“Custody” is defined as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” When an RIA takes custody of a client’s funds or securities, the risk to that individual increases dramatically. The Custody Rule was passed to protect clients from unscrupulous investment advisors.
RIAs are subject to Rule 206(4)-2 under the Investment Advisers Act, better known as the Custody Rule. The Custody Rule was amended on December 16, 2009. In her statement at an open meeting on that same day, SEC Chairman Mary L. Schapiro explained why the Commission was adopting rules to enhance custody controls. Schapiro said that the SEC’s goal was to strengthen the protections provided to investors who turn over assets to RIAs. The Custody Rule shines a spotlight on advisory relationships that might result in fraudulent activity. The risk to investors and advisory clients is much higher when an RIA has custody over their assets instead of turning them over to an independent third party custodian.
The logic behind the Custody Rule is simple. Having a third party involved minimizes opportunities for theft or misappropriation. As an example, when two people make a bet, they often ask a neutral third party to hold the wager. This usually prevents the people placing the wager from welching on their bets.
Amendments to the Custody Rule were prompted by Bernard Madoff’s Ponzi scheme that targeted investors. According to Schapiro, the SEC fine-tuned the rules to apply safeguards where the risk of fraud is heightened by the degree of control the RIA has over a client’s assets. The heightened risk stems from the fact that assets are not being held by an independent custodian. A truly independent custodian plays an important role in guarding against fraud and misappropriation by RIAs.
The SEC has also taken action to ensure that broker-dealers are not mishandling investors’ funds. On June 15, 2011, the SEC unanimously proposed amendments to the broker-dealer financial reporting rule, which was to strengthen audits of broker-dealers. The proposed amendments were also intended to improve the SEC’s oversight of how broker-dealers handle their customers’ securities and cash. The proposed rule mandates an audit of the controls implemented by a broker-dealer to protect and account for customer assets.
The proposed rule also permits SEC staff, as well as the relevant designated examining authority, to review the work papers of the public accounting firm that audits the broker-dealer. The SEC also proposed a new form designed to elicit information about the custody practices of the broker-dealer, which can be used as a starting point for regulatory examinations. According to Mary Schapiro, the proposed rule ensures that broker-dealers will hold and invest assets as directed by an RIA.
Requirements of the Custody Rule
The Custody Rule targets RIAs that hold a client’s assets, as well as arrangements where advisory firms are affiliated with the custodian holding those assets. In either situation, the RIA is required to submit to an annual surprise inspection by an independent public accountant. Although the date of the audit is unknown, the advisor does know that it will occur during the year. The independent public accountant must be registered with and subject to regular inspection by the Public Company Accounting Oversight Board (PCAOB)—a non-profit corporation in the private sector created by the Sarbanes-Oxley Act. The statute was passed to implement higher corporate standards and prevent accounting fraud that led to scandals such as Enron, WorldCom, and Adelphia.
RIAs subjected to surprise inspections must enter into a written contract with a PCAOB-registered independent public accountant, who will then verify client assets. If the surprise exam uncovers missing assets or material discrepancies, the accountant is required to notify the SEC within one business day.
Aside from the surprise inspection, an RIA that acts as its own qualified custodian, or that is affiliated with the custodian holding those assets, must obtain an internal control report on an annual basis. This internal control report contains an independent public accountant’s opinion regarding the adviser or related person’s controls governing the custody of client assets. This public accountant must also be registered with the PCAOB and must be subject to regular inspection by that corporation.
RIAs with Enhanced Authority over Client Assets
The Custody Rule also targets other advisory relationships posing an increased risk of fraud. According to Schapiro, additional safeguards are needed where advisers possess enhanced authority over client assets which equates to having custody, even though they utilize an independent custodian. Therefore, the surprise inspection requirement applies to RIAs engaging in activities such as:
- holding power of attorney;
- having the ability to write checks on a client’s account;
- serving as the trustee to a trust.
In a deficiency letter issued by the Philadelphia Regional Office on June 23, 2011, the branch chief reiterated that the Custody Rule applies to arrangements where the RIA or one of its employees has power of attorney or serves as a trustee to a client account. Because an employee of the firm did act as a trustee, the RIA must receive an independent verification of these client funds and securities by an independent public accountant at least once during each calendar year. The RIA was required to send the SEC a copy of an engagement letter to document that the independent verification would take place.
The Custody Rule mandates that an RIA with custody of client funds or securities must reasonably believe—after due inquiry—that the qualified custodian is sending out account statements directly to the client. These statements must be sent at least once per quarter. The SEC’s Adopting Release for the Custody Rule suggested that receiving a duplicate copy of the account statement sent to clients satisfies the “due inquiry” requirement.
When a Surprise Exam is not Required
A surprise exam is not required if an RIA is deemed to be operationally independent of an affiliated custodian. To be operationally independent, according to Schapiro’s statement, the RIA and the affiliate must “operate as distinct entities with no overlap of personnel, office space or common supervision.” All entities holding client assets, whether they are RIAs, affiliates, or operationally independent affiliates, are required to undergo an annual review of the controls they have implemented related to custody.
The surprise examination requirement does not apply in situations where an RIA uses an independent custodian and only has the ability to deduct fees from a client’s account. In excluding this group from the surprise inspection requirement, the SEC recognized that the ability to deduct fees is merely a limited form of custody, and does not present the same degree of opportunity for fraud and misappropriation. The SEC expects advisory firms to implement controls and procedures ensuring each and every fee deduction is proper.
RIAs should implement policies and procedures to ensure that fees are calculated correctly, and should require supervision of the calculation and fee deduction process. The firm’s compliance manual might require a sign-off process to making certain that fees are consistent with the client’s advisory contract.
Any accountant that audits a private fund must be registered with and subject to regular inspection by the PCAOB. Advisors to private funds held by independent custodians are not subject to surprise exams if they issue financial statements to the fund’s investors within 120 days of its fiscal year end. Those financial statements must be audited by an accounting firm registered with and subject to PCAOB inspection.
The Big Picture
An RIA’s practices regarding custody are disclosed on Form ADV Part 1A, which requires RIAs to disclose whether the firm or a related person has custody of clients’ accounts, and the number of clients whose assets are in the custody of the RIA or a related person. The form also requires the RIA to disclose the approximate amount of client funds and securities for which the firm has custody. This data is used by securities regulators in determining the level of risk posed by the firm. A firm with custody over several large client accounts may be examined more frequently than an RIA that does not have custody.
Advisors may not realize that their activities trigger the application of the Custody Rule. For example, a client may send stock certificates or cash to the RIA instead of to the broker-dealer. The advisor must send them back to the client within three business days after receiving them or the RIA will be viewed as having custody. When an RIA holds clients’ stock certificates or cash, even for a short amount of time, there is a risk that funds will be lost or misused.
An RIA should not forward client funds and securities to the broker-dealer, as this will be construed as having custody. Advisors are permitted to help clients prepare documents, however, so they can be forwarded to a broker-dealer or custodian.
An RIA may hold a check drawn by a client and made payable to a third party without being viewed as having custody of the individual’s funds. Nevertheless policies and procedures should clarify how those checks will be handled. For example, a firm’s policies and procedures might say:
Possession of a check drawn by the client and made payable to a custodian (third party) does not constitute custody of client funds. However, it is Company policy to forward such third-party checks to the appropriate custodian within one business day.
Because of the strict requirements in the Custody Rule, RIAs should be on the lookout for situations where the firm might inadvertently take custody of a client’s funds. Except for fee deductions, an advisor authorized to withdraw funds or securities from a client’s account has custody. Similarly, having power of attorney to sign checks on a client’s behalf or withdraw funds equates to having custody over that person’s assets. Therefore, unless an RIA is prepared to comply with the Custody Rule, an advisor should not offer a bill-paying service to clients.
Sometimes going the extra mile for a client can inadvertently trigger custody. Suppose the client of an RIA moves and gives the advisor power of attorney to sign documents at the closing. The RIA could be viewed as having custody over the client’s assets.
According to a January 13, 2010 publication by the law firm of Haynes and Boone, state-registered RIAs may wish to comply with the Custody Rule, even if compliance is not required by securities regulators. As an example, the Texas State Securities Board has recommended that RIAs comply with the federal Custody Rule as a best practice.