A Compilation Of Non-Enforcement Actions

Non-Enforcement Matters

SEC Revises Its Custody Rule

The SEC's Custody Rule (Rule 206(4)-2) was recently revised by the SEC* to target the abuses cited in the Madoff Ponzi scheme and other frauds.

The revisions to the Custody Rule (Rule), which are summarized below and effective March 12, 2010, will affect a significant number of registered investment advisers (RIAs), including those who manage private funds. Although the Rule is directly applicable only to those investment advisers registered with the SEC under the Investment Advisers Act of 1940, investment advisers registered under state securities laws also will be subject to these requirements, as many of the state securities laws require a state-registered investment adviser to comply with the SEC's Rule.

The Rule governs the RIA's custody of client funds and securities. The Rule applies if the RIA holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them. Accordingly, having custody includes the obvious and not so obvious situations. An RIA will have custody for, among other things, if the RIA maintains the client's checkbook, if it has the authority to deduct its fees directly from the client's account, if it is the general partner or manager of a private fund in which it has legal ownership or access to the fund's cash or securities, if it or one of its associated persons is a trustee for a client's account, or if an affiliate has custody of client assets. The SEC staff has historically applied an expansive interpretation of when an RIA, directly or indirectly, has custody of client funds or securities.

The Rule requires that the client funds or securities be held by a "Qualified Custodian" (which term includes a bank or registered broker-dealer). The Rule requires the RIA to have reasonable belief that the Qualified Custodian has sent account statements, on at least a quarterly basis, to the clients. The option under the prior Rule for the RIA to send clients the required account statements instead of the Qualified Custodian is no longer available. The reasonable belief requirement can be met by having the RIA receive a copy of the client account statements that were sent by the Qualified Custodian. The SEC has determined that the reasonable belief requirement could not be met by the RIA merely confirming that the account statements were on the Qualified Custodian's Web site. The RIA is required to notify its clients in writing if the client's funds and securities are maintained at a Qualified Custodian and changes in such arrangement. In addition, if the RIA also sends out statements to clients (billing statements, for example), it is required to remind...