Wednesday, July 7, 2010

Custody Issues

Let's cover potential exam concepts concerning custody issues since you almost certainly will get one or two questions on this stuff. First, you should probably read NASAA's model rule on custody requirements for Investment Advisers at Second, you need to understand the background here: most advisers don't want to be deemed to have custody of client assets. If they are deemed to have possession of client securities and/or cash--or the ability to appropriate securities and/or cash--advisers are generally subject to higher net worth requirements ($35,000 minimum) and the annual surprise CPA audit. So, a wise adviser usually avoids being deemed to have custody. For example, if the client sends the adviser a 3rd- party check, that check needs to be forwarded to the payee within 24 hours. If not, the adviser had custody of client assets. If the adviser receives client securities in the mail, the adviser needs to return them to the sender in 3 days to avoid being deemed to have custody of those securities. In both cases, if the adviser keeps records as to what happened, the adviser will not be deemed to have had custody and will not need to notify the Administrator by updating Form ADV. Advisers who manage client portfolios typically have the discretion to trade the account, with the account held by a custodial broker-dealer such as Charles Schwab, TD Ameritrade, or Fidelity. So far, such an adviser would not be deemed to have custody of client assets; however, the adviser will likely want to get paid by the custodian quarterly. If the adviser can obtain his advisory fee from the client's account, he does have the ability to appropriate client assets and is considered to have custody. Does he have to maintain the higher financial requirements and the CPA audit? Not if he follows certain safeguards. The Adviser needs to indicate on Form ADV that they intend to follow the safeguards, and if they do, in fact, follow them, the net worth/bonding and the CPA audit requirements are waived. Here are the safeguards:
  • written authorization from the client to deduct advisory fees from the account held with the qualified custodian
  • Each time a fee is directly deducted from a client account, the investment adviser must send the qualified custodian an invoice of the amount of the fee to be deducted from the client’s account and send the client an invoice itemizing the fee. Itemization includes the formula used to calculate the fee, the amount of assets under management the fee is based on, and the time period covered by the fee.

So, the adviser does have custody if he can obtain his advisory fee directly from the custodian. But, he can avoid the usual hassles related to custody by following certain safeguards. What's the big deal about custody? Well, Bernie Madoff would not have made off with people's money if they would not have let him have custody of those assets. Since their "adviser" was able to send account statements, with no independent oversight, he was able to show clients any numbers he thought they'd believe, even after all the money was gone. If the custodian is independent of the adviser, there is no reason to doubt the veracity of the account balances. When the adviser can show you whatever numbers he thinks you'll believe he can A) overcharge your account or B) mislead you into thinking that you actually have an account when, in fact, all the money was drained years ago.

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