Saturday, January 31, 2009

Custody issues for advisers

The issue of "custody" for investment advisers is one of the most challenging of all the big "testable" topics on the Series 65/66. What does it mean to have custody? In Plain English, it means to have control over client securities and/or cash in a way that would make any sensible regulator nervous. NASAA defines custody like this: holding directly or indirectly, client funds or securities, or having any authority to obtain possession of them [or has the ability to appropriate them]. Basically, if the adviser has control or access to client assets, he has custody. What's the big deal? Advisers "deemed to maintain custody" of client assets have higher net capital requirements and must be audited annually by a CPA, who will report to the Administrator on whether the books are or are not in order. Imagine for a second the frightening responsibility of maintaining custody of client assets. Every day the markets are open stock prices change. Customers buy more shares here, sell some shares there, receive a big dividend check here, a big interest check there. The cash is swept into a money market account, and somebody has to credit the proper amount of interest for all that. I mean, I have five investment accounts myself, and I do some really lousy record keeping on just those few accounts with my own money and stock inside them. I can't imagine how fast the IL Securities Department would end up shutting me down if I registered as an adviser and then indicated on Form ADV that I would be maintaining custody of client assets. If you've seen It's a Wonderful Life, I think we can safely say that I'd end up stammering worse than ole' George Bailey as the family's building & loan was about to go belly up.
What I would do instead is use a "qualified custodian." According to NASAA, a "qualified custodian" includes:

(i)A bank or savings association that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act;
(ii) A registered broker-dealer holding the client assets in customer accounts;
(iii) A registered futures commission merchant register under Section 4f(a) of the Commodity Exchange Act, holding the client assets in customer accounts, but only with respect to clients’ funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon and
(iv)A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer accounts segregated from its proprietary assets.

So, unless you're a bank or a custodial broker-dealer, I'm not sure why you'd want to be "deemed to maintain custody." You don't want to maintain the $35,000 minimum net capital, take on the awesome responsibility of the all the record keeping, deal with the annual surprise audit, etc. This is why your exam will likely ask a question or two about custody issues. For example, you might see one like this:

In which of the following cases would an investment adviser be deemed to maintain custody of client assets and, therefore, be required to maintain a higher minimum net capital?
A. the adviser forwards a client’s third-party check to the payee within 24 hours
B. the adviser inadvertently receives a client’s securities in the mail from the client and promptly forwards them to the custodian.
C. the adviser inadvertently receives a client’s securities in the mail from the client and returns the securities two days later, keeping records of the receipt and return
D. the adviser sends the qualified custodian a billing statement and also a statement to the client but does not deliver quarterly account statements to the client directly

Pretty tough question. As always, let's take them one at a time, attempting to eliminate each answer choice until we find one that can't be eliminated. If the adviser forwards a check written to a third-party within 24 hours, the firm does not need to maintain higher net capital requirements. If the adviser receives client securities, they need to be returned to the sender within 3 business days, with detailed records of what happened, when and how they were returned, etc. If the adviser does that, he/they do not have to maintain the higher net capital requirements, the annual audit, etc. Even though the adviser in choice "D" is considered to have custody, since the adviser can appropriate money from the client's account, as long as certain "safeguards" are in place, the adviser does not have to meet the higher net capital, etc. Choice "D" describes those safeguards pretty well--send a billing statement to the custodian and to the client; the custodian will send the account statements. Why is the answer "B"? The adviser should have returned the securities to the sender, as opposed to forwarding them to another party. Because the adviser forwarded the securities, the firm, therefore, had possession of the securities (at least for purposes of an exam question).

Yes, unfortunately, your exam can get at least this detailed, even though "custody" is but one of many, many testable points. Welcome to the world of the Series 65/66. Don't worry--it will all be over soon.

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