In August 2023, the Securities and Exchange Commission reopened the comment period on a Custody Rule proposal that would:
- expand the scope of assets subject to custodial oversight,
- increase the roles of custodians and independent public accountants,
- require extensive contractual relationships between investment advisers and these entities, and
- require more detailed records of trade and transaction activity.
During the original comment period, firms expressed concern that the proposal would cause undue burden and negatively impact investment advisers.
The comment period has been reopened to provide firms with time to determine how the new audit provision in the recently passed Private Funds Rule impacts the proposal.
Background
SEC examinations regularly include a review of custody of client funds. An adviser is deemed to have custody if it or an affiliate holds client funds or securities, directly or indirectly, or has any authority to obtain possession of client funds or securities.
The Custody Rule requires an adviser that has custody of client funds or securities to maintain those assets with a “qualified custodian,” such as a bank or broker-dealer, and have a reasonable basis to believe that the qualified custodian sends quarterly account statements directly to the client.
What Firms Should Be Doing Now
Monitor Custody Rule compliance closely on an ongoing basis, and document this in the adviser ’s Annual Compliance Report required by SEC Rule 206(4)-7.
If applicable, be prepared for surprise annual examinations. All advisers that have custody of client assets are subject to an annual surprise examination conducted by an independent public accountant to verify that the client assets are protected. The accountant’s exam results must be filed with the SEC. A surprise audit is not required if the adviser has custody solely because it has authority to deduct advisory fees from client accounts. A surprise audit is also not required if the firm is an adviser to pooled investment vehicles subject to an annual financial statement audit by an independent public accountant registered with, and subject to, regular inspection by the PCAOB, and that distributes the audited financial statements to investors in the pool.
Examine for routinely and include in the annual compliance report the following:
- trading authority
- background checks of employees and service providers with access to client assets
- reconciliation of custody statements
- identity theft
- identification of any questionable conduct or red flags
- escalation of red flags to Senior Management/Chief Compliance Officer for immediate attention
Ensure policies and procedures are in place to mitigate the possibility of inadvertently triggering the Custody Rule. For example, this has happened where the adviser receives client assets such as cash or a check and does not immediately return the assets.
What If the Proposed Rule Passes?
If the proposed rule passes, advisers will need to make significant changes to several areas of operations and within the Compliance program. Policies, procedures, and controls will need to be created or revised to accommodate the additional scope of assets subject to custody, the complexity of custodian contracts, expansion of the rule’s audit provision, and new requirements for recordkeeping and Form ADV.
Oyster Consulting’s experts stay current with regulatory and compliance issues and are ready to help you navigate the challenges that your firm faces. Our consultants have regulatory and compliance experience to effectively conduct Annual Compliance Reviews and DOL-PTE reviews, as well as assist with other regulatory hot button issues.
