• SEC registered advisers must continue to indicate if the firm has custody at Items 9.A.(1) and (b), but may now mark “No” if “a related person maintains client funds or securities as a qualified custodian but [the adviser has] overcome the presumption that [it is] not operationally independent (pursuant to Advisers Act rule 206(4)(2)-(d)(5)) from the related person.”
• Addition of Item 9.A.(2) to report the total dollar amount of client funds and securities as well as the total number of clients for which the adviser has custody.
• Addition of Item 9.B.(2) to report the total dollar amount of client funds and securities as well as the total number of clients for which the adviser’s related persons have custody.
• Addition of Item 9.C. for advisers to indicate whether a qualified custodian sends quarterly account statements and whether an independent public accountant conducts an annual audit, an annual surprise examination, or prepares an internal control report.  If the answer is in the affirmative with respect to any of the independent public accountant questions, the adviser is required to complete Section 9.C of Schedule D for each independent public accountant that fulfills those functions.
• Addition of Item 9.D. to report whether the adviser or related persons of the adviser act as a qualified custodian for adviser’s clients.  If the adviser has a related person that acts as a qualified custodian, the adviser must fill out Section 9.D of Schedule D for each related person that acts as a qualified custodian for the adviser’s clients.
• Addition of Item 9.E. to list the date of any surprise examinations conducted by an independent public accountant during the adviser’s previous fiscal year.

The SEC has modified Item 7.A.(1) so that now all related persons that are investment advisers, broker dealers, municipal securities dealers, or government securities broker or dealers mustbe listed on Section 7.A. of Schedule D.  The SEC commented that these changes will provide investors with additional safeguards and will provide “better information about the custodial practices of investment advisors.” 

Also, the CRD/IARD Software Release 2010.4 included an announcement that the increased disclosure period from two to ten years on FINRA BrokerCheck and on IAPD (Investment Adviser Public Disclosure) became effective November 6.  This means the general public will be able to view information for 10 years following the individual or firm’s departure from the industry.

Finally, accounting firms hired by investment advisers to conduct surprise verification examinations, in accordance with the custody rule, must now submit Form ADV-E and the accompanying accountant’s examination certificate online through IARD.  A Form ADV-E must also be submitted by the accounting firm within four days of its resignation or dismissal from, or other termination of, the engagement with the investment adviser, or removing itself or being removed from consideration from reappointment, Investment adviser firms will receive notification via email when an accountant submits a surprise examination report via Form ADV-E.

Question II.5
Q: Does an adviser have custody if it has authority to instruct the qualified custodian that maintains a client’s account to remit the funds or securities from the account to the same client at his or her address of records?
A: We do not interpret the authority to instruct the qualified custodian maintaining a client’s account to remit the funds or securities from the account to the same client at his or her address of record as having custody if (1) the client has granted such authority to the adviser in writing and a copy of that authorization is provided to the qualified custodian, and (2) the adviser has neither the authority to open an account on behalf of the client nor the authority to designate or change the client’s address of record with the qualified custodian. (Posted May 20, 2010).

Question II.6
Q: If an adviser has the ID number and password to a client’s pension fund account to rebalance and adjust investments in the account, does the adviser have custody?
A: The adviser has custody if password access provides the adviser with the ability to withdraw funds or securities or transfer them to an account not in the client’s name at a qualified custodian. (Posted May 20, 2010).

Starr, who is not the Kenneth Starr who served as the prosecutor in the Whitewater investigation, allegedly used his registered investment advisor firm, Starr & Company, LLC, to conduct the fraud.  Through the investment advisor firm, Starr presented himself as an accountant and investment adviser representative to obtain management and control of over millions of dollars of client finds.  In some instances, Starr assumed total control over his clients’ funds by collecting their earnings, paying their bills, and then investing their savings.

Starr allegedly transferred client funds to a trust account to make it appear as if the funds were being directed to investments.  However, those funds were actually diverted to risky investments in which Starr had a financial interest or Starr would use the funds for his personal expenses, including the purchase of a condo on Upper East Side of New York City, for $7.5 million.  When Starr’s clients made demands for payments, he would transfer funds from one client to another client.  This behavior caused the Government to label Starr’s activity as “characteristic of a ‘Ponzi’ scheme.”  If convicted, Starr faces up to 45 years in a federal prison.

This alleged Ponzi scheme involving a high profile registered investment advisor will undoubtedly increase regulatory scrutiny of other registered investment advisor’s custody practices and should serve as reminder to registered investment advisers of the need to address fully the requirements of the SEC’s new custody rule.

Our webinar, Impact of New Custody Rule on an RIA Operating a B-D, Qualified Custodian or Private Investment Fund, recorded on March 25, 2010, is a must for investment advisers using affiliated qualified custodians and affiliated introducing broker/dealers. Jarrod James and Tammy Emsick discuss custody rule guidance issued in March 2010 by the staff of the SEC’s Division of Investment Management. Our presenters give SEC registered investment advisers with introducing broker-dealers specific examples of how to avoid being deemed by the SEC as having custody under the new rule. Finally, specific attention is given to requirements affecting investment advisers that own or operate pooled investment vehicles such as hedge funds, private real estate deals and other private placement securities.

Take this opportunity to understand the implications of the SEC’s new custody rule as relates to the activities of your affiliated introducing broker-dealer, qualified custodian and pooled investment vehicle. You can purchase your seat to this recorded webinar by clicking here.

As a result, RIA Compliance Consultants is encouraging SEC registered investment advisers to listen to the recording of our February 25, 2010 webinar, Exploring the SEC’s New Custody Rule . During this webinar Jarrod James and Bryan Hill of RIA Compliance Consultants explore common investment adviser practices that result in custody as defined by the SEC and answer questions about the new custody rule’s impact on investment advisers. Focus is given to the deduction of advisory fees, acceptance of third-party checks from clients, trustee relationships, withdrawal authorization from client accounts and other common custody situations.

All federally registered investment adviser firms are encouraged to listen to this important webinar to better understand the SEC new custody rule’s impact on their operations. Click here to purchase your seat to this recording.

According to SEC Rule 206(4)-2 under the Investment Advisers Act of 1940, “custody includes 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.”

Even though the SEC has excluded the practice of accepting and forwarding third-party checks from the definition of custody, investment advisers must implement and memorialize sufficient compliance procedures designed to ensure third-party checks are delivered to the qualified custodian. A classic example of this situation is when a client wants to make a deposit to the client’s brokerage account. The client prepares a check payable to the qualified custodian holding the account. The client will deliver the check to the investment adviser who will then forward the check to the qualified custodian. While this procedure is not deemed to be custody by the investment adviser there is still risk of losing the check or not delivering the check on time so it is important to implement sufficient procedures and controls. Such procedures could include proper oversight, use of check receipt logs and follow- up to memorialize delivery of the check to the qualified custodian. It must be understood that an investment adviser would have custody of client funds if it holds a check drawn by the client and made payable to the investment adviser with instructions to pass the funds through to a custodian or to a third party. Unless the investment adviser is a qualified custodian, this must never be allowed.

While the receipt of checks drawn by clients and made payable to third parties is not considered custody for purposes of Rule 206(4)-2, the acceptance of securities (i.e. stock certificates) is considered custody even when the stock power is endorsed to the qualified custodian. Recently, RIA Compliance Consultants has seen this issue raised during SEC examinations. During these recent examinations, the SEC has stated an investment adviser that accepts securities is in violation of the custody rule’s requirement that all securities be maintained at a qualified custodian. The SEC’s position is that when securities are held by the investment adviser, even for a very brief time period, the investment adviser has violated the custody rule if the investment adviser is not a qualified custodian. Therefore, investment advisers that are not also qualified custodians need to make sure they don’t accept client securities. To the extent an investment adviser receives client securities inadvertently; the investment adviser needs to return the securities to the client within 3 days. It is acceptable for an investment adviser to meet with clients to prepare or compile documents, including stock certificates, for forwarding to the qualified custodian. However, the client must be responsible for delivering such documents to the qualified custodian.

Many investment adviser employees are also registered representatives of a broker/dealer. Often it is asked if the custody rule permits these employees to forward securities. The SEC has provided the following guidance, “[y]es, so long as (1) the employees are acting within the scope of their employment with the affiliated broker-dealer, and (2) the affiliated broker-dealer is a qualified custodian , has opened accounts for these clients, and sends them account statements at least quarterly. Under these circumstances, the employees would be acting in their capacity as registered representatives of the broker-dealer when they accept the securities.” (See Staff Responses to Questions About Amended Custody Rule – http://www.sec.gov/divisions/investment/custody_faq.htm ). It should be noted that often the employee is a registered representative of an introducing broker/dealer and not the clearing broker/dealer (i.e. qualified custodian).

You can learn more about the SEC’s custody rule, recent changes to the rule, and best practices designed to avoid custody, by purchasing our webinar recorded on February 25, 2010.

Investment advisers that operate pooled investment vehicles are required to: use a qualified custodian (e.g. a registered broker/dealer or registered bank) to hold assets of the pooled investment vehicle; form a reasonable belief that the qualified custodian delivers account statements to all investors; and comply with the annual surprise verification examination. Many pooled investment vehicles own or hold assets, such as real estate, not held at a qualified custodian. Therefore, complying with the qualified custodian, account statements and surprise verification examination requirements will prove impossible. For this reason, the SEC has provided relief to these requirements so long as the pooled investment vehicle is subject to an annual financial statement audit performed by an independent accounting firm; the audit is performed within 120 days after the pooled investment vehicle’s fiscal year-end; and the results of the audit are delivered to all investors of the pooled investment vehicle.

Many pooled investment vehicles are already subject to annual financial statement audits and deliver the results to investors so the new rule will have little impact in this regard. However, the new rule requires pooled investment vehicles to hire and retain independent accounting firms that are registered with and inspected by the Public Company Accounting Oversight Board (PCAOB). Pooled investment vehicles that are not subject to an annual financial statement audit performed by a PCAOB registered and inspected accounting firm and/or do not deliver the results of such an audit to investors, must ensure assets are held with a qualified custodian, all investors receive statements directly from the qualified custodian(s), and ensure compliance with the annual surprise examination requirements.

This Thursday, March 25, we will be hosting our second webinar on the new SEC custody rule. The webinar will begin at 12:00 p.m. Central and will focus specifically on how the rule applies to pooled invest vehicles and investment advisers operating a qualified custodian and/or introducing broker-dealer. We discuss the annual audit requirements and many other pressing issues for pooled investment vehicles. Click here to enroll.

Earlier this month, new requirements under SEC Rule 206(4)-2 of the Investment Advisers Act of 1940 went into effect. The most stringent (and expensive) of these requirements is the new internal control report rule. Investment advisers or their related persons that serve as qualified custodian for investment advisory client funds or securities must annually obtain, or receive from its related person, a written internal control report. The internal control report must include an opinion with respect to the investment adviser’s or the related person’s controls relating to custody of client assets. The internal control report must be issued by an independent public accountant who is registered with and subject to regular inspection by the Public Company Accounting Oversight Board (PCAOB). The investment adviser must maintain the internal control report in its records and make the report available to the SEC staff upon request. The independent public accountant preparing the internal control report must verify that the client funds and securities are reconciled to a custodian other than the adviser or its related person.

Operationally Independent

In addition to the internal control reports, investment advisers with custody of client funds and securities must attain an annual surprise examination verifying the location of client funds and securities. When an investment adviser uses a related person qualified custodian, the investment adviser can avoid the surprise verification examination if it can prove the investment adviser is operationally independent from the related person qualified custodian. However, proving operationally independent may prove difficult. According to the new SEC rule, a related person that holds or has authority to obtain possession of advisory client assets is presumed not to be operationally independent of the investment adviser unless the following conditions are met and no other circumstances can reasonably be expected to compromise the operational independence of the related person: (i) client assets in the custody of the related person are not subject to claims of the adviser’s creditors; (ii) advisory personnel do not have custody or possession of, or direct or indirect access to client assets of which the related person has custody, or the power to control the disposition of such client assets to third parties for the benefit of the adviser or its related persons, or otherwise have the opportunity to misappropriate such client assets; (iii) advisory personnel and personnel of the related person who have access to advisory client assets are not under common supervision; and (iv) advisory personnel do not hold any position with the related person or share premises with the related person. The SEC has specifically commented that it would not consider a related person that shares management persons with the investment adviser, including an owner that was actively involved in the management of the two firms, to be operationally independent.

Introducing Broker/Dealer

In light of the new SEC rule, many investment advisers are analyzing the new requirement’s impact in their operations as a dually registered introducing broker/dealer or their related person introducing broker/dealer. Based on our understanding of the procedures and functions performed by introducing broker/dealers, most introducing broker/dealers have custody of advisory client assets and securities thus they are subject to the surprise verification examination. In addition, introducing broker/dealers must analyze their operations to determine if they perform functions requiring an internal control report. Recently, the SEC provided guidance on the applicability of the new custody rule on introducing broker/dealers. The following questions and answers have been posted on the SEC’s Division of Investment Management website and should be examined by all introducing broker/dealers affiliated with or registered as investment advisers.

Question XIV.1

A: It depends. An adviser or its related person may have custody of client funds and securities without maintaining those funds or securities as qualified custodian for purposes of paragraph (a)(6) of the rule. For example, if the adviser or its related person has authority to withdraw client funds or securities maintained by the carrying broker, the adviser has custody of those assets. In that case, the adviser would be subject to all the applicable requirements of the rule, including the surprise examination requirement under paragraph (a)(4) of the rule. (Posted March 10, 2010)

This Thursday, March 25, RIA Compliance Consultants will be hosting our second webinar on the new SEC custody rule for federally registered investment advisers. The webinar will begin at 12:00 p.m. Central and will focus specifically on how the SEC’s rule applies to pooled invest vehicles and investment advisers operating a qualified custodian and/or introducing broker-dealer. Click here to register.

For your easy reference, the following are the specific changes that have been made to pages 3 and 4 of this Investment Adviser Compliance Alert:SEC Adopts to Custody Rule under Investment Advisers Act of 1940:

Serving as Trustee is Deemed to be Custody

A: The Division would not consider an adviser to have custody under rule 206(4)-2 in such circumstances if (i) the adviser is prohibited by the trust instrument or by law from withdrawing any assets from the trust without the prior written consent of all of its co-trustees, (ii) each grantor who has contributed assets to the trust acts as co-trustee, and (iii) the qualified custodian delivers account statements directly to each co-trustee. (Posted March 10, 2010.)

See: http://www.sec.gov/divisions/investment/custody_faq_030510.htm

We are also encouraging chief compliance officers of investment adviser firms to review the SEC’s recently updated set of frequently asked questions related to the SEC’s new custody rule. Prior to the recent update on March 5, 2010, the SEC’s Division of Investment Management last updated the FAQs in 2005. In order to review the updated FAQs, please click here.

Finally, you can learn more about the SEC’s new custody rule, best practices for complying with the rule and ways to avoid being deemed to have custody by attending our webinar on Thursday, March 25 at 12:00 p.m. Central. This webinar will focus specifically on how the rule applies to pooled invest vehicles and investment advisers operating a qualified custodian or broker-dealer.