In December 2009, the Securities and Exchange Commission ("SEC") made it more onerous and expensive for a registered investment adviser ("RIA") to continue operations with the passage of amendments to the existing custody requirements of Rule 206(4)-(2) under the Investment Advisers Act of 1940 (the "Act"). RIA's with custody of client accounts or affiliates of the RIA that have custody are now required to undergo an annual surprise examination.
If a RIA manages or controls any "pooled investment vehicle", such as a hedge fund or investment partnership, a surprise exam is required unless the vehicle claims the "audit provision". This audit provision allows for exclusion of the investors and assets managed in the pooled investment vehicle from a surprise examination if an audited financial statement is completed and distributed audited financial statements to investors within 120 days of the pooled investment vehicle's fiscal year end (180 days for "fund of funds"). The financial statements must be prepared under Generally Accepted Accounting Principles ("GAAP") and if the vehicle is in liquidation, the financial statements must be distributed promptly to all limited partners when complete. If the vehicle is organized outside of the United States ("US") or principal place of business is outside of the US, the vehicle can use non-US GAAP, however the financial statements must contain substantially all information required by US GAAP and a reconciliation of material differences. The audit needs to be completed by a CPA firm that is registered and subject to PCAOB oversight to qualify.
If a RIA manages institutional Accounts, WRAP Accounts, or Sponsors, a surprise exam is required if the adviser or related person acts as a qualified custodian, trustee, or has power of attorney. If the adviser or related person does not act as a qualified custodian or hold the assets and is "operationally independent", then a surprise examination is not needed.
It is important to select an appropriate Public Company Accounting Oversight Board (PCAOB) registered and inspected independent accounting firm to conduct the surprise examination. There are approximately 850 firms in the United States that meet the criteria, which can be identified by reviewing the PCAOB website. There are two lists, one for registered firms and one for inspected firms along with guidance for understanding the nuances of the inspection process. Be sure that the independent accounting firm that you are working with is on both lists. Registered accounting firms that audit brokers and dealers are now subject to inspection by the PCAOB. The PCAOB expects to begin conducting inspections of these firms in 2011.
Starting with the 2011 surprise examination, the RIA should have a signed engagement letter in place with the accounting firm as of the beginning of the year. Upon a SEC routine examination, if the surprise examination has not been completed for the current year, they will request the executed engagement letter. The surprise examination must be completed within six months of the adviser becoming subject to the Custody Rule.
The SEC requires that the auditor performing the examination issue an opinion noting whether the adviser was in compliance, in all material respects, with paragraph (a)(1) of the Custody Rule as of the examination date and had complied with the Recordkeeping Rule during the period since the prior examination. Paragraph (a)(1) of the Custody Rule requires advisers with custody of client funds to utilize a qualified custodian to maintain those funds in a separate account for each client under that client's name, or in accounts that contain only the client's funds under the adviser's name as agent or trustee for the clients. The Recordkeeping Rule requires advisers with custody of client funds to maintain certain books and records of client transactions and positions. An auditor needs to address both the Custody Rule and Recordkeeping Rule requirements in its surprise examination.
Rule 206(4)-2(a)(6) establishes additional requirements for an investment that itself, or its related person, maintains client funds or securities as a qualified custodian in connection with advisery services provided to clients. Such an investment must at least once each calendar year obtain or receive from its related person an internal control report related to its or its affiliates' custody services, including the safeguarding of funds and securities, prepared by an independent public auditor that is registered with, and subject to inspection by, the PCAOB. If an investment adviser has the assets it is advising housed at a separate unrelated qualified custodian, then this aforementioned internal control report is not needed.
Although an adviser will not know the date of an examination in advance, there are certain steps an adviser can take to prepare for a surprise examination. These including the following:
- Proactively review client and custodian contracts to identify which accounts are subject to custody
- Consider engaging legal / compliance experts for complex situations where it's not immediately clear whether custody has been triggered
- Maintain an updated account listing which identifies those accounts that are subject to examination
- Make sure all contracts with clients and custodians are readily accessible and include the latest amendments, if any
- Maintain current contact information (addresses, phone numbers, email addresses) for clients, custodians, and counterparties for privately offered securities
- Create and update internal control documentation explaining how systems and processes work - in particular, these should address trading, reconciliation, process for evaluating custody concerns, and other key areas
- Maintain organized records supporting all transactions
- Perform position and transaction reconciliations on a timely basis
Advisers with custody of client funds should review their existing policies and procedures that impact accounts with custody. Sound controls should be in place, such as policies that require more than one employee to authorize disbursements of client funds. Policies and procedures should be created to provide segregation of duties, such that one employee doesn't have the ability to authorize a payment, make the related accounting entries, and perform reconciliations of the cash activity.
On the surprise visit date (which could coincide with the examination date) the auditor will arrive at the RIA office and provide a list of information which will include a listing of all open, closed and transferred client accounts subject to custody requirements during the period from the previous surprise examination date. The accountant will set the current examination date and request a listing of all holdings as of that date. The auditor will perform a count of any physical securities held on the premises for the clients and reconcile those back to the examination date, if different from the surprise visit date. A sample of client accounts will be selected from the list for further testing.
The auditor will discuss with the RIA its process for determining which accounts are subject to custody requirements to determine that the list provided by the adviser was accurate and that the sample is being drawn from a population that contains all accounts that should be subject to surprise examination. Management will be asked to provide representation of why the accounts noted are subject to the custody rules and that the account list provided is complete and accurate.
For the sample of accounts subject to the surprise examination, the auditor will confirm funds and securities with both the qualified custodian and the client, and will confirm contributions and withdrawals with clients. If the list of securities held includes privately offered securities, as defined in Rule 206(4)-(2) of the Act, then the auditor will confirm the holdings with the counterparties. All confirmations will be reconciled to the adviser's records. Confirmations not received by the auditor will be subject to further procedures.
In order to assess an adviser's compliance with the Recordkeeping Rule, the auditor will select a sample of transactions and request supporting documentation, such as trade confirmations.
Auditors are required to submit Form ADV-E and the examination report within 120 days of the examination date. The Custody Rule has the following additional reporting requirements:
- If the auditor finds any material discrepancies during the surprise examination, the auditor must notify the SEC of such findings within one business day.
- If the auditor resigns or is dismissed from the surprise examination engagement, the auditor must file a statement notifying the SEC of date and reasons (such as problems relating to the examination) for the resignation or dismissal within four business days.