Question: If an adviser inadvertently receives securities from a client, under the amended rule may the adviser forward the securities to the qualified custodian instead of returning the securities to the client?

Answer: No. If the adviser does not return the securities to the sender within three business days, the adviser not only has custody but has also violated the amended rule’s requirement that client securities be maintained in an account with a qualified custodian. However, the Division would not recommend enforcement action to the Commission under certain circumstances if an adviser inadvertently receives tax refunds from tax authorities, or client settlement proceeds from administrators in connection with class action lawsuits and other legal actions, or stock certificates, dividends, or evidence of new debt from issuers in connection with class action lawsuits involving bankruptcy or business reorganization, and forwards these client assets within five business days of its receipt and maintains appropriate records.

This past Friday, the staff of the Division of Investment Management issued its much anticipated responses to questions about the amended custody rule. I will address each one in turn, but since I have been focusing on the due inquiry requirement I want to start with that first. There had been a question of how an adviser could satisfy the due inquiry requirement when clients receive their account statements from their qualified custodian by way of a download from the custodian’s web site. here is the SEC’s response:

“Advisers whose clients receive electronic statements from qualified custodians must still form a reasonable belief after due inquiry that the clients are receiving those statements. The adviser may satisfy this requirement by, for example, being copied on the email notifications of account statement postings sent to clients in addition to having access to client statements on the custodian’s website, although this is not the exclusive means of forming that reasonable belief.”

Apparently Fidelity is putting together a response to the “due inquiry” requirement regarding the delivery of account statements. Somehow Fidelity believes that because they are a qualified custodian that the adviser does not need to get copies of the account statement. I ask you, did Fidelity’s lawyers actually go to law school? The rule is 100% clear as to an adviser’s responsibilities. No where does it state that the qualified custodian can take responsibility for the adviser’s due inquiry.

Requirement

Advisers with custody of client assets are required to undergo a surprise examination of those assets by an independent public accountant.

Objective

The objective of the accountant’s examination is to verify that client funds and securities of which an investment adviser has custody are held by a qualified custodian in a separate account for each client under that client’s name, or in accounts that contain only clients’ funds and securities, under the investment adviser’s name as agent or trustee for the clients.

PCAOB Registration and Inspection

The surprise examination must be conducted by an independent public accountant that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (“PCAOB”).

Surprise Audit

The accountant should obtain from the investment adviser records that detail client funds and securities of which the investment adviser has custody and the identification of the qualified custodian(s) of those funds and securities. The accountant should also obtain records of accounts that were closed during the period or that have a zero balance as of the date of the examination.

For a sample of client accounts, the accountant should obtain records of the purchases, sales, contributions, withdrawals and any other debits or credits to each selected client’s account occurring since the date of the last examination. The accountant’s procedures to meet the objective of the examination should normally include, but are not limited to, the following with respect to each selected client account:

• Confirmation with the qualified custodian(s) of client funds and securities as of the date of the examination and that the 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 investment adviser as agent or trustee for clients;
• Confirmation with the client of 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; where confirmation replies are not received, the accountant should perform alternative procedures; and
• Reconciliation of confirmations received and other evidence obtained to the investment adviser’s records.

Commission Reporting

Under amended rule 206(4)-2, each investment adviser subject to the surprise examination requirement must enter into a written agreement with an independent public accountant to conduct the surprise examination. The agreement must require the accountant, among other things:

• To submit Form ADV-E via the IARD system to the SEC accompanied by the accountant’s certificate within 120 days of the time chosen by the accountant for the surprise examination, stating that the accountant has examined the funds and securities and describing the nature and extent of the examination;
• To notify the SEC within one business day of finding any material discrepancy during the course of the examination; and
• To file via the IARD system, upon dismissal or resignation within four business days a statement regarding the termination along with Form ADV-E.

As we all know by now, investment advisers that send out their own statements to clients are required to place a notice on any such statement “urging” the client to compare the adviser’s information with the statement sent by the client’s qualified custodian. From my conversations with clients and other compliance professionals, the prevailing wisdom is that unless the statement sent by the investment adviser contains much of the same type of information sent by qualified custodian, it is not a “statement” and no notice is required. I have come to find out that this is wrong, wrong, wrong. One of my clients - who always seems to know more than I do - spoke with a representative of the SEC and was told point blank that the SEC intended to use the term “statement” generically and that if the “statement”, “report”, “appraisal” or whatever other term an adviser applied to what they send to clients “contains account balance information” then it is a statement and must have the required notice. Therefore, even if what the adviser sends to clients does not contain transactional information or even holdings information, the SEC would expect to see a version of the following notice:

“Pursuant to recent amendments to Rule 206(4) under the Investment Advisers Act of 1940, the Securities and Exchange Commission now requires us to urge clients to compare the information set forth in this statement with the statements you receive directly from your custodian to ensure that all account transactions are proper.”

I have a great client that always challenges me with well, challenging compliance questions. His latest was something along the lines of:

“In the case where an adviser representative has a general power of attorney for a client, and thereby has access to a client’s bank accounts as well as brokerage accounts, do you think the requirement to reconcile statements as well as the scope of the audit extend to these bank accounts or would it be confined to accounts over which the adviser provides advice?”

My response was as follows:

The following language can be found in the Final Rule Release:

“Advisers also should consider developing policies regarding the ability of individual employees to acquire custody of client assets (i.e., as trustees for client assets), because their custody may be attributable to the firm, which will thereby acquire responsibility for those assets under the rule.”

While the SEC offers no examples of when it “may or may not” be attributable to the firm, at least they contemplated such a situation. Since it is ambiguous, however, maybe the tipping point could be something along the lines of whether the firm provides advice to the client. I just cannot say for sure. It may have to be one of those things that must wait until either an audit or a no-action letter.

Requirement

When a related person serves as a qualified custodian for advisory client funds or securities, an adviser must receive from its related person, no less frequently than once each calendar year, a written report, which includes an opinion from an independent public accountant with respect to the related person’s controls relating to custody of client assets.

Objective

The objective of the examination supporting the internal control report is to obtain reasonable assurance that the related party’s controls have been placed in operation as of a specific date and are suitably designed and are operating effectively to meet control objectives related to custody of funds and securities.

PCAOB Registration and Inspection

The internal control report must be prepared by an independent public accountant that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (“PCAOB”).

Internal Control Report

The internal control report should address control objectives and associated controls related to the areas of client account setup and maintenance, authorization and processing of client transactions, security maintenance and setup, processing of income and corporate action transactions and client reporting.

The internal control report objectives should include:

· Documentation for the opening and modification of client accounts is received, authenticated, and established completely, accurately, and timely on the applicable system.

· Client transactions, including contributions and withdrawals, are authorized and processed in a complete, accurate, and timely manner.

· Trades are properly authorized, settled, and recorded completely, accurately, and timely in the client account.

· New securities and changes to securities are authorized and established in a complete, accurate and timely manner.

· Securities income and corporate action transactions are processed to client accounts in a complete, accurate, and timely manner.

· Physical securities are safeguarded from loss or misappropriation.

· Cash and security positions are reconciled completely, accurately and on a timely basis between the custodian and depositories.

· Account statements reflecting cash and security positions are provided to clients in a complete, accurate and timely manner.

As part of the internal control report, the independent public accountant must verify that funds and securities are reconciled to a custodian other than the adviser or its related person (for example, the Depository Trust Corporation). The accountant’s tests of the custodian’s reconciliation(s) should include either direct confirmation, on a test basis, with unaffiliated custodians or other procedures designed to verify that the data used in reconciliations performed by the qualified custodian is obtained from unaffiliated custodians and is unaltered.

The accountant’s internal control report should identify the control objectives included within the scope of the examination and include the accountant’s opinion as to whether controls have been placed in operation as of the specific date, and are suitably designed and are operating effectively to meet the identified control objectives during the specified period. The report should also describe the nature, timing, extent and results of the accountant’s procedures performed to verify that funds and securities are reconciled to depositories and other unaffiliated custodians.

Is anyone else bemused at the SEC’s inability to get it right?  The SEC issued a new custody rule that not only neglects to consider future custodial practices, but ignores current practices as well. As you should know by now, the SEC has created a new “due inquiry” standard for investment advisers when forming a reasonable belief that a client’s qualified custodian sends out account statements. And yet, they are without any clue as to how an adviser that has clients that can only obtain account statements by accessing the statement via the custodian’s web site can satisfy the due inquiry standard. Do they want everyone to go back to receiving paper statements? Not very green if you ask me. Did they even consult with the larger custodians such as Schwab, Fidelity or TD Ameritrade?