New SEC Custody Requirements for Registered Investment Advisers

The compliance period for new SEC amendments to Rule 206(4)-2, which governs the custody of client securities and funds by federally registered investment advisers (RIAs), commenced on April 1, 2004.

Under the amended rule, RIAs that have custody of client funds and securities must use a “qualified custodian.” If the adviser’s qualified custodian sends account statements directly to the adviser’s clients, the adviser will be relieved from the following requirements: (1) sending out its own account statements; (2) annual surprise inspections by an independent auditor; and (3) providing its own audited balance sheets as part of its brochure. Special provisions apply to custody of mutual fund shares and investments in private investment companies.

The following questions and answers will help to clarify the application of the amended regulations.

When is an RIA considered to have custody of client assets so that the rule will apply to its advisory activities?

An RIA has custody of a client’s funds or securities when it directly or indirectly holds them, or when it has any authority to obtain possession of them.

The amended rule provides three examples of situations where an RIA would be deemed to have custody:

If the adviser has possession of client funds or securities.

Note: Two exceptions - (1) when the adviser holds a check drawn by the client that is payable to a third party, or (2) when the adviser inadvertently receives client funds or securities and returns them to the sender promptly, but in any case within 3 business days of receiving them.
If there is any arrangement under which the adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the adviser’s instruction to the custodian.

Note: an adviser who is authorized to deduct advisory fees or expenses from the client’s account is deemed to have custody.
If the adviser has a capacity under which the adviser or its supervised person has legal ownership or access to client funds or securities.

Note: Such a capacity would generally include an investment adviser who manages a pooled investment vehicle (such as, a general partner of a limited partnership, a manager of a limited liability company, or a comparable position) or a trustee of a trust.

If an RIA is deemed to have custody of funds or securities, what are the RIA’s responsibilities under the amended Rule?

If an RIA has custody of client funds or securities, the RIA must meet safekeeping requirements which include:

maintenance of the funds and securities with a qualified custodian either in a separate account under each client’s name or in accounts that contain only client funds and securities under the RIA’s name as agent or trustee for the clients; and
delivery of account statements to each client by either the qualified custodian or the adviser at least quarterly as provided in the rule (see below for details).

What entities meet the requirements for acting as a “qualified custodian”?

The SEC has identified four kinds of financial institutions as qualified custodians for the purposes of the rule, including:

banks (as defined in the Advisers Act) or savings associations that have deposits insured by the FDIC;
registered broker-dealers holding the customer assets in customer accounts;
registered futures commission merchants holding funds, securities futures, or securities incidental to commodity contracts and options, in customer accounts; and
foreign financial institutions that customarily hold financial assets for their customers, provided that the institution keeps advisory client assets in customer accounts segregated from its proprietary assets.

Of course, some advisers are themselves institutions that meet the requirements for being qualified custodians, and some advisers have custodial relationships with affiliates that are qualified custodians. If the qualified custodian fulfills the obligations for acting as a qualified custodian, there is no prohibition against these advisory relationships.

What are the requirements for delivery of account statements if the delivery is made directly by the qualified custodian?

If the account statements will be delivered by the qualified custodian directly to the RIA’s clients, the adviser must reasonably believe that at least quarterly the qualified custodian will send to each of the adviser’s clients for which it maintains funds or securities an account statement that identifies

the amount of funds and of each security at the end of the period, and
sets forth all transactions in the account during the period.

What are the requirements for delivery of account statements if the delivery is made by the adviser?

If the RIA will deliver the account statements, then the adviser must send quarterly account statements to each of its clients for whom the adviser has custody of funds or securities, and the account statement must set forth:

the amount of funds and of each security of which the client has custody at the end of the period; and
all transactions during the period.

In addition,

Surprise Inspection -- an independent public accountant must verify all funds and securities by actual examination at least once each calendar year at an irregular time chosen by the accountant without prior notice or announcement to the adviser, and the accountant must file a certificate on Form ADV-E with the SEC within 30 days after the completion of the examination, stating that it has examined the funds and securities and the extent and nature of the examination; and
Report of Material Discrepancies -- if the accountant finds any material discrepancies in the examination, then the accountant must notify the SEC within one business day of the finding, by fax or e-mail, followed by first class mail, directed to the attention of the Director of the Office of Compliance Inspections and Examinations.

What about mutual fund shares ( which are generally uncertificated and not physically possessed or held in custody by any entity)?

With respect to the shares of publicly traded mutual funds, the adviser may use the mutual fund itself, or the mutual fund’s transfer agent, as if it were the qualified custodian.

What about the uncertificated securities sold in private offerings?

An RIA is generally not required to meet the custodial requirements of the rule with respect to securities that are: (1) acquired in a private placement; (2) uncertificated with ownership recorded only on the books of the issuer or its transfer agent in the name of the client; and (3) transferable only with the prior consent of the issuer or holders of the outstanding securities.

There is an exception to the generality of this provision where the securities are held by a pooled investment vehicle, such as a limited partnership or limited liability company. Such an entity is exempt only if it is audited at least annually and distributes financial statements prepared in accordance with GAAP to all its limited partners (or other beneficial owners) within 120 days of the end of its fiscal year.

What about RIAs that take legal title to the client assets they manage through investment vehicles such as private investment limited partnerships or private limited liability companies that pool investments?

An RIA that is the general partner of a limited partnership (or the managing partner of a limited liability company, or holds a comparable position for another type of pooled investment vehicle) is generally subject to the same qualified custodian requirements as other RIAs. However, if the limited partnership (or other investment vehicle) is audited at least annually and financial statements prepared in accordance with GAAP are sent to all of the limited partners (or other beneficial owners) within 120 days of the end of the entity’s fiscal year, then the RIA is exempt from the reporting requirements of the rule.

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The foregoing discussion is only a general statement of the principal provisions of Rule 206(4)-2 as of April 1, 2004, and is not intended to exhaustively review all aspects of that rule or the manner in which it may apply in certain circumstances.

For more information, please contact Ward Hinkle at Hodgson Russ LLP. Mr. Hinkle concentrates his practice in the area of federal and state securities law, including the representation of investment advisers and private investment companies. He is available to assist you in meeting your compliance requirements. Mr. Hinkle can be reached at 716.848.1281 or whinkle@hodgsonruss.com