Overview of the Custody Rule 206(4)-2

Dave Banerjee CPA provides surprise custody examinations to Registered Investment Advisers (“RIA’s”) subject to the Custody Rule. Registered with the PCAOB, Dave Banerjee CPA is one of the most well-known accounting firms specializing in the investment management industry. Our role as the leading provider of regulatory consulting has resulted in a thorough understanding of your operations that will facilitate an efficient and effective custody examination.

RIA’s required to obtain a surprise examination must enter into a written agreement with an independent public accountant that provides that the first examination will take place by December 31, 2010 or, for RIA’s that become subject to the new requirement after March 12, 2010, within six months of becoming subject to the requirement.

Surprise Custody Rule Requirements

RIA’s that have custody are required to obtain an annual surprise examination. An RIA is deemed to have custody if they directly or indirectly hold client funds or securities, or have authority to obtain possession of them. This may include (see exemptions below):

  • Accounts for which RIA has ability to withdraw or have access to client funds or securities;
  • Assets indirectly or directly held by a related party; or
  • Acting as general partner for a limited partnership or manager of a limited liability company.

If the RIA or related party is the custodian, the surprise examination must be conducted by an independent account firm registered with the Public Company Accounting Oversight Board (“PCAOB”).

On December 30, 2009, the Securities and Exchange Commission (“SEC”) released its final amendments to Rule 206(4)-2 of the Investment Advisers Act of 1940 (the “Amended Rule”). The amendments, effective March 12, 2010, are intended to better safeguard client funds held by RIA’s. Custody as defined by the current and amended rule means, “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. You have custody if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services you provide to clients. Custody includes:

  • 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;
  • 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
  • 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.”

The custody rule previously required that an RIA with custody of client assets:

  • maintain the assets with a qualified custodian, such as a broker-dealer or bank;
  • notify clients of certain information if the RIA opens an account with a custodian on the client’s behalf; and,
  • have a reasonable belief that the qualified custodian sends account statements directly to clients or, alternatively the RIA sends quarterly statements to clients and undergoes an annual surprise audit.

In order to strengthen the custodial controls on RIAs with custody of client funds or securities, the Amended Rule provides that registered investment RIAs with custody of client funds or securities (with significant exceptions) is required, among other things:

  • maintain the assets with a qualified custodian in a separate account for each client under that client’s name; or in accounts that contain only your clients’ funds and securities, under your name as agent or trustee for the clients;
  • notify clients of certain information if the RIA opens an account with a custodian on the client’s behalf and following any changes to this information. If you send account statements to client, include in the notice and in any subsequent account statement a statement urging the client to compare the account statements from the custodian with those from the RIA;
  • have a reasonable belief, after due inquiry, that qualified custodian sends account statement at least quarterly to clients for which it maintains funds or securities;
  • undergo an annual surprise examination by an independent public accountant to verify client assets; and,
  • unless client assets are maintained by an independent custodian, to undergo an annual surprise examination and to obtain a report of the custodian’s internal controls relating to the custody of those assets (typically a SAS-70 Report) both from an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”).

Surprise Custody Examinations

The surprise examination will at a minimum include:

  • Examination of the books and records as they relate to the RIA’s custody
  • Confirmation with the qualified custodian(s) & client(s)

->Confirmation with the qualified custodian(s):

    • client funds and securities as of the date of the examination, and
    • client’s funds and securities are held in either a separate account under the client’s name or in accounts under the name of the RIA as agent or trustee for clients.

->Confirmation with the client(s):

    • funds and securities held in the account as of the date of the examination, and
    • contributions and withdrawals of funds and securities to and from the account since the date of the last examination.
    • Reconciliation of confirmations and other information received.

Exemptions to Surprise Custody Examination

The rule exempts some RIA’s from the surprise examination:

  • Those deemed to have custody solely because a related person has custody of client assets,
  • Those deemed to have custody solely because they are a general partner to a pooled investment vehicle that is subject to an annual financial statement audit by an independent public accountant, registered with the PCAOB, and that distributes the audited financial statements prepared in accordance with generally accepted accounting principles to the pool’s investors within 120 days of the fund’s fiscal year end.
  • Those that are deemed to have custody solely because its related person holds client assets; and (ii) the adviser is “operationally independent” of its related custodian.