
[Federal Register: January 11, 2010 (Volume 75, Number 6)]
[Rules and Regulations]               
[Page 1455-1492]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr11ja10-11]                         


[[Page 1455]]

-----------------------------------------------------------------------

Part II





Securities and Exchange Commission





-----------------------------------------------------------------------







17 CFR Parts 275, 276 and 279



Custody of Funds or Securities of Clients by Investment Advisers; 
Commission Guidance Regarding Independent Public Accountant Engagements 
Performed Pursuant to Rule 206(4)-2 Under the Investment Advisers Act 
of 1940; Final Rules


[[Page 1456]]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 275 and 279

[Release No. IA-2968; File No. S7-09-09]
RIN 3235-AK32

 
Custody of Funds or Securities of Clients by Investment Advisers

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

-----------------------------------------------------------------------

SUMMARY: The Securities and Exchange Commission is adopting amendments 
to the custody and recordkeeping rules under the Investment Advisers 
Act of 1940 and related forms. The amendments are designed to provide 
additional safeguards under the Advisers Act when a registered adviser 
has custody of client funds or securities by requiring such an adviser, 
among other things: To undergo an annual surprise examination by an 
independent public accountant to verify client assets; to have the 
qualified custodian maintaining client funds and securities send 
account statements directly to the advisory clients; and unless client 
assets are maintained by an independent custodian (i.e., a custodian 
that is not the adviser itself or a related person), to obtain, or 
receive from a related person, a report of the internal controls 
relating to the custody of those assets from an independent public 
accountant that is registered with and subject to regular inspection by 
the Public Company Accounting Oversight Board. Finally, the amended 
custody rule and forms will provide the Commission and the public with 
better information about the custodial practices of registered 
investment advisers.

DATES: Effective Date: March 12, 2010. Compliance Dates: An investment 
adviser required to obtain a surprise examination must enter into a 
written agreement with an independent public accountant that provides 
that the first examination will take place by December 31, 2010. An 
investment adviser also required to obtain or receive an internal 
control report because it or a related person maintains client assets 
as a qualified custodian must obtain or receive an internal control 
report within six months of the effective date. Section III of this 
Release contains additional information on the effective and compliance 
dates.

FOR FURTHER INFORMATION CONTACT: Vivien Liu, Senior Counsel, Melissa A. 
Roverts, Senior Counsel, Daniel S. Kahl, Branch Chief, or Sarah A. 
Bessin, Assistant Director, at (202) 551-6787 or IArules@sec.gov, 
Office of Investment Adviser Regulation, Division of Investment 
Management, U.S. Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission 
(``Commission'') is adopting amendments to rule 204-2 [17 CFR 275.204-
2], rule 206(4)-2 [17 CFR 275.206(4)-2] under the Investment Advisers 
Act of 1940 [15 U.S.C. 80b] (the ``Advisers Act'' or ``Act''), to Form 
ADV [17 CFR 279.1], and to Form ADV-E [17 CFR 279.8].

Table of Contents

I. Background
II. Discussion
III. Effective and Compliance Dates
IV. Paperwork Reduction Act
V. Cost-Benefit Analysis
VI. Final Regulatory Flexibility Analysis
VII. Effects on Competition, Efficiency and Capital Formation
VIII. Statutory Authority
Text of Rule and Form Amendments

I. Background

    Earlier this year we began a comprehensive review of our rules 
regarding the safekeeping of investor assets in connection with our 
bringing several fraud cases involving investment advisers and broker-
dealers.\1\ As part of this effort, we proposed amendments to rule 
206(4)-2, the rule under the Advisers Act that governs an adviser's 
custody of client funds and securities (``client assets'').\2\ Our 
staff is currently reviewing potential recommendations to enhance the 
oversight of broker-dealer custody of customer assets. Thus today's 
adoption represents a first step in the effort to enhance custody 
protections, with consideration of additional enhancements of the rules 
governing custody of customer assets by broker-dealers to follow.
---------------------------------------------------------------------------

    \1\ Since the beginning of this year, the Commission has brought 
several enforcement actions against investment advisers and broker-
dealers alleging fraudulent conduct, including misappropriation or 
other misuse of investor assets. See cases cited in footnote 11 of 
Custody of Funds or Securities of Clients by Investment Advisers, 
Investment Advisers Act Release No. 2876 (May 20, 2009) [74 FR 25354 
(May 27, 2009)] (the ``Proposing Release''). In addition to these 
actions, we have brought several others more recently alleging 
similar types of misconduct. See, e.g., In re Stratum Wealth 
Management, LLC and Charles B. Ganz, Advisers Act Release No. 2930 
(Sept. 29, 2009) (settled action in which Commission alleged a 
registered investment adviser, through its sole owner and chairman, 
misappropriated over $400,000 from a client account during the 
course of nearly a year to pay for his personal expenses and 
falsified client account statements, among other things); SEC v. 
Titan Wealth Management, LLC, et al., Litigation Release No. 21184 
(Aug. 26, 2009) (complaint alleges a registered investment adviser 
misappropriated 80% of investor funds for personal use, to make 
Ponzi payments to certain investors or transfers to others); In the 
Matter of Paul W. Oliver, Jr., Advisers Act Release No. 2903 (Jul. 
17, 2009) (settled action in which Commission alleged a registered 
investment adviser's chairman aided and abetted misappropriations of 
more than $23 million in client funds by the investment adviser's 
co-founder and president); SEC v. Weitzman, Litigation Release No. 
21078 (June 10, 2009) (settled action in which Commission's 
complaint alleged registered investment adviser's co-founder and 
principal stole more than $6 million in investor funds for his own 
personal use and falsified client account statements). See also SEC 
v. Frederick J. Barton, Barton Asset Management, LLC, and TwinSpan 
Capital Management, LLC, Litigation Release No. 21016 (Apr. 29, 
2009) (default judgment entered against registered investment 
adviser and its direct and indirect majority owner for diverting 
approximately $493,100 of offering proceeds for personal use and for 
misappropriating $685,000 from one advisory client and $970,000 from 
another); SEC v. Crossroads Financial Planning, Inc., et al., 
Litigation Release No. 20996 (Apr. 10, 2009) (complaint alleges 
registered investment adviser, through its president, chief 
operating officer and principal owner, misappropriated at least $2.3 
million of client assets).
    \2\ We use the term ``client assets'' solely for ease of 
reference in this Release; it does not modify the scope of client 
funds or securities subject to the rule.
---------------------------------------------------------------------------

    The amendments we proposed earlier this year to rule 206(4)-2 were 
designed to strengthen the existing custodial controls imposed by the 
rule. Under rule 206(4)-2, advisers, in most cases, must maintain 
client funds and securities with a ``qualified custodian.'' \3\ 
Qualified custodians under the rule include the types of financial 
institutions to which clients and advisers customarily turn for 
custodial services, including banks, registered broker-dealers, and 
registered futures commission merchants.\4\ These institutions' 
custodial activities are subject to regulation and oversight.\5\ In 
addition, advisers must have a reasonable belief that the qualified 
custodian sends account statements directly to advisory clients.\6\ The 
rule also permits advisers (rather than custodians) to send account 
statements if the adviser is subject to an annual surprise verification 
of client assets by an independent public accountant.\7\
---------------------------------------------------------------------------

    \3\ Rule 206(4)-2(a)(1).
    \4\ Rule 206(4)-2(c)(3).
    \5\ See Proposing Release, at note 4.
    \6\ Rule 206(4)-2(a)(3)(i).
    \7\ Rule 206(4)-2(a)(3)(ii).
---------------------------------------------------------------------------

    The proposed amendments were designed to eliminate certain 
exemptions in the rule, thus expanding the protections afforded 
advisory clients by requiring all registered advisers with custody of 
client assets to be subject to an annual surprise examination,\8\ and 
requiring that they have a reasonable belief that qualified custodians 
send account statements directly to the

[[Page 1457]]

clients.\9\ When the adviser or its related person serves as qualified 
custodian for client assets, the proposed amendments would require that 
the adviser undergo an annual surprise examination and obtain, or 
receive from the related person, an internal control report with 
respect to custody controls, both of which must be performed or 
prepared by an independent public accountant that is registered with, 
and subject to regular inspection by, the Public Company Accounting 
Oversight Board (``PCAOB'').\10\ Amendments to Form ADV would require 
advisers to report current information to us about these custodial 
arrangements.
---------------------------------------------------------------------------

    \8\ Proposed rule 206(4)-2(a)(4).
    \9\ Proposed rule 206(4)-2(a)(3). The proposed amendments, 
however, would not eliminate an exception to the direct delivery 
requirement currently available to advisers to pooled investment 
vehicles that are subject to an annual audit and distribute the 
audited financial statements to investors in the pool. See proposed 
rule 206(4)-2(b)(3).
    \10\ Proposed rule 206(4)-2(a)(6)(ii)(B).
---------------------------------------------------------------------------

    We received more than 1,300 comment letters on the proposed 
amendments. Most were from investment advisers, broker-dealers, banks, 
and their trade associations that would be affected by the amended rule 
and which objected to significant parts of our rulemaking 
initiative.\11\ Commenters generally expressed their support for our 
goal of strengthening protections provided to advisory clients under 
the custody rule. Most urged us to make changes to our proposal 
particularly as it applies to advisers that have custody solely because 
of their authority to deduct advisory fees from client accounts. Many 
suggested that we update our guidance on the elements of the annual 
surprise examination performed by an independent public accountant.\12\
---------------------------------------------------------------------------

    \11\ Other commenters included accountants, law firms, 
consultants, and investors. Of the 1,300 letters, approximately 
1,100 were form letters or substantially similar letters submitted 
by smaller advisory firms.
    \12\ The comment letters are available for public inspection and 
photocopying in the Commission's Public Reference Room, 100 F 
Street, NE., Washington, DC (File No. S7-09-09). They are also 
available on our Web site at http://www.sec.gov/comments/s7-09-09/
s70909.shtml.
---------------------------------------------------------------------------

II. Discussion

    We are today adopting amendments to rule 206(4)-2 to strengthen 
controls over the custody of client assets by registered investment 
advisers and to encourage the use of independent custodians. We are 
also adopting related amendments to rule 204-2, Form ADV, and Form ADV-
E that will improve our ability to oversee advisers' custody practices. 
In response to comments, we made several modifications from the 
proposal. In addition, we are today publishing a companion release to 
provide guidance for accountants with respect to the surprise 
examination and internal control report required under rule 206(4)-2.
    We believe these amendments, together with the guidance for 
accountants, will provide for a more robust set of controls over client 
assets designed to prevent those assets from being lost, misused, 
misappropriated or subject to advisers' financial reverses. We 
acknowledge that no set of regulatory requirements we could adopt will 
prevent all fraudulent activities by advisers or custodians. We 
believe, however, that this rule, together with our examination 
program's increased focus on the safekeeping of client assets, will 
help deter fraudulent conduct, and increase the likelihood that 
fraudulent conduct will be detected earlier so that client losses will 
be minimized.

A. Delivery of Account Statements and Notice to Client

    As discussed above, rule 206(4)-2 currently requires advisers that 
have custody, with certain limited exceptions, to maintain client funds 
or securities with a ``qualified custodian,'' which the adviser must 
have a reasonable basis for believing sends an account statement, at 
least quarterly, to each client for which the qualified custodian 
maintains funds or securities.\13\ The requirement is designed so that 
advisory clients will receive a statement from the qualified custodian 
that they can compare with any statements (or other information) they 
receive from their adviser to determine whether account transactions, 
including deductions to pay advisory fees, are proper.\14\
---------------------------------------------------------------------------

    \13\ Rule 206(4)-2(a)(1). If the adviser is a general partner of 
a limited partnership or holds a similar position with another type 
of pooled investment vehicle, the account statement must be provided 
to the limited partners or other investors in the pooled investment 
vehicle. Rule 206(4)-2(a)(3)(iii). For convenience, we will presume 
in this Release that all advisers to pooled investment vehicles hold 
such a position.
    \14\ Rule 206(4)-2(a)(3)(i). The rule provides an exception to 
this requirement for an adviser to a pooled investment vehicle if 
the pooled investment vehicle is audited annually by an independent 
public accountant and distributes the audited financial statements 
to the investors in the pool. See rule 206(4)-2(b)(3).
---------------------------------------------------------------------------

    We are adopting, as proposed, an amendment to the rule that 
eliminates an alternative to the requirement under which an adviser can 
send quarterly account statements to clients if it undergoes a surprise 
examination by an independent public accountant at least annually. We 
believe that direct delivery of account statements by qualified 
custodians will provide greater assurance of the integrity of account 
statements received by clients.
    Most commenters that addressed this aspect of our proposal 
supported it as reflective of best practices followed by most 
advisers.\15\ A few commenters objected to the proposal, suggesting 
that a client's desire for privacy may override the Commission's goal 
of investor protection.\16\ In light of recent frauds, we believe 
generally that the protections provided by direct delivery of account 
statements by custodians are of substantially greater value than the 
privacy and confidentiality concerns that led us to permit this 
alternative.\17\ Privacy concerns can be addressed through custodial 
contracts, or other agreements that restrict the custodian's use of 
confidential information, as one commenter suggested.\18\
---------------------------------------------------------------------------

    \15\ Comment letter of Compliance Solution Group (July 24, 2009) 
(``CAS Letter''); comment letter of CFA Institute Centre for 
Financial Market Integrity (Dec. 11, 2009) (``CFA Institute 
Letter''); comment letter from The Cornell Securities Law Clinic 
(July 28, 2009) (``Cornell Letter''); comment letter from E*Trade 
Financial Corp. (July 28, 2009) (``E*Trade Letter''); comment letter 
from Investment Adviser Association (July 24, 2009) (``IAA 
Letter''); comment letter from North American Securities 
Administrators Association, Inc. (Aug. 5, 2009) (``NASAA Letter''); 
comment letter from National Regulatory Services (July 28, 2009) 
(``NRS Letter''); comment letter from Timothy P. Turner (July 27, 
2009) (``Turner Letter'').
    \16\ Comment letter from American Bar Association (Committee on 
Federal Regulation of Securities) (July 28, 2009) (``ABA Letter''); 
NRS Letter; comment letter from The Private Equity Council (July 28, 
2009) (``PEC Letter'').
    \17\ See Custody of Funds or Securities of Clients by Investment 
Advisers, Investment Advisers Act Release No. 2176 (Sept. 25, 2003) 
[68 FR 56692 (Oct. 1, 2003)] (``2003 Adopting Release''), at Section 
II.C. Qualified custodians may use service providers to deliver 
their account statements. The rule does not prohibit this practice, 
so long as the statements are sent to the client directly and not 
through the adviser. See 2003 Adopting Release at n.30.
    \18\ See IAA Letter. In support of its assertion that a client's 
desire for privacy could override the Commission's goal of investor 
protection, the ABA argued that contractual or other alternative 
means of protecting confidentiality would be insufficient and 
potentially very costly, although they did not provide support for 
these assertions. We note, in addition to contractual protections, 
other privacy protections are relevant in this context. As discussed 
in the Proposing Release at n.60, a U.S. qualified custodian would, 
with respect to individual clients who obtain custodial services for 
their personal, family or household purposes, be subject to the 
limitations on information sharing in the privacy rules adopted 
pursuant to Title V of the Gramm-Leach-Bliley Act. See, e.g., 12 CFR 
Parts 40, 216, 332, 573 (privacy rules adopted by the Office of the 
Comptroller of the Currency, the Federal Reserve Board, the Office 
of Thrift Supervision, and the National Credit Union 
Administration); 17 CFR Parts 160, 248 (privacy rules adopted by the 
Commodity Futures Trading Commission and the SEC).
---------------------------------------------------------------------------

    As proposed, the amended rule requires that an adviser's reasonable 
belief that the qualified custodian sends account statements directly 
to clients

[[Page 1458]]

must be formed by the adviser after ``due inquiry.'' \19\ We are not 
prescribing a single method for forming this belief, as was suggested 
by one commenter,\20\ but rather are providing advisers with 
flexibility to determine how best to meet this requirement. For 
instance, an adviser could form a reasonable belief after ``due 
inquiry'' if the qualified custodian provides the adviser with a copy 
of the account statement that was delivered to the client.\21\
---------------------------------------------------------------------------

    \19\ Amended rule 206(4)-2(a)(3).
    \20\ Comment letter of Fifth Third Asset Management, Inc. (July 
28, 2009) (``FTAM Letter'').
    \21\ This practice is followed by many advisers today. 
Commenters suggested that we permit advisers to satisfy the 
requirement of forming a reasonable belief after ``due inquiry'' by 
accessing qualified custodian account statements through the 
custodian's Web site. See comment letter from Curian Capital LLC, 
Financial Wealth Management, Inc, LPL Financial Corporation, and SEI 
Investments Company (July 28, 2009) (``Curian Letter''). We believe 
that accessing account statements through the Web site merely 
confirms that they are available. If an adviser does not take 
additional steps to determine whether account statements were sent 
to clients, or that clients obtained statements through the Web 
site, the adviser would have an inadequate basis for forming a 
reasonable belief, after due inquiry, that the qualified custodian 
sends account statements to clients.
---------------------------------------------------------------------------

    Rule 206(4)-2 requires investment advisers to notify their clients 
promptly upon opening a custodial account on their behalf and when 
there are changes to the information required in that notification.\22\ 
We are amending the rule, as proposed, to require advisers to include a 
legend in the notice urging clients to compare the account statements 
they receive from the custodian with those they receive from the 
adviser.\23\ Several commenters asserted that advisers may not (and are 
not required by rule 206(4)-2 to) send statements separate from the 
ones the custodian delivers and thus the proposed disclosure could 
confuse clients.\24\ We agree and have, therefore, modified this notice 
requirement so that the cautionary legend must be included only if the 
adviser elects to send its own account statements to clients.\25\ 
Finally, we had requested comment on whether to require advisers who 
choose to send statements to also include in those statements the 
cautionary legend urging clients to compare the information the adviser 
sends to clients with the information reflected in the qualified 
custodian's account statements.\26\ We believe providing regular notice 
will serve to more effectively remind clients to take steps to protect 
their assets. Accordingly, we are amending the rule to require those 
investment advisers, in any subsequent statements they deliver to 
clients after the initial notice, to urge clients to compare the 
adviser's statements with the account statements they receive from the 
custodian.\27\
---------------------------------------------------------------------------

    \22\ Rule 206(4)-2(a)(2).
    \23\ Proposed rule 206(4)-2(a)(2). One commenter suggested not 
only requiring the legend in the initial notice, as proposed, but 
also adding a requirement to include the legend as an annual 
reminder in the annual Form ADV delivery offer or in the annual 
privacy statement. See comment letter of The National Association of 
Personal Financial Advisors (July 21, 2009) (``NAPFA Letter''). We 
would not discourage advisers from adopting such a practice. As 
described above, we are adopting a regular notice requirement today 
for advisers.
    \24\ CAS Letter; comment letter from Dechert LLP (July 28, 2009) 
(``Dechert Letter''); IAA Letter; comment letter from MarketCounsel, 
LLC (July 28,2009) (``MarketCounsel Letter''); NRS Letter.
    \25\ Amended rule 206(4)-2(a)(2).
    \26\ See Proposing Release, at Section II.C. We did not receive 
comment on this particular approach.
    \27\ Amended rule 206(4)-2(a)(2).
---------------------------------------------------------------------------

B. Annual Surprise Examination of Client Assets

    The Commission is adopting the proposed amendment to rule 206(4)-2 
to require registered advisers with custody of client assets to undergo 
a surprise examination (or an audit, if applicable) of those assets by 
an independent public accountant, except as discussed below.\28\ We are 
also adopting several amendments to the custody rule and related forms 
that will strengthen the utility of the surprise examination as a means 
of deterring misuse of client assets and will improve our ability to 
identify potential misuse of those assets. We are revising the guidance 
we provide to accountants that are engaged to perform these 
examinations in order to modernize the surprise examination and make it 
more effective. We believe these changes, discussed below, will improve 
protection of client assets.
---------------------------------------------------------------------------

    \28\ Amended rule 206(4)-2(a)(4).
---------------------------------------------------------------------------

1. Applicability of Surprise Examination
    We proposed to require that all advisers with custody obtain a 
surprise examination of client assets by an independent public 
accountant in order to provide ``another set of eyes'' on client 
assets, and thus an additional set of protections against their 
misappropriation. Because advisers with custody often have authority to 
access, obtain and, potentially, misuse client funds or securities, we 
believed the additional review provided by an independent public 
accountant would help identify problems that clients may not, and thus 
would provide deterrence against fraudulent conduct by advisers.\29\
---------------------------------------------------------------------------

    \29\ Some commenters agreed and expressed support of this 
proposal. See comment letter of Ascendant Compliance Management 
(July 27, 2009) (expressing support with respect to advisers that 
are registered as broker-dealers (``dual registrants'')); CFA 
Institute Letter; comment letter of CLS Investments, LLC (July 28, 
2009) (``CLS Letter'') (expressing support with respect to dual 
registrants); comment letter of The Consortium (July 18, 2009) 
(``Consortium Letter'') (supporting the requirement other than for 
advisers who have custody solely because of their authority to 
deduct advisory fees from client accounts); comment letter of First 
Manhattan Co. (July 28, 2009) (``FMC Letter'') (expressing support 
with respect to dual registrants); NASAA Letter.
---------------------------------------------------------------------------

    Many commenters opposed the surprise examination requirement, 
arguing that it would provide little additional protection to client 
assets when assets are held with an independent qualified custodian 
that sends account statements directly to clients.\30\ Almost all 
advisers that commented raised concerns about the high costs of the 
surprise examination and many asserted that the costs could drive 
smaller advisers that typically have custody only because of authority 
to deduct advisory fees out of business,\31\ or, with respect to 
advisers that serve in capacities such as trustee on a limited basis, 
would cause them to cease providing such services to their clients.\32\
---------------------------------------------------------------------------

    \30\ See, e.g., ABA Letter; comment letter of Advisor Solution 
Group (July 28, 2009) (``ASG Letter''); comment letter of Davis Polk 
& Wardwell LLP (July 28, 2009) (``Davis Polk Letter''); comment 
letter of Grandfield & Dodd, LLC (July 28, 2009) (``G&D Letter''); 
Form Letter F; comment letter of Financial Planning Association 
(July 28, 2009) (``FPA Letter''); IAA Letter; comment letter of 
Jackson, Grant Investment Advisers, Inc. (July 28, 2009) (``Jackson 
Letter''); MarketCounsel Letter; NRS Letter; comment letter of 
Pickard and Djinis LLP (July 28, 2009) (``Pickard Letter''); comment 
letter of SIFMA Asset Management Group (July 28, 2009) (``SIFMA(AMG) 
Letter'').
    \31\ See, e.g., comment letter of TD Ameritrade, Inc. (July 24, 
2009) (``Ameritrade Letter''); CAS Letter; Cornell Letter; comment 
letter of Ronald P. Denk (July 3, 2009) (``Denk Letter''); comment 
letter of Janet Elder (July 1, 2009); Form Letter D; comment letter 
of Financial Services Institute (July 28, 2009) (``FSI Letter''); 
G&D Letter; comment letter of Thomas Hamilton (July 23, 2009); IAA 
letter; comment letter of The International Association of Small 
Broker Dealers and Advisors (May 27, 2009) (``IASBDA Letter''); 
comment letter of Carol K. Lampe (July 1, 2009); comment letter of 
Walter Marbert (July 1, 2009); comment letter of Scott A. McCord 
(July 1, 2009); NAPFA Letter; comment letter of Don Slabaugh (July 
1, 2009); comment letter of Jeff Toadvine (July 1, 2009); comment 
letter of Anthony W. Welch (July 1, 2009).
    \32\ See infra note 38.
---------------------------------------------------------------------------

    The focus of most commenters, however, was not on the utility of 
the surprise examination, but whether the proposed requirement should 
apply to certain advisers and advisory accounts, which we address 
below.\33\ Some urged

[[Page 1459]]

that if we expand the surprise examination requirement, we should 
update our guidance to accountants on examination methodology, which 
dates back to 1966 and requires verification of all client assets, a 
potentially expensive procedure not required in most audits.\34\
---------------------------------------------------------------------------

    \33\ Most commenters urged us to except advisers that have 
custody solely because of deducting advisory fees from the surprise 
examination requirement. See, e.g., ASG Letter; comment letter of 
Certified Financial Planner Board of Standards, Inc. (July 28, 2009) 
(``CFP Board Letter''); comment letter of Center for Capital Markets 
Competitiveness, Chamber of Commerce (July 28, 2009) (``Chamber of 
Commerce Letter''); Curian Letter; Dechert Letter; E*Trade Letter; 
comment letter of GE Asset Management (July 24, 2009) (``GE Asset 
Letter''); G&D Letter; Form Letters B, F, and G; FPA Letter; IAA 
Letter; Jackson Letter; comment letter of The Money Management 
Institute (July 28, 2009) (``MMI Letter''); NRS Letter; SIFMA(AMG) 
Letter; comment letter of SIFMA Private Client Legal Committee (July 
28, 2009) (``SIFMA(PCLC) Letter''); comment letter of Warshaw 
Burstein Cohen Schlesinger & Kuh, LLP (July 24, 2009) (``Warshaw 
Letter'').
    \34\ Comment letter of The American Institute of Certified 
Public Accountants (July 28, 2009) (``AICPA Letter); comment letter 
of Center for Audit Quality (July 28, 2009) (``CAQ Letter''); 
Chamber of Commerce Letter; comment letter of Cohen Fund Audit 
Services, Ltd. (July 21, 2009) (``Cohen Letter''); Curian Letter; 
comment letter of Deloitte & Touche LLP (July 28, 2009) (``Deloitte 
Letter''); comment letter of Ernst & Young (July 28, 2009) (``E&Y 
Letter''); FPA Letter; FTAM Letter; comment letter of KPMG LLP (July 
28, 2009) (``KPMG Letter''); comment letter of Managed Fund 
Association (July 28, 2009) (``MFA Letter''); MMI Letter; comment 
letter of McGladrey & Pullen LLP (July 28, 2009) (``M&P Letter''); 
comment letter of PricewaterhouseCoopers LLP (July 28, 2009) (``PWC 
Letter''); comment letter of Charles Schwab (July 28, 2009) 
(``Schwab Letter''); SIFMA(AMG) Letter; SIFMA(PCLC) Letter.
---------------------------------------------------------------------------

    We believe the surprise examination requirement will deter 
fraudulent conduct by investment advisers, and that it provides 
important protections to advisory clients, even when their assets are 
maintained by an independent qualified custodian.\35\ If fraud does 
occur, a surprise examination will increase the likelihood that it is 
uncovered and thus reduce client losses.\36\ Therefore, we are 
requiring advisers with custody of client assets to obtain a surprise 
examination (or an audit, if applicable in the case of a pooled 
investment vehicle) of client assets by an independent public 
accountant, other than as discussed below.\37\
---------------------------------------------------------------------------

    \35\ We have recently brought enforcement cases in which we 
alleged advisers misappropriated client assets that were maintained 
by an independent qualified custodian. See In re Stratum Wealth 
Management, LLC and Charles B. Ganz, Advisers Act Release No. 2930 
(Sept. 29, 2009); In the Matter of Paul W. Oliver, Jr., Advisers Act 
Release No. 2903 (Jul. 17, 2009); SEC v. Weitzman, Litigation 
Release No. 21078 (June 10, 2009); SEC v. Crossroads Financial 
Planning, Inc., et al., Litigation Release No. 20996 (Apr. 10, 
2009).
    \36\ Under the amended rule, the independent public accountant 
conducting a surprise examination will verify client funds and 
securities of which an adviser has custody, including those 
maintained with a qualified custodian and those that are not 
required to be maintained with a qualified custodian, such as 
certain privately offered securities and mutual fund shares.
    \37\ Amended rule 206(4)-2(a)(4). An investment adviser required 
to obtain a surprise examination must enter into a written agreement 
with an independent public accountant that provides that the first 
examination will take place by December 31, 2010 or, for advisers 
that become subject to the rule after the effective date, within six 
months of becoming subject to the requirement. If the adviser itself 
maintains client assets as qualified custodian, however, the 
agreement must provide for the first surprise examination to occur 
no later than six months after obtaining the internal control 
report. See infra Section III.B.1.
---------------------------------------------------------------------------

    We acknowledge the concerns raised by commenters with respect to 
the impact of the surprise examination requirement on smaller advisers 
whose client assets are maintained by an independent qualified 
custodian. For this reason, we have directed our staff to evaluate the 
impact of the surprise examination requirement on smaller advisers that 
have the authority to obtain possession of client funds or securities 
and whose client assets are maintained by an independent qualified 
custodian. We have also asked the staff to evaluate the impact of the 
surprise exam on these advisers' clients. Following the completion of 
the first round of surprise examinations of these advisers under the 
requirements of the amended rule, our staff will conduct a review and 
provide the Commission with the results of this review, along with any 
recommendations for amendments necessary to improve the effectiveness 
of the rule as it applies to these advisers, or address unnecessary 
burdens on them.
a. Advisers With Limited Custody Due to Fee Deduction
    Commenters have persuaded us that the surprise examination will not 
provide materially greater protection to advisory clients when the 
adviser has custody of client assets solely because of its authority to 
deduct advisory fees from client accounts.\38\ The principal risk 
associated with this limited form of custody is that a fee will be 
deducted to which the adviser is not entitled under the advisory 
contract. The amended rule addresses this risk by enabling the client 
to monitor the amount of advisory fees deducted by reviewing the 
account statement which, as discussed above, must be sent directly to 
the client by the qualified custodian.\39\ Further, as several 
commenters noted the surprise examination may not be an effective tool 
to identify inappropriate fee deductions as it requires the accountant 
to verify client assets, not determine the accuracy of fees paid.\40\ 
On balance, we believe that the magnitude of the risks of client losses 
from overcharging advisory fees does not warrant the costs of a 
obtaining a surprise examination. However, we do believe that 
appropriate controls should be in place regarding fee deduction, as 
discussed below.\41\
---------------------------------------------------------------------------

    \38\ Amended rule 206(4)-2(b)(3). This exception would also be 
available to such an adviser when the adviser can rely on amended 
rule 206(4)-2(b)(6). See infra Section II.C.2. of this Release. The 
exception would not be available, however, to an adviser that has 
custody under the rule for other reasons. Several commenters opposed 
applying the surprise examination requirement to advisers that serve 
as trustees for their clients. See comment letter of Allegheny 
Investments (July 28, 2009); Consortium Letter; G&D Letter; IAA 
Letter; NRS Letter; comment letter of Bruce Siegel (July 28, 2009). 
Some explained that most advisers that serve as trustees do so as a 
convenience to existing clients and either do not charge a separate 
fee or charge only a minimal fee for this service, and that 
requiring surprise examinations for these advisers will discourage 
advisers from serving as trustees and result in clients paying 
higher fees for this service. An adviser acting as trustee typically 
has significant authority over the assets in the trust, which would 
likely include the ability to access and, potentially, misuse those 
assets. We believe that the broad access that trustees typically 
have to trust assets makes the protections of the surprise 
examination important for these advisory clients to protect against 
potential abuse.
    \39\ Many commenters expressed similar views in their letters. 
See ASG Letter; CFP Board Letter; Dechert Letter; E*Trade Letter; 
FMC Letter; GE Asset Letter; G&D Letter; Form Letters B, F, and G; 
IAA Letter; Jackson Letter; MMI Letter; NRS Letter; SIFMA(AMG) 
Letter; SIFMA(PCLC) Letter; Warshaw Letter.
    \40\ ABA Letter; Dechert Letter; FMC Letter; IAA Letter; MMI 
Letter; Pickard Letter; comment letter of Seward & Kissel LLP (July 
29, 2009) (``S&K Letter'').
    \41\ See infra notes 140 and 141 and accompanying text.
---------------------------------------------------------------------------

b. Pooled Investment Vehicle Audit
    We proposed to require all registered investment advisers with 
custody of client assets to obtain an annual surprise examination, 
which included pooled investment vehicles subject to an annual 
financial statement audit. Several commenters asserted that a surprise 
examination would be duplicative of the annual financial statement 
audit and would not materially benefit investors.\42\
---------------------------------------------------------------------------

    \42\ See comment letter of Adams Street Partners, LLC (July 28, 
2009) (``Adams Street Letter''); Davis Polk Letter; Deloitte Letter; 
IAA Letter; MFA Letter; comment letter of The Bank of New York 
Mellon (July 28, 2009) (``Mellon Letter''); comment letter of 
National Society of Compliance Professionals, Inc. (July 28, 2009) 
(``NSCP Letter''); comment letter of National Venture Capital 
Association (July 28, 2009) (``NVCA Letter''); PEC Letter; 
SIFMA(AMG) Letter; S&K Letter; Warshaw Letter.
---------------------------------------------------------------------------

    During the course of a financial statement audit, the accountant 
performs procedures comparable to those performed as part of a surprise 
examination, including verifying the existence of the pooled investment 
vehicle's funds and securities and obtaining confirmation from 
investors.\43\ The financial statement audit also addresses additional 
matters important to pool investors that are not covered by the 
surprise examination, such as tests of valuations of pool investments, 
income, operating expenses, and, if

[[Page 1460]]

applicable, incentive fees and allocations that accrue to the 
adviser.\44\
---------------------------------------------------------------------------

    \43\ See AICPA, Audit and Accounting Guide, Investment 
Companies, (May 1, 2009).
    \44\ Id.
---------------------------------------------------------------------------

    We believe that these and other procedures performed by the 
accountant during the course of a financial statement audit provide 
meaningful protections to investors, and that the surprise examination 
would not significantly add to these protections. Although the annual 
audit is not required to be performed at a time of the accountant's 
choosing (as is a surprise examination), we believe other elements of 
the audit incorporate an element of uncertainty similar to the surprise 
element of the surprise examination, with corresponding benefits to 
investors. Specifically, in the course of an annual audit, the auditor 
will select transactions to test during the period that the adviser 
will not be able to anticipate.
    We have therefore amended the rule to deem an adviser to a pooled 
investment vehicle that is subject to an annual financial statement 
audit by an independent public accountant, and that distributes the 
audited financial statements prepared in accordance with generally 
accepted accounting principles to the pool's investors,\45\ to have 
satisfied the annual surprise examination requirement (``annual audit 
provision'').\46\
---------------------------------------------------------------------------

    \45\ Amended rule 206(4)2(b)(4)(i) requires that the audited 
financial statements be distributed within 120 days of the end of 
the pooled investment vehicle's fiscal year. In 2006, our staff 
issued a letter indicating that it would not recommend enforcement 
action to the Commission under section 206(4) of the Act or rule 
206(4)-2 against an adviser of a fund of funds relying on the annual 
audit provision of rule 206(4)-2 if the audited financial statements 
of the fund of funds are distributed to investors in the fund of 
funds within 180 days of the end of its fiscal year. See ABA 
Committee on Private Investment Entities, SEC Staff Letter (Aug. 10, 
2006). The amendments we are adopting today do not affect the views 
of the staff expressed in that letter.
    \46\ Amended rule 206(4)-2(b)(4). We note that an adviser that 
relies on the annual audit provision must nonetheless undergo an 
annual surprise examination of non-pooled investment vehicle assets 
of which it has custody.
---------------------------------------------------------------------------

    In addition, at the suggestion of several commenters,\47\ we are 
limiting the rule's recognition of such audits as satisfying the 
surprise verification requirement to those audits performed by an 
independent public accountant registered with, and subject to regular 
inspection by, the PCAOB.\48\ We have greater confidence in the quality 
of such audits.\49\
---------------------------------------------------------------------------

    \47\ ABA Letter; Adams Street Letter; comment letter of 
Coalition of Private Investment Companies (July 31, 2009) (``CPIC 
Letter''); MFA Letter.
    \48\ Amended rule 206(4)-2(b)(4). The independent public 
accountant must be registered with, and subject to regular 
inspection by, the PCAOB as of the commencement of the professional 
engagement period, and as of each calendar year-end. Several 
commenters suggested other approaches, including enhancing the audit 
performed on the pool to include verification of securities 
(SIFMA(AMG) Letter), requiring an internal control report only 
instead of both the report and a surprise examination (ABA Letter; 
PEC Letter), and requiring several specific custody controls for 
advisers to pooled investment vehicles (CPIC Letter). We have 
considered the alternative approaches, some of which are beyond the 
scope of the proposal, and we believe, for the reasons discussed 
above, that our amendment to this aspect of the rule strikes the 
right balance.
    \49\ See infra note 122 and accompanying text.
---------------------------------------------------------------------------

    We note that under rule 206(4)-2, an adviser to a pooled investment 
vehicle that distributes to its investors audited financial statements 
is not required to have a reasonable belief that a qualified custodian 
delivers account statements to investors.\50\ As a consequence, 
investors in pooled investment vehicles do not have the benefit of 
regularly receiving reports that the assets underlying their 
investments are properly held. We are therefore concerned that the 
current protections of the rule may be insufficient, and we have 
directed our staff to explore ways in which we could remedy this 
potential shortcoming while respecting the confidential nature of 
proprietary information.
---------------------------------------------------------------------------

    \50\ Rule 206(4)-2(b)(4).
---------------------------------------------------------------------------

2. Commission Reporting
    We are also adopting a number of rule and form amendments that will 
result in the Commission and the public receiving greater information 
about the custody practices of advisers and thus a greater ability to 
identify potential risks to clients. Under amended rule 206(4)-2, each 
investment adviser subject to the surprise examination requirement must 
enter into a written agreement with an independent public accountant to 
conduct the surprise examination. The agreement must require the 
accountant, among other things, to notify the Commission within one 
business day of finding any material discrepancy during the course of 
the examination, and to submit Form ADV-E to the Commission accompanied 
by the accountant's certificate within 120 days of the time chosen by 
the accountant for the surprise examination, stating that the 
accountant has examined the funds and securities and describing the 
nature and extent of the examination.\51\ The agreement also must 
provide that, upon resignation or dismissal, the accountant must file 
within four business days a statement regarding the termination along 
with Form ADV-E.\52\ Accountants will file Form ADV-E with us 
electronically, through the Investment Adviser Registration Depository 
(``IARD'').\53\ We are adopting these amendments as proposed. The 
information they provide will assist the Commission's examination staff 
and the public in identifying risks raised by the investment adviser's 
custodial practices and in determining the frequency and scope of our 
staff's examination of an investment adviser.
---------------------------------------------------------------------------

    \51\ Amended rule 206(4)-2(a)(4)(i) and (ii). The written 
agreement will also require, in accordance with the current 
requirements of rule 206(4)-2, the independent public accountant to 
perform the surprise examination. Advisers must maintain copies of 
these written agreements under rule 204-2(a)(10). The obligation to 
maintain the records will apply for five years from the end of the 
fiscal year during which the last entry was made, the first two 
years in an appropriate office of the investment adviser. Rule 204-
2(e)(1).
    \52\ Amended rule 206(4)-2(a)(4)(iii). The written agreement 
must require that the statement include (i) the date of such 
termination or removal, and the name, address, and contact 
information of the accountant, and (ii) an explanation of any 
problems relating to examination scope or procedure that contributed 
to such termination. Id. One commenter specifically expressed 
support for these time frames. CFA Institute Letter.
    \53\ Until the IARD system is upgraded to accept Form ADV-E, 
accountants performing surprise examinations should continue paper 
filing of Form ADV-E. Advisers will be notified as soon as the IARD 
system can accept Form ADV-E.
---------------------------------------------------------------------------

    The new requirement that accountants file Form ADV-E within 120 
days of the time chosen by the accountant for the surprise examination 
is designed to require more timely completion of these examinations. 
Several commenters suggested that we extend the filing deadline to 180 
days, asserting that more complex surprise examinations may take more 
time.\54\ We note that these commenters' estimate of the duration of a 
surprise examination was based on the nature and extent of procedures 
contemplated under the existing guidance for accountants,\55\ which 
many asserted was unnecessarily time consuming. As discussed more fully 
below, our revised guidance for accountants should address many of 
these concerns.\56\ As a result, we believe that 120 days will be 
sufficient for an accountant to complete the examination.
---------------------------------------------------------------------------

    \54\ IAA Letter; M&P Letter; PWC Letter. See also Dechert 
Letter; KPMG Letter; SIFMA(AMG) Letter (advocating for an extension, 
but not specifying that it be 180 days). One commenter suggested 
that we shorten it to 45-60 days. CFA Institute Letter.
    \55\ Statement of the Commission describing nature of 
examination required to be made of all funds and securities held by 
an investment adviser and the content of related accountant's 
certificate, Accounting Series Release No. 103, Investment Advisers 
Act Release No. 201 (May 26, 1966) (``ASR No. 103'').
    \56\ See Section II.B.4. of this Release.
---------------------------------------------------------------------------

    Several commenters suggested we modify the requirement regarding 
the accountant's filing of a statement upon termination. Some argued 
that these filings should not be made available to

[[Page 1461]]

the public,\57\ that they should not be required if the accountant was 
terminated for innocuous reasons,\58\ and that the adviser should have 
primary responsibility to report accountant dismissals, so that the 
accountant would submit a report only if the adviser failed to do 
so.\59\ We have not revised the requirement in response to these 
comments. We believe it is important that the public have access to the 
termination statements to permit clients and prospective clients to 
assess for themselves the reasons for the termination of an 
accountant's engagement or an accountant's removal from consideration 
for being reappointed. Disclosure of a termination, even for apparently 
innocuous reasons, could provide useful information to advisory clients 
and to our staff. For example, identifying frequent changes in 
accountants could put clients and prospective clients on notice to 
inquire about the reasons for these events. Finally, while advisers are 
responsible for reporting accountant dismissals on Form ADV, the 
accountant's statement serves as an independent check on the adviser's 
filing and, as such, is important to increasing the effectiveness of 
the surprise examination requirement.
---------------------------------------------------------------------------

    \57\ E*Trade Letter (arguing more broadly that no Form ADV-E 
filings should be made public, regardless of the reason for filing); 
IAA Letter; S&K Letter; Turner Letter.
    \58\ Davis Polk Letter; E*Trade Letter; IAA Letter.
    \59\ KPMG Letter.
---------------------------------------------------------------------------

3. Privately Offered Securities
    We are adopting, as proposed, amendments to rule 206(4)-2 to no 
longer permit the accountant conducting the annual verification of 
client assets to forego examining certain privately offered securities, 
as defined in the rule.\60\ As a result, advisers that maintain custody 
of privately offered securities on behalf of clients will be subject to 
the surprise examination requirement.\61\
---------------------------------------------------------------------------

    \60\ The amended rule retains the current definition of 
``privately offered securities'' as securities that are (i) acquired 
from the issuer in a transaction or chain of transactions not 
involving any public offering, (ii) uncertificated, and ownership 
thereof is recorded only on the books of the issuer or its transfer 
agent in the name of the client, and (iii) transferable only with 
prior consent of the issuer or holders of the outstanding securities 
of the issuer. See amended rule 206(4)-2(b)(2).
    \61\ We received various suggestions from commenters, some 
conflicting, regarding our approach to privately offered securities. 
See ABA Letter (suggesting that the Commission only subject 
privately offered securities held by the adviser or by related 
persons to surprise examinations, arguing that such a limitation 
would reduce costs and target the assets at greatest risk of 
misappropriation); MFA Letter (proposing that the Commission 
affirmatively state that some assets, such as bank loans and swaps, 
are not securities for purposes of rule 206(4)-2 and are, therefore, 
not subject to the rule). Others advocated expanding the annual 
verification requirement. See CPIC Letter (suggesting that the 
custody rule cover all assets held by private funds, not just 
securities and funds and proposing that all non-traditional assets 
should be held in the name of the custodian and all cash flows 
should be required to go through the custodian). We have considered 
the comments and, for the reasons discussed above, we believe our 
amendment to this aspect of the rule strikes the right balance with 
respect to privately offered securities.
---------------------------------------------------------------------------

    Several commenters supported expanding the rule in this 
respect.\62\ Others, however, asserted that the risk of fraud or 
misappropriation is low with respect to privately offered securities 
because they are not easily transferable, while the costs and practical 
difficulties of including these securities in a surprise exam may be 
considerable.\63\ While privately offered securities may present little 
risk with respect to transferability, they present significant risks in 
other regards. First, it is difficult for advisory clients to verify 
that these assets actually exist because ownership of such securities 
is recorded only on the issuers' books. Second, clients may have to 
rely on the information provided by the adviser to confirm their 
ownership of privately offered securities, as well as the existence of 
the underlying investment, when the adviser maintains custody of these 
securities.\64\ Because clients are more dependent on the adviser with 
respect to the safeguarding of these securities, advisory clients may 
be exposed to additional risks when their advisers acquire these 
securities on their behalf. To mitigate these risks and to provide 
assurance that privately offered securities are properly safeguarded, 
we believe that it is appropriate to require an independent third-party 
to verify client ownership with the issuers of the securities by 
requiring that these securities be subject to the surprise examination 
requirement under the amended rule.\65\
---------------------------------------------------------------------------

    \62\ ABA Letter; CFA Institute Letter; CPIC Letter; comment 
letter of The New York State Society of Certified Public Accountants 
(July 27, 2009).
    \63\ Davis Polk Letter; MFA Letter; NVCA Letter; PWC Letter.
    \64\ Rule 206(4)-2 does not require advisers, with one limited 
exception, to maintain these assets with a qualified custodian 
because of the difficulties raised by recording ownership of the 
securities only on the books of the issuer. Rule 206(4)-2(b)(2). See 
also 2003 Adopting Release, at Section II.B.
    \65\ Under amended rule 206(4)-2 an adviser may maintain custody 
of privately offered securities without being subject to the 
requirements that apply to advisers that maintain custody of client 
assets as qualified custodians set forth in paragraph (a)(6) of the 
rule, such as the internal control report, because the adviser need 
not be a qualified custodian to maintain custody of those 
securities. Amended rule 206(4)-2(b)(2). If, however, the adviser 
holding the privately offered securities also has custody of other 
client funds or securities as qualified custodian, the adviser is 
subject to the requirements set forth in paragraph (a)(6) of the 
rule.
---------------------------------------------------------------------------

    It is our understanding that many accountants today do verify 
private securities in the course of a surprise examination, and several 
commenters requested that we provide guidance as to the procedures that 
an accountant should undertake with respect to the surprise examination 
of privately offered securities.\66\ In our companion release, we 
provide guidance for accountants regarding conducting a surprise 
examination of client assets, including privately offered 
securities.\67\
---------------------------------------------------------------------------

    \66\ MFA Letter; comment letter of The Association of Global 
Custodians (Aug. 03, 2009) (``AGC Letter''); MarketCounsel Letter; 
comment letter of Sullivan & Cromwell (July 28, 2009).
    \67\ See infra note 70 and accompanying text. In the Proposing 
Release we requested comment on whether we should require the 
accountant performing the surprise examination to perform testing on 
the valuation of securities, including privately offered securities. 
One commenter stated that, although valuation is a very important 
issue closely related to client assets, it covers an area that goes 
beyond custody. Dechert Letter. We agree and are therefore not 
requiring accountants to perform testing of valuation as part of the 
surprise examination.
---------------------------------------------------------------------------

4. Guidance for Accountants
    In the Proposing Release, we requested that commenters address 
whether, and if so how, we should revise the guidance for accountants 
that we issued regarding the surprise examination.\68\ Commenters that 
responded all generally agreed that our existing guidance, which we 
published in 1966, is inadequate because it neither reflects today's 
custodial practices nor adequately recognizes certain commonly accepted 
auditing practices.\69\ In a companion release, we are providing 
updated guidance for accountants that addresses the surprise 
examination, as well as the internal control report required under 
amended rule 206(4)-2 and the relationship between them.\70\ Our 
guidance discusses the relevant auditing and attestation standards that 
apply to these engagements, and, among other things, the nature and 
extent of the accountant's procedures with respect to the surprise 
examination. The revised guidance for accountants will

[[Page 1462]]

modernize the procedures for the surprise examination.
---------------------------------------------------------------------------

    \68\ Proposing Release, at Section II.
    \69\ AICPA Letter; CAQ Letter; Chamber of Commerce Letter; Cohen 
Letter; Curian Letter; Deloitte Letter; E&Y Letter; FTAM Letter; 
KPMG Letter; MFA Letter; MMI Letter; M&P Letter; PWC Letter; Schwab 
Letter; SIFMA(AMG) Letter; SIFMA(PCLC) Letter.
    \70\ See Commission Guidance Regarding Independent Public 
Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the 
Investment Advisers Act of 1940, Investment Advisers Act Release No. 
2969 (Dec. 30, 2009) (``Accounting Release'').
---------------------------------------------------------------------------

C. Custody by Adviser and Related Person

    As amended, rule 206(4)-2 imposes additional requirements when 
advisory client assets are maintained by the adviser itself or by a 
related person rather than with an independent qualified custodian. As 
proposed, the amended rule requires, in addition to the surprise 
examination discussed above,\71\ that when an adviser or its related 
person serves as a qualified custodian for advisory client funds or 
securities under the rule, the adviser obtain, or receive from its 
related person, no less frequently than once each calendar year, a 
written report, which includes an opinion from an independent public 
accountant with respect to the adviser's or related person's controls 
relating to custody of client assets (``internal control report''), 
such as a Type II SAS 70 report.\72\ The amended rule also requires, in 
these circumstances, that the accountant issuing the internal control 
report, as well as the accountant performing the surprise examination, 
be registered with, and subject to regular inspection by, the 
PCAOB.\73\ The adviser must maintain the internal control report in its 
records and make it available to the Commission staff upon request.\74\
---------------------------------------------------------------------------

    \71\ See supra notes 28-37 and accompanying text. Several 
commenters asserted that the surprise examination would be 
duplicative of existing regulatory requirements (see, e.g., comment 
letter of American Bankers Association (July 28, 2009)(``American 
Bankers Letter''); comment letter of LPL Financial (July 28, 2009) 
(``LPL Letter''); Mellon Letter; Schwab Letter; and SIFMA(PCLC) 
Letter). As we discuss later, the surprise examination requirement 
is important and not duplicative because it works in concert with 
the internal control report to protect advisory clients and because 
there are no existing regulatory requirements specifically focused 
on risks that may arise in the self or affiliated custody context. 
See infra notes 85-87 and accompanying text. Other commenters agreed 
that the surprise examination and internal control report are 
independently valuable and not duplicative (see E&Y Letter and NASAA 
Letter).
    \72\ Amended rule 206(4)-2(a)(6)(ii). As discussed in more 
detail below, other types of reports could also satisfy the internal 
control report requirement. See infra notes 98-100 and accompanying 
text.
    \73\ Amended rule 206(4)-2(a)(6)(i) and (ii)(C). The 
Commission's standards for the independence of accountants is set 
forth in Article 2, Rule 2-01 of Regulation S-X [17 CFR 210.2-01]. 
See 2003 Adopting Release at n.32. Article 2-01 does not preclude 
the accountant performing the surprise examination from also 
preparing the internal control report. The determination, however, 
of whether an accountant is independent under Article 2-01 includes 
consideration of all the relevant facts and circumstances.
    \74\ Amended rule 204-2(a)(17)(iii).
---------------------------------------------------------------------------

1. Internal Control Report
    Related person custody arrangements can present higher risks to 
advisory clients than maintaining assets with an independent custodian. 
As we pointed out in the Proposing Release, several of the recent 
enforcement actions in which we have alleged misappropriation of client 
assets have involved advisers or related persons that maintained client 
assets.\75\ We requested comment on whether we should prohibit advisers 
from advising clients whose assets are maintained with the adviser or a 
related person.
---------------------------------------------------------------------------

    \75\ See supra note 1.
---------------------------------------------------------------------------

    Some commenters supported requiring an ``independent'' qualified 
custodian,\76\ although many commenters opposed the requirement.\77\ 
Several argued that use of an independent custodian would be an 
impractical requirement for many types of advisory accounts held by 
smaller investors with broker-dealers, such as wrap fee accounts, in 
which a client receives bundled advisory and brokerage services from a 
single firm (or related firms) regulated as both an investment adviser 
and a broker-dealer.\78\ It is common for institutional clients to 
maintain assets in a custodial account, often with a bank that is 
unaffiliated with the client's adviser. We are concerned, however, that 
requiring an independent custodian could make unavailable many advisory 
accounts popular with smaller investors, which are today maintained by 
the adviser or its affiliated brokerage firm or bank. Therefore, we are 
not amending the rule to require use of an independent custodian, 
although we encourage the use of custodians independent of the adviser 
to maintain client assets as a best practice whenever feasible.
---------------------------------------------------------------------------

    \76\ See, e.g., NASAA Letter; comment letter of The National 
Association of Active Investment Managers (July 27, 2009) (``NAAIM 
Letter''); NVCA Letter; comment letter of Kay Conheady (June 4, 
2009); comment letter of Carol Y. Godsave (June 15, 2009); comment 
letter of Michael A. Pagano (June 26, 2009); comment letter of 
Robert J. Reed (June 1, 2009); comment letter of Robert N. Veres 
(June 27, 2009).
    \77\ See, e.g., ABA Letter; AGC Letter; CLS Letter; Curian 
Letter; Davis Polk Letter; Dechert Letter; E*Trade Letter; FPA 
Letter; comment letter of Lincoln Investment (July 28, 2009); LPL 
Letter; comment letter of National Planning Holdings, Inc. (July 28, 
2009) (``NPH Letter''); Pickard Letter; Schwab Letter; SIFMA(PCLC) 
Letter; comment letter of L.A. Schnase (July 3, 2009) (``Schnase 
Letter''); comment letter of State Street Corporation (July 28, 
2009).
    \78\ ABA Letter; Curian Letter; Davis Polk Letter; E*Trade 
Letter; Pickard Letter; Schnase Letter; Schwab Letter; SIFMA(PCLC) 
Letter.
---------------------------------------------------------------------------

    To address the custodial risks associated with an affiliated 
custodial relationship, we proposed requiring, in addition to the 
surprise examination, an adviser to obtain, or receive from its related 
person, an annual internal control report, which would include an 
opinion from an independent public accountant with respect to the 
adviser's or related person's custody controls. We were concerned that 
the surprise examination alone would not adequately address custodial 
risks associated with self or related person custody because the 
independent public accountant seeking to verify client assets would 
rely, in part, on custodial reports issued by the adviser or the 
related person.
    Several commenters expressed their support for the proposed 
internal control report requirement.\79\ Two stated that our approach 
appropriately targets the frauds we are concerned about.\80\ One large 
custodian urged us to require all qualified custodians to obtain an 
internal control report.\81\ Another agreed with our assessment that 
when the adviser or its related person acts as qualified custodian, 
there is increased risk to clients because the adviser may 
``misappropriate assets as a result of collusion with [its] affiliated 
custodians.'' \82\ Other commenters, including those representing banks 
and broker-dealers, however, objected to the internal control report 
requirement, arguing that qualified custodians are already subject to 
extensive regulatory oversight and that the additional requirement 
would be duplicative of existing legal and regulatory requirements.\83\ 
They argued that we would be imposing an unnecessary additional 
regulatory burden on affected custodians.
---------------------------------------------------------------------------

    \79\ AICPA Letter; CFP Board Letter; Cornell Letter; comment 
letter of Diamant Asset Management, Inc. (July 20, 2009); E&Y 
Letter; FMC Letter; IAA Letter; NASAA Letter; NPH Letter; Pickard 
Letter; comment letter of T. Rowe Price Associates, Inc. (July 28, 
2009) (``T. Rowe Letter'').
    \80\ CFP Board Letter; IAA Letter.
    \81\ Schwab Letter.
    \82\ ABA Letter.
    \83\ LPL Letter; MMI Letter; NSCP Letter; comment letter of 
Pershing LLC (July 28, 2009) (``Pershing Letter''); SIFMA(PCLC) 
Letter; American Bankers Letter; comment letter of J.P. Morgan (Aug. 
26, 2009).
---------------------------------------------------------------------------

    The internal control report requirement we are adopting today will 
provide important additional safeguards for client assets maintained 
with the adviser or a related person. As discussed in more detail 
below, the adviser must obtain or receive an internal control report 
that demonstrates that it, or its related person, has established 
appropriate custodial

[[Page 1463]]

controls.\84\ As we noted in the Proposing Release, the internal 
control report can significantly strengthen the utility of the surprise 
examination when the adviser or a related person acts as qualified 
custodian for client assets because it provides a basis for the 
independent public accountant performing the surprise examination to 
obtain additional comfort that the confirmations received from the 
related custodian are reliable.\85\ The requirement to obtain an 
internal control report therefore serves both to inform the surprise 
examination process and may itself act as a deterrent to fraud by 
advisers that may consider misappropriating client assets directly or 
through a related person.\86\
---------------------------------------------------------------------------

    \84\ Amended rule 206(4)-2(a)(6). An investment adviser subject 
to this requirement must obtain or receive an initial internal 
control report within six months of becoming subject to the 
requirement. See infra Section III.B.2. of this Release.
    \85\ Proposing Release, at Section II.B.2.
    \86\ See id.
---------------------------------------------------------------------------

    We have carefully considered commenters' concerns about regulatory 
duplication in designing the internal control report requirement. We 
are adopting this requirement because there is no existing regulatory 
requirement applicable to investment advisers or other entities, such 
as broker-dealers and banks, that serve as qualified custodians that we 
believe is specifically focused on internal control risks that may 
arise in the affiliated custody context. We have, however, developed 
our guidance for accountants to permit accountants, when preparing an 
internal control report, to rely on their own relevant audit work 
performed for other purposes, including audit work performed to meet 
existing regulatory requirements, which should increase efficiencies in 
the audit process and help address commenters' concerns about 
duplication.\87\
---------------------------------------------------------------------------

    \87\ For example, accountants for broker-dealers perform a 
variety of procedures as part of a broker-dealer's financial 
statement audit and to satisfy related requirements under the 
Securities Exchange Act of 1934 (``Exchange Act''), including 
reconciliation procedures required for broker-dealers under the 
Exchange Act. See infra note 95.
---------------------------------------------------------------------------

    We do not believe that the internal control report requirement will 
be unduly burdensome. A qualified custodian would only have to obtain 
an internal control report if it maintains the funds or securities of 
its own advisory clients or those of advisory clients of related 
persons. As one securities industry commenter noted, custodians often 
provide Type II SAS 70 reports to clients who demand a rigorous 
evaluation of internal control as a condition of obtaining their 
business.\88\ A related person custodian therefore may be able to use a 
Type II SAS 70 report it is already obtaining and providing to other 
clients to satisfy the rule's requirement, and may also be able to use 
the same internal control report to satisfy the rule's requirement for 
several related advisers whose clients use the custodian.
---------------------------------------------------------------------------

    \88\ SIFMA(AMG) Letter (noting that obtaining such a report is 
an ``industry best practice'').
---------------------------------------------------------------------------

    The elements of the required internal control report are set forth 
in the companion release we are issuing today, which includes guidance 
for accountants regarding the overall objectives and scope of the 
internal control examination.\89\ The internal control report must 
include the accountant's opinion as to whether the qualified 
custodian's internal controls have been placed in operation as of a 
specific date, and are suitably designed, and are operating effectively 
to meet control objectives related to custodial services, including the 
safeguarding of funds and securities of advisory clients during the 
year.\90\ In order for the accountant to be able to form this opinion, 
the internal control report should address control objectives and 
associated controls related to the areas of client account setup and 
maintenance, authorization and processing of client transactions, 
security maintenance and setup, processing of income and corporate 
action transactions, reconciliation of funds and security positions to 
depositories and other unaffiliated custodians, and client 
reporting.\91\
---------------------------------------------------------------------------

    \89\ See Accounting Release.
    \90\ Amended rule 206(4)-2(a)(6)(ii)(A).
    \91\ See Accounting Release.
---------------------------------------------------------------------------

    We have revised the amended rule to state that, for the internal 
control report to satisfy the rule's requirements, the independent 
public accountant preparing the report must verify that the client 
funds and securities are reconciled to a custodian other than the 
adviser or its related person.\92\ Reconciliation of custodial records 
to depositories is a key control objective of the internal control 
report, which will report on, among other things, tests of controls 
designed to meet this specific objective.\93\ Internal control reports 
regarding custody, such as Type II SAS 70 reports, however, may not 
necessarily include specific procedures performed by the accountant 
that are designed to verify the reconciliation of funds and securities 
of unaffiliated custodians. Verification with unaffiliated custodians 
serves as a critical check on potential collusion when the adviser or 
its related person acts as custodian. The accountant preparing the 
internal control report is in the best position to perform this check 
because the accountant will have access to the information necessary to 
verify assets when testing controls over the custodian's reconciliation 
processes. For this reason, we are requiring this verification to be 
performed in connection with, and reported in, the internal control 
report.
---------------------------------------------------------------------------

    \92\ Amended rule 206(4)-2(a)(6)(ii)(B).
    \93\ See Proposing Release at Section II.B.2.
---------------------------------------------------------------------------

    As described in our guidance for accountants, the accountant's 
verification that client funds and securities are reconciled to an 
unaffiliated custodian (e.g., the Depository Trust Corporation) can be 
accomplished in one of two ways.\94\ The accountant may either obtain 
direct confirmation, on a test basis, with unaffiliated custodians or 
perform other procedures designed to verify that the data used in 
reconciliations performed by the qualified custodian is obtained from 
unaffilated custodians and is unaltered.\95\
---------------------------------------------------------------------------

    \94\ See Accounting Release.
    \95\ In meeting this requirement, the accountant can also 
incorporate its own work performed pursuant to other regulatory 
requirements, such as requirements under the Exchange Act. Under 
rule 17a-13 under the Exchange Act, most brokers and dealers are 
required to conduct a securities count at least once each calendar 
quarter, which includes, among other things, a physical examination 
and count of all securities held, verification (through confirmation 
or other form of outside documentation) of all securities deposited 
or otherwise subject to the broker-dealer's control or direction, 
and reconciliation of the results of such count and verification to 
the broker-dealer's records. Under rule 17a-5, the broker-dealer's 
independent accountant provides a supplemental report on internal 
control which addresses, among other things, the broker-dealer's 
compliance with rule 17a-13. See Rules 17a-13 and 17a-5 under the 
Exchange Act [17 CFR Parts 240.17a-13 and 17a-5].
---------------------------------------------------------------------------

    We noted several specific control objectives in the Proposing 
Release that we suggested might be included in the scope of an internal 
control report prepared under the proposed rule.\96\ Some commenters 
urged that we establish minimum control objectives that need to be 
addressed as part of the internal control report as a means of ensuring 
consistency in practice.\97\ In response to these comments, we are 
identifying certain minimum control objectives within our revised 
guidance for accountants.
---------------------------------------------------------------------------

    \96\ See Proposing Release, at Section II.B.2.
    \97\ See, e.g., AICPA Letter; Deloitte Letter.
---------------------------------------------------------------------------

    We are not requiring that a specific type of internal control 
report be provided under the rule as long as the objectives noted above 
are addressed. This flexibility should permit

[[Page 1464]]

accountants of qualified custodians to leverage audit work they have 
performed to satisfy existing regulatory requirements to which these 
custodians are subject, or work currently performed as part of internal 
control reports prepared to meet client demand. In the Proposing 
Release, we indicated that a Type II SAS 70 report would be sufficient 
to satisfy the requirements of the internal control report.\98\ As we 
noted in our guidance for accountants, a report issued in connection 
with an examination of internal control conducted in accordance with AT 
Section 601, Compliance Attestation (``AT 601'') under the standards of 
the American Institute of Certified Public Accountants \99\ would also 
be sufficient, provided that such examination meets the objectives set 
forth in our guidance.\100\
---------------------------------------------------------------------------

    \98\ See Proposing Release, at Section II.B.2.
    \99\ AT 601 provides guidance to accountants for engagements 
related to either a firm's compliance with the requirements of 
particular laws or rules, or the effectiveness of the firm's 
internal controls over compliance with those particular 
requirements.
    \100\ We have made technical changes to the description of the 
internal control report in amended rule 206(4)-2(a)(6)(ii)(A) to 
reflect that our adopted rule permits use of internal control 
reports other than the Type II SAS 70.
---------------------------------------------------------------------------

2. Related Persons
    We are amending rule 206(4)-2, as proposed, to provide that an 
adviser has custody of any client securities or funds that are directly 
or indirectly held by a ``related person'' in connection with advisory 
services provided by the adviser to its clients.\101\ A related person 
is defined by the rule as a person directly or indirectly controlling 
or controlled by the adviser and any person under common control with 
the adviser.\102\ We received some support for this proposal.\103\ 
Several commenters urged us to instead adopt the approach our staff has 
taken in no-action letters in which the staff expressed the view that 
custody of client assets by a related person would not be attributed to 
the adviser if the related person was operationally separate.\104\ 
Those letters expressed our staff's views regarding the scope of the 
custody rule which, at that time, did not explicitly address the 
applicability of the rule to an entity related to the adviser as parent 
company, sister company or wholly-owned subsidiary that holds or has 
access to client assets.\105\ We believe that the authority or 
influence an adviser may have over such related persons presents 
sufficient risks as a result of a related person's ability to obtain 
client assets, that we should treat the adviser itself as having 
custody over the client assets.\106\ Therefore, we are adopting the 
amendment as proposed.\107\
---------------------------------------------------------------------------

    \101\ Amended rule 206(4)-2(d)(2) (defining ``custody'').
    \102\ Amended rule 206(4)-2(d)(7). For advisers that are part of 
multi-service financial organizations, for example, such related 
person custodians may include broker-dealers and banks.
    \103\ See CFA Institute Letter; Cornell Letter; FPA Letter; 
NAAIM Letter.
    \104\ See, e.g., IAA Letter; Mellon Letter; MMI Letter; NRS 
Letter; Pershing Letter. Several other commenters suggested similar 
approaches, including revising the definition of custody based on 
the factors the staff considered in these no-action letters (T. Rowe 
Letter), and not considering firms under common control to be deemed 
related persons under the rule (IAA Letter; Pickard Letter; Schnase 
Letter; SIFMA(PCLC) Letter). We are not adopting either of these 
approaches for the same reasons as explained above.
    \105\ See, e.g., Crocker Investment Management Corp., SEC Staff 
Letter (Apr. 14, 1978) (``Crocker'').
    \106\ See Proposing Release, Section II.B.1. We note that under 
rule 206(4)-2, as amended, only client assets held by a related 
person ``in connection with advisory services'' provided by the 
adviser would be attributable to the adviser. See rule 206(4)-
2(d)(2). Consequently, an adviser will not be deemed to have custody 
of client assets held with a qualified custodian that is a related 
person of the adviser if the adviser does not provide advice with 
respect to such assets.
    \107\ Amended rule 206(4)-2. In light of our amended definition 
of custody, our staff is withdrawing several no-action letters to 
the extent such letters are inconsistent with this definition, 
including Crocker and Pictet et Cie, SEC Staff Letter (Jun. 22, 
1980). Advisers, including those firms that have relied on these 
letters in the past, must comply with the amended rule.
---------------------------------------------------------------------------

    We are, however, addressing commenters' concerns in a different way 
by providing a limited exception from the surprise examination 
requirements in circumstances when the adviser is deemed to have 
custody solely as a result of a related person having custody.\108\ The 
exception is available to an adviser that is (i) deemed to have custody 
solely as a result of certain of its related persons holding client 
assets, and (ii) ``operationally independent'' of the custodian.\109\
---------------------------------------------------------------------------

    \108\ Amended rule 206(4)-2(b)(6).
    \109\ Id.
---------------------------------------------------------------------------

    As discussed above, a key premise of our approach to the custody 
rule is that client assets may be at greater risk when they are 
maintained by a related person of the investment adviser. As commenters 
suggested, however, firms under common ownership that are operationally 
independent of each other present substantially lower client custodial 
risks than those that are not because misuse of client assets would 
tend to require collusion among employees, not significantly different 
than would be necessary to engage in similar misconduct between 
unaffiliated organizations.\110\
---------------------------------------------------------------------------

    \110\ MMI Letter; Davis Polk Letter. This conclusion is implicit 
in our staff's no-action letter upon which the staff has relied to 
determine whether an adviser indirectly has custody of client assets 
when its related person does. See Crocker, supra note 105.
---------------------------------------------------------------------------

    Under the amended rule, a related person that holds, or has 
authority to obtain possession of, advisory client assets would be 
presumed not to be operationally independent of the adviser unless the 
adviser can meet the rule's conditions, which are similar to the 
factors that our staff has used to evaluate whether an adviser has 
custody of client funds and securities indirectly under the rule as a 
consequence of the custody of a related person,\111\ and no other 
circumstances exist that can reasonably be expected to compromise the 
operational independence of the related person.\112\ An adviser that is 
able to satisfy these conditions and overcome the presumption that it 
is not operationally independent of its related person would not have 
to obtain a surprise examination of client assets held by a related 
person, including a related person that is a qualified custodian. The 
adviser would, however, have to comply with the other provisions of the 
rule (unless an exception is available), including notifying the client 
where the assets are maintained, forming a reasonable belief after due 
inquiry that the qualified custodian sends the client account 
statements, and obtaining an internal control report from a related 
person that is a qualified custodian.\113\ We believe that the 
conditions set out in the rule appropriately accomplish our objective 
of identifying advisers that are not operationally independent and thus 
present sufficient custodial risks that

[[Page 1465]]

the adviser should be subject to a surprise examination.
---------------------------------------------------------------------------

    \111\ Amended rule 206(4)-2(d)(5) (defining ``operationally 
independent''). The conditions set out in the rule are: (i) Client 
assets in the custody of the related person are not subject to 
claims of the adviser's creditors; (ii) advisory personnel do not 
have custody or possession of, or direct or indirect access to 
client assets of which the related person has custody, or the power 
to control the disposition of such client assets to third parties 
for the benefit of the adviser or its related persons, or otherwise 
have the opportunity to misappropriate such client assets; (iii) 
advisory personnel and personnel of the related person who have 
access to advisory client assets are not under common supervision; 
and (iv) advisory personnel do not hold any position with the 
related person or share premises with the related person. We would 
not consider a related person that shared management persons with 
the adviser, including an owner that was actively involved in the 
management of the two firms, to be operationally independent.
    \112\ For example, the management of the adviser and related 
person could be controlled by persons with close familial 
relationships such as spouses, siblings, or parents and adult 
children.
    \113\ We believe these safeguards remain important because even 
when an adviser has demonstrated that a related person is 
operationally independent, the risks to client assets raised by 
common control may be greater than if client assets were maintained 
by an independent custodian.
---------------------------------------------------------------------------

    We emphasize that an adviser that has custody due to reasons in 
addition to, or other than, a related person having custody cannot 
rebut the presumption contained in the rule. Thus, for example, an 
adviser that has custody because it serves as a trustee with respect to 
client assets held in an account at a broker-dealer that is a related 
person could not rely on the exception from the surprise examination on 
the grounds that the broker-dealer was operationally independent and 
that the factors discussed above were met.\114\ Such an adviser would 
be subject to the surprise examination requirement and would have to 
receive an internal control report from the related person qualified 
custodian.\115\ We are also amending rule 204-2 to require an adviser 
whose client assets are held by a related person but does not undergo a 
surprise examination to make and keep a memorandum describing the 
relationship with the related person in connection with advisory 
services the adviser provides to clients and including an explanation 
of the adviser's basis for determining that it has overcome the 
presumption that it is not operationally independent of the related 
person with respect to the related person's custody of client 
assets.\116\
---------------------------------------------------------------------------

    \114\ We have also amended the rule so that the exception from 
the surprise examination requirement with respect to client assets 
of advisers that have custody as a result of their ability to deduct 
advisory fees from client assets applies to such advisers when their 
client assets are held by a custodian that is not a related person 
of the adviser as well as when the adviser can rely on amended rule 
206(4)-2(b)(6). See amended rule 206(4)-2(b)(3). For the reasons 
described above, when the related person custodian is operationally 
independent, we do not believe the custodial risks raised warrant 
the costs of obtaining a surprise examination.
    \115\ Under the rule, an adviser whose client assets are 
maintained by a related person qualified custodian that is not 
operationally independent from the adviser, must obtain a surprise 
examination of those assets as if it held the assets itself and were 
required to obtain a surprise examination with respect to those 
assets. As a result, for example, a broker-dealer that is also a 
qualified custodian of its client's advisory assets could not avoid 
obtaining a surprise examination by creating an operationally 
integrated subsidiary to provide investment advice.
    \116\ See amended rule 204-2(b)(5).
---------------------------------------------------------------------------

3. PCAOB Registration and Inspection
    Under the amendments, the surprise examination and internal control 
report required when the adviser or its related person serves as 
qualified custodian for client assets may be satisfied only when 
performed or prepared by an independent public accountant that is 
registered with, and subject to regular inspection by, the PCAOB.\117\ 
We have greater confidence in the quality of the surprise examination 
and the internal control report when prepared by an independent public 
accountant that is registered with, and subject to regular inspection 
by, the PCAOB.
---------------------------------------------------------------------------

    \117\ Amended rule 206(4)-2(a)(6). The independent public 
accountant must be registered with, and subject to regular 
inspection by, the PCAOB as of the commencement of the professional 
engagement period, and as of each calendar year-end.
---------------------------------------------------------------------------

    Many commenters supported this requirement, agreeing with us that 
PCAOB registration would provide an important quality check on the 
independent accountants performing these services.\118\ Two of those 
commenters asserted that PCAOB registration would serve to discourage 
accounting fraud in the higher risk situation posed by an adviser or 
its related person maintaining client assets.\119\ Commenters opposing 
the requirement expressed concern that the PCAOB's authority is limited 
to inspecting accountants with respect to audits of public issuers, 
which does not include the surprise examinations and internal control 
reports meeting the requirements of rule 206(4)-2.\120\ One commenter 
urged us to exempt offshore advisers from this requirement, asserting 
that some foreign countries do not have enough accountants registered 
with the PCAOB to support a competitive marketplace for their 
services.\121\
---------------------------------------------------------------------------

    \118\ Surprise exam and internal control report--E&Y Letter; 
NAAIM Letter; internal control report only--CPIC Letter; IAA Letter; 
Pickard Letter; NASAA Letter; surprise examination only--ABA Letter; 
Curian Letter; FPA Letter; Turner Letter.
    \119\ CPIC Letter; FPA Letter.
    \120\ CAS Letter; CAQ Letter; Chamber of Commerce Letter; FTAM 
Letter.
    \121\ ABA Letter.
---------------------------------------------------------------------------

    We acknowledge that the PCAOB does not currently inspect auditor 
engagements required solely as a result of rule 206(4)-2. We 
nonetheless believe a requirement that excludes accountants that are 
not registered with and examined by the PCAOB will provide greater 
confidence in the quality of the independent public accountant and 
complement the enhanced controls under the rule that apply when client 
assets are not maintained by an independent qualified custodian and in 
audits of certain pooled investment vehicles.\122\ While PCAOB 
inspection is focused on public company audit engagements, we believe 
that requiring that the accountant not only be registered with the 
PCAOB but subject to its inspection can provide indirect benefits 
regarding the quality of the accountant's other engagements.
---------------------------------------------------------------------------

    \122\ The PCAOB performs regular inspections with respect to any 
registered public accounting firm that, during any of the three 
prior calendar years, issued an audit report with respect to at 
least one issuer. Under the amended rule, an adviser's use of an 
independent public accountant that is registered with the PCAOB but 
not subject to regular inspection would not satisfy the rule's 
requirements. See PCAOB rule 4003.
---------------------------------------------------------------------------

    We recognize that there may be fewer PCAOB-registered and inspected 
independent public accountants in certain foreign jurisdictions. Based 
on discussions with accounting firms, however, we do not expect 
advisers will have significant difficulty in finding a local auditor 
that is eligible under the rule. Many PCAOB-registered independent 
public accountants currently have practices in those jurisdictions in 
which most offshore advisers and funds are domiciled.\123\ In addition, 
some accounting firms have international practices, which may 
ameliorate concerns regarding offshore availability. Finally, we will 
continue to monitor the situation as the rule is implemented and 
consider any issues that may arise.
---------------------------------------------------------------------------

    \123\ See http://www.pcaobus.org/Registration/Registered_
Firms_by_Location.pdf. We also note that our staff has issued a 
letter indicating that it would not recommend enforcement action to 
the Commission under section 206(4) of the Advisers Act or rule 
206(4)-2 under the Act against offshore advisers to offshore pooled 
investment vehicles if those advisers did not comply with certain 
substantive rules under the Advisers Act, including the custody 
rule. See ABA Subcommittee on Private Investment Entities, SEC Staff 
Letter (Aug. 10, 2006). The amendments we are adopting today do not 
affect the views of the staff expressed in that letter.
---------------------------------------------------------------------------

D. Liquidation Audit

    As proposed, the amended rule requires that advisers to pooled 
investment vehicles that distribute the pool's audited financial 
statements to investors under the rule's annual audit provision must, 
in addition to obtaining an annual audit, obtain a final audit of the 
pool's financial statements upon liquidation of the pool and distribute 
the financial statements to pool investors promptly after the 
completion of the audit.\124\ This amendment is designed to assure that 
the proceeds of the liquidation are appropriately accounted for so that 
pool investors can take timely steps to protect their rights.
---------------------------------------------------------------------------

    \124\ Amended rule 206(4)-2(b)(4). Each such set of audited 
financial statements must be prepared in accordance with generally 
accepted accounting principles.
---------------------------------------------------------------------------

    One commenter thought that liquidation audits should not be 
required as the costs outweigh the benefits.\125\ We disagree. We 
believe that a liquidation audit is an important control to protect 
assets at a time they

[[Page 1466]]

may be particularly vulnerable to misappropriation.
---------------------------------------------------------------------------

    \125\ S&K Letter.
---------------------------------------------------------------------------

E. Pooled Investment Vehicles

    The custody rule's application to investment advisers to pooled 
investment vehicles will change in several aspects as a result of the 
amendments we are adopting today. Because a detailed discussion of each 
of these changes appears throughout multiple different sections of this 
Release, we are providing a centralized summary here.
    Under amended rule 206(4)-2, advisers to pooled investment vehicles 
may be deemed to comply with the surprise verification requirements of 
the rule by obtaining an audit of the pool and delivering the audited 
financial statements to pool investors within 120 days of the pool's 
fiscal year-end.\126\ The audit must be conducted by an accounting firm 
registered with, and subject to regular inspection by, the PCAOB.\127\ 
If the pooled investment vehicle does not distribute audited financial 
statements to its investors, the adviser must obtain an annual surprise 
examination and must have a reasonable basis, after due inquiry, for 
believing that the qualified custodian sends an account statement of 
the pooled investment vehicle to its investors in order to comply with 
the custody rule.\128\ The rule requires the accounting firm performing 
the surprise examination to verify privately offered securities, along 
with other funds and securities, held by a pool that is not subject to 
a financial statement audit.\129\ Regardless of whether an adviser to a 
pooled investment vehicle obtains a surprise examination or satisfies 
that requirement by obtaining an audit, if the pooled investment 
vehicle's assets are maintained with a qualified custodian that is 
either the adviser to the pool or a related person of the adviser, the 
adviser to the pool would have to obtain, or receive from the related 
person, an internal control report.\130\ Finally, the rule requires 
advisers to pools complying with the rule by distributing audited 
financial statements to investors to also obtain an audit upon 
liquidation of the pool when the liquidation occurs prior to the fund's 
fiscal year-end.\131\
---------------------------------------------------------------------------

    \126\ Amended rule 206(4)-2(b)(4). See supra note 45.
    \127\ Amended rule 206(4)-2(b)(4)(ii).
    \128\ Amended rule 206(4)-2(b)(4).
    \129\ Section II.B.3. of this Release. Accounting firms that 
perform surprise examinations under the amended rule are required to 
report material deficiencies to our staff and also report on Form 
ADV-E the termination of an engagement as well as the results of the 
surprise examination.
    \130\ See paragraphs (a)(6), and (b)(4) of amended rule 206(4)-
2. This applies only where the use of a qualified custodian is 
required by the rule.
    \131\ Amended rule 206(4)-2(b)(4)(iii).
---------------------------------------------------------------------------

F. Delivery to Related Persons

    The Commission is adopting a new provision in rule 206(4)-2 that 
would preclude advisers from using layers of pooled investment vehicles 
to avoid meaningful application of the protections of the Rule. 
Specifically, we are adding a new paragraph (c), which provides that 
sending an account statement (paragraph (a)(5)) or distributing audited 
financial statements (paragraph (b)(4)) will not meet the requirements 
of the rule if all of the investors in a pooled investment vehicle to 
which the statements are sent are themselves pooled investment vehicles 
that are related persons of the adviser.
    Investment advisers to pooled investment vehicles may from time to 
time use special purpose vehicles (SPVs) to facilitate investments in 
certain securities by one or more pooled investment vehicles that the 
advisers manage. These SPVs are typically established or controlled by 
the investment adviser or its related persons who often serve as 
general partners of limited partnerships (or managing members of 
limited liability companies, or persons who hold comparable positions 
for another type of pooled investment vehicle). Therefore, a literal 
application of the rule could result in account statements and 
financial statements designed to permit investors to protect their 
interests being sent to the adviser itself, rather than to the parties 
the rule was designed to protect.\132\
---------------------------------------------------------------------------

    \132\ In certain circumstances, the use of SPVs could constitute 
a violation of section 208(d) of the Act, which prohibits an 
investment adviser, ``indirectly, or through or by any other person, 
to do any act or thing which it would be unlawful for such person to 
do directly under'' the Act or any of our rules.
---------------------------------------------------------------------------

    To comply with the rule, as amended, the investment adviser could 
either treat the SPV as a separate client, in which case the adviser 
will have custody of the SPV's assets, or treat the SPV's assets as 
assets of the pooled investment vehicles of which it has custody 
indirectly. If the adviser treats the SPV as a separate client, rule 
206(4)-2 requires the adviser to comply separately with the custody 
rule's audited financial statement distribution or account statement 
and surprise examination requirements (e.g., distribute audited 
financial statements of the SPV pursuant to the requirements of rule 
206(4)-2). Accordingly, advisers should distribute the audited 
financial statements or account statements of the SPV to the beneficial 
owners of the pooled investment vehicles. If, however, the adviser 
treats the SPV's assets as assets of the pooled investment vehicles of 
which it has custody indirectly, such assets must be considered within 
the scope of the pooled investment vehicle's financial statement audit 
or surprise examination.

G. Compliance Policies and Procedures

    Rule 206(4)-7 under the Advisers Act requires registered investment 
advisers to adopt and implement written policies and procedures 
reasonably designed to prevent violations of the Advisers Act and its 
rules.\133\ As we stated in 2003 when we adopted that rule, these 
policies and procedures must address, among other things, the 
safeguarding of client assets from conversion or inappropriate use by 
advisory personnel.\134\ We believe that an adviser's maintenance of 
strong policies and procedures, in addition to the measures we are 
adopting today, is an essential component of a comprehensive approach 
to addressing the potential risks raised by an adviser's custody of 
client assets. We are therefore taking this opportunity to provide 
guidance regarding the types of policies and procedures relating to 
safekeeping of client assets that advisers should consider including in 
their compliance programs.
---------------------------------------------------------------------------

    \133\ 17 CFR 275.206(4)-7.
    \134\ Compliance Programs of Investment Companies and Investment 
Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003) 
[68 FR 74714 (Dec. 24, 2003)] (``Compliance Rule Release''), at 
Section II.A.1.
---------------------------------------------------------------------------

    Compliance with rule 206(4)-7 requires an adviser with custody to 
adopt controls over access to client assets that are reasonably 
designed to prevent misappropriation or misuse of client assets, 
develop systems or procedures to assure prompt detection of any misuse, 
and take appropriate action if any misuse does occur.\135\ Commenters 
on our Proposing Release suggested several policies and procedures that 
advisers should consider adopting in order to comply with rule 206(4)-
7,\136\ many of which we have incorporated into this guidance.
---------------------------------------------------------------------------

    \135\ See id.
    \136\ See, e.g., Comment letter of Investment Adviser 
Association (March 6, 2009); CPIC Letter.
---------------------------------------------------------------------------

    Advisers with custody of client assets should consider the value of 
instituting the following policies and procedures as part of their 
compliance programs: \137\
---------------------------------------------------------------------------

    \137\ In addition to these policies and procedures, an adviser 
should consider: (i) Policies and procedures to establish that it 
has a basis for its reasonable belief that qualified custodians send 
account statements to advisory clients; and (ii) if the adviser has 
overcome the presumption that it is not operationally independent of 
its related person under amended rule 206(4)-2(d)(5), policies and 
procedures reasonably designed to ensure that it continues to 
overcome the presumption set forth in that provision as long as it 
continues to rely on the provision. See supra Sections II.A and 
II.C.2. of this Release.

---------------------------------------------------------------------------

[[Page 1467]]

     Conducting background and credit checks on employees of 
the investment adviser who will have access (or could acquire access) 
to client assets to determine whether it would be appropriate for those 
employees to have such access;
     Requiring the authorization of more than one employee 
before the movement of assets within, and withdrawals or transfers 
from, a client's account, as well as before changes to account 
ownership information;
     Limiting the number of employees who are permitted to 
interact with custodians with respect to client assets and rotating 
them on a periodic basis; and
     If the adviser also serves as a qualified custodian for 
client assets, segregating the duties of its advisory personnel from 
those of custodial personnel to make it difficult for any one person to 
misuse client assets without being detected.\138\
---------------------------------------------------------------------------

    \138\ An adviser utilizing a segregation of duties approach 
should also consider having different personnel authorize custodial 
transfers from client accounts than those who reconcile client 
account balances at the adviser with the custodian's records of 
client transactions and holdings.
---------------------------------------------------------------------------

    Advisers should consider including in their policies and procedures 
a requirement that any problems be brought to the immediate attention 
of the management of the adviser. Advisers also should consider 
developing policies regarding the ability of individual employees to 
acquire custody of client assets, because their custody may be 
attributable to the firm, which will thereby acquire responsibility for 
those assets under the rule. Many firms preclude employees from 
acquiring custody by prohibiting them from, for example, becoming 
trustees for client assets or obtaining powers of attorney for clients 
separate and apart from the advisory firm.\139\ Advisers that permit 
employees to serve in capacities whereby the firm acquires custody of 
client assets should take steps to assure themselves that their 
employees' custodial practices conform to the firm's policies and 
procedures, and that the adviser's chief compliance officer (``CCO'') 
has access to sufficient information to enforce those policies and 
procedures.
---------------------------------------------------------------------------

    \139\ When a supervised person of an adviser serves as the 
executor, conservator or trustee for an estate, conservatorship or 
personal trust solely because the supervised person has been 
appointed in these capacities as a result of family or personal 
relationship with the decedent, beneficiary or grantor (and not as a 
result of employment with the adviser), we would not view the 
adviser to have custody of the funds or securities of the estate, 
conservatorship, or trust. See 2003 Adopting Release at n.15.
---------------------------------------------------------------------------

    The adviser's custody of client assets presents elevated compliance 
risks for the adviser and its clients. Advisers and their CCOs 
therefore must accord these risks appropriate attention in the 
adviser's compliance program. Accordingly, the adviser should consider 
developing procedures by which the CCO periodically tests the 
effectiveness of the firm's controls over the safekeeping of client 
assets. For example, the CCO could periodically test the reconciliation 
of account statements prepared by advisers with account statements as 
reported by qualified custodians. In addition, the CCO could compare, 
on a sample basis, client addresses obtained from the clients' 
qualified custodians to which the custodian sends client statements, 
with client addresses maintained by the adviser, to look for 
inconsistencies or patterns that suggest possible manipulation of 
address information as a means for concealing misappropriation from 
these accounts by advisory personnel.
    Advisers that have custody as a result of their authority to deduct 
advisory fees directly from client accounts held at a qualified 
custodian should have policies and procedures in place that address the 
risk that the adviser or its personnel could deduct fees to which the 
adviser is not entitled under the terms of the advisory contract, which 
would violate the contract and which may constitute fraud under the 
Advisers Act. The adviser's policies and procedures should take into 
account how and when clients will be billed; be reasonably designed to 
ensure that the amount of assets under management on which the fee is 
billed is accurate and has been reconciled with the assets under 
management reflected on statements of the client's qualified custodian; 
and be reasonably designed to ensure that clients are billed accurately 
in accordance with the terms of their advisory contracts.\140\ Examples 
of policies and procedures such an adviser should consider include: 
\141\
---------------------------------------------------------------------------

    \140\ Our staff has taken the view that, under some 
arrangements, clients may pay advisory fees deducted directly from 
assets held in their advisory accounts without causing the adviser 
to have custody of those assets and being subject to the custody 
rule. Under these arrangements, a client will instruct its qualified 
custodian as its agent to determine the amount of the advisory fee 
and to remit the amount of the fee to the adviser. Our staff 
therefore takes the view, under these circumstances, that the 
adviser has no access to the client's funds or securities. See Staff 
Responses to Questions About Amended Custody Rule, at Section III. 
Fee Deduction, Question III.3, available at http://www.sec.gov/
divisions/investment/custody_faq.htm.
    \141\ Some of these suggestions came from commenters. See, e.g., 
CPIC Letter.
---------------------------------------------------------------------------

     Periodic testing on a sample basis of fee calculations for 
client accounts to determine their accuracy;
     Testing of the overall reasonableness of the amount of 
fees deducted from all client accounts for a period of time based on 
the adviser's aggregate assets under management; and
     Segregating duties between those personnel responsible for 
processing billing invoices or listings of fees due from clients that 
are provided to and used by custodians to deduct fees from clients' 
accounts and those personnel responsible for reviewing the invoices and 
listings for accuracy, as well as the employees responsible for 
reconciling those invoices and listings with deposits of advisory fees 
by the custodians into the adviser's proprietary bank account to 
confirm that accurate fee amounts were deducted.
    Because different controls may be appropriate for different 
advisers in designing effective compliance programs, we are not 
suggesting a single set of policies and procedures. As we noted in 2003 
when we adopted rule 206(4)-7, we recognize that advisers are too 
varied in their operations and size for such an approach to work.\142\ 
Policies and procedures that are appropriate for a 500 employee firm 
that also operates as a broker-dealer will be unlikely to work (or be 
necessary) for a five person firm that provides asset allocation 
advice. Advisers with only a few employees may, for example, find 
segregation of duties impractical, but for advisers with a large number 
of employees such a control may be highly effective. Advisers to pooled 
investment vehicles should consider whether these practices, or others, 
should cover investor accounts in the pool, for example, to prevent an 
employee from misappropriating assets from the pool by processing false 
investor withdrawals. We have therefore provided the guidance set out 
above primarily in the form of examples; we expect advisers to tailor 
their custody policies and procedures to fit both the size and the 
particular risks that are raised by their business model.
---------------------------------------------------------------------------

    \142\ Compliance Rule Release, at Section II.A.1.
---------------------------------------------------------------------------

H. Amendments to Form ADV

    We are adopting several amendments to Part 1A and Schedule D of 
Form ADV. The amendments require registered advisers to report to us 
more

[[Page 1468]]

detailed information about their custody practices in their 
registration form and to update the information. The information will 
enhance our ability to identify compliance risks associated with 
custody of client assets.\143\ The amendments primarily affect only 
those advisers that have custody of client assets under rule 206(4)-2.
---------------------------------------------------------------------------

    \143\ These revisions respond in part to concerns raised by the 
Government Accountability Office in its August 2007 report on our 
examination program, which concluded that 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.
---------------------------------------------------------------------------

    Item 7. We are adopting the amendments to Item 7 and Section 7.A. 
of Schedule D that we proposed to require each adviser to report all 
related persons who are broker-dealers and to identify which, if any, 
serve as qualified custodians with respect to the adviser's clients' 
funds or securities.\144\ We did not receive comments on these proposed 
amendments. We also are amending Section 7.A. of Schedule D to require 
an adviser to report whether it has determined that it has overcome the 
presumption that it is not operationally independent from a related 
person broker-dealer qualified custodian, and thus is not required to 
obtain a surprise examination for the clients' assets maintained at 
that custodian.
---------------------------------------------------------------------------

    \144\ The item had required an adviser to identify on Schedule D 
of Form ADV each related person that is an investment adviser, but 
made reporting of the names of related person broker-dealers 
optional.
---------------------------------------------------------------------------

    Item 9. We are adopting amendments to Item 9 to require each 
registered adviser to report to us: (i) Whether the adviser or a 
related person has custody of client assets, and if so, both the total 
U.S. dollar amount of those assets as well as the number of clients for 
whose accounts the adviser or its related person has custody; \145\ 
(ii) if the adviser, or a related person, acts as an adviser to a 
pooled investment vehicle, whether (a) the pool is audited, and (b) the 
qualified custodians send account statements to pool investors; \146\ 
(iii) whether an independent public accountant conducts an annual 
surprise examination of client assets; \147\ and (iv) whether an 
independent public accountant prepares an internal control report with 
respect to the adviser or its related person; \148\ and (v) whether the 
adviser or a related person serves as qualified custodian for the 
adviser's clients.\149\ In addition, we are amending Schedule D to 
require that advisers (i) identify and provide certain information 
about the accountants that perform audits or surprise examinations and 
that prepare internal control reports; \150\ and (ii) to identify 
related persons, such as banks, that serve as qualified custodians with 
respect to their clients' funds or securities, but are not otherwise 
reported in Item 7. We also are amending Schedule D to require an 
adviser to report whether it has determined that it has overcome the 
presumption that it is not operationally independent from a related 
person qualified custodian, and thus is not required to obtain a 
surprise examination for the clients' assets maintained at that 
custodian.\151\
---------------------------------------------------------------------------

    \145\ Items 9.A. and 9.B of Part 1A of Form ADV.
    \146\ Item 9.C.(1) and (2) of Part 1A of Form ADV.
    \147\ Item 9.C.(3) of Part 1A of Form ADV.
    \148\ Item 9.C.(4) of Part 1A of Form ADV. Two commenters 
suggested that we eliminate the requirements in Item 9.C. that 
require an adviser to disclose the actions taken by the adviser's 
qualified custodian and accountant pursuant to the proposed custody 
rule (as well as corresponding portions of Schedule D), stating that 
advisers cannot guarantee third-party actions and that reporting 
compliance with aspects of the custody rule is an inappropriate use 
of Form ADV. See IAA Letter; MMI Letter. These items do not require 
an adviser to guarantee actions of third parties, but merely require 
the adviser to report on obligations it has (e.g., to form a 
reasonable belief) under the revised custody rule, which if not met 
would result in the adviser's violation of the rule.
    \149\ Item 9.D. of Part 1A of Form ADV.
    \150\ In addition to providing the accountant's name and 
address, advisers must indicate whether the accountant is registered 
with and subject to regular inspection by the PCAOB. Advisers must 
also indicate whether the accountant's report contained an 
unqualified opinion. Section 9.C. of Schedule D to Part 1A of Form 
ADV. One commenter stated that we should not require advisers to 
report whether the accountants they, or their related persons, 
engage are registered with and subject to inspection by the PCAOB 
because this information is readily available on the PCAOB's Web 
site. See AICPA Letter. An adviser, or related person custodian, 
would have to collect this information in the course of retaining an 
accountant to perform the necessary engagements to comply with the 
revised custody rule, and we expect that accountants would make 
these representations to their clients. As a result, reporting this 
information should not be burdensome to advisers.
    \151\ Section 9.D. of Schedule D to Part 1A of Form ADV.
---------------------------------------------------------------------------

    Several commenters generally supported these amendments to Form 
ADV, and many requested clarification or modification to parts of the 
form.\152\ In response to several commenters' requests for 
clarification or modification of Item 9,\153\ we have added an 
instruction to clarify that an adviser must separately report the 
amount of assets of which it has custody, excluding those assets 
maintained by a related person qualified custodian, and the amount of 
assets of which a related person has custody, including when the 
related person serves as a qualified custodian.\154\
---------------------------------------------------------------------------

    \152\ Cornell Letter; IAA Letter; MMI Letter; NRS Letter; Turner 
Letter.
    \153\ IAA Letter; NSCP Letter; ASG Letter; CAS Letter.
    \154\ We also are revising an existing instruction to Item 9.A. 
to specify that in addition to advisers that have custody only 
because they have authority to deduct fees that if they also have 
custody because a related person maintains client assets but the 
adviser has overcome the presumption of not being operationally 
independent they may continue to answer ``no'' to Item 9.A. Advisers 
must report information about these custody arrangements in Item 
9.B.
     It will be several months before FINRA, which operates the IARD 
for us, completes reprogramming the IARD to implement this change to 
Item 9. In the interim, advisers registered with the Commission 
should provide responses following the amended instruction.
---------------------------------------------------------------------------

I. Amendments to Form ADV-E

    We are adopting, as proposed, three amendments to the instructions 
to Form ADV-E. First, we have amended the form instructions to require 
that the form and the accompanying accountant's examination certificate 
be filed electronically with the Commission through the IARD.\155\ 
Advisers will, however, continue to file form ADV on paper until the 
IARD system begins accepting electronic filings of Form ADV-E, which we 
expect to occur sometime in late 2010. Investment advisers will be 
notified at that time. The second and third amendments we are adopting 
conform Form ADV-E instructions to amended rule 206(4)-(2), which, as 
discussed above, requires that (i) the surprise examination certificate 
must be filed within 120 days of the time chosen by the accountant for 
the surprise examination,\156\ and (ii) a termination statement be 
filed by an accountant within four business days of its resignation, 
dismissal, or removal.\157\
---------------------------------------------------------------------------

    \155\ Instruction 3(a) to Form ADV-E. Several comments supported 
electronic filing and the amendments to Form ADV-E generally. See 
Cornell Letter; IAA Letter; Turner Letter.
    \156\ Instruction 3(i) to Form ADV-E.
    \157\ Instruction 3(ii) to Form ADV-E. Commenters suggested that 
we revise the timing of the filing and that we do not make the 
filing available to the public. We have addressed these comments in 
Section II.B.2 of this Release. See supra notes 54 and 57 and 
accompanying text.
---------------------------------------------------------------------------

J. Required Records

    We also are adopting amendments, as proposed, to rule 204-2 to 
require an adviser to maintain a copy of (i) the internal control 
report that such adviser is required to obtain or receive from its 
related person, pursuant to amended rule 206(4)-2(a)(6), and (ii) the 
memorandum describing the basis upon which the adviser determined that 
the presumption that any related person is not operationally 
independent, pursuant to amended rule 206(4)-2(d)(5), has

[[Page 1469]]

been overcome, for five years from the end of the fiscal year in which, 
as applicable, the internal control report or memorandum is finalized. 
Requiring an adviser to retain a copy of these items will provide our 
examiners with important information about the safeguards in place at 
an adviser or related person that maintains client assets. Information 
from these records will also assist our staff in assessing custody-
related risks at a particular adviser.

III. Effective and Compliance Dates

A. Effective Date

    The effective date of the amendments to rules 206(4)-2, 204-2, and 
Forms ADV and ADV-E is March 12, 2010.

B. Compliance Dates and Related Rule Amendments

    Advisers registered with us must comply with amended rules 206(4)-
2, 204-2, and Forms ADV and ADV-E, as amended, on and after March 12, 
2010, the effective date of these amendments, except as described 
below. Immediately upon the effective date advisers that have custody 
of client assets must promptly upon opening a custodial account on a 
client's behalf, and following any changes to the custodial account 
information, as specified in rule 206(4)-2(a)(2) send a notification to 
the client, including a legend urging the client to compare the account 
statements the client receives from the custodian with those the client 
receives from the adviser. Such legend should also be included in any 
account statements that advisers send to these clients after they are 
required to send the notification discussed above. In addition, 
immediately upon the effective date, each adviser that has custody of 
client assets must have a reasonable belief (except with respect to 
pooled investment vehicles the financial statements of which are 
audited and delivered to investors) that a qualified custodian sends 
account statements directly to clients at least quarterly, in 
accordance with rule 206(4)-2(a)(3). We believe 60 days is sufficient 
for advisers to comply with the amended rule regarding the three 
requirements described above because they are modifications to the 
existing rule requirements.
    Compliance dates for other provisions of amended rules 206(4)-2, 
204-2, and Forms ADV and ADV-E are described below.\158\
---------------------------------------------------------------------------

    \158\ Some commenters requested that we delay the compliance 
date by 12-24 months from the effective date of the rule. See Curian 
Letter; CAQ Letter; Dechert Letter; Deloitte Letter; E&Y Letter; 
KPMG Letter; PWC Letter. In determining the compliance dates for the 
amended rules and forms, we balanced the urgency of enhancing 
investor protection afforded under the Advisers Act, the need to 
provide sufficient time for advisers to comply with the requirements 
under the amended rules, and the extent of changes we made from the 
proposal on which the commenters' requests were based.
---------------------------------------------------------------------------

1. Surprise Examinations
    An investment adviser required to obtain a surprise examination 
must enter into a written agreement with an independent public 
accountant that provides that the first examination will take place by 
December 31, 2010 or, for advisers that become subject to the rule 
after the effective date, within six months of becoming subject to the 
requirement.\159\ If the adviser itself maintains client assets as 
qualified custodian, however, the agreement must provide for the first 
surprise examination to occur no later than six months after obtaining 
the internal control report.\160\ We believe these compliance dates 
will provide sufficient time for an adviser to hire an independent 
public accountant for purposes of the surprise examination and for the 
accountant to perform the surprise examination.
---------------------------------------------------------------------------

    \159\ An adviser could first become subject to the surprise 
examination requirement by, for example, registering with the 
Commission or accepting custody of a client's assets.
    \160\ An independent public accountant conducting a surprise 
examination on an adviser that also serves as the qualified 
custodian for its clients (i.e., self custody) would have to verify 
the existence of client assets with the adviser itself. Because of 
the added assurance of having an internal control report, we believe 
that investors would be better served if the first round of surprise 
examinations is conducted with the benefit of the internal control 
report. An adviser with multiple related persons that serve as 
qualified custodians must undergo a surprise examination within six 
months of receiving the last internal control report it is required 
to receive.
---------------------------------------------------------------------------

2. Internal Control Reports
    An investment adviser also required to obtain or receive an 
internal control report because it or a related person maintains client 
assets as a qualified custodian must obtain or receive an internal 
control report within six months of becoming subject to the 
requirement. As noted above, an adviser obtaining an internal control 
report because it (rather than a related person) also serves as a 
qualified custodian of its clients' assets (e.g., a broker-dealer) need 
not undergo a surprise examination until six months after obtaining the 
internal control report.
3. Audits of Pooled Investment Vehicles
    An investment adviser to a pooled investment vehicle may rely on 
the annual audit provision if the adviser (or a related person) becomes 
contractually obligated to obtain an audit of the financial statements 
of the pooled investment vehicle for fiscal years beginning on or after 
January 1, 2010 by an independent public accountant registered with, 
and subject to regular inspection by, the PCAOB.
4. Forms ADV and ADV-E
    Investment advisers registered with us must provide responses to 
the revised Form ADV in their first annual amendment after January 1, 
2011.\161\ Until the IARD system is upgraded to accept Form ADV-E, 
accountants performing surprise examinations should continue paper 
filing of Form ADV-E. Investment advisers will be notified as soon as 
the IARD system can accept filings of Form ADV-E.\162\
---------------------------------------------------------------------------

    \161\ Based on discussions with our contractor, we anticipate 
that IARD will reflect the changes to Form ADV we are adopting today 
and accept electronic filing of Form ADV-E in the fourth quarter of 
2010. Form ADV-Es filed with us on paper before electronic filing 
will be available upon request through the Commission's Public 
Reference Room, 100 F Street, NE., Washington, DC 20549.
    \162\ We urge advisers in the meantime to confirm that their 
email contact information on Form ADV is correct and to update the 
information promptly if necessary.
---------------------------------------------------------------------------

IV. Paperwork Reduction Act

    Certain provisions of rule 206(4)-2, Form ADV, and Form ADV-E that 
we are amending today contain ``collection of information'' 
requirements within the meaning of the Paperwork Reduction Act of 1995 
(``PRA'').\163\ In the Proposing Release, the Commission published 
notice soliciting comment on the collection of information 
requirements. The Commission submitted the collection of information 
requirements to the Office of Management and Budget (``OMB'') for 
review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11 under 
control numbers 3235-0241, 3235-0049, and 3235-0361, respectively. The 
titles for the collections of information are ``Rule 206(4)-2, 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.\164\ An

[[Page 1470]]

agency may not sponsor, or conduct, and a person is not required to 
respond to, a collection of information unless it displays a currently 
valid OMB control number.
---------------------------------------------------------------------------

    \163\ 44 U.S.C. 3501.
    \164\ We also are adopting amendments to rule 204-2 that require 
approximately 337 advisers to maintain the internal control reports 
they obtain, or receive from related persons, and if these advisers 
have determined that the presumption that a related person is 
operationally independent has been overcome, a memorandum describing 
the basis upon which that determination was made. In addition, rule 
204-2(a)(10) already requires an adviser to maintain all written 
agreements relating to its business as such, which would require an 
adviser to maintain the written agreement concerning the surprise 
examination required by the amended rule. The current approved 
collection of information burden for rule 204-2 is 1,945,109 hours 
and has an estimated cost of $13,551,390 under OMB control number 
3235-0278. The two new retention requirements and the additional 
written agreements that will be maintained as a result of more 
surprise examinations will result in a negligible increase to the 
currently approved burden for rule 204-2.
---------------------------------------------------------------------------

    The collections of information under rule 206(4)-2 are necessary to 
ensure that clients' funds and securities in the custody of advisers 
are safeguarded, and information contained in the collections is used 
by staff of the Commission in its enforcement, regulatory, and 
examination programs. The respondents are investment advisers 
registered with us that have custody of client funds and securities 
(``client assets''). The collections of information under Form ADV are 
necessary for use by staff of the Commission in its examination and 
oversight program, and some advisory clients also may find them useful. 
The respondents are investment advisers seeking to register with the 
Commission or to update their registrations. The collections of 
information under Form ADV-E are necessary for use by staff of the 
Commission in its examination and oversight program, and some advisory 
clients also may find them useful. The respondents are investment 
advisers registered with us that have custody of client assets and are 
subject to an annual surprise examination requirement under rule 
206(4)-2. All responses required by the rule are mandatory. With the 
exception of an accountant's notification of any material discrepancies 
identified in a surprise examination pursuant to rule 206(4)-
2(a)(4)(ii), responses provided to the Commission are not kept 
confidential.

A. Rule 206(4)-2

    The Commission is adopting amendments to the custody rule under the 
Advisers Act. The amendments are designed to provide additional 
safeguards under the Advisers Act when a registered adviser has custody 
of client funds or securities by requiring such an adviser, among other 
things: (i) To undergo an annual surprise examination by an independent 
public accountant to verify client assets; (ii) to have a reasonable 
basis after due inquiry, for believing that the qualified custodian 
maintaining client funds and securities sends account statements 
directly to the advisory clients; and (iii) unless client assets are 
maintained by an independent custodian (i.e., a custodian that is not 
the adviser itself or a related person) to obtain or receive a report 
of the internal controls relating to the custody of those assets from 
an independent public accountant that is registered with and subject to 
regular inspection by the PCAOB.
    The amendments to rule 206(4)-2 that we are adopting today differ 
from our proposed amendments in three respects that affect our 
Paperwork Reduction Act analysis. First, we are providing an exception 
to the surprise examination requirement for advisers that have custody 
because they have authority to deduct advisory fees from client 
accounts and advisers that have custody solely because a related person 
holds the adviser's client assets and the related person is 
operationally independent of the adviser.\165\ Second, advisers to 
pooled investment vehicles that are subject to an annual audit and that 
distribute audited financial statements to investors in the pools are 
deemed to comply with the surprise examination requirement as long as 
the accountant performing the annual audit is registered with, and 
subject to regular inspection by, the PCAOB.\166\ Third, if an adviser 
sends account statements to its clients, it must not only insert a 
legend in the required notice to clients upon opening accounts on their 
behalf, but must also insert the legend in subsequent account 
statements sent to those clients urging the client to compare the 
account statements from the custodian with those from the adviser.\167\
---------------------------------------------------------------------------

    \165\ Amended rule 206(4)-2(b)(3) and amended rule 206(4)-
2(b)(6).
    \166\ Amended rule 206(4)-2(b)(4).
    \167\ Amended rule 206(4)-2(a)(2).
---------------------------------------------------------------------------

    We requested comment on the Paperwork Reduction Act analysis 
contained in the Proposing Release. A number of commenters expressed 
concerns that the paperwork burdens associated with our proposed 
amendments to rule 206(4)-2 were understated.\168\ In response to these 
comments as well as the differences in the amendments we are adopting 
from those we proposed, as described above, and the guidance for 
accountants published in a companion release,\169\ we have adjusted our 
Paperwork Reduction Act estimates as discussed below.
---------------------------------------------------------------------------

    \168\ See, e.g., ASG Letter; MMI Letter; Schwab Letter. These 
commenters did not provide empirical data that is relevant to our 
estimates of burden hours in this Paperwork Reduction Act analysis, 
but did provide cost estimates that we have considered in Section V 
of this Release.
    \169\ See Accounting Release.
---------------------------------------------------------------------------

    Annual surprise examination. The current approved annual burden for 
rule 206(4)-2 is 415,303 hours, 21,803 of which relate to the 
requirement to obtain a surprise examination and the delivery of 
quarterly account statements by the adviser. We estimated in the 
Proposing Release that 9,575 advisers registered with the Commission 
would be subject to the surprise examination.\170\ As noted above, the 
amended rule we are adopting today excludes certain advisers with 
custody from the requirement to undergo an annual surprise examination 
and deems certain advisers to audited pooled investment vehicles to 
have complied with the requirement.\171\ Advisers that have custody for 
other reasons, however, such as because they or their related person 
serves as the qualified custodian for client assets, or because they 
serve as the trustee of a client trust, must undergo an annual surprise 
examination.\172\ As a result, we now estimate that 1,859 advisers will 
be subject to the surprise examination requirement under the amended 
rule 206(4)-2.\173\
---------------------------------------------------------------------------

    \170\ Based on Form ADVs filed as of February 2009. See the 
Proposing Release at n.77 for explanation of our estimate.
    \171\ Amended rule 206(4)-2(b)(3) (exception from surprise 
examination for advisers that have custody because they have 
authority to deduct fees from client accounts) and amended rule 
206(4)-2(b)(4)(deems advisers to audited pooled investment vehicles 
that distribute audited financial statements to pool investors to 
comply with the surprise examination requirement if the audit is 
conducted by a public accountant registered with, and subject to 
regular inspection by, the PCAOB). See supra Section II.B.1 of this 
Release.
    \172\ Under amended rule 206(4)-2 an adviser has custody if its 
related person has custody of its client assets. Amended rule 
206(4)-2(d)(2). A related person is defined as a person directly or 
indirectly controlling or controlled by the adviser, and any person 
under common control with the adviser. Amended rule 206(4)-2(d)(7).
    \173\ Based on Form ADVs filed as of November 2, 2009 (unless 
indicated otherwise, all data we use in this release were as of 
November 2, 2009), there were 3,689 advisers that answered ``yes'' 
to Form ADV, Part 1A Items 9.A or 9.B (indicating that they or a 
related person has custody of client assets. This excludes advisers 
that have custody solely because they have authority to deduct fees 
from clients' accounts). We exclude from this number (i) 38 of these 
advisers that only have clients that are investment companies (Item 
5.D(4)); (ii) 703 (or 90%, which is based on staff observation that 
the vast majority of pooled investment vehicles are subject to an 
annual audit) of the 781 of these advisers that only have clients 
that are pooled investment vehicles (Items 5.D(6) or 5.D(4)); (iii) 
1,030 (or 80%) of the 1,288 advisers that have some clients that are 
pooled investment vehicles (10% of which is based on the number of 
advisers (from IARD data) that have both pooled investment vehicle 
clients and non-pooled investment vehicle clients that will not have 
to undergo a surprise examination because they do not have custody 
under the rule of the non-pooled investment vehicle client assets 
that would require a surprise examination and 10% of which is based 
on an estimate of the pooled investment vehicles that are subject to 
an annual audit). We further estimate that of the 396 advisers we 
estimate that are currently using related person qualified 
custodians, 59 (or 15%) will choose to use independent qualified 
custodians and, as a result, will no longer retain custody of client 
assets under the rule that would require these advisers to undergo 
the surprise examination. See infra note 282 for explanation of this 
estimate. (3,689-38-703-1,030-59 = 1,859).

---------------------------------------------------------------------------

[[Page 1471]]

    For purposes of estimating the collection of information burden we 
have divided the estimated 1,859 advisers into 3 subgroups. First, we 
estimate that 337 advisers have custody because (i) they serve as 
qualified custodians for their clients and are also broker-dealers, 
banks or futures commission merchants,\174\ or (ii) they have a related 
person that serves as qualified custodian for clients in connection 
with advisory services the adviser provides to the clients.\175\ We 
estimate that these advisers will be subject to an annual surprise 
examination with respect to 100 percent of their clients (or 2,315 
clients per adviser) based on the assumption that all of their clients 
maintain custodial accounts with the adviser or related person.\176\ We 
estimate that each adviser will spend an average of 0.02 hours for each 
client to create a client contact list for the independent public 
accountant. The estimated total annual aggregate burden with respect to 
the surprise examination requirement for this group of advisers is 
15,603 hours.\177\
---------------------------------------------------------------------------

    \174\ We estimate that 91 investment advisers that are also 
banks, registered broker-dealers or futures commission merchants 
would custody client assets as a qualified custodian under the rule.
    \175\ Based on IARD data, we also estimate that 305 investment 
advisers have a related person bank, registered broker-dealer or 
futures commission merchant that is a qualified custodian for 
advisory client assets. 91 (advisers that are also banks or broker-
dealers) + 305 (advisers using related persons as custodians) = 396. 
396-59 (advisers that will stop using related persons as custodians) 
= 337 (see supra note 173 for explanation of 59 advisers removed).
    \176\ In the Proposing Release, we estimated that each adviser 
had, on average, 1,092 clients. See Proposing Release at n.79. That 
estimate was based on the average number of clients of all advisers 
registered with us (excluding the two largest firms). We now base 
our estimate on IARD data of all the advisers that will be subject 
to the surprise examination under the amended rule (also excluding 
these two largest firms). This new estimate excludes from the 
calculation about 6,000 advisers that have custody solely because of 
deducting fees, which tend to have fewer clients. As a result the 
estimated average number of clients for the advisers that will be 
subject to the surprise examination under the amended rule is 
increased.
    \177\ 337 advisers x 2,315 (average number of clients subject to 
the surprise examination requirement) x 0.02 hour = 15,603 hours. As 
addressed later, some of these advisers will not have to obtain a 
surprise examination as a result of the exception to the surprise 
examination requirement under amended rule 206(4)-2(b)(6) for an 
adviser that has custody because of its related person's custody of 
client assets and that can overcome the presumption that it is not 
operationally independent of the related person custodian. See infra 
note 283. We do not have data or another resource to provide an 
estimate of the number of advisers that use related person 
custodians that will be able to overcome the presumption. This 
estimated annual hour burden may, as a result, overestimate the 
collection of information requirement as advisers that have overcome 
the presumption will not have to create client contact lists.
---------------------------------------------------------------------------

    A second group of advisers, estimated at 1,315,\178\ are those that 
have custody because they have broad authority to access client assets 
held at an independent qualified custodian, such as through a power of 
attorney or acting as a trustee for a client's trust. Based on our 
staff's experience, advisers that have access to client assets through 
a power of attorney, acting as trustee, or similar legal authority 
typically do not have access to all of their client accounts, but 
rather only to a small percentage of their client accounts pursuant to 
these special arrangements. We estimate that these advisers will be 
subject to an annual surprise examination with respect to 5 percent of 
their clients (or 116 clients per adviser) \179\ who have these types 
of arrangements with the adviser. We estimate that each adviser will 
spend an average of 0.02 hours for each client to create a client 
contact list for the independent public accountant. The estimated total 
annual aggregate burden with respect to the surprise examination 
requirement for this group of advisers is 3,051 hours.\180\
---------------------------------------------------------------------------

    \178\ This estimate is based on the total number of advisers 
subject to surprise examinations less those described above in the 
first group (custody as a result of serving as, or having related 
person serving as qualified custodians) and below in the third group 
(advisers to pooled investment vehicles) 1,859-337-207 = 1,315. See 
infra note 182 and accompanying text.
    \179\ Based on the IARD data, we estimate that the average 
number of clients of advisers subject to the surprise examination 
requirement is 2,315. (2,315 x 5% = 116).
    \180\ 1,315 x 116 x 0.02 = 3,051.
---------------------------------------------------------------------------

    A third group of advisers, estimated at 207,\181\ provide advice to 
pooled investment vehicles that are not undergoing an annual audit, and 
therefore will be subject to the surprise examination with respect to 
100 percent of their pooled investment vehicle clients (which we 
estimate to be 5 funds and 250 investors per adviser providing advisory 
services exclusively to pooled investment vehicles, and 2 funds and 100 
investors per adviser not providing advisory services exclusively to 
pooled investment vehicles).\182\ We estimate that the advisers to 
these pooled investment vehicles will spend 1 hour for the pool and 
0.02 hours for each investor in the pool to create a contact list for 
the independent public accountant, for an estimated total annual burden 
with respect to the surprise examination requirement for these advisers 
of 1,296 hours.\183\ These estimates bring the total annual aggregate 
burden with respect to the surprise examination requirement for all 
three groups of advisers to 19,950 hours.\184\ This estimate does not 
include the collection of information discussed below relating to the 
written agreement required by paragraph (a)(4) of the rule.
---------------------------------------------------------------------------

    \181\ Based on IARD data, we estimate that there are 781 
advisers that provide advisory services exclusively to pooled 
investment vehicles. See supra note 173. We further estimate, based 
on our staff's experience, that only ten percent of advisers to 
pooled investment vehicles will be subject to an annual surprise 
examination because the pooled investment vehicles they advise do 
not undergo an annual audit. We further estimate, based upon staff 
experience, that ten percent of the 1,288 advisers that provide 
services not exclusively to pooled investment vehicles will be 
subject to an annual surprise examination because the pooled 
investment vehicles they advise do not undergo an annual audit. (781 
x 10%) + (1,288 x 10%) = 78 + 129 = 207.
    \182\ The number of funds per adviser is estimated based on the 
information we collected from Item 5.C. of Form ADV filed by 
advisers that provide advisory services only to pooled investment 
vehicles. The estimate of 250 investors per adviser is a staff 
estimate used in the currently approved collection of information 
burden.
    \183\ [(78 x 5) + (78 x 250 x 0.02)] + [(129 x 2) + (129 x 100 x 
0.02)] = [390 + 390] + [258 + 258] = 1,296.
    \184\ 1,296 + 15,603 + 3,051 = 19,950. By contrast, our estimate 
in the Proposing Release for the surprise examination as proposed 
was 177,242 hours.
---------------------------------------------------------------------------

    Written agreement with accountant. Consistent with the proposal, 
amended rule 206(4)-2 requires that an adviser subject to the surprise 
examination requirement must enter into a written agreement with the 
independent public accountant engaged to conduct the surprise 
examination and specify certain duties to be performed by the 
independent public accountant.\185\ As stated in the Proposing Release, 
we believe that written agreements are commonplace and reflect industry 
practice when a person retains the services of a professional such as 
an accountant, and they are typically prepared by the independent 
public accountant in advance. We therefore estimate that each adviser 
will spend 0.25 hour to add the required provisions to the written 
agreement, with an aggregate of 465 hours for all advisers subject to 
surprise examinations.\186\ Therefore the total annual burden in 
connection with the surprise examination is estimated at 20,415 hours 
under the amended rule.\187\
---------------------------------------------------------------------------

    \185\ Amended rule 206(4)-2(a)(4).
    \186\ 1,859 x 0.25 = 465.
    \187\ 19,950 + 465 = 20,415.
---------------------------------------------------------------------------

    Audited pooled investment vehicles. The rule currently excepts, and 
the amended rule continues to except,

[[Page 1472]]

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.\188\ As explained in the Proposing Release, we overestimated the 
burden for this delivery requirement in the past.\189\ The collection 
of information burden imposed on an adviser relating to the mailing of 
audited financial statements to each investor in a pool that it manages 
should be minimal, as the financial statements could be included with 
account statements or other mailings. We estimate, consistent with the 
estimate in the proposing release, that the average burden for advisers 
to mail audited financial statements to investors in the pool is 1 
minute per investor.\190\ Under our revised estimate of the number of 
advisers to audited pooled investment vehicles,\191\ we estimate that 
the aggregate annual hour burden in connection with the distribution of 
audited financial statements is 4,861 hours.\192\
---------------------------------------------------------------------------

    \188\ We estimated that 3,148 advisers to pooled investment 
vehicles were subject to this information collection under the 
current rule. We further estimated that each adviser had, on 
average, 250 investors in the funds it advises, and that each 
adviser spent 0.5 hours per investor annually for delivering audited 
financial statements to its 250 investors. 3,148 x 250 x 0.5 = 
393,500.
    \189\ We previously estimated that an adviser would spend 0.5 
hours per investor sending investors audited financial statements. 
This estimate incorrectly included time for preparation of the 
audited financial statements, which after the audit should have been 
readily available to the adviser for distribution.
    \190\ Proposing Release at n. 94.
    \191\ Based on IARD data, 2,069 advisers with custody of client 
assets provided advice to pooled investment vehicles as of November 
2, 2009. Of these 2,069 advisers, we estimate that 781 advisers will 
each on average provide advice to five pooled investment vehicles 
that have a total of 250 investors. 5 (pools) x 50 (investors) = 
250. We estimate that of these 781 advisers, 703 (or 90%) will have 
their pooled investment vehicles audited and distribute the audited 
financial statements to the investors in the pool. We further 
estimate that of the remaining 1,288 advisers, on average, each 
provides advice to two pooled investment vehicles that have a total 
of 100 investors. 2 (pools) x 50 (investors) = 100. We estimate that 
of these 1,288 advisers, 1,159 (or 90%) will have their pooled 
investment vehicles audited and will distribute the audited 
financial statements to the investors in the pool.
    \192\ [(703 x 250 x 1)/60] + [(1,159 x 100 x 1)/60] = 2,929 + 
1,932 = 4,861.
---------------------------------------------------------------------------

    The amended rule requires that an adviser to a pooled investment 
vehicle that is relying on the annual audit provision must have the 
pool audited and distribute the audited financial statements to the 
investors in the pool promptly after completion of the audit if the 
fund liquidates at a time other than its fiscal year-end. We estimate 
that 5 percent of pooled investment vehicles are liquidated annually at 
a time other than their fiscal year-end, which results in an additional 
burden of 243 hours per year.\193\ As a result, the total annual hour 
burden in connection with the distribution of audited financial 
statements in connection with annual audit and liquidation audit under 
the amended rule is estimated to be 5,104 hours.\194\
---------------------------------------------------------------------------

    \193\ 4,861 (total burden hours relating to distribution of 
audited financials) x 0.05 = 243.
    \194\ 4,861 + 243 = 5,104.
---------------------------------------------------------------------------

    Notice to clients. The amended rule also requires each adviser, if 
the adviser sends account statements in addition to those sent by the 
custodian, to add a legend in its notification to clients upon opening 
a custodial account on their behalf, and in any subsequent account 
statements it sends to those clients, urging them to compare the 
account statements from the qualified custodian to those from the 
adviser.\195\ Although the legend requirement is new, it will be placed 
in a notification that is currently required to be sent to clients at 
specified times. We believe that the increase in this collection of 
information burden, if any, is negligible. We estimate that 80 percent 
of the 2,986 advisers would be subject to this collection of 
information,\196\ and that each adviser will on average open a new 
custodial account for 5% of its clients per year, either because the 
adviser has new clients that request that the adviser open an account 
on their behalf, or because the adviser selects a new custodian and 
moves its existing clients' accounts to that custodian. We further 
estimate that the adviser will spend 10 minutes per client drafting and 
sending the notice. The total hour burden relating to this requirement 
is estimated at 41,724 hours per year.\197\
---------------------------------------------------------------------------

    \195\ Amended rule 206(4)-2(a)(2).
    \196\ We understand that advisers having custody solely because 
of deducting fees do not typically open custodial accounts on behalf 
of their clients. Excluding those advisers and 703 advisers to 
audited pooled investment vehicles to which the notice requirement 
does not apply, we estimate that 2,986 advisers may be subject to 
this information collection (advisers that answered ``yes'' to Item 
9A. or B. of Part 1A. of Form ADV). See supra note 173 and 
accompanying text. Based on our staff's observation, we further 
estimate that clients of 80% of these advisers will receive account 
statements from their advisers in addition to the account statements 
from the qualified custodian. [0.8 x 2,986 = 2,389].
    \197\ [(2,986 x 0.8 x 2,096 (average number of clients for the 
advisers with custody of client assets) x 0.05) x 10]/60 = 41,724 
hours.
---------------------------------------------------------------------------

    Based on the above estimates, we anticipate that the estimated 
total information collection burden under amended rule 206(4)-2 would 
be 67,243 hours.\198\ This represents a decrease of 348,060 hours from 
the currently approved burden,\199\ primarily due to our change of 
methodology in estimating the collection of information with respect to 
distribution of audited financial statements to investors in pooled 
investment vehicles.\200\
---------------------------------------------------------------------------

    \198\ 20,415 (surprise examination) + 5,104 (distribution of 
audited financial statements) + 41,724 (notice to clients) = 67,243.
    \199\ 415,303-67,243 = 348,060 hours.
    \200\ See supra note 188 and accompanying text.
---------------------------------------------------------------------------

    Annual aggregate cost. The currently approved collection of 
information for the custody rule includes an aggregate accounting fee 
of $281,000. Based on the amendments we are adopting today, we estimate 
a total annual aggregate accounting fee of $122,965,000.\201\ The 
increase in estimated aggregated cost is attributable to an increase in 
the number of advisers that will be subject to the surprise 
examination, an increase in the estimated cost for the surprise 
examination, and the estimated cost for an adviser to obtain, or to 
receive from its related persons, an internal control report when the 
adviser or related person serves as qualified custodian for the 
adviser's clients' assets.
---------------------------------------------------------------------------

    \201\ See infra note 211 and accompanying text.
---------------------------------------------------------------------------

    In the Proposing Release, we estimated that advisers subject to the 
surprise examination would on average pay an accounting fee of $8,100 
annually.\202\ Many commenters asserted that this estimate was too 
low.\203\ In revising our estimates, we have considered the commenters' 
estimates,\204\ engaged in further discussions with industry 
participants and accounting firms, including accounting firms that are 
registered with, and subject to regular inspection by, the PCAOB, and 
considered the cost implications for the surprise examination of 
certain aspects of our guidance for accountants that we are issuing 
today.\205\ We now estimate that of the 1,859 advisers subject to the 
surprise examination requirement, 337 advisers will be subject to the 
surprise examination with respect to 100 percent of their clients and 
will each spend an

[[Page 1473]]

average of $125,000 annually,\206\ 262 medium sized advisers will be 
subject to the surprise examination requirement with respect to 5% of 
their clients and will each spend an average of $20,000 annually, and 
1,260 small sized advisers will be subject to the surprise examination 
requirement with respect to 5% of their clients and will each spend an 
average of $10,000 annually, with an aggregate annual accounting fee of 
$59,965,000 for all advisers subject to the surprise examination.\207\
---------------------------------------------------------------------------

    \202\ See Proposing Release at n.102 and accompanying text.
    \203\ See infra notes 276 to 278 and accompanying text.
    \204\ We note that commenters based their cost estimates for 
surprise examinations on the current guidance for accountants, which 
requires verification of 100% of client assets. We believe that 
these estimates would have been significantly lower if they had 
reflected the modernized procedures for the surprise examination 
described in the guidance for accountants issued in a companion 
release. See Accounting Release.
    \205\ Id.
    \206\ As stated in infra note 282, we estimate, based on IARD 
data, that there will be 396 advisers that do not currently use an 
independent qualified custodian and will be subject to the surprise 
examination with respect to 100% of their clients. We expect 15% of 
these advisers will choose to use independent custodians instead of 
incurring these costs to comply with the rule. (396 x 85%) = 337.
    We note that the costs of reporting to the Commission (i) 
regarding ``material discrepancy'' pursuant to amended rule 206(4)-
2(a)(4)(ii) and (ii) upon termination of engagement pursuant to 
amended rule 206(4)-2(a)(4)(iii) are included in the estimated 
accounting fees.
    \207\ (337 x $125,000) + (262 x $20,000) + (1,260 x $10,000) = 
$42,125,000 + $5,240,000 + $12,600,000 = $59,965,000. See infra 
notes 282 to 286 and accompanying text for explanation of the 
estimated amounts. We also note that we may have overestimated the 
costs for the surprise examination for advisers that have custody 
because a related person has custody of client assets in connection 
with advisory services. As we have indicated, as a result of the 
exception to the surprise examination requirement under amended rule 
206(4)-2(b)(6) for an adviser that has custody because of its 
related person's custody of client assets and that can overcome the 
presumption that it is not operationally independent of the related 
person custodian, some of the 337 advisers may not have to obtain a 
surprise examination. Those advisers that overcome the presumption 
may, however, incur outside legal expenses to assist with that 
determination. See infra note 283.
---------------------------------------------------------------------------

    We understand that the cost to prepare an internal control report 
relating to custody will vary based on the size and services offered by 
the qualified custodian. We estimated in the Proposing Release that, on 
average, an internal control report would cost approximately $250,000 
per year for each adviser subject to the requirement.\208\ We estimate 
that under amended rule 206(4)-2, 252 advisers will be subject to the 
requirement of obtaining or receiving an internal control report.\209\ 
Therefore the total cost attributable to this requirement will be 
$63,000,000.\210\ The total estimated accounting fee under the amended 
rule 206(4)-2 is therefore estimated at $122,965,000.\211\
---------------------------------------------------------------------------

    \208\ One commenter, the Chamber of Commerce, generally stated 
that the Commission's estimate of $250,000 was too low, but did not 
provide alternative data. See the Chamber of Commerce Letter. 
Another commenter, Securities Industry and Financial Markets 
Association, however, concurred with our cost estimate of $250,000. 
See SIFMA(PCLC) Letter. A third commenter, Managed Funds 
Association, estimated that the internal control report of a hedge 
fund adviser would cost approximately $500,000 and over $1 million 
in some cases. See MFA Letter. We understand that advisers to pooled 
investment vehicles typically do not maintain client assets as 
qualified custodians and, as a result few advisers to pooled 
investment vehicles would have to obtain an internal control report. 
Rather, it is more likely that the internal control report would be 
for a related person broker-dealer, which costs we believe are 
accurately reflected in the comment letter sent by the Securities 
Industry and Financial Markets Association. See SIFMA(PCLC) Letter. 
After further consultation with several accounting firms that have 
experience in preparing Type II SAS 70 reports, including accounting 
firms that are registered with the PCAOB, we believe our estimate of 
$250,000 is reasonable. Moreover, we are not requiring that a 
specific type of internal control report be provided under the rule 
as long as the objectives noted above are addressed. This 
flexibility should permit accountants of qualified custodians to 
leverage audit work they have performed to satisfy existing 
regulatory requirements to which these custodians are subject, which 
may reduce the costs for advisers to comply with the internal 
control report requirement.
    \209\  Of the 337 advisers (see supra note 206 for this 
estimate) that will be subject to both the surprise examination and 
internal control report requirement, we further estimate, based on 
consultation with several accounting firms, that 10% of these 
advisers already obtain an internal control report for purposes 
other than the custody rule. In addition, we believe that some 
related persons may serve as the qualified custodian for more than 
one affiliated adviser. We estimate that this will reduce the number 
of required internal control reports by an additional 15%. See infra 
notes 289 and 290 and accompanying text for explanation of this 
estimate. 337-(337 x 10%)-(337 x 15%) = 337-34-51 = 252.
    \210\ $250,000 x 252 = $63,000,000. See supra note 207 and infra 
notes 275 to 292 and accompanying text for explanation of our 
estimate of costs of the internal control report.
    \211\ $59,965,000 (accounting fee for surprise examination) + 
$63,000,000 (accounting fee for internal control report) = 
$122,965,000.
---------------------------------------------------------------------------

    One-time computer system programming costs. As stated above, the 
amended rule would require an adviser that has an obligation under the 
rule to provide a notice to clients upon opening a new account on 
behalf of the client or changes to such account and that sends account 
statements to its client to include in the account statement a legend 
urging the client to compare its account statement with those sent by 
the qualified custodian. We expect that the requirement would cause 
advisers that are subject to the notice requirement and that send 
account statements to clients to reprogram their computer system to 
include the legend in account statements to clients. We estimate that 
half of the advisers that are subject to the rule or 1,195 advisers 
will hire a computer programmer to modify their computer system to 
automatically add the legend to client account statements at an average 
cost of $1,000 each.\212\ We believe the other half routinely use off-
the-shelf software to provide client account statements and will bear 
little or no direct costs because we expect the software vendors will 
not pass the reprogramming costs on to their customers (i.e. the 
advisers) due to a very low per unit cost. Based on the above 
estimates, we believe that the total one-time computer system 
programming cost would be $1,195,000 for the advisers subject to this 
requirement.\213\
---------------------------------------------------------------------------

    \212\ As stated above, we estimated that there will be 2,389 
advisers subject to this requirement. See supra note 196 and 
accompanying text. 2,389/2 = 1,195.
    \213\ 1,195 x $1,000 = $1,195,000. See infra note 294 for 
explanation of the estimate.
---------------------------------------------------------------------------

    PCAOB registration. For an investment adviser to rely on the 
provision in amended rule 206(4)-2 that deems pooled investment 
vehicles to have satisfied the surprise examination requirement if 
audited financial statements are distributed to investors in the pool, 
the accountant that audits the pooled investment vehicle's financial 
statements must be registered with, and subject to regular inspection 
by, the PCAOB.\214\ We acknowledge that not all pooled investment 
vehicle audits are performed by accountants meeting the PCAOB 
requirement as this is a new requirement. However, our staff has 
reviewed several third-party databases that contain the identity of 
accountants that perform these audits, and substantially all the pools 
that identified accountants were audited by PCAOB registered and 
inspected firms or their affiliates.\215\ Moreover, a representative of 
venture capital firms stated that the ``vast majority'' of venture 
capital funds are audited and, as far as it could determine, all 
venture capital fund audits are conducted by PCAOB registered 
accounting firms that are subject to PCAOB inspection.\216\ As a 
result, we do not believe there will be a substantial dislocation of 
pooled investment vehicle auditors as a result of the amended rule. For 
those pools that will have to change accounting firms, we do not 
believe based on discussions with accountants that there will be 
additional costs to retain an accounting firm registered with, and 
subject to inspection by, the PCAOB, as accountants that perform these 
financial statement audits are likely to be with national accounting 
firms or accounting firms that specialize in auditing pooled investment 
vehicles and that charge equivalent fees to accountants registered

[[Page 1474]]

with, and subject to inspection by, the PCAOB.\217\
---------------------------------------------------------------------------

    \214\ Amended rule 206(4)-2(b)(4).
    \215\ These databases do not distinguish between funds managed 
by registered advisers from those managed by exempt advisers (who 
would not be subject to the rule).
    \216\ NVCA Letter.
    \217\ Two commenters expressed concerns about costs with respect 
to the requirement of PCAOB registration for accountants performing 
surprise examinations and preparing internal control reports for 
advisers that serve, or have related persons serve, as the qualified 
custodian for their client assets. See Consortium Letter; Chamber of 
Commerce Letter. These comments, however, were not directed to the 
costs of engaging PCAOB registered accountants for audits of pooled 
investment vehicles, and the commenters that did recommend the PCAOB 
requirement did not indicate there would be increased costs for such 
a requirement. See, e.g., CPIC Letter, MFA Letter.
---------------------------------------------------------------------------

B. Form ADV

    In connection with our proposed amendments to Form ADV, we 
submitted cost and burden estimates of the collection of information 
requirements to the Office of Management and Budget (``OMB''). We 
estimated that these amendments would increase the annual information 
collection burden in connection with Form ADV from 22.25 hours to 22.50 
hour for each adviser.\218\ The total information collection burden 
resulting from the amendments would be 3,068 hours.\219\ We solicited 
comment in the Proposing Release on our estimates, but did not receive 
comments. We do not believe that the amendments to Form ADV we are 
adopting today will result in a collection of information requirement 
different than what we estimated in the Proposing Release. Therefore, 
we are not revising our PRA burden and cost estimates submitted to the 
OMB with respect to Form ADV.
---------------------------------------------------------------------------

    \218\ See the Proposing Release at n.169 and accompanying text. 
We received no comments on the estimate and we are keeping the 
estimate unchanged.
    \219\ See the Proposing Release at n.170 and accompanying text. 
We received no comments on the estimate and we are keeping the 
estimate unchanged.
---------------------------------------------------------------------------

C. Form ADV-E

    The currently approved collection of information for Form ADV-E is 
9 hours. We estimate that this collection of information will increase 
to 112 hours based on the amendments.\220\ This increase results 
primarily from an increase in the estimated number of advisers that 
will be subject to the requirement of completing Form ADV-E under the 
amended rule 206(4)-2 and the additional collections of information 
required by the amendments to the rule.\221\
---------------------------------------------------------------------------

    \220\ We requested comment on our estimates of the collection of 
information burden relating to Form ADV-E and received no comment.
    \221\ Form ADV-E is the cover sheet for the required filing with 
the Commission by the accountant performing the surprise examination 
pursuant to amended rule 206(4)-2(a)(4)(i) and (iii). The adviser 
completes Form ADV-E and provides it to the accountant, which 
results in an estimated hour burden for the advisers.
---------------------------------------------------------------------------

    For the currently approved annual hour burden for Form ADV-E, we 
estimated that 231 advisers would be subject to the annual surprise 
examination requirement, including the requirement to complete Form 
ADV-E, and that each of the advisers would spend approximately 0.05 
hour to complete Form ADV-E. We now estimate that 1,859 advisers will 
be required to undergo an annual surprise examination and complete Form 
ADV-E, and that the total annual hour burden for Form ADV-E in 
connection with the surprise examination requirement will therefore 
increase to 93 hours.\222\
---------------------------------------------------------------------------

    \222\ 1,859 x 0.05 = 93.
---------------------------------------------------------------------------

    In addition, amended rule 206(4)-2 requires an adviser subject to 
the surprise examination to enter into a written agreement with the 
independent public accountant that specifies the accountant's duties, 
including filing Form ADV-E upon the termination of its engagement. 
Based on an assumption that advisers change their independent public 
accountants every five years on average and an estimate that advisers 
spend approximately 0.05 hours to complete Form ADV-E, advisers will be 
required each year to complete Form ADV-E with respect to an 
accountant's termination with an annual burden of 19 hours.\223\ The 
total annual hour burden for advisers to complete Form ADV-E in 
connection with the surprise examination and the termination statement 
will be 112 hours.\224\
---------------------------------------------------------------------------

    \223\ 1,859/5 = 372. 372 x 0.05 = 19.
    \224\ 93 + (372 x 0.05) = 93 + 19 = 112.
---------------------------------------------------------------------------

V. Cost-Benefit Analysis

A. Background

    The Commission is sensitive to the costs and benefits resulting 
from its rules. Rule 206(4)-2, the custody rule, seeks to protect 
clients' funds and securities in the custody of registered advisers 
from misuse or misappropriation by requiring advisers to maintain their 
clients' assets with a qualified custodian, such as a broker-dealer or 
a bank. The custody rule, as amended, requires all registered advisers 
that have custody of client assets to have a reasonable belief, formed 
after due inquiry, that a qualified custodian sends an account 
statement directly to each advisory client for which the qualified 
custodian maintains assets.\225\ The amended rule also requires 
advisers that have custody of client assets to undergo an annual 
surprise examination by an independent public accountant with the 
exception of advisers that have custody solely because of their 
authority to deduct advisory fees from client accounts,\226\ and 
advisers that have custody solely because a related person holds the 
adviser's client assets and the related person is operationally 
independent of the adviser.\227\ In addition, advisers to pooled 
investment vehicles are deemed to comply with the surprise examination 
requirement if the pools are subject to an annual financial statement 
audit by an independent public accountant that is registered with, and 
subject to regular inspection by, the PCAOB, and if the audited 
financial statements are delivered to the pool's investors.\228\
---------------------------------------------------------------------------

    \225\ Amended rule 206(4)-2(a)(3). We have retained the 
exception from the account statement delivery requirement for 
certain advisers to pooled investment vehicles. Amended rule 206(4)-
2(b)(4).
    \226\ Amended rule 206(4)-2(b)(3). This exception would also be 
available to such an adviser when the adviser can rely on amended 
rule 206(4)-2(b)(6). See Section II.C.2. of this Release. The 
exception would not be available, however, to an adviser that has 
custody under the rule for other reasons.
    \227\ Amended rule 206(4)-2(b)(6).
    \228\ Amended rule 206(4)-2(b)(4).
---------------------------------------------------------------------------

    We are also adopting amendments to the rule to impose additional 
requirements when advisory client assets are maintained by the adviser 
itself or by a related person rather than with an independent qualified 
custodian. The amended rule requires, in addition to the surprise 
examination discussed above,\229\ that the adviser obtain, or receive 
from its related person, no less frequently than once each calendar 
year, a written report, which includes an opinion from an independent 
public accountant with respect to the adviser's or related person's 
controls relating to custody of client assets, such as a Type II SAS 70 
report.\230\ The amended rule also requires, in these circumstances, 
that the independent public accountant issuing the internal control 
report, as well as the independent public accountant performing the 
surprise examination, be registered with, and subject to regular 
inspection by, the PCAOB.\231\ The adviser must maintain the internal 
control report in its records and make it available to the Commission 
or staff upon request.\232\
---------------------------------------------------------------------------

    \229\ Amended rule 206(4)-2(a)(6).
    \230\ Amended rule 206(4)-2(a)(6)(ii). As discussed in the costs 
section below, other types of reports could also satisfy the 
internal control report requirement.
    \231\ Amended rule 206(4)-2(a)(6)(i) and (ii)(C).
    \232\ Amended rule 204-2(a)(17)(iii).
---------------------------------------------------------------------------

    Finally, we are adopting several amendments to Form ADV and Form 
ADV-E. The amendments to Form ADV require registered advisers to report 
to us more detailed information about their custody practices. The 
amendments to

[[Page 1475]]

Form ADV-E require that the form and the accompanying accountant's 
examination certificate, or statement upon termination, be filed 
electronically with the Commission through the IARD and conform Form 
ADV-E instructions to amended rule 206(4)-(2).
    In the Proposing Release, we requested comment and empirical data 
regarding the costs and benefits of the amendments. Most of the 1,300 
commenters expressed their support for our goal of strengthening 
protections provided to advisory clients under the custody rule. One 
opined that the benefits of the proposed additional safeguards to 
investors whose assets are held in custodial accounts outweigh the 
costs to advisers.\233\ Many, however, generally expressed concern 
about the costs, particularly to small advisers, of our proposal as it 
would have applied to advisers that have custody solely because of 
their authority to deduct advisory fees from client accounts.\234\ As 
noted above, we have provided an exception from the surprise 
examination requirement for these advisers. Several commenters provided 
comments on the costs and benefits in the Proposing Release, which we 
address below.
---------------------------------------------------------------------------

    \233\ CFA Institute Letter.
    \234\ Of the 1,300 comment letters, approximately 1,100 were 
form letters or substantially similar letters submitted by smaller 
advisory firms that, in part, generally expressed concerns regarding 
the costs of the proposal as it related to the surprise examination 
for advisers with custody solely due to authority to withdraw 
advisory fees.
---------------------------------------------------------------------------

B. Benefits

    Improved protection for advisory clients. The rule and form 
amendments we are adopting today are designed to strengthen controls 
over the custody of client assets by registered investment advisers and 
to encourage the use of independent custodians. They will also improve 
our ability to oversee advisers' custody practices and, together with 
the guidance for independent public accountants that we are issuing, 
may prevent client assets from being lost, misused, misappropriated or 
subject to advisers' financial reverses. The benefits to investors are 
difficult to quantify, and commenters did not submit empirical data on 
potential benefits. We believe, however, that these benefits will be 
substantial, including, generally, increased confidence investors will 
have when obtaining advisory services from registered investment 
advisers. In addition, we believe the amendments to the rule could, to 
a limited extent, promote efficiency and capital formation as a result 
of such increased investor confidence. In particular, increased 
investor confidence could lead to more efficient allocation of investor 
assets, which could result in an increase in the assets under 
management of investment advisers and, depending on how those assets 
are invested, a potential increase in the availability of capital.
    As described above, the amended custody rule requires investment 
advisers registered with us that have custody of client assets, subject 
to certain exceptions, to obtain a surprise examination of client 
assets by an independent public accountant. As a result, advisers that 
have custody because, for example, they or their related person serves 
as qualified custodian for client assets, or because they serve as 
trustee of a client trust or have a power of attorney over client 
affairs, must undergo an annual surprise examination.\235\ The surprise 
examination requirement should significantly contribute to deterring 
fraudulent conduct by investment advisers because advisers subject to 
the surprise examination will know their clients' assets are subject to 
verification at any time, and therefore may be less likely to engage in 
misconduct. If fraud does occur, the surprise examination requirement 
will increase the likelihood that fraudulent conduct will be detected 
earlier so that client losses will be minimized.\236\ The additional 
review provided by an independent public accountant will also benefit 
advisory clients because it may help identify problems that clients may 
not be in the position to uncover through the review of account 
statements. We estimate that the rule will require 1,859 advisers \237\ 
to obtain an annual surprise examination, and as a result provide the 
benefits identified above with respect to 956,237 clients.\238\
---------------------------------------------------------------------------

    \235\ See Section II. B of this Release.
    \236\ The independent public accountant conducting a surprise 
examination is required to verify client assets of which an adviser 
has custody, including those maintained with a qualified custodian 
and those that are not required to be maintained with a qualified 
custodian, such as certain privately offered securities and mutual 
fund shares.
    \237\ See supra note 173 and accompanying text for explanation 
of this estimate.
    \238\ [337 (advisers) x 2,315 (average number of clients for 
advisers subject to the surprise examination)] + (1,522 x 2,315 x 
0.05 (percentage of clients whose assets are subject to the surprise 
examination)) = 780,155 + 176,172 = 956,237.
---------------------------------------------------------------------------

    As amended, rule 206(4)-2 requires, in addition to the surprise 
examination discussed above, that when an adviser or its related person 
serves as a qualified custodian for advisory client assets, the adviser 
obtain, or receive from its related person, no less frequently than 
once each calendar year, a written report, which includes an opinion 
from an independent public accountant with respect to the adviser's or 
related person's controls relating to custody of client assets 
(``internal control report''), such as a Type II SAS 70 report.\239\ 
The amended rule also requires, in these higher risk situations, that 
the independent public accountant issuing the internal control report, 
as well as the independent public accountant performing the surprise 
examination, be registered with, and subject to regular inspection by, 
the PCAOB.\240\
---------------------------------------------------------------------------

    \239\ Amended rule 206(4)-2(a)(6)(ii). As discussed in more 
detail below, other types of reports could also satisfy the internal 
control report requirement.
    \240\ Amended rule 206(4)-2(a)(6)(i) and (ii)(C).
---------------------------------------------------------------------------

    The internal control report requirement will provide important 
benefits to advisory clients by imposing additional safeguards when 
client assets are maintained with the adviser or a related person. 
First, the internal control report will indicate whether the qualified 
custodian (the adviser or its related person) has established 
appropriate custodial controls by including an accountant's opinion 
regarding whether the custodian's internal controls are suitably 
designed and are operating effectively to meet control objectives 
related to custodial services, including the safeguarding of funds and 
securities.\241\ Second, to satisfy the rule's requirements, the 
independent public accountant preparing the internal control report 
must verify that client assets are reconciled to a custodian other than 
the adviser or its related person, which will serve as a critical check 
when the custodian is not independent.\242\ Third, an internal control 
report may also significantly strengthen the utility of the surprise 
examination when the adviser or a related person custodian maintains 
client assets because the independent public accountant performing the 
surprise examination may obtain additional comfort that confirmations 
received from the qualified custodian in the course of the surprise 
examination are reliable. Clients of approximately 337 advisers will 
benefit from the protections provided by the internal control report 
requirement.\243\
---------------------------------------------------------------------------

    \241\ See Accounting Release.
    \242\ Amended rule 206(4)-2(a)(6)(ii)(B).
    \243\ See supra notes 174 and 175 and accompanying text for 
explanation of the estimated number. Because these advisers serve, 
or have a related person serve, as the qualified custodian for their 
client assets, they are subject to the internal control report 
requirement. Amended rule 206(4)-2(a)(6).
---------------------------------------------------------------------------

    As noted above, the amended rule provides a limited exception from 
the surprise examination requirement in certain circumstances when the 
adviser

[[Page 1476]]

is deemed to have custody solely as a result of a related person having 
custody.\244\ The exception is available to an adviser that is (i) 
deemed to have custody solely as a result of certain of its related 
persons holding client assets, and (ii) ``operationally independent'' 
of its related person.\245\ Advisers that can overcome the presumption 
that they are not operationally independent of their related person 
will benefit from the cost savings of not having to obtain a surprise 
examination under these circumstances.\246\ Clients may also benefit 
from this provision in two respects. First, it may encourage advisers 
with a choice of related person qualified custodians to use those that 
are operationally independent over those that are not, which may lower 
custodial risks to clients. Second, while clients will not have the 
benefit of the surprise examination under these circumstances, they 
will benefit from the protections of the internal control report that 
the adviser must receive from a related person that is a qualified 
custodian.
---------------------------------------------------------------------------

    \244\ Rule 206(4)-2(b)(6).
    \245\ Id.
    \246\ We have estimated that each of these surprise examinations 
would cost an adviser $125,000. See infra notes 282--283 and 
accompanying text.
---------------------------------------------------------------------------

    When the adviser or its related person serves as qualified 
custodian for client assets, the surprise examination and internal 
control report must be performed or prepared by an independent public 
accountant that is registered with, and subject to regular inspection 
by, the PCAOB.\247\ We are also amending rule 206(4)-2 to require that 
in order to be deemed to comply with the surprise examination 
requirement, advisers to audited pooled investment vehicles must have 
the pool's annual audited financial statements prepared by an 
independent public accountant that is registered with, and subject to 
regular inspection by, the PCAOB and distribute the audited financial 
statements to the investors in the pool.\248\ Advisory clients and pool 
investors will benefit by having greater confidence in the quality of 
the surprise examination, the internal control report and pooled 
investment vehicle audits when performed or prepared by an independent 
public accountant that is registered with, and subject to regular 
inspection by, the PCAOB. While PCAOB inspection is focused on public 
company audit engagements, we believe that requiring that the 
accountant not only be registered with the PCAOB but be subject to its 
inspection can provide indirect benefits regarding the quality of the 
accountant's other engagements.
---------------------------------------------------------------------------

    \247\ Amended rule 206(4)-2(a)(6)(i) and (ii)(C).
    \248\ Amended rule 206(4)-2(b)(4).
---------------------------------------------------------------------------

    The amendments also eliminate the alternative, currently provided 
in the rule, under which an adviser with custody can send its own 
account statements to clients if the adviser is subject to an annual 
surprise examination. Instead, all advisers with custody are required 
to have a reasonable belief, after due inquiry, that the qualified 
custodian sends account statements directly to clients. As a result, we 
expect that clients of approximately 190 advisory firms that currently 
send their own account statements to clients will, under the amended 
rule, receive account statements directly from qualified 
custodians.\249\ Where the qualified custodian is independent, this 
change provides advisory clients confidence that erroneous or 
unauthorized transactions will be reflected in the account statement. 
As a result, this change may deter advisers from engaging in fraudulent 
activities and allow clients to detect any unauthorized activity in 
their accounts promptly, thereby averting or reducing losses. Clients 
of these 190 advisers will benefit from this amendment and will start 
receiving account statements directly from qualified custodians.
---------------------------------------------------------------------------

    \249\ Based on ADV-E filings, there were 190 advisers that 
underwent surprise examinations during 2008.
---------------------------------------------------------------------------

    The amended rule requires advisers to include a legend in the 
notice that they are currently required to send to their clients upon 
opening a custodial account on their clients' behalf if the adviser 
sends its own account statements to clients and in any subsequent 
account statements it sends to clients.\250\ The legend will urge 
clients to compare the account statements they receive from the 
custodian with those they receive from the adviser. As discussed above, 
client review of periodic account statements from the qualified 
custodian is an important measure that can enable clients to discover 
improper account transactions or other fraudulent activity. Raising 
clients' awareness of this safeguard under the custody rule at account 
opening and with each subsequent account statement sent by the adviser 
may cause clients to uncover any unauthorized transactions by their 
advisers in their accounts more promptly, thereby averting or reducing 
losses. We estimate that 250,367 clients would receive notices and 
subsequent account statements containing this additional 
information.\251\
---------------------------------------------------------------------------

    \250\ Amended rule 206(4)-2(a)(2).
    \251\ We estimated that approximately 2,986 advisers open 
accounts on behalf of their clients. Based on our staff's 
observation, we further estimate that 80% of these advisers send 
account statements to their clients. (2,986 x 0.8 = 2,389). We 
estimate that each year these 2,389 advisers on average open 
accounts for about 5% of their 2,096 clients (average number of 
clients of the advisers with custody of client assets) who are 
either new clients or whose accounts have been transferred to new 
qualified custodians and that these advisers also send their own 
account statements to clients. (2,389 x (2,096 x 0.05) = 250,367).
---------------------------------------------------------------------------

    Under the amended rule, each adviser that is required to undergo an 
annual surprise examination must enter into a written agreement with an 
independent public accountant to perform the surprise examination. The 
written agreement will require the independent public accountant to, 
among other things, (i) file Form ADV-E accompanied by a certificate 
within 120 days of the time chosen by the accountant for the surprise 
examination stating that it has examined the client assets and 
describing the nature and extent of the examination, (ii) report to the 
Commission any material discrepancies discovered in the examination 
within one business day, and (iii) upon the accountant's termination or 
dismissal, or removal from consideration for reappointment, file Form 
ADV-E within 4 business days accompanied by a statement explaining any 
problems relating to examination scope or procedure that contributed to 
the resignation, dismissal, removal, or other termination. These 
filings and reports will provide our staff additional information to 
assist in establishing advisers' risk profiles for purposes of 
prioritizing examinations. The rule will result in the electronic 
filing of Form ADV-E and the accountant statement on the IARD 
system.\252\ Clients will benefit from electronic filing of the Form 
ADV-E because it will allow them to easily access important information 
about the surprise examinations performed on their advisers. We 
estimate that 4,303,585 advisory clients will benefit from the 
amendment.\253\ Furthermore, the availability to the general public of 
Form ADV-E information on the Commission's web site may result in 
additional benefits, including deterring misconduct before it occurs 
and providing additional information for

[[Page 1477]]

clients to consider when deciding which investment adviser to select.
---------------------------------------------------------------------------

    \252\ Until the IARD system is upgraded to accept Form ADV-E, 
accountants performing surprise examinations should continue paper 
filing of Form ADV-E. Investment advisers will be notified as soon 
as the IARD system can accept filings of Form ADV-E.
    \253\ 1,859 x 2,315 (average number of clients of the advisers 
subject to the surprise examination) = 4,303,585.
---------------------------------------------------------------------------

    We are adopting the amendments to Item 7 and Section 7.A. of 
Schedule D that we proposed to require each adviser to report all 
related persons who are broker-dealers and to identify which, if any, 
serve as qualified custodians with respect to the adviser's clients' 
funds or securities.\254\ We are also amending Item 9 to require 
advisers that have custody (or whose related persons have custody) of 
client assets to provide additional information about their custodial 
practices under the custody rule. In addition, the revised Schedule D 
of Form ADV requires an adviser to provide additional details including 
information about the independent public accountants that perform 
annual audits, surprise examinations or that prepare internal control 
reports,\255\ whether a report prepared by an independent public 
accountant contains an unqualified opinion,\256\ and about any related 
person that serves as a qualified custodian for the adviser's 
clients.\257\ We also are amending Schedule D to require an adviser to 
report whether it has determined that it has overcome the presumption 
that it is not operationally independent from a related person 
qualified custodian, and thus is not required to obtain a surprise 
examination for the clients' assets maintained at that custodian. These 
disclosures will provide our staff more information to determine 
advisers' risk profiles and prepare for examinations. Moreover, this 
information will be filed electronically when IARD accepts these 
filings, and as a result the information will be available to the 
public through the Commission's Web site. Clients will benefit directly 
from these amendments by obtaining more information about their 
advisers' custodial practices. They may also benefit indirectly because 
advisers will be incentivized to implement strong controls and 
practices to avoid receiving a qualified opinion from an independent 
public accountant.
---------------------------------------------------------------------------

    \254\ The item had required an adviser to identify on Schedule D 
of Form ADV each related person that is an investment adviser, but 
made reporting of the names of related person broker-dealers 
optional.
    \255\ Section 9.C. of Schedule D of Form ADV.
    \256\ Id.
    \257\ Section 9.D of Schedule D of Form ADV.
---------------------------------------------------------------------------

    Finally, under the amended rule, an adviser to pooled investment 
vehicles that is deemed to comply with the surprise examination 
requirement and that is excepted from the account statement delivery 
requirement by having the pooled investment vehicle audited and 
distributing the audited financial statements to the investors must, in 
addition to obtaining an annual audit, obtain a final audit of the 
fund's financial statements upon liquidation of the fund and distribute 
the financial statements to fund investors promptly after the 
completion of the audit.\258\ This amendment provides fund investors 
the information necessary to protect their rights and to make sure that 
the proceeds of the liquidation are appropriately accounted for.
---------------------------------------------------------------------------

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

    Improved clarity of the rule. We anticipate that investment 
advisers will find it easier to understand and comply with the rule as 
a result of the amendments, which may result in cost savings for 
advisers. The amendments will improve the clarity of the rule by adding 
several definitions, including amending the definition of ``custody'' 
to address related person custodian situations, and adding definitions 
of ``control'' and ``related person.'' \259\
---------------------------------------------------------------------------

    \259\ Amended rule 206(4)-2(d).
---------------------------------------------------------------------------

C. Costs

    Surprise Examination. As noted above, the amended rule we are 
adopting today excludes certain advisers with custody from the 
requirement to undergo an annual surprise examination and deems certain 
others to comply with the requirement.\260\ Advisers that have custody 
for other reasons, however, such as because they or their related 
person serves as the qualified custodian for client assets, or because 
they serve as the trustee of a client trust, must undergo an annual 
surprise examination.\261\ As a result, we now estimate that 1,859 
advisers will be subject to the surprise examination requirement under 
amended rule 206(4)-2.\262\ Reducing that number by the 190 advisers 
that already undergo an annual surprise examination under the current 
rule,\263\ we estimate that the amendments will result in approximately 
1,669 additional advisers being required to obtain a surprise 
examination.\264\
---------------------------------------------------------------------------

    \260\ Amended rule 206(4)-2(b)(3) (exception from surprise 
examination for advisers that have custody because they have 
authority to deduct fee from client accounts); amended rule 206(4)-
2(b)(6) (exception from surprise examination for advisers that have 
custody solely because a related person holds the adviser's client 
assets and the related person is operationally independent of the 
adviser); and amended rule 206(4)-2(b)(4) (deemed compliance with 
the surprise examination requirement for advisers to audited pooled 
investment vehicles that distribute audited financial statements to 
pool investors if the audit was conducted by an independent public 
accountant registered with, and subject to regular inspection by, 
the PCAOB).
    \261\ Under amended rule 206(4)-2 an adviser has custody if its 
related person has custody of its client assets. Amended rule 
206(4)-2(d)(2). A related person is defined as a person directly or 
indirectly controlling or controlled by the adviser, and any person 
under common control with the adviser. Amended rule 206(4)-2(d)(7).
    \262\ See supra note 173.
    \263\ See supra note 249.
    \264\ 1,859-190 = 1,669.
---------------------------------------------------------------------------

    For purposes of the PRA analysis, we estimate that the total annual 
collection of information burden in connection with the surprise 
examination, before including the hours spent on conforming written 
agreements with accountants to the amended rule, will be 19,950 
hours.\265\ Based on this estimate, we anticipate that advisers will 
incur an aggregate cost of approximately $1,256,850 per year for these 
estimated hours.\266\
---------------------------------------------------------------------------

    \265\ See supra note 184 accompanying text for explanation of 
the estimate.
    \266\ We expect that the function of providing lists of clients 
to the independent public accountant in assisting its examination, 
totaling 19,950 hours, would be performed by compliance clerks. Data 
from the Securities Industry and Financial Markets Association's 
Office Salaries in the Securities Industry 2008, modified by 
Commission staff to account for an 1800-hour work-year and 
multiplied by 2.93 to account for bonuses, firm size, employee 
benefits and overhead, suggest that cost for this position is $63 
per hour. Therefore the total costs would be $1,256,850.
---------------------------------------------------------------------------

    Written agreement. As proposed, amended rule 206(4)-2 requires that 
an adviser subject to the surprise examination requirement must enter 
into a written agreement with the independent public accountant engaged 
to conduct the surprise examination and specify certain duties to be 
performed by the independent public accountant.\267\ As stated in the 
Proposing Release, we believe that written agreements are commonplace 
and reflect industry practice when a person retains the services of a 
professional such as an independent public accountant, and they are 
typically prepared by the accountant in advance. Because the amended 
rule applies to investment advisers (and not accountants) we believe 
that the burden to add the provisions to the written agreement will be 
borne by the adviser. We estimate that each adviser will spend 0.25 
hour to add the required provisions to the written agreement, with an 
aggregate of 465 hours for all advisers subject to surprise 
examinations.\268\ Requiring certain additional items to be included in 
the written agreement will not significantly increase costs for 
advisers.\269\ Moreover,

[[Page 1478]]

we do not believe that the new requirements placed on the independent 
public accountant by the written agreement (electronic filing of Form 
ADV-E and termination statement) will materially increase the 
accounting fees for the surprise examination discussed above.
---------------------------------------------------------------------------

    \267\ Amended rule 206(4)-2(a)(4).
    \268\ 1,859 x 0.25 = 465.
    \269\ We estimate that it will take each adviser about 0.25 hour 
to add the required specifications. See supra note 186 and 
accompanying text. Converting the hour burden to costs, each adviser 
would spend $64.50. See infra note 271.
---------------------------------------------------------------------------

    For purposes of the PRA analysis, we estimate a total annual 
collection of information burden in connection with the surprise 
examination of 20,415 hours.\270\ Based on this estimate, we anticipate 
that advisers will incur an aggregate cost of approximately $1,376,820 
per year for the total hours their employees spend in complying with 
the surprise examination requirement.\271\
---------------------------------------------------------------------------

    \270\ This estimated number includes the hours an adviser spends 
on providing client lists to the accountant performing the surprise 
examination and meeting the rule's requirements for the written 
agreement with the accountant regarding its engagement to perform 
the surprise examination. 15,603 hours (advisers subject to the 
surprise exam for 100% of clients to provide client lists) + 3,051 
(advisers subject to the surprise exam for advisers with custody of 
a small portion of their clients to provide client lists) + 1,296 
(advisers to pooled investment vehicles that are subject to the 
surprise examination to provide investor lists) + 465 (written 
agreement with accountants) = 20,415.
    \271\ As we stated above, the total estimated burden hours 
related to the surprise examination requirement, before including 
the hours for written agreement with the accountant, are 19,950 
hours with an estimated costs of $1,256,850. See supra note 184 for 
explanation of the estimated hours and supra note 266 for 
explanation of estimated cost. We expect that the function of adding 
certain duties of the accountant to the written agreement with the 
accountant, totaling 465 hours, would be performed by compliance 
managers. Data from the Securities Industry and Financial Markets 
Association's Management & Professional Earnings in the Securities 
Industry 2008, modified by Commission staff to account for an 1800-
hour work-year and multiplied by 5.35 to account for bonuses, firm 
size, employee benefits and overhead, suggest that the cost for this 
position is $258 per hour. Therefore the total costs would be 
$1,376,820 ((19,950 x $63) + (465 x $258) = $1,376,820).
---------------------------------------------------------------------------

    In the Proposing Release, we estimated that there would have been 
9,575 advisers subject to the surprise examination and they would each 
pay, on average, an annual accounting fee of $8,100 for the surprise 
examination.\272\ The estimated total accounting fees for all surprise 
examinations would therefore have been $77,557,500.\273\ As explained 
above, the amended rule excepts from the surprise examination 
requirement, advisers that have custody because of deducting advisory 
fees, and advisers that have custody solely because a related person 
holds the adviser's client assets and the related person is 
operationally independent of the adviser, and it deems advisers to 
audited pooled investment vehicles to comply with the requirement under 
certain circumstances,\274\ reducing our estimated number of advisers 
subject to the surprise examination requirement from 9,575 to 
1,859.\275\
---------------------------------------------------------------------------

    \272\ See Proposing Release at n.102 and accompanying text.
    \273\ 9,575 x $8,100 = $77,557,500.
    \274\ See Section II.C.2. of this Release.
    \275\ See supra notes 170 to 173 and accompanying text.
---------------------------------------------------------------------------

    Several commenters believed that our cost estimates for surprise 
examination accounting fees were too low.\276\ Some of them provided 
their own estimates ranging from an amount close to our estimate (for 
smaller advisers),\277\ to over one million dollars for the largest 
firms.\278\ We believe that the costs of the surprise examination are 
lower than the costs suggested by commenters because commenters' 
estimates were based on two critical assumptions that no longer are 
valid. First, these estimates were generally based on an understanding 
that the examination would involve verifying 100% of client assets, as 
is currently required under our existing guidance for accountants.\279\ 
The revised guidance for accountants we are issuing, however, among 
other things, permits accountants to use sampling in the course of the 
surprise examination.\280\ Second, many of these estimates are based on 
an assumption that an adviser would have custody of all of its clients' 
accounts based on our proposal to require the surprise examination if 
an adviser had custody because of the authority to deduct advisory fees 
directly from client accounts. The rule now provides an exception from 
the surprise examination when fee deduction is the reason the adviser 
has custody. As a result, many advisers that have custody under the 
amended rule will have custody with respect to a limited number of 
client accounts, and the scope of work for the accountant performing 
the surprise examination will be significantly reduced.
---------------------------------------------------------------------------

    \276\ See, e.g., FPA Letter (estimated costs of $15,000 to 
$24,000), IAA Letter (estimated costs of $20,000 to $300,000).
    \277\ CFP Board Letter (estimating cost of surprise examination 
from $5,000 to $10,000).
    \278\ SIFMA(PCLC) Letter (member survey indicated average cost 
estimate of $200,000 with one response of over $1,000,000).
    \279\ See ASR No. 103.
    \280\ See Accounting Release.
---------------------------------------------------------------------------

    While, for reasons discussed above, we believe commenters' 
estimates of the cost of surprise examination are too high, they have 
caused us to reexamine our cost estimates and to determine that it 
would be more appropriate to categorize advisers into subcategories to 
estimate surprise exam costs. Instead of a single average cost, we have 
divided the 1,859 advisers that are subject to the surprise examination 
requirement into three distinct groups.\281\ We now estimate that 337 
advisers either serve as qualified custodian for their clients or have 
a related person that serves as qualified custodian.\282\ These 
advisers would likely be subject to the surprise examination with 
respect to 100 percent of their clients, and as these advisers 
typically are large advisers with many clients, we estimate they will 
each spend an average of $125,000 annually.\283\ We estimate that the 
rest of the advisers will be subject to surprise examination with 
respect to 5 percent of

[[Page 1479]]

their client accounts.\284\ We have divided these 1,522 advisers into 
two groups based on their number of clients: 262 medium-sized advisers 
and 1,260 small-sized advisers.\285\ We estimate that medium-sized 
advisers will on average have accounting fees of $20,000 annually and 
small-sized advisers will on average have accounting fees of $10,000 
annually for the surprise examination. Therefore the aggregate account 
fee relating to the surprise examination is estimated at 
$59,965,000.\286\
---------------------------------------------------------------------------

    \281\ The revised estimated costs are based on the experience of 
our staff and discussions with public accounting firms regarding the 
surprise examination requirement, modern accounting practices, and 
commenters' estimates.
    \282\ Based on IARD data, we estimated 396 advisers either serve 
as qualified custodian for their clients or have a related person 
that serves as qualified custodian. These advisers would likely be 
subject to the surprise examination with respect to 100 percent of 
their clients. We expect 15% of these advisers will use independent 
custodians instead of incurring these costs. This estimate is based 
on comments that we received about the high costs of the proposed 
requirements with respect to advisers using a related person as the 
qualified custodian. We believe that these advisers will do their 
own analysis of the benefits of continuing using their related 
persons as qualified custodians. Some of the advisers that maintain 
client assets with their related person custodians on an incidental 
basis may decide to use independent qualified custodians instead to 
avoid the costs of complying with the requirements. (396 x 85%) = 
337.
    \283\ Several of these large advisers are advisers with 
thousands of client accounts, while others have significantly fewer 
client accounts. The largest advisers will likely incur expenses 
higher than $125,000. Whereas those with significantly fewer client 
accounts will likely incur expenses less than $125,000. Moreover, as 
a result of the exception to the surprise examination requirement 
under amended rule 206(4)-2(b)(6) for an adviser that has custody 
because of its related person's custody of client assets and that 
can overcome the presumption that it is not operationally 
independent of the related person custodian, some of these 337 
advisers would not have to obtain the surprise examination. We do 
not have data or another resource to provide an estimate of the 
number of advisers that use related person custodians that will be 
able to overcome the presumption. As a result, we are unable to 
estimate with specificity the reduced costs due to this exception. 
We do estimate that of the 337 advisers subject to the surprise 
examination, that 259 (after the 15% reduction noted above) use 
related person qualified custodians. See supra note 175. If 75% of 
the 259 of these advisers could overcome the presumption, the cost 
estimates for the surprise examination would be overstated by 
$24,281,250 ((259 x .75) x $125,000), if one half of them could 
overcome the presumption the costs would be overstated by 
$16,187,500 ((259 x .5) x $125,000), or if one quarter of them could 
overcome the presumption the costs would be overstated by $8,093,750 
((259 x .25) x $125,000). Those advisers that overcome the 
presumption may, however, incur outside legal expenses to assist 
with the determination. We estimate that on average, such legal 
assistance would cost an adviser between $4,000 (for 10 hours) and 
$16,000 (for 40 hours), significantly less than the estimated costs 
for the surprise examination. The hourly cost estimate of $400 on 
average is based on our consultation with advisers and law advisers 
who regularly assist them in legal and compliance matters.
    \284\ Advisers are required to undergo an annual surprise 
examination with respect to only those client accounts to which they 
have access that causes them to have custody, including through a 
power of attorney, acting as trustee, or similar legal authority. 
Based on the experience of our staff, we estimate that on average, 
only 5 percent of client accounts of these advisers will be subject 
to the surprise examination.
    \285\ Based on responses to Item 5.C of Form ADV, we estimate 
that the average number of clients for these 1,522 advisers is 806. 
We determined, for purposes of this analysis, that an adviser with 
clients more than this average number is a medium size adviser and 
an adviser with clients less than this average number is a small 
adviser. 337 + 262 + 1,260 = 1,859.
    \286\ (337 x $125,000) + (262 x $20,000) + (1,260 x $10,000) = 
$42,125,000 + $5,240,000 + $12,600,000 = $59,965,000.
---------------------------------------------------------------------------

    Internal Control Report. Under amended rule 206(4)-2, if an adviser 
or a related person serves as a qualified custodian for client assets 
in connection with advisory services the adviser provides to clients, 
the adviser must obtain, or receive from the related person, no less 
frequently than once each calendar year, a written report of the 
internal controls relating to the custody of those assets from an 
independent public accountant that is registered with and subject to 
regular inspection by the PCAOB. We estimate that approximately 337 
investment advisers must obtain, or receive from a related person, an 
internal control report relating to custodial services.\287\ One 
securities industry commenter noted that custodians often already 
provide Type II SAS 70 reports to clients who demand a rigorous 
evaluation of internal control as a condition of obtaining their 
business.\288\ We estimate that 10% of the advisers that must obtain or 
receive an internal control report will themselves or their related 
person qualified custodian will already obtain an internal control 
report for purposes other than the custody rule.\289\ In addition, a 
single internal control report will satisfy the rule's requirement for 
several related advisers if their clients use the same related person 
as qualified custodian. We estimate that this will reduce the number of 
required internal control reports by an additional 15%.\290\ As a 
result, we estimate that independent public accountants will prepare 
252 internal control reports as a result of the rule amendments. Based 
on discussions with accounting professionals, we understand that the 
cost to prepare an internal control report relating to custody will 
vary based on the size and services offered by the qualified custodian, 
but that on average an internal control report will cost approximately 
$250,000 per year,\291\ for total costs attributable to this section of 
the proposed rule to be $63,000,000.\292\ These advisers also will need 
to maintain the report as a required record. We anticipate that the 
cost of maintaining these records will be minimal.
---------------------------------------------------------------------------

    \287\ See supra notes 276-278 for explanation of this estimate.
    \288\ SIFMA(AMG) Letter.
    \289\ Our estimate of 10% is based on our consultation with 
accounting firms that have experience in preparing internal control 
reports. 337 x 10% = 34.
    \290\ Our estimate of 15% is based on the IARD data. 337 x 15% = 
51.
    \291\ See supra note 208 and accompanying text for explanation 
of this estimate.
    \292\ $250,000 x (337 -34 -51) = $250,000 x 252 = 
$63,000,000.
---------------------------------------------------------------------------

    Although the amended rule does not require use of an independent 
custodian, we encourage the use of custodians independent of the 
adviser to maintain client assets as a best practice whenever feasible. 
As a result of the amendments and our encouragement, there may be 
effects on competition if additional advisers (and clients) begin using 
independent custodians, which is a common practice of many advisers 
today, particularly among those that are not themselves, or affiliated 
with, large financial service firms.
    The total cost estimate above may overestimate actual costs 
incurred for internal control reports because of the factors discussed 
below. Accountants preparing an internal control report may incorporate 
relevant audit work performed for other purposes, including audit work 
performed to meet existing regulatory requirements, which should 
increase efficiencies in the audit process. These efficiencies are not 
represented in the estimated costs as the estimates are based on a 
custodian entering a new engagement for an internal control report. And 
any report that meets the objectives of the internal control report 
would be acceptable under the rule. In addition to the Type II SAS 70 
report, other reports a qualified custodian already obtains could 
satisfy the rule's requirements. For instance, a report issued in 
connection with an attestation conducted in accordance with AT 601 
under the standard of the AICPA would be sufficient, provided that such 
examination meets the objectives set forth in our guidance for 
accountants.
    One-time computer system programming costs. As stated above, the 
amended rule would require an adviser that has obligation under the 
rule to provide a notice to clients upon opening a new account on 
behalf of the client or changes to such account and that sends account 
statements to its client to include in the account statement a legend 
urging the clients to compare its account statement with those sent by 
the qualified custodian. We expect that the requirement would cause 
advisers that are subject to the notice requirement and that send 
account statement to clients to reprogram their computer system to 
include the legend in account statements to clients. We estimate that 
half of the advisers that are subject to the rule or 1,195 advisers 
will hire a computer programmer to modify their computer system to 
automatically add the legend to client account statements at an average 
cost of $1,000 each.\293\ We believe the other half routinely use off-
the-shelf software to provide client account statements and will bear 
little or no direct costs because we expect the software vendors will 
not pass the reprogramming costs on to their customers (i.e. the 
advisers) due to a very low per unit cost. Based on the above 
estimates, we believe that the total one-time computer system 
programming cost would be $1,195,000 for the advisers subject to this 
requirement.\294\
---------------------------------------------------------------------------

    \293\ As stated above, we estimated that there will be 2,389 
advisers subject to this requirement. See supra note 196 and 
accompanying text. 2,389/2 = 1,195.
    \294\ 1,195 x $1,000 = $1,195,000. Data from the Securities 
Industry and Financial Markets Association's Management & 
Professional Earnings in the Securities Industry 2008, modified by 
Commission staff to account for an 1800-hour work-year and 
multiplied by 5.35 to account for bonuses, firm size, employee 
benefits and overhead, suggest that the cost for this position is 
$193 per hour. We further estimate that such reprogramming will take 
about 5 hours for each adviser. $193 x 5 hours = $965. Based on the 
above, we estimate that each adviser will spend approximately $1,000 
as reprogramming costs.
---------------------------------------------------------------------------

    PCAOB registration. For an investment adviser to rely on the 
provision in amended rule 206(4)-2 that deems pooled investment 
vehicles to have satisfied the surprise examination requirement if 
audited financial statements are distributed to investors in the pool, 
the accountant that audits the pooled investment vehicle's financial 
statements must be registered with, and subject to regular inspection

[[Page 1480]]

by, the PCAOB.\295\ We acknowledge that not all pooled investment 
vehicle audits are performed by accountants meeting the PCAOB 
requirement as this is a new requirement. However, our staff has 
reviewed several third-party databases that contain the identity of 
accountants that perform these audits, and substantially all the pools 
that identified accountants were audited by PCAOB registered and 
inspected firms or their affiliates.\296\ Moreover, a representative of 
venture capital firms stated that the ``vast majority'' of venture 
capital funds are audited and, as far as it could determine, all 
venture capital fund audits are conducted by PCAOB registered 
accounting firms that are subject to PCAOB inspection.\297\ As a 
result, we do not believe there will be a substantial dislocation of 
pooled investment vehicle auditors as a result of the amended rule. For 
those pools that will have to change accounting firms, we do not 
believe based on discussions with accountants that there will be 
additional costs to retain an accounting firm registered with, and 
subject to inspection by, the PCAOB, as accountants that perform these 
financial statement audits are likely to be with national accounting 
firms or accounting firms that specialize in auditing pooled investment 
vehicles and that charge equivalent fees to accountants registered 
with, and subject to inspection by, the PCAOB.\298\
---------------------------------------------------------------------------

    \295\ Amended rule 206(4)-2(b)(4).
    \296\ These databases do not distinguish between funds managed 
by registered advisers from those managed by exempt advisers (who 
would not be subject to the rule).
    \297\ NVCA Letter.
    \298\ Two commenters expressed concerns about costs with respect 
to the requirement of PCAOB registration for accountants performing 
surprise examinations and preparing internal control reports for 
advisers that serve, or have related person serve, as the qualified 
custodian for their client assets. See Consortium Letter; Chamber of 
Commerce Letter. These comments, however, were not directed to the 
costs of engaging PCAOB registered accountants for audits of pooled 
investment vehicles, and the commenters that did recommend the PCAOB 
requirement did not indicate there would be increased costs for such 
a requirement. See, e.g., CPIC Letter, MFA Letter.
---------------------------------------------------------------------------

    Liquidation Audit. The amended rule specifically requires an 
adviser to a pooled investment vehicle that is relying on the annual 
audit provision to obtain a final audit if the pool is liquidated at a 
time other than the end of a fiscal year.\299\ This requirement will 
assure that the proceeds of the liquidation are appropriately accounted 
for. We believe this requirement will not materially increase the costs 
for advisers to pooled investment vehicles because we believe most of 
these pooled investment vehicles are subject to contractual obligations 
with their investors to obtain a liquidation audit.\300\ For purposes 
of PRA analysis, we estimate that advisers will spend 243 hours 
complying with the requirement\301\ and thus will incur an aggregate 
cost of $15,309 for all advisers subject to the requirement.\302\
---------------------------------------------------------------------------

    \299\ Amended rule 206(4)-2(b)(4)(iii).
    \300\ As discussed above, amended rule 206(4)-2(c) provides that 
an adviser's sending an account statement (paragraph (a)(5)) or 
distributing audited financial statements (paragraph (b)(4)) will 
not meet the requirements of the rule if all of the investors in a 
pooled investment vehicle to which the statements are sent are 
themselves pooled investment vehicles that are related persons of 
the adviser. We do not believe this requirement will impose new 
costs on advisers under the rule because the application of the rule 
as required by this new provision was incorporated into our prior 
cost estimates.
    \301\ See supra note 193 and accompanying text.
    \302\ 243 x $63 (hourly wage) = $15,309. See supra note 266 for 
explanation of advisory employee wage estimate.
---------------------------------------------------------------------------

    Qualified Custodian Account Statements. With the exception of 
advisers to certain pooled investment vehicles that distribute audited 
financial statements, the amended rule requires all registered advisers 
that have custody of client assets to have a reasonable belief, after 
due inquiry, that the qualified custodian sends account statements 
directly to their clients at least quarterly. We believe few advisers 
will have to change their practices to meet the requirement that all 
clients receive account statements directly from qualified custodians. 
Most advisers subject to the rule have qualified custodians that 
deliver account statements directly to clients and already conduct an 
inquiry of whether the qualified custodian sends account statements to 
clients.\303\ For those advisers that previously had sent account 
statements directly to clients instead of having the 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.
---------------------------------------------------------------------------

    \303\ Filing data indicates that 190 advisers (other than those 
that have custody but only have pooled investment vehicle clients 
that are subject to an annual audit) did not have the qualified 
custodian send account statements directly to their clients.
---------------------------------------------------------------------------

    Based on the above analysis, we conclude that the aggregate annual 
accounting fee to comply with the surprise examination requirement and 
the internal control report requirement under amended rule 206(4)-2 is 
estimated at $122,965,000. In addition, we estimate that the total 
hours spent by advisory employees to comply with the amendments \304\ 
will be 29,003 at a total cost of $1,917,864 \305\ The total cost 
estimated for complying with amendments to 206(4)-2 is estimated at 
$126,077,864.\306\
---------------------------------------------------------------------------

    \304\ The total hours include time spent to produce client 
contact lists for the accountant performing the surprise 
examination, add required language in a written agreement with the 
accountant engaged to perform the surprise examination, prepare a 
required legend in notices and subsequent statements to clients 
urging them to compare information contained in the account 
statements sent by the adviser with those sent by the qualified 
custodian, and distribute audited financial statements, including 
those related to liquidation audit, to fund investors. See Section 
IV of this Release for explanation of the estimates.
    \305\ See supra notes 270 and 271 and accompanying text for 
explanation of these estimates. [(19,950 (employee hours for 
surprise examination) + 243 (employee hours for distributing audited 
financials related to liquidation audit) + 8,345 (employee hours for 
adding a legend in the notice to clients)) x $63] + (465 (employee 
hours for adding language in written agreements) x $258) = 
$1,797,894 + $119,970 = $1,917,864.
    We estimated that advisory employees will spend a total of 
41,724 hours to comply with the notice requirement. The estimated 
8,345 hours noted above for adding the legend to the required notice 
represents 20% of the total hour burden relating to the notice, 
which is 41,724 hours. (41,724 x 0.2) = 8,345. See supra note 197 
for explanation of the estimate.
    \306\ ($122,965,000 (aggregate accounting fees) + $1,917,864 
(costs of hours advisory employees spent) + $1,195,000 (cost of one-
time computer system programming) = $126,077,864).
---------------------------------------------------------------------------

    Form ADV. We are adopting substantially as proposed several 
amendments to Part 1A of Form ADV that are designed to provide us with 
additional details regarding the custody practices of advisers 
registered with the Commission, and to provide additional data to 
assist in our risk-based examination program. For purposes of the PRA 
analysis, we estimated that these amendments will increase the annual 
information collection burden in connection with Form ADV from 22.25 
hours to 22.50 hours for each adviser.\307\ The total information 
collection burden resulting from the amendments would be 3,068 
hours.\308\ Based on this estimate, we anticipate that advisers will 
incur an aggregate cost of approximately $193,284 per year for the 
total hours their employees spend in connection with the amendments to 
Form ADV.\309\
---------------------------------------------------------------------------

    \307\ See supra note 218 and accompanying text.
    \308\ See supra note 219 and accompanying text. We received no 
comments on the estimate and we are keeping the estimate unchanged.
    \309\ We expect that the function of completing Form ADV would 
be performed by compliance clerks at a cost of $63 per hour. The 
total cost would be $193,284 (3,068 x $63 = $193,284). See supra 
note 266 for explanation of the hourly compliance clerk cost 
estimate.

---------------------------------------------------------------------------

[[Page 1481]]

    Form ADV-E. For purposes of the PRA analysis, we estimate that the 
collection of information in connection with Form ADV-E will increase 
from the currently approved 9 hours to 112 hours based on the 
requirements of the amended rule. This increase results from an 
increase in the estimated number of advisers that will be subject to 
the requirement of completing Form ADV-E under the amendments to rule 
206(4)-2 and the additional collections of information required by the 
amendments relating to completing Form ADV-E when an independent public 
accountant performing the surprise examination terminates its 
engagement. This represents an increase of 103 hours \310\ with an 
estimated aggregated annual cost of approximately $7,056.\311\
---------------------------------------------------------------------------

    \310\ 112 -9 = 103. We received no comments on this estimate.
    \311\ We expect that the function of completing Form ADV-E would 
be performed by compliance clerks at a cost of $63 per hour. The 
total cost would therefore be $7,056 (112 x $63 = $7,056). See supra 
note 266 for explanation of the hourly compliance clerk cost 
estimate.
---------------------------------------------------------------------------

    We recognize that there also might be certain costs to investment 
advisers, advisory clients and others that are not easily quantifiable. 
For instance, some advisers may choose to only use independent 
qualified custodians, and as a result, they may lose advisory clients 
if those clients insist on maintaining their assets with a particular 
custodian that happens to be a related person of the adviser. Advisory 
clients that are unwilling to change custodians also may lose the 
ability to hire an adviser that is related to the custodian if the 
adviser will only accept clients that use independent custodians. 
Advisers that chose to only use independent qualified custodians might 
also lose efficiencies that resulted from self-custody or related 
person custody arrangements, which could result in increased costs to 
advisory clients. Additionally, to the extent that advisers discontinue 
existing relationships with custodians, accountants or other service 
providers as a result of, or as required by, the amended rule, these 
service providers may lose revenues and incur other costs.
    Based on the above analysis, we estimate that the aggregate costs 
for complying with the amendments to rule 206(4)-2, rule 204-2, Form 
ADV, and Form ADV-E will be $126,278,204.\312\ Of this amount, we 
estimate that $1,195,000 is one-time computer system programming costs 
related to account statement legends, while the remainder will be 
recurred on an annual basis.
---------------------------------------------------------------------------

    \312\ $126,077,864 (total costs for complying amendments to rule 
206(4)-2) + $193,284 (total costs for complying with amendments to 
Form ADV) + $7,056 (total costs for complying with amendments to 
Form ADV-E) = $126,278,204.
---------------------------------------------------------------------------

VI. Final Regulatory Flexibility Analysis

    The Commission has prepared the following Final Regulatory 
Flexibility Analysis regarding rule 206(4)-2 in accordance with section 
3(a) of the Regulatory Flexibility Act.\313\ We prepared an Initial 
Regulatory Flexibility Analysis (``IRFA'') in conjunction with the 
Proposing Release in May 2009. A summary of that IRFA was published 
with the Proposing Release.\314\
---------------------------------------------------------------------------

    \313\ 5 U.S.C. 605(b).
    \314\ See Proposing Release at Section VI.
---------------------------------------------------------------------------

A. Need for the Rule

    Rule 206(4)-2, the custody rule, requires registered advisers to 
maintain their clients' assets with a qualified custodian, such as a 
broker-dealer or a bank. To enhance the protections afforded to 
clients' assets, we are adopting amendments to the rule to require all 
registered advisers that have custody of client assets, among other 
things: (i) To undergo an annual surprise examination by an independent 
public accountant to verify client assets; (ii) to have a reasonable 
basis, after due inquiry, for believing that the qualified custodian 
maintaining client funds and securities sends account statements 
directly to the advisory clients; and (iii) unless client assets are 
maintained by an independent custodian (i.e., a custodian that is not 
the adviser itself or a related person) to obtain, or receive from a 
related person, a report of the internal controls relating to the 
custody of those assets from an independent public accountant that is 
registered with and subject to regular inspection by the PCAOB.
    We have designed the amendments to enhance the protections afforded 
to clients when their advisers have custody of client assets. We 
believe that the surprise examination requirement will deter fraudulent 
activities by advisers. Moreover, an independent public accountant may 
identify misuse that clients have not, which would result in the 
earlier detection of fraudulent activities and reduce resulting client 
losses.
    The amendments adopted today provide that an adviser is deemed to 
have custody of client assets held by related persons. Related person 
custody arrangements can present higher risks to advisory clients than 
those that maintain assets with an independent custodian. We were 
concerned that the surprise examination alone would not adequately 
address custodial risks associated with self or related person custody 
because the independent public accountant seeking to verify client 
assets would rely on custodial reports issued by the adviser or the 
related person. To address these risks, we are adopting a requirement 
that a registered adviser obtain, or receive from its related person, 
an annual internal control report, which would include an opinion from 
an independent public accountant with respect to the adviser's or 
related person's custody controls.

B. Significant Issues Raised by Public Comment

    In the Proposing Release, we requested comment on the IRFA. We 
received a number of comments related to the impact of our proposal on 
small advisers. They argued that the proposed amendments to the rule, 
particularly those that would have imposed the surprise examination 
requirement on advisers that have custody solely because of their 
authority to deduct advisory fees, would be disproportionately 
expensive for, and would impose an undue regulatory burden on, smaller 
firms.\315\
---------------------------------------------------------------------------

    \315\ Mallon P.C. Letter (asserting that the requirement would 
cost 10 percent of smaller firms' gross income). See also CAS 
Letter; Consortium Letter; Cornell Letter; Form Letter D; FSI 
Letter; IAA Letter; NAPFA Letter; FPA Letter; Denk Letter. Some 
commenters argued that, at a minimum, it would force most small 
advisers to eliminate a convenient billing method chosen by many of 
their clients. ASG Letter; Cornell Letter; Form Letters C and D; FSI 
Letter; MarketCounsel Letter. Others urged us to consider that this 
proposal would likely drive many small advisers out of business, and 
would create a barrier to entry for others. Ameritrade Letter; 
IASBDA Letter; NAPFA Letter.
---------------------------------------------------------------------------

    We are sensitive to the burdens our rule amendments will have on 
small advisers. We believe that the amendments to the custody rule we 
are adopting today will alleviate many of the commenters' concerns 
regarding small advisers. In particular, as described above, we have 
provided an exception from the surprise examination requirement for 
advisers who have custody because they have authority to deduct 
advisory fees from client accounts. Moreover, for small advisers still 
subject to the surprise examination requirement, the revised guidance 
for accountants modernizes the procedures for surprise examinations, 
which may reduce the burden on small advisers.\316\
---------------------------------------------------------------------------

    \316\ See Accounting Release.
---------------------------------------------------------------------------

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

[[Page 1482]]

entity if it: (i) Has assets under management having a total value of 
less than $25 million; (ii) did not have total assets of $5 million or 
more on the last day of its most recent fiscal year; and (iii) does not 
control, is not controlled by, and is not under common control with 
another investment adviser that has assets under management of $25 
million or more, or any person (other than a natural person) that had 
$5 million or more on the last day of its most recent fiscal year.\317\
---------------------------------------------------------------------------

    \317\ 17 CFR 275.0-7(a).
---------------------------------------------------------------------------

    The Commission estimates that as of November 2, 2009 approximately 
73 SEC-registered investment advisers that have custody of client 
assets were small entities that will be subject to the surprise 
examination requirement under amended rule 206(4)-2(a)(4), and that no 
more than eight small entity advisers that have custody of client 
assets will be subject to the requirement of obtaining or receiving an 
internal control report under amended rule 206(4)-2(a)(6).\318\
---------------------------------------------------------------------------

    \318\ Based on IARD data.
---------------------------------------------------------------------------

D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

    The rule amendments impose certain reporting, recordkeeping and 
compliance requirements on advisers, including small advisers. The rule 
requires advisers that are subject to the surprise examination to 
complete Form ADV-E and to maintain internal control reports in certain 
instances. In addition, under the amendments, each adviser that is 
required to undergo an annual surprise examination must enter into a 
written agreement with the independent public accountant that performs 
the surprise examination that specifies certain duties the accountant 
must perform as part of the surprise examination engagement. Investment 
advisers, under the proposed rule amendments, must maintain a copy of 
an internal control report that an adviser is required to obtain, or 
receive from its related person, for five years from the end of the 
fiscal year in which the internal control report is finalized.
    We estimate that a total of 1,859 advisers will be subject to the 
surprise examination requirement, of which 337 advisers will be subject 
to the surprise examination with respect to 100 percent of their 
clients and will each spend an average of $125,000 annually,\319\ and 
1,522 will be subject to the surprise examination with respect to 5 
percent of their clients. Of the 1,522 advisers, 262 medium-sized 
advisers will each spend an average of $20,000 annually,\320\ and 1,260 
small-sized advisers will each spend an average of $10,000 
annually.\321\ The advisers subject to the surprise examination that 
fall into the definition of ``small entities'' under section 3(a) of 
the Regulatory Flexibility Act are among the smallest within the small-
sized advisers group, with an average of fewer than 6 clients whose 
accounts would be subject to the surprise examination requirement.\322\ 
As a result, the accounting fees for the surprise examination conducted 
on the client accounts at these advisers may be lower than our 
estimated average cost of $10,000.\323\ As a result, the potential 
impact of the amendments on these small entities due to the surprise 
examination requirement should not be substantial.
---------------------------------------------------------------------------

    \319\ See supra note 206 and accompanying text for explanation 
of the estimate.
    \320\ These advisers report a larger number of clients than the 
average number of clients for the subset of advisers that are 
subject to the surprise examination for only a portion (estimated at 
5%) of their clients.
    \321\ These advisers report a smaller number of clients than the 
average number of clients for the subset of advisers that are 
subject to the surprise examination for only a portion (estimated at 
5%) of their clients.
    \322\ Based on IARD data, we estimate that more than half (43) 
of the 73 small advisers will be subject to the surprise examination 
with respect to no more than 6 clients.
    \323\ For the four small entity advisers that may be subject to 
the surprise examination with respect to 100% of their clients, we 
believe the cost will be significantly less than the $125,000 annual 
fee estimated for the 337 advisers. Based on IARD data, we estimate 
that the average number of clients for these advisers would be 120 
rather than the 2,315 we estimate for other advisers that are in the 
same group. See supra note 176 and accompanying text for explanation 
of our estimate of average number of clients for the 337 advisers.
---------------------------------------------------------------------------

    We also estimate that, on average, an internal control report will 
cost approximately $250,000 per year, but would vary based on the size 
and services offered by the qualified custodian. As stated above, we 
estimate that no more than eight small entity advisers will be subject 
to the internal control report requirement, half of which will obtain 
the report and the other half will receive the report from a related 
person. We believe that the cost of an internal control report for the 
four small entity advisers that must obtain one will be lower than the 
estimated $250,000 because of the small scale of their businesses. 
Alternatively, these advisers may simply advise their clients to select 
independent qualified custodians so that they will not be subject to 
the requirement of obtaining an internal control report.

E. Agency Action To Minimize Effect on Small Entities

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objective, 
while minimizing any significant adverse impact on small entities. In 
connection with the rule amendments, the Commission considered the 
following alternatives: (i) The establishment of differing compliance 
or reporting requirements or timetables that take into account the 
resources available to small entities; (ii) the clarification, 
consolidation, or simplification of compliance and reporting 
requirements under the rule for such small entities; (iii) the use of 
performance rather than design standards; and (iv) an exemption from 
coverage of the rule, or any part thereof, for such small entities.
    Regarding the first and fourth alternatives, we do not believe that 
differing compliance or reporting requirements or an exemption from 
coverage of the rule amendments, or any part thereof, for small 
entities, would be appropriate or consistent with investor protection. 
Because the protections of the Advisers Act are intended to apply 
equally to clients of both large and small advisory firms, it would be 
inconsistent with the purposes of the Act to specify different 
requirements for small entities under the amendments.
    Regarding the second alternative, the amendments clarify when an 
investment adviser, including a small adviser, has custody. In 
addition, we are providing updated guidance for accountants that 
modernize the procedures for the surprise examination and should 
provide clarification to investment advisers, including small entities, 
and accountants on certain issues regarding the surprise examination. 
We also have endeavored to consolidate and simplify the rule, by adding 
new definitions to the rule.
    Regarding the third alternative, we do not consider using 
performance rather than design standards to be consistent with our 
statutory mandate of investor protection with respect to custody of 
client assets by investment advisers.

VII. Effects on Competition, Efficiency and Capital Formation

    We are adopting amendments to rule 204-2, Part 1A of Form ADV and 
Form ADV-E, in part, pursuant to our authority under Section 204. 
Section 204 requires the Commission, when engaging in rulemaking 
pursuant to that authority, to consider whether the rule is ``necessary 
or appropriate in the public interest or for the protection of 
investors.'' \324\ Section 202(c)(1) of the Advisers Act requires the 
Commission, when engaging in rulemaking that

[[Page 1483]]

requires it to consider or determine whether an action is necessary or 
appropriate in the public interest, to consider, in addition to the 
protection of investors, whether the action will promote efficiency, 
competition, and capital formation.\325\ In the Proposing Release, we 
solicited comment on whether, if adopted, the proposed rule and form 
amendments would promote efficiency, competition and capital formation. 
We further encouraged commenters to provide empirical data to support 
their views on any burdens on efficiency, competition or capital 
formation that might result from adoption of the proposed amendments. 
We did not receive any empirical data in this regard concerning the 
proposed amendments. We received some general comments asserting that 
the proposed amendments to require a surprise examination for advisers 
with custody of client assets as a result of deducting advisory fees 
from client accounts would have a significant adverse impact on 
competition.\326\
---------------------------------------------------------------------------

    \324\ 15 U.S.C. 80b-4(a).
    \325\ 15 U.S.C. 80b-2(c). We are adopting amendments to rule 
206(4)-2 pursuant to our authority set forth in Sections 206(4) and 
211(a) of the Advisers Act, neither of which requires us to consider 
the factors indentified in Section 202(c). Analysis of the effects 
of these amendments is contained in Sections IV, V, and VI above.
    \326\ See, e.g., ASG Letter; Ameritrade Letter. The amended rule 
excludes from the surprise examination requirement advisers that 
have custody of client assets because of deducting advisory fees 
from client accounts. See amended rule 206(4)-2(b)(3).
---------------------------------------------------------------------------

    We believe the amendments we are adopting today to rule 204-2, Part 
1A of Form ADV and Form ADV-E in connection with amendments to rule 
206(4)-2, which are substantively similar to those we proposed, will 
promote efficiency and competition, but have little or no effect on 
capital formation.
    The amendments to Part 1A of Form ADV are designed to provide us 
with additional details concerning the custody practices of advisers 
registered with the Commission, and to provide additional data to 
assist in our risk-based examination program. Under the amendments to 
Form ADV-E, the form and attached accountant's certificate will be 
filed electronically on the IARD system. In addition, the rule requires 
the accountant performing an annual surprise examination to, upon the 
accountant's termination or dismissal, or removal from consideration 
for reappointment, file Form ADV-E within 4 business days accompanied 
by a statement explaining any problems relating to examination scope or 
procedure that contributed to the resignation, dismissal, removal, or 
other termination. Both Part 1A of Form ADV and Form ADV-E will be 
available to the public on the Commission's web site.
    Public availability of more detailed disclosure of advisers' 
custodial practices will permit investors to use this information 
together with other information they obtain from Form ADV in making 
more informed decisions about whether to hire or retain a particular 
adviser. A more informed investing public will create a more efficient 
marketplace and strengthen competition among advisers. Moreover, the 
electronic filing requirements are expected to expedite and simplify 
the process of filing Form ADV-E and attached accountant's certificate 
with the Commission, thus further improving efficiency. We believe, 
however, that the amendments are unrelated to, and will have little or 
no effect on, capital formation.
    We are amending rule 204-2 to require (i) that, if an independent 
custodian does not maintain client assets but the adviser or a related 
person instead serves as a qualified custodian for client funds or 
securities under the rule in connection with advisory services the 
adviser provides to clients, the adviser must maintain a copy of any 
internal control report obtained or received pursuant to amended rule 
206(4)-2(a)(6), and (ii) the memorandum describing the basis upon which 
the adviser determined that the presumption that a related person is 
not operationally independent was overcome, pursuant to amended rule 
206(4)-2(d)(5) for five years from the end of the fiscal year in which, 
as applicable, the internal control report or memorandum is 
finalized.\327\ The amendment is designed to provide our examiners 
important information about the safeguards in place and assess custody-
related risks at an adviser or a related person that maintains client 
assets. We believe that these amendments will not materially increase 
the compliance burden on advisers under rule 204-2 and thus will not 
affect competition, efficiency and capital formation.
---------------------------------------------------------------------------

    \327\ Rule 206(4)-2 requires that if an independent custodian 
does not maintain client assets but the adviser or a related person 
instead serves as a qualified custodian for client funds or 
securities under the rule in connection with advisory services the 
adviser provides to clients, the adviser must obtain, or receive 
from the related person, no less frequently than once each calendar 
year an internal control report, which includes an opinion from an 
independent public accountant with respect to the adviser's or 
related person's controls relating to custody of client assets. See 
amended rule 206(4)-2(a)(6)(ii).
---------------------------------------------------------------------------

VIII. Statutory Authority

    We are adopting amendments to rule 206(4)-2 (17 CFR 275.206(4)-2) 
pursuant to our authority set forth in sections 206(4) and 211(a) of 
the Advisers Act (15 U.S.C. 80b-6(4) and 80b-11(a)). We are adopting 
amendments to rule 204-2 pursuant to the authority set forth in 
sections 204 and 211 of the Advisers Act (15 U.S.C. 80b-4 and 80b-11). 
We are adopting amendments to Part 1 of Form ADV (17 CFR 279.1) 
pursuant to our authority set forth in sections 203(c)(1), 204, and 
211(a) of the Advisers Act (15 U.S.C. 80b-3(c)(1), 80b-4 and 80b-
11(a)). We are adopting amendment to Form ADV-E (17 CFR 279.8) pursuant 
to our authority set forth in sections 204, 206(4), and 211(a) of the 
Advisers Act (15 U.S.C. 80b-4, 80b-6(4), and 80b-11(a)).

List of Subjects in 17 CFR Parts 275 and 279

    Reporting and recordkeeping requirements, Securities.

Text of Rule and Form Amendments

0
For the reasons set out in the preamble, Title 17, Chapter II of the 
Code of Federal Regulations is amended as follows.

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

0
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.
* * * * *

0
2. Section 275.204-2 is amended by:
0
a. Removing ``in effect, and'' at the end of paragraph (a)(17)(i) and 
adding in its place ``in effect;'' ;
0
b. Removing the period at the end of paragraph (a)(17)(ii) and adding 
in its place a semicolon;
0
c. Adding paragraph (a)(17)(iii); and
0
d. Adding paragraph (b)(5).
    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).
    (b) * * *
    (5) A memorandum describing the basis upon which you have 
determined that the presumption that any related person is not 
operationally independent

[[Page 1484]]

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

0
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. If you send account 
statements to a client to which you are required to provide this 
notice, include in the notification provided to that client and in any 
subsequent account statement you send that client a statement urging 
the client to compare the account statements from the custodian with 
those from the adviser.
    (3) Account statements to clients. You have a reasonable basis, 
after due inquiry, for believing that the qualified custodian sends an 
account statement, at least quarterly, to each of your clients for 
which it maintains funds or securities, identifying the amount of funds 
and of each security in the account at the end of the period and 
setting forth all transactions in the account during that period.
    (4) Independent verification. The client funds and securities of 
which you have custody are verified by actual examination at least once 
during each calendar year, except as provided below, by an independent 
public accountant, pursuant to a written agreement between you and the 
accountant, at a time that is chosen by the accountant without prior 
notice or announcement to you and that is irregular from year to year. 
The written agreement must provide for the first examination to occur 
within six months of becoming subject to this paragraph, except that, 
if you maintain client funds or securities pursuant to this section as 
a qualified custodian, the agreement must provide for the first 
examination to occur no later than six months after obtaining the 
internal control report. The written agreement must require the 
accountant to:
    (i) File a certificate on Form ADV-E (17 CFR 279.8) with the 
Commission within 120 days of the time chosen by the accountant in 
paragraph (a)(4) of this section, stating that it has examined the 
funds and securities and describing the nature and extent of the 
examination;
    (ii) Upon finding any material discrepancies during the course of 
the examination, notify the Commission within one business day of the 
finding, by means of a facsimile transmission or electronic mail, 
followed by first class mail, directed to the attention of the Director 
of the Office of Compliance Inspections and Examinations; and
    (iii) Upon resignation or dismissal from, or other termination of, 
the engagement, or upon removing itself or being removed from 
consideration for being reappointed, file within four business days 
Form ADV-E accompanied by a statement that includes:
    (A) The date of such resignation, dismissal, removal, or other 
termination, and the name, address, and contact information of the 
accountant; and
    (B) An explanation of any problems relating to examination scope or 
procedure that contributed to such resignation, dismissal, removal, or 
other termination.
    (5) Special rule for limited partnerships and limited liability 
companies. If you or a related person is a general partner of a limited 
partnership (or managing member of a limited liability company, or hold 
a comparable position for another type of pooled investment vehicle), 
the account statements required under paragraph (a)(3) of this section 
must be sent to each limited partner (or member or other beneficial 
owner).
    (6) Investment advisers acting as qualified custodians. If you 
maintain, or if you have custody because a related person maintains, 
client funds or securities pursuant to this section as a qualified 
custodian in connection with advisory services you provide to clients:
    (i) The independent public accountant you retain to perform the 
independent verification required by paragraph (a)(4) of this section 
must be registered with, and subject to regular inspection as of the 
commencement of the professional engagement period, and as of each 
calendar year-end, by, the Public Company Accounting Oversight Board in 
accordance with its rules; and
    (ii) You must obtain, or receive from your related person, within 
six months of becoming subject to this paragraph and thereafter no less 
frequently than once each calendar year a written internal control 
report prepared by an independent public accountant:
    (A) The internal control report must include an opinion of an 
independent public accountant as to whether controls have been placed 
in operation as of a specific date, and are suitably designed and are 
operating effectively to meet control objectives relating to custodial 
services, including the safeguarding of funds and securities held by 
either you or a related person on behalf of your advisory clients, 
during the year;
    (B) The independent public accountant must verify that the funds 
and securities are reconciled to a custodian other than you or your 
related person; and
    (C) The independent public accountant must be registered with, and 
subject to regular inspection as of the commencement of the 
professional engagement period, and as of each calendar year-end, by, 
the Public Company Accounting Oversight Board in accordance with its 
rules.
    (7) Independent representatives. A client may designate an 
independent representative to receive, on his behalf, notices and 
account statements as required under paragraphs (a)(2) and (a)(3) of 
this section.
    (b) Exceptions. (1) Shares of mutual funds. With respect to shares 
of an 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 the 
books of the issuer or its transfer agent in the name of the client; 
and
    (C) Transferable only with prior consent of the issuer or holders 
of the outstanding securities of the issuer.
    (ii) Notwithstanding paragraph (b)(2)(i) of this section, the 
provisions of this paragraph (b)(2) are available with

[[Page 1485]]

respect to securities held for the account of a limited partnership (or 
a limited liability company, or other type of pooled investment 
vehicle) only if the limited partnership is audited, and the audited 
financial statements are distributed, as described in paragraph (b)(4) 
of this section.
    (3) Fee deduction. Notwithstanding paragraph (a)(4) of this 
section, you are not required to obtain an independent verification of 
client funds and securities maintained by a qualified custodian if:
    (i) you have custody of the funds and securities solely as a 
consequence of your authority to make withdrawals from client accounts 
to pay your advisory fee; and
    (ii) if the qualified custodian is a related person, you can rely 
on paragraph (b)(6) of this section.
    (4) Limited partnerships subject to annual audit. You are not 
required to comply with paragraphs (a)(2) and (a)(3) of this section 
and you shall be deemed to have complied with paragraph (a)(4) of this 
section with respect to the account of a limited partnership (or 
limited liability company, or another type of pooled investment 
vehicle) that is subject to audit (as defined in rule 1-02(d) of 
Regulation S-X (17 CFR 210.1-02(d))):
    (i) At least annually and distributes its audited financial 
statements prepared in accordance with generally accepted accounting 
principles to all limited partners (or members or other beneficial 
owners) within 120 days of the end of its fiscal year;
    (ii) By an independent public accountant that is registered with, 
and subject to regular inspection as of the commencement of the 
professional engagement period, and as of each calendar year-end, by, 
the Public Company Accounting Oversight Board in accordance with its 
rules; and
    (iii) Upon liquidation and distributes its audited financial 
statements prepared in accordance with generally accepted accounting 
principles to all limited partners (or members or other beneficial 
owners) promptly after the completion of such audit.
    (5) Registered investment companies. You are not required to comply 
with this section (17 CFR 275.206(4)-2) with respect to the account of 
an investment company registered under the Investment Company Act of 
1940 (15 U.S.C. 80a-1 to 80a-64).
    (6) Certain Related Persons. Notwithstanding paragraph (a)(4) of 
this section, you are not required to obtain an independent 
verification of client funds and securities if:
    (i) you have custody under this rule solely because a related 
person holds, directly or indirectly, client funds or securities, or 
has any authority to obtain possession of them, in connection with 
advisory services you provide to clients; and
    (ii) your related person is operationally independent of you.
    (c) Delivery to Related Person. Sending an account statement under 
paragraph (a)(5) of this section or distributing audited financial 
statements under paragraph (b)(4) of this section shall not satisfy the 
requirements of this section if such account statements or financial 
statements are sent solely to limited partners (or members or other 
beneficial owners) that themselves are limited partnerships (or limited 
liability companies, or another type of pooled investment vehicle) and 
are your related persons.
    (d) Definitions. For the purposes of this section:
    (1) Control means the power, directly or indirectly, to direct the 
management or policies of a person, whether through ownership of 
securities, by contract, or otherwise. Control includes:
    (i) Each of your firm's officers, partners, or directors exercising 
executive responsibility (or persons having similar status or 
functions) is presumed to control your firm;
    (ii) A person is presumed to control a corporation if the person:
    (A) Directly or indirectly has the right to vote 25 percent or more 
of a class of the corporation's voting securities; or
    (B) Has the power to sell or direct the sale of 25 percent or more 
of a class of the corporation's voting securities;
    (iii) A person is presumed to control a partnership if the person 
has the right to receive upon dissolution, or has contributed, 25 
percent or more of the capital of the partnership;
    (iv) A person is presumed to control a limited liability company if 
the person:
    (A) Directly or indirectly has the right to vote 25 percent or more 
of a class of the interests of the limited liability company;
    (B) Has the right to receive upon dissolution, or has contributed, 
25 percent or more of the capital of the limited liability company; or
    (C) Is an elected manager of the limited liability company; or
    (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) Operationally independent: for purposes of paragraph (b)(6) of 
this section, a related person is presumed not to be operationally 
independent unless each of the following conditions is met and no other 
circumstances can reasonably be expected to compromise the operational 
independence of the related person: (i) Client assets in the custody of 
the related person are not subject to claims of the adviser's 
creditors; (ii) advisory personnel do not have custody or possession 
of, or direct or indirect access to client assets of which the related 
person has custody, or the power to control the disposition of

[[Page 1486]]

such client assets to third parties for the benefit of the adviser or 
its related persons, or otherwise have the opportunity to 
misappropriate such client assets; (iii) advisory personnel and 
personnel of the related person who have access to advisory client 
assets are not under common supervision; and (iv) advisory personnel do 
not hold any position with the related person or share premises with 
the related person.
    (6) Qualified custodian means:
    (i) A bank as defined in section 202(a)(2) of the Advisers Act (15 
U.S.C. 80b-2(a)(2)) or a savings association as defined in section 
3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) 
that has deposits insured by the Federal Deposit Insurance Corporation 
under the Federal Deposit Insurance Act (12 U.S.C. 1811);
    (ii) A broker-dealer registered under section 15(b)(1) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78o(b)(1)), holding the 
client assets in customer accounts;
    (iii) A futures commission merchant registered under section 4f(a) 
of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client 
assets in customer accounts, but only with respect to clients' funds 
and security futures, or other securities incidental to transactions in 
contracts for the purchase or sale of a commodity for future delivery 
and options thereon; and
    (iv) A foreign financial institution that customarily holds 
financial assets for its customers, provided that the foreign financial 
institution keeps the advisory clients' assets in customer accounts 
segregated from its proprietary assets.
    (7) Related person means any person, directly or indirectly, 
controlling or controlled by you, and any person that is under common 
control with you.

PART 279--FORMS PRESCRIBED UNDER THE INVESTMENT ADVISERS ACT OF 
1940

0
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.


0
5. Form ADV (referenced in Sec.  279.1) is amended by:
0
a. In the General Instructions, revising the first bullet and last 
paragraph of instruction 4;
0
b. In Part 1A, revising the last paragraph of Item 7.A. and revising 
Item 9; and
0
c. In Schedule D, revising Section 7.A., and adding Sections 9.C. and 
9.D.
    The revisions read as follows:

    Note: The text of Form ADV does not and this amendment will not 
appear in the Code of Federal Regulations.

BILLING CODE 8011-01-P

[[Page 1487]]

[GRAPHIC] [TIFF OMITTED] TR11JA10.000


[[Page 1488]]


[GRAPHIC] [TIFF OMITTED] TR11JA10.001


[[Page 1489]]


[GRAPHIC] [TIFF OMITTED] TR11JA10.002


[[Page 1490]]


[GRAPHIC] [TIFF OMITTED] TR11JA10.003


[[Page 1491]]


[GRAPHIC] [TIFF OMITTED] TR11JA10.004

BILLING CODE 8011-01-C

[[Page 1492]]


0
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 Commission or appropriate state securities administrators. 
File the original and one copy with the Securities and Exchange 
Commission's principal office in Washington, DC at the address on the 
top of this Form, and one copy with the regional office for the region 
in which the investment adviser's principal business operations are 
conducted, or one copy with the appropriate state administrator(s), if 
applicable; or
    (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.
* * * * *

    Dated: December 30, 2009.

    By the Commission.
Florence E. Harmon,
Deputy Secretary.
[FR Doc. 2010-18 Filed 1-8-10; 8:45 am]
BILLING CODE 8011-01-P

