “distribute[d]…promptly” to the limited partners, members or other owners.

[5] The definition of privately offered securities would not change and would continue to include securities that are (i) acquired from the issuer in a transaction or chain of transactions not involving any public offering, (ii) uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client), and (iii) transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

[6] The constitutionality of the PCAOB has been challenged and will be argued before the United States Supreme Court later this year in a case entitled Free Enterprise Fund v. Public Company Accounting Oversight Board.

[7] Statement on Auditing Standards (SAS) No. 70, Service Organizations, is an auditing standard developed by the American Institute of Certified Public Accountants (AICPA).  A SAS 70 Audit means the service organization (in this case, the investment adviser) has been through an in-depth audit of its control objectives and control activities, which often include controls over information technology and related processes.  A Type II report would mean the investment adviser’s controls would have been subjected to detailed testing over a minimum six month period.

[8] Control objectives that would be the subject of an opinion would include, among other things, physical safeguarding of client assets, timely and accurate reconciliations of cash and security positions and processing of transactions to client accounts, proper authorization and recording of client-initiated trades, and complete and accurate establishment of duly received and authenticated documentation for opening client accounts.

[9] Among other things, broker-dealers are already required to submit to annual audits that assess their ability to safeguard securities.

For additional information regarding the Custody Rule, see our other Hedge Fund and Investment Managers Advisories: “Modernized Custody Rule Adopted: Compliance Relief for Hedge Fund Managers (October 7, 2003), “More About Account Statements Under the SEC’s New Custody Rule”(May 24, 2004), and “SEC Takes a Tough Stance on the Hedge Fund Exception to the Investment Adviser Custody Rule”(December 19, 2005), all of which may be found on this web site.  You may also contact Howard A. Neuman or Carol Spawn Desmond.