On November 5, 2003 in an effort to harmonize the Investment Advisors Act of 1940 (the “Advisors Act”) with current industry practices and clarify the circumstances under which an investment advisor has custody of client assets, the Securities and Exchange Commission adopted amendments to Rule 206(4)-2 (the “Rule”). The Rule requires investment advisors that are registered under the Advisor’s Act and that have custody of client securities or funds to adopt certain procedures intended to protect those client securities or funds from being lost, misused, misappropriated or subject to the investment advisor’s financial reverses.

Beginning on April 1, 2004, all investment advisors registered under the Advisor’s Act are required to be in compliance with the amended provisions.

The amendments make three major changes to the Rule: (1) the addition of a definition of the word “custody”, (2) the addition of a requirement that investment advisors with custody of funds or securities maintain such client assets with a “qualified custodian”, and (3) the addition of a requirement that a periodic account statement be delivered to each client.

1. Definition of Custody. The amendments add a definition of the term “custody” to the Rule. For purposes of the Rule, the term custody is defined as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” In an effort to clarify this definition, the amendments contain three (3) examples of situations in which an investment advisor has custody of client assets. Unless client funds or securities were received by an investment advisor inadvertently and they were promptly returned to the sender within three (3) business days of their receipt, an investment advisor has custody of client funds or securities if such funds or securities are in the investment advisor’s possession. Further, an investment advisor has custody of client funds or securities if the investment advisor is authorized or permitted to withdraw such funds or securities maintained with a custodian upon the investment advisor’s instruction to the custodian. Finally, the amendments state that an investment advisor has custody of client funds or securities if the investment advisor has any capacity, including as general partner of a limited partnership, as managing member of a limited liability company or another type of pooled investment vehicle, or trustee of a trust, that gives the investment advisor or a supervised person of the investment advisor, legal ownership of, or access to, client funds or securities.

2. Qualified Custodian Requirement. The amendments to the Rule require an investment advisor who has custody of client securities or funds to maintain those customer assets with a “qualified custodian”. Qualified custodian means: (i) a bank or savings association insured by the Federal Deposit Insurance Corporation, (ii) a broker-dealer registered under the Securities Exchange Act of 1934 who holds client assets in customer accounts, (iii) certain futures commission merchants registered under the Commodity Exchange Act, and (iv) certain foreign financial institutions. The commentary to the amendments acknowledges that many investment advisors fall within the definition of a qualified custodian and therefore may themselves maintain their clients’ funds and securities. Further, investment advisors may maintain client funds and securities with affiliates who are qualified custodians.

   The amendments contain special provisions for two specific types of securities. Where an investment advisor purchases mutual fund shares directly from the mutual fund’s transfer agent, and not through a broker-dealer or other intermediary, the mutual fund’s transfer agent generally maintains the securities for the client on the books of the mutual fund. In this instance, if the investment advisor also has custody of the securities, the investment advisor is permitted to use the mutual fund transfer agent rather than a qualified custodian with respect to those shares. Further, investment advisors are exempt from the qualified custodian rule with respect to privately-offered, uncertificated securities in a client account if (i) ownership of the securities is recorded only in the books of the issuer or its transfer agent in the name of the client, and (ii) transfer of ownership of those securities is subject to the prior consent of the issuer or the holders of the issuer’s outstanding securities. If the private securities are held for the account of a limited partnership or other pooled investment vehicle, this latter exception to the qualified custodian rule may only be used if the pooled investment vehicle is audited annually and the audited financial statements are distributed to all beneficial owners.

3. Delivery of Account Statements. Investment advisors with custody of client assets must have a reasonable belief that the qualified custodian holding the assets provides account statements, at least quarterly, directly to the client. If the qualified custodian is not sending account statements directly to the client, the investment advisor must send such account statements and must have an annual audit by an independent public accountant at a time chosen by that accountant without prior notice to the investment advisor. An investment advisor need not comply with the account statement provisions of the amendments with respect to pooled investment vehicles that are subject to audit at least annually and which distributes audited financial statements prepared in accordance with generally accepted accounting principles to all of its beneficial owners within 120 days of the end of each fiscal year.

In connection with the amendments to the Rule, Form ADV will be amended. Specifically, the instruction to Item 9 will be amended to specify that investment advisors who have custody solely because they deduct fees from client accounts may answer “no” when asked in Item 9 if they have custody of client securities or funds. It will take some time for this amendment to be included on Form ADV, but in the interim investment advisors may answer “no” to Item 9 if they have custody solely because they deduct their fees from client accounts. Finally, the amended Form ADV eliminates the requirement currently set forth in Part II Item 14 of Form ADV that investment advisors with custody of client assets include an audited balance sheet with their disclosure statements made to clients.

Investment advisors need not comply with the amendments to the Rule with respect to those clients which are registered investment companies. Registered investment companies and their investment advisors must continue to comply with the requirements of Section 17(f) and related custody rules of the Investment Company Act of 1940.

This legal alert is merely a highlight of significant provisions of the rule. Please see the rule itself, included in SEC Release No. IA-2176, for more detailed information.

Please do not hesitate to contact Thomas E. Willett at (585) 419-8646, Catherine A. King at (585) 419-8619 or the Harris Beach attorney with whom you usually work with any questions you might have about this Rule.

This legal alert is not intended to address specific compliance or interpretation issues under the above-described SEC Release; it does not constitute legal advice as to the application of the Rule to any specific situation and it is not intended to be a substitute for the advice of counsel on specific issues and/or specific situations.