One of the most critical rules under the Investment Advisers Act of 1940 (“Advisers Act”) is the custody rule, which is designed to protect advisory clients from the misuse or misappropriation of their funds and securities. With an adequate custody assessment, your firm should be able to recognize whether it has “custody” as defined under the custody rule and has appropriate controls to comply with the custody requirements. Your firm should also build appropriate controls and procedures to ensure future compliance with the custody rule, as applicable to the firm.
As a starting point, it’s important to do a custody assessment to determine what level of custody, if any, you have. Most IA’s do have limited forms of custody. But the question to be answered is whether you are required to conduct an annual surprise exam or list the assets on your ADV Part 1. Whether you have custody or not, it’s important to understand the full rule because the SEC applies the definition of custody quite broadly as “…holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them….” If you are subject to and do conduct a surprise exam, the SEC could still cite a deficiency if you are not correctly tracking every instance of custody. If you are not engaged to have a surprise exam, then you must understand the rule to avoid taking on custody inadvertently.
Examples of Custody Not Subject to Surprise Examinations
Listed below are some common examples of custody. The list is not exhaustive but should start the process of getting you to think about how the custody rule might apply to your firm.
Let’s start with the basics. Limited forms of custody, which most IA’s have (and which do not require a surprise exam but may require listing the assets on your ADV Part 1), include:
- Advisory fees are debited directly from a client’s account.
- Standing Letters of Authorization to disburse funds to third parties on behalf of the client (while following the SEC no-action letter); Standing Letters of Authorization can be checks or wires, but most frequently are ACH links that allow the customer to transfer money back and forth between their brokerage account and a bank account. If you have any ACH links, you should review the SEC no-action letter and verify how your custodian follows the 7-steps. If the 7-steps are not followed correctly, then a surprise exam would be required.
Other forms of custody do require a surprise exam. There is no de minimis exemption applicable to custody. One instance of custody requires that you enter into a written agreement for a surprise exam with an independent public accountant within 6 months. Keep in mind that regulators will look at your ability to disburse or transfer funds or securities. For example, if a client appoints you as trustee, giving you the legal authority to transfer funds, but as a matter of firm policy, you require the client to sign off on all transfers, then you still have custody, and you are still required to conduct a surprise exam. However, if the Adviser is a co-trustee with the grantor and the trust document prohibits the Adviser from withdrawing funds without the prior written consent of all of its co-trustees then a surprise exam can be avoided. With this in mind, some of the most common events that require a surprise exam (non-exhaustive) are below.
Examples of Custody Subject to Surprise Examinations
Examples of Custody requiring a surprise examination by an independent public accountant (non-exhaustive):
- Receipt of checks from the client made payable to the IA instead of the Custodian, mutual fund company, or similar third party; Receipt of checks made payable to the client.
- Obtaining blank signed forms for future wires or transfers.
- Acting on a wire, journal, or similar transfer instructions without obtaining complete forms.
- Acting on third-party SLOA instructions without following the 7-steps as listed in the SEC no-action letter.
- Accepting physical stock certificates.
- Serving as a Trustee, Executor, or similar role for an advisory client.
- General partner of a limited partnership, managing member of LLC, or comparable position for another type of pooled investment vehicle in which your clients are invested.
- Having certain access to client passwords.
- Check writing-authority, including bill pay services, or similar signatory authority.
- Transferring worthless securities to the firm’s worthless account without authorization from the client; Full (general) power of attorney; and
- Inadvertent contractual custody is provided in the agreement between a custodian and the IA. Examples include any custodial agreement:
- that grants the client’s adviser the right to receive money, securities, and property of every kind and dispose of the same
- under which a custodian may rely on an adviser’s instructions without any direction from the client and ratifies and
- under which a custodian may rely on an adviser’s instructions without any direction from the client and ratifies and confirms any transactions with the custodian made by an adviser for the client’s account; or
- that provides authorization for the client’s custodian to instruct the adviser to disburse cash from the client account for any purpose
If you receive checks that are not made out correctly or stock certificates, you are required to either return them within 3 business days or engage in a surprise exam. If you think a surprise exam is required, we recommend that you promptly contact us so we can make you aware of additional requirements.
We cannot list every possible instance of custody since the definition is so broad. The list provided above is a starting point that you should review in conjunction with the resources below. The goal is to help you understand the intent of the Custody Rule so that you can think about how it might apply to your firm.
It is equally important that your advisors and support staff understand the rule so that they can follow the Firm’s procedures. They are often the first line of defense in identifying possible instances of custody involving checks, stock certificates, and third-party SLOAs.
MasterCompliance provides expert consulting, outsourcing, and implementation tools in planning and budgeting your firm’s compliance responsibilities. If there are any areas where you would like to explore additional assistance or services, please contact us.