Question I.1

Q:

When must an adviser begin complying with, or transition to, the amended rule?

A:

Between November 5, 2003 (the effective date) and March 31, 2004, advisers may choose to comply with either the old custody rule or the amended custody rule. Starting on April 1, 2004 (the compliance date), all advisers that have custody as defined in the amended rule must comply with the amended rule.

Question I.2

Q:

May advisers continue to rely on SEC staff no-action letters (such as Bennett Management Co. (Feb. 26, 1990); PIMS, Inc. (Oct. 21, 1991); John B. Kennedy (June 5, 1996), and Blum Shapiro Financial Services, Inc. (Apr. 16, 1993) to avoid having custody?

A:

Advisers that are currently relying on those SEC staff no-action letters to avoid having custody may continue relying on those letters through March 31, 2004. However, the letters are withdrawn effective April 1, 2004 and from that date forward advisers must comply with the amended rule (footnotes 11 and 15 of the Adopting Release).

Question I.3

Q:

If an adviser will no longer need a surprise exam under the amended rule because qualified custodians will send account statements directly to all of its advisory clients, must the qualified custodian have begun sending those account statements before April 1, 2004?

A:

No. By April 1, 2004, the adviser must establish a reasonable belief that the qualified custodian will send account statements directly to all of the adviser's clients after April 1, 2004. The adviser may establish this reasonable belief if, before April 1, the custodian has begun sending statements directly and the adviser is receiving duplicate copies of the statements (footnote 29 of the Adopting Release). However, this is not the only means by which the adviser can establish a reasonable belief. If the qualified custodian's account statements are not due to be sent until, for example, May 1, the adviser could get the custodian's commitment that it will send the statements and will provide the adviser with duplicate copies.

Question II.1

Q:

If an adviser inadvertently receives securities from a client, under the amended rule may the adviser forward the securities to the qualified custodian instead of returning the securities to the client?

A:

No. If the adviser does not return the securities to the sender within three business days, the adviser not only has custody but has also violated the amended rule's requirement that client securities be maintained in an account with a qualified custodian.¹

Question II.2

Q:

Several employees of an adviser are also registered representatives of the adviser's affiliated broker-dealer. Does the amended custody rule permit these employees to forward securities?

A:

Yes, so long as (1) the employees are acting within the scope of their employment with the affiliated broker-dealer, and (2) the affiliated broker-dealer is a qualified custodian, has opened accounts for these clients, and sends them account statements at least quarterly. Under these circumstances, the employees would be acting in their capacity as registered representatives of the broker-dealer when they accept the securities.

Question II.3

Q:

The staff's Crocker Investment Management Corp. (Apr. 14, 1978) no-action letter laid out factors for determining whether an adviser would be deemed to have custody because its affiliate has custody. Are the principles established in Crocker still in effect under the amended rule?

A:

Yes (footnote 4 of the Adopting Release).

Question II.4

Q:

If an employee of an advisory firm serves as a trustee to a firm client, does the firm have custody?

A:

Generally, yes. The role of the supervised person as trustee is imputed to the advisory firm, thus causing the firm to have custody.

Footnote 15 of the Adopting Release explains, however, that the role of the supervised person as trustee will not be imputed to the advisory firm if the supervised person has been appointed as trustee as a result of a family or personal relationship with the grantor or beneficiary and not as a result of employment with the adviser. A similar analysis would apply where the supervised person serves as the executor to an estate as a result of a family or personal relationship with the deceased. A personal relationship developed as a result of providing advisory services to a client over many years is not the type of "personal relationship" contemplated by footnote 15.

Question II.5

Q:

If an adviser has custody under the amended custody rule because it automatically deducts fees, does the adviser necessarily have custody for all other purposes (such as the scope of their liability coverage)?

A:

No. Footnote 12 of the Adopting Release states that "an adviser that has 'custody' for purposes of rule 206(4)-2 may not necessarily have custody for other purposes."

Question II.6

Q:

If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A:

No. Rule 206(4)-2 applies only to clients' funds and securities.

Question III.1

Q:

Some advisers were relying on staff no-action letters that required them to send invoices and fee calculation statements to clients when deducting fees. Now that these advisers must comply with the custody rule, does the amended rule require advisers to continue sending these invoices and statements?

A:

No. Amended rule 206(4)-2 does not require advisers to send invoices or fee calculation statements to clients when deducting fees from the clients' accounts. However, before discontinuing sending invoices and fee calculation statements to clients, advisers should review their disclosure documents and contracts to see whether they have committed separately to sending that information.

Question III.2

Q:

If an adviser has custody under the amended rule because it deducts fees from client accounts, but its client contracts say it does not take custody, must the adviser amend its client contracts?

A:

Rule 206(4)-2 cannot answer this question, which involves interpretation of an advisory contact rather than the amended custody rule. However, footnote 12 of the Adopting Release states that "an adviser that has 'custody' for purposes of rule 206(4)-2 may not necessarily have custody for other purposes."

Question III.3

Q:

A client has instructed its custodian to debit the client's account for advisory fees each quarter. The custodian makes all fee calculations, based on the advisory contract. The adviser does not calculate the fee, nor does it send a bill. Does the adviser have custody?

A:

No. Under these circumstances, the custodian is acting only as agent for the client, and the adviser does not have access to the client's funds.

Question IV.1

Q:

May account statements be delivered electronically?

A:

Yes. Electronic delivery is permissible, so long as (1) the client has given informed consent to receiving the information electronically; (2) the client can effectively access the electronically delivered information; and (3) evidence of the delivery is received, such as an email return-receipt or other confirmation that the information was accessed. See Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information; Additional Examples under the Securities Act of 1933, Securities Exchange Act of 1934, and Investment Company Act of 1940, Release No. 33-7288 (May 9, 1996) [61 FR 24644 (May 15, 1996)]. These guidelines are available at www.sec.gov/rules/concept/33-7288.txt.

Advisers whose clients receive electronic statements from qualified custodians must still form a reasonable belief that the clients are receiving those statements. These advisers may, for example, want to consider requesting to be copied on the electronically delivered custodial statements, although this is not the exclusive means of forming that reasonable belief (footnote 29 of the Adopting Release).

Question IV.2

Q:

If qualified custodians send account statements directly to some, but not all, of an adviser's clients, what must the adviser's annual surprise examination cover?

A:

Under the amended custody rule, the surprise examination must cover all funds or securities that are in the adviser's custody but that are not the subject of statements sent directly to clients by qualified custodians. If some clients receive no statements directly from qualified custodians, the exam must cover all of those clients' funds and securities in the adviser's custody. If a client receives account statements directly from a qualified custodian but those statements cover only a portion of the client's funds and securities in the adviser's custody, the exam must cover the balance of those funds and securities (footnote 33 of the Adopting Release). The accountant performing the examination must satisfy itself that all client funds and securities in the adviser's custody either are covered by statements sent directly from qualified custodians or are covered by the surprise examination. There is one exception, for certain privately issued securities; this exception is discussed below in Section VII.

Question IV.3

Q:

Can an adviser voluntarily continue to send its own quarterly account statements to clients in addition to the statements that the clients receive directly from qualified custodians?

A:

Yes.

Question IV.4

Q:

If an accounting firm regularly audits an advisory firm's books or the books of a limited partnership run by the advisory firm, can that accounting firm also be an "independent" public accountant for purposes of performing the surprise examination under the custody rule?

A:

Yes.

Question V.1

Q:

An adviser uses three different custodians for one of its clients, and the assets are moved among them depending on the trading in the account. At any given moment, one or two of those custodians might not be holding that client's funds or securities. Must the adviser provide the client with a new notice each time the assets are moved, or can the adviser provide the client with notice at one time advising the client of all three custodians?

A:

The adviser can give the client a one-time notice of all three custodians, and is not required to provide a new notice each time the assets move among the three. The purpose of the notice is to tell the client whom to contact to get his assets, if necessary, and this purpose is satisfied even if the client has to contact three custodians.

Question VI.1

Q:

What are the approaches that an adviser acting as general partner of a limited partnership (or other pooled investment vehicle) may take to comply with the reporting requirements of the amended custody rule?

A:

There are three approaches that an adviser to a pooled investment vehicle may take to comply with the reporting requirements of amended rule 206(4)-2. Under each of these options, the account statements or audited financial statements may be sent to the investors' independent representatives rather than the investors themselves.

• The pooled investment vehicle may be audited annually and the audited financial statements sent to all the investors in the pooled investment vehicle within 120 days after the pool's fiscal year end (the "audit approach") (see Section II. D. 2. of the Adopting Release);
   
• A qualified custodian may send quarterly account statements directly to the investors in the pool; or
   
• The adviser may send its own quarterly account statements to the investors and undergo an annual surprise examination.

Question VI.2

Q:

Should the account statements sent to the investors be a statement of the transactions and holdings of the pool, or a statement of the investor's holdings in the shares of the pool (i.e., how many limited partnership units the investor owns)?

A:

They must be a statement of the transactions and holdings of the pool.

Question VI.3

Q:

Does each limited partner need to have a separate independent representative or can one independent representative serve for all limited partners?

A:

The representative can serve for all limited partners, so long as the representative is, in fact, independent and satisfies the definition in rule 206(4)-2(c)2.

Question VI.4

Q:

To use the "audit approach" under the amended custody rule, is it the adviser, or the limited partnership that the adviser manages, that must be audited annually?

A:

To use the "audit approach" under the amended custody rule, the limited partnership must be audited annually

Question VI.5

Q:

To use the "audit approach" under the amended custody rule, must the financial statements be prepared in accordance with U.S. GAAP?

A:

Yes, with one exception. Pooled vehicles organized outside of the United States, or having a general partner or other manager with a principal place of business outside the United States, may have their financial statements prepared in accordance with accounting standards other than U.S. GAAP so long as they contain information substantially similar to statements prepared in accordance with U.S. GAAP and any material differences are reconciled. Both U.S. and non-U.S. pooled investment vehicles must be audited in accordance with U.S. Generally Accepted Auditing Standards and, in particular with Article I, Section 2(d) of Regulation S-X (governing independence standards) (footnote 41 of the Adopting Release).

Question VI.6

Q:

To use the "audit approach" under the amended custody rule, must the audit meet the requirements of U.S. Generally Accepted Auditing Standards?

A:

Yes. If the audit does not meet U.S. GAAS requirements, then account statements must be delivered to each of the underlying investors of the pool or to their independent representative(s).

Question VI.7

Q:

Does a fund of funds have to meet the 120-day deadline for sending out its audited financial statements?

A:

An adviser using the “audit approach” for a fund of funds now has 180 days from the end of the fund of funds’ fiscal year to distribute the audited financials to investors. This amendment to the custody rule was adopted in Release No. IA-2333 and is effective January 10, 2005. A fund of funds is defined in the rule to mean a pooled investment vehicle that invests 10 percent or more of its total assets in other pooled investment vehicles that are not, and are not advised by, a related person of the pool, its general partner, or its adviser. A “related person” of an adviser includes officers, partners, directors, most employees, and anyone controlled by, controlling or under common control with the adviser.

Question VI.8

Q:

An adviser’s client is a pooled investment vehicle that invests in a fund of funds, but the “top tier” pool does not meet the definition of a fund of funds because it is affiliated with the fund of funds in which it invests – for example, the top tier pool is a feeder fund in a master-feeder structure where the master fund is a fund of funds. If the top tier pool wishes to use the “audit approach,” must it distribute its audited financial statements within 120 days of its fiscal year end, or may it use the extended 180-day deadline available to the fund of funds?

A:

In these circumstances, the auditors of the top tier pool, like the auditors to the fund of funds, might not be able to complete their work until the audit reports of the funds underlying the fund of funds are available. The Division would not recommend enforcement action for a violation of rule 206(4)-2 against an adviser to a top tier pool that invests 10 percent or more of its total assets in a fund of funds if the adviser distributes the top tier pool’s audited financial statements within 180 days of the end of the fiscal year of the fund of funds.

Question VI.9

Q:

If a pooled investment vehicle is subject to an annual audit and its adviser is relying on the “audit approach” under rule 206(4)-2(b)(3), would the adviser be in violation of the rule if the pooled vehicle fails to distribute its audited financial statements within 120 days after the end of its fiscal year?

A:

The Division would not recommend enforcement action for a violation of rule 206(4)-2 against an adviser that is relying on rule 206(4)-2(b)(3) and that reasonably believed that the pool’s audited financial statements would be distributed within the 120-day deadline.

Question VII.1

Q:

If the client is a pooled investment vehicle that does not use the "audit approach" under the amended custody rule, may the adviser use the exception for privately issued securities for that client?

A:

No.

Question VII.2

Q:

The limited partnership an adviser manages does not undergo an annual audit, and the amended custody rule therefore requires that privately issued securities owned by the limited partnerships be maintained with qualified custodians. Some of these securities, however, are recorded only on the books of their issuers that are not qualified custodians. In this circumstance, there is no way to maintain the security itself with a qualified custodian. May the adviser satisfy this requirement of rule 206(4)-2 by keeping the subscription agreement for the security with a qualified custodian?

A:

Yes. Under this circumstance, where there is no way to maintain the security itself with a qualified custodian, an adviser may satisfy the requirements of rule 206(4)-2(a)(1) by keeping the originally signed subscription agreement (instead of the security itself) with a qualified custodian.

Question VII.3

Q:

If an adviser is using the exception for privately issued securities and is not required to maintain these securities with a qualified custodian, the qualified custodian's quarterly account statements will not cover these securities. Must the adviser send out its own quarterly account statements covering these securities, and must it undergo an annual surprise examination?

A:

No. The adviser does not have to comply with any section of the custody rule with respect to the privately issued securities, if the adviser can rely on the exception.

Question VIII.1

Q:

May either the client or the adviser appoint an independent representative?

A:

Yes.

Question VIII.2

Q:

If an adviser appoints an independent representative for a client, must the adviser obtain the client's consent?

A:

The amended custody rule does not address this point. However, an adviser's fiduciary duties, client contract or limited partnership contract may require it to obtain client consent for the appointment. Appointment of a representative without consent of the client suggests that the representative may be controlled by the adviser and is not truly independent.

Question VIII.3

Q:

If an accounting firm acts as the independent auditor (or independent surprise examiner) of an adviser, may the accounting firm also act as the independent representative for the limited partners of a pooled investment vehicle run by the adviser?

A:

Likely not. The accounting firm would have to meet the definition of "independent representative" set out in the amended custody rule. We note that the concept of independence for purposes of the definition of "independent representative" under the amended custody rule is distinct from the concept of independence for purposes of the Commission's auditor independence rules.

Question VIII.4

Q:

If an accounting firm acts as the independent auditor of a pooled investment vehicle, may the accounting firm also act as the independent representative for the investors in the pool?

A:

Likely not. The accounting firm would have to meet the definition of "independent representative" set out in the amended custody rule. As noted in the previous question, the concept of independence for purposes of the definition of "independent representative" under the amended custody rule is distinct from the concept of independence for purposes of the Commission's auditor independence rules.

In addition, if the audited financial statements are intended to be delivered to the independent representative rather than to the investors in the pooled vehicle, then the accounting firm would be receiving its own audit results; in those circumstances, we believe that the accountant may not be able to act solely in the limited partners' interests.

Question VIII.5

Q:

If an adviser is a trustee for a client's trust, can a co trustee be the "independent representative" to receive statements for the trust?

A:

The co-trustee can be the independent representative provided it meets the tests for independence set out in the rule.

Question VIII.6

Q:

Can someone who is an advisory client of an adviser act as an independent representative for other clients of that adviser?

A:

Yes, if it meets the tests for independence set out in the rule. If the client relationship is a "material business relationship" (or the person has another material business relationship) with the advisory firm, the person will not meet the tests for independence.

Question IX.1

Q:

If an adviser that is a qualified custodian uses a sub-custodian (that is also a qualified custodian) to hold some book-entry securities, may the adviser send its advisory clients consolidated account statements that incorporate the sub custodian's account statements, or must the sub-custodian send separate account statements?

A:

If the adviser/custodian's account includes the assets maintained with the sub custodian, the adviser/custodian can send a consolidated statement.

Question X.1

Q:

Can an adviser use the audit approach under the new custody rule with respect to the account of a client that is not a pooled investment vehicle (e.g., an endowment, an individual, or a pension fund)? What if the client co-invests alongside an audited private pool?

A:

No. The audit approach is not available if the client is not a pooled investment vehicle; account statements must be sent to the client (either by a qualified custodian or, if the adviser undergoes an annual surprise exam, by the adviser). The answer does not change if the client co-invests alongside an audited pool.

Question XI.1

Q:

Under what circumstances must an adviser still provide an audited balance sheet to its advisory clients?

A:

Although having custody no longer causes SEC-registered advisers to be subject to the balance sheet requirement, Item 14 of Form ADV Part II still requires advisers that charge prepayment of fees exceeding $500 and six or more months in advance to provide audited balance sheets to their clients.

Modified: 01/10/2005