OCIE Examiners Offer Key Custody Takeaways for Registered Advisers.

[ by Howard Haykin ]

SEC Registered Investment Advisers ("RIAs") were advised to review their practices and responsibilities under the custody rule because OCIE examiners are finding numerous deficiencies that lead to violations of to Advisers Act custody rule. 

This alert from the Office of Compliance Inspections and Examinations provides advisers with key takeaways that will enable them to implement stronger policies and procedures so as to better protect customers assets, and avoid violating provisions of the Investment Advisers Act of 1940.

Significant Deficiencies Involving Adviser Custody and Safety of Client Assets.   If the custody rule is such a critical rule under the Advisers Act, why do 33% of advisers have inadequate custody procedures in place?   Significant deficiencies means that advisory client assets are not adequately protected from misuse of misappropriation, and advisers are getting sanctioned for rule violations. Those statistics were compiled from examinations conducted by NEP (National Exam Program) staff - principally members of the Office of Inspection & Examinations, or OCIE.

When the NEP staff identifies a risk priority area on which it will focus during an exam, it often means the examiners will review the adviser’s books and records, business, and operations as they relate to the safety of its clients’ assets. Upon discovering deficiencies and violations of rule provisions, examiners look for remedial measures taken by advisers, including among other things, drafting, amending or enhancing their written compliance procedures, policies, or processes; changing their business practices; or devoting more resources or attention to the area of custody.  NEP examiners also refer their findings to the SEC’s Division of Enforcement, where appropriate.

Background of the Custody Rule.   RIAs with custody of client assets must comply with the custody rule. Having custody means the Adviser or one of its related person holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them.

e.g. -   an adviser that serves as the general partner of a pooled investment vehicle (“PIV”) (or holds a comparable position), generally has custody of client assets because the position of general partner gives legal ownership or access to client funds and securities. 

In this case, the custody rule prescribes a number of requirements designed to enhance the safety of client assets by insulating them from any possible unlawful activities or financial reverses of the investment adviser, including insolvency. The custody rule’s key safeguards include:

• Use of “qualified custodians” to hold client assets.  An adviser with custody generally must maintain client funds and securities at a qualified custodian - e.g., a bank or a broker-dealer - either in a separate account for the client under the client’s name or in an account under the adviser’s name as agent or trustee for the adviser’s clients that contains only client assets - i.e., client assets may not be commingled with the adviser’s assets.

• Notices to clients detailing how their assets are being held.  An adviser that opens an account with a qualified custodian on the client’s behalf must notify the client in writing and provide the client with certain information.

• Account statements for clients detailing their holdings. An adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends account statements to clients at least quarterly.

• Annual surprise exams. Advisers that have custody of client assets in many cases must undergo an annual surprise examination by an independent public accountant that verifies client funds and securities.

• Additional protections when a related qualified custodian is used.  If the adviser’s related person (or the adviser itself) acts as the qualified custodian, then the annual surprise examination must be conducted by an independent accountant registered with, and subject to regular inspection by, the PCAOB, and the adviser must obtain from the accountant at least once each year a report of the internal controls relating to the custody of client assets.
• The audit approach for advisers to pooled investment vehicles. With the “audit approach,” the adviser, at least annually, distributes audited financial statements to investors in the pooled investment vehicles. If using the “audit approach,” advisers to pooled investment vehicles do not have to comply with the notice and account statement delivery obligations of Rule 206(4)-2(a)(2) and (a)(3) and are deemed to have satisfied the surprise examination requirement of Rule 206(4)-2(a)(4).

Deficiencies Identified.   There are 4 categories of custody-related deficiencies that the NEP staff observed:

1. failure by an adviser to recognize that it has “custody” as defined under the custody rule;
2. failures to comply with the rule’s “surprise exam” requirement;
3. failures to comply with the “qualified custodian” requirements; and,
4. failures to comply with the audit approach for pooled investment vehicles.

Here, the SEC expands upon each of the 4 categories:

► 1.  Failure By Advisers To Recognize They Have Custody.    Here are scenarios where this occurred:

• Employees or Related Persons may serve as trustee or are granted power of attorney for client accounts.
• Adviser provides Bill-Paying Services for clients and, therefore, is authorized to withdraw funds or securities from the client’s account.
• Adviser manages portfolios by directly accessing online client accounts, using clients' User IDs and Passwords without restrictions - thus, they have ability to withdraw funds and securities from the clients’ accounts.
• Adviser serves as a General Partner of a limited partnership or holds a comparable position for a different type of pooled investment vehicle.
• Adviser has physical Possession of Assets, such as securities certificates.
• Adviser has check-writing and signatory authority for client accounts.
• Advisor receives checks made payable to clients and fails to return them promptly to the sender.

► 2.  Surprise Exam Requirement.   NEP staff observed deficiencies when: 

• A Form ADV-E was not filed within 120 days after the date of the exam chosen by the accountant.
• Evidence suggested that 'surprise' exams were not being conducted - e.g., exams conducted at he same time each year).

► 3. Qualified Custodian Requirements.  Such requirements were not satisfied when:

• Client assets were held in the adviser’s name, but not in an account that was under the adviser’s name as agent or trustee for the client and that held only client assets.
• Adviser commingled client, proprietary, and employee assets into one account.
• Certificates of securities held by the adviser’s fund were held in a safe deposit box controlled by the adviser at a local bank.
• Adviser did not have a reasonable basis, after due inquiry, for believing that a qualified custodian was sending quarterly account statements to the client.
• Upon opening a custodial account on behalf of a client, the statements sent by adviser fail to include notification urging clients to compare the account statements from the custodian with those from the adviser.

► 4. Audit Approach Issues.  Some advisers that relied on the “audit approach” with respect to pooled investment vehicles were not in compliance because:

• The accountant that audited the financial statement was not “independent” under Regulation S-X, as required by the custody rule.
• Audited financial statements not prepared in accordance with GAAP  - for example:

⇒  organizational expenses were improperly amortized rather than expensed as incurred, resulting in a qualified audit opinion;
⇒  financial statements prepared on a federal income tax basis;
⇒  adviser could not substantiate fair valuations and accountant therefore could not issue an unqualified opinion on the financial statements).
⇒  adviser failed to demonstrate that audited financial statements were distributed to all fund investors.  Instead, it appeared that statements often were made available upon request.
⇒  audited financial statements not sent to investors within 120 days of the private funds’ fiscal Y/Es (or 180 days for fund of funds).
⇒  auditor was not PCAOB-registered and subject to PCAOB inspection.
⇒  final audit was not performed on liquidated pooled investment vehicles.
⇒  adviser requested investor approval to waive the annual financial audit of a fund - but did not obtain a surprise examination - adviser therefore failed to either undergo a surprise exam or comply with the audit approach.

Additional Deficiencies Registrants Should be Aware of.    In addition to the above, examination staff observed that advisers to some PIVs may be using financial statements for those PIVs to satisfy the custody rule’s audit approach that are not prepared in accordance with U.S. GAAP or audited in accordance with U.S. Generally Accepted Auditing Standards ("GAAS") as described in the 2003 Custody Rule Adopting Release, without satisfying the conditions set out in that guidance.
 

For further details, go to:   [ SEC NEP Risk Alert - Vo. III, Issue 1, 3/4/13 ].