SEC Keeps Custody Compliance on their Radar as Investment Managers Fail to Comply. Are you in Compliance?

SEC Announces Initiative

The Securities and Exchange Commission announced in February 2014 that its Office of Compliance Inspections and Examinations (OCIE) has launched an initiative directed at investment advisers that have never been examined, focusing on those that have been registered with the SEC for three or more years.As part of the initiative, OCIE will conduct examinations that will concentrate on the advisers’ compliance programs, filings and disclosure, marketing, portfolio management, and custody of client assets. The SEC’s National Examination Program (“NEP”) has prioritized custody of client assets in their examination since they continue to find a considerable amount of significant deficiencies that involve custody-related issues. In a recent industry conference, Andrew Bowden, Director at the SEC stressed the fiduciary duty advisers have to institute controls within their organization to ensure that client assets are protected, segregated and reported properly. Many advisers, however, don’t even realize that they have custody of client assets or what these new rules entail. This article will provide information on the requirements of the SEC Custody Rules as well as explore some of the deficiencies uncovered during SEC examinations and suggest best practices to ensure compliance with the Custody Rule.

Background of the Custody Rule

The SEC considers the Custody Rule one of the most critical rules under the Investment Adviser Act of 1940 which was designed to protect advisory clients from the misuse or misappropriation of their funds and securities. The Custody Rule requires SEC-registered investment advisers who have custody over client assets to comply with certain requirements in order to protect advisory clients from misuse or misappropriation of their funds and securities. While this rule has been around for decades, the rules were amended in 2009 due to the SEC’s intense pressure to help protect investors from the many investment frauds such as Madoff. The amendments and new requirements became effective in 2010.

Who is deemed to have custody?

The term “custody” is defined very broadly to convey any instance where an investment adviser or its related person holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them. Investment Advisers to private pooled investment vehicles and hedge funds are likely to be deemed to have custody because the adviser or a related party of the adviser is in a position of authority with respect to the cash and investments and/or fund either through actual possession, ownership or another business arrangement. Therefore, advisers of private funds are usually deemed to have custody even though the adviser may not have physical custody of cash or securities.

What is required of the investment adviser?

Use of “qualified custodians” to hold client assets
An adviser with custody generally must maintain client funds and securities at a qualified custodian such as a bank or a broker-dealer, either in a separate account for the client under the client’s name or in an account under the adviser’s name as agent or trustee for the adviser’s clients that contains only client assets so long as to not commingle client assets with the adviser’s assets.

Notices to clients detailing how their assets are being held
An adviser that opens an account with a qualified custodian on the client’s behalf must notify the client in writing and provide the client with certain information.

Account statements for clients detailing their holdings
An adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends account statements to clients on at least a quarterly basis.

Annual surprise exams
Advisers that have custody of client assets in many cases must undergo an annual surprise examination by an independent public accountant that verifies client funds and securities.

The annual audit provision for advisers to pooled investment vehicles
With the “annual audit provision,” the adviser, at least annually, distributes audited financial statements to investors in the pooled investment vehicle. If using the audit approach, advisers to pooled investment vehicles do not have to comply with the notice and account statement delivery obligations and are deemed to have satisfied the surprise examination requirement in accordance with the Custody Rule. The Custody Rule requires that the audited financial statements be distributed to all investors within 120 after the end of each fiscal year end (180 days for fund of funds and 260 days for fund-of-fund-of-funds). In addition, the audited financial statements are required to be audited by an independent public accounting firm that is registered with and subject to regular examination by the Public Company Accounting Oversight Board (PCAOB) and the audited financial statements must be audited in accordance with U.S. GAAS (no exceptions) and prepared in accordance with U.S. GAAP with limited exceptions. Reporting on Other Comprehensive Basis of Accounting (OCBOA) would not be acceptable for compliance with this provision. Furthermore, the audit opinion must be unqualified; a qualified or disclaimer of opinion on the financial statements would prohibit relying on the audit provision.

Additional protections when a related qualified custodian is used
If the adviser or an adviser’s related person acts as the qualified custodian (as in the case with Madoff whereby the investment adviser and the broker that held the “securities” were the same person), then the annual surprise examination must be conducted by an independent accountant registered with, and subject to regular inspection by, the PCAOB. In addition, the adviser must obtain from the accountant at least once each year a report of the internal controls relating to the custody of client assets.

NEP discovers deficiencies

In previous NEP examinations the staff has uncovered custody-related deficiencies which were grouped into four categories: failure by an adviser to recognize that it has “custody” as defined under the Custody Rule; failure to comply with the rule’s “surprise exam” requirement; failure to comply with the “qualified custodian” requirements; and failure to comply with the audit approach for pooled investment vehicles.

Situations where investment advisers failed to recognize they had custody of a client’s assets:

• The adviser’s personnel or a “related person”served as a trustee.
• The adviser was authorized to withdraw funds or securities from the client’s account as part of bill-paying services (including payment of management fees to the adviser) or had such ability by managing portfolios through direct and unrestricted online access to client accounts.
• The adviser’s personnel had access to client user names and passwords to withdraw funds and manage client portfolios.
• The adviser had signatory or check-writing authority for client accounts.
• The adviser had physical possession of client assets, such as securities certificates.
• The adviser obtained checks from clients that weren’t deposited after a reasonable period of time.

Situations where investment advisers failed to meet the “surprise exam” requirements:
The NEP noted that the surprise examinations were not being conducted on a “surprise” basis (e.g., in instances where the exam was performed at the same time each year). The NEP also observed that in certain cases, the required Form ADV-E was not filed within 120 days after the exam date.

Situations where investment advisers did not satisfy the “qualified custodian” requirements:
The NEP found that certain advisers failed to satisfy the requirements of maintaining client funds and securities with third party custodians in instances in which:

• Client, proprietary and employee assets were commingled into a single account.
• Certificates of securities issued in the name of the adviser’s fund were held in a safe deposit box controlled by the adviser at a local bank.
• The adviser lacked a reasonable basis to believe the client’s quarterly account statements were sent to the client by the custodian.

Situations where investment advisers relying on the audit approach (“annual audit provision”) with respect to pooled investment vehicles were not in compliance with applicable requirements:

• The accountant was not “independent” under the SEC’s Regulation S-X. Accountants providing accounting services or consulting to an adviser may not be independent with respect to auditing the financial statements.
• The audited financial statements were not prepared in accordance with U.S. GAAP. International Financial Reporting Standards (IFRS) may be acceptable, in certain circumstances when pooled investment vehicles are organized outside the United States or their general partner/manager are based outside the United States. In these circumstances they may have their financial statements prepared in accordance with accounting standards other than U.S. GAAP so long as they include reconciliation for any material differences to U.S. GAAP.
• The audited financial statements were made only “upon request” rather than delivered to all fund investors.
• The audited financial statements were not delivered to the fund investors within 120 days of the fund’s fiscal year-end.
• The adviser obtained investor approval to waive the annual audit or perform a long year audit but did not obtain a surprise examination.
• A final audit was not performed on liquidated pooled investment vehicles.

Are you in compliance with the custody rule?

The following are some best practices to ensure compliance with the Custody Rule and be prepared for a surprise custody examination if needed:

• Determine if your organization has custody of client assets. This can be difficult in certain circumstances, such as when there are numerous related parties involved with the investment adviser. It may be in the adviser’s best interest to obtain advice from legal counsel as to whether the investment adviser is deemed to have custody of client assets. If determined that the investment adviser has (or does not have) custody, keep this information documented in your records along with a list of all assets you’re deemed to have custody of and make sure the list is kept current.
• If the investment adviser determines it is deemed to have custody of client assets and cannot rely on the audit provision (for pooled investment vehicles):
• Engage with an independent public accountant to perform an annual surprise custody exam. The engagement letter must be executed before or during the year the assets must be counted. For instance, for 2014 the engagement letter must be executed before December 31, 2014 and the accountants can select any day during the year for the surprise examination. They will have up to 120 days after the date selected to issue a report on compliance with the Custody Rule to the SEC.
• Make sure all cash and securities are held with a qualified custodian. Uncertificated securities held by a pooled investment vehicle such as private investments, subscription agreements for underlying funds and investment vehicles and other private interests must also be held with a qualified custodian (if the audit provision cannot be relied on). There is a privately offered securities exception for holding these investments with a qualified custodian but it would not apply to assets of an unaudited pool.
• Make sure your qualified custodian is sending out statements to all your investors (or trustees on behalf of investors) that include cash and securities held at the end of the period as well as all transactions within the account during the period.
• Have all contracts with clients and custodians readily accessible and include the latest amendments, if any.
• Maintain current contact information for clients, custodians, and counterparties for privately offered securities.
• Create and update internal control documentation detailing how your organization’s systems and processes work. The documentation should demonstrate internal controls over trading, reconciliation, safe-guarding assets, the process for evaluating custody concerns, and other key areas.
• Maintain organized records supporting all transactions and ledgers of client activities.
• Perform position and transaction reconciliations to custody statements on a timely basis.

The SEC remains firm on enforcing custody issues to reduce the likelihood of investors being defrauded. Advisers with custody of client funds should review their existing policies and procedures that impact accounts with custody. Compliance with the Custody Rule should encompass an ongoing review of all client assets to make sure the investment adviser is in compliance from year to year. It is important that those in charge with compliance not only understand the Custody Rule but also all transactions and aspects of the investment adviser that relate to the custody of client assets. If you have any questions regarding custody, reach out to a Marcum professional to help.

Marni Pankin, CPA, Partner- Alternative Investment Group contributed to this article.