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 

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 
 2

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 <IArules@sec.gov>, 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 
 3

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 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 

 

1

 Since the beginning of this year, the Commission has brought several enforcement 

actions against investment advisers and broker-dealers 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 

co-founder 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 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. 
 4

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 broker-dealers 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 perm

advisers (rather than custodians) to send account statements if the adviser is subject to

annual surprise verification of client assets by an independent publ

its 

 an 

ic 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 

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). 
 5

statements directly to the 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 

 

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-
 6

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 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 

 

09-09). They are also available on our website at http://www.sec.gov/comments/s7-09-

09/s70909.shtml. 
 7

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 

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 

 

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). 

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”). 
 8

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 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 

 

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 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). 

19 Amended rule 206(4)-2(a)(3). 

20 Comment letter of Fifth Third Asset Management, Inc. (July 28, 2009)(“FTAM Letter”). 
 9

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 

 

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 website. 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 website 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 

website, 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). 
 10

require advisers who choose to send statements to also include in those statements the 

cautionary legend urging clients to compare the information the adviser sends to client

with the information reflected in the qualified custodian’s account statements.

s 

teps 

 

26 We

believe providing regular notice will serve to more effectively remind clients to take s

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 

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). 
 11

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

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 

 

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”)); 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”). 
 12

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 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 

 

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 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 
 13

 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 

 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 

 

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 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 
 14

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 

 

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. 
 15

which the adviser is not entitled under 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 

 

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. 
 16

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 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 

 

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

44 Id. 
 17

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 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 

 

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 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. 
 18

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 

agreement also must provide that, upon resignation or dismissal, the accountant must file 

 

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). 
 19

within four business days a statement regarding the termination along with Form ADVE.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 

 

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”). 
 20

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 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. 

 

56 See Section II.B.4. of this Release. 

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. 
 21

3. Privately Offered Securities

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 

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 

 

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 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. 
 22

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 thirdparty 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

 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 

 

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 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). 
 23

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 modernize 

the procedures for the surprise examination. 

 

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”). 
 24

 C. Custody by Adviser and Related Person 

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 

 

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. 
 25

internal control report in its records and make it available to the Commission staff upon 

request.74 

1. Internal Control Report 

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 

 

74 Amended rule 204-2(a)(17)(iii). 

75 See supra note 1. 

76 See, 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). 
 26

related firms) regulated as both an investment adviser and a broker-dealer.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 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 

 

78 ABA Letter; Curian Letter; Davis Polk Letter; E*Trade Letter; Pickard Letter; Schnase 

Letter; Schwab Letter; SIFMA(PCLC) Letter. 

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. 
 27

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 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 

 

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).

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. 
 28

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 

 

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 

broker-dealer’s financial statement audit and to satisfy related requirements under the 

Securities Exchange Act of 1934 ("Exchange Act"), including reconciliation procedures 

required for broker-dealers under the Exchange Act. See infra note 95. 
 29

control as a 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 

 

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. 
 30

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 

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

 

92 Amended rule 206(4)-2(a)(6)(ii)(B). 

93 See Proposing Release at Section II.B.2. 

94 See Accounting Release. 

95 In 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 
 31

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 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 

 

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. 

98 See Proposing Release, at Section II.B.2. 
 32

the standards of the American Institute of Certified Public Accountants99 would also be 

sufficient, provided that such examination meets the objectives set forth in our 

guidance.100

2. Related Persons 

We are amending rule 206(4)-2, as proposed, to provide that an adviser has 

custody of any client securities or funds that are directly or indirectly held by a “related 

person” in connection with advisory services provided by the adviser to its clients.101 A 

related person is defined by the rule as a person directly or indirectly controlling or 

controlled by the adviser and any person under common control with the adviser.102 

We received some support for this proposal.103 Several commenters urged us to instead 

adopt the approach our staff has taken in no-action letters in which the staff expressed the 

view that custody of client assets by a related person would not be attributed to the 

adviser if the related person was operationally separate.104 Those letters expressed our 

staff’s views regarding the scope of the custody rule which, at that time, did not explicitly 

 

99 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 adopting either of these approaches for the same reasons as explained above. 
 33

address the applicability of the rule to an entity related to the adviser as parent company, 

sister company or wholly-owned 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 result of a related 

person having custody.108 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 the custodian.109 

 As discussed above, a key premise of our approach to the custody rule is that 

client assets may be at greater risk when they are maintained by a related person of the 

investment adviser. As commenters suggested, however, firms under common ownership 

 

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. 
 34

that are operationally independent of each other present substantially lower client 

custodial risks than those that are not because misuse of client assets would tend to 

require collusion among employees, not significantly different than would be necessary 

to engage in similar misconduct between unaffiliated organizations.110 

 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 operationa

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 

lly 

 

110 MMI Letter; Davis Polk Letter. This conclusion is implicit in our staff’s no-action letter 

upon which 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. 
 35

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 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 brokerdealer 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 

 

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. 

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 
 36

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

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 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 

 

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). 

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 year-end. 
 37

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 focused on public company audit 

engagements, we believe that requiring that the accountant not only be registered with the 

 

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. 
 38

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 

 

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. 
 39

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 may be particularly vulnerable to 

misappropriation. 

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 

 

125 S&K Letter. 

126 Amended rule 206(4)-2(b)(4). See supra note 45. 

127 Amended rule 206(4)-2(b)(4)(ii). 

128 Amended rule 206(4)-2(b)(4). 
 40

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

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. 

 

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. 

131 Amended rule 206(4)-2(b)(4)(iii). 
 41

 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 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 

 

132 In 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. 
 42

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 

 

133 17 CFR 275.206(4)-7. 

134 Compliance 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. 
 43

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

● 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 

 

137 and 

e 

at it 

inues 

136 See, e.g., Comment letter of Investment Adviser Association (March 6, 2009); CPIC 

Letter. 

In addition to these policies and procedures, an adviser should consider: (i) policies 

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 th

presumption that it is not operationally independent of its related person under amended 

rule 206(4)-2(d)(5), policies and procedures reasonably designed to ensure th

continues to overcome the presumption set forth in that provision as long as it cont

to rely on the provision. See supra Sections II.A and II.C.2. of this Release. 
 44

it difficult for any one person to misuse client assets without being 

detected.138 

 Advisers should consider including in their policies and procedures a require

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.

ment 

to 

rm to the firm’s policies 

and pro

e 

s 

139 Advisers that permit employees to 

serve in capacities whereby the firm acquires custody of client assets should take steps 

assure themselves that their employees’ custodial practices confo

cedures, 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 th

adviser and its clients. Advisers and their CCOs therefore must accord these risk

appropriate attention in the adviser's compliance program. Accordingly, the adviser 

should consider developing procedures by which the CCO periodically tests the 

 

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. 
 45

effectiveness of the firm’s controls over the safekeeping of client assets. For examp

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 custodia

le, 

n sends client statements, with client addresses 

maintai

m 

t. The 

d 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 of policies and procedures such an adviser should 

conside

 

ned by the adviser, to look for inconsistencies or patterns that suggest possible 

manipulation of address information as a means for concealing misappropriation fro

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 Ac

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 reflecte

r include:141

 

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 c

arrangements, a client will instruct its qualified custodian as i

140 

ustody rule. Under these 

ts agent to determine the 

Our staff 

ccess to the 

amount of the advisory fee and to remit the amount of the fee to the adviser. 

therefore takes the view, under these circumstances, that the adviser has no a
 46

● 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 

 

Rule, at Section III. Fee Deduction, Question III.3, available at 

client’s funds or securities. See Staff Responses to Questions About Amended Custody 

http://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. 
 47

such a control may be highly effective. Advisers to pooled investment vehicles shou

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 th

ld 

e form of examples; we expect advisers to tailor their custody 

policies pr the particular risks that are raised by their 

busines

. The 

y compliance risks associated with custody 

 and ocedures to fit both the size and

s 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 detailed information 

about their custody practices in their registration form and to update the information

information will enhance our ability to identif

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 Schedu

D that we proposed to require each adviser to report all related persons who are brokerdealers and to identify which, if any, serve as qualified custodians with respect to the 

le 

 

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 

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 Acco

Office, Securities and Exchange Commission;

143 

our 

untability 

 Steps Being Taken to Make Examination 

Program More Risk-Based and Transparent (August 2007), available at

http://www.gao.gov/new.items/d071053.pdf.
 48

adviser’s clients’ funds or securities.144 We did not receive comments on these propose

amendments. We also are amending Section 7.A. of Schedule D to require an adviser to 

report whether i

d 

t has determined that it has overcome the presumption that it is not 

t 

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 a

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

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;

 a 

 (iii) 

control report with respect to the adviser or its related person;148 and (v) whether the 

 

146

whether an independent public accountant conducts an annual surprise examination of 

client assets;147 and (iv) whether an independent public accountant prepares an internal 

 

The item had required an adviser to identify on Schedule D of Form ADV each related 

person that is an investme

144 

nt adviser, but made reporting of the names of related person 

 ADV. 

148 he 

ised custody 

 the adviser’s violation of the rule. 

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

147 Item 9.C.(3) of Part 1A of Form ADV. 

Item 9.C.(4) of Part 1A of Form ADV. Two commenters suggested that we eliminate t

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 rev

rule, which if not met would result in
 49

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 th

not operationa

at it is 

lly independent from a related person qualified custodian, and thus is not 

d 

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 

 

required to obtain a surprise examination for the clients’ assets maintained at that 

custodian.151

 Several commenters generally supported these amendments to Form ADV, an

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 

150 

the 

e

this 

r clients. As a result, reporting this information 

Turner Letter. 

149 Item 9.D. of Part 1A of Form ADV. 

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 

PCAOB because this information is readily available on the PCAOB’s website. Se

AICPA Letter. An adviser, or related person custodian, would have to collect 

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 thei

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; 
 50

custodian, and 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

 

IAA Letter; NSCP Letter; ASG Letter; CAS Letter. 

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 

overcome the presumption o

153 

154 

has 

f not being operationally independent they may continue to 

s 

ing the IARD to implement this change to Item 9. In the interim, advisers 

 Several comments supported electronic filing and the 

156 

157 timing of the 

 not make the filing available to the public. We have addressed these 

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, complete

reprogramm

registered with the Commission should provide responses following the amended 

instruction. 

155 Instruction 3(a) to Form ADV-E. 

amendments to Form ADV-E generally. See Cornell Letter; IAA Letter; Turner Letter. 

Instruction 3(i) to Form ADV-E. 

Instruction 3(ii) to Form ADV-E. Commenters suggested that we revise the

filing and that we do
 51

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 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 

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 

 

accompanying text. 

comments in Section II.B.2 of this Release. See supra notes 54 and 57 and 
 52

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 ame

of amended rules 206(4)-2, 204-2, and 

orms 

e first 

ject to 

the rule after the effective date, within six months of becoming subject to the 

 

nded rule regarding the three requirements described above because they are 

modifications to the existing rule requirements. 

Compliance dates for other provisions 

F ADV and ADV-E are described below.158

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 th

examination will take place by December 31, 2010 or, for advisers that become sub

 

Some commenters requested that we delay the compliance date by 12 - 24 months from 

the effective date of the rule. See Curian Letter; CAQ Letter; Dechert Letter; Deloitte 

Letter; E&Y Letter; KPMG Letter; PWC Letter. In determining the compliance dates 

the amended rules and forms, we balanced the urgency of enhancing investor protectio

afforded under the Advisers Act, the need to provide sufficient time for ad

158 

for 

n 

visers 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. 
 53

requirement.159 If the adviser itself maintains client assets as qualified custodian, 

however, the agreement must provide for the first surprise examination to occur

than six months after obtaining the internal control report.

 no later 

 of the surprise examination and for the accountant to perform the 

surprise ex

obtain 

 it 

o a surprise examination until six months after 

cal 

160 We believe these 

compliance dates will provide sufficient time for an adviser to hire an independent public 

accountant for purposes

amination. 

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 

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

(rather than a related person) also serves as a qualified custodian of its clients’ assets 

(e.g., a broker-dealer) need not underg

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 obligated to 

obtain an audit of the financial statements of the pooled investment vehicle for fis

 

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. 
 54

years b in independent public accountant 

register

evised 

in orm ADV-E. Investment advisers will be 

notified

 are 

ng of 

o 

.S.C. 

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 

eginn g on or after January 1, 2010 by an

ed 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 r

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

exam ations should continue paper filing of F

 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

amending today contain “collection of information” requirements within the meani

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 t

the Office of Management and Budget (“OMB”) for review in accordance with 44 U

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, 

 

 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 ADVE 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, 

161

162

100 F Street, NE, Washington, DC 20549. 

 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. 
 55

funds in the custody of an investment adviser,” under the Advisers Act.164 An 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 

 

163

164 

ly 

d 

rol 

 44 U.S.C. 3501. 

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 operational

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 

adviser to maintain the written agreement concerning the surprise examination require

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 cont

number 3235-0278. The two new retention requirements and the additional written 
 56

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. 

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 

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 

 

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. 

165 Amended rule 206(4)-2(b)(3) and amended rule 206(4)-2(b)(6). 
 57

audit and that distribute audited financial statements to investors in the pools are

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.

 deemed 

ng 

ompare the account statements from the custodian with those from the 

adviser.

the 

.

168 

ts 

se,169 we have adjusted our Paperwork Reduction Act 

stimat

rprise 

estimated in the Proposing Release that 9,575 advisers registered with the Commission 

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 urgi

the client to c

167 

We requested comment on the Paperwork Reduction Act analysis contained in 

Proposing Release. A number of commenters expressed concerns that the paperwork 

burdens associated with our proposed amendments to rule 206(4)-2 were understated

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 accountan

published in a companion relea

e es as discussed below. 

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 su

examination and the delivery of quarterly account statements by the adviser. We 

 

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. 
 58

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 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 
 59

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 brokerdealers, 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 

 

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. 
 60

accountant. The estimated total annual aggregate burden with respect to the surprise 

examination requirement for this group of advisers is 15,603 hours.177 

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 

 

177 337 advisers x 2,315 (average number of clients subject to the surprise examination 

requirement) x 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 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 x 5% = 116). 
 61

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 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 

 

180 1,315 x 116 x 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 x 10%) + (1,288 x 10%) = 78 + 129 = 207. 

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 x 5) + (78 x 250 x 0.02)] + [(129 x 2) + (129 x 100 x 0.02)] = [390 + 390] + [258 + 

258] = 1,296. 
 62

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, 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 

 

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 x 0.25 = 465. 

187 19,950 + 465 = 20,415. 
 63

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 

 

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 x 

250 x 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) x 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) x 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 x 250 x 1)/60] + [(1,159 x 100 x 1)/60] = 2,929 + 1,932 = 4,861.
 64

 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 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 

 

193 4,861 (total burden hours relating to distribution of audited financials) x 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 
 65

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 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 

 

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 x 2,986 = 2,389] 

197 [(2,986 x 0.8 x 2,096 (average number of clients for the advisers with custody of client 

assets) x 0.05) x 10]/60 = 41,724 hours. 

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. 
 66

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 average of $125,000 

annually,206 262 medium sized advisers will be subject to the surprise examination 

 

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. 

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 x 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. 
 67

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 

 

207 (337 x $125,000) + (262 x $20,000) + (1,260 x $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 broker-dealer, which costs we believe are accurately reflected in the 

comment letter sent by the Securities Industry and Financial Markets 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 
 68

estimate that under 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 

 

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 x 10%) – (337 x 15%) = 337 – 34 – 51 = 

252. 

210 $250,000 x 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. 
 69

account statements at an average cost of $1,000 each.212 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.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 

 

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. 

213 1,195 x $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). 
 70

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 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 

 

216 NVCA Letter. 

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. 
 71

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. 

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

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

 

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 it to the 

accountant, which results in an estimated hour burden for the advisers. 

222 1,859 x 0.05 = 93. 
 72

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 broker-dealer 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 

223 1,859/5 = 372. 372 x 0.05 = 19. 

224 93 + (372 x 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). 
 73

of client assets to undergo an annual 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

the adviser’s or related person’s controls relating to custody of client assets, such as a 

Type II SAS 70 report.

 to 

hat 

he 

 

230 The amended rule also requires, in these circumstances, t

the independent public accountant issuing the internal control report, as well as t

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). 
 74

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 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 

 

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). 

233 CFA Institute Letter. 

234 Of 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 
 75

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 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 

 

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. 
 76

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 advisers237 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 

 

235 See Section II. B of this Release. 

236 The 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) x 2,315 (average number of clients for advisers subject to the surprise 

examination)] + (1,522 x 2,315 x 0.05(percentage of clients whose assets are subject to 

the surprise examination)) = 780,155 + 176,172 = 956,237. 
 77

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.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 

 

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). 
 78

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 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. 

 

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). 

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. 
 79

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 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 

 

247 Amended rule 206(4)-2(a)(6)(i) and (ii)(C). 
 80

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 

 

248 Amended rule 206(4)-2(b)(4). 

249 Based on ADV-E filings, there were 190 advisers that underwent surprise examinations 

during 2008. 

250 Amended rule 206(4)-2(a)(2). 
 81

reducing losses. We estimate that 250,367 clients would receive notices and subsequent 

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 

 

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 x 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 x (2,096 x 0.05) = 

250,367). 
 82

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 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 

 

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 x 2,315 (average number of clients of the advisers subject to the surprise 

examination) = 4,303,585. 

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.
 83

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 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. 

 

257 Section 9.D of Schedule D of Form ADV. 

258 Amended rule 206(4)-2(b)(4)(iii). 
 84

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 

 

259 Amended 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. 
 85

that already undergo an annual surprise examination under the 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 

 

263 See supra note 249. 

264 1,859 – 190 = 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). 
 86

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, 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 

 

268 1,859 x 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. 

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 
 87

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 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 

 

hour. Therefore the total costs would be $1,376,820 ((19,950 x $63) + (465 x $258) = 

$1,376,820). 

272 See Proposing Release at n.102 and accompanying text. 

273 9,575 x $8,100 = $77,557,500. 

274 See Section II.C.2. of this Release. 

275 See 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). 
 88

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 

three distinct groups.281 We now estimate that 337 advisers either serve as qualified 

 

279 See ASR No. 103.

280 See Accounting Release. 

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. 
 89

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 

 

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 x 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 x .75) x 

$125,000), if one half of them could overcome the presumption the costs would be 

overstated by $16,187,500 ((259 x .5) x $125,000), or if one quarter of them could 

overcome the presumption the costs would be overstated by $8,093,750 ((259 x .25) x 

$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. 
 90

to 5 percent of 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 smallsized 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 

 

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 x $125,000) + (262 x $20,000) + (1,260 x $10,000) = $42,125000 + $5,240,000 + 

$12,600,000 = $59,965,000. 

287 See supra notes 276-278 for explanation of this estimate. 
 91

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 

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 

 

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 x 10% = 34. 

290 Our estimate of 15% is based on the IARD data. 337 x 15% = 51. 

291 See supra note 208 and accompanying text for explanation of this estimate. 

292 $250,000 x (337 – 34 – 51) = $250,000 x 252 = $63,000,000. 
 92

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 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 
 93

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 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 

 

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 x $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 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 $193 per hour. We further estimate that such reprogramming will 

take about 5 hours for each adviser. $193 x 5 hours = $965. Based on the above, we 

estimate that each adviser will spend approximately $1,000 as reprogramming costs. 

295 Amended rule 206(4)-2(b)(4). 
 94

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 

 

296 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). 

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. 
 95

investment vehicles because we believe most of these pooled 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 

 

299 Amended rule 206(4)-2(b)(4)(iii). 

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 x $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.
 96

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 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 

amendments304 will be 29,003 at a total cost of $1,917,864305 The total cost estimated 

for complying with amendments to 206(4)-2 is estimated at $126,077,864.306 

 

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 hour for 

distributing audited financials related to liquidation audit) + 8,345 (employee hours for 

adding a legend in the notice to clients)) x $63] + (465 (employee hours for adding 

language in written agreements) x $258) = $1,797,894 + $119,970 = $1,917,864. 

We estimated that advisory employees will spend a total of 41,724 hours to comply 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 x 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). 
 97

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 hour 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

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 

 

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 x 

$63 = $193,284). See supra note 266 for explanation of the hourly compliance clerk cost 

estimate. 
 98

examination terminates its engagement. This represents an increase of 103 hours310 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 

 

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 x $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 
 99

system 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. 

 

313 5 U.S.C. 605(b). 

314 See Proposing Release at Section VI. 
 100

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 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 

 

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; 
 101

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 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 SECregistered investment advisers that have custody of client assets were small entities that 

 

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. 
 102

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 

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 

 

317 17 CFR 275.0-7(a). 

318 Based on IARD data. 

319 See supra note 206 and accompanying text for explanation of the estimate. 
 103

to 5 percent of their clients. Of the 1,522 advisers, 262 medium-sized advisers will each 

spend 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 

 

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. 
 104

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 

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. 
 105

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 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 

 

324 15 U.S.C. 80b-4(a). 

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. 
 106

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 risk-based 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, 

 

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). 
 107

removal, or other termination. Both Part 1A of From 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 

 

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 
 108

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. 

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. 80b6(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 80b11). 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. 

 

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). 
 109

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, 80b6(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 under § 

275.206(4)-2(d)(5) has been overcome. 

* * * * * 
 110

3. Section 275.206(4)-2 is revised to read as follows: 

§ 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 
 111

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 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: 
 112

(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 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: 
 113

(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 openend 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; 
 114

(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 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)): 
 115

(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: 

(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 
 116

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 
 117

(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 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 
 118

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 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 
 119

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. 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. 

 

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 
 120

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. 

Form ADV 

* * * * * 

Form ADV: General Instructions 

* * * * * 

4. * * * 

● information you provided in response to Items 1, 3, 9 (except 9.A.(2), 

9.B.(2), and 9.(E)), or 11 of Part 1A or Items 1, 2.A. through 2.F., or 2.I. 

of Part 1B becomes inaccurate in any way; 

* * * * * 

If you are submitting an other-than-annual amendment, you are not required to 

update your responses to Items 2, 5, 6, 7, 9.A.(2), 9.B.(2), 9.E., or 12 of Part 1A or Items 

2.H. or 2.J. of Part 1B even if your responses to those items have become inaccurate. If 

you are amending Part II, do not file the amendment with the SEC. 

* * * * * 

Part 1A 

* * * * * 

Item 7 Financial Industry Affiliates 

* * * * * 

A. * * * 
 121

If you checked Items 7.A.(1) or (3), you must list on Section 7.A. of Schedule D 

all your related persons that are investment advisers, broker-dealers, municipal securities 

dealers, or government securities broker or dealers. 

* * * * * 

Item 9 Custody 

In this Item, we ask you whether you or a related person has custody of client 

assets and about your custodial practices. 

A. (1) Do you have custody of any advisory clients’: 

 Yes No

 (a) cash or bank accounts? □ □

 (b) securities? □ □ 

If you are registering or registered with the SEC, answer “No” to Item 9.A.(1)(a) 

and (b) if you have custody solely because (i) you deduct your advisory fees 

directly from your clients’ accounts, or (ii) a related person maintains client 

funds or securities as a qualified custodian but you have overcome the 

presumption that you are not operationally independent (pursuant to Advisers Act 

rule 206(4)(2)-(d)(5)) from the related person.

(2) If you checked “yes” to Item 9.A.(1)(a) or (b), what is the amount of client 

funds and securities and total number of clients for which you have custody: 

 U.S. Dollar Amount Total Number of Clients 

 (a) $________________ (b) _____________ 

If your related person serves as qualified custodian of client assets, do not include 

the amount of those assets and the number of those clients in your response to 

Item 9.A.(2). Instead, include that information in your response to Item 9.B.(2). 

B. (1) Do any of your related persons have custody of any of your advisory clients’: 

 

Yes No 

 (a) cash or bank accounts? □ □

(b) securities? □ □

You are required to answer this item regardless of how you answered Item 

9.A.(1)(a) or (b). 
 122

(2) If you checked “yes” to Item 9.B.(1)(a) or (b), what is the amount of client 

funds and securities and total number of clients for which your related 

persons have custody: 

 U.S. Dollar Amount Total Number of Clients 

 (a) $________________ (b) _____________ 

C. If you or your related persons have custody of client funds or securities, check all 

the following that apply: 

 

⁪ (1) A qualified custodian(s) sends account statements at least quarterly to 

the investors in the pooled investment vehicle(s) you manage.

⁪ (2) An independent public accountant audits annually the pooled 

investment vehicle(s) that you manage and the audited financial 

statements are distributed to the investors in the pools. 

⁪ (3) An independent public accountant conducts an annual surprise 

examination of client funds and securities. 

⁪ (4) An independent public accountant prepares an internal control report 

with respect to custodial services when you or your related persons are 

qualified custodians for client funds and securities. 

If you checked Item 9.C.(2), C.(3) or C.(4), list in Section 9.C. of Schedule D the 

accountants that are engaged to perform the audit or examination or prepare an 

internal control report. 

D. Do you or your related persons act as qualified custodians for your clients in 

connection with advisory services you provide to clients? 

 Yes No

 (1) you act as a qualified custodian □ □ 

(2) your related persons act as qualified custodians □ □

If you checked “yes” to Item 9.D.(2), list in Section 9.D. of Schedule D all your 

related persons that act as qualified custodians for your clients in connection with 

advisory services you provide to clients (you do not have to list broker-dealers 

already identified as qualified custodians in Section 7.A. of Schedule D). 

E. If you are filing your annual updating amendment and you were subject to a 

surprise examination by an independent public accountant during your last fiscal 

year, provide the date (MM/YYYY) the examination commenced: ___________

* * * * * 
 123

Schedule D 

* * * * * 

SECTION 7.A. Affiliated Investment Advisers and Broker-Dealers 

You must complete the following information for each related person investment 

adviser and broker-dealer. You must complete a separate Schedule D Page 3 for 

each listed related person. 

Check only one box: Add Delete Amend 

Legal Name of Related Person: 

________________________________________________________________ 

Primary Business Name of Related Person: 

___________________________________________________________ 

Related person is (check only one box): Investment Adviser BrokerDealer Dual (Investment Adviser and Broker-Dealer)

If the related person is a broker-dealer, is it a qualified custodian for your clients

in connection with advisory services you provide to clients? Yes No 

If you are registering or registered with the SEC and you have answered “yes,” 

have you overcome the presumption that you are not operationally independent 

(pursuant to Advisers Act rule 206(4)(2)-(d)(5)) from the related person brokerdealer, and thus are not required to obtain a surprise examination for your clients’

funds or securities that are maintained at the related person? 

 Yes No 

Related Person Adviser’s SEC File Number (if any) 801- ______________ 

Related Person’s CRD Number (if any): _________________ 

* * * * * 

SECTION 9.C. Independent Public Accountant 

You must complete the following information for each independent public 

accountant engaged to perform a surprise examination, perform an audit of a 

pooled investment vehicle that you manage, or prepare an internal control report. 

You must complete a separate Schedule D Page 4 for each independent public 

accountant. 

Check only one box: Add Delete Amend 

(1) Name of the independent public accountant: 

__________________________________________________ 

(2) The location of the independent public accountant’s office responsible for the 

services provided: 
 124

______________________________________________________________ 

 (number and street) 

 ______________________________________________________________ 

 (city) (state/country) (zip+4/postal code) 

 

(3) Is the independent public accountant registered with the Public Company 

Accounting Oversight Board? Yes No 

(4) If yes to (3) above, is the independent public accountant subject to regular 

inspection by the Public Company Accounting Oversight Board in accordance 

with its rules? Yes No 

(5) The independent public accountant is engaged to: 

 

A. audit a pooled investment vehicle 

B. perform a surprise examination of client assets 

C. prepare an internal control report 

(6) Does the report prepared by the independent public accountant that audited 

the pooled investment vehicle or that examined internal controls contain an 

unqualified opinion? 

Yes No 

SECTION 9.D. Related Person Qualified Custodian 

You must complete the following information for each of your related persons

that acts as a qualified custodian for your clients in connection with advisory 

services you provide to clients (you do not have to list broker-dealers already 

identified as qualified custodians in Section 7.A. of Schedule D). You must 

complete a separate Schedule D Page 5 for each listed related person. 

Check only one box: Add Delete Amend 

Legal Name of Related Person: 

________________________________________________________________ 

Primary Business Name of Related Person: 

___________________________________________________________ 

The location of the related person’s office responsible for custody of your clients’ 

assets: 

__________________________________________________________________

 (number and street) 

__________________________________________________________________ 

 (city) (state/country) (zip+4/postal code) 

Related Person is (check only one box): 

 U.S. Bank or Savings Association 
 125

 Futures Commission Merchant 

 Foreign Financial Institution 

If you are registering or registered with the SEC, have you overcome the 

presumption that you are not operationally independent (pursuant to Advisers Act 

rule 206(4)(2)-(d)(5)) from the related person qualified custodian, and thus are 

not required to obtain a surprise examination for your clients’ funds or securities 

that are maintained at the related person? Yes No 

* * * * * 

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). 

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 
 126

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 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 
 127

(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. 

* * * * * 

By the Commission. 

Florence E. Harmon

Deputy Secretary 

December 30, 2009