Is anyone else surprised that the “new” SEC custody rule does not take into account current custodial practices (let alone future practices). It seems to have escaped the notice of the SEC that most custodians have gone green (okay, are trying to save money) by eliminating the delivery of paper account statements. At a recent CCOutreach session, a client asked a SEC official if would it be enough (e.g., would it constitute due inquiry) to call those clients that must access their account statements via the custodian’s web site to confirm that they did indeed access such statements? The SEC official responded:

“It is not clear how you would be able to derive a reasonable belief from this information. Just because the client says they were delivered the statements, how do you know they actually did receive them? Does the client know who all their custodians are, and do they remember receiving all of them at the time you are asking them?”

Of course, the same SEC official refused to say what would constitute due inquiry under these circumstances. Perhaps investment advisers need to have their clients take lie detector tests or better yet, perhaps advisers need to station an employee in each client’s home to confirm that the client accessed all their account statements.

Yesterday I had an informative discussion with Vivien Liu about one troubling aspect of the new SEC Custody Rule. Ms. Liu is Senior Counsel at the SEC and one of the primary drafters of the new rule.

Due Inquiry

Among the many new requirements under the Custody Rule, the one that will affect almost every SEC-registered investment adviser is the requirement that an adviser can only form a reasonable belief that the qualified custodian sends account statement directly to clients after “due inquiry”.

What then, as many of our client’s have asked, suffices as “due inquiry”?

Account Statements Sent by Mail

If the qualified custodian sends out paper copies of account statements to the client, the adviser can satisfy the “due inquiry” standard by receiving a duplicate account statement directly from the custodian.

Electronic Account Statements

It becomes a bit more problematic when custodians do not send paper copies of the account statement and either (1) email the statement to clients or (2) make the statement available to clients via the custodian’s web site (whether this is at the option of the client or the policy of the custodian).

Accordingly to Ms. Liu, if the custodian emails account statements, then “due inquiry” would be satisfied if the adviser was “cc’d” on any such email. In effect, this would be analogous to the adviser receiving a duplicate paper copy via regular mail.

It is the second scenario - where the client must access the account statement via the custodian’s web site - that prompted my call to the SEC. This is because a footnote in the new rule states that:

“Advisers are not permitted to satisfy the requirement of forming a reasonable belief after “due inquiry” by accessing qualified custodian account statements through the custodian’s website. Accessing account statements through the website merely confirms that they are available. If an adviser does not take additional steps to determine whether account statements were sent to clients, or that clients obtained statements through the website, the adviser would have an inadequate basis for forming a reasonable belief, after due inquiry, that the qualified custodian sends account statements to clients.”

When the question of what “additional steps” an adviser must take in this situation was put to Ms. Liu, she agreed that there was no obvious solution. Hardly encouraging. However, Ms. Liu did state that the SEC would probably issue a clarification in the coming weeks which, of course, will prompt yet another Client Alert! Our view on the matter - beyond surprise that the SEC did not seem to take current custodial reporting practices into account when formulating the new rule - is that the “additional step” that an adviser must take is follow-up phone calls to clients to confirm that they actually accessed their account statements.

I know, I know . . . outrageously time-consuming, onerous and unfairly burdensome. Guilty on all three counts. However, until the SEC issues some clarification, this seems to be the only way to satisfy the due inquiry requirement in this situation. Though many of you think us infallible (and rightly so) we are certainly open to other suggestions as to how to best handle this troubling scenario.

The new SEC custody rule requires that an investment adviser have a reasonable belief that the qualified custodian sends account statements directly to clients must be formed by the adviser after “due inquiry.”  One adviser asked whether calling their clients on a quarterly basis to “inquire” whether or not they are receiving statements from the qualified custodian would constitute ‘due inquiry”. Absolutely.

When first released, the SEC Final Rule: Custody of Funds or Securities of Clients by Investment Advisers had an uncertain effective date. As stated in the Final Rule, ”the effective date of the amendments to rules 206(4)-2, 204-2 and Forms ADV and ADV-E is 60 days after publication in the Federal Register.”

The Final Rule was published in the Federal Register on January 11, 2010 which makes the effective date March 11, 2010.

Therefore, starting on March 11, 2010:

1. Advisers that elect to send their own account statements to clients must include a legend in the notice urging clients to compare the account statements they receive from the custodian with those they receive from the adviser; and
2. Advisers that send their own account statements to clients, in any subsequent statements they deliver to clients after the initial notice, must urge clients to compare the adviser’s statements with the account statements they receive from the custodian.

Other actions that should be taken by investment advisers by the effective date include adopting the following policies and procedures as part of their compliance program:

1. Conducting background and credit checks on employees of the investment adviser who will have access (or could acquire access) to client assets to determine whether it would be appropriate for those employees to have such access;
2. Requiring the authorization of more than one employee before the movement of assets within, and withdrawals or transfers from, a client’s account, as well as before changes to account ownership information;
3. Limiting the number of employees who are permitted to interact with custodians with respect to client assets and rotating them on a periodic basis; and
4. If the adviser also serves as a qualified custodian for client assets, segregating the duties of its advisory personnel from those of custodial personnel to make it difficult for any one person to misuse client assets without being detected.

Advisers should also consider:

1. Including in their policies and procedures a requirement that any problems be brought to the immediate attention of the management of the adviser.
2. Developing policies regarding the ability of individual employees to acquire custody of client assets (i.e., as trustees for client assets), because their custody may be attributable to the firm, which will thereby acquire responsibility for those assets under the rule.
3. Developing procedures by which the CCO periodically tests the effectiveness of the firm’s controls over the safekeeping of client assets, including:

• Periodically testing the reconciliation of account statements prepared by advisers with account statements as reported by qualified custodians; and
• Comparing, on a sample basis, client addresses obtained from the clients’ qualified custodians to which the custodian sends client statements, with client addresses maintained by the adviser, to look for inconsistencies or patterns that suggest possible manipulation of address information as a means for concealing misappropriation from these accounts by advisory personnel.

Compliance Dates

Also, remember that in addition to the effective date, the Final Rule carried with it specific compliance dates as follows:

Notice Requirement

Immediately upon the effective date advisers that have custody of client assets must promptly upon opening a custodial account on a client’s behalf, and following any changes to the custodial account information, as specified in rule 206(4)-2(a)(2) send a notification to the client, including a legend urging the client to compare the account statements the client receives from the custodian with those the client receives from the adviser. Such legend should also be included in any account statements that advisers send to these clients after they are required to send the notification discussed above. In addition, immediately upon the effective date, each adviser that has custody of client assets must have a reasonable belief (except with respect to pooled investment vehicles the financial statements of which are audited and delivered to investors) that a qualified custodian sends account statements directly to clients at least quarterly.

Surprise Examination Requirement

An investment adviser required to obtain a surprise examination must enter into a written agreement with an independent public accountant that provides that the examination will take place by December 31, 2010 or, for advisers that become subject to the rule after the effective date, within six months of becoming subject to the requirement. If the adviser itself maintains client assets as qualified custodian, however, the agreement must provide for the first surprise examination to occur no later than six months after obtaining the internal control report.

Internal Control Reports Requirement

An investment adviser also required to obtain or receive an internal control report because it or a related person maintains client assets as a qualified custodian must obtain or receive an internal control report within six months of becoming subject to the requirement.

Audit of Pooled Investment Vehicles

An investment adviser to a pooled investment vehicle may rely on the annual audit provision if the adviser (or a related person) becomes contractually obligated to obtain an audit of the financial statements of the pooled investment vehicle for fiscal years beginning on or after January 1, 2010.

Amended Form ADV Requirement

Investment advisers registered with the SEC must provide responses to the revised Form ADV in their first annual amendment after January 1, 2011.

Just to drill down a bit on one aspect of the new custody rule:

As amended, rule 206(4)-2 imposes additional requirements when advisory client assets are maintained by the adviser itself or by a related person rather than with an independent qualified custodian. As proposed, the amended rule requires, in addition to the surprise examination,  that when an adviser or its related person serves as a qualified custodian for advisory client funds or securities under the rule, the adviser obtain, or receive from its related person, no less frequently than once each calendar year, a written report, which includes an opinion from an independent public accountant with respect to the adviser’s or related person’s controls relating to custody of client assets

The internal control report should address control objectives and associated controls related to the areas of client account setup and maintenance, authorization and processing of client transactions, security maintenance and setup, processing of income and corporate action transactions, reconciliation of funds and securities to depositories and other unaffiliated custodians, and client reporting. Control objectives addressing these areas should include –

1. Documentation for the opening and modification of client accounts is received, authenticated, and established completely, accurately, and timely on the applicable system.
2. Client transactions, including contributions and withdrawals, are authorized and processed in a complete, accurate, and timely manner.
3. Trades are properly authorized, settled, and recorded completely, accurately, and timely in the client account.
4. New securities and changes to securities are authorized and established in a complete, accurate and timely manner.
5. Securities income and corporate action transactions are processed to client accounts in a complete, accurate, and timely manner.
6. Physical securities are safeguarded from loss or misappropriation.
7. Cash and security positions are reconciled completely, accurately and on a timely basis between the custodian and depositories.
8. Account statements reflecting cash and security positions are provided to clients in a complete, accurate and timely manner.