(The article featured below is a selection from Federal Securities Law Reporter, which is available to subscribers of that publication.)

Accounting Firms Recommend Improvements to Investment Adviser Custody Proposal

Ernst & Young LLP, Deloitte & Touche LLP, PricewaterhouseCoopers LLP and KPMG LLP have recommended improvements to the SEC's rule proposal (Fed. Sec. L. Rep. ¶88,623) that contemplates an enhanced role for independent public accountants in confirming the assets of investment advisers' clients. The proposal would require registered investment advisers that have custody of client funds or securities to undergo an annual surprise examination by an independent public accountant. Unless client accounts are maintained by an independent qualified custodian, the adviser would also have to obtain a written report from an independent public accountant which includes an opinion on the custodian's controls with respect to the custody of client assets. The comment period closed July 28, 2009.

Ernst & Young asked the SEC to clarify client assets under the rule and recommended that the definition be enhanced in connection with the scope of a surprise examination. The proposed amendments do not address the procedures the SEC may expect an independent auditor to perform to verify the existence of securities that are not held with a qualified custodian. Ernst & Young said the verification of these securities' existence may require confirmation procedures involving numerous parties and may require alternative procedures if there is no response to a confirmation request. The firm urged the SEC to provide guidance to clarify its expectations, including whether privately held securities and other assets that are not held by qualified custodians are included in the scope of the surprise examination.

Each of the firms urged the SEC to allow for confirmations based on sampling if the auditor deems that approach appropriate. If sampling techniques are allowed, KPMG urged the SEC to provide guidance on the required confidence levels, acceptable error rates and other factors. Deloitte & Touche said the SEC should consider permitting confirmations based on sampling for both securities and client account balances.

The firms also agreed that the investment adviser should not be required to engage different independent accountants to perform the surprise and the internal control examinations. Separate accountants could be costly and without significant benefit, in KPMG's view. PricewaterhouseCoopers said the requirement to use two different accountants could have an adverse impact on market choices for larger investment advisers.

KPMG recommended that the surprise examination and internal control audit requirements not include testing the valuation of securities in advisers' custody. Valuation testing would significantly increase the scope of the proposed rule and increase costs significantly, according to the firm. KPMG also believes that the inclusion of privately offered securities within the scope of the proposed rule would create a number of operational issues for advisers and attestation issues for their accountants. KPMG said it is appropriate to require a registered adviser to certify a listing of funds, securities and client accounts that were examined by the accountant as part of the surprise examination.

PricewaterhouseCoopers noted that the proposed amendments would allocate a vast amount of resources to the misappropriation and misreporting of securities owned regardless of the potential risk. The firm urged the SEC to consider reliance on chief compliance officers to provide additional safeguards of clients' funds and securities. The firm also recognized the potential deterrent effect of a surprise audit, but suggested that the use of an independent representative or a similar alternative would be far more cost-effective.

PricewaterhouseCoopers also supports greater involvement of the adviser's chief compliance officer in the attestation process. The chief compliance officer is in a much better position to evaluate valuation controls than an annual point-in-time examination, according to the firm. A compliance officer is also in a position to evaluate other compliance controls more effectively. PricewaterhouseCoopers believes that chief compliance officer CCO attestation about the adequacy of client controls and procedures would be more effective than expanding the surprise audit procedures, and it would be more cost-effective.

KPMG recommended a 12-month transition for compliance with the final rule. PricewaterhouseCoopers also called for a 12-month transition for the internal control reports and annual surprise examinations. Deloitte & Touche said a 12-month transition for the surprise examinations would provide time for the accounting profession to develop policies and procedures in response to the final rule and to allow advisers to make arrangements to meet the requirements before they become effective. Deloitte & Touche also suggested that, during the transition period for the internal control reports, the SEC encourage investment advisers to internally identify the pertinent controls and make an internal assessment of the controls. This effort can be very time consuming. The implementation of the requirement will be more efficient if management first undergoes the initial process internally, the firm said, prior to subjecting the controls to an examination by an independent audit firm.