[Federal Register: January 11, 2010 (Volume 75, Number 6)]
[Rules and Regulations]
[Page 1455-1492]
[DOCID:fr11ja10-11]

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Part II

Securities and Exchange Commission

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17 CFR Parts 275, 276 and 279

Custody of Funds or Securities of Clients by Investment Advisers;
Commission Guidance Regarding Independent Public Accountant Engagements
Performed Pursuant to Rule 206(4)-2 Under the Investment Advisers Act
of 1940; Final Rules

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 275 and 279

[Release No. IA-2968; File No. S7-09-09]
RIN 3235-AK32

Custody of Funds or Securities of Clients by Investment Advisers

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission is adopting amendments
to the custody and recordkeeping rules under the Investment Advisers
Act of 1940 and related forms. The amendments are designed to provide
additional safeguards under the Advisers Act when a registered adviser
has custody of client funds or securities by requiring such an adviser,
among other things: To undergo an annual surprise examination by an
independent public accountant to verify client assets; to have the
qualified custodian maintaining client funds and securities send
account statements directly to the advisory clients; and unless client
assets are maintained by an independent custodian (i.e., a custodian
that is not the adviser itself or a related person), to obtain, or
receive from a related person, a report of the internal controls
relating to the custody of those assets from an independent public
accountant that is registered with and subject to regular inspection by
the Public Company Accounting Oversight Board. Finally, the amended
custody rule and forms will provide the Commission and the public with
better information about the custodial practices of registered
investment advisers.

DATES: Effective Date: March 12, 2010. Compliance Dates: An investment
adviser required to obtain a surprise examination must enter into a
written agreement with an independent public accountant that provides
that the first examination will take place by December 31, 2010. An
investment adviser also required to obtain or receive an internal
control report because it or a related person maintains client assets
as a qualified custodian must obtain or receive an internal control
report within six months of the effective date. Section III of this
Release contains additional information on the effective and compliance
dates.

FOR FURTHER INFORMATION CONTACT: Vivien Liu, Senior Counsel, Melissa A.
Roverts, Senior Counsel, Daniel S. Kahl, Branch Chief, or Sarah A.
Bessin, Assistant Director, at<PHONE_NUMBER> 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 adopting amendments to rule 204-2 [17 CFR 275.204-
2], rule 206(4)-2 [17 CFR 275.206(4)-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. Effective and Compliance Dates
IV. Paperwork Reduction Act
V. Cost-Benefit Analysis
VI. Final Regulatory Flexibility Analysis
VII. Effects on Competition, Efficiency and Capital Formation
VIII. Statutory Authority
Text of Rule and Form Amendments

I. Background

    Earlier this year we began a comprehensive review of our rules
regarding the safekeeping of investor assets in connection with our
bringing several fraud cases involving investment advisers and broker-
dealers.\1\ As part of this effort, we proposed amendments to rule
206(4)-2, the rule under the Advisers Act that governs an adviser's
custody of client funds and securities (``client assets'').\2\ Our
staff is currently reviewing potential recommendations to enhance the
oversight of broker-dealer custody of customer assets. Thus today's
adoption represents a first step in the effort to enhance custody
protections, with consideration of additional enhancements of the rules
governing custody of customer assets by broker-dealers to follow.
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    \1\ Since the beginning of this year, the Commission has brought
several enforcement actions against investment advisers and broker-
dealers alleging fraudulent conduct, including misappropriation or
other misuse of investor assets. See cases cited in footnote 11 of
Custody of Funds or Securities of Clients by Investment Advisers,
Investment Advisers Act Release No. 2876 (May 20, 2009) [74 FR 25354
(May 27, 2009)] (the ``Proposing Release''). In addition to these
actions, we have brought several others more recently alleging
similar types of misconduct. See, e.g., In re Stratum Wealth
Management, LLC and Charles B. Ganz, Advisers Act Release No. 2930
(Sept. 29, 2009) (settled action in which Commission alleged a
registered investment adviser, through its sole owner and chairman,
misappropriated over $400,000 from a client account during the
course of nearly a year to pay for his personal expenses and
falsified client account statements, among other things); SEC v.
Titan Wealth Management, LLC, et al., Litigation Release No. 21184
(Aug. 26, 2009) (complaint alleges a registered investment adviser
misappropriated 80% of investor funds for personal use, to make
Ponzi payments to certain investors or transfers to others); In the
Matter of Paul W. Oliver, Jr., Advisers Act Release No. 2903 (Jul.
17, 2009) (settled action in which Commission alleged a registered
investment adviser's chairman aided and abetted misappropriations of
more than $23 million in client funds by the investment adviser's
co-founder and president); SEC v. Weitzman, Litigation Release No.
21078 (June 10, 2009) (settled action in which Commission's
complaint alleged registered investment adviser's co-founder and
principal stole more than $6 million in investor funds for his own
personal use and falsified client account statements). See also SEC
v. Frederick J. Barton, Barton Asset Management, LLC, and TwinSpan
Capital Management, LLC, Litigation Release No. 21016 (Apr. 29,
2009) (default judgment entered against registered investment
adviser and its direct and indirect majority owner for diverting
approximately $493,100 of offering proceeds for personal use and for
misappropriating $685,000 from one advisory client and $970,000 from
another); SEC v. Crossroads Financial Planning, Inc., et al.,
Litigation Release No. 20996 (Apr. 10, 2009) (complaint alleges
registered investment adviser, through its president, chief
operating officer and principal owner, misappropriated at least $2.3
million of client assets).
    \2\ We use the term ``client assets'' solely for ease of
reference in this Release; it does not modify the scope of client
funds or securities subject to the rule.
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    The amendments we proposed earlier this year to rule 206(4)-2 were
designed to strengthen the existing custodial controls imposed by the
rule. Under rule 206(4)-2, advisers, in most cases, must maintain
client funds and securities with a ``qualified custodian.'' \3\
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.\4\ These institutions'
custodial activities are subject to regulation and oversight.\5\ In
addition, advisers must have a reasonable belief that the qualified
custodian sends account statements directly to advisory clients.\6\ The
rule also permits advisers (rather than custodians) to send account
statements if the adviser is subject to an annual surprise verification
of client assets by an independent public accountant.\7\
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    \3\ Rule 206(4)-2(a)(1).
    \4\ Rule 206(4)-2(c)(3).
    \5\ See Proposing Release, at note 4.
    \6\ Rule 206(4)-2(a)(3)(i).
    \7\ Rule 206(4)-2(a)(3)(ii).
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    The proposed amendments were designed to eliminate certain
exemptions in the rule, thus expanding the protections afforded
advisory clients by requiring all registered advisers with custody of
client assets to be subject to an annual surprise examination,\8\ and
requiring that they have a reasonable belief that qualified custodians
send account statements directly to the

clients.\9\ When the adviser or its related person serves as qualified
custodian for client assets, the proposed amendments would require that
the adviser undergo an annual surprise examination and obtain, or
receive from the related person, an internal control report with
respect to custody controls, both of which must be performed or
prepared by an independent public accountant that is registered with,
and subject to regular inspection by, the Public Company Accounting
Oversight Board (``PCAOB'').\10\ Amendments to Form ADV would require
advisers to report current information to us about these custodial
arrangements.
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    \8\ Proposed rule 206(4)-2(a)(4).
    \9\ Proposed rule 206(4)-2(a)(3). The proposed amendments,
however, would not eliminate an exception to the direct delivery
requirement currently available to advisers to pooled investment
vehicles that are subject to an annual audit and distribute the
audited financial statements to investors in the pool. See proposed
rule 206(4)-2(b)(3).
    \10\ Proposed rule 206(4)-2(a)(6)(ii)(B).
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    We received more than 1,300 comment letters on the proposed
amendments. Most were from investment advisers, broker-dealers, banks,
and their trade associations that would be affected by the amended rule
and which objected to significant parts of our rulemaking
initiative.\11\ Commenters generally expressed their support for our
goal of strengthening protections provided to advisory clients under
the custody rule. Most urged us to make changes to our proposal
particularly as it applies to advisers that have custody solely because
of their authority to deduct advisory fees from client accounts. Many
suggested that we update our guidance on the elements of the annual
surprise examination performed by an independent public accountant.\12\
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    \11\ Other commenters included accountants, law firms,
consultants, and investors. Of the 1,300 letters, approximately
1,100 were form letters or substantially similar letters submitted
by smaller advisory firms.
    \12\ The comment letters are available for public inspection and
photocopying in the Commission's Public Reference Room, 100 F
Street, NE., Washington, DC (File No. S7-09-09). They are also
available on our Web site at http://www.sec.gov/comments/s7-09-09/
s70909.shtml.
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II. Discussion

    We are today adopting amendments to rule 206(4)-2 to strengthen
controls over the custody of client assets by registered investment
advisers and to encourage the use of independent custodians. We are
also adopting related amendments to rule 204-2, Form ADV, and Form ADV-
E that will improve our ability to oversee advisers' custody practices.
In response to comments, we made several modifications from the
proposal. In addition, we are today publishing a companion release to
provide guidance for accountants with respect to the surprise
examination and internal control report required under rule 206(4)-2.
    We believe these amendments, together with the guidance for
accountants, will provide for a more robust set of controls over client
assets designed to prevent those assets from being lost, misused,
misappropriated or subject to advisers' financial reverses. We
acknowledge that no set of regulatory requirements we could adopt will
prevent all fraudulent activities by advisers or custodians. We
believe, however, that this rule, together with our examination
program's increased focus on the safekeeping of client assets, will
help deter fraudulent conduct, and increase the likelihood that
fraudulent conduct will be detected earlier so that client losses will
be minimized.

A. Delivery of Account Statements and Notice to Client

    As discussed above, rule 206(4)-2 currently requires advisers that
have custody, with certain limited exceptions, to maintain client funds
or securities with a ``qualified custodian,'' which the adviser must
have a reasonable basis for believing sends an account statement, at
least quarterly, to each client for which the qualified custodian
maintains funds or securities.\13\ The requirement is designed so that
advisory clients will receive a statement from the qualified custodian
that they can compare with any statements (or other information) they
receive from their adviser to determine whether account transactions,
including deductions to pay advisory fees, are proper.\14\
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    \13\ Rule 206(4)-2(a)(1). If the adviser is a general partner of
a limited partnership or holds a similar position with another type
of pooled investment vehicle, the account statement must be provided
to the limited partners or other investors in the pooled investment
vehicle. Rule 206(4)-2(a)(3)(iii). For convenience, we will presume
in this Release that all advisers to pooled investment vehicles hold
such a position.
    \14\ Rule 206(4)-2(a)(3)(i). The rule provides an exception to
this requirement for an adviser to a pooled investment vehicle if
the pooled investment vehicle is audited annually by an independent
public accountant and distributes the audited financial statements
to the investors in the pool. See rule 206(4)-2(b)(3).
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    We are adopting, as proposed, an amendment to the rule that
eliminates an alternative to the requirement under which an adviser can
send quarterly account statements to clients if it undergoes a surprise
examination by an independent public accountant at least annually. We
believe that direct delivery of account statements by qualified
custodians will provide greater assurance of the integrity of account
statements received by clients.
    Most commenters that addressed this aspect of our proposal
supported it as reflective of best practices followed by most
advisers.\15\ A few commenters objected to the proposal, suggesting
that a client's desire for privacy may override the Commission's goal
of investor protection.\16\ In light of recent frauds, we believe
generally that the protections provided by direct delivery of account
statements by custodians are of substantially greater value than the
privacy and confidentiality concerns that led us to permit this
alternative.\17\ Privacy concerns can be addressed through custodial
contracts, or other agreements that restrict the custodian's use of
confidential information, as one commenter suggested.\18\
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    \15\ Comment letter of Compliance Solution Group (July 24, 2009)
(``CAS Letter''); comment letter of CFA Institute Centre for
Financial Market Integrity (Dec. 11, 2009) (``CFA Institute
Letter''); comment letter from The Cornell Securities Law Clinic
(July 28, 2009) (``Cornell Letter''); comment letter from E*Trade
Financial Corp. (July 28, 2009) (``E*Trade Letter''); comment letter
from Investment Adviser Association (July 24, 2009) (``IAA
Letter''); comment letter from North American Securities
Administrators Association, Inc. (Aug. 5, 2009) (``NASAA Letter'');
comment letter from National Regulatory Services (July 28, 2009)
(``NRS Letter''); comment letter from Timothy P. Turner (July 27,
2009) (``Turner Letter'').
    \16\ Comment letter from American Bar Association (Committee on
Federal Regulation of Securities) (July 28, 2009) (``ABA Letter'');
NRS Letter; comment letter from The Private Equity Council (July 28,
2009) (``PEC Letter'').
    \17\ See 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''), at Section
II.C. 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.
    \18\ See IAA Letter. In support of its assertion that a client's
desire for privacy could override the Commission's goal of investor
protection, the ABA argued that contractual or other alternative
means of protecting confidentiality would be insufficient and
potentially very costly, although they did not provide support for
these assertions. We note, in addition to contractual protections,
other privacy protections are relevant in this context. As discussed
in the Proposing Release at n.60, a U.S. qualified custodian would,
with respect to individual clients who obtain custodial services for
their personal, family or household purposes, 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).
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    As proposed, the amended rule requires that an adviser's reasonable
belief that the qualified custodian sends account statements directly
to clients

must be formed by the adviser after ``due inquiry.'' \19\ We are not
prescribing a single method for forming this belief, as was suggested
by one commenter,\20\ but rather are providing advisers with
flexibility to determine how best to meet this requirement. For
instance, an adviser could form a reasonable belief after ``due
inquiry'' if the qualified custodian provides the adviser with a copy
of the account statement that was delivered to the client.\21\
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    \19\ Amended rule 206(4)-2(a)(3).
    \20\ Comment letter of Fifth Third Asset Management, Inc. (July
28, 2009) (``FTAM Letter'').
    \21\ This practice is followed by many advisers today.
Commenters suggested that we permit advisers to satisfy the
requirement of forming a reasonable belief after ``due inquiry'' by
accessing qualified custodian account statements through the
custodian's Web site. See comment letter from Curian Capital LLC,
Financial Wealth Management, Inc, LPL Financial Corporation, and SEI
Investments Company (July 28, 2009) (``Curian Letter''). We believe
that accessing account statements through the Web site merely
confirms that they are available. If an adviser does not take
additional steps to determine whether account statements were sent
to clients, or that clients obtained statements through the Web
site, the adviser would have an inadequate basis for forming a
reasonable belief, after due inquiry, that the qualified custodian
sends account statements to clients.
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    Rule 206(4)-2 requires investment advisers to notify their clients
promptly upon opening a custodial account on their behalf and when
there are changes to the information required in that notification.\22\
We are amending the rule, as proposed, to require advisers to include a
legend in the notice urging clients to compare the account statements
they receive from the custodian with those they receive from the
adviser.\23\ Several commenters asserted that advisers may not (and are
not required by rule 206(4)-2 to) send statements separate from the
ones the custodian delivers and thus the proposed disclosure could
confuse clients.\24\ We agree and have, therefore, modified this notice
requirement so that the cautionary legend must be included only if the
adviser elects to send its own account statements to clients.\25\
Finally, we had requested comment on whether to require advisers who
choose to send statements to also include in those statements the
cautionary legend urging clients to compare the information the adviser
sends to clients with the information reflected in the qualified
custodian's account statements.\26\ We believe providing regular notice
will serve to more effectively remind clients to take steps to protect
their assets. Accordingly, we are amending the rule to require those
investment advisers, in any subsequent statements they deliver to
clients after the initial notice, to urge clients to compare the
adviser's statements with the account statements they receive from the
custodian.\27\
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    \22\ Rule 206(4)-2(a)(2).
    \23\ Proposed rule 206(4)-2(a)(2). One commenter suggested not
only requiring the legend in the initial notice, as proposed, but
also adding a requirement to include the legend as an annual
reminder in the annual Form ADV delivery offer or in the annual
privacy statement. See comment letter of The National Association of
Personal Financial Advisors (July 21, 2009) (``NAPFA Letter''). We
would not discourage advisers from adopting such a practice. As
described above, we are adopting a regular notice requirement today
for advisers.
    \24\ CAS Letter; comment letter from Dechert LLP (July 28, 2009)
(``Dechert Letter''); IAA Letter; comment letter from MarketCounsel,
LLC (July 28,2009) (``MarketCounsel Letter''); NRS Letter.
    \25\ Amended rule 206(4)-2(a)(2).
    \26\ See Proposing Release, at Section II.C. We did not receive
comment on this particular approach.
    \27\ Amended rule 206(4)-2(a)(2).
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B. Annual Surprise Examination of Client Assets

    The Commission is adopting the proposed amendment to rule 206(4)-2
to require registered advisers with custody of client assets to undergo
a surprise examination (or an audit, if applicable) of those assets by
an independent public accountant, except as discussed below.\28\ We are
also adopting several amendments to the custody rule and related forms
that will strengthen the utility of the surprise examination as a means
of deterring misuse of client assets and will improve our ability to
identify potential misuse of those assets. We are revising the guidance
we provide to accountants that are engaged to perform these
examinations in order to modernize the surprise examination and make it
more effective. We believe these changes, discussed below, will improve
protection of client assets.
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    \28\ Amended rule 206(4)-2(a)(4).
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1. Applicability of Surprise Examination
    We proposed to require that all advisers with custody obtain a
surprise examination of client assets by an independent public
accountant in order to provide ``another set of eyes'' on client
assets, and thus an additional set of protections against their
misappropriation. Because advisers with custody often have authority to
access, obtain and, potentially, misuse client funds or securities, we
believed the additional review provided by an independent public
accountant would help identify problems that clients may not, and thus
would provide deterrence against fraudulent conduct by advisers.\29\
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    \29\ Some commenters agreed and expressed support of this
proposal. See comment letter of Ascendant Compliance Management
(July 27, 2009) (expressing support with respect to advisers that
are registered as broker-dealers (``dual registrants'')); CFA
Institute Letter; comment letter of CLS Investments, LLC (July 28,
2009) (``CLS Letter'') (expressing support with respect to dual
registrants); comment letter of The Consortium (July 18, 2009)
(``Consortium Letter'') (supporting the requirement other than for
advisers who have custody solely because of their authority to
deduct advisory fees from client accounts); comment letter of First
Manhattan Co. (July 28, 2009) (``FMC Letter'') (expressing support
with respect to dual registrants); NASAA Letter.
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    Many commenters opposed the surprise examination requirement,
arguing that it would provide little additional protection to client
assets when assets are held with an independent qualified custodian
that sends account statements directly to clients.\30\ Almost all
advisers that commented raised concerns about the high costs of the
surprise examination and many asserted that the costs could drive
smaller advisers that typically have custody only because of authority
to deduct advisory fees out of business,\31\ or, with respect to
advisers that serve in capacities such as trustee on a limited basis,
would cause them to cease providing such services to their clients.\32\
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    \30\ See, e.g., ABA Letter; comment letter of Advisor Solution
Group (July 28, 2009) (``ASG Letter''); comment letter of Davis Polk
& Wardwell LLP (July 28, 2009) (``Davis Polk Letter''); comment
letter of Grandfield & Dodd, LLC (July 28, 2009) (``G&D Letter'');
Form Letter F; comment letter of Financial Planning Association
(July 28, 2009) (``FPA Letter''); IAA Letter; comment letter of
Jackson, Grant Investment Advisers, Inc. (July 28, 2009) (``Jackson
Letter''); MarketCounsel Letter; NRS Letter; comment letter of
Pickard and Djinis LLP (July 28, 2009) (``Pickard Letter''); comment
letter of SIFMA Asset Management Group (July 28, 2009) (``SIFMA(AMG)
Letter'').
    \31\ See, e.g., comment letter of TD Ameritrade, Inc. (July 24,
2009) (``Ameritrade Letter''); CAS Letter; Cornell Letter; comment
letter of Ronald P. Denk (July 3, 2009) (``Denk Letter''); comment
letter of Janet Elder (July 1, 2009); Form Letter D; comment letter
of Financial Services Institute (July 28, 2009) (``FSI Letter'');
G&D Letter; comment letter of Thomas Hamilton (July 23, 2009); IAA
letter; comment letter of The International Association of Small
Broker Dealers and Advisors (May 27, 2009) (``IASBDA Letter'');
comment letter of Carol K. Lampe (July 1, 2009); comment letter of
Walter Marbert (July 1, 2009); comment letter of Scott A. McCord
(July 1, 2009); NAPFA Letter; comment letter of Don Slabaugh (July
1, 2009); comment letter of Jeff Toadvine (July 1, 2009); comment
letter of Anthony W. Welch (July 1, 2009).
    \32\ See infra note 38.
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    The focus of most commenters, however, was not on the utility of
the surprise examination, but whether the proposed requirement should
apply to certain advisers and advisory accounts, which we address
below.\33\ Some urged

that if we expand the surprise examination requirement, we should
update our guidance to accountants on examination methodology, which
dates back to 1966 and requires verification of all client assets, a
potentially expensive procedure not required in most audits.\34\
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    \33\ Most commenters urged us to except advisers that have
custody solely because of deducting advisory fees from the surprise
examination requirement. See, e.g., ASG Letter; comment letter of
Certified Financial Planner Board of Standards, Inc. (July 28, 2009)
(``CFP Board Letter''); comment letter of Center for Capital Markets
Competitiveness, Chamber of Commerce (July 28, 2009) (``Chamber of
Commerce Letter''); Curian Letter; Dechert Letter; E*Trade Letter;
comment letter of GE Asset Management (July 24, 2009) (``GE Asset
Letter''); G&D Letter; Form Letters B, F, and G; FPA Letter; IAA
Letter; Jackson Letter; comment letter of The Money Management
Institute (July 28, 2009) (``MMI Letter''); NRS Letter; SIFMA(AMG)
Letter; comment letter of SIFMA Private Client Legal Committee (July
28, 2009) (``SIFMA(PCLC) Letter''); comment letter of Warshaw
Burstein Cohen Schlesinger & Kuh, LLP (July 24, 2009) (``Warshaw
Letter'').
    \34\ Comment letter of The American Institute of Certified
Public Accountants (July 28, 2009) (``AICPA Letter); comment letter
of Center for Audit Quality (July 28, 2009) (``CAQ Letter'');
Chamber of Commerce Letter; comment letter of Cohen Fund Audit
Services, Ltd. (July 21, 2009) (``Cohen Letter''); Curian Letter;
comment letter of Deloitte & Touche LLP (July 28, 2009) (``Deloitte
Letter''); comment letter of Ernst & Young (July 28, 2009) (``E&Y
Letter''); FPA Letter; FTAM Letter; comment letter of KPMG LLP (July
28, 2009) (``KPMG Letter''); comment letter of Managed Fund
Association (July 28, 2009) (``MFA Letter''); MMI Letter; comment
letter of McGladrey & Pullen LLP (July 28, 2009) (``M&P Letter'');
comment letter of PricewaterhouseCoopers LLP (July 28, 2009) (``PWC
Letter''); comment letter of Charles Schwab (July 28, 2009)
(``Schwab Letter''); SIFMA(AMG) Letter; SIFMA(PCLC) Letter.
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    We believe the surprise examination requirement will deter
fraudulent conduct by investment advisers, and that it provides
important protections to advisory clients, even when their assets are
maintained by an independent qualified custodian.\35\ If fraud does
occur, a surprise examination will increase the likelihood that it is
uncovered and thus reduce client losses.\36\ Therefore, we are
requiring advisers with custody of client assets to obtain a surprise
examination (or an audit, if applicable in the case of a pooled
investment vehicle) of client assets by an independent public
accountant, other than as discussed below.\37\
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    \35\ We have recently brought enforcement cases in which we
alleged advisers misappropriated client assets that were maintained
by an independent qualified custodian. See In re Stratum Wealth
Management, LLC and Charles B. Ganz, Advisers Act Release No. 2930
(Sept. 29, 2009); In the Matter of Paul W. Oliver, Jr., Advisers Act
Release No. 2903 (Jul. 17, 2009); SEC v. Weitzman, Litigation
Release No. 21078 (June 10, 2009); SEC v. Crossroads Financial
Planning, Inc., et al., Litigation Release No. 20996 (Apr. 10,
2009).
    \36\ Under the amended rule, the independent public accountant
conducting a surprise examination will verify client funds and
securities of which an adviser has custody, including those
maintained with a qualified custodian and those that are not
required to be maintained with a qualified custodian, such as
certain privately offered securities and mutual fund shares.
    \37\ Amended rule 206(4)-2(a)(4). An investment adviser required
to obtain a surprise examination must enter into a written agreement
with an independent public accountant that provides that the first
examination will take place by December 31, 2010 or, for advisers
that become subject to the rule after the effective date, within six
months of becoming subject to the requirement. If the adviser itself
maintains client assets as qualified custodian, however, the
agreement must provide for the first surprise examination to occur
no later than six months after obtaining the internal control
report. See infra Section III.B.1.
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    We acknowledge the concerns raised by commenters with respect to
the impact of the surprise examination requirement on smaller advisers
whose client assets are maintained by an independent qualified
custodian. For this reason, we have directed our staff to evaluate the
impact of the surprise examination requirement on smaller advisers that
have the authority to obtain possession of client funds or securities
and whose client assets are maintained by an independent qualified
custodian. We have also asked the staff to evaluate the impact of the
surprise exam on these advisers' clients. Following the completion of
the first round of surprise examinations of these advisers under the
requirements of the amended rule, our staff will conduct a review and
provide the Commission with the results of this review, along with any
recommendations for amendments necessary to improve the effectiveness
of the rule as it applies to these advisers, or address unnecessary
burdens on them.
a. Advisers With Limited Custody Due to Fee Deduction
    Commenters have persuaded us that the surprise examination will not
provide materially greater protection to advisory clients when the
adviser has custody of client assets solely because of its authority to
deduct advisory fees from client accounts.\38\ The principal risk
associated with this limited form of custody is that a fee will be
deducted to which the adviser is not entitled under the advisory
contract. The amended rule addresses this risk by enabling the client
to monitor the amount of advisory fees deducted by reviewing the
account statement which, as discussed above, must be sent directly to
the client by the qualified custodian.\39\ Further, as several
commenters noted the surprise examination may not be an effective tool
to identify inappropriate fee deductions as it requires the accountant
to verify client assets, not determine the accuracy of fees paid.\40\
On balance, we believe that the magnitude of the risks of client losses
from overcharging advisory fees does not warrant the costs of a
obtaining a surprise examination. However, we do believe that
appropriate controls should be in place regarding fee deduction, as
discussed below.\41\
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    \38\ Amended rule 206(4)-2(b)(3). This exception would also be
available to such an adviser when the adviser can rely on amended
rule 206(4)-2(b)(6). See infra Section II.C.2. of this Release. The
exception would not be available, however, to an adviser that has
custody under the rule for other reasons. Several commenters opposed
applying the surprise examination requirement to advisers that serve
as trustees for their clients. See comment letter of Allegheny
Investments (July 28, 2009); Consortium Letter; G&D Letter; IAA
Letter; NRS Letter; comment letter of Bruce Siegel (July 28, 2009).
Some explained that most advisers that serve as trustees do so as a
convenience to existing clients and either do not charge a separate
fee or charge only a minimal fee for this service, and that
requiring surprise examinations for these advisers will discourage
advisers from serving as trustees and result in clients paying
higher fees for this service. An adviser acting as trustee typically
has significant authority over the assets in the trust, which would
likely include the ability to access and, potentially, misuse those
assets. We believe that the broad access that trustees typically
have to trust assets makes the protections of the surprise
examination important for these advisory clients to protect against
potential abuse.
    \39\ Many commenters expressed similar views in their letters.
See ASG Letter; CFP Board Letter; Dechert Letter; E*Trade Letter;
FMC Letter; GE Asset Letter; G&D Letter; Form Letters B, F, and G;
IAA Letter; Jackson Letter; MMI Letter; NRS Letter; SIFMA(AMG)
Letter; SIFMA(PCLC) Letter; Warshaw Letter.
    \40\ ABA Letter; Dechert Letter; FMC Letter; IAA Letter; MMI
Letter; Pickard Letter; comment letter of Seward & Kissel LLP (July
29, 2009) (``S&K Letter'').
    \41\ See infra notes 140 and 141 and accompanying text.
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b. Pooled Investment Vehicle Audit
    We proposed to require all registered investment advisers with
custody of client assets to obtain an annual surprise examination,
which included pooled investment vehicles subject to an annual
financial statement audit. Several commenters asserted that a surprise
examination would be duplicative of the annual financial statement
audit and would not materially benefit investors.\42\
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    \42\ See comment letter of Adams Street Partners, LLC (July 28,
2009) (``Adams Street Letter''); Davis Polk Letter; Deloitte Letter;
IAA Letter; MFA Letter; comment letter of The Bank of New York
Mellon (July 28, 2009) (``Mellon Letter''); comment letter of
National Society of Compliance Professionals, Inc. (July 28, 2009)
(``NSCP Letter''); comment letter of National Venture Capital
Association (July 28, 2009) (``NVCA Letter''); PEC Letter;
SIFMA(AMG) Letter; S&K Letter; Warshaw Letter.
---------------------------------------------------------------------------

    During the course of a financial statement audit, the accountant
performs procedures comparable to those performed as part of a surprise
examination, including verifying the existence of the pooled investment
vehicle's funds and securities and obtaining confirmation from
investors.\43\ The financial statement audit also addresses additional
matters important to pool investors that are not covered by the
surprise examination, such as tests of valuations of pool investments,
income, operating expenses, and, if

applicable, incentive fees and allocations that accrue to the
adviser.\44\
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    \43\ See AICPA, Audit and Accounting Guide, Investment
Companies, (May 1, 2009).
    \44\ Id.
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    We believe that these and other procedures performed by the
accountant during the course of a financial statement audit provide
meaningful protections to investors, and that the surprise examination
would not significantly add to these protections. Although the annual
audit is not required to be performed at a time of the accountant's
choosing (as is a surprise examination), we believe other elements of
the audit incorporate an element of uncertainty similar to the surprise
element of the surprise examination, with corresponding benefits to
investors. Specifically, in the course of an annual audit, the auditor
will select transactions to test during the period that the adviser
will not be able to anticipate.
    We have therefore amended the rule to deem an adviser to a pooled
investment vehicle that is subject to an annual financial statement
audit by an independent public accountant, and that distributes the
audited financial statements prepared in accordance with generally
accepted accounting principles to the pool's investors,\45\ to have
satisfied the annual surprise examination requirement (``annual audit
provision'').\46\
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    \45\ Amended rule 206(4)2(b)(4)(i) requires that the audited
financial statements be distributed within 120 days of the end of
the pooled investment vehicle's fiscal year. In 2006, our staff
issued a letter indicating that it would not recommend enforcement
action to the Commission under section 206(4) of the Act or rule
206(4)-2 against an adviser of a fund of funds relying on the annual
audit provision of rule 206(4)-2 if the audited financial statements
of the fund of funds are distributed to investors in the fund of
funds within 180 days of the end of its fiscal year. See ABA
Committee on Private Investment Entities, SEC Staff Letter (Aug. 10,
2006). The amendments we are adopting today do not affect the views
of the staff expressed in that letter.
    \46\ Amended rule 206(4)-2(b)(4). We note that an adviser that
relies on the annual audit provision must nonetheless undergo an
annual surprise examination of non-pooled investment vehicle assets
of which it has custody.
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    In addition, at the suggestion of several commenters,\47\ we are
limiting the rule's recognition of such audits as satisfying the
surprise verification requirement to those audits performed by an
independent public accountant registered with, and subject to regular
inspection by, the PCAOB.\48\ We have greater confidence in the quality
of such audits.\49\
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    \47\ ABA Letter; Adams Street Letter; comment letter of
Coalition of Private Investment Companies (July 31, 2009) (``CPIC
Letter''); MFA Letter.
    \48\ Amended rule 206(4)-2(b)(4). The independent public
accountant must be registered with, and subject to regular
inspection by, the PCAOB as of the commencement of the professional
engagement period, and as of each calendar year-end. Several
commenters suggested other approaches, including enhancing the audit
performed on the pool to include verification of securities
(SIFMA(AMG) Letter), requiring an internal control report only
instead of both the report and a surprise examination (ABA Letter;
PEC Letter), and requiring several specific custody controls for
advisers to pooled investment vehicles (CPIC Letter). We have
considered the alternative approaches, some of which are beyond the
scope of the proposal, and we believe, for the reasons discussed
above, that our amendment to this aspect of the rule strikes the
right balance.
    \49\ See infra note 122 and accompanying text.
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    We note that under rule 206(4)-2, an adviser to a pooled investment
vehicle that distributes to its investors audited financial statements
is not required to have a reasonable belief that a qualified custodian
delivers account statements to investors.\50\ As a consequence,
investors in pooled investment vehicles do not have the benefit of
regularly receiving reports that the assets underlying their
investments are properly held. We are therefore concerned that the
current protections of the rule may be insufficient, and we have
directed our staff to explore ways in which we could remedy this
potential shortcoming while respecting the confidential nature of
proprietary information.
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    \50\ Rule 206(4)-2(b)(4).
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2. Commission Reporting
    We are also adopting a number of rule and form amendments that will
result in the Commission and the public receiving greater information
about the custody practices of advisers and thus a greater ability to
identify potential risks to clients. Under amended rule 206(4)-2, each
investment adviser subject to the surprise examination requirement must
enter into a written agreement with an independent public accountant to
conduct the surprise examination. The agreement must require the
accountant, among other things, to notify the Commission within one
business day of finding any material discrepancy during the course of
the examination, and to submit Form ADV-E to the Commission accompanied
by the accountant's certificate within 120 days of the time chosen by
the accountant for the surprise examination, stating that the
accountant has examined the funds and securities and describing the
nature and extent of the examination.\51\ The agreement also must
provide that, upon resignation or dismissal, the accountant must file
within four business days a statement regarding the termination along
with Form ADV-E.\52\ Accountants will file Form ADV-E with us
electronically, through the Investment Adviser Registration Depository
(``IARD'').\53\ We are adopting these amendments as proposed. The
information they provide will assist the Commission's examination staff
and the public in identifying risks raised by the investment adviser's
custodial practices and in determining the frequency and scope of our
staff's examination of an investment adviser.
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    \51\ Amended rule 206(4)-2(a)(4)(i) and (ii). The written
agreement will also require, in accordance with the current
requirements of rule 206(4)-2, the independent public accountant to
perform the surprise examination. Advisers must maintain copies of
these written agreements under rule 204-2(a)(10). The obligation to
maintain the records will 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. Rule 204-
2(e)(1).
    \52\ Amended rule 206(4)-2(a)(4)(iii). The written agreement
must require that the statement include (i) the date of such
termination or removal, 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 termination. Id. One commenter specifically expressed
support for these time frames. CFA Institute Letter.
    \53\ Until the IARD system is upgraded to accept Form ADV-E,
accountants performing surprise examinations should continue paper
filing of Form ADV-E. Advisers will be notified as soon as the IARD
system can accept Form ADV-E.
---------------------------------------------------------------------------

    The new requirement that accountants file Form ADV-E within 120
days of the time chosen by the accountant for the surprise examination
is designed to require more timely completion of these examinations.
Several commenters suggested that we extend the filing deadline to 180
days, asserting that more complex surprise examinations may take more
time.\54\ We note that these commenters' estimate of the duration of a
surprise examination was based on the nature and extent of procedures
contemplated under the existing guidance for accountants,\55\ which
many asserted was unnecessarily time consuming. As discussed more fully
below, our revised guidance for accountants should address many of
these concerns.\56\ As a result, we believe that 120 days will be
sufficient for an accountant to complete the examination.
---------------------------------------------------------------------------

    \54\ IAA Letter; M&P Letter; PWC Letter. See also Dechert
Letter; KPMG Letter; SIFMA(AMG) Letter (advocating for an extension,
but not specifying that it be 180 days). One commenter suggested
that we shorten it to 45-60 days. CFA Institute Letter.
    \55\ Statement of the Commission describing nature of
examination required to be made of all funds and securities held by
an investment adviser and the content of related accountant's
certificate, Accounting Series Release No. 103, Investment Advisers
Act Release No. 201 (May 26, 1966) (``ASR No. 103'').
    \56\ See Section II.B.4. of this Release.
---------------------------------------------------------------------------

    Several commenters suggested we modify the requirement regarding
the accountant's filing of a statement upon termination. Some argued
that these filings should not be made available to

the public,\57\ that they should not be required if the accountant was
terminated for innocuous reasons,\58\ and that the adviser should have
primary responsibility to report accountant dismissals, so that the
accountant would submit a report only if the adviser failed to do
so.\59\ We have not revised the requirement in response to these
comments. We believe it is important that the public have access to the
termination statements to permit clients and prospective clients to
assess for themselves the reasons for the termination of an
accountant's engagement or an accountant's removal from consideration
for being reappointed. Disclosure of a termination, even for apparently
innocuous reasons, could provide useful information to advisory clients
and to our staff. For example, identifying frequent changes in
accountants could put clients and prospective clients on notice to
inquire about the reasons for these events. Finally, while advisers are
responsible for reporting accountant dismissals on Form ADV, the
accountant's statement serves as an independent check on the adviser's
filing and, as such, is important to increasing the effectiveness of
the surprise examination requirement.
---------------------------------------------------------------------------

    \57\ E*Trade Letter (arguing more broadly that no Form ADV-E
filings should be made public, regardless of the reason for filing);
IAA Letter; S&K Letter; Turner Letter.
    \58\ Davis Polk Letter; E*Trade Letter; IAA Letter.
    \59\ KPMG Letter.
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3. Privately Offered Securities
    We are adopting, as proposed, amendments to rule 206(4)-2 to no
longer permit the accountant conducting the annual verification of
client assets to forego examining certain privately offered securities,
as defined in the rule.\60\ As a result, advisers that maintain custody
of privately offered securities on behalf of clients will be subject to
the surprise examination requirement.\61\
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    \60\ The amended rule retains the current definition of
``privately offered securities'' 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. See amended rule 206(4)-2(b)(2).
    \61\ We received various suggestions from commenters, some
conflicting, regarding our approach to privately offered securities.
See ABA Letter (suggesting that the Commission only subject
privately offered securities held by the adviser or by related
persons to surprise examinations, arguing that such a limitation
would reduce costs and target the assets at greatest risk of
misappropriation); MFA Letter (proposing that the Commission
affirmatively state that some assets, such as bank loans and swaps,
are not securities for purposes of rule 206(4)-2 and are, therefore,
not subject to the rule). Others advocated expanding the annual
verification requirement. See CPIC Letter (suggesting that the
custody rule cover all assets held by private funds, not just
securities and funds and proposing that all non-traditional assets
should be held in the name of the custodian and all cash flows
should be required to go through the custodian). We have considered
the comments and, for the reasons discussed above, we believe our
amendment to this aspect of the rule strikes the right balance with
respect to privately offered securities.
---------------------------------------------------------------------------

    Several commenters supported expanding the rule in this
respect.\62\ Others, however, asserted that the risk of fraud or
misappropriation is low with respect to privately offered securities
because they are not easily transferable, while the costs and practical
difficulties of including these securities in a surprise exam may be
considerable.\63\ While privately offered securities may present little
risk with respect to transferability, they present significant risks in
other regards. First, it is difficult for advisory clients to verify
that these assets actually exist because ownership of such securities
is recorded only on the issuers' books. Second, clients may have to
rely on the information provided by the adviser to confirm their
ownership of privately offered securities, as well as the existence of
the underlying investment, when the adviser maintains custody of these
securities.\64\ Because clients are more dependent on the adviser with
respect to the safeguarding of these securities, advisory clients may
be exposed to additional risks when their advisers acquire these
securities on their behalf. To mitigate these risks and to provide
assurance that privately offered securities are properly safeguarded,
we believe that it is appropriate to require an independent third-party
to verify client ownership with the issuers of the securities by
requiring that these securities be subject to the surprise examination
requirement under the amended rule.\65\
---------------------------------------------------------------------------

    \62\ ABA Letter; CFA Institute Letter; CPIC Letter; comment
letter of The New York State Society of Certified Public Accountants
(July 27, 2009).
    \63\ Davis Polk Letter; MFA Letter; NVCA Letter; PWC Letter.
    \64\ Rule 206(4)-2 does not require advisers, with one limited
exception, to maintain these assets with a qualified custodian
because of the difficulties raised by recording ownership of the
securities only on the books of the issuer. Rule 206(4)-2(b)(2). See
also 2003 Adopting Release, at Section II.B.
    \65\ Under amended rule 206(4)-2 an adviser may maintain custody
of privately offered securities without being subject to the
requirements that apply to advisers that maintain custody of client
assets as qualified custodians set forth in paragraph (a)(6) of the
rule, such as the internal control report, because the adviser need
not be a qualified custodian to maintain custody of those
securities. Amended rule 206(4)-2(b)(2). If, however, the adviser
holding the privately offered securities also has custody of other
client funds or securities as qualified custodian, the adviser is
subject to the requirements set forth in paragraph (a)(6) of the
rule.
---------------------------------------------------------------------------

    It is our understanding that many accountants today do verify
private securities in the course of a surprise examination, and several
commenters requested that we provide guidance as to the procedures that
an accountant should undertake with respect to the surprise examination
of privately offered securities.\66\ In our companion release, we
provide guidance for accountants regarding conducting a surprise
examination of client assets, including privately offered
securities.\67\
---------------------------------------------------------------------------

    \66\ MFA Letter; comment letter of The Association of Global
Custodians (Aug. 03, 2009) (``AGC Letter''); MarketCounsel Letter;
comment letter of Sullivan & Cromwell (July 28, 2009).
    \67\ See infra note 70 and accompanying text. In the Proposing
Release we requested comment on whether we should require the
accountant performing the surprise examination to perform testing on
the valuation of securities, including privately offered securities.
One commenter stated that, although valuation is a very important
issue closely related to client assets, it covers an area that goes
beyond custody. Dechert Letter. We agree and are therefore not
requiring accountants to perform testing of valuation as part of the
surprise examination.
---------------------------------------------------------------------------

4. Guidance for Accountants
    In the Proposing Release, we requested that commenters address
whether, and if so how, we should revise the guidance for accountants
that we issued regarding the surprise examination.\68\ Commenters that
responded all generally agreed that our existing guidance, which we
published in 1966, is inadequate because it neither reflects today's
custodial practices nor adequately recognizes certain commonly accepted
auditing practices.\69\ In a companion release, we are providing
updated guidance for accountants that addresses the surprise
examination, as well as the internal control report required under
amended rule 206(4)-2 and the relationship between them.\70\ Our
guidance discusses the relevant auditing and attestation standards that
apply to these engagements, and, among other things, the nature and
extent of the accountant's procedures with respect to the surprise
examination. The revised guidance for accountants will

modernize the procedures for the surprise examination.
---------------------------------------------------------------------------

    \68\ Proposing Release, at Section II.
    \69\ AICPA Letter; CAQ Letter; Chamber of Commerce Letter; Cohen
Letter; Curian Letter; Deloitte Letter; E&Y Letter; FTAM Letter;
KPMG Letter; MFA Letter; MMI Letter; M&P Letter; PWC Letter; Schwab
Letter; SIFMA(AMG) Letter; SIFMA(PCLC) Letter.
    \70\ See Commission Guidance Regarding Independent Public
Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the
Investment Advisers Act of 1940, Investment Advisers Act Release No.
2969 (Dec. 30, 2009) (``Accounting Release'').
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C. Custody by Adviser and Related Person

    As amended, rule 206(4)-2 imposes additional requirements when
advisory client assets are maintained by the adviser itself or by a
related person rather than with an independent qualified custodian. As
proposed, the amended rule requires, in addition to the surprise
examination discussed above,\71\ that when an adviser or its related
person serves as a qualified custodian for advisory client funds or
securities under the rule, the adviser obtain, or receive from its
related person, no less frequently than once each calendar year, a
written report, which includes an opinion from an independent public
accountant with respect to the adviser's or related person's controls
relating to custody of client assets (``internal control report''),
such as a Type II SAS 70 report.\72\ The amended rule also requires, in
these circumstances, that the accountant issuing the internal control
report, as well as the accountant performing the surprise examination,
be registered with, and subject to regular inspection by, the
PCAOB.\73\ The adviser must maintain the internal control report in its
records and make it available to the Commission staff upon request.\74\
---------------------------------------------------------------------------

    \71\ See supra notes 28-37 and accompanying text. Several
commenters asserted that the surprise examination would be
duplicative of existing regulatory requirements (see, e.g., comment
letter of American Bankers Association (July 28, 2009)(``American
Bankers Letter''); comment letter of LPL Financial (July 28, 2009)
(``LPL Letter''); Mellon Letter; Schwab Letter; and SIFMA(PCLC)
Letter). As we discuss later, the surprise examination requirement
is important and not duplicative because it works in concert with
the internal control report to protect advisory clients and because
there are no existing regulatory requirements specifically focused
on risks that may arise in the self or affiliated custody context.
See infra notes 85-87 and accompanying text. Other commenters agreed
that the surprise examination and internal control report are
independently valuable and not duplicative (see E&Y Letter and NASAA
Letter).
    \72\ Amended rule 206(4)-2(a)(6)(ii). As discussed in more
detail below, other types of reports could also satisfy the internal
control report requirement. See infra notes 98-100 and accompanying
text.
    \73\ Amended rule 206(4)-2(a)(6)(i) and (ii)(C). The
Commission's standards for the independence of accountants is set
forth in Article 2, Rule 2-01 of Regulation S-X [17 CFR 210.2-01].
See 2003 Adopting Release at n.32. Article 2-01 does not preclude
the accountant performing the surprise examination from also
preparing the internal control report. The determination, however,
of whether an accountant is independent under Article 2-01 includes
consideration of all the relevant facts and circumstances.
    \74\ Amended rule 204-2(a)(17)(iii).
---------------------------------------------------------------------------

1. Internal Control Report
    Related person custody arrangements can present higher risks to
advisory clients than maintaining assets with an independent custodian.
As we pointed out in the Proposing Release, several of the recent
enforcement actions in which we have alleged misappropriation of client
assets have involved advisers or related persons that maintained client
assets.\75\ We requested comment on whether we should prohibit advisers
from advising clients whose assets are maintained with the adviser or a
related person.
---------------------------------------------------------------------------

    \75\ See supra note 1.
---------------------------------------------------------------------------

    Some commenters supported requiring an ``independent'' qualified
custodian,\76\ although many commenters opposed the requirement.\77\
Several argued that use of an independent custodian would be an
impractical requirement for many types of advisory accounts held by
smaller investors with broker-dealers, such as wrap fee accounts, in
which a client receives bundled advisory and brokerage services from a
single firm (or related firms) regulated as both an investment adviser
and a broker-dealer.\78\ It is common for institutional clients to
maintain assets in a custodial account, often with a bank that is
unaffiliated with the client's adviser. We are concerned, however, that
requiring an independent custodian could make unavailable many advisory
accounts popular with smaller investors, which are today maintained by
the adviser or its affiliated brokerage firm or bank. Therefore, we are
not amending the rule to require use of an independent custodian,
although we encourage the use of custodians independent of the adviser
to maintain client assets as a best practice whenever feasible.
---------------------------------------------------------------------------

    \76\ See, e.g., NASAA Letter; comment letter of The National
Association of Active Investment Managers (July 27, 2009) (``NAAIM
Letter''); NVCA Letter; comment letter of Kay Conheady (June 4,
2009); comment letter of Carol Y. Godsave (June 15, 2009); comment
letter of Michael A. Pagano (June 26, 2009); comment letter of
Robert J. Reed (June 1, 2009); comment letter of Robert N. Veres
(June 27, 2009).
    \77\ See, e.g., ABA Letter; AGC Letter; CLS Letter; Curian
Letter; Davis Polk Letter; Dechert Letter; E*Trade Letter; FPA
Letter; comment letter of Lincoln Investment (July 28, 2009); LPL
Letter; comment letter of National Planning Holdings, Inc. (July 28,
2009) (``NPH Letter''); Pickard Letter; Schwab Letter; SIFMA(PCLC)
Letter; comment letter of L.A. Schnase (July 3, 2009) (``Schnase
Letter''); comment letter of State Street Corporation (July 28,
2009).
    \78\ ABA Letter; Curian Letter; Davis Polk Letter; E*Trade
Letter; Pickard Letter; Schnase Letter; Schwab Letter; SIFMA(PCLC)
Letter.
---------------------------------------------------------------------------

    To address the custodial risks associated with an affiliated
custodial relationship, we proposed requiring, in addition to the
surprise examination, an adviser to obtain, or receive from its related
person, an annual internal control report, which would include an
opinion from an independent public accountant with respect to the
adviser's or related person's custody controls. We were concerned that
the surprise examination alone would not adequately address custodial
risks associated with self or related person custody because the
independent public accountant seeking to verify client assets would
rely, in part, on custodial reports issued by the adviser or the
related person.
    Several commenters expressed their support for the proposed
internal control report requirement.\79\ Two stated that our approach
appropriately targets the frauds we are concerned about.\80\ One large
custodian urged us to require all qualified custodians to obtain an
internal control report.\81\ Another agreed with our assessment that
when the adviser or its related person acts as qualified custodian,
there is increased risk to clients because the adviser may
``misappropriate assets as a result of collusion with [its] affiliated
custodians.'' \82\ Other commenters, including those representing banks
and broker-dealers, however, objected to the internal control report
requirement, arguing that qualified custodians are already subject to
extensive regulatory oversight and that the additional requirement
would be duplicative of existing legal and regulatory requirements.\83\
They argued that we would be imposing an unnecessary additional
regulatory burden on affected custodians.
---------------------------------------------------------------------------

    \79\ AICPA Letter; CFP Board Letter; Cornell Letter; comment
letter of Diamant Asset Management, Inc. (July 20, 2009); E&Y
Letter; FMC Letter; IAA Letter; NASAA Letter; NPH Letter; Pickard
Letter; comment letter of T. Rowe Price Associates, Inc. (July 28,
2009) (``T. Rowe Letter'').
    \80\ CFP Board Letter; IAA Letter.
    \81\ Schwab Letter.
    \82\ ABA Letter.
    \83\ LPL Letter; MMI Letter; NSCP Letter; comment letter of
Pershing LLC (July 28, 2009) (``Pershing Letter''); SIFMA(PCLC)
Letter; American Bankers Letter; comment letter of J.P. Morgan (Aug.
26, 2009).
---------------------------------------------------------------------------

    The internal control report requirement we are adopting today will
provide important additional safeguards for client assets maintained
with the adviser or a related person. As discussed in more detail
below, the adviser must obtain or receive an internal control report
that demonstrates that it, or its related person, has established
appropriate custodial

controls.\84\ As we noted in the Proposing Release, the internal
control report can significantly strengthen the utility of the surprise
examination when the adviser or a related person acts as qualified
custodian for client assets because it provides a basis for the
independent public accountant performing the surprise examination to
obtain additional comfort that the confirmations received from the
related custodian are reliable.\85\ The requirement to obtain an
internal control report therefore serves both to inform the surprise
examination process and may itself act as a deterrent to fraud by
advisers that may consider misappropriating client assets directly or
through a related person.\86\
---------------------------------------------------------------------------

    \84\ Amended rule 206(4)-2(a)(6). An investment adviser subject
to this requirement must obtain or receive an initial internal
control report within six months of becoming subject to the
requirement. See infra Section III.B.2. of this Release.
    \85\ Proposing Release, at Section II.B.2.
    \86\ See id.
---------------------------------------------------------------------------

    We have carefully considered commenters' concerns about regulatory
duplication in designing the internal control report requirement. We
are adopting this requirement because there is no existing regulatory
requirement applicable to investment advisers or other entities, such
as broker-dealers and banks, that serve as qualified custodians that we
believe is specifically focused on internal control risks that may
arise in the affiliated custody context. We have, however, developed
our guidance for accountants to permit accountants, when preparing an
internal control report, to rely on their own relevant audit work
performed for other purposes, including audit work performed to meet
existing regulatory requirements, which should increase efficiencies in
the audit process and help address commenters' concerns about
duplication.\87\
---------------------------------------------------------------------------

    \87\ For example, accountants for broker-dealers perform a
variety of procedures as part of a broker-dealer's financial
statement audit and to satisfy related requirements under the
Securities Exchange Act of 1934 (``Exchange Act''), including
reconciliation procedures required for broker-dealers under the
Exchange Act. See infra note 95.
---------------------------------------------------------------------------

    We do not believe that the internal control report requirement will
be unduly burdensome. A qualified custodian would only have to obtain
an internal control report if it maintains the funds or securities of
its own advisory clients or those of advisory clients of related
persons. As one securities industry commenter noted, custodians often
provide Type II SAS 70 reports to clients who demand a rigorous
evaluation of internal control as a condition of obtaining their
business.\88\ A related person custodian therefore may be able to use a
Type II SAS 70 report it is already obtaining and providing to other
clients to satisfy the rule's requirement, and may also be able to use
the same internal control report to satisfy the rule's requirement for
several related advisers whose clients use the custodian.
---------------------------------------------------------------------------

    \88\ SIFMA(AMG) Letter (noting that obtaining such a report is
an ``industry best practice'').
---------------------------------------------------------------------------

    The elements of the required internal control report are set forth
in the companion release we are issuing today, which includes guidance
for accountants regarding the overall objectives and scope of the
internal control examination.\89\ The internal control report must
include the accountant's opinion as to whether the qualified
custodian's internal controls have been placed in operation as of a
specific date, and are suitably designed, and are operating effectively
to meet control objectives related to custodial services, including the
safeguarding of funds and securities of advisory clients during the
year.\90\ In order for the accountant to be able to form this opinion,
the internal control report should address control objectives and
associated controls related to the areas of client account setup and
maintenance, authorization and processing of client transactions,
security maintenance and setup, processing of income and corporate
action transactions, reconciliation of funds and security positions to
depositories and other unaffiliated custodians, and client
reporting.\91\
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    \89\ See Accounting Release.
    \90\ Amended rule 206(4)-2(a)(6)(ii)(A).
    \91\ See Accounting Release.
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    We have revised the amended rule to state that, for the internal
control report to satisfy the rule's requirements, the independent
public accountant preparing the report must verify that the client
funds and securities are reconciled to a custodian other than the
adviser or its related person.\92\ Reconciliation of custodial records
to depositories is a key control objective of the internal control
report, which will report on, among other things, tests of controls
designed to meet this specific objective.\93\ Internal control reports
regarding custody, such as Type II SAS 70 reports, however, may not
necessarily include specific procedures performed by the accountant
that are designed to verify the reconciliation of funds and securities
of unaffiliated custodians. Verification with unaffiliated custodians
serves as a critical check on potential collusion when the adviser or
its related person acts as custodian. The accountant preparing the
internal control report is in the best position to perform this check
because the accountant will have access to the information necessary to
verify assets when testing controls over the custodian's reconciliation
processes. For this reason, we are requiring this verification to be
performed in connection with, and reported in, the internal control
report.
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    \92\ Amended rule 206(4)-2(a)(6)(ii)(B).
    \93\ See Proposing Release at Section II.B.2.
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    As described in our guidance for accountants, the accountant's
verification that client funds and securities are reconciled to an
unaffiliated custodian (e.g., the Depository Trust Corporation) can be
accomplished in one of two ways.\94\ The accountant may either obtain
direct confirmation, on a test basis, with unaffiliated custodians or
perform other procedures designed to verify that the data used in
reconciliations performed by the qualified custodian is obtained from
unaffilated custodians and is unaltered.\95\
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    \94\ See Accounting Release.
    \95\ In meeting this requirement, the accountant can also
incorporate its own work performed pursuant to other regulatory
requirements, such as requirements under the Exchange Act. Under
rule 17a-13 under the Exchange Act, most brokers and dealers are
required to conduct a securities count at least once each calendar
quarter, which includes, among other things, a physical examination
and count of all securities held, verification (through confirmation
or other form of outside documentation) of all securities deposited
or otherwise subject to the broker-dealer's control or direction,
and reconciliation of the results of such count and verification to
the broker-dealer's records. Under rule 17a-5, the broker-dealer's
independent accountant provides a supplemental report on internal
control which addresses, among other things, the broker-dealer's
compliance with rule 17a-13. See Rules 17a-13 and 17a-5 under the
Exchange Act [17 CFR Parts 240.17a-13 and 17a-5].
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    We noted several specific control objectives in the Proposing
Release that we suggested might be included in the scope of an internal
control report prepared under the proposed rule.\96\ Some commenters
urged that we establish minimum control objectives that need to be
addressed as part of the internal control report as a means of ensuring
consistency in practice.\97\ In response to these comments, we are
identifying certain minimum control objectives within our revised
guidance for accountants.
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    \96\ See Proposing Release, at Section II.B.2.
    \97\ See, e.g., AICPA Letter; Deloitte Letter.
---------------------------------------------------------------------------

    We are not requiring that a specific type of internal control
report be provided under the rule as long as the objectives noted above
are addressed. This flexibility should permit

accountants of qualified custodians to leverage audit work they have
performed to satisfy existing regulatory requirements to which these
custodians are subject, or work currently performed as part of internal
control reports prepared to meet client demand. In the Proposing
Release, we indicated that a Type II SAS 70 report would be sufficient
to satisfy the requirements of the internal control report.\98\ As we
noted in our guidance for accountants, a report issued in connection
with an examination of internal control conducted in accordance with AT
Section 601, Compliance Attestation (``AT 601'') under the standards of
the American Institute of Certified Public Accountants \99\ would also
be sufficient, provided that such examination meets the objectives set
forth in our guidance.\100\
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    \98\ See Proposing Release, at Section II.B.2.
    \99\ AT 601 provides guidance to accountants for engagements
related to either a firm's compliance with the requirements of
particular laws or rules, or the effectiveness of the firm's
internal controls over compliance with those particular
requirements.
    \100\ We have made technical changes to the description of the
internal control report in amended rule 206(4)-2(a)(6)(ii)(A) to
reflect that our adopted rule permits use of internal control
reports other than the Type II SAS 70.
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2. Related Persons
    We are amending rule 206(4)-2, as proposed, 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.\101\ A related person
is defined by the rule as a person directly or indirectly controlling
or controlled by the adviser and any person under common control with
the adviser.\102\ We received some support for this proposal.\103\
Several commenters urged us to instead adopt the approach our staff has
taken in no-action letters in which the staff expressed the view that
custody of client assets by a related person would not be attributed to
the adviser if the related person was operationally separate.\104\
Those letters expressed our staff's views regarding the scope of the
custody rule which, at that time, did not explicitly address the
applicability of the rule to an entity related to the adviser as parent
company, sister company or wholly-owned subsidiary that holds or has
access to client assets.\105\ We believe that the authority or
influence an adviser may have over such related persons presents
sufficient risks as a result of a related person's ability to obtain
client assets, that we should treat the adviser itself as having
custody over the client assets.\106\ Therefore, we are adopting the
amendment as proposed.\107\
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    \101\ Amended rule 206(4)-2(d)(2) (defining ``custody'').
    \102\ Amended rule 206(4)-2(d)(7). For advisers that are part of
multi-service financial organizations, for example, such related
person custodians may include broker-dealers and banks.
    \103\ See CFA Institute Letter; Cornell Letter; FPA Letter;
NAAIM Letter.
    \104\ See, e.g., IAA Letter; Mellon Letter; MMI Letter; NRS
Letter; Pershing Letter. Several other commenters suggested similar
approaches, including revising the definition of custody based on
the factors the staff considered in these no-action letters (T. Rowe
Letter), and not considering firms under common control to be deemed
related persons under the rule (IAA Letter; Pickard Letter; Schnase
Letter; SIFMA(PCLC) Letter). We are not adopting either of these
approaches for the same reasons as explained above.
    \105\ See, e.g., Crocker Investment Management Corp., SEC Staff
Letter (Apr. 14, 1978) (``Crocker'').
    \106\ See Proposing Release, Section II.B.1. We note that under
rule 206(4)-2, as amended, only client assets held by a related
person ``in connection with advisory services'' provided by the
adviser would be attributable to the adviser. See rule 206(4)-
2(d)(2). Consequently, an adviser will not be deemed to have custody
of client assets held with a qualified custodian that is a related
person of the adviser if the adviser does not provide advice with
respect to such assets.
    \107\ Amended rule 206(4)-2. In light of our amended definition
of custody, our staff is withdrawing several no-action letters to
the extent such letters are inconsistent with this definition,
including Crocker and Pictet et Cie, SEC Staff Letter (Jun. 22,
1980). Advisers, including those firms that have relied on these
letters in the past, must comply with the amended rule.
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    We are, however, addressing commenters' concerns in a different way
by providing a limited exception from the surprise examination
requirements in circumstances when the adviser is deemed to have
custody solely as a result of a related person having custody.\108\ The
exception is available to an adviser that is (i) deemed to have custody
solely as a result of certain of its related persons holding client
assets, and (ii) ``operationally independent'' of the custodian.\109\
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    \108\ Amended rule 206(4)-2(b)(6).
    \109\ Id.
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    As discussed above, a key premise of our approach to the custody
rule is that client assets may be at greater risk when they are
maintained by a related person of the investment adviser. As commenters
suggested, however, firms under common ownership that are operationally
independent of each other present substantially lower client custodial
risks than those that are not because misuse of client assets would
tend to require collusion among employees, not significantly different
than would be necessary to engage in similar misconduct between
unaffiliated organizations.\110\
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    \110\ MMI Letter; Davis Polk Letter. This conclusion is implicit
in our staff's no-action letter upon which the staff has relied to
determine whether an adviser indirectly has custody of client assets
when its related person does. See Crocker, supra note 105.
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    Under the amended rule, a related person that holds, or has
authority to obtain possession of, advisory client assets would be
presumed not to be operationally independent of the adviser unless the
adviser can meet the rule's conditions, which are similar to the
factors that our staff has used to evaluate whether an adviser has
custody of client funds and securities indirectly under the rule as a
consequence of the custody of a related person,\111\ and no other
circumstances exist that can reasonably be expected to compromise the
operational independence of the related person.\112\ An adviser that is
able to satisfy these conditions and overcome the presumption that it
is not operationally independent of its related person would not have
to obtain a surprise examination of client assets held by a related
person, including a related person that is a qualified custodian. The
adviser would, however, have to comply with the other provisions of the
rule (unless an exception is available), including notifying the client
where the assets are maintained, forming a reasonable belief after due
inquiry that the qualified custodian sends the client account
statements, and obtaining an internal control report from a related
person that is a qualified custodian.\113\ We believe that the
conditions set out in the rule appropriately accomplish our objective
of identifying advisers that are not operationally independent and thus
present sufficient custodial risks that

the adviser should be subject to a surprise examination.
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    \111\ Amended rule 206(4)-2(d)(5) (defining ``operationally
independent''). The conditions set out in the rule are: (i) Client
assets in the custody of the related person are not subject to
claims of the adviser's creditors; (ii) advisory personnel do not
have custody or possession of, or direct or indirect access to
client assets of which the related person has custody, or the power
to control the disposition of such client assets to third parties
for the benefit of the adviser or its related persons, or otherwise
have the opportunity to misappropriate such client assets; (iii)
advisory personnel and personnel of the related person who have
access to advisory client assets are not under common supervision;
and (iv) advisory personnel do not hold any position with the
related person or share premises with the related person. We would
not consider a related person that shared management persons with
the adviser, including an owner that was actively involved in the
management of the two firms, to be operationally independent.
    \112\ For example, the management of the adviser and related
person could be controlled by persons with close familial
relationships such as spouses, siblings, or parents and adult
children.
    \113\ We believe these safeguards remain important because even
when an adviser has demonstrated that a related person is
operationally independent, the risks to client assets raised by
common control may be greater than if client assets were maintained
by an independent custodian.
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    We emphasize that an adviser that has custody due to reasons in
addition to, or other than, a related person having custody cannot
rebut the presumption contained in the rule. Thus, for example, an
adviser that has custody because it serves as a trustee with respect to
client assets held in an account at a broker-dealer that is a related
person could not rely on the exception from the surprise examination on
the grounds that the broker-dealer was operationally independent and
that the factors discussed above were met.\114\ Such an adviser would
be subject to the surprise examination requirement and would have to
receive an internal control report from the related person qualified
custodian.\115\ We are also amending rule 204-2 to require an adviser
whose client assets are held by a related person but does not undergo a
surprise examination to make and keep a memorandum describing the
relationship with the related person in connection with advisory
services the adviser provides to clients and including an explanation
of the adviser's basis for determining that it has overcome the
presumption that it is not operationally independent of the related
person with respect to the related person's custody of client
assets.\116\
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    \114\ We have also amended the rule so that the exception from
the surprise examination requirement with respect to client assets
of advisers that have custody as a result of their ability to deduct
advisory fees from client assets applies to such advisers when their
client assets are held by a custodian that is not a related person
of the adviser as well as when the adviser can rely on amended rule
206(4)-2(b)(6). See amended rule 206(4)-2(b)(3). For the reasons
described above, when the related person custodian is operationally
independent, we do not believe the custodial risks raised warrant
the costs of obtaining a surprise examination.
    \115\ Under the rule, an adviser whose client assets are
maintained by a related person qualified custodian that is not
operationally independent from the adviser, must obtain a surprise
examination of those assets as if it held the assets itself and were
required to obtain a surprise examination with respect to those
assets. As a result, for example, a broker-dealer that is also a
qualified custodian of its client's advisory assets could not avoid
obtaining a surprise examination by creating an operationally
integrated subsidiary to provide investment advice.
    \116\ See amended rule 204-2(b)(5).
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3. PCAOB Registration and Inspection
    Under the amendments, the surprise examination and internal control
report required when the adviser or its related person serves as
qualified custodian for client assets may be satisfied only when
performed or prepared by an independent public accountant that is
registered with, and subject to regular inspection by, the PCAOB.\117\
We have greater confidence in the quality of the surprise examination
and the internal control report when prepared by an independent public
accountant that is registered with, and subject to regular inspection
by, the PCAOB.
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    \117\ Amended rule 206(4)-2(a)(6). The independent public
accountant must be registered with, and subject to regular
inspection by, the PCAOB as of the commencement of the professional
engagement period, and as of each calendar year-end.
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    Many commenters supported this requirement, agreeing with us that
PCAOB registration would provide an important quality check on the
independent accountants performing these services.\118\ Two of those
commenters asserted that PCAOB registration would serve to discourage
accounting fraud in the higher risk situation posed by an adviser or
its related person maintaining client assets.\119\ Commenters opposing
the requirement expressed concern that the PCAOB's authority is limited
to inspecting accountants with respect to audits of public issuers,
which does not include the surprise examinations and internal control
reports meeting the requirements of rule 206(4)-2.\120\ One commenter
urged us to exempt offshore advisers from this requirement, asserting
that some foreign countries do not have enough accountants registered
with the PCAOB to support a competitive marketplace for their
services.\121\
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    \118\ Surprise exam and internal control report--E&Y Letter;
NAAIM Letter; internal control report only--CPIC Letter; IAA Letter;
Pickard Letter; NASAA Letter; surprise examination only--ABA Letter;
Curian Letter; FPA Letter; Turner Letter.
    \119\ CPIC Letter; FPA Letter.
    \120\ CAS Letter; CAQ Letter; Chamber of Commerce Letter; FTAM
Letter.
    \121\ ABA Letter.
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    We acknowledge that the PCAOB does not currently inspect auditor
engagements required solely as a result of rule 206(4)-2. We
nonetheless believe a requirement that excludes accountants that are
not registered with and examined by the PCAOB will provide greater
confidence in the quality of the independent public accountant and
complement the enhanced controls under the rule that apply when client
assets are not maintained by an independent qualified custodian and in
audits of certain pooled investment vehicles.\122\ While PCAOB
inspection is focused on public company audit engagements, we believe
that requiring that the accountant not only be registered with the
PCAOB but subject to its inspection can provide indirect benefits
regarding the quality of the accountant's other engagements.
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    \122\ 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 amended 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 PCAOB rule 4003.
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    We recognize that there may be fewer PCAOB-registered and inspected
independent public accountants in certain foreign jurisdictions. Based
on discussions with accounting firms, however, we do not expect
advisers will have significant difficulty in finding a local auditor
that is eligible under the rule. Many PCAOB-registered independent
public accountants currently have practices in those jurisdictions in
which most offshore advisers and funds are domiciled.\123\ In addition,
some accounting firms have international practices, which may
ameliorate concerns regarding offshore availability. Finally, we will
continue to monitor the situation as the rule is implemented and
consider any issues that may arise.
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    \123\ See http://www.pcaobus.org/Registration/Registered_
Firms_by_Location.pdf. We also note that our staff has issued a
letter indicating that it would not recommend enforcement action to
the Commission under section 206(4) of the Advisers Act or rule
206(4)-2 under the Act against offshore advisers to offshore pooled
investment vehicles if those advisers did not comply with certain
substantive rules under the Advisers Act, including the custody
rule. See ABA Subcommittee on Private Investment Entities, SEC Staff
Letter (Aug. 10, 2006). The amendments we are adopting today do not
affect the views of the staff expressed in that letter.
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D. Liquidation Audit

    As proposed, the amended rule requires that advisers to pooled
investment vehicles that distribute the pool's audited financial
statements to investors under the rule's annual audit provision must,
in addition to obtaining an annual audit, obtain a final audit of the
pool's financial statements upon liquidation of the pool and distribute
the financial statements to pool investors promptly after the
completion of the audit.\124\ This amendment is designed to assure that
the proceeds of the liquidation are appropriately accounted for so that
pool investors can take timely steps to protect their rights.
---------------------------------------------------------------------------

    \124\ Amended rule 206(4)-2(b)(4). Each such set of audited
financial statements must be prepared in accordance with generally
accepted accounting principles.
---------------------------------------------------------------------------

    One commenter thought that liquidation audits should not be
required as the costs outweigh the benefits.\125\ We disagree. We
believe that a liquidation audit is an important control to protect
assets at a time they

may be particularly vulnerable to misappropriation.
---------------------------------------------------------------------------

    \125\ S&K Letter.
---------------------------------------------------------------------------

E. Pooled Investment Vehicles

    The custody rule's application to investment advisers to pooled
investment vehicles will change in several aspects as a result of the
amendments we are adopting today. Because a detailed discussion of each
of these changes appears throughout multiple different sections of this
Release, we are providing a centralized summary here.
    Under amended rule 206(4)-2, advisers to pooled investment vehicles
may be deemed to comply with the surprise verification requirements of
the rule by obtaining an audit of the pool and delivering the audited
financial statements to pool investors within 120 days of the pool's
fiscal year-end.\126\ The audit must be conducted by an accounting firm
registered with, and subject to regular inspection by, the PCAOB.\127\
If the pooled investment vehicle does not distribute audited financial
statements to its investors, the adviser must obtain an annual surprise
examination and must have a reasonable basis, after due inquiry, for
believing that the qualified custodian sends an account statement of
the pooled investment vehicle to its investors in order to comply with
the custody rule.\128\ The rule requires the accounting firm performing
the surprise examination to verify privately offered securities, along
with other funds and securities, held by a pool that is not subject to
a financial statement audit.\129\ Regardless of whether an adviser to a
pooled investment vehicle obtains a surprise examination or satisfies
that requirement by obtaining an audit, if the pooled investment
vehicle's assets are maintained with a qualified custodian that is
either the adviser to the pool or a related person of the adviser, the
adviser to the pool would have to obtain, or receive from the related
person, an internal control report.\130\ Finally, the rule requires
advisers to pools complying with the rule by distributing audited
financial statements to investors to also obtain an audit upon
liquidation of the pool when the liquidation occurs prior to the fund's
fiscal year-end.\131\
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    \126\ Amended rule 206(4)-2(b)(4). See supra note 45.
    \127\ Amended rule 206(4)-2(b)(4)(ii).
    \128\ Amended rule 206(4)-2(b)(4).
    \129\ Section II.B.3. of this Release. Accounting firms that
perform surprise examinations under the amended rule are required to
report material deficiencies to our staff and also report on Form
ADV-E the termination of an engagement as well as the results of the
surprise examination.
    \130\ See paragraphs (a)(6), and (b)(4) of amended rule 206(4)-
2. This applies only where the use of a qualified custodian is
required by the rule.
    \131\ Amended rule 206(4)-2(b)(4)(iii).
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F. Delivery to Related Persons

    The Commission is adopting a new provision in rule 206(4)-2 that
would preclude advisers from using layers of pooled investment vehicles
to avoid meaningful application of the protections of the Rule.
Specifically, we are adding a new paragraph (c), which provides that
sending an account statement (paragraph (a)(5)) or distributing audited
financial statements (paragraph (b)(4)) will not meet the requirements
of the rule if all of the investors in a pooled investment vehicle to
which the statements are sent are themselves pooled investment vehicles
that are related persons of the adviser.
    Investment advisers to pooled investment vehicles may from time to
time use special purpose vehicles (SPVs) to facilitate investments in
certain securities by one or more pooled investment vehicles that the
advisers manage. These SPVs are typically established or controlled by
the investment adviser or its related persons who often serve as
general partners of limited partnerships (or managing members of
limited liability companies, or persons who hold comparable positions
for another type of pooled investment vehicle). Therefore, a literal
application of the rule could result in account statements and
financial statements designed to permit investors to protect their
interests being sent to the adviser itself, rather than to the parties
the rule was designed to protect.\132\
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    \132\ In certain circumstances, the use of SPVs could constitute
a violation of section 208(d) of the Act, which prohibits an
investment adviser, ``indirectly, or through or by any other person,
to do any act or thing which it would be unlawful for such person to
do directly under'' the Act or any of our rules.
---------------------------------------------------------------------------

    To comply with the rule, as amended, the investment adviser could
either treat the SPV as a separate client, in which case the adviser
will have custody of the SPV's assets, or treat the SPV's assets as
assets of the pooled investment vehicles of which it has custody
indirectly. If the adviser treats the SPV as a separate client, rule
206(4)-2 requires the adviser to comply separately with the custody
rule's audited financial statement distribution or account statement
and surprise examination requirements (e.g., distribute audited
financial statements of the SPV pursuant to the requirements of rule
206(4)-2). Accordingly, advisers should distribute the audited
financial statements or account statements of the SPV to the beneficial
owners of the pooled investment vehicles. If, however, the adviser
treats the SPV's assets as assets of the pooled investment vehicles of
which it has custody indirectly, such assets must be considered within
the scope of the pooled investment vehicle's financial statement audit
or surprise examination.

G. Compliance Policies and Procedures

    Rule 206(4)-7 under the Advisers Act requires registered investment
advisers to adopt and implement written policies and procedures
reasonably designed to prevent violations of the Advisers Act and its
rules.\133\ As we stated in 2003 when we adopted that rule, these
policies and procedures must address, among other things, the
safeguarding of client assets from conversion or inappropriate use by
advisory personnel.\134\ We believe that an adviser's maintenance of
strong policies and procedures, in addition to the measures we are
adopting today, is an essential component of a comprehensive approach
to addressing the potential risks raised by an adviser's custody of
client assets. We are therefore taking this opportunity to provide
guidance regarding the types of policies and procedures relating to
safekeeping of client assets that advisers should consider including in
their compliance programs.
---------------------------------------------------------------------------

    \133\ 17 CFR 275.206(4)-7.
    \134\ Compliance Programs of Investment Companies and Investment
Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003)
[68 FR 74714 (Dec. 24, 2003)] (``Compliance Rule Release''), at
Section II.A.1.
---------------------------------------------------------------------------

    Compliance with rule 206(4)-7 requires an adviser with custody to
adopt controls over access to client assets that are reasonably
designed to prevent misappropriation or misuse of client assets,
develop systems or procedures to assure prompt detection of any misuse,
and take appropriate action if any misuse does occur.\135\ Commenters
on our Proposing Release suggested several policies and procedures that
advisers should consider adopting in order to comply with rule 206(4)-
7,\136\ many of which we have incorporated into this guidance.
---------------------------------------------------------------------------

    \135\ See id.
    \136\ See, e.g., Comment letter of Investment Adviser
Association (March 6, 2009); CPIC Letter.
---------------------------------------------------------------------------

    Advisers with custody of client assets should consider the value of
instituting the following policies and procedures as part of their
compliance programs: \137\
---------------------------------------------------------------------------

    \137\ In addition to these policies and procedures, an adviser
should consider: (i) Policies and procedures to establish that it
has a basis for its reasonable belief that qualified custodians send
account statements to advisory clients; and (ii) if the adviser has
overcome the presumption that it is not operationally independent of
its related person under amended rule 206(4)-2(d)(5), policies and
procedures reasonably designed to ensure that it continues to
overcome the presumption set forth in that provision as long as it
continues to rely on the provision. See supra Sections II.A and
II.C.2. of this Release.

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     Conducting background and credit checks on employees of
the investment adviser who will have access (or could acquire access)
to client assets to determine whether it would be appropriate for those
employees to have such access;
     Requiring the authorization of more than one employee
before the movement of assets within, and withdrawals or transfers
from, a client's account, as well as before changes to account
ownership information;
     Limiting the number of employees who are permitted to
interact with custodians with respect to client assets and rotating
them on a periodic basis; and
     If the adviser also serves as a qualified custodian for
client assets, segregating the duties of its advisory personnel from
those of custodial personnel to make it difficult for any one person to
misuse client assets without being detected.\138\
---------------------------------------------------------------------------

    \138\ An adviser utilizing a segregation of duties approach
should also consider having different personnel authorize custodial
transfers from client accounts than those who reconcile client
account balances at the adviser with the custodian's records of
client transactions and holdings.
---------------------------------------------------------------------------

    Advisers should consider including in their policies and procedures
a requirement that any problems be brought to the immediate attention
of the management of the adviser. Advisers also should consider
developing policies regarding the ability of individual employees to
acquire custody of client assets, because their custody may be
attributable to the firm, which will thereby acquire responsibility for
those assets under the rule. Many firms preclude employees from
acquiring custody by prohibiting them from, for example, becoming
trustees for client assets or obtaining powers of attorney for clients
separate and apart from the advisory firm.\139\ Advisers that permit
employees to serve in capacities whereby the firm acquires custody of
client assets should take steps to assure themselves that their
employees' custodial practices conform to the firm's policies and
procedures, and that the adviser's chief compliance officer (``CCO'')
has access to sufficient information to enforce those policies and
procedures.
---------------------------------------------------------------------------

    \139\ When a supervised person of an adviser serves as the
executor, conservator or trustee for an estate, conservatorship or
personal trust solely because the supervised person has been
appointed in these capacities as a result of family or personal
relationship with the decedent, beneficiary or grantor (and not as a
result of employment with the adviser), we would not view the
adviser to have custody of the funds or securities of the estate,
conservatorship, or trust. See 2003 Adopting Release at n.15.
---------------------------------------------------------------------------

    The adviser's custody of client assets presents elevated compliance
risks for the adviser and its clients. Advisers and their CCOs
therefore must accord these risks appropriate attention in the
adviser's compliance program. Accordingly, the adviser should consider
developing procedures by which the CCO periodically tests the
effectiveness of the firm's controls over the safekeeping of client
assets. For example, the CCO could periodically test the reconciliation
of account statements prepared by advisers with account statements as
reported by qualified custodians. In addition, the CCO could compare,
on a sample basis, client addresses obtained from the clients'
qualified custodians to which the custodian sends client statements,
with client addresses maintained by the adviser, to look for
inconsistencies or patterns that suggest possible manipulation of
address information as a means for concealing misappropriation from
these accounts by advisory personnel.
    Advisers that have custody as a result of their authority to deduct
advisory fees directly from client accounts held at a qualified
custodian should have policies and procedures in place that address the
risk that the adviser or its personnel could deduct fees to which the
adviser is not entitled under the terms of the advisory contract, which
would violate the contract and which may constitute fraud under the
Advisers Act. The adviser's policies and procedures should take into
account how and when clients will be billed; be reasonably designed to
ensure that the amount of assets under management on which the fee is
billed is accurate and has been reconciled with the assets under
management reflected on statements of the client's qualified custodian;
and be reasonably designed to ensure that clients are billed accurately
in accordance with the terms of their advisory contracts.\140\ Examples
of policies and procedures such an adviser should consider include:
\141\
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    \140\ Our staff has taken the view that, under some
arrangements, clients may pay advisory fees deducted directly from
assets held in their advisory accounts without causing the adviser
to have custody of those assets and being subject to the custody
rule. Under these arrangements, a client will instruct its qualified
custodian as its agent to determine the amount of the advisory fee
and to remit the amount of the fee to the adviser. Our staff
therefore takes the view, under these circumstances, that the
adviser has no access to the client's funds or securities. See Staff
Responses to Questions About Amended Custody Rule, at Section III.
Fee Deduction, Question III.3, available at http://www.sec.gov/
divisions/investment/custody_faq.htm.
    \141\ Some of these suggestions came from commenters. See, e.g.,
CPIC Letter.
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     Periodic testing on a sample basis of fee calculations for
client accounts to determine their accuracy;
     Testing of the overall reasonableness of the amount of
fees deducted from all client accounts for a period of time based on
the adviser's aggregate assets under management; and
     Segregating duties between those personnel responsible for
processing billing invoices or listings of fees due from clients that
are provided to and used by custodians to deduct fees from clients'
accounts and those personnel responsible for reviewing the invoices and
listings for accuracy, as well as the employees responsible for
reconciling those invoices and listings with deposits of advisory fees
by the custodians into the adviser's proprietary bank account to
confirm that accurate fee amounts were deducted.
    Because different controls may be appropriate for different
advisers in designing effective compliance programs, we are not
suggesting a single set of policies and procedures. As we noted in 2003
when we adopted rule 206(4)-7, we recognize that advisers are too
varied in their operations and size for such an approach to work.\142\
Policies and procedures that are appropriate for a 500 employee firm
that also operates as a broker-dealer will be unlikely to work (or be
necessary) for a five person firm that provides asset allocation
advice. Advisers with only a few employees may, for example, find
segregation of duties impractical, but for advisers with a large number
of employees such a control may be highly effective. Advisers to pooled
investment vehicles should consider whether these practices, or others,
should cover investor accounts in the pool, for example, to prevent an
employee from misappropriating assets from the pool by processing false
investor withdrawals. We have therefore provided the guidance set out
above primarily in the form of examples; we expect advisers to tailor
their custody policies and procedures to fit both the size and the
particular risks that are raised by their business model.
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    \142\ Compliance Rule Release, at Section II.A.1.
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H. Amendments to Form ADV

    We are adopting several amendments to Part 1A and Schedule D of
Form ADV. The amendments require registered advisers to report to us
more

detailed information about their custody practices in their
registration form and to update the information. The information will
enhance our ability to identify compliance risks associated with
custody of client assets.\143\ The amendments primarily affect only
those advisers that have custody of client assets under rule 206(4)-2.
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    \143\ These 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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    Item 7. We are adopting the amendments to Item 7 and Section 7.A.
of Schedule D that we proposed to require each 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.\144\ We did not receive comments on these proposed
amendments. We also are amending Section 7.A. of Schedule D to require
an adviser to report whether it has determined that it has overcome the
presumption that it is not operationally independent from a related
person broker-dealer qualified custodian, and thus is not required to
obtain a surprise examination for the clients' assets maintained at
that custodian.
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    \144\ The item had required an adviser to identify on Schedule D
of Form ADV each related person that is an investment adviser, but
made reporting of the names of related person broker-dealers
optional.
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    Item 9. We are adopting amendments to Item 9 to require each
registered adviser to report to us: (i) Whether the adviser or a
related person has custody of client assets, and if so, both the total
U.S. dollar amount of those assets as well as the number of clients for
whose accounts the adviser or its related person has custody; \145\
(ii) if the adviser, or a related person, acts as an adviser to a
pooled investment vehicle, whether (a) the pool is audited, and (b) the
qualified custodians send account statements to pool investors; \146\
(iii) whether an independent public accountant conducts an annual
surprise examination of client assets; \147\ and (iv) whether an
independent public accountant prepares an internal control report with
respect to the adviser or its related person; \148\ and (v) whether the
adviser or a related person serves as qualified custodian for the
adviser's clients.\149\ In addition, we are amending Schedule D to
require that advisers (i) identify and provide certain information
about the accountants that perform audits or surprise examinations and
that prepare internal control reports; \150\ and (ii) to identify
related persons, such as banks, that serve as qualified custodians with
respect to their clients' funds or securities, but are not otherwise
reported in Item 7. We also are amending Schedule D to require an
adviser to report whether it has determined that it has overcome the
presumption that it is not operationally independent from a related
person qualified custodian, and thus is not required to obtain a
surprise examination for the clients' assets maintained at that
custodian.\151\
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    \145\ Items 9.A. and 9.B of Part 1A of Form ADV.
    \146\ Item 9.C.(1) and (2) of Part 1A of Form ADV.
    \147\ Item 9.C.(3) of Part 1A of Form ADV.
    \148\ Item 9.C.(4) of Part 1A of Form ADV. Two commenters
suggested that we eliminate the requirements in Item 9.C. that
require an adviser to disclose the actions taken by the adviser's
qualified custodian and accountant pursuant to the proposed custody
rule (as well as corresponding portions of Schedule D), stating that
advisers cannot guarantee third-party actions and that reporting
compliance with aspects of the custody rule is an inappropriate use
of Form ADV. See IAA Letter; MMI Letter. These items do not require
an adviser to guarantee actions of third parties, but merely require
the adviser to report on obligations it has (e.g., to form a
reasonable belief) under the revised custody rule, which if not met
would result in the adviser's violation of the rule.
    \149\ Item 9.D. of Part 1A of Form ADV.
    \150\ In addition to providing the accountant's name and
address, advisers must indicate whether the accountant is registered
with and subject to regular inspection by the PCAOB. Advisers must
also indicate whether the accountant's report contained an
unqualified opinion. Section 9.C. of Schedule D to Part 1A of Form
ADV. One commenter stated that we should not require advisers to
report whether the accountants they, or their related persons,
engage are registered with and subject to inspection by the PCAOB
because this information is readily available on the PCAOB's Web
site. See AICPA Letter. An adviser, or related person custodian,
would have to collect this information in the course of retaining an
accountant to perform the necessary engagements to comply with the
revised custody rule, and we expect that accountants would make
these representations to their clients. As a result, reporting this
information should not be burdensome to advisers.
    \151\ Section 9.D. of Schedule D to Part 1A of Form ADV.
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    Several commenters generally supported these amendments to Form
ADV, and many requested clarification or modification to parts of the
form.\152\ In response to several commenters' requests for
clarification or modification of Item 9,\153\ we have added an
instruction to clarify that an adviser must separately report the
amount of assets of which it has custody, excluding those assets
maintained by a related person qualified custodian, and the amount of
assets of which a related person has custody, including when the
related person serves as a qualified custodian.\154\
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    \152\ Cornell Letter; IAA Letter; MMI Letter; NRS Letter; Turner
Letter.
    \153\ IAA Letter; NSCP Letter; ASG Letter; CAS Letter.
    \154\ We also are revising an existing instruction to Item 9.A.
to specify that in addition to advisers that have custody only
because they have authority to deduct fees that if they also have
custody because a related person maintains client assets but the
adviser has overcome the presumption of not being operationally
independent they may continue to answer ``no'' to Item 9.A. Advisers
must report information about these custody arrangements in Item
9.B.
     It will be several months before FINRA, which operates the IARD
for us, completes reprogramming the IARD to implement this change to
Item 9. In the interim, advisers registered with the Commission
should provide responses following the amended instruction.
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I. Amendments to Form ADV-E

    We are adopting, as proposed, three amendments to the instructions
to Form ADV-E. First, we have amended the form instructions to require
that the form and the accompanying accountant's examination certificate
be filed electronically with the Commission through the IARD.\155\
Advisers will, however, continue to file form ADV on paper until the
IARD system begins accepting electronic filings of Form ADV-E, which we
expect to occur sometime in late 2010. Investment advisers will be
notified at that time. The second and third amendments we are adopting
conform Form ADV-E instructions to amended rule 206(4)-(2), which, as
discussed above, requires that (i) the surprise examination certificate
must be filed within 120 days of the time chosen by the accountant for
the surprise examination,\156\ and (ii) a termination statement be
filed by an accountant within four business days of its resignation,
dismissal, or removal.\157\
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    \155\ Instruction 3(a) to Form ADV-E. Several comments supported
electronic filing and the amendments to Form ADV-E generally. See
Cornell Letter; IAA Letter; Turner Letter.
    \156\ Instruction 3(i) to Form ADV-E.
    \157\ Instruction 3(ii) to Form ADV-E. Commenters suggested that
we revise the timing of the filing and that we do not make the
filing available to the public. We have addressed these comments in
Section II.B.2 of this Release. See supra notes 54 and 57 and
accompanying text.
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J. Required Records

    We also are adopting amendments, as proposed, to rule 204-2 to
require an adviser to maintain a copy of (i) the internal control
report that such adviser is required to obtain or receive from its
related person, pursuant to amended rule 206(4)-2(a)(6), and (ii) the
memorandum describing the basis upon which the adviser determined that
the presumption that any related person is not operationally
independent, pursuant to amended rule 206(4)-2(d)(5), has

been overcome, for five years from the end of the fiscal year in which,
as applicable, the internal control report or memorandum is finalized.
Requiring an adviser to retain a copy of these items will provide our
examiners with important information about the safeguards in place at
an adviser or related person that maintains client assets. Information
from these records will also assist our staff in assessing custody-
related risks at a particular adviser.

III. Effective and Compliance Dates

A. Effective Date

    The effective date of the amendments to rules 206(4)-2, 204-2, and
Forms ADV and ADV-E is March 12, 2010.

B. Compliance Dates and Related Rule Amendments

    Advisers registered with us must comply with amended rules 206(4)-
2, 204-2, and Forms ADV and ADV-E, as amended, on and after March 12,
2010, the effective date of these amendments, except as described
below. Immediately upon the effective date advisers that have custody
of client assets must promptly upon opening a custodial account on a
client's behalf, and following any changes to the custodial account
information, as specified in rule 206(4)-2(a)(2) send a notification to
the client, including a legend urging the client to compare the account
statements the client receives from the custodian with those the client
receives from the adviser. Such legend should also be included in any
account statements that advisers send to these clients after they are
required to send the notification discussed above. In addition,
immediately upon the effective date, each adviser that has custody of
client assets must have a reasonable belief (except with respect to
pooled investment vehicles the financial statements of which are
audited and delivered to investors) that a qualified custodian sends
account statements directly to clients at least quarterly, in
accordance with rule 206(4)-2(a)(3). We believe 60 days is sufficient
for advisers to comply with the amended rule regarding the three
requirements described above because they are modifications to the
existing rule requirements.
    Compliance dates for other provisions of amended rules 206(4)-2,
204-2, and Forms ADV and ADV-E are described below.\158\
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    \158\ Some commenters requested that we delay the compliance
date by 12-24 months from the effective date of the rule. See Curian
Letter; CAQ Letter; Dechert Letter; Deloitte Letter; E&Y Letter;
KPMG Letter; PWC Letter. In determining the compliance dates for the
amended rules and forms, we balanced the urgency of enhancing
investor protection afforded under the Advisers Act, the need to
provide sufficient time for advisers to comply with the requirements
under the amended rules, and the extent of changes we made from the
proposal on which the commenters' requests were based.
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1. Surprise Examinations
    An investment adviser required to obtain a surprise examination
must enter into a written agreement with an independent public
accountant that provides that the first examination will take place by
December 31, 2010 or, for advisers that become subject to the rule
after the effective date, within six months of becoming subject to the
requirement.\159\ If the adviser itself maintains client assets as
qualified custodian, however, the agreement must provide for the first
surprise examination to occur no later than six months after obtaining
the internal control report.\160\ We believe these compliance dates
will provide sufficient time for an adviser to hire an independent
public accountant for purposes of the surprise examination and for the
accountant to perform the surprise examination.
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    \159\ An adviser could first become subject to the surprise
examination requirement by, for example, registering with the
Commission or accepting custody of a client's assets.
    \160\ An independent public accountant conducting a surprise
examination on an adviser that also serves as the qualified