ACI Blog

FINRA 2011 Annual Regulatory and Examination Priorities 
On February 8th, FINRA released their 2011 Annual Regulatory and Examination Priorities letter detailing regulatory developments over the last year and examination focuses for the coming year. To follow is a summary of the letter which provides information on new rules affecting broker dealers and guidance on key areas that will bear increased focus and scrutiny during a FINRA examination of the member firm.

New Rules Affecting Broker Dealers
  

Examination Priorities
The goal of FINRA examination program and guidance to its member firms is to "assess whether internal controls, supervisory systems and risk management practices properly address the matters discussed."

Fraud Detection
Member firms should spot and must investigate red flags that may indicate fraudulent behavior. FINRA Rule 4160 , February 1, 2011 - Strengthens FINRA's ability to verify independently customer and proprietary assets maintained by a member firm at a non-member financial institution.

Fraudulent Activity Associated with Customer Accounts
Maintain Supervisory Systems and AML Monitoring Systems to detect and report suspicious transactions and identifying clients who engage in high-risk activity.

High-Frequency Trading, Algorithms, Sponsored Access, Direct Market Access & Trading Pause
July 14, 2011 - Maintain effective controls over electronic order routing, and surveillance of algorithmic trading and HFT strategies. CEO must certify annually that the risk management controls and supervisory procedures comply with SEA Rule 15c3-5 and that regular reviews were conducted. There should be adequate policies in place and a pause in trading whenever the price of any covered security moves 10 percent or more from a sale in a preceding five-minute period. End on April 11, 2011.

Short Sales and Regulation SHO
Direct Market Access trading systems for their customers that were designed to block the execution of short sale orders unless a "locate" had been obtained and documented. FINRA found, however, that the firm disabled this system in certain instances and its clearing firm created a separate system for certain customers. February 28, 2011 - Regulation SHO Amendments - Implement a short-sale related circuit breaker for NMS stocks triggered by a 10 percent or more decrease in the price of the security from the security's closing price at the end of regular trading hours on the prior trading day.

Information Barriers
Concern about weak information barriers and making sure they are equipped to prevent insider trading, front running or other misuse of material and non-public information. The company-specific information provided by outside research firms in some cases may be considered material, non-public information, depending on the source and how it is disseminated.

Private Placements and Private Self-Offerings
Concern with suitability, supervision, advertising, and illegal distributions of unregistered securities. FINRA reminds firms to conduct reasonable investigations into Regulation D offerings.

Trading in Non-Public Securities
Any transaction in unregistered securities must be conducted pursuant to a valid exemption from registration requirements.

High-Yield Investments
FINRA is concerned retail investors may not consider or understand credit risk and liquidity trade-offs related to high-yield investments and that certain products bear an inverse relationship to interest rate moves and the principal is not guaranteed.

Municipal Securities
Must understand the municipal securities sold and meet disclosure, suitability, and pricing obligations. Material information must be disclosed to customers, allowing them to evaluate these investments.

Non-Conventional Investments
Focus on firms that offer structured products and riskier asset-backed securities and ensuring brokers understand risks and costs associated with these products (eg. collateralized mortgage obligations CMOs).

Exchange-Traded Funds and Notes
Marketing materials should include the material risk disclosure. FINRA is conducting targeted exams to gather information on advertising and sales literature pertaining to ETPs that are not registered investment companies.

Vulnerable Customers
Firms may not mislead customers regarding expertise and qualifications to advise on areas such as retirement planning through use of professional designations. Procedures must be in place to ensure those designations are legitimate and are not misleading - especially to ensure the protection of retired, elderly or ill customers as well as those in affinity groups that may be considered vulnerable to certain risks.

Electronic Communications and Social Media
Text messages, blogs, bulletin boards, interactive forums, social networks and Skype messaging should all be retained and supervised. This includes any electronic communication sent from a registered representative or firm to a customer/prospective customer relating to the firm's business. Prior approval of communications is required for static content. Interactive/Real-time communications can be supervised with post-review.

Consolidated Account Reports
Could mislead investors or be used to perpetrate fraudulent activity. The firm must have procedures in place to conduct due diligence on the valuation of assets prior to including them on financial account reports to customers.

Hiring and Compensation Practices
Attention to newly hired individuals, enhanced compensation packages, applicant's background, and potential conflicts.

Outside Business Activities and Private Securities Transactions
Registered persons are prohibited from engaging in any outside business activity unless prior written notice has been provided to the firm. Firm's have until June 15, 2011 to review pre-existing activities under the current standards.

Master/Sub-Account Relationships
There is the concern that Master/sub-account relationships carry the risk that the firm does not know the identity of its "customer" as required. FINRA reviews procedures for determining the beneficial ownership of each account within a master/sub-account structure.

Funding and Liquidity Risk Management
Broker dealers must have liquidity and risk management practices in place to be prepared to manage their daily operations under severe and prolonged adverse market conditions. Firms should establish a risk-limit structure, periodic stress testing and scenario analysis, and should develop and maintain a contingency funding plan.

Intercompany Transactions/Affiliate Relationships and Activities
Firms must maintain accurate books and records for affiliate transactions and perform reconciliations. These reconciliations include expense sharing, revenue sharing or other serve level agreements.

Governance and Control Over Margin Lending
The firm should have a governance process in place for approving large margin loans to demonstrate controls over margin lending. Control of risks should include assessing the type and sufficiency of collateral, credit worthiness of the borrower, valuation and liquidity of the collateral, concentrations of collateral, ability of the firm to fund the loan (liquidity risk) and other factors.

On Friday, January 21^st, 2011, the SEC released a Study on Broker Dealers and Investment Advisors as required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The study aims to evaluate the effectiveness of existing regulations governing the provision of investment advice to retail customers - and - whether there are gaps, shortcomings, or overlaps in the different standards of protection currently employed.

From the Regulators on a Uniform Fiduciary Standard and Harmonization of Regulation

In the study on broker dealers and investment advisors, the Staff of the SEC finds that retail investors are generally not aware of the differences in regulatory guidelines governing broker dealers and investment advisors nor the legal implications of those differences and investor protection would be increased through a uniform fiduciary standard and harmonization of regulation.

Study Recommendations:

• Uniform Fiduciary Standard - "The Staff... recommends establishing a uniform fiduciary standard for investment advisers and broker-dealers when providing investment advice about securities to retail customers that is consistent with the standard that currently applies to investment advisers. The recommendations also include suggestions for considering harmonization of the broker-dealer and investment advisor regulatory regimes, with a view toward enhancing their effectiveness in the retail marketplace." This would include engaging in rulemaking, eliminating/disclosing conflicts of interest under a duty of loyalty, providing guidance on how broker dealers can meet the standard while still engaging in principal trading, Duty of Care, defining personalized investment advice about securities, and increased investor education.

• Harmonization of Regulation - "The Staff believes that a harmonization of regulation... would offer several advantages." The Staff suggests that the commission should consider consistent rules for advertising and other communications, review the use of finders and solicitors, review supervisory requirements, review disclosure requirements in Form ADV vs. Form BD, consider continuing education and licensing requirements for investment advisor representatives, and consideration of books and records retention requirements for investment advisors.

In a statement released by Commissioners Troy Paredes and Kathleen Casey, it is declared that though the study recommends the adoption of a uniform fiduciary standard "the Study does not identify whether retail investors are systematically being harmed or disadvantaged under one regulatory regime as compared to the other" nor does it identify what problems would specifically be alleviated through the harmonization. To that end, they propose that the study does not reasonably conclude that investor protection would be enhanced by a uniform fiduciary standard.

From the Industry's Advocacy Groups

In a statement released by SIFMA, The Securities Industry and Financial Markets Association, the broker dealer advocate firm found that the SEC had "appropriately articulated a workable comprehensive approach for personalized investment advice for retail customers." That said, SIFMA reiterated the concern that "the SEC ensure that the broker-dealer role is not hindered" and called for leadership in "applying comparable oversight, examination and enforcement" for any regulation passed.

Similarly, in a statement released by FSI, The Financial Services Institute supports the study's "roadmap to improved investor protection through a uniform standard of care" while reinforcing the need for guidance on how to cost-effectively implement such a plan.

The National Association of Insurance and Financial Advisors, NAIFA, said that they are concerned with potential costs of the recommended study. As per their NAIFA statement, "NAIFA's fundamental concern is that the potential additional costs and increased potential liability of applying a ‘one size fits all' fiduciary standard of care to the broker-dealer business model could result in middle- and lower- market investors having less access to the account services and investment advice that are currently being delivered by registered representatives of broker-dealers."

The Financial Planning Coalition has long advocated for a uniform standard for all those providing personalized investment advice for the highest standard of investor protection and in their statement release "applauds the SEC study for recommending ... to establish a uniform fiduciary standard that applies to both broker-dealers and investment advisers that is no less stringent than the standard currently applied to investment advisers." 

Regulatory Compliance - from Debate to Implementation

As the debate continues, regulators will continue to look to the financial community for guidance on how regulatory changes will affect their firms, so ACI encourages our clients and members of the financial community to consider how these changes would affect them and what guidance they'll need to react accordingly when the time comes. For assistance with regulatory compliance programs, contact info@acisecure.com or call 212-668-8700.

The National Society of Compliance Professionals (NSCP) released their 2010 Census information detailing demographic and planning information for compliance departments. The report included informaton on the number of compliance professionals in the department, experience level, level of education and salary information for the member firms that completed the Census. Below are compliance industry trends gleaned from the data and insights into anticipated hiring practices based on the report.

Compliance and CCO Salary
Salaries for compliance professionals and Chief Compliance Officers (CCOs) increase exponentially over time, with education having minimal impact on salary unless a JD is held. Salary potential increases through job moves and levels off after 6 years.

• Compliance staff with 3-5 years experience as a majority make annually $75k-99,999.
• CCOs with 3-5 years experience make mostly $100-149,999k
• After 20+ years, salary increases to$150k-199,999.
• Education has minimal impact on salary unless a JD is held.
• High school ($75k-150k), BA ($100k-150k), and JD ($150k-$199,999).
• The Eastern Region is more likely to be making higher incomes ($100k-$149,999 and $150-$199,999 and up). Median incomes are then found in the Midwest and West ($75k-99,999 and $100k-149,999 and up). The South income is less than all categories ($100k-149,999 and $75k-99,999 and down).

Hiring Compliance Personnel

• 30% of firms are hiring in compliance departments, mostly larger established firms and some start-ups
• Dual Registrants and Private Equity firms are hiring in compliance more than IAs, BDs, HFs alone.
• Compliance Software is the largest area for planned compliance hiring (67%)

SEC/FINRA Examinations

• Most firms questioned are examined annually or ever 1-2 years,
• Of firms with 1-2 compliance staff, those with 6-10 reps were examined most frequently.

Regional Structure

The management and reporting structure for the compliance department differs based on region.

• CCOs are mostly on the East Coast (38%) where they report mostly to the legal department.
• If not on the East Coast, the Midwest is next most popular at (29%) and report to In House Counsel
• In the South and on the West Coast, the majority of CCOs report to the President

Data Sourced: NSCP 2010 Census Survey

To keep up with increased regulatory obligations and oversight, small firm CCOs shared their thoughts, experiences, and insights from the front line. To follow are some tips for CCOs at small firms on how to maintain a compliance program with limited resources. For these purposes, a small Firm is defined as a firm with fewer than 50 Reps with maybe more than one branch.

For small firm’s it’s incredibly important for CCO’s and compliance departments to leverage their limited resources to be effective, particularly, to tackle the dichotomy of staff cuts in the face of greater regulatory oversight.

Cross-Training can be a great way for small firms with limited compliance staff to leverage additional internal resources by deputizing administrative and operational staff to assist with compliance issues. If internal resources are too lean to accommodate cross-departmental responsibilities, outsourcing compliance administrative, operational, and consulting functions can be more cost effective than hiring additional personnel and can provide support on a project basis where needed.

Outsourcing can provide efficiency and cost-savings, but does not remove supervisory risk. Your CCO maintains supervisory responsibility as do the individuals at the firm for their reporting and documentation responsibilities.

For small firm CCOs, remaining educated on the latest regulatory developments and implementation tips from other small firms is an invaluable resource. By attending industry educational events and working with regulatory consultants, small firm CCOs can grow their general knowledge base and have a resource to call for specific questions on how other companies within the consulting firm’s client base have addressed specific regulations or areas of particular concern during exams.

FINRA, additionally, provides a number of resources for small firms such as the:

o   FINRA Weekly Update

o   FINRA Rule Conversion Charts

o   AML Small Firm Template

o   WSP Checklist

When vetting new products the firm must conduct 2 levels of Suitability Analysis – suitability on “Reasonable-basis” and “Customer-Specific” basis. The initial approval for new product offerings should be both a business and compliance decision. The CCO / Compliance team need(s) to understand products to make sure sales knows what they’re selling and to put in the breaks and controls to make sure it’s done right – that brokers have adequate knowledge on products and there is some type of surveillance. The decision as to whether or not to offer the product is not up to compliance. The continued review of products is also an important factor in product offerings. Has your firm revisited a new product 6 months later? Are you paying attention to market conditions down the road with surveillance? Have you documented it?

For better risk management of your compliance program, the firm should develop risk-based policies and procedures that are conformed to the firm’s actual business and specifies who is responsible for specific tasks, who verifies or reviews that it has been done, and who approves it. To do so, identify firm risks, form a policy on those risks, be able to monitor it, and communicate it to the company through training and surveillance. By conducting the required 3012 Supervisory Controls review, the firm verifies a connection between what policies and procedures say and what is being done. The WSPs are a road map for understanding and reviewing the compliance program. If it says it in the WSPs it should be there if an examiner asks for it.

As exhibiting sponsor of the 2010 NSCP Annual Membership Meeting, an educational forum for compliance professionals within the securities industry, ACI benefited from the dissemination of a dizzying amount of information regarding regulatory developments for broker dealers, investment advisors and hedge funds. While the following is nowhere near a comprehensive summary of compliance regulations and obligations for industry professionals and should not be considered legal advice of any kind, there were a number of take away items regarding the impact of Dodd Frank financial regulations on small broker dealers and tips from small firm CCOs.

The Dodd Frank Wall St. Reform and Consumer Protection Act – A Few Considerations for Small Firm Broker Dealer

The structure of oversight has changed with the introduction of new organizations such as the Financial Stability Oversight Council (FSOC) and the Office of Financial Research within the FSOC. The Financial Stability Oversight Council (a 10 Member board of regulators) is invested with the authority to designate those entities significant for supervision based on those deemed systemically significant. By procedure, the Federal Reserve will identify those potentially “significant” companies and the council will then qualify which of those are/are not significant. The criteria to consider what entities are systemically significant is being developed and could include factors such as leverage, counterparty exposure, extent to which they apply credit, and the degree to which assets are managed vs. owned. The Financial Stability and Oversight Council is mandated to look across all markets to make sure regulations are doing what they’re intended to do, so it will likely interact with other regulatory agencies such as the SEC and SROs such as FINRA.  In that effort, the Office of Financial Research – within the Financial Stability Oversight Council – has the role to collect data, and broker dealers can expect to receive requests for information to be reviewed.

The Volker Rule (Title 6) – prohibits a bank or institution that owns a bank from engaging in proprietary trading that isn't at the mandate of its clients, and from owning or investing in a hedge fund or private equity fund, as well as limiting the liabilities that the largest banks could hold. There are definite concerns regarding the competitiveness of banks in global marketplaces in light of this rule.

OTC Swap Markets (Title 7) - Major swap participants subject to new collateral requirements

For Investment Advisors (Title 4) (Section 4.12) or dually registered BD/IAs there are changes to the definition of accredited investor for Reg D, and in regards to the $1 million net worth test – when calculating net worth the firm may exclude the value of prime residence.

Credit Rating Agencies (Title 9) – can now be sued which will likely have the practical effect of resulting in increased fees. Additionally, MSRB Registration is required for municipal advisors.

Uniform Fiduciary Standard – in the words of Suzanne Barlyn at The Wall Street Journal “brokers are required to recommend investments that are suitable for each client, taking into account factors such as the client's age, goals and risk tolerance. ‘Suitable,’ however, doesn't necessarily mean ‘best.’" - Suzanne Barlyn, WSJ, “What’s No. 1 for Brokers”.

There is a New Registration Category for qualified back office personnel that targets unregistered persons to make sure back-office understands securities industry and requirements. These individuals are fingerprinted in CRD already but will need to undergo an examination process which is being developed.

See Part 2 for more on: Small Broker Dealers: The Impact of Dodd Frank and tips from CCOs who know

ACI provides guidance to investment advisor firms who need assistance converting their ADV Part II from the check the box format to the new ADV Part 2 plain english narrative format based on the SEC ruling this past July. The final ruling from the SEC on the new ADV Part 2 details the format for the "plain English" narrative and new disclosure requirements. The SEC provided additional guidance on the format and information to be included in the New ADV Part 2 and the following guide on what is meant by writing in plain English.

For many firms, even with guidance, this still proves to be a difficult process or simply not something that there is time to address with competing regulatory priorities. For this reason, ACI is working with our clients to manage the conversion and writing process to the New ADV Part 2 in plain English.

To develop the New ADV Part 2, ACI first verifies with your firm that the information provided on your original Form ADV and Form ADV II is accurate, current, and complete and updates the information accordingly if it is not. ACI then performs the administrative function of transferring and reformatting the information on your Form ADVII into a working ‘plain English' document, the new ADV Part 2. Once the information has been transferred to a working draft document, an ACI consultant will review the document with your staff to make the necessary revisions and add the new disclosure information. After the final draft of the completed document is reviewed and approved by the client as accurate, current, and complete, ACI will upload a PDF version of the document to the IARD system. The narrative documents will be public and searchable making this a highly important document that should be completed with care.

The advisors must also provide the firm brochure to each client, even if the advisory agreement is only an oral agreement, and the ADV 2 should be delivered to the client before or at the time of entering into an advisory agreement.

"These amendments are designed to provide new and prospective advisory clients with clearly written, meaningful, current disclosure of the business practices, conflicts of interest and background of the investment adviser and its advisory personnel." - U.S. Securities and Exchange Commission

For more information on working with ACI to develop your ADV Part 2 in plain english contact info@acisecure.com or 212-668-8700.

At a New York City Roundtable hedge fund managers and chief compliance officers expressed their concerns about new regulations for hedge funds. Key topics of concern for hedge funds included:

• Custody Rules - and the need for ongoing guidance which is currently being met through Q&A.

• Foreign Investors - which have a low threshold for registration may jeopardize foreign client relationships by having to warn investors the SEC may be calling.

• Pay-to-Play Policies -
  • Concerns that a new hire will lie about hiring and firing and difficulties in truly conducting a thorough background check in the former case

• ADV Part II - will be available in the new plain English format, through the IARD system for anyone, including competitors, to view.

• Whistle Blowers - there is a possible preference to address potential issues where hedge funds develop a strong top-down compliance approach in which the CCO is a known person and resource to go to in these situations.

• Disclosures and Communications - Experienced CCOs know that for the newly regulated funds there may be a learning curve to get the CEO and portfolio managers on the same page as the CCO - so that all communications need to be approved by the CCO and general counsel.
  • Funds may want to prepare an RFP approved database of responses.
  • Concerns regarding what might be deemed as selective disclosures and information potentially available through the Freedom of Information Act (FOIA)

• Diligence Policies - Due diligence records could be misread without proper context or details on decision making process after due diligence information received.  

• Need for more Guidance - There are ambiguities in new financial regulations that could leave open holes despite best compliance efforts. Hedge Funds should remain involved in the legislative dialogue as the meaning of these rules are being determined, and if anonymity is important to funds who may want to be more vocal - they can work through outside counsel, consultants, and trade organizations to maintain anonymity.

Where it was once debated whether the SEC should remain a government agency or if the public would be better served by having its responsibilities absorbed into other existing agencies, there was no debate amongst the esteemed panelists at the Fordham Law School's Seminar on September 27th regarding the important place the SEC holds in the future of the financial industry. According to former SEC Chairman Harvey Pit, in the wake of the financial crisis if we didn't have it [the SEC], we'd be creating it. Joining Pit at the Fordham Law School were Richard Breeden former SEC Chairman and current SEC Chairman Mary Shapiro who offered their insights into the past, present, and future of the SEC. (Video of the 90 Minute Panel Discussion)

As a consulting firm that specializes in providing compliance support to broker dealer, investment advisor, and hedge fund clients, ACI is looking to the SEC with each new rulemaking to help navigate the changing financial regulatory landscape with and for our clients. We're now seeing a transformation in the SEC as it responds to today's financial crisis, a transformation that reinforces the original mission and values of the SEC (fairness, transparency, disclosure, and accountability) while investing it with more regulatory and enforcement power.

As Breeden said, the SEC aims to sustain democratic markets in a democratic society and has a mission to protect markets that operate on supply and demand. By creating as much integrity in those markets as possible the SEC works to keep up demand and to make the market, as much as possible, fair and equal to everyone.

Mary Shapiro highlighted the very "special" nature of the SEC as a government agency, in the combination of its amazing mission to serve as the investor's advocate while developing confidence and maintaining integrity of capital markets - and - its jurisdiction over a unique combination of responsibilities: regulation of disclosures for public companies, mutual funds, market structure, corporate governance and also as a major law enforcement agency.

During her time as SEC Chairman, Shapiro has already overseen several initiatives and leveraged the existence of other government organizations and third parties to develop greater oversight and stability in capital markets. Examples of SEC initiatives include:

• Creating a risk based exam program in which to evaluate investment advisors and hedge funds for systemic risk. In some cases, depending on the assets under management of the firm, this will fall under State enforcement jurisdiction.
• Calling for custody reviews to occur, leveraging independent CPA firms to be 3^rd party gatekeepers by conducting surprise custody examinations.
• Undergoing internal housekeeping, removing a layer of internal bureaucracy for greater efficiency, and hiring specialized and diverse individuals to join its staff (eg. Former traders, hedge fund specialists, etc).
• Relying on SROs such as FINRA to develop costly technologies such as a consolidated audit trail system that the SEC can then leverage in their efforts. Right now, the SEC is unable to reconstruct real-time markets for analytic purposes, which is in part why it took so long to issue the recently released report on the May 6^th flash crash.

The panelists also highlighted the SEC's attempt to make a distinction between the company and the individual in its mission of investor protection as far as regulations affecting retail investors vs. institutional investors and liability/fines in enforcement cases. The panel concluded that in enforcement cases, it's necessary to have a combination of individual and company liability so that companies remain responsible for the actions of their employees, but that there is also individual liability so that too much of the burden does not fall on company tax holders while allowing corporate fines to reinforce that there are real penalties for transgression of securities laws.

And the future of the SEC does not look any less busy. Over the next year alone, SEC responsibilities under the Dodd Frank Act include

• opening 5 new offices,
• producing about 105 new rulemakings, and
• conducting 20 case studies for the benefit of capital formation and investor protection.

The first of those rulemakings, the registration of municipal advisors, went into effect on October 1^st. Other key areas undergoing rule changes over the next year include proxy voting, credit agency regulations, OTC derivatives, and the creation of a uniform fiduciary standard.

For domestic success, Shapiro says there needs to be greater cooperation between the SEC and States, as state officials play a valuable role in meeting the resources demands faced. There is also too much cross border business in the world today for the SEC to ignore its role on the international state, and the SEC has a leadership role to play.

In his words of wisdom to the audience and Ms. Shapiro, Mr. Breeden heeds us all to remember that there are real investors behind the headlines, and their investments are critical to the future of the financial markets so that other people can use these investments to create businesses, factories, and jobs so that savings lead to capital formation and investors feel safe to make the leap to take that risk.

ACI helps our clients to achieve this mission by developing tailored programs for that account for the firm's individual risks relating to size, strategy, structure, and business practices, to create and maintain cost effective business and regulatory programs that will withstand the scrutiny of regulators, auditors, and investors. ACI is the premier accounting and compliance consulting firm on Wall Street. Contact ACI at 212-668-8700 or info@acisecure.com.

Changes to Custody Rules for Investment Advisors
Investment Advisors with custody of client assets are subject to new custody rules and regulations. The following outline highlights certain aspects of the new Custody Rules for Investment Advisors; however, it should not be used as a comprehensive summary or to make decisions as to whether these rules apply to your firm. ACI does not perform the newly required custody examinations, however, recognizes that this information is highly relevant for the investment advisor community for which we perform other bookkeeping and compliance outsourcings services.


FULL SEC RULE

Surprise Custody Examinations
An independent public accountant must conduct a surprise examination to verify assets in custody of the Investment Advisor. The examination should include: 

• A review of client accounts for which the firm has custody (on a sample basis per client account)
• Confirmation of the clients funds and securities with both the qualified custodian and the client
• Confirmation of contributions and withdrawals with clients
• The auditor must notify the SEC within 1 business day of finding any material discrepancy during the exam as required by the regulation.
• The audit must be performed by December 31, 2010.

Custody Examination Report

• Following the examination, the service provider should provide an examination report with an informed opinion as to whether the adviser is in compliance with the rule.

 Custody Examination Exemptions and Exemption Memorandum

• If the firm is exempt from the surprise examination, it will need to development and submit a memorandum that describes the relationship between the related person and adviser to explain the exemption for operational independence is satisfied.
• Exemptions may apply for

o Advisors with custody of the assets solely as a consequence of their authority to deduct advisory fees from client accounts

o Advisors to pooled investment vehicles that distribute annual audited financial statements to the pool's investors prepared by a PCAOB registered independent public accountant according to GAAP standards

o Advisors deemed to have custody solely because a related person who is ‘operationally independent' of the advisor holds the assets or has any authority to obtain possession of them in connection with services provided by the advisor.  

Internal Control Report -

• Annual written control report (SAS 70) if a related custodian maintains client assets. In addition to the report the PCAOB registered firm must verify that the client funds and securities are reconciled to a custodian other than the adviser or its related person.
• The Internal Control Report must be developed by September 12, 2010
• This report must be created by PCAOB registered firm

Recommended Update of Compliance Policies and Procedures

• Update of compliance manual to include policies and procedures for conducting and responding to custody audit, internal controls report, and disclosure requirements. ACI can assist in updating compliance policies and procedures accordingly.

Update of Disclosures

• Amend Form ADV / ADV-E as relevant to include additional disclosures regarding custodial practices during first annual Form ADV amendment post January 1, 2011 (within 120 days of the examination).