The Securities and Exchange Commission (SEC) is charged with regulating the activity of registered investment advisors. There are numerous compliance rules advisors are expected to adhere to as outlined in the Investment Advisers Act. Rule 206(4)-2, commonly referred to as the custody rule, defines RIA responsibilities as they relate to the holding of client assets. Ready to connect with new clients? SmartAdvisor helps bring qualified leads to you.
What Is the SEC Custody Rule?
The custody rule applies to RIAs and the way that client assets are held. Specifically, the rule dictates that RIAs must:
- Maintain client assets and securities with a financial institution or entity that meets the criteria to be a qualified custodian.
- Notify clients in writing of the custodian’s name, address and the way in which assets are held.
- Reasonably believe that the custodian will send account statements to clients in a timely manner.
- Submit to a surprise exam on an annual basis for independent verification of client assets and securities holdings.
The rule allows RIAs to hold client assets and securities in a separate account for each client, under that client’s name or in an account under the advisor’s name. If funds are held by the adviser, they must be named as an agent or trustee for their clients.
Custody Rule FAQ
It’s important to understand the custody rule in order to ensure that your business is compliant with regulatory guidelines. Here are some of the most commonly asked questions about the SEC custody rule.
Q: What is custody under the custody rule?
Custody is defined as “holding, directly or indirectly, client funds or securities or having any authority to obtain possession of them.” An RIA is deemed to have custody if it has possession or control over client assets, authority to withdraw funds from client accounts or acts in a capacity that grants access to or ownership of client assets.
For example, the SEC considers an advisor to have custody if they have password access to client accounts allowing them to withdraw funds or securities.
Q: Who is a qualified custodian under the SEC custody rule?
Qualified custodians are responsible for holding client assets and securities on behalf of a registered investment advisor. The term “qualified custodian” can refer to banks, registered broker-dealers, futures commission merchants or certain foreign entities.
Q: Who must an advisor notify if they have custody of client assets?
When an RIA opens an account with a qualified custodian on behalf of a client, the advisor is responsible for notifying the client in writing. Specifically, the RIA must provide the client with the custodian’s name, address and the manner in which funds or securities are held. Notice is required to be sent promptly when the account is opened and when any of the information provided changes.
Q: How often must qualified custodians send account statements to clients?
The custody rule requires custodians to send out client account statements on at least a quarterly basis. Qualified custodians must furnish these statements to clients directly. Advisors can produce their own account statements but are required to advise clients to compare these statements to the ones sent by the custodian.
Q: When is a surprise examination required?
If an investment advisor has custody of client assets, they are automatically subject to an annual surprise examination. This examination is conducted by an independent public accountant who is charged with verifying some or all of the client assets being managed by an advisor.
Q: What is the custody rule for private securities?
The custody rule allows an exception for assets that are considered to be privately offered securities under the Investment Advisers Act. Privately offered securities are securities that are:
- Acquired from the issuer outside the scope of a public offering
- Uncertificated, with ownership recorded only on the books of the issuer or its transfer agent in the name of the client
- Transferable only with the prior consent of the issuer
If an RIA is managing those types of assets, they’re not required to hold them with a qualified custodian.
Q: If an employee of an advisory firm serves as a trustee to one or more of the firm’s clients, does the firm have custody?
Yes, under SEC rules the role of the supervised person as trustee is sufficient to cause the firm to have custody of client assets. However, there is an exception if the supervised person is appointed as trustee as a result of a family or personal relationship with the grantor or beneficiary, rather than as a consequence of their employment.
Q: If an advisor manages client assets other than funds or securities, does the custody rule apply?
The custody rule applies only to clients’ funds and securities. If an RIA manages other assets on behalf of a client outside of those categories, they are not required to hold them with a qualified custodian.
Q: What happens if an RIA is not in compliance with the custody rule?
The SEC takes compliance with the custody rule and other regulatory guidelines seriously and can charge firms that are found to be in violation. Noncompliant firms can be subject to steep civil penalties and individual advisors may be subject to further disciplinary action, including censure.
Q: What are the proposed changes to the custody rule?
In early 2023, the SEC proposed changes to the custody rule that would expand its scope. One of the most significant changes would extend the custody rule beyond client funds and securities to include a broader range of assets. Specifically, that would include things like options and short positions, real estate, artwork, precious metals, certain commodities, cryptocurrencies and other digital assets. The proposal would also require qualified custodians to maintain possession or control of client assets, pursuant to a written agreement with a registered advisor.
The SEC’s custody rule is important to understand when completing your RIA compliance requirements checklist. Noncompliance could be costly, in more ways than one. You can find a more detailed schedule of custody rule FAQ on the SEC website, along with the latest updates on proposed amendments to this and other regulatory guidelines for RIAs.
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