
[Federal Register: May 27, 2009 (Volume 74, Number 100)]
[Proposed Rules]               
[Page 25353-25380]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr27my09-19]                         


[[Page 25353]]

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Part IV





Securities and Exchange Commission





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17 CFR Parts 275 and 279



Custody of Funds or Securities of Clients by Investment Advisors; 
Proposed Rule


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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.

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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 rule-comments@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.
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    \1\ Unless 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.''
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    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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    \2\ Rule 206(4)-2(a)(1).
    \3\ Rule 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.
    \4\ See 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 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).

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    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\
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    \5\ Rule 206(4)-2(a)(3)(i).
    \6\ Rule 206(4)-2(b)(3).
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    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\
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    \7\ Rule 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.
    \8\ As 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.
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    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\
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    \10\ Rule 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.
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II. Discussion

    In recent months, the Commission has brought several enforcement 
actions against investment advisers and broker-dealers 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.
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    \11\ See, 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, broker-dealer, 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).
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    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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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\
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    \12\ Proposed 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.
    \13\ Adoption 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.
    \14\ See 2003 Adopting Release, at Section II.C.
    \15\ The 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.
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    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.
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    \16\ See supra note 11.
    \17\ The 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.
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    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?
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    \18\ Advisers 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.
    \19\ Rule 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.
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    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?
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    \20\ Proposed rule 206(4)-2(b)(3).
    \21\ See AICPA Investment Company Audit and Accounting Guide, 
May 1, 2008.
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    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 broker-dealer's 
procedures for safeguarding securities.\24\ Would the surprise

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examination's ``verification'' of client assets provide additional 
protection for clients of advisers that are also broker-dealers? 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?
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    \22\ Section 17(e)(1)(A) [15 U.S.C. 78q(e)(1)(A)] of the 
Exchange Act.
    \23\ Exchange Act Rule 17a-5(g) [17 CFR 240.17a-5(g)].
    \24\ Id.
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    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?
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    \25\ See supra note 8.
    \26\ 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.
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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?
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    \27\ Proposed 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.
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    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?
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    \28\ Rule 206(4)-2(b)(3).
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    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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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?
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    \29\ Proposed 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 broker-dealer must attach 
to its notice the former auditor's statement as to whether it agrees 
with the broker-dealer'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 client funds or securities at an earlier time 
to allow our staff to take prompt action if necessary.
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    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.
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    \30\ The 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).
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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.
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    \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.
    \33\ Ownership 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.
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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\
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    \34\ Proposed rule 206(4)-2(c)(2) (defining ``custody'').
    \35\ Proposed rule 206(4)-2(c)(6) (defining ``related person'').
    \36\ Proposed rule 206(4)-2(c)(1) (defining ``control''). Form 
ADV [17 CFR 297.1] also uses the same definition.
    \37\ Today, 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).
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    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.
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    \38\ Rule 206(4)-2(c)(1) (defining ``custody'').
    \39\ See 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.
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    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\
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    \40\ Cf. Rule 206(4)-4(b) (establishing a rebuttable presumption 
that certain legal or disciplinary events are material and therefore 
must be disclosed to clients).
    \41\ See, 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).
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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

[[Page 25359]]

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\
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    \42\ Proposed 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.
    \43\ Proposed rule 204-2(a)(17)(iii). See 17 CFR 275.204-2.
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    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.
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    \44\ See supra note 11.
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    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.
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    \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.
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    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\
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    \46\ Proposed rule 206(4)-2(a)(6).
    \47\ See supra note 42.
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    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.
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    \48\ Proposed 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).
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    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

[[Page 25360]]

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\
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    \49\ Proposed rule 206(4)-2(a)(6)(i).
    \50\ Cf. 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).
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    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\
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    \51\ See American Institute of Certified Public Accountants, 
Audit and Accounting Guide: Investment Companies Sec.  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].
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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\
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    \52\ See 2003 Adopting Release at Section II.B.
    \53\ See 2002 Proposing Release at Section II.
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    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?
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    \54\ According 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).
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    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

[[Page 25361]]

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 well-known 
clients.\57\
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    \55\ Proposed 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).
    \56\ Rule 206(4)-2(a)(3)(ii).
    \57\ See 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).
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    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\
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    \58\ An ``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)].
    \59\ See 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.
    \60\ We 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 Gramm-Leach-Bliley Act. See, e.g., 12 CFR 
Parts 40, 216, 332, 573 (privacy rules adopted by the Office of the 
Comptroller of the Currency, the Federal Reserve Board, the Office 
of Thrift Supervision, and the National Credit Union 
Administration); 17 CFR Parts 160, 248 (privacy rules adopted by the 
Commodity Futures Trading Commission and the SEC). 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).
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    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\
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    \61\ There 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.
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    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?
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    \62\ Based on the number of Form ADV-Es filed with us during 
2008, we estimate 190 advisers relied on the exception.
---------------------------------------------------------------------------

    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?
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    \63\ Proposed rule 206(4)-2(a)(2).
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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

[[Page 25362]]

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?
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    \64\ Proposed rule 206(4)-2(b)(3)(ii).
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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 broker-dealer. 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\
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    \65\ Proposed Section 7.A. of Schedule D of Form ADV.
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    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.
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    \66\ Proposed 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.
    \67\ Proposed Item 9.D. of Part 1A of Form ADV.
    \68\ Proposed Item 9.C. of Part 1A of Form ADV.
    \69\ Proposed 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.
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    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\
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    \70\ Proposed Section 9.C. of Schedule D of Form ADV.
    \71\ Proposed 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.
    \72\ These 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.
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    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

[[Page 25363]]

amendments. Are there additional changes to Form ADV-E that we should 
consider?
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    \73\ Currently 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.
    \74\ Proposed rule 206(4)-2(a)(4).
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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.
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    \75\ 44 U.S.C. 3501 to 3520.
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    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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    \76\ The 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.
    \77\ Based 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 respect to a client 
that is a registered investment company.

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[[Page 25364]]

    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 broker-dealers, 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.
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    \78\ Based 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 broker-
dealers, 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.
    \79\ Based 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 non-discretionary 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.
    \80\ There 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.
    \81\ We 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.
    \82\ Based 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.
    \83\ See supra note 79.
    \84\ We estimate that each of these advisers would advise, on 
average, 2 pooled investment vehicles with 50 investors in each of 
the pools.
    \85\ Based 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.
    \86\ The number of funds per adviser is estimated based on the 
information we collected from Item 5 C. of Form ADV filed by 
advisers that provide advisory services only to pooled investment 
vehicles (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 x 1092 x 0.02) + [(1,281 x 928 
x 0.02) + (1,281 x 100 x 0.02) + (1,281 x 2 x 1)] + [(796 x 250 x 
0.02) + (796 x 5 x 1)] = 177,242.
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    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\
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    \88\ 9,575 x 0.25 = 2,394.
    \89\ 177,242 + 2,394 = 179,636.
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    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

[[Page 25365]]

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\
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    \90\ We estimated that 3,148 advisers to pooled investment 
vehicles were subject to this information collection under the 
current rule. We further estimated that each adviser had, on 
average, 250 investors in the funds it advises, and that each 
adviser spent 0.5 hours per investor annually for delivering audited 
financial statements to its 250 investors. 3,148 x 250 x 0.5 = 
393,500.
    \91\ Based 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.
    \92\ See supra note 90.
    \93\ We 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 x 250 x 1 minute) + (1,316 x 100 x 1 minute)]/60 = 
5,510 hours.
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    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\
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    \95\ 5,510 x 0.05 = 276.
    \96\ 5,510 + 276 = 5,786.
    \97\ 393,500 - 5,786 = 387,714.
    \98\ See supra note 90.
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    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\
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    \99\ We 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 x (1,092 x 0.05) x 10 minutes]/60 = (3,617 x 55 
(rounded up from 54.60) x 10 minutes)/60 = 33,156 hours.
    \101\ 177,242 + 5,786 + 33,156 = 216,184.
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    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.
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    \102\ We 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 x 9,575 = $77,557,500.
    \104\ $77,557,500 - $281,000 = $77,276,500.
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    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

[[Page 25366]]

total costs attributable to this element of the proposed rule to be 
93,000,000.\107\
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    \105\ See infra note 163 for explanation of our estimate.
    \106\ We consulted accounting firms that issue these reports to 
prepare this estimate.
    \107\ $250,000 x 372 = $93,000,000. See infra notes 165-166 and 
accompanying text for additional discussion on this estimate.
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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.
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    \108\ This 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) x (670 x 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) x 
(1,092 clients x 0.10) x 0.02 hours = 12,272 x 109 x 0.02 = 26,753 
hours.
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    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\
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    \109\ Proposed Section 7 A. of Schedule D of Form ADV.
    \110\ Proposed Section 9 C. of Schedule D of Form ADV.
    \111\ Id.
    \112\ Proposed Section 9 D. of Schedule D of Form ADV.
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    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\
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    \113\ Based 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 x 12,272 = 276,120.
    \115\ Every 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.
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    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\
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    \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 x 1.5 x 0.75 = 13,806.
    \119\ See supra note 108.
    \120\ 92,040 + 13,806 + 26,753 = 132,599 hours.
    \121\ 132,599 - 109,678 = 22,921 hours.
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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\
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    \122\ 231 x 0.05 = 11.55 hours.
    \123\ 9,575 x 0.05 = 479.
---------------------------------------------------------------------------

    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

[[Page 25367]]

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\
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    \124\ 9,57 5/5 = 1,915.
    \125\ 1,915 x 0.05 = 96.
    \126\ 479 + 96 = 575.
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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 broker-dealer 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\
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    \127\ Under 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.
    \128\ Rule 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).
---------------------------------------------------------------------------

    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\
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    \129\ Proposed 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.
    \130\ Proposed rule 206(4)-2(a)(4).
    \131\ Proposed 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.
    \132\ Proposed rule 206(4)-2(a)(6)(ii).
    \133\ Proposed rule 206(4)-2(a)(6)(ii)(B).
    \134\ Proposed Rule 206(4)-2(a)(6)(i).
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    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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    \135\ For 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) 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.

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[[Page 25368]]

    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\
---------------------------------------------------------------------------

    \136\ As 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 x 100) + (796 x 250) = 
327,100].
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
    \138\ We 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.
---------------------------------------------------------------------------

    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\
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    \139\ Based on ADV-E filings, there were 190 advisers that 
underwent surprise examinations during 2008.
    \140\ We 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 x 928 = 176,320).
---------------------------------------------------------------------------

    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

[[Page 25369]]

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.
---------------------------------------------------------------------------

    \141\ See supra notes 135 and 136 and accompanying text for 
further information.
---------------------------------------------------------------------------

    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\
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    \142\ Rule 206(4)-2(a)(2).
    \143\ We 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 x (1,092 x 0.05) = 3,617 x 55 (rounded up from 
54.60) = 198,935).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \144\ Proposed Section 7.A. of Schedule D of Form ADV.
    \145\ Proposed Section 9.C. of Schedule D of Form ADV.
    \146\ Id.
    \147\ Proposed Section 9.D of Schedule D of Form ADV.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \148\ Rule 206(4)-2(c).
---------------------------------------------------------------------------

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\
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    \149\ Under 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.
    \150\ We 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.
    \151\ Based 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.
    \152\ See supra note 139 and 140.
    \153\ 9,575 -190 = 9,385.
    \154\ See 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.
    \155\ We 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 work-year and multiplied by 5.35 to account for 
bonuses, firm size, employee benefits and overhead, suggest that the 
cost for this position is $258 per hour. Therefore the total costs 
would be $11,783,898 ((177,242 x $63) + (2,394 x $258)).
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    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,

[[Page 25370]]

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\
---------------------------------------------------------------------------

    \156\ We 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.
    \157\ (11 x $8,000) + (193 x $1,000) = $281,000.
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    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\
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    \158\ See supra note 102 and accompanying text.
    \159\ 9,575 x $8,100 = $77,557,500.
    \160\ $77,557,500-$281,000 = $77,276,500.
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    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.
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    \161\ Proposed rule 206(4)-2(a)(4).
    \162\ We 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.
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    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\
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    \163\ Some 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 x 372 = $93,000,000.
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    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\
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    \165\ For 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].
    \166\ For instance, an advisory client may be referred to the 
adviser by a related person broker-dealer that would continue to 
maintain custody of the client assets even though the adviser is 
managing the assets.
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    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.
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    \167\ Proposed rule 206(4)-2(b)(3)(ii).
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    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.
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    \168\ Filing data indicates that 190 advisers (other than those 
that have custody but only have pooled investment vehicle clients 
that are subject to an annual audit) did not have the qualified 
custodian send account statements directly to their clients; see 
supra notes 139 and 140.
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    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

[[Page 25371]]

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\
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    \169\ See supra notes 113-121 and accompanying text.
    \170\ As 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) x 12,272 = 3,068).
    \171\ We expect that the function of completing Form ADV would 
be performed by compliance clerks at a cost of $63 per hour. The 
total cost would be $193,284 (3,068 x $63 = $193,284). See supra 
note 155 for explanation of the hourly compliance clerk cost 
estimate.
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    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\
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    \172\ 575 - 12 = 563.
    \173\ We expect that the function of completing Form ADV-E would 
be performed by compliance clerks at a cost of $63 per hour. The 
total cost would therefore be $35,469. See supra note 155 for 
explanation of the hourly compliance clerk cost estimate.
---------------------------------------------------------------------------

D. Request for Comment

     The Commission requests comments on all aspects of the 
cost-benefit 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\
---------------------------------------------------------------------------

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

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\
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    \175\ Rule 206(4)-2(a)(3)(i) and (ii).
    \176\ Rule 206(4)-2(a)(3)(iii) and (b)(3).
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    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.
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    \177\ Proposed 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.
    \178\ Proposed rule 206(4)-2(a)(4).
    \179\ Proposed 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.
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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

[[Page 25372]]

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\
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    \180\ 17 CFR 275.0-7(a).
---------------------------------------------------------------------------

    The Commission estimates that as of February 2009 approximately 177 
SEC-registered 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\
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    \181\ This estimate is based on the information submitted by 
SEC-registered advisers on Form ADV, Part 1A [17 CFR 279.1].
---------------------------------------------------------------------------

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.
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    \182\ See supra note 102.
    \183\ Based 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.
---------------------------------------------------------------------------

    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\
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    \184\ 15 U.S.C. 80b-2(c).
    \185\ We 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.
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    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 additional data 
to assist in our risk-

[[Page 25373]]

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.
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    \186\ Proposed 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).
---------------------------------------------------------------------------

    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.
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    \187\ Public 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).
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    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:


Sec.  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 Sec.  275.206(4)-2(a)(6)(ii).
* * * * *
    3. Section 275.206(4)-2 is revised to read as follows:


Sec.  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.

[[Page 25374]]

    (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 Sec.  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-than-annual amendment, you are not 
required to update your responses to Items 2, 5, 6, 7, 9.A.(2), 
9.B.(2), 9.E., or 12 of Part 1A or Items 2.H. or 2.J. of Part 1B even 
if your responses to those items have become inaccurate. If you are 
amending Part II, do not file the amendment with the SEC.
* * * * *
Part 1A
* * * * *
Item 7 Financial Industry Affiliates
* * * * *
    A. * * *
    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.
* * * * *
BILLING CODE 8010-01-P

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    6. Form ADV-E (referenced in Sec.  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

[[Page 25380]]

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]

BILLING CODE 8010-01-C
