Custody arrangements will always be reviewed in a routine regulatory examination. Violations of Rule 206(4)-2, more commonly referred to as the Custody Rule (the “Rule”) are also rapidly becoming a key enforcement area for the Securities and Exchange Commission (“SEC”). This primer will cover the important points of the Rule and discuss the most common violations.
- The Rule
At its most basic, the Rule:
- Defines custody as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them;
- Requires safekeeping of client assets, which means maintaining them at a qualified custodian such as a bank or broker-dealer. Assets must be in a segregated account either for each client under its name, or in an account that contains only clients’ assets with the adviser’s name as agent or trustee;
- Requires the adviser to notify clients when accounts are opened for them and reasonably believe, after due inquiry, that custodians deliver account statements directly to clients at least quarterly; and
- Requires independent, surprise verification of assets by an accountant. Private fund managers can satisfy this requirement by arranging for their funds to be audited annually (more on this in the next section).
- Important Nuances
Though simple on its face, there are some important nuances to consider:
- An adviser can have custody through an affiliate (e.g., the general partner, or equivalent of a private fund);
- The authority to obtain possession of funds or securities creates custody, regardless of whether such authority is exercised;
- The accountant retained to provide either the surprise verification or the annual audit of a fund must be an independent public accountant that is both registered with and inspected by the Public Company Accounting Oversight Board or PCAOB.
- Common Violations
The SEC’s National Examination Program (“NEP”) staff recognized four common deficiencies during their recent investigations:
- Advisers often failed to recognize that they had custody under the Rule. The NEP staff cited examples of advisers having physical or electronic possession of assets, but not fulfilling their Rule obligations;
- Some surprise exams were not conducted on a “surprise” basis. The NEP staff collected evidence suggesting that the examinations were being conducted at a predictable time each year;
- Certain advisers did not meet the qualified custodian requirements. Advisers that commingled client’s assets with employee or propriety assets were in violation of the Rule. The NEP staff also noted that some client assets were held in an adviser’s name, but not in an account that was under the adviser’s name as an agent or trustee for the client and that held only client assets; and
- Some audits were considered to be unacceptable. Some auditors could not be considered to be independent under Regulation S-X or were not registered with the PCAOB. In other instances, audited financial statements were not prepared in accordance to generally accepted accounting principles standards.
- Compliance Tips
To comply with the Rule, adviser should consider:
- Creating policies and procedures that address the application of the Rule. Advisers should consider how future Rule changes may alter their policies. SEC press releases about rule changes can be found here. Advisers should also consider how changes in their business may affect their Rule obligations and update policies accordingly; and
- Ensuring that all parties involved consistently follow the prescribed procedures. The Rule is quite technical, and it is important that all parties involved understand the Rule, policies, and procedures.
Many violations of the Rule were the result of advisers not recognizing and understanding their obligations. These issues can be avoided by establishing clear written policies and procedures, distributing them firm-wide and training key staff on their role in implementing the adviser’s custody rule procedures.