March 5, 2010

SEC Final Amendments to Advisers Act Custody Rule Effective March 12, 2010: Practical Considerations for Hedge Fund Managers

Arnold & Porter Advisory

As has been widely reported, the Securities and Exchange Commission (the "SEC") has adopted final amendments to its custody rule (Rule 206(4)-2) under the Investment Advisers Act of 1940 (the "Advisers Act"). These amendments are intended to strengthen controls over the custody of client assets by investment advisers registered with the SEC under the Advisers Act, and they will become effective on March 12, 2010.

Amended Rule 206(4)-2 (the "New Custody Rule") is the culmination of a process that the SEC began in May 2009, when it first proposed amendments to current Rule 206(4)-2 (the "Old Custody Rule").1 While the New Custody Rule applies broadly to all SEC-registered investment advisers, this Client Alert will focus on the New Custody Rule as it applies to managers of hedge funds and other pooled investment vehicles specifically.

Q: I am a hedge fund manager. How will the New Custody Rule affect me?

A: The best answer is that it depends on your particular facts and circumstances. In most cases, however, the practical answer is likely to be "not very much."

First, like the Old Custody Rule, the New Custody Rule only applies to SEC-registered investment advisers with "custody" of client assets — so in particular, if you are not currently registered2 with the SEC, then you are not subject to the New Custody Rule.

Second, even if you are a hedge fund manager registered as an investment adviser with the SEC, then it is likely that whatever you are already doing to comply with the Old Custody Rule is largely sufficient under the New Custody Rule as well — subject to a few caveats that we discuss in more detail below.

Q: I am SEC-registered, but all of my clients' assets are custodied with a prime broker. Can you remind me why I'm subject to the SEC's custody rules in the first place?

A: Even if an institution like a prime broker or a bank has actual custody of your clients' assets, the SEC considers you to have "custody" if you have sufficient "access" to those assets. In particular, if you are the general partner (or managing member, say) to a fund organized as limited partnership (or a limited liability company), you are deemed to have "custody" under the New Custody Rule (just as under the Old Custody Rule). You are also deemed to have "custody" of assets held in separately managed accounts if you have the right to deduct fees from those accounts directly.

Q: OK, so I am deemed to have "custody" of client assets (even though I'm not the custodian). What is the easiest way for me to comply with the New Custody Rule?

A: The New Custody Rule (like the Old Custody Rule) requires SEC-registered advisers to follow certain procedures designed to prevent them from abusing their access rights over client assets. First and foremost, the New Custody Rule (like the Old Custody Rule) requires all SEC-registered advisers to maintain client assets with "qualified custodians" (generally defined to mean banks, registered broker-dealers, registered futures commission merchants and certain types of foreign financial institutions).

Aside from the "qualified custodian" requirement, most of the other substantive procedures contemplated by the New Custody Rule — like annual surprise examinations and detailed quarterly reporting — are not well-suited to advisers to private funds, where the nature of the relationship between the adviser and the fund's investors is fundamentally different from the relationship between (say) a financial planner and his or her individual clients. Recognizing this poor fit, the New Custody Rule provides an alternative for advisers to hedge funds and other pooled investment vehicles — the "annual audit" approach.

Under the New Custody Rule's "annual audit" approach, if you are an SEC-registered adviser to a hedge fund or other pooled investment vehicle — AND the fund's assets are held by an independent "qualified custodian" — then you will be in compliance with the New Custody Rule so long as the fund's investors receive: (1) within 120 days of each fiscal year-end, financial statements prepared in accordance with generally accepted accounting principles ("GAAP") and audited by an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (the "PCAOB"); and (2) promptly upon liquidation of the fund, financial statements prepared in accordance with GAAP and audited by a PCAOB-registered and inspected accounting firm.

If you plan to rely on the New Custody Rule's "annual audit" approach to avoid surprise examinations and detailed quarterly reporting, you should therefore confirm, before the end of the fund's 2010 fiscal year, that the fund's auditors are, or will be, registered with, and subject to inspection by, the PCAOB3 before commencing the fund's next audit.4

We should also mention that in adopting the New Custody Rule, the SEC also adopted amendments to Form ADV to reflect the changes in reporting requirements resulting from the New Custody Rule. Registered investment advisers will not be required to use the new Form ADV, however, until filing their first annual Form ADV amendment after January 1, 2011.

CAVEAT: One important caveat to the foregoing is that the New Custody Rule does impose special requirements on "self-custodying" advisers — that is, advisers who have custody of client assets because they, or a "related person"5, maintain those assets as qualified custodian.6 Of these, the most significant is that such "self-custodying" advisers are required to obtain an annual internal control report, such as a Type II SAS 70 report, prepared by a PCAOB-registered and inspected accounting firm, within six months of becoming subject to the requirement, and thereafter no less frequently than once each calendar year. We have assumed throughout this Alert that you are not a "self-custodying" adviser, but if you have any questions about whether these special requirements might apply to you, you should contact us.

Q: The "annual audit" approach sounds very familiar — is it new?

A: Not fundamentally — the Old Custody Rule also permitted fund advisers to comply with most of the Old Custody Rule's substantive requirements through annual audits. The New Custody Rule's "annual audit" approach builds on the Old Custody Rule's by requiring that audits be conducted by a PCAOB-registered and inspected firm. The requirement that the fund be audited upon liquidation is also new.

Q: Why wouldn't I just use the audit approach and be done with it?

A: You probably would; the vast majority of fund managers have historically relied on the Old Rule's "annual audit" approach, and we don't know why the changes reflected in the New Custody Rule would change that for most managers. One thing to remember, though, is that (just as under the Old Custody Rule) fund managers who rely on the "audit approach" may face difficult issues if, for whatever reason, they find that they are unable to deliver GAAP-compliant audited financials by the deadlines imposed under the New Custody Rule — particularly in those cases where problems with the preparation or audit of the financial statements only become apparent when the opportunity to otherwise comply with the New Custody Rule's annual surprise examination requirement has passed.7

Q: In addition to managing funds, I manage a number of separate accounts — how will the New Custody Rule affect my management of those accounts?

A: It is true that the New Custody Rule's "audit approach" only applies to "pooled investment vehicles" — it does not apply to separately managed accounts. However, the New Custody Rule also exempts from its surprise examination requirement those advisers who are deemed to have custody of client assets solely because the adviser has authority to deduct advisory fees (so long as the adviser uses a qualified custodian who is either not a related person of, or is "operationally independent" from, the adviser).

In light of this "limited custody" exception, we expect that most our SEC-registered clients who manage separate accounts will be able to avoid the New Custody Rule's surprise examination requirement as to those accounts because they have, at most, limited power of attorney under their investment management contracts to deduct advisory fees from the account (and because their clients' assets are custodied with an independent qualified custodian — see the caveat above). If you are an SEC-registered adviser who manages separate accounts, you should review your existing contractual arrangements with clients as soon as practicable to confirm that this is the case.

If you are a manager of separate accounts with "limited custody" and are therefore exempt from surprise examinations under the New Custody Rule, you are still required to comply with the New Custody Rule's account statement delivery and notice requirements. In particular, if you must — as of the New Custody Rule's March 12, 2010 effective date — have a reasonable basis, after due inquiry8, for believing that the qualified custodian sends account statements, at least quarterly, to each client, identifying the assets in the account as of the end of the reporting period and setting forth all transactions in the account during that period; and you must provide notices to clients upon opening custodial accounts on a client's behalf and following any changes to notices previously provided — including, if applicable, a legend9 urging the client to compare the account statements the client receives from you with those that the client receives from the qualified custodian.

If you have the authority to deduct advisory fees directly from client accounts, you may also want to review your internal policies and procedures regarding the exercise of that authority: in the adopting release for the New Custody Rule, the SEC made clear that it believes that registered advisers should have policies and procedures in place that address the risk that the adviser or its personnel could deduct fees to which the adviser is not entitled under the terms of the advisory contract. The SEC further stated that these policies and procedures could include:

  • periodic testing on a sample basis of fee calculations for client accounts to determine their accuracy;
  • testing of the overall reasonableness of the amount of fees deducted from all client accounts for a period of time based on the adviser's aggregate assets under management; and
  • segregating duties between those personnel responsible for processing billing invoices or listings of fees due from clients that are provided to and used by custodians to deduct fees from clients' accounts and those personnel responsible for reviewing the invoices and listings for accuracy, as well as the employees responsible for reconciling those invoices and listings with deposits of advisory fees by the custodians into the adviser's proprietary bank account to confirm that accurate fee amounts were deducted.

Q: Is there anything else I should know about the New Custody Rule?

A: This Alert is only intended to provide a general summary of the New Custody Rule, and you should not assume that it addresses every aspect of the New Custody Rule that may apply to you. We would be happy to discuss with you in detail what impact (if any) the New Custody Rule will have on you specifically.

1 The SEC's adopting release, which includes the full text of the New Custody Rule, is available at
2 Of course, implicit in this assumption is that you are not SEC-registered, either because you are not required to register pursuant to a valid exemption from registration under the Advisers Act, or because you are ineligible to do so because you have assets under management that are less than the SEC's minimum threshold for registration (currently $25 million).
3 The PCAOB maintains a publicly available list of PCAOB-registered firms, available through the PCAOB website at In general, for a PCAOB-registered firm to be subject to PCAOB inspection as of a particular date, the firm must have performed at least one audit of an SEC-reporting entity in the three years preceding that date.
4 We note that, in the adopting release for the New Custody Rule, the SEC stated that an adviser to a pooled investment vehicle seeking to rely on the New Custody Rule's "audit approach" must become "contractually obligated" to obtain an audit for fiscal years beginning on or after January 1, 2010. While not expressly set forth in the New Custody Rule itself, the SEC staff has confirmed to us informally that advisers to hedge funds and other pooled investment vehicles may enter into this "contractual obligation" with a PCAOB-registered and inspected accounting firm at any time prior to commencement of the next audit (i.e., in most cases, not before December 31, 2010) — in particular, the "contractual obligation" need not be in place before the New Custody Rule's March 12 effective date. The SEC staff has stated, however, that this "contractual agreement" should be in writing.

5 Under the New Custody Rule, a "related person" of an adviser is any person, directly or indirectly, "controlling, controlled by, or under common control" with the adviser. "Control" is defined to mean "the power, directly or indirectly, to direct the management or policies of a person, whether through ownership of securities, by contract, or otherwise." Firm officers, partners, and directors exercising executive responsibility (or persons having similar status or functions) over a firm's affairs, as well as "elected managers" to limited liability companies and trustees and managing agents to trusts are each presumed possess control. In addition, control is generally presumed to exist under the New Custody Rule where a person has economic or voting rights as to 25% or more of the securities, capital or interests of another person organized corporation, partnership or limited liability company.
6 The New Custody Rule does not require that the qualified custodian be independent of the adviser, but the SEC did state in the New Custody Rule's adopting release that it regards the use of independent custodians as a "best practice whenever feasible."
7 We also note that the SEC's adoption of the New Custody Rule provides only "cold comfort" for managers of "funds-of-funds" who may find complying with the New Custody Rule's 120-day deadline for delivery of GAAP-compliant audited financial statements challenging: instead of simply including an express provision in the New Custody Rule that would have extended this 120-day deadline to 180 days for funds-of-funds — which would have been consistent with a previous version of the Old Custody Rule, as well as the SEC staff's position as set forth in a 2006 no-action letter — the SEC only stated in a footnote to the adopting release for the New Custody Rule that adoption of the New Custody Rule does not affect the views of the staff expressed in the no-action letter.
8 The New Custody Rule does not demand (or prescribe) any particular means of satisfying the "due inquiry" requirement. In the adopting release, the SEC did state, however, that one (perhaps not surprising) way for an adviser to satisfy the requirement is to arrange for the qualified custodian to deliver to the adviser copies of the account statements delivered to clients.
9 The legend requirement is a new feature of the New Custody Rule.

Howard Rice Investment Management Group
André W. Brewster
Ellen Kaye Fleishhacker
Jennifer Starkey

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