Order Updating Custody Requirements
For State-Registered Investment Advisers
WHEREAS, the Banking Commissioner ("Commissioner") is charged with administering Chapter 672a of the Connecticut General Statutes, the Connecticut Uniform Securities Act ("Act"), and Sections 36b-31-2 to 36b-31-33, inclusive, of the Regulations of Connecticut State Agencies ("Regulations") promulgated under the Act;
WHEREAS, Section 36b-31(a) of the Act provides, in pertinent part, that "[t]he commissioner may from time to time make . . . such . . . orders as are necessary to carry out the provisions of . . . [the Act] . . . . For the purpose of . . . orders, the commissioner may classify securities, persons and matters within his jurisdiction, and prescribe different requirements for different classes";
WHEREAS, Section 36b-31(b) of the Act provides, in pertinent part, that "[n]o . . . order may be made . . . unless the commissioner finds that the action is necessary or appropriate in the public interest or for the protection of investors and consistent with the purposes fairly intended by the policy and provisions of . . . [the Act]";
WHEREAS, the Commissioner finds that the issuance of this Order is necessary and appropriate in the public interest and for the protection of investors and consistent with the purposes fairly intended by the policy and provisions of the Act;
WHEREAS, Section 36b-31(c) of the Act adds that "[t]o encourage uniform interpretation and administration of . . . [the Act] and effective securities regulation and enforcement, the commissioner may cooperate with the securities agencies or administrators of other states . . . [and with] the Securities and Exchange Commission . . .";
WHEREAS, Section 36b-5(c) of the Act provides that "[i]t is unlawful for any investment adviser that is registered or required to be registered under . . . [the Act] to take or have custody of any securities or funds of any client if: (1) The commissioner by regulation prohibits custody; or (2) in the absence of a regulation, the investment adviser fails to notify the commissioner that he has or may have custody";
WHEREAS, the Commissioner, acting pursuant to the authority granted by Section 36b-5(c) of the Act, promulgated Section 36b-31-5b of the Regulations, which makes it a fraudulent, deceptive or misleading act, practice or course of business for any investment adviser having custody or possession of funds or securities in which any client has any beneficial interest to take any action, directly or indirectly, with respect to those funds or securities unless certain requirements are met;
WHEREAS, Section 36b-31-5b of the Regulations was patterned after Securities and Exchange Commission ("SEC") Rule 206(4)-2, 17 C.F.R. § 275.206(4)-2, promulgated under the Investment Advisers Act of 1940;
WHEREAS, effective November 5, 2003, the SEC revised Rule 206(4)-2 to conform the rule to modern custodial practices. The revised rule required federally-regulated investment advisers to comply with its terms by April 1, 2004;
WHEREAS, on April 18, 2004, the North American Securities Administrators Association, Inc. ("NASAA") adopted amendments to the NASAA model rules governing investment adviser custody which amendments paralleled the SEC's revisions to Rule 206(4)-2;
WHEREAS, Section 36b-31-31c of the Regulations provides that "[t]he commissioner may exempt a person, security or transaction from a specified provision of sections 36b-31-2 to 36b-31-33, inclusive, of the regulations upon a finding that such exemption is in the public interest";
AND WHEREAS, the Commissioner finds that the exemption provided by this Order is in the public interest.
NOW THEREFORE, THE COMMISSIONER ORDERS AS FOLLOWS:
| 1. |
Definitions. For purposes of this Order:
| (a) |
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"Custody" means holding, directly or indirectly, client funds or securities, having any authority to obtain possession of them, or having the ability to appropriate them. "Custody" includes (i) possession of client funds or securities unless received inadvertently and returned 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 the investment adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the investment adviser's 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 the investment adviser or its investment adviser agent legal ownership of or access to client funds or securities. "Custody" does not include the receipt of checks drawn by clients and made payable to unrelated third parties where the checks are forwarded to the third party within twenty-four hours of receipt; |
| (b) |
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"Independent party", as used in paragraph 3(g) of this Order, means a person that: (i) is engaged by the investment adviser to act as a gatekeeper for the payment of fees, expenses and capital withdrawals from a pooled investment; (ii) does not control, is not controlled by and is not under common control with the investment adviser; and (iii) does not have, and has not had within the past two years, a material business relationship with the investment adviser; |
| (c) |
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"Independent representative" means a person who (i) acts as agent for an advisory client, including, in the case of a pooled investment vehicle, for limited partners of a limited partnership, members of a limited liability company, or other beneficial owners of another type of pooled investment vehicle, and who by law or contract is obliged to act in the best interest of the advisory client or the limited partners, members or other beneficial owners; (ii) does not control, is not controlled by, and is not under common control with the investment adviser; and (iii) does not have, and has not had within the past two years, a material business relationship with the investment adviser; |
| (d) |
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"Qualified custodian" means the following independent institutions or entities: (i) a bank or savings association that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act; (ii) a registered broker-dealer 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; | |
| 2. |
Exemption for Compliance With Updated Custody Requirements. An investment adviser registered or required to be registered under the Act that fulfills the conditions for having custody set forth in this Order shall be exempt from the custody requirements in Section 36b-31-5b(a) of the Regulations; |
| 3. |
Conditions to be Met.
| (a) |
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Notice to the Commissioner. The investment adviser shall notify the Commissioner promptly in writing on Form ADV that the investment adviser has or may have custody. |
| (b) |
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Maintenance of Client Funds and Securities by Qualified Custodian.
| (i) |
General Rule. A qualified custodian shall maintain client funds and securities (A) in a separate account for each client under that client's name, or (B) in accounts that contain only the investment adviser clients' funds and securities, under the name of the investment adviser as agent or trustee for the clients. |
| (ii) |
Exceptions.
| (A) |
With respect to shares of an open-end company as defined in Section 5(a)(1) of the Investment Company Act of 1940, 15 U.S.C. 80a-5(a)(1) ("mutual fund"), an investment adviser registered or required to be registered under the Act may use the mutual fund's transfer agent in lieu of a qualified custodian. |
| (B) |
An investment adviser that intends to have custody of client funds or securities but is not able to utilize a qualified custodian shall first obtain approval from the Commissioner and shall comply with all of the applicable safekeeping requirements under paragraph 3 of this Order, including taking responsibility for those provisions that are designated to be performed by a qualified custodian. | | |
| (c) |
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Notice to Clients. If the investment adviser opens an account with a qualified custodian on behalf of the advisory client, either under the client's name or under the investment adviser's name as agent, the investment adviser shall 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; |
| (d) |
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| (i) |
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Sending of Account Statements to Clients. Account statements shall be sent to clients, either by a qualified custodian or by the investment adviser. If the investment adviser is a general partner of a limited partnership, a managing member of a limited liability company or holds a comparable position for another type of pooled investment vehicle, the account statements shall be sent to each limited partner, member or other beneficial owner or the independent representative of such limited partner, member or other beneficial owner:
| (A) |
By a Qualified Custodian. If the account statement is sent by a qualified custodian, the investment adviser shall have a reasonable basis for believing that the qualified custodian sends an account statement at least quarterly to each of the investment adviser's clients for whom the qualified custodian maintains funds or securities. The account statement shall identify the amount of funds and the amount of each security in the account at the end of the period and shall set forth all transactions in the account during that period; or |
| (B) |
By the Adviser. If the investment adviser sends account statements to clients:
| (1) |
The investment adviser shall send a quarterly account statement at least quarterly to each client for whom the investment adviser has custody of funds or securities. The account statement shall identify the amount of funds and the amount of each security of which the investment adviser has custody at the end of the period and shall set forth all transactions during that period; |
| (2) |
An independent certified public accountant shall verify all client funds and securities by actual examination at least once during each calendar year at a time chosen by the accountant without prior notice or announcement to the investment adviser and that is irregular from year to year, and shall file a copy of the auditor's report and financial statements with the Commissioner within 30 days after the completion of the examination, along with a letter stating that it has examined the funds and securities and describing the nature and extent of the examination; and |
| (3) |
The independent certified public accountant, upon finding any material discrepancies during the course of the examination, shall notify the Commissioner within one business day of the finding, by means of a facsimile transmission or electronic mail, followed by first class mail, directed to the Commissioner. | | |
| (ii) |
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Exemption for Limited Partnerships Subject to Annual Audit. An investment adviser registered or required to be registered under the Act is not required to comply with the account statement requirement in paragraph 3(d)(i) of this Order with respect to the account of a limited partnership, limited liability company or another type of pooled investment vehicle that is subject to audit at least annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners, 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. The investment adviser shall notify the Commissioner in writing on Form ADV that the investment adviser intends to employ the audit safeguards described in this paragraph.= | |
| (e) |
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Client Designation of Independent Representative. A client may designate an independent representative to receive, on the client's behalf, the notices and account statements required under paragraphs 3(c) and 3(d) of this Order. |
| (f) |
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Direct Fee Deduction. An investment adviser having custody by virtue of having fees directly deducted from client accounts shall also provide the following safeguards:
| (i) |
Written Authorization. The investment adviser shall obtain written authorization from the client to deduct advisory fees from the account held with the qualified custodian. |
| (ii) |
Notice of Fee Deduction. Each time a fee is directly deducted from a client account, the investment adviser shall concurrently:
| (A) |
Send the qualified custodian notice of the amount of the fee to be deducted from the client's account; and |
| (B) |
Send the client an invoice itemizing the fee. The itemization shall include the formula used to calculate the fee, the amount of assets under management upon which the fee is based and the time period covered by the fee. | |
| (iii) |
Notice of Safeguards. The investment adviser shall notify the Commissioner in writing on Form ADV that the investment adviser intends to use the safeguards described in paragraph 3(f) of this Order. | |
| (g) |
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Additional Requirements for Pooled Investments. Unless excepted under paragraph 4 of this Order, an investment adviser having custody by virtue of its acting in a 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 the investment adviser or its investment adviser agent legal ownership of or access to client funds or securities, shall comply with the additional requirements in this paragraph:
| (i) |
Engagement of Independent Party. The investment adviser shall hire an independent party to review all fees, expenses and capital withdrawals from the pooled accounts. |
| (ii) |
Review of Fees. The investment adviser shall send all invoices or receipts to the independent party, detailing the amount of the fee, expenses or capital withdrawal and the calculation method such that the independent party can (A) determine that the payment is in accordance with the pooled investment vehicle standards as described in such instruments as the partnership agreement or the membership agreement; and (B) forward approval for payment of the invoice to the qualified custodian with a copy to the investment adviser. |
| (iii) |
Notice of Safeguards. The investment adviser shall notify the Commissioner in writing on Form ADV that the investment adviser intends to use the safeguards described in paragraph 3(g) of this Order. | | |
| 4. |
Exceptions.
| (a) |
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Certain Privately Offered Securities. An investment adviser registered or required to be registered under the Act need not comply with the custody requirements of this Order or Section 36b-31-5b of the Regulations with respect to securities that are:
| (i) |
Acquired from the issuer in a transaction or chain of transactions not involving any public offering; |
| (ii) |
Uncertificated and ownership thereof is recorded only on books of the issuer or its transfer agent in the name of the client; and |
| (iii) |
Transferable only with the prior consent of the issuer or the holders of the outstanding securities of the issuer. | |
| (b) |
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Limited Partnerships Subject to Annual Audit. The exception in paragraph 4(a) of this Order is available with respect to securities held for the account of a limited partnership, limited liability company or other type of pooled investment vehicle only if the limited partnership, limited liability company or other type of pooled investment vehicle is audited, the audited financial statements are distributed as described in paragraph 3(d)(ii) of this Order and the investment adviser notifies the Commissioner in writing on Form ADV that the investment adviser intends to provide audited financial statements as described in this paragraph. |
| (c) |
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Registered Investment Companies. An investment adviser registered or required to be registered under the Act need not comply with the custody requirements of this Order or Section 36b-31-5b of the Regulations with respect to the account of an investment company registered under the Investment Company Act of 1940, 15 U.S.C. 80a-1 to 80a-64, inclusive. |
| (d) |
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Beneficial Trusts. An investment adviser registered or required to be registered under the Act need not comply with the custody requirements of this Order or Section 36b-31-5b of the Regulations if the investment adviser has custody because it is the trustee for a beneficial trust, provided that all of the following conditions are met for each trust:
| (i) |
The beneficial owner of the trust is a parent, grandparent, spouse, sibling, child or grandchild of the investment adviser. Such relationships shall include "step" relationships; and |
| (ii) |
For each account described in paragraph 4(d)(i) of this Order, the investment adviser:
| (A) |
Provides a written statement to each beneficial owner of the account describing the requirements in paragraph 3 of this Order or Section 36b-31-5b of the Regulations, as the case may be, and the reasons why the investment adviser will not be complying with such requirements; |
| (B) |
The investment adviser obtains from each beneficial owner a signed, dated statement acknowledging receipt of the written statement described in paragraph 4(d)(ii)(A) of this Order; and |
| (C) |
The investment adviser maintains a copy of the written statement and acknowledgement described in paragraphs 4(d)(ii)(A) and 4(d)(ii)(B) of this Order until the account is closed or the investment adviser is no longer trustee. | | | |
| 5. |
This Order shall remain in effect until modified, superseded or vacated by the Commissioner or other lawful authority. |
So ordered at Hartford, Connecticut
this 4th day of February 2005. |
John P. Burke
Banking Commissioner |
