The SEC has found that Registered Investment Advisers (“RIAs”) may not realize they have custody. Custody” is defined as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” When an RIA takes custody of a client’s funds or securities, the risk to that person increases dramatically. The Custody Rule, found in Rule 206(4)-2 under the Investment Advisers Act, was passed primarily to protect clients from unscrupulous investment advisers. Nonetheless, well-intentioned investment advisers may not realize that their actions may trigger the application of the Custody Rule. As such, we have listed several scenarios that trigger custody below.
For example, holding a power of attorney for a client or serving as a trustee, will cause the firm to have custody. If so, the RIA will be required to comply with the requirements set forth in the Custody Rule.
An RIA may inadvertently have custody if a client sends the firm funds or stock certificates instead sending them directly to the broker-dealer. The RIA must return the funds or stock certificates promptly (i.e., within three business days after receipt), or the firm will be viewed as having custody. When an RIA holds clients’ funds or stock certificates, even for a short period, there is a risk that funds or stock certificates will be lost or misused. An RIA should never forward client funds or stock certificates directly to the broker-dealer, since this will also be viewed as having custody.
An RIA may temporarily hold and forward a check drawn by a client and made payable to a third party (e.g., a broker-dealer, trust company, or insurance company, etc.) without having custody of the individual’s funds. Nevertheless, policies and procedures should clarify how those checks will be handled.
On some occasions, it is unclear if an RIA has custody over clients’ assets. RIAs often are granted the authority to move money between like-titled or same-registered accounts. This authority, according to the September 2016 IAA Newsletter, enables the RIA to move cash or pay bills for the client. An SEC answer to frequently asked questions about the Custody Rule states that the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) does not treat the authority to transfer a client’s assets between the client’s accounts maintained at one or more custodians as having custody. This answer presumes that the client authorized the RIA in writing to make the transfers, and a copy of the authorization is provided to qualified custodians. The IAA asked for clarification, because some examiners have criticized RIAs for not acknowledging custody on Form ADV if these like-titled or same-registered accounts were not identified specifically. The SEC has not issued a response to the IAA’s question yet.
Sometimes going the extra mile for a client can inadvertently trigger custody. Suppose a client of an RIA moves and gives the adviser a power of attorney to sign documents at the closing. The RIA could be viewed as having custody over the client’s assets.
An RIA that has the power of attorney to sign checks on a client’s behalf or withdraw funds is deemed to having custody over that person’s assets. Therefore, unless an RIA is prepared to comply with the Custody Rule, an RIA should not offer a bill-paying service to clients. In addition, an RIA may be deemed to have custody if it keeps a client’s debit or credit card numbers on file.
An RIA that is authorized to withdraw funds or securities from a client’s account has custody. The SEC has recognized that the ability to deduct fees is only a limited form of custody and does not present the same degree of opportunity for fraud and misappropriation. The SEC expects advisory firms to implement controls and procedures to ensure that every fee deduction is proper. The firm’s compliance manual might require a sign-off process to making certain that fees are consistent with the client’s advisory contract.
Some states require state-registered investment advisers to send concurrent fee notices to their clients. Compliance with this requirement is especially critical for state registered RIAs based in Florida because failure to comply will result in significant fines. A state-registered adviser’s failure to send concurrent fee notices to clients means the RIA is deemed to have custody, which triggers higher net capital requirements and other compliance obligations. SEC-registered advisers are not subject to this invoicing requirement.
State-registered RIAs may wish to comply with the SEC’s Custody Rule, even if compliance is not required by securities regulators in their jurisdiction. As an example, the Texas State Securities Board has recommended that RIAs comply with the federal Custody Rule as a best practice.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Boca Raton, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.
RIA Compliance Group, LLC – 5301 North Federal Highway, Suite 380, Boca Raton, FL 33487 – Tel: 561-600-0564 – sales@ria-compliance.com.
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