In this CCO Buzz we examine “constructive” custody and custody trapsand discuss steps firms are required to take when deemed to have custody.
CCO Buzz: Hello and welcome back! We hope you got everything you wished for over the holidays because we’ve got a semi-late gift for you… episode 30 of the CCO Buzz.
Today we’re doing things a bit different and were just going to hit the ground running. This week’s episode is on custody and key considerations.
Custody for investment advisers remains a very hot topic for regulators. Typically, a firm may think they don’t have custody since they are not physically holding client assets. Because that’s the custodian’s job, right?
There are many ways advisers can fall into the custody trap, without ever touching client assets. It’s generally referred to as having “constructive” custody. In this CCO Buzz we’re going to examine a few and discuss steps firms are required to take when deemed to have custody.
The definition of custody under Rule 206(4)-2 of the Investment Advisers Act not only includes an adviser having possession of client assets, but also their authority to withdraw assets from a client’s account. This authority can be transmitted in a plethora of ways, including through written agreements, standing transfer letters with custodians, and having client passwords to obtain access to online accounts.
The most important thing to remember here is that you could be deemed with custody in each of these situations regardless of whether or not you act on the authority you possess. The mere fact that you have the authority is what constitutes the determination. The good news is that certain facts and circumstances could help negate having custody. For example, if the client login credentials you have don’t provide the ability to withdraw or transfer assets, then you probably would not be considered to have custody.
In addition, the SEC recently updated their FAQs on the application of the Custody Rule to clarify that if a firm is given authorization to withdraw or transfer client account assets in a custodian agreement, but does not have a copy of the agreement and the firm has no knowledge (or reason to have knowledge) of the authority, then the adviser would not be deemed with custody.
There are other ways an adviser could have constructive custody, including but not limited to serving as trustee or executor to a client’s account or accepting and forwarding checks or securities to the custodian.
In this area an adviser can take a check from a client and forward to the custodian, so long as it is a check drawn on the client’s bank account. The SEC also provided limited no action relief for receipt of checks and securities in certain circumstances, which also is outlined in the SEC’s FAQs.
Check writing or bill paying authority or having an affiliate that has such authority also means custody, in addition to having written power of attorney to enter into agreements to invest in private funds on behalf of clients.
The most common form of custody is when a firm has authority to debit their advisory fees.
Having custody is not prohibited, it just means you have to follow certain protocols outlined in the Custody Rule. These include:
- All [client] managed assets must be maintained with a qualified custodian.
- The firm has to take reasonable steps to confirm that clients are receiving statements directly from the custodian. This can accomplished by receiving certification letters from custodians stating they’ve sent statements to clients and also periodically confirming with clients they have received statements.
- Depending on the type of custody, a firm must also obtain annual surprise audits. Notably, this is not required if the only reason you have custody is due to the authority to debit fees from clients’ accounts.
Chief Compliance Officers are generally tasked with the responsibility of monitoring their firm’s adherence to the Custody rule and can ensure compliance by performing testing and reviews each year as part of the firm’s required annual review. Having written policies and procedures that require approval prior to the firm accepting any role that would constitute custody is a good internal control.
Training employees on the rule requirements and firm policy also goes a long way to helping ensure compliance. If your firm has custody that requires an annual surprise audit, be sure to calendar that in the Form ADV-E reflecting completion of the audit as has to be filed annually.
If you need help identifying whether or not your firm has custody or have questions on adhering to the rule and implementing strong procedures and controls, give us a call at 619-278-0020. We wish you all a very merry holiday season and happy new year!
Well that’s it for this week’s episode. If you’d like additional information, please check out our website at www.corecls.com. You can also follow us on Facebook, LinkedIn or Twitter @CoreCLS. Thank you and we hope you tune into next week’s episode of the CCO Buzz.