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News February 6 & 13, 2012 Issue

Safety and Soundness of Client Assets/Custody

Every time an examination team arrives at your office, theyíre starting from scratch, said SEC assistant director Donna Esau. They may have done their due diligence in advance of their arrival, but they really want a sense directly from the firm that thereís no fraud. The staff really wants to understand the firmís custody arrangements and get assurance that assets are where theyíre supposed to be.

So began the final panel of the day, which highlighted issues under and tips for managing compliance with the custody rule.

On both sides, we probably want to have lots of patience while the staff understands the firmís custody arrangements, said Esau.

When the staff comes in, theyíve definitely done their homework, said Allianz Global Investors executive vice president Nancy Morris, (formerly secretary of the SEC). Custody has become a significant portion of the examination in the past two years. The staff will also examine custody-related issues such as the fee schedules, policies and procedures surrounding custody, whether the firm has an internal audit structure, whether there is segregation of duties, and of course, client names, account numbers and locations where assets are custodied.

Custodians have no responsibility to comply with an SEC request for records, said Morris. If the client does not ask the custodian to respond, then independent records may not be produced. The SEC knows this, she said, and as long as the firm puts forth a good faith effort to assist with the inquiry, thatís all the SEC can expect.

"In a way, custody is a window into the whole compliance program," said Prudential Financial chief ethics and compliance officer Lee Augsberger. The custody rule is probably one of the most complex rules under the Advisers Act, and it really does take a methodical process to comply, he said.

Consult the experts when determining whether you have custody of client assets.

1,500 surprise examination reports were filed in the last year, said IM assistant director Daniel Kahl. The most common deficiency the staff found was advisers that were deemed to have custody where the adviser didnít think that it did.

Augsberger said his firm initially believed that it did not have custody of client assets. Upon digging a little deeper however, they found that clients had instructed the custodian to pay the adviserís bill as it came in. That caused the firm to be deemed to have custody of certain client assets.

The adviserís ability to withdraw fees is what gives the adviser custody, said Kahl. Itís literally, I can get the money to me, personally, said Morris.

Because the determination of whether an adviser has custody is so consequential, having outside counsel on the tough calls is critical, said Augsberger. If youíre subject to the custody rule, the surprise audit and outside audits cost money. You want to know whether you have those expenses and what the expenses are before you price your product. "When you need an expert, get one," he said.

Far and away, we spent the most time analyzing this rule, said Augsberger. For example, some of our products are bank loans. Those are not securities and therefore not subject to the rule.

I would double, triple underscore the need for outside assistance with an analysis, said Morris. The custody rule presents significant issues you need to work through with outside counsel.

Privately offered securities provide a good example, said Kahl. The definition of privately offered securities in the rule is narrower than you might think. If you meet the definition though, you get benefits under the rule. The wrong interpretation can lead to deficiencies, he said.

Some things to think about.

It is worth revisiting the adopting release for the most recent amendments, said Kahl. Think about what it means to have a "reasonable belief" in account statement delivery. How will the adviser establish the "due inquiry" requirement? The integrity of employees with access to client assets is important. Does the firm conduct background checks and/or credit checks on employees with access? Does the firm segregate custodial duties from advisory duties? When deducting fees, does the firm review fees or conduct account testing?

Operational independence is another area of analysis under the rule, said Kahl. Distant affiliates, separate organizations Ė the adviser must keep records supporting operational independence and an analysis of how the adviser meets the test or custody will be imputed, he said.

Another imputed custody trap to avoid is holding a clientís check too long, said Morris. The big checks go out fast and typically donít cause issues, itís the $2 checks that can trip you up. Test at both ends of the spectrum, she advised.

What about private equity funds with legacy assets waiting for a liquidation event?

The fund must perform a liquidation audit, said Kahl. It is an area of interest for the staff with all the new private equity fund advisers registering. "If you can present alternatives that would protect investors as well as the audit, weíd be interested in hearing it," he said.

What constitutes due inquiry into custodial statementing?

The SEC is not going to tell you, said Morris. Maybe youíre getting copies of the confirmations from the custodian. Maybe youíre in there annually confirming custodial practices. How your firm does it will be based on your business, your clients and your relationship with the custodian, she said.

How can you demonstrate that you have a reasonable belief that statements are being sent to clients?

Think about how you would answer this question from an examiner, said Esau.

The adviser should be taking steps that provide some assurance that the investment exists. Whatever records you have to show that you would know will support a reasonable belief, said Esau.

Are copies of custodian statements sufficient?

You can use them, but you should be comparing them to your own records as a test, said Morris.

"At the end of the day, we want that comfort that those assets are there," said Esau. It is telling if a firm has no reconciliation process. How can you tell what you have if youíre not reconciling? It would be beneficial for a firm to do its own reconciliation and where discrepancies exist, be prepared to explain them, said Esau.

Does the CCO need to call the custodian?

Thatís an internal business decision, said Esau.

Common deficiencies under the custody rule.

Esau noted some custody rule deficiencies that the staff commonly sees:

  • General partners to private pools of capital fail to deliver annual audited financial statements on a timely basis, or at all;
  • Securities certificates are held in safe deposit boxes rather than properly custodied;
  • Financials are not audited in accordance with GAAP;
  • Written agreements include an unrestricted ability to transfer assets;
  • The adviser has no understanding of whether clients are receiving statements from their custodian; and
  • The adviser is deemed to have custody of client assets, but doesnít know it.

What does the SEC expect of CCOs regarding custody?

The staff wants to see that the CCO understands the adviserís business, and appropriately tailors the firmís compliance with the custody rule around that business, said Esau.