By Thomas J. Urban
Each year, the Securities and Exchange Commission (“SEC”) issues reminders regarding the custody rules (the “Custody Rule”) it mandated under the Investment Advisers Act of 1940 and amendments to Rule 206(4)-2. In light of the recent financial crisis and the increased frequency of SEC examinations, a quick refresher on the Custody Rule requirements may be all that’s needed to help ensure that you’re comprehensively safeguarding your client’s assets.
The Custody Rule is designed to protect advisory clients from the misuse or misappropriation of their funds and securities. As defined by the SEC, an advisor has custody if it holds client funds or securities (“client assets”), directly or indirectly, or has any authority to obtain possession of them. When a Registered Investment Advisor (“RIA”) has “custody” of its clients’ assets the Custody Rule requires such an RIA to adhere to these requirements:
- Maintain client assets with a “qualified custodian” in (i) a separate account for each individual client under that client’s name or (ii) in accounts which contain assets for multiple clients under the RIA’s name who is acting as an agent or trustee for those clients*;
- Have a reasonable basis for believing that the qualified custodian sends account statements, at least quarterly, to each client for whom it maintains funds or securities;
- Notify clients promptly, and in writing, when (i) opening a custodial account on the client’s behalf and (ii) whenever changes which affect the manner in which the assets are maintained are made;
- In the event that the custodian is the RIA or a related person of the RIA and maintains advisory client assets in connection with advisory services, they must obtain an annual report of the internal controls relating to custody of client assets as prepared by an independent public accountant who is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (PCAOB); and
- Undergo an annual surprise examination to verify client funds and securities. The accountant will (i) complete a certificate using Form ADV-E stating that he or she has examined the funds and securities, (ii) detail the nature and extent of the examination, and (iii) file the form with the SEC within 120 days following the inspection. **
Another way to satisfy the Custody Rule is by obtaining annual financial statement audits of pooled investment vehicles performed by an independent public accountant who is registered with, and subject to regular inspection by, the PCAOB.
In addition, it’s important to review and take into consideration the amendments the SEC made to the RIAs’ “Books and Records Rule”. RIAs must establish and maintain effective internal controls over compliance with the requirements of Rule 204-2(b). In doing so, Rule 204-2(b) under the Act requires that an RIA who has custody or possession of any client’s assets must record all transactions for such clients both in a journal and in separate ledger accounts. They must also maintain copies of confirmations of all transactions in such accounts and a position record for each security in which a client has an interest.
If you’re interested in learning more about how the nuances of the Custody Rule may apply to your particular situation, please contact your Untracht Early advisor for more details.