Custody Deficiencies Revealed

Since the Bernie Madoff scandal became public in 2008, regulators have been implementing new regulations governing the financial industry in an attempt to protect investors from theft and other misuse of their assets.  The custody rule was one such regulation; it requires advisors that are deemed to have custody of client accounts to undergo an annual surprise examination.  Although the rule was passed in December 2009, the Securities and Exchange Commission (the “SEC”) Risk Alert issued in March 2013 reported extensive noncompliance with the custody rule in its recent examinations.  The alert reports approximately one third of the examinations with significant deficiencies were custody related deficiencies.  One of the main categories of noncompliance identified in the alert was the failure of advisors to recognize that they had custody and would therefore result in noncompliance with the surprise examination requirement.

The amended custody rule only expanded the definition of custody for advisors by adding the reference to related parties, yet advisors are having significant issues complying with the rules.  Custody is now defined by the rule as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.  You have custody if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory service you provide to clients.”  Common situations where advisors fail to identify that they have custody include an employee serving as a trustee of an account, performing bill paying services, maintaining online access to client accounts or having check writing authority.  The SEC also identified advisors failing to recognize they have custody when they have physical possession of assets or act as a general partner.

Advisors should re-evaluate their practices and client relationships regularly to identify where they have custody of client accounts.  Advisors should also be aware that a surprise examination must be performed by independent certified public account that is registered with the Public Company Accounting Oversight Board (PCAOB) and be performed annually.  If an advisor becomes subject to the examination for the first time, the examination must start within six months of becoming subject to the rule.

With the public outcry over this topic and the recent reports of widespread noncompliance, this issue is sure to be an area of scrutiny during your next visit from the SEC.