The Securities and Exchange Commission yesterday adopted rules designed to increase the oversight of SEC-registered investment advisers that maintain custody of client assets. Most investment advisers do not maintain physical custody of their clients’ assets. Instead, those assets are held by a qualified third-party custodian, such as a regulated bank or a broker-dealer. However, over the past year, the SEC has brought a series of enforcement cases against advisers who had access to their clients’ assets and allegedly misused them. The SEC alleged in certain of these enforcement actions that advisers often concealed the misuse of client assets by distributing false account statements to their clients reflecting assets that did not really exist. The SEC’s new rules were adopted in response to these SEC concerns.

The SEC’s custody rule as amended will encourage independent custody and require the use of independent public accountants as third-party monitors. Depending on the investment adviser’s custody arrangement, the rules will require the adviser to be subject to a surprise exam and custody controls review that are generally not required under the prior rules.

Surprise Exam
Investment advisers are now required to engage an independent public accountant to conduct an annual “surprise exam” to verify that client assets exist. The accountants are required to contact the SEC if they discover client assets are missing.

Custody Controls Review
When the adviser or an affiliate serves as custodian of client assets, the adviser is now required to obtain a written report — prepared by an accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board — that, among other things, describes the controls in place at the custodian, tests the operating effectiveness of those controls and provides the results of those tests.

The new rules also will impose a new control on advisers to hedge funds and other private funds that comply with the custody rule by obtaining an audit of the fund and delivering the fund’s financial statements to fund investors. The rule will require that the auditor of such a private fund be registered with and subject to regular inspection by the PCAOB.

The new rules also require that the adviser reasonably believe that the client’s custodian delivers the account statements directly to the client. This requirement is intended to provide greater assurance of the integrity of these account statements and enable clients to compare the account statement they receive from their adviser to determine that the account transactions are proper.

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