Don't Get Surprised by a Surprise Custody Examination

To increase protections for investors who entrust their securities and funds to registered investment advisers, the Securities and Exchange Commission ("SEC"), on December 30, 2009, finalized amendments to the custody requirements of Rule 206(4)-2 under the Investment Advisers Act of 1940 and related forms (“Custody Rule”). The Custody Rule contains a number of key provisions including an independent verification or “surprise custody examination”. Although the Custody Rule allows certain exemptions, registered investment advisers with custody of client funds and securities with a related party are required to have a qualified independent accountant conduct an annual surprise examination of those assets.

Effective March 12, 2010 and before December 31, 2010, registered investment advisers with custody of client funds and securities must have an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”) perform a surprise custody examination.

With the December 31 deadline quickly approaching, registered investment advisors need to be proactive to avoid unwanted “surprises”. Below are a number of things registered investment advisers may find useful in preparing for this new requirement:

  1. Treat the Surprise Examination as a project and assign sufficient resources for a successful outcome including the assignment of a Project Team Leader to be responsible for organizing and coordinating all aspects of the surprise examination;
  2. Document the steps taken to prepare for the surprise examination into a written Action Plan in order to build a sustainable, repeatable process;
  3. Develop an understating of the Custody Rules and the Surprise Examination requirements (including disclosure requirements, etc.) in order to form an initial assessment of your company’s preparedness;
  4. Educate yourself about the independent accounting firm’s audit process, including scope, objectives and areas of focus;
  5. Perform an internal Surprise Custody Examination before the independent audit team performs the real thing. This will help you assess the design and operating effectiveness of the custody controls and your institution’s readiness for the actual surprise examination;
  6. As required, remediate any exceptions noted during the internal Surprise Custody Examination;
  7. To better prepare your investment adviser representatives, provide an informational training event on the new custody rules and the process that will be followed for the audit of your particular firm. Prepare them for the fact that independent letters may be mailed directly to their clients and this is not an optional requirement;
  8. To better prepare your clients, send out an advance notice of the changes in the Custody Rules so that there will be no confusion or unnecessary concern by your clients when they are asked to confirm their funds and securities;
  9. Be active in the preparation of the confirmation letter that will be used with clients during the surprise custody audit to make sure it communicates the requirements and conveys the right message in a client friendly way;
  10. Be familiar with form ADV-E and what information must be provided by the registered investment adviser for the form so there is no delay when the qualified independent auditor is ready to forward the form with the audit report within the prescribed 120 day requirements;
  11. Make sure the independent auditor selected for your surprise custody audit is sufficiently experienced and equipped to perform such audits rather than a firm that does this work as an accommodation on a one off basis; and
  12. Understand the requirements to receive an unqualified audit report and the ramifications to your organization if a qualified opinion report is received.

By following a logical, measured approach, registered investment advisers subject to the new custody rules will be better positioned to ensure that they have developed an efficient internal process to avoid unwanted surprises during a “Surprise Examination”, including enhanced regulatory attention or worse.

Alan Frank is a Senior Manager in the CPA Firm, EisnerAmper LLP, a large regional accounting firm serving the New York and Philadelphia metropolitan areas. EisnerAmper is well qualified to perform both surprise custody audits and prepare any necessary internal control reports. EisnerAmper also has individuals with significant experience in the performance of surprise custody audits under the pre-2003 SEC custody rules and a well established internal controls (SAS 70) audit team. Please contact Alan Frank or EisnerAmper for further information on this significant new regulatory requirement.

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