Corporate & Securities Law

The SEC has adopted rules designed to substantially increase the protections for investors who turn their money and securities over to an investment adviser registered with the SEC.  The new rules provide safeguards where there is a heightened potential for fraud or theft of client assets.

Most investment advisers do not maintain physical custody of their clients' assets.  Instead, those assets are held by a qualified third-party custodian, such as a regulated bank or a broker-dealer. However, over the past year, the SEC has brought a series of enforcement cases against advisers who had access to their clients' assets and misused them.  These advisers often covered up the misuse by distributing false account statements to their clients reflecting assets that didn't really exist.  The SEC's new rules are intended to help prevent that from happening.

"The Madoff Ponzi scheme and other frauds have caused investors to question whether their assets are safe when they entrust them to an investment adviser," said SEC Chairman Mary Schapiro.  "These new rules will apply additional safeguards where the safeguards are needed most - that is, where the risk of fraud is heightened by the degree of control the adviser has over the client's assets."

The SEC's custody rule as amended would promote independent custody and require the use of independent public accountants as third-party monitors.  Depending on the investment adviser's custody arrangement, the rules would require the adviser to be subject to a surprise exam and custody controls review that are generally not required under existing rules.

Surprise Exam - The adviser is now required to engage an independent public accountant to conduct an annual "surprise exam" to verify that client assets exist.  Such a surprise examination would provide another set of eyes on the client's assets, and provide additional protection against theft or misuse.  The accountants would have to contact the SEC if they discovered client assets were missing.

Custody Controls Review - When the adviser or an affiliate serves as custodian of client assets, the adviser is now required to obtain a written report - prepared by an accountant that is registered with and subject to regular inspection by the PCAOB - that, among other things, describes the controls in place at the custodian, tests the operating effectiveness of those controls and provides the results of those tests.  These reports are commonly known as SAS-70 reports.  Requiring that the accountant be registered with and subject to inspection by the PCAOB provides greater confidence regarding the quality of these reports.

The new rules also will impose an important new control on advisers to hedge funds and other private funds that comply with the custody rule by obtaining an audit of the fund and delivering the fund's financial statements to fund investors.  The rule will require that the auditor of such a private fund be registered with and subject to regular inspection by the PCAOB.

The new rules also require that the adviser reasonably believe that the client's custodian delivers the account statements directly to the client, to provide greater assurance of the integrity of these account statements.  It also will enable clients to compare the account statement they receive from their adviser to determine that the account transactions are proper.

Source: SEC Press Release 2009-269