Comment Letter Managed Funds Association

July 28, 2009
Via Electronic Mail:

[email protected]

Elizabeth M. Murphy
Secretary
U.S. Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-1090
Re:

File Number S7-09-09; Custody of Funds or Securities of Clients by Investment
Advisers

Dear Ms. Murphy:
Managed Funds Association (“MFA”)1 appreciates the opportunity to comment on the
Securities and Exchange Commission’s proposed amendments to the custody rules for registered
investment advisers.2 The safekeeping of client assets is a fundamental obligation of an investment
adviser, and we support the Commission’s efforts to enhance Rule 206(4)-2 under the Investment
Advisers Act in light of recent events. The fraudulent activities of a single unscrupulous manager can
cause widespread damage to investor confidence in the alternative investment industry, and MFA and
its members strongly support efforts to prevent, detect and punish fraudulent conduct.
Registered investment advisers, including those that serve as managers to certain privately
offered investment pools, which rely on the exclusion from the definition of “investment company”
under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act (“hedge funds”), are subject
to Rule 206(4)-2 if they are deemed to have custody of client funds or securities.3 Under the definition
of custody adopted by the Commission in 2003,4 advisers that do not physically hold client funds or
1

MFA is the voice of the global alternative investment industry. Its members are professionals in hedge funds,
funds of funds and managed futures funds, as well as industry service providers. Established in 1991, MFA is the
primary source of information for policy makers and the media and the leading advocate for sound business
practices and industry growth. MFA members include the vast majority of the largest hedge fund groups in the
world who manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies.
MFA is headquartered in Washington, D.C., with an office in New York.

2

Custody of Funds or Securities of Clients by Investment Advisers, SEC Release No. IA-2876 (May 20, 2009),
74 FR 25354 (May 27, 2009) (“Release”).
3

Rule 206(4)-2 does not apply to investment advisers that are neither registered, nor required to be registered
with, the Commission. In addition, offshore advisers are not subject to Rule 206(4)-2 with respect to non-U.S.
funds or clients. See Uniao de Bancos de Brasilerios S.A., SEC No-Action Letter (July 28, 1992); Registration
Under the Advisers Act of Certain Hedge Fund Advisers, SEC Release No. IA-2333 (Dec. 2, 2004), 69 FR
72054 (Dec. 10, 2004); American Bar Association, SEC No-Action Letter (Aug. 10, 2006).

4

Custody of Funds or Securities of Clients by Investment Advisers, SEC Release No. IA-2176 (Sept. 25, 2003),
68 FR 56692 (Oct. 1, 2003).

Ms. Elizabeth Murphy
July 28, 2009
Page 2 of 12
securities are nevertheless deemed to have custody if they, or a supervised person,5 serve as general
partner or managing member of a pooled investment vehicle and have legal ownership of or access to
the funds or securities,6 or if they are authorized to withdraw client funds or securities maintained with
a custodian.7 Hedge fund managers typically are subject to the Rule pursuant to one of these
definitions.
The proposals would impose a new requirement on hedge fund managers subject to the Rule -­
each manager would be required to engage an accountant to perform an annual “surprise exam” of
client assets. We strongly support the objective of the SEC in enhancing the safekeeping of client
assets in light of recent fraudulent activity. For the reasons discussed below, however, we believe that
the implementation of an annual surprise exam for pooled investment vehicles advised by registered
investment advisers would be overly burdensome, inefficient, and unresponsive to investor demands.
A surprise exam requirement would also be redundant for most hedge funds that already have an
independent annual audit.
We recommend that, instead, the Commission amend Rule 206(4)-2 to require registered
investment advisers to pooled investment vehicles with custody of client funds or securities to arrange
for each pooled investment vehicle to be subject to an annual audit conducted by an independent
public accountant registered with, and subject to inspection by, the Public Company Accounting
Oversight Board (“PCAOB”), and to distribute audited financial statements, prepared in accordance
with generally accepted accounting principles, to each investor in the fund. The requirement should
apply to all advisers subject to the Rule that manage pooled investment vehicles, except in cases where
an adviser does not have the authority to require an audit.8
Mandatory Annual Audit for Pooled Investment Vehicles
Under current Rule 206(4)-2(a)(3), a registered investment adviser must either direct a
qualified custodian to send an account statement, at least quarterly, to each client for which it
maintains funds or securities, or itself deliver a quarterly account statement to each client and arrange
for an annual surprise exam by an independent public accountant. Rule 206(4)-2 provides that an
adviser to a pooled investment vehicle that is subject to audit at least annually,9 and distributes its
audited financial statements, prepared in accordance with generally accepted accounting principles, to

5

“Supervised person” means any partner, officer, director (or other person occupying a similar status or
performing similar functions), or employee of an investment adviser, or other person who provides investment
advice on behalf of the investment adviser and is subject to the supervision and control of the investment adviser.
Advisers Act § 202(a)(25).
6

Rule 206(4)-2(c)(1)(iii).

7

Rule 206(4)-2(c)(1)(ii).

8

For example, when an adviser provides investment advice to a hedge fund through a third-party platform
arrangement, the third-party entity would typically have such authority.

9

The accountant performing the audit must meet the standards of independence in Rule 2-01 of Regulation S-X.

Ms. Elizabeth Murphy
July 28, 2009
Page 3 of 12
each investor in the fund is not required also to deliver account statements under subsection (a)(3) of
the Rule.10
A substantial proportion of hedge fund managers, whether or not they are registered with the
Commission, provide independently audited financial statements of the fund to investors. Current
SEC rules do not require managers to provide investors with audited financial statements, and yet
managers provide them to investors primarily as a result of the demands of their investors. Hedge
fund investors are typically sophisticated institutional or high net worth clients that perform extensive
due diligence prior to investing with a particular manager. It is our understanding that most investors
will not consider investing in a private fund unless they receive independently audited financial
statements regarding that fund. Providing annual audited financial statements to investors is a longstanding best practice in the hedge fund industry, and is recommended in both the Report of the Asset
Managers’ Committee to the President’s Working Group on Financial Markets (“PWG Report”),11 and
MFA’s Sound Practices for Hedge Fund Managers 2009 (“Sound Practices”).12 This practice is a
result of the competitive environment of the hedge fund industry, which requires fund managers to
meet the demands of their highly sophisticated investors.
Because most hedge fund managers provide audited financial statements to investors in
accordance with Rule 206(4)-2(b)(3), most managers are not subject to the account statement delivery
or surprise exam requirement in Rule 206(4)-2(a)(3)(ii). We believe building upon and enhancing the
widely used independent audit process would be the most effective means for the SEC to provide
investors with protection against the risk that an adviser would intentionally misuse client assets. We
recommend therefore that the Commission require investment advisers to pooled investment vehicles
with custody of client funds or securities to arrange for each pooled investment vehicle to be subject to
an independent annual audit by a qualified audit firm and to distribute audited financial statements,
prepared in accordance with generally accepted accounting principles, to each investor in the fund. To
enhance safekeeping of client assets through a rigorous and robust audit process, we believe the
Commission should include the following requirements in its rules.
First, the accountant performing the audit must be sufficiently independent from the
investment adviser. As currently required for a pooled investment vehicle relying on the audit
exception in Rule 206(4)-2, the accountant should be required to meet the independence standards
adopted by the Commission.13 Such a requirement would establish a consistent, uniform standard for
accountants performing audits of hedge funds and other pooled investment vehicles. Currently, hedge
fund managers that are not subject to Rule 206(4)-2 may engage accountants to audit funds they
manage that comply with different independence standards, such as those set out by the AICPA.14 If
Congress enacts legislation this year that would significantly narrow or eliminate the exception to
10

To rely on this exception, the adviser must deliver the audited financial statements within 120 days of the end
of a fund’s fiscal year, or within 180 days of the end of the fiscal year of a fund of fund.

11

The PWG Report is available at http://www.amaicmte.org/Public/AMC%20Report%20-%20Final.pdf.

12

MFA’s
Sound
Practices
is
http://www.managedfunds.org/files/pdf's/MFA_Sound_Practices_2009.pdf.
13

See Rule 2-01 of Regulation S-X.

14

See e.g., Deloitte & Touche LLP, SEC No-Action Letter (August 28, 2006).

available

at

Ms. Elizabeth Murphy
July 28, 2009
Page 4 of 12
registration with the SEC upon which many investment advisers rely,15 as widely expected, many
hedge fund managers would become subject to the Rule. Under our proposal, each registered manager
would be required to subject funds it manages to an annual audit performed by an accounting firm that
complies with the SEC’s heightened independence standards.
Second, the firm performing the audit should be subject to the highest standards of the
accounting industry, and be sufficiently knowledgeable and capable of performing a comprehensive
and rigorous audit. This is an important requirement to ensure that advisers are properly safeguarding
client assets, and we believe that such a requirement would significantly reduce the ability of an
unscrupulous adviser to engage in fraudulent activities. It is especially important for accountants
performing audits of hedge funds, which frequently engage in sophisticated investment techniques, to
employ highly experienced personnel with extensive knowledge of the industry. Accordingly, we
support the SEC’s proposed requirement that an independent public accountant under Rule 206(4)-2
be registered with, and subject to inspection by, the PCAOB, and recommend that the Commission
amend the Rule to require that accountants performing audits of pooled investment vehicles meet this
standard. We further encourage the SEC to work with the PCAOB to consider developing any
additional standards for firms to meet that perform audits of pooled investment vehicles.
Third, the firm should meet generally accepted auditing standards (“GAAS”) in terms of
verifying a percentage of client funds and securities to ensure the safekeeping of client assets.
Auditing standards currently require an accountant preparing financial statements in accordance with
GAAS to verify a substantial proportion of client assets during audits of pooled investment vehicles,
including hedge funds.16 As a result, an appropriate same of hedge fund assets are verified on an
annual basis. We believe that an accountant verifying a substantial amount of assets during an annual
audit is an effective measure to detect any misuse of client assets. A requirement for registered
investment advisers to pooled investment vehicles with custody of client funds or securities to arrange
for each pooled investment vehicle to be subject to an annual audit conducted by an independent
public accountant registered with, and subject to inspection, by the PCAOB, and to distribute audited
financial statements, prepared in accordance with GAAS, to each investor in the fund, would ensure
that hedge fund assets are appropriately verified by an experienced, independent accountant.
Accountants conduct annual audits following the end of the fund’s fiscal year, whereas
accountants would perform surprise exams at an unannounced time that varies from year to year. We
do not believe that the unpredictable timing of a surprise exam would provide greater protection for
client assets. It is unlikely that the timing of an exam would be completely unpredictable, since a
manager would be actively involved in approving the engagement terms of the accountant and scope
of the examination, identifying the locations of client assets, and providing access to client accounts.
15

See U.S. Department of Treasury, Financial Regulatory Reform: A New Foundation, available at http://www.
Financialstability.gov/docs/regs/FinalReport_web.pdf (June 17, 2009); Private Fund Transparency Act of 2009
(June 16, 2009); Testimony of Richard H. Baker, President and CEO, MFA, before the House Subcommittee on
Capital Markets, Insurance, and Government Sponsored Enterprises (May 7, 2009), available at
http://www.managedfunds.org/downloads/FINAL%20Written%20Testimony%20for%20May%207%20hearing.
pdf.
16

See Paragraphs 2.174 and 2.175 of the AICPA Investment Company Audit and Accounting Guide, May 1,
2009. Although not required, we understand some accountants nevertheless do verify all assets during annual
audits of hedge funds.

Ms. Elizabeth Murphy
July 28, 2009
Page 5 of 12
For many hedge funds, particularly large funds with diversified investment techniques, an annual audit
is a complex, lengthy process with accountants reviewing a fund for many months. As a result,
accountants may be reviewing the fund at various times during the year, and a surprise exam could
overlap with an annual audit. In addition, an annual audit conducted in accordance with GAAS
already includes procedures necessary to confirm client assets, including those performed during a
surprise exam. A mandatory, independent, effective annual audit for each pooled investment vehicle
would serve as a substantial obstacle to an adviser attempting to misuse client assets.
We believe that a mandatory annual audit of a pooled investment vehicle by an independent
accountant registered with, and subject to inspection by, the PCAOB would effectively deter and
detect any fraudulent activity in connection with the custody of client assets. A requirement that each
registered investment adviser to a pooled investment vehicle, including managers to hedge funds and
other private funds, engage an accountant to perform an annual audit performed in accordance with
GAAS would standardize audit practices across the industry and promote investor confidence. While
most hedge funds distribute audited financial statements already, our proposal would have a
significant effect on those managers that engage accountants that fall below industry standards or that
advise funds that are not subject to annual audits, and are more vulnerable to fraudulent conduct.
As noted in the Release, the Commission has proposed these changes to prevent fraudulent
conduct and increase the likelihood that an accountant or an investor would detect an adviser’s misuse
of client assets earlier than under the current Rule. We expect that if the Commission adopts the rule
as proposed to require a surprise exam, most advisers to hedge funds would still continue to arrange
for an accountant to perform an annual audit of their funds, in addition to the surprise exam because
investors will not accept less. Most funds, therefore, would receive verification of their assets by an
accountant twice per year, which would substantially increase cost burdens. We believe that a
mandatory annual audit by an independent accountant registered with, and subject to inspection by, the
PCAOB would be more effective in preventing fraudulent activity than a surprise exam.
In addition, if the SEC adopts the surprise exam requirement as proposed, we are concerned
that substantial implementation challenges could arise. According to the Release, last year only 190
investment advisers were subject to a surprise examination, while approximately 9,575 advisers would
receive a surprise exam if the proposals are adopted.17 As noted above, it is widely expected that
Congress will enact legislation this year that would significantly narrow or eliminate the exception to
registration with the SEC upon which many investment advisers rely, and as a result a substantial
number of hedge fund managers would become subject to Rule 206(4)-2.18 As described below, we
are concerned that accounting firms and fund managers would be uncertain how to comply with the
existing surprise exam guidance.

17

18

Release at 25363.

Following such legislation, hedge fund managers would engage a significant number of accounting firms to
perform both annual audits and surprise exams. We are concerned that the accounting profession may not have
sufficient capacity to examine hedge fund assets twice per year, and as a result managers may be forced to
engage less qualified accountants.

Ms. Elizabeth Murphy
July 28, 2009
Page 6 of 12

Recommended Changes to Surprise Exam Requirements
If the SEC determines to nevertheless require investment advisers to receive a surprise exam,
we urge the Commission to review and update its surprise exam guidance. In the Release, the SEC
requests comment on whether it should revise its guidance relating to surprise examinations.19 As an
initial matter, we note that, under current Rule 206(4)-2, most hedge fund managers arrange for
accountants to perform annual audits of funds, rather than surprise exams. Significant changes have
occurred in the ways in which investment advisers manage client assets and provide for safekeeping of
those assets since the SEC issued the surprise exam guidance in 1966, and we are concerned that the
existing guidance does not address these developments. For example, hedge fund managers typically
enter into an agreement with a broker-dealer firm to act as a prime broker to the fund and perform a
variety of services, including centralized clearing of transactions, financing, securities lending, and
custody. In performing the custody services for hedge funds managed by registered advisers, prime
brokers serve as qualified custodians and maintain fund assets in compliance with Rule 206(4)-2.
Neither prime brokerage nor the hedge fund industry existed at the time the SEC determined the
procedures for an accountant to conduct a surprise exam under the Rule. In this respect, we note that
an accounting firm experienced in performing surprise exams previously indicated to the SEC that the
surprise exam guidance “no longer recognizes current securities depositary, banking, or auditing
practice,” and if the SEC were to continue to require surprise examinations, even in limited
circumstances, it was “essential” that it be updated.20 Because the rule proposals would have such a
significant effect on the hedge fund industry, we urge the Commission to review and update its
surprise exam guidance. Below, we make recommendations with respect to a number of the existing
surprise exam requirements.21
The SEC should require that an accountant conducting a surprise exam verify client assets in
the same manner as required for an accountant to perform an annual audit and prepare financial
statements in accordance with GAAS. As noted above, accountants preparing GAAS-compliant
financial statements generally verify an appropriate proportion of, but not all, client assets during
audits of pooled investment vehicles, including hedge funds. Verifying a high percentage of client
assets gives the accountant sufficient assurance as to the appropriate treatment and safekeeping of the
assets. Requiring an accountant to verify all assets over which an investment adviser has custody, as
required by the SEC’s guidance, is unnecessary and would be unduly burdensome in the case of many
hedge fund managers. As described below, hedge funds invest in a wide variety of assets other than
exchange-traded equity securities, including privately offered securities, bank loans, and derivative
instruments, that present little potential for misuse but are typically held or recorded on a fund’s books
in a manner that would require an accountant to expend significant resources to verify. The surprise
exam should allow for an accountant to verify an appropriate proportion of client assets, in keeping
with current audit practice.

19

Release at 25357.

20

Comments of PricewaterhouseCoopers LLP (Sept. 25, 2002) to 2002 Proposing Release (“PwC Letter”).

21

See Nature of Examination Required to be Made of All Funds and Securities Held in Custody of Investment
Advisers and Related Accountant’s Certificate, SEC Release No. IA-201 (May 26, 1966), 31 FR 7821 (June 2,
1966) (“Surprise Exam Release”).

Ms. Elizabeth Murphy
July 28, 2009
Page 7 of 12
If the SEC determines to require investment advisers to receive a surprise exam, it should also
clarify how an accountant would “make a physical examination of securities and obtain confirmation
as appropriate” and “reconcile the physical count and confirmations to the books and records” for
privately offered securities.22 The rule proposal would eliminate the current exemption for privately
offered securities, and subject them to the surprise examination requirement. Typically when a hedge
fund invests in a privately offered security, such as an interest in another private fund or privately
placed security, the hedge fund manager and the issuer, or their respective administrators, will each
hold a copy of the subscription agreement. A requirement to physically inspect and reconcile the
count for each privately offered security could impose significant compliance burdens on the
accountant performing the surprise exam, if the accountant needed to receive a physical copy of the
agreement from the manager, issuer or administrator. In the case of funds of funds, which invest in a
large number of privately placed securities, or funds with many private fund investors, the requirement
to physically confirm securities could be unduly burdensome. Moreover, because privately placed
securities are subject to significant restrictions on transfer, they are less likely to be misused by an
adviser. The Commission should adopt guidance, following GAAS requirements for performing an
audit, for an accountant performing a surprise exam with respect to privately offered securities.
The SEC also needs to provide clear guidance on how an accountant performing a surprise
exam should treat assets that are not securities, including swap arrangements and other derivative
instruments.23 Under a swap arrangement, a fund and a counterparty agree to make certain defined
payments to one another over a set time period based on the value of an underlying asset. Typically, a
hedge fund will post initial margin, usually cash or cash equivalents, to the counterparty at the time it
enters into a swap, and may thereafter post additional margin to the counterparty depending on the
change in value of the underlying asset. The documentation evidencing the swap arrangement is
typically either a physical or electronic written confirmation of the transaction between the fund and
the counterparty. Industry participants are actively working with regulators to develop and implement
systems to enhance the existing confirmation process, and transition from physical confirmations to
electronic confirmations. MFA and its members strongly support measures designed to improve
documentation of derivatives transactions, and over the past several years we have played a key role in
facilitating this process. We note, however, that, as in the case of privately offered securities, physical
examination of each written or electronic confirmation of a swap agreement would be burdensome. If
the SEC determines to require advisers to receive a surprise exam, it should explain how, if at all, an
accountant performing a surprise exam should verify a percentage of assets other than securities.
Because the surprise exam requirement and related guidance are designed to apply only to client funds
and securities, we believe an annual audit would be more effective in providing assurance to investors
with respect to assets other than securities held by a fund, and would minimize the costs to verify these
assets.
In addition to the physical examination and reconciliation requirements, an accountant
performing a surprise exam must obtain written confirmation from clients of their assets as of the date
of the physical examination.24 While we support the goal of seeking client participation in ensuring
22

Surprise Exam Release at 7821.

23

Under proposed Rule 206(4)-2(a)(4), an adviser must arrange for client funds and securities for which it has
custody to be verified.
24

Surprise Exam Release at 7821.

Ms. Elizabeth Murphy
July 28, 2009
Page 8 of 12
the adviser properly safeguards client assets, we are concerned that an accountant would be unlikely to
receive written confirmations from each investor in a pooled investment vehicle, and in fact may not
obtain even a high percentage of responses.25 Accordingly, if the SEC determines that client
confirmations are necessary, it should establish guidelines concerning the appropriate proportion of
client confirmations that would provide sufficient verification of client assets.
Including client confirmations as part of a surprise exam also creates unnecessary complexity
with little added benefit. Surprise exams by their nature must occur at irregular time periods, whereas
advisers provide account information to hedge fund investors at regular periods, such as the end of a
quarter. Clients generally do not have account information as of the date of the accountant’s physical
examination, and may not be able to provide confirmation in response to an accountant’s request.
Furthermore, many investors in private funds make their investments through brokers or other
intermediaries, and prefer for these intermediaries to manage all aspects of their investments, including
receiving account statements on their behalf and conducting other administrative tasks. Requiring an
accountant to contact each investor and receive a confirmation of the investor’s assets would be
inconsistent with the expectations and preferences of many investors. Also, an investor that confirms
its assets to the accountant conducting the surprise exam would do so on the basis of account
statements provided by the fund manager. Such a confirmation may be of limited value to serve as an
independent review of the investor’s assets and ensure that a manager has not misused those assets.
Extending the surprise exam requirement to registered advisers with custody of client assets
will affect a large number of advisers, and, if the SEC decides to require investment advisers to receive
a surprise exam, it should identify precisely the appropriate procedures accountants must follow under
the rule proposals.26 In addition to issues associated with specific assets inspected during a surprise
exam, the SEC should define and provide examples of activity that would constitute a “material
discrepancy” under the Rule, as well as any “reasonable steps” an accountant may take to establish a
basis for believing a material discrepancy exists.27 Because of the significance of a finding of a
material discrepancy to an adviser and its clients, an accountant should be given clear guidance in
making this determination and reporting its finding to the Commission within one business day.
Further, the SEC should consider clarifying its requirement that an accountant perform “additional
audit procedures [as it] deems necessary under the circumstances” and describe whether anything
came to the accountant’s attention to cause it to believe the adviser had not been complying with the
Rule prior to the exam.28 We believe that the requirements should state that the accountant should

25

See PwC Letter. The SEC’s Office of Compliance Inspections and Examinations also requests certain clients
of investment advisers it examines to provide, on a voluntary basis, written confirmations of the total amounts of
funds in their accounts. The SEC should consider the results of these requests in designing an effective
confirmation process under Rule 206(4)-2.
26

In determining the procedures to be followed during a surprise exam, the SEC should consult with the
appropriate auditing bodies, such as the AICPA.
27

Release at note 10.

28

Surprise Exam Release at 7823.

Ms. Elizabeth Murphy
July 28, 2009
Page 9 of 12
perform any such additional audit procedures during a fund’s annual audit, rather than during a
surprise exam.29
In assessing the potential cost of a surprise exam, it is important to recognize that hedge funds
utilize highly sophisticated investment strategies, trading operations, and risk management techniques.
As described above, custody practices of hedge fund managers continue to evolve in response to
investor demand and other market forces. The estimate for a surprise exam provided in the Release
significantly underestimates the actual amount an accountant will charge a hedge fund manager to
perform a surprise examination and file Form ADV-E.30 Based on current hedge fund audit fees and
recent conversations with accounting firms, a surprise exam by an experienced, independent public
accountant would cost varying amounts depending on the type and complexity of the fund, but we
expect the exam to be at a minimum $50,000, and estimates our members have received rise in some
cases to well in excess of $1 million. As an example of the complexity of this task, many hedge fund
managers engage multiple prime brokers to perform custodial and other services for a particular fund
or client account. Managers diversify client assets across many prime brokers for a number of reasons,
but primarily to mitigate risk. Counterparty risk is a key concern for managers in the current
economic environment, and the PWG Report and MFA’s Sound Practices recommend that managers
actively monitor and manage such risk. The recent failure of Lehman Brothers, a significant prime
broker for hedge funds, for example, and the ongoing ineffectual bankruptcy process for its U.K.
affiliate, Lehman Brothers International (Europe), caused a number of funds to suffer substantial
losses, leading in some cases to liquidation. In response, many hedge funds have sought to reduce their
exposure to a single prime broker. We are concerned that hedge funds managers’ use of multiple
prime brokers as qualified custodians, as well as other industry developments, will create substantially
more complexity for an accountant performing a surprise examination than the Commission
anticipated when it issued its guidance. In this regard, the SEC recognized the cost of a surprise
examination as a significant issue for advisers when it amended Rule 206(4)-2 to permit a pooled
investment vehicle to be subject to an annual audit rather than a surprise exam.31
For these reasons, we recommend that the Commission amend Rule 206(4)-2 to require
investment advisers to pooled investment vehicles with custody of client funds or securities to arrange
for each pooled investment vehicle to be subject to an annual audit by an independent public
accountant registered with, and subject to inspection, by the PCAOB, and distribute audited financial
statements, prepared in accordance with generally accepted accounting principles, to each investor in
the fund. The audit requirement should apply to all advisers subject to the Rule that manage pooled
investment vehicles, except in cases where an adviser does not have the authority to require an audit.

29

For example, the Release requests comment on whether the proposed rule should require an accountant to
perform testing on the valuation of securities, including privately offered securities, as part of a surprise exam.
We strongly urge the Commission not to incorporate any valuation procedures in a surprise exam.

30

31

The SEC estimates a surprise exam would on average cost $8,100. Release at 25365.

Custody of Funds or Securities of Clients by Investment Advisers, SEC Release No. IA-2044 (July 18, 2002),
67 FR 48579 (July 25, 2002) (“2002 Proposing Release”).

Ms. Elizabeth Murphy
July 28, 2009
Page 10 of 12

Internal Control Report
The rule proposals would require a registered investment adviser to obtain an annual internal
control report from an independent public accountant registered with, and subject to regular inspection
by, the PCAOB if it, or a related person, serves as a qualified custodian for any client funds or
securities.32 This proposal is extremely overreaching, and would impose costs on hedge fund
managers and investors that would substantially outweigh any likely benefits. As part of the annual
audit process conducted pursuant to GAAS, the accountant performing the audit must examine the
controls in place to assess the financial statements. Once again, an audit performed by a qualified,
independent accountant that prepares financial statements in accordance with GAAS should include
the necessary procedures to ensure the safekeeping of client assets.
We appreciate that an adviser or a related person maintaining client assets could more easily
misappropriate client assets than an adviser that engages an independent custodian, and that additional
protections may be necessary. In determining the appropriate level of investor protection, the SEC
should consider that an adviser, or a related person, serving as a qualified custodian under the Rule is
subject to an additional set of regulatory requirements. For example, an adviser or a related person
serving as a qualified custodian as a registered broker-dealer is itself subject to separate audit and
internal control requirements. Any additional protections the Commission adopts should complement
these existing requirements and address any existing gaps that could be exploited.
We also encourage the SEC to weigh the potential benefits and costs of an internal control
report. In determining the benefits of a report, we believe the observations of investors in pooled
investment vehicles would be particularly helpful. As noted above, certain investors currently request
additional assurances from hedge fund managers concerning their custody practices. We believe that
investors are well suited to provide the SEC with their views on the type of information that they
would find to be most beneficial. Advisers required to obtain an internal control report would likely
pass on the costs to its investors. Based on preliminary discussions with accounting firms, we believe
that an accounting firm would charge a hedge fund manager approximately $500,000 for an internal
control report, and over $1 million in some cases.33 In its review, the SEC should also consider that
the expected legislation to require managers to pooled investment vehicles to register with the SEC
would likely increase the number of advisers required to obtain an internal control report.34
We are concerned that a manager may inadvertently become subject to the internal control
report requirement if the fund it manages acquires certain investments that are not typically maintained
with other assets. For example, hedge fund managers and other advisers invest in bank loans, which
may be considered to be “securities” for purposes of the Advisers Act.35 Bank loans, like certain other
investments, are typically recorded on a fund’s books, and may be difficult for a manager to maintain
with an independent qualified custodian. These investments pose a low risk of misuse, but may not
32

Release at 25358.

33

The SEC estimates that the average cost for an internal control report would be approximately $250,000 per
year. Release at 25365.
34

The SEC estimates that 372 investment advisers would be subject to the requirement. Release at 25370. It
appears that this amount should also be referenced in Section VI.D of the Release.

35

“Security” is defined in Section 202(a)(18).

Ms. Elizabeth Murphy
July 28, 2009
Page 11 of 12
fall within the exemption for privately offered securities in Rule 206(4)-2. The SEC should ensure
that a fund manager would not be deemed to serve as a qualified custodian and subject to the
provisions of subsection (a)(6) of proposed Rule 206(4)-2, including the requirement to obtain an
annual internal control report, if it maintains bank loans and other similar assets.36 The SEC should
also confirm that assets that are not securities, such as swap arrangements and other derivative
instruments, would not subject a manager to proposed Rule 206(4)-2.
Similarly, the SEC should make clear that an adviser maintaining possession of privately
offered securities in accordance with subsection (b)(2) would not be maintaining securities as a
qualified custodian, and therefore would not be subject to subsection (a)(6). Subsection (b)(2) of
proposed Rule 206(4)-2 would exempt an adviser from complying with subsection (a)(1) of the Rule,
which requires that a qualified custodian maintain client funds and securities, with respect to privately
offered securities. An adviser relying on this exemption may choose to maintain possession of such
securities, rather than place them with a qualified custodian. We seek clarification that an investment
adviser that chooses to maintain possession of privately offered securities would not be acting as a
qualified custodian and would not be subject to the requirement to obtain an internal control report in
subsection (a)(6).

Additional Comments
The rule proposals would preserve the exemption from the account statement delivery
requirements for pooled investment vehicles that distribute financial statements to investors, but would
reduce the time period allowed for funds of funds37 to distribute audited financial statements to
investors from 180 days to 120 days within the end of their fiscal year. This time period would be
difficult, if not impossible, for funds of funds to meet.38 Funds of funds are not able to complete their
annual audits until they receive statements from the underlying funds in which they invest, and an
underlying fund under Rule 206(4)-2 has 120 days after the end of its fiscal year to distribute its
financial statements. The Commission should amend the rule proposals to continue to permit funds of
funds to comply with audit provisions of Rule 206(4)-2 by distributing financial statements to
investors within 180 days of the end of their fiscal year.
Many registered investment advisers, including hedge fund managers, perform advisory
services for clients through managed accounts. Under the rule proposals, an adviser to a managed
account would no longer have the option to deliver account statements to its client; the qualified
custodian would be required to send the statements directly to the client. As noted above, hedge fund
managers typically engage a number of prime brokers to act as qualified custodians, and it is not
uncommon for a manager to use five or more. A manager may adjust the allocation of assets among
them during a quarter to enhance the performance of the account. As a result, under the rule
proposals, a managed account client would receive multiple quarterly account statements from prime
36

We suggest that the SEC include an exemption for these assets, similar to the exemption included in
subsection (b)(2) of the proposed Rule for privately offered securities.
37

A fund of fund is defined as a pooled investment vehicle that invests ten percent or more of its total assets in
other pooled investment vehicles that are not, and are not advised by, a related person. Rule 206(4)-2(c)(4).
38

Comments to the 2002 Proposing Release also addressed this issue.

Ms. Elizabeth Murphy
July 28, 2009
Page 12 of 12
brokers, which may be significantly different from previous statements. Thus, an unintended
consequence of the proposals may be that clients are not provided with clear, usable information about
their accounts.
In the Release, the SEC requests comment on whether it should require, as a substitute to an
annual surprise exam, a chief compliance officer of an investment adviser to submit a certification to
the SEC that “all client assets are properly protected and accounted for on behalf of clients.”39 We do
not believe such a requirement would be appropriate in the case of hedge fund managers. While a
manager’s compliance policies and procedures, as required by Rule 206(4)-7 under the Advisers Act,
should address safeguarding of client assets, a chief compliance officer does not regularly perform
verifications necessary to submit such a certification. A requirement for each chief compliance officer
to do so would impose significant burdens on a manager, especially smaller managers with limited
compliance personnel. The verification process is more appropriately done during an annual audit by
an independent accounting firm with sufficient resources and expertise to confirm that a manager is
properly safeguarding client assets.

Conclusion
We support the Commission’s efforts to enhance the safekeeping of client assets under Rule
206(4)-2. We believe that requiring registered investment advisers with custody of client funds or
securities to arrange for each pooled investment vehicle to be subject to an annual audit by an
independent accountant would best accomplish this objective while reducing any unnecessary
compliance burdens. We welcome an opportunity to further discuss any of the recommendations made
above with Commissioners or its staff if it would assist in your rulemaking efforts. If the
Commissioners or staff have any questions or comments, please contact Matthew Newell or the
undersigned at (202) 367-1140.

Respectfully submitted,
/s/ Stuart J. Kaswell
Stuart J. Kaswell
Executive Vice President and Managing Director,
General Counsel

39

Release at 25356.