Compliance Solutions for Investment Advisers

FAQs — Custody

 

The Basics

What is the definition of custody?

Custody is defined as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them” under Rule 206(4)-2(c)(1) of the Advisers Act.

When is an investment adviser deemed to have custody over client assets?

An adviser is deemed to have custody under the following circumstances:

  • Possession of client funds or securities (but not of checks drawn by clients and made payable to third parties) unless you receive them inadvertently and you return them to the sender promptly but in any case within three business days of receiving them;
  • Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and
  • Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities.

Does the deduction of advisory fees directly from a client’s account constitute custody?

Yes.

What are the basic requirements for advisers with custody?

First and foremost, if an investment adviser has custody, it must maintain client assets at a qualified custodian.

What is a qualified custodian?

Qualified custodians include the types of financial institutions to which clients and advisers customarily turn for custodial services, including banks, registered broker-dealers, and registered futures commission merchants.

Are there other requirements in addition to maintaining client assets at a qualified custodian?

Yes.  An adviser must have a reasonable belief that the qualified custodian sends at least a quarterly account statement to its clients.

Can an advisory firm send quarterly account statements to clients in lieu of the qualified custodian?

No.

What constitutes “reasonable belief?”

In the adopting release that accompanied the most recent amendments to the custody rules, the SEC wrote that an adviser’s reasonable belief can only be formed by an adviser after “due inquiry.”

What are some examples of “due inquiry” that would support an advisory firm’s reasonable belief that the qualified custodian was indeed sending quarterly statements to its clients?

The most straightforward example is if the qualified custodian sends an advisory firm a copy of the account statement at the same time it is sent to clients.

Can an investment adviser simply access the client’s account statement on the custodian’s web site?

No. The SEC believes that accessing account statements through the web site merely confirms that they are available. If an adviser does not take additional steps to determine whether account statements were sent to clients, or that clients obtained statements through the web site, the adviser would have an inadequate basis for forming a reasonable belief, after due inquiry, that the qualified custodian sends account statements to clients. However, advisers whose clients receive electronic statements from qualified custodians may satisfy the reasonable belief requirement by being copied on the email notifications of account statement postings sent to clients in addition to having access to client statements on the custodian’s web site.

Are there any notice requirements associated with the custody rules?

Yes. Rule 206(4)-2 requires investment advisers to notify their clients promptly upon opening a custodial account on their behalf and when there are changes to the information required in that notification.

Besides the account opening notice requirement, are there any additional notice requirements?

Yes. If an investment adviser sends its own account statements to clients in additional to those sent by the qualified custodian, the adviser must include in those statements a cautionary legend urging clients to compare the information the adviser sends to the client with the information reflected in the qualified custodian’s account statements.

 

Annual Surprise Audit

When is an investment adviser required to undergo an annual surprise examination of client assets?

When the adviser has custody of client assets and there are no applicable exceptions.

What are the exceptions to the annual surprise examination requirement?

When an adviser has custody of client assets solely because of its authority to deduct advisory fees from client accounts it does not have to get the surprise audit. In addition, if your advisory firm has custody because it is the general partner of a limited partnership, it would not have to undergo the surprise examination if that limited partnership was subject to an annual audit and the results of that audit were distributed to the limited partners within 120 days of the end of the partnership’s fiscal year.

Who is required to conduct the annual surprise examination?

The annual surprise examination must be conducted by an independent public accountant. Each investment adviser subject to the surprise examination requirement must enter into a written agreement with an independent public accountant to conduct the surprise examination. The agreement must require the accountant, among other things:

  • To submit Form ADV-E via the IARD system to the SEC accompanied by the accountant’s certificate within 120 days of the time chosen by the accountant for the surprise examination, stating that the accountant has examined the funds and securities and describing the nature and extent of the examination;
  • To notify the SEC within one business day of finding any material discrepancy during the course of the examination;  and
  • To file via the IARD system, upon dismissal or resignation within four business days a statement regarding the termination along with Form ADV-E.

When does the independent public accountant have to be registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (PCAOB)?

The independent public accountant must be registered with, and subject to regular inspection by, the PCAOB when a limited partnership is using its annual audit in lieu of the annual surprise examination.

 

Specific Issues

If an investment adviser inadvertently receives securities from a client, may the adviser forward the securities to the qualified custodian instead of returning the securities to the client?

No. If the adviser does not return the securities to the sender within three business days, the adviser not only has custody, but has also violated the Custody Rule’s requirement that client securities be maintained in an account with a qualified custodian.

What about the inadvertent receipt by an investment adviser of assets other securities?

It would not be considered custody if an adviser inadvertently receives tax refunds from tax authorities, or client settlement proceeds from administrators in connection with class action lawsuits and other legal actions, or stock certificates, dividends, or evidence of new debt from issuers in connection with class action lawsuits involving bankruptcy or business reorganization, and forwards these client assets within five business days of its receipt and maintains appropriate records.

If an employee of an advisory firm serves as a trustee to a firm client, does the advisory firm have custody?

Generally, yes. The role of the supervised person as trustee is imputed to the advisory firm, thus causing the firm to have custody.

Are there any exceptions to trusteeships causing custody?

Yes. The role of the supervised person as trustee will not be imputed to the advisory firm if the supervised person has been appointed as trustee as a result of a family or personal relationship with the grantor or beneficiary and not as a result of employment with the adviser.

If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

No.

Does an adviser have custody if it has authority to transfer client funds or securities between two or more of accounts owned by a client maintained with the same qualified custodian or different qualified custodians?

Not if the client has authorized the adviser in writing to make such transfers and a copy of that authorization is provided to the qualified custodian(s), specifying the client accounts maintained with qualified custodian(s).

Does an adviser have custody if it has authority to instruct the qualified custodian that maintains an account owned by a client to remit the funds or securities from the account to the same client at his or her address of record?

Not if (i) the client has granted such authority to the adviser in writing and a copy of that authorization is provided to the qualified custodian, (ii) the adviser has no authority to open an account on behalf of the client; and (iii) the adviser has no authority to designate or change the client’s address of record with the qualified custodian.

If an adviser has the ID number and password to a pension fund account owned by a client to rebalance and adjust investments in the account, does the adviser have custody?

The adviser has custody if password access provides the adviser with the ability to withdraw funds or securities or transfer them to an account not in the client’s name at a qualified custodian.

 

Important Information

The information contained in this Frequently Asked Questions is only a summary and is not intended to be a comprehensive analysis of the rules and regulations applicable to registered investment advisers. It is not intended to constitute legal or compliance consulting advice or apply to any one investment adviser’s particular situation. For more information, please see our Terms of Use.

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