Tag Archives: investment advisor custody

Mallon P.C. Comments on Proposed Investment Adviser Custody Rule

In May we reported that the SEC was requesting comments on the new Proposed Investment Adviser Custody Rules. The SEC’s comment period ended this past week with a flurry of activity before the submission deadline. As we reported previously, there has been a general industry backlash against the rule because it does not provide any substantive protection for investors and creates significant additional costs for investment advisory firms – including the requirement of a surprise audit for those adviser which directly debit advisory fees from the client’s brokerage account.

Mallon P.C. participated in this discussion by submitting the following Comment on Proposed Investment Adviser Custody Rule. Specifically we found that there would be no good reason to institute the rule as written and believe that it would harm small investment advisory firms disproportionately. Additionally, we urged the SEC to consider alternatives to the proposed rule which would have more effective investor protections with less impact on the business aspects of the investment advisers who would be subject to the rule.

****

Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

Net Capital Requirement for State Registered Hedge Fund Managers

4 Replies

Overview of Net Capital Requirement and Bond Alternative

Hedge fund managers who need to register as investment advisors in their state of residence often have to deal with the net capital requirement issue. Usually there will be two separate net capital requirements for the investment advisor (meaning the fund’s management company) depending on the nature of the advisor’s business:

Advisors with Discretionary Authority – $10,000
Advisors with Custody – $35,000

[Note: these requirements do not usually apply to forex hedge fund managers unless such managers are also registered as investment advisors.]

Generally all state-registered hedge fund managers will have discretionary authority of the hedge fund’s investments so most advisors will need to maintain the $10,000 requirement. Also, most hedge fund managers will also be deemed to have “custody” of the fund assets because they will either have direct access to the hedge fund’s bank account or because they will directly deposit their management fees from the fund’s brokerage account. Accordingly, most state-registered hedge fund managers will need to maintain the more burdensome $35,000 net capital requirement. There is no requirement to combine the $10,000 with the $35,000 for managers with both discretionary authority and custody – in these situations the manager will only need to maintain the $35,000.

Investment Advisor Bond

As an alternative to maintaining a firm net capital according to the rules above, some states will allow hedge fund managers to post a bond in the required amount instead. Not all states will allow a manager to post a bond instead, so you should be sure to talk with your hedge fund attorney or compliance professional before you begin the process of securing a bond.

Securing the Bond

There are a number of groups out there that can underwrite these sorts of bonds for the money managers. The fees for such bonds will be anywhere from $250 to $1,000, depending on a number of factors including the credit history of the managing member of the fund management company. It will generally take anywhere from a few days to a couple of weeks to secure the bond and from there, the manager will likely need to show proof to the state securities division that the bond has been secured in the appropriate amount.

****

Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs Hedge Fund Law Blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. Cole-Frieman & Mallon LLP will also help state based Investment Advisors to register with their state securities division. If you are a hedge fund manager who is looking to start a hedge fund or an investment advisor looking to register, please call Mr. Mallon directly at 415-296-8510.

Proposed Amendments to the Investment Advisers Act: SEC Requests Feedback

1 Reply

The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.

Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. The amendments are summarized in the bullet points below:

Rule 206(4)-2: All registered investment advisers:

must have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients
must undergo an annual surprise audit examination by an independent accountant
is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services
must obtain or receive an annual internal control report, if the adviser also acts as a qualified custodian over client assets
must inform the SEC within one business day of finding any material discrepancies during an audit examination

Rule 204-2: All registered investment advisers:

must maintain a copy of an internal control report for five years from the end of the fiscal year in which the internal control report is finalized

Form ADV: All registered investment advisers:

must report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds
must report the dollar amount of client assets and the number of clients of which he/she has custody
must identify and provide detailed information regarding the accountants that perform the audits/examinations and prepare internal control reports

Form ADV-E: All PCAOB-registered accountants:

must file Form ADV-E with the SEC within 120 days of the completion of the audit examination
must submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes details of the resignation

All comments to the proposed amendments must be received by the SEC on or before July 28, 2009. Please contact us if you have any questions on the above proposed amendments or would like to start a hedge fund. Additionally, we will be submitting our comments to the SEC with regard to the proposed amendments and would like to know what you think as well – please comment below.

****

For further information regarding the proposed amendments, please refer to the more detailed abstract below. The full text of the proposed rules can be found here.

SEC Proposed Custody Amendments Abstract

The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms, with the intent to enhance the protections afforded to clients’ assets under the Advisers Act when an advisor has custody of client funds or securities. These amendments are proposed as a response to a number of recent enforcement actions against investment advisors alleging fraudulent conduct, including misappropriation or other misuse of investor assets. Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.

Rule 206(4)-2, also known as the ‘custody rule’, seeks to protect clients’ funds and securities in the custody of registered advisers from misuse or misappropriation by requiring advisers to implement certain controls. The current rule requires registered advisers to maintain their clients’ assets in separate identifiable accounts with a qualified custodian, such as a broker-dealer or bank. Presently, advisors may comply with the rule by either a) having a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients or alternatively b) the advisor sending his/her own quarterly account statements to clients and undergoing an annual surprise audit examination by an independent public accountant. Similarly, an adviser to a pooled investment vehicle may currently comply with the rule by having the pool audited annually by an independent public accountant and distributing the audited financials to the investors in the pool within 120 days of the end of the pool’s fiscal year.

The proposed amendments to Rule 206(4)-2 aim to codify both of the above mentioned compliance alternatives by requiring that all registered advisers having custody of client assets must a) have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients and b) undergo an annual surprise examination. The amendments also explicitly state that an adviser is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services. The SEC additionally proposes that if an independent qualified custodian does maintain client assets, but rather the advisor or a related person him/herself serves as a qualified custodian for the client, then the advisor must obtain or receive from the related person an annual internal control report which would include a) an opinion from an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB), and b) a description of the relevant controls in place relating to custodial services and the objectives of these controls, as well as the accountant’s tests of operating effectiveness and the test results. Lastly, the newly amended rule would also require the adviser and the accountant to inform the SEC within one business day of finding any material discrepancies during an examination that may assist in protecting advisory client assets. Together, these revisions to Rule 206(4)-2 are designed to strengthen the controls relating to the advisors’ custody of client assets and deter advisors from fraudulent activity.

Rule 204-2, governing record maintenance, presently requires that investment advisors obtain or receive a copy of an internal control report from its related person. The proposed amendment to this rule would additionally require the advisor to maintain the copy for five years from the end of the fiscal year in which the internal control report is finalized. This amendment to Rule 204-2 is designed to further implement safeguards to protect clients’ assets and offset custody-related risks.

Form ADV, which outlines the data to be reported to the SEC by investment advisors, has also been amended to provide the SEC with additional data and more complete information from the perspective of the advisor. Currently, Item 7 of Part1A requires advisers to report on Schedule D of Form ADV each related person that is an investment adviser, and permits advisers to report the names of related person broker-dealers. The new amendment modifies Item 7 to require an advisor to report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds. Similarly, Item 9 of Part1A currently requires advisers to report whether they or a related person have custody of client funds. The new amendment to Item 9 requires an adviser to report the dollar amount of client assets and the number of clients of which he/she has custody. Other reporting duties to be implemented under the new amendments include: a) whether a qualified custodian sends quarterly account statements to investors in pooled investment vehicles managed by the adviser, b) whether these account statements are audited, c) whether the adviser’s clients’ funds are subject to a surprise examination and the month in which the last examination commenced, and d) whether an independent PCAOB-registered accountant prepare an internal control report when the adviser is also acting as a qualified custodian for the clients’ funds. Schedule D of Form ADV would also be amended to require additional reporting duties of the adviser, including: a) identifying the accountants that perform the audits/examinations and prepare internal control reports, b) providing information about the accountants including address, PCAOB registration, and inspection status, c) indicating the type of engagement (audit, examination, or internal control report), and d) indicating whether the accountant’s report was unqualified. These proposed amendments to Form ADV are designed to allow the SEC to better monitor compliance with the requirements of Rules 206(4)-2 and 204-2 and better assess the compliance risks of an adviser.

Form ADV-E, which outlines the data to be reported to the SEC by designated accountants, has also been amended to provide the SEC with additional data and more complete information to the SEC from the perspective of the accountant. Currently, the rule requires this form to be filed within 30 days of the completion of the examination, accompanied by a certificate confirming that the accountant completed an examination of the funds and describing the nature and extent of the examination. The SEC proposes to amend this rule governing Forms ADV and ADV-E to extend the grace period within which the forms must be submitted to a period of 120 days from the time of the examination. Based on SEC observations, an adviser’s surprise examination may sometimes continue for an extended period of time, warranting this extension. Additionally, the amendment requires that the accountant submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes a) the date of such resignation, dismissal or termination, b) the accountant’s name, address and contact information, and c) an explanation of any problems relating to examination scope or procedure that contributed to such resignation, dismissal or termination. This proposed amendment to Form ADV-E is designed to provide the SEC with the information necessary to further evaluate the need for an examination to determine whether the clients’ assets are at risk.

The SEC strongly urges investment advisors, public auditors/accountants, and related professionals in the field of securities and investments to review the proposed amendments to the Advisers Act and submit relevant feedback that may assist the Commission in analyzing the effectiveness, efficiency, and feasibility of the proposed amendments as well as the possible impact of these new legislative measures on the global marketplace. While all proposed amendments are designed to provide additional safeguards to client funds or securities under adviser custody, the potential ramifications of their enforcement is currently being assessed. Comments may be submitted in electronically via the Commission’s internet comment form (http://www.sec.gov/rules/proposed.shtml), via e-mail to [email protected], or via the Federal eRulemaking Portal (http:/www.regulations.gov). Paper comments can be sent in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. All comments to the proposed amendments must be received by the SEC on or before July 28, 2009. All submissions must refer to File Number S7-09-09, and will be made available to the public via the Commission’s Internet Website: http://www.sec.gov/rule/proposed.shtml.

SEC Chairman Discusses Potential New IA Custody Rules

Leave a reply

Hedge Fund Advisors May be Impacted

Yesterday SEC Chairman Mary Schapiro discussed many new SEC initiatives in a speech given to the Society of American Business Editors and Writers. One of the new initiatives involves those advisors who have “custody” of client assets. With respect to such advisors, Shapiro said:

I anticipate that this proposal will include a consideration of “surprise” examinations by a certified public accountant, and a requirement that investment advisers undergo third-party compliance audits.

The tone of the speech was that of a new gunslinger who has come into town to clean up – in addition to the new custody provisions, she discussed regulatory reform and giving SEC examiners more room to initiate investigations. Many of the ideas expressed in the speech may be worrisome to investment advisors and investors because the initiatives are likely to add significantly to the operating costs of hedge fund managers who are registered as investment advisors. Additionally, registered managers may face increase inquiries into their business by nosy SEC examiners which will not go over well within the industry.

Below I have reprinted what I thought were important or interesting parts of the speech; the full text can be found here.

****

Speech by SEC Chairman:
Address to the Society of American Business Editors and Writers

Chairman Mary L. Schapiro
U.S. Securities and Exchange Commission
SABEW Annual Conference 2009
Denver, Colorado
April 27, 2009

…

Policies/Rules:

Enforcement has been the most visible program at the SEC in recent history. But the financial crisis teaches us that there are policy and regulatory gaps that the SEC must also address.

Again, if investors are to have confidence in the ratings assigned to securities, that corporate boards are working on behalf of stockholders, that investment advisers are not running Ponzi schemes, that money market funds won’t break the buck, then the SEC needs to be pushing forward a real agenda of reform.

Let me just highlight a few of these:

…

Custody:

In response to major investment scams — such as Madoff — and a rash of Ponzi schemes, we will be considering two proposals as part of a package of initiatives designed to better assure the safekeeping of investor assets.

In short order, the Commission will consider a proposal to strengthen the controls applicable to investment advisers with custody of client funds and securities. I anticipate that this proposal will include a consideration of “surprise” examinations by a certified public accountant, and a requirement that investment advisers undergo third-party compliance audits.

Also, as part of this package, I have asked the staff to draft a Commission requirement that a senior officer from broker-dealers and investment advisers with custody certify that controls are in place to protect investor assets.

***

Reforming the Landscape:

As a result, there is significant debate about regulatory reform — not about whether it should happen, but about what form it will take. You might say the train has left the station, but no one quite knows for sure where it will come to stop.

Whatever form it takes, I support the view that there is a need for system-wide consideration of risks to the financial system and to create mechanisms to reduce and avert such systemic risks.

But, at the same time, I believe that any reform must not — and cannot — compromise the quality of our capital markets or the protection of investors.

If we cannot show investors that we are looking out for their interests as much as the interests of the financial institutions — then we will have little success in restoring confidence.

Investors need to see that we are going after those who engage in wrongdoing. They need to see that we are forcing companies to be truthful and transparent in their reporting. They need to see that we are limiting risk in areas where substantial risk is not what they’re buying. And, they need to see that we’re rooting out fraud.

In short, they need an agency that’s there for them — and primarily them. They need an independent agency that exists not just to protect Wall Street, but to protect Main Street.

By offering that to investors, we can help to restore confidence.

****

In addition, I have streamlined our enforcement procedures by no longer requiring full Commission approval to launch an investigation. And, I’ve eliminated the need for full Commission approval before negotiating a settlement with a corporate defendant.

Before these directives, enforcement attorneys will tell you that they worried about red lights at every turn — now they see green.

Additionally, I brought on a consulting firm to assess and revamp the way we handle the nearly 1 million tips and complaints we get each year. Because we do not have unlimited resources we cannot pursue every lead — we get about 2,000 every day. But we can do a better job ensuring that each tip lands on the right desk and that the person reviewing it has the necessary skills.

Further, we are looking at improving our training programs and hiring new skill sets — from financial analysis to experts in complex trading strategies. It’s all an effort to keep pace with the fraudsters and the ever-changing financial concoctions of the day.

For me, the progress cannot be fast enough.

When I review the pipeline of cases I see how much we are confronting.

We have approximately 150 active hedge fund investigations, some of which include possible Ponzi schemes, misappropriations, and performance smoothing.
We have about two dozen active municipal securities investigations possibly involving offering frauds; arbitrage-driven fraud; public corruption; and price transparency.
And, we have more than 50 current investigations involving Credit Default Swaps, Collateralized Debt Obligations and other derivatives-related investments.

… and that’s just a small slice.

Please contact us if you have a question on this issue or if you would like to start a hedge fund. If you would like more information, please see our articles on starting a hedge fund. Other related hedge fund law articles include: