25354 Federal Register / Vol. 74, No. 100 / Wednesday, May 27, 2009 / Proposed Rules 

1Unless otherwise noted, when we refer to rule 

206(4)–2 or any paragraph of the rule, we are 

referring to 17 CFR 275.206(4)–2 of the Code of 

Federal Regulations in which the rule is published. 

See also 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’’). From 

time to time for convenience, this release refers to 

rule 206(4)–2 as the ‘‘custody rule.’’ 

2Rule 206(4)–2(a)(1). 

3Rule 206(4)–2(c)(3) (defining ‘‘qualified 

custodian’’). In addition, ‘‘qualified custodian’’ 

includes a foreign financial institution that 

customarily holds financial assets for its customers, 

provided that the foreign financial institution keeps 

advisory clients’ assets in customer accounts 

segregated from its proprietary assets. Foreign 

custody arrangements may be necessary to permit 

clients to trade in securities traded in foreign 

markets, or to accommodate clients with existing 

relationships with foreign institutions. When we 

amended the custody rule in 2003, we explained 

that when an adviser selects a foreign financial 

institution to hold clients’ assets, the adviser’s 

fiduciary obligations require it either to have a 

reasonable basis for believing that the foreign 

institution will provide a level of safety for client 

assets similar to that which would be provided by 

a ‘‘qualified custodian’’ in the United States or to 

fully disclose to clients any material risks attendant 

to maintaining the assets with the foreign 

custodian. See 2003 Adopting Release, at n. 22. 

4See Custody of Funds or Securities of Clients by 

Investment Advisers, Investment Advisers Act 

Release No. 2044 (Jul. 18, 2002) [67 FR 48579 (Jul. 

25, 2002)] (‘‘2002 Proposing Release’’), at n. 30 

(regulatory agencies or self-regulatory organizations 

require these financial institutions to carry fidelity 

bonds to cover possible losses caused by their 

employees’ fraudulent activities). In addition, rule 

15c3–3 [17 CFR 240.15c3–3] under the Securities 

Exchange Act of 1934 (the ‘‘Exchange Act’’), 

requires a broker-dealer to segregate customer funds 

held by the broker-dealer for the accounts of 

customers and to take certain steps to protect 

customer assets. Under rules 17a–3 and 17a–4 

under the Exchange Act [17 CFR 240.17a–3 and 

17a–4] a broker-dealer must create and maintain 

current, specified books and records to allow the 

broker-dealer to easily identify what assets belong 

to each customer. Similarly, national banks, Federal 

SECURITIES AND EXCHANGE 

COMMISSION 

17 CFR Parts 275 and 279 

[Release No. IA–2876; File No. S7–09–09] 

RIN 3235–AK32 

Custody of Funds or Securities of 

Clients by Investment Advisers 

AGENCY: Securities and Exchange 

Commission. 

ACTION: Proposed rule. 

SUMMARY: The Securities and Exchange 

Commission is proposing amendments 

to the custody rule under the 

Investment Advisers Act of 1940 and 

related forms. The amendments, among 

other things, would require registered 

investment advisers that have custody 

of client funds or securities to undergo 

an annual surprise examination by an 

independent public accountant to verify 

client funds and securities. In addition, 

unless client accounts are maintained 

by an independent qualified custodian 

(i.e., a custodian other than the adviser 

or a related person), the adviser or 

related person must obtain a written 

report from an independent public 

accountant that includes an opinion 

regarding the qualified custodian’s 

controls relating to custody of client 

assets. Finally, the amendments would 

provide the Commission with better 

information about the custodial 

practices of registered investment 

advisers. The amendments are designed 

to provide additional safeguards under 

the Advisers Act when an adviser has 

custody of client funds or securities. 

DATES: Comments must be received on 

or before July 28, 2009. 

ADDRESSES: Comments may be 

submitted by any of the following 

methods: 

Electronic Comments 

• Use the Commission’s Internet 

comment form (http://www.sec.gov/ 

rules/proposed.shtml); or 

• Send an e-mail to rulecomments@sec.gov. Please include File 

Number S7–09–09 on the subject line; 

or 

• Use the Federal eRulemaking Portal 

(http://www.regulations.gov). Follow the 

instructions for submitting comments. 

Paper Comments 

• Send paper comments in triplicate 

to Elizabeth M. Murphy, Secretary, 

Securities and Exchange Commission, 

100 F Street, NE., Washington, DC 

20549–1090. 

All submissions should refer to File 

Number S7–09–09. This file number 

should be included on the subject line 

if e-mail is used. To help us process and 

review your comments more efficiently, 

please use only one method. The 

Commission will post all comments on 

the Commission’s Internet Web site 

(http://www.sec.gov/rules/ 

proposed.shtml). Comments are also 

available for public inspection and 

copying in the Commission’s Public 

Reference Room, 100 F Street, NE., 

Washington, DC 20549 on official 

business days between the hours of 10 

a.m. and 3 p.m. All comments received 

will be posted without change; we do 

not edit personal identifying 

information from submissions. You 

should submit only information that 

you wish to make available publicly. 

FOR FURTHER INFORMATION CONTACT: 

Vivien Liu, 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 requesting public 

comment on proposed amendments to 

rule 206(4)–2 [17 CFR 275.206(4)–2], 

rule 204–2 [17 CFR 275.204–2] 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. General Request for Comment 

IV. Paperwork Reduction Act 

V. Cost-Benefit Analysis 

VI. Initial Regulatory Flexibility Analysis 

VII. Effects on Competition, Efficiency and 

Capital Formation 

VIII. Consideration of Impact on the 

Economy 

IX. Statutory Authority; Text of Proposed 

Rule and Form Amendments 

I. Background 

Rule 206(4)–2 regulates the custody 

practices of investment advisers 

registered under the Advisers Act.1

Unlike banks and broker-dealers, 

investment advisers typically do not 

maintain physical custody of client 

funds or securities but rather may have 

custody because they have the authority 

to obtain client assets, such as by 

deducting advisory fees from a client 

account, writing checks or withdrawing 

funds on behalf of a client, or by acting 

in a capacity, such as general partner of 

a limited partnership, that gives an 

adviser or its supervised person the 

authority to withdraw funds or 

securities from the limited partnership’s 

account. Rule 206(4)–2 requires advisers 

that have custody of client funds or 

securities to implement controls 

designed to protect those client assets 

from being lost, misused, 

misappropriated or subject to the 

advisers’ financial reverses, such as 

insolvency. The rule contains two 

primary protections. 

First, the rule requires advisers that 

have custody, with certain limited 

exceptions, to maintain client funds or 

securities with a ‘‘qualified 

custodian.’’ 2 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.3 These 

institutions’ custodial activities are 

subject to extensive regulation and 

oversight.4


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Federal Register / Vol. 74, No. 100 / Wednesday, May 27, 2009 / Proposed Rules 25355 

savings associations, and other U.S. banking 

institutions are subject to extensive regulation and 

oversight. See 12 U.S.C. 92a. (national banks must 

have authorization from the Comptroller of the 

Currency before establishing a trust department and 

taking custody of customer assets); 12 U.S.C. 

1464(n) (Federal savings associations shall segregate 

all assets held in any fiduciary capacity and shall 

keep a separate set of books and records showing 

all transactions in the accounts); Comptroller’s 

Handbook, Custody Services at 6, 15 (Jan. 2002) (a 

bank should have adequate systems in place to 

identify, measure, monitor, and control risks in the 

custody services area and a custodian’s accounting 

records and internal controls should ensure that 

assets of each custody account are kept separate 

from the assets of the custodian). 

5Rule 206(4)–2(a)(3)(i). 

6Rule 206(4)–2(b)(3). 

7Rule 206(4)–2(a)(3)(ii). Under the rule, an 

adviser is not required to obtain a surprise 

examination if the qualified custodian delivers 

account statements directly to the adviser’s clients. 

An adviser to a pooled investment vehicle that is 

unable, or chooses not to, rely on the exception for 

audited financial statements and that does not have 

a qualified custodian send the required account 

statements to pool investors must provide account 

statements to pool investors and the adviser must 

obtain a surprise examination of pool assets. 

8As stated in note 33 of the 2003 Adopting 

Release, the accountant must perform the 

examination in accordance with U.S. Generally 

Accepted Auditing or Attestation Standards and the 

standards established by the Commission, except 

that the accountant must verify all or substantiate 

all client funds and securities covered by the 

examination. The examination should include 

confirmation of all client cash and securities of 

which an adviser has custody, regardless of whether 

they are held by qualified custodians, and 

reconciliation of all such cash and securities to the 

books and records of client accounts maintained by 

the adviser, as well as confirmation of such 

information with the adviser’s clients. See Nature 

of Examination Required to be Made of All Funds 

and Securities Held in Custody of Investment 

Advisers and Related Accountant’s Certificate, 

Investment Advisers Act Release No. 201 and 

Accounting Series Release No. 103 (May 26, 1966) 

[31 FR 7821 (Jun. 2, 1966)]. Section 404.01.b. of the 

Commission’s Codification of Financial Reporting 

Policies. The examination must be performed at a 

time chosen by the accountant without prior notice 

or announcement to the adviser, and the timing of 

the examination must be irregular from year to year, 

so that the adviser will be unaware of the date on 

which it will take place. Rule 206(4)–2(a)(3)(ii)(B). 

9 Id. 

10Rule 206(4)–2(a)(3)(ii)(C). As we stated in note 

34 of the 2003 Adopting Release, the independent 

public accountant may first take reasonable steps to 

establish the basis for believing a material 

discrepancy exists. The obligation to notify the 

Commission arises once the accountant has a basis 

for believing there is a material discrepancy. 

Ordinarily, an accountant should be able to 

determine promptly whether it has a basis for 

believing there is a material discrepancy. 

11See, e.g., SEC v. Donald Anthony Walker 

Young, et al., Litigation Release No. 21006 (Apr. 20, 

2009) (complaint alleges registered investment 

adviser and its principal misappropriated in excess 

of $23 million, provided false account statements to 

investors in limited partnership, and provided false 

custodial statements to limited partnership’s 

introducing broker); SEC v. Isaac I. Ovid, et al., 

Litigation Release No. 20998 (Apr. 14, 2009) 

(complaint alleges that defendants, including 

registered investment adviser and manager of 

purported hedge funds, misappropriated in excess 

of $12 million); SEC v. The Nutmeg Group, LLC, et 

al., Litigation Release No. 20972 (Mar. 25, 2009) 

(complaint alleges that registered investment 

adviser misappropriated in excess of $4 million of 

client assets, failed to maintain client assets with a 

qualified custodian, and failed to obtain a surprise 

examination); SEC v. WG Trading Investors, L.P., et 

al., Litigation Release No. 20912 (Feb. 25, 2009) 

(complaint alleges that registered broker-dealer and 

affiliated registered adviser orchestrated fraudulent 

investment scheme, including misappropriating as 

much as $554 million of the $667 million invested 

by clients and sending clients misleading account 

information); SEC v. Stanford International Bank, et 

al., Litigation Release No. 20901 (Feb. 17, 2009) 

(complaint alleges that the affiliated bank, brokerdealer, and advisers colluded with each other in 

carrying out an $8 billion fraud); SEC v. Bernard L. 

Madoff, et al., Litigation Release No. 20889 (Feb. 9, 

2009) (complaint alleges that Madoff and Bernard 

L. Madoff Investment Securities LLC (a registered 

investment adviser and registered broker-dealer) 

committed a $50 billion fraud). 

Second, the rule requires that an 

adviser with custody of client assets 

have a reasonable belief that the 

qualified custodian holding the assets 

provides account statements directly to 

clients, or investors in pooled 

investment vehicles, at least quarterly.5

Clients can use the statements they 

receive from the qualified custodians to 

compare them with the statements (or 

other information) they receive from 

their advisers to determine whether 

account transactions, including 

deductions to pay advisory fees, are 

proper. An adviser to a pooled 

investment vehicle is not required to 

comply with the rule’s account 

statement delivery requirement if the 

pooled investment vehicle is audited at 

least annually and distributes its 

audited financial statements to investors 

in the pool within 120 days of the end 

of its fiscal year.6

If, however, clients do not receive 

account statements directly from their 

qualified custodians, the adviser must 

itself deliver quarterly account 

statements to clients and engage an 

independent public accountant to verify 

the client assets in a surprise 

examination that must occur at least 

once during each calendar year.7 During 

a surprise examination, an independent 

public accountant generally must (i) 

confirm with the custodian all cash and 

securities held by the custodian, 

including physical examination of 

securities if applicable, and will 

reconcile all such cash and securities to 

the books and records of client accounts 

maintained by the adviser, (ii) verify the 

books and records of client accounts 

maintained by the adviser by examining 

the security records and transactions 

since the last examination and by 

confirming with clients all funds and 

securities in client accounts, and (iii) 

confirm with clients, on a test basis, 

closed accounts or securities or funds 

that have been returned since the last 

examination.8 The results of the 

examination must be reported by the 

accountant to the Commission.9

The surprise examination may 

uncover problems indicating that client 

assets may be at risk. Accordingly, we 

have designed the surprise examination 

requirement to provide timely 

information to the Commission staff in 

the event that the accountant uncovers 

a problem during the examination. 

Under the existing rule, the accountant 

must notify our Office of Compliance 

Inspections and Examinations within 

one business day of finding any material 

discrepancies during an examination.10

II. Discussion 

In recent months, the Commission has 

brought several enforcement actions 

against investment advisers and brokerdealers alleging fraudulent conduct, 

including misappropriation or other 

misuse of investor assets.11 The 

Commission is intensively investigating 

this conduct, including the role of the 

investment advisers, broker-dealers, and 

individuals that may have participated 

in the conduct. We continue to work 

with criminal authorities and other 

Federal and State regulators to see that 

the full weight of the law is brought to 

bear on any advisers and broker-dealers 

that are found to have betrayed investor 

trust and confidence. In addition, our 

staff is conducting examinations of 

broker-dealer and adviser custodial 

practices designed to evaluate whether 

the assets entrusted to these firms are 

appropriately accounted for and that the 

firms have in place controls reasonably 

designed to prevent the theft, 

misappropriation or other misuse of 

investor assets. 

We also are undertaking a 

comprehensive review of the rules 

regarding the safekeeping of investor 

assets in order to determine changes we 

might make that would decrease the 

likelihood that client assets are misused, 

or would increase the likelihood that 

fraudulent activities are discovered 

earlier and client losses are thereby 

reduced. We are proposing today for 

comment several revisions to rule 

206(4)–2 under the Advisers Act that are 

designed to improve the safekeeping of 

client assets. 

A. Annual Surprise Examination of 

Client Assets 

1. Application to All Advisers With 

Custody 

The Commission proposes to require 

that all registered investment advisers 

with custody of client assets engage an 

independent public accountant to 

conduct an annual surprise examination 


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25356 Federal Register / Vol. 74, No. 100 / Wednesday, May 27, 2009 / Proposed Rules 

12Proposed rule 206(4)–2(a)(4). Proposed rule 

206(4)–2(c)(3) would define independent public 

accountant as a public accountant that meets the 

standards for independence described in rule 2– 

01(b) and (c) of Regulation S–X. As discussed 

further below, the annual surprise examination 

requirement would be in addition to the 

requirement that the adviser have a reasonable 

belief that qualified custodians deliver account 

statements directly to clients. 

13Adoption of Rule 206(4)–2 under the 

Investment Advisers Act of 1940, Investment 

Advisers Act Release No. 123 (Feb. 27, 1962) [27 

FR 2149 (Mar. 6, 1962)]. In 1997, we amended the 

rule to make it applicable only to advisers who are 

registered, or required to be registered, with the 

Commission. Rules Implementing Amendments to 

the Investment Advisers Act of 1940, Investment 

Advisers Act Release No. 1633 (May 15, 1997) [62 

FR 28112 (May 22, 1997)] at Section II.I.5. 

14See 2003 Adopting Release, at Section II.C. 

15The custody rule provides a limited exception 

to the requirement of maintaining client assets with 

a qualified custodian with respect to mutual fund 

shares and certain privately offered securities. Rule 

206(4)–2(b)(1) and (2). As a result, these securities 

may not be reflected on the qualified custodian’s 

account statements. 

16See supra note 11. 

17The independent public accountant conducting 

a surprise examination would independently verify 

all client funds and securities of which an adviser 

has custody, including those maintained with a 

qualified custodian and those that are not 

maintained with a qualified custodian, such as 

certain privately offered securities and mutual fund 

shares. See supra note 15. 

18Advisers registered with the Commission that 

have authority to deduct advisory fees from client 

assets have custody and are subject to rule 206(4)– 

2, but are not required to report that they have 

custody on Form ADV. See Item 9 of Part 1 of Form 

ADV (‘‘If you are registering or registered with the 

SEC and you deduct your advisory fees directly 

from your clients’ accounts but you do not 

otherwise have custody of your clients’ funds or 

securities, you may answer ‘‘no’’ to Item 9A.(1) and 

9A.(2).’’). This would not change under the 

proposed rule. 

19Rule 206(4)–7 (17 CFR 275.206(4)–7). When we 

adopted rule 206(4)–7 in 2003, we stated that an 

adviser’s compliance policies and procedures 

adopted and implemented under the rule should 

address ‘‘safeguarding of client assets from 

conversion or inappropriate use by advisory 

personnel.’’ See Compliance Programs of 

Investment Companies and Investment Advisers, 

Investment Advisers Act Release 2204 (Dec. 17, 

2003) [68 FR 74714 (Dec. 24, 2003)], at Section 

II.A.1. 

20Proposed rule 206(4)–2(b)(3). 

21See AICPA Investment Company Audit and 

Accounting Guide, May 1, 2008. 

22Section 17(e)(1)(A) [15 U.S.C. 78q(e)(1)(A)] of 

the Exchange Act. 

23Exchange Act Rule 17a–5(g) [17 CFR 240.17a5(g)]. 

24 Id. 

of client assets.12 When we adopted the 

custody rule in 1962, each adviser with 

custody of client securities or funds was 

required by rule 206(4)–2 to engage an 

independent public accountant to 

conduct an annual surprise 

examination.13 In 2003, we amended the 

rule to eliminate the annual surprise 

examination with respect to client 

accounts for which the adviser has a 

reasonable belief that ‘‘qualified 

custodians’’ provide account statements 

directly to clients.14 We believed that 

direct delivery of account statements by 

qualified custodians would provide 

clients confidence that any erroneous or 

unauthorized transactions would be 

reflected and, as a result, would be 

sufficient to deter advisers from 

fraudulent activities.15

We have decided to revisit the 2003 

rulemaking in light of the significant 

enforcement actions we have recently 

brought alleging misappropriation of 

client assets.16 We believe that a 

surprise examination by an independent 

public accountant would provide 

‘‘another set of eyes’’ on client assets, 

and thus additional protection against 

their misuse. 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.17 Therefore, we 

propose to require all registered 

investment advisers with custody of 

client assets to obtain an annual 

surprise examination regardless of 

whether a qualified custodian directly 

provides statements to clients or, in the 

case of a pooled investment vehicle, the 

pool is audited at least annually and 

distributes its audited financial 

statements to its limited partners (or 

other investors) within 120 days of the 

end of its fiscal year. We are proposing 

a number of additional enhancements to 

the rule, discussed below, including 

additional adviser and accountant 

reporting requirements and independent 

review of custody controls in certain 

circumstances, that we believe would 

improve the utility of the surprise 

examination requirement and address 

some of the concerns we had in 2003. 

We request comment on our proposal 

to require investment advisers with 

custody of client assets to undergo an 

annual surprise examination. Would an 

annual surprise examination increase 

protections afforded to advisory clients, 

including pooled investment vehicles 

(and the investors in those vehicles)? 

Should we except from the surprise 

examination requirement advisers that 

have custody of client funds or 

securities solely as a result of their 

authority to withdraw advisory fees 

from client accounts? 18 Is this form of 

custody, which is common to advisers 

with discretionary authority, less likely 

to be subject to abuse? Should we 

instead specify requirements or 

restrictions regarding withdrawing fees 

from client accounts? If so, what should 

they be? Are there alternatives to the 

surprise examination that might provide 

similar protections, or are there 

additional requirements that we should 

also consider? For example, should we 

instead (or also) amend rule 206(4)–7, 

which requires advisers to adopt 

compliance policies and procedures 

administered by a chief compliance 

officer, to require that the chief 

compliance officer submit a certification 

to us on a periodic basis that all client 

assets are properly protected and 

accounted for on behalf of clients? 19

Should we specify certain minimum 

procedures that each chief compliance 

officer should implement to assure 

herself that all client assets are properly 

protected and accounted for? Given the 

variety of custodial arrangements, is it 

feasible for us to specify minimum 

requirements? Should the rule require 

surprise examinations to be conducted 

more frequently than annually or, 

alternatively, on a regular periodic 

basis, e.g., semi-annually? 

Many advisers have custody as a 

result of serving as a general partner (or 

in some other capacity) of a limited 

partnership or other form of pooled 

investment vehicle. The proposed rule 

would continue to except advisers from 

the requirement to have a qualified 

custodian send account statements with 

respect to a pooled investment vehicle 

that is audited at least annually and 

distributes its audited financial 

statements to its limited partners (or 

other investors) within 120 days of the 

end of its fiscal year.20 It would not, 

however, except such advisers from the 

surprise examination requirement. The 

annual audit serves a similar purpose as 

the surprise examination because it 

involves a verification process, although 

it is not required to cover all funds or 

securities.21 Should we continue to 

except advisers from the surprise 

examination requirement with respect 

to client assets held in pooled vehicles 

that are audited at least annually? 

As explained above, the proposed rule 

would require all registered advisers 

that have custody of client assets, 

including advisers that are also 

registered as broker-dealers and thus are 

permitted to act as qualified custodians 

for their clients’ assets, to obtain an 

annual surprise examination. Under the 

Exchange Act, a broker-dealer’s 

financial statements must be audited 

annually by a registered public 

accounting firm.22 This audit must 

include a review of the broker-dealer’s 

procedures for safeguarding securities.23

The scope of this review must be 

sufficient for the auditor to provide 

reasonable assurance that material 

inadequacies do not exist in a brokerdealer’s procedures for safeguarding 

securities.24 Would the surprise 


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25See supra note 8. 26See Nature of Examination Required to be 

Made of All Funds and Securities Held in Custody 

of Investment Advisers and Related Accountant’s 

Certificate, supra note 8. 

27Proposed rule 206(4)–2(a)(4). The written 

agreement would also require, in accordance with 

the current requirements of rule 206(4)–2, the 

independent public accountant to perform the 

surprise examination. The current rule does not 

specifically require that the adviser enter into a 

written agreement with the independent public 

accountant. Rule 206(4)–2(a)(3)(ii)(B) and (C). 

Advisers would have to keep these written 

agreements under rule 204–2(a)(10) [17 CFR 

275.204–2(a)(10)] as they would be written 

agreements that an adviser enters into in its 

business as such. The obligation to maintain the 

records would 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. 

28Rule 206(4)–2(b)(3). 

29Proposed rule 206(4)–2(a)(4)(iii). Similarly, we 

require companies registered under Section 12 or 

15(d) of the Exchange Act to file with us, within 

four business days of the dismissal or resignation 

of their auditors, a Form 8–K containing 

information relating to the circumstances under 

which the auditor was terminated, whether the 

auditor had issued any adverse reports about the 

company, whether there had been any 

disagreements between the company and the 

auditor and certain other information. The former 

auditor must respond in a publicly available 

document whether it agrees with the company’s 

statement. Form 8–K, Current Report, Item 4.01, 17 

CFR 249.308; Changes In and Disagreements With 

Accountants on Accounting and Financial 

Disclosure, Regulation S–K, Item 304, [17 CFR 

229.304]. We also require broker-dealers registered 

with us to file a notice with us within 15 business 

days of the dismissal or resignation of their 

auditors. In the notice, the broker-dealer must, 

among other things, disclose any problem in the 

past two years of which, if not resolved, the former 

auditor would have to make reference in its report 

and state whether the former auditor’s report of the 

past two years contained any adverse or qualified 

opinion or any disclaimer of opinion. The brokerdealer must attach to its notice the former auditor’s 

statement as to whether it agrees with the brokerdealer’s disclosure. See rule 17a–5(f)(4) under the 

Exchange Act. We have chosen the four business 

day standard to provide us with notice of potential 

problems with an investment adviser’s custody of 

Continued 

examination’s ‘‘verification’’ of client 

assets provide additional protection for 

clients of advisers that are also brokerdealers? Do the custody obligations for 

banks present the same issues if an 

adviser is also a bank and maintains 

custody of client assets? Instead of 

requiring a surprise examination for 

advisers that also act as the qualified 

custodian for their clients’ assets, 

should we instead consider a different 

approach, such as requiring these 

advisers to segregate custodial duties 

from advisory duties and implement 

additional internal controls to protect 

client assets? 

We also request comment on whether 

we should revise or expand the 

guidance we have provided regarding 

the surprise examination.25 For 

example, are there other procedures an 

accountant should perform as part of a 

surprise examination? Should we 

require an accountant to perform testing 

on the valuation of securities, including 

privately offered securities, as part of a 

surprise examination? Should we 

require an adviser to certify a listing of 

funds and securities and client accounts 

that were examined by the accountant 

as part of the surprise examination? Are 

there any procedures currently required 

to be performed as part of a surprise 

examination that are no longer 

necessary? If so, what procedures and 

why are they no longer necessary? For 

example, is confirming all client 

balances necessary to adequately protect 

investors? If not, what extent of 

confirmation would be appropriate? Are 

there any procedures currently required 

to be performed as part of a surprise 

examination that should be clarified? If 

so, how should they be clarified? Have 

investment advisers’ custodial practices 

or operations changed such that we 

should revise our existing guidance on 

performing the surprise examination? 26

If so, what revisions should we make? 

If the proposed rule is adopted and a 

greater variety of advisers become 

subject to the rule’s surprise 

examination requirement, should we 

provide additional guidance to assist 

different types of advisers and their 

accountants in complying with the 

surprise examination requirement? If so, 

what additional guidance should we 

provide? 

2. Commission Reporting 

We propose to amend rule 206(4)–2 to 

require investment advisers subject to 

the rule to enter into a written 

agreement with an independent public 

accountant to conduct the surprise 

examination requiring the accountant, 

among other things, to notify the 

Commission within one business day of 

finding material discrepancies, and to 

submit Form ADV–E to the Commission 

accompanied by a certificate within 120 

days of the time chosen by the 

accountant for the surprise examination, 

stating that it has examined the funds 

and securities and describing the nature 

and extent of the examination.27 The 

accountant’s certificate describing the 

nature and extent of the examination 

assists the Commission’s examination 

staff in identifying and assessing risks 

raised by the investment adviser’s 

custodial practices and in determining 

the scope of the Commission staff’s 

examination of an investment adviser. 

The reporting by the independent 

public accountant of a material 

discrepancy provides the Commission’s 

examination staff with notice of a 

possible problem with the investment 

adviser’s custodial practices. Should we 

require additional information be 

included in the accountant’s certificate? 

Although we are not proposing to 

change the requirement, is the term 

‘‘material discrepancy,’’ as used in the 

context of a surprise examination, 

widely understood by independent 

public accountants? If not, should we 

define the term or provide guidance as 

to the requirement? Should we require 

the accountant’s certificate to be 

provided to clients or investors in 

pooled investment vehicles? 

Currently, the custody rule requires 

that the accountant that performs the 

surprise examination file Form ADV–E 

with the Commission within 30 days of 

the completion of the examination 

stating that it has examined the funds 

and securities and describing the nature 

and extent of the examination. Our 

examination staff has found that an 

adviser’s surprise examination may 

sometimes continue for an extended 

period of time. We propose to amend 

the rule to require that the accountant 

instead file Form ADV–E within 120 

days of the time chosen by the 

accountant for the surprise examination. 

As described above, 120 days is the 

period of time in which a pooled 

investment vehicle managed by an 

adviser relying on the rule’s annual 

audit exception must distribute its 

audited financial statements to investors 

in the pool.28 Accordingly, we believe 

120 days should be sufficient time for 

an accountant to complete a surprise 

examination and file Form ADV–E. 

Would this change create any 

difficulties for the accountant or the 

adviser to comply with the filing 

requirement? Is 120 days reasonable for 

all types of advisers? If not, what time 

limit should we require for the surprise 

examination? 

In addition, we propose that the 

written agreement require the 

independent public accountant to 

submit Form ADV–E to the Commission 

within four business days of its 

resignation, dismissal from, or other 

termination, of the engagement, or upon 

removing itself or being removed from 

consideration for being reappointed, 

accompanied by a statement that 

includes (i) the date of such resignation, 

dismissal, removal, or other 

termination, 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 

resignation, dismissal, removal, or other 

termination (‘‘termination 

statement’’).29 This information would 


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client funds or securities at an earlier time to allow 

our staff to take prompt action if necessary. 

30The IARD system will not be able to accept 

electronic filings of Form ADV–E until it is 

upgraded with this function. If the proposed 

amendments are adopted, it is possible that 

accountants performing surprise examinations may 

have to continue paper filing of Form ADV–E for 

a period of time until the IARD system has been 

upgraded. Public access to these filings would be 

made available on our Web site through the 

Investment Adviser Public Disclosure system 

(IAPD). 

31 ‘‘Privately offered securities’’ are defined by 

rule 206(4)–2(b)(2) 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. The proposed 

rule would retain this definition. 

32 Id. 

33Ownership of private securities is recorded 

only on the books of the issuer, which poses 

difficulties to maintain them in accounts with 

qualified custodians. See 2003 Adopting Release, at 

Section II.B. 

34Proposed rule 206(4)–2(c)(2) (defining 

‘‘custody’’). 

35Proposed rule 206(4)–2(c)(6) (defining ‘‘related 

person’’). 

36Proposed rule 206(4)–2(c)(1) (defining 

‘‘control’’). Form ADV [17 CFR 297.1] also uses the 

same definition. 

37Today, an adviser may, for example, have 

custody if its related person holds assets of the 

adviser’s clients and the adviser either controls the 

related person’s operations or has access to the 

client assets through the related person. See section 

208(d) of the Advisers Act [15 U.S.C. 80b–8(d)] (an 

adviser may not, indirectly or through or by any 

other person, do any act or thing that would be 

unlawful for the adviser to do directly). 

38Rule 206(4)–2(c)(1) (defining ‘‘custody’’). 

39See 2003 Adopting Release at n.4 (citing 

Crocker Investment Management Corp., SEC Staff 

No-Action Letter (Apr. 14, 1978)). Our staff would 

withdraw this no-action letter if we adopt the 

proposed amendment. 

40Cf. Rule 206(4)–4(b) (establishing a rebuttable 

presumption that certain legal or disciplinary 

events are material and therefore must be disclosed 

to clients). 

41See, e.g., Financial and Disciplinary 

Information That Investment Advisers Must 

Disclose to Clients, Investment Advisers Act 

Release No. 1083 (Sept. 25, 1987) [52 FR 36915 

(Oct. 2, 1987)] (discussing factors an adviser should 

consider in assessing the presumption that certain 

disciplinary information is material and therefore 

should be disclosed to clients). 

permit our staff to compare information 

provided by the adviser with the 

perspective of the accountant, and to 

further evaluate the need for an 

examination of the adviser to determine 

whether client assets are at risk. We 

request comment on this proposed filing 

requirement. Is this the right standard 

for notification of potential problems or 

disagreements between an adviser and 

its independent public accountant 

performing the surprise examination? Is 

it too broad? Too narrow? Is there more 

information that should be required in 

this notification? If so, what additional 

information should be required? Is the 

required explanation of the reason for 

the withdrawal sufficient? Should this 

notification requirement provide for 

more detailed standards such as those 

included in Item 304(a)(1) of Regulation 

S–K with respect to a change in an 

issuer’s independent public accountant? 

We propose to have accountants file 

Form ADV–E with us electronically, 

through the Investment Adviser 

Registration Depository (‘‘IARD’’), 

which would enhance our ability to use 

the information by, for example, 

comparing information provided by 

advisers and their independent public 

accountants and thus to identify 

potential custodial risks. We currently 

are working with our contractor to 

develop changes to the IARD system 

that would permit it to accept Form 

ADV–E and allow us to make the filings 

available through our Web site.30 We 

request comment on whether we should 

require that Form ADV–E be filed 

electronically, and whether we should 

make the accountant’s termination 

statement publicly available. 

3. Privately Offered Securities 

We also propose to amend the rule to 

make privately offered securities that 

investment advisers hold on behalf of 

their clients subject to the surprise 

examination requirement.31 Currently, 

privately offered securities are excluded 

from all aspects of the custody rule.32

While it may not be practical to require 

that these securities in all cases be held 

by a qualified custodian,33 we believe 

subjecting these securities to the 

surprise examination would provide 

greater assurance that such securities 

are properly safeguarded in furtherance 

of the purposes of the rule. We request 

comment on the feasibility of requiring 

that advisers obtain a surprise 

examination with respect to privately 

offered securities. 

B. Custody by Adviser and Its Related 

Persons 

1. Custody by Related Persons 

The Commission proposes to amend 

rule 206(4)–2 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.34 A ‘‘related 

person’’ would be a person directly or 

indirectly controlling or controlled by 

the adviser and any person under 

common control with the adviser.35 For 

purposes of this definition we would 

define ‘‘control’’ as the power, directly 

or indirectly, to direct the management 

or policies of a person, whether through 

ownership of securities, by contract, or 

otherwise.36 As a result, the protections 

of the rule would be afforded to clients 

when their funds and securities are not 

held with an independent custodian, 

but rather with the adviser itself or 

indirectly through a related person.37

Under rule 206(4)–2, an adviser has 

custody of client assets if it holds, 

directly or indirectly, client funds or 

securities or has any authority to obtain 

possession of them.38 In our release 

adopting the 2003 amendments to rule 

206(4)–2, we explained that an adviser 

may have custody of client assets under 

circumstances in which the adviser or 

its personnel have access to those client 

assets through a related person, and 

cited one of our staff interpretive letters 

that set forth factors the staff will 

consider in determining whether an 

adviser has ‘‘indirect’’ custody of client 

assets.39 The proposed amendments 

would simply deem advisers whose 

‘‘related persons’’ hold client assets to 

have custody under the rule if those 

assets are held by the related person in 

connection with the advisory services 

provided by the adviser. We believe that 

the risks to advisory clients that arise as 

a result of a related person’s ability to 

obtain client assets, regardless of the 

separation between the adviser and a 

related person, may be substantial 

enough to require the adviser to comply 

with the custody rule. The ‘‘in 

connection with’’ limitation of the 

proposed rule is designed to prevent an 

adviser from being deemed to have 

custody of client assets held by a related 

person broker-dealer (or other qualified 

custodian) with respect to which the 

adviser does not provide advice. 

Should we deem an adviser to have 

custody if its related persons hold assets 

in connection with the adviser’s 

advisory services? Are there 

circumstances where a related person’s 

custody of client assets should not be 

imputed to the adviser? If so, should the 

rule contain a rebuttable presumption 

that an adviser has custody if any of its 

related persons have custody of 

advisory client assets? 40 What factors, if 

any, should we identify for advisers to 

consider when assessing whether the 

presumption can be rebutted? 41

2. Internal Control Report and PCAOB 

Registration and Inspection 

The Commission also proposes to 

amend rule 206(4)–2 to require 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 


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42Proposed rule 206(4)–2(a)(6). A report on the 

description of controls placed in operation and tests 

of operating effectiveness (commonly referred to as 

a ‘‘Type II SAS 70 Report’’) conducted in 

accordance with PCAOB standards would be 

sufficient for purposes of satisfying the 

requirements of the internal control report. See AU 

324 Service Organizations of the PCAOB interim 

standards. 

43Proposed rule 204–2(a)(17)(iii). See 17 CFR 

275.204–2. 

44See supra note 11. 

45 In addition to the specific procedures an 

independent public accountant must follow during 

a surprise examination, the accountant should 

perform any additional audit procedures it deems 

necessary under the circumstances. See Nature of 

Examination Required to be Made of All Funds and 

Securities Held in Custody of Investment Advisers 

and Related Accountant’s Certificate, supra note 8. 

46Proposed rule 206(4)–2(a)(6). 

47See supra note 42. 

48Proposed rule 206(4)–2(a)(6). 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 

proposed 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 Rule 4003 

of the PCAOB’s Bylaws and Rules, effective 

pursuant to Exchange Act Release No. 56738, File 

No. PCAOB–2006–03 (Nov. 2, 2007) and Exchange 

Act Release No. 49787, File No. PCAOB–2003–08 

(Jun. 1, 2004). 

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 

(‘‘internal control report’’), which 

includes an opinion from an 

independent public accountant 

registered with, and subject to regular 

inspection by, the Public Company 

Accounting Oversight Board 

(‘‘PCAOB’’), with respect to the 

adviser’s or related person’s controls 

relating to custody of client assets.42

The adviser would be required to 

maintain the internal control report in 

its records and make it available to the 

Commission or its staff upon request.43

We are proposing this addition to the 

rule because we believe maintaining 

client assets with the adviser or a 

related person instead of with an 

independent custodian can present 

higher risks to advisory clients. Indeed, 

several of the recent enforcement 

actions we have brought alleging 

misappropriation of client assets by 

investment advisers have involved 

advisers or related persons that 

maintained client assets.44 While 

advisers that are themselves, or use 

related persons that are, qualified 

custodians would be required to obtain 

a surprise examination, the utility of the 

surprise examination may be limited 

because the independent public 

accountant seeking to verify client 

assets may have to rely on custodial 

reports issued by the adviser or its 

related person. Because of the 

relationship between the adviser and 

the custodian, we believe that there is 

a greater risk that the custodian could be 

a party to any fraud and therefore the 

custodian’s reports could be 

compromised. Requiring these advisers 

to also obtain an internal control report 

would provide an additional check on 

the safeguards relating to client assets 

held by the adviser or the related person 

qualified custodian. 

An internal control report could also 

significantly strengthen the utility of the 

surprise examination when the adviser 

or a related person custodian maintains 

client assets because the independent 

public accountant performing the 

surprise examination could obtain 

additional comfort that confirmations 

received from the qualified custodian in 

the course of the surprise examination 

are reliable and, where a broker-dealer 

is the qualified custodian, may be able 

to leverage existing tests performed in 

compliance with broker-dealer auditing 

and internal control requirements. The 

internal control report may also reveal 

control problems, which could be 

significant.45 Thus, the requirement to 

obtain an internal control report informs 

the surprise examination process and 

may itself act as a deterrent to advisers 

that may consider misappropriating 

client assets directly or through a 

related person in the guise of providing 

custodial services as a qualified 

custodian. 

The proposed amendments would 

require that the internal control report 

include an opinion of an independent 

public accountant registered with, and 

subject to regular inspection by, the 

PCAOB, that is issued in accordance 

with the standards of the PCAOB, with 

respect to the description of controls 

placed in operation relating to custodial 

services, including the safeguarding of 

cash and securities held by either the 

adviser or a related person on behalf of 

the adviser’s clients, and tests of 

operating effectiveness.46 In addition, 

the internal control report would also 

contain a description of the relevant 

controls, the control objectives and 

related controls, and the independent 

public accountant’s tests of operating 

effectiveness that were performed and 

the results of those tests.47

Opinions provided in reports on 

controls over custodial services 

conducted in accordance with PCAOB 

standards address control objectives 

relevant to the custodial operations, as 

well as the general control environment 

and information systems. Control 

objectives relevant to custodial 

operations might include: 

• Physical securities are safeguarded 

from loss or misappropriation; 

• Cash and security positions are 

reconciled accurately and on a timely 

basis between the custodian and 

depositories, and between the custodian 

and accounting systems; 

• Client-initiated trades are properly 

authorized and recorded completely and 

accurately in the client account; 

• Securities income and corporate 

action transactions are processed to 

client accounts in an accurate and 

timely manner; 

• Net settlement procedures for 

delivery and receive transactions are 

performed accurately; 

• Documentation for the opening of 

accounts is received and authenticated, 

and established completely and 

accurately on the applicable system; and 

• Market values of securities obtained 

from various outside pricing sources 

have been recorded accurately in client 

accounts. 

We are proposing that the 

independent public accountant issuing 

the internal control report be registered 

with, and subject to regular inspection 

by, the PCAOB, in accordance with the 

rules of the PCAOB.48 We believe that 

registration and the periodic inspection 

of an independent public accountant’s 

overall quality control system by the 

PCAOB will provide us greater 

confidence in the quality of the internal 

control report. 

We request comment on whether we 

should require advisers that serve, or 

have related persons that serve, as 

qualified custodians for client funds and 

securities to obtain or receive an 

internal control report. Would this 

requirement provide additional 

protections for clients? How would the 

timing of the internal control report 

relate to the timing of the surprise 

examination? Does it make sense to 

require both an internal control report 

and a surprise examination? Would 

these requirements be duplicative? If so, 

in which respects? Should we require 

that the independent public accountant 

that performs the surprise examination 

be a different accountant than the 

accountant that prepares the internal 

control report? Should we require that 

the independent public accountant that 

prepares the internal control report be 

registered with the PCAOB? If so, 

should we require that the independent 

public accountant also be subject to 

regular inspection by the PCAOB? 

Would the requirement of using 

independent public accountants 

registered with, and subject to regular 


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49Proposed rule 206(4)–2(a)(6)(i). 50Cf. SEC v. David G. Friehling, C.P.A., et al., 

Litigation Release No. 20959 (Mar. 18, 2009) 

(Commission charged auditors with fraud alleging, 

among other things, that auditors misrepresented 

that the financial statements of Bernard L. Madoff 

Investment Securities LLC (BMIS) were audited 

pursuant to Generally Accepted Auditing 

Standards, including the requirements to maintain 

auditor independence and perform audit 

procedures regarding custody of securities; did not 

perform a meaningful audit of the BMIS; and did 

not perform procedures to confirm that the 

securities BMIS purportedly held on behalf of its 

customers even existed). 

51See American Institute of Certified Public 

Accountants, Audit and Accounting Guide: 

Investment Companies § 2.160 Footnote 47 (May 1, 

2008), which requires confirmation of security 

holdings with the highest-level of unaffiliated 

subcustodian in connection with examinations 

performed pursuant to rule 17f–2 of the Investment 

Company Act of 1940 [17 CFR 270.17f–2]. 

52See 2003 Adopting Release at Section II.B. 53See 2002 Proposing Release at Section II. 54According to Lipper’s LANA Database, more 

than 95 percent of registered open-end investment 

company assets are held in custody at a bank or 

trust company (based on Dec. 31, 2008 data). 

inspection by, the PCAOB increase the 

costs to obtain these reports or make it 

too difficult to obtain a qualified 

accounting firm to provide an internal 

control report? Have we provided 

sufficient guidance for the independent 

public accountants that will produce 

these reports? Should we require that 

specific control objectives be addressed 

within the internal control report? If so, 

what control objectives? Would 

obtaining or receiving an internal 

control report present additional issues 

if an adviser, or its related person, that 

acts as qualified custodian for client 

assets is located outside of the United 

States? Would the requirement that the 

independent public accountant be 

registered with, and subject to regular 

inspection by, the PCAOB make it more 

difficult for such advisers or their 

related persons to engage an accountant 

to prepare the internal control report? 

3. Surprise Examination and PCAOB 

Registration 

We also are proposing to require that 

when an adviser or a related person 

serves as a qualified custodian for the 

adviser’s clients’ funds or securities, the 

surprise examination discussed above 

be performed by an independent public 

accountant registered with, and subject 

to regular inspection by, the PCAOB, in 

accordance with the rules of the 

PCAOB.49 We are proposing this 

requirement because, as discussed 

above, we believe PCAOB registration 

and inspection will provide us greater 

confidence in the quality of the 

examination performed by the 

independent public accountant, which 

is even more important when an adviser 

or its related person, rather than an 

independent custodian, maintains client 

funds or securities.50

We request comment on this proposed 

amendment to the rule. Should we 

require that the independent public 

accountant performing the surprise 

examination of an adviser that serves, or 

whose related person serves, as a 

qualified custodian be registered with 

the PCAOB and subject to its 

inspection? Should we instead require 

all surprise examinations under the rule 

to be conducted by independent public 

accountants registered with, and subject 

to regular inspection by, the PCAOB? 

Does requiring the independent public 

accountant to be PCAOB-registered and 

inspected provide meaningful quality 

assurance for surprise examinations? 

Would the requirement of using a 

PCAOB-registered and inspected 

independent public accountant increase 

the costs to obtain these examinations or 

make it difficult to obtain a qualified 

accounting firm to conduct the 

examination? Would the requirement of 

using a PCAOB-registered and inspected 

independent public accountant 

disproportionally impact small 

accounting firms or small investment 

advisers? 

If we require the independent public 

accountants that prepare the internal 

control report and perform the surprise 

examination to be registered with, and 

subject to regular inspection by, the 

PCAOB, should we also consider a 

similar revision to the current rule’s 

audit exception for certain pooled 

investment vehicles? Specifically, 

should we require, as a condition of the 

adviser’s reliance on the audit exception 

when the adviser or its related person 

serves as qualified custodian for funds 

or securities of the pool, that the 

independent public accountant that 

performs the audit of the pooled 

investment vehicle’s financial 

statements be registered with, and 

subject to regular inspection by, the 

PCAOB? Would advisers to offshore 

pools find it too difficult to engage an 

auditor that is PCAOB-registered and 

inspected? Should we instead, or in 

addition, require the independent 

public accountant, as part of the 

surprise examination, to confirm 

security holdings with the highest-level 

unaffiliated subcustodian (e.g., 

Depository Trust Company) in addition 

to confirming the security holdings with 

the qualified custodian, similar to the 

requirements for auditors performing 

examinations for advisers to registered 

investment companies that are deemed 

to have custody pursuant to rule 17f–2 

of the Investment Company Act of 

1940? 51

4. Independent Qualified Custodians 

We request comment on whether, as 

an alternative to our proposal to impose 

additional conditions on advisers that 

serve as, or have related persons that 

serve as, qualified custodians for client 

assets, we should simply amend rule 

206(4)–2 to require that an independent 

qualified custodian hold client assets. 

The use of a custodian not affiliated 

with the adviser would address the 

conflict, and potentially greater risks to 

client assets, that may be presented 

when an adviser or its related person 

acts as custodian for client assets. 

When we amended rule 206(4)–2 in 

2003 to require that advisers with 

custody of client funds or securities 

maintain those assets with a qualified 

custodian, we acknowledged that the 

rule would permit advisers that are also 

qualified custodians to hold their 

clients’ assets or to maintain them with 

related persons that are qualified 

custodians.52 Most qualified custodians 

are banks and broker-dealers, which are 

subject to extensive regulation and 

oversight of their custodial practices, 

and we did not believe that permitting 

advisers to maintain securities with 

them presented additional custodial 

risk.53

We are interested in exploring the 

practical aspects of requiring, as an 

alternative to some or all of the 

amendments we are today proposing, an 

independent qualified custodian. For 

example, such a requirement could 

preclude a broker-dealer that is subject 

to rule 206(4)–2, i.e., is also a registered 

investment adviser, from providing 

advisory services to a brokerage 

customer unless the customer held 

securities over which the adviser had 

discretionary authority in a brokerage 

account at another brokerage firm, or in 

a custodial account at a bank or other 

qualified custodian. While institutional 

investors such as mutual funds often 

hold securities and cash in custodial 

accounts,54 would the use of custodial 

accounts be too costly for small advisory 

clients? Would they be consistent with 

the operation of certain types of 

combined advisory and brokerage 

accounts, such as wrap fee programs? 

We request comment on the practical 

aspects of requiring advisers that have 

custody to maintain client assets with 

an independent qualified custodian. 

Would the requirement of using an 

independent qualified custodian result 

in greater costs? If yes, would the 

additional custodial protections for 

client assets afforded by an independent 

qualified custodian warrant the 

additional costs? Would the 


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55Proposed rule 206(4)–2(a)(3). An adviser to a 

limited partnership or other pooled investment 

vehicle that is subject to an annual audit and that 

distributes its financial statements to investors 

would remain excepted from the account statement 

delivery requirement with respect to assets held by 

the pool. Proposed rule 206(4)–2(b)(3). 

56Rule 206(4)–2(a)(3)(ii). 

57See 2002 Proposing Release at Section II.C. See 

also 2003 Adopting Release at Section II.C. 

(recognizing that certain advisers had presented 

reasons for allowing a direct delivery exception, 

and citing Section II.C. of the 2002 Proposing 

Release). 

58An ‘‘independent representative’’ is a person 

that (i) acts as agent for an advisory client and by 

law or contract is obligated to act in the best interest 

of the advisory client; (ii) does not control, is not 

controlled by, and is not under common control 

with the adviser; and (iii) does not have, and has 

not had within the past two years a material 

business relationship with the adviser. Rule 206(4)– 

2(c)(2) [unchanged as proposed rule 206(4)–2(c)(4)]. 

59See Section II.C. of the 2003 Adopting Release. 

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. 

60We also note that with respect to individual 

clients who obtain custodial services for their 

personal, family or household purposes, a U.S. 

qualified custodian would be subject to the 

limitations on information sharing in the privacy 

rules adopted pursuant to Title V of the GrammLeach-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). Under these privacy rules, a qualified 

custodian would be prohibited from sharing the 

advisory client’s personal information with 

nonaffiliated third parties (other than under an 

exception) unless the custodian first provides the 

client with a notice explaining its information 

sharing practices and the opportunity to opt out of 

the information sharing and the client does not opt 

out. See, e.g., 17 CFR 248.10(a)(1). 

61There are a number of ways advisers could 

satisfy the ‘‘due inquiry’’ requirement. For example, 

in the 2003 Adopting Release, we explained that an 

adviser could form this reasonable belief if the 

qualified custodian provides the adviser with a 

copy of the account statement that was delivered to 

the client. See the 2003 Adopting Release at n. 29. 

The receipt of these statements would satisfy the 

‘‘due inquiry’’ requirement. As another example, an 

adviser could satisfy the due inquiry requirement 

if the qualified custodian confirms in writing, 

including sending a fax or an e-mail to the adviser, 

that it has sent account statements to the adviser’s 

clients; such confirmation would need to cover 

each quarter during which the qualified custodian 

is expected to send account statements to the 

clients. 

62Based on the number of Form ADV–Es filed 

with us during 2008, we estimate 190 advisers 

relied on the exception. 

63Proposed rule 206(4)–2(a)(2). 

requirement result in greater burdens on 

advisory clients of firms that are 

registered both as investment advisers 

and broker-dealers or cause them to lose 

access to services or other efficiencies 

they currently receive? Is there any 

reason why the custodial protections 

afforded by the banking laws and our 

rules under the Exchange Act (and the 

rules of the self-regulatory 

organizations) are sufficient to protect 

bank and brokerage customers, but may 

not be sufficient to protect custodial 

accounts of advisory clients? 

C. Delivery of Account Statements and 

Notice to Clients 

The Commission proposes to amend 

rule 206(4)–2 to require registered 

advisers with custody of client funds or 

securities to have a reasonable basis for 

believing that the qualified custodian 

sends an account statement, at least 

quarterly, to each client for which the 

qualified custodian maintains funds or 

securities.55 The amendment would 

eliminate the alternative, currently 

provided in the rule, under which an 

adviser can send reports to clients if it 

undergoes a surprise examination by an 

independent public accountant at least 

annually.56 We permitted the latter 

alternative delivery option because 

some advisers did not wish to disclose 

the names of their clients to custodians 

to prevent a potential competitor from 

having access to their lists of clients, or 

to protect the privacy of some wellknown clients.57

We are proposing to eliminate the 

alternative delivery option and require 

all advisers with custody of client assets 

to have a reasonable belief that the 

qualified custodian delivers account 

statements to advisory clients or their 

representatives (and not through the 

investment adviser).58 We believe that 

direct delivery will provide greater 

assurance of the integrity of those 

account statements, which we now 

believe, in light of recent frauds, is of 

substantially greater value than the 

concerns that led us in 2003 to 

accommodate those advisers that 

wished not to share client names with 

custodians.59 The confidentiality 

concern, we believe, could also be 

addressed in custodial contracts or 

agreements outside of the contract that 

would restrict the custodian’s use of the 

information.60

We are also proposing to amend rule 

206(4)–2 to state that advisers relying on 

the qualified custodian to send account 

statements directly to clients must form 

their reasonable belief that such account 

statements are sent after ‘‘due inquiry.’’ 

Because the effectiveness of the rule 

depends significantly on direct delivery 

of account statements by the qualified 

custodian, we are making it explicit that 

the adviser is obligated under the rule 

to conduct some inquiry to form a 

reasonable belief.61

We request comment on these 

proposed changes to the rule. Should 

we eliminate the alternative delivery 

option in rule 206(4)–2? We understand 

that most advisers do not currently take 

advantage of the alternative delivery 

option, and that this proposal will not 

have a significant effect on a substantial 

number of advisers or clients.62 We 

request comment on our understanding. 

Are there securities for which a 

qualified custodian would not send 

account statements? If so, is this due to 

legal, tax, or practical limitations? Are 

there other alternatives that would 

provide greater assurance of the 

integrity of client account statements? 

Should we include the due inquiry 

requirement in the rule? Should we 

instead specify particular steps an 

adviser must take to seek to determine 

that the qualified custodian sends 

account statements directly to clients? 

We also propose to revise the content 

of the notice advisers are currently 

required to send to clients upon opening 

a custodial account on their behalf. 

Specifically, we propose to require 

advisers to include a statement in the 

notice urging clients to compare the 

account statements they receive from 

the custodian with those they receive 

from the adviser.63 Client review of 

periodic account statements from the 

qualified custodian can enable clients to 

discover improper account transactions 

or other fraudulent activity. Raising 

client awareness of this safeguard at 

account opening could enhance its 

effectiveness. We request comment on 

this notice requirement. Advisers are 

not required by the Advisers Act or 

rules to send their own account 

statements to clients. Should we require 

advisers that have custody and elect to 

send account statements to include a 

legend urging clients to compare the 

information the adviser sends to clients 

with the information reflected in the 

qualified custodian’s account 

statements? Should we require all 

advisers that have custody to deliver 

account statements and include such a 

legend? If so, should we provide 

specific language for the legend? Are 

there other disclosure requirements we 

should consider? 

D. Liquidation Audit 

We are proposing an amendment to 

clarify the provision of the rule that 

exempts advisers from the account 

statement provisions with respect to 

those limited partnerships or other 

pooled investment vehicles that are 

subject to an annual audit and that 

distribute financial statements to 

investors. The proposed amendment 

would clarify the availability of the 

annual audit exception to pooled 


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25362 Federal Register / Vol. 74, No. 100 / Wednesday, May 27, 2009 / Proposed Rules 

64Proposed rule 206(4)–2(b)(3)(ii). 

65Proposed Section 7.A. of Schedule D of Form 

ADV. 

66Proposed Item 9.A.(2) and B(2) of Part 1A of 

Form ADV. This information would only be 

required to be updated when the adviser prepares 

its annual updating amendment. 

67Proposed Item 9.D. of Part 1A of Form ADV. 

68Proposed Item 9.C. of Part 1A of Form ADV. 

69Proposed Item 9.E. of Part 1A of Form ADV. 

This information would only be required to be 

updated when the adviser prepares its annual 

updating amendment. 

70Proposed Section 9.C. of Schedule D of Form 

ADV. 

71Proposed Section 9.D. of Schedule D of Form 

ADV. Proposed Item 7 of Form ADV and Section 

7.A. of Schedule D of Form ADV would require 

advisers to report the same information for an 

affiliated broker-dealer that is a qualified custodian 

for the adviser. See supra note 65 and 

accompanying text. 72These proposed revisions respond in part to 

concerns raised by the Government Accountability 

Office in its August 2007 report on our examination 

program, which concluded that our examination 

staff should continue to assess and refine the risk 

algorithm to enhance the risk assessment process, 

which would include the identification and 

collection of additional data through Form ADV. 

See United States Government Accountability 

Office, Securities and Exchange Commission; Steps 

Being Taken to Make Examination Program More 

Risk-Based and Transparent (August 2007), 

available at http://www.gao.gov/new.items/ 

d071053.pdf. 

73Currently accountants submit Form ADV–E 

and the attached examination certificates to the 

Commission by mail. Electronic filing of Form 

ADV–E would be through the IARD system and 

would begin only when the system is upgraded for 

this function. 

74Proposed rule 206(4)–2(a)(4). 

investment vehicles that liquidate and 

make final distributions other than at 

year end.64 This amendment is designed 

to assure that the proceeds of the 

liquidation are appropriately accounted 

for so that investors can take timely 

steps to protect their rights. Do 

commenters agree with us that this 

clarification would provide additional 

protection to the investors in the pool? 

Are there alternatives to a liquidation 

audit that we should consider that 

would also protect pool investors? 

E. Amendments to Form ADV 

We are proposing several 

amendments to Part 1A and Schedule D 

of Form ADV. The amendments are 

designed to provide more complete 

information about the custody practices 

of advisers registered with the 

Commission, and to provide us with 

additional data to improve our ability to 

identify compliance risks. 

Item 7. Item 7 of Part 1A requires 

advisers to report certain financial 

industry affiliations, including whether 

the adviser has a related person that is 

an investment adviser or a brokerdealer. The item requires an adviser to 

identify on Schedule D of Form ADV 

each related person that is an 

investment adviser, and permits 

advisers to report the names of related 

person broker-dealers. We propose to 

modify Item 7 to require an 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.65

Item 9. Item 9 of Part 1A requires 

advisers to report to us whether they or 

a related person have custody of client 

funds or securities. We propose to 

amend the item to require advisers that 

have custody (or whose related persons 

have custody) of client funds or 

securities to provide additional 

information about their custodial 

practices under rule 206(4)–2. 

Specifically, we propose to amend 

Item 9 of Part 1A to require an adviser 

to report the amount in U.S. dollars of 

client assets and number of clients of 

which it or its related person has 

custody,66 and whether it or its related 

person serves as qualified custodian 

with respect to the adviser’s clients’ 

funds or securities.67 We would also 

add a new subsection that would 

require an adviser with custody to 

report (i) whether a qualified custodian 

sends quarterly account statements to 

investors in pooled investment vehicles 

the adviser manages, (ii) whether the 

financial statements of the pooled 

investment vehicles the adviser 

manages are audited, (iii) whether the 

adviser’s clients’ funds or securities are 

subject to a surprise examination, and 

(iv) whether an independent public 

accountant registered with, and subject 

to regular inspection by, the PCAOB 

prepares an internal control report with 

respect to the adviser or its related 

persons’ custodial services when acting 

as a qualified custodian for advisory 

client funds or securities.68 We also 

propose to amend Item 9 to require 

advisers that are subject to the surprise 

examination to report the month in 

which the last examination 

commenced.69 Last, we propose to 

amend Form ADV: General Instruction 

number 4 to make conforming changes 

to reflect that certain of the proposed 

questions are only required to be 

updated in an adviser’s annual 

amendment. The information we 

propose to collect would improve our 

ability to monitor compliance with the 

custody rule. 

We also propose to amend Schedule 

D of Form ADV by adding items to 

require additional details relevant to an 

adviser’s response to the proposed 

amendments to Item 9 discussed above. 

With respect to accountants, these 

amendments would require advisers to: 

(i) Identify the accountants that perform 

audits or surprise examinations and that 

prepare internal control reports; (ii) 

provide information about the 

accountants, including address and 

PCAOB registration and inspection 

status; (iii) indicate the type of 

engagement (audit, surprise 

examination, internal control report); 

and (iv) indicate whether the 

accountant’s report was unqualified.70

With respect to qualified custodians, 

these amendments would require 

advisers to identify any related person 

that serves as a qualified custodian for 

its clients by reporting the related 

person’s name and address, and indicate 

whether the related person qualified 

custodian is a bank, futures commission 

merchant or foreign financial 

institution.71 This information would 

allow our staff to better monitor 

compliance with the requirements of 

rule 206(4)–2, and, together with other 

data reported on Form ADV, would 

allow our staff to better assess the 

compliance risks of an adviser.72

We request comment on the amended 

items. We understand that the 

additional information we would 

require is readily available to 

investment advisers and should not be 

burdensome to provide. Is our 

understanding correct? Are the new 

questions clear? If not, what changes 

should we make to make them clearer? 

We do not believe that the information 

we propose to require is proprietary 

information the disclosure of which 

would have adverse consequences to the 

adviser or its clients. Are we correct in 

this belief? 

F. Amendments to Form ADV–E 

We are proposing three amendments 

to the instructions to Form ADV–E. 

First, we propose to amend the 

instructions to require that the form and 

the accountant’s examination certificate 

that accompanies it be filed 

electronically with the Commission.73

Second, we propose to amend the 

instructions to reflect the proposed 

requirement that Form ADV–E and the 

examination certificate must be filed 

within 120 days of the time chosen by 

the accountant for the surprise 

examination.74 Third, we propose to 

add an instruction that would 

implement the proposed rule change 

regarding the accountant’s obligation 

under the written agreement with the 

adviser to file Form ADV–E 

accompanied by the termination 

statement, described above, within four 

business days of the accountant’s 

resignation, dismissal, or removal. We 

request comment on these proposed 


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Federal Register / Vol. 74, No. 100 / Wednesday, May 27, 2009 / Proposed Rules 25363 

75 44 U.S.C. 3501 to 3520. 

76The proposed amended rule would deem an 

adviser to have custody if its related persons have 

custody of its client assets in connection with the 

adviser’s advisory services. Proposed rule 206(4)– 

2(c)(2). A related person would be defined as a 

person directly or indirectly controlling or 

controlled by the adviser, and any person under 

common control with the adviser. Proposed rule 

206(4)–2(c)(6). The proposed amended rule would 

require that the surprise examination be performed 

by an independent public accountant registered 

with, and subject to regular inspection by, the 

PCAOB when an adviser or a related person serves 

as a qualified custodian for the adviser’s clients. 

77Based on information filed through the IARD as 

of February 2009. The 9,575 advisers include both 

advisers that have custody of their client assets and 

advisers whose related persons have custody of the 

adviser’s client assets (including advisers that 

answered ‘‘yes’’ to Item 9.A. or B. of Part 1A of 

Form ADV). The number also includes those 

advisers that have discretionary authority over 

client accounts, which we understand 

predominantly reflects arrangements with clients to 

withdraw fees from client accounts. The 9,575 

advisers, however, do not include 42 advisers that 

provide advisory services exclusively to registered 

investment companies (advisers that checked only 

(4) under Item 5.D). Under rule 206(4)–2(b)(4) and 

proposed rule 206(4)–2(b)(4), advisers are not, and 

would not be, subject to the custody rule with 

Continued 

amendments. Are there additional 

changes to Form ADV–E that we should 

consider? 

G. Required Records 

We also are proposing to amend rule 

204–2 to require the adviser to maintain 

a copy of the internal control report that 

an adviser would be required to obtain 

or receive from its related person, 

pursuant to proposed rule 206(4)–2(a)(6) 

for five years from the end of the fiscal 

year in which the internal control report 

is finalized. Requiring an adviser to 

retain a copy of the internal control 

report would provide our examiners 

with important information about the 

safeguards in place at an adviser or 

related person that maintains client 

assets. Information from these reports 

would also assist our staff in assessing 

custody-related risks at a particular 

adviser. We request comment on this 

proposal. Is there any additional 

documentation relating to the internal 

control report that should be maintained 

under rule 204–2? 

III. General Request for Comment 

The Commission requests comment 

on the rule amendments proposed in 

this Release, suggestions for additional 

changes to the existing rules and 

comment on other matters that might 

have an effect on the proposals 

contained in this Release. Commenters 

should provide empirical data to 

support their views. 

IV. Paperwork Reduction Act 

The proposed amendments contain 

several ‘‘collection of information’’ 

requirements within the meaning of the 

Paperwork Reduction Act of 1995,75 and 

the Commission has submitted the 

amendments to the Office of 

Management and Budget (‘‘OMB’’) for 

review in accordance with 44 U.S.C. 

3507(d) and 5 CFR 1320.11. The titles 

for the collections of information are 

‘‘Rule 206(4)–2, Custody of Funds or 

Securities of Clients by Investment 

Advisers,’’ ‘‘Form ADV,’’ and ‘‘Form 

ADV–E, cover sheet for each certificate 

of accounting of client securities and 

funds in the custody of an investment 

adviser,’’ under the Advisers Act. The 

rule and the forms contain currently 

approved collection of information 

numbers under OMB control numbers 

3235–0241, 3235–0049, and 3235–0361, 

respectively. An agency may not 

conduct or sponsor, and a person is not 

required to respond to, a collection of 

information unless it displays a 

currently valid 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 clients’ funds or 

securities. 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. 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. With the exception of an 

accountant’s notification of any material 

discrepancies identified in a surprise 

examination, responses provided to the 

Commission are not kept confidential. 

A. Rule 206(4)–2 

Currently approved burdens. The 

current annual collection of information 

burden approved by OMB for rule 

206(4)–2 is 415,303 hours. Rule 206(4)– 

2 currently requires each registered 

investment adviser that has custody of 

client funds or securities to maintain 

those client assets with a qualified 

custodian. The rule also requires that an 

adviser with custody of client assets 

send quarterly account statements to its 

clients and undergo an annual surprise 

examination unless the adviser has a 

reasonable belief that the qualified 

custodian sends account statements 

directly to its clients at least quarterly. 

In the case of an adviser to a pooled 

investment vehicle, the adviser does not 

have to obtain an annual surprise 

examination and deliver account 

statements to investors if the pooled 

investment vehicle is audited at least 

annually by an independent public 

accountant and distributes its audited 

financials to investors in the pool 

within 120 days of the end of the pool’s 

fiscal year. 

The current approved annual burden 

relating to the requirement to obtain a 

surprise examination and the delivery of 

quarterly account statements by the 

adviser is 21,803 hours. We estimated 

that 204 advisers were subject to the two 

requirements. We estimated that each 

adviser had 670 clients on average and 

that 193 of the 204 advisers were subject 

to the two requirements only with 

respect to 1 percent of their clients and 

the remainder (11 advisers) were subject 

to the two requirements with respect to 

100 percent of their clients. We further 

estimated that each adviser would 

spend 2.5 hours per client in connection 

with delivering quarterly account 

statements to clients and undergoing an 

annual surprise examination pursuant 

to the rule. 

Annual surprise examination. The 

proposed amendments would eliminate 

the option for an adviser that has 

custody of client assets to choose not to 

have a qualified custodian deliver 

quarterly account statements directly to 

clients if the adviser arranges for an 

annual surprise examination verifying 

client assets. The proposed rule also 

would reinstate the requirement for an 

annual surprise examination for (i) 

advisers with custody that currently rely 

on qualified custodians to send account 

statements directly to advisory clients, 

(ii) advisers that custody client assets 

themselves as qualified custodians or 

advisers with client assets held at a 

qualified custodian that is a related 

person,76 and (iii) advisers to audited 

pooled investment vehicles. Thus the 

proposed rule would require all advisers 

that have custody of client funds or 

securities to be subject to an annual 

surprise examination. The proposed 

amendments are designed to enhance 

protections afforded to advisory clients 

by the custody rule. We estimate that 

9,575 out of the 11,272 advisers 

registered with the Commission fall into 

this category.77


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25364 Federal Register / Vol. 74, No. 100 / Wednesday, May 27, 2009 / Proposed Rules 

respect to a client that is a registered investment 

company. 

78Based on the number of advisers that answered 

‘‘yes’’ to Item 9.A. or B. of Part 1A of Form ADV 

(having custody) and checked ‘‘none’’ under Item 

5.D.(6) (clients that are pooled investment vehicles) 

as of February 2009, excluding 42 advisers that 

provide advisory services only to registered 

investment companies (see supra note 77), and 

those advisers that are also registered brokerdealers, banks or futures commission merchants or 

have a related person broker-dealer, bank or futures 

commission merchant that serves as qualified 

custodian, which are accounted for separately in 

the second group. See infra notes 80 and 81 and 

accompanying text. 

79Based on data collected from the IARD (Item 

5.F.(2)(d) and (e) of Form ADV), we estimate that 

on average 85 percent of the client accounts 

managed by these advisers are discretionary 

accounts and the remaining 15 percent are nondiscretionary accounts. We believe that advisers 

have custody due to withdrawal of fees only with 

respect to the discretionary accounts that they 

manage. 

We estimate that each adviser has, on average, 

1,092 clients. This average is based on advisers’ 

responses to Item 5.C. of Part 1A of Form ADV as 

of November 2008, excluding the two advisers that 

reported the largest number of clients. Those 

advisers account for over 51 percent of all advisory 

clients of SEC registrants and not excluding them 

would raise the average client count to 2,265 

clients. These two firms provide advisory services 

primarily over the Internet and we believe that it 

is appropriate to exclude these firms from our 

calculations. 

80There are 139 of these investment advisers 

based on the number of advisers that answered 

‘‘yes’’ to Item 9.A. of Part 1A of Form ADV (having 

custody) and checked Item 6.A.(1), (3), or (6) 

(indicating that the adviser is also a broker-dealer, 

futures commission merchant, commodity pool 

operator, commodity trading advisor, or bank). We 

eliminated advisers that are commodity pool 

operators or commodity trading advisors, by a firm 

by firm search of the National Futures Association 

registration database. 

81We estimate that there are 233 of these 

investment advisers based on a percentage of the 

number of advisers that answered ‘‘yes’’ to Item 9.B. 

of Part 1A of Form ADV (related person custody) 

and checked Item 7.A.(4) or (5) (indicating that the 

adviser has a related person bank or futures 

commission merchant), and answered ‘‘yes’’ to Item 

9.C. of Part 1A of Form ADV that the related person 

that has custody is a registered broker-dealer. 

82Based on the number of advisers that answered 

‘‘yes’’ to Item 9.A. or B. of Part 1A of Form ADV 

(having custody) and checked Item 5 D.(6) 

(indicating that they have pooled investment 

vehicles as clients) as of February 2009, excluding 

those that checked only (6) under Item 5 D. and 

those advisers that are also broker-dealers, banks, or 

futures commission merchants and custody client 

assets or have a related person broker-dealer, bank 

or futures commission merchant that serves as 

qualified custodian, which are accounted for 

separately in the second group. 

83See supra note 79. 

84We estimate that each of these advisers would 

advise, on average, 2 pooled investment vehicles 

with 50 investors in each of the pools. 

85Based on the number of advisers that answered 

‘‘yes’’ to Item 9 A. or B. of Part 1A of (having 

custody) and checked Item 5 D.(6) only (indicating 

that all their clients are pooled investment vehicles) 

as of February 2009 less those advisers that are also 

broker-dealers, banks, or futures commission 

merchants and custody client assets or have a 

related person broker-dealer, bank or futures 

commission merchant that serves as qualified 

custodian, which are accounted for separately in 

the second group. 

86The 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 (checked only (6) under Item 5 D.) as of 

February 2009. We found that 77 percent of these 

advisers had clients in the range of 1–10. We picked 

the middle point of the range for our estimate. The 

estimate of 250 investors per adviser is based on the 

calculation we submitted for the currently approved 

hour burden. 

87 (7,126 x 928 x 0.02) + (372 × 1092 × 0.02) + 

[(1,281 × 928 × 0.02) + (1,281 × 100 × 0.02) + (1,281 

× 2 × 1)] + [(796 × 250 × 0.02) + (796 × 5 × 1)] = 

177,242. 

88 9,575 × 0.25 = 2,394. 

89 177,242 + 2,394 = 179,636. 

90We estimated that 3,148 advisers to pooled 

investment vehicles were subject to this 

information collection under the current rule. We 

further estimated that each adviser had, on average, 

250 investors in the funds it advises, and that each 

adviser spent 0.5 hours per investor annually for 

delivering audited financial statements to its 250 

investors. 3,148 × 250 × 0.5 = 393,500. 

91Based on the number of advisers that answered 

‘‘yes’’ to Item 9 A. or B. of Part 1A of Form ADV 

(having custody) and checked Item 5 D.(6) 

(indicating that they have clients that are pooled 

investment vehicles) as of February 2009. 

We have categorized the estimated 

9,575 advisers that report that they have 

custody of client assets into 4 subgroups 

for purposes of estimating the collection 

of information burden. First, we 

estimate that 7,126 of the 9,575 advisers 

do not have pooled investment vehicles 

as their clients.78 Based on our records 

and staff’s examination experiences, we 

estimate that these advisers would be 

subject to surprise examinations with 

respect to 85 percent of their client 

accounts (or 928 clients per adviser).79

A second group of advisers that have 

custody, totaling 372, are also brokerdealers, banks or futures commission 

merchants,80 or have a related person 

that serves as a qualified custodian for 

advisory clients’ funds or securities.81

We estimate that these advisers would 

be subject to an annual surprise 

examination with respect to 100 percent 

of their clients (or 1,092 clients per 

adviser) based on the assumption that 

all of their clients maintain custodial 

accounts with the adviser or related 

person. A third group of advisers, 

totaling 1,281,82 advise both pooled 

investment vehicles and other clients, 

and would be subject to the surprise 

examination with respect to 85 percent 

of their non-pooled investment vehicle 

clients (or 928 clients per adviser) 83 and 

100 percent of their pooled investment 

vehicle clients (or 2 funds with 100 

investors per adviser).84 A fourth group 

of advisers, totaling 796,85 provide 

advice exclusively to pooled investment 

vehicles and would be subject to the 

surprise examination with respect to 

100 percent of their pooled investment 

vehicle clients (or 5 funds and 250 

investors per adviser).86 We estimate 

that each adviser would spend an 

average of 0.02 hours for each client that 

is not a pooled investment vehicle to 

create a client contact list for the 

independent public accountant. We 

further estimate that the advisers to 

pooled investment vehicles would 

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. These estimates 

would bring the total annual aggregate 

burden in connection with the surprise 

examination to 177,242 hours.87 This 

does not nclude the collection of 

information discussed below, relating to 

the written agreement required by 

paragraph (a)(4) of the custody rule, as 

proposed to be amended. 

Written agreement with accountant. 

Requiring the agreement with the 

independent public accountant that 

performs the surprise examination to be 

in writing and to specify certain duties 

to be performed by the accountant 

should not significantly increase the 

paperwork burden on advisers. 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 accountant in advance. 

We therefore estimate that each adviser 

would spend 0.25 hour to add the 

required provisions to the written 

agreement, with an aggregate of 2,394 

hours for all advisers subject to surprise 

examinations.88 Therefore the total 

annual burden in connection with the 

surprise examination would be 179,636 

hours under the proposed 

amendments.89

Exception for audited pooled 

investment vehicles. The rule currently 

excepts, and the proposed rule would 

continue 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 connection with the required 

distribution of audited financial 

statements is 393,500 hours.90

According to data we obtained from the 

IARD, 2,112 advisers with custody of 

client assets provided advice to pooled 

investment vehicles as of February 

2009.91 Of these 2,112 advisers, we 

estimate that 796 advisers would each 

on average provide advice to five pooled 


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Federal Register / Vol. 74, No. 100 / Wednesday, May 27, 2009 / Proposed Rules 25365 

92See supra note 90. 

93We previously estimated that an adviser would 

spend 0.5 hour 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. 

94 [(796 × 250 × 1 minute) + (1,316 × 100 × 1 

minute)]/60 = 5,510 hours. 

95 5,510 × 0.05 = 276. 

96 5,510 + 276 = 5,786. 

97 393,500 ¥ 5,786 = 387,714. 

98See supra note 90. 

99We assume that advisers have custody solely 

because of deducting fees do not typically open 

custodial accounts on behalf of their clients. 

Excluding those advisers we have 3,617 advisers 

that may be subject to this information collection 

(advisers that answered ‘‘yes’’ to Item 9A. or B. of 

Part 1A. of Form ADV). 100 [3,617 × (1,092 × 0.05) × 10 minutes]/60 = 

(3,617 × 55 (rounded up from 54.60) × 10 minutes)/ 

60 = 33,156 hours. 101 177,242 + 5,786 + 33,156 = 216,184. 

102We believe that the average accounting fee for 

advisers with 85 percent of client accounts subject 

to the surprise examination would not be materially 

different from that for advisers with 100 percent of 

client accounts subject to the surprise examination. 

We consulted with a few accounting firms before 

reaching these estimates, which include the costs of 

the surprise examination and any filing and 

reporting obligations the accountant has with 

respect to the surprise examination. The estimates 

are consistent with the estimates we made in 2002 

and 2003 when last revising rule 206(4)–2. See the 

2002 Proposing Release, at nn.72 and 73, and 

Section VI.A of the 2003 Adopting Release. The 

revised estimate reflects requirements under the 

proposed rule. 

103 $8,100 × 9,575 = $77,557,500. 

104 $77,557,500 ¥ $281,000 = $77,276,500. 

105See infra note 163 for explanation of our 

estimate. 

106We consulted accounting firms that issue 

these reports to prepare this estimate. 

investment vehicles that have a total of 

250 investors.92 We further estimate that 

the remaining advisers, 1,316 advisers, 

would on average each provide advice 

to two pooled investment vehicles that 

have a total of 100 investors. The hour 

burden imposed on the adviser relating 

to the mailing of the audited financial 

statements with respect to each investor 

in the pool should be minimal, and 

could be included with account 

statements or other mailings. We 

overestimated the burden for this 

delivery requirement in the past,93 and 

are now revising it to an estimated 1 

minute per investor for mailing audited 

financial statements. The aggregate 

annual hour burden in connection with 

the distribution of audited financial 

statements would therefore be 5,510 

hours.94

Under the proposed amendments, the 

rule would clarify that an adviser to a 

pooled investment vehicle that is 

relying on the annual audit exception 

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. Based on an 

assumption that 5 percent of pooled 

investment vehicles are liquidated 

annually at a time other than their fiscal 

year-end, this amendment would 

impose an additional burden of 276 

hours per year.95 As a result, the total 

annual hour burden in connection with 

the distribution of audited financial 

statements under the proposed 

amendments would be 5,786 hours.96

This represents a decrease of 387,714 

hours in our estimated burden.97 This 

decrease in burden is primarily due to 

the reduction in the estimated hour 

burden regarding the delivery of audited 

financial statements to each investor 

and the reduction of the total number of 

the advisers subject to the requirement 

from an estimated 3,148 to 2,112.98

Notice to clients. Under the proposed 

amendments, the rule would also 

require each adviser to add a statement 

in its notification to clients upon 

opening a custodial account on their 

behalf, urging them to compare the 

account statements from the qualified 

custodian to those from the adviser if 

the adviser sends statements to clients. 

Although the statement requirement is 

new, it would 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, would be 

negligible. We estimate that 3,617 

advisers would be subject to this 

collection of information,99 and that 

each adviser would 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 would 

spend 10 minutes per client drafting 

and sending the notice. The total hour 

burden relating to this requirement 

would be 33,156 hours per year.100

Based on the analysis above, we 

estimate that the total hour collection of 

information burden for advisers subject 

to rule 206(4)–2, as proposed to be 

amended, would be 216,184 hours per 

year.101

Annual aggregate cost. The currently 

approved collection of information for 

the custody rule includes an aggregate 

cost estimate of $281,000. We estimated 

that the accounting fees for 11 advisers 

that are subject to the surprise 

examination with respect to 100 percent 

of their clients would be $8,000 each 

annually, on average, and 193 advisers 

would be subject to the surprise 

examination with respect to only to 1 

percent of their clients and therefore 

have accounting fees of $1,000 annually, 

on average. Based on the proposed rule 

changes we now estimate total annual 

aggregate costs of $170,557,500. The 

increase in estimated aggregated costs is 

attributable to an increase in the number 

of advisers that would be subject to the 

surprise examination and the 

requirement that an adviser obtain, or 

receive from related persons, an internal 

control report with respect to the 

description of controls placed in 

operation relating to custodial services 

when the adviser or related person 

serves as qualified custodian for the 

adviser’s clients’ funds or securities. 

Based on the subcategories of advisers 

with custody as described above, we 

now estimate that all 9,575 advisers that 

would be subject to the surprise 

examination requirement and pay an 

accounting fee, on average, of $8,100.102

The estimated total accounting fees for 

all surprise examinations would 

therefore be $77,557,500.103 This would 

represent an increase of $77,276,500 in 

the cost estimate,104 primarily resulting 

from an increase in the number of 

advisers that would be subject to the 

surprise examination. 

If an adviser or a related person serves 

as a qualified custodian for client funds 

or securities under the proposed 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 a written internal 

control report that provides an opinion 

from an independent public accountant 

with respect to the adviser’s or related 

person’s controls relating to custody of 

client assets. We are proposing that the 

independent public accountant issuing 

the internal control report be registered 

with, and subject to regular inspection 

by, the PCAOB. We estimate that 

approximately 372 investment advisers 

would have to obtain, or receive from a 

related person, an internal control 

report relating to custodial services, and 

would have to maintain the report as a 

required record.105 We anticipate the 

cost of maintaining these records will be 

minimal. Based on discussions with 

accounting professionals, we 

understand that the cost to prepare an 

internal control report relating to 

custody would vary based on the size 

and services offered by the qualified 

custodian, but that on average an 

internal control report would cost 

approximately $250,000 per year,106 for 


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107 $250,000 × 372 = $93,000,000. See infra notes 

165–166 and accompanying text for additional 

discussion on this estimate. 108This number also includes a burden of 26,753 

hours associated with the requirement of delivering 

to clients copies of the adviser’s code of ethics upon 

clients’ request. The currently approved hour 

burden associated with this requirement is 78,973 

hours, based on the estimates that there were 11,787 

advisers subject to this burden (10,787 currently 

registered advisers + 1,000 new advisers). We 

estimated that each adviser had 670 clients and that 

10 percent of those clients would request the 

adviser’s code of ethics. We further estimated that 

satisfying each delivery request would impose a 

burden of 0.10 hour. (10,787 + 1,000) × (670 × 0.10) 

x 0.10 = 78,973. 

We now estimate that 12,272 advisers (11,272 

currently registered advisers + 1,000 new advisers) 

are subject to this burden and that each adviser has 

1,092 clients. See supra note 79 for calculation of 

average client number. We further estimate that 10 

percent of the clients would request their adviser’s 

code of ethics and that satisfying each delivery 

request would impose a burden of 0.02 hour. The 

total burden under the new estimates would be 

26,753 hours. (11,272 currently registered advisers 

+ 1,000 new advisers) × (1,092 clients × 0.10) × 0.02 

hours = 12,272 × 109 × 0.02 = 26,753 hours. 

109Proposed Section 7 A. of Schedule D of Form 

ADV. 

110Proposed Section 9 C. of Schedule D of Form 

ADV. 

111 Id. 

112Proposed Section 9 D. of Schedule D of Form 

ADV. 

113Based on the information collected from the 

IARD as of February 2009, 11,272 advisers were 

registered with us. In addition, based on historical 

data of the IARD, we estimate that there are 

approximately 1,000 new applicants for registration 

with the Commission each year. 11,272 + 1,000 = 

12,272. 

114 22.5 × 12,272 = 276,120. 

115Every three years, we must submit for 

approval by the OMB collections of information 

imposed by our rules and thus the three-year period 

reflects the effective period of OMB’s approval of 

this collection of information. 

116 276,120 / 3 = 92,040; 92,040 / 12,272 = 7.5. 

117 In addition to the required annual update of 

their Form ADV, advisers must amend their Form 

ADV by filing additional amendments promptly if 

information they provided in response to certain 

items of Form ADV becomes inaccurate in any way. 

See General Instructions to Form ADV. 

118 12,272 × 1.5 × 0.75 = 13,806. 

119See supra note 108. 

120 92,040 + 13,806 + 26,753 = 132,599 hours. 

121 132,599 ¥ 109,678 = 22,921 hours. 

122 231 × 0.05 = 11.55 hours. 

123 9,575 × 0.05 = 479. 

total costs attributable to this element of 

the proposed rule to be 93,000,000.107

B. Form ADV 

The currently approved collection of 

information for all advisers completing 

and amending Form ADV is 109,678 

hours. Based on the proposed 

amendments, we estimate an increase to 

this collection of information, to 

132,599 hours.108 The increased burden 

would result from the shortening of the 

amortization period currently in use for 

the approved collection of information, 

increases to our estimates of the number 

of advisers and advisory clients, and the 

proposed amendments to Part 1A and 

Schedule D of Form ADV. 

We are proposing 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. The proposed 

amendments would revise Item 7 of 

Form ADV, under which advisers report 

certain financial industry affiliates, to 

require an adviser to report all related 

persons who are broker-dealers and to 

identify which, if any, serve as qualified 

custodians with respect to the advisers’ 

client assets.109 We also propose to 

amend 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 proposed rule 

206(4)–2. In addition, the proposed 

amendments to Schedule D of Form 

ADV would require an adviser, 

depending on the adviser’s response to 

Item 9, to provide additional details 

including information about the 

accountants that perform annual audits 

or surprise examinations or that prepare 

internal control reports,110 whether a 

report prepared by an independent 

public accountant contains an 

unqualified opinion,111 and information 

about any related person that serves as 

a qualified custodian for the adviser’s 

clients.112

Investment advisers should already 

have the information that we would 

require them to report on Form ADV, so 

the increased collection of information 

burden should not be significant. We 

estimate that these amendments would 

increase the average collection of 

information burden for the initial 

application and annual amendment of 

Form ADV from the currently approved 

22.25 hours per adviser to 22.50 hours 

per adviser. We also estimate that there 

would be 12,272 advisers subject to this 

information collection.113 The total 

annual burden for initial filing and 

annual amendments would therefore be 

276,120.114 For the currently approved 

hour burden, the Commission staff 

chose a fifteen-year amortization, 

however, for purposes of our proposal, 

we are amortizing the estimated burden 

over a shorter period of time—three 

years.115 Therefore the annual burden, 

after amortizing it over the three year 

period, would be 92,040 hours or 7.5 

hours per adviser.116

In addition to the burden associated 

with the initial filing and annual 

amendments to Form ADV, we 

estimated for the currently approved 

collection of information that, on 

average, each adviser filing Form ADV 

through the IARD system would likely 

amend its form 1.5 times during the 

year.117 We estimated that the collection 

of information burden for such 

amendments would be 0.75 hours per 

amendment. We believe our proposal 

would not increase the hour burden per 

adviser in connection with such 

amendments. The total hour burden in 

connection with such amendments 

would therefore be 13,806 hours.118

Adding the annual burden of 26,753 

hours associated with the requirement 

of delivering to clients the advisers’ 

code of ethics upon clients’ request,119

the total annual hour burden for Form 

ADV under the proposed amendments 

would be 132,599 hours.120 This 

represents an increase of 22,921 hours 

from the currently approved annual 

hour burden, primarily due to the 

shortening of the amortization period 

from 15 year to three years, the increase 

in our estimates of the numbers of 

advisers and advisory clients, and the 

proposed amendments to Part 1A of 

Form ADV.121

C. Form ADV–E 

The currently approved collection of 

information for Form ADV–E is 12 

hours. We estimate that this collection 

of information would increase to 575 

hours based on the proposed rule 

amendments. This increase results 

primarily from an increase in the 

estimated number of advisers that 

would be subject to the requirement of 

completing Form ADV–E under the 

proposed amendments to rule 206(4)–2 

and the additional collections of 

information proposed by the 

amendments to the rule. 

For the currently approved annual 

hour burden for Form ADV–E, we 

estimated that there would be 231 

advisers 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.122 We now 

estimate that there would be 9,575 

advisers 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 would thus be 

increased to 479 hours.123

In addition, under the proposed 

amendments, rule 206(4)–2 would 

require an adviser subject to the surprise 

examination to enter into a written 

agreement with the independent public 

accountant that specifies the 


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124 9,57 5/5 = 1,915. 

125 1,915 × 0.05 = 96. 

126 479 + 96 = 575. 

127Under rule 206(4)–2(c)(3), a qualified 

custodian means a bank, a savings association, a 

registered broker-dealer, a registered futures 

commission merchant, and in certain instances a 

foreign custodial institution. 

128Rule 206(4)–2(a)(3)(i) and (ii). In the case of a 

pooled investment vehicle, the account statements 

and surprise examination requirements can be 

satisfied if the pooled investment vehicle is audited 

at least annually and distributes its audited 

financial statements to the investors in the pool 

within 120 days of the end of the pool’s fiscal year. 

Rule 206(4)–2(a)(3)(iii) and (b)(3). 

129Proposed rule 206(4)–2(a)(3). We would retain 

the exemption from the account statement delivery 

requirement, described above in supra note 128 for 

an adviser to a pooled investment vehicle. 

130Proposed rule 206(4)–2(a)(4). 

131Proposed rule 206(4)–2(c)(2). Currently, an 

adviser may, depending on the circumstances, be 

deemed to have custody of client assets held by an 

affiliate. See supra note 76 and accompanying text. 

132Proposed rule 206(4)–2(a)(6)(ii). 

133Proposed rule 206(4)–2(a)(6)(ii)(B). 

134Proposed Rule 206(4)–2(a)(6)(i). 

135For purposes of Paperwork Reduction Act 

analysis, we estimate that there would be 9,575 

advisers subject to the surprise examination with 

respect to 8,214,462 advisory clients’ accounts: (i) 

Continued 

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, 1,915 advisers would, under 

our proposal, be required each year to 

complete Form ADV–E with respect to 

an accountant’s termination.124 The 

total annual hour burden in connection 

with this proposal would be 96 

hours,125 and the total annual hour 

burden for advisers to complete Form 

ADV–E in connection with the surprise 

examination and the termination 

statement would be 575 hours.126

D. Request for Comment 

We request comment whether these 

estimates are reasonable. Pursuant to 44 

U.S.C. 3506(c)(2)(B), the Commission 

solicits comments to: 

• Evaluate whether the proposed 

collections of information are necessary 

for the proper performance of the 

functions of the Commission, including 

whether the information will have 

practical utility; 

• Evaluate the accuracy of the 

Commission’s estimate of the burden of 

the proposed collections of information; 

• Determine whether there are ways 

to enhance the quality, utility, and 

clarity of the information to be 

collected; and 

• Determine whether there are ways 

to minimize the burden of the 

collections of information on those who 

are to respond, including through the 

use of automated collection techniques 

or other forms of information 

technology. 

Persons wishing to submit comments 

on the collection of information 

requirements should direct them to the 

Office of Management and Budget, 

Attention: Desk Officer for the 

Securities and Exchange Commission, 

Office of Information and Regulatory 

Affairs, Room 3208, Washington, DC 

20503, and also should send a copy to 

Elizabeth M. Murphy, Secretary, 

Securities and Exchange Commission, 

100 F Street, NE., Washington, DC 

20549–1090 with reference to File No. 

S7–09–09. OMB is required to make a 

decision concerning the collections of 

information between 30 and 60 days 

after publication, so a comment to OMB 

is best assured of having its full effect 

if OMB receives the comment within 30 

days after publication of this release. 

Requests for materials submitted to 

OMB by the Commission with regard to 

these collections of information should 

be in writing, refer to File No. S7–09– 

09, and be submitted to the Securities 

and Exchange Commission, Office of 

Investor Education and Advocacy, 100 F 

Street, NE., Washington, DC 20549– 

0213. 

V. Cost-Benefit Analysis 

A. Background 

The Commission is sensitive to the 

costs and benefits resulting from its 

rules. Rule 206(4)–2, the custody rule, 

seeks to protect clients’ funds and 

securities in the custody of registered 

advisers from misuse or 

misappropriation by requiring advisers 

to maintain their clients’ assets with a 

qualified custodian, such as a brokerdealer or a bank.127 Advisers may 

comply with the current custody rule by 

either having the qualified custodian 

send account statements directly to their 

clients at least quarterly or by sending 

their own quarterly account statements 

to their clients and undergoing an 

annual surprise examination.128

The rule, as proposed to be amended, 

would retain the requirement that 

advisers maintain clients’ assets with a 

qualified custodian, but would require 

all registered advisers that have custody 

of client assets to have a reasonable 

belief after due inquiry that the 

qualified custodian sends an account 

statement directly to each client or its 

representative for which the qualified 

custodian maintains assets.129 The 

proposed rule would also require all 

advisers that have custody of client 

assets to undergo an annual surprise 

examination.130 In addition, we propose 

to amend the rule to provide that an 

adviser has custody if any of its related 

persons has custody of the adviser’s 

client assets in connection with the 

adviser’s advisory services.131 In 

situations where an adviser or a related 

person serves as a qualified custodian 

for client funds or securities under the 

proposed 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 

a written internal control report that 

provides an opinion from an 

independent public accountant with 

respect to the adviser’s or related 

person’s controls relating to custody of 

client assets.132 We are proposing that 

the independent public accountant 

issuing the internal control report be 

registered with, and subject to regular 

inspection by, the PCAOB.133 We also 

are proposing to require that when an 

adviser or a related person serves as a 

qualified custodian for the adviser’s 

clients’ funds or securities, the surprise 

examination would have to be 

performed by an independent public 

accountant registered with, and subject 

to regular inspection by, the PCAOB.134

These proposed amendments are 

designed to improve the safekeeping of 

advisory client assets. We have 

identified, below, certain costs and 

benefits that may result from the 

proposed rule amendments. We request 

comment on the costs and benefits of 

the proposed rule amendments, and 

encourage commenters to identify, 

discuss, analyze, and supply relevant 

data regarding these or any additional 

costs and benefits. 

B. Benefits 

Improved protection for advisory 

clients. We have designed the proposed 

amended rule to provide greater 

protection for advisory clients’ assets. 

The potential benefits to investors, 

however, are difficult to quantify. The 

proposed rule would require all 

registered advisers with custody of 

client assets to undergo an annual 

surprise examination by an independent 

public accountant that would provide 

‘‘another set of eyes’’ on client assets, 

and thus additional protection against 

their misuse. In addition, the 

independent public accountant may 

identify mishandling of client assets, 

which may result in the earlier 

detection of fraudulent activities and 

reduce resulting client losses. We 

estimate that the rule, if amended to 

make this change, would require 9,575 

advisers to obtain an annual surprise 

examination with respect to 8,214,462 

clients’ accounts.135


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928 clients for each of the 7,126 advisers that would 

have non-pool clients only, (ii) 1,092 clients for 

each of the 372 advisers that are themselves 

qualified custodians, (iii) 930 clients (928 

individual clients and 2 fund clients) for each of the 

1,281 advisers that provide advice to both 

individual clients and pooled investment vehicles; 

and (iv) 5 fund clients for each of the 796 advisers 

that provide advice to pooled investment vehicles 

only. See supra notes 77–86 and accompanying 

text. 

136As stated above in supra notes 77–86 and 

accompanying text, for purposes of the Paperwork 

Reduction Act analysis, we estimated that 1,281 

advisers that provide advice to both individual 

clients and pooled investment vehicles would each 

be subject to the surprise examination with respect 

to two pooled investment vehicles with 50 investors 

in each pool and 796 advisers that provide advice 

exclusively to pooled investment vehicles would be 

subject to the surprise examination with respect to 

five pooled investment vehicles with 50 investors 

in each pool. [(1,281 × 100) + (796 × 250) = 

327,100]. 

137 In addition to the specific procedures an 

independent public accountant must follow during 

a surprise examination, the accountant should 

perform any additional audit procedures deemed 

necessary under the circumstances. See Nature of 

Examination Required to be Made of All Funds and 

Securities Held in Custody of Investment Advisers 

and Related Accountant’s Certificate, supra note 8. 

138We estimate that 139 investment advisers that 

are also banks, registered broker-dealers or futures 

commission merchants would custody client assets 

as a qualified custodian under the rule. Based on 

IARD data, we also estimate that 233 investment 

advisers have a related person bank, registered 

broker-dealer or futures commission merchant that 

is a qualified custodian for advisory client assets. 

139 + 233 = 372. 

139Based on ADV–E filings, there were 190 

advisers that underwent surprise examinations 

during 2008. 140We estimate that approximately 190 advisers 

would be subject to the surprise examination with 

respect to 928 clients each under the current 

custody rule. The proposed elimination of the 

option for advisers to send account statements 

would result in approximately 176,320 clients 

receiving account statements directly from the 

qualified custodian. (190 × 928 = 176,320). 

These benefits would also extend to 

investors in pooled investment vehicles 

managed by a registered adviser, 

because the amended rule would 

require the adviser to obtain an annual 

surprise examination with respect to 

those assets. The annual surprise 

examination would be in addition to 

any annual audit of the pool (required 

if the qualified custodian is not sending 

account statements directly to 

investors), which is performed at the 

end of each fiscal year. The surprise 

examination requirement therefore 

would provide an additional deterrent 

to fraudulent activity by advisers that 

are relying on the audit exception. 

Based on IARD data, we estimate that 

327,100 investors would benefit from 

the additional protection afforded by the 

proposal.136

Amending the rule to state that 

advisers have custody if their ‘‘related 

persons’’ hold client assets in 

connection with advisory services 

provided by the adviser, would extend 

the protections of the custody rule to 

these clients. This amendment to the 

rule would result in client assets held 

by the adviser or its related persons 

becoming subject to a surprise 

examination performed by an 

independent public accountant 

registered with, and subject to regular 

inspection by, the PCAOB and other 

requirements of the rule, which may 

deter fraudulent activity perpetrated by 

an adviser through its related persons, 

and provide an independent check on 

the adviser’s ability to convert client 

assets to its own use. 

The proposed rule would require an 

adviser to obtain, or receive from a 

related person, no less frequently than 

once each calendar year a written 

internal control report from an 

independent public accountant 

registered with, and subject to regular 

inspection by, the PCAOB with respect 

to controls relating to custody when the 

adviser or a related person serves as a 

qualified custodian for client funds or 

securities in connection with advisory 

services the adviser provides to clients. 

This requirement would provide 

important safeguards to advisory clients 

in these higher risk situations. Requiring 

these advisers to also obtain an internal 

control report would provide an 

additional check on the safeguards 

relating to client assets held at a related 

person qualified custodian. An internal 

control report could also significantly 

strengthen the utility of the surprise 

examination when the adviser or a 

related person custodian maintains 

client assets because the independent 

public accountant performing the 

surprise examination could obtain 

additional comfort that confirmations 

received from the qualified custodian in 

the course of the surprise examination 

are reliable and, where a broker-dealer 

is the qualified custodian, may be able 

to leverage existing tests performed in 

compliance with broker-dealer auditing 

and internal control requirements. The 

internal control report may also reveal 

control problems, which could be 

significant.137 Thus, the requirement to 

obtain an internal control report informs 

the surprise examination process and 

may itself act as a deterrent to advisers 

that may consider misappropriating 

client assets directly or through a 

related person in the guise of providing 

custodial services as a qualified 

custodian. We also propose to require 

advisers to maintain the internal control 

report as a required record to provide 

our staff access to the accountant’s 

report. Based on IARD data, we estimate 

clients of 372 advisers would benefit 

from the protections provided by the 

internal control report requirement.138

The proposed amendments would 

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 would be required to have a 

reasonable belief, after due inquiry, that 

the qualified custodian sends account 

statements directly to clients. As a 

result, we expect that clients of 

approximately 190 advisory firms that 

currently send their own account 

statements to clients would, under the 

proposed amendments, receive account 

statements directly from qualified 

custodians.139 This change would 

provide clients confidence that any 

erroneous or unauthorized transactions 

would be reflected and, as a result, deter 

advisers from fraudulent activities. 

Based on IARD data, we estimate that 

176,320 clients would benefit from this 

proposal and would receive account 

statements directly from qualified 

custodians.140

As proposed to be amended, the rule 

would require each adviser that is 

required to undergo an annual surprise 

examination to enter into a written 

agreement with an independent public 

accountant to perform the surprise 

examination. The written agreement 

would 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 of engagement, 

file Form ADV–E within 4 business days 

accompanied by a statement explaining 

the reasons for such termination if 

related to examination scope or 

procedure. These filings and reports 

would provide our staff additional 

information to prioritize examinations 

and would assist in establishing 

advisers’ risk profiles. As proposed, the 

rule would result in the electronic filing 

of Form ADV–E and the accountant 

statement on the Internet-based IARD 

system. Clients would benefit from 

electronic filing of the Form ADV–E 

because it would allow them to easily 

access important information about the 

surprise examinations performed on 

their advisers. We estimate that 

8,214,462 advisory clients and 327,100 


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141See supra notes 135 and 136 and 

accompanying text for further information. 

142Rule 206(4)–2(a)(2). 

143We estimated that approximately 3,617 

advisers open accounts on behalf of their clients 

and each year on average open accounts for about 

5% of their 1,092 clients who are either new clients 

or whose accounts have been transferred to new 

qualified custodians. (3,617 × (1,092 × 0.05) = 3,617 

× 55 (rounded up from 54.60) = 198,935). 

144Proposed Section 7.A. of Schedule D of Form 

ADV. 

145Proposed Section 9.C. of Schedule D of Form 

ADV. 

146 Id. 

147Proposed Section 9.D of Schedule D of Form 

ADV. 

148Rule 206(4)–2(c). 

149Under the current custody rule, depending on 

circumstances, an adviser may or may not have 

custody if a related person has custody of its 

clients’ assets. See supra note 76. 

150We also have proposed to amend the rule to 

make privately offered securities that investment 

advisers hold on behalf of their clients subject to 

the surprise examination requirement. It is unlikely 

that an adviser would be subject to the surprise 

examination requirement solely based on this rule 

change, but rather the amendment would subject 

these positions to the surprise examination 

requirement. 

151Based on responses to Item 9.A. or Item 9.B. 

and Item 5 of Part 1A, Form ADV as of February 

2009. We reduced this number by the 42 advisers 

that provide advisory services exclusively to 

registered investment companies (advisers that 

checked only (4) under Item 5 D.). Under rule 

206(4)–2(b)(4) and proposed rule 206(4)–2(b)(5), 

advisers are not subject to the custody rule with 

respect to the account of a registered investment 

company. 

152See supra note 139 and 140. 

153 9,575 ¥190 = 9,385. 

154See supra note 89 and accompanying text for 

further information. We estimate that of the 179,636 

hours, 177,242 would be spent on providing clients 

lists and other information to the independent 

public accountant performing the examination and 

2,394 hours would be spent on adding to the 

written agreement with the accountant the specified 

duties the rule would require the accountant 

perform. 

155We expect that the function of providing lists 

of clients and other information to the independent 

public accountant in assisting its examination, 

totaling 177,242 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. 

We expect that the function of adding certain duties 

of the accountant to the written agreement with the 

accountant, totaling 2,394 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 workyear and multiplied by 5.35 to account for bonuses, 

firm size, employee benefits and overhead, suggest 

that the cost for this position is $258 per hour. 

Therefore the total costs would be $11,783,898 

((177,242 × $63) + (2,394 × $258)). 

156We did the estimate in connection with our 

2007 application for hour burden approval from the 

OMB under the Paperwork Reduction Act with 

respect to information collection required by the 

current custody rule. 

investors in pooled investment vehicles 

would benefit from the proposed 

change.141 Furthermore, the availability 

to the general public of Form ADV–E 

information on the Commission’s Web 

site may result in additional benefits, 

including to potential clients deciding 

which investment adviser to select. 

We are proposing to require advisers 

to include a statement in the notice that 

they are currently required to send to 

their clients upon opening a custodial 

account on their clients’ behalf.142 The 

statement would 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 could enhance the 

rule’s effectiveness. We estimate that 

198,935 clients would receive notices 

containing this additional 

information.143

Finally, we propose to amend Form 

ADV in connection with the 

amendments to the custody rule. We 

would modify Item 7 of Part 1A under 

which advisers report certain financial 

industry affiliates, to require an adviser 

to report all related persons that are 

broker-dealers and to identify which, if 

any, serve as qualified custodians with 

respect to the adviser’s client assets.144

We also would amend 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 proposed 

amendments to Schedule D of Form 

ADV would require an adviser, 

depending on the adviser’s response to 

Item 9, to provide additional details 

including information about the 

accountants that perform annual audits, 

surprise examinations or that prepare 

internal control reports,145 whether a 

report prepared by an accountant 

contains an unqualified opinion,146 and 

about any related person that serves as 

a qualified custodian for the adviser’s 

clients.147 These disclosures would 

provide our staff more information to 

determine advisers’ risk profiles and 

prepare for examinations. Moreover, 

this information would be filed 

electronically under the proposed 

amended rule and would be available to 

the public on the Commission’s Web 

site. Clients would therefore benefit by 

obtaining more information about their 

advisers’ custodial practices. 

Improved clarity of the rule. We 

anticipate that investment advisers 

would find it easier to understand and 

comply with the rule as a result of the 

proposed amendments, which may 

result in cost savings for advisers. The 

proposed amendments would 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.’’ 148

C. Costs 

Surprise Examination. As discussed 

above, the proposed amended rule 

would require all advisers with custody 

of client assets to undergo an annual 

surprise examination. This amendment 

would result in a new requirement to 

obtain a surprise examination for (i) 

advisers with custody that rely on 

qualified custodians to send account 

statements directly to advisory clients, 

(ii) advisers that custody client assets 

themselves as qualified custodians or 

advisers with client assets held at a 

qualified custodian that is a related 

person,149 and (iii) advisers to pooled 

investment vehicles that are subject to 

an annual audit and deliver the audited 

financial statements to investors in the 

pool.150 Based on the data we collected 

from Form ADV as of February 2009, we 

estimate that the proposed amended 

rule would subject 9,575 advisers to an 

annual surprise examination.151

Reducing that number by the 190 

advisers that already undergo an annual 

surprise examination under the current 

rule,152 we estimate that the proposed 

amendments would result in 

approximately 9,385 additional advisers 

being required to obtain a surprise 

examination.153 For purposes of the 

Paperwork Reduction Act analysis, we 

estimate a total annual collection of 

information burden in connection with 

the surprise examination of 179,636 

hours.154 Based on this estimate we 

anticipate that advisers would incur an 

aggregate cost of approximately 

$11,783,898 per year for the total hours 

their employees spend in complying 

with the surprise examination 

requirement.155

In addition, advisers subject to the 

surprise examination requirement 

would incur accounting fees to comply 

with the requirement. We previously 

estimated that there were 204 advisers 

subject to the surprise examination 

requirement under the current custody 

rule.156 Of the 204 advisers, 11 advisers 

were subject to the surprise examination 

with respect to 100 percent of their 

clients and spent $8,000 each annually, 


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157 (11 × $8,000) + (193 × $1,000) = $281,000. 

158See supra note 102 and accompanying text. 

159 9,575 × $8,100 = $77,557,500. 

160 $77,557,500¥$281,000 = $77,276,500. 

161Proposed rule 206(4)–2(a)(4). 

162We estimate that it would take each adviser 

about 0.25 hour to add the required specifications. 

See supra note 88 and accompanying text. 

Converting the hour burden to costs, each adviser 

would spend $64.50. See supra note 155. 

163Some advisers may have client assets that are 

in custody with more than one related person 

qualified custodian, but a related person qualified 

custodian also may provide custody services to 

more than one related person investment adviser. 

For purposes of this analysis we assume that these 

alternatives offset one another since those advisers 

that have more than one related person that is a 

qualified custodian is likely part of a large financial 

service provider and the custodian is more likely to 

be providing custody services to more than one 

adviser. The same internal control report would 

satisfy the rule’s obligations for related person 

advisers that use a common related qualified 

custodian. 

164 $250,000 × 372 = $93,000,000. 

165For instance, it is our understanding after 

discussions with several large accounting firms that 

mutual fund custodians obtain internal control 

reports to assist funds in meeting their obligations 

under the Investment Company Act compliance 

program rule (rule 38a– 1) [17 CFR 270.38a–1]. 

166For instance, an advisory client may be 

referred to the adviser by a related person brokerdealer that would continue to maintain custody of 

the client assets even though the adviser is 

managing the assets. 

167Proposed rule 206(4)–2(b)(3)(ii). 

168Filing 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; see 

supra notes 139 and 140. 

169See supra notes 113–121 and accompanying 

text. 

on average, and 193 advisers were 

subject to the surprise examination with 

respect to only 1 percent of their clients 

and spent $1,000 each annually, on 

average. The total estimated accounting 

fees were therefore $281,000.157

We now estimate that there would be 

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.158

The estimated total accounting fees for 

all surprise examinations would 

therefore be $77,557,500.159 This 

represents an increase of $77,276,500 in 

estimated costs attributable to this 

rulemaking, resulting primarily from the 

increase in the estimated number of 

advisers that would be subject to the 

surprise examination.160

Under the proposed amended rule 

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, 

specifying certain duties that the 

accountant would perform under the 

rule.161 We believe that the requirement 

of a written agreement reflects current 

industry practice and that advisers 

therefore would have a written 

agreement with their accountants 

regardless of whether it is required by 

the custody rule. Requiring certain 

additional items to be included in the 

written agreement would not 

significantly increase costs for 

advisers.162 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) would materially increase 

the accounting fees for the surprise 

examination discussed above. 

Internal Control Report. As discussed 

above, in situations where an adviser or 

a related person serves as a qualified 

custodian for client funds or securities 

under the proposed 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 a written internal 

control report that provides an opinion 

from an independent public accountant 

with respect to the adviser’s or related 

person’s controls relating to custody of 

client assets. We are proposing that the 

independent public accountant issuing 

the internal control report be registered 

with, and subject to regular inspection 

by, the PCAOB. We estimate that 

approximately 372 investment advisers 

would have to obtain, or receive from a 

related person, an internal control 

report relating to custodial services, and 

would have to maintain the report as a 

required record.163 We anticipate the 

cost of maintaining these records will be 

minimal. Based on discussions with 

accounting professionals, we 

understand that the cost to prepare an 

internal control report relating to 

custody would vary based on the size 

and services offered by the qualified 

custodian, but that on average an 

internal control report would cost 

approximately $250,000 per year, for 

total costs attributable to this section of 

the proposed rule to be $93,000,000.164

Our estimated cost of implementing 

the internal control report requirement 

is based on information available to us. 

We believe, however, that actual costs 

may be lower than estimated because (i) 

some qualified custodians already 

obtain an internal control report on their 

custody practices,165 (ii) advisers that 

have more than one related person 

qualified custodian may concentrate 

these custody arrangements with a 

single related person qualified 

custodian, and (iii) that to the extent 

advisers have accommodated certain 

client arrangements that result in a 

related person maintaining client funds 

or securities on an infrequent basis, they 

may discontinue these 

accommodations.166

Liquidation Audit. The proposed 

amended rule would specifically require 

an adviser to a pooled investment 

vehicle that is relying on the annual 

audit exception to obtain a final audit if 

the pool is liquidated at a time other 

than the end of a fiscal year.167 This 

clarification would assure that the 

proceeds of the liquidation are 

appropriately accounted for. We believe 

this clarification would not materially 

increase the costs for advisers to pooled 

investment vehicles because we believe 

most of these pooled investment 

vehicles are subject to contractual 

obligations with their investors to obtain 

a liquidation audit. 

Due Inquiry. The proposed rule would 

require 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, with the exception for 

certain pooled investment vehicles, 

described above. 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, so we believe few advisers 

would have to change their practices.168

For those advisers that previously had 

sent account statements directly to 

clients instead of having the qualified 

custodian send account statements to 

clients, the costs should not be 

significant because qualified custodians 

send account statements to clients in 

their normal course of business. The 

requirement that advisers form their 

reasonable belief after due inquiry 

similarly should not have significant 

costs, as we understand that today most 

advisers receive duplicate copies of 

client account statements from 

custodians. 

Form ADV. As discussed above, we 

are proposing 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 Paperwork Reduction Act analysis, 

we estimate that these amendments 

would increase the annual information 

collection burden in connection with 

Form ADV from 22.25 hours to 22.50 

hours for each adviser.169 The total 


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170As stated above we estimate that there would 

be 12,272 advisers subject to the Form ADV filing 

requirement. See supra note 113 ((22.50 – 22.25) × 

12,272 = 3,068). 

171We expect that the function of completing 

Form ADV would be performed by compliance 

clerks at a cost of $63 per hour. The total cost 

would be $193,284 (3,068 × $63 = $193,284). See 

supra note 155 for explanation of the hourly 

compliance clerk cost estimate. 

172 575 ¥ 12 = 563. 

173We 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 $35,469. See supra note 155 for 

explanation of the hourly compliance clerk cost 

estimate. 

174 5 U.S.C. 603(a). 

175Rule 206(4)–2(a)(3)(i) and (ii). 

176Rule 206(4)–2(a)(3)(iii) and (b)(3). 

177Proposed rules 206(4)–2(a)(3) and (b)(3). As 

described above, the rules would continue to 

contain a limited exception to this requirement for 

audited pooled investment vehicles. 

178Proposed rule 206(4)–2(a)(4). 

179Proposed rule 206(4)–2(c)(2). Under the 

current custody rule, an adviser may or may not 

have custody if a related person has custody of its 

clients’ assets. 

information collection burden resulting 

from the proposed amendments would 

be 3,068 hours.170 Based on this 

estimate we anticipate that advisers 

would incur an aggregate cost of 

approximately $193,284 per year for the 

total hours their employees spend in 

connection with the proposed 

provisions of Form ADV.171

Form ADV–E. For purposes of the 

Paperwork Reduction Act analysis, we 

estimate that the collection of 

information in connection with Form 

ADV–E would increase from the 

currently approved 12 hours to 575 

hours based on the proposed rule 

amendments. This increase results from 

an increase in the estimated number of 

advisers that would be subject to the 

requirement of completing Form ADV– 

E under the proposed amendments to 

rule 206(4)–2 and the additional 

collections of information proposed by 

the amendments relating to filing Form 

ADV–E when an independent public 

accountant performing the surprise 

examination terminates its engagement. 

This represents an increase of 563 

hours 172 with an estimated aggregated 

annual cost of approximately 

$35,469.173

D. Request for Comment 

• The Commission requests 

comments on all aspects of the costbenefit analysis, including the accuracy 

of the potential costs and benefits 

identified and assessed in this release, 

as well as any other costs or benefits 

that may result from the proposals. 

• We encourage commenters to 

identify, discuss, analyze, and supply 

relevant data regarding these or 

additional costs and benefits. 

VI. Initial Regulatory Flexibility 

Analysis 

The Commission has prepared the 

following Initial Regulatory Flexibility 

Analysis (‘‘IRFA’’) regarding proposed 

rule 206(4)–2 in accordance with 

section 3(a) of the Regulatory Flexibility 

Act.174

A. Reasons for Proposed Action 

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. Advisers may comply with the 

current custody rule either by having a 

reasonable belief that the qualified 

custodian sends periodic account 

statements directly to the advisory 

clients or by the adviser sending its own 

quarterly account statements to its 

clients and undergoes an annual 

surprise examination.175 An adviser to a 

pooled investment vehicle may comply 

with the rule by having the pool audited 

annually by an independent public 

accountant and distributing the audited 

financials to the investors in the pool 

within 120 days of the end of the pool’s 

fiscal year.176

To enhance the protections afforded 

to clients’ assets, we are proposing to 

require all registered advisers that have 

custody of client assets to have a 

reasonable belief that the qualified 

custodian that holds advisory client 

assets sends account statements directly 

to advisory clients at least quarterly.177

Under the proposed amendments, the 

rule would require all advisers having 

custody of client assets to undergo an 

annual surprise examination.178 In 

addition, the rule would explicitly state 

that an adviser has custody if any of its 

related persons has custody of the 

adviser’s client assets in connection 

with the adviser’s advisory services.179

The rule would also require the adviser 

and the accountant, under the terms of 

its agreement with the adviser, to report 

information to the Commission that 

would assist the Commission in 

protecting advisory client assets. 

Together, these revisions to the rule are 

designed to strengthen the controls 

relating to advisers’ custody of client 

assets and deter advisers from 

fraudulent activities. 

B. Objectives and Legal Basis 

We have designed the proposed 

amendments to enhance the protections 

afforded to clients when their advisers 

have custody of client assets. The 

surprise examination requirement of the 

rule may 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 proposed 

amendments would eliminate the 

exemption from the requirement of an 

annual surprise examination provided 

under the current rule for advisers to 

audited pooled investment vehicles. 

Annual surprise examinations of pooled 

investment vehicles would provide the 

investors in the pool additional 

protection. Unlike an annual audit of 

the pool, which is performed at the end 

of each fiscal year, the accountant could 

choose to conduct the surprise 

examination at any time during the year. 

The possibility of an unscheduled 

examination at any time would act as an 

additional deterrent to fraudulent 

activity by advisers, and would provide 

an independent check on the safety of 

pooled investment vehicle assets. 

The proposed amendments would 

provide that an adviser is deemed to 

have custody of client assets held by 

related persons. These amendments 

would result in the rule being easier to 

understand for advisers. Similarly, the 

proposed amendments would add to the 

rule definitions of ‘‘control’’ and 

‘‘related person’’ to assist advisers in 

understanding the rule. 

The Commission is proposing to 

amend rule 206(4)–2 pursuant to the 

authority set forth in sections 206(4) and 

211(a) of the Advisers Act [15 U.S.C. 

80b–6(4) and 80b–11(a)]; to amend rule 

204–2 pursuant to the authority set forth 

in sections 204 and 211 of the Advisers 

Act [15 U.S.C. 80b–4 and 80b–11]; to 

amend Form ADV pursuant to the 

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)]; and to amend Form ADV–E 

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)]. Section 206(4) 

gives us authority to issue rules 

designed to prevent fraudulent, 

deceptive, or manipulative acts or 

practices. Section 211 gives us authority 

to classify, by rule, persons and matters 

within our jurisdiction and to prescribe 

different requirements for different 

classes of persons, as necessary or 

appropriate to the exercise of our 

authority under the Act. Section 

203(c)(1) gives us authority to prescribe 

registration forms, by rule, to collect 

information and documents, as 

necessary or appropriate in the public 

interest or for the protection of 

investors. Section 204 gives us authority 

to prescribe, by rule, such records and 

reports that an adviser must make, keep 


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180 17 CFR 275.0–7(a). 181This estimate is based on the information 

submitted by SEC-registered advisers on Form ADV, 

Part 1A [17 CFR 279.1]. 

182See supra note 102. 

183Based on data collected from the IARD as of 

February 2009, more than half of the 177 small 

advisers would be subject to the surprise 

examination with respect to no more than 6 

accounts. 

184 15 U.S.C. 80b–2(c). 

185We are proposing amendments to rule 206(4)– 

2 pursuant to our authority set forth in sections 

206(4) and 211(a) of the Advisers Act. Analysis of 

the effects of these proposed amendments is 

contained in sections IV, V, and VI above. 

for prescribed periods, or disseminate, 

as necessary or appropriate in the public 

interest or for the protection of 

investors. 

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.180

The Commission estimates that as of 

February 2009 approximately 177 SECregistered investment advisers that have 

custody of client assets were small 

entities, and that no more than 8 of 

these advisers or their related persons 

would serve as a qualified custodian for 

client funds or securities under the 

proposed rule in connection with 

advisory services the advisers provides 

to their clients.181

D. Reporting, Recordkeeping, and Other 

Compliance Requirements 

The proposed rule amendments 

would impose certain reporting, 

recordkeeping and compliance 

requirements on advisers, including 

small advisers. The rule would require 

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 proposed 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 would specify 

certain duties the accountant would 

have to perform as part of the surprise 

examination engagement. Investment 

advisers, under the proposed rule 

amendments, would have to maintain a 

copy of an internal control report that 

an adviser would be 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 estimated that the average annual 

accounting fee for such surprise 

examination would be $8,100 for each 

of the advisers subject to the surprise 

examination.182 This is based on our 

estimate that each adviser, on average, 

would be subject to the surprise 

examination with respect to 928 client 

accounts. Most small advisers that 

would be subject to the surprise 

examination have less than 6 accounts 

that would be included in the surprise 

examination.183 Thus the accounting 

fees for surprise examination conducted 

on small advisers would likely be much 

lower than our estimated average cost. 

As a result, the potential impact of the 

amendments on small entities due to the 

proposed surprise examination 

requirement should not be significant. 

We also estimated that on average an 

internal control report would 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 advisers would 

have to obtain these reports, half of 

which would have to obtain the report 

and the other half would have to receive 

the report from a related person. 

E. Duplicative, Overlapping, or 

Conflicting Federal Rules 

The Commission believes that there 

are no rules that duplicate, overlap, or 

conflict with the proposed rule 

amendments. 

F. Significant Alternatives 

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 

proposed 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 proposed amendments. 

Regarding the second alternative, the 

proposed amendments would clarify 

when an investment adviser, including 

a small adviser, has custody. 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. 

G. Solicitation of Comments 

We encourage written comments on 

matters discussed in this IRFA. In 

particular, the Commission seeks 

comment on: 

• The number of small entities that 

would be affected by the proposed rule; 

and 

• whether the effect of the proposed 

rule on small entities would be 

economically significant. 

Commenters are asked to describe the 

nature of any effect and provide 

empirical data supporting the extent of 

the effect. 

VII. Effects on Competition, Efficiency 

and Capital Formation 

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.184

Today the Commission is proposing 

amendments to rule 204–2, Part 1A of 

Form ADV and Form ADV–E in 

connection with proposing amendments 

to rule 206(4)–2, the rule governing 

registered investment adviser custodial 

practices.185

The proposed 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 

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186Proposed rule 206(4)–2 would require that if 

an independent custodian does not maintain client 

assets but the adviser or a related person instead 

serves as a qualified custodian for client funds or 

securities under the rule in connection with 

advisory services the adviser provides to clients, the 

adviser must obtain, or receive from the related 

person, no less frequently than once each calendar 

year an internal control report, which includes an 

opinion from an independent public accountant 

with respect to the adviser’s or related person’s 

controls relating to custody of client assets. See 

proposed rule 206(4)–2(a)(6)(ii). 

187Public Law No. 104–121, Title II, 110 Stat. 857 

(1996) (codified in various sections of 5 U.S.C., 15 

U.S.C. and as a note to 5 U.S.C. 601). 

based examination program. Under the 

proposed amendments to Form ADV–E, 

the form and attached accountant’s 

certificate would be filed electronically 

on the IARD system. In addition, the 

rule would require the accountant 

performing an annual surprise 

examination to, upon termination of its 

engagement, file a Form ADV–E and a 

termination statement to explain the 

reasons for such termination. Both Part 

1A of Form ADV and Form ADV–E 

would 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 

proposed amendments are unrelated to, 

and will have little or no effect on, 

capital formation. 

We are proposing to amend rule 204– 

2 to require 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 rule 206(4)–2(a)(6) 

for five years from the end of the fiscal 

year in which the internal control report 

is finalized.186 The proposed 

amendment is designed to provide our 

examiners important information about 

the safeguards in place at an adviser or 

a related person that maintains client 

assets. We believe that the proposed 

amendment would not materially 

increase the compliance burden on 

advisers under rule 204–2 and thus 

would not affect competition, efficiency 

and capital formation. 

The Commission requests comment 

whether the above proposals, if adopted, 

would promote efficiency, competition, 

and capital formation. Commenters are 

requested to provide empirical data to 

support their views. 

VIII. Consideration of Impact on the 

Economy 

For purposes of the Small Business 

Regulatory Enforcement Fairness Act of 

1996, or ‘‘SBREFA,’’ 187 the Commission 

must advise OMB whether a proposed 

regulation constitutes a ‘‘major’’ rule. 

Under SBREFA, a rule is considered 

‘‘major’’ where, if adopted, it results in 

or is likely to result in: (1) An annual 

effect on the economy of $100 million 

or more; (2) a major increase in costs or 

prices for consumers or individual 

industries; or (3) significant adverse 

effects on competition, investment or 

innovation. 

We request comment on the potential 

impact of the proposed rule 

amendments on the economy on an 

annual basis. Commenters are requested 

to provide empirical data and other 

factual support for their views to the 

extent possible. 

IX. Statutory Authority 

We are proposing amendments to rule 

206(4)–2 (17 CFR 275.206(4)–2) 

pursuant to our authority set forth in 

sections 206(4) and 211(a) of the 

Advisers Act (15 U.S.C. 80b–6(4) and 

80b–11(a)). We are proposing 

amendments to rule 204–2 pursuant to 

the authority set forth in sections 204 

and 211 of the Advisers Act (15 U.S.C. 

80b–4 and 80b–11). We are proposing 

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 proposing amendments 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 Proposed Rule and Form 

Amendments 

For the reasons set out in the 

preamble, Title 17, Chapter II of the 

Code of Federal Regulations is proposed 

to be amended as follows. 

PART 275—RULES AND 

REGULATIONS, INVESTMENT 

ADVISERS ACT OF 1940 

1. The authority citation for Part 275 

continues to read in part as follows: 

Authority: 15 U.S.C. 80b–2(a)(11)(G), 80b– 

2(a)(17), 80b–3, 80b–4, 80b–4a, 80b–6(4), 

80b–6a, and 80b–11, unless otherwise noted. 

* * * * * 

2. Section 275.204–2 is amended by: 

a. Removing ‘‘in effect, and’’ at the 

end of paragraph (a)(17)(i) and adding in 

its place ‘‘in effect;’’; 

b. Removing the period at the end of 

paragraph (a)(17)(ii) and adding in its 

place a semicolon; and 

c. Adding paragraph (a)(17)(iii). 

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). 

* * * * * 

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. Include in the notification 

a statement urging the client to compare 

the account statements he or she shall 

receive from the custodian with those 

from the adviser. 


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(3) Account statements to clients. You 

have a reasonable basis, after due 

inquiry, for believing that the qualified 

custodian sends an account statement, 

at least quarterly, to each of your clients 

for which it maintains funds or 

securities, identifying the amount of 

funds and of each security in the 

account at the end of the period and 

setting forth all transactions in the 

account during that period. 

(4) Independent verification. The 

client funds and securities for which 

you have custody are verified by actual 

examination at least once during each 

calendar year 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 also require the 

accountant to: 

(i) File a certificate on Form ADV–E 

(17 CFR 279.8) with the Commission 

within 120 days of the time chosen by 

the accountant in paragraph (a)(4) of 

this section, stating that it has examined 

the funds and securities and describing 

the nature and extent of the 

examination; 

(ii) Upon finding any material 

discrepancies during the course of the 

examination, notify the Commission 

within one business day of the finding, 

by means of a facsimile transmission or 

electronic mail, followed by first class 

mail, directed to the attention of the 

Director of the Office of Compliance 

Inspections and Examinations; and 

(iii) Upon resignation or dismissal 

from, or other termination of, the 

engagement, or upon removing itself or 

being removed from consideration for 

being reappointed, file within four 

business days Form ADV–E 

accompanied by a statement that 

includes: 

(A) The date of such resignation, 

dismissal, removal, or other 

termination, and the name, address, and 

contact information of the accountant; 

and 

(B) An explanation of any problems 

relating to examination scope or 

procedure that contributed to such 

resignation, dismissal, removal, or other 

termination. 

(5) Special rule for limited 

partnerships and limited liability 

companies. If you or a related person is 

a general partner of a limited 

partnership (or managing member of a 

limited liability company, or hold a 

comparable position for another type of 

pooled investment vehicle), the account 

statements required under paragraph 

(a)(3) of this section must be sent to 

each limited partner (or member or 

other beneficial owner). 

(6) Investment advisers acting as 

qualified custodians. If you or 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 

a member registered with, and that is 

subject to regular inspection as of the 

commencement of the professional 

engagement period by, the Public 

Company Accounting Oversight Board 

in accordance with its rules; and 

(ii) You must obtain, or receive from 

your related person, no less frequently 

than once each calendar year, a written 

internal control report prepared by an 

independent public accountant: 

(A) The internal control report must 

include an opinion of an independent 

public accountant, issued in accordance 

with the standards of the Public 

Company Accounting Oversight Board, 

with respect to the description of 

controls placed in operation 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, and 

tests of operating effectiveness; and 

(B) The independent public 

accountant must be a member registered 

with, and that is subject to regular 

inspection as of the commencement of 

the professional engagement period by, 

the Public Company Accounting 

Oversight Board in accordance with its 

rules. 

(7) Independent representatives. A 

client may designate an independent 

representative to receive, on his behalf, 

notices and account statements as 

required under paragraphs (a)(2) and 

(a)(3) of this section. 

(b) Exceptions. (1) Shares of mutual 

funds. With respect to shares of an 

open-end company as defined in section 

5(a)(1) of the Investment Company Act 

of 1940 (15 U.S.C. 80a–5(a)(1)) (‘‘mutual 

fund’’), you may use the mutual fund’s 

transfer agent in lieu of a qualified 

custodian for purposes of complying 

with paragraph (a) of this section. 

(2) Certain privately offered securities. 

(i) You are not required to comply with 

paragraph (a)(1) of this section with 

respect to securities that are: 

(A) Acquired from the issuer in a 

transaction or chain of transactions not 

involving any public offering; 

(B) Uncertificated, and ownership 

thereof is recorded only on 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 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)(3) of this section. 

(3) Limited partnerships subject to 

annual audit. You are not required to 

comply with paragraph (a)(3) 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 section 2(d) of 

Article 1 of Regulation S–X (17 CFR 

210.1–02(d)): 

(i) At least annually and distributes its 

audited financial statements prepared in 

accordance with generally accepted 

accounting principles to all limited 

partners (or members or other beneficial 

owners) within 120 days of the end of 

its fiscal year; and 

(ii) 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. 

(4) 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). 

(c) 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 


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contributed, 25 percent or more of the 

capital of the partnership; 

(iv) A person is presumed to control 

a limited liability company (‘‘LLC’’) if 

the person: 

(A) Directly or indirectly has the right 

to vote 25 percent or more of a class of 

the interests of the LLC; 

(B) Has the right to receive upon 

dissolution, or has contributed, 25 

percent or more of the capital of the 

LLC; or 

(C) Is an elected manager of the LLC; 

or 

(v) A person is presumed to control a 

trust if the person is a trustee or 

managing agent of the trust. 

(2) Custody means holding, directly or 

indirectly, client funds or securities, or 

having any authority to obtain 

possession of them. You have custody if 

a related person holds, directly or 

indirectly, client funds or securities, or 

has any authority to obtain possession 

of them, in connection with advisory 

services you provide to clients. Custody 

includes: 

(i) Possession of client funds or 

securities, (but not of checks drawn by 

clients and made payable to third 

parties) unless you receive them 

inadvertently and you return them to 

the sender promptly but in any case 

within three business days of receiving 

them; 

(ii) Any arrangement (including a 

general power of attorney) under which 

you are authorized or permitted to 

withdraw client funds or securities 

maintained with a custodian upon your 

instruction to the custodian; and 

(iii) Any capacity (such as general 

partner of a limited partnership, 

managing member of a limited liability 

company or a comparable position for 

another type of pooled investment 

vehicle, or trustee of a trust) that gives 

you or your supervised person legal 

ownership of or access to client funds 

or securities. 

(3) Independent public accountant 

means a public accountant that meets 

the standards of independence 

described in rule 2–01(b) and (c) of 

Regulation S–X (17 CFR 210.2–01(b) 

and (c)). 

(4) Independent representative means 

a person that: 

(i) Acts as agent for an advisory client, 

including in the case of a pooled 

investment vehicle, for limited partners 

of a limited partnership (or members of 

a limited liability company, or other 

beneficial owners of another type of 

pooled investment vehicle) and by law 

or contract is obliged to act in the best 

interest of the advisory client or the 

limited partners (or members, or other 

beneficial owners); 

(ii) Does not control, is not controlled 

by, and is not under common control 

with you; and 

(iii) Does not have, and has not had 

within the past two years, a material 

business relationship with you. 

(5) Qualified custodian means: 

(i) A bank as defined in section 

202(a)(2) of the Advisers Act (15 U.S.C. 

80b–2(a)(2)) or a savings association as 

defined in section 3(b)(1) of the Federal 

Deposit Insurance Act (12 U.S.C. 

1813(b)(1)) that has deposits insured by 

the Federal Deposit Insurance 

Corporation under the Federal Deposit 

Insurance Act (12 U.S.C. 1811); 

(ii) A broker-dealer registered under 

section 15(b)(1) of the Securities 

Exchange Act of 1934 (15 U.S.C. 

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. 

(6) 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 

c. In Schedule D, revising Sections 

7.A., 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-thanannual 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. * * * 

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. 

* * * * * 

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6. Form ADV–E (referenced in 

§ 279.8) is amended by revising the 

instructions to the Form. 

The revisions read as follows: 

Note: The text of Form ADV–E does not 

and this amendment will not appear in the 

Code of Federal Regulations. 

Form ADV–E 

* * * * * 

Instructions 

This Form must be completed by 

investment advisers that have custody 

of client funds or securities and that are 

subject to an annual surprise 

examination. This Form may not be 

used to amend any information 

included in an investment adviser’s 

registration statement (e.g., business 

address). 

Investment Adviser 

1. All items must be completed by the 

investment adviser. 

2. Give this Form to the independent 

public accountant that, in compliance 

with rule 206(4)–2 under the Investment 

Advisers Act of 1940 (the ‘‘Act’’) or 

applicable State law, examines client 

funds and securities in the custody of 

the investment adviser within 120 days 

of the time chosen by the accountant for 

the surprise examination and upon such 

accountant’s resignation or dismissal 

from, or other termination of, the 

engagement, or if the accountant 

removes itself or is removed from 

consideration for being reappointed. 

Accountant 

3. The independent public accountant 

performing the surprise examination 

must submit (i) this Form and a 

certificate of accounting required by 

rule 206(4)–2 under the Act or 

applicable State law within 120 days of 

the time chosen by the accountant for 

the surprise examination, and (ii) this 

Form and a statement, within four 

business days of its resignation or 

dismissal from, or other termination of, 

the engagement, or removing itself or 

being removed from consideration for 

being reappointed, that includes (A) the 

date of such resignation, dismissal, 

removal, or other termination, and the 

name, address, and contact information 

of the accountant, and (B) an 

explanation of any problems relating to 

examination scope or procedure that 

contributed to such resignation, 

dismissal, removal, or other 

termination: 

(a) By mail, until the Investment 

Adviser Registration Depository 

(‘‘IARD’’) accepts electronic filing of the 

Form, to the Securities and Exchange 


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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, one 

copy with the regional office for the 

region in which the investment 

adviser’s principal business operations 

are conducted, or one copy with the 

appropriate State administrator(s), if 

applicable; or 

(b) By electronic filing of the 

certificate of accounting and statement 

regarding resignation, dismissal, other 

termination, or removal from 

consideration for reappointment on the 

IARD, when the IARD accepts electronic 

filing of the Form. 

* * * * * 

By the Commission. 

Dated: May 20, 2009. 

Elizabeth M. Murphy, 

Secretary. 

[FR Doc. E9–12182 Filed 5–26–09; 8:45 am] 

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