Protection of investor assets is governed by the Investment Advisers Act of 1940 “Custody Rule” amendment, which is a series of risk management guidelines professional advisors must follow. It’s designed to safeguard assets and protect individual investors from unwarranted financial harm.
Registered investment advisors and other investment professionals are of course familiar with the Custody Rule, which requires that:
- Qualified custodians who hold assets meet the requirements of the Rule.
- Notices are sent to clients regarding custodians.
- Account statements are sent to clients covering holdings on at least a quarterly basis.
- Annual surprise examinations are conducted by an accounting firm registered by the Public Company Accounting Oversight Board (PCAOB).
But advisors, are you confident you’ve identified all the client assets that are considered to be in your custody? It may not be as cut-and-dry as you believe.
Recently the Custody Rule has been thrust into the spotlight courtesy of the financial crisis, high-profile Ponzi schemes, and risk alerts from the U.S. Securities and Exchange Commission. And that’s focused increased attention on investment advisors’ compliance.
Assets could be at risk
One recent risk alert from the SEC came after the Great Recession. In that alert, the commission reported that a high number of investment advisory firms had deficiencies related to asset custody.
The most significant issue cited by the SEC pertained to awareness. In many of these cases, the firms didn’t know they possessed legal custody of a client’s funds. This meant they were not following the guidelines set forth by the Custody Rule, and therefore were non-compliant.
What is custody?
What does custody actually entail? This is one of the main points of confusion for some investment advisors, broker/dealers, investment firms and financial institutions with trust departments.
At its core, “custody” is defined by the SEC as “the holding of client funds or securities.” This holding can be either direct or indirect, including if an applicable party has authorization to possess assets. One common indication of custody is power of attorney. Others include the ability to:
- Pay bills
- Withdraw funds from clients’ accounts
- Dispose of assets outside of authorized trading
While the above examples are common instances where custody comes into play, they aren’t the only scenarios.
Examples of custody not commonly recognized
In many cases, custody is easy to identify. Other times, however, advisors, broker/dealers and other applicable parties may not be aware they actually have custody over a client’s assets.
Consider these two scenarios where advisors have recently been found to be unknowingly in custody:
- The advisor was in possession of a client’s password/log-in information
- The advisor was listed as trustee on an account
Complying with the Custody Rule
What needs to occur once the Custody Rule is applicable? Specifically, the rule requires that an independent PCAOB CPA firm conducts a surprise examination of client assets on annual basis. During this time, the CPA will perform a multitude of procedures, including verifying these funds and securities. Should the custodian not comply with any element of the Custody Rule – including if the surprise examination is not performed – the SEC is able to mandate fines.
Pair with qualified CPAs
Not every CPA firm is qualified to conduct the Custody Rule examinations. On a base level, the independent CPA firm must be registered with, and subject to, regular inspection by the PCAOB.
Clark Schaefer Hackett’s CPA team is registered with the PCAOB, and our professionals have substantial experience advising clients on the Custody Rule and the related examination. With CSH, advisors, firms, broker/dealers and other financial institutions will know exactly which scenarios are applicable under this rule, as well as the best strategies to maintain compliance.