Tag: Custody Rule

Custody of Funds or Securities of Clients by Investment Advisers

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The SEC released the final version of its new custody rule (.pdf). The Commissioners had announced their approval of the rule on December 17 and then released the final text on December 30. The rule goes into effect 60 days after publication in the Federal Register.

The amendments are designed to provide additional safeguards under the Advisers Act when a registered adviser has custody of client funds or securities by requiring such an adviser, among other things: to undergo an annual surprise examination by an independent public accountant to verify client assets; to have the qualified custodian maintaining client funds and securities send account statements directly to the advisory clients; and unless client assets are maintained by an independent custodian (i.e., a custodian that is not the adviser itself or a related person), to obtain, or receive from a related person, a report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board. Finally, the amended custody rule and forms will provide the Commission and the public with better information about the custodial practices of registered investment advisers.

This new custody rule is designed to catch a Madoff fraud.

The rule is limited in scope. Only SEC-registered investment advisories that control custody of their client’s assets – as Madoff did — are subject to the rule. Independent RIAs with client assets in custody with unaffiliated third parties are exempt from the final version of the rule.

The difference is that the SEC exempted investment advisers who were deemed to have custody merely because they had the authority to deduct their advisory fees from client accounts from the surprise audit requirement. The SEC also exempted pooled investment vehicles from the requirement if they have an annual GAAP audit by an independent public accountant.

Between 1,500 and 1,900 SEC-registered investment advisories provide in-house custody of securities and most of these are either broker-dealer affiliates or alternative-investment managers. This leaves well over 9,000 SEC-regulated RIAs and at least that many state-registered investment adviser firms free from the burdens of the rule. The SEC estimates the annual cost of compliance at about $8,000 a year, but TD Ameritrade estimates the cost is closer to $25,000 per year.

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SEC Approves New Custody Rule

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The Securities and Exchange Commission adopted the proposed Custody Rule for investment advisers originally proposed last May. (See: SEC Releases Proposed Custody Rules for Investment Advisers)

As is typical with the SEC, they announced the rule was approved before they made the final version of rule available. The rule amendments will be effective 60 days after their publication in the Federal Register.

The SEC press release highlights the two biggest changes:

Surprise Exam

“The adviser is now required to engage an independent public accountant to conduct an annual “surprise exam” to verify that client assets exist. Such a surprise examination would provide another set of eyes on the client’s assets, and provide additional protection against theft or misuse. The accountants would have to contact the SEC if they discovered client assets were missing.”

Custody Controls Review

“When the adviser or an affiliate serves as custodian of client assets, the adviser is now required to obtain a written report — prepared by an accountant that is registered with and subject to regular inspection by the PCAOB — that, among other things, describes the controls in place at the custodian, tests the operating effectiveness of those controls and provides the results of those tests. These reports are commonly known as SAS-70 reports. Requiring that the accountant be registered with and subject to inspection by the PCAOB provides greater confidence regarding the quality of these reports.”

The rules are amendments to Rule 206(4)-2 [17 CFR 275.206(4)-2], Rule 204-2 [17 CFR 275.204-2] under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (the “Advisers Act” or “Act”), to Form ADV [17 CFR 279.1], and to Form ADV-E [17 CFR 279.8].

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