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SEC Issues Risk Alert Regarding Adviser Examinations


The SEC's Office of Compliance Inspections and Examinations issued a Risk Alert (the "Risk Alert") on March 4, 2013 highlighting the SEC's ongoing concern with "significant deficiencies" in registered investment advisers' compliance with the so-called Custody Rule, Rule 206(4)-2 of the Investment Advisers Act of 1940. In particular, the SEC noted that it had found custody-related issues in approximately one-third of recent investment adviser examinations in which significant deficiencies had been found. 

The SEC's heightened concern with custody-related issues is a continuation of its post-Bernand Madoff focus on registered investment advisers. The Ponzi scheme perpetrated by Madoff was in part possible because Madoff had custody of client assets and there were no safeguards in place to prevent his misappropriation. Following the revelation of the Madoff debacle, the SEC adopted amendments to the Custody Rule that were designed to better protect investor assets. Those rule modifications require advisers to submit to annual surprise audits conducted by a Public Company Accounting Oversight Board (PCAOB) registered certified public accountant with respect to assets in the custody of the adviser itself, an affiliate that is not operationally independent, or an independent, third party custodian if the adviser has authority to withdraw client funds. Advisers that do not custody assets with independent third parties are also required to obtain third party written reports assessing the controls put in place to safeguard customer assets, the tests performed on those controls, and the results of those tests.

The custody related findings identified in the Risk Alert include:

Failure by advisers to recognize that they have custody, such as where:

  • the adviser's personnel or an affiliate is a trustee or has a power of attorney for a client account;
  • the adviser can withdraw funds to pay the client's bills; and
  • the adviser has direct online access to a client's account to withdraw funds or securities.

Surprise examination failures, including failure to timely file reports of surprise examinations and evidence that examinations were not being conducted on a surprise basis.

Failure to satisfy qualified custodian requirements by, for example,

  • commingling customer assets with proprietary and employee assets in a single account;
  • holding client assets in the adviser's name but not as trustee or agent for the client;
  • not verifying that a qualified custodian is sending quarterly account statements to the clients; and
  • failing to urge clients to compare the account statements from the custodian with those from the adviser.

The SEC has taken a range of actions in response to its findings, ranging from requiring that advisers immediately enhance their compliance policies, procedures and processes and devote more resources to custody issues, to referrals to the SEC's Division of Enforcement and subsequent litigation. A companion Investor Bulletin issued by the SEC cautions investors to make sure they know where their assets are custodied and in whose name and to ensure that they are receiving quarterly statements and to check those statements for discrepancies. 

In light of the findings reviewed in the Risk Alert, investment advisers should focus on reviewing and enhancing the robustness of their custody-related policies and procedures to avoid being found deficient.  

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For more information, please contact the professional(s) listed below, or your regular Crowell & Moring contact.

Linda Lerner
Partner – New York
Phone: +1 212.803.4073