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Surprise Audit Requirement Suspended for Certain Sub-advisors

In a recent no-action letter, the SEC said that sub-advisors could avoid the Custody Rule’s burdensome annual surprise audit requirement under certain circumstances. This relief is available to sub-advisors who lack actual custody of client assets but are deemed to have custody because they’re affiliated with the primary advisor and qualified custodian.

 

Custody Rule Refresher

To safeguard client assets against loss, misuse, and misappropriation, the SEC’s “Custody Rule” imposes additional requirements on Registered Investment Advisors (RIAs) that either hold client funds or securities (directly or indirectly) or have the ability to obtain possession of them. In addition, an RIA is deemed to have custody of client assets if an affiliate or other “related person” — any person that controls, is controlled by, or is under common control with the RIA — has custody of those assets.

An RIA with custody of client assets must, among other things:

  • Maintain the assets with a qualified custodian, such as a bank or broker-dealer;
  • Provide clients with notices regarding the qualified custodian;
  • Confirm that the qualified custodian sends quarterly account statements to clients, and
  • Undergo annual surprise audits by an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB).

In addition, if the RIA itself or a related person serves as qualified custodian, the RIA must obtain annual internal control reports prepared by an independent PCAOB-registered accountant.\

RIAs are exempt from the surprise audit requirement if they’re: deemed to have custody solely because they’re authorized to deduct advisory fees; advise certain funds that distribute audited financial statements to their investors; or are deemed to have custody solely because the qualified custodian is a related party from whom the RIA is “operationally independent.”

Application to Sub-advisors

RIAs often engage sub-advisors to manage certain investments within a portfolio. For example, fund managers may use sub-advisors with expertise in a particular investment strategy.

Before the no-action letter, the Custody Rule’s requirements were generally understood to apply to affiliated sub-advisors in the same manner they applied to primary advisors. As a result, primary advisors and affiliated sub-advisors could both be required to undergo surprise audits related to the same client assets. The SEC issued the no-action letter to provide relief from these duplicative audits under certain circumstances.

The no-action letter applies to RIAs that act as sub-advisors in an investment advisory program for which a related person is the qualified custodian and primary advisor — or an affiliate of the primary advisor. Under these circumstances, the sub-advisor isn’t required to undergo surprise audits, provided the sub-advisor:

  • Is deemed to have custody solely because of its affiliation with the qualified custodian and primary advisor;
  • Will comply with the Custody Rule’s requirements;
  • Doesn’t hold client assets itself, have authority to obtain possession of client assets, or have authority to deduct fees from clients’ accounts; and
  • Will continue to obtain the internal control reports described above.

Proceed with Caution

The no-action letter provides affiliated sub-advisors with welcome relief from the surprise audit requirement, but you should review your circumstances carefully before you rely on it and consult with your Untracht Early advisor, as needed. Among other things, ensure that you’re not deemed to have custody of client assets for some reason other than your status as a related person. And it’s a good idea to ask the primary advisor for written assurances that it will fulfill its obligations under the custody rule.

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