Custody rule checklist and key considerations for SEC-registered investment advisors (RIAs)
The Securities and Exchange Commission (SEC) custody rule, also known as Rule 206(4)-2 under the Investment Advisors Act, creates a lot of confusion among registered investment advisors (RIAs). This article serves as a comprehensive RIA compliance checklist and custody rule FAQ to help navigate the complexities of safeguarding advisory client assets and meeting SEC-registered investment advisor requirements.
Common violations disclosed in the SEC National Examination Program show that this confusion is widespread. Often these violations result from an RIA’s inability to determine their custody status under the investment advisor custody rule, highlighting the importance of understanding regulatory requirements and compliance obligations.
The following checklists provide some helpful tips to simplify the Investment Advisors Act custody rule and assist you in determining whether you are in line with its requirements for safeguarding client assets. Generally, an advisor is deemed to have custody of client assets when they hold, directly or indirectly, client funds or securities or have any authority to obtain possession of them. Here are some basic questions to help you with custody status.
How to determine RIA custody status
If the advisor is deemed to have custody and does not qualify for an exception noted below, the funds must be maintained by an SEC-qualified custodian, and the advisor should ensure it is meeting relevant requirements for safeguarding assets.
Determining RIA custody exceptions
- 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 advisor has custody due to their authority to make withdrawals from client accounts for advisory fees, the advisor 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 assets requirements.
- If an advisor is deemed to have custody solely due to a related person, and the related person is operationally independent, the advisor is not required to obtain an independent verification of client funds.
RIAs and separately managed accounts
For an RIA newly subject to the SEC custody rule, a surprise examination or custody audit can seem intimidating. In fact, many advisors exert significant effort to ensure they are not subject to the custody rule.
In some cases, advisors are deemed to have custody of only a few accounts. For example, the advisor might act as a trustee for some clients or is granted discretionary authority to move funds via a standing letter of authorization. Rather than avoid these situations, advisors 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 advisor’s client.
The following is a checklist to follow when engaging a firm to perform an SEC custody rule audit requirement.
SEC custody exam checklist for RIAs
- The exam should be annual with the first exam occurring within six months of the RIA being deemed to have custody.
- The exam time should be 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 audit, the advisor must sign a letter representing that the advisor follows the custody rule.
Checklist for SEC custody rule requirements
In addition to obtaining a custody exam, the custody rule requires an advisor to:
- Maintain funds with an SEC-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 advisor’s clients under the advisor’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 and 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.
RIA guidance for managing 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, they may qualify for a custody rule audit exemption 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 the account statement to clients.
Vehicles planning to use this custody rule exemption must adhere to a few SEC requirements. In fact, the SEC included the improper use of this exception as one of the common custody violations found in their exams. To qualify for this exemption, the RIA must adhere to the following requirements outlined below.
SEC 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, the distribution must occur within 90 days, and for a fund of funds, the distribution must be within 180 days.
- The audit must be conducted by an independent accountant who 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.
Additional resources for RIAs
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, including the latest custody rule amendments and proposals. To learn more about how we can assist with your RIA custodian needs and help ensure compliance with the investment advisor custody rule, visit our Financial services webpage. We can help you navigate the complexities of SEC RIA compliance, including Rule 204-2 (the SEC books and records rule for investment advisors) and stay updated on any new custody rule proposals or changes to the SEC safeguarding rule.
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