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TITLE 7BANKING AND SECURITIES
PART 7STATE SECURITIES BOARD
CHAPTER 116INVESTMENT ADVISERS AND INVESTMENT ADVISER REPRESENTATIVES
RULE §116.17Custody of Funds or Securities of Clients by Registered Investment Advisers

(a) Definitions. The following words and terms, when used in this section, shall have the following meanings, unless the context clearly indicates otherwise.

  (1) Audit--when used in regard to financial statements, an examination of the financial statements by an independent accountant in accordance with generally accepted auditing standards, as may be modified or supplemented by the Board, for the purpose of expressing an opinion thereon.

  (2) Control--the power, directly or indirectly, to direct the management or policies of a person, whether through ownership of securities, by contract, or otherwise. Control includes:

    (A) each of the investment adviser's officers, partners, or directors exercising executive responsibility (or persons having similar status or functions) is presumed to control the firm;

    (B) a person is presumed to control a corporation if the person:

      (i) directly or indirectly has the right to vote 25% or more of a class of the corporation's voting securities; or

      (ii) has the power to sell or direct the sale of 25% or more of a class of the corporation's voting securities;

    (C) a person is presumed to control a partnership if the person has the right to receive upon dissolution, or has contributed, 25% or more of the capital of the partnership;

    (D) a person is presumed to control a limited liability company if the person:

      (i) directly or indirectly has the right to vote 25% or more of a class of the interests of the limited liability company;

      (ii) has the right to receive upon dissolution, or has contributed, 25% or more of the capital of the limited liability company; or

      (iii) is an elected manager of the limited liability company; or

    (E) a person is presumed to control a trust if the person is a trustee or managing agent of the trust.

  (3) Custody--holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. The investment adviser has custody if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services the investment adviser provides to clients. Custody includes:

    (A) possession of client funds or securities (but not of checks drawn by clients and made payable to third parties) unless the investment adviser receives them inadvertently and returns them to the sender promptly but in any case within three business days of receiving them;

    (B) 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

    (C) 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 supervised person legal ownership of or access to client funds or securities.

  (4) Independent public accountant--a public accountant that meets the standards of independence described in Securities and Exchange Commission, Rule 2-01(b) and (c) of Regulation S-X (17 CFR §210.2-01(b) and (c)) as existed on April 1, 2010.

  (5) Independent representative--a person that:

    (A) acts as agent for an advisory client, including in the case of a pooled investment vehicle, for limited partners of a limited partnership (or members of a limited liability company, or other beneficial owners of another type of pooled investment vehicle) and by law or contract is obliged to act in the best interest of the advisory client or the limited partners (or members, or other beneficial owners);

    (B) does not control, is not controlled by, and is not under common control with the investment adviser; and

    (C) does not have, and has not had within the past two years, a material business relationship with the investment adviser.

  (6) Open-end company--a management company which is offering for sale or has outstanding any redeemable security of which it is the issuer.

  (7) Operationally independent--for purposes of subsection (c)(6) of this section, a related person is presumed not to be operationally independent unless each of the following conditions is met and no other circumstances can reasonably be expected to compromise the operational independence of the related person:

    (A) client assets in the custody of the related person are not subject to claims of the adviser's creditors;

    (B) advisory personnel do not have custody or possession of, or direct or indirect access to client assets of which the related person has custody, or the power to control the disposition of such client assets to third parties for the benefit of the adviser or its related persons, or otherwise have the opportunity to misappropriate such client assets;

    (C) advisory personnel and personnel of the related person who have access to advisory client assets are not under common supervision; and

    (D) advisory personnel do not hold any position with the related person or share premises with the related person.

  (8) Qualified custodian--

    (A) a bank as defined in the Investment Advisers Act of 1940, §202(a)(2), or a savings association as defined in the Federal Deposit Insurance Act, §3(b)(1), that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act;

    (B) a broker-dealer registered under the Securities Exchange Act of 1934, §15(b)(1), holding the client assets in customer accounts;

    (C) a futures commission merchant registered under the Commodity Exchange Act, §4f(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

    (D) 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.

  (9) Related person--any person, directly or indirectly, controlling or controlled by the investment adviser, and any person that is under common control with the investment adviser.

(b) Safekeeping required. No registered investment adviser may have custody of client funds or securities unless:

  (1) Qualified custodian. A qualified custodian maintains those 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's clients' funds and securities, under the investment adviser's name as agent or trustee for the clients.

  (2) Notice to clients. If the investment adviser opens an account with a qualified custodian on behalf of the client, either under the client's name or under the investment adviser's name as agent, the investment adviser notifies 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. If the investment adviser sends account statements to a client to which the investment adviser is required to provide this notice, the investment adviser includes in the notification provided to that client and in any subsequent account statement the investment adviser sends that client, a statement urging the client to compare the account statements from the custodian with those from the investment adviser.

  (3) Account statements to clients. The investment adviser has a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of the investment adviser's clients for which it maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions in the account during that period.

  (4) Independent verification. The client funds and securities of which the investment adviser has custody are verified by actual examination at least once during each calendar year, except as provided below, by an independent public accountant, pursuant to a written agreement between the investment adviser and the accountant, at a time that is chosen by the accountant without prior notice or announcement to the investment adviser and that is irregular from year to year. The written agreement must provide for the first examination to occur within six months of becoming subject to this paragraph, except that, if the investment adviser maintains client funds or securities pursuant to this section as a qualified custodian, the agreement must provide for the first examination to occur no later than six months after obtaining the internal control report. The written agreement must require the accountant to:

    (A) file a certificate on Form ADV-E with the Securities Commissioner within 120 days of the time chosen by the accountant in paragraph (4) of this subsection, stating that it has examined the funds and securities and describing the nature and extent of the examination;

    (B) upon finding any material discrepancies during the course of the examination, notify the Securities 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 attention of the Director of the Inspections and Compliance Division; and

    (C) upon resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed, file with the Securities Commissioner within four business days Form ADV-E accompanied by a statement that includes:

      (i) the date of such resignation, dismissal, removal, or other termination, and the name, address, and contact information of the accountant; and

      (ii) an explanation of any problems relating to examination scope or procedure that contributed to such resignation, dismissal, removal, or other termination.

  (5) Special rule for limited partnerships and limited liability companies. If the investment adviser or a related person is a general partner of a limited partnership (or managing member of a limited liability company, or holds a comparable position for another type of pooled investment vehicle), the account statements required under paragraph (3) of this subsection must be sent to each limited partner (or member or other beneficial owner).

  (6) Investment advisers acting as qualified custodians. If the investment adviser maintains, or if the investment adviser has custody because a related person maintains, client funds or securities pursuant to this subsection as a qualified custodian in connection with advisory services the investment adviser provides to clients:

    (A) the independent public accountant the investment adviser retains to perform the independent verification required by paragraph (4) of this subsection must be registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and

    (B) the investment adviser must obtain, or receive from the investment adviser's related person, within six months of becoming subject to this paragraph and thereafter no less frequently than once each calendar year a written internal control report prepared by an independent public accountant:

      (i) the internal control report must include an opinion of an independent public accountant as to whether controls have been placed in operation as of a specific date, and are suitably designed and are operating effectively to meet control objectives relating to custodial services, including the safeguarding of funds and securities held by either the investment adviser or a related person on behalf of the investment adviser's clients, during the year;

      (ii) the independent public accountant must verify that the funds and securities are reconciled to a custodian other than the investment adviser or the investment adviser's related person; and

      (iii) the independent public accountant must be registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules.

  (7) Independent representatives. A client may designate an independent representative to receive, on his or her behalf, notices and account statements as required under paragraphs (2) and (3) of this subsection.

(c) Exceptions.

  (1) Shares of an open-end company. With respect to shares of an open-end company (as defined in this section), the investment adviser may use the open-end company's transfer agent in lieu of a qualified custodian for purposes of complying with subsection (b) of this section.

  (2) Certain privately offered securities.

    (A) The investment adviser is not required to comply with subsection (b)(1) of this section 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 the books of the issuer or its transfer agent in the name of the client; and

Cont'd...

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