The SEC Custody Rule

By Courtney K. Corallo, CPA, Business Assurance & Advisory Services Senior Manager

The SEC Custody Rule

What investment advisors need to know about Custody Rule compliance

The Security and Exchange Commission’s (“SEC”) mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.  In order to protect investors, the SEC enforces federal securities laws, including the SEC Custody Rule (the “Custody Rule” or “Rule”). It is critical for Registered Investment Advisers (“RIAs” or “advisers”) to ensure compliance with the Custody Rule. However, the Rule can create confusion given different interpretations, exceptions, and alternatives. This article presents a summary of the Rule, as defined and described by the SEC, along with options to assist RIAs in complying with the Rule.

First of all, what is custody?

As defined by the SEC, “an adviser has custody if it holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them…specifically include[d] in the definition of custody [is] arrangements where an adviser’s related person has custody of client assets in connection with advisory services the adviser provides to clients. For example, if an affiliated broker-dealer of an investment adviser maintains custody of client assets as qualified custodian in connection with advisory services the investment adviser would have custody of those client assets.”

An adviser holds custody over client accounts. Now what?

Unless covered by the Audit Provision Exception, the SEC Custody Rule requires the adviser to do the following:

  • Maintain client assets with a “qualified custodian” such as a bank, broker-dealer, or futures commission merchant. Have a reasonable basis, after due inquiry, for believing that the qualified custodian sends quarterly account statements directly to each client. These statements must include the amount of funds of each security at each quarter end as well as a list of call account transactions during the statement period.
    • In addition, advisers must notify their clients promptly upon opening custodial accounts on their behalf.
    • Client funds must be segregated in separate accounts for each client in the client’s name (or in an account containing only funds of the adviser’s clients under the adviser’s name as agent/trustee).
  • Undergo an annual surprise examination by an independent public accountant to verify client assets, including privately offered securities in which the adviser has custody.
    • The first exam must occur within six months of the RIA being deemed to have custody.
    • The exam must be annual, with the exam time chosen by the independent public accountant and irregular from year to year.
    • The exam must comply with the American Institute of Certified Public Accountant (“AICPA”) standards; however, the independent public accountant must be registered with the Public Company Accounting Oversight Board (“PCAOB”) and subject to their regular inspection program.
    • The adviser must sign a letter representing that the adviser is in compliance with the Custody Rule.

Note: The annual surprise examination is not required if the adviser has custody solely because of its authority to deduct advisory fees from client accounts.

  • The adviser must enter into a written agreement with the independent public accountant that will conduct the surprise examination. The agreement must contain the following provisions:
    • The accountant will notify the SEC within one business day of finding any material discrepancy during the examination.
    • The accountant will submit Form ADV-E to the SEC, accompanied by the accountant’s certificate, within 120 days of the time chosen by the accountant for the surprise examination.
    • Upon resignation or dismissal, the accountant will submit within four business days a statement regarding the termination along with Form ADV-E to the SEC.
  • If the custodian is the adviser or a related person of the adviser and maintains advisory client assets in connection with advisory services, the adviser must obtain a report of the internal controls (such as a Type II SAS 70 report) relating to custody of client assets prepared by an independent public accountant that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (“PCAOB”).
    • This “internal control report” is required in addition to the obligation to obtain an annual surprise examination. There is one exception – The adviser is deemed to have custody solely because of its related person having custody and the adviser is “operationally independent” of the custodian as defined in the Rule.
    • Related persons under the rule are persons that are directly or indirectly controlled by the adviser, control the adviser, or are under common control with the adviser.

What is the Audit Provision Exception?

The Audit Provision Exception is available to an adviser to a pooled investment vehicle (“PIV” or “pool”) that is subject to annual financial statement audits by an independent public accountant registered with, and subject to regular inspection by, the PCAOB, similar to the custody examination requirement.  The annual audited financial statements must be distributed to investors in the pool within 120 days after the pool’s fiscal year end.

  • PIV entities are often already subject to an audit. Governing documents often include provisions requiring advisors to provide their investors with an annual audit.
  • Advisors to PIVs that are not subject to the audit as described above must obtain an annual surprise examination as described above.
  • Advisors to PIVs that are subject to the audit as described above that liquidate prior to a fiscal year end must obtain a final audit of the pool’s financial statements upon liquidation of the pool and distribute the financial statements to pool investors promptly after the completion of the audit.
  • Sending an account statement or distributing audited financial statements will not meet the requirements of the Rule if all of the investors in a PIV to which the statements are sent are themselves PIVs that are related persons of the adviser.
  • The 120-day deadline may be extended to 180-days for “fund of funds”.

Interested in learning more about the accounting and reporting impact of the SEC Custody Rule? Contact your Keiter Opportunity Advisor today or reach out to our Financial Services industry team. Email|Call 804.747.0000.


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About the Author

Courtney K. Corallo

Courtney K. Corallo, CPA, Business Assurance & Advisory Services Senior Manager

Courtney is a member of Keiter’s Business Assurance and Advisory Services team. Courtney provides audit and review services for not-for-profit organizations and financial services companies. She is a member of the Not-for-Profit team and Financial Services Industry team.

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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.


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