Often, the difference between safety from a regulator and an enforcement action is knowing where the regulatory lines are drawn and what conduct constitutes an act that crosses those lines.
Among the murkiest areas of regulatory concern is Custody. It’s a topic that seems easy enough to grasp, yet it entangles so many due to the layers of nuance. To help make sense of the finer points of Custody, let us first consider what Custody is.
Custody is defined as the ability to hold “directly or indirectly client funds or securities or has any authority to obtain possession of them.” A short, straightforward definition. But what sorts of things will trigger this definition? What conduct crosses that line?
To help answer these questions, this month’s Risk Management Update will take you on a “Custody Cruise!” This journey will examine the various types of Custody as ports of call along the cruise. All aboard!
When you’re on the Custody Cruise, the key to pleasant visits to your ports of call is knowing how to keep yourself safe and compliant with their local customs and ordinances. This is important to help reduce your exposure to risks like pickpockets or a required Surprise Examination.
Holding Client Assets
Your first stop is to the ancient twin cities, Hold Client Assets and Inadvertent Receipt. These cities were first developed in the region and have a standing ordinance prohibiting you and/or your firm from holding client assets, even temporarily. A notable exception, however, involves you or your firm receiving client assets by mistake. In this case, the local authorities allow you three business days to return the assets to the client.
Standing Letters of Authorization (“SLOA”)
Your second stop is the exotic port city of SLOA—shorthand for Standing Letter of Authorization. Visiting this city entails a client granting you or your firm standing permission to disperse said client’s assets to an outside third party for purposes other than authorized trading, such as sending money to a charitable cause. SLOA has a very law and order focus, which is reflected in their ordinances:
- Client must provide written instruction to the qualified custodian that includes the client’s signature, the third party’s name, and either the third party’s address or the third party’s account number at a custodian to which the assets should be transferred.
- Client grants written authorization to investment adviser, either on the qualified custodian’s form or separately, to transfer assets to the third party either on a specified schedule or from time to time.
- Client’s qualified custodian must verify the instruction, such as a signature review or other method, to verify the client’s authorization, and furnish the client with a transfer of funds notice promptly after each transfer.
- Client must be able to terminate or change the instruction to the client’s qualified custodian.
- Investment adviser has no authority or ability to designate or change the identity of the third party, the address, or any other information about the third party contained in the client’s instruction.
- Investment adviser maintains records showing that the third party is unrelated to/unaffiliated with the investment adviser and not located at the same address as the investment adviser.
- Client’s qualified custodian sends a written initial “confirmation of instruction” notice to the client and an annual reconfirmation notice thereafter.
While visiting SLOA, you must declare your custody to the local customs officials using Item 9 of Form ADV Part 1. However, when following the aforementioned ordinances, a Surprise Examination is not required.
Direct Deduction of Fees
Your third port of call is the small, yet popular island outpost of Direct Deduction of Fees. A visit here includes deducting advisory fees directly from a client’s account. Please note that the locals here have permissive attitudes and custody for this reason and only this reason does not require a declaration of custody to local customs officials on Item 9 of Form ADV Part 1. As a result, no Surprise Exam is required, either.
Non-Holding Direction Ability/Authority
Your final port of call is to the modern and sophisticated city of Possession of Client Login Credentials. The local people are known for their technological savvy and nuanced thinking, which are reflected in the local ordinances. Visiting here involves possessing the login credentials for a client’s online account access, but only if the online account access has the capability to send client assets out of the account to an outside third party; if the online account access is “view only”, then it is not deemed to be a form of custody.
Custody in this type of situation is limited to the account(s) where the relevant access is possessed. You must declare custody to the local customs officials only for those accounts using Item 9 of Form ADV Part 1. Such accounts are subject to the Surprise Exam requirement.
Your journey will not be long, but it will be informative and relevant for years to come. And so thus relaxed and well versed in the customs and ordinances of the ports of call you visited during your voyage on the Custody Cruise, you will be in a position to tell all of your friends of the breathtaking scenic wonders you took in at these exotic locations.
While the requirements of the Custody Rule can be challenging and even a little murky at times, it certainly is not impossible to comply with them. Careful attention to the Rule’s requirements and associated governance over your firm’s business can be an effective mitigator of risk around the Rule. Core Compliance can assist you with your compliance program to help ensure that you’re not running afoul of the Custody Rule or any other significant regulatory requirements. If you have questions, reach out to us today at (619) 278-0020 or at info@corecls.com.
Author: Matthew Rothchild, Sr. Compliance Consultant; Editor: Maggie Tavares, Sr. Compliance Consultant, Core Compliance & Legal Services (“Core Compliance”). Core Compliance works extensively with investment advisers, broker-dealers, investment companies, and private fund managers on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon regarding any particular facts or circumstances without first consulting with a lawyer and/or tax professional.