The Security and Exchange Commission’s (SEC) custody rule creates a lot of confusion among registered investment advisers (RIAs).
Common violations disclosed in the SEC National Examination Program show that this confusion is widespread. Often these violations result from a RIA’s inability to determine its custody status.
The following tables provide some helpful tips to simplify the custody rule and assist you in determining whether you are in line with its requirements.
Generally, an adviser is deemed to have custody of client assets when it holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them. Here are some basic questions to help you determine your custody status:
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Does the Adviser Have Custody? |
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If the adviser is deemed to have custody and does not qualify for an exception noted below, the funds must be maintained by a qualified custodian and the adviser should ensure it is meeting relevant requirements for safekeeping assets.
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Do Any Exceptions Apply? |
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Separately Managed Accounts
For an RIA newly subject to the custody rule, a surprise independent verification or custody exam can seem intimidating. In fact, many advisers exert significant effort to ensure they are not subject to the custody rule.
In some cases, advisers are deemed to have custody of only a few accounts. For example, the adviser might act as trustee for some clients or is granted authority to move funds via a standing letter of authorization. Rather than avoid these situations, advisers should be aware that, unlike an audit, a custody exam’s procedures are minimal with the primary purpose of verifying the existence of assets.
This often includes confirming the account’s value and activity with the custodian and with the adviser’s client.
The following is a checklist to follow when engaging a firm to perform a custody exam:
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Custody Exam Checklist |
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It’s important to note that before completing a custody exam, the adviser must sign a letter representing that the adviser is in compliance with the custody rule.
In addition to obtaining a custody exam, the custody rule requires an adviser to:
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Custody Rule Requirements |
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Pooled Investment Vehicles
RIAs managing a pooled investment vehicle have two different options. The entity is often already subject to an audit. For instance, hedge funds often include a provision in their governing documents to provide their investors with an annual audit. In such cases, if the RIA complies with a few additional requirements, it does not need to obtain a custody exam for the fund. Furthermore, the RIA is also exempt from the custody rule’s new account notification requirement and from ensuring the qualified custodian sends account statement to clients.
Vehicles planning to use this audit exception must adhere to a few SEC requirements. In fact, the SEC included the improper use of this exception as one of the common violations found in their exams. To qualify for this exemption, the RIA must adhere to the following requirements:
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Pooled Investment Vehicle Exception Requirements |
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Additional Resources
The SEC provides resources that can help you further understand the scope and regulatory obligations of custody requirements.
This content was co-authored by Matthew Soldato, Director at Duff and Phelps, and Sarah Williams, Manager at Wipfli.
