An investment adviser is considered to take custody of funds or securities from a customer if it

Authored by Kristen Hughes and Matthew O’Rourke

Registered investment advisers (RIAs) that maintain custody of customer assets, and who are registered with the Securities and Exchange Commission (SEC), are subject to various regulations intended to protect their clients. One such rule under the Investment Advisers Act of 1940 – the “custody rule” (i.e., SEC Rule 206(4)) – requires RIAs to obtain external assurance for customer accounts through either a surprise custody examination or by conducting a financial statement audit.

What is custody according to the SEC?

Investment advisers are deemed to have custody of a client’s assets if the investment adviser directly or indirectly holds client funds / securities or has authority to obtain possession of them in connection with their advisory services. This includes the following:

• Possession of client cash or securities.
• An arrangement where the adviser is authorized or permitted to withdraw client cash or securities that are maintained with a custodian.
• Any position that gives the adviser legal ownership or access to client cash or securities, including acting as a general partner for a limited partnership or as a manager of a limited liability company.

There are three significant exceptions to the annual examination requirement. In each of these cases, an annual surprise examination is either not required or is otherwise deemed to be satisfied:

1. The RIA has custody of client assets solely because of its authority to deduct advisory fees.
2. The RIA’s client is a pooled investment vehicle subject to an annual U.S. GAAP financial statement audit and distributes these to the pool’s investors. Note the audit must be performed by an independent Public Company Accounting Oversight Board (PCAOB)-registered accountant and the financial statements must be distributed within 120 days of the fiscal year end, or 180 days after the fiscal year end for a fund of funds.
3. The RIA is deemed to have custody solely because a related person holds or has the authority to obtain possession of a client’s assets and is operationally independent of the related person.

The custody rule

When an adviser is deemed to have custody of a client’s funds or securities, the custody rule subjects the adviser to the following requirements:

• The adviser must obtain an annual surprise examination by a PCAOB-registered independent accounting firm.
• The adviser must have the qualified custodian who maintains the client’s cash and securities send account statements directly to the advisory clients.
• Unless the client’s assets are maintained by an independent custodian, the adviser is required to obtain a report on the internal controls relating to the custody of those assets from a PCAOB-registered independent public accountant.

A surprise examination requires procedures such as, but not limited to, the examination of certain books and records that relate to the adviser’s custody and confirmation with both the qualified custodians and clients. The examination must be completed and the report submitted electronically to the SEC within 120 days after the surprise examination date, as chosen by the independent accountant.

Financial statement audit vs. surprise examination

In certain cases, a custody examination may be a more efficient service than an audit, primarily when a fund does not have a legally-imposed investor mandate for audited financial statements. If the fund is registered with a foreign authority that requires audited financial statements (e.g., the Cayman Islands Monetary Authority), a surprise custody examination may be duplicative of the work already performed.

Custody examinations are more limited in scope than audits since custody examinations focus on equity activities (e.g., subscriptions and redemptions) and investment existence, but not the underlying valuation. An audit requires more substantial planning / assessment of risks and testing of the entirety of the fund’s financial statements, including valuation of investments. The financial statement audit also requires management to develop sufficient and appropriate procedures and controls over valuation and financial reporting to comply with U.S. GAAP.

These factors typically cause the custody examination to be less expensive, intrusive and time consuming as compared to a financial statement audit. While the RIA must still design appropriate policies and procedures, there can be a sizeable administrative resource efficiency and cost effectiveness to exploring the surprise examination option.

Special caution regarding custody examinations for funds that self-custody investments, including digital and virtual currencies

RIAs that self-custody their assets, including those invested in digital and virtual currencies, should pay special attention to whether they self-custody their assets or whether the assets are held by a qualified custodian.

The SEC defines qualified custodians narrowly to include:

1. Banks and savings associations;
2. Registered broker dealers;
3. Registered futures commission merchants; or
4. Foreign financial institutions that customarily hold financial assets for their customers, provided that the foreign financial institution keeps advisory clients' assets in customer accounts segregated from its proprietary assets.

Management should carefully evaluate whether their holdings are held by an appropriately qualified custodian.

Additional requirements under Internal Control Report – Rule 206(4)-2(a)(6)

Internal Control Report – Rule 206(4)-2(a)(6) establishes additional requirements for an investment adviser that itself, or its related person, maintain client funds or securities as a qualified custodian in connection with advisory services provided to clients. Such an investment adviser must obtain or receive from its related person an internal control report related to itself or its affiliates’ custody services, including the safeguarding of funds and securities, prepared by an independent public accountant that is registered with, and subject to inspection, by the PCAOB at least once each calendar year.

These rules may add a significant complexity to an RIA seeking to obtain a custody examination to satisfy its custody requirements.

Conclusion

Each investment adviser must review the requirements for their organization to determine the right path. We strongly recommend discussing your unique situation with an audit advisor prior to making a decision to ensure pertinent factors are considered in your decision.

For more information on this topic, or to learn how Baker Tilly asset management industry specialists can help, contact our team.

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