Custody Rule

Today I go into more detail about the Custody Rule, which I first introduced here.

Custody fits into my world as described in this fourth paragraph. If I want to start managing wealth for others, then do I want to pursue work as an Investment Adviser [Representative] (IA) or hedge fund? Do I want to trade in SMAs (Appendix A, third paragraph)? Part of me doesn’t want the trouble of holding onto others’ money, and I would strongly suggest others not give their money over to anyone else.

From a legal perspective, custody is a complicated issue. Anyone [thinking about pursuing] working in the financial industry usually gets a question(s) about custody on the Series exams. If you are thinking about hiring a wealth manager or investing in a [hedge] fund, then custody should be understood to protect yourself.

Custody is a big deal because much fraud in the advisory business could be avoided if client assets were never turned over in the first place. This pertains to smaller operators. Don’t give your money to someone you met through a friend of a friend: you may never get it back. Full-service financial firms with a bank, IA, insurance company, recognizable brand name, etc., are okay. Custody is natural to have for an IA that is an affiliate of a large bank or broker-dealer, too.

I will now explain custody and detail some regulations surrounding it.

An IA has custody of client assets when the adviser actually holds funds/securities or can appropriate them. If the adviser can automatically deduct funds from the client’s account or write checks out of the account, then the advisor has custody of client assets. If the adviser has an ownership stake in the entity (e.g. broker-dealer) who maintains custody, then the adviser has custody of client assets. If the adviser is the general partner in a limited partnership or a managing member of an investment LLC, then the adviser has custody of client assets.*

Regulation of IAs is conducted through the state securities Administrator and/or the Securities and Exchange Commission.

By law (Uniform Securities Act), an IA must first discover whether the Administrator has any rule prohibiting custody of client assets. Custody should not be taken if such a rule exists.

When an IA takes custody, the Administrator must be notified in writing promptly. Promptly is not immediately nor is it months to years. Promptly is a reasonable amount of time and probably open to interpretation. I would not feel comfortable trying to unnecessarily try to drag this out.

Custodial IAs must maintain a higher minimum net worth, must provide an audited balance sheet to regulators and to clients, and must pay an independent CPA to conduct a surprise audit once per year. If the CPA cannot decipher securities and cash positions from the books and records, then the CPA is to notify the regulators promptly.

If an IA inadvertently receives client securities in the mail, then securities must be returned to sender within three business days to avoid IA being deemed as having custody. IA should also keep records explaining what happened to avoid having to maintain a higher net worth, having to get an expensive CPA audit, and having to update its registration information.

If an IA receives check from client payable to third party, then similar steps must be taken to avoid IA being deemed as having custody. First, third party must not be an affiliate of the IA. Second, check must be forwarded to third party within three business days. Finally, advisor must keep records as to what happened.

Custody is not just a minor inconvenience: it’s a bona fide PITA. Most IAs avoid it; banks and broker-dealers who provide custodial services often do so for a reasonable charge.

* — A fuller description would go into more detail about broker-dealers and corporate structure.