Previously on our blog we discussed situations where advisers are deemed to have custody, Assessing Custody for Registered Investment Advisers. If your firm has deemed itself to have custody, you need to ensure your firm is compliant with the Custody Rule requirements. If this is the case, consider the following:
Use of “Qualified Custodians” To Hold Client Assets
With certain limited exceptions, an adviser is required to maintain client funds and securities with a “qualified custodian.” Qualified custodians can be banks, registered broker-dealers, futures commission merchants, or certain foreign entities. A qualified custodian either maintains client funds and securities in a separate account for each client under that client’s name, or in accounts that contain only client funds and securities under the name of the investment adviser as agent or trustee for the clients.
Notices to Clients Detailing How Their Assets Are Being held
If the adviser opens the custodial account, it must notify clients 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. Also, in any account statement sent by the adviser, the adviser must advise its clients to compare account statements sent by the adviser with the account statements.
Due Inquiry of Statement Delivery
Advisers must have a reasonable basis to believe that the qualified custodians that maintain client funds and securities send account statements at least quarterly to the adviser’s clients directly. This permits advisory clients to compare the statements they receive from the custodian with any statements or other information they receive from their adviser and to determine whether account transactions, including deductions to pay advisory fees, are proper.
Investment advisors are required to form a reasonable belief after “due inquiry” that the qualified custodian is sending quarterly (or more frequent) statements directly to clients. The SEC has said that there is no single method for forming this belief and has left investment advisors with flexibility to determine how best to meet this requirement. For example, an investment advisor could form a reasonable belief if the custodian also provides the investment advisor with a copy of the client’s quarterly account statement.
An advisor could also satisfy the due inquiry requirement if the custodian confirms in writing that it has sent account statements to the advisor’s clients each quarter. A practice that would not satisfy the “due requirement is if the investment advisor accesses account statements only through the qualified custodian’s website. According to the SEC, viewing a statement on the website merely confirms that the statements are available—not that they were sent.
Annual Surprise Exams
In most cases, if the adviser has custody of client assets, it must enter into a written agreement with an independent public accountant to examine those assets on a surprise basis every year. The accountant performing the “surprise” examination will contact some, or all, advisory clients to confirm their holdings with those listed on the records of the adviser. The engagement of the independent public accountant must be done pursuant to a written agreement, and such agreement must:
- Provide for the first examination to occur no later than six months (following the engagement);
- Require the accountant to file a certificate on Form ADV-E within 120 days of the time chosen by the accountant, stating that the accountant has examined the funds and securities and describing the nature and extent of the examination; and
- Provide that upon finding any material discrepancies during the course of the examination, the accountant must notify the SEC within one business day and upon resignation, dismissal, or termination of the accountant’s engagement, the accountant must file Form ADV-E within four business days.
Additional Protections When A Related Qualified Custodian Is Used
If the custodian is also the adviser or is affiliated with the adviser in some way, the adviser must, among other things, obtain a report from the related qualified custodian that includes an opinion of an independent public accountant regarding the effectiveness of the custodian’s procedures for safeguarding client funds and securities every year. Additionally, an adviser that uses a related qualified custodian is itself subject to annual surprise exams, as described in the preceding paragraph.
Adv Disclosure
Most instances of custody must be disclosed in Item 9 of Form ADV Part 1. This includes the existence of SLOAs, which constitutes custody, even if the Firm might be exempt from the surprise audit component of the rule.
For more blogs similar to custody requirements for advisers, check out some of our other blogs:
If your firm needs assistance understanding and complying with the custody requirements, please contact us. MasterCompliance provides expert consulting, outsourcing, and implementation tools in planning and budgeting your firm’s compliance responsibilities.
