custody. definition of custody nasaa vs. sec eight safekeeping requirements exam items
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Custody
Custody
• Definition of Custody
• NASAA vs. SEC
• Eight Safekeeping Requirements
• Exam Items
Custody Definition
Having possession of
or
having access to
client funds or securities
Custody – So What?Client funds are at much greater risk from an insolvent or unscrupulous adviser.
Advisers are prohibited from having custody unless they follow certain Safekeeping Requirements.
Failure to follow Safekeeping Requirements may be considered a fraudulent business practice.
Adviser is usually required to maintain a significantly higher net worth and/or surety bond.
Adviser usually has additional financial reporting requirements.
Adviser usually has additional recordkeeping and disclosure requirements.
Custody Deficiencies
In the 2009 NASAA Coordinated IA Exams of 423 advisers, 11.8% of all exams noted deficiencies related to custody.
Custody68 Deficiencies
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0%
Trustee for Relative
Signatory
Non-disclosed Custody
Physical Custody
General Power of Attorney
General Partner
Trustee
Other - Custody
Inadvertent Custody
Direct Fee Deduction
>$500, >6 months fees
Annual Audit of PIV
Notice to Administrator
PIN to Client Account
11.8% of all advisers had at least one deficiency.
NASAA vs. SEC Custody
• SEC amended custody rules in 2010
• Did not change the definitions of custody
NASAA vs. SEC Custody Definition
NASAA MODEL RULE 102(e)(1)-1(c)(1)
“Custody” means holding directly or indirectly, client funds or securities, or having any authority to obtain possession of them [or has the ability to appropriate them]. Custody includes:
IA Act Rule 206(4)-2(c)1
"Custody" means holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. Custody includes:
NASAA 4 Custody Scenarios
1. Possession of client funds or securities unless received inadvertently and returned to the sender promptly, but in any case within three business days of receiving them;
2. Receipt of checks drawn by clients and made payable to unrelated third parties will not meet the definition of custody if forwarded to the third party within 24 hours of receipt and the adviser maintains the records required under Rule 203(a)2-22;
SEC 3 Custody Scenarios
1. Possession of client funds or securities, (but not of checks drawn by clients and made payable to third parties,) unless you receive them inadvertently and you return them to the sender promptly but in any case within three business days of receiving them;
These are the only “It’s custody, unless...” scenarios
3. Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and
4. Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities.
2. Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and
3. Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities.
NASAA SEC
NASAA Custody Scenario #1
Possession of client funds or securities unless received inadvertently and returned to the sender promptly, but in any case within three business days of receiving them
Examples:
1. Adviser receives stock certificates from client
2. Adviser receives cash from client for deposit into client’s account
3. Adviser receives a check made payable to the adviser for deposit into the client’s account
In order to not have custody...
Clock starts ticking...The adviser has 3 business days to return to the sender and document the return
NASAA Custody Scenario #2
Receipt of checks drawn by clients and made payable to unrelated third parties will not meet the definition of custody if forwarded to the third party within 24 hours of receipt and the adviser maintains the records required under Rule 203(a)2-22
Examples:
1. Adviser receives check from client made payable to client’s Schwab account
In order to not have custody...
Clock starts ticking...The adviser has 24 hours to forward to Schwab plus document the forwarding
Wait...Document What?
• Securities received and returned, or Checks forwarded
NASAA Model Rule 230(a)-2(a)(22)– Issuer (Payor)– Type of security and series (Type of Check)– Date of issue (Date of Check)– For debt instruments, the denomination, interest rate,
maturity date (Amount of Check)– Certificate number, including alphabetical prefix or
suffix (Check Number)– Name in which registered (Payee)– Date given to adviser– Date sent to client or sender, or date forwarded– Form of delivery, or copy of form of delivery– Mail confirmation number, or confirmation of delivery
NASAA Custody Scenario #3
Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian
Examples:
1. Direct fee deduction
2. General POA to withdraw funds from custodian
NASAA Custody Scenario #4
Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities
Examples:
1. Adviser is General Partner of pooled investment
2. Adviser is a Trustee for client
3. Adviser is Executor for client’s estate
OK, So what’s an adviser to do?
Eight Safekeeping Requirements
Serious violation of anti-fraud provisions
These do not provide relief from custody definition
May provide relief from increased net worth, bonding, and financial reporting requirements if jurisdiction grants waiver
Eight Safekeeping Requirements
• #1 Notice to Administrator• #2 Qualified Custodian• #3 Notice to Clients• #4 Account Statements
• #5 Independent Representative (more of a definition)• #6 Direct Fee Deduction• #7 General Partner of Investment Partnership
(with or without annual audits)• #8 Trustee or Executor for a client
Safekeeping Requirement #1
• Notice to Administrator– An investment adviser with custody must
notify the State securities administrator i.e. Secretary of State’s office, Securities Commission, etc… that the adviser has or may have custody. Such notification is required to be given on Form ADV part 1A Item 9 and part 1B Item 2(I)
Safekeeping Requirement #2
• Must use a Qualified Custodian– bank or savings association insured by FDIC– registered broker-dealer holding client assets in customer
accounts – registered futures commission merchant holding client assets in
customer accounts – foreign financial institution customarily holding financial assets
for its customers
• Customer Accounts must be– Segregated in separate accounts under client’s name, or– In accounts that contain only the adviser’s clients’ funds and
securities, under the adviser’s name as agent or trustee for the clients
Safekeeping Requirement #3
• Notice to Clients– At time of account opening– Any time the custodian changes– Custodian’s name, address, and the manner
in which the funds or securities are maintained
• Adviser’s responsibility
• Usually found in client’s advisory contract or in adviser’s ADV
Safekeeping Requirement #4
• Account Statements from Custodian– At least Quarterly– Shows all funds, each security and amounts, and all
transactions during the period
• If Adviser holds client funds and securities and provides statements– Independent CPA audit (yearly, unannounced,
reported to Administrator– Discrepancies reported to Administrator
#6 Direct Fee Deduction
• Notify Administrator (on ADV)
• Obtain written authorization from client
• Dual invoice client and custodian
– Client invoice must show• Amount of fee• Time period covered• Fee formula• Assets for which fee applied
– Custodian invoice must only show• Amount of fee and who it’s for
#7 GP of Investment Partnership(That has annual audits)
• Notify Administrator (on ADV)
• Has annual audit (minimally)
• Audit prepared in accordance with GAAP
• Audited Financial Statements distributed to all partners, owners, or members within 120 days of fiscal year end
#7 GP of Investment Partnership(That doesn’t have annual audits)
• Notify Administrator (on ADV)• Hire an independent “Gatekeeper”• Send gatekeeper all invoices and receipts for
fees, expenses, capital withdrawals
– Gatekeeper will• Determine if appropriate• Approve fee• Forward to custodian for payment
– Gatekeeper is “independent” if• No control relationship with adviser• No material business relationship within two years
#8 Adviser as Trustee (or Executor)• Notify Administrator (on ADV)• Invoice Requirement
– Dual invoice grantor and custodian just like direct fee deduction• Written Agreement with Custodian for
– Payment of Fees to Adviser• Grantor must authorize custodian to pay fees to adviser• Must be a detailed invoice for advisory fee• Custodian must send detailed quarterly statement to grantor
– Distribution of Assets• By instruction from authorized signatory only• Distributed only to
– Trust company, bank, or broker-dealer– Grantors or beneficiaries of the trust– Independent 3rd persons (attorneys, taxes, etc...)
Adviser as Trustee for Relative• Gives relief from all Custody Requirements (Including Safekeeping)• Gives relief from increased net worth, bonding, financial reporting
• Owner of trust must be a parent, grandparent, spouse, sibling, child or grandchild (includes “step” relations)
• The adviser must– Provide a written statement to each owner of the trust listing the
four Safekeeping Requirements and why the adviser will not be complying with them
– Obtain a signed acknowledgement for that statement from each owner of the trust
– Maintain a copy of both documents until account is closed or adviser is no longer trustee
Examination Time
Keep in mind that the adviser may not understand if it has custody or not. Exam Module interview questions address custody scenarios.
The Main IA Module lists custody and potential custody scenarios and provides questions to determine if adviser is in compliance with the safekeeping requirements for that particular type of custody scenario.
Get help from an experienced accounting person for examining an adviser acting as custodian
The Three “I”s…
• Identify custody situations
• Independence of custodian, CPA, auditors, and gatekeepers
• Investigate the flow of funds– Trace a customer’s purchase, deposit,
securities transfer, etc… from the customer to the custodian, ESPECIALLY if it passes through the adviser, asset verification
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