	Background

Investment advisers provide a wide range of investment advisory services  and help individuals and institutions make financial decisions. Nearly 10,000 advisers were registered with SEC as of April 1, 2013.Collectively, these advisers managed nearly $54 trillion in assets for  about 24 million clients. The rule requires advisers that have custody of client assets to have a  reasonable basis, after due inquiry, for believing that the custodian sends  periodic statements directly to the clients. The SEC custody rule requires advisers with custody of client assets to  hire an independent public accountant to conduct an annual surprise  examination, unless the advisers qualify for an exception. In 2003, SEC amended the custody rule by generally  requiring an adviser to maintain client assets with qualified custodians  and relieving the adviser from the examination requirement if its qualified  custodian sent account statements directly to the adviser’s clients. As shown in figure 3, advisers meeting the following  conditions may not be required to undergo a surprise examination: an adviser that is deemed to have custody of client assets solely  because of its authority to deduct fees from client accounts; an adviser that is deemed to have custody because a related person  has custody, and the adviser is “operationally independent” of the  related person serving as the custodian; or an adviser to a pooled investment vehicle (e.g., hedge fund) that is  subject to an annual financial statement audit by an independent  public accountant registered with and subject to regular inspection by  the Public Company Accounting Oversight Board (PCAOB) and  distributes the audited financial statements prepared in accordance  with generally accepted accounting principles to its clients is deemed  to have satisfied the surprise examination requirement. Instead, the rule generally imposes more stringent requirements  on advisers whose custodial arrangements, in SEC’s view, pose greater  risk of misappropriation or other misuse of client assets. Importantly, these advisers vary widely in  terms of the number of their clients under custody—reported by advisers  as ranging from 1 client to over 1 million clients—and other factors that  affect the cost of surprise examinations. Consequently, the cost of  surprise examinations varies widely across the advisers. In  response to SEC’s 2009 proposed amendments to the custody rule,  industry associations provided SEC with cost estimates. Similar to  surprise examination costs, the cost of internal control reports varies  based on a number of factors, such as the size of and services offered by  the qualified custodian. A Limited Number of Advisers Do Not Undergo Surprise Examinations Because They Use Related but Operationally Independent Custodians

As of April 1, 2013, 169 registered advisers reported having custody of  client assets and using related but operationally independent custodians and not undergoing an annual surprise examination for certain clients.These advisers account for around 2 percent of all SEC-registered  advisers and about 42 percent of the approximately 400 SEC-registered  advisers that have a related person holding client assets. According to SEC staff, this outcome is to be expected  given that the adviser and custodian staff cannot be considered  operationally independent while under common supervision and sharing  the same premises. Similarly, the amount of  client assets under their custody ranged from $680,000 to $320 billion. Appendix I: Objectives, Scope, and Methodology

This report describes (1) the requirements of and costs associated with  the Securities and Exchange Commission (SEC) custody rule, including  any related record-keeping requirements, for registered investment  advisers, and (2) SEC’s rationale for not requiring advisers using related  but operationally independent custodians to undergo surprise  examinations, and the number and characteristics of such advisers. To obtain data on the costs of complying with the SEC custody rule,  particularly its surprise examination and internal control report  requirements, and other information, we interviewed a limited number of  investment advisers and accounting firms.
Why GAO Did This Study

Investment advisers provide a wide range of services and collectively manage around $54 trillion in assets for around 24 million clients. Unlike banks and broker-dealers, investment advisers typically do not maintain physical custody of client assets. However, under federal securities regulations, advisers may be deemed to have custody because of their authority to access client assets, for example, by deducting advisory fees from a client account. High-profile fraud cases in recent years highlighted the risks faced by investors when an adviser has custody of their assets. In response, SEC amended its custody rule in 2009 to require a broader range of advisers to undergo annual surprise examinations by independent accountants. At the same time, SEC provided relief from this requirement to certain advisers, including those deemed to have custody solely because of their use of related but "operationally independent" custodians. The Dodd-Frank Wall Street Reform and Consumer Protection Act mandates GAO to study the costs associated with the custody rule. This report describes (1) the requirements of and costs associated with the custody rule and (2) SEC's rationale for not requiring advisers using related but operationally independent custodians to undergo surprise examinations.
To address the objectives, GAO reviewed federal securities laws and related rules, analyzed data on advisers, and met with SEC, advisers, accounting firms, and industry and other associations.

What GAO Found

Designed to safeguard client assets, the Securities and Exchange Commission's(SEC) rule governing advisers' custody of client assets (custody rule) imposes various requirements and, in turn, costs on investment advisers. To protect investors, the rule requires advisers that have custody to (1) use qualified custodians (e.g., banks or broker-dealers) to hold client assets and (2) have a reasonable basis for believing that the custodian sends account statements directly to clients.
The rule also requires advisers with custody, unless they qualify for an exception, to hire an independent public accountant to conduct annually a surprise examination to verify custody of client assets. According to accountants that GAO interviewed, examination cost depends on an adviser's number of clients under custody and other factors. These factors vary widely across advisers that currently report undergoing surprise examinations: for example, their reported number of clients under custody ranged from 1 client to over 1 million clients as of April 2013. Thus, the cost of the examinations varies widely across the advisers. The rule also requires advisers maintaining client assets or using a qualified custodian that is a related person to obtain an internal control report to assess the suitability and effectiveness of controls in place. The cost of these reports varies across custodians based on their size and services.
SEC provided an exception from the surprise examination requirement to, among others, advisers deemed to have custody solely because of their use of related but "operationally independent" custodians. According to SEC, an adviser and custodian under common ownership but having operationally independent management pose relatively lower client custodial risks, because the misuse of client assets would tend to require collusion between the firms' employees. To be considered operationally independent, an adviser and its related custodian must not be under common supervision, not share premises, and meet other conditions. About 2 percent of the SEC-registered advisers qualify for this exception for at least some of their clients. If the exception were eliminated, the cost of the surprise examination would vary across the advisers because the factors that affect examination cost vary widely across the advisers.