Asset custody could get a little bit easier and less confusing now that the SEC has changed Rule 206(4)-2 which oversees asset custody under the Investment Advisers Act of 1940. Effective on Nov. 5, the agency withdrew previous no-action letters, which governed custody rules. Now the 8,048 SEC-registered advisers must comply with the new rules by April 1, 2004.
According to the SEC, the amended rule:
1. Gives a formal definition to custody. Advisers now have custody if they "hold directly or indirectly, client funds or securities or have any authority to obtain possession of them." Examples include brief custody, the ability to draw funds from a clients account, any capacity that gives the adviser legal ownership of or access to client funds, and access to client funds for fee deduction (approximately 90% of SEC-registered advisers deduct fees from client accounts).
2. Requires that advisers with custody maintain client funds and securities with a broker/dealer, bank or other qualified custodian. The qualified custodian must send statements directly to the client (or an independent representative), which relieves advisers of sending their own statements (under most circumstances) and from undergoing an annual surprise examination. Advisers, who are also registered broker/dealers, registered investment companies or affiliated with pooled investment vehicles, do not qualify for this rule.
3. Removes the requirement set by Form ADV where these advisers must include an audited balance sheet in their disclosure brochure to clients. "If you have the authority to take fees out of the account, you have the authority to misappropriate fees therefore you have custody," is what this new SEC rule means, said Nancy Lininger, a compliance consultant with The Consortium, Camarillo, Calif. "Its a wake-up call that they do have custody now. Under the old custody rules it was way too onerous to comply with custody and advisers would avoid it."
According to the SEC, only 11% (867) of the total SEC-registered investment advisers actually do custody their clients assets, however the changes may encourage more advisers to take on custody.