How does securities custody work

A: Yes. Under rule b 3 -1 b 4 , an adviser relying on the exemption from registration provided by section b 3 of the Investment Advisers Act of need not count as a client any person for whom the adviser provides investment advisory services without compensation. However, rule b 3 -1 does not control the determination of when a person is considered the client of a registered investment adviser for purposes of rule 4 Q: If an adviser has custody of a client's assets that include a swap agreement with a counterparty and posts funds or securities as collateral in connection with the swap on behalf of the client, must the collateral be maintained with a qualified custodian?

Such collateral must be maintained with a qualified custodian. If the qualified custodian is a related person, the adviser must receive an internal control report from the custodian.

In addition, the adviser must undergo a surprise examination unless the custodian is operationally independent. Both the surprise examination, if required, and internal control report must be performed by an accountant that is registered with, and subject to regular inspection by, the PCAOB. Specifically, the Guidance Update described circumstances where a custodial agreement between a client and qualified custodian, to which the client's adviser is not a party, might permit the adviser to instruct the custodian to disburse, or transfer, funds or securities.

We are an advisory firm that does not know whether any of our clients' custodial agreements would give our firm Inadvertent Custody. Are we now required to comply with the custody rule for those client accounts? A: An adviser that does not have a copy of a client's custodial agreement, and does not know, or have reason to know whether the agreement would give the adviser Inadvertent Custody, need not comply with the custody rule with respect to that client's account if Inadvertent Custody would be the sole basis for custody.

The Division of Investment Management would not recommend enforcement action to the Commission under the custody rule or under Section of the Advisers Act against any such investment adviser if that adviser neither complied with the requirements of the custody rule nor indicated it has custody in its Form ADV filing. We note, however, that this relief is not available where the adviser recommended, requested, or required a client's custodian. Posted June 5, Q: We are an advisory firm with clients, and we have check-writing authority on 60 of our clients' accounts.

Of the remaining 40 accounts, we deduct our advisory fee from 10 accounts. We do not know or have reason to know whether any of our clients' custodial agreements would give our firm Inadvertent Custody, as described in Question II. We have no basis for having custody other than the check-writing authority and fee deduction. We currently comply with the custody rule with respect to the 60 client accounts for which we have check-writing authority, and we rely on the exception from the surprise examination requirement for the 10 accounts from which we deduct our advisory fee.

Should we comply with the custody rule for the remaining 30 client accounts? A: Under the facts you posed, the Division would not recommend enforcement action for not complying with the custody rule or the custody-related ADV reporting requirements for the 30 accounts, consistent with the response to Question II.

The Division would not recommend enforcement action to the Commission under the custody rule or under Section of the Advisers Act if the adviser proceeded to rely on the exception in the custody rule for fee deduction, and completed Form ADV accordingly, for the 10 accounts from which the adviser deducts its advisory fee.

In addition, the Division would, therefore, expect you to continue to comply with the custody rule with respect to the 60 client accounts for which you have check-writing authority, and we would expect you to continue to comply with all but the surprise examination requirement with respect to the 10 client accounts from which you deduct fees. Q: A client has instructed its custodian to debit the client's account for advisory fees each quarter. The custodian makes all fee calculations, based on the advisory contract.

The adviser does not calculate the fee, nor does it send a bill. Does the adviser have custody? A: If the qualified custodian is not a related person of the adviser, the adviser does not have custody. Under these circumstances, the custodian is acting only as agent for the client, and the adviser does not have access to the client's funds.

Modified May 20, Electronic delivery is permissible, if 1 the client has given informed consent to receiving the information electronically; 2 the client can effectively access the electronically delivered information; and 3 evidence of the delivery is received, such as an email return-receipt or other confirmation that the information was accessed. These guidelines are available at www. Advisers whose clients receive electronic statements from qualified custodians must still form a reasonable belief after due inquiry that the clients are receiving those statements.

The adviser may satisfy this requirement by, for example, being copied on the email notifications of account statement postings sent to clients in addition to having access to client statements on the custodian's website, although this is not the exclusive means of forming that reasonable belief footnote 21 of the Adopting Release. Q: Can an adviser voluntarily continue to send its own quarterly account statements to clients in addition to the statements that the clients receive directly from qualified custodians?

If an adviser voluntarily sends account statements, it must insert a legend required under paragraph a 2 of the rule urging the client to compare information provided in its statements with those from the qualified custodian in account opening notices and subsequent statements sent to the client for whom the adviser opens custodial accounts with the qualified custodian.

Q: Is there an example of a report that may be issued by the independent public accountant performing a surprise examination of the adviser?

IA , the surprise examination is a compliance examination to be conducted in accordance with AICPA attestation standards. Posted September 9, When an investment adviser becomes subject to the surprise examination requirement for the first time, what period should such opinion cover? A: The accountant should report on the investment adviser's compliance with rule b for a period beginning no later than the date the adviser became subject to the surprise examination requirement through the examination date.

Posted December 2, Paper filings are no longer accepted. Q: Our firm is subject to the surprise examination requirement. Would our firm be in violation of the rule if the independent public accountant did not complete the examination and submit Form ADV-E to file its certificate of accounting within days after the date chosen by the independent public accountant?

A: The Division would not recommend enforcement action for a violation of rule 4 -2 against an adviser that reasonably believed that its independent public accountant would complete its examination and submit Form ADV-E to file its certificate of accounting by the day deadline, but failed to do so due to the logistical disruptions described above, as long as the independent public accountant files such report as soon as practicable, but not later than 45 days after the original due date.

Posted March 30, Q: An adviser uses three different custodians for one of its clients, and the assets are moved among them depending on the trading in the account. At any given moment, one or two of those custodians might not be holding that client's funds or securities.

Must the adviser provide the client with a new notice each time the assets are moved, or can the adviser provide the client with notice at one time advising the client of all three custodians? A: The adviser can give the client a one-time notice of all three custodians, and is not required to provide a new notice each time the assets move among the three. The purpose of the notice is to tell the client whom to contact to get his assets, if necessary, and this purpose is satisfied even if the client has to contact three custodians.

Posted Q: How does an investment adviser to a pooled investment vehicle comply with the custody rule if it does not use the "audit provision"? A: If the financial statements of the pooled investment vehicle are not audited and distributed to investors in accordance with paragraph b 4 of the rule, the exceptions provided in that paragraph will not be available to the adviser.

As a consequence, the adviser, among other things, must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends quarterly account statements to each investor in the pool and must obtain an annual surprise examination with respect to the pool's assets.

We note that, because the privately offered securities exception provided in paragraph b 2 is not available with respect to assets of an unaudited pool, the adviser must maintain privately offered securities owned by the pool with a qualified custodian.

Q: When a qualified custodian is required to send account statements directly to investors in a pooled investment vehicle, should each account statement be a statement of funds and securities held by the pool and transactions entered into by the pool, or a statement of the investor's ownership interest in the pool e. A: Each account statement sent should be a statement of funds and securities held by the pool and transactions entered into by the pool.

Q: Should the accountant's confirmation procedures for a surprise examination of a pooled investment vehicle include confirmation with investors of the pooled investment vehicle? The accountant should obtain confirmation from investors of i funds and securities held by the pooled investment vehicle as of the date of the examination and ii contributions and withdrawals of funds and securities to and from the pooled investment vehicle by the investor since the date of the last examination.

The quarterly account statements required to be sent by the qualified custodian[s] see also Question VI. Q: Does each limited partner need to have a separate independent representative or can one independent representative serve for all limited partners? A: The representative can serve for all limited partners, so long as the representative is, in fact, independent and satisfies the definition in rule 4 -2 d 4.

Q: To use the "audit approach" relying on rule 4 -2 b 4 , must the financial statements be prepared in accordance with U. A: Yes, the financial statements for pooled vehicles must be prepared in accordance with U. GAAP in order to meet the requirements of the rule, with some exceptions for non-U. Pooled vehicles organized outside of the United States, or having a general partner or other manager with a principal place of business outside the United States, may have their financial statements prepared in accordance with accounting standards other than U.

GAAP so long as they contain information substantially similar to statements prepared in accordance with U. Any material differences with U. GAAP must be reconciled. The Division would not recommend enforcement action if that reconciliation is included only in the financial statements delivered to U.

The required audit of those financial statements must be by an independent public accountant and meet with requirements of U.

In addition, offshore advisers registered with the SEC are not subject to the custody rule, with respect to offshore funds. The terms "offshore adviser" and "offshore fund" are defined in the ABA Letter.

Modified March 10, Q: To use the "audit provision" allowed under rule 4 -2 b 4 , must the audit meet the requirements of U. If the audit does not meet U. GAAS requirements, the adviser cannot rely upon the "audit provision. Q: Does a fund of funds have to meet the day deadline for sending out its audited financial statements?

A: The Division has issued a letter indicating that it would not recommend enforcement action to the Commission if an adviser relying on the "audit provision" for a fund of funds distributes the audited financials to investors within days from the end of the fund of funds' fiscal year. A fund of funds is a pooled investment vehicle that invests 10 percent or more of its total assets in other pooled investment vehicles that are not, and are not advised by, a related person of the pool, its general partner, or its adviser.

A "related person" of an adviser includes officers, partners, directors, most employees, and anyone controlled by, controlling or under common control with the adviser. Q: An adviser's client is a pooled investment vehicle that invests in a fund of funds, but the "top tier" pool is not a fund of funds as defined in the ABA Letter because it is affiliated with the fund of funds in which it invests — for example, the top tier pool is a feeder fund in a master-feeder structure where the master fund is a fund of funds.

If the top tier pool wishes to rely on the "audit provision," must it distribute its audited financial statements within days of its fiscal year end, or may it use the extended day deadline available to the fund of funds?

A: In these circumstances, the auditors of the top tier pool, like the auditors to the fund of funds, might not be able to complete their work until the audit reports of the funds underlying the fund of funds are available. The Division would not recommend enforcement action for a violation of rule 4 -2 against an adviser to a top tier pool that invests 10 percent or more of its total assets in a fund of funds if the adviser distributes the top tier pool's audited financial statements within days of the end of the fiscal year of the fund of funds.

Q: An adviser's client is a "top tier" pooled investment vehicle that invests in one or more funds of funds. Such top tier pool invests 10 percent or more of its total assets in one or more funds of funds, as defined in the ABA Letter, that are not, and are not advised by, a related person of the top tier pool, its general partner, or its adviser.

An audit of the top tier pool cannot be completed prior to the completion of the audits of the funds of funds in which it invests, whose advisers have up to days after the end of their fiscal year to distribute audited financial statements.

If the adviser to the top tier pool wishes to rely on the "audit provision," when must it distribute its audited financial statements? A: The Division would not recommend enforcement action to the Commission under rule 4 -2 if the audited financial statements of the top tier pool are distributed to pool investors within days of the end of the top tier pool's fiscal year.

Posted April 1, Q: If a pooled investment vehicle is subject to an annual audit and its adviser is relying on the "audit provision" under rule 4 -2 b 4 , would the adviser be in violation of the rule if the pooled vehicle fails to distribute its audited financial statements within days, days in the case of a fund of funds, in light of FAQ VI.

A: The Division would not recommend enforcement action for a violation of rule 4 -2 against an adviser that is relying on rule 4 -2 b 4 and that reasonably believed that the pool's audited financial statements would be distributed within the day, day in light of FAQ VI.

Modified April 27, Q: Some registered fund families have organized unregistered money market funds for investment exclusively by their registered investment companies, in compliance with rule 12d under the Investment Company Act of Under rule 4 -2 c , sending audited financial statements solely to pooled investment vehicle investors that are themselves pooled investment vehicles and related persons of the adviser does not satisfy the financial statement delivery requirement under rule 4 -2 b 4.

Must the financial statements of the unregistered money market funds be delivered to each shareholder in the registered investment companies investing in the unregistered fund? A: The Division would not recommend enforcement action to the Commission under rule 4 -2 if the audited financial statements of the unregistered money market funds are not delivered to the shareholders of the registered investment companies, provided that the financial statements are delivered to each registered investment company's chief compliance officer, audit committee members and the members of the board of directors who are not interested persons of the adviser.

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Contact us to learn more. Click here. If your adviser is registered with a state, rather than with the SEC, contact your state securities regulator www. Fees can have a material effect on your investment return. Always consider fees when making an investment decision. The custody rule is designed to provide additional safeguards for investors against possible theft or misappropriation by SEC-registered investment advisers.

Regardless, you should exercise care when making investment decisions and remain vigilant in monitoring your investments. Search SEC. Securities and Exchange Commission. Investor Alerts and Bulletins. What is custody? What does the custody rule require? What does the custody rule mean for investors?