Investment Adviser Workshop:Investment Adviser Workshop: the New Form ADV Part 2, New Rules, and the IA Switchthe New Form ADV Part 2, New Rules, and the IA Switch

The SEC’s 2010 Custody Rule:The SEC’s 2010 Custody Rule:Changes and New RequirementsChanges and New Requirements

Sheila ThomasSheila ThomasExaminerExaminer

Custody Rules

PurposePurpose• Prevent loss, misuse, and misappropriation Prevent loss, misuse, and misappropriation of clients’ assetsof clients’ assets

• Encourage the use of an independent Encourage the use of an independent custodiancustodian

• Additional Requirements for:Additional Requirements for:• Advisers with Custody orAdvisers with Custody or• Whose Related Person has CustodyWhose Related Person has Custody

Custody Rules

• Utah incorporated by reference the Utah incorporated by reference the SEC custody rulesSEC custody rules

• Utah Uniform Securities Act 61-1-2(3)Utah Uniform Securities Act 61-1-2(3)• Utah Administrative Rule R164-6-1g(E)(15)Utah Administrative Rule R164-6-1g(E)(15)

• SEC custody rules adopted in 2003SEC custody rules adopted in 2003

• Amended in 2009, became effective Amended in 2009, became effective March 12, 2010March 12, 2010

What Did Not ChangeWhat Did Not Change

Custody Rules

• Annual Surprise Examinations Annual Surprise Examinations (independent verification) (independent verification)

• Internal Control ReportsInternal Control Reports

• Client / Custodial StatementsClient / Custodial Statements

What is NewWhat is New

Custody Rules

CUSTODY: CUSTODY:

Adviser or its related person holds, Adviser or its related person holds, directly or indirectly, client funds directly or indirectly, client funds or securities, or has any or securities, or has any authority to obtain possession of authority to obtain possession of them. them.

DefinitionDefinition

Custody Rules

Direct CustodyDirect Custody• Possession of client funds or securitiesPossession of client funds or securities

• Permission to withdraw client funds or Permission to withdraw client funds or securities upon Adviser’s instruction (including securities upon Adviser’s instruction (including a general power of attorney) a general power of attorney)

• Legal ownership capacity or access to client Legal ownership capacity or access to client funds or securities (GP of limited partnership, funds or securities (GP of limited partnership, managing member of LLC, equivalent position managing member of LLC, equivalent position pooled investment vehicles, trustee of trust)pooled investment vehicles, trustee of trust)

Custody Rules

Indirect CustodyIndirect Custody• Advisers that receive client checks Advisers that receive client checks written to a third party but fail to written to a third party but fail to forward to the third party in a timely forward to the third party in a timely fashion. fashion.

• Limited power of authority to transfer Limited power of authority to transfer funds or securitiesfunds or securities

• Direct Deduction of Advisory FeesDirect Deduction of Advisory Fees

Custody Rules

RELATED PERSON:RELATED PERSON:

Any person, directly or indirectly, Any person, directly or indirectly, controlling or controlled by IA, and any controlling or controlled by IA, and any person that is under common control person that is under common control with the IA (may include banks and with the IA (may include banks and broker-dealers).broker-dealers).

DefinitionDefinition

Custody Rules

CONTROL:CONTROL:

• The power to directly or indirectly The power to directly or indirectly control, manage or set policies of the IAcontrol, manage or set policies of the IA

• Officers, partners, directors, LLC Officers, partners, directors, LLC manager, trustee, managing agent, other manager, trustee, managing agent, other persons with management controlpersons with management control

• Presumption control – ownership > 25%Presumption control – ownership > 25%

DefinitionDefinition

Custody Rules

QUALIFIED CUSTODIAN (QC):QUALIFIED CUSTODIAN (QC):• Bank, savings association, registered broker-Bank, savings association, registered broker- dealer, registered futures commission merchant dealer, registered futures commission merchant

• QC maintains client funds and securities QC maintains client funds and securities

(i)(i) in a separate account for each client under such in a separate account for each client under such client's name; orclient's name; or

(ii)(ii) in accounts that contain only client funds and in accounts that contain only client funds and securities, under the IA’s name as agent or trustee securities, under the IA’s name as agent or trustee for the clientsfor the clients

DefinitionDefinition

Custody Rules

SCOPE OF THE EXAMSCOPE OF THE EXAM

“…“…verify clients funds and securities of verify clients funds and securities of which an adviser has custody, including which an adviser has custody, including those maintained with a qualified custodian those maintained with a qualified custodian and those that are not required to be and those that are not required to be maintained with a qualified custodian, such maintained with a qualified custodian, such as privately offered securities and mutual as privately offered securities and mutual fund shares.” fund shares.” Footnote: 36 SEC Custody Rule Adopting Release IA-2968.Footnote: 36 SEC Custody Rule Adopting Release IA-2968.

Annual Surprise ExamAnnual Surprise Exam

Custody RulesAnnual Surprise ExamAnnual Surprise Exam

If the adviser or related person has custody:If the adviser or related person has custody:

• Independent verification of client funds and Independent verification of client funds and securities by actual examination securities by actual examination

• At least once during each calendar yearAt least once during each calendar year

• Exam date chosen by accountantExam date chosen by accountant

• Unannounced with no advance noticeUnannounced with no advance notice

• Irregular from year to yearIrregular from year to year

Custody Rules

Advisers must enter into a written contract Advisers must enter into a written contract • Independent Auditor Independent Auditor • PCAOB registration - Public CompanyPCAOB registration - Public Company Accounting Oversight Board Accounting Oversight Board • Subject to PCAOB reviewSubject to PCAOB review• Contract must state the exam will start by Contract must state the exam will start by December 31, 2010, or 6 months afterDecember 31, 2010, or 6 months after becoming subject to requirementbecoming subject to requirement

EngagementEngagement

Custody Rules

• Financial statements U.S. GAAP/ Audit Financial statements U.S. GAAP/ Audit conducted pursuant to U.S. GAASconducted pursuant to U.S. GAAS

• Auditor must agree to inform Utah within one Auditor must agree to inform Utah within one business day of discovery of a material business day of discovery of a material discrepancy discrepancy

• Auditor must file within four business days a Auditor must file within four business days a statement regarding the auditor’s termination statement regarding the auditor’s termination along with a hard copy of the Form ADV-Ealong with a hard copy of the Form ADV-E

EngagementEngagement

Custody Rules

• Website: Website: pcaobus.orgpcaobus.org

• PDF listPDF list

• Searchable databaseSearchable database

• Export Excel listExport Excel list

Finding an AuditorFinding an Auditor

Custody RulesInternal Control ReportInternal Control Report

If the adviser has custody or If the adviser has custody or adviser’s related person has custody adviser’s related person has custody (is a qualified custodian), then the (is a qualified custodian), then the independent auditor performing the independent auditor performing the surprise exam must be engaged to surprise exam must be engaged to prepare a written internal control prepare a written internal control report of the related person QCreport of the related person QC

Custody Rules

• Auditor’s Opinion states whether:Auditor’s Opinion states whether:• Controls have been placed in operation Controls have been placed in operation as of a specific dateas of a specific date• Controls are suitably designedControls are suitably designed• Controls are operating effectively to meet Controls are operating effectively to meet control objectives of custodial services, control objectives of custodial services, including safeguarding of client fundsincluding safeguarding of client funds

Internal Control ReportInternal Control Report

Custody Rules

• Independent auditor must verify funds Independent auditor must verify funds and securities are reconciled to a and securities are reconciled to a custodian other than the Adviser or their custodian other than the Adviser or their related personrelated person

• Independent auditor is PCAOB registeredIndependent auditor is PCAOB registered

• Report within 6 months of becoming Report within 6 months of becoming subject to the rule and annually thereaftersubject to the rule and annually thereafter

Internal Control ReportInternal Control Report

Custody Rules

Custodial Conditions Surprise Examination Internal Control Report

Fee Deduction Only NO NO“Enhanced” Custody, butQC ≠ Related Person andNo Common Ownership

YES NO

“Enhanced” Custody and QC = Related/Affiliated or Has Common Ownership

YES YES

Physical Custody YES YESPooled Investment Vehicles (PIVs) or other types of investment funds

Since these can be organized in many ways, each model will need to be evaluated independently. Please contact the Division to discuss the requirements for these funds.

SummarySummary

Custody Rules

• Initial Notice to Clients Initial Notice to Clients

• Account opened with QC, prompt, written notificationAccount opened with QC, prompt, written notification to clientsto clients

• QC name, address, & how funds/securities areQC name, address, & how funds/securities are maintainedmaintained

• Prompt written notification of any changes Prompt written notification of any changes

• If Adviser sends his own statements in addition toIf Adviser sends his own statements in addition to QC, notification must urge clients to compareQC, notification must urge clients to compare adviser’s statements to QCadviser’s statements to QC

QC StatementsQC Statements

Custody Rules

• Advisers must have a reasonable basis, after Advisers must have a reasonable basis, after due inquiry, for believing the qualified custodian due inquiry, for believing the qualified custodian sends at least quarterly statements to clientssends at least quarterly statements to clients

• Statements sent Statements sent directly directly from a QC to clientfrom a QC to client

• Statements must identify the amount of funds and Statements must identify the amount of funds and securities held for client and all transactions in the securities held for client and all transactions in the account during the periodaccount during the period

• Insufficient to merely confirm that statements are Insufficient to merely confirm that statements are available to clientavailable to client

QC StatementsQC Statements

Custody Rules

• Auditor’s surprise examination agreement Auditor’s surprise examination agreement

• Auditor’s signed & finalized report Auditor’s signed & finalized report

• Internal control report Internal control report

• QC account opening noticesQC account opening notices

• QC client statement due inquiry workpapersQC client statement due inquiry workpapers

• Keep 5 yearsKeep 5 years

Books and RecordsBooks and Records

Custody Rules

Adopt and implement written Adopt and implement written policies and procedures reasonably policies and procedures reasonably designed to prevent violations and designed to prevent violations and provide for supervision of IA’s provide for supervision of IA’s representatives. representatives.

Policies and ProceduresPolicies and Procedures

Custody Rules

SURPRISE EXAMSURPRISE EXAM• CPA engagement letter (written agreement) CPA engagement letter (written agreement) on or before December 31, 2010on or before December 31, 2010

• Exam complete and auditor certification with Exam complete and auditor certification with 120 days after the exam begins 120 days after the exam begins

• Exam must be within 6 months of becoming Exam must be within 6 months of becoming subject to the rule subject to the rule

Compliance Dates (SEC)Compliance Dates (SEC)

Custody Rules

INTERNAL CONTROL REPORTINTERNAL CONTROL REPORT

• 6 Months after Effective Date 6 Months after Effective Date (Sept 2010) (Sept 2010)

• 6 months after becoming subject 6 months after becoming subject to the ruleto the rule

Compliance Dates (SEC)Compliance Dates (SEC)

Custody Rules

POOLED INVESTMENT VEHICLE AUDITSPOOLED INVESTMENT VEHICLE AUDITS

• Non fund of funds: “reasonable belief” that audited financials will be distributed to investors within 120 days of the pool’s FYE

• Fund of funds: 180 days after pool’s FYE

• ADV: new disclosures must be in the first annual amendment filed after Jan. 1, 2011.

Compliance Dates (SEC)Compliance Dates (SEC)

For more information, please callFor more information, please call (801) 530-6600(801) 530-6600