Under the amended custody rule, registered hedge fund managers that are excepted from the surprise examination requirement still may be subject to the internal control report requirement.  That is, under the amended custody rule, a registered hedge fund manager with actual or deemed custody of client assets generally would be required to undergo an annual surprise examination.  However, the rule contains an exception to the surprise examination requirement for advisers to pooled investment vehicles that deliver annual audited financial statements (prepared by an independent, PCAOB-registered accountant) to investors in the pool within 120 days of the end of the pool’s fiscal year (180 days for funds of funds).  See “How Can Hedge Fund Managers Structure Managed Accounts to Remain Outside the Purview of the Amended Custody Rule’s Surprise Examination Requirement?,” Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2010).  Similarly, under the amended custody rule, a registered hedge fund manager that self-custodies client assets or uses a related person to custody client assets is required to obtain or receive from that related person, at least annually, a written report from a PCAOB-registered accountant describing (as discussed more fully in this article) the manager’s or the related person’s custody controls, tests of those controls performed by the accountant and the results of such tests.  The amended custody rule does not contain an exception to the internal control report requirement for advisers to pooled investment vehicles.  Accordingly, a hedge fund manager may avoid the surprise examination requirement while remaining subject to the internal control report requirement.  For example, a hedge fund manager controlled indirectly by a bank holding company that custodies client assets at a broker-dealer also indirectly controlled by that bank holding company would be subject to the internal control report requirement, but could avoid the surprise examination requirement.  While the so-called Volcker Rule would prohibit the foregoing scenario, even independent hedge fund managers that custody assets at affiliated broker-dealers would have to comply with the internal control report requirement.  See "Senate Banking Committee Hears Testimony from Hedge Fund Industry Experts and Academics on 'Volcker Rule,'" below, in this issue of the Hedge Fund Law Report.  Because commissioning an initial internal control report and subsequent reports is likely to be expensive, especially for smaller hedge fund managers, the internal control report requirement generated controversy when the custody rule amendments were originally proposed.  Nonetheless, the requirement made it into the final rule, and the SEC’s apparent disregard of industry comments on this point appears to contain an element of action-forcing: the SEC’s stated goal in amending the custody rule was to “encourage custodians independent of the adviser to maintain client assets as a best practice whenever feasible.”  A hedge fund manager that maintains custody at an independent custodian would not be subject to the internal control report requirement.  Therefore, the cost of preparing internal control reports may be understood as a penalty for self-custody or related-party custody.  In an effort to assess the real impact of the internal control report requirement on hedge fund managers, this article discusses: the specific elements required to be included in internal control reports; who may prepare such reports; the interaction of surprise examinations and internal control reports; potential use by the SEC of such reports in the course of inspections and examinations; whether or not such reports will be public; how such reports will factor into the institutional investor due diligence process; and fee levels and structures for preparation of internal control reports.