Rule_206(4)-2_Supporting_Statement (FINAL)

SUPPORTING STATEMENT
For the Paperwork Reduction Act Information Collection Submission for
Rule 206(4)-2
A.

JUSTIFICATION
1.

Necessity for the Information Collection

Section 206(4) of the Investment Advisers Act of 1940 (“Advisers Act”) [15 U.S.C.
80b-6(4)] prohibits any investment adviser from engaging in any act, practice or course of
business which is fraudulent, deceptive or manipulative and gives the Commission the power, by
rules and regulations, to define and prescribe means reasonably designed to prevent such acts,
practices and courses of business.
Rule 206(4)-2 under the Advisers Act requires advisers to protect the assets that their
clients have entrusted to their custody. 1 The rule contains several “collection of information”
requirements within the meaning of the Paperwork Reduction Act of 1995 [44 U.S.C. 3510 to
3520]. The title for the collection of information is “Rule 206(4)-2 under the Investment
Advisers Act of 1940 -- Custody of Funds or Securities of Clients by Investment Advisers.” The
collection of information is currently approved under OMB control number 3235-0241. The
Commission is submitting this Paperwork Reduction Act submission for an extension and a
revision to the currently approved collection of information requirements.
Rule 206(4)-2 requires each registered investment adviser that has custody of client funds
or securities to maintain those client funds or securities with a broker-dealer, bank or other
“qualified custodian.” 2 This requirement is necessary to safeguard the client assets over which
1

17 CFR 275.206(4)-2.

2

Rule 206(4)-2(a)(1).

2
the adviser has control or access. The rule requires the adviser to promptly notify clients as to
the place and manner of custody after opening an account for the client and following any
changes. 3 If an adviser sends account statements to its clients, it must insert a legend in the
notice and in subsequent account statements sent to those clients urging them to compare the
account statements from the custodian with those from the adviser. 4 The adviser also must 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 undergo an
annual surprise examination by an independent public accountant to verify client assets pursuant
to a written agreement with the accountant that specifies certain duties. 5 Unless client assets are
maintained by an independent custodian (i.e., a custodian that is not the adviser itself or a related
person), the adviser also is required 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 Public Company Accounting Oversight Board (“PCAOB”). 6

Advisers to limited partnerships, limited liability companies and other pooled investment
vehicles are excepted from the account statement delivery requirement and are deemed to
comply with the annual surprise examination requirement if the limited partnerships, limited
liability companies or pooled investment vehicles are subject to annual audit by an independent
3

Rule 206(4)-2(a)(2).

4

Rule 206(4)-2(a)(2).

5

Rule 206(4)-2(a)(3), (4).

6

Rule 206(4)-2(a)(6).

3
public accountant registered with, and subject to regular inspection by the PCAOB, and the
audited financial statements are distributed to investors in the pools. 7 The rule also provides an
exception to the surprise examination requirement for advisers that have custody solely 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. 8
These collection of information requirements are found at 17 CFR 275.206(4)-2 and are
mandatory. As discussed, advisory clients use this information to confirm proper handling of
their accounts. The Commission’s staff uses the information obtained through the collection in
its enforcement, regulatory and examination programs. The respondents to this information
collection are those investment advisers that are registered with the Commission and have
custody of client funds or securities.
2.

Purpose of the Information Collection

As discussed above, the Commission uses the information required by rule 206(4)-2 in
connection with its investment adviser enforcement, regulatory, and examination programs.
Advisory clients use the information required by rule 206(4)-2 to monitor their advisers’
handling of their accounts. Without the information collected under the rule, the Commission
would be less efficient and effective in its programs and advisory clients would not have
information they need to monitor the adviser’s handling of their accounts.

7

Rule 206(4)-2(b)(4).

8

Rule 206(4)-2(b)(3), (b)(6).

4

3.

Role of Improved Information Technology

The collection of information requirements under rule 206(4)-2 take the form of (1)
annual surprise examinations conducted by independent public accountants, (2) mailing of
audited financial statements to investors in a fund, (3) mailing of notices to clients about new
custodial accounts, and (4) internal control reports by independent public accountants registered
with, and subject to regular inspection by, the PCAOB. Accordingly, the Commission’s use of
computer technology may have little effect. The Commission currently permits advisers to
provide to clients the information required by rule 206(4)-2 electronically. 9
4.

Duplication

The requirements of rule 206(4)-2 are not duplicated elsewhere for those investment
advisers that must comply with the rule.
5.

Effect on Small Entities

The requirements of rule 206(4)-2 apply equally to all investment advisers that are
registered with the Commission and have custody of funds or securities of their clients, including
those advisers that are small entities. It would defeat the purpose of the rule to exempt small
entities from these requirements.
6.

Consequences of Less Frequent Collection

If the information required by rule 206(4)-2 is either not collected or is collected less

9

See Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment
Advisers for Delivery of Information; Additional Examples Under the Securities Act of
1933, Securities Exchange Act of 1934, and Investment Company Act of 1940,
Investment Advisers Act Release 1562, (May 9, 1996).

5
frequently, both the Commission's ability to protect investors and the ability of clients to monitor
the handling of their accounts would be reduced.
7.

Inconsistencies with Guidelines in 5 CFR 1320.5(d)(2)

Investment advisers registered with the Commission may be required to maintain and
preserve certain information required under rule 206(4)-2 for more than three years. The longterm retention of these records is necessary for the Commission's inspection program to ascertain
compliance with the Investment Advisers Act.
8.

Consultation Outside the Agency

The Commission requested public comment on the collection of information
requirements in rule 206(4)-2 before it submitted this request for extension and approval to the
Office of Management and Budget. The Commission received no comments in response to its
request.
The Commission and the staff of the Division of Investment Management also participate
in an ongoing dialogue with representatives of the investment adviser industry through public
conferences, meetings and informal exchanges. These various forums provide the Commission
and the staff with a means of ascertaining and acting upon paperwork burdens confronting the
industry.
9.

Payment or Gift

Not applicable.
10.

Confidentiality

Not applicable.

6
11.

Sensitive Questions

Not applicable.
12.

Estimate of Hour Burden

Currently approved burdens. The current annual collection of information burden
approved by OMB for rule 206(4)-2 is 518,275 hours. This burden includes 106,710 hours
relating to the requirement to obtain a surprise examination, 342 hours to enter into a written
agreement with an independent public accountant engaged to conduct the surprise examination,
357,494 hours to distribute audited financial statements to investors in pools managed by the
adviser, and 53,729 hours to add a legend in notifications and account statements.
We now estimate the total information collection hours to be 816,285 hours. 10 The
primary cause of the change is an increase in the total number of investment advisers that
reported having custody on Form ADV.
Annual surprise examination. Rule 206(4)-2 requires each registered investment adviser
that has custody of client funds or securities to undergo an annual surprise examination by an
independent public accountant to verify client assets pursuant to a written agreement with the
accountant that specifies certain duties. 11 The current approved annual burden for rule 206(4)-2
includes 107,052 hours that relate to the requirement to obtain a surprise examination. We
estimated that 1,368 advisers registered with the Commission would be subject to the surprise
examination. We now estimate that 1,514 advisers are subject to the surprise examination

10

See infra note 36.

11

Rule 206(4)-2(a)(4).

7
requirement under rule 206(4)-2. 12
For purposes of estimating the collection of information burden, we have divided the
estimated 1,514 advisers into three subgroups. First, we estimate that 480 advisers have custody
because they serve as qualified custodians for their clients, or they have a related person that
serves as qualified custodian for clients in connection with advisory services the adviser provides
to the clients. 13 We estimate that these advisers are subject to an annual surprise examination
with respect to 100 percent of their clients (or 6,750 clients per adviser) based on the assumption
that all of their clients maintain custodial accounts with the adviser or related person. 14 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 64,800 hours. 15

12

Based on data from the Investment Adviser Registration Depository (“IARD”) as of June
1, 2015 (unless indicated otherwise, all data we use in this Supporting Statement were as
of June 1, 2015), 5,228 advisers 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, excluding
advisers that have custody solely because they have authority to deduct fees from clients’
accounts) or answered “yes” to another question in Part 1A Item 9.C. Of these advisers,
1,514 advisers indicated in response to Item 9.C.(3) that an independent public
accountant conducts an annual surprise examination of client funds and securities.

13

Based on IARD data, 476 advisers indicated that an independent public accountant
prepares an internal control report because the adviser or its affiliate acts as a qualified
custodian (in response to Item 9.C.(4)). Similarly, 80 advisers indicated that they act as a
qualified custodian (in response to Item 9.D.(1)), and 404 advisers that indicated that
their related person(s) act as qualified custodian(s) (in response to Item 9.D.(2)). 80 +
404 = 484.

14

We base our estimate on IARD data of the average number of clients of all the advisers
that will be subject to the surprise examination under the rule (excluding the three largest
firms).

15

480 advisers x 6,750 (average number of clients subject to the surprise examination

8
The second group of advisers, estimated at 896, 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. 16 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 338 clients per adviser) who have these types of arrangements with
the adviser. 17 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 6,057 hours. 18
A third group of advisers provide advice to pooled investment vehicles that are not
undergoing an annual audit, and therefore would undergo the surprise examination with respect
to those pooled investment vehicle clients. Based on current IARD data, we estimate that 14
advisers provide advice exclusively to pooled investment vehicles and undergo the surprise

requirement) x 0.02 hour = 64,800 hours.
16

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 a
related person serving as qualified custodian) less those described below in the third
group (custody as a result of solely managing private funds). 1,514 – 480 – 138 = 896.

17

Based on the IARD data, we estimate that the average number of clients of advisers
subject to the surprise examination requirement is 6,750. 6,750 x 0.05 = 338.

18

896 advisers x 338 clients x 0.02 hours = 6,057 hours.

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examination with respect to all of their pooled investment vehicle clients. 19 We estimate that 79
advisers that provide advice exclusively to pooled investment vehicles are subject to an annual
surprise examination because some of the pooled investment vehicles they advise do not undergo
an annual audit. 20 We further estimate that 45 advisers that provide advice not exclusively to
pooled investment vehicles are subject to an annual surprise examination because some of the
pooled investment vehicles they advise do not undergo an annual audit. 21 We estimate that each
adviser providing advisory services exclusively to pooled investment vehicles will have 15 funds
and 577 investors, and each adviser not providing advisory services exclusively to pooled
investment vehicles will have 14 funds and 768 investors. 22 We estimate that advisers to these
pooled investment vehicles will spend 1 hour for the pool and 0.02 hours for each investor in the

19

Based on IARD data, we estimate that 551 advisers manage private funds and undergo a
surprise examination (responses to Items 7.B. and 9.C.(3)). Of these advisers, 14 solely
manage pooled investment vehicles, undergo a surprise examination, and do not undergo
an annual audit of the pooled investment vehicles they manage (responses to Item 5.D.(1)
and Item 9.C.).

20

Based on IARD data, we estimate that 79 advisers that provide services exclusively to
pooled investment vehicles undergo an annual audit and obtain an annual surprise
examination because some of the pooled investment vehicles they advise do not undergo
an annual audit (responses to Items 5.D.(1), 7.B., 9.C.(2) and 9.C.(3)).

21

We estimate, based on staff experience, that ten percent of the 458 advisers that provide
services not exclusively to pooled investment vehicles obtain an annual surprise
examination because some of the pooled investment vehicles they advise do not undergo
an annual audit (responses to Items 5.D.(1), 7.B. and 9.C.(3)).

22

The number of funds and investors per adviser is estimated based on the information we
collected from Schedule D of Form ADV filed by advisers that indicated that they
undergo a surprise examination and provide advisory services to pooled investment
vehicles.

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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 3,789 hours. 23
These estimates bring the total annual aggregate burden with respect to the surprise
examination requirement for all three groups of advisers to 74,646. 24 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. 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. 25 We estimate that each adviser will spend
0.25 hour to add the required provisions to the written agreement, with an aggregate of
approximately 379 hours for all advisers that undergo surprise examinations. 26 Therefore the
total annual burden in connection with the surprise examination is estimated at 75,025 hours
under the rule. 27
Audited pooled investment vehicles. The rule excepts advisers to pooled investment
vehicles from having a qualified custodian send quarterly account statements to the investors in a

23

[((15 funds x 1 hour) + (577 investors x 0.02 hours)) x (93 advisers] + [((14 funds x 1
hour) + (768 investors x 0.02 hours)) x 45 advisers] = [26.54 hours x 93 advisers] +
[29.36 hours x 45 advisers] = 2,468 hours + 1,321 hours = 3,789 hours.

24

64,800 hours + 6,057 hours + 3,789 hours = 74,646 hours.

25

Rule 206(4)-2(a)(4).

26

1,514 advisers required to obtain a surprise examination x 0.25 = 379.

27

74,646 exam hours + 379 written agreement hours = 75,025 hours.

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pool if it is audited annually by an independent public accountant and the audited financial
statements are distributed to the investors in the pool. 28 The rule also 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 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. 29
The currently approved annual burden in connection with the required distribution of
audited financial statements in connection with the annual audit and liquidation audit
requirements is 357,494 hours. We estimate that the average burden for advisers to mail audited
financial statements to investors in the pool is 1 minute per investor. Under our revised estimate
of the number of advisers to audited pooled investment vehicles, the number of pooled
investment vehicles and the number of investors, we estimate that the aggregate annual hour
burden in connection with the distribution of annual audited financial statements is 653,536
hours. 30 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 32,677 hours per

28

Rule 206(4)-2(b)(4).

29

Id.

30

Based on IARD data, we estimate that 3,897 advisers have custody of client assets and
provide advisory services to pooled investment vehicles. Of these advisers, we estimate
that 3,759 advisers will have their pooled investment vehicles audited and distribute
audited financial statements to investors in the pool. [3,897 advisers to pooled
investment vehicles – 138 advisers that undergo a surprise examination = 3,759 advisers
that undergo an audit] We estimate that the 3,759 advisers provide advice to 22,554
pooled investment vehicles that have a total of 38,443,293 investors. 38,443,293
investors x 0.017 hour = 653,536 total burden hours to distribute annual audited
financials.

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year. 31 As a result, the total annual hour burden to distribute audited financial statements in
connection with the annual audit and liquidation audit requirements under the rule is estimated to
be 686,213 hours. 32
Notice to clients. The 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. 33 The legend is placed in a notification that is otherwise
required to be sent to clients at specified times, so the collection of information burden is
negligible. We estimate that 2,675 advisers will be subject to this collection of information, 34
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

31

653,536 (total burden hours relating to distribution of annual audited financials) x 0.05 =
32,677 hours.

32

653,536 (total burden hours relating to distribution of annual audited financials) + 32,677
(total burden hours relating to distribution of liquidation audited financials) = 686,213
hours.

33

Rule 206(4)-2(a)(2).

34

Based on IARD data, 5,035 advisers reported that they have custody (this excludes
advisers having custody solely because of deducting fees, which we understand do not
typically open custodial accounts on behalf of their clients). Of those advisers, 1,761 are
advisers exclusively to audited pooled investment vehicles. Since we estimate that 96%
of advisers to audited pooled investment vehicles obtain an annual audit (see supra note
30), the notice requirement does not apply to 1,691 advisers, leaving 3,344 advisers that
may be subject to this information collection. [5,035 advisers with custody – (1,761
advisers to pooled investment vehicles x 0.96) = 5,035 – 1,691 = 3,344 advisers] Based
on our staff’s observation, we estimate that clients of 80% of these advisers will receive
account statements from their advisers in addition to the account statements from the

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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 55,047
hours per year. 35
Based on the above estimates, we anticipate that the estimated total information
collection burden under rule 206(4)-2 would be 816,285 hours. 36 This represents an increase
from the currently approved burden, primarily due to an increase in the total number of
investment advisers that reported having custody on Form ADV. The total costs due to this
information collection hour burden is estimated at $52,325,241. 37
13.

Estimate of Total Annual Cost Burden

The currently approved collection of information for the custody rule includes an
aggregate accounting fee estimate of $152,905,000. We now estimate a total annual aggregate

qualified custodian. 0.8 x 3,344 = 2,675.
35

[2,675 x 2,421 (average number of clients for the advisers with custody of client assets) x
0.05] x 0.17 hours = 55,047 hours.

36

75,025 (surprise examination) + 686,213 (distribution of audited financial statements) +
55,047 (notice to clients) = 816,285.

37

[379 (hours spent on written agreement) x $283 (average hour rate for compliance
managers)] + [815,906 (hours spent on complying with other provisions of the rule) x
$64 (average rate for compliance clerks)] = $107,257 + $52,217,984 = $52,325,241.
Data from the Securities Industry and Financial Markets Association’s Office Salaries in
the Securities Industry 2013, 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 a compliance clerk is $64 per hour, and data from the
Securities Industry and Financial Markets Association’s Management & Professional
Earnings in the Securities Industry 2013, 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 (“SIFMA Management & Professional Earnings”), suggest that the

14
accounting fee of $147,440,000. 38 The decrease in estimated aggregated cost is attributable to a
decrease in the estimated number of investment advisers subject to a surprise examination with
respect to all of their clients and a decrease in the estimated number of investment advisers
required to obtain or receive an internal control report, based on data from Form ADV.
We estimate that of the 1,514 advisers subject to the surprise examination requirement,
approximately 324 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, 39 104 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 1,086 small sized advisers will
be subject to the surprise examination requirement with respect to 5% of their clients and will

cost for a compliance manager position is $283 per hour.
38

See infra note 44 and accompanying text.

39

We estimate, based on IARD data, there are 324 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 (they indicated on Form ADV, Part 1A, Items 9.C.(3) and
9.C.(4) that they are subject to examination and have internal control reports because the
adviser or its related person is a qualified custodian).
We note that the costs of reporting to the Commission (i) regarding “material
discrepancy” pursuant to rule 206(4)-2(a)(4)(ii) and (ii) upon termination of engagement
pursuant to rule 206(4)-2(a)(4)(iii) are included in the estimated accounting fees.

15
each spend an average of $10,000 annually, 40 with an aggregate annual accounting fee of
$53,440,000 for all advisers subject to the surprise examination. 41
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 estimate that, on
average, an internal control report would cost approximately $250,000 per year for each adviser
subject to the requirement. We estimate that under rule 206(4)-2, 376 advisers will be subject to
the requirement of obtaining or receiving an internal control report. 42 Therefore the total cost
attributable to this requirement will be $94,000,000. 43 The total estimated accounting fee under
the rule 206(4)-2 is therefore estimated at $147,440,000. 44
14.

Estimate of Cost to the Federal Government

40

Based on responses to Item 5.C. of Form ADV, we estimate that the average number of
clients for the 1,190 advisers that indicated they do not have internal control reports is
1,247. We determined, for purposes of this analysis, that an adviser with clients more
than this average number is a medium size adviser (104) and an adviser with clients less
than this average number is a small adviser (1,086).

41

(324 x $125,000) + (104 (medium advisers) x $20,000) + (1,086 (small advisers) x
$10,000) = $40,500,000 + $2,080,000 + $10,860,000 = $53,440,000.

42

We estimate that 480 advisers obtain an internal control report (see supra note 13 for this
estimate). Of the 324 advisers that will be subject to both the surprise examination and
internal control report requirement (see supra note 39 for this estimate), 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%. 480 – (324 x 10%) – (480 x 15%) = 480 –
32 – 72 = 376.

43

$250,000 x 376 = $94,000,000.

44

$53,440,000 (accounting fee for surprise examination) + $94,000,000 (accounting fee for
internal control report) = $147,440,000.

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There are no additional costs to the federal government.
15.

Explanation of Changes in Burden

The current annual burden approved by OMB for rule 206(4)-2 is 518,275 hours. We
now estimate that the total information collection hours is 816,285 hours. The primary cause of
such increase is an increase in the total number of investment advisers that reported having
custody on Form ADV. The currently approved annual burden under rule 206(4)-2 includes an
aggregate cost estimate of $152,905,000. We now estimate that the annual cost burden under the
rule would decrease to $147,440,000, which is primarily caused by a decrease in the estimated
number of investment advisers subject to a surprise examination with respect to all of their
clients and a decrease in the estimated number of investment advisers required to obtain or
receive an internal control report, based on data from Form ADV.
16.

Information Collection Planned for Statistical Purposes

Not applicable.
17.

Approval to Omit OMB Expiration Date

The Commission is not seeking approval to not display the expiration date for OMB
approval.
18.

Exception to Certification Statement

Not applicable.
B.

COLLECTION OF INFORMATION EMPLOYING STATISTICAL METHODS
Not applicable.