When it comes to custody, most registered investment advisers avoid it like you avoid the obnoxious coworker at the company party. Both require careful maneuvering to evade, are easy to confront if you’re not paying attention, and can be extremely challenging to understand when engaged. Suffice it to say, accidental or unintentional custody can have extreme consequences. So what exactly triggers custody, and what steps should an adviser take to limit the potential impact of the Custody Rule?
Regulatory Framework
The Custody Rule is actually Rule 206(4)-2 of the Investment Advisers Act of 1940 (the Act). After significant amendments in 2003 and 2009, it has enjoyed considerable periods in the regulatory spotlight due to its broader reach and added complexity, most notably for advisers who may not have previously had custody on their radar. The SEC even went so far as to publish answers to frequently asked questions regarding the Custody Rule, which were last updated in December 2011.1
This year, the Custody Rule made its way into the SEC’s examination priorities letter,2 as well as a March 2013 SEC risk alert entitled “Significant Deficiencies Involving Adviser Custody and Safety of Client Assets.”3 In the risk alert, the SEC reported “widespread and varied non-compliance with elements of the Custody Rule,” with about one-third of all adviser exams containing “custody-related issues.” Advisers, small and large, should expect custody to be addressed at least in some capacity on a SEC exam.
For the adviser thinking, “I use a third-party custodian for all of my clients’ assets, so I really don’t need to worry about this dribble,” think again. Technical custody is easier to cross than you might think.
Custody Scenarios
Whenever I need to interpret a rule or regulation, I like to start with the definitions section. How a particular term is used colloquially and how it is interpreted legally can be the difference between night and day.
Not shockingly, “custody” itself is a defined term in the Custody Rule: “Custody means holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.”4 As this article will attempt to explain, there is a wealth of nuance in these 19 words and a few critical exceptions scattered in the Custody Rule that are important to understand. Perhaps the best way to navigate this rule is to explore various scenarios that may or may not trigger the Custody Rule’s application.
Scenario 1: Client mails adviser a check drawn from client’s account made payable to custodian for deposit into client’s account. Adviser forwards client’s check to custodian.
Result: No custody.
Take-away: A check drawn by a client and payable to a third party, even if held directly or indirectly by an adviser, does not constitute custody. This is a narrow but important exception to the Custody Rule that allows advisers to receive checks from clients that are intended to be deposited into client accounts. Importantly, such checks should not be made payable to the adviser. Conversely, checks received from third parties made payable to a client cannot be forwarded to the custodian and must be returned to sender.
Scenario 2: Client mails adviser a security certificate she found in her safe deposit box. Adviser immediately forwards the security certificate to custodian.
Result: Custody.
Take-away: Security certificates, cash, or other client securities or funds may not be forwarded to the custodian by adviser. Such client securities or funds must be returned to sender within three business days. Helping a client prepare such documents for the client to send to the custodian is permissible, but an adviser should not do this on a client’s behalf.
Scenario 3: A supervised person of adviser is the trustee of client’s trust account, which is held at custodian. This supervised person, in his capacity as trustee, has never effected any money movement whatsoever in client’s trust account.
Result: Custody.
Take-away: The SEC makes it clear that any arrangement under which an adviser is authorized or permitted to withdraw client funds or securities from a client’s account constitutes custody. The fact that an adviser never actually exercised his or her ability to withdraw the client’s funds is irrelevant (remember, mere “authority to obtain or possess” client funds or securities is the relevant consideration). Acting as a trustee, pursuant to a general power of attorney, or with check-writing/bill-pay authority are classic examples of when custody would be triggered. An adviser serving as a general partner of a client’s limited partnership or managing member of a client’s limited liability company also would confer legal ownership of funds and securities of the entity, thus also triggering custody. There is, however, a narrow exception for a supervised person of an adviser serving as a trustee for a client’s account if that supervised person is appointed as trustee because of a family or personal relationship with the decedent, beneficiary, or grantor.
Scenario 4: Client can’t remember her username or password to access her accounts online, and she can’t figure out how to navigate her custodian’s website. She asks adviser to log on for her and make some portfolio adjustments. Adviser follows client’s instructions, and never logs into client’s account again.
Result: Custody.
Take-away: Logging into a client’s account using a client’s username and password constitutes custody if the adviser would have the ability to withdraw funds and securities from the client’s account, even if this ability is never exercised.
Scenario 5: Adviser resides in a custody-proof bunker below the earth’s crust so he is insulated from client funds and securities, cannot serve as trustee to any client accounts, cannot write checks on the client’s behalf, and quite frankly cannot even manage his client’s account. But, because adviser still has to keep the lights on in his bunker, he retains the ability to deduct his advisory fees from client’s account.
Result: Custody, with a caveat.
Takeaway: If the adviser retains the ability to deduct advisory fees from client’s account (which is not uncommon), even if none of the other custody triggers are pulled, the adviser has custody. The caveat is this: if an adviser has custody of a client’s funds or securities solely because adviser has the authority to deduct advisory fees, an adviser is not required to obtain an independent verification of client funds and securities maintained by a qualified custodian (also known as a “surprise examination”). More on this principle later, as it has massive repercussions.
I Have Custody… So What?
The point of the Custody Rule is first to keep client assets safe, and second to impute certain duties and obligations upon advisers who have custody of client funds or securities, even if accidentally or temporarily.5
For starters, advisers with custody must use a “qualified custodian” to maintain such funds and securities in separate accounts for each client or in the name of the adviser as agent or trustee. A qualified custodian is generally a bank or savings association, broker-dealer, futures commission merchant, or foreign financial institution. For open-end mutual fund shares, an adviser also may use the fund’s transfer agent in lieu of a qualified custodian.
An adviser with custody also must notify clients of this qualified custodian relationship, and urge them in writing to compare the adviser’s account statements (if any) to those of the qualified custodian.
One important and often overlooked duty of advisers with custody is to get confirmation that a client’s qualified custodian is actually sending account statements to the client at least quarterly. In the words of the Custody Rule, the adviser must have a “reasonable basis” that this is occurring via “due inquiry” into the qualified custodian. The SEC explains that an adviser with custody may satisfy this requirement by “… being copied on the email notifications of account statement postings sent to clients in addition to having access to client statements on the custodian’s website … .”6 Merely having access to view statements online is insufficient. The SEC’s one example isn’t the only way an adviser can satisfy his or her “due inquiry” duty, but the following conversations also would be insufficient:
Adviser: “Hey custodian, did you happen to mail all my clients account statements last quarter?”
Custodian: “Yup!”
Perhaps the biggest whammy of the Custody Rule is that advisers with custody are required to undergo a surprise examination by an independent public accountant on an annual basis. Read that sentence again—it’s brutal. One important exception, however, is addressed in Scenario 5: if an adviser has custody of funds or securities solely because adviser has the authority to deduct advisory fees, adviser is not required to undergo the annual surprise exam. This caveat is likely applicable to a fair number of advisers, but it’s important to remember that all the other requirements of the custody rule besides the annual surprise exam requirement (use of a qualified custodian, due inquiry, etc.) still apply.
In addition, an adviser is deemed to have custody by default even if only because its related person is deemed to have custody in connection with the advisory services the adviser provides to its clients. A “related person” for purposes of the Custody Rule means “any person, directly or indirectly, controlling or controlled by you, and any person that is under common control with you.” That said, such an adviser is also excepted from the annual surprise exam if the related person is “operationally independent.”7 Like the advisory fee deduction exception, all the other requirements of the Custody Rule besides the annual surprise exam requirement continue to apply. The requirements imposed upon qualified custodians are even more severe, though they are not within the scope of this article.
This article can’t possibly cover every intricacy and instance of custody, but the resources the SEC has published regarding the Custody Rule are immensely helpful (particularly the FAQ and risk alert noted earlier).
Advisers who want to avoid the potentially harsh repercussions of custody would do well to review their policies and procedures in conjunction with SEC guidance, and immediately remove any trip wires. Also, be mindful of how to appropriately answer Item 9 of Form ADV Part 1, which specifically asks about custody. As for dealing with the obnoxious coworker at the company party, you’re on your own.
Endnotes
- www.sec.gov/divisions/investment/custody_faq_030510.htm.
- www.sec.gov/about/offices/ocie/national-examination-program-priorities-2013.pdf
- www.sec.gov/about/offices/ocie/custody-risk-alert.pdf.
- Rule 206(4)-2(d)(2).
- “Whether an adviser has custody of client funds and securities depends upon whether the adviser directly or indirectly holds the securities or has any authority to possess them. Custody does not turn on whether the securities are maintained with a qualified custodian.” — Answer to question VII.3 of “Staff Responses to Questions about the Custody Rule” at www.sec.gov/divisions/investment/custody_faq_030510.htm.
- Answer to question IV.1 of “Staff Responses to Questions about the Custody Rule” at www.sec.gov/divisions/investment/custody_faq_030510.htm.
- The definition of “operationally independent” can be found in Section (d)(5) of the Custody Rule.
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This article originally appeared in the August 2013 issue of the Journal of Financial Planning.