Understand what 'custody' means to the SEC—and to you.
By Eric Clarke
By its nature, the Securities and Exchange Commission wants to protect investors. When it comes to registered investment advisers having possession of a client's assets, the SEC's concern is that such possession—temporary or otherwise—puts assets at risk of misuse or loss.
To protect investors, the SEC adopted in September 2003 amendments to the Investment Advisers Act of 1940 regarding custody. It broadly defines "custody" as "brief possession," "distribution access," and "legally own." In a nutshell:
Brief possession. The advisor has possession of client funds or securities, however briefly. If you inadvertently receive funds or securities, you can avoid custody issues as long as you return the assets to the sender within three business days of receipt. Note that you cannot forward clients' funds without having custody. One exception: you may possess a client check made payable to a third party, such as a mutual fund, without possessing the actual funds.
Distribution access. The advisor has authority to withdraw funds or securities from a client's account. Examples include if you have power of attorney to sign checks on the client's behalf, withdraw funds or securities directly from an account, or dispose of client funds or securities for any purpose other than authorized trading. Most commonly, advisors authorized to deduct expenses such as advisory fees directly from an account have access to, and by extension, custody of, its assets. While you may not actually possess a client's assets in such a scenario, your authority to obtain possession means that you ultimately have custody.
Legally own. An advisor acts in a capacity that gives legal ownership of, or access to, the client's funds or securities. For example, if your firm acts as both a general partner and investment advisor to a limited partnership, you have access to the partnership's account and therefore custody of the assets.
The result: Nearly all RIAs can be determined to have custody of client assets. And that means you have a significant decision to make: Do you maintain client assets at a qualified custodian or subject yourself to an audit process unique to the SEC custody rule? Let's examine the pros and cons.
Option A: Without a 'Qualified Custodian'
If you retain custody of a client's assets without the use of a qualified custodian, you must report quarterly to your client all holdings and transactions You must also undergo a newly established annual audit process designed to verify account holdings and values reported, as well as the legitimacy of any transactions.
An independent public accountant must perform the yearly audit, required as an unscheduled visit. Unlike a typical statistical sampling audit, the CPA must review and substantiate every client security or fund not included on statements from a qualified custodian, including confirmation of all cash and physical securities on the premises. In addition to disrupting the RIA's business with a surprise audit, guidance issued by the SEC provides that the audit must include contacting and receiving confirmation from each of the firm's clients, asking them to verify account values and transactions associated with trading or fees. Upon completion, the auditing CPA must file a certificate on ADV-E within 30 days explaining the nature and results of the examination. Any discrepancy must be reported to the SEC within one business day via fax or e-mail.
Understandably, you may prefer to avoid such an extensive audit and unexpected disruption to your business, especially when it involves contacting and requesting confirmations from all of your clients. But you can avoid these troubles by designating a qualified custodian.
Option B: With a 'Qualified Custodian'
Approved custodians include a bank or savings association with deposits insured by the FDIC, a registered broker/dealer, a registered futures commission merchant, or a foreign financial institution holding client assets. The SEC has provided additional guidance in the form of a no-action letter stating that, under certain circumstances, the SEC would not take action against a registered investment adviser that is authorized to withdraw its fees from a client's variable annuity contract even though the insurance company maintaining the variable annuity separate account was not a qualified custodian.
Qualified custodians must deliver account statements directly to clients—not through advisors—on at least a quarterly basis. Clients can select independent third-party representatives to receive statements, but be careful: the recipient is obligated by law or contract to act in the client's best interest and can neither be affiliated with the advisor nor have had a material relationship with the advisor for the past two years. The qualified custodian's account statement must include account positions, values, and all transactions within the statement period. Note that some statements, particularly those from insurance companies and banks, may include positions but not transaction details and so would fail to meet this rule's requirements. So you can see, it isn't simply a matter of finding a custody proxy for you. You must ensure the custodian follows the rule's requirements.
Benefits to You
The adoption of the 2003 rule led to the withdrawal of the John B. Kennedy and Securities America Advisers, Inc. SEC Staff No-Action Letters regarding advisory fee notices. Because qualified custodians will provide transactional details—including fee transactions—in quarterly client statements, you may no longer be required to send fee notices. One caveat: many RIAs include a line item in their investment advisory agreement stipulating that clients would be notified as to how fees were calculated in advance of advisory fee deduction. In this case, simply alter your investment advisory agreement to remove this statement before ceasing delivery of fee notices.
Another significant benefit: simplified paperwork. You may no longer be required to provide clients with an audited balance statement as part of the ADV disclosure. Moreover, you may no longer have to disclose internal financials to clients and prospects. One exception: advisors who charge prepayment of fees exceeding $500 and six or more months in advance must continue providing balance sheets.
The text of the updated custody rule is complex, and its correct application may vary from advisor to advisor. Consult a compliance professional before adopting significant changes to your firm's business practices, as a violation of the new qualified custodian rule could lead to administrative proceedings and possible sanctions, including monetary fines, issued by the SEC.
- All RIAs can be found to have custody of client assets.
- Advisors with custody can maintain assets with a qualified custodian or endure a rigorous annual audit.
- Verify that the qualified custodian sends quarterly statements including account positions, values, and fee transactions.
- Advance fee notices are no longer required—review your client agreements.
- You no longer need to provide audited balance sheets to clients. Consult a compliance professional for more information.
Eric Clarke is president of Orion Advisor Services LLC in Omaha, Nebraska. He has served as the firm's president since 2003 and manages operations, IT and business strategy.