Executive Summary: Rule 206(4)-2 of the Investment Advisers Act of 1940 (the "Rule") defines custody as "holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them." While recent revisions to the Rule have provided further protections for the investing public, questions remain as to how advisers registered with the United States Securities and Exchange Commission (SEC) might apply the Rule and its revisions to their business practices.
Determining when a firm may have custody can be dependent on the facts and circumstances. To follow are some frequently asked questions and answers regarding custody.
My investment adviser collects fees directly from the client's account under the terms of our advisory agreements, which are signed by the client. Would we be considered to have custody of the client's funds or securities?
Generally speaking, many advisers engaged in portfolio management have compensation arrangements with clients where the adviser is given the authority to deduct his or her fees directly from client accounts. Provided that this account is held with a broker-dealer or a bank, the adviser's access to client funds and/or securities to collect a fee is not deemed to be custody.
A client sent me a check payable to the clearing firm/custodian for deposit into his or her account. Am I considered to be in custody of the client's funds? What should I do with this check?
Where advisers receive client checks made payable to third parties, some have argued that this indirect receipt of client funds is indicative of possession and thus subject to the requirements within the Rule. However, the Rule specifies that possession does not include receipt of checks drawn by clients and made payable to third parties. Therefore, you would not be in custody of the client's funds and you should promptly forward the check to the clearing firm/custodian for deposit into the client's account.
I opened the mail today and there was a check and stock certificate from a client that should have been directed to the clearing firm/custodian but was sent to me inadvertently. To further complicate this, the client made the check and stock power out in the name of our investment adviser firm in error. The client had been instructed to make the check and stock power out to the clearing firm/custodian, but he said he was in a hurry and forgot. Is the investment adviser in custody of the client's funds and securities?
The Rule indicates that the possession of client funds or securities is indeed custody. An exception is created when we examine the possession of client funds or securities received by the adviser on an inadvertent basis. The adviser would be deemed to have custody where the firm maintains possession of client funds or securities, except when they were received inadvertently and are returned to the sender promptly or within three days of receipt.
Determining custody can be confusing. Further, during an examination by a regulator, if questions should arise about whether or not your firm had custody, the burden of proof to show why it was not custody will rest with your firm. Therefore, it is important to carefully document your files to show the facts and circumstances surrounding the receipt of client funds or securities. Keeping copies of clients' checks or securities in their files and logging the receipt and disposition of these items is key.
In addition, where the funds or securities are payable to the investment adviser, be sure you maintain documentation to support that they were received inadvertently and returned to the client within the required timeframes. Documentation can include forms sent to the client showing the appropriate way to remit checks or securities to the clearing firm/custodian, notes regarding a conversation with the client following the receipt of the funds or securities, and evidence of the checks or securities being returned to the client within the timeframe allowed. .
If you have other questions about custody, please contact a Regulatory Compliance investment adviser specialist at 603-434-3594.
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