SEC Adopts Safeguards to Protect Client Assets Controlled by Investment Advisers

On December 16, 2009, the SEC announced that it had adopted rules to increase the protections for investors who turn their money and securities over to SEC-registered investment advisers.

The new rules stem in large part from the recent Madoff Ponzi scheme and other frauds where client assets were misappropriated by advisers and address two main areas of risk:

• Where an adviser serves as custodian to client assets (as in the Madoff case); and
• Where the custodian of client assets is an adviser affiliate.

Highlights of the new rules include a surprise exam and certain custody controls.  An adviser that holds client assets must engage an independent public accountant to conduct an annual surprise exam.  If the surprise exam indicates any evidence of missing client assets or material misrepresentations, the accountant would have one day to notify the SEC of its findings.  Additionally, when the adviser or an affiliate serves as custodian, the adviser must obtain a written report from an independent public accountant that would describe the custodian controls in place, the testing of the operating effectiveness of those controls, and the results of those tests.   

The new rules will impose an important new control on investment advisers of hedge funds and other private funds by requiring that any auditor that audits a private fund be registered with and subject to regular inspection by the Public Company Accounting Oversight Board (“PCAOB”).  At the SEC open meeting on December 16, 2009, SEC Chairman Mary L. Schapiro stated that “[i]t is my expectation that the new rules will encourage the use of fully independent custodians because these measures would not be required under such arrangements and I encourage all advisers and their clients to consider that approach.”

 The SEC has not yet released the final text of the new rules.