Investment Companies Advisor: Evaluating the Need for a Surprise Examination: An Important Custody Rule Consideration for Registered Investment Advisory Firms

December 3, 2015

In October 2014, the Securities and Exchange Commission announced that it had sanctioned three investment advisory firms, citing the firms with violations of the Custody Rule. With fines approaching $1 million from these enforcement actions, this serves as the most recent example of actions taken over the past three years focused on enforcing the Custody Rule, which mandates investment firms to meet specific standards while maintaining custody of funds or securities on behalf of their clients.

These actions by the SEC were the latest in the heightened enforcement of regulations established by the Dodd-Frank Act, which was passed in 2010. According to the SEC, violations of the Custody Rule were a recurring theme during recent SEC exams of private equity fund advisers and other investment adviser registrants. Those who failed to comply with Custody Rule obligations most often had not recognized they had custody of clients’ assets or the need to engage a public accounting firm to perform a surprise examination.

The SEC Custody Rule provides basic client protections when a registered investment adviser has custody or is deemed to have custody of client assets. Among other requirements, the Rule requires the adviser to engage an accounting firm registered with and inspected by the PCAOB to perform an annual surprise examination to verify existence of client assets. Surprise examinations provide additional safeguards against assets being stolen or misused.

The responsibility for determining whether or not a surprise examination is warranted falls on the registered adviser firm or more often the firm’s Chief Compliance Officer, whose sole responsibility to ensure that the company complies with SEC standards and other laws and regulations. The adviser should monitor its compliance with the SEC Custody Rule on an ongoing basis as a change in circumstances may trigger a requirement to have a surprise examination.

Although Rule 206(4)-2 of the Investment Advisers Act of 1940 offers a broad overview of custody, it does not provide an explicit checklist to advisers to analyze their unique situation. Below is a listing of the most common situations that indicate an adviser has custody of client assets, requiring the adviser to engage an accounting firm to perform a surprise examination:

  • Receiving checks written to a client and depositing the checks to the client account.
  • Writing checks or paying bills on behalf of the client.
  • Having knowledge of client investment account password recovery questions. (Example: The adviser helped the client to set up an account.)
  • Having access to client investment accounts, including read-only access.
  • Adviser or its employee serves as a trustee or has power of attorney over client’s assets.
  • Serving as general partner, managing member or comparable position for any type of pooled investment vehicle that gives the adviser, or its supervised person, legal ownership of or access to client funds or securities.
  • The adviser relies on the audited financial statement exemption for pooled investment vehicles, but a) the auditor who performed the audit is not registered with and inspected by the PCAOB, or b) the audited financial statements of the pooled investment vehicle have not been distributed to the investors within the specified period.
  • Customer assets are held with an affiliated custodian.
  • Customers do not receive quarterly account statements from a qualified custodian.

Costs Can Go Beyond Fines

The actual cost of Custody Rule violations, including failure to obtain a custody examination, goes well beyond the fines incurred. Investment advisory firms with potential violations must endure the time and expense of going through an investigation, hiring lawyers and preparing a defense. There is also the scrutiny of an investigation and the damage to public confidence that can be done to an investment adviser firm’s brand name. In the most recent announcement of Custody Rule violations by the SEC, one of the firms cited was suspended from the investment industry for a one-year period and was assessed nearly $350,000 in fines.

Custody Rule compliance is not limited to advisers registered with the SEC, as many states have instituted similar registration rules. Some states allow for fewer custody audit exemptions, resulting in regulations for investment advisers that are much stricter than those enforced by the SEC.

It is imperative for investment advisers to monitor and evaluate their compliance with the SEC and state Custody Rules on an ongoing basis. To their credit, it appears that many advisers are beginning to look more closely at the regulations surrounding the Custody Rule due to the recent enforcement actions brought by the SEC against advisers.

We Can Help!

In the past few years, the SEC has made Custody Rule enforcement a priority. Investment advisers and their chief compliance officers should be acutely aware of their responsibilities and the penalties involved for the failure to recognize the need to have a surprise custody examination. Elliott Davis Decosimo is registered with and inspected by the PCAOB and performs annual surprise custody examinations of registered investment advisers. Our audit team has the knowledge and experience to cover all aspects of these examinations. If you have any questions regarding custody examinations, please check with your Elliott Davis Decosimo adviser or contact our Investment Companies Practice Leader Renee Ford at renee.ford@elliottdavis.com.

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