SEC Lightens Touch on the Investment Adviser Custody Rule

September 27, 2007

On September 20, 2007, the Securities and Exchange Commission (“SEC”) issued a no-action letter interpreting Rule 206(4)-2 under the Investment Advisers Act (known as the “Custody Rule”) so that a more reasonable approach is applied to investment advisers that inadvertently receive client assets in certain instances. 

Rule 206(4)-2 was amended in 2003 to “modernize the rule by conforming the rule to modern custodial practices” (see our Hedge Fund & Investment Managers Advisory dated October 7, 2003).  As we then reported, the Custody Rule requires an investment adviser that has custody of client funds or securities (a “Custodial Adviser”) to maintain both client funds and client securities with “qualified custodians,” identifies circumstances under which an adviser has custody of client assets, and eliminates a Custodial Adviser’s obligations to send each of its clients a quarterly account statement and to undergo an annual surprise examination, if the qualified custodian sends quarterly account statements directly to the adviser’s clients.

The Custody Rule provides that an adviser has “custody” of client assets when it holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them.  That Rule also provides examples that illustrate the application of the definition and includes within the Rule a limited exception for advisers that inadvertently receive client assets. As illustrated in one of the examples, an adviser has custody when it has any possession or control of client funds or securities, even temporarily.  To avoid technical violations as a result of actions by third parties, the inadvertent receipt of client funds or securities is expressly excluded from the custody definition so long as the adviser returns them to the sender within three (3) business days of receiving them. Under the Rule, advisers are not able to forward such assets to the intended third-party recipient, despite the delays inherent in returning the assets to the sender solely to be resent to the intended recipient. 

Recently, the Investment Adviser Association (the “IAA”) wrote to the SEC’s Division of Investment Management asking for assurance that a hedge fund adviser could avoid violating the Custody Rule in the event it inadvertently received client assets from third parties such as tax authorities, bankruptcy or other trust estate administrators and securities and investment earnings issuers (“Third Parties”) and promptly forwards such assets to its client or a qualified custodian within five business days of receipt and adopts and implements written policies and procedures reasonably designed to ensure the safekeeping of client assets that the adviser inadvertently receives from such Third Parties. Some of the policies and procedures suggested were requiring the adviser promptly to identify client assets that it inadvertently receives and the client (or former client) to whom such client assets are attributable; promptly to either (i) forward client assets to its client (or former client) or a qualified custodian or (ii) return to the appropriate Third Party any inadvertently received client assets that the adviser does not forward to its client (or former client) or a qualified custodian, but in no event later than five business days following the adviser’s receipt of such assets; and to maintain and preserve appropriate records of all client assets inadvertently received by it, including a written explanation of whether (and, if so, when) the client assets were forwarded to its client (or former client) or a qualified custodian, or returned to a third party.  In requesting this relief, the IAA underscored that, among other things, advisers have no control over such Third Parties and they have not directly or indirectly caused the Third Party to deliver client assets to them, and that some Third Parties continue to deliver client assets to the advisers without regard to the advisers’ instructions to address and send such client assets to the relevant client or a qualified custodian.  The IAA was explicit in making its request inapplicable to assets inadvertently received from a client, which would still have to be returned to the sender (the client) within three business days.

In issuing the no-action letter, the SEC confirmed it would not recommend enforcement action against an adviser only “if it promptly forwards client assets that it inadvertently receives from Third Parties in the [specific] situations and under the [specific] circumstances…within five business days of the adviser’s receipt of such assets, to its client (or former client) or a qualified custodian.” For an adviser to rely on this broader reading of custody in “more than rare or isolated instances”, though, the SEC expects the adviser to adopt written policies and procedures to ensure it took the required steps for appropriate disposition of client assets. 

For additional information regarding Rule 206(4)-2, see our Hedge Fund & Investment Managers Advisory dated October 7, 2003, entitled “Modernized Custody Rule Adopted: Compliance Relief for Hedge Fund Managers”, our Hedge Fund & Investment Managers Advisory dated May 24, 2004, entitled “More About Account Statements Under the SEC’s New Custody Rule,” and our Hedge Fund & Investment Managers Advisory dated December 19, 2005, entitled “SEC Takes a Tough Stance on the Hedge Fund Exception to the Investment Adviser Custody Rule”, each of which may be found on this site.  You may also contact Howard A. Neuman and Carol Spawn Desmond.