surprise annual audit proposed for investment … | surprise annual audit proposed for investment...

eapdlaw.com

Client Advisory | June 2009

Surprise Annual Audit Proposed for Investment Advisers with “Custody” of Client Assets

The Securities and Exchange Commission proposes to reinstate surprise annual audits for registered investment advisers with “custody.” This applies to any adviser that has authority to obtain possession of client funds or securities. Advisers whose affiliates (e.g., fund general partners or trustees) control advisory client assets are deemed to have custody, so this would apply to the fund or trust assets. In an overreaction to the Madoff scandal, it will also apply to all advisers who have custody only because their fees are deducted directly from client accounts.

The proposal does not include the excep-tions to the surprise audit requirement that such advisers relied on (without significant problems) before 2004. It has generated a number of comments; the vast majority object to including advisers whose only indicia of custody are direct fee deductions. Commenters also have proposed mandat-ing independent custodians, applying the annual audit only to advisers with affiliated custodians, and requiring custodians to monitor fee withdrawals, among other alter-natives. No comments have yet been filed that propose alternatives to the surprise audit for investment fund or trust assets. The SEC is accepting comments from the public until July 28, so you should consider submitting your own.

Do You Have Custody of Client Assets?

Custody for this purpose may have little to do with physical possession. Your firm has custody if it, directly or indirectly (including through certain affiliates), has any author-ity to obtain possession of client funds and securities, even if it never actually holds them. This includes where:

You or a control affiliate have physical Q

possession of client funds or securities.For example, where you hold cli-• ent stock certificates in your safe or accept funds or securities for for-warding to a custodian.

You have access to client funds or secu- Q

rities for other than trading.Such access could, e.g., be under a • general power of attorney or by hav-ing check-writing authority on a cli-ent’s account.The most common custody situa-• tion is where the adviser’s fees are paid directly from the account upon request to the custodian.

You or your control affiliate have legal Q

ownership of client funds or securities in any capacity.

This includes where the adviser or • affiliate is trustee or executor of a client trust or estate or general part-ner or managing member of a client limited partnership or LLC.

Current Requirements

Until 2004, an adviser that had custody was required to comply with costly safeguards, in particular having surprise annual audits and providing an audited balance sheet with Form ADV. However:

an adviser that had fees deducted di- Q

rectly could avoid the audit requirement by having a separate invoice and peri-odic custodial statement sent directly to the client, andan adviser deemed to have custody Q

of trust or partnership assets could avoid the audit requirement by having

Matthew C. Dallett, Partner

eapdlaw.com

Client Advisory | June 2009

Surprise Annual Audit Proposed for Investment

Advisers with “Custody” of Client Assets

The Securities and Exchange Commission proposes to reinstate surprise annual

audits for registered investment advisers with “custody.” This applies to any adviser

that has authority to obtain possession of client funds or securities. Advisers whose

affiliates (e.g., fund general partners or trustees) control advisory client assets

are deemed to have custody, so this would apply to the fund or trust assets. In an

overreaction to the Madoff scandal, it will also apply to all advisers who have custody

only because their fees are deducted directly from client accounts.

The proposal does not include the excep- Q You have access to client funds or secu-

tions to the surprise audit requirement that rities for other than trading.such advisers relied on (without significant • Such access could, e.g., be under a

problems) before 2004. It has generated general power of attorney or by hav-

a number of comments; the vast majority ing check-writing authority on a cli-

object to including advisers whose only ent’s account.indicia of custody are direct fee deductions. • The most common custody situa-Commenters also have proposed mandat- tion is where the adviser’s fees areing independent custodians, applying the paid directly from the account upon

Matthew C. Dallett, Partner annual audit only to advisers with affiliated request to the custodian.

custodians, and requiring custodians to Q You or your control affiliate have legalmonitor fee withdrawals, among other alter- ownership of client funds or securities innatives. No comments have yet been filed any capacity.

that propose alternatives to the surprise • This includes where the adviser oraudit for investment fund or trust assets. affiliate is trustee or executor of aThe SEC is accepting comments from the client trust or estate or general part-public until July 28, so you should consider ner or managing member of a clientsubmitting your own. limited partnership or LLC.

Do You Have Custody of Client Assets? Current Requirements

Custody for this purpose may have little to Until 2004, an adviser that had custody wasdo with physical possession. Your firm has required to comply with costly safeguards,custody if it, directly or indirectly (including in particular having surprise annual auditsthrough certain affiliates), has any author- and providing an audited balance sheetity to obtain possession of client funds and with Form ADV. However:

securities, even if it never actually holds Q an adviser that had fees deducted di-them. This includes where: rectly could avoid the audit requirement

Q You or a control affiliate have physical by having a separate invoice and peri-possession of client funds or securities. odic custodial statement sent directly to

• For example, where you hold cli- the client, andent stock certificates in your safe Q an adviser deemed to have custodyor accept funds or securities for for- of trust or partnership assets couldwarding to a custodian. avoid the audit requirement by having

Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=6aecff5b-9e5a-4968-9b96-21fb93b9db92

2 | Surprise Annual Audit Proposed for Investment Advisers with “Custody” of Client Assets

a third party review distributions to the adviser. Following rule changes in 2004, surprise

audits have been required only as a fallback. For accounts where an adviser has custody:

the assets must be maintained with a Q

“qualified custodian” – typically a bank or broker – either in a separate account for each client under that client’s name or in accounts that contain only client funds and securities, under the ad-viser’s name as agent or trustee for the clients, andeither (a) the custodian sends a quar- Q

terly account statement directly to each client or (b) the adviser sends the state-ment and has a surprise annual audit of the client assets. (Alternative (b) was ad-opted at the request of advisers who did not want to disclose client identities to third parties for competitive reasons.)

For pooled investment funds, the • quarterly statements must be sent to each investor. However, this require-ment may be avoided if the partner-ship is obligated to have an annual audit and distributes the audited financials to its investors within 120 days after the fiscal year end (180 days in the case of a fund of funds).

The SEC’s Proposed Rule Changes

Definition of “Custody” – The SEC proposes to provide that an adviser has “custody” if a person in a control relationship with the adviser holds or has any authority to obtain possession of client funds and securities in connection with the adviser’s advisory services.

This will sweep in arrangements that are Q

not now deemed “custody” because the adviser has no control over or access to the assets. Among other things, it makes clear that a registered adviser to a pooled investment fund has custody of the fund’s assets if a control affiliate is the general partner or managing member.

Surprise Annual Audit – For all advisers with custody, the SEC proposes reinstituting the annual surprise audit by an independent public accountant to verify client assets of which the adviser has custody.

The securities subject to the audit will Q

now include privately placed, book-entry securities, which are not currently cov-ered by the custody rule.

As under the current rule for elective sur- Q

prise audits, the accountant would need to flag any material discrepancies to the SEC by the next business day. The accountant would have to report Q

to the SEC the termination of its en-gagement with the adviser and, if applicable, any problems with the ex-amination that led to the termination of its engagement. When the adviser or an affiliate acts as Q

qualified custodian for client assets, both the surprise audit and a SAS 70 custody control review would have to be conducted by a PCAOB-registered accountant.

Additional Requirements – An adviser with custody of client assets would also be required to:

make inquiry to confirm that the inde- Q

pendent custodian is sending account statements,disclose in its Form ADV information Q

about its custody of assets, including the identity of the accountant that per-forms the surprise audits, andinstruct clients to compare account state- Q

ments they receive from the custodian with those received from the adviser. Pooled investment vehicles that wish

to avoid having quarterly custodial state-ments sent to each investor will be required to provide investors with audited financials upon liquidation, as well as annually. In addition, funds of funds would have only 120 days after year-end to distribute the annual audit, not 180 (although this may have been an oversight in the proposal).Opportunity to Comment – The SEC is accepting public comments on the pro-posed rules until July 28. Among other things, it has solicited suggestions for alternative approaches to achieve its goals. If you would like to discuss the substance of a comment, or any assistance in prepar-ing one, please contact one of the lawyers listed below.

Related Developments

These proposed rules are not the only responses to Madoff’s reported practices. In addition to a significant increase in enforcement actions against alleged Ponzi schemes:

SEC examiners are now, as a matter of Q

routine examination practice, requesting

For all advisers with

custody, the SEC

proposes reinstituting the

annual surprise audit by

an independent public

accountant to verify

client assets of which the

adviser has custody.


a third party review distributions to the Q As under the current rule for elective sur-

adviser. prise audits, the accountant would needFollowing rule changes in 2004, surprise to flag any material discrepancies to the

audits have been required only as a fallback. SEC by the next business day.

For accounts where an adviser has custody: Q The accountant would have to report

Q the assets must be maintained with a to the SEC the termination of its en-“qualified custodian” - typically a bank gagement with the adviser and, ifor broker - either in a separate account applicable, any problems with the ex-for each client under that client’s name amination that led to the termination ofor in accounts that contain only client its engagement. For all advisers with

funds and securities, under the ad- Q When the adviser or an affiliate acts as custody, the SECviser’s name as agent or trustee for the qualified custodian for client assets,clients, and both the surprise audit and a SAS 70 proposes reinstituting the

Q either (a) the custodian sends a quar- custody control review would have to annual surprise audit byterly account statement directly to each be conducted by a PCAOB-registered

an independent publicclient or (b) the adviser sends the state- accountant.ment and has a surprise annual audit of Additional Requirements - An adviser with accountant to verifythe client assets. (Alternative (b) was ad- custody of client assets would also be client assets of which theopted at the request of advisers who did required to:not want to disclose client identities to Q make inquiry to confirm that the inde- adviser has custody.

third parties for competitive reasons.) pendent custodian is sending account

• For pooled investment funds, the statements,quarterly statements must be sent to Q disclose in its Form ADV informationeach investor. However, this require- about its custody of assets, includingment may be avoided if the partner- the identity of the accountant that per-ship is obligated to have an annual forms the surprise audits, and

audit and distributes the audited Q instruct clients to compare account state-

financials to its investors within 120 ments they receive from the custodiandays after the fiscal year end (180 with those received from the adviser.days in the case of a fund of funds). Pooled investment vehicles that wish

to avoid having quarterly custodial state-The SEC’s Proposed Rule Changes ments sent to each investor will be requiredDefinition of “Custody” - The SEC proposes to provide investors with audited financialsto provide that an adviser has “custody” if upon liquidation, as well as annually. Ina person in a control relationship with the addition, funds of funds would have onlyadviser holds or has any authority to obtain 120 days after year-end to distribute thepossession of client funds and securities annual audit, not 180 (although this mayin connection with the adviser’s advisory have been an oversight in the proposal).services. Opportunity to Comment - The SEC is

Q This will sweep in arrangements that are accepting public comments on the pro-not now deemed “custody” because the posed rules until July 28. Among otheradviser has no control over or access to things, it has solicited suggestions forthe assets. Among other things, it makes alternative approaches to achieve its goals.clear that a registered adviser to a pooled If you would like to discuss the substanceinvestment fund has custody of the fund’s of a comment, or any assistance in prepar-assets if a control affiliate is the general ing one, please contact one of the lawyerspartner or managing member. listed below.

Surprise Annual Audit - For all advisers withRelated Developmentscustody, the SEC proposes reinstituting the

annual surprise audit by an independent These proposed rules are not the onlypublic accountant to verify client assets of responses to Madoff’s reported practices.which the adviser has custody. In addition to a significant increase in

Q The securities subject to the audit will enforcement actions against alleged Ponzinow include privately placed, book-entry schemes:

securities, which are not currently cov- Q SEC examiners are now, as a matter ofered by the custody rule. routine examination practice, requesting



This advisory is published by Edwards Angell Palmer & Dodge for the benefit of clients, friends and fellow professionals on matters of interest. The information contained herein is not to be construed as legal advice or opinion. We provide such advice or opinion only after being engaged to do so with respect to particular facts and circumstances. The firm is not authorized under the U.K. Financial Services and Markets Act 2000 to offer UK investment services to clients. In certain circumstances, as members of the U.K. Law Society, we are able to provide these investment services if they are an incidental part of the professional services we have been engaged to provide.

Please note that your contact details, which may have been used to provide this bulletin to you, will be used for communications with you only. If you would prefer to discontinue receiving information from the firm, or wish that we not contact you for any purpose other than to receive future issues of this bulletin, please contact us at [email protected].

© 2009 Edwards Angell Palmer & Dodge LLP a Delaware limited liability partnership including professional corporations and Edwards Angell Palmer & Dodge UK LLP a limited liability partnership registered in England (registered number OC333092) and regulated by the Solicitors Regulation Authority.

Disclosure required under U.S. Circular 230: Edwards Angell Palmer & Dodge LLP informs you that any tax advice contained in this communica-tion, including any attachments, was not intended or written to be used, and cannot be used, for the purpose of avoiding federal tax related penalties, or promoting, marketing or recommending to another party any transaction or matter addressed herein.

ATTORNEY ADVERTISING: This publication may be considered “advertising material” under the rules of professional conduct governing attor-neys in some states. The hiring of an attorney is an important decision that should not be based solely on advertisements. Prior results do not guarantee similar outcomes.

eapdlaw.com

This advisory is for guidance only and is not intended to be a substitute for specific legal advice. If you would like further information, please contact the Edwards Angell Palmer & Dodge LLP attorney responsible for your matters or one of the following members of the firm’s Investment Companies / Hedge Funds and Fund Formation practice groups:

Matthew C. Dallett, Partner 617.239.0303 [email protected] M. Stone, Partner 617.951.3331 [email protected] T. Barrett, Partner 617.239.0385 [email protected]

confirmation from third parties, such as custodians, brokers, counterparties and clients, to verify the existence of assets under management in a sample of client accounts, as well as the transactions in those accounts, and

clients and their advocates are in- Q

sisting that their assets be held in the clients’ names with independent custodians.These developments will undoubt-

edly also affect your business.


confirmation from third parties, such as Q clients and their advocates are in-custodians, brokers, counterparties and sisting that their assets be held inclients, to verify the existence of assets the clients’ names with independentunder management in a sample of client custodians.accounts, as well as the transactions in These developments will undoubt-those accounts, and edly also affect your business.

This advisory is for guidance only and is not intended to be a substitute for specific legal advice. If you would like furtherinformation, please contact the Edwards Angell Palmer & Dodge LLP attorney responsible for your matters or one of thefollowing members of the firm’s Investment Companies / Hedge Funds and Fund Formation practice groups:

Matthew C. Dallett, Partner 617.239.0303 [email protected] M. Stone, Partner 617.951.3331 [email protected] T. Barrett, Partner 617.239.0385 [email protected]

This advisory is published by Edwards Angell Palmer & Dodge for the benefit of clients, friends and fellow professionals on matters of interest.The information contained herein is not to be construed as legal advice or opinion. We provide such advice or opinion only after being engaged

to do so with respect to particular facts and circumstances. The firm is not authorized under the U.K. Financial Services and Markets Act 2000 to

offer UK investment services to clients. In certain circumstances, as members of the U.K. Law Society, we are able to provide these investment

services if they are an incidental part of the professional services we have been engaged to provide.

Please note that your contact details, which may have been used to provide this bulletin to you, will be used for communications with you only.

If you would prefer to discontinue receiving information from the firm, or wish that we not contact you for any purpose other than to receivefuture issues of this bulletin, please contact us at [email protected].

© 2009 Edwards Angell Palmer & Dodge LLP a Delaware limited liability partnership including professional corporations and Edwards Angell

Palmer & Dodge UK LLP a limited liability partnership registered in England (registered number OC333092) and regulated by the SolicitorsRegulation Authority.

Disclosure required under U.S. Circular 230: Edwards Angell Palmer & Dodge LLP informs you that any tax advice contained in this communica-

tion, including any attachments, was not intended or written to be used, and cannot be used, for the purpose of avoiding federal tax relatedpenalties, or promoting, marketing or recommending to another party any transaction or matter addressed herein.

ATTORNEY ADVERTISING: This publication may be considered “advertising material” under the rules of professional conduct governing attor-

neys in some states. The hiring of an attorney is an important decision that should not be based solely on advertisements. Prior results do not eapdlaw.comguarantee similar outcomes.


surprise annual audit proposed for investment … | surprise annual audit proposed for investment...

Documents