Rule 206(4)-2 of the Investment Advisers Act of 1940, known as the Custody Rule, can be extremely complex to apply. The Custody Rule was first adopted in 1962, and the current version follows amendments made by the SEC in 2009 as a response to Bernie Madoff’s Ponzi scheme. The Custody Rule requires four primary controls of investment advisers that have custody of client funds:
- Client assets must generally be maintained with a qualified custodian. If the qualified custodian is a related person, an internal control report is also required.
- Clients must be notified who the qualified custodian is, as well as when any changes are made to the custodial relationship.
- Qualified custodians should send account statements directly to clients at least quarterly and advisers must have a reasonable belief that the qualified custodians are doing so.
- Advisers must generally have an annual surprise examination by an independent public accountant.
For further background on the Custody Rule, the adopting release containing the latest amendments can be found here. The SEC has also posted several frequently asked questions, known as the Staff Responses, here.
Common Custody Rule Pitfalls
At times, an in-depth evaluation of individual circumstances may be required to determine whether an adviser has custody and should be subject to the requirements of the Custody Rule and an annual surprise examination. Based on years of performing such surprise examinations, our team has identified three common Custody Rule pitfalls. The SEC also identified some of these pitfalls as significant deficiencies in this 2013 risk alert as well as in this 2017 risk alert. We continue to see them today.
Pitfall #1: Client Checks
Rule 206(4)-2(d)(2)(i) specifically indicates that custody includes, “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.”
Based on that language, an adviser that has a client check or other assets in its possession, even momentarily, has custody. While Question II.1 of the Staff Responses indicate limited circumstances – such as receipt and forwarding of tax refunds from taxing authorities – do not constitute custody, as noted, the only way an adviser can normally alleviate itself of the requirements of having custody would be to return the client check to the sender within three business days of receipt. Thus, an adviser should have policies and procedures in place to address such situations.
We’ve often heard the argument from advisers that the purpose of the Custody Rule is to safeguard client assets and, therefore, routing a check back to the sender likely puts it in more danger of being lost than just forwarding it to the custodian on the client’s behalf. Such an argument may make a great point, but unfortunately the Custody Rule does not permit an adviser to forward client checks to the custodian. An adviser’s only option is to log the receipt of the check and promptly return the client check to the sender.
This type of situation could be a double whammy for an adviser. If it fails to return the client check, not only would that adviser have custody and be subject to all the other requirements of the Custody Rule, but it would likely also fail the requirement that client assets be maintained with a qualified custodian. That is unless the adviser is a qualified custodian.
Pitfall #2: Pooled Investment Vehicle Financial Statements
As noted above, the Custody Rule requires four primary controls of investment advisers that have custody of client funds. Advisers to pooled investment vehicles (e.g., hedge funds, private equity funds, etc.) generally have custody of the pooled investment vehicles they offer due to their role, or an affiliate’s role, as general partner. With that said, an adviser may be permitted to self-custody such assets rather than maintain them with a qualified custodian and would be exempt from the notice, account statement, and surprise examination requirements if the adviser relies on and complies with the audit exemption contained in Rules 206(4)-2(b)(2)(ii) and 206(4)-2(b)(4).
The most common pitfall we have come across when an adviser attempts to comply with the audit exemption is that it has not prepared the financial statements of the pooled investment vehicle in accordance with accounting principles generally accepted in the United States (U.S. GAAP). More specifically, advisers cannot comply with these provisions of the Custody Rule by providing financial statements prepared on the tax basis of accounting.
Additionally, advisers cannot apply U.S. GAAP on a selective basis. For instance, if U.S. GAAP requires all investments to be maintained at fair value, an adviser cannot value only those that are easy to value while leaving those that are more difficult, at cost.
Pitfall #3: Employees or Related Persons
Rule 206(4)-2(d)(7) defines a related person as “any person, directly or indirectly, controlling or controlled by you, and any person that is under common control with you.” Based on that description, an adviser is responsible for the actions of its employees and/or affiliated entities (e.g., any wholly owned subsidiary, etc.).
Taking that one step further, an adviser is responsible for the actions – at least as it relates to the Custody Rule – of employees of affiliated entities. Ultimately, an adviser is deemed to have custody and thus subject to the requirements of the Custody Rule if its employees or affiliated entities are deemed to have custody.
The most common pitfall we have come across is an adviser’s failure to identify that one of its employees serves as trustee to a firm client. This is the exact subject of Question II.2 of the Staff Responses. The SEC’s response is that, “The role of the supervised person as trustee is imputed to the advisory firm, thus causing the firm to have custody.” Consequently, an adviser should have policies and procedures in place that require all employees to identify any current or potential new situations where it is asked to serve as trustee. These policies should be in place prior to an employee officially agreeing to take on such a role.
Honorable Mentions
The following topics have also tripped up advisers when it comes to the Custody Rule:
- Bill-paying services: Due to this added service, an adviser can withdraw funds or securities and would thus be deemed to have custody.
- Online access: If an adviser has access to a client’s online account, including knowing the client’s username and password, and such access is not read-only, the adviser is deemed to have custody because of its ability to withdraw funds or securities.
- Inadvertent custody through custodial agreement language: An adviser’s investment management agreement does not overwrite language in a custodial agreement that provides the adviser access to client funds, even if the investment management agreement indicates the adviser will not take custody.
- SLOAs (Standing Letters of Authorization): While the SEC has issued a no-action letter for an adviser to avoid a surprise examination as long as it complies with certain criteria, advisers nevertheless have custody and must comply with all other aspects of the Custody Rule.
- Books and records to be maintained by investment advisers: Although not specifically under the Custody Rule, advisers that have custody or possession of funds and securities must also maintain certain documentation in accordance with Rule 204-2(b) (the Recordkeeping Rule). A qualified custodian’s maintenance of books and records for an adviser’s custody accounts, including trade confirmations, does not relieve the adviser from its requirement to maintain these records under the Recordkeeping Rule. Advisers should understand the retention policies of these records at custodians, especially if the adviser is not maintaining physical copies. This understanding should include the adviser’s ability to access the records in the event it is no longer the adviser or the custodian relationship has terminated.
If any of the above pitfalls impact your firm or you have another topic that might be subject to the intricacies of the Custody Rule, we’d be happy to have a conversation.
For more information, contact Craig Evans, Director, Audit & Accounting at cevans@kmco.com or Eric Sakelaridos, Director, Audit & Accounting at esakelaridos@kmco.com.
