Rule 206(4)-2’s adopting release regarding custody provides a definition of “custody” and interpretative guidance by providing discussion and clarification of the most common examples of what is, and what is not, custody. Under the amended Rule, an adviser has custody (and thus must comply with the above new amended Rule requirements) if it holds client funds or securities directly or indirectly, or if it has any authority to obtain possession of them.
Ability to Debit Account for Fees: An adviser has custody if it has the ability to debit the client’s account for payment of advisory fees. However, per the above, this type of custody will not require the adviser to indicate that it has custody on Form ADV, undergo an annual surprise CPA examination, nor provide an audited financial statement if assets are held by a qualified custodian who sends quarterly statements directly to the client.
Ability to Sign Checks or Withdraw Funds: An adviser has custody if it has a power of attorney to sign checks on a client’s behalf, to withdraw funds or securities from a client’s account, and/or to dispose of client funds for any purpose other than authorized trading would be deemed to have custody and subject to the above referenced annual surprise CPA examination.
Possession of Bank Account or Credit Card Information: An adviser who maintains possession of client bank account or credit card information for the purpose of the adviser debiting/charging said accounts to pay the adviser’s fee, would be deemed to have custody and be subject to the annual CPA surprise examination.
Possession of Stock Certificates: An adviser has possession of client funds or securities if it holds client stock certificates, even temporarily, because such possession puts those assets at risk of misuse or loss. However, the Rule specifically excludes inadvertent receipt by the adviser of client funds or securities, so long as the adviser returns them to the sender within three (3) business days of receiving them. An adviser may continue to meet with clients to prepare or compile documents, including stock certificates, for forwarding by the client to a custodian or third party, without the adviser having custody. However, if the client were to leave the stock certificate in the possession of the adviser thereafter, such possession would most likely not be inadvertent, and would result in custody of client assets.
Possession of Signed Checks: An adviser’s possession of a check drawn by the client and made payable to a third party does not amount to custody of client funds by the adviser. However, an adviser would have custody of client funds if it holds a check drawn by the client and made payable to the adviser with instructions to pass the funds through a custodian or to a third party.
Trustee Service: The adviser would be deemed to have custody when it (or a related person as defined under the Adviser Act, including any access person) acts as both trustee and investment adviser of a trust. In these situations, the adviser shall be subject to the above referenced annual surprise CPA examination. However, the adopting release did clarify that it would not view an adviser to have custody of the funds or securities of an estate, conservatorship, or trust solely because the supervised person has been appointed in these capacities as a result of a family or personal relationship with the decedent, beneficiary or grantor (and not a result of employment with the adviser). If the adviser or its related person is a Co-Trustee, the adviser shall be relieved of the surprise examination requirement if the co-Trustee is a qualified custodian or the trust Grantor (which will not be applicable for irrevocable trusts).
Adviser’s 401k Plan: If any member of the Adviser serves as a trustee to the Firm’s qualified retirement plan, and the Adviser also serves as the investment adviser to the plan, the Adviser would be deemed to have custody and be subject to the annual CPA surprise examination. This adverse custody determination also applies if the qualified plan is self-directed but the Adviser manages certain assets allocation models from which the participants may choose.
Possession of Client 401k Passwords: An adviser who maintains possession of client 401k passwords for the purpose of allocating the client’s retirement account among the investment options provided under the plan shall be deemed to have custody and correspondingly be subject to the annual CPA surprise examination if the plan web site permit’s the adviser (regardless of whether the adviser has any intention to do so) to electronically (via the web site) to compromise the integrity for the underlying assets or beneficiaries (i.e., the ability to make account distributions and/or change account beneficiaries).
Investment Partnerships: An adviser has custody if it acts in any capacity that gives the adviser legal ownership of, or access to, client funds or securities. An advisory firm that acts as both general partner and investment adviser to a limited partnership, by virtue of its position as general partner, generally has authority to dispose of funds and securities in the limited partnership’s account and thus has custody of client assets. The SEC also indicated that this example applies equally to an adviser that acts as both managing member and investment adviser of a limited liability company or another type of investment vehicle. See discussion above and below relative to annual audited financial statement exception from surprise examination and custody control review
If you have any questions regarding custody or any other compliance questions or concerns, Red Oak is always here to help you.
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