SEC Grants Sub-Advisers No-Action Relief from Custody Rule Audit Requirements
A U.S. Securities and Exchange Commission (SEC) no-action letter issued on April 25, 2016 provides relief from the annual surprise audit requirement of the “Custody Rule” for a registered investment adviser (RIA) participating in an investment advisory program where one or more affiliates act as primary adviser and qualified custodian to clients in the program.
In the no-action letter to the Investment Adviser Association (IAA), the staff of the SEC's Division of Investment Management (Staff) provides guidance concerning the independent verification requirement set forth in Rule 206(4)-2 under the Investment Advisers Act of 1940 (Custody Rule).1 Under the IAA No-Action Letter, to the extent that (among other things) the sub-adviser is deemed to have custody solely by virtue of its affiliate serving as qualified custodian, and the affiliated primary adviser complies with the Custody Rule’s relevant requirements, the sub-adviser is not required to undergo a separate surprise examination.
Background: The Custody Rule
The Custody Rule generally regulates an RIA with respect to circumstances where the RIA or its affiliate has custody, possession or an ability to obtain client funds and securities.2 The Custody Rule was designed to protect client assets against loss, misuse and misappropriation and to ensure that client assets “will be insulated from and not be jeopardized by financial reverses, including insolvency,” of an RIA.3
An RIA is deemed to have “custody” of client assets if it holds client funds or securities “directly or indirectly” or if it has “any authority to obtain possession of them.”4 This would include circumstances where client assets are directly or indirectly held by a “related person” as qualified custodian in connection with advisory services provided by the adviser to its clients.5 The SEC has noted that while these advisers might not have actual, physical possession of client assets, they still have the authority to obtain possession.
In most cases, RIAs having custody of client funds or securities must:
- maintain client assets with a qualified custodian, in the manner described in the Custody Rule;6
- notify clients, in writing, of the identity of the qualified custodian when a custody account is opened on the client’s behalf or when changes are made;
- obtain reasonable belief that the qualified custodian is providing quarterly account statements to clients showing all holdings and transactions in the relevant account;
- undergo surprise verification by an independent public accountant on an annual basis;7 and
- receive or obtain from the qualified custodian a written report of the internal controls relating to custody of client assets from an independent public accountant on an annual basis, if those assets are maintained by a qualified custodian that is a related person or the RIA itself.
Applicability of the Custody Rule to Sub-Advisers
Although the Custody Rule does not require the use of independent qualified custodians, the IAA No-Action Letter “recognizes that affiliated custodial relationships present higher risks to advisory clients than where client funds or securities are maintained with an independent custodian.” Certain investment advisory programs involve a primary adviser/sponsor that is, or is a related person of, the qualified custodian (e.g., wrap fee programs). Such programs may make use of sub-advisers that are affiliated with the primary adviser/sponsor.
Under the current regulatory regime, such sub-advisers would be deemed to have custody of client assets if the primary adviser/sponsor, as a related person to the sub-adviser, is or is affiliated with the sub-adviser. As such, both the sub-adviser and the primary adviser/sponsor would be subject to the Custody Rule requirements set forth above, including submitting to surprise examinations by, and obtaining written internal control reports from, an independent public accounting firm.
Relief Granted by the IAA No-Action Letter
The IAA No-Action Letter provides welcome relief from duplicative surprise examinations of both the sub-adviser and the primary adviser/sponsor. The Staff confirmed that it would not recommend enforcement action to the SEC if the sub-adviser does not itself obtain a surprise audit examination where the primary adviser/sponsor complies with the Custody Rule requirements. The IAA No-Action Letter states:
[The Staff’s] position is based, in particular, on the following:
(1) the sole basis for the sub-adviser having custody is its affiliation with the qualified custodian and the primary adviser [or sponsor];
(2) the primary adviser [or sponsor] will comply with [the Custody Rule], including by having client funds and securities in the investment advisory program verified by a surprise examination conducted by an independent public accountant registered with the Public Company Accounting Oversight Board (‘PCAOB’) pursuant to an agreement entered into by the primary adviser [or sponsor];
(3) the sub-adviser does not: (i) hold client funds or securities itself; (ii) have authority to obtain possession of clients’ funds or securities; or (iii) have authority to deduct fees from clients’ accounts; and
(4) the sub-adviser will continue to be required to obtain from the primary adviser [or sponsor] or qualified custodian annually a written internal control report prepared by an independent public accountant registered with and subject to regular inspection by the PCAOB, as required by [the Custody Rule].
While surprise examinations by an independent auditor provide useful protections from custodial risks, the IAA No-Action Letter seems to recognize that any incremental benefit to duplicative surprise examinations relating to the same program accounts is outweighed by the related costs. However, in light of recent SEC enforcement actions against RIAs for Custody Rule violations, including the failure to conduct an adequate surprise examination,8 RIAs seeking to rely on the IAA No-Action Letter should ensure that they meet all of the required conditions.
1) Investment Adviser Association, SEC No-Action Letter (Apr. 25, 2016), available here (IAA No-Action Letter).
2) For convenience, this OnPoint refers to client funds and securities as “client assets.” However, assets that are neither funds (i.e., cash) nor securities are outside the scope of the Custody Rule. Staff Responses to Questions About the Custody Rule, Question II.3 (Sept. 1, 2013), available here.
3) Adoption of Rule 206(4)-2 Under the Investment Advisers Act of 1940, Investment Advisers Act Release No. 123 (Feb. 27, 1962).
4) Rule 206(4)-2(c)(1).
5) Custody of Funds or Securities of Clients by Investment Advisers, Investment Advisers Act Release No. 2876 (May 20, 2009) (2009 Release). For purposes of the Custody Rule, a “related person” is defined as “any person, directly or indirectly controlling the adviser, controlled by [the adviser] or under common control with [the adviser],” where “control” is defined as the “power, directly or indirectly, to direct the management or policies of [an adviser], whether through ownership of securities, by contract, or otherwise.” For instance, if a related person of an adviser has the ability to withdraw funds in connection with the adviser’s services, the custody of the related person is also considered to be attributed to the adviser. This attribution concept provided in the 2009 Release differs from the Staff’s previous position, set forth in various no-action letters, that custody would not be attributed to an adviser by virtue of a related person’s custody of client assets if the two were “operationally independent.” See e.g., Crocker Investment Management Corp., SEC No-Action Letter (Apr. 14, 1987). The rule, as amended, attributes custody even to an adviser that is “operationally independent” and only provides limited exceptions from certain substantive requirements, as discussed in footnote 7 below.
6) The term “qualified custodian” includes broker-dealers, banks, commodity futures merchants and certain foreign custodians. Rule 206(4)-2(d)(6).
7) Rule 206(4)-2(b)(6) provides certain exceptions from the surprise examination requirement – for example, where an adviser has custody solely because it has authority to deduct advisory fees, or where a related person qualified custodian is “operationally independent” of the adviser. Under Rule 206(4)-2(d)(5), a related person is presumed to be operationally independent if each of the following conditions are met: “(i) client assets in the custody of the related person are not subject to claims of the adviser’s creditors; (ii) advisory personnel do not have custody or possession of, or direct or indirect access to, client assets of 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 its related persons, or otherwise have the opportunity to misappropriate such client assets; (iii) advisory personnel and personnel of the related person who have access to advisory client assets are not under common supervision; and (iv) advisory personnel do not hold any position with the related person or share premises with the related person.” A sub-adviser may not be able to establish that it is operationally independent of a related person qualified custodian, and thus would have to comply with the surprise examination requirement even if the primary adviser/sponsor also complied with this requirement. The IAA No-Action Letter provides relief from such duplicative compliance.
8) Most recently, the SEC brought fraud charges against SFX Financial Advisory Management Enterprises (SFX) and its CCO for allegedly: misappropriating client assets for personal use; negligently failing to conduct reviews of cash flows in client accounts (as required by the firm’s compliance policies); and not performing an annual compliance review. The SEC also brought charges against SFX’s accounting firm and one of the firm’s partners for allegedly: conducting deficient surprise custody examinations; failing to adequately consider fraud risk factors; and filing false statements with the SEC (including noting that client assets were held with a qualified custodian when in fact they were not). SEC Press Releases, Accounting Firm, Partner Conducted Deficient Surprise Exams (Apr. 29, 2016); Investment Advisory Firm’s Former President Charged with Stealing Client Funds (June 15, 2015).