This month, Lexington Compliance focuses on custody issues and addresses the question “Does your firm have ‘custody’ and not realize it?”
In March 2013, the Securities and Exchange Commission (SEC) issued a risk alert outlining significant deficiencies that the agency's national registered investment adviser (RIA) examination program discovered related to investment adviser custody and safety of client assets. The SEC's investment adviser examination program noted that approximately one-third of RIA regulatory compliance deficiencies discovered during investment adviser audits were related to custody issues. Similar to the SEC's past risk alerts, custody was once again one of the most common regulatory compliance deficiencies for state-registered investment advisory firms according to the recently released North American Securities Administrators Association (NASAA) 2015 Investment Adviser Coordinated Examinations Report. As RIA compliance consultants, we frequently find that investment advisers do not fully understand the many scenarios that can lead to an investment advisory firm being deemed to have custody.
Given that we are currently in the midst of the RIA registration renewal season, now is a good time for an investment advisory firm's Chief Compliance Officer (CCO) to review the firm's business practices to ensure that the firm does or does not have custody of client funds. Often, RIA firms assume that they do not have custody if they are utilizing a traditional RIA custodian, such as Scottrade® Advisor Services, to manage all client accounts separately. However, there are a number of common scenarios that the SEC has identified in which an RIA firm may fail to identify that it is deemed to have custody. Some of these scenarios include:
- Bill-Paying Services: Many firms that cater to the high or ultra-high net worth client segments have been looking to offer additional "high-touch" services to their clients. One such common service is bill paying. An RIA firm is not restricted from providing bill-paying services, but it is likely that offering this new service will mean that the firm is now deemed to have custody given that the firm now has the ability to withdraw funds from client accounts.
- Check-Writing Authority: Similar to bill-paying services, if an advisory firm has the ability to write checks on behalf of its clients, it will likely be deemed to have custody.
- Online Login Access to Client Accounts: RIA firms should never possess a client's individual username and password in order to access the client's account to manage it. If an RIA firm does possess this login information, it will likely be deemed to have custody given that it now has direct access to the client's accounts to make withdrawals, etc. A better practice would be for the investment adviser to be granted a separate login account which only gives the adviser the ability to execute trades, etc. and not transfer funds in any manner.
- Trustee or Power of Attorney: If an adviser or related person of an RIA firm serves as the trustee or has power of attorney over any client account, the RIA firm will likely be deemed to have custody.
- General Partner of a Pooled Investment Vehicle: If the RIA firm is looking to expand into alternative investments and perhaps offer clients access to limited partnerships managed by the advisory firm, the firm will likely be serving as the general partner of the investment vehicle and may be deemed to have custody.
By no means are these five scenarios an exhaustive list of all the circumstances which may trigger an RIA firm to be deemed to have custody by the SEC or relevant state(s), but these are some common scenarios which have been known to trip up RIA firms in regard to custody. It should also be noted that each state has its own individual investment adviser custody compliance requirements. While the custody rules for some states may closely mirror those of the SEC, some states have their own unique regulatory requirements. Thus, as RIA compliance consultants, we recommend that all investment advisory firms review the custody requirements in their relevant jurisdictions to determine if the firm may be deemed to have custody.
For more information, check out our recent blog posts titled: Does my RIA firm have custody? or Does my RIA firm have custody due to direct fee deduction of investment advisory fees?
To learn how Lexington Compliance can help you understand compliance issues, please visit riainabox.com. Talk to your advisor service team at 877.726.8741 or firstname.lastname@example.org about the free basic compliance hotline* provided by Lexington Compliance to independent investment advisors who custody their assets with Scottrade.
*The scope of this service will include basic questions about the operation of a registered investment advisor and related compliance and registration areas. If an inquiry requires extensive research, significant review of materials or drafting of materials, then Lexington will offer its standard compliance consulting packages for a fee. If you choose to retain Lexington for compliance consulting services that are outside the scope of the hotline, you are responsible for making all required payments.
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