Do You Have Custody AND Are You Compliant? Part I
Main Contributor: Elizabeth Cope, CPA, CSCP, CIPM, CEO & Lead Consultant
Background
The SEC designed the custody rule to protect advisory clients from the misuse and misappropriation of funds. As an advisor, you or a related person have custody if you hold (directly or indirectly) client funds or securities or if you have the ability to obtain possession of those assets. Sounds simple…well, hang on, because I am going to unpack that for you over this two-part article series. Over the years, we have seen advisors not only receive deficiencies during an exam, but we have also seen them sent to enforcement for items such as:
Not delivering the financial statements of a private fund to investors within the required time frame.
Not updating the ADV promptly after the financial statements were delivered to private fund investors.
Not indicating on the ADV when they actually have custody.
Not obtaining a surprise custody exam from an auditor when they indicate they have custody (and, in some cases, the auditor didn’t conduct the exam as a surprise).
Many advisors are surprised to hear that they are deemed to have custody and with the SEC putting a heightened focus on custody (including pending re-write of the existing rules), issuing several enforcement cases just this year, it’s of the utmost importance for you to spend some time reading through the requirements to ensure your firm is properly positioned.
Three Categories of Custody
Within Rule 206(4)-2 of the Advisors Act the SEC provides us with three categories of situations in which an advisor or its related persons are considered to have custody.
Possession: Possession of client funds or securities. This does not include checks drawn by clients and made payable to third parties. This does not include funds received inadvertently, as long as you return them to the sender promptly (i.e., within three (3) business days of receiving them).
Authorization: Any arrangement under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian. Types of arrangements include a general power of attorney.
Capacity: Any capacity that gives you or your supervised person legal ownership of or access to client funds or securities. This could be in the form of a general partner of a limited partnership, a managing member of a limited liability company, a comparable position for another type of pooled investment vehicle, or a trustee of a trust.
Related Party
A related party includes:
Any person (individual or institution) that is under control or common control with you.
This includes officers, partners, or directors exercising executive responsibility.
This includes a trustee.
Any person with 25% ownership, 25% voting rights, or 25% rights upon dissolution is presumed to have control.
Example of How a Related Party Applies to Custody
An Adviser and accounting firm are under common control, and the accounting firm offers bill pay services (e.g., check writing) for the Adviser’s advisory clients – the Advisor is deemed to have custody of those advisory clients.
Examples and Application of the Requirements
The custody rule is confusing. Even after 20 years in the industry, I find myself scratching my head. Instead of regurgitating the requirements, I am going to take a different approach by providing examples of when you would be deemed to have custody and then follow that particular example with the specific requirements. I also provided examples of when you would not be considered to have custody and the requirements in that case.
Direct Debit of Fees
If you have the authority for the custodian to pull the management fee directly from the client’s accounts with your instruction, you WILL be deemed to have custody.
What’s required?
All client assets must be held at an independent qualified custodian.
The custodian must be sending statements directly to the client or an independent representative of the client on at least a quarterly basis.
You must have a reasonable assurance that the custodian is sending those statements.
You must update ADV Part 1 Item 9.F, with the total number of custodians for which you have this authority (plus for any other accounts you have custody for).
Disclose in ADV Part 2A Item 5 this practice of direct debiting fees and whether clients have the option to have fees invoiced directly.
Receipt/Disbursement of Checks - Custody
Examples of when you WILL be deemed to have custody:
If you receive checks written out to clients from third parties and deposit those checks.
If you provide bill-pay services for clients, providing you power of attorney to pay third parties on behalf of the client.
What’s required?
Must obtain a surprise custody examination annually by an independent accountant (they do not have to be subject to the oversight and examination of).
Receipt/Disbursement of Checks – Not Custody
Examples of when you WILL NOT have custody:
Checks in your possession that are written out by the client and made payable to a third party.
Checks in your possession written out to the client by a third party, if received inadvertently, AND you do the following:
Return to the third party within 3 business days of receipt.
Either forward to the client or return to the third party within 5 days of receipt, if checks are received for the following reasons:
Tax refunds, Class action settlements, Dividends.
Keep a log that includes, at a minimum:
Date of receipt, Client name, name of the third party, and date either forwarded or returned.
Have written policies and procedures defining your process for when checks are received.
Make an effort to inform the third party about not sending these types of checks to your firm.
Stock Certificates - Custody
Businesses are no longer required to issue stock certificates, however, there may be instances where you come into the possession of one, as the investor can still request them or have one from a while ago. If you have possession of a client’s stock certificate you WILL be deemed to have custody.
What’s required?
Must obtain a surprise custody examination annually by an independent accountant (they do not have to be subject to the oversight and examination of PCAOB).
Have written policies and procedures in place to mitigate the risks of having access to client funds.
Disclose in ADV Part 1, Item 9 that you have custody by addressing the relevant questions.
Disclose in ADV Part 2A, Item 15 how you have custody and the controls in place.
Comply with books and records requirements (identified in our second article)
Stock Certificates – NOT Custody
You WILL NOT have custody of a stock certificate if you inadvertently receive it, and you do the following:
Either forward to the client or return to the third party within 5 business days of receipt.
Keep a log that includes, at a minimum:
Date of receipt, Client name, name of the third party, and date either forwarded or returned.
Have written policies and procedures defining your process for when stock certificates are received.
Conclusion
This article is just the tip of the custody iceberg. Next month, we will cover more complex examples and application tips so keep an eye out. As always, if any of the content in this article raises bigger questions for your firm and its practices, feel free to reach out.