The Securities Exchange Commission (“SEC”) recently released a no-action letter allowing sub-advisers in certain situations to avoid the annual surprise examination requirement of Rule 206(4)-2 for investment advisers with custody of client funds or securities. Going forward, sub-advisers who do not have actual custody of client assets but are deemed to have custody because they are related to the qualified custodian and primary adviser will no longer have to comply with this burdensome requirement, so long as certain conditions are met.
As a review, custody is defined by Rule 206(4)-2 under the Investment Advisers Act of 1940 as the holding, directly or indirectly, of client funds or securities, or having any authority to obtain possession of them. This includes situations where a “related person,” or a person controlled by you or under common control with you, has custody of client funds. Pursuant to SEC Rule 206(4)-2, investment advisers with custody of client funds must take certain steps to safeguard such client assets. Those steps include: 1) maintaining assets with a qualified custodian; 2) notifying clients about the qualified custodian; 3) ensuring that the qualified custodian sends quarterly account statements to client; and 4) obtaining an annual surprise examination by an independent public accountant.
In certain cases, investment advisers may act as sub-advisers in an investment advisory program for which a related person is the qualified custodian and primary adviser, or an affiliate of the primary adviser. The practical impact of the custody rule meant that since both advisers had custody, both needed to get an annual surprise examination by an independent public accountant. In addition, Rule 206(4)-2 imposes heightened requirements on investment advisers who serve as qualified custodians or who have a related person serve as the qualified custodian. The independent public accountant retained to perform the annual surprise examination must be registered with the Public Company Accounting Oversight Board. Furthermore, each year the sub-adviser must obtain an annual written internal control report prepared by the independent public accountant from its related person assessing the suitability of internal custodial controls.
These heightened requirements were thought necessary because of the higher risks present to clients by affiliated custodial relationships, as opposed to when client assets are maintained with an independent custodian. However, the SEC’s no-action letter it makes clear that it will not recommend enforcement action against a sub-adviser in the above-described situation who does not obtain a surprise annual examination, as long as the primary adviser is responsible for complying with the custody rule and its requirements.
Specifically, the SEC bases its no-action relief on the following: 1) the sole basis for the sub-adviser having custody must be its affiliation with the qualified custodian and primary adviser; 2) primary adviser must comply with all the requirements of Rule 206(4)-2 including the surprise annual examination; 3) sub-adviser must not hold any client funds or securities, have authority to obtain possession of those funds or securities, or have authority to deduct fees from client accounts; and 4) sub-adviser must continue to obtain the annual written internal control report prepared by the independent public accountant from the primary adviser or qualified custodian.
This new development reflects the SEC’s belief that the double annual surprise examination requirement for related investment advisers with custody was duplicative and unnecessarily costly. However, before relying on the no-action relief, sub-advisers should take care to verify that they do not have custody of client assets in some other way besides just through a related person. In addition, they should take some measures to memorialize the primary adviser’s responsibility to comply with Rule 206(4)-2 and its requirements, either through a written acknowledgement or in the sub-advisory agreement.
Parker MacIntyre provides legal and compliance services to investment advisers, broker dealers, registered representatives, hedge funds, and issuers of securities, among others. Our regulatory practice group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our website for more information.