Frequent Compliance Issues under the SEC’s Custody
Rule under the Investment Advisers Act*
By Edwin C. Laurenson
I
nvestment advisers generally understand that safeguarding
client assets entrusted to their care is one of their most important duties. In order to assure that they do so, the SEC’s
custody rule (the “Custody Rule” or the “Rule”)1 under the
Investment Advisers Act of 1940 (the “Advisers Act” or the “Act”)
– which was revised in 2009 in the wake of the Madoff scandal2
– imposes detailed requirements governing the manner in which
an SEC-registered investment adviser must hold client assets and
related obligations. The SEC examination staff closely inspects a
registered adviser’s compliance with the Custody Rule’s requirements
in the Staff’s periodic compliance examinations and may engage in
special custody examinations if reason is found to do so. Drawing
on a National Exam Program Risk Alert issued by the SEC’s Office
of Compliance, Inspections and Examinations earlier this year (the
“OCIE Alert” or the “Alert”),3 this article discusses failures that
the SEC examination staff and others have identified in registered
advisers’ compliance with the Custody Rule and measures that
advisers may wish to consider to provide assurance that violations
of the Rule will not occur.4
What is “custody” under the Custody Rule, and
how must client assets be held?
Edwin (Ted) C. Laurenson is a partner at the
New York City office of McDermott Will &
Emery LLP.**
The OCIE Alert notes that some registered advisers apparently did not
understand the breadth of the Custody Rule’s definition of “custody”
and, as a consequence, did not take steps to comply with the Rule’s
provisions when they should have. In ordinary parlance a person
is considered to have custody if he holds an asset in his possession.
However, physical custody has little to do with the determination
of whether an adviser has custody for purposes of the Rule. In fact,
with one narrow exception recently announced by the SEC Staff, the
Custody Rule forbids a registered investment adviser to hold physical
custody of client funds or securities.5 Instead, the rule’s definition of
custody primarily keys off the power of an adviser – or its “related
persons” – to control the disposition of client assets for the potential
benefit of the adviser or its related persons.6
©2013, Edwin C. Laurenson
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Frequent Compliance Issues under the SEC’s Custody Rule under the Investment Advisers Act
Thus, while custody for purposes of the Custody Rule does
not arise from mere possession of the power to buy and sell
securities for a client pursuant to a grant of discretionary investment management authority,7 custody is deemed present
for purposes of the rule when the adviser or one of its related
persons (i.e., a natural person or entity controlled, controlled
by or under common control with the same adviser)8 has the
“direct or indirect authority” (regardless of whether exercise
of that authority would be improper) to “obtain possession”
of client funds or securities in connection with the adviser’s
provision of investment advisory services. The OCIE Alert
The adviser received checks made out to clients and failed
to return them promptly to the sender.11
The adviser or one of its affiliates serves as the general partner
of a limited partnership or holds a comparable position for
a different type of pooled investment vehicle (such as by
serving as the manager or managing member of a limited
liability company or as the trustee of a business trust).12
The adviser has physical possession of client assets, such
as securities certificates.
Registered advisers should note that, in this connection,
they are almost never permitted to hold client securities certificates in their own possession. If an adviser
possesses the kind of power over client
The SEC examination staff closely inspects a
assets that gives rise to custody under
the Rule, with strictly limited exceptions
registered adviser’s compliance with the Custody
(described below), the Rule requires that
Rule’s requirements in the Staff’s periodic compliance all client funds and securities assets be held
at a “qualified custodian.”13 If an adviser
examinations and may engage in special custody
does not possess that kind of power, it
examinations if reason is found to do so.
would generally not make sense for the
adviser to engage in practices that would
notes that the SEC Staff had observed failures by advisers
otherwise give rise to custody under the Rule because doing
to realize that they were deemed to have custody in the folso would subject the adviser to the Rule’s requirements when
lowing circumstances:
those requirements would not otherwise apply.
The adviser’s personnel or a related person serve as
For practical purposes, the interaction of these principles
trustee or have been granted power of attorney for client
means that at least when a registered adviser has discreaccounts.9
tionary trading authority over a client’s account or effects
transactions for a client upon the client’s instruction, the
The adviser (1) provides bill-paying services for clients and,
client’s securities will almost always be held in a segregated
therefore, is authorized to withdraw funds or securities
account at a bank or savings association, broker or futures
from the client’s account, (2) manages portfolios by
commission merchant that has the ability to act as a qualidirectly accessing online accounts using clients’ personal
fied custodian regardless of whether the adviser has custody
usernames and passwords without restrictions and,
under the Custody Rule.14 When the adviser does not have
therefore, has the ability to withdraw funds and securities
from the clients’ accounts or (3) has signatory and check
the kind of authority that gives rise to custody under the
writing authority for client accounts.10
Rule, this is true because an adviser with discretionary
trading authority or execution authority must be able to
If it wants to avoid the attribution of custody on these
give instructions (pursuant to a power of attorney or other
bases, an adviser must rigorously assure that the power of
“standing instructions”) to the person holding the client’s
attorney or other instrument or arrangement that grants
funds or securities to effect transactions on the client’s
the adviser authority to execute transactions on the client’s
behalf. To be sure, if the adviser does not have custody for
behalf grants no more than trading authority or the abilpurposes of the Rule, the person holding the client funds
ity to transfer client assets between the client’s custodial
or securities that are subject to the adviser’s discretionary
accounts. In the case of a power of attorney or similar
or transaction execution authority need not comply with
instrument (such as a “standing instruction”), that is best
the Rule’s technical definition of “qualified custodian.”
accomplished by including wording that specifically disHowever, for practical purposes that person will almost
claims other powers.
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Frequent Compliance Issues under the SEC’s Custody Rule under the Investment Advisers Act
always need to hold securities for the adviser’s client in book
entry form in order to be able to use modern settlement
procedures and will need to be either a qualifying bank or
savings association, a broker-dealer or a futures commission
merchant. Because U.S. banks and savings associations,
brokers and futures commission merchants are subject to
regulatory requirements that impose obligations to segregate
client securities from the holding institution’s proprietary
assets, client securities held in the United States will almost
always be held in a separate account that is segregated from
the custodian’s own assets.
On the other hand, if custody under the Custody Rule is
not present and the client elects to hold funds or securities
outside the United States, there can be a genuine difference
in the way the assets and funds are held from the manner in
which they must be held if the Rule applies. If custody under
the Rule is present, the adviser must see to it that a foreign
qualified custodian “keeps the advisory clients’ assets in customer accounts segregated from [the qualified custodian’s]
proprietary assets.” Because not all foreign regulatory authorities require the segregation of client securities, a registered
adviser with mere trading or execution authority, but not
custody under the Rule, need not assure that client securities held with an offshore bank or broker are segregated by
the custodian from its proprietary assets; rather, that is up to
client. In addition, while an adviser with custody can always
hold power over client funds held in a properly designated,
qualifying U.S. bank or savings association account,15 the
Custody Rule by its terms does not allow an adviser with
custody to have power over client funds that are held in a
non-U.S. bank account16 – whereas a client operates under
no such restriction when the client’s adviser does not have
custody for purposes of the Rule.
The Custody Rule’s requirement that a qualified custodian
hold the client’s assets when custody is present under the
Rule is subject to two strictly limited exceptions, one of
which was recently modified by the SEC Staff. First, the
qualified custodian for mutual fund shares (i.e., shares of
open-end investment companies registered under the Investment Company Act of 1940, including registered money
market funds17) may be the mutual fund’s transfer agent.
Second, the Rule provides that an adviser is not required
to arrange for a qualified custodian to hold uncertificated,
privately offered securities that are transferable only with
the permission of the issuer of the securities. In August of
this year the Staff modified a previous position to permit
the investment manager of a pooled investment vehicle
to hold certificates for privately offered securities that are
transferable only with the permission of the issuer, subject
to specified conditions.18 In the case of a pooled investment
vehicle, an adviser with custody over the vehicle’s assets
must also employ the “audit approach” (discussed below)
in order for the adviser to be permitted to hold the vehicle’s
privately offered securities in its own custody rather than in
the custody of a qualified custodian.19
Importantly, even if an adviser with custody under the
Rule can rely upon these alternative methods for holding
client securities with respect to all client securities under the
adviser’s control,20 the adviser would still have custody and
need to comply with the Custody Rule’s other requirements
even though the adviser would not need to retain a qualified
custodian to hold the securities.
Compliance Issues When Custody is Present
The OCIE Alert reports that the SEC Staff had observed a
number of failures to comply with the Custody Rule’s requirements when an adviser properly recognized that it has
custody under the Rule:
Although the Custody Rule permits client assets held at
a qualified custodian to be held in the adviser’s name as
agent or trustee for its clients, it does not permit an adviser
to commingle its own proprietary assets and assets of its
employees with client assets in that kind of account. The
OCIE Alert found that some advisers failed to honor the
agent/trustee designation requirement and others engaged
in improper commingling.
Registered advisers with custody should note in this connection that even though the Custody Rule does not by its
terms forbid commingling the assets of multiple clients in a
single custodial account established by the adviser as agent or
trustee, doing so in effect requires the establishment of subaccounts for each client. Except when the adviser’s client is a
pooled investment vehicle and the audit approach is used, the
Rule requires an adviser holding custody to have “a reasonable
basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each
of [the adviser’s] clients for which [the qualified custodian]
maintains funds or securities, identifying the amount of funds
and of each security in the account at the end of the period
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Frequent Compliance Issues under the SEC’s Custody Rule under the Investment Advisers Act
and setting forth all transactions in the account during that
period.”21 In order for the custodian to perform this function
without revealing the assets and transactions of one client to
other clients, the custodian must have an adequate basis for
determining which assets and transactions relate to which
client. That would be difficult (or impossible) to arrange if
client assets were commingled and could implicate privacy
concerns under regulations that apply to the custodian. In
when they meet with their clients to inquire as to the clients’
receipt of custodian statements.
Where the adviser opened a custodial account on behalf
of a client and sent account statements to the client,
the OCIE Alert notes that the statements sent by some
advisers failed to include the required notification urging
clients to compare the account statements from the
custodian with those from the adviser.25
Because the Rule requires that qualified
custodians’ account statements be sent
With one narrow exception … the Custody Rule forbids
only quarterly (although many custodians
a registered investment adviser to hold physical custody send statements monthly), an adviser with
custody that sends its own statements to
of client funds or securities.
clients on a more frequent basis may report asset values or holdings that diverge
addition, if the adviser has custody because the client has
from the values or holdings shown in the custodian’s report.
granted the adviser authority to write checks or otherwise
This should not be problematic so long as the statement sent
disburse funds to third parties on the client’s behalf, it is
by the adviser is accurate as of its date.
difficult (or impossible) to see how it could be appropriate
Rather than being held by the custodian directly, the OCIE
to do so out of a custodial account that the adviser holds in
Alert notes that some advisers improperly placed securities
its own name for the benefit of multiple clients. Therefore,
certificates in a safe deposit box controlled by the adviser
we believe that for practical purposes an adviser holding
at a local bank.26
multiple clients’ assets in a properly established account at a
Although the Custody Rule generally imposes a
qualified custodian must arrange for the custodian to estabrequirement that a registered adviser with custody undergo
lish a subaccount for each client – indeed, we believe that
an annual surprise examination by an independent public
the establishment of subaccounts under such circumstances
accountant,27 the OCIE Alert reports that the Staff found
should be required by qualified custodians. As a result, it is
evidence suggesting that examinations were not being
not clear that any efficiency advantage would be conferred by
conducted on a “surprise” basis (for example, exams were
the adviser’s establishment of a single account, with multiple
conducted at the same time each year). In order to comply
subaccounts, as opposed to a separate account for each client.
with the “surprise” requirement, the accountant should
Relatedly, the OCIE Alert notes that some advisers
select a time that varies each year without notice to the
did not have a reasonable basis, after due inquiry, for
adviser. In addition, the Alert notes that some examining
believing that a client’s qualified custodian was sending
accountants did not, as required, file a Form ADV-E
quarterly account statements to the client (or the client
reporting audit results to the SEC within 120 days after
“independent representative”22).23
the date of the exam chosen by the accountant.
While the Custody Rule specifies that an adviser with cusIn its 2009 Amending Release, which imposed the
tody must insist upon a provision in the adviser’s agreement
custodian-provided-statement requirement, the SEC did not
with an examining accountant requiring the accountant to file
generally specify what kind of “due inquiry” is necessary to
a Form ADV-E with the SEC within the specified period,28 the
provide an adviser with a reasonable basis for believing that the
custodian sends the required statement. The 2009 Amending
Rule does not require the adviser to assure that the accountant
Release does indicate, however, that the adviser’s receipt of a
actually complies with that contractual obligation. Nevertheduplicate copy of custodian statements will generally meet
less, we believe that a registered adviser is well-advised to insist
the standard, whereas the adviser’s merely checking on the
on obtaining evidence of the required filing by the accountant,
online availability of the statement on the custodian’s website
if for no other reason than to show the SEC Staff that the
would not.24 Advisers should also make it a standard practice
adviser is eager to demonstrate full compliance with the Rule.
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Frequent Compliance Issues under the SEC’s Custody Rule under the Investment Advisers Act
Pooled Investment Vehicle Issues
In addition to observing in the OCIE Alert that some advisers
failed to recognize that they had custody when the adviser or a related person served as the general partner, manager or managing
member of a pooled investment vehicle, the SEC Staff noted
a number of other compliance deficiencies under the Rule by
advisers that manage vehicles of that kind. Importantly, several
of the Rule’s requirements that apply to non-pooled-investmentvehicle advisers that are deemed to have custody do not apply
to a pooled vehicle manager with custody of the vehicle’s assets
if the vehicle is audited annually, and upon liquidation, by an
independent public accountant registered with, and subject
to inspection by, the Public Company Accounting Oversight
Board (the “PCAOB”) and the audit report is provided to the
vehicle’s investors or their independent representatives within
a specified period.29 The OCIE Alert refers to this is exception
as the “audit approach.”30 The OCIE Alert flags the following
issues in connection with the use of the audit approach:
The accountant that conducted the financial statement audit
was not, as required by the Custody Rule, “independent”
under the SEC’s Regulation S-X31 or was not registered
with, and subject to inspection by, the PCAOB.
Advisers that do not use the audit approach – either because
they are pooled investment vehicle managers with custodial
powers but elect not to use it or because they do not manage
pooled investment vehicles – should note that the independence requirement also applies to advisers that instead arrange
for a surprise audit. However, in that case the accountant
performing the examination need not be registered with, and
subject to inspection by, the PCAOB unless the adviser or
one of its related persons serves as the qualified custodian.32
The audited financial statements were not prepared in
accordance with U.S. generally accepted accounting
principles (“GAAP”) (e.g., organizational expenses were
improperly amortized rather than expensed as incurred,
resulting in a qualified audit opinion; financial statements
were prepared on a federal income tax basis; the adviser
could not substantiate fair valuations and the accountant
therefore could not issue an unqualified opinion on the
financial statements).
In the case of offshore pooled investment vehicles managed
by a registered adviser with its principal office and place of
business in the United States, the Staff has indicated that it
is permissible to have the vehicle’s accounting statements
prepared in accordance with another accounting regime,
such as international financial reporting standards, but
only if material differences are reconciled with GAAP in
financial statements sent to U.S. investors.33 The OCIE
Alert indicates that some advisers have not seen to it that
the required reconciliation was provided.
Relatedly, the OCIE Alert notes that some accountants
conducting an audit of such an offshore pooled investment
vehicle at times did not comply with U.S. generally accepted
auditing standards (“GAAS”). Counterintuitively, while a
lapse of this kind would appear to be attributable to the accountants rather than the adviser, in the Staff’s view the lapse
would disqualify the adviser from relying on the audit approach.34 Therefore, advisers who retain non-U.S. accountants
to audit offshore pooled investment vehicles in compliance
with the audit approach would be well advised to obtain the
accountants’ assurance that they will comply with GAAS in
performing the audit.35
The adviser failed to demonstrate that the audited financial
statements were distributed to all pooled investment vehicle
investors. Rather, it appeared that in many instances the
statements were only made available “upon request.”
The audited financial statements were not sent to investors
within 120 days of the pooled investment vehicles’ fiscal
year ends (or 180 days for fund of funds).36
Advisers should note that although the Staff Responses
indicate that a failure to distribute pooled investment vehicle financial statements within the required periods will
not necessarily preclude reliance upon the audit approach if
the adviser “reasonably believed” that the deadline would be
met and the failure is attributable to “certain unforeseeable
circumstances,”37 neither the SEC nor the Staff has defined
what those circumstances are. Therefore, it behooves an adviser relying on the audit approach to cooperate willingly in
the audit and impress the need to meet the applicable deadline
upon the investment vehicle’s accountant.
A final audit was not performed on liquidated pooled
investment vehicles.
The adviser requested (and apparently received) investor
approval to waive the annual financial audit of a pooled
investment vehicle but did not arrange instead to undergo
a surprise examination. Therefore, since the Custody Rule
requires a pooled investment vehicle adviser with custody
to use one of the two approaches and does not permit
investor waiver, the adviser violated the Rule.
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Frequent Compliance Issues under the SEC’s Custody Rule under the Investment Advisers Act
While the OCIE Alert specifically mentions the applicability of the surprise examination requirement when the
full requirements of the audit approach are not met only in
the context of a pooled investment vehicle adviser’s failure
to see to it that the vehicle was audited, any of the failures
to comply with the audit approach noted above can give
rise to a requirement to arrange for a surprise examination.
Also, although not mentioned in the OCIE Alert, it is worth
noting that, in addition to arranging to undergo a surprise
examination, a pooled investment vehicle adviser that does
not comply with the audit approach must (1) assure that the
vehicle’s qualified custodian sends quarterly statements to the
vehicle’s investors38 and (2) comply with the Custody Rule
requirement that any account statement sent by the adviser to
the vehicle’s investors contain “a statement urging the [investors] to compare the account statements from the custodian
with those from the adviser.”39
***
As the issues discussed in this article demonstrate, proper
compliance with the Custody Rule requires close attention both to the Rule’s wording and related SEC releases
and SEC Staff interpretations. SEC registered advisers
should be sure to consult qualified compliance professionals to assure that they meet the requirements of this
important provision.
ENDNOTES
* This article is intended only as a general discussion of
the issues treated in it. It should not be regarded as
legal advice. The author would be pleased to provide
additional details or advice about specific situations.
** Edwin C. Laurenson has decades of experience advising U.S. and international investment advisers and
managers and public and private investment funds
on all aspects of U.S. securities regulation, including
compliance with the Investment Advisers Act of 1940,
the Investment Company Act of 1940, the Securities
Act of 1933 and the Securities Exchange Act of 1934,
and the establishment and offering of interests in
investment funds of all kinds (including related areas
of partnership, limited liability company and corporate
law). Ted is a graduate of Amherst College and Yale Law
School.
1
Rule 206(4)-2 under the Advisers Act.
2
Advisers Act Release No. 2968 (December 30, 2009)
(cited in this article as the “2009 Amending Release”).
At the same time the SEC published an interpretive
release for independent public accountants providing
direction with respect to the independent verification
and internal control reports required by amended Rule
206(4)-2, Advisers Act Release No. 2969 (December
30, 2009). The amendments adopted in the 2009
Amending Release were proposed in Advisers Act
Release No. 2876 (May 20, 2009).
3
Office of Compliance, Inspections and Examinations,
“Significant Deficiencies Involving Adviser Custody and
Safety of Client Assets,” National Exam Program Risk
Alert, Vol. 3, Issue 1 (March 4, 2013).
4
This article makes no attempt to comprehensively
describe the Custody Rule’s requirements or its interpretation. To achieve a full understanding of the Rule,
registered advisers should consult qualified compliance professionals.
5
The Custody Rule does not apply to client assets that
are not funds or securities. See “Staff Responses to
Questions About the Custody Rule” (most recently
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6
7
updated December 13, 2011) (the “Staff Responses”)
at question II.3 (available at http://www.sec.gov/
divisions/investment/custody_faq_030510.htm).
The Custody Rule does, however, apply to a registered adviser’s custody of funds or securities even if
the advisory relationship is uncompensated (Staff
Responses at question II.9). Under the Custody Rule
swap transaction collateral must also be held at a
qualified custodian pursuant to arrangements that
meet all applicable requirements (Staff Responses at
question II.10).
The definition of “custody” (in paragraph (d)(2) of the
Custody Rule) is as follows:
Custody means holding, directly or indirectly, client
funds or securities, or having any authority to obtain
possession of them. You have 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 you provide
to clients. Custody includes:
(i) Possession of client funds or securities (but not
of checks drawn by clients and made payable to third
parties) unless you receive them inadvertently and you
return them to the sender promptly but in any case
within three business days of receiving them;
(ii) Any arrangement (including a general power of
attorney) under which you are authorized or permitted
to withdraw client funds or securities maintained with
a custodian upon your instruction to the custodian; and
(iii) Any capacity (such as general partner of a
limited partnership, managing member of a limited
liability company or a comparable position for another
type of pooled investment vehicle, or trustee of a trust)
that gives you or your supervised person legal ownership of or access to client funds or securities.
See Advisers Act Release No. 2176 (September 25,
2003) (the “2003 Amending Release”) at notes 5 and
10. The 2009 Amending Release did not change the
Custody Rule’s definition of “custody.” An adviser is
8
not deemed to have custody as a result of having been
granted the power to transfer assets between accounts
at the qualified custodians holding client assets or to
instruct a qualified custodian to distribute assets to
the client pursuant to authority granted by the client
(Staff Responses at questions II.4-6).
Custody Rule paragraph (d)(7). “Control” is defined
paragraph (d)(1) as follows:
Control means the power, directly or indirectly,
to direct the management or policies of a person,
whether through ownership of securities, by contract,
or otherwise. Control includes:
(i) Each of your firm’s officers, partners, or directors
exercising executive responsibility (or persons having
similar status or functions) is presumed to control your
firm;
(ii) A person is presumed to control a corporation if
the person:
(A) Directly or indirectly has the right to vote 25
percent or more of a class of the corporation’s voting
securities; or
(B) Has the power to sell or direct the sale of 25
percent or more of a class of the corporation’s voting
securities;
(iii) A person is presumed to control a partnership if
the person has the right to receive upon dissolution,
or has contributed, 25 percent or more of the capital
of the partnership;
(iv) A person is presumed to control a limited liability
company if the person:
(A) Directly or indirectly has the right to vote 25
percent or more of a class of the interests of the limited
liability company;
(B) Has the right to receive upon dissolution, or has
contributed, 25 percent or more of the capital of the
limited liability company; or
(C) Is an elected manager of the limited liability
company; or
(v) A person is presumed to control a trust if the person
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10
11
12
is a trustee or managing agent of the trust.
The SEC Staff has stated that it will not recommend
enforcement action against an adviser under the
Custody Rule if, without compliance with the Custody
Rule, a related person of the adviser serves as trustee
of a participant-directed defined contribution pension
plan for the adviser’s employees but (i) neither the
adviser nor one of its related persons otherwise acts
as an investment adviser to the plan or any investment
option under the plan and (ii) the adviser and the
related person trustee are, to the extent applicable,
in compliance with the Employee Retirement Income
Security Act of 1974 and related rules and regulations
with respect to the plan (Staff Responses at question
XII.1).
An adviser is not deemed to have custody of client
assets by virtue of providing investment advisory or
management services to a related natural person with
respect to assets that are both legally and beneficially
owned by that person and over which that person
holds power of disposition (Staff Reponses at question II.7) or to a supervised person who is appointed
a trustee or executor solely as a result of personal or
family connections (but not as a result of a personal
relationship deriving from the provision of advisory
services to a client) (2009 Amending Release at note
139 and Staff Responses at question II.2).
The Staff Responses to questions XII.2 and 3 discuss
circumstances in which an adviser may not be deemed
to have custody when the adviser or one of its related
persons serves as a co-trustee.
A registered adviser’s power to withdraw funds from
a client’s account for this purpose could also give rise
to a need to comply with the SEC’s identity theft
“red flags” rules. See “Identity Theft Red Flags Rules,”
Release Nos. 34-69359, IA-3582, IC-30456 (April
10, 2013) (promulgated jointly with the Commodity
Futures Trading Commission).
This restriction does not apply to checks drawn by
a client and made payable to a third party. The SEC
Staff has taken the position that it will not recommend enforcement action if an adviser inadvertently
receives tax refunds, class action settlement proceeds,
dividends and certain other items and forwards them
to the client within five business days, subject to the
requirement that the adviser maintains appropriate
records. See Staff Responses at question II.1.
Most pooled investment vehicles with advisers subject
to the Custody Rule are “private investment companies” that qualify for one of the “private investment
company” exemptions from investment company
status under the Investment Company Act of 1940
(sections 3(c)(1) or 3(c)(7) of the Investment Company
Act); however, in some case other Investment Company Act exemptions apply. In the case of hedge funds,
private equity funds and venture capital funds, either
the adviser/manager or one of its affiliates almost
always serves as the general partner (or manager or
managing member) of the fund, thereby conferring
13
14
15
16
custody under the Rule. In the case of certain other
pooled investment vehicles, such as structured collateralized loan obligation and collateralized debt obligation funds, it is less likely that the vehicle’s investment
adviser will possess the kind of power that gives rise to
custody under the Rule; however, in every such case
counsel must rigorously examine the documentation
that confers powers upon the adviser to determine
whether it gives rise to custody under the Rule.
No explicit SEC guidance is available with regard
to whether a registered adviser is deemed to have
custody when a control person of the adviser or one
of its employees serves as a director or officer of a
pooled investment vehicle organized as a corporation.
However, in our experience SEC examiners have taken
the position that custody exists in those circumstances,
at least when the director or officer appears to have a
control relationship with the vehicle.
Although investment companies and business
development companies registered as such under the
Investment Company Act are also, of course, pooled
investment vehicles, Custody Rule paragraph (b)(5)
provides that an adviser is not required to comply with
the Custody Rule with respect to entities of that kind
because the Investment Company Act and SEC rules
under it impose their own rigorous custody requirements.
The term “qualified custodian” is defined in Custody
Rule paragraph (d)(6). Under this definition a qualified
custodian is either a U.S. commercial bank or savings
association that has deposits insured by the FDIC, a
U.S. registered broker-dealer or futures commission
merchant holding client assets in customer accounts
subject to the rules of the SEC or the Commodity Futures Trading Commission applicable to such accounts
or a foreign financial institution that customarily
holds financial assets for its customer and keeps the
adviser’s clients’ assets in customer accounts that are
segregated from the custodian’s proprietary assets.
If custody under the Rule is not present and the advisory relationship is both nondiscretionary and does
not involve the adviser’s execution of transactions on
the client’s behalf, the client can, of course, hold its
assets any way it wants to.
Although the Custody Rule requires that a U.S. bank
or savings association acting as a qualified custodian
be insured by the FDIC, almost all U.S. deposit-taking
banks and savings associations (albeit not credit
unions) are so insured (and, in any event, the FDICinsurance qualification can be easily checked). It should
be noted in this connection that the obligation of a
bank to its depositors constitutes a debtor-creditor
relationship under which the assets backing the bank’s
obligations are not segregated from the bank’s proprietary assets.
While there is no written SEC Staff position that permits a registered adviser with custody to hold client assets in a properly designated non-U.S. bank account, in
oral consultations relating to a private investment fund
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a member of the Staff advised the author that use of a
non-U.S. bank account (established for administrative
purposes at a non-U.S. bank that was an affiliate of the
private fund’s administrator) could be permissible if the
adviser/manager (1) determined that holding funds in
such an account was in the best interests of the private
fund and (2) engaged in an appropriate investigation
of the soundness of the bank in question. Because this
is not a written position, however, it is not clear that it
should be relied upon.
Custody Rule paragraph (b)(1). Note, however, that
this exception does not apply in the case of a privately
offered money market fund that is not registered
under the Investment Company Act of 1940 (cf. Staff
Responses at question VI.10). If a mutual fund’s transfer
agent is a related person of the investment adviser, the
transfer agent must comply with the Rule’s internal
control report and surprise examination requirements
(or, in the case of a pooled investment vehicle, the
annual audit requirements that must be met if the
“audit approach” is used (discussed further below))
(Staff Responses at question XV.1).
“Privately Offered Securities Under the Investment
Advisers Act Custody Rule,” IM Guidance Update No.
2013-04 (August 2013). In addition to meeting the
“audit approach” requirement discussed below, the
conditions stated in the Guidance Update are that (1)
the certificate can only be used to effect a transfer or
to otherwise facilitate a change in beneficial ownership
of the security with the prior consent of the issuer or
holders of the outstanding securities of the issuer; (2)
ownership of the security is recorded on the books
of the issuer or its transfer agent in the name of the
client; (3) the certificate contains a legend restricting
transfer; and (4) the certificate must be appropriately
safeguarded by the adviser and can be replaced upon
loss or destruction.
The Staff had previously refused to extend the kinds
of privately offered, restricted transfer securities that
could be held by an adviser to certificated securities,
on the grounds that the SEC itself had explicitly considered and rejected that possibility. See Response C.2
in ABA Subcommittee on Private Investment Entities
(December 8, 2005). Although it does not refer to that
previous position, the Guidance Update indicates that
the rationale for the change largely lies in the verification procedures that a pooled investment vehicle’s
independent accountant must apply in connection
with the audit approach, which was inserted into the
Custody Rule by the 2009 amendments.
In a footnote, the Guidance Update also noted
that (1) “securities that are evidenced by ISDA master
agreements that cannot be assigned or transferred
without the consent of the counterparty” are privately
offered securities under privately offered, restricted
transfer securities exception and, therefore, are eligible for relief with regard to the custody of related
certificates (if such a certificate exists), as well as when
there is no related certificate, and (2), as stated in the
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Frequent Compliance Issues under the SEC’s Custody Rule under the Investment Advisers Act
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21
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2003 Amending Release, partnership agreements,
subscription agreements and LLC agreements are not
“certificates” under the Custody Rule and, therefore,
privately offered, restricted transfer securities evidenced by that kind of documentation need not be
held by a qualified custodian if the relevant conditions
(including compliance with the audit approach in the
case of a pooled investment vehicle) are met.
Separately, if the adviser’s client is not a pooled
investment vehicle over which the adviser or one of
its related persons has powers that confer custody
as defined in the Custody Rule, the adviser may not
have custody of a privately offered security if the client
must sign the subscription agreement for that security
and the adviser has no authority to transfer or redeem
the security without client consent (Staff Responses
at question VII.3).
Custody Rule paragraph (b)(2); Staff Responses at
question VII.1. If the audit approach is not available
to an adviser to a pooled investment vehicle – with
the result that the vehicle’s adviser must arrange to
hold privately offered, restricted transfer securities
at a qualified custodian – the adviser may satisfy the
holding requirement with respect to an uncertificated
security by arranging for the applicable subscription
agreement to be held by a qualified custodian or for a
qualified custodian to serve as the vehicle’s nominee
(Staff Responses at question VII.2).
While it would be unusual for this to be the case with
respect to most advisees, a private equity or venture
capital fund could hold only privately offered securities and, perhaps, money market fund investments, all
of which would qualify for the exceptions described
above. Note, however, that if such a fund subsequently
came to hold securities that would not qualify for those
exemptions (as a result, for instance, of an IPO by one
of the fund’s portfolio companies or the sale or merger
of a portfolio company in which the consideration
received by the fund consisted of public company
stock), the fund’s investment manager would then
need to engage a qualified custodian to hold those
fund securities.
Custody Rule paragraph (a)(3).
Custody Rule paragraph (a)(7). The term “independent
representative” is defined in Custody Rule paragraph
(d)(4). See Staff Responses at questions IV.4 and VIII.15 for answers to questions relating to independent
representatives.
Note that, as discussed below, this requirement does
not apply to pooled investment vehicles and their
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28
29
30
31
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investors if the vehicle’s adviser sees to it that the
vehicle complies with the “audit approach.”
2009 Amending Release at notes 20-21.
Custody Rule paragraph (a)(2).
As the SEC has explained, because client funds and
securities must be held on behalf of the client by the
qualified custodian so that the qualified custodian can
provide account information to the clients, keeping
stock certificates in the adviser’s bank safe deposit
box, for example, would not satisfy the requirements
of the Rule. See the 2003 Amending Release at note
18.
Custody Rule paragraph (a)(4). The surprise audit
requirement does not apply (1) in the case of a pooled
investment vehicle if the adviser complies with the
“audit approach” discussed below (Custody Rule
paragraph b(4)) or (2) when an adviser has custody
only because it has the right to requisition payments
of the adviser’s agreed fees from the client’s qualified
custodian (Custody Rule paragraph (b)(3)).
Custody Rule paragraph (a)(4)(i). The agreement must
also require that (1) if the examining accountant finds
material discrepancies in the course of the surprise
examination, the accountant will inform the SEC of the
discrepancies within one business day (Custody Rule
paragraph (a)(4)(ii)), and (2) if the accountant resigns,
is dismissed or either is removed from or removes
itself from reappointment, the accountant will file a
statement with the SEC on Form ADV-E within four
business days, giving the date of the relevant event and
containing an explanation of any problems relating to
examination scope or procedure that contributed to
the accountant’s dismissal or removal (Custody Rule
paragraph (a)(4)(iii)).
Custody Rule paragraph (b)(4). See below for a discussion of the period within which reports must be
provided.
Registered pooled investment vehicle managers are
not required to use the audit approach, but must
comply with the Custody Rule’s otherwise applicable
requirements if they elect not to do so.
17 CFR part 210.
Custody Rule paragraphs (a)(4) and (a)(6).
Staff Responses at question VI.5. In accordance with
previous guidance, that Staff Response also affirms
that an offshore registered adviser is not subject to the
Custody Rule in relation to an offshore pooled investment vehicle, even if that vehicle has U.S. investors.
Staff Responses at question VI.6.
This assurance should be straightforwardly forthcom-
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ing in view of the fact that an accountant retained in
connection with an adviser’s use of the audit approach
must be registered with, and subject to examination
by, the PCAOB.
Custody Rule paragraph (b)(4), which establishes the
audit approach, specifies only the 120-day period. The
180-day period for funds of funds is an SEC Staff position. In addition, the Staff has taken the position that
a pooled investment vehicle that invests 10 percent or
more of its assets in funds of funds can provide financial
statements within 260 days without jeopardizing the
fund adviser’s reliance on the audit approach. Staff
Responses at questions VI.7, VI.8A and VI.8B.
Staff Responses at question VI.9.
Custody Rule paragraphs (a)(5). Custody Rule paragraph (c) requires that account statements and audited
financial statements must be sent to investors in a
related vehicle if, as in a master-feeder structure, the
investor’s interest is held through other vehicles in
which investors invest. The account statements sent
with respect to such a pooled investment vehicle must
relate to the assets of the vehicle as a whole, not a slice
of those assets attributable to a particular investor’s
interest in the vehicle, and should provide investors
with information necessary to respond to accountant
confirmation requests with regard to deposits and
withdrawals (Staff Responses at questions VI.2 and 3).
In the absence of the availability of the audit approach, Custody Rule paragraph (a)(2) also requires
the adviser to notify its “client” of the identity of the
qualified custodian that holds the client’s assets. Because, in the case of a pooled investment vehicle, the
adviser’s client is the vehicle and not its investors, this
notification requirement is presumably automatically
met – i.e., since the adviser or one of its affiliates controls the vehicle, the adviser would in effect be giving
notice to itself, and the requirement in Custody Rule
paragraph (a)(5) that account statements be sent to a
pooled investment vehicle’s investors when the audit
approach is not used does not by its terms require the
adviser to notify the vehicle’s investors of the identity
of the vehicle’s qualified custodian. In any case, pooled
investment vehicle private placement memoranda
customarily name the vehicle’s custodian. Clearly,
however, if the audit approach is not used or not available, a pooled investment vehicle’s adviser must see
to that the vehicle’s investors know the identity of the
vehicle’s custodian since the investors will be receiving
quarterly statements from the custodian.
Custody Rule paragraph (a)(2).
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