Investment Management
OCTOBER 2003
Amendments to Custody Rule Under the Investment
Advisers Act of 1940
On September 11, 2003, the Securities and Exchange
Commission approved adoption of amendments to
Rule 206(4)-2, the custody rule under the Investment
Advisers Act of 1940 (“Advisers Act”). The
amendments were adopted substantially as proposed
in July 2002 with a few changes in response to
commenters’ recommendations. Among other things,
amended Rule 206(4)-2:
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Adds a definition of “custody” to the rule and
illustrates circumstances under which an
adviser is deemed to have custody of client
funds or securities;
n
Requires advisers with custody of client funds
or securities to maintain all client assets with a
“qualified custodian” and either (i) arrange for
the custodian to deliver quarterly account
statements directly to clients or (ii) deliver
quarterly account statements to clients
themselves and have an independent public
accountant conduct an annual surprise
examination to verify the clients’ assets; and
n
Removes the Form ADV requirement that
advisers with custody include an audited
balance sheet in their disclosure brochures
provided to clients.
The rule amendments do not apply to custody of
mutual fund assets, which is governed by the existing
custody rules under the Investment Company Act of
1940.
The rule amendments should require only modest
changes to the practices of most advisers managing
separate accounts, because these advisers often
already maintain custody of client assets with entities
that are “qualified custodians.” In these cases,
advisers will have to ensure that their custodians
comply with the quarterly account statement delivery
requirement, or will deliver the statements
themselves and arrange for an annual surprise audit.
In most cases, advisers managing separate accounts
probably already have these procedures in place.
Advisers that open a custody account for a client also
must provide certain information about the custodian
to the client.
The rule amendments will have a significant impact
on hedge funds and certain other pooled investment
vehicles that are advised by a registered investment
adviser. These funds generally will have to maintain
custody of their assets with a qualified custodian.
Funds that have an annual audit will not, however, be
required to provide or arrange for the custodian to
provide quarterly account statements. In light of the
recent proposal by the Commission staff in its hedge
fund study to require many hedge fund advisers to
register as investment advisers, these custody
requirements may in the future become relevant to a
large number of hedge fund managers that currently
are not SEC-registered advisers.
Whether the rule amendments will apply to a
registered investment adviser that manages a
particular private equity or venture capital fund will
depend upon what investments the fund can make. As
discussed below, the amended rule does not apply to
privately offered securities that are uncertificated,
book-entry securities, and that are not transferable
without the prior consent of the issuer or other
security holders. The manager of a private equity or
venture capital fund that holds only these types of
securities would not be subject to the rule. There is a
question, however, as to whether the rule would
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apply to the manager of such a fund if the fund
eventually received publicly offered securities, and
was required to hold those publicly offered securities
pursuant to a lock up or similar restriction. The fund
might receive publicly traded securities, for example,
following an initial public offering of a portfolio
company, or in connection with the acquisition of a
portfolio company for the shares of a public
company. The rule might also apply if the private
equity or venture capital fund was able to invest in
short-term debt or other securities pending the use of
money for investment purposes or pending the
distribution of investment proceeds. We will follow
up with the Commission staff on these and other
issues raised by the rule amendments.
The amendments will become effective on November
5, 2003, at which time advisers may begin relying on
the amended rule. Advisers must be in compliance
with the new requirements by April 1, 2004. The
release adopting amendments to Rule 206(4)-2
(“Adopting Release”) is available on the
Commission’s website at http://www.sec.gov/rules/
final/ia-2176.htm. A summary of the rule
amendments is set forth below.
DEFINITION OF CUSTODY
Under amended Rule 206(4)-2, an adviser is deemed
to have custody of client assets when it holds,
“directly or indirectly, client funds or securities, or
[has] any authority to obtain possession of them.”
The rule provides three examples designed to
illustrate circumstances under which an adviser has
custody of client funds or securities.
The first example clarifies that an adviser has
custody when it has possession of client assets,
unless the adviser inadvertently receives them and
returns them to the sender within three business days.
As originally proposed, advisers would have had one
business day to return assets, but in response to
commenters’ suggestion that advisers would need a
longer time to return assets, the Commission
extended the period to three business days. The
example clarifies that an adviser’s possession of a
check drawn by a client and made payable to a third
party is not possession of client funds for purposes of
Rule 206(4)-2. In the Adopting Release, the
Commission also noted that, although an adviser that
holds a check drawn by a client and made payable to
the adviser with instructions to forward the check to
a custodian or other third party would have custody,
a check made out to the adviser for payment of
advisory or similar fees would not represent client
funds within the meaning of the rule.
The second example clarifies that an adviser has
custody of client funds or securities if it has the
authority, pursuant to a general power of attorney or
otherwise, to withdraw assets from a client’s account.
In the Adopting Release, the Commission specified
that an adviser that has authority to sign checks on a
client’s behalf, to withdraw assets from a client’s
account or to dispose of client assets for any purpose
other than authorized trading activity would have
access to the client’s assets and thus custody of those
assets. Similarly, the Commission noted that an
adviser with authority to deduct advisory fees or
other expenses directly from a client’s account has
access to, and thus custody of, the assets in that
account. Some commenters requested the
Commission to afford advisers the alternative of
continuing to rely on staff no-action letters that
permit advisers to deduct fees from client accounts
without being deemed to have custody, provided that
they follow the conditions set forth in the no-action
letters. The Commission, however, explicitly stated
in the Adopting Release that its staff would be
withdrawing those letters and that advisers who are
relying on them must comply with the amended rule
by April 1, 2004. As discussed below, the
Commission also has amended Form ADV so that
advisers with custody of client assets solely because
they deduct fees will not have to amend their Form
ADVs to indicate that they have custody.
The third example clarifies that an adviser has
custody if it acts in any capacity that gives it legal
ownership of, or access to, client funds or securities.
This situation arises most commonly when a firm
acts as both general partner and investment adviser to
a limited partnership. By virtue of its position as
general partner, the adviser has authority to dispose
of assets in the partnership’s account. Currently,
many of these advisers rely on PIMS, Inc. (Oct. 21,
1991) and other no-action letters issued by the
Commission’s staff outlining procedures that may be
followed to avoid being deemed to have custody.
These letters are being withdrawn, and advisers
currently relying on them must comply with the
amended rule by April 1, 2004. As discussed below,
however, the Commission has provided a limited
exemption for advisers to certain limited partnerships
and similar pooled investment vehicles.
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USE OF QUALIFIED CUSTODIANS AND
DELIVERY OF QUARTERLY ACCOUNT
STATEMENTS
Qualified Custodians. Under the amended rule,
advisers with custody of client funds or securities
must maintain them with qualified custodians in an
account either in the client’s name or in the adviser’s
name as agent or trustee for its clients. “Qualified
custodians” are defined under the rule to include
banks and savings associations, registered brokerdealers, registered futures commission merchants and
foreign financial institutions that customarily hold
financial assets. Registered futures commission
merchants are deemed qualified custodians only with
respect to client funds and security futures or other
securities incidental to futures and options on futures
transactions. The rule also provides that foreign
financial institutions that customarily hold financial
assets for their customers are deemed qualified
custodians only if the institutions maintain the
advisory clients’ assets in customer accounts
segregated from the institutions’ proprietary assets.
In the Adopting Release, the Commission noted that
many registered advisers are themselves qualified
custodians under the amended rule (e.g., registered
broker-dealers). Under the amended rule, these
advisers may maintain their own clients’ assets,
subject to the account statement delivery requirement
described below and the rules imposed by the
regulators of the advisers’ custodial functions.
Similarly, advisers may maintain client assets with
affiliates that are qualified custodians, subject to the
account statement delivery requirement.
The amended rule contains exemptions from the
qualified custodian requirement for two types of
securities. First, an adviser may use a mutual fund
transfer agent in lieu of a qualified custodian with
respect to shares of a mutual fund purchased directly
from the fund’s transfer agent (and thus maintained
on the fund’s books) rather than through another
intermediary such as a broker-dealer. Second,
advisers are exempt from the qualified custodian
requirement with respect to privately offered
uncertificated securities in their clients’ accounts, if
ownership of the securities is recorded only on the
books of the issuer or its transfer agent, in the name
of the client, and transfer of ownership is subject to
prior consent of the issuer or holders of the issuer’s
outstanding securities. An adviser may use this
exemption with respect to the account of a limited
partnership (or other pooled investment vehicle) only
if the limited partnership is audited annually and the
audited financial statements are distributed to the
limited partners, as described in the amended rule
and discussed below.
Quarterly Account Statements. The amended rule
requires advisers with custody of client funds or
securities to have a reasonable belief that the
qualified custodian delivers quarterly account
statements directly to those clients. As proposed, the
rule would have required delivery of monthly
account statements; however, in response to the
comment that some custodial accounts are on
quarterly reporting cycles and changing to a monthly
cycle could increase expenses substantially, the
Commission adopted the quarterly delivery
requirement. Advisers that arrange for account
statements to be delivered directly to clients by a
qualified custodian are relieved from having to send
their own client account statements and from
undergoing an annual surprise examination.
The rule recognizes that there may be circumstances
under which an adviser would want to continue the
approach of the current rule. For example, an
adviser might not wish to provide the custodian with
information about its clients. As an alternative, the
amended rule provides that, if clients do not receive
account statements directly from the qualified
custodian, the adviser must continue sending
quarterly account statements to its clients and
undergo an annual surprise examination by an
independent public accountant to verify the clients’
assets. The amendments require the independent
public accountant to notify the Commission’s Office
of Compliance Inspections and Examinations within
one business day of finding any material
discrepancies during a surprise examination.
If a client does not wish to receive its account
statements directly from a qualified custodian or the
adviser, the amended rule permits the client to
designate an independent representative to receive
statements on its behalf. Moreover, for purposes of
delivery of account statements with respect to pooled
investment vehicles for which an adviser also serves
as general partner, managing member or in a similar
capacity, the amended rule contains a special
provision clarifying that account statements (whether
delivered by a qualified custodian or the adviser)
must be sent directly to the investors in the pool.
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Exemptions. Under the rule amendments, advisers
are exempted from the rule in its entirety with respect
to clients that are registered investment companies
and are exempted in part with respect to certain other
pooled investment vehicles. Specifically, advisers
are not required to comply with the amended rule’s
reporting requirements with respect to limited
partnerships and similar pooled investment vehicles
if the pool (i) is audited at least annually and
(ii) distributes its audited financial statements
prepared in accordance with generally accepted
accounting principles (“GAAP”) to all limited
partners (or members or other beneficial owners)
within 120 days of the end of its fiscal year. As
proposed, advisers to such entities would have been
exempted from all the rule’s requirements. However,
the Commission determined to exempt them only
from the reporting requirements. Such advisers will
therefore be required to maintain the pool’s funds
and securities with a qualified custodian. The
proposal also would have required delivery of
audited financials within 90 days of the end of the
pool’s fiscal year. Commenters pointed out that
funds-of-funds usually wait for the underlying
investment vehicles to complete their financial
statements before finalizing their own and requested
that the Commission extend the proposed 90-day
period. In response, the Commission extended the
period to 120 days to allow funds-of-funds sufficient
time to complete their financial statements.
Commenters also urged the Commission to permit
financial statements for foreign pooled investment
vehicles to be prepared according to the GAAP of a
jurisdiction other than the United States. The
Adopting Release clarifies that an adviser may use
financial statements prepared in accordance with
International Accounting Standards or some
comprehensive body of accounting standards other
than U.S. GAAP if (i) the pool has its place of
organization outside the United States or (ii) a
general partner or other manager of the pool has a
principal place of business outside the United States.
However, the financial statements must contain
(i) information that is substantially similar to
financial statements prepared in accordance with
U.S. GAAP and (ii) a footnote reconciling any
material variations between the comprehensive body
of accounting standards and U.S. GAAP.
AMENDMENTS TO FORM ADV
The Commission also adopted two amendments to
Form ADV related to amended Rule 206(4)-2. First,
the Commission amended an instruction to Item 9 of
Part 1A, which inquires whether an adviser has
custody of client funds or securities. Recognizing
that a large number of SEC-registered advisers
deduct their fees directly from client accounts and
currently answer “no” to this item in reliance on
certain no-action letters that are, as noted above,
being withdrawn by the Commission staff, the new
instruction specifies that advisers having custody
only because they deduct fees may answer “no” to
Item 9. Commenters recommended, and the
Commission agreed to, this change to avoid requiring
a large number of advisers to amend their Form
ADVs in this regard. In the Adopting Release, the
Commission noted that it will take several months
before the NASD will be able to reprogram the
Investment Adviser Registration Depository to
implement the change. The Commission indicated
that, in the interim, advisers registered with the
Commission that have custody only because they
deduct fees from client accounts should continue to
answer “no” to this item.
The other amendment to Form ADV eliminates the
requirement that advisers with custody of client
assets include an audited balance sheet in their
disclosure brochure delivered to clients. The
Commission maintained that the requirement is no
longer necessary in light of the adoption of Rule
206(4)-4 under the Advisers Act, which requires an
adviser to disclose to clients any financial condition
that is reasonably likely to impair the adviser’s
ability to meet its contractual commitments to its
clients. Form ADV still requires advisers that collect
certain fee prepayments from clients to include an
audited balance sheet in their disclosure brochures.
ALAN C. PORTER
202.778.9186
aporter@kl.com
CARY J. MEER
202.778.9107
cmeer@kl.com
MARTICHA L. CARY
202.778.9209
mcary@kl.com
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Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States,
with more than 60 lawyers devoting all or a substantial portion of their practice to this area and its related
specialties. The American Lawyer Corporate Scorecard, published in April 2003, lists K&L as a primary legal
counsel to the investment companies, board members or advisory firms for 15 of the 25 largest mutual fund
complexes. No law firm was mentioned more frequently in the Scorecard.
We represent mutual funds, closed-end funds, insurance companies, broker-dealers, investment advisers, retirement
plans, banks and trust companies, hedge funds, offshore funds and other financial institutions. We also regularly
represent mutual fund distributors, independent directors of investment companies and service providers to the
investment management industry. In addition, we frequently serve as outside counsel to industry associations on a
variety of projects, including legislative and policy matters.
We work with clients in connection with the full range of investment company industry products and activities,
including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance
products, private and offshore investment funds and unit investment trusts. Our practice involves all aspects of the
investment company business.
We invite you to contact one of the members of the practice, listed below, for additional assistance. You may also
visit our website at www.kl.com for more information, or send general inquiries via email to
investmentmanagement@kl.com.
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Michael S. Caccese
Philip J. Fina
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617.261.3133
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310.552.5071
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Beth R. Kramer
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SAN FRANCISCO
Eilleen M. Clavere
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WASHINGTON
Clifford J. Alexander
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Catherine S. Bardsley
Arthur J. Brown
Arthur C. Delibert
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202.778.9068
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This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2003 KIRKPATRICK & LOCKHART LLP.
ALL RIGHTS RESERVED.