What is the Custody Rule
The Custody Rule and its Adopting Release: An Introduction
Recently, the Securities and Exchange Commission (SEC) adopted a new rule governing how investment advisors manage the assets under their control. The SEC adopted the "Custody Rule," which amends Rule 206(4)-2 (the "Existing Rule") under the Investment Advisers Act of 1940 (the "Advisers Act"). These amended rules are intended to increase investor protection by enforcing new requirements for advisers that have custody of client assets. The Custody Rule also addresses concerns about financial transparency by making it necessary for registered investment advisers with regulatory assets under management exceeding $1 billion to undergo a surprise examination by an independent public accountant instead of relying on a "surprise examination" by an independent public accountant to ascertain whether any cash or checks of clients are missing.
When the Custody Rule was first passed in 1939, it was designed to prevent fraud. Since then, the investment world has undergone tremendous changes. From a few hundred to several thousand investment advisers, ranging from large banks to family offices, the SEC has commented on the advantages of the Custody Rule, "anticipated benefits of the proposed amendments include: (i) requiring advisers to establish policies and procedures to prevent the misuse of client funds; (ii) enhancing the likelihood that fund audits will take place and occur with appropriate frequency; and (iii) facilitating timely detection of fraud." (Release No. IA-2968)
Following the amendment to the Custody Rule , prior SEC Chair Mary Schapiro stated, "when an advisory firm has custody over client assets, it is crucial that there be independent verification of the amount of client assets held, and that those assets are properly accounted for."
A number of commenters expressed concern about the cost of the amended rule and how it would affect smaller investment advisers. In approving the rule, the Commission considered the ability of small investment advisors to acquire a surprise exam. The Commission stated that they took into consideration the burdens imposed by the rule and "determined that the costs associated with the surprise exam would not impose a significant hardship on small advisers." In response to commenters concerns regarding the application of the surprise exam to larger advisors, the Commission believes that the costs associated with the surprise exam would not be significant.
However, smaller investment advisors have a valid concern about the possible increase in fees charged by accountants to conduct surprise examinations. As a result, many in the industry expect to see a significant increase in costs for clients to maintain their investment advisors.
The new rules will be effective beginning March 30, 2010, with compliance required by December 31, 2010.
History and Evolution of the Custody Rule
The custody rule began in the mid 1960s as an early effort at protecting client assets. The initial impetus came from a 1964 crime wave in which news reports included these accounts of rip-offs: A Memphis lawyer was sentenced to a year in prison for stealing clients’ escrow money; a Philadelphia lawyer hired to represent a movie star absconded with $63,000 from her accounts; an Atlanta lawyer was sentenced to 10 years for theft of $300,000 in clients’ money; and a New York lawyer created fictitious trust account records as part of a scheme to steal $1.5 million over a 12 year period. In response, the AICPA and the ABA collaborated to create the Model Rule that required lawyers to maintain a separate client trust account and subject it to a formal safeguard system.
In 2006, the AICPA appointed a task force to review its original custody rule in light of SEC comments. The SEC had suggested that the AICPA’s 1992 custody rules were too "condoned" giving financial advisors undeserved discretion over client funds. As a result, the task force incorporated several of the SEC’s recommendations regarding enhanced disclosures and oversight. Based on a two-year process that involved research, field-testing and input from members, the AICPA adopted the revised Custody Rule (Rule 204-2) and related guidance December 6, 2010.
The Adopting Release The Basics
The release adopting the custody rule also amended the definitions of "custody" and "qualified individual." The following changes were made to these definitions:
• With respect to the custody rule, the term "custody" was changed to include safeguards in addition to the 1979 custody rule principles already in place. "Custody" now means the holding of funds or securities for an advisory client that is (1) maintained with a qualified custodian; (2) in an account that is in the name of the client or in the name of the investment adviser as agent or trustee for the client; or (3) outside the client’s account with a qualified custodian when the qualified custodian sends account statements to the advisor, the client and the qualified custodian agrees to send account statements to the client at least quarterly (and the qualified custodian sends an initial statement to the investor if there is a one-time deposit, and the qualified custodian provides to the investor an initial statement if there is a one-time deposit).
• The definition of "qualified custodian" was revised to clarify that broker-dealers may not qualify as a "qualified custodian" (except for up to $1,200 of client money to facilitate securities transactions). Accordingly, notwithstanding the changes to the custody rule, investment advisers should not rely on accounts maintained by a registered broker-dealer to establish custody of client assets. The change also affects custodians that are not broker-dealers. The definition of a "qualified custodian" is now limited to institutions that are either subject to a regulatory regime that provides consumer protections against theft or loss or that have a $10 million net worth. Banks, for example, are now included in the definition of a "qualified custodian" under the amended custody rule, even though they are excluded from the definition of a "qualified custodian" under the custody rule’s account statements provision.
Effects on Investment Advisors
Advisors – Registered Investment Advisors ("RIAs") and investment firms – will be most affected by the rule adopting release because they are the service providers tasked with utilizing policies and procedures to ensure accurate account statements are sent to clients. As a general matter, the investment advisors must comply with the custody rule for products such as: (i) hedge funds (including feeder funds); (ii) pooled investment vehicles; and (iii) the now broad category of security based swaps for which the credit provider advises a pooled account.
To show compliance with the custody rule adopting release, an RIA must include in its compliance policies and procedures: Additionally, the advisor must maintain examples of the e-mail communication in its books and records showing that the account statement was sent to the client. Also and very importantly, the RIA must retain the information that is sufficient to demonstrate the advisor’s compliance with its obligations to clients.
The adopting release states that if an investment advisor only has "limited custody" or "no custody," then it may appoint an "authorized contact person" to obtain account statements. However, the advisor must still comply with the requirements of section 206(3) and give the client prior written consent. The RIA cannot use an authorized contact person to avoid complying with the custody rule autonomously. The RIA should look very carefully at the authorized contact person’s relationship to the client to determine both whether it appoints an authorized contact person itself (RIAs can be the authorized contact person), and who it appoints to be the "authorized contact person" of the client. As noted above, the advisor is not allowed to use authorized contact person as a shell to masquerade for custody under section 206(3).
Challenges and Compliance Strategies
Though the adopting release is intended to clarify and simplify compliance with the custody rule, it has created some challenges that financial firms must overcome in order to come into compliance by the required date. As one example, the adopting release now requires firms to present the audited financial statements to clients, whereas the previous version of the custody rule allowed many firms to only send the audited financial statements to the plan administrator. This change affects audits required by Section 1210 of ERISA, including the audit of employee benefit plans subject to Title I of ERISA and the audits of any private funds within the meaning of the Investment Advisers Act of 1940 ("advisers act") that are required by the SEC rules.
As another example, the adopting release will also require firms to ensure that the financial statements of the plan to which the firm is providing investment advice be audited as of the fund’s or plan’s fiscal year end if the firm has custody over the assets of the plan. While this standard is not currently required for many non-ERISA covered funds, it is now being extended to all funds while also eliminating relief relating to adviser discretion over accounts of existing clients who have not made a choice of funding intermediary.
A change to client agreements may also have to be made in situations where a financial firm is responsible for maintaining a client’s assets through a separate account custodian . Certain provisions of Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act require that registered advisers who manage any account of a pension or retirement plan (including individual retirement accounts or IRAs) must also provide their clients the ability to authorize a registered public accounting firm registered with the Public Company Accounting Oversight Board to examine certain client assets over which that adviser has custody in order to prevent unnecessary costs (which these rules were enacted to eliminate).
To comply with these rules, financial firms should ensure that they have the following measures in place to be able to accommodate the new changes: Firms should also be aware that the new adopting release will have no effect on their registration status under the Advisers Act. Firms should also note that having a separate account custody arrangement will not alter their ability to rely on the relying adviser rule provisions in the adopting release. Firms should consider taking time out of a busy schedule for the holidays coming up to have an open discussion with staff members handling compliance. While the new requirements are not to be implemented until March 2016, they are so radical that staff should discuss these issues to ensure they have enough time to implement and modify authorizations, templates and due diligence practices.
The Role and Impact of Regulators
Citing "significant jurisdictional and resource constraints," the SEC has left most enforcement of the custody rule to the states. State regulators generally have broad investigative and enforcement authority under their securities laws, and are responsible for managing state regulatory agencies responsible for enforcing the custody rule. Regulators have typically expressed satisfaction with how well firms have complied with the custody rule. For example, the North American Securities Administrators Association ("NASAA") examined custody rules in the U.S. between July 1, 2006, and January 11, 2007. The NASAA found that "requirements to safeguard client assets and maintain books and records of client transactions are consistently part of the examiners’ procedures." In a separate survey of its members during 2010 and 2011 – using the SEC’s 2011 "Risk Alert" as a guide – NASAA reported that 24 members found no instances of compliance violations or deficiencies, while seven others issued exam deficiencies and one more referred to a second examination to verify compliance.
Both the SEC and NASAA have promulgated guidance for examiners, with the goal of meeting their enforcement challenges through enhanced technological resources among supervisory and issuance systems that are used in examinations, plus better training and educational initiatives.
Future Issues and Considerations
While the adopting release has been received favorably in the investment industry, we strongly caution that firms have a systematic way of deconstructing the implications of the new client relationship management, internal compliance management, disclosure, risk assessment, training and e-discovery obligations to avoid unintended consequences. Firms doing business in multiple states have found compliance burdens to be particularly onerous and costly. We predict that the custody rule will be the subject of further regulatory and potentially legislative adjustments. The new requirements create additional regulatory burdens not just for dual registrants continuing to interact with their affiliated investment adviser but also for independent investment advisers. The depth and breadth of disclosure to clients is remarkable. When the cash "checkbook" of client accounts moves into broker-dealers, this will create endless vulnerabilities (to the extent not already thoroughly addressed in an amended custodian agreement) and legal liability for independent investment advisers. The SEC will probably propose amendments to the scrutiny provisions of the custody rule, particularly issues involving loans made to related parties, requiring standardized account statements and the role of accountants and third parties.
The Takeaway
In conclusion, the custody rule and its adopting release were designed to dovetail with a 2009 interim final rule of the Department of Labor ("DOL") that requires certain retirement plans governed by the ERISA to allow participants to transfer their assets into comparable investments in the event that a service provider has invested in its proprietary investment funds. A service provider’s failure to comply with the custody rule and the adopting release could have serious implications. Best practices for a compliance program include developing an internal procedure to ensure the custody rule and adopting release are broadly disseminated and reviewed by key personnel , as well as discussing with management the consequences of failing to comply with the custody rule and adopting release.
The adopting release requires all registered investment advisers who maintain custody (directly or indirectly) of client funds or securities to deliver account statements to clients account "at least quarterly," rather than annually under the current rule, and prohibits the adviser from having "actual" knowledge that the qualified custodian is also not delivering account statements directly to the client. It would seem that the adopting release would have little or no impact on a majority of registered investment advisers that have limited contact with clients to review or discuss account activity.
The adopting release represents a step forward in preparing the ground for more expansive liability of investment advisers under state laws that potentially could extend beyond pure civil liability for professional errors or omissions.