Accepting third-party checks and securities for forwarding to a client’s qualified custodian seems to be a common practice at many investment advisory firms. Many investment advisers process the delivery of third-party checks and securities as a convenience to clients; however, it is important to understand the implication such processes have on the firm’s custody policies and procedures.
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.
Posted by Bryan Hill