United States: Regulation Of Custodial Practices Under The Investment Advisers Act Of 1940 Rule 206(4)-2

I. Background

A. Adoption in 1962

The SEC has regulated custodial practices of investment advisers since 1962, when it first adopted rule 206(4)-2 (the "Custody Rule") under the Investment Advisers Act of 1940 ("Advisers Act") under newly-acquired authority to adopt rules to prevent fraud by investment advisers. The purpose of the rule was to require advisers that have custody of client funds or securities to implement a set of controls to insulate them from "any unlawful activities or financial reverses, including insolvency, of the adviser."¹

The 1962 rule required advisers to adopt the best practices of the day, which included segregating client securities from those of the adviser, "marking" them to indicate the name of the client, and holding them in "some place reasonably free from risk of destruction or other loss."² All cash had to be kept in a bank account. Monthly client statements were required, identifying the "location" and "manner" in which the securities were held. At least once each year, the securities were required to be subject to a surprise "physical examination" by an independent public accountant hired by the adviser for that purpose. The rule reflected the paper-based system of owning and holding securities then in place. The SEC felt no need to define the term custody used in the rule—in 1962 it could mean but one thing.³

Between 1962 and 2003, the SEC dealt with the limitations of the Custody Rule in a rapidly evolving securities market in which securities were increasingly held in book-entry form on account at regulated financial intermediaries rather than in locked file cabinets.⁴ The SEC staff issued a series of no-action letters that accommodated new ways of holding securities. But these letters themselves begat interpretive issues, leading to more noaction letters—almost 90 of them. They sometimes addressed the question of whether the adviser had custody and other times whether a surprise examination could be avoided. Collectively, the letters and the conditions they imposed created a separate regulatory regime that challenged the most knowledgeable adviser wishing to comply with the rules.

These staff letters and related interpretations during this period provided in many respects the foundation for today's rule, establishing, for example, that an adviser could have custody even if it did not have physical possession of securities or funds, that an adviser could have custody indirectly through a related person,⁵ that authority to deduct fees from client assets implicates the Custody Rule,⁶ and providing an allowance for inadvertent custody.⁷

B. 2003 Amendments

In 2003, the SEC adopted revisions to rule 206(4)-2 designed to clarify advisers' obligations under the rule and to reflect modern custodial practices ("2003 Amendments").⁸ The 2003 Amendments incorporated into the rule a definition of "custody," and swept away all traces of the vintage paper-based assumptions of the 1962 version of the rule. Advisers could avoid the cost of annual surprise examination if they maintained client assets with one or more "qualified custodians," such as a broker-dealer, a bank or a commodity futures merchant, and the custodian provided quarterly custodial reports directly to clients. These custodians were themselves regulated as custodians under different regulatory regimes, and, as the SEC pointed out, an independent verification of assets accomplished little if the assets were already missing when the accountant later arrived for the annual verification.⁹ Direct reporting by custodians would provide clients the ability to identify discrepancies, and the knowledge that custodial reports would be provided directly to clients would deter advisers from misusing client assets.¹⁰

The 2003 Amendments also for the first time directly addressed the obligations of advisers to pooled investment vehicles under the rule, codifying the long-standing staff position that advisers also serving as general partners to a fund have custody of fund assets, while acknowledging that the audited financial statements typically required by investors provided their own form of protections against misuse of client assets. The 2003 Amendments therefore excused advisers to audited pooled investment vehicles from the rule's surprise examination and account statement delivery requirements.

One of the most significant advances of the 2003 Amendments was the elimination of the need for advisers and their counsel to rely on the large body of SEC staff no-action letters to discern whether the adviser had "custody" of client assets. The complexity of the question arose in most cases as a result of the development of a book entry system of ownership of securities, so that an adviser could have access and control over a client's assets without having physical custody of paper certificates. Constructive custody, in which the adviser has access to or legal title to client securities, presents many of the same custodial risks but without the regulatory certainty that paper certificates provided.

The 2003 Amendments did not provide regulatory certainty as to whether an adviser had custody (and thus was subject to the Custody Rule) so much as they provided a significant degree of certainty as to whether an adviser was in compliance with the Custody Rule.

As long as client assets were held with a qualified custodian (as they customarily are) that delivers custodial statements directly to clients (which became the norm) there was little practical need to worry about whether the adviser had custody of the assets or, indeed, whether the assets were "securities" or "funds."¹¹ Compliance with the rule was met by an adviser operating within standard industry best practice in which the custodial report provided a check on misuse of client assets by the adviser. The prospect of just one client (or custodian) reviewing the report and recognizing an inconsistency provided a significant deterrence to advisers and their personnel.

Footnotes

1 Advisers Act Rel. No. 123 (Feb. 27, 1962). The adopting release was three pages long.

2 Id. The SEC amended the Custody Rule, along with the other anti-fraud rules under the Advisers Act, in 1997 to make them inapplicable to unregistered investment advisers, including advisers registered solely with state securities authorities. Rules Implementing Amendments to the Investment Advisers Act, Advisers Act Rel. No. 1633 (May 15, 1997).

3 In 1985, the SEC developed a definition of custody and added it to Form ADV. Under that definition, which has been incorporated into rule 206(4)-2, an adviser has custody if it directly or indirectly holds client funds or securities, has any authority to obtain possession of them, or has the ability to appropriate them. See Glossary of Terms, Form ADV; Uniform Investment Adviser Registration Application Form, Advisers Act Rel. No. 991 (Oct. 15, 1985).

4 During this period the SEC also updated custody rules under the Investment Company Act. See Custody of Investment Company Assets with a Securities Depository, Investment Company Act Rel. No. 25266 (Nov. 15, 2001).

5 Crocker Investment Mgmt. Corp., SEC Staff No-Action Letter (Mar. 15, 1978)

6 Bennett Mgmt. Co., SEC Staff No-Action Letter (Feb. 26, 1990); Investment Counsel Association of America, Inc., SEC Staff No-Action Letter (July 9, 1982).

7 Hayes Financial Services, Inc., SEC Staff No-Action Letter (Apr. 2, 1991).

8 Custody of Funds or Securities of Clients by Investment Advisers, Advisers Act Rel. No. 2176 (Sept. 25, 2003) (adopting amendments to rule 206(4)-2) ("2003 Adopting Release").

9 Custody of Funds or Securities of Clients by Investment Advisers, Advisers Act Rel. No. 2044 (July 18, 2002) (proposing amendments to rule 206(4)-2) at Section II.C.

10 See John B. Kennedy, SEC Staff No-Action Letter (June 15, 1996) ("We agree . . . that the client rather than the custodian is in the best position to ascertain whether an advisory fee has been properly calculated.")

11 There has, however, always been the need for an adviser to ascertain whether it has custody of client securities or funds for purposes of responding to an item in Form ADV that requested such information.

Regulation of Custodial Practices Under the Investment Advisers Act of 1940 Rule 206(4)-2

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