Custody Exam/Audit May Not Be Required When Adviser and Client Are the Same
It may seem a bit odd for advisory firms to arrange surprise independent verification exams of funds in principal accounts. Now they may no longer have to.
The SEC staff, in a March 23 no-action letter, told an advisory firm that it would not recommend enforcement action against it for violating Rule 206(4)-2, the Custody Rule, if the firm does not comply with the Rule’s independent verification and account statement delivery provisions. As with most no-action letters, the staff limited its decision to the facts and representations in this particular situation. Nonetheless, the decision provides a window into the SEC staff’s thinking on the subject.
With some exceptions, the Custody Rule requires advisers with custody of client assets to undergo either an annual surprise exam by an independent public accountant to verify the client funds and securities or, in the case of pooled investment vehicles, a financial statement audit by an independent public accountant. In addition, advisers that have annual surprise exams must ensure that a qualified custodian sends quarterly account statements directly to the client.
"This is helpful for advisers who set up funds for their principals and their families," said Mayer Brown attorney Adam Kanter, something that many advisers do. These advisers will probably save some money by not having to arrange for verification exams or audits.
"It can be onerous for advisers to go through the expense of getting an exam or audit on a fund that is owned by principals or family members, particularly because there is no policy reason for doing so," said Morgan Lewis attorney Christine Lombardo, who said that her firm receives a lot of questions involving these kinds of funds. Until this no-action letter, she said, "the answer was yes, as a technical matter, those entities were clients that would generally require an audit or a surprise examination under the Custody Rule," adding that now, with this guidance from the SEC staff, that may not necessarily continue to be the case.
The adviser sought relief through counsel from the verification and account statement delivery provisions on the basis that "the client protections provided by the Custody Rule are unnecessary where the client and the investment adviser are essentially the same."
Registered with the Commission as an adviser since 2009, the adviser specializes in municipal securities trading, and manages several separate accounts. Three individuals, along with family members and family trusts, together own 91 percent of the firm, with the remainder owned by a passive investor. Two of the owners act as the firm’s portfolio managers, while the third has overall administrative and operational control of the firm. All three have statutory and plenary access to the firm’s information.
The firm also manages a master fund and a feeder fund, and the three owners are the joint managers of the master fund’s general partner, which has sole control over the master fund. In addition, the three firm owners are the sole directors of the feeder fund.
Custody Rule requirements
The Custody Rule requires that advisers with custody:
Maintain client funds and securities with "qualified custodians," either under the client’s name or under the adviser’s name as agent or trustee for the client;
Have a reasonable basis, after due inquiry, for believing that the qualified custodian sends quarterly account statements directly to the client; and
Undergo an annual surprise exam by an independent public accountant to verify the client funds and securities.
However, if the adviser is the general partner of a limited partnership (or holds a similar position with another form of pooled investment vehicle), the adviser can choose to have the pool’s financial statements audited by an independent public accountant, provided the audited statements are distributed to the pool’s investors. In such a case, the adviser does not need to meet the surprise exam requirement, nor does it need to take steps to ensure that quarterly account statements are distributed to clients.
The staff decision
The SEC staff, in its no-action letter, accepted the firm’s rationale for why it did not need to meet the Custody Rule’s surprise examination and audit provisions, as well as quarterly account statement provision. The logic behind the firm’s argument, according to the SEC staff, was that the policy considerations that informed the Commission’s adoption of the provisions "are not implicated" when the only investors in a pooled investment vehicle client of which a registered investment adviser has custody are individuals who:
Have plenary access to information (either statutory, contractual or some combination of the two) concerning the management of the investment adviser, the pooled investment vehicle and the vehicle’s general partner or managing member;
Are listed as control persons in Form ADV, Schedule A because of their status as an officer or director with executive responsibility or a similar status or function; and
Have a material ownership interest in the adviser (in other words, they are a principal of the firm).