Under Rule 206(4)-2 of the Investment Advisers Act of 1940 (“Investment Advisers Act”), custody means “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” An investment adviser registered with the U.S. Securities and Exchange Commission (“SEC”) will be deemed to have custody of a client’s assets if it meets this definition or if a related person of the investment adviser holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services the investment adviser provides to clients. Examples of custody include: “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; any arrangement (including a general power of attorney) under which [the investment adviser] is authorized or permitted to withdraw client funds or securities maintained with a custodian upon [the investment adviser’s] instruction to the custodian; and any capacity (such as general partner of a limited partnership, managing member of a limited liability company or comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives [the investment adviser] or [its] supervised persons legal ownership of or access to client funds or securities.”
Many investment advisers are under the false perception that automatic fee deduction is not considered custody; however, the investment adviser will be deemed to have custody if it has the ability to have fees or other expenses deducted directly from a client’s account by the account custodian and the fees are then paid directly to the investment adviser. Because most SEC registered investment advisers have the authority to deduct fees from the clients’ accounts, most SEC registered investment advisers are therefore deemed to have custody and must meet the requirements listed below under Rule 206(4)-2 of the Investment Advisers Act. It is important to note that SEC registered investment advisers that have the authority to deduct fees or other expenses directly from a client’s account are exempt from the surprise examination requirement (number 3 below), but the investment adviser must meet all other custody rule requirements.
1. “Qualified Custodian” Requirements: SEC registered investment advisers deemed to have custody must maintain client accounts with “Qualified Custodians.” The client funds or securities that are maintained by the registered investment adviser, including those funds and securities of a hedge fund, must be maintained by a qualified custodian, which includes most regulated banks, registered broker-dealers, and other financial institutions providing custodial services, for example. Funds and securities maintained by a qualified custodian must be in a separate account for each client under the client’s name and/or each fund must be in separate account under the fund’s name. Funds and securities may also be held in accounts under the name of the investment adviser as an agent or trustee for the clients if the accounts contain only the funds and securities of the investment adviser’s clients. Client assets cannot be commingled with proprietary and employee assets into one account.
2. Notice to Clients: If the investment adviser opens an account with a qualified custodian on behalf of the client, upon opening the account, the investment adviser must notify the client, in writing, of the qualified custodian’s name, address and how the funds or securities are maintained. This information must be provided to the client promptly upon opening the account and following any changes.
3. Independent Verification: The registered investment adviser that is deemed to have custody of client’s assets must utilize an independent public accountant* to verify the client funds and securities by way of surprise examination at least once each calendar year. The first surprise examination must occur within six months of the investment adviser having custody.
*Accountants must be public accountants that meet the standards of independence described in Rule 2-01(b) and (c) of SEC Regulation S-X.
4. Periodic Account Statements: Registered investment advisers with custody must form a reasonable belief, upon due inquiry, that the qualified custodian maintaining the accounts holding the client’s funds or securities sends accounts statements directly to each client. The account statement must be issued to each client at least quarterly showing the amount of funds and each security in the account at the end of the period must be identified and the statement must reflect all transactions that occurred in the account during the time period reflected. Qualified custodians may use third party services providers to deliver account statements. Additionally, clients can attain account statements through a website, but the investment adviser firm still needs to form a reasonable belief upon due inquiry that the client logs into the website to retrieve the statement.
5. Performance or Position Reports issued by Investment Advisers: If the investment adviser deemed to have custody also provides any sort of performance report, position report, or other form of account statement to supplement the official account statements generated by qualified custodians, the investment adviser must include a footer on the investment adviser’s generated report urging the client to compare the investment adviser’s generated reports against account statements received from the qualified custodian.
Most state registered investment advisers will also be deemed to have custody if the investment adviser has the ability to have fees deducted from the client’s account and paid directly to the investment adviser by the account custodian. However, state securities regulations for investment advisers having custody can vary from the SEC requirements previously stated. Some states still require state registered investment advisers to send a fee notification statement, prior to or at the same time that the fee will be deducted, to the client showing, at a minimum, the total fee and the manner in which the fee was calculated. If you are a state registered investment adviser, you should closely review the state securities regulations for investment advisers to make sure you understand how the state defines custody and to make sure you are in compliance with the state custody requirements.
To further discuss custody and the custody rule requirements for registered investment advisers, RIA Compliance Consultant’s is hosting a webinar, “Custody Implications for Investment Advisers,” on August 15, 2013, at 12:00 PM CDT. During this webinar our consultants will dissect the SEC’s definition of custody and analyze what triggers the additional requirements for investment adviser firms with custody. For more information or to register for this event, click here.
If your investment adviser would like to discuss how RIA Compliance Consultants can assist your firm in determining if you have custody or to explore how we may help ensure you are meeting the custody rule requirements, click here to schedule a time to speak to one of our senior compliance consultants concerning our services.
