Custody

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Custody
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Custody

• Definition of Custody
• NASAA vs. SEC
• Eight Safekeeping Requirements
• Exam Items

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Custody Definition

• Having possession of
• or
• having access to
• client funds or securities

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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.
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Custody Deficiencies
In the 2009 NASAA Coordinated IA Exams of 423
advisers, 11.8 of all exams noted deficiencies
related to custody.
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11.8 of all advisers had at least one deficiency.
gt500, gt6 months fees Annual Audit of PIV Notice
to Administrator PIN to Client Account
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NASAA vs. SEC Custody

• SEC amended custody rules in 2010
• Did not change the definitions of custody

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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
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• NASAA 4 Custody Scenarios
• 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
• 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 Its custody, unless...
scenarios
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NASAA
SEC

• 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.

1. 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
2. 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.

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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 clients account 3. Adviser receives
a check made payable to the adviser for deposit
into the clients 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
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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 clients Schwab
account
In order to not have custody... Clock starts
ticking...The adviser has 24 hours to forward to
Schwab plus document the forwarding
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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

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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
• Direct fee deduction
• General POA to withdraw funds from custodian

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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
• Adviser is General Partner of pooled investment
• Adviser is a Trustee for client
• Adviser is Executor for clients estate

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OK, So whats 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
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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

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Safekeeping Requirement 1

• Notice to Administrator
• An investment adviser with custody must notify
  the State securities administrator i.e. Secretary
  of States 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)

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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 clients
  name, or
• In accounts that contain only the advisers
  clients funds and securities, under the
  advisers name as agent or trustee for the clients

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Safekeeping Requirement 3

• Notice to Clients
• At time of account opening
• Any time the custodian changes
• Custodians name, address, and the manner in
  which the funds or securities are maintained

• Advisers responsibility
• Usually found in clients advisory contract or in
  advisers ADV

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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

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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 its for

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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

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7 GP of Investment Partnership(That doesnt
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

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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...)

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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

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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
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The Three Is

• Identify custody situations
• Independence of custodian, CPA, auditors, and
  gatekeepers
• Investigate the flow of funds
• Trace a customers purchase, deposit, securities
  transfer, etc from the customer to the
  custodian, ESPECIALLY if it passes through the
  adviser, asset verification