Written by: Evan Barrows
The AdvisorAssist CCO Series: Understanding Custody
Regulators, both the SEC and the various States, continue to place focus on how firms identify, monitor and test custody scenarios with client assets. The custody rule was introduced in the Advisers Act of 1940 and was most recently refined in 2009 and in the 2017 SEC no-action letter
This letter provided additional guidance with respect to standing letters of authorization (SLOA) and how it affects constructive custody versus real custody.
Real or Constructive
According to the Advisers Act of 1940, a registered investment advisor is deemed to have custody of client assets or funds if it: directly or indirectly holds client assets or funds; has authority to obtain possession of client assets or funds; or has the ability to appropriate client assets or funds.
The SEC further breaks custody down into two (2) categories: constructive and real. Maintaining real custody requires an annual surprise audit in all circumstances. A firm having constructive custody may avoid this audit requirement by satisfying the seven (7) conditions
outlined by the SEC. Some common examples of constructive and real custody include:
Constructive Custody - (annual surprise custody audit not required) Deducting advisory fees from client accounts Maintaining standing letters of authorization (“SLOA”) to third parties
Real Custody - (annual surprise custody audit required) Collecting more than $1,200/$500 in advisory fees, six months or more in advance Maintaining client login credentials Serving as a trustee for client accounts Having power of attorney over client accounts Holding onto client checks for longer than 72 hours (3 business days) Receiving stock certificates from the client and forwarding them to the custodian Receiving of third-party checks made payable to the client and forwarding them to the custodian Managing a private fund Advisors that have real custody of client assets must obtain a surprise "custody audit" at least annually from an independent auditor compliant with the AICPA attestation standards.
Related: The Penalty for Insufficient Resources for a Compliance Program
Through the Regulator's Eyes
Regulators want to ensure that all parties (registered investment advisors, clients, and regulators) understand when and to what extent advisors have "possession" of client securities or funds
. This includes fee deductions, client account access, money movements or the timing of deposits or withdrawals.As a firm, it is critical to: Identify when you have custody. Train your supervised persons regarding custody rules and firm policies. If custody is identified, promptly make the appropriate disclosures to your regulatory documents, compliance program and inform state regulators, if required.
CCO Best Practices Be sure that you understand the concept of custody, both real and constructive so that you remain aware of any practices that may be construed as each. Be diligent prior to adding new vendors, products, practices or procedures within the firm that may potentially trigger a custody situation. Perform "due inquiry" on your custodian to ensure that each of your clients are receiving statements at least quarterly. This can be accomplished by either requesting copies of client statements or asking your custodian for written confirmation that statements were sent to each client. If your firm receives checks directly from clients, maintain a "check log" and ensure the firm is remitting these checks within 72 hours of receipt. If you are ever in receipt of a client’s stock certificate, return to the client immediately. State-registered RIA firms must invoice clients directly each time you initiate advisory fee deductions. This invoice must include a simple explanation of how client fees were calculated. If your firm does have real custody, contract with an independent accounting firm to perform an annual surprise custody audit.