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The adviser custody rule, rule 206(4)-2 under the Investment Advisers Act of 1940 (Advisers Act), was first adopted in 1962, at a time when the business was far simpler and operated quite differently than it does today. The rule as originally adopted required that an adviser deemed to have custody of client assets had to comply with certain conditions, the most unpopular of which was subjecting itself to an annual surprise audit. As a result, numerous advisers sought no-action letters from the Securities and Exchange Commission (SEC or Commission) staff in order to avoid compliance with the rule's conditions. Over time, these letters began to read more like rules than a promise to refrain from recommending enforcement action. The SEC staff realized that the rule was badly in need of an overhaul and, after lengthy consideration, the SEC proposed amendments to the rule on July 17, 2002. (1) On September 11, 2003, rule amendments were adopted, (2) striking a sound balance between protecting client assets and minimizing regulatory burdens.
Amended Rule 206(4)-2
Definition of Custody
Amended Rule 206(4)-2 includes a clear definition of "custody." The rule states that an adviser has custody when it holds, "directly or indirectly, client funds or securities or [has] any authority to obtain possession of them." (3) The amended rule contains three examples to illustrate circumstances under which an adviser would be deemed to have custody of client funds or securities. (4)
In the first example, an adviser has custody when it has any possession of client funds or securities, even temporarily. (5) The rule excludes inadvertent receipt by the adviser of client funds or securities so long as the adviser returns them within three business days. (6)
The second example clarifies that an adviser has custody if it has the authority to withdraw funds or securities from a client's account. (7) Therefore, an adviser with authorization to dispose of funds or securities for purposes other than trading would be deemed to have custody. This includes, of course, the authorization to deduct advisory fees (or other expenses) directly from a client's account, a practice common in the industry for quite some time, and which had generated numerous requests for no-action relief. (8)
Several commenters recommended that the Commission change the proposed definition of custody to exclude advisers' access to client funds through fee deductions and instead permit continued reliance on the no-action letters. These letters granted relief from the custody rule requirements (i.e., the surprise audit) by …