Based on deficiency letters that we have seen over the past year and especially in the past few months, it appears that many advisers either didn’t believe that the SEC Staff was serious about looking closely at the adequate safekeeping of client assets, or didn’t understand that they had custody. In the National Exam Program Examination Priorities for 2014 (January 9, 2014), the SEC identified its concerns for fiscal year 2014. The first item under Investment Adviser/Investment Company Program was Safety of Assets and Custody. The SEC Staff stated:
“If the markets run on trust, then few things are more important than the safekeeping of clients’ assets. Yet, the NEP continues to observe non-compliance with Rule 206(4)-2 under the Advisers Act (‘Custody Rule’). In March, 2013, the NEP published a Risk Alert, sharing observations regarding the most common issues of non-compliance. Given the importance of this requirement for a fiduciary, the staff will continue to test compliance with the Custody Rule and confirm the existence of assets through a risk-based asset verification process. Examiners will pay particular attention to those instances where advisers fail to realize they have custody and therefore fail to comply with requirements of the Custody Rule.” (Emphasis added.)
The Custody Rule defines Custody as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” You have custody if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services you provide to clients. Per the Custody, Custody includes:
- (i) 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;
- (ii) Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and
- (iii) Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities.
In the National Exam Program Risk Alert – Significant Deficiencies Involving Adviser Custody and Safety of Client Assets (March 4, 2013), the SEC Examination Staff indicated that one of the problems was the “failure by advisers to recognize they have custody.” In its review, the Examination Staff observed the following situations where an adviser failed to recognize that it had custody under the rule:
- “The adviser’s personnel or a ‘related person’ serve as trustee or have been granted power of attorney for client accounts.” This may be mitigated by the client having a personal relationship with the adviser’s personnel or related person, prior to asking them to be a trustee.
- “The adviser provides bill-paying services for clients and, therefore, is authorized to withdraw funds or securities from the client’s account.” Fairly straight-forward here.
- “The adviser manages portfolios by directly accessing online accounts using clients’ personal usernames and passwords without restrictions and, therefore, has the ability to withdraw funds and securities from the clients’ accounts.” This may be mitigated by the client signing a letter of authorization for a specific disbursement with a copy from the client to the custodian.
- “The adviser serves as the general partner of a limited partnership or holds a comparable position for a different type of pooled investment vehicle.”
- “The adviser has physical possession of client assets, such as securities certificates.” Obviously custody.
- “The adviser or a related person has signatory and check writing authority for client accounts.” Also obviously custody.
- “The adviser received checks made out to clients and failed to return them promptly to the sender.” This may be allowed if checks cannot be returned to the sender, such as tax refunds or proceeds from class action lawsuits.
My personal favorite is an adviser having the ability to direct debit fees from a client account, and being allowed by the instructions on Form ADV Part 1 to indicate in response to Item 9A.(1) that it does not have custody. However, the instructions for Form ADV Part 2 do not allow the adviser the same freedom; custody must be disclosed in Form ADV Part 2A, Item 15. Likewise, being able to deny custody in Part 1 under these circumstances does not relieve you of the burden of having a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of your clients for which it maintains funds or securities. We have seen SEC Examiners, in some of the regions, accept that the receipt of a statement from the custodian marked as a “duplicate copy” is sufficient as due inquiry, and SEC Examiners in other regions that expect additional substantiation.
Just when we thought we understood most of these situations, the SEC came out with Custody Q&A, which in some cases does not simplify the questions, but makes them more complex. This next question is one we have seen addressed by the SEC in deficiency letters.
We have heard many authorities at conferences and webinars tell us that the adviser does not have custody if it transfers a client’s assets from one client account to another account of the same name at the written direction of the client. However, when we read the Q&A, we find out that the correct answer is that the SEC does not consider it custody if the client has authorized the adviser in writing to make such transfers and a copy of that authorization is provided to the qualified custodians, specifying the client accounts maintained with the same or other qualified custodians.
A question that I have been asked recently is whether an adviser who has the ID number and password for a client’s account to rebalance and adjust investments in the account, but has never done so, and has no intention to do so, would have custody? I’m afraid the answer is yes, access to a client’s assets gives you custody, whether you ever use it or not, because some other individual at the adviser may someday take advantage of that ability.
We have noticed that the SEC has been more aggressive lately than in the past, evidenced by the number of enforcement actions and dollar value of penalties. As the SEC has asserted in cases citing advisers for stating that the only deficiencies identified by the SEC examination staff were immaterial, there is no such thing as an immaterial SEC deficiency, although not all deficiencies will rise to the level of enforcement action.
National Exam Program Examination Priorities for 2014 (January 9, 2014) – http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf
National Exam Program Risk Alert – Significant Deficiencies Involving Adviser Custody and Safety of Client Assets (March 4, 2013) – http://www.sec.gov/about/offices/ocie/custody-risk-alert.pdf