Under rule 206(4)-2 of the Advisers Act, otherwise known as the Custody Rule, it is a fraudulent practice for a registered investment adviser to have custody of client funds or securities, unless the adviser takes certain required steps to protect the assets.  Over the past year the SEC’s Enforcement division has been relatively active investigating and enforcing the rule – which, at most, requires a showing of negligence – with a number of complicated provisions that can trip up the uninformed.

Recently, the SEC brought enforcement actions that highlight two key areas under the Custody Rule that can result in liability. First, in addition to maintaining client funds and securities with a “qualified custodian,” advisers with custody of the funds and securities must obtain either (i) a “surprise examination” of those assets annually from an independent public accountant or (ii)  an annual audit of its financial statements by an independent public accounting firm that is registered with (and is subject to regular inspection by) the PCAOB and distribute the financial statements prepared in accordance with GAAP to each investor in the fund within 120 days of the fund’s fiscal year end (180 days for fund of funds).  Most registered private fund advisers rely on the annual audit approach.