Posted December 30, 2009

In 2009, the SEC adopted amendments to the custody and recordkeeping rules under the Investment Advisers Act of 1940 to provide additional safeguards when a registered adviser has custody of client funds or securities, providing greater guidance and stronger protections for investors. TIA was then (and still is) pleased with this improved rule change. The final rules require the adviser, among other things:

  • 1. to undergo an annual surprise examination by an independent public accountant to verify client assets;
  • 2. to have the qualified custodian maintaining client funds and securities send account statements directly to the advisory clients; and unless client assets are maintained by an independent custodian (i.e., a custodian that is not the adviser itself or a related person),
  • 3. to obtain, or receive from a related person, a report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board.

Finally, the amended custody rule and forms will provide the Commission and the public with better information about the custodial practices of registered investment advisers. The amendment goes into effect on March 12, 2010 and registered advisors must comply with the new rules as of that date.

The highly publicized losses by virtually all investors with Bernard Madoff and numerous other advisors focused public attention on investment custodial issues and the need to strengthen requirements for the safekeeping of client assets. The purpose of the new custody rule amendments is to impose additional controls on registered advisors that have access to client funds or securities. The primary tool for this is independent verification of the assets. The form of such verification varies depending on the nature of the advisor’s access to or control over the assets.

While subject to the new rules, TIA has always made it a policy and practice to maintain the custody of client funds with the clients directly. Thus, TIA never seeks nor gets custody of any client funds.

All SEC-registered investment advisors will be required to comply with the enhanced custody rules. The amendments will be effective March 12, 2010, and registered advisors must comply with the new rules as of that date, except in certain cases where other compliance dates are specified.


Currently, Advisors Act Rule 206(4)-2 imposes certain requirements on a registered investment advisor that has “custody” of client assets, as defined in the rule. A registered investment advisor may be deemed to have custody either through physical possession or by virtue of authority to obtain client assets, such as by deducting advisory fees from a client account, writing checks or withdrawing funds on behalf of a client or acting in a capacity, such as general partner of a limited partnership, that gives the advisor the authority to withdraw funds or securities from the client account.

Under the rule prior to amendment, a registered investment advisor with custody of client assets has been required to: (i) maintain those client assets with a qualified custodian; (ii) notify the client in writing of the qualified custodian’s name and address; and (iii) send quarterly account statements to its clients identifying the amount of funds and of each security in the advisor’s custody and all transactions in such assets during the period, unless the advisor has a reasonable belief that the qualified custodian sends account statements containing such information directly to its clients at least quarterly. Advisors who send statements themselves have also been required to undergo a surprise examination each year by independent public accountants. An advisor to a pooled investment vehicle does not have to obtain an annual surprise examination or deliver quarterly account statements to investors if the vehicle is audited at least annually by an independent public accountant and distributes its audited financials to investors within 120 days of the end of the pool’s fiscal year (or 180 days for a fund of funds).


A. Definition of Custody
The SEC has clarified that an advisor has “custody” not only if it physically possesses client funds or securities itself or has the authority to obtain possession of them, but also if a “related person” of the advisor has such authority. A “related person” means any person directly or indirectly controlling or controlled by the advisor, and any person that is under common control with the advisor.

B. Client Reporting
The amended rule eliminates the option for advisors to deliver account statements themselves; all account statements must be delivered directly by the custodian. The rule provides that an advisor must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement (at least quarterly) directly to each client for which it maintains custody, detailing the assets and transactions in the client’s account. While the SEC has not set precise requirements for what constitutes “due inquiry,” it stated that the standard would be satisfied where the qualified custodian provides the advisor with a copy of the account statement that was delivered to the client.

Notices required to be sent to clients upon the opening of an account with the qualified custodian must contain a legend urging the client to compare the account statements from the custodian with any statements provided by the advisor. The cautionary legend must be included in subsequent account statements if the advisor elects to send its own account statements to clients in addition to those provided by the qualified custodian.

C. Annual Surprise Examinations
Despite some controversy, the SEC adopted a requirement that registered advisors with custody of client assets undergo an annual surprise examination of those assets by an independent public accountant registered with the PCAOB. As discussed more fully below, these requirements do not apply to advisors who have custody solely because they are authorized to deduct fees from client accounts. Nor is the annual surprise examination required of advisors to pooled investment vehicles or advisors who have custody solely because they maintain custody of client assets with related persons, both of which are subject to other controls discussed more fully below.

Any advisor that is subject to the surprise audit requirement must enter into a written agreement with the accountant requiring it to: (i) file a certificate on Form ADV-E within 120 days of the date of the examination describing the nature and scope of the examination; (ii) notify the SEC within one business day of any finding of material discrepancies during the course of the examination; and (iii) file Form ADV-E within four business days of its resignation or dismissal from the engagement or upon a voluntary or involuntary removal from consideration for reappointment, along with a narrative statement providing contact information and an explanation of any problems encountered that may have contributed to such termination.

Following the completion of the first round of surprise examinations, the SEC will review the impact of the surprise examination requirement on smaller advisors.

Compliance Date. The first surprise examination must take place no later than December 31, 2010, or for advisors that become subject to the rule after the effective date, within six months of becoming subject to the rule. If the advisor itself (and not a related person) acts as qualified custodian, the first examination must take place no later than six months after obtaining an internal control report, as discussed below.

Exceptions. There are three significant exceptions to the annual surprise examination requirement:

1. Advisors with Custody Due Solely to Fee Deduction. An investment advisor that has custody of client assets solely because of its authority to deduct advisory fees is not required to obtain annual surprise examinations as detailed above. This is a departure from the proposed amendments, which the SEC said were made in response to comments that (i) the risk involved “deduction of a fee to which the advisor is not entitled under its advisory contract” would not be addressed in an annual examination designed to verify the existence of client assets, and (ii) such risks may be identified by the client by reviewing account statements sent directly to the client by the qualified custodian.

2. Pooled Investment Vehicles Subject to Audit. An investment advisor to a pooled investment vehicle that is subject to an annual financial statement audit and distributes the audited financial statements (prepared in accordance with U.S. GAAP) to the pool’s investors is deemed to have satisfied the annual surprise examination requirement. The audit must be performed by an independent PCAOB-registered accountant and the financial statements must be distributed to investors within 120 days of the end of the pooled investment vehicle’s fiscal year end (or 180 days for a fund of funds). In addition, if a pooled investment vehicle is liquidated, it must be audited upon liquidation and the audited financial statements distributed to all investors “promptly” after completion of the audit.

The SEC noted that under the amended rule, an advisor to a pooled investment vehicle that satisfies reporting obligations by delivering audited financial statements to investors is not required to have a reasonable belief that the qualified custodian delivers account statements to investors. The SEC has directed its staff to explore ways in which additional protections may be afforded to investors in such vehicles.

3. Custody through “Operationally Independent” Related Person. An investment advisor that is deemed to have custody solely because a related person acts as qualified custodian for clients’ assets and that is “operationally independent” of the related custodian is not required to obtain an annual surprise examination. A related person is presumed not to be “operationally independent” unless: (i) client assets in the custody of the related person are not subject to claims of the advisor’s creditors; (ii) advisory personnel do not have access to client assets (or the power to control the disposition of such assets to third parties for the benefit of the advisor or its related persons) of which the related person has custody; (iii) advisory personnel and personnel of the related person who have access to client assets are not under common supervision; and (iv) advisory personnel do not hold any positions with the related person or share premises with the related person.

D. Investment Advisors Acting as Qualified Custodians
An advisor that acts as qualified custodian itself or maintains custody with a related person (rather than with an independent qualified custodian) must, in addition to the annual surprise examination described above, obtain (or receive from its related person) an annual internal control report, such as a Type II SAS 70 Report, with respect to its controls over custody of client assets. The report must be prepared by an independent PCAOB-registered accountant. The SEC noted that in order for the internal control report to satisfy the rule’s requirements, the accountant preparing the report must verify that the client funds and securities are reconciled to a custodian other than the advisor (or its related persons).

The SEC has amended Form ADV Part 1A and Schedule D to require that advisors disclose more detailed information regarding their custody practices. In addition, advisors must report (i) the identity of and certain other information concerning the accountants that perform audits, surprise examinations, and/or internal control reviews, and (ii) the identity of any related persons such as banks and broker-dealers that act as qualified custodians.

Compliance Date. An advisor must obtain its first internal control report within six months of becoming subject to the requirement and, as indicated above, must have a surprise examination within six months thereafter.

Investment Advisors Act Release No. 2876 (May 20, 2009)

Investment Advisors Act Release No. 2968 (December 30, 2009)

Investment Advisors Act Release No. 2969 (December 30, 2009)