SEC Proposes Additional Custody Requirements for Investment Advisers

May 15, 2009

On May 14, 2009, the U.S. Securities and Exchange Commission held an open meeting to consider proposed amendments to rule 206(4)-2 under the Investment Advisers Act of 1940.  According to Andrew J. Donohue, Director of the SEC’s Division of Investment Management, the proposed amendments “would significantly strengthen controls over client assets held by registered investment advisers — especially when those assets are held directly by the adviser itself or a related person of the adviser.”  The SEC’s action is specifically aimed at preventing future potential Ponzi schemes and related activities.  Several Commissioners noted that the proposals discussed in the open meeting are simply one part of a larger package of reforms (and a potential overhaul of the entire Advisers Act).

The  proposed the amendments would expand the definition of “custody” under rule 206(4)-2 to include any registered investment adviser who has the ability to deduct fees directly from its clients’ accounts.  As proposed, rule 206(4)-2 would require that an investment adviser who has custody of its clients’ funds and securities obtain a surprise examination by an independent public accountant on an annual basis.  The proposed amendments would also:

  • Require that privately placed and uncertificated securities be included in the audit.  The current rule contains an exception for privately placed, uncertificated securities that managers of private equity funds have been able to rely upon.

  • Require the investment adviser to include in reports filed with the SEC, the name of the independent accountant conducting the audit, and amend such report any time the adviser changes the accountant providing the audit.

  • Require accountants to inform the SEC within one business day if any “material discrepancies” that are discovered in an adviser’s audited accounts.  A report must also be filed if the accountant or investment adviser terminates the engagement, and the reasons for any such termination.

  • Require both the custodian and the investment adviser to send clients copies of their statements and notify them when an account has been opened in their name, or money from their account has been moved.  Under the current rule, if the custodian is delivering account statements then the investment adviser is not required to deliver them.

Under current law the funds or securities of an investment adviser’s client may be maintained by a custodian who is an affiliate of the adviser.  Where such a relationship exists, the proposed rule would require that an accountant perform an annual custody control examination and that the accountant be registered with, and subject to inspection by, the Public Company Accounting Oversight Board.  The SEC intends for this proposed requirement to accomplish two goals:  (1) the exam will help ensure that an investment adviser with an affiliated custodian has proper custody control protections, and (2) the administrative and financial burden of the annual examination will encourage investment advisers to retain independent custodians for their clients’ accounts.

The current rule applies only to registered investment advisers.  The proposed amendments do not change the application of the rule so investment advisers, including managers of private equity and hedge funds, who are not registered (or required to be registered) under the Advisers Act will not be effected by the proposed amendments.

We expect the Commission to publish its release and proposed rule text shortly. Comments will be due 60 days after the release is published in the Federal Register.

Gibson, Dunn & Crutcher LLP

Gibson Dunn attorneys advise clients on the full spectrum of regulatory, business, and compliance issues confronting the securities industry. Our clients include global investment banks; executing, clearing, and prime brokers; alternative trading systems and exchanges; institutional and retail brokers, proprietary trading firms, market makers, and exchange specialists, and M&A advisory firms. We also represent registered and unregistered investment advisers on a variety of regulatory and compliance issues.

Gibson, Dunn & Crutcher attorneys are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work or any of the following: 

Washington, D.C.
K. Susan Grafton (202-887-3554, [email protected])
Amy L. Goodman (202-955-8653, [email protected])
Barry R. Goldsmith (202-955-8580, [email protected])

New York
Edward D. Sopher (212-351-3918, [email protected])
Edward D. Nelson
(212-351-2666, [email protected])
Mark K. Schonfeld (212-351-2433, [email protected])

© 2009 Gibson, Dunn & Crutcher LLP

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.