Federal Register

Monday,
January 11, 2010

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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Federal Register / Vol. 75, No. 6 / Monday, January 11, 2010 / Rules and Regulations

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

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AGENCY: Securities and Exchange
Commission.
ACTION: Final rule.
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 (202) 551–6787 or

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[email protected], 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
1 Since the beginning of this year, the
Commission has brought several enforcement
actions against investment advisers and brokerdealers 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 cofounder 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

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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 brokerdealers to follow.
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
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
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.
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).
8 Proposed rule 206(4)–2(a)(4).

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Federal Register / Vol. 75, No. 6 / Monday, January 11, 2010 / Rules and Regulations
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.
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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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
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).
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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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
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
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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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
As proposed, the amended rule
requires that an adviser’s reasonable
belief that the qualified custodian sends
account statements directly to clients
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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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
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
19 Amended

rule 206(4)–2(a)(3).
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.
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).

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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
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.
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
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).
28 Amended rule 206(4)–2(a)(4).
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’’));

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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
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
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.
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.
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

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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
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
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.
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

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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
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.
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.

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1459

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
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
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
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.
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.
43 See AICPA, Audit and Accounting Guide,
Investment Companies, (May 1, 2009).

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applicable, incentive fees and
allocations that accrue to the adviser.44
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
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

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44 Id.
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.
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

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greater confidence in the quality of such
audits.49
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.
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
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.
50 Rule 206(4)–2(b)(4).
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).

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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.
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.
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
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.
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.

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Federal Register / Vol. 75, No. 6 / Monday, January 11, 2010 / Rules and Regulations
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.
3. Privately Offered Securities

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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
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.
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

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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
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.
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

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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
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
qualified custodian, the adviser is subject to the
requirements set forth in paragraph (a)(6) of the
rule.
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.
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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modernize the procedures for the
surprise examination.

1. Internal Control Report

C. Custody by Adviser and Related
Person

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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).

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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.
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 brokerdealer.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.
To address the custodial risks
associated with an affiliated custodial
75 See

supra note 1.
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.
76 See,

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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.
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
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).

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

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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.
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
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
88 SIFMA(AMG) Letter (noting that obtaining such
a report is an ‘‘industry best practice’’).
89 See Accounting Release.
90 Amended rule 206(4)–2(a)(6)(ii)(A).
91 See Accounting Release.
92 Amended rule 206(4)–2(a)(6)(ii)(B).
93 See Proposing Release at Section II.B.2.

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1463

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.
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
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.
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
94 See

Accounting Release.
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].
96 See Proposing Release, at Section II.B.2.
97 See, e.g., AICPA Letter; Deloitte Letter.
95 In

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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 whollyowned 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
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
2. Related Persons
result of a related person having
We are amending rule 206(4)–2, as
custody.108 The exception is available to
proposed, to provide that an adviser has an adviser that is (i) deemed to have
custody of any client securities or funds custody solely as a result of certain of
that are directly or indirectly held by a
its related persons holding client assets,
‘‘related person’’ in connection with
and (ii) ‘‘operationally independent’’ of
advisory services provided by the
the custodian.109
101
adviser to its clients.
A related person
As discussed above, a key premise of
is defined by the rule as a person
our approach to the custody rule is that
directly or indirectly controlling or
client assets may be at greater risk when
controlled by the adviser and any
they are maintained by a related person
person under common control with the
of the investment adviser. As
adviser.102 We received some support
commenters suggested, however, firms
for this proposal.103 Several commenters under common ownership that are
urged us to instead adopt the approach
operationally independent of each other
our staff has taken in no-action letters in present substantially lower client
which the staff expressed the view that
custodial risks than those that are not
custody of client assets by a related
because misuse of client assets would
person would not be attributed to the
tend to require collusion among
adviser if the related person was
employees, not significantly different
operationally separate.104 Those letters
than would be necessary to engage in
similar misconduct between unaffiliated
98 See Proposing Release, at Section II.B.2.
organizations.110
99

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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

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.
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

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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.
108 Amended rule 206(4)–2(b)(6).
109 Id.
110 MMI Letter; Davis Polk Letter. This conclusion
is implicit in our staff’s no-action letter upon which

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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 staff has relied to determine whether an adviser
indirectly has custody of client assets when its
related person does. See Crocker, supra note 105.
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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Federal Register / Vol. 75, No. 6 / Monday, January 11, 2010 / Rules and Regulations
the adviser should be subject to a
surprise examination.
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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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
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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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.
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
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
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 yearend.
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.
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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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.
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.
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.
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
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.
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.
125 S&K Letter.

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may be particularly vulnerable to
misappropriation.

liquidation occurs prior to the fund’s
fiscal year-end.131

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

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
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

126 Amended

rule 206(4)–2(b)(4). See supra note

45.
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127 Amended

rule 206(4)–2(b)(4)(ii).
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.
128 Amended

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131 Amended

rule 206(4)–2(b)(4)(iii).
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.
132 In

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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.
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.
Advisers with custody of client assets
should consider the value of instituting
the following policies and procedures as
part of their compliance programs: 137
133 17

CFR 275.206(4)–7.
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.
135 See id.
136 See, e.g., Comment letter of Investment
Adviser Association (March 6, 2009); CPIC Letter.
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
134 Compliance

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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
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
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.
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.
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.

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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.
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
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://

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1467

of policies and procedures such an
adviser should consider include: 141
• 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.
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
www.sec.gov/divisions/investment/
custody_faq.htm.
141 Some of these suggestions came from
commenters. See, e.g., CPIC Letter.
142 Compliance Rule Release, at Section II.A.1.

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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.
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.
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
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.
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.
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

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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
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
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.
152 Cornell Letter; IAA Letter; MMI Letter; NRS
Letter; Turner Letter.
153 IAA Letter; NSCP Letter; ASG Letter; CAS
Letter.

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the amount of assets of which a related
person has custody, including when the
related person serves as a qualified
custodian.154
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
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
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.
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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Federal Register / Vol. 75, No. 6 / Monday, January 11, 2010 / Rules and Regulations
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

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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
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
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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.
2. Internal Control Reports
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 becoming subject to the
requirement. As noted above, an adviser
obtaining an internal control report
because it (rather than a related person)
also serves as a qualified custodian of its
clients’ assets (e.g., a broker-dealer)
need not undergo a surprise
examination until six months after
obtaining the internal control report.
3. Audits of Pooled Investment Vehicles
An investment adviser to a pooled
investment vehicle may rely on the
annual audit provision if the adviser (or
a related person) becomes contractually
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.
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 custodian for its clients (i.e.,
self custody) would have to verify the existence of
client assets with the adviser itself. Because of the
added assurance of having an internal control
report, we believe that investors would be better
served if the first round of surprise examinations is
conducted with the benefit of the internal control
report. An adviser with multiple related persons
that serve as qualified custodians must undergo a
surprise examination within six months of
receiving the last internal control report it is
required to receive.

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obligated to obtain an audit of the
financial statements of the pooled
investment vehicle for fiscal years
beginning on or after January 1, 2010 by
an independent public accountant
registered with, and subject to regular
inspection by, the PCAOB.
4. Forms ADV and ADV–E
Investment advisers registered with us
must provide responses to the revised
Form ADV in their first annual
amendment after January 1, 2011.161
Until the IARD system is upgraded to
accept Form ADV–E, accountants
performing surprise examinations
should continue paper filing of Form
ADV–E. Investment advisers will be
notified as soon as the IARD system can
accept filings of Form ADV–E.162
IV. Paperwork Reduction Act
Certain provisions of rule 206(4)–2,
Form ADV, and Form ADV–E that we
are amending today contain ‘‘collection
of information’’ requirements within the
meaning of the Paperwork Reduction
Act of 1995 (‘‘PRA’’).163 In the Proposing
Release, the Commission published
notice soliciting comment on the
collection of information requirements.
The Commission submitted the
collection of information requirements
to the Office of Management and Budget
(‘‘OMB’’) for review in accordance with
44 U.S.C. 3507(d) and 5 CFR 1320.11
under control numbers 3235–0241,
3235–0049, and 3235–0361,
respectively. The titles for the
collections of information are ‘‘Rule
206(4)–2, Custody of Funds or
Securities of Clients by Investment
Advisers,’’ ‘‘Form ADV,’’ and ‘‘Form
ADV–E, cover sheet for each certificate
of accounting of client securities and
funds in the custody of an investment
adviser,’’ under the Advisers Act.164 An
161 Based on discussions with our contractor, we
anticipate that IARD will reflect the changes to
Form ADV we are adopting today and accept
electronic filing of Form ADV–E in the fourth
quarter of 2010. Form ADV–Es filed with us on
paper before electronic filing will be available upon
request through the Commission’s Public Reference
Room, 100 F Street, NE., Washington, DC 20549.
162 We urge advisers in the meantime to confirm
that their email contact information on Form ADV
is correct and to update the information promptly
if necessary.
163 44 U.S.C. 3501.
164 We also are adopting amendments to rule 204–
2 that require approximately 337 advisers to
maintain the internal control reports they obtain, or
receive from related persons, and if these advisers
have determined that the presumption that a related
person is operationally independent has been
overcome, a memorandum describing the basis
upon which that determination was made. In
addition, rule 204–2(a)(10) already requires an
adviser to maintain all written agreements relating
to its business as such, which would require an

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agency may not sponsor, or conduct,
and a person is not required to respond
to, a collection of information unless it
displays a currently valid OMB control
number.
The collections of information under
rule 206(4)–2 are necessary to ensure
that clients’ funds and securities in the
custody of advisers are safeguarded, and
information contained in the collections
is used by staff of the Commission in its
enforcement, regulatory, and
examination programs. The respondents
are investment advisers registered with
us that have custody of client funds and
securities (‘‘client assets’’). The
collections of information under Form
ADV are necessary for use by staff of the
Commission in its examination and
oversight program, and some advisory
clients also may find them useful. The
respondents are investment advisers
seeking to register with the Commission
or to update their registrations. The
collections of information under Form
ADV–E are necessary for use by staff of
the Commission in its examination and
oversight program, and some advisory
clients also may find them useful. The
respondents are investment advisers
registered with us that have custody of
client assets and are subject to an
annual surprise examination
requirement under rule 206(4)–2. All
responses required by the rule are
mandatory. With the exception of an
accountant’s notification of any material
discrepancies identified in a surprise
examination pursuant to rule 206(4)–
2(a)(4)(ii), responses provided to the
Commission are not kept confidential.

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A. Rule 206(4)–2
The Commission is adopting
amendments to the custody rule under
the Advisers Act. 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: (i) To
undergo an annual surprise examination
by an independent public accountant to
verify client assets; (ii) to have a
reasonable basis after due inquiry, for
believing that the qualified custodian
maintaining client funds and securities
sends account statements directly to the
advisory clients; and (iii) unless client
adviser to maintain the written agreement
concerning the surprise examination required by
the amended rule. The current approved collection
of information burden for rule 204–2 is 1,945,109
hours and has an estimated cost of $13,551,390
under OMB control number 3235–0278. The two
new retention requirements and the additional
written agreements that will be maintained as a
result of more surprise examinations will result in
a negligible increase to the currently approved
burden for rule 204–2.

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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 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 PCAOB.
The amendments to rule 206(4)–2 that
we are adopting today differ from our
proposed amendments in three respects
that affect our Paperwork Reduction Act
analysis. First, we are providing an
exception to the surprise examination
requirement for advisers that have
custody because they have authority to
deduct advisory fees from client
accounts and advisers that have custody
solely because a related person holds
the adviser’s client assets and the
related person is operationally
independent of the adviser.165 Second,
advisers to pooled investment vehicles
that are subject to an annual audit and
that distribute audited financial
statements to investors in the pools are
deemed to comply with the surprise
examination requirement as long as the
accountant performing the annual audit
is registered with, and subject to regular
inspection by, the PCAOB.166 Third, if
an adviser sends account statements to
its clients, it must not only insert a
legend in the required notice to clients
upon opening accounts on their behalf,
but must also insert the legend in
subsequent account statements sent to
those clients urging the client to
compare the account statements from
the custodian with those from the
adviser.167
We requested comment on the
Paperwork Reduction Act analysis
contained in the Proposing Release. A
number of commenters expressed
concerns that the paperwork burdens
associated with our proposed
amendments to rule 206(4)–2 were
understated.168 In response to these
comments as well as the differences in
the amendments we are adopting from
those we proposed, as described above,
and the guidance for accountants
published in a companion release,169 we
have adjusted our Paperwork Reduction
Act estimates as discussed below.
165 Amended rule 206(4)–2(b)(3) and amended
rule 206(4)–2(b)(6).
166 Amended rule 206(4)–2(b)(4).
167 Amended rule 206(4)–2(a)(2).
168 See, e.g., ASG Letter; MMI Letter; Schwab
Letter. These commenters did not provide empirical
data that is relevant to our estimates of burden
hours in this Paperwork Reduction Act analysis, but
did provide cost estimates that we have considered
in Section V of this Release.
169 See Accounting Release.

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Annual surprise examination. The
current approved annual burden for rule
206(4)–2 is 415,303 hours, 21,803 of
which relate to the requirement to
obtain a surprise examination and the
delivery of quarterly account statements
by the adviser. We estimated in the
Proposing Release that 9,575 advisers
registered with the Commission would
be subject to the surprise
examination.170 As noted above, the
amended rule we are adopting today
excludes certain advisers with custody
from the requirement to undergo an
annual surprise examination and deems
certain advisers to audited pooled
investment vehicles to have complied
with the requirement.171 Advisers that
have custody for other reasons,
however, such as because they or their
related person serves as the qualified
custodian for client assets, or because
they serve as the trustee of a client trust,
must undergo an annual surprise
examination.172 As a result, we now
estimate that 1,859 advisers will be
subject to the surprise examination
requirement under the amended rule
206(4)–2.173
170 Based on Form ADVs filed as of February
2009. See the Proposing Release at n.77 for
explanation of our estimate.
171 Amended rule 206(4)–2(b)(3) (exception from
surprise examination for advisers that have custody
because they have authority to deduct fees from
client accounts) and amended rule 206(4)–
2(b)(4)(deems advisers to audited pooled
investment vehicles that distribute audited
financial statements to pool investors to comply
with the surprise examination requirement if the
audit is conducted by a public accountant
registered with, and subject to regular inspection
by, the PCAOB). See supra Section II.B.1 of this
Release.
172 Under amended rule 206(4)–2 an adviser has
custody if its related person has custody of its client
assets. Amended rule 206(4)–2(d)(2). A related
person is defined as a person directly or indirectly
controlling or controlled by the adviser, and any
person under common control with the adviser.
Amended rule 206(4)–2(d)(7).
173 Based on Form ADVs filed as of November 2,
2009 (unless indicated otherwise, all data we use
in this release were as of November 2, 2009), there
were 3,689 advisers that answered ‘‘yes’’ to Form
ADV, Part 1A Items 9.A or 9.B (indicating that they
or a related person has custody of client assets. This
excludes advisers that have custody solely because
they have authority to deduct fees from clients’
accounts). We exclude from this number (i) 38 of
these advisers that only have clients that are
investment companies (Item 5.D(4)); (ii) 703 (or
90%, which is based on staff observation that the
vast majority of pooled investment vehicles are
subject to an annual audit) of the 781 of these
advisers that only have clients that are pooled
investment vehicles (Items 5.D(6) or 5.D(4)); (iii)
1,030 (or 80%) of the 1,288 advisers that have some
clients that are pooled investment vehicles (10% of
which is based on the number of advisers (from
IARD data) that have both pooled investment
vehicle clients and non-pooled investment vehicle
clients that will not have to undergo a surprise
examination because they do not have custody
under the rule of the non-pooled investment vehicle
client assets that would require a surprise
examination and 10% of which is based on an

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For purposes of estimating the
collection of information burden we
have divided the estimated 1,859
advisers into 3 subgroups. First, we
estimate that 337 advisers have custody
because (i) they serve as qualified
custodians for their clients and are also
broker-dealers, banks or futures
commission merchants,174 or (ii) they
have a related person that serves as
qualified custodian for clients in
connection with advisory services the
adviser provides to the clients.175 We
estimate that these advisers will be
subject to an annual surprise
examination with respect to 100 percent
of their clients (or 2,315 clients per
adviser) based on the assumption that
all of their clients maintain custodial
accounts with the adviser or related
person.176 We estimate that each adviser
will spend an average of 0.02 hours for
each client to create a client contact list
for the independent public accountant.
The estimated total annual aggregate
burden with respect to the surprise
examination requirement for this group
of advisers is 15,603 hours.177
estimate of the pooled investment vehicles that are
subject to an annual audit). We further estimate that
of the 396 advisers we estimate that are currently
using related person qualified custodians, 59 (or
15%) will choose to use independent qualified
custodians and, as a result, will no longer retain
custody of client assets under the rule that would
require these advisers to undergo the surprise
examination. See infra note 282 for explanation of
this estimate. (3,689¥38¥703¥1,030¥59 = 1,859).
174 We estimate that 91 investment advisers that
are also banks, registered broker-dealers or futures
commission merchants would custody client assets
as a qualified custodian under the rule.
175 Based on IARD data, we also estimate that 305
investment advisers have a related person bank,
registered broker-dealer or futures commission
merchant that is a qualified custodian for advisory
client assets. 91 (advisers that are also banks or
broker-dealers) + 305 (advisers using related
persons as custodians) = 396. 396¥59 (advisers that
will stop using related persons as custodians) = 337
(see supra note 173 for explanation of 59 advisers
removed).
176 In the Proposing Release, we estimated that
each adviser had, on average, 1,092 clients. See
Proposing Release at n.79. That estimate was based
on the average number of clients of all advisers
registered with us (excluding the two largest firms).
We now base our estimate on IARD data of all the
advisers that will be subject to the surprise
examination under the amended rule (also
excluding these two largest firms). This new
estimate excludes from the calculation about 6,000
advisers that have custody solely because of
deducting fees, which tend to have fewer clients.
As a result the estimated average number of clients
for the advisers that will be subject to the surprise
examination under the amended rule is increased.
177 337 advisers × 2,315 (average number of
clients subject to the surprise examination
requirement) × 0.02 hour = 15,603 hours. As
addressed later, some of these advisers will not
have to obtain a surprise examination as a result of
the exception to the surprise examination
requirement under amended rule 206(4)–2(b)(6) for
an adviser that has custody because of its related
person’s custody of client assets and that can
overcome the presumption that it is not

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A second group of advisers, estimated
at 1,315,178 are those that have custody
because they have broad authority to
access client assets held at an
independent qualified custodian, such
as through a power of attorney or acting
as a trustee for a client’s trust. Based on
our staff’s experience, advisers that have
access to client assets through a power
of attorney, acting as trustee, or similar
legal authority typically do not have
access to all of their client accounts, but
rather only to a small percentage of their
client accounts pursuant to these special
arrangements. We estimate that these
advisers will be subject to an annual
surprise examination with respect to 5
percent of their clients (or 116 clients
per adviser) 179 who have these types of
arrangements with the adviser. We
estimate that each adviser will spend an
average of 0.02 hours for each client to
create a client contact list for the
independent public accountant. The
estimated total annual aggregate burden
with respect to the surprise examination
requirement for this group of advisers is
3,051 hours.180
A third group of advisers, estimated at
207,181 provide advice to pooled
investment vehicles that are not
undergoing an annual audit, and
therefore will be subject to the surprise
examination with respect to 100 percent
of their pooled investment vehicle
clients (which we estimate to be 5 funds
operationally independent of the related person
custodian. See infra note 283. We do not have data
or another resource to provide an estimate of the
number of advisers that use related person
custodians that will be able to overcome the
presumption. This estimated annual hour burden
may, as a result, overestimate the collection of
information requirement as advisers that have
overcome the presumption will not have to create
client contact lists.
178 This estimate is based on the total number of
advisers subject to surprise examinations less those
described above in the first group (custody as a
result of serving as, or having related person serving
as qualified custodians) and below in the third
group (advisers to pooled investment vehicles)
1,859¥337¥207 = 1,315. See infra note 182 and
accompanying text.
179 Based on the IARD data, we estimate that the
average number of clients of advisers subject to the
surprise examination requirement is 2,315. (2,315 ×
5% = 116).
180 1,315 × 116 × 0.02 = 3,051.
181 Based on IARD data, we estimate that there are
781 advisers that provide advisory services
exclusively to pooled investment vehicles. See
supra note 173. We further estimate, based on our
staff’s experience, that only ten percent of advisers
to pooled investment vehicles will be subject to an
annual surprise examination because the pooled
investment vehicles they advise do not undergo an
annual audit. We further estimate, based upon staff
experience, that ten percent of the 1,288 advisers
that provide services not exclusively to pooled
investment vehicles will be subject to an annual
surprise examination because the pooled
investment vehicles they advise do not undergo an
annual audit. (781 × 10%) + (1,288 × 10%) = 78 +
129 = 207.

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1471

and 250 investors per adviser providing
advisory services exclusively to pooled
investment vehicles, and 2 funds and
100 investors per adviser not providing
advisory services exclusively to pooled
investment vehicles).182 We estimate
that the advisers to these pooled
investment vehicles will spend 1 hour
for the pool and 0.02 hours for each
investor in the pool to create a contact
list for the independent public
accountant, for an estimated total
annual burden with respect to the
surprise examination requirement for
these advisers of 1,296 hours.183 These
estimates bring the total annual
aggregate burden with respect to the
surprise examination requirement for all
three groups of advisers to 19,950
hours.184 This estimate does not include
the collection of information discussed
below relating to the written agreement
required by paragraph (a)(4) of the rule.
Written agreement with accountant.
Consistent with the proposal, amended
rule 206(4)–2 requires that an adviser
subject to the surprise examination
requirement must enter into a written
agreement with the independent public
accountant engaged to conduct the
surprise examination and specify
certain duties to be performed by the
independent public accountant.185 As
stated in the Proposing Release, we
believe that written agreements are
commonplace and reflect industry
practice when a person retains the
services of a professional such as an
accountant, and they are typically
prepared by the independent public
accountant in advance. We therefore
estimate that each adviser will spend
0.25 hour to add the required provisions
to the written agreement, with an
aggregate of 465 hours for all advisers
subject to surprise examinations.186
Therefore the total annual burden in
connection with the surprise
examination is estimated at 20,415
hours under the amended rule.187
Audited pooled investment vehicles.
The rule currently excepts, and the
amended rule continues to except,
182 The number of funds per adviser is estimated
based on the information we collected from Item
5.C. of Form ADV filed by advisers that provide
advisory services only to pooled investment
vehicles. The estimate of 250 investors per adviser
is a staff estimate used in the currently approved
collection of information burden.
183 [(78 × 5) + (78 × 250 × 0.02)] + [(129 × 2) +
(129 × 100 × 0.02)] = [390 + 390] + [258 + 258] =
1,296.
184 1,296 + 15,603 + 3,051 = 19,950. By contrast,
our estimate in the Proposing Release for the
surprise examination as proposed was 177,242
hours.
185 Amended rule 206(4)–2(a)(4).
186 1,859 × 0.25 = 465.
187 19,950 + 465 = 20,415.

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advisers to pooled investment vehicles
from having a qualified custodian send
quarterly account statements to the
investors in a pool if it is audited
annually by an independent public
accountant and the audited financial
statements are distributed to the
investors in the pool. The currently
approved annual burden in connection
with the required distribution of audited
financial statements is 393,500 hours.188
As explained in the Proposing Release,
we overestimated the burden for this
delivery requirement in the past.189 The
collection of information burden
imposed on an adviser relating to the
mailing of audited financial statements
to each investor in a pool that it
manages should be minimal, as the
financial statements could be included
with account statements or other
mailings. We estimate, consistent with
the estimate in the proposing release,
that the average burden for advisers to
mail audited financial statements to
investors in the pool is 1 minute per
investor.190 Under our revised estimate
of the number of advisers to audited
pooled investment vehicles,191 we
estimate that the aggregate annual hour
burden in connection with the
distribution of audited financial
statements is 4,861 hours.192
The amended rule requires that an
adviser to a pooled investment vehicle
that is relying on the annual audit
provision must have the pool audited
and distribute the audited financial
188 We estimated that 3,148 advisers to pooled
investment vehicles were subject to this
information collection under the current rule. We
further estimated that each adviser had, on average,
250 investors in the funds it advises, and that each
adviser spent 0.5 hours per investor annually for
delivering audited financial statements to its 250
investors. 3,148 × 250 × 0.5 = 393,500.
189 We previously estimated that an adviser
would spend 0.5 hours per investor sending
investors audited financial statements. This
estimate incorrectly included time for preparation
of the audited financial statements, which after the
audit should have been readily available to the
adviser for distribution.
190 Proposing Release at n. 94.
191 Based on IARD data, 2,069 advisers with
custody of client assets provided advice to pooled
investment vehicles as of November 2, 2009. Of
these 2,069 advisers, we estimate that 781 advisers
will each on average provide advice to five pooled
investment vehicles that have a total of 250
investors. 5 (pools) × 50 (investors) = 250. We
estimate that of these 781 advisers, 703 (or 90%)
will have their pooled investment vehicles audited
and distribute the audited financial statements to
the investors in the pool. We further estimate that
of the remaining 1,288 advisers, on average, each
provides advice to two pooled investment vehicles
that have a total of 100 investors. 2 (pools) × 50
(investors) = 100. We estimate that of these 1,288
advisers, 1,159 (or 90%) will have their pooled
investment vehicles audited and will distribute the
audited financial statements to the investors in the
pool.
192 [(703 × 250 × 1)/60] + [(1,159 × 100 × 1)/60]
= 2,929 + 1,932 = 4,861.

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statements to the investors in the pool
promptly after completion of the audit
if the fund liquidates at a time other
than its fiscal year-end. We estimate that
5 percent of pooled investment vehicles
are liquidated annually at a time other
than their fiscal year-end, which results
in an additional burden of 243 hours per
year.193 As a result, the total annual
hour burden in connection with the
distribution of audited financial
statements in connection with annual
audit and liquidation audit under the
amended rule is estimated to be 5,104
hours.194
Notice to clients. The amended rule
also requires each adviser, if the adviser
sends account statements in addition to
those sent by the custodian, to add a
legend in its notification to clients upon
opening a custodial account on their
behalf, and in any subsequent account
statements it sends to those clients,
urging them to compare the account
statements from the qualified custodian
to those from the adviser.195 Although
the legend requirement is new, it will be
placed in a notification that is currently
required to be sent to clients at specified
times. We believe that the increase in
this collection of information burden, if
any, is negligible. We estimate that 80
percent of the 2,986 advisers would be
subject to this collection of
information,196 and that each adviser
will on average open a new custodial
account for 5% of its clients per year,
either because the adviser has new
clients that request that the adviser open
an account on their behalf, or because
the adviser selects a new custodian and
moves its existing clients’ accounts to
that custodian. We further estimate that
the adviser will spend 10 minutes per
client drafting and sending the notice.
The total hour burden relating to this
requirement is estimated at 41,724
hours per year.197
Based on the above estimates, we
anticipate that the estimated total
193 4,861 (total burden hours relating to
distribution of audited financials) × 0.05 = 243.
194 4,861 + 243 = 5,104.
195 Amended rule 206(4)–2(a)(2).
196 We understand that advisers having custody
solely because of deducting fees do not typically
open custodial accounts on behalf of their clients.
Excluding those advisers and 703 advisers to
audited pooled investment vehicles to which the
notice requirement does not apply, we estimate that
2,986 advisers may be subject to this information
collection (advisers that answered ‘‘yes’’ to Item 9A.
or B. of Part 1A. of Form ADV). See supra note 173
and accompanying text. Based on our staff’s
observation, we further estimate that clients of 80%
of these advisers will receive account statements
from their advisers in addition to the account
statements from the qualified custodian. [0.8 ×
2,986 = 2,389].
197 [(2,986 × 0.8 × 2,096 (average number of
clients for the advisers with custody of client assets)
× 0.05) × 10]/60 = 41,724 hours.

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information collection burden under
amended rule 206(4)–2 would be 67,243
hours.198 This represents a decrease of
348,060 hours from the currently
approved burden,199 primarily due to
our change of methodology in
estimating the collection of information
with respect to distribution of audited
financial statements to investors in
pooled investment vehicles.200
Annual aggregate cost. The currently
approved collection of information for
the custody rule includes an aggregate
accounting fee of $281,000. Based on
the amendments we are adopting today,
we estimate a total annual aggregate
accounting fee of $122,965,000.201 The
increase in estimated aggregated cost is
attributable to an increase in the number
of advisers that will be subject to the
surprise examination, an increase in the
estimated cost for the surprise
examination, and the estimated cost for
an adviser to obtain, or to receive from
its related persons, an internal control
report when the adviser or related
person serves as qualified custodian for
the adviser’s clients’ assets.
In the Proposing Release, we
estimated that advisers subject to the
surprise examination would on average
pay an accounting fee of $8,100
annually.202 Many commenters asserted
that this estimate was too low.203 In
revising our estimates, we have
considered the commenters’
estimates,204 engaged in further
discussions with industry participants
and accounting firms, including
accounting firms that are registered
with, and subject to regular inspection
by, the PCAOB, and considered the cost
implications for the surprise
examination of certain aspects of our
guidance for accountants that we are
issuing today.205 We now estimate that
of the 1,859 advisers subject to the
surprise examination requirement, 337
advisers will be subject to the surprise
examination with respect to 100 percent
of their clients and will each spend an
198 20,415 (surprise examination) + 5,104
(distribution of audited financial statements) +
41,724 (notice to clients) = 67,243.
199 415,303¥67,243 = 348,060 hours.
200 See supra note 188 and accompanying text.
201 See infra note 211 and accompanying text.
202 See Proposing Release at n.102 and
accompanying text.
203 See infra notes 276 to 278 and accompanying
text.
204 We note that commenters based their cost
estimates for surprise examinations on the current
guidance for accountants, which requires
verification of 100% of client assets. We believe
that these estimates would have been significantly
lower if they had reflected the modernized
procedures for the surprise examination described
in the guidance for accountants issued in a
companion release. See Accounting Release.
205 Id.

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average of $125,000 annually,206 262
medium sized advisers will be subject to
the surprise examination requirement
with respect to 5% of their clients and
will each spend an average of $20,000
annually, and 1,260 small sized advisers
will be subject to the surprise
examination requirement with respect
to 5% of their clients and will each
spend an average of $10,000 annually,
with an aggregate annual accounting fee
of $59,965,000 for all advisers subject to
the surprise examination.207
We understand that the cost to
prepare an internal control report
relating to custody will vary based on
the size and services offered by the
qualified custodian. We estimated in the
Proposing Release that, on average, an
internal control report would cost
approximately $250,000 per year for
each adviser subject to the
requirement.208 We estimate that under
206 As stated in infra note 282, we estimate, based
on IARD data, that there will be 396 advisers that
do not currently use an independent qualified
custodian and will be subject to the surprise
examination with respect to 100% of their clients.
We expect 15% of these advisers will choose to use
independent custodians instead of incurring these
costs to comply with the rule. (396 × 85%) = 337.
We note that the costs of reporting to the
Commission (i) regarding ‘‘material discrepancy’’
pursuant to amended rule 206(4)–2(a)(4)(ii) and (ii)
upon termination of engagement pursuant to
amended rule 206(4)–2(a)(4)(iii) are included in the
estimated accounting fees.
207 (337 × $125,000) + (262 × $20,000) + (1,260
× $10,000) = $42,125,000 + $5,240,000 +
$12,600,000 = $59,965,000. See infra notes 282 to
286 and accompanying text for explanation of the
estimated amounts. We also note that we may have
overestimated the costs for the surprise examination
for advisers that have custody because a related
person has custody of client assets in connection
with advisory services. As we have indicated, as a
result of the exception to the surprise examination
requirement under amended rule 206(4)–2(b)(6) for
an adviser that has custody because of its related
person’s custody of client assets and that can
overcome the presumption that it is not
operationally independent of the related person
custodian, some of the 337 advisers may not have
to obtain a surprise examination. Those advisers
that overcome the presumption may, however,
incur outside legal expenses to assist with that
determination. See infra note 283.
208 One commenter, the Chamber of Commerce,
generally stated that the Commission’s estimate of
$250,000 was too low, but did not provide
alternative data. See the Chamber of Commerce
Letter. Another commenter, Securities Industry and
Financial Markets Association, however, concurred
with our cost estimate of $250,000. See
SIFMA(PCLC) Letter. A third commenter, Managed
Funds Association, estimated that the internal
control report of a hedge fund adviser would cost
approximately $500,000 and over $1 million in
some cases. See MFA Letter. We understand that
advisers to pooled investment vehicles typically do
not maintain client assets as qualified custodians
and, as a result few advisers to pooled investment
vehicles would have to obtain an internal control
report. Rather, it is more likely that the internal
control report would be for a related person brokerdealer, which costs we believe are accurately
reflected in the comment letter sent by the
Securities Industry and Financial Markets

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amended rule 206(4)–2, 252 advisers
will be subject to the requirement of
obtaining or receiving an internal
control report.209 Therefore the total
cost attributable to this requirement will
be $63,000,000.210 The total estimated
accounting fee under the amended rule
206(4)–2 is therefore estimated at
$122,965,000.211
One-time computer system
programming costs. As stated above, the
amended rule would require an adviser
that has an obligation under the rule to
provide a notice to clients upon opening
a new account on behalf of the client or
changes to such account and that sends
account statements to its client to
include in the account statement a
legend urging the client to compare its
account statement with those sent by
the qualified custodian. We expect that
the requirement would cause advisers
that are subject to the notice
requirement and that send account
statements to clients to reprogram their
computer system to include the legend
in account statements to clients. We
estimate that half of the advisers that are
subject to the rule or 1,195 advisers will
hire a computer programmer to modify
their computer system to automatically
add the legend to client account
statements at an average cost of $1,000
each.212 We believe the other half
Association. See SIFMA(PCLC) Letter. After further
consultation with several accounting firms that
have experience in preparing Type II SAS 70
reports, including accounting firms that are
registered with the PCAOB, we believe our estimate
of $250,000 is reasonable. Moreover, 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,
which may reduce the costs for advisers to comply
with the internal control report requirement.
209 Of the 337 advisers (see supra note 206 for
this estimate) that will be subject to both the
surprise examination and internal control report
requirement, we further estimate, based on
consultation with several accounting firms, that
10% of these advisers already obtain an internal
control report for purposes other than the custody
rule. In addition, we believe that some related
persons may serve as the qualified custodian for
more than one affiliated adviser. We estimate that
this will reduce the number of required internal
control reports by an additional 15%. See infra
notes 289 and 290 and accompanying text for
explanation of this estimate. 337¥(337 ×
10%)¥(337 × 15%) = 337¥34¥51 = 252.
210 $250,000 × 252 = $63,000,000. See supra note
207 and infra notes 275 to 292 and accompanying
text for explanation of our estimate of costs of the
internal control report.
211 $59,965,000 (accounting fee for surprise
examination) + $63,000,000 (accounting fee for
internal control report) = $122,965,000.
212 As stated above, we estimated that there will
be 2,389 advisers subject to this requirement. See
supra note 196 and accompanying text. 2,389/2 =
1,195.

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routinely use off-the-shelf software to
provide client account statements and
will bear little or no direct costs because
we expect the software vendors will not
pass the reprogramming costs on to their
customers (i.e. the advisers) due to a
very low per unit cost. Based on the
above estimates, we believe that the
total one-time computer system
programming cost would be $1,195,000
for the advisers subject to this
requirement.213
PCAOB registration. For an
investment adviser to rely on the
provision in amended rule 206(4)–2 that
deems pooled investment vehicles to
have satisfied the surprise examination
requirement if audited financial
statements are distributed to investors
in the pool, the accountant that audits
the pooled investment vehicle’s
financial statements must be registered
with, and subject to regular inspection
by, the PCAOB.214 We acknowledge that
not all pooled investment vehicle audits
are performed by accountants meeting
the PCAOB requirement as this is a new
requirement. However, our staff has
reviewed several third-party databases
that contain the identity of accountants
that perform these audits, and
substantially all the pools that identified
accountants were audited by PCAOB
registered and inspected firms or their
affiliates.215 Moreover, a representative
of venture capital firms stated that the
‘‘vast majority’’ of venture capital funds
are audited and, as far as it could
determine, all venture capital fund
audits are conducted by PCAOB
registered accounting firms that are
subject to PCAOB inspection.216 As a
result, we do not believe there will be
a substantial dislocation of pooled
investment vehicle auditors as a result
of the amended rule. For those pools
that will have to change accounting
firms, we do not believe based on
discussions with accountants that there
will be additional costs to retain an
accounting firm registered with, and
subject to inspection by, the PCAOB, as
accountants that perform these financial
statement audits are likely to be with
national accounting firms or accounting
firms that specialize in auditing pooled
investment vehicles and that charge
equivalent fees to accountants registered
213 1,195 × $1,000 = $1,195,000. See infra note
294 for explanation of the estimate.
214 Amended rule 206(4)–2(b)(4).
215 These databases do not distinguish between
funds managed by registered advisers from those
managed by exempt advisers (who would not be
subject to the rule).
216 NVCA Letter.

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with, and subject to inspection by, the
PCAOB.217
B. Form ADV
In connection with our proposed
amendments to Form ADV, we
submitted cost and burden estimates of
the collection of information
requirements to the Office of
Management and Budget (‘‘OMB’’). We
estimated that these amendments would
increase the annual information
collection burden in connection with
Form ADV from 22.25 hours to 22.50
hour for each adviser.218 The total
information collection burden resulting
from the amendments would be 3,068
hours.219 We solicited comment in the
Proposing Release on our estimates, but
did not receive comments. We do not
believe that the amendments to Form
ADV we are adopting today will result
in a collection of information
requirement different than what we
estimated in the Proposing Release.
Therefore, we are not revising our PRA
burden and cost estimates submitted to
the OMB with respect to Form ADV.

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C. Form ADV–E
The currently approved collection of
information for Form ADV–E is 9 hours.
We estimate that this collection of
information will increase to 112 hours
based on the amendments.220 This
increase results primarily from an
increase in the estimated number of
advisers that will be subject to the
requirement of completing Form ADV–
E under the amended rule 206(4)–2 and
the additional collections of information
required by the amendments to the
rule.221
217 Two commenters expressed concerns about
costs with respect to the requirement of PCAOB
registration for accountants performing surprise
examinations and preparing internal control reports
for advisers that serve, or have related persons
serve, as the qualified custodian for their client
assets. See Consortium Letter; Chamber of
Commerce Letter. These comments, however, were
not directed to the costs of engaging PCAOB
registered accountants for audits of pooled
investment vehicles, and the commenters that did
recommend the PCAOB requirement did not
indicate there would be increased costs for such a
requirement. See, e.g., CPIC Letter, MFA Letter.
218 See the Proposing Release at n.169 and
accompanying text. We received no comments on
the estimate and we are keeping the estimate
unchanged.
219 See the Proposing Release at n.170 and
accompanying text. We received no comments on
the estimate and we are keeping the estimate
unchanged.
220 We requested comment on our estimates of the
collection of information burden relating to Form
ADV–E and received no comment.
221 Form ADV–E is the cover sheet for the
required filing with the Commission by the
accountant performing the surprise examination
pursuant to amended rule 206(4)–2(a)(4)(i) and (iii).
The adviser completes Form ADV–E and provides

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For the currently approved annual
hour burden for Form ADV–E, we
estimated that 231 advisers would be
subject to the annual surprise
examination requirement, including the
requirement to complete Form ADV–E,
and that each of the advisers would
spend approximately 0.05 hour to
complete Form ADV–E. We now
estimate that 1,859 advisers will be
required to undergo an annual surprise
examination and complete Form ADV–
E, and that the total annual hour burden
for Form ADV–E in connection with the
surprise examination requirement will
therefore increase to 93 hours.222
In addition, amended rule 206(4)–2
requires an adviser subject to the
surprise examination to enter into a
written agreement with the independent
public accountant that specifies the
accountant’s duties, including filing
Form ADV–E upon the termination of
its engagement. Based on an assumption
that advisers change their independent
public accountants every five years on
average and an estimate that advisers
spend approximately 0.05 hours to
complete Form ADV–E, advisers will be
required each year to complete Form
ADV–E with respect to an accountant’s
termination with an annual burden of
19 hours.223 The total annual hour
burden for advisers to complete Form
ADV–E in connection with the surprise
examination and the termination
statement will be 112 hours.224
V. Cost-Benefit Analysis
A. Background
The Commission is sensitive to the
costs and benefits resulting from its
rules. Rule 206(4)–2, the custody rule,
seeks to protect clients’ funds and
securities in the custody of registered
advisers from misuse or
misappropriation by requiring advisers
to maintain their clients’ assets with a
qualified custodian, such as a brokerdealer or a bank. The custody rule, as
amended, requires all registered
advisers that have custody of client
assets to have a reasonable belief,
formed after due inquiry, that a
qualified custodian sends an account
statement directly to each advisory
client for which the qualified custodian
maintains assets.225 The amended rule
also requires advisers that have custody
of client assets to undergo an annual
it to the accountant, which results in an estimated
hour burden for the advisers.
222 1,859 × 0.05 = 93.
223 1,859/5 = 372. 372 × 0.05 = 19.
224 93 + (372 × 0.05) = 93 + 19 = 112.
225 Amended rule 206(4)–2(a)(3). We have
retained the exception from the account statement
delivery requirement for certain advisers to pooled
investment vehicles. Amended rule 206(4)–2(b)(4).

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surprise examination by an independent
public accountant with the exception of
advisers that have custody solely
because of their authority to deduct
advisory fees from client accounts,226
and advisers that have custody solely
because a related person holds the
adviser’s client assets and the related
person is operationally independent of
the adviser.227 In addition, advisers to
pooled investment vehicles are deemed
to comply with the surprise
examination requirement if the pools
are subject to an annual financial
statement audit by an independent
public accountant that is registered
with, and subject to regular inspection
by, the PCAOB, and if the audited
financial statements are delivered to the
pool’s investors.228
We are also adopting amendments to
the rule to impose additional
requirements when advisory client
assets are maintained by the adviser
itself or by a related person rather than
with an independent qualified
custodian. The amended rule requires,
in addition to the surprise examination
discussed above,229 that 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, such as a Type II SAS 70
report.230 The amended rule also
requires, in these circumstances, that
the independent public accountant
issuing the internal control report, as
well as the independent public
accountant performing the surprise
examination, be registered with, and
subject to regular inspection by, the
PCAOB.231 The adviser must maintain
the internal control report in its records
and make it available to the Commission
or staff upon request.232
Finally, we are adopting several
amendments to Form ADV and Form
ADV–E. The amendments to Form ADV
require registered advisers to report to
us more detailed information about their
custody practices. The amendments to
226 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 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.
227 Amended rule 206(4)–2(b)(6).
228 Amended rule 206(4)–2(b)(4).
229 Amended rule 206(4)–2(a)(6).
230 Amended rule 206(4)–2(a)(6)(ii). As discussed
in the costs section below, other types of reports
could also satisfy the internal control report
requirement.
231 Amended rule 206(4)–2(a)(6)(i) and (ii)(C).
232 Amended rule 204–2(a)(17)(iii).

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Form ADV–E require that the form and
the accompanying accountant’s
examination certificate, or statement
upon termination, be filed electronically
with the Commission through the IARD
and conform Form ADV–E instructions
to amended rule 206(4)–(2).
In the Proposing Release, we
requested comment and empirical data
regarding the costs and benefits of the
amendments. Most of the 1,300
commenters expressed their support for
our goal of strengthening protections
provided to advisory clients under the
custody rule. One opined that the
benefits of the proposed additional
safeguards to investors whose assets are
held in custodial accounts outweigh the
costs to advisers.233 Many, however,
generally expressed concern about the
costs, particularly to small advisers, of
our proposal as it would have applied
to advisers that have custody solely
because of their authority to deduct
advisory fees from client accounts.234
As noted above, we have provided an
exception from the surprise examination
requirement for these advisers. Several
commenters provided comments on the
costs and benefits in the Proposing
Release, which we address below.
B. Benefits
Improved protection for advisory
clients. The rule and form amendments
we are adopting today are designed to
strengthen controls over the custody of
client assets by registered investment
advisers and to encourage the use of
independent custodians. They will also
improve our ability to oversee advisers’
custody practices and, together with the
guidance for independent public
accountants that we are issuing, may
prevent client assets from being lost,
misused, misappropriated or subject to
advisers’ financial reverses. The benefits
to investors are difficult to quantify, and
commenters did not submit empirical
data on potential benefits. We believe,
however, that these benefits will be
substantial, including, generally,
increased confidence investors will
have when obtaining advisory services
from registered investment advisers. In
addition, we believe the amendments to
the rule could, to a limited extent,
promote efficiency and capital
formation as a result of such increased
investor confidence. In particular,
increased investor confidence could
233 CFA

Institute Letter.
the 1,300 comment letters, approximately
1,100 were form letters or substantially similar
letters submitted by smaller advisory firms that, in
part, generally expressed concerns regarding the
costs of the proposal as it related to the surprise
examination for advisers with custody solely due to
authority to withdraw advisory fees.
234 Of

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lead to more efficient allocation of
investor assets, which could result in an
increase in the assets under
management of investment advisers
and, depending on how those assets are
invested, a potential increase in the
availability of capital.
As described above, the amended
custody rule requires investment
advisers registered with us that have
custody of client assets, subject to
certain exceptions, to obtain a surprise
examination of client assets by an
independent public accountant. As a
result, advisers that have custody
because, for example, they or their
related person serves as qualified
custodian for client assets, or because
they serve as trustee of a client trust or
have a power of attorney over client
affairs, must undergo an annual surprise
examination.235 The surprise
examination requirement should
significantly contribute to deterring
fraudulent conduct by investment
advisers because advisers subject to the
surprise examination will know their
clients’ assets are subject to verification
at any time, and therefore may be less
likely to engage in misconduct. If fraud
does occur, the surprise examination
requirement will increase the likelihood
that fraudulent conduct will be detected
earlier so that client losses will be
minimized.236 The additional review
provided by an independent public
accountant will also benefit advisory
clients because it may help identify
problems that clients may not be in the
position to uncover through the review
of account statements. We estimate that
the rule will require 1,859 advisers 237 to
obtain an annual surprise examination,
and as a result provide the benefits
identified above with respect to 956,237
clients.238
As amended, rule 206(4)–2 requires,
in addition to the surprise examination
discussed above, that when an adviser
or its related person serves as a qualified
custodian for advisory client assets, the
adviser obtain, or receive from its
related person, no less frequently than
once each calendar year, a written
235 See

Section II. B of this Release.
independent public accountant
conducting a surprise examination is required to
verify client assets 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.
237 See supra note 173 and accompanying text for
explanation of this estimate.
238 [337 (advisers) × 2,315 (average number of
clients for advisers subject to the surprise
examination)] + (1,522 × 2,315 × 0.05 (percentage
of clients whose assets are subject to the surprise
examination)) = 780,155 + 176,172 = 956,237.
236 The

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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.239 The
amended rule also requires, in these
higher risk situations, that the
independent public accountant issuing
the internal control report, as well as the
independent public accountant
performing the surprise examination, be
registered with, and subject to regular
inspection by, the PCAOB.240
The internal control report
requirement will provide important
benefits to advisory clients by imposing
additional safeguards when client assets
are maintained with the adviser or a
related person. First, the internal control
report will indicate whether the
qualified custodian (the adviser or its
related person) has established
appropriate custodial controls by
including an accountant’s opinion
regarding whether the custodian’s
internal controls are suitably designed
and are operating effectively to meet
control objectives related to custodial
services, including the safeguarding of
funds and securities.241 Second, to
satisfy the rule’s requirements, the
independent public accountant
preparing the internal control report
must verify that client assets are
reconciled to a custodian other than the
adviser or its related person, which will
serve as a critical check when the
custodian is not independent.242 Third,
an internal control report may also
significantly strengthen the utility of the
surprise examination when the adviser
or a related person custodian maintains
client assets because the independent
public accountant performing the
surprise examination may obtain
additional comfort that confirmations
received from the qualified custodian in
the course of the surprise examination
are reliable. Clients of approximately
337 advisers will benefit from the
protections provided by the internal
control report requirement.243
As noted above, the amended rule
provides a limited exception from the
surprise examination requirement in
certain circumstances when the adviser
239 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.
240 Amended rule 206(4)–2(a)(6)(i) and (ii)(C).
241 See Accounting Release.
242 Amended rule 206(4)–2(a)(6)(ii)(B).
243 See supra notes 174 and 175 and
accompanying text for explanation of the estimated
number. Because these advisers serve, or have a
related person serve, as the qualified custodian for
their client assets, they are subject to the internal
control report requirement. Amended rule 206(4)–
2(a)(6).

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is deemed to have custody solely as a
result of a related person having
custody.244 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
its related person.245 Advisers that can
overcome the presumption that they are
not operationally independent of their
related person will benefit from the cost
savings of not having to obtain a
surprise examination under these
circumstances.246 Clients may also
benefit from this provision in two
respects. First, it may encourage
advisers with a choice of related person
qualified custodians to use those that
are operationally independent over
those that are not, which may lower
custodial risks to clients. Second, while
clients will not have the benefit of the
surprise examination under these
circumstances, they will benefit from
the protections of the internal control
report that the adviser must receive
from a related person that is a qualified
custodian.
When the adviser or its related person
serves as qualified custodian for client
assets, the surprise examination and
internal control report must be
performed or prepared by an
independent public accountant that is
registered with, and subject to regular
inspection by, the PCAOB.247 We are
also amending rule 206(4)–2 to require
that in order to be deemed to comply
with the surprise examination
requirement, advisers to audited pooled
investment vehicles must have the
pool’s annual audited financial
statements prepared by an independent
public accountant that is registered
with, and subject to regular inspection
by, the PCAOB and distribute the
audited financial statements to the
investors in the pool.248 Advisory
clients and pool investors will benefit
by having greater confidence in the
quality of the surprise examination, the
internal control report and pooled
investment vehicle audits when
performed or prepared by an
independent public accountant that is
registered with, and subject to regular
inspection by, the PCAOB. 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
244 Rule

206(4)–2(b)(6).

245 Id.
246 We have estimated that each of these surprise
examinations would cost an adviser $125,000. See
infra notes 282—283 and accompanying text.
247 Amended rule 206(4)–2(a)(6)(i) and (ii)(C).
248 Amended rule 206(4)–2(b)(4).

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be subject to its inspection can provide
indirect benefits regarding the quality of
the accountant’s other engagements.
The amendments also eliminate the
alternative, currently provided in the
rule, under which an adviser with
custody can send its own account
statements to clients if the adviser is
subject to an annual surprise
examination. Instead, all advisers with
custody are required to have a
reasonable belief, after due inquiry, that
the qualified custodian sends account
statements directly to clients. As a
result, we expect that clients of
approximately 190 advisory firms that
currently send their own account
statements to clients will, under the
amended rule, receive account
statements directly from qualified
custodians.249 Where the qualified
custodian is independent, this change
provides advisory clients confidence
that erroneous or unauthorized
transactions will be reflected in the
account statement. As a result, this
change may deter advisers from
engaging in fraudulent activities and
allow clients to detect any unauthorized
activity in their accounts promptly,
thereby averting or reducing losses.
Clients of these 190 advisers will benefit
from this amendment and will start
receiving account statements directly
from qualified custodians.
The amended rule requires advisers to
include a legend in the notice that they
are currently required to send to their
clients upon opening a custodial
account on their clients’ behalf if the
adviser sends its own account
statements to clients and in any
subsequent account statements it sends
to clients.250 The legend will urge
clients to compare the account
statements they receive from the
custodian with those they receive from
the adviser. As discussed above, client
review of periodic account statements
from the qualified custodian is an
important measure that can enable
clients to discover improper account
transactions or other fraudulent activity.
Raising clients’ awareness of this
safeguard under the custody rule at
account opening and with each
subsequent account statement sent by
the adviser may cause clients to uncover
any unauthorized transactions by their
advisers in their accounts more
promptly, thereby averting or reducing
losses. We estimate that 250,367 clients
would receive notices and subsequent
249 Based on ADV–E filings, there were 190
advisers that underwent surprise examinations
during 2008.
250 Amended rule 206(4)–2(a)(2).

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account statements containing this
additional information.251
Under the amended rule, each adviser
that is required to undergo an annual
surprise examination must enter into a
written agreement with an independent
public accountant to perform the
surprise examination. The written
agreement will require the independent
public accountant to, among other
things, (i) file Form ADV–E
accompanied by a certificate within 120
days of the time chosen by the
accountant for the surprise examination
stating that it has examined the client
assets and describing the nature and
extent of the examination, (ii) report to
the Commission any material
discrepancies discovered in the
examination within one business day,
and (iii) upon the accountant’s
termination or dismissal, or removal
from consideration for reappointment,
file Form ADV–E within 4 business days
accompanied by a statement explaining
any problems relating to examination
scope or procedure that contributed to
the resignation, dismissal, removal, or
other termination. These filings and
reports will provide our staff additional
information to assist in establishing
advisers’ risk profiles for purposes of
prioritizing examinations. The rule will
result in the electronic filing of Form
ADV–E and the accountant statement on
the IARD system.252 Clients will benefit
from electronic filing of the Form ADV–
E because it will allow them to easily
access important information about the
surprise examinations performed on
their advisers. We estimate that
4,303,585 advisory clients will benefit
from the amendment.253 Furthermore,
the availability to the general public of
Form ADV–E information on the
Commission’s web site may result in
additional benefits, including deterring
misconduct before it occurs and
providing additional information for
251 We estimated that approximately 2,986
advisers open accounts on behalf of their clients.
Based on our staff’s observation, we further estimate
that 80% of these advisers send account statements
to their clients. (2,986 × 0.8 = 2,389). We estimate
that each year these 2,389 advisers on average open
accounts for about 5% of their 2,096 clients
(average number of clients of the advisers with
custody of client assets) who are either new clients
or whose accounts have been transferred to new
qualified custodians and that these advisers also
send their own account statements to clients. (2,389
× (2,096 × 0.05) = 250,367).
252 Until the IARD system is upgraded to accept
Form ADV–E, accountants performing surprise
examinations should continue paper filing of Form
ADV–E. Investment advisers will be notified as
soon as the IARD system can accept filings of Form
ADV–E.
253 1,859 × 2,315 (average number of clients of the
advisers subject to the surprise examination) =
4,303,585.

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clients to consider when deciding
which investment adviser to select.
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.254 We are also amending Item
9 to require advisers that have custody
(or whose related persons have custody)
of client assets to provide additional
information about their custodial
practices under the custody rule. In
addition, the revised Schedule D of
Form ADV requires an adviser to
provide additional details including
information about the independent
public accountants that perform annual
audits, surprise examinations or that
prepare internal control reports,255
whether a report prepared by an
independent public accountant contains
an unqualified opinion,256 and about
any related person that serves as a
qualified custodian for the adviser’s
clients.257 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. These
disclosures will provide our staff more
information to determine advisers’ risk
profiles and prepare for examinations.
Moreover, this information will be filed
electronically when IARD accepts these
filings, and as a result the information
will be available to the public through
the Commission’s Web site. Clients will
benefit directly from these amendments
by obtaining more information about
their advisers’ custodial practices. They
may also benefit indirectly because
advisers will be incentivized to
implement strong controls and practices
to avoid receiving a qualified opinion
from an independent public accountant.
Finally, under the amended rule, an
adviser to pooled investment vehicles
that is deemed to comply with the
surprise examination requirement and
that is excepted from the account
statement delivery requirement by
having the pooled investment vehicle
audited and distributing the audited
financial statements to the investors
254 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.
255 Section 9.C. of Schedule D of Form ADV.
256 Id.
257 Section 9.D of Schedule D of Form ADV.

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must, in addition to obtaining an annual
audit, obtain a final audit of the fund’s
financial statements upon liquidation of
the fund and distribute the financial
statements to fund investors promptly
after the completion of the audit.258
This amendment provides fund
investors the information necessary to
protect their rights and to make sure
that the proceeds of the liquidation are
appropriately accounted for.
Improved clarity of the rule. We
anticipate that investment advisers will
find it easier to understand and comply
with the rule as a result of the
amendments, which may result in cost
savings for advisers. The amendments
will improve the clarity of the rule by
adding several definitions, including
amending the definition of ‘‘custody’’ to
address related person custodian
situations, and adding definitions of
‘‘control’’ and ‘‘related person.’’ 259
C. Costs
Surprise Examination. As noted
above, the amended rule we are
adopting today excludes certain
advisers with custody from the
requirement to undergo an annual
surprise examination and deems certain
others to comply with the
requirement.260 Advisers that have
custody for other reasons, however,
such as because they or their related
person serves as the qualified custodian
for client assets, or because they serve
as the trustee of a client trust, must
undergo an annual surprise
examination.261 As a result, we now
estimate that 1,859 advisers will be
subject to the surprise examination
requirement under amended rule
206(4)–2.262 Reducing that number by
the 190 advisers that already undergo an
annual surprise examination under the
258 Amended

rule 206(4)–2(b)(4)(iii).
rule 206(4)–2(d).
260 Amended rule 206(4)–2(b)(3) (exception from
surprise examination for advisers that have custody
because they have authority to deduct fee from
client accounts); amended rule 206(4)–2(b)(6)
(exception from surprise examination for advisers
that have custody solely because a related person
holds the adviser’s client assets and the related
person is operationally independent of the adviser);
and amended rule 206(4)–2(b)(4) (deemed
compliance with the surprise examination
requirement for advisers to audited pooled
investment vehicles that distribute audited
financial statements to pool investors if the audit
was conducted by an independent public
accountant registered with, and subject to regular
inspection by, the PCAOB).
261 Under amended rule 206(4)–2 an adviser has
custody if its related person has custody of its client
assets. Amended rule 206(4)–2(d)(2). A related
person is defined as a person directly or indirectly
controlling or controlled by the adviser, and any
person under common control with the adviser.
Amended rule 206(4)–2(d)(7).
262 See supra note 173.
259 Amended

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1477

current rule,263 we estimate that the
amendments will result in
approximately 1,669 additional advisers
being required to obtain a surprise
examination.264
For purposes of the PRA analysis, we
estimate that the total annual collection
of information burden in connection
with the surprise examination, before
including the hours spent on
conforming written agreements with
accountants to the amended rule, will
be 19,950 hours.265 Based on this
estimate, we anticipate that advisers
will incur an aggregate cost of
approximately $1,256,850 per year for
these estimated hours.266
Written agreement. As proposed,
amended rule 206(4)–2 requires that an
adviser subject to the surprise
examination requirement must enter
into a written agreement with the
independent public accountant engaged
to conduct the surprise examination and
specify certain duties to be performed
by the independent public
accountant.267 As stated in the
Proposing Release, we believe that
written agreements are commonplace
and reflect industry practice when a
person retains the services of a
professional such as an independent
public accountant, and they are
typically prepared by the accountant in
advance. Because the amended rule
applies to investment advisers (and not
accountants) we believe that the burden
to add the provisions to the written
agreement will be borne by the adviser.
We estimate that each adviser will
spend 0.25 hour to add the required
provisions to the written agreement,
with an aggregate of 465 hours for all
advisers subject to surprise
examinations.268 Requiring certain
additional items to be included in the
written agreement will not significantly
increase costs for advisers.269 Moreover,
263 See

supra note 249.
= 1,669.
265 See supra note 184 accompanying text for
explanation of the estimate.
266 We expect that the function of providing lists
of clients to the independent public accountant in
assisting its examination, totaling 19,950 hours,
would be performed by compliance clerks. Data
from the Securities Industry and Financial Markets
Association’s Office Salaries in the Securities
Industry 2008, modified by Commission staff to
account for an 1800-hour work-year and multiplied
by 2.93 to account for bonuses, firm size, employee
benefits and overhead, suggest that cost for this
position is $63 per hour. Therefore the total costs
would be $1,256,850.
267 Amended rule 206(4)–2(a)(4).
268 1,859 × 0.25 = 465.
269 We estimate that it will take each adviser
about 0.25 hour to add the required specifications.
See supra note 186 and accompanying text.
Converting the hour burden to costs, each adviser
would spend $64.50. See infra note 271.
264 1,859¥190

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we do not believe that the new
requirements placed on the independent
public accountant by the written
agreement (electronic filing of Form
ADV–E and termination statement) will
materially increase the accounting fees
for the surprise examination discussed
above.
For purposes of the PRA analysis, we
estimate a total annual collection of
information burden in connection with
the surprise examination of 20,415
hours.270 Based on this estimate, we
anticipate that advisers will incur an
aggregate cost of approximately
$1,376,820 per year for the total hours
their employees spend in complying
with the surprise examination
requirement.271
In the Proposing Release, we
estimated that there would have been
9,575 advisers subject to the surprise
examination and they would each pay,
on average, an annual accounting fee of
$8,100 for the surprise examination.272
The estimated total accounting fees for
all surprise examinations would
therefore have been $77,557,500.273 As
explained above, the amended rule
excepts from the surprise examination
requirement, advisers that have custody
because of deducting advisory fees, and
advisers that have custody solely
because a related person holds the
adviser’s client assets and the related
person is operationally independent of
the adviser, and it deems advisers to
audited pooled investment vehicles to
270 This estimated number includes the hours an
adviser spends on providing client lists to the
accountant performing the surprise examination
and meeting the rule’s requirements for the written
agreement with the accountant regarding its
engagement to perform the surprise examination.
15,603 hours (advisers subject to the surprise exam
for 100% of clients to provide client lists) + 3,051
(advisers subject to the surprise exam for advisers
with custody of a small portion of their clients to
provide client lists) + 1,296 (advisers to pooled
investment vehicles that are subject to the surprise
examination to provide investor lists) + 465 (written
agreement with accountants) = 20,415.
271 As we stated above, the total estimated burden
hours related to the surprise examination
requirement, before including the hours for written
agreement with the accountant, are 19,950 hours
with an estimated costs of $1,256,850. See supra
note 184 for explanation of the estimated hours and
supra note 266 for explanation of estimated cost.
We expect that the function of adding certain duties
of the accountant to the written agreement with the
accountant, totaling 465 hours, would be performed
by compliance managers. Data from the Securities
Industry and Financial Markets Association’s
Management & Professional Earnings in the
Securities Industry 2008, modified by Commission
staff to account for an 1800-hour work-year and
multiplied by 5.35 to account for bonuses, firm size,
employee benefits and overhead, suggest that the
cost for this position is $258 per hour. Therefore the
total costs would be $1,376,820 ((19,950 × $63) +
(465 × $258) = $1,376,820).
272 See Proposing Release at n.102 and
accompanying text.
273 9,575 × $8,100 = $77,557,500.

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comply with the requirement under
certain circumstances,274 reducing our
estimated number of advisers subject to
the surprise examination requirement
from 9,575 to 1,859.275
Several commenters believed that our
cost estimates for surprise examination
accounting fees were too low.276 Some
of them provided their own estimates
ranging from an amount close to our
estimate (for smaller advisers),277 to
over one million dollars for the largest
firms.278 We believe that the costs of the
surprise examination are lower than the
costs suggested by commenters because
commenters’ estimates were based on
two critical assumptions that no longer
are valid. First, these estimates were
generally based on an understanding
that the examination would involve
verifying 100% of client assets, as is
currently required under our existing
guidance for accountants.279 The
revised guidance for accountants we are
issuing, however, among other things,
permits accountants to use sampling in
the course of the surprise
examination.280 Second, many of these
estimates are based on an assumption
that an adviser would have custody of
all of its clients’ accounts based on our
proposal to require the surprise
examination if an adviser had custody
because of the authority to deduct
advisory fees directly from client
accounts. The rule now provides an
exception from the surprise examination
when fee deduction is the reason the
adviser has custody. As a result, many
advisers that have custody under the
amended rule will have custody with
respect to a limited number of client
accounts, and the scope of work for the
accountant performing the surprise
examination will be significantly
reduced.
While, for reasons discussed above,
we believe commenters’ estimates of the
cost of surprise examination are too
high, they have caused us to reexamine
our cost estimates and to determine that
it would be more appropriate to
categorize advisers into subcategories to
estimate surprise exam costs. Instead of
a single average cost, we have divided
the 1,859 advisers that are subject to the
surprise examination requirement into
274 See
275 See

Section II.C.2. of this Release.
supra notes 170 to 173 and accompanying

text.
276 See, e.g., FPA Letter (estimated costs of
$15,000 to $24,000), IAA Letter (estimated costs of
$20,000 to $300,000).
277 CFP Board Letter (estimating cost of surprise
examination from $5,000 to $10,000).
278 SIFMA(PCLC) Letter (member survey
indicated average cost estimate of $200,000 with
one response of over $1,000,000).
279 See ASR No. 103.
280 See Accounting Release.

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three distinct groups.281 We now
estimate that 337 advisers either serve
as qualified custodian for their clients or
have a related person that serves as
qualified custodian.282 These advisers
would likely be subject to the surprise
examination with respect to 100 percent
of their clients, and as these advisers
typically are large advisers with many
clients, we estimate they will each
spend an average of $125,000
annually.283 We estimate that the rest of
the advisers will be subject to surprise
examination with respect to 5 percent of
281 The revised estimated costs are based on the
experience of our staff and discussions with public
accounting firms regarding the surprise
examination requirement, modern accounting
practices, and commenters’ estimates.
282 Based on IARD data, we estimated 396
advisers either serve as qualified custodian for their
clients or have a related person that serves as
qualified custodian. These advisers would likely be
subject to the surprise examination with respect to
100 percent of their clients. We expect 15% of these
advisers will use independent custodians instead of
incurring these costs. This estimate is based on
comments that we received about the high costs of
the proposed requirements with respect to advisers
using a related person as the qualified custodian.
We believe that these advisers will do their own
analysis of the benefits of continuing using their
related persons as qualified custodians. Some of the
advisers that maintain client assets with their
related person custodians on an incidental basis
may decide to use independent qualified custodians
instead to avoid the costs of complying with the
requirements. (396 × 85%) = 337.
283 Several of these large advisers are advisers
with thousands of client accounts, while others
have significantly fewer client accounts. The largest
advisers will likely incur expenses higher than
$125,000. Whereas those with significantly fewer
client accounts will likely incur expenses less than
$125,000. Moreover, as a result of the exception to
the surprise examination requirement under
amended rule 206(4)–2(b)(6) for an adviser that has
custody because of its related person’s custody of
client assets and that can overcome the
presumption that it is not operationally
independent of the related person custodian, some
of these 337 advisers would not have to obtain the
surprise examination. We do not have data or
another resource to provide an estimate of the
number of advisers that use related person
custodians that will be able to overcome the
presumption. As a result, we are unable to estimate
with specificity the reduced costs due to this
exception. We do estimate that of the 337 advisers
subject to the surprise examination, that 259 (after
the 15% reduction noted above) use related person
qualified custodians. See supra note 175. If 75% of
the 259 of these advisers could overcome the
presumption, the cost estimates for the surprise
examination would be overstated by $24,281,250
((259 × .75) × $125,000), if one half of them could
overcome the presumption the costs would be
overstated by $16,187,500 ((259 × .5) × $125,000),
or if one quarter of them could overcome the
presumption the costs would be overstated by
$8,093,750 ((259 × .25) × $125,000). Those advisers
that overcome the presumption may, however,
incur outside legal expenses to assist with the
determination. We estimate that on average, such
legal assistance would cost an adviser between
$4,000 (for 10 hours) and $16,000 (for 40 hours),
significantly less than the estimated costs for the
surprise examination. The hourly cost estimate of
$400 on average is based on our consultation with
advisers and law advisers who regularly assist them
in legal and compliance matters.

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their client accounts.284 We have
divided these 1,522 advisers into two
groups based on their number of clients:
262 medium-sized advisers and 1,260
small-sized advisers.285 We estimate
that medium-sized advisers will on
average have accounting fees of $20,000
annually and small-sized advisers will
on average have accounting fees of
$10,000 annually for the surprise
examination. Therefore the aggregate
account fee relating to the surprise
examination is estimated at
$59,965,000.286
Internal Control Report. Under
amended rule 206(4)–2, if an adviser or
a related person serves as a qualified
custodian for client assets in connection
with advisory services the adviser
provides to clients, the adviser must
obtain, or receive from the related
person, no less frequently than once
each calendar year, a written 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 PCAOB. We estimate
that approximately 337 investment
advisers must obtain, or receive from a
related person, an internal control
report relating to custodial services.287
One securities industry commenter
noted that custodians often already
provide Type II SAS 70 reports to
clients who demand a rigorous
evaluation of internal control as a
condition of obtaining their business.288
We estimate that 10% of the advisers
that must obtain or receive an internal
control report will themselves or their
related person qualified custodian will
already obtain an internal control report
for purposes other than the custody
rule.289 In addition, a single internal
control report will satisfy the rule’s
284 Advisers are required to undergo an annual
surprise examination with respect to only those
client accounts to which they have access that
causes them to have custody, including through a
power of attorney, acting as trustee, or similar legal
authority. Based on the experience of our staff, we
estimate that on average, only 5 percent of client
accounts of these advisers will be subject to the
surprise examination.
285 Based on responses to Item 5.C of Form ADV,
we estimate that the average number of clients for
these 1,522 advisers is 806. We determined, for
purposes of this analysis, that an adviser with
clients more than this average number is a medium
size adviser and an adviser with clients less than
this average number is a small adviser. 337 + 262
+ 1,260 = 1,859.
286 (337 × $125,000) + (262 × $20,000) + (1,260
× $10,000) = $42,125,000 + $5,240,000 +
$12,600,000 = $59,965,000.
287 See supra notes 276–278 for explanation of
this estimate.
288 SIFMA(AMG) Letter.
289 Our estimate of 10% is based on our
consultation with accounting firms that have
experience in preparing internal control reports.
337 × 10% = 34.

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requirement for several related advisers
if their clients use the same related
person as qualified custodian. We
estimate that this will reduce the
number of required internal control
reports by an additional 15%.290 As a
result, we estimate that independent
public accountants will prepare 252
internal control reports as a result of the
rule amendments. Based on discussions
with accounting professionals, we
understand that the cost to prepare an
internal control report relating to
custody will vary based on the size and
services offered by the qualified
custodian, but that on average an
internal control report will cost
approximately $250,000 per year,291 for
total costs attributable to this section of
the proposed rule to be $63,000,000.292
These advisers also will need to
maintain the report as a required record.
We anticipate that the cost of
maintaining these records will be
minimal.
Although the amended rule does not
require use of an independent
custodian, we encourage the use of
custodians independent of the adviser
to maintain client assets as a best
practice whenever feasible. As a result
of the amendments and our
encouragement, there may be effects on
competition if additional advisers (and
clients) begin using independent
custodians, which is a common practice
of many advisers today, particularly
among those that are not themselves, or
affiliated with, large financial service
firms.
The total cost estimate above may
overestimate actual costs incurred for
internal control reports because of the
factors discussed below. Accountants
preparing an internal control report may
incorporate relevant audit work
performed for other purposes, including
audit work performed to meet existing
regulatory requirements, which should
increase efficiencies in the audit
process. These efficiencies are not
represented in the estimated costs as the
estimates are based on a custodian
entering a new engagement for an
internal control report. And any report
that meets the objectives of the internal
control report would be acceptable
under the rule. In addition to the Type
II SAS 70 report, other reports a
qualified custodian already obtains
could satisfy the rule’s requirements.
For instance, a report issued in
connection with an attestation
290 Our estimate of 15% is based on the IARD
data. 337 × 15% = 51.
291 See supra note 208 and accompanying text for
explanation of this estimate.
292 $250,000 × (337 ¥34 ¥51) = $250,000 × 252
= $63,000,000.

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1479

conducted in accordance with AT 601
under the standard of the AICPA would
be sufficient, provided that such
examination meets the objectives set
forth in our guidance for accountants.
One-time computer system
programming costs. As stated above, the
amended rule would require an adviser
that has obligation under the rule to
provide a notice to clients upon opening
a new account on behalf of the client or
changes to such account and that sends
account statements to its client to
include in the account statement a
legend urging the clients to compare its
account statement with those sent by
the qualified custodian. We expect that
the requirement would cause advisers
that are subject to the notice
requirement and that send account
statement to clients to reprogram their
computer system to include the legend
in account statements to clients. We
estimate that half of the advisers that are
subject to the rule or 1,195 advisers will
hire a computer programmer to modify
their computer system to automatically
add the legend to client account
statements at an average cost of $1,000
each.293 We believe the other half
routinely use off-the-shelf software to
provide client account statements and
will bear little or no direct costs because
we expect the software vendors will not
pass the reprogramming costs on to their
customers (i.e. the advisers) due to a
very low per unit cost. Based on the
above estimates, we believe that the
total one-time computer system
programming cost would be $1,195,000
for the advisers subject to this
requirement.294
PCAOB registration. For an
investment adviser to rely on the
provision in amended rule 206(4)–2 that
deems pooled investment vehicles to
have satisfied the surprise examination
requirement if audited financial
statements are distributed to investors
in the pool, the accountant that audits
the pooled investment vehicle’s
financial statements must be registered
with, and subject to regular inspection
293 As stated above, we estimated that there will
be 2,389 advisers subject to this requirement. See
supra note 196 and accompanying text. 2,389/2 =
1,195.
294 1,195 × $1,000 = $1,195,000. Data from the
Securities Industry and Financial Markets
Association’s Management & Professional Earnings
in the Securities Industry 2008, modified by
Commission staff to account for an 1800-hour workyear and multiplied by 5.35 to account for bonuses,
firm size, employee benefits and overhead, suggest
that the cost for this position is $193 per hour. We
further estimate that such reprogramming will take
about 5 hours for each adviser. $193 × 5 hours =
$965. Based on the above, we estimate that each
adviser will spend approximately $1,000 as
reprogramming costs.

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by, the PCAOB.295 We acknowledge that
not all pooled investment vehicle audits
are performed by accountants meeting
the PCAOB requirement as this is a new
requirement. However, our staff has
reviewed several third-party databases
that contain the identity of accountants
that perform these audits, and
substantially all the pools that identified
accountants were audited by PCAOB
registered and inspected firms or their
affiliates.296 Moreover, a representative
of venture capital firms stated that the
‘‘vast majority’’ of venture capital funds
are audited and, as far as it could
determine, all venture capital fund
audits are conducted by PCAOB
registered accounting firms that are
subject to PCAOB inspection.297 As a
result, we do not believe there will be
a substantial dislocation of pooled
investment vehicle auditors as a result
of the amended rule. For those pools
that will have to change accounting
firms, we do not believe based on
discussions with accountants that there
will be additional costs to retain an
accounting firm registered with, and
subject to inspection by, the PCAOB, as
accountants that perform these financial
statement audits are likely to be with
national accounting firms or accounting
firms that specialize in auditing pooled
investment vehicles and that charge
equivalent fees to accountants registered
with, and subject to inspection by, the
PCAOB.298
Liquidation Audit. The amended rule
specifically requires an adviser to a
pooled investment vehicle that is
relying on the annual audit provision to
obtain a final audit if the pool is
liquidated at a time other than the end
of a fiscal year.299 This requirement will
assure that the proceeds of the
liquidation are appropriately accounted
for. We believe this requirement will not
materially increase the costs for advisers
to pooled investment vehicles because
we believe most of these pooled
295 Amended

rule 206(4)–2(b)(4).
databases do not distinguish between
funds managed by registered advisers from those
managed by exempt advisers (who would not be
subject to the rule).
297 NVCA Letter.
298 Two commenters expressed concerns about
costs with respect to the requirement of PCAOB
registration for accountants performing surprise
examinations and preparing internal control reports
for advisers that serve, or have related person serve,
as the qualified custodian for their client assets. See
Consortium Letter; Chamber of Commerce Letter.
These comments, however, were not directed to the
costs of engaging PCAOB registered accountants for
audits of pooled investment vehicles, and the
commenters that did recommend the PCAOB
requirement did not indicate there would be
increased costs for such a requirement. See, e.g.,
CPIC Letter, MFA Letter.
299 Amended rule 206(4)–2(b)(4)(iii).

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investment vehicles are subject to
contractual obligations with their
investors to obtain a liquidation
audit.300 For purposes of PRA analysis,
we estimate that advisers will spend 243
hours complying with the
requirement301 and thus will incur an
aggregate cost of $15,309 for all advisers
subject to the requirement.302
Qualified Custodian Account
Statements. With the exception of
advisers to certain pooled investment
vehicles that distribute audited financial
statements, the amended rule requires
all registered advisers that have custody
of client assets to have a reasonable
belief, after due inquiry, that the
qualified custodian sends account
statements directly to their clients at
least quarterly. We believe few advisers
will have to change their practices to
meet the requirement that all clients
receive account statements directly from
qualified custodians. Most advisers
subject to the rule have qualified
custodians that deliver account
statements directly to clients and
already conduct an inquiry of whether
the qualified custodian sends account
statements to clients.303 For those
advisers that previously had sent
account statements directly to clients
instead of having the qualified
custodian send account statements to
clients, the costs should not be
significant because qualified custodians
send account statements to clients in
their normal course of business. The
requirement that advisers form their
reasonable belief after due inquiry
similarly should not have significant
costs, as we understand that today most
advisers receive duplicate copies of
client account statements from
custodians.
Based on the above analysis, we
conclude that the aggregate annual
accounting fee to comply with the
surprise examination requirement and
the internal control report requirement
300 As discussed above, amended rule 206(4)–2(c)
provides that an adviser’s 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. We do not believe this requirement will
impose new costs on advisers under the rule
because the application of the rule as required by
this new provision was incorporated into our prior
cost estimates.
301 See supra note 193 and accompanying text.
302 243 × $63 (hourly wage) = $15,309. See supra
note 266 for explanation of advisory employee wage
estimate.
303 Filing data indicates that 190 advisers (other
than those that have custody but only have pooled
investment vehicle clients that are subject to an
annual audit) did not have the qualified custodian
send account statements directly to their clients.

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under amended rule 206(4)–2 is
estimated at $122,965,000. In addition,
we estimate that the total hours spent by
advisory employees to comply with the
amendments 304 will be 29,003 at a total
cost of $1,917,864 305 The total cost
estimated for complying with
amendments to 206(4)–2 is estimated at
$126,077,864.306
Form ADV. We are adopting
substantially as proposed several
amendments to Part 1A of Form ADV
that are designed to provide us with
additional details regarding the custody
practices of advisers registered with the
Commission, and to provide additional
data to assist in our risk-based
examination program. For purposes of
the PRA analysis, we estimated that
these amendments will increase the
annual information collection burden in
connection with Form ADV from 22.25
hours to 22.50 hours for each adviser.307
The total information collection burden
resulting from the amendments would
be 3,068 hours.308 Based on this
estimate, we anticipate that advisers
will incur an aggregate cost of
approximately $193,284 per year for the
total hours their employees spend in
connection with the amendments to
Form ADV.309
304 The total hours include time spent to produce
client contact lists for the accountant performing
the surprise examination, add required language in
a written agreement with the accountant engaged to
perform the surprise examination, prepare a
required legend in notices and subsequent
statements to clients urging them to compare
information contained in the account statements
sent by the adviser with those sent by the qualified
custodian, and distribute audited financial
statements, including those related to liquidation
audit, to fund investors. See Section IV of this
Release for explanation of the estimates.
305 See supra notes 270 and 271 and
accompanying text for explanation of these
estimates. [(19,950 (employee hours for surprise
examination) + 243 (employee hours for
distributing audited financials related to liquidation
audit) + 8,345 (employee hours for adding a legend
in the notice to clients)) × $63] + (465 (employee
hours for adding language in written agreements) ×
$258) = $1,797,894 + $119,970 = $1,917,864.
We estimated that advisory employees will spend
a total of 41,724 hours to comply with the notice
requirement. The estimated 8,345 hours noted
above for adding the legend to the required notice
represents 20% of the total hour burden relating to
the notice, which is 41,724 hours. (41,724 × 0.2) =
8,345. See supra note 197 for explanation of the
estimate.
306 ($122,965,000 (aggregate accounting fees) +
$1,917,864 (costs of hours advisory employees
spent) + $1,195,000 (cost of one-time computer
system programming) = $126,077,864).
307 See supra note 218 and accompanying text.
308 See supra note 219 and accompanying text.
We received no comments on the estimate and we
are keeping the estimate unchanged.
309 We expect that the function of completing
Form ADV would be performed by compliance
clerks at a cost of $63 per hour. The total cost
would be $193,284 (3,068 × $63 = $193,284). See
supra note 266 for explanation of the hourly
compliance clerk cost estimate.

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Federal Register / Vol. 75, No. 6 / Monday, January 11, 2010 / Rules and Regulations
Form ADV–E. For purposes of the
PRA analysis, we estimate that the
collection of information in connection
with Form ADV–E will increase from
the currently approved 9 hours to 112
hours based on the requirements of the
amended rule. This increase results
from an increase in the estimated
number of advisers that will be subject
to the requirement of completing Form
ADV–E under the amendments to rule
206(4)–2 and the additional collections
of information required by the
amendments relating to completing
Form ADV–E when an independent
public accountant performing the
surprise examination terminates its
engagement. This represents an increase
of 103 hours 310 with an estimated
aggregated annual cost of approximately
$7,056.311
We recognize that there also might be
certain costs to investment advisers,
advisory clients and others that are not
easily quantifiable. For instance, some
advisers may choose to only use
independent qualified custodians, and
as a result, they may lose advisory
clients if those clients insist on
maintaining their assets with a
particular custodian that happens to be
a related person of the adviser. Advisory
clients that are unwilling to change
custodians also may lose the ability to
hire an adviser that is related to the
custodian if the adviser will only accept
clients that use independent custodians.
Advisers that chose to only use
independent qualified custodians might
also lose efficiencies that resulted from
self-custody or related person custody
arrangements, which could result in
increased costs to advisory clients.
Additionally, to the extent that advisers
discontinue existing relationships with
custodians, accountants or other service
providers as a result of, or as required
by, the amended rule, these service
providers may lose revenues and incur
other costs.
Based on the above analysis, we
estimate that the aggregate costs for
complying with the amendments to rule
206(4)–2, rule 204–2, Form ADV, and
Form ADV–E will be $126,278,204.312
Of this amount, we estimate that
$1,195,000 is one-time computer system

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310 112

¥9 = 103. We received no comments on
this estimate.
311 We expect that the function of completing
Form ADV–E would be performed by compliance
clerks at a cost of $63 per hour. The total cost
would therefore be $7,056 (112 × $63 = $7,056). See
supra note 266 for explanation of the hourly
compliance clerk cost estimate.
312 $126,077,864 (total costs for complying
amendments to rule 206(4)–2) + $193,284 (total
costs for complying with amendments to Form
ADV) + $7,056 (total costs for complying with
amendments to Form ADV–E) = $126,278,204.

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programming costs related to account
statement legends, while the remainder
will be recurred on an annual basis.
VI. Final Regulatory Flexibility
Analysis
The Commission has prepared the
following Final Regulatory Flexibility
Analysis regarding rule 206(4)–2 in
accordance with section 3(a) of the
Regulatory Flexibility Act.313 We
prepared an Initial Regulatory
Flexibility Analysis (‘‘IRFA’’) in
conjunction with the Proposing Release
in May 2009. A summary of that IRFA
was published with the Proposing
Release.314
A. Need for the Rule
Rule 206(4)–2, the custody rule,
requires registered advisers to maintain
their clients’ assets with a qualified
custodian, such as a broker-dealer or a
bank. To enhance the protections
afforded to clients’ assets, we are
adopting amendments to the rule to
require all registered advisers that have
custody of client assets, among other
things: (i) To undergo an annual
surprise examination by an independent
public accountant to verify client assets;
(ii) to have a reasonable basis, after due
inquiry, for believing that the qualified
custodian maintaining client funds and
securities sends account statements
directly to the advisory clients; and (iii)
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
PCAOB.
We have designed the amendments to
enhance the protections afforded to
clients when their advisers have
custody of client assets. We believe that
the surprise examination requirement
will deter fraudulent activities by
advisers. Moreover, an independent
public accountant may identify misuse
that clients have not, which would
result in the earlier detection of
fraudulent activities and reduce
resulting client losses.
The amendments adopted today
provide that an adviser is deemed to
have custody of client assets held by
related persons. Related person custody
arrangements can present higher risks to
advisory clients than those that
maintain assets with an independent
custodian. We were concerned that the
313 5

U.S.C. 605(b).
Proposing Release at Section VI.

314 See

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1481

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 on custodial reports
issued by the adviser or the related
person. To address these risks, we are
adopting a requirement that a registered
adviser 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.
B. Significant Issues Raised by Public
Comment
In the Proposing Release, we
requested comment on the IRFA. We
received a number of comments related
to the impact of our proposal on small
advisers. They argued that the proposed
amendments to the rule, particularly
those that would have imposed the
surprise examination requirement on
advisers that have custody solely
because of their authority to deduct
advisory fees, would be
disproportionately expensive for, and
would impose an undue regulatory
burden on, smaller firms.315
We are sensitive to the burdens our
rule amendments will have on small
advisers. We believe that the
amendments to the custody rule we are
adopting today will alleviate many of
the commenters’ concerns regarding
small advisers. In particular, as
described above, we have provided an
exception from the surprise examination
requirement for advisers who have
custody because they have authority to
deduct advisory fees from client
accounts. Moreover, for small advisers
still subject to the surprise examination
requirement, the revised guidance for
accountants modernizes the procedures
for surprise examinations, which may
reduce the burden on small advisers.316
C. Small Entities Subject to Rule
Under Commission rules, for the
purposes of the Advisers Act and the
Regulatory Flexibility Act, an
investment adviser generally is a small
315 Mallon P.C. Letter (asserting that the
requirement would cost 10 percent of smaller firms’
gross income). See also CAS Letter; Consortium
Letter; Cornell Letter; Form Letter D; FSI Letter; IAA
Letter; NAPFA Letter; FPA Letter; Denk Letter.
Some commenters argued that, at a minimum, it
would force most small advisers to eliminate a
convenient billing method chosen by many of their
clients. ASG Letter; Cornell Letter; Form Letters C
and D; FSI Letter; MarketCounsel Letter. Others
urged us to consider that this proposal would likely
drive many small advisers out of business, and
would create a barrier to entry for others.
Ameritrade Letter; IASBDA Letter; NAPFA Letter.
316 See Accounting Release.

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entity if it: (i) Has assets under
management having a total value of less
than $25 million; (ii) did not have total
assets of $5 million or more on the last
day of its most recent fiscal year; and
(iii) does not control, is not controlled
by, and is not under common control
with another investment adviser that
has assets under management of $25
million or more, or any person (other
than a natural person) that had $5
million or more on the last day of its
most recent fiscal year.317
The Commission estimates that as of
November 2, 2009 approximately 73
SEC-registered investment advisers that
have custody of client assets were small
entities that will be subject to the
surprise examination requirement under
amended rule 206(4)–2(a)(4), and that
no more than eight small entity advisers
that have custody of client assets will be
subject to the requirement of obtaining
or receiving an internal control report
under amended rule 206(4)–2(a)(6).318

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D. Projected Reporting, Recordkeeping,
and Other Compliance Requirements
The rule amendments impose certain
reporting, recordkeeping and
compliance requirements on advisers,
including small advisers. The rule
requires advisers that are subject to the
surprise examination to complete Form
ADV–E and to maintain internal control
reports in certain instances. In addition,
under the amendments, each adviser
that is required to undergo an annual
surprise examination must enter into a
written agreement with the independent
public accountant that performs the
surprise examination that specifies
certain duties the accountant must
perform as part of the surprise
examination engagement. Investment
advisers, under the proposed rule
amendments, must maintain a copy of
an internal control report that an adviser
is required to obtain, or receive from its
related person, for five years from the
end of the fiscal year in which the
internal control report is finalized.
We estimate that a total of 1,859
advisers will be subject to the surprise
examination requirement, of which 337
advisers will be subject to the surprise
examination with respect to 100 percent
of their clients and will each spend an
average of $125,000 annually,319 and
1,522 will be subject to the surprise
examination with respect to 5 percent of
their clients. Of the 1,522 advisers, 262
medium-sized advisers will each spend
317 17

CFR 275.0–7(a).
on IARD data.
319 See supra note 206 and accompanying text for
explanation of the estimate.
318 Based

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an average of $20,000 annually,320 and
1,260 small-sized advisers will each
spend an average of $10,000
annually.321 The advisers subject to the
surprise examination that fall into the
definition of ‘‘small entities’’ under
section 3(a) of the Regulatory Flexibility
Act are among the smallest within the
small-sized advisers group, with an
average of fewer than 6 clients whose
accounts would be subject to the
surprise examination requirement.322 As
a result, the accounting fees for the
surprise examination conducted on the
client accounts at these advisers may be
lower than our estimated average cost of
$10,000.323 As a result, the potential
impact of the amendments on these
small entities due to the surprise
examination requirement should not be
substantial.
We also estimate that, on average, an
internal control report will cost
approximately $250,000 per year, but
would vary based on the size and
services offered by the qualified
custodian. As stated above, we estimate
that no more than eight small entity
advisers will be subject to the internal
control report requirement, half of
which will obtain the report and the
other half will receive the report from a
related person. We believe that the cost
of an internal control report for the four
small entity advisers that must obtain
one will be lower than the estimated
$250,000 because of the small scale of
their businesses. Alternatively, these
advisers may simply advise their clients
to select independent qualified
custodians so that they will not be
subject to the requirement of obtaining
an internal control report.
E. Agency Action To Minimize Effect on
Small Entities
The Regulatory Flexibility Act directs
the Commission to consider significant
320 These advisers report a larger number of
clients than the average number of clients for the
subset of advisers that are subject to the surprise
examination for only a portion (estimated at 5%) of
their clients.
321 These advisers report a smaller number of
clients than the average number of clients for the
subset of advisers that are subject to the surprise
examination for only a portion (estimated at 5%) of
their clients.
322 Based on IARD data, we estimate that more
than half (43) of the 73 small advisers will be
subject to the surprise examination with respect to
no more than 6 clients.
323 For the four small entity advisers that may be
subject to the surprise examination with respect to
100% of their clients, we believe the cost will be
significantly less than the $125,000 annual fee
estimated for the 337 advisers. Based on IARD data,
we estimate that the average number of clients for
these advisers would be 120 rather than the 2,315
we estimate for other advisers that are in the same
group. See supra note 176 and accompanying text
for explanation of our estimate of average number
of clients for the 337 advisers.

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alternatives that would accomplish the
stated objective, while minimizing any
significant adverse impact on small
entities. In connection with the rule
amendments, the Commission
considered the following alternatives: (i)
The establishment of differing
compliance or reporting requirements or
timetables that take into account the
resources available to small entities; (ii)
the clarification, consolidation, or
simplification of compliance and
reporting requirements under the rule
for such small entities; (iii) the use of
performance rather than design
standards; and (iv) an exemption from
coverage of the rule, or any part thereof,
for such small entities.
Regarding the first and fourth
alternatives, we do not believe that
differing compliance or reporting
requirements or an exemption from
coverage of the rule amendments, or any
part thereof, for small entities, would be
appropriate or consistent with investor
protection. Because the protections of
the Advisers Act are intended to apply
equally to clients of both large and small
advisory firms, it would be inconsistent
with the purposes of the Act to specify
different requirements for small entities
under the amendments.
Regarding the second alternative, the
amendments clarify when an
investment adviser, including a small
adviser, has custody. In addition, we are
providing updated guidance for
accountants that modernize the
procedures for the surprise examination
and should provide clarification to
investment advisers, including small
entities, and accountants on certain
issues regarding the surprise
examination. We also have endeavored
to consolidate and simplify the rule, by
adding new definitions to the rule.
Regarding the third alternative, we do
not consider using performance rather
than design standards to be consistent
with our statutory mandate of investor
protection with respect to custody of
client assets by investment advisers.
VII. Effects on Competition, Efficiency
and Capital Formation
We are adopting amendments to rule
204–2, Part 1A of Form ADV and Form
ADV–E, in part, pursuant to our
authority under Section 204. Section
204 requires the Commission, when
engaging in rulemaking pursuant to that
authority, to consider whether the rule
is ‘‘necessary or appropriate in the
public interest or for the protection of
investors.’’ 324 Section 202(c)(1) of the
Advisers Act requires the Commission,
when engaging in rulemaking that
324 15

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Federal Register / Vol. 75, No. 6 / Monday, January 11, 2010 / Rules and Regulations
requires it to consider or determine
whether an action is necessary or
appropriate in the public interest, to
consider, in addition to the protection of
investors, whether the action will
promote efficiency, competition, and
capital formation.325 In the Proposing
Release, we solicited comment on
whether, if adopted, the proposed rule
and form amendments would promote
efficiency, competition and capital
formation. We further encouraged
commenters to provide empirical data to
support their views on any burdens on
efficiency, competition or capital
formation that might result from
adoption of the proposed amendments.
We did not receive any empirical data
in this regard concerning the proposed
amendments. We received some general
comments asserting that the proposed
amendments to require a surprise
examination for advisers with custody
of client assets as a result of deducting
advisory fees from client accounts
would have a significant adverse impact
on competition.326
We believe the amendments we are
adopting today to rule 204–2, Part 1A of
Form ADV and Form ADV–E in
connection with amendments to rule
206(4)–2, which are substantively
similar to those we proposed, will
promote efficiency and competition, but
have little or no effect on capital
formation.
The amendments to Part 1A of Form
ADV are designed to provide us with
additional details concerning the
custody practices of advisers registered
with the Commission, and to provide
additional data to assist in our riskbased examination program. Under the
amendments to Form ADV–E, the form
and attached accountant’s certificate
will be filed electronically on the IARD
system. In addition, the rule requires the
accountant performing an annual
surprise examination to, upon the
accountant’s termination or dismissal,
or removal from consideration for
reappointment, file Form ADV–E within
4 business days accompanied by a
statement explaining any problems
relating to examination scope or
procedure that contributed to the
resignation, dismissal, removal, or other

termination. Both Part 1A of Form ADV
and Form ADV–E will be available to
the public on the Commission’s web
site.
Public availability of more detailed
disclosure of advisers’ custodial
practices will permit investors to use
this information together with other
information they obtain from Form ADV
in making more informed decisions
about whether to hire or retain a
particular adviser. A more informed
investing public will create a more
efficient marketplace and strengthen
competition among advisers. Moreover,
the electronic filing requirements are
expected to expedite and simplify the
process of filing Form ADV–E and
attached accountant’s certificate with
the Commission, thus further improving
efficiency. We believe, however, that the
amendments are unrelated to, and will
have little or no effect on, capital
formation.
We are amending rule 204–2 to
require (i) that, if an independent
custodian does not maintain client
assets but the adviser or a related person
instead serves as a qualified custodian
for client funds or securities under the
rule in connection with advisory
services the adviser provides to clients,
the adviser must maintain a copy of any
internal control report obtained or
received 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 a related person is not
operationally independent was
overcome, pursuant to amended rule
206(4)–2(d)(5) for five years from the
end of the fiscal year in which, as
applicable, the internal control report or
memorandum is finalized.327 The
amendment is designed to provide our
examiners important information about
the safeguards in place and assess
custody-related risks at an adviser or a
related person that maintains client
assets. We believe that these
amendments will not materially
increase the compliance burden on
advisers under rule 204–2 and thus will
not affect competition, efficiency and
capital formation.

325 15 U.S.C. 80b–2(c). We are adopting
amendments to rule 206(4)–2 pursuant to our
authority set forth in Sections 206(4) and 211(a) of
the Advisers Act, neither of which requires us to
consider the factors indentified in Section 202(c).
Analysis of the effects of these amendments is
contained in Sections IV, V, and VI above.
326 See, e.g., ASG Letter; Ameritrade Letter. The
amended rule excludes from the surprise
examination requirement advisers that have
custody of client assets because of deducting
advisory fees from client accounts. See amended
rule 206(4)–2(b)(3).

327 Rule 206(4)–2 requires that if an independent
custodian does not maintain client assets but the
adviser or a related person instead serves as a
qualified custodian for client funds or securities
under the rule in connection with advisory services
the adviser provides to clients, the adviser must
obtain, or receive from the related person, no less
frequently than once each calendar year an internal
control 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. See amended rule 206(4)–
2(a)(6)(ii).

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1483

VIII. Statutory Authority
We are adopting amendments to rule
206(4)–2 (17 CFR 275.206(4)–2)
pursuant to our authority set forth in
sections 206(4) and 211(a) of the
Advisers Act (15 U.S.C. 80b–6(4) and
80b–11(a)). We are adopting
amendments to rule 204–2 pursuant to
the authority set forth in sections 204
and 211 of the Advisers Act (15 U.S.C.
80b–4 and 80b–11). We are adopting
amendments to Part 1 of Form ADV (17
CFR 279.1) pursuant to our authority set
forth in sections 203(c)(1), 204, and
211(a) of the Advisers Act (15 U.S.C.
80b–3(c)(1), 80b–4 and 80b–11(a)). We
are adopting amendment to Form ADV–
E (17 CFR 279.8) pursuant to our
authority set forth in sections 204,
206(4), and 211(a) of the Advisers Act
(15 U.S.C. 80b–4, 80b–6(4), and 80b–
11(a)).
List of Subjects in 17 CFR Parts 275 and
279
Reporting and recordkeeping
requirements, Securities.
Text of Rule and Form Amendments
For the reasons set out in the
preamble, Title 17, Chapter II of the
Code of Federal Regulations is amended
as follows.

■

PART 275—RULES AND
REGULATIONS, INVESTMENT
ADVISERS ACT OF 1940
1. The authority citation for Part 275
continues to read in part as follows:

■

Authority: 15 U.S.C. 80b–2(a)(11)(G), 80b–
2(a)(17), 80b–3, 80b–4, 80b–4a, 80b–6(4),
80b–6a, and 80b–11, unless otherwise noted.

*

*
*
*
*
2. Section 275.204–2 is amended by:
■ a. Removing ‘‘in effect, and’’ at the end
of paragraph (a)(17)(i) and adding in its
place ‘‘in effect;’’ ;
■ b. Removing the period at the end of
paragraph (a)(17)(ii) and adding in its
place a semicolon;
■ c. Adding paragraph (a)(17)(iii); and
■ d. Adding paragraph (b)(5).
The addition reads as follows:
■

§ 275.204–2 Books and records to be
maintained by investment advisers.

(a) * * *
(17) * * *
(iii) A copy of any internal control
report obtained or received pursuant to
§ 275. 206(4)–2(a)(6)(ii).
(b) * * *
(5) A memorandum describing the
basis upon which you have determined
that the presumption that any related
person is not operationally independent

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under § 275.206(4)–2(d)(5) has been
overcome.
*
*
*
*
*
■ 3. Section 275.206(4)–2 is revised to
read as follows:

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§ 275.206(4)–2 Custody of funds or
securities of clients by investment advisers.

(a) Safekeeping required. If you are an
investment adviser registered or
required to be registered under section
203 of the Act (15 U.S.C. 80b–3), it is
a fraudulent, deceptive, or manipulative
act, practice or course of business
within the meaning of section 206(4) of
the Act (15 U.S.C. 80b–6(4)) for you to
have custody of client funds or
securities unless:
(1) Qualified custodian. A qualified
custodian maintains those funds and
securities:
(i) In a separate account for each
client under that client’s name; or
(ii) In accounts that contain only your
clients’ funds and securities, under your
name as agent or trustee for the clients.
(2) Notice to clients. If you open an
account with a qualified custodian on
your client’s behalf, either under the
client’s name or under your name as
agent, you notify the client in writing of
the qualified custodian’s name, address,
and the manner in which the funds or
securities are maintained, promptly
when the account is opened and
following any changes to this
information. If you send account
statements to a client to which you are
required to provide this notice, include
in the notification provided to that
client and in any subsequent account
statement you send that client a
statement urging the client to compare
the account statements from the
custodian with those from the adviser.
(3) Account statements to clients. You
have a reasonable basis, after due
inquiry, for believing that the qualified
custodian sends an account statement,
at least quarterly, to each of your clients
for which it maintains funds or
securities, identifying the amount of
funds and of each security in the
account at the end of the period and
setting forth all transactions in the
account during that period.
(4) Independent verification. The
client funds and securities of which you
have custody are verified by actual
examination at least once during each
calendar year, except as provided
below, by an independent public
accountant, pursuant to a written
agreement between you and the
accountant, at a time that is chosen by
the accountant without prior notice or
announcement to you and that is
irregular from year to year. The written
agreement must provide for the first

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examination to occur within six months
of becoming subject to this paragraph,
except that, if you maintain client funds
or securities pursuant to this section as
a qualified custodian, the agreement
must provide for the first examination to
occur no later than six months after
obtaining the internal control report.
The written agreement must require the
accountant to:
(i) File a certificate on Form ADV–E
(17 CFR 279.8) with the Commission
within 120 days of the time chosen by
the accountant in paragraph (a)(4) of
this section, stating that it has examined
the funds and securities and describing
the nature and extent of the
examination;
(ii) Upon finding any material
discrepancies during the course of the
examination, notify the Commission
within one business day of the finding,
by means of a facsimile transmission or
electronic mail, followed by first class
mail, directed to the attention of the
Director of the Office of Compliance
Inspections and Examinations; and
(iii) Upon resignation or dismissal
from, or other termination of, the
engagement, or upon removing itself or
being removed from consideration for
being reappointed, file within four
business days Form ADV–E
accompanied by a statement that
includes:
(A) The date of such resignation,
dismissal, removal, or other
termination, and the name, address, and
contact information of the accountant;
and
(B) An explanation of any problems
relating to examination scope or
procedure that contributed to such
resignation, dismissal, removal, or other
termination.
(5) Special rule for limited
partnerships and limited liability
companies. If you or a related person is
a general partner of a limited
partnership (or managing member of a
limited liability company, or hold a
comparable position for another type of
pooled investment vehicle), the account
statements required under paragraph
(a)(3) of this section must be sent to
each limited partner (or member or
other beneficial owner).
(6) Investment advisers acting as
qualified custodians. If you maintain, or
if you have custody because a related
person maintains, client funds or
securities pursuant to this section as a
qualified custodian in connection with
advisory services you provide to clients:
(i) The independent public
accountant you retain to perform the
independent verification required by
paragraph (a)(4) of this section must be
registered with, and subject to regular

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inspection as of the commencement of
the professional engagement period, and
as of each calendar year-end, by, the
Public Company Accounting Oversight
Board in accordance with its rules; and
(ii) You must obtain, or receive from
your related person, within six months
of becoming subject to this paragraph
and thereafter no less frequently than
once each calendar year a written
internal control report prepared by an
independent public accountant:
(A) The internal control report must
include an opinion of an independent
public accountant as to whether
controls have been placed in operation
as of a specific date, and are suitably
designed and are operating effectively to
meet control objectives relating to
custodial services, including the
safeguarding of funds and securities
held by either you or a related person
on behalf of your advisory clients,
during the year;
(B) The independent public
accountant must verify that the funds
and securities are reconciled to a
custodian other than you or your related
person; and
(C) The independent public
accountant must be registered with, and
subject to regular inspection as of the
commencement of the professional
engagement period, and as of each
calendar year-end, by, the Public
Company Accounting Oversight Board
in accordance with its rules.
(7) Independent representatives. A
client may designate an independent
representative to receive, on his behalf,
notices and account statements as
required under paragraphs (a)(2) and
(a)(3) of this section.
(b) Exceptions. (1) Shares of mutual
funds. With respect to shares of an
open-end company as defined in section
5(a)(1) of the Investment Company Act
of 1940 (15 U.S.C. 80a–5(a)(1)) (‘‘mutual
fund’’), you may use the mutual fund’s
transfer agent in lieu of a qualified
custodian for purposes of complying
with paragraph (a) of this section.
(2) Certain privately offered securities.
(i) You are not required to comply with
paragraph (a)(1) of this section with
respect to securities that are:
(A) Acquired from the issuer in a
transaction or chain of transactions not
involving any public offering;
(B) Uncertificated, and ownership
thereof is recorded only on the books of
the issuer or its transfer agent in the
name of the client; and
(C) Transferable only with prior
consent of the issuer or holders of the
outstanding securities of the issuer.
(ii) Notwithstanding paragraph
(b)(2)(i) of this section, the provisions of
this paragraph (b)(2) are available with

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Federal Register / Vol. 75, No. 6 / Monday, January 11, 2010 / Rules and Regulations
respect to securities held for the account
of a limited partnership (or a limited
liability company, or other type of
pooled investment vehicle) only if the
limited partnership is audited, and the
audited financial statements are
distributed, as described in paragraph
(b)(4) of this section.
(3) Fee deduction. Notwithstanding
paragraph (a)(4) of this section, you are
not required to obtain an independent
verification of client funds and
securities maintained by a qualified
custodian if:
(i) you have custody of the funds and
securities solely as a consequence of
your authority to make withdrawals
from client accounts to pay your
advisory fee; and
(ii) if the qualified custodian is a
related person, you can rely on
paragraph (b)(6) of this section.
(4) Limited partnerships subject to
annual audit. You are not required to
comply with paragraphs (a)(2) and (a)(3)
of this section and you shall be deemed
to have complied with paragraph (a)(4)
of this section with respect to the
account of a limited partnership (or
limited liability company, or another
type of pooled investment vehicle) that
is subject to audit (as defined in rule 1–
02(d) of Regulation S–X (17 CFR 210.1–
02(d))):
(i) At least annually and distributes its
audited financial statements prepared in
accordance with generally accepted
accounting principles to all limited
partners (or members or other beneficial
owners) within 120 days of the end of
its fiscal year;
(ii) By an independent public
accountant that is registered with, and
subject to regular inspection as of the
commencement of the professional
engagement period, and as of each
calendar year-end, by, the Public
Company Accounting Oversight Board
in accordance with its rules; and
(iii) Upon liquidation and distributes
its audited financial statements
prepared in accordance with generally
accepted accounting principles to all
limited partners (or members or other
beneficial owners) promptly after the
completion of such audit.
(5) Registered investment companies.
You are not required to comply with
this section (17 CFR 275.206(4)–2) with
respect to the account of an investment
company registered under the
Investment Company Act of 1940 (15
U.S.C. 80a–1 to 80a–64).
(6) Certain Related Persons.
Notwithstanding paragraph (a)(4) of this
section, you are not required to obtain
an independent verification of client
funds and securities if:

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(i) you have custody under this rule
solely because a related person holds,
directly or indirectly, client funds or
securities, or has any authority to obtain
possession of them, in connection with
advisory services you provide to clients;
and
(ii) your related person is
operationally independent of you.
(c) Delivery to Related Person.
Sending an account statement under
paragraph (a)(5) of this section or
distributing audited financial statements
under paragraph (b)(4) of this section
shall not satisfy the requirements of this
section if such account statements or
financial statements are sent solely to
limited partners (or members or other
beneficial owners) that themselves are
limited partnerships (or limited liability
companies, or another type of pooled
investment vehicle) and are your related
persons.
(d) Definitions. For the purposes of
this section:
(1) Control means the power, directly
or indirectly, to direct the management
or policies of a person, whether through
ownership of securities, by contract, or
otherwise. Control includes:
(i) Each of your firm’s officers,
partners, or directors exercising
executive responsibility (or persons
having similar status or functions) is
presumed to control your firm;
(ii) A person is presumed to control
a corporation if the person:
(A) Directly or indirectly has the right
to vote 25 percent or more of a class of
the corporation’s voting securities; or
(B) Has the power to sell or direct the
sale of 25 percent or more of a class of
the corporation’s voting securities;
(iii) A person is presumed to control
a partnership if the person has the right
to receive upon dissolution, or has
contributed, 25 percent or more of the
capital of the partnership;
(iv) A person is presumed to control
a limited liability company if the
person:
(A) Directly or indirectly has the right
to vote 25 percent or more of a class of
the interests of the limited liability
company;
(B) Has the right to receive upon
dissolution, or has contributed, 25
percent or more of the capital of the
limited liability company; or
(C) Is an elected manager of the
limited liability company; or
(v) A person is presumed to control a
trust if the person is a trustee or
managing agent of the trust.
(2) Custody means holding, directly or
indirectly, client funds or securities, or
having any authority to obtain
possession of them. You have custody if
a related person holds, directly or

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1485

indirectly, client funds or securities, or
has any authority to obtain possession
of them, in connection with advisory
services you provide to clients. Custody
includes:
(i) Possession of client funds or
securities (but not of checks drawn by
clients and made payable to third
parties) unless you receive them
inadvertently and you return them to
the sender promptly but in any case
within three business days of receiving
them;
(ii) Any arrangement (including a
general power of attorney) under which
you are authorized or permitted to
withdraw client funds or securities
maintained with a custodian upon your
instruction to the custodian; and
(iii) Any capacity (such as general
partner of a limited partnership,
managing member of a limited liability
company or a comparable position for
another type of pooled investment
vehicle, or trustee of a trust) that gives
you or your supervised person legal
ownership of or access to client funds
or securities.
(3) Independent public accountant
means a public accountant that meets
the standards of independence
described in rule 2–01(b) and (c) of
Regulation S–X (17 CFR 210.2–01(b)
and (c)).
(4) Independent representative means
a person that:
(i) Acts as agent for an advisory client,
including in the case of a pooled
investment vehicle, for limited partners
of a limited partnership (or members of
a limited liability company, or other
beneficial owners of another type of
pooled investment vehicle) and by law
or contract is obliged to act in the best
interest of the advisory client or the
limited partners (or members, or other
beneficial owners);
(ii) Does not control, is not controlled
by, and is not under common control
with you; and
(iii) Does not have, and has not had
within the past two years, a material
business relationship with you.
(5) Operationally independent: for
purposes of paragraph (b)(6) of this
section, a related person is presumed
not to be operationally independent
unless each of the following conditions
is met and no other circumstances can
reasonably be expected to compromise
the operational independence of the
related person: (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

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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.
(6) Qualified custodian means:
(i) A bank as defined in section
202(a)(2) of the Advisers Act (15 U.S.C.
80b–2(a)(2)) or a savings association as
defined in section 3(b)(1) of the Federal
Deposit Insurance Act (12 U.S.C.
1813(b)(1)) that has deposits insured by
the Federal Deposit Insurance
Corporation under the Federal Deposit
Insurance Act (12 U.S.C. 1811);
(ii) A broker-dealer registered under
section 15(b)(1) of the Securities
Exchange Act of 1934 (15 U.S.C.

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78o(b)(1)), holding the client assets in
customer accounts;
(iii) A futures commission merchant
registered under section 4f(a) of the
Commodity Exchange Act (7 U.S.C.
6f(a)), holding the client assets in
customer accounts, but only with
respect to clients’ funds and security
futures, or other securities incidental to
transactions in contracts for the
purchase or sale of a commodity for
future delivery and options thereon; and
(iv) A foreign financial institution that
customarily holds financial assets for its
customers, provided that the foreign
financial institution keeps the advisory
clients’ assets in customer accounts
segregated from its proprietary assets.
(7) Related person means any person,
directly or indirectly, controlling or
controlled by you, and any person that
is under common control with you.

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PART 279—FORMS PRESCRIBED
UNDER THE INVESTMENT ADVISERS
ACT OF 1940
4. The authority citation for Part 279
continues to read as follows:

■

Authority: The Investment Advisers Act of
1940, 15 U.S.C. 80b–1, et seq.

5. Form ADV (referenced in § 279.1) is
amended by:
■ a. In the General Instructions, revising
the first bullet and last paragraph of
instruction 4;
■ b. In Part 1A, revising the last
paragraph of Item 7.A. and revising Item
9; and
■ c. In Schedule D, revising Section
7.A., and adding Sections 9.C. and 9.D.
The revisions read as follows:
■

Note: The text of Form ADV does not and
this amendment will not appear in the Code
of Federal Regulations.
BILLING CODE 8011–01–P

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■ 6. Form ADV–E (referenced in § 279.8)
is amended by revising the instructions
to the Form.
The revisions read as follows:

Note: The text of Form ADV–E does not
and this amendment will not appear in the
Code of Federal Regulations.

Form ADV–E
*

*

*

*

*

Instructions
This Form must be completed by
investment advisers that have custody
of client funds or securities and that are
subject to an annual surprise
examination. This Form may not be
used to amend any information
included in an investment adviser’s
registration statement (e.g., business
address).

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Investment Adviser
1. All items must be completed by the
investment adviser.
2. Give this Form to the independent
public accountant that, in compliance
with rule 206(4)–2 under the Investment
Advisers Act of 1940 (the ‘‘Act’’) or
applicable state law, examines client
funds and securities in the custody of
the investment adviser within 120 days
of the time chosen by the accountant for
the surprise examination and upon such
accountant’s resignation or dismissal
from, or other termination of, the
engagement, or if the accountant
removes itself or is removed from
consideration for being reappointed.
Accountant
3. The independent public accountant
performing the surprise examination
must submit (i) this Form and a
certificate of accounting required by
rule 206(4)–2 under the Act or
applicable state law within 120 days of
the time chosen by the accountant for
the surprise examination, and (ii) this
Form and a statement, within four
business days of its resignation or
dismissal from, or other termination of,
the engagement, or removing itself or
being removed from consideration for
being reappointed, that includes (A) the
date of such resignation, dismissal,
removal, or other termination, and the
name, address, and contact information
of the accountant, and (B) an
explanation of any problems relating to
examination scope or procedure that
contributed to such resignation,
dismissal, removal, or other
termination:
(a) By mail, until the Investment
Adviser Registration Depository
(‘‘IARD’’) accepts electronic filing of the
Form, to the Securities and Exchange
Commission or appropriate state

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securities administrators. File the
original and one copy with the
Securities and Exchange Commission’s
principal office in Washington, DC at
the address on the top of this Form, and
one copy with the regional office for the
region in which the investment
adviser’s principal business operations
are conducted, or one copy with the
appropriate state administrator(s), if
applicable; or
(b) By electronic filing of the
certificate of accounting and statement
regarding resignation, dismissal, other
termination, or removal from
consideration for reappointment on the
IARD, when the IARD accepts electronic
filing of the Form.
*
*
*
*
*
Dated: December 30, 2009.
By the Commission.
Florence E. Harmon,
Deputy Secretary.
[FR Doc. 2010–18 Filed 1–8–10; 8:45 am]
BILLING CODE 8011–01–P

SECURITIES AND EXCHANGE
COMMISSION
17 CFR Parts 276
[Release Nos. IA–2969; FR–81]

Commission Guidance Regarding
Independent Public Accountant
Engagements Performed Pursuant to
Rule 206(4)–2 Under the Investment
Advisers Act of 1940
AGENCY: Securities and Exchange
Commission.
ACTION: Interpretation.
SUMMARY: The Securities and Exchange
Commission (the ‘‘Commission’’) is
publishing interpretive guidance for
independent public accountants in
connection with the adoption of
amendments to Rule 206(4)–2 under the
Investment Advisers Act of 1940 (the
‘‘Custody Rule’’). This guidance provides
direction with respect to the
independent verification and internal
control report as required under the
amended Custody Rule.
DATES: Effective Date March 12, 2010.
FOR FURTHER INFORMATION CONTACT:
General questions about this release
should be referred to Bryan J. Morris,
Assistant Chief Accountant, Jaime L.
Eichen, Assistant Chief Accountant, or
Richard F. Sennett, Chief Accountant at
(202) 551–6918 or [email protected],
Office of the Chief Accountant, Division
of Investment Management, U.S.
Securities and Exchange Commission,
100 F Street, NE., Washington, DC
20549–8626. Questions about Rule

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206(4)–2 should be directed to staff of
the Office of Investment Adviser
Regulation, Division of Investment
Management, U.S. Securities and
Exchange Commission, 100 F Street,
NE., Washington, DC 20549–8549 at
(202) 551–6787 or [email protected].
SUPPLEMENTARY INFORMATION:

I. Background
Rule 206(4)–2(a) under the Investment
Advisers Act of 1940 (the ‘‘Act’’)
provides, among other things, that it is
a fraudulent, deceptive or manipulative
act, practice, or course of business
within the meaning of Section 206(4) of
the Act for any investment adviser
registered (or required to be registered)
under Section 203 of the Act (herein
‘‘investment adviser’’) to have custody of
client funds or securities unless:
(1) A qualified custodian maintains
those funds and securities in a separate
account for each client under that
client’s name; or in accounts that
contain only clients’ funds and
securities, under the investment
adviser’s name as agent or trustee for the
clients;
(2) Clients are notified promptly in
writing of the qualified custodian’s
name, address, and the manner in
which the funds or securities are
maintained, when an account is opened
by an investment adviser on a client’s
behalf and following any changes to this
information; and
(3) The investment adviser has a
reasonable basis, after due inquiry, for
believing that the qualified custodian
sends an account statement, at least
quarterly, to each of its clients for which
it maintains funds or securities,
identifying the amount of funds and of
each security in the account at the end
of the period and setting forth all
transactions in the account during that
period.
Rule 206(4)–2(a) generally requires
that client funds and securities of which
an investment adviser has custody
under the rule be verified by actual
examination at least once during each
calendar year by an independent public
accountant 1 (‘‘accountant’’), pursuant to
a written agreement, between the
investment adviser and the accountant,
at a time that is chosen by the
accountant without prior notice or
announcement to the investment
1 If the investment adviser itself or a related
person maintains clients’ funds and securities as
qualified custodian, the independent public
accountant must be registered with, and subject to
inspection by, the Public Company Accounting
Oversight Board (‘‘PCAOB’’). See Rule 206(4)–
2(a)(6)(i).

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