More About Account Statements Under The SEC’s New Custody Rule

May 24, 2004

Reasonable Belief

Our October 7, 2003 Hedge Fund and Investment Managers Advisory discussed recent amendments to Securities and Exchange Commission (“SEC”) Rule 206(4)-2, the investment adviser custody rule (the “Rule”).  Among the Rule’s principal new elements is a provision that eliminates a custodial investment adviser’s obligations to send each of its clients a quarterly account statement and to undergo an annual surprise examination if the adviser has formed a reasonable belief by April 1, 2004 that the qualified custodians holding client assets send quarterly account statements directly to the clients or to their independent representatives. Although the staff of the SEC (the “Staff”) has noted that there is not just one way by which to form the requisite reasonable belief, the only method proposed by the Staff to date is to receive copies of all statements the qualified custodians send to the adviser’s clients. 

A March 15, 2004 Q&A issued by the staff addressed reliance with respect to electronic statements.  They are permissible if the client has given informed consent to receiving the information that way, the client can effectively access the electronically delivered information, and evidence of the delivery, such as an email return-receipt or other confirmation that the information was accessed, is received.  As with other types of notices an adviser must form a reasonable belief that the clients are receiving their quarterly statements.  For this purpose the Staff again suggested that the adviser request to be copied on all electronically delivered account statements.

Funds of Funds

Like investment advisers to other pooled investment vehicles, advisers to hedge funds only have to insure that the funds they manage comply with three requirements in order to satisfy their own requirements under the Rule.  The three requirements are to undergo an annual audit, to have the audited financial statements prepared in accordance with generally accepted accounting principles, and to distribute the audited financials to all their investors within one hundred twenty (120) days of the end of the fiscal year.  Managers of funds of funds have expressed concern that they may not be able to comply with the 120 day requirement because their own funds’ audits may be delayed by the late receipt of audited financial statements from the underlying funds in which they invest.

The SEC staff addressed this dilemma in the Q&A.  The staff stated that it would not recommend enforcement action against an adviser that reasonably believed that the fund of fund’s audited financial statements would be distributed prior to expiration of the 120-day deadline. However, the staff took the position that an adviser to a fund of funds “should investigate its underlying funds’ (and those funds’ auditors’) ability and willingness to timely complete their audits and provide the audit results within the time frame necessary for the fund of funds to complete its own audit and distribute the audited financial statements within 120 days. If an underlying fund fails to provide needed information in a timely fashion in one year, it may be unreasonable for the fund of funds’ adviser to believe that the underlying fund will provide timely needed information in subsequent years.” The staff left open the possibility that it might recommend enforcement action against an adviser whose fund of funds repeatedly fails to meet the 120 day deadline because an underlying fund repeatedly fails to provide necessary information in a timely manner. 

Fee Invoices and Calculation Statements

The Rule does not require advisers to send fee invoices or fee calculation statements to clients once a qualified custodian has begun sending its statements describing all account activity, including fee payments, directly to clients. However, according to the SEC staff there are circumstances under which an adviser must continue to send invoices or fee calculation statements to clients.  If an adviser’s disclosure documents and investment advisory agreements include obligations to send that information, the adviser must continue to do so until the necessary changes eliminating the requirement can be implemented.  All investment advisers should review their client account documents before changing any billing procedures.

For additional information on this topic, you may contact Howard A. Neuman or Carol Spawn Desmond.