[Federal Register: May 27, 2009 (Volume 74, Number 100)]
[Proposed Rules]
[Page 25353-25380]
[DOCID:fr27my09-19]

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Part IV

Securities and Exchange Commission

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17 CFR Parts 275 and 279

Custody of Funds or Securities of Clients by Investment Advisors;
Proposed Rule

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 275 and 279

[Release No. IA-2876; File No. S7-09-09]
RIN 3235-AK32

Custody of Funds or Securities of Clients by Investment Advisers

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission is proposing amendments
to the custody rule under the Investment Advisers Act of 1940 and
related forms. The amendments, among other things, would require
registered investment advisers that have custody of client funds or
securities to undergo an annual surprise examination by an independent
public accountant to verify client funds and securities. In addition,
unless client accounts are maintained by an independent qualified
custodian (i.e., a custodian other than the adviser or a related
person), the adviser or related person must obtain a written report
from an independent public accountant that includes an opinion
regarding the qualified custodian's controls relating to custody of
client assets. Finally, the amendments would provide the Commission
with better information about the custodial practices of registered
investment advisers. The amendments are designed to provide additional
safeguards under the Advisers Act when an adviser has custody of client
funds or securities.

DATES: Comments must be received on or before July 28, 2009.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to<EMAIL_ADDRESS>Please include
File Number S7-09-09 on the subject line; or
     Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.

All submissions should refer to File Number S7-09-09. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549 on official business days between the hours of 10 a.m. and 3 p.m.
All comments received will be posted without change; we do not edit
personal identifying information from submissions. You should submit
only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Vivien Liu, Senior Counsel, Daniel S.
Kahl, Branch Chief, or Sarah A. Bessin, Assistant Director, at (202)
551-6787 or<EMAIL_ADDRESS>Office of Investment Adviser Regulation,
Division of Investment Management, U.S. Securities and Exchange
Commission, 100 F Street, NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission
(``Commission'') is requesting public comment on proposed amendments to
rule 206(4)-2 [17 CFR 275.206(4)-2], rule 204-2 [17 CFR 275.204-2]
under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (the
``Advisers Act'' or ``Act''), to Form ADV [17 CFR 279.1], and to Form
ADV-E [17 CFR 279.8].

Table of Contents

I. Background
II. Discussion
III. General Request for Comment
IV. Paperwork Reduction Act
V. Cost-Benefit Analysis
VI. Initial Regulatory Flexibility Analysis
VII. Effects on Competition, Efficiency and Capital Formation
VIII. Consideration of Impact on the Economy
IX. Statutory Authority; Text of Proposed Rule and Form Amendments

I. Background

    Rule 206(4)-2 regulates the custody practices of investment
advisers registered under the Advisers Act.\1\ Unlike banks and broker-
dealers, investment advisers typically do not maintain physical custody
of client funds or securities but rather may have custody because they
have the authority to obtain client assets, such as by deducting
advisory fees from a client account, writing checks or withdrawing
funds on behalf of a client, or by acting in a capacity, such as
general partner of a limited partnership, that gives an adviser or its
supervised person the authority to withdraw funds or securities from
the limited partnership's account. Rule 206(4)-2 requires advisers that
have custody of client funds or securities to implement controls
designed to protect those client assets from being lost, misused,
misappropriated or subject to the advisers' financial reverses, such as
insolvency. The rule contains two primary protections.
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    \1\ Unless otherwise noted, when we refer to rule 206(4)-2 or
any paragraph of the rule, we are referring to 17 CFR 275.206(4)-2
of the Code of Federal Regulations in which the rule is published.
See also Custody of Funds or Securities of Clients by Investment
Advisers, Investment Advisers Act Release No. 2176 (Sept. 25, 2003)
[68 FR 56692 (Oct. 1, 2003)] (``2003 Adopting Release''). From time
to time for convenience, this release refers to rule 206(4)-2 as the
``custody rule.''
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    First, the rule requires advisers that have custody, with certain
limited exceptions, to maintain client funds or securities with a
``qualified custodian.'' \2\ Qualified custodians under the rule
include the types of financial institutions to which clients and
advisers customarily turn for custodial services, including banks,
registered broker-dealers, and registered futures commission
merchants.\3\ These institutions' custodial activities are subject to
extensive regulation and oversight.\4\
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    \2\ Rule 206(4)-2(a)(1).
    \3\ Rule 206(4)-2(c)(3) (defining ``qualified custodian''). In
addition, ``qualified custodian'' includes a foreign financial
institution that customarily holds financial assets for its
customers, provided that the foreign financial institution keeps
advisory clients' assets in customer accounts segregated from its
proprietary assets. Foreign custody arrangements may be necessary to
permit clients to trade in securities traded in foreign markets, or
to accommodate clients with existing relationships with foreign
institutions. When we amended the custody rule in 2003, we explained
that when an adviser selects a foreign financial institution to hold
clients' assets, the adviser's fiduciary obligations require it
either to have a reasonable basis for believing that the foreign
institution will provide a level of safety for client assets similar
to that which would be provided by a ``qualified custodian'' in the
United States or to fully disclose to clients any material risks
attendant to maintaining the assets with the foreign custodian. See
2003 Adopting Release, at n. 22.
    \4\ See Custody of Funds or Securities of Clients by Investment
Advisers, Investment Advisers Act Release No. 2044 (Jul. 18, 2002)
[67 FR 48579 (Jul. 25, 2002)] (``2002 Proposing Release''), at n. 30
(regulatory agencies or self-regulatory organizations require these
financial institutions to carry fidelity bonds to cover possible
losses caused by their employees' fraudulent activities). In
addition, rule 15c3-3 [17 CFR 240.15c3-3] under the Securities
Exchange Act of 1934 (the ``Exchange Act''), requires a broker-
dealer to segregate customer funds held by the broker-dealer for the
accounts of customers and to take certain steps to protect customer
assets. Under rules 17a-3 and 17a-4 under the Exchange Act [17 CFR
240.17a-3 and 17a-4] a broker-dealer must create and maintain
current, specified books and records to allow the broker-dealer to
easily identify what assets belong to each customer. Similarly,
national banks, Federal savings associations, and other U.S. banking
institutions are subject to extensive regulation and oversight. See
12 U.S.C. 92a. (national banks must have authorization from the
Comptroller of the Currency before establishing a trust department
and taking custody of customer assets); 12 U.S.C. 1464(n) (Federal
savings associations shall segregate all assets held in any
fiduciary capacity and shall keep a separate set of books and
records showing all transactions in the accounts); Comptroller's
Handbook, Custody Services at 6, 15 (Jan. 2002) (a bank should have
adequate systems in place to identify, measure, monitor, and control
risks in the custody services area and a custodian's accounting
records and internal controls should ensure that assets of each
custody account are kept separate from the assets of the custodian).

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    Second, the rule requires that an adviser with custody of client
assets have a reasonable belief that the qualified custodian holding
the assets provides account statements directly to clients, or
investors in pooled investment vehicles, at least quarterly.\5\ Clients
can use the statements they receive from the qualified custodians to
compare them with the statements (or other information) they receive
from their advisers to determine whether account transactions,
including deductions to pay advisory fees, are proper. An adviser to a
pooled investment vehicle is not required to comply with the rule's
account statement delivery requirement if the pooled investment vehicle
is audited at least annually and distributes its audited financial
statements to investors in the pool within 120 days of the end of its
fiscal year.\6\
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    \5\ Rule 206(4)-2(a)(3)(i).
    \6\ Rule 206(4)-2(b)(3).
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    If, however, clients do not receive account statements directly
from their qualified custodians, the adviser must itself deliver
quarterly account statements to clients and engage an independent
public accountant to verify the client assets in a surprise examination
that must occur at least once during each calendar year.\7\ During a
surprise examination, an independent public accountant generally must
(i) confirm with the custodian all cash and securities held by the
custodian, including physical examination of securities if applicable,
and will reconcile all such cash and securities to the books and
records of client accounts maintained by the adviser, (ii) verify the
books and records of client accounts maintained by the adviser by
examining the security records and transactions since the last
examination and by confirming with clients all funds and securities in
client accounts, and (iii) confirm with clients, on a test basis,
closed accounts or securities or funds that have been returned since
the last examination.\8\ The results of the examination must be
reported by the accountant to the Commission.\9\
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    \7\ Rule 206(4)-2(a)(3)(ii). Under the rule, an adviser is not
required to obtain a surprise examination if the qualified custodian
delivers account statements directly to the adviser's clients. An
adviser to a pooled investment vehicle that is unable, or chooses
not to, rely on the exception for audited financial statements and
that does not have a qualified custodian send the required account
statements to pool investors must provide account statements to pool
investors and the adviser must obtain a surprise examination of pool
assets.
    \8\ As stated in note 33 of the 2003 Adopting Release, the
accountant must perform the examination in accordance with U.S.
Generally Accepted Auditing or Attestation Standards and the
standards established by the Commission, except that the accountant
must verify all or substantiate all client funds and securities
covered by the examination. The examination should include
confirmation of all client cash and securities of which an adviser
has custody, regardless of whether they are held by qualified
custodians, and reconciliation of all such cash and securities to
the books and records of client accounts maintained by the adviser,
as well as confirmation of such information with the adviser's
clients. See Nature of Examination Required to be Made of All Funds
and Securities Held in Custody of Investment Advisers and Related
Accountant's Certificate, Investment Advisers Act Release No. 201
and Accounting Series Release No. 103 (May 26, 1966) [31 FR 7821
(Jun. 2, 1966)]. Section 404.01.b. of the Commission's Codification
of Financial Reporting Policies. The examination must be performed
at a time chosen by the accountant without prior notice or
announcement to the adviser, and the timing of the examination must
be irregular from year to year, so that the adviser will be unaware
of the date on which it will take place. Rule 206(4)-2(a)(3)(ii)(B).
    \9\ Id.
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    The surprise examination may uncover problems indicating that
client assets may be at risk. Accordingly, we have designed the
surprise examination requirement to provide timely information to the
Commission staff in the event that the accountant uncovers a problem
during the examination. Under the existing rule, the accountant must
notify our Office of Compliance Inspections and Examinations within one
business day of finding any material discrepancies during an
examination.\10\
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    \10\ Rule 206(4)-2(a)(3)(ii)(C). As we stated in note 34 of the
2003 Adopting Release, the independent public accountant may first
take reasonable steps to establish the basis for believing a
material discrepancy exists. The obligation to notify the Commission
arises once the accountant has a basis for believing there is a
material discrepancy. Ordinarily, an accountant should be able to
determine promptly whether it has a basis for believing there is a
material discrepancy.
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II. Discussion

    In recent months, the Commission has brought several enforcement
actions against investment advisers and broker-dealers alleging
fraudulent conduct, including misappropriation or other misuse of
investor assets.\11\ The Commission is intensively investigating this
conduct, including the role of the investment advisers, broker-dealers,
and individuals that may have participated in the conduct. We continue
to work with criminal authorities and other Federal and State
regulators to see that the full weight of the law is brought to bear on
any advisers and broker-dealers that are found to have betrayed
investor trust and confidence. In addition, our staff is conducting
examinations of broker-dealer and adviser custodial practices designed
to evaluate whether the assets entrusted to these firms are
appropriately accounted for and that the firms have in place controls
reasonably designed to prevent the theft, misappropriation or other
misuse of investor assets.
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    \11\ See, e.g., SEC v. Donald Anthony Walker Young, et al.,
Litigation Release No. 21006 (Apr. 20, 2009) (complaint alleges
registered investment adviser and its principal misappropriated in
excess of $23 million, provided false account statements to
investors in limited partnership, and provided false custodial
statements to limited partnership's introducing broker); SEC v.
Isaac I. Ovid, et al., Litigation Release No. 20998 (Apr. 14, 2009)
(complaint alleges that defendants, including registered investment
adviser and manager of purported hedge funds, misappropriated in
excess of $12 million); SEC v. The Nutmeg Group, LLC, et al.,
Litigation Release No. 20972 (Mar. 25, 2009) (complaint alleges that
registered investment adviser misappropriated in excess of $4
million of client assets, failed to maintain client assets with a
qualified custodian, and failed to obtain a surprise examination);
SEC v. WG Trading Investors, L.P., et al., Litigation Release No.
20912 (Feb. 25, 2009) (complaint alleges that registered broker-
dealer and affiliated registered adviser orchestrated fraudulent
investment scheme, including misappropriating as much as $554
million of the $667 million invested by clients and sending clients
misleading account information); SEC v. Stanford International Bank,
et al., Litigation Release No. 20901 (Feb. 17, 2009) (complaint
alleges that the affiliated bank, broker-dealer, and advisers
colluded with each other in carrying out an $8 billion fraud); SEC
v. Bernard L. Madoff, et al., Litigation Release No. 20889 (Feb. 9,
2009) (complaint alleges that Madoff and Bernard L. Madoff
Investment Securities LLC (a registered investment adviser and
registered broker-dealer) committed a $50 billion fraud).
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    We also are undertaking a comprehensive review of the rules
regarding the safekeeping of investor assets in order to determine
changes we might make that would decrease the likelihood that client
assets are misused, or would increase the likelihood that fraudulent
activities are discovered earlier and client losses are thereby
reduced. We are proposing today for comment several revisions to rule
206(4)-2 under the Advisers Act that are designed to improve the
safekeeping of client assets.

A. Annual Surprise Examination of Client Assets

1. Application to All Advisers With Custody
    The Commission proposes to require that all registered investment
advisers with custody of client assets engage an independent public
accountant to conduct an annual surprise examination

of client assets.\12\ When we adopted the custody rule in 1962, each
adviser with custody of client securities or funds was required by rule
206(4)-2 to engage an independent public accountant to conduct an
annual surprise examination.\13\ In 2003, we amended the rule to
eliminate the annual surprise examination with respect to client
accounts for which the adviser has a reasonable belief that ``qualified
custodians'' provide account statements directly to clients.\14\ We
believed that direct delivery of account statements by qualified
custodians would provide clients confidence that any erroneous or
unauthorized transactions would be reflected and, as a result, would be
sufficient to deter advisers from fraudulent activities.\15\
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    \12\ Proposed rule 206(4)-2(a)(4). Proposed rule 206(4)-2(c)(3)
would define independent public accountant as a public accountant
that meets the standards for independence described in rule 2-01(b)
and (c) of Regulation S-X. As discussed further below, the annual
surprise examination requirement would be in addition to the
requirement that the adviser have a reasonable belief that qualified
custodians deliver account statements directly to clients.
    \13\ Adoption of Rule 206(4)-2 under the Investment Advisers Act
of 1940, Investment Advisers Act Release No. 123 (Feb. 27, 1962) [27
FR 2149 (Mar. 6, 1962)]. In 1997, we amended the rule to make it
applicable only to advisers who are registered, or required to be
registered, with the Commission. Rules Implementing Amendments to
the Investment Advisers Act of 1940, Investment Advisers Act Release
No. 1633 (May 15, 1997) [62 FR 28112 (May 22, 1997)] at Section
II.I.5.
    \14\ See 2003 Adopting Release, at Section II.C.
    \15\ The custody rule provides a limited exception to the
requirement of maintaining client assets with a qualified custodian
with respect to mutual fund shares and certain privately offered
securities. Rule 206(4)-2(b)(1) and (2). As a result, these
securities may not be reflected on the qualified custodian's account
statements.
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    We have decided to revisit the 2003 rulemaking in light of the
significant enforcement actions we have recently brought alleging
misappropriation of client assets.\16\ We believe that a surprise
examination by an independent public accountant would provide ``another
set of eyes'' on client assets, and thus additional protection against
their misuse. Moreover, an independent public accountant may identify
misuse that clients have not, which would result in the earlier
detection of fraudulent activities and reduce resulting client
losses.\17\ Therefore, we propose to require all registered investment
advisers with custody of client assets to obtain an annual surprise
examination regardless of whether a qualified custodian directly
provides statements to clients or, in the case of a pooled investment
vehicle, the pool is audited at least annually and distributes its
audited financial statements to its limited partners (or other
investors) within 120 days of the end of its fiscal year. We are
proposing a number of additional enhancements to the rule, discussed
below, including additional adviser and accountant reporting
requirements and independent review of custody controls in certain
circumstances, that we believe would improve the utility of the
surprise examination requirement and address some of the concerns we
had in 2003.
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    \16\ See supra note 11.
    \17\ The independent public accountant conducting a surprise
examination would independently verify all client funds and
securities of which an adviser has custody, including those
maintained with a qualified custodian and those that are not
maintained with a qualified custodian, such as certain privately
offered securities and mutual fund shares. See supra note 15.
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    We request comment on our proposal to require investment advisers
with custody of client assets to undergo an annual surprise
examination. Would an annual surprise examination increase protections
afforded to advisory clients, including pooled investment vehicles (and
the investors in those vehicles)? Should we except from the surprise
examination requirement advisers that have custody of client funds or
securities solely as a result of their authority to withdraw advisory
fees from client accounts? \18\ Is this form of custody, which is
common to advisers with discretionary authority, less likely to be
subject to abuse? Should we instead specify requirements or
restrictions regarding withdrawing fees from client accounts? If so,
what should they be? Are there alternatives to the surprise examination
that might provide similar protections, or are there additional
requirements that we should also consider? For example, should we
instead (or also) amend rule 206(4)-7, which requires advisers to adopt
compliance policies and procedures administered by a chief compliance
officer, to require that the chief compliance officer submit a
certification to us on a periodic basis that all client assets are
properly protected and accounted for on behalf of clients? \19\ Should
we specify certain minimum procedures that each chief compliance
officer should implement to assure herself that all client assets are
properly protected and accounted for? Given the variety of custodial
arrangements, is it feasible for us to specify minimum requirements?
Should the rule require surprise examinations to be conducted more
frequently than annually or, alternatively, on a regular periodic
basis, e.g., semi-annually?
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    \18\ Advisers registered with the Commission that have authority
to deduct advisory fees from client assets have custody and are
subject to rule 206(4)-2, but are not required to report that they
have custody on Form ADV. See Item 9 of Part 1 of Form ADV (``If you
are registering or registered with the SEC and you deduct your
advisory fees directly from your clients' accounts but you do not
otherwise have custody of your clients' funds or securities, you may
answer ``no'' to Item 9A.(1) and 9A.(2).''). This would not change
under the proposed rule.
    \19\ Rule 206(4)-7 (17 CFR 275.206(4)-7). When we adopted rule
206(4)-7 in 2003, we stated that an adviser's compliance policies
and procedures adopted and implemented under the rule should address
``safeguarding of client assets from conversion or inappropriate use
by advisory personnel.'' See Compliance Programs of Investment
Companies and Investment Advisers, Investment Advisers Act Release
2204 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)], at Section
II.A.1.
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    Many advisers have custody as a result of serving as a general
partner (or in some other capacity) of a limited partnership or other
form of pooled investment vehicle. The proposed rule would continue to
except advisers from the requirement to have a qualified custodian send
account statements with respect to a pooled investment vehicle that is
audited at least annually and distributes its audited financial
statements to its limited partners (or other investors) within 120 days
of the end of its fiscal year.\20\ It would not, however, except such
advisers from the surprise examination requirement. The annual audit
serves a similar purpose as the surprise examination because it
involves a verification process, although it is not required to cover
all funds or securities.\21\ Should we continue to except advisers from
the surprise examination requirement with respect to client assets held
in pooled vehicles that are audited at least annually?
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    \20\ Proposed rule 206(4)-2(b)(3).
    \21\ See AICPA Investment Company Audit and Accounting Guide,
May 1, 2008.
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    As explained above, the proposed rule would require all registered
advisers that have custody of client assets, including advisers that
are also registered as broker-dealers and thus are permitted to act as
qualified custodians for their clients' assets, to obtain an annual
surprise examination. Under the Exchange Act, a broker-dealer's
financial statements must be audited annually by a registered public
accounting firm.\22\ This audit must include a review of the broker-
dealer's procedures for safeguarding securities.\23\ The scope of this
review must be sufficient for the auditor to provide reasonable
assurance that material inadequacies do not exist in a broker-dealer's
procedures for safeguarding securities.\24\ Would the surprise

examination's ``verification'' of client assets provide additional
protection for clients of advisers that are also broker-dealers? Do the
custody obligations for banks present the same issues if an adviser is
also a bank and maintains custody of client assets? Instead of
requiring a surprise examination for advisers that also act as the
qualified custodian for their clients' assets, should we instead
consider a different approach, such as requiring these advisers to
segregate custodial duties from advisory duties and implement
additional internal controls to protect client assets?
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    \22\ Section 17(e)(1)(A) [15 U.S.C. 78q(e)(1)(A)] of the
Exchange Act.
    \23\ Exchange Act Rule 17a-5(g) [17 CFR 240.17a-5(g)].
    \24\ Id.
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    We also request comment on whether we should revise or expand the
guidance we have provided regarding the surprise examination.\25\ For
example, are there other procedures an accountant should perform as
part of a surprise examination? Should we require an accountant to
perform testing on the valuation of securities, including privately
offered securities, as part of a surprise examination? Should we
require an adviser to certify a listing of funds and securities and
client accounts that were examined by the accountant as part of the
surprise examination? Are there any procedures currently required to be
performed as part of a surprise examination that are no longer
necessary? If so, what procedures and why are they no longer necessary?
For example, is confirming all client balances necessary to adequately
protect investors? If not, what extent of confirmation would be
appropriate? Are there any procedures currently required to be
performed as part of a surprise examination that should be clarified?
If so, how should they be clarified? Have investment advisers'
custodial practices or operations changed such that we should revise
our existing guidance on performing the surprise examination? \26\ If
so, what revisions should we make? If the proposed rule is adopted and
a greater variety of advisers become subject to the rule's surprise
examination requirement, should we provide additional guidance to
assist different types of advisers and their accountants in complying
with the surprise examination requirement? If so, what additional
guidance should we provide?
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    \25\ See supra note 8.
    \26\ See Nature of Examination Required to be Made of All Funds
and Securities Held in Custody of Investment Advisers and Related
Accountant's Certificate, supra note 8.
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2. Commission Reporting
    We propose to amend rule 206(4)-2 to require investment advisers
subject to the rule to enter into a written agreement with an
independent public accountant to conduct the surprise examination
requiring the accountant, among other things, to notify the Commission
within one business day of finding material discrepancies, and to
submit Form ADV-E to the Commission accompanied by a certificate within
120 days of the time chosen by the accountant for the surprise
examination, stating that it has examined the funds and securities and
describing the nature and extent of the examination.\27\ The
accountant's certificate describing the nature and extent of the
examination assists the Commission's examination staff in identifying
and assessing risks raised by the investment adviser's custodial
practices and in determining the scope of the Commission staff's
examination of an investment adviser. The reporting by the independent
public accountant of a material discrepancy provides the Commission's
examination staff with notice of a possible problem with the investment
adviser's custodial practices. Should we require additional information
be included in the accountant's certificate? Although we are not
proposing to change the requirement, is the term ``material
discrepancy,'' as used in the context of a surprise examination, widely
understood by independent public accountants? If not, should we define
the term or provide guidance as to the requirement? Should we require
the accountant's certificate to be provided to clients or investors in
pooled investment vehicles?
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    \27\ Proposed rule 206(4)-2(a)(4). The written agreement would
also require, in accordance with the current requirements of rule
206(4)-2, the independent public accountant to perform the surprise
examination. The current rule does not specifically require that the
adviser enter into a written agreement with the independent public
accountant. Rule 206(4)-2(a)(3)(ii)(B) and (C). Advisers would have
to keep these written agreements under rule 204-2(a)(10) [17 CFR
275.204-2(a)(10)] as they would be written agreements that an
adviser enters into in its business as such. The obligation to
maintain the records would apply for five years from the end of the
fiscal year during which the last entry was made, the first two
years in an appropriate office of the investment adviser.
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    Currently, the custody rule requires that the accountant that
performs the surprise examination file Form ADV-E with the Commission
within 30 days of the completion of the examination stating that it has
examined the funds and securities and describing the nature and extent
of the examination. Our examination staff has found that an adviser's
surprise examination may sometimes continue for an extended period of
time. We propose to amend the rule to require that the accountant
instead file Form ADV-E within 120 days of the time chosen by the
accountant for the surprise examination. As described above, 120 days
is the period of time in which a pooled investment vehicle managed by
an adviser relying on the rule's annual audit exception must distribute
its audited financial statements to investors in the pool.\28\
Accordingly, we believe 120 days should be sufficient time for an
accountant to complete a surprise examination and file Form ADV-E.
Would this change create any difficulties for the accountant or the
adviser to comply with the filing requirement? Is 120 days reasonable
for all types of advisers? If not, what time limit should we require
for the surprise examination?
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    \28\ Rule 206(4)-2(b)(3).
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    In addition, we propose that the written agreement require the
independent public accountant to submit Form ADV-E to the Commission
within four business days of its resignation, dismissal from, or other
termination, of the engagement, or upon removing itself or being
removed from consideration for being reappointed, accompanied by a
statement that includes (i) the date of such resignation, dismissal,
removal, or other termination, and the name, address, and contact
information of the accountant, and (ii) an explanation of any problems
relating to examination scope or procedure that contributed to such
resignation, dismissal, removal, or other termination (``termination
statement'').\29\ This information would

permit our staff to compare information provided by the adviser with
the perspective of the accountant, and to further evaluate the need for
an examination of the adviser to determine whether client assets are at
risk. We request comment on this proposed filing requirement. Is this
the right standard for notification of potential problems or
disagreements between an adviser and its independent public accountant
performing the surprise examination? Is it too broad? Too narrow? Is
there more information that should be required in this notification? If
so, what additional information should be required? Is the required
explanation of the reason for the withdrawal sufficient? Should this
notification requirement provide for more detailed standards such as
those included in Item 304(a)(1) of Regulation S-K with respect to a
change in an issuer's independent public accountant?
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    \29\ Proposed rule 206(4)-2(a)(4)(iii). Similarly, we require
companies registered under Section 12 or 15(d) of the Exchange Act
to file with us, within four business days of the dismissal or
resignation of their auditors, a Form 8-K containing information
relating to the circumstances under which the auditor was
terminated, whether the auditor had issued any adverse reports about
the company, whether there had been any disagreements between the
company and the auditor and certain other information. The former
auditor must respond in a publicly available document whether it
agrees with the company's statement. Form 8-K, Current Report, Item
4.01, 17 CFR 249.308; Changes In and Disagreements With Accountants
on Accounting and Financial Disclosure, Regulation S-K, Item 304,
[17 CFR 229.304]. We also require broker-dealers registered with us
to file a notice with us within 15 business days of the dismissal or
resignation of their auditors. In the notice, the broker-dealer
must, among other things, disclose any problem in the past two years
of which, if not resolved, the former auditor would have to make
reference in its report and state whether the former auditor's
report of the past two years contained any adverse or qualified
opinion or any disclaimer of opinion. The broker-dealer must attach
to its notice the former auditor's statement as to whether it agrees
with the broker-dealer's disclosure. See rule 17a-5(f)(4) under the
Exchange Act. We have chosen the four business day standard to
provide us with notice of potential problems with an investment
adviser's custody of client funds or securities at an earlier time
to allow our staff to take prompt action if necessary.
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    We propose to have accountants file Form ADV-E with us
electronically, through the Investment Adviser Registration Depository
(``IARD''), which would enhance our ability to use the information by,
for example, comparing information provided by advisers and their
independent public accountants and thus to identify potential custodial
risks. We currently are working with our contractor to develop changes
to the IARD system that would permit it to accept Form ADV-E and allow
us to make the filings available through our Web site.\30\ We request
comment on whether we should require that Form ADV-E be filed
electronically, and whether we should make the accountant's termination
statement publicly available.
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    \30\ The IARD system will not be able to accept electronic
filings of Form ADV-E until it is upgraded with this function. If
the proposed amendments are adopted, it is possible that accountants
performing surprise examinations may have to continue paper filing
of Form ADV-E for a period of time until the IARD system has been
upgraded. Public access to these filings would be made available on
our Web site through the Investment Adviser Public Disclosure system
(IAPD).
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3. Privately Offered Securities
    We also propose to amend the rule to make privately offered
securities that investment advisers hold on behalf of their clients
subject to the surprise examination requirement.\31\ Currently,
privately offered securities are excluded from all aspects of the
custody rule.\32\ While it may not be practical to require that these
securities in all cases be held by a qualified custodian,\33\ we
believe subjecting these securities to the surprise examination would
provide greater assurance that such securities are properly safeguarded
in furtherance of the purposes of the rule. We request comment on the
feasibility of requiring that advisers obtain a surprise examination
with respect to privately offered securities.
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    \31\ ``Privately offered securities'' are defined by rule
206(4)-2(b)(2) as securities that are (i) acquired from the issuer
in a transaction or chain of transactions not involving any public
offering, (ii) uncertificated, and ownership thereof is recorded
only on the books of the issuer or its transfer agent in the name of
the client, and (iii) transferable only with prior consent of the
issuer or holders of the outstanding securities of the issuer. The
proposed rule would retain this definition.
    \32\ Id.
    \33\ Ownership of private securities is recorded only on the
books of the issuer, which poses difficulties to maintain them in
accounts with qualified custodians. See 2003 Adopting Release, at
Section II.B.
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B. Custody by Adviser and Its Related Persons

1. Custody by Related Persons
    The Commission proposes to amend rule 206(4)-2 to provide that an
adviser has custody of any client securities or funds that are directly
or indirectly held by a ``related person'' in connection with advisory
services provided by the adviser to its clients.\34\ A ``related
person'' would be a person directly or indirectly controlling or
controlled by the adviser and any person under common control with the
adviser.\35\ For purposes of this definition we would define
``control'' as the power, directly or indirectly, to direct the
management or policies of a person, whether through ownership of
securities, by contract, or otherwise.\36\ As a result, the protections
of the rule would be afforded to clients when their funds and
securities are not held with an independent custodian, but rather with
the adviser itself or indirectly through a related person.\37\
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    \34\ Proposed rule 206(4)-2(c)(2) (defining ``custody'').
    \35\ Proposed rule 206(4)-2(c)(6) (defining ``related person'').
    \36\ Proposed rule 206(4)-2(c)(1) (defining ``control''). Form
ADV [17 CFR 297.1] also uses the same definition.
    \37\ Today, an adviser may, for example, have custody if its
related person holds assets of the adviser's clients and the adviser
either controls the related person's operations or has access to the
client assets through the related person. See section 208(d) of the
Advisers Act [15 U.S.C. 80b-8(d)] (an adviser may not, indirectly or
through or by any other person, do any act or thing that would be
unlawful for the adviser to do directly).
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    Under rule 206(4)-2, an adviser has custody of client assets if it
holds, directly or indirectly, client funds or securities or has any
authority to obtain possession of them.\38\ In our release adopting the
2003 amendments to rule 206(4)-2, we explained that an adviser may have
custody of client assets under circumstances in which the adviser or
its personnel have access to those client assets through a related
person, and cited one of our staff interpretive letters that set forth
factors the staff will consider in determining whether an adviser has
``indirect'' custody of client assets.\39\ The proposed amendments
would simply deem advisers whose ``related persons'' hold client assets
to have custody under the rule if those assets are held by the related
person in connection with the advisory services provided by the
adviser. We believe that the risks to advisory clients that arise as a
result of a related person's ability to obtain client assets,
regardless of the separation between the adviser and a related person,
may be substantial enough to require the adviser to comply with the
custody rule. The ``in connection with'' limitation of the proposed
rule is designed to prevent an adviser from being deemed to have
custody of client assets held by a related person broker-dealer (or
other qualified custodian) with respect to which the adviser does not
provide advice.
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    \38\ Rule 206(4)-2(c)(1) (defining ``custody'').
    \39\ See 2003 Adopting Release at n.4 (citing Crocker Investment
Management Corp., SEC Staff No-Action Letter (Apr. 14, 1978)). Our
staff would withdraw this no-action letter if we adopt the proposed
amendment.
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    Should we deem an adviser to have custody if its related persons
hold assets in connection with the adviser's advisory services? Are
there circumstances where a related person's custody of client assets
should not be imputed to the adviser? If so, should the rule contain a
rebuttable presumption that an adviser has custody if any of its
related persons have custody of advisory client assets? \40\ What
factors, if any, should we identify for advisers to consider when
assessing whether the presumption can be rebutted? \41\
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    \40\ Cf. Rule 206(4)-4(b) (establishing a rebuttable presumption
that certain legal or disciplinary events are material and therefore
must be disclosed to clients).
    \41\ See, e.g., Financial and Disciplinary Information That
Investment Advisers Must Disclose to Clients, Investment Advisers
Act Release No. 1083 (Sept. 25, 1987) [52 FR 36915 (Oct. 2, 1987)]
(discussing factors an adviser should consider in assessing the
presumption that certain disciplinary information is material and
therefore should be disclosed to clients).
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2. Internal Control Report and PCAOB Registration and Inspection
    The Commission also proposes to amend rule 206(4)-2 to require
that, if an independent custodian does not maintain client assets but
the adviser or a related person instead serves as a qualified custodian
for client funds or securities under the rule in connection

with advisory services the adviser provides to clients, the adviser
must obtain, or receive from the related person, no less frequently
than once each calendar year a written report (``internal control
report''), which includes an opinion from an independent public
accountant registered with, and subject to regular inspection by, the
Public Company Accounting Oversight Board (``PCAOB''), with respect to
the adviser's or related person's controls relating to custody of
client assets.\42\ The adviser would be required to maintain the
internal control report in its records and make it available to the
Commission or its staff upon request.\43\
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    \42\ Proposed rule 206(4)-2(a)(6). A report on the description
of controls placed in operation and tests of operating effectiveness
(commonly referred to as a ``Type II SAS 70 Report'') conducted in
accordance with PCAOB standards would be sufficient for purposes of
satisfying the requirements of the internal control report. See AU
324 Service Organizations of the PCAOB interim standards.
    \43\ Proposed rule 204-2(a)(17)(iii). See 17 CFR 275.204-2.
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    We are proposing this addition to the rule because we believe
maintaining client assets with the adviser or a related person instead
of with an independent custodian can present higher risks to advisory
clients. Indeed, several of the recent enforcement actions we have
brought alleging misappropriation of client assets by investment
advisers have involved advisers or related persons that maintained
client assets.\44\ While advisers that are themselves, or use related
persons that are, qualified custodians would be required to obtain a
surprise examination, the utility of the surprise examination may be
limited because the independent public accountant seeking to verify
client assets may have to rely on custodial reports issued by the
adviser or its related person. Because of the relationship between the
adviser and the custodian, we believe that there is a greater risk that
the custodian could be a party to any fraud and therefore the
custodian's reports could be compromised. Requiring these advisers to
also obtain an internal control report would provide an additional
check on the safeguards relating to client assets held by the adviser
or the related person qualified custodian.
---------------------------------------------------------------------------

    \44\ See supra note 11.
---------------------------------------------------------------------------

    An internal control report could also significantly strengthen the
utility of the surprise examination when the adviser or a related
person custodian maintains client assets because the independent public
accountant performing the surprise examination could obtain additional
comfort that confirmations received from the qualified custodian in the
course of the surprise examination are reliable and, where a broker-
dealer is the qualified custodian, may be able to leverage existing
tests performed in compliance with broker-dealer auditing and internal
control requirements. The internal control report may also reveal
control problems, which could be significant.\45\ Thus, the requirement
to obtain an internal control report informs the surprise examination
process and may itself act as a deterrent to advisers that may consider
misappropriating client assets directly or through a related person in
the guise of providing custodial services as a qualified custodian.
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    \45\ In addition to the specific procedures an independent
public accountant must follow during a surprise examination, the
accountant should perform any additional audit procedures it deems
necessary under the circumstances. See Nature of Examination
Required to be Made of All Funds and Securities Held in Custody of
Investment Advisers and Related Accountant's Certificate, supra note
8.
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    The proposed amendments would require that the internal control
report include an opinion of an independent public accountant
registered with, and subject to regular inspection by, the PCAOB, that
is issued in accordance with the standards of the PCAOB, with respect
to the description of controls placed in operation relating to
custodial services, including the safeguarding of cash and securities
held by either the adviser or a related person on behalf of the
adviser's clients, and tests of operating effectiveness.\46\ In
addition, the internal control report would also contain a description
of the relevant controls, the control objectives and related controls,
and the independent public accountant's tests of operating
effectiveness that were performed and the results of those tests.\47\
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    \46\ Proposed rule 206(4)-2(a)(6).
    \47\ See supra note 42.
---------------------------------------------------------------------------

    Opinions provided in reports on controls over custodial services
conducted in accordance with PCAOB standards address control objectives
relevant to the custodial operations, as well as the general control
environment and information systems. Control objectives relevant to
custodial operations might include:
     Physical securities are safeguarded from loss or
misappropriation;
     Cash and security positions are reconciled accurately and
on a timely basis between the custodian and depositories, and between
the custodian and accounting systems;
     Client-initiated trades are properly authorized and
recorded completely and accurately in the client account;
     Securities income and corporate action transactions are
processed to client accounts in an accurate and timely manner;
     Net settlement procedures for delivery and receive
transactions are performed accurately;
     Documentation for the opening of accounts is received and
authenticated, and established completely and accurately on the
applicable system; and
     Market values of securities obtained from various outside
pricing sources have been recorded accurately in client accounts.
    We are proposing that the independent public accountant issuing the
internal control report be registered with, and subject to regular
inspection by, the PCAOB, in accordance with the rules of the
PCAOB.\48\ We believe that registration and the periodic inspection of
an independent public accountant's overall quality control system by
the PCAOB will provide us greater confidence in the quality of the
internal control report.
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    \48\ Proposed rule 206(4)-2(a)(6). The PCAOB performs regular
inspections with respect to any registered public accounting firm
that, during any of the three prior calendar years, issued an audit
report with respect to at least one issuer. Under the proposed rule,
an adviser's use of an independent public accountant that is
registered with the PCAOB but not subject to regular inspection
would not satisfy the rule's requirements. See Rule 4003 of the
PCAOB's Bylaws and Rules, effective pursuant to Exchange Act Release
No. 56738, File No. PCAOB-2006-03 (Nov. 2, 2007) and Exchange Act
Release No. 49787, File No. PCAOB-2003-08 (Jun. 1, 2004).
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    We request comment on whether we should require advisers that
serve, or have related persons that serve, as qualified custodians for
client funds and securities to obtain or receive an internal control
report. Would this requirement provide additional protections for
clients? How would the timing of the internal control report relate to
the timing of the surprise examination? Does it make sense to require
both an internal control report and a surprise examination? Would these
requirements be duplicative? If so, in which respects? Should we
require that the independent public accountant that performs the
surprise examination be a different accountant than the accountant that
prepares the internal control report? Should we require that the
independent public accountant that prepares the internal control report
be registered with the PCAOB? If so, should we require that the
independent public accountant also be subject to regular inspection by
the PCAOB? Would the requirement of using independent public
accountants registered with, and subject to regular

inspection by, the PCAOB increase the costs to obtain these reports or
make it too difficult to obtain a qualified accounting firm to provide
an internal control report? Have we provided sufficient guidance for
the independent public accountants that will produce these reports?
Should we require that specific control objectives be addressed within
the internal control report? If so, what control objectives? Would
obtaining or receiving an internal control report present additional
issues if an adviser, or its related person, that acts as qualified
custodian for client assets is located outside of the United States?
Would the requirement that the independent public accountant be
registered with, and subject to regular inspection by, the PCAOB make
it more difficult for such advisers or their related persons to engage
an accountant to prepare the internal control report?
3. Surprise Examination and PCAOB Registration
    We also are proposing to require that when an adviser or a related
person serves as a qualified custodian for the adviser's clients' funds
or securities, the surprise examination discussed above be performed by
an independent public accountant registered with, and subject to
regular inspection by, the PCAOB, in accordance with the rules of the
PCAOB.\49\ We are proposing this requirement because, as discussed
above, we believe PCAOB registration and inspection will provide us
greater confidence in the quality of the examination performed by the
independent public accountant, which is even more important when an
adviser or its related person, rather than an independent custodian,
maintains client funds or securities.\50\
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    \49\ Proposed rule 206(4)-2(a)(6)(i).
    \50\ Cf. SEC v. David G. Friehling, C.P.A., et al., Litigation
Release No. 20959 (Mar. 18, 2009) (Commission charged auditors with
fraud alleging, among other things, that auditors misrepresented
that the financial statements of Bernard L. Madoff Investment
Securities LLC (BMIS) were audited pursuant to Generally Accepted
Auditing Standards, including the requirements to maintain auditor
independence and perform audit procedures regarding custody of
securities; did not perform a meaningful audit of the BMIS; and did
not perform procedures to confirm that the securities BMIS
purportedly held on behalf of its customers even existed).
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    We request comment on this proposed amendment to the rule. Should
we require that the independent public accountant performing the
surprise examination of an adviser that serves, or whose related person
serves, as a qualified custodian be registered with the PCAOB and
subject to its inspection? Should we instead require all surprise
examinations under the rule to be conducted by independent public
accountants registered with, and subject to regular inspection by, the
PCAOB? Does requiring the independent public accountant to be PCAOB-
registered and inspected provide meaningful quality assurance for
surprise examinations? Would the requirement of using a PCAOB-
registered and inspected independent public accountant increase the
costs to obtain these examinations or make it difficult to obtain a
qualified accounting firm to conduct the examination? Would the
requirement of using a PCAOB-registered and inspected independent
public accountant disproportionally impact small accounting firms or
small investment advisers?
    If we require the independent public accountants that prepare the
internal control report and perform the surprise examination to be
registered with, and subject to regular inspection by, the PCAOB,
should we also consider a similar revision to the current rule's audit
exception for certain pooled investment vehicles? Specifically, should
we require, as a condition of the adviser's reliance on the audit
exception when the adviser or its related person serves as qualified
custodian for funds or securities of the pool, that the independent
public accountant that performs the audit of the pooled investment
vehicle's financial statements be registered with, and subject to
regular inspection by, the PCAOB? Would advisers to offshore pools find
it too difficult to engage an auditor that is PCAOB-registered and
inspected? Should we instead, or in addition, require the independent
public accountant, as part of the surprise examination, to confirm
security holdings with the highest-level unaffiliated subcustodian
(e.g., Depository Trust Company) in addition to confirming the security
holdings with the qualified custodian, similar to the requirements for
auditors performing examinations for advisers to registered investment
companies that are deemed to have custody pursuant to rule 17f-2 of the
Investment Company Act of 1940? \51\
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    \51\ See American Institute of Certified Public Accountants,
Audit and Accounting Guide: Investment Companies Sec.  2.160
Footnote 47 (May 1, 2008), which requires confirmation of security
holdings with the highest-level of unaffiliated subcustodian in
connection with examinations performed pursuant to rule 17f-2 of the
Investment Company Act of 1940 [17 CFR 270.17f-2].
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4. Independent Qualified Custodians
    We request comment on whether, as an alternative to our proposal to
impose additional conditions on advisers that serve as, or have related
persons that serve as, qualified custodians for client assets, we
should simply amend rule 206(4)-2 to require that an independent
qualified custodian hold client assets. The use of a custodian not
affiliated with the adviser would address the conflict, and potentially
greater risks to client assets, that may be presented when an adviser
or its related person acts as custodian for client assets.
    When we amended rule 206(4)-2 in 2003 to require that advisers with
custody of client funds or securities maintain those assets with a
qualified custodian, we acknowledged that the rule would permit
advisers that are also qualified custodians to hold their clients'
assets or to maintain them with related persons that are qualified
custodians.\52\ Most qualified custodians are banks and broker-dealers,
which are subject to extensive regulation and oversight of their
custodial practices, and we did not believe that permitting advisers to
maintain securities with them presented additional custodial risk.\53\
---------------------------------------------------------------------------

    \52\ See 2003 Adopting Release at Section II.B.
    \53\ See 2002 Proposing Release at Section II.
---------------------------------------------------------------------------

    We are interested in exploring the practical aspects of requiring,
as an alternative to some or all of the amendments we are today
proposing, an independent qualified custodian. For example, such a
requirement could preclude a broker-dealer that is subject to rule
206(4)-2, i.e., is also a registered investment adviser, from providing
advisory services to a brokerage customer unless the customer held
securities over which the adviser had discretionary authority in a
brokerage account at another brokerage firm, or in a custodial account
at a bank or other qualified custodian. While institutional investors
such as mutual funds often hold securities and cash in custodial
accounts,\54\ would the use of custodial accounts be too costly for
small advisory clients? Would they be consistent with the operation of
certain types of combined advisory and brokerage accounts, such as wrap
fee programs?
---------------------------------------------------------------------------

    \54\ According to Lipper's LANA Database, more than 95 percent
of registered open-end investment company assets are held in custody
at a bank or trust company (based on Dec. 31, 2008 data).
---------------------------------------------------------------------------

    We request comment on the practical aspects of requiring advisers
that have custody to maintain client assets with an independent
qualified custodian. Would the requirement of using an independent
qualified custodian result in greater costs? If yes, would the
additional custodial protections for client assets afforded by an
independent qualified custodian warrant the additional costs? Would the

requirement result in greater burdens on advisory clients of firms that
are registered both as investment advisers and broker-dealers or cause
them to lose access to services or other efficiencies they currently
receive? Is there any reason why the custodial protections afforded by
the banking laws and our rules under the Exchange Act (and the rules of
the self-regulatory organizations) are sufficient to protect bank and
brokerage customers, but may not be sufficient to protect custodial
accounts of advisory clients?

C. Delivery of Account Statements and Notice to Clients

    The Commission proposes to amend rule 206(4)-2 to require
registered advisers with custody of client funds or securities to have
a reasonable basis for believing that the qualified custodian sends an
account statement, at least quarterly, to each client for which the
qualified custodian maintains funds or securities.\55\ The amendment
would eliminate the alternative, currently provided in the rule, under
which an adviser can send reports to clients if it undergoes a surprise
examination by an independent public accountant at least annually.\56\
We permitted the latter alternative delivery option because some
advisers did not wish to disclose the names of their clients to
custodians to prevent a potential competitor from having access to
their lists of clients, or to protect the privacy of some well-known
clients.\57\
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    \55\ Proposed rule 206(4)-2(a)(3). An adviser to a limited
partnership or other pooled investment vehicle that is subject to an
annual audit and that distributes its financial statements to
investors would remain excepted from the account statement delivery
requirement with respect to assets held by the pool. Proposed rule
206(4)-2(b)(3).
    \56\ Rule 206(4)-2(a)(3)(ii).
    \57\ See 2002 Proposing Release at Section II.C. See also 2003
Adopting Release at Section II.C. (recognizing that certain advisers
had presented reasons for allowing a direct delivery exception, and
citing Section II.C. of the 2002 Proposing Release).
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    We are proposing to eliminate the alternative delivery option and
require all advisers with custody of client assets to have a reasonable
belief that the qualified custodian delivers account statements to
advisory clients or their representatives (and not through the
investment adviser).\58\ We believe that direct delivery will provide
greater assurance of the integrity of those account statements, which
we now believe, in light of recent frauds, is of substantially greater
value than the concerns that led us in 2003 to accommodate those
advisers that wished not to share client names with custodians.\59\ The
confidentiality concern, we believe, could also be addressed in
custodial contracts or agreements outside of the contract that would
restrict the custodian's use of the information.\60\
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    \58\ An ``independent representative'' is a person that (i) acts
as agent for an advisory client and by law or contract is obligated
to act in the best interest of the advisory client; (ii) does not
control, is not controlled by, and is not under common control with
the adviser; and (iii) does not have, and has not had within the
past two years a material business relationship with the adviser.
Rule 206(4)-2(c)(2) [unchanged as proposed rule 206(4)-2(c)(4)].
    \59\ See Section II.C. of the 2003 Adopting Release. Qualified
custodians may use service providers to deliver their account
statements. The rule does not prohibit this practice, so long as the
statements are sent to the client directly and not through the
adviser. See 2003 Adopting Release at n.30.
    \60\ We also note that with respect to individual clients who
obtain custodial services for their personal, family or household
purposes, a U.S. qualified custodian would be subject to the
limitations on information sharing in the privacy rules adopted
pursuant to Title V of the Gramm-Leach-Bliley Act. See, e.g., 12 CFR
Parts 40, 216, 332, 573 (privacy rules adopted by the Office of the
Comptroller of the Currency, the Federal Reserve Board, the Office
of Thrift Supervision, and the National Credit Union
Administration); 17 CFR Parts 160, 248 (privacy rules adopted by the
Commodity Futures Trading Commission and the SEC). Under these
privacy rules, a qualified custodian would be prohibited from
sharing the advisory client's personal information with
nonaffiliated third parties (other than under an exception) unless
the custodian first provides the client with a notice explaining its
information sharing practices and the opportunity to opt out of the
information sharing and the client does not opt out. See, e.g., 17
CFR 248.10(a)(1).
---------------------------------------------------------------------------

    We are also proposing to amend rule 206(4)-2 to state that advisers
relying on the qualified custodian to send account statements directly
to clients must form their reasonable belief that such account
statements are sent after ``due inquiry.'' Because the effectiveness of
the rule depends significantly on direct delivery of account statements
by the qualified custodian, we are making it explicit that the adviser
is obligated under the rule to conduct some inquiry to form a
reasonable belief.\61\
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    \61\ There are a number of ways advisers could satisfy the ``due
inquiry'' requirement. For example, in the 2003 Adopting Release, we
explained that an adviser could form this reasonable belief if the
qualified custodian provides the adviser with a copy of the account
statement that was delivered to the client. See the 2003 Adopting
Release at n. 29. The receipt of these statements would satisfy the
``due inquiry'' requirement. As another example, an adviser could
satisfy the due inquiry requirement if the qualified custodian
confirms in writing, including sending a fax or an e-mail to the
adviser, that it has sent account statements to the adviser's
clients; such confirmation would need to cover each quarter during
which the qualified custodian is expected to send account statements
to the clients.
---------------------------------------------------------------------------

    We request comment on these proposed changes to the rule. Should we
eliminate the alternative delivery option in rule 206(4)-2? We
understand that most advisers do not currently take advantage of the
alternative delivery option, and that this proposal will not have a
significant effect on a substantial number of advisers or clients.\62\
We request comment on our understanding. Are there securities for which
a qualified custodian would not send account statements? If so, is this
due to legal, tax, or practical limitations? Are there other
alternatives that would provide greater assurance of the integrity of
client account statements? Should we include the due inquiry
requirement in the rule? Should we instead specify particular steps an
adviser must take to seek to determine that the qualified custodian
sends account statements directly to clients?
---------------------------------------------------------------------------

    \62\ Based on the number of Form ADV-Es filed with us during
2008, we estimate 190 advisers relied on the exception.
---------------------------------------------------------------------------

    We also propose to revise the content of the notice advisers are
currently required to send to clients upon opening a custodial account
on their behalf. Specifically, we propose to require advisers to
include a statement in the notice urging clients to compare the account
statements they receive from the custodian with those they receive from
the adviser.\63\ Client review of periodic account statements from the
qualified custodian can enable clients to discover improper account
transactions or other fraudulent activity. Raising client awareness of
this safeguard at account opening could enhance its effectiveness. We
request comment on this notice requirement. Advisers are not required
by the Advisers Act or rules to send their own account statements to
clients. Should we require advisers that have custody and elect to send
account statements to include a legend urging clients to compare the
information the adviser sends to clients with the information reflected
in the qualified custodian's account statements? Should we require all
advisers that have custody to deliver account statements and include
such a legend? If so, should we provide specific language for the
legend? Are there other disclosure requirements we should consider?
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    \63\ Proposed rule 206(4)-2(a)(2).
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D. Liquidation Audit

    We are proposing an amendment to clarify the provision of the rule
that exempts advisers from the account statement provisions with
respect to those limited partnerships or other pooled investment
vehicles that are subject to an annual audit and that distribute
financial statements to investors. The proposed amendment would clarify
the availability of the annual audit exception to pooled

investment vehicles that liquidate and make final distributions other
than at year end.\64\ This amendment is designed to assure that the
proceeds of the liquidation are appropriately accounted for so that
investors can take timely steps to protect their rights. Do commenters
agree with us that this clarification would provide additional
protection to the investors in the pool? Are there alternatives to a
liquidation audit that we should consider that would also protect pool
investors?
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    \64\ Proposed rule 206(4)-2(b)(3)(ii).
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E. Amendments to Form ADV

    We are proposing several amendments to Part 1A and Schedule D of
Form ADV. The amendments are designed to provide more complete
information about the custody practices of advisers registered with the
Commission, and to provide us with additional data to improve our
ability to identify compliance risks.
    Item 7. Item 7 of Part 1A requires advisers to report certain
financial industry affiliations, including whether the adviser has a
related person that is an investment adviser or a broker-dealer. The
item requires an adviser to identify on Schedule D of Form ADV each
related person that is an investment adviser, and permits advisers to
report the names of related person broker-dealers. We propose to modify
Item 7 to require an adviser to report all related persons who are
broker-dealers and to identify which, if any, serve as qualified
custodians with respect to the adviser's clients' funds or
securities.\65\
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    \65\ Proposed Section 7.A. of Schedule D of Form ADV.
---------------------------------------------------------------------------

    Item 9. Item 9 of Part 1A requires advisers to report to us whether
they or a related person have custody of client funds or securities. We
propose to amend the item to require advisers that have custody (or
whose related persons have custody) of client funds or securities to
provide additional information about their custodial practices under
rule 206(4)-2.
    Specifically, we propose to amend Item 9 of Part 1A to require an
adviser to report the amount in U.S. dollars of client assets and
number of clients of which it or its related person has custody,\66\
and whether it or its related person serves as qualified custodian with
respect to the adviser's clients' funds or securities.\67\ We would
also add a new subsection that would require an adviser with custody to
report (i) whether a qualified custodian sends quarterly account
statements to investors in pooled investment vehicles the adviser
manages, (ii) whether the financial statements of the pooled investment
vehicles the adviser manages are audited, (iii) whether the adviser's
clients' funds or securities are subject to a surprise examination, and
(iv) whether an independent public accountant registered with, and
subject to regular inspection by, the PCAOB prepares an internal
control report with respect to the adviser or its related persons'
custodial services when acting as a qualified custodian for advisory
client funds or securities.\68\ We also propose to amend Item 9 to
require advisers that are subject to the surprise examination to report
the month in which the last examination commenced.\69\ Last, we propose
to amend Form ADV: General Instruction number 4 to make conforming
changes to reflect that certain of the proposed questions are only
required to be updated in an adviser's annual amendment. The
information we propose to collect would improve our ability to monitor
compliance with the custody rule.
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    \66\ Proposed Item 9.A.(2) and B(2) of Part 1A of Form ADV. This
information would only be required to be updated when the adviser
prepares its annual updating amendment.
    \67\ Proposed Item 9.D. of Part 1A of Form ADV.
    \68\ Proposed Item 9.C. of Part 1A of Form ADV.
    \69\ Proposed Item 9.E. of Part 1A of Form ADV. This information
would only be required to be updated when the adviser prepares its
annual updating amendment.
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    We also propose to amend Schedule D of Form ADV by adding items to
require additional details relevant to an adviser's response to the
proposed amendments to Item 9 discussed above. With respect to
accountants, these amendments would require advisers to: (i) Identify
the accountants that perform audits or surprise examinations and that
prepare internal control reports; (ii) provide information about the
accountants, including address and PCAOB registration and inspection
status; (iii) indicate the type of engagement (audit, surprise
examination, internal control report); and (iv) indicate whether the
accountant's report was unqualified.\70\ With respect to qualified
custodians, these amendments would require advisers to identify any
related person that serves as a qualified custodian for its clients by
reporting the related person's name and address, and indicate whether
the related person qualified custodian is a bank, futures commission
merchant or foreign financial institution.\71\ This information would
allow our staff to better monitor compliance with the requirements of
rule 206(4)-2, and, together with other data reported on Form ADV,
would allow our staff to better assess the compliance risks of an
adviser.\72\
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    \70\ Proposed Section 9.C. of Schedule D of Form ADV.
    \71\ Proposed Section 9.D. of Schedule D of Form ADV. Proposed
Item 7 of Form ADV and Section 7.A. of Schedule D of Form ADV would
require advisers to report the same information for an affiliated
broker-dealer that is a qualified custodian for the adviser. See
supra note 65 and accompanying text.
    \72\ These proposed revisions respond in part to concerns raised
by the Government Accountability Office in its August 2007 report on
our examination program, which concluded that our examination staff
should continue to assess and refine the risk algorithm to enhance
the risk assessment process, which would include the identification
and collection of additional data through Form ADV. See United
States Government Accountability Office, Securities and Exchange
Commission; Steps Being Taken to Make Examination Program More Risk-
Based and Transparent (August 2007), available at http://
www.gao.gov/new.items/d071053.pdf.
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    We request comment on the amended items. We understand that the
additional information we would require is readily available to
investment advisers and should not be burdensome to provide. Is our
understanding correct? Are the new questions clear? If not, what
changes should we make to make them clearer? We do not believe that the
information we propose to require is proprietary information the
disclosure of which would have adverse consequences to the adviser or
its clients. Are we correct in this belief?

F. Amendments to Form ADV-E

    We are proposing three amendments to the instructions to Form ADV-
E. First, we propose to amend the instructions to require that the form
and the accountant's examination certificate that accompanies it be
filed electronically with the Commission.\73\ Second, we propose to
amend the instructions to reflect the proposed requirement that Form
ADV-E and the examination certificate must be filed within 120 days of
the time chosen by the accountant for the surprise examination.\74\
Third, we propose to add an instruction that would implement the
proposed rule change regarding the accountant's obligation under the
written agreement with the adviser to file Form ADV-E accompanied by
the termination statement, described above, within four business days
of the accountant's resignation, dismissal, or removal. We request
comment on these proposed

amendments. Are there additional changes to Form ADV-E that we should
consider?
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    \73\ Currently accountants submit Form ADV-E and the attached
examination certificates to the Commission by mail. Electronic
filing of Form ADV-E would be through the IARD system and would
begin only when the system is upgraded for this function.
    \74\ Proposed rule 206(4)-2(a)(4).
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G. Required Records

    We also are proposing to amend rule 204-2 to require the adviser to
maintain a copy of the internal control report that an adviser would be
required to obtain or receive from its related person, pursuant to
proposed rule 206(4)-2(a)(6) for five years from the end of the fiscal
year in which the internal control report is finalized. Requiring an
adviser to retain a copy of the internal control report would provide
our examiners with important information about the safeguards in place
at an adviser or related person that maintains client assets.
Information from these reports would also assist our staff in assessing
custody-related risks at a particular adviser. We request comment on
this proposal. Is there any additional documentation relating to the
internal control report that should be maintained under rule 204-2?

III. General Request for Comment

    The Commission requests comment on the rule amendments proposed in
this Release, suggestions for additional changes to the existing rules
and comment on other matters that might have an effect on the proposals
contained in this Release. Commenters should provide empirical data to
support their views.

IV. Paperwork Reduction Act

    The proposed amendments contain several ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act of 1995,\75\ and the Commission has submitted the
amendments to the Office of Management and Budget (``OMB'') for review
in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The titles for
the collections of information are ``Rule 206(4)-2, Custody of Funds or
Securities of Clients by Investment Advisers,'' ``Form ADV,'' and
``Form ADV-E, cover sheet for each certificate of accounting of client
securities and funds in the custody of an investment adviser,'' under
the Advisers Act. The rule and the forms contain currently approved
collection of information numbers under OMB control numbers 3235-0241,
3235-0049, and 3235-0361, respectively. An agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information unless it displays a currently valid control number.
---------------------------------------------------------------------------

    \75\ 44 U.S.C. 3501 to 3520.
---------------------------------------------------------------------------

    The collections of information under rule 206(4)-2 are necessary to
ensure that clients' funds and securities in the custody of advisers
are safeguarded, and information contained in the collections is used
by staff of the Commission in its enforcement, regulatory, and
examination programs. The respondents are investment advisers
registered with us that have custody of clients' funds or securities.
The collections of information under Form ADV are necessary for use by
staff of the Commission in its examination and oversight program, and
some advisory clients also may find them useful. The respondents are
investment advisers seeking to register with the Commission or to
update their registrations. The collections of information under Form
ADV-E are necessary for use by staff of the Commission in its
examination and oversight program. The respondents are investment
advisers registered with us that have custody of client assets and are
subject to an annual surprise examination requirement under rule
206(4)-2. With the exception of an accountant's notification of any
material discrepancies identified in a surprise examination, responses
provided to the Commission are not kept confidential.

A. Rule 206(4)-2

    Currently approved burdens. The current annual collection of
information burden approved by OMB for rule 206(4)-2 is 415,303 hours.
Rule 206(4)-2 currently requires each registered investment adviser
that has custody of client funds or securities to maintain those client
assets with a qualified custodian. The rule also requires that an
adviser with custody of client assets send quarterly account statements
to its clients and undergo an annual surprise examination unless the
adviser has a reasonable belief that the qualified custodian sends
account statements directly to its clients at least quarterly. In the
case of an adviser to a pooled investment vehicle, the adviser does not
have to obtain an annual surprise examination and deliver account
statements to investors if the pooled investment vehicle is audited at
least annually by an independent public accountant and distributes its
audited financials to investors in the pool within 120 days of the end
of the pool's fiscal year.
    The current approved annual burden relating to the requirement to
obtain a surprise examination and the delivery of quarterly account
statements by the adviser is 21,803 hours. We estimated that 204
advisers were subject to the two requirements. We estimated that each
adviser had 670 clients on average and that 193 of the 204 advisers
were subject to the two requirements only with respect to 1 percent of
their clients and the remainder (11 advisers) were subject to the two
requirements with respect to 100 percent of their clients. We further
estimated that each adviser would spend 2.5 hours per client in
connection with delivering quarterly account statements to clients and
undergoing an annual surprise examination pursuant to the rule.
    Annual surprise examination. The proposed amendments would
eliminate the option for an adviser that has custody of client assets
to choose not to have a qualified custodian deliver quarterly account
statements directly to clients if the adviser arranges for an annual
surprise examination verifying client assets. The proposed rule also
would reinstate the requirement for an annual surprise examination for
(i) advisers with custody that currently rely on qualified custodians
to send account statements directly to advisory clients, (ii) advisers
that custody client assets themselves as qualified custodians or
advisers with client assets held at a qualified custodian that is a
related person,\76\ and (iii) advisers to audited pooled investment
vehicles. Thus the proposed rule would require all advisers that have
custody of client funds or securities to be subject to an annual
surprise examination. The proposed amendments are designed to enhance
protections afforded to advisory clients by the custody rule. We
estimate that 9,575 out of the 11,272 advisers registered with the
Commission fall into this category.\77\
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    \76\ The proposed amended rule would deem an adviser to have
custody if its related persons have custody of its client assets in
connection with the adviser's advisory services. Proposed rule
206(4)-2(c)(2). A related person would be defined as a person
directly or indirectly controlling or controlled by the adviser, and
any person under common control with the adviser. Proposed rule
206(4)-2(c)(6). The proposed amended rule would require that the
surprise examination be performed by an independent public
accountant registered with, and subject to regular inspection by,
the PCAOB when an adviser or a related person serves as a qualified
custodian for the adviser's clients.
    \77\ Based on information filed through the IARD as of February
2009. The 9,575 advisers include both advisers that have custody of
their client assets and advisers whose related persons have custody
of the adviser's client assets (including advisers that answered
``yes'' to Item 9.A. or B. of Part 1A of Form ADV). The number also
includes those advisers that have discretionary authority over
client accounts, which we understand predominantly reflects
arrangements with clients to withdraw fees from client accounts. The
9,575 advisers, however, do not include 42 advisers that provide
advisory services exclusively to registered investment companies
(advisers that checked only (4) under Item 5.D). Under rule 206(4)-
2(b)(4) and proposed rule 206(4)-2(b)(4), advisers are not, and
would not be, subject to the custody rule with respect to a client
that is a registered investment company.

---------------------------------------------------------------------------

    We have categorized the estimated 9,575 advisers that report that
they have custody of client assets into 4 subgroups for purposes of
estimating the collection of information burden. First, we estimate
that 7,126 of the 9,575 advisers do not have pooled investment vehicles
as their clients.\78\ Based on our records and staff's examination
experiences, we estimate that these advisers would be subject to
surprise examinations with respect to 85 percent of their client
accounts (or 928 clients per adviser).\79\ A second group of advisers
that have custody, totaling 372, are also broker-dealers, banks or
futures commission merchants,\80\ or have a related person that serves
as a qualified custodian for advisory clients' funds or securities.\81\
We estimate that these advisers would be subject to an annual surprise
examination with respect to 100 percent of their clients (or 1,092
clients per adviser) based on the assumption that all of their clients
maintain custodial accounts with the adviser or related person. A third
group of advisers, totaling 1,281,\82\ advise both pooled investment
vehicles and other clients, and would be subject to the surprise
examination with respect to 85 percent of their non-pooled investment
vehicle clients (or 928 clients per adviser) \83\ and 100 percent of
their pooled investment vehicle clients (or 2 funds with 100 investors
per adviser).\84\ A fourth group of advisers, totaling 796,\85\ provide
advice exclusively to pooled investment vehicles and would be subject
to the surprise examination with respect to 100 percent of their pooled
investment vehicle clients (or 5 funds and 250 investors per
adviser).\86\ We estimate that each adviser would spend an average of
0.02 hours for each client that is not a pooled investment vehicle to
create a client contact list for the independent public accountant. We
further estimate that the advisers to pooled investment vehicles would
spend 1 hour for the pool and 0.02 hours for each investor in the pool
to create a contact list for the independent public accountant. These
estimates would bring the total annual aggregate burden in connection
with the surprise examination to 177,242 hours.\87\ This does not
nclude the collection of information discussed below, relating to the
written agreement required by paragraph (a)(4) of the custody rule, as
proposed to be amended.
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    \78\ Based on the number of advisers that answered ``yes'' to
Item 9.A. or B. of Part 1A of Form ADV (having custody) and checked
``none'' under Item 5.D.(6) (clients that are pooled investment
vehicles) as of February 2009, excluding 42 advisers that provide
advisory services only to registered investment companies (see supra
note 77), and those advisers that are also registered broker-
dealers, banks or futures commission merchants or have a related
person broker-dealer, bank or futures commission merchant that
serves as qualified custodian, which are accounted for separately in
the second group. See infra notes 80 and 81 and accompanying text.
    \79\ Based on data collected from the IARD (Item 5.F.(2)(d) and
(e) of Form ADV), we estimate that on average 85 percent of the
client accounts managed by these advisers are discretionary accounts
and the remaining 15 percent are non-discretionary accounts. We
believe that advisers have custody due to withdrawal of fees only
with respect to the discretionary accounts that they manage.
    We estimate that each adviser has, on average, 1,092 clients.
This average is based on advisers' responses to Item 5.C. of Part 1A
of Form ADV as of November 2008, excluding the two advisers that
reported the largest number of clients. Those advisers account for
over 51 percent of all advisory clients of SEC registrants and not
excluding them would raise the average client count to 2,265
clients. These two firms provide advisory services primarily over
the Internet and we believe that it is appropriate to exclude these
firms from our calculations.
    \80\ There are 139 of these investment advisers based on the
number of advisers that answered ``yes'' to Item 9.A. of Part 1A of
Form ADV (having custody) and checked Item 6.A.(1), (3), or (6)
(indicating that the adviser is also a broker-dealer, futures
commission merchant, commodity pool operator, commodity trading
advisor, or bank). We eliminated advisers that are commodity pool
operators or commodity trading advisors, by a firm by firm search of
the National Futures Association registration database.
    \81\ We estimate that there are 233 of these investment advisers
based on a percentage of the number of advisers that answered
``yes'' to Item 9.B. of Part 1A of Form ADV (related person custody)
and checked Item 7.A.(4) or (5) (indicating that the adviser has a
related person bank or futures commission merchant), and answered
``yes'' to Item 9.C. of Part 1A of Form ADV that the related person
that has custody is a registered broker-dealer.
    \82\ Based on the number of advisers that answered ``yes'' to
Item 9.A. or B. of Part 1A of Form ADV (having custody) and checked
Item 5 D.(6) (indicating that they have pooled investment vehicles
as clients) as of February 2009, excluding those that checked only
(6) under Item 5 D. and those advisers that are also broker-dealers,
banks, or futures commission merchants and custody client assets or
have a related person broker-dealer, bank or futures commission
merchant that serves as qualified custodian, which are accounted for
separately in the second group.
    \83\ See supra note 79.
    \84\ We estimate that each of these advisers would advise, on
average, 2 pooled investment vehicles with 50 investors in each of
the pools.
    \85\ Based on the number of advisers that answered ``yes'' to
Item 9 A. or B. of Part 1A of (having custody) and checked Item 5
D.(6) only (indicating that all their clients are pooled investment
vehicles) as of February 2009 less those advisers that are also
broker-dealers, banks, or futures commission merchants and custody
client assets or have a related person broker-dealer, bank or
futures commission merchant that serves as qualified custodian,
which are accounted for separately in the second group.
    \86\ The number of funds per adviser is estimated based on the
information we collected from Item 5 C. of Form ADV filed by
advisers that provide advisory services only to pooled investment
vehicles (checked only (6) under Item 5 D.) as of February 2009. We
found that 77 percent of these advisers had clients in the range of
1-10. We picked the middle point of the range for our estimate. The
estimate of 250 investors per adviser is based on the calculation we
submitted for the currently approved hour burden.
    \87\ (7,126 x 928 x 0.02) + (372 x 1092 x 0.02) + [(1,281 x 928
x 0.02) + (1,281 x 100 x 0.02) + (1,281 x 2 x 1)] + [(796 x 250 x
0.02) + (796 x 5 x 1)] = 177,242.
---------------------------------------------------------------------------

    Written agreement with accountant. Requiring the agreement with the
independent public accountant that performs the surprise examination to
be in writing and to specify certain duties to be performed by the
accountant should not significantly increase the paperwork burden on
advisers. We believe that written agreements are commonplace and
reflect industry practice when a person retains the services of a
professional such as an accountant, and they are typically prepared by
the accountant in advance. We therefore estimate that each adviser
would spend 0.25 hour to add the required provisions to the written
agreement, with an aggregate of 2,394 hours for all advisers subject to
surprise examinations.\88\ Therefore the total annual burden in
connection with the surprise examination would be 179,636 hours under
the proposed amendments.\89\
---------------------------------------------------------------------------

    \88\ 9,575 x 0.25 = 2,394.
    \89\ 177,242 + 2,394 = 179,636.
---------------------------------------------------------------------------

    Exception for audited pooled investment vehicles. The rule
currently excepts, and the proposed rule would continue to except,
advisers to pooled investment vehicles from having a qualified
custodian send quarterly account statements to the investors in a pool
if it is audited annually by an independent public accountant and the
audited financial statements are distributed to the investors in the
pool. The currently approved annual burden in connection with the
required distribution of audited financial statements is 393,500
hours.\90\ According to data we obtained from the IARD, 2,112 advisers
with custody of client assets provided advice to pooled investment
vehicles as of February 2009.\91\ Of these 2,112 advisers, we estimate
that 796 advisers would each on average provide advice to five pooled

investment vehicles that have a total of 250 investors.\92\ We further
estimate that the remaining advisers, 1,316 advisers, would on average
each provide advice to two pooled investment vehicles that have a total
of 100 investors. The hour burden imposed on the adviser relating to
the mailing of the audited financial statements with respect to each
investor in the pool should be minimal, and could be included with
account statements or other mailings. We overestimated the burden for
this delivery requirement in the past,\93\ and are now revising it to
an estimated 1 minute per investor for mailing audited financial
statements. The aggregate annual hour burden in connection with the
distribution of audited financial statements would therefore be 5,510
hours.\94\
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    \90\ We estimated that 3,148 advisers to pooled investment
vehicles were subject to this information collection under the
current rule. We further estimated that each adviser had, on
average, 250 investors in the funds it advises, and that each
adviser spent 0.5 hours per investor annually for delivering audited
financial statements to its 250 investors. 3,148 x 250 x 0.5 =
393,500.
    \91\ Based on the number of advisers that answered ``yes'' to
Item 9 A. or B. of Part 1A of Form ADV (having custody) and checked
Item 5 D.(6) (indicating that they have clients that are pooled
investment vehicles) as of February 2009.
    \92\ See supra note 90.
    \93\ We previously estimated that an adviser would spend 0.5
hour per investor sending investors audited financial statements.
This estimate incorrectly included time for preparation of the
audited financial statements, which after the audit should have been
readily available to the adviser for distribution.
    \94\ [(796 x 250 x 1 minute) + (1,316 x 100 x 1 minute)]/60 =
5,510 hours.
---------------------------------------------------------------------------

    Under the proposed amendments, the rule would clarify that an
adviser to a pooled investment vehicle that is relying on the annual
audit exception must have the pool audited and distribute the audited
financial statements to the investors in the pool promptly after
completion of the audit if the fund liquidates at a time other than its
fiscal year-end. Based on an assumption that 5 percent of pooled
investment vehicles are liquidated annually at a time other than their
fiscal year-end, this amendment would impose an additional burden of
276 hours per year.\95\ As a result, the total annual hour burden in
connection with the distribution of audited financial statements under
the proposed amendments would be 5,786 hours.\96\ This represents a
decrease of 387,714 hours in our estimated burden.\97\ This decrease in
burden is primarily due to the reduction in the estimated hour burden
regarding the delivery of audited financial statements to each investor
and the reduction of the total number of the advisers subject to the
requirement from an estimated 3,148 to 2,112.\98\
---------------------------------------------------------------------------

    \95\ 5,510 x 0.05 = 276.
    \96\ 5,510 + 276 = 5,786.
    \97\ 393,500 - 5,786 = 387,714.
    \98\ See supra note 90.
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    Notice to clients. Under the proposed amendments, the rule would
also require each adviser to add a statement in its notification to
clients upon opening a custodial account on their behalf, urging them
to compare the account statements from the qualified custodian to those
from the adviser if the adviser sends statements to clients. Although
the statement requirement is new, it would be placed in a notification
that is currently required to be sent to clients at specified times. We
believe that the increase in this collection of information burden, if
any, would be negligible. We estimate that 3,617 advisers would be
subject to this collection of information,\99\ and that each adviser
would on average open a new custodial account for 5% of its clients per
year, either because the adviser has new clients that request that the
adviser open an account on their behalf, or because the adviser selects
a new custodian and moves its existing clients' accounts to that
custodian. We further estimate that the adviser would spend 10 minutes
per client drafting and sending the notice. The total hour burden
relating to this requirement would be 33,156 hours per year.\100\ Based
on the analysis above, we estimate that the total hour collection of
information burden for advisers subject to rule 206(4)-2, as proposed
to be amended, would be 216,184 hours per year.\101\
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    \99\ We assume that advisers have custody solely because of
deducting fees do not typically open custodial accounts on behalf of
their clients. Excluding those advisers we have 3,617 advisers that
may be subject to this information collection (advisers that
answered ``yes'' to Item 9A. or B. of Part 1A. of Form ADV).
    \100\ [3,617 x (1,092 x 0.05) x 10 minutes]/60 = (3,617 x 55
(rounded up from 54.60) x 10 minutes)/60 = 33,156 hours.
    \101\ 177,242 + 5,786 + 33,156 = 216,184.
---------------------------------------------------------------------------

    Annual aggregate cost. The currently approved collection of
information for the custody rule includes an aggregate cost estimate of
$281,000. We estimated that the accounting fees for 11 advisers that
are subject to the surprise examination with respect to 100 percent of
their clients would be $8,000 each annually, on average, and 193
advisers would be subject to the surprise examination with respect to
only to 1 percent of their clients and therefore have accounting fees
of $1,000 annually, on average. Based on the proposed rule changes we
now estimate total annual aggregate costs of $170,557,500. The increase
in estimated aggregated costs is attributable to an increase in the
number of advisers that would be subject to the surprise examination
and the requirement that an adviser obtain, or receive from related
persons, an internal control report with respect to the description of
controls placed in operation relating to custodial services when the
adviser or related person serves as qualified custodian for the
adviser's clients' funds or securities.
    Based on the subcategories of advisers with custody as described
above, we now estimate that all 9,575 advisers that would be subject to
the surprise examination requirement and pay an accounting fee, on
average, of $8,100.\102\ The estimated total accounting fees for all
surprise examinations would therefore be $77,557,500.\103\ This would
represent an increase of $77,276,500 in the cost estimate,\104\
primarily resulting from an increase in the number of advisers that
would be subject to the surprise examination.
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    \102\ We believe that the average accounting fee for advisers
with 85 percent of client accounts subject to the surprise
examination would not be materially different from that for advisers
with 100 percent of client accounts subject to the surprise
examination. We consulted with a few accounting firms before
reaching these estimates, which include the costs of the surprise
examination and any filing and reporting obligations the accountant
has with respect to the surprise examination. The estimates are
consistent with the estimates we made in 2002 and 2003 when last
revising rule 206(4)-2. See the 2002 Proposing Release, at nn.72 and
73, and Section VI.A of the 2003 Adopting Release. The revised
estimate reflects requirements under the proposed rule.
    \103\ $8,100 x 9,575 = $77,557,500.
    \104\ $77,557,500 - $281,000 = $77,276,500.
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    If an adviser or a related person serves as a qualified custodian
for client funds or securities under the proposed rule in connection
with advisory services the adviser provides to clients, the adviser
must obtain, or receive from the related person, no less frequently
than once each calendar year a written internal control report that
provides an opinion from an independent public accountant with respect
to the adviser's or related person's controls relating to custody of
client assets. We are proposing that the independent public accountant
issuing the internal control report be registered with, and subject to
regular inspection by, the PCAOB. We estimate that approximately 372
investment advisers would have to obtain, or receive from a related
person, an internal control report relating to custodial services, and
would have to maintain the report as a required record.\105\ We
anticipate the cost of maintaining these records will be minimal. Based
on discussions with accounting professionals, we understand that the
cost to prepare an internal control report relating to custody would
vary based on the size and services offered by the qualified custodian,
but that on average an internal control report would cost approximately
$250,000 per year,\106\ for

total costs attributable to this element of the proposed rule to be
93,000,000.\107\
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    \105\ See infra note 163 for explanation of our estimate.
    \106\ We consulted accounting firms that issue these reports to
prepare this estimate.
    \107\ $250,000 x 372 = $93,000,000. See infra notes 165-166 and
accompanying text for additional discussion on this estimate.
---------------------------------------------------------------------------

B. Form ADV

    The currently approved collection of information for all advisers
completing and amending Form ADV is 109,678 hours. Based on the
proposed amendments, we estimate an increase to this collection of
information, to 132,599 hours.\108\ The increased burden would result
from the shortening of the amortization period currently in use for the
approved collection of information, increases to our estimates of the
number of advisers and advisory clients, and the proposed amendments to
Part 1A and Schedule D of Form ADV.
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    \108\ This number also includes a burden of 26,753 hours
associated with the requirement of delivering to clients copies of
the adviser's code of ethics upon clients' request. The currently
approved hour burden associated with this requirement is 78,973
hours, based on the estimates that there were 11,787 advisers
subject to this burden (10,787 currently registered advisers + 1,000
new advisers). We estimated that each adviser had 670 clients and
that 10 percent of those clients would request the adviser's code of
ethics. We further estimated that satisfying each delivery request
would impose a burden of 0.10 hour. (10,787 + 1,000) x (670 x 0.10)
x 0.10 = 78,973.
    We now estimate that 12,272 advisers (11,272 currently
registered advisers + 1,000 new advisers) are subject to this burden
and that each adviser has 1,092 clients. See supra note 79 for
calculation of average client number. We further estimate that 10
percent of the clients would request their adviser's code of ethics
and that satisfying each delivery request would impose a burden of
0.02 hour. The total burden under the new estimates would be 26,753
hours. (11,272 currently registered advisers + 1,000 new advisers) x
(1,092 clients x 0.10) x 0.02 hours = 12,272 x 109 x 0.02 = 26,753
hours.
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    We are proposing several amendments to Part 1A of Form ADV that are
designed to provide us with additional details regarding the custody
practices of advisers registered with the Commission, and to provide
additional data to assist in our risk-based examination program. The
proposed amendments would revise Item 7 of Form ADV, under which
advisers report certain financial industry affiliates, to require an
adviser to report all related persons who are broker-dealers and to
identify which, if any, serve as qualified custodians with respect to
the advisers' client assets.\109\ We also propose to amend Item 9 to
require advisers that have custody (or whose related persons have
custody) of client assets to provide additional information about their
custodial practices under proposed rule 206(4)-2. In addition, the
proposed amendments to Schedule D of Form ADV would require an adviser,
depending on the adviser's response to Item 9, to provide additional
details including information about the accountants that perform annual
audits or surprise examinations or that prepare internal control
reports,\110\ whether a report prepared by an independent public
accountant contains an unqualified opinion,\111\ and information about
any related person that serves as a qualified custodian for the
adviser's clients.\112\
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    \109\ Proposed Section 7 A. of Schedule D of Form ADV.
    \110\ Proposed Section 9 C. of Schedule D of Form ADV.
    \111\ Id.
    \112\ Proposed Section 9 D. of Schedule D of Form ADV.
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    Investment advisers should already have the information that we
would require them to report on Form ADV, so the increased collection
of information burden should not be significant. We estimate that these
amendments would increase the average collection of information burden
for the initial application and annual amendment of Form ADV from the
currently approved 22.25 hours per adviser to 22.50 hours per adviser.
We also estimate that there would be 12,272 advisers subject to this
information collection.\113\ The total annual burden for initial filing
and annual amendments would therefore be 276,120.\114\ For the
currently approved hour burden, the Commission staff chose a fifteen-
year amortization, however, for purposes of our proposal, we are
amortizing the estimated burden over a shorter period of time--three
years.\115\ Therefore the annual burden, after amortizing it over the
three year period, would be 92,040 hours or 7.5 hours per adviser.\116\
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    \113\ Based on the information collected from the IARD as of
February 2009, 11,272 advisers were registered with us. In addition,
based on historical data of the IARD, we estimate that there are
approximately 1,000 new applicants for registration with the
Commission each year. 11,272 + 1,000 = 12,272.
    \114\ 22.5 x 12,272 = 276,120.
    \115\ Every three years, we must submit for approval by the OMB
collections of information imposed by our rules and thus the three-
year period reflects the effective period of OMB's approval of this
collection of information.
    \116\ 276,120 / 3 = 92,040; 92,040 / 12,272 = 7.5.
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    In addition to the burden associated with the initial filing and
annual amendments to Form ADV, we estimated for the currently approved
collection of information that, on average, each adviser filing Form
ADV through the IARD system would likely amend its form 1.5 times
during the year.\117\ We estimated that the collection of information
burden for such amendments would be 0.75 hours per amendment. We
believe our proposal would not increase the hour burden per adviser in
connection with such amendments. The total hour burden in connection
with such amendments would therefore be 13,806 hours.\118\ Adding the
annual burden of 26,753 hours associated with the requirement of
delivering to clients the advisers' code of ethics upon clients'
request,\119\ the total annual hour burden for Form ADV under the
proposed amendments would be 132,599 hours.\120\ This represents an
increase of 22,921 hours from the currently approved annual hour
burden, primarily due to the shortening of the amortization period from
15 year to three years, the increase in our estimates of the numbers of
advisers and advisory clients, and the proposed amendments to Part 1A
of Form ADV.\121\
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    \117\ In addition to the required annual update of their Form
ADV, advisers must amend their Form ADV by filing additional
amendments promptly if information they provided in response to
certain items of Form ADV becomes inaccurate in any way. See General
Instructions to Form ADV.
    \118\ 12,272 x 1.5 x 0.75 = 13,806.
    \119\ See supra note 108.
    \120\ 92,040 + 13,806 + 26,753 = 132,599 hours.
    \121\ 132,599 - 109,678 = 22,921 hours.
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C. Form ADV-E

    The currently approved collection of information for Form ADV-E is
12 hours. We estimate that this collection of information would
increase to 575 hours based on the proposed rule amendments. This
increase results primarily from an increase in the estimated number of
advisers that would be subject to the requirement of completing Form
ADV-E under the proposed amendments to rule 206(4)-2 and the additional
collections of information proposed by the amendments to the rule.
    For the currently approved annual hour burden for Form ADV-E, we
estimated that there would be 231 advisers subject to the annual
surprise examination requirement, including the requirement to complete
Form ADV-E, and that each of the advisers would spend approximately
0.05 hour to complete Form ADV-E.\122\ We now estimate that there would
be 9,575 advisers required to undergo an annual surprise examination
and complete Form ADV-E, and that the total annual hour burden for Form
ADV-E in connection with the surprise examination requirement would
thus be increased to 479 hours.\123\
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    \122\ 231 x 0.05 = 11.55 hours.
    \123\ 9,575 x 0.05 = 479.
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    In addition, under the proposed amendments, rule 206(4)-2 would
require an adviser subject to the surprise examination to enter into a
written agreement with the independent public accountant that specifies
the

accountant's duties, including filing Form ADV-E upon the termination
of its engagement. Based on an assumption that advisers change their
independent public accountants every five years on average, 1,915
advisers would, under our proposal, be required each year to complete
Form ADV-E with respect to an accountant's termination.\124\ The total
annual hour burden in connection with this proposal would be 96
hours,\125\ and the total annual hour burden for advisers to complete
Form ADV-E in connection with the surprise examination and the
termination statement would be 575 hours.\126\
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    \124\ 9,57 5/5 = 1,915.
    \125\ 1,915 x 0.05 = 96.
    \126\ 479 + 96 = 575.
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D. Request for Comment

    We request comment whether these estimates are reasonable. Pursuant
to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments to:
     Evaluate whether the proposed collections of information
are necessary for the proper performance of the functions of the
Commission, including whether the information will have practical
utility;
     Evaluate the accuracy of the Commission's estimate of the
burden of the proposed collections of information;
     Determine whether there are ways to enhance the quality,
utility, and clarity of the information to be collected; and
     Determine whether there are ways to minimize the burden of
the collections of information on those who are to respond, including
through the use of automated collection techniques or other forms of
information technology.
    Persons wishing to submit comments on the collection of information
requirements should direct them to the Office of Management and Budget,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Room 3208, Washington, DC
20503, and also should send a copy to Elizabeth M. Murphy, Secretary,
Securities and Exchange Commission, 100 F Street, NE., Washington, DC
20549-1090 with reference to File No. S7-09-09. OMB is required to make
a decision concerning the collections of information between 30 and 60
days after publication, so a comment to OMB is best assured of having
its full effect if OMB receives the comment within 30 days after
publication of this release. Requests for materials submitted to OMB by
the Commission with regard to these collections of information should
be in writing, refer to File No. S7-09-09, and be submitted to the
Securities and Exchange Commission, Office of Investor Education and
Advocacy, 100 F Street, NE., Washington, DC 20549-0213.

V. Cost-Benefit Analysis

A. Background

    The Commission is sensitive to the costs and benefits resulting
from its rules. Rule 206(4)-2, the custody rule, seeks to protect
clients' funds and securities in the custody of registered advisers
from misuse or misappropriation by requiring advisers to maintain their
clients' assets with a qualified custodian, such as a broker-dealer or
a bank.\127\ Advisers may comply with the current custody rule by
either having the qualified custodian send account statements directly
to their clients at least quarterly or by sending their own quarterly
account statements to their clients and undergoing an annual surprise
examination.\128\
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    \127\ Under rule 206(4)-2(c)(3), a qualified custodian means a
bank, a savings association, a registered broker-dealer, a
registered futures commission merchant, and in certain instances a
foreign custodial institution.
    \128\ Rule 206(4)-2(a)(3)(i) and (ii). In the case of a pooled
investment vehicle, the account statements and surprise examination
requirements can be satisfied if the pooled investment vehicle is
audited at least annually and distributes its audited financial
statements to the investors in the pool within 120 days of the end
of the pool's fiscal year. Rule 206(4)-2(a)(3)(iii) and (b)(3).
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    The rule, as proposed to be amended, would retain the requirement
that advisers maintain clients' assets with a qualified custodian, but
would require all registered advisers that have custody of client
assets to have a reasonable belief after due inquiry that the qualified
custodian sends an account statement directly to each client or its
representative for which the qualified custodian maintains assets.\129\
The proposed rule would also require all advisers that have custody of
client assets to undergo an annual surprise examination.\130\ In
addition, we propose to amend the rule to provide that an adviser has
custody if any of its related persons has custody of the adviser's
client assets in connection with the adviser's advisory services.\131\
In situations where an adviser or a related person serves as a
qualified custodian for client funds or securities under the proposed
rule in connection with advisory services the adviser provides to
clients, the adviser must obtain, or receive from the related person,
no less frequently than once each calendar year a written internal
control report that provides an opinion from an independent public
accountant with respect to the adviser's or related person's controls
relating to custody of client assets.\132\ We are proposing that the
independent public accountant issuing the internal control report be
registered with, and subject to regular inspection by, the PCAOB.\133\
We also are proposing to require that when an adviser or a related
person serves as a qualified custodian for the adviser's clients' funds
or securities, the surprise examination would have to be performed by
an independent public accountant registered with, and subject to
regular inspection by, the PCAOB.\134\
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    \129\ Proposed rule 206(4)-2(a)(3). We would retain the
exemption from the account statement delivery requirement, described
above in supra note 128 for an adviser to a pooled investment
vehicle.
    \130\ Proposed rule 206(4)-2(a)(4).
    \131\ Proposed rule 206(4)-2(c)(2). Currently, an adviser may,
depending on the circumstances, be deemed to have custody of client
assets held by an affiliate. See supra note 76 and accompanying
text.
    \132\ Proposed rule 206(4)-2(a)(6)(ii).
    \133\ Proposed rule 206(4)-2(a)(6)(ii)(B).
    \134\ Proposed Rule 206(4)-2(a)(6)(i).
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    These proposed amendments are designed to improve the safekeeping
of advisory client assets. We have identified, below, certain costs and
benefits that may result from the proposed rule amendments. We request
comment on the costs and benefits of the proposed rule amendments, and
encourage commenters to identify, discuss, analyze, and supply relevant
data regarding these or any additional costs and benefits.

B. Benefits

    Improved protection for advisory clients. We have designed the
proposed amended rule to provide greater protection for advisory
clients' assets. The potential benefits to investors, however, are
difficult to quantify. The proposed rule would require all registered
advisers with custody of client assets to undergo an annual surprise
examination by an independent public accountant that would provide
``another set of eyes'' on client assets, and thus additional
protection against their misuse. In addition, the independent public
accountant may identify mishandling of client assets, which may result
in the earlier detection of fraudulent activities and reduce resulting
client losses. We estimate that the rule, if amended to make this
change, would require 9,575 advisers to obtain an annual surprise
examination with respect to 8,214,462 clients' accounts.\135\
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    \135\ For purposes of Paperwork Reduction Act analysis, we
estimate that there would be 9,575 advisers subject to the surprise
examination with respect to 8,214,462 advisory clients' accounts:
(i) 928 clients for each of the 7,126 advisers that would have non-
pool clients only, (ii) 1,092 clients for each of the 372 advisers
that are themselves qualified custodians, (iii) 930 clients (928
individual clients and 2 fund clients) for each of the 1,281
advisers that provide advice to both individual clients and pooled
investment vehicles; and (iv) 5 fund clients for each of the 796
advisers that provide advice to pooled investment vehicles only. See
supra notes 77-86 and accompanying text.

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    These benefits would also extend to investors in pooled investment
vehicles managed by a registered adviser, because the amended rule
would require the adviser to obtain an annual surprise examination with
respect to those assets. The annual surprise examination would be in
addition to any annual audit of the pool (required if the qualified
custodian is not sending account statements directly to investors),
which is performed at the end of each fiscal year. The surprise
examination requirement therefore would provide an additional deterrent
to fraudulent activity by advisers that are relying on the audit
exception. Based on IARD data, we estimate that 327,100 investors would