Written by Sarah Williams, Wipfli and Matt Soldato, Duff & Phelps
The Security and Exchange Commission’s (SEC) custody rule creates a lot of confusion among registered investment advisers (RIA).
Common violations disclosed in the SEC National Examination Program show that this confusion is widespread. Often these violations result from a RIA’s inability to determine its custody status.
The following tables provide some helpful tips to simplify the custody rule and assist you in determining whether you are in line with its requirements.
Generally, an adviser is deemed to have custody of client assets when it holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them. Here are some basic questions to help you determine your custody status:
|Does the adviser have custody?
- Does the adviser have possession of client funds or securities (for any length of time)?
- Can the adviser withdraw funds or securities on behalf of the client?
- Can the adviser deduct certain fees on behalf of the client?
- Does the adviser have legal ownership of, or access to, client funds or securities?
- Does a related person have custody over the client’s funds or securities?
If the adviser is deemed to have custody and does not qualify for an exception noted below, the funds must be maintained by a qualified custodian and the adviser should ensure it is meeting relevant requirements for safekeeping assets.
|Do any exceptions apply?
- For shares of mutual funds, the firm may rely on a transfer agent in lieu of a qualified custodian.
- Certain privately offered securities may not require a qualified custodian, subject to certain criteria.
- If the adviser has custody due to its authority to make withdrawals from client accounts for advisory fees, the adviser is not required to obtain independent verification of client funds from a qualified custodian.
- Limited partnerships and pooled investment vehicles subject to annual audits may be exempt from notice and account statement delivery if they meet certain criteria.
- An investment company registered under the Investment Company Act of 1940 is exempt from safekeeping requirements.
- If an adviser is deemed to have custody solely due to a related person, and the related person is operationally independent, the adviser is not required to obtain an independent verification of client funds.
Separately managed accounts
For an RIA newly subject to the custody rule, a surprise independent verification or custody exam can seem intimidating. In fact, many advisers exert significant effort to ensure they are not subject to the custody rule.
In some cases, advisers are deemed to have custody of only a few accounts. For example, the adviser might act as trustee for some clients or is granted authority to move funds via a standing letter of authorization. Rather than avoid these situations, advisers should be aware that, unlike an audit, a custody exam’s procedures are minimal with the primary purpose of verifying the existence of assets.
This often includes confirming the account’s value and activity with the custodian and with the adviser’s client.
The following is a checklist to follow when engaging a firm to perform a custody exam:
|Custody exam checklist
- The exam should be annual with the first exam occurring within six months of the RIA being deemed to have custody.
- The exam time is chosen by the independent public accountant and should be irregular from year to year.
- The exam must comply with the American Institute of Certified Public Accountants (AICPA) standards.
- The agreement between the RIA and the accountant must be in writing.
- The agreement must outline specific procedures, including requiring the accountant to file a Form ADV-E certificate after the examination and notifying the SEC of any discrepancies or termination.
It’s important to note that before completing a custody exam, the adviser must sign a letter representing that the adviser is in compliance with the custody rule.
In addition to obtaining a custody exam, the custody rule requires an adviser to:
|Custody rule requirements
- Maintain funds with a qualified custodian.
- Keep client funds segregated in separate accounts for each client in the client’s name (or in an account containing only funds of the adviser’s clients under the adviser’s name as agent/trustee).
- Promptly notify the client whenever a new account is opened with a qualified custodian. The notice must be in writing, include the qualified custodian’s name, address and the manner in which funds/securities are maintained.
- Have reasonable belief that the custodian is sending statements to the clients. These account statements must be sent at least quarterly by the qualified custodian directly to the client including the amount of funds and of each security at quarter end as well as a list of all account transactions during the statement period.
Pooled investment vehicles
RIAs managing a pooled investment vehicle have two different options. The entity is often already subject to an audit. For instance, hedge funds often include a provision in their governing documents to provide their investors with an annual audit. In such cases, if the RIA complies with a few additional requirements, it does not need to obtain a custody exam for the fund. Furthermore, the RIA is also exempt from the custody rule’s new account notification requirement and from ensuring the qualified custodian sends account statement to clients.
Vehicles planning to use this audit exception must adhere to a few SEC requirements. In fact, the SEC included the improper use of this exception as one of the common violations found in their exams. To qualify for this exemption, the RIA must adhere to the following requirements:
|Pooled investment vehicle exception requirements
- Distribute audited financial statements to all limited partners (or members or beneficial owners) within 120 days of the end of the vehicle’s fiscal year. Note: For NFA vehicles, distribution must occur within 90 days and for a fund of funds, distribution must be within 180 days.
- The audit must be conducted by an independent accountant that is registered with and inspected by the Public Company Accounting Oversight Board (PCAOB).
- Upon liquidation, the vehicle needs to undergo a final audit, and upon completion, the financial statements must be promptly distributed to pooled investors.
The SEC provides resources that can help you further understand the scope and regulatory obligations of custody requirements.
How Wipfli can help
Our financial services team understands RIA needs and SEC requirements. To learn more, visit our web page.