Regulation of Custodial Practices Under the Investment Advisers Act of 1940 Rule 206(4)-2 - September 2020

Proskauer Rose LLP

A. Adoption in 1962 -

The SEC has regulated custodial practices of investment advisers since 1962, when it first adopted rule 206(4)-2 (the “Custody Rule”) under the Investment Advisers Act of 1940 (“Advisers Act”) under newly-acquired authority to adopt rules to prevent fraud by investment advisers. The purpose of the rule was to require advisers that have custody of client funds or securities to implement a set of controls to insulate them from “any unlawful activities or financial reverses, including insolvency, of the adviser.”

The 1962 rule required advisers to adopt the best practices of the day, which included segregating client securities from those of the adviser, “marking” them to indicate the name of the client, and holding them in “some place reasonably free from risk of destruction or other loss.” All cash had to be kept in a bank account. Monthly client statements were required, identifying the “location” and “manner” in which the securities were held. At least once each year, the securities were required to be subject to a surprise “physical examination” by an independent public accountant hired by the adviser for that purpose. The rule reflected the paper-based system of owning and holding securities then in place. The SEC felt no need to define the term custody used in the rule—in 1962 it could mean but one thing.

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