In late 2009, the SEC adopted amendments to Rule 206(4)-2 (Custody Rule) under the Investment Advisers Act of 1940, as amended (Advisers Act).  (The Hedge Fund Law Report has analyzed the implications of the amended Custody Rule for, among other things, compliance policies and procedures; the balance of power between hedge fund managers and accountants; structuring of managed accounts; internal control reporting; and hedge fund liquidations.)  As amended, the Custody Rule creates a general rule that is bad for hedge fund managers, an exception to the general rule that is good for hedge fund managers, and parameters for applying the exception that are ambiguous for hedge fund managers.  In brief, the general rule is that any investment adviser deemed to have custody of client securities or assets – and most hedge fund managers would have deemed custody within the Custody Rule’s broad definition of custody – is required to undergo an annual surprise examination conducted by an independent public accountant.  The exception is that advisers to pooled investment vehicles (such as hedge funds) are excepted from the surprise examination requirement if their funds are audited annually in accordance with GAAP by “an independent public accountant that is 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 (PCAOB) in accordance with its rules.”  Advisers Act Rule 206(4)-2(b)(4)(ii).  The exemption also requires a hedge fund to distribute its audited financial statements to investors within 120 days (180 days for funds of funds) of the fund’s fiscal year-end.  The ambiguity in application of the exception is essentially as follows: A hedge fund manager is only excepted from the surprise examination requirement if the independent public accountant that it retains to perform annual audits of its funds is (1) registered with the PCAOB and (2) subject to regular inspection by the PCAOB (3) as of the commencement of the professional engagement period and (4) as of each calendar year-end.  But many of the independent public accountants that routinely audit hedge funds are not subject to regular inspection by the PCAOB, and it is not yet clear what “as of the commencement of the professional engagement period” will mean for purposes of the Custody Rule.  In other words, many independent public accountants would not satisfy the second and third elements of the test for eligibility to provide annual audits that can except a hedge fund manager from the surprise examination requirement.  Therefore, to avoid the surprise examination requirement, many hedge fund managers would have to replace their current auditors with auditors that are subject to “regular inspection” by the PCAOB.  Only auditors to public companies currently are subject to regular inspection by the PCAOB.  In many cases, such public company auditors are larger and more expensive, and have less institutional knowledge (and in some cases less industry knowledge), than auditors focused specifically on the hedge fund industry.  In short, absent relief and clarification, the Custody Rule would require many hedge fund managers to replace their funds’ current auditors, which in turn could: raise funds’ costs; increase the length of audits; increase the time of hedge fund manager personnel and other manager resources committed to annual audits; diminish or eliminate the value of institutional knowledge; and sever by regulation professional engagements that in many cases have been long-standing and mutually productive.  Fortunately, in an October 12, 2010 no-action letter to the law firm Seward & Kissel LLP (Seward Letter), the Staff of the SEC’s Division of Investment Management provided such relief and clarification.  This article further describes the legal, accounting and operational problems created by the Custody Rule, and the relief offered by the Seward Letter with respect to those problems.