The Securities and Exchange Commission (SEC) on Dec. 30 published amendments to the Investment Advisers Act of 1940 aimed at better safeguarding clients’ funds held by Registered Investment Advisers (RIAs).
Triggering events leading to the amended rules include the Madoff scandal and other financial frauds. In 2009 alone, more than 150 Ponzi or pyramid schemes collapsed, brought down by investors looking to cash out during the financial-market meltdown.
Responding to these financial frauds and to criticism it wasn’t doing enough to protect investors, the SEC issued new amendments to its so-called Custody Rule to further monitor RIAs.
Under the amended rule, an adviser is defined to have custody of client assets if a related person of the adviser holds, directly or indirectly, client funds, or has the authority to obtain possession of them, in connection with services provided by the adviser. This would apply to registered investment advisers who answered yes to questions 9A (1) or (2), or 9B (1) or (2) on their Form ADV filing with the SEC indicating that they or a related party had custody of cash, bank accounts, or securities for their clients.
All advisers with custody are required to have an annual surprise examination of client assets in order to provide “another set of eyes” on the assets and an additional set of protections against misappropriation. No exemptions are provided for advisers who have custody through trustee or executor relationships. In addition, advisers who maintain custody of privately offered securities on behalf of clients will also be required to obtain an annual surprise examination.
Privately offered securities will have to be verified with other funds and securities during the surprise examination. If the adviser is a public company, has pooled investment vehicles or is subject to the internal-control reporting requirements, then the surprise examination is required to be performed by a PCAOB-registered, independent certified public accounting firm.
An adviser or a related and operationally dependent individual who is the custodian for advisory client funds or securities is required to obtain an internal-control report, such as a Type II SAS 70 report. The internal-control report must include an opinion from a PCAOB- registered, independent certified public accounting firm regarding the adviser’s or related person’s controls to maintain custody of and safeguard client assets. This requirement also applies to pooled investment vehicles, where assets are maintained with a custodian that is the adviser, or related person to the adviser, of the pool.
Financial statement audits of pooled investment vehicles
When audited financial statements are distributed to investors in pooled investment vehicles in lieu of the annual surprise examination requirement, the audit is required to be performed by a PCAOB-registered, independent certified public accounting firm. A final audit of the financial statements is now required when the pool is liquidated.
Exemption criteria for surprise examinations
Advisers are exempt from the surprise examination requirement when the adviser:
• Is only deemed to have custody because of their ability to deduct fees from client accounts.
• Advises pooled investment vehicles that are subject to an annual financial statement audit. The audited financial statements must be distributed to all investors in the pools. The investors receiving the audited financial statements can’t be limited to only other investment pools that are related to the adviser.
Exemption criteria for internal-control reporting
Under the amended rule, an adviser who uses a related party as custodian is presumed to be operationally dependent unless the following conditions are met:
• Client assets in custody of the related person are not subject to claims of the adviser’s creditors.
• Advisory personnel do not have custody or possession of, or direct or indirect access to, client assets for which the related person has custody or the power to control the disposition of such client assets to third parties for the benefit of the adviser or the related person.
• Advisory personnel and personnel of the related person who have access to advisory client assets are not under common supervision.
• Advisory personnel do not hold any position with the related person or share premises with the related person.
Account statements
Advisory clients must now receive account statements directly from the custodian. There is no longer an exemption for advisers to deliver statements to clients as long as the adviser underwent an annual surprise examination. As previously mentioned, pooled investment vehicles are exempted as long as audited financial statements are annually distributed to the investors and the investors are not limited to other pooled investment vehicles related to the adviser. •
Larry Kaplan is the managing director in charge of financial services at CBIZ Tofias, a provider of tax and consulting services. John Robichaud is the director in charge of internal controls at the firm, which has offices nationwide, including Providence, Newport and New Bedford.
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