Do I need a Surprise Custody Examination?
Rule 206(4)-2 (the “Custody Rule”) of the Investment Advisers Act of 1940 (“Advisers Act”), is one of the most important rules designed to protect advisory clients from the misuse or misappropriation of their funds and securities. The concept of Custody continues to be one of the most confusing and challenging topics for Registered Investment Advisors (“RIA”). This is not surprising given the complexities of the definition of “custody” and the requirements for avoiding it or complying if an advisor has it. When most people think of Custody they think of physical possession. And in the cases where the RIA has physical custody, it is straight forward.
It’s important to note that RIAs can be deemed to have custody for many reasons, including their ability to have management fees paid directly to them from the clients custodial account. Or even inadvertently based on language in an agreement between the third-party custodian and the RIAs client, that the RIA may never have seen or had access to. In essence, any ability to move funds outside of normal trading authority, could be considered as custody. Where to find answers is another story. RIAs must not only go to the Advisors Act, but also within various No-Action Letters, Risk Alerts, Guidance Statements, and the Security and Exchange Commission’s (“SEC”) staff response to questions on the custody rule.
With the issue of custody still on the SEC’s areas of hot topic, it is of imperative important that you review your firm’s situations, even if those areas that might not be so obvious.
The Custody Rule was first adopted in 1962 to protect against a RIA’s misuse or misappropriation of a client’s assets.
Major amendments were made in 2003 and again in 2009 as a direct result of Madoff and other Ponzi related schemes. The most recent 2010 amendment increased requirements for RIA, including surprise custody examinations for those considered to have “custody”.
Custody continued to be of concern and on the SEC’s radar. Following a national examination campaign related to safekeeping of client assets, they issued a risk alert on the custody-related findings on March 4, 2013.
In 2017, the SEC further addressed their concerns to custody in a no-action letter to the Investment Advisers Association on Standing Letters of Authorization (“SLOA”) and the SEC’s Division of Investment Management provided additional guidance on RIAs risks of having inadvertent custody. This guidance, collectively, illustrates the complexity of the Custody Rule and the need for a registered investment adviser to take steps to assure that it complies with the Custody Rule, including recognizing those situations where it has custody.
Definition of Custody
The Custody Rule defines Custody as “…holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. “
The SEC has provided three examples within the Act of what Custody includes:
- Possession: 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;
- Authorization: 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
- Capacity: 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.
You also have custody “…if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services you provide to clients.”
Related person means any person, directly or indirectly, controlling or controlled by you, and any person that is under common control with you.
Control means the power, directly or indirectly, to direct the management or policies of a person, whether through ownership of securities, by contract, or otherwise.
- Each of your firm’s officers, partners, or directors exercising executive responsibility (or persons having similar status or functions) is presumed to control your firm;
- A person is presumed to control a corporation if the person:
- Directly or indirectly has the right to vote 25 percent or more of a class of the corporation’s voting securities; or
- Has the power to sell or direct the sale of 25 percent or more of a class of the corporation’s voting securities;
- A person is presumed to control a partnership if the person has the right to receive upon dissolution, or has contributed, 25 percent or more of the capital of the partnership;
- A person is presumed to control a limited liability company if the person:
- Directly or indirectly has the right to vote 25 percent or more of a class of the interests of the limited liability company;
- Has the right to receive upon dissolution, or has contributed, 25 percent or more of the capital of the limited liability company; or
- Is an elected manager of the limited liability company; or
- A person is presumed to control a trust if the person is a trustee or managing agent of the trust.
The SEC has taken a broad interpretation of the above definition and has published multiple sources to support their interpretation via various means. Common Examples (not all inclusive) included below.
- Listed as Trustee of has Power of Attorney over an investment account
- Acts at the general partner on a fund and does not undergo an annual financial statement audit and is deemed to have custody
- Has third party disbursement authority and does not meet the relief outlined in the SEC IAA No-Action letter on SLOAs
- Has login access to client accounts using client credentials and is deemed to have custody per the 2013 SEC Risk Alert
- Provides bill paying services and is deemed to have custody per the 2013 SEC Risk Alert.
- Has inadvertent custody due to contract language that the independent qualified custodian has in agreements and is deemed to have custody per the SEC IM Guidance Inadvertent Custody.
Oh no, I have custody!
Once a RIA determines they have custody, the next step is to determine the further measures for their firm in terms of policies and procedures, books and records, disclosures, a surprise custody exam, a financial statement, and their obligations to confirming actions of third parties.
Surprise Custody Examinations:
The SEC requires that the auditor performing the examination issue an opinion noting whether the adviser was in compliance, in all material respects, with paragraph (a)(1) of the Custody Rule as of the examination date and had complied with the Recordkeeping Rule during the period since the prior examination. Paragraph (a)(1) of the Custody Rule requires advisers with custody of client funds to utilize a qualified custodian to maintain those funds in a separate account for each client under that client’s name, or in accounts that contain only the client’s funds under the adviser’s name as agent or trustee for the clients. The Recordkeeping Rule requires advisers with custody of client funds to maintain certain books and records of client transactions and positions. An auditor, such as Ashland Partners, needs to address both the Custody Rule and Recordkeeping Rule requirements in its surprise examination.
Advisers with custody of client funds should review their existing policies and procedures that impact accounts with custody. Policies and procedures should be created to provide segregation of duties, such that one employee doesn’t have the ability to authorize a payment, make the related accounting entries, and perform reconciliations of the cash activity.
Although an advisor will not know the date of an examination in advance, there are certain steps an advisor can take to prepare for a surprise examination.
- Proactively review contracts to identify accounts that are subject to custody
- Proactively review websites to identify accounts that are subject to custody
- Maintain an updated account listing subject to exam
- Maintain current contact information
- Create and maintain policies & procedures explaining how systems and processes work
- Maintain organized records supporting all transactions
- Perform position and transaction reconciliations on a timely basis
Surprise Custody Examination Process:
On the surprise exam date, we will request a list of information which will include a listing of all open, closed and transferred client accounts subject to custody requirements during the period from the previous surprise examination date. A sample of client accounts will be selected from the list for further testing.
We will discuss with the RIA its process for determining which accounts are subject to custody requirements to determine that the list provided by the adviser was accurate and that the sample is being drawn from a population that contains all accounts that should be subject to surprise examination.
For the sample of accounts subject to the surprise examination, we will request various records to support the advisor’s compliance with the Recordkeeping Rule and will confirm funds and securities with both the qualified custodian and the client (or legal independent representative). We will also confirm contributions and withdrawals with clients. If the list of securities held includes privately offered securities, as defined in Rule 206(4)-(2) of the Act, then the holdings will be confirmed with counterparties. All confirmations will be reconciled to the adviser’s records. Confirmations not received or confirmations noting exceptions will be subject to further alternative testing procedures.
Auditors are required to submit Form ADV-E and the examination report within 120 days of the examination date. The Custody Rule has the following additional reporting requirements:
- If the auditor finds any material discrepancies during the surprise examination, the auditor must notify the SEC of such findings within one business day.
- If the auditor resigns or is dismissed from the surprise examination engagement, the auditor must file a statement notifying the SEC of date and reasons (such as problems relating to the examination) for the resignation or dismissal within four business days.
Please contact us to learn more about our surprise custody exam services and how we can help you!