Custody | Examinations and Audits | Form ADV

Advisers May Have Custody and Not Even Know it….

SECSEC exam staff has been finding a deficiency where most advisers don’t expect it.  Recent SEC exams of registered investment advisers have included scrutiny of the standard custody arrangements that retail investment advisers have with some of the major custodians.  The questions raised by the SEC are focused on an adviser’s authorization to transfer funds between same-registered accounts at different custodians.  A number of advisers have received deficiency letters, stating that this authority gives the adviser custody over those accounts and requiring them to comply with the annual surprise exam requirements under the Investment Advisers Act Custody RuleBob Veres discussed this problem back in September, and it looks like the SEC may be close to addressing the issue in a no-action letter, based on a communication sent out by Schwab Advisors Services.

The language causing the problem is included in the account opening documents with custodians such as Schwab Advisory Services and Fidelity.  The documents provide that the custodian may remit checks, wire funds and make disbursement of funds from the client’s account to another financial institutional for credit to an account of identical registration.  The document further states that it is the investment adviser’s responsibility, not the custodian’s, to ensure that the account receiving the money is actually that same client’s account.   SEC staff has taken the view that advisers with authority to transfer funds or securities between same-registered accounts, where that authority does not include the specific account numbers, have custody under the Custody Rule, and are required to have an “annual surprise exam” to verify the assets in these accounts.

To avoid a potential deficiency, Fidelity has been telling advisers to review the SEC Custody Rule FAQ II.4. The response to this question states that an adviser can avoid having custody if the adviser gets written authorization from the client identifying the specific accounts maintained with each custodian where funds can be transferred, and sends copies of these authorizations to the respective custodians.

More recently, Schwab Advisor Services notified its clients that it expects the SEC to specifically state that an adviser with authority to transfer client funds to another financial institution has custody under Rule 206(4)-1 of the Advisers Act. Schwab anticipates that the SEC will issue a “No-Action Letter” in the next couple of weeks to provide more clarity on this issue. The expectation is that advisers who meet certain requirements will not have to conduct a surprise exam, although they will still need to declare custody over accounts where they have a standing letter of authorization to move funds.  Schwab expects that one requirement will be to have clients provide advisers with an account number at the same time they provide advisers with authorization to move funds.