Securities Lawyer's Deskbook                          published by The University of Cincinnati College of Law

Rule 206(4)-2 -- Custody or Possession of Funds or Securities of Clients by Investment Advisors

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1. Safekeeping required. If you are an investment adviser registered or required to be registered under section 203 of the Act, it is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Act for you to have custody of client funds or securities unless --
   
   
   1. Qualified custodian. A qualified custodian maintains those funds and securities -- (i) In a separate account for each client under that client's name; or (ii) In accounts that contain only your clients' funds and securities, under your name as agent or trustee for the clients.
      
      
   2. Notice to clients. If you open an account with a qualified custodian on your client's behalf, either under the client's name or under your name as agent, you notify the client in writing of the qualified custodian's name, address, and the manner in which the funds or securities are maintained, promptly when the account is opened and following any changes to this information.
      
      
   3. Account statements to clients. (i) By qualified custodian. You have a reasonable basis for believing that the qualified custodian sends an account statement, at least quarterly, to each of your clients for which it maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions in the account during that period; or
      
      (ii) By adviser,
      
      
   1. You send a quarterly account statement to each of your clients for whom you have custody of funds or securities, identifying the amount of funds and of each security of which you have custody at the end of the period and setting forth all transactions during that period;
      
      
   2. An independent public accountant verifies all of those funds and securities by actual examination at least once during each calendar year at a time that is chosen by the accountant without prior notice or announcement to you and that is irregular from year to year, and files a certificate on Form ADV-E [17 CFR 279.8] with the Commission within 30 days after the completion of the examination, stating that it has examined the funds and securities and describing the nature and extent of the examination; and
      
      
   3. The independent public accountant, upon finding any material discrepancies during the course of the examination, notifies the Commission within one business day of the finding, by means of a facsimile transmission or electronic mail, followed by first class mail, directed to the attention of the Director of the Office of Compliance Inspections and Examinations; and
      
      
   (iii) Special rule for limited partnerships and limited liability companies. If you are a general partner of a limited partnership (or managing member of a limited liability company, or hold a comparable position for another type of pooled investment vehicle), the account statements required under paragraphs (a)(3)(i) or (a)(3)(ii) of this section must be sent to each limited partner (or member or other beneficial owner).
   
   
   4. Independent representatives. A client may designate an independent representative to receive, on his behalf, notices and account statements as required under paragraphs (a)(2) and (a)(3) of this section.
      
      
2. Exceptions.
   
   
   1. Shares of mutual funds. With respect to shares of an open-end company as defined in section 5(a)(1) of the Investment Company Act of 1940 ("mutual fund"), you may use the mutual fund's transfer agent in lieu of a qualified custodian for purposes of complying with paragraph (a) of this section;
   
   
   
   2. Certain privately offered securities.
   
   
   (i) You are not required to comply with this section with respect to securities that are:
   
   
   1. acquired from the issuer in a transaction or chain of transactions not involving any public offering;
      
      
   2. uncertificated, and ownership thereof is recorded only on books of the issuer or its transfer agent in the name of the client; and
      
      
   3. transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.
   
   

   (ii) Notwithstanding paragraph (b)(2)(i) of this section, the provisions of this paragraph (b)(2) are available with respect to securities held for the account of a limited partnership (or limited liability company, or other type of pooled investment vehicle) only if the limited partnership is audited, and the audited financial statements are distributed, as described in paragraph (b)(3) of this section.

   3. Limited partnerships subject to annual audit. You are not required to comply with paragraph (a)(3)of this section with respect to the account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) that is subject to audit (as defined in section 2(d) of Article 1 of Regulation S-X at least annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year or in the case of a fund of funds within 180 days of the end of its fiscal year; and
      
      
   4. Registered investment companies. You are not required to comply with this section with respect to the account of an investment company registered under the Investment Company Act of 1940.
   
   
   
3. Definitions. For the purposes of this section --
   
   
   1. "Custody" means holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. Custody includes --

   (i) Possession of client funds or securities, (but not of checks drawn by clients and made payable to third parties,) unless you receive them inadvertently and you return them to the sender promptly but in any case within three business days of receiving them;

   (ii) Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and

   (iii) Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities.

   2. "Independent representative" means a person that —

   (i) Acts as agent for an advisory client, including in the case of a pooled investment vehicle, for limited partners of a limited partnership (or members of a limited liability company, or other beneficial owners of another type of pooled investment vehicle) and by law or contract is obliged to act in the best interest of the advisory client or the limited partners (or members, or other beneficial owners);

   (ii) Does not control, is not controlled by, and is not under common control with you; and

   (iii) Does not have, and has not had within the past two years, a material business relationship with you.

   3. "Qualified custodian" means --

   (i) A bank as defined in Section 202(a)(2) of the Advisers Act or a savings association as defined in Section 3(b)(1) of the Federal Deposit Insurance Act [12 U.S.C. 1813(b)(1)] that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act [12 U.S.C. 1811];

   (ii) A broker-dealer registered under Section 15(b)(1) of the Securities Exchange Act of 1934 holding the client assets in customer accounts;

   (iii) A futures commission merchant registered under Section 4f(a) of the Commodity Exchange Act [7 U.S.C. 6f(a)], holding the client assets in customer accounts, but only with respect to clients' funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon; and

   (iv) A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients' assets in customer accounts segregated from its proprietary assets.
   
   

   4. Fund of funds means a limited partnership (or limited liability company, or another type of pooled investment vehicle) that invests 10 percent or more of its total assets in other pooled investment vehicles that are not, and are not advised by, a related person (as defined in Form ADV ), of the limited partnership, its general partner, or its adviser.

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