Policy Statement on Custody Requirements

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In conjunction with the release of a preliminary report describing an initiative by the Registration, Inspections, Compliance and Examinations Section of the Massachusetts Securities Division of the Office of the Secretary of the Commonwealth (the “Division”) to examine advisers that registered with the Commonwealth as a result of the Dodd-Frank Act (“Switch Advisers”), the Division issued a policy statement (the “Policy Statement”) addressing compliance with the two elements of the Division’s custody requirements applicable to investment advisers registered with the Commonwealth: (1) custody resulting from trustee and other similar relationships with clients; and (2) the deduction of advisory fees from client accounts.  Although it identifies fifteen different categories of deficiencies found in the Switch Adviser examinations, the preliminary report highlights custody rule compliance as an area of particular concern.

Custody.  The Policy Statement provides that, while custody under 950 MASS. CODE REGS. 12.205(5)(b)(1) is defined by reference to the SEC custody rule under the Investment Advisers Act of 1940, the Division does not recognize  the exception from the definition of custody available to an SEC-registered adviser “[w]hen a supervised person of the adviser serves as the executor, conservator or trustee for an estate, conservatorship or personal trust solely because the supervised person has been appointed in these capacities as a result of family or personal relationship with the decedent, beneficiary or grantor (and not as a result of employment with the adviser).”  The Policy Statement provides that investment advisers with custody “by virtue of trustee relationships (or other similar sorts of relationships) raise significant regulatory concerns” and that “[t]hese regulatory concerns exist whether the supervised person functions as a sole or co-trustee.”

Fee Deduction.  The Policy Statement reminds  Massachusetts-registered advisers that (a) the Division’s waiver of the requirement for independent verification of custodial assets when custody exists solely because of an adviser’s withdrawal of advisory fees directly from clients’ accounts is conditioned on the adviser: (i) having written authorization from the client to deduct advisory fees from the account held with the qualified custodian; and (ii) sending the qualified custodian and client an invoice or statement of the amount of the fee to be deducted from the client’s account each time a fee is directly deducted.  Records demonstrating compliance with these procedures must be maintained and preserved for a period of not less than five years, the first two years in an appropriate office of the investment adviser.