Complying With the Custody Rule and the New Custody Proposal

Experts explained common compliance mistakes involving the custody rule and spoke to the new custody rule proposal.

Compliance experts and officials from the Securities and Exchange Commission warned advisers that the SEC’s custody rule may apply even if an adviser does not intend to use it or is not aware of it.

Mukya Porter, the chief compliance officer at CIM Group, explained at the Investment Adviser Association’s Adviser Compliance Conference that anything in a client contract that grants “power of attorney” can bestow the obligations of the custody rule on an adviser.

Among other things, the custody rule requires advisers to ensure assets in their custody are kept with a certified custodian and that the adviser submit to annual surprise SEC exams to verify the existence of those assets.

Natasha Greiner, a national associate director of the investment company examination program at the SEC, said the issues highlighted in a 2017 risk alert are still applicable today. The risk alert said that online access to a client’s assets, power of attorney or authorization to withdraw funds as payment can all impose custody obligations, but that many advisers examined by the SEC were unaware of this.

The alert also said many advisers who pay outside consultants to conduct a surprise exam are not actually surprised at all, because the exams had been planned or always happen on the same day each year but are presented as a “surprise” in the adviser’s compliance policies. In other cases, the third-party audits did not include a complete accounting of all of the assets in an adviser’s custody.

SEC regulatory guidance issued the same year also said advisers can become an unintentional custodian due to wording in their client agreements. Whenever an adviser can withdraw or transfer funds, it is considered a custodian, even if it has never actually used that power or intended to.

On February 15, the SEC proposed a new rule for adviser custody that would apply to all assets over which an adviser might acquire custody. The new rule requires that an adviser clearly segregate its assets from client assets so that the client’s assets are safe in the event that the adviser declares bankruptcy. These two provisions interact in an important way, because they prevent advisers from comingling their assets with their clients’ in previously uncovered asset classes, such as cryptocurrencies, which can leave investors stuck if their adviser goes bankrupt.

The new rule would also apply to agreements in which an adviser has discretionary trading authority, the ability to buy and sell clients’ assets without receiving client permission on a trade-by-trade basis.

William Birdthistle, the director for the investment management division at the SEC which drafted the new custody rule proposal, was especially enthusiastic about the provision that would apply custodial obligations onto discretionary trading agreements. He told the audience at the IAA Compliance Conference that “discretionary trading can create problems,” and updating the rule to include it is critical. It is unclear how this or other elements of the latest SEC custody proposal will end up in the final version of the rule.

The comment period for the new custody rule expires May 8, and directions on how to submit a comment can be found here.