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Investment advisers are responsible for filing Form ADV Part 1 and Form ADV Part 2A/2B during the initial registration process. One of the items that a registered investment adviser (“RIA”) will be required to disclose is whether the firm has custody of client funds or securities. Firms that only manage separately managed accounts that are held away at an unaffiliated qualified custodian are often too quick to disclose that they do not have custody. Depending on whether the firm directly deducts its advisory fees from client accounts, the firm may be considered to have a limited form of custody, but that is not the focus of this post.
Generally speaking, registered investment advisers that act as the Investment Manager and General Partner to a fund that is structured as a Limited Partnership are considered to have custody of that fund. As a result, the firm’s disclosures must reflect that the firm has custody. Compliance officers often fear that prospective investors will be alarmed by the fact that their firm is deemed to have custody, but such fears may be assuaged by drafting detailed disclosures.
Although there are other sections of the Form ADV Part 1 where the issue of custody becomes relevant, focus your attention on Item 15 of the Form ADV Part 2A Brochure – “Custody” at the moment. Instead of only writing a sentence that states, “Our investment adviser firm is deemed to have custody of client assets,” elaborate on that statement: “Our investment adviser firm is deemed to have custody of client assets because [Firm’s Name] is the General Partner and Investment Manager to [Fund Name], LP (the “Fund”). [Firm’s Name] does not have custody of any other client accounts, including our separately managed accounts.” Go into even more detail if needed. Not only will prospective investors appreciate the information, but regulators will too.
Determining whether an investment adviser has custody of client accounts requires a careful analysis of SEC Rule 206(4)-2(d)(2), included below, if the RIA is registered with the SEC.
The SEC Custody Rule
SEC Rule 206(4)-2(d)(2) defines custody as:
- holding, directly or indirectly,
- client funds or securities, or
- having any authority to obtain possession of them.
The rule goes on to explain that custody also arises where:
- A related person
- Directly or indirectly,
- Client funds or securities
- Or has any authority to obtain possession of them,
- In connection with advisory services you provide to clients.
If the RIA is registered with a state, call the state regulator’s office and ask if they might direct you to your state’s custody rule if the state did not adopt the SEC Custody Rule. The regulator might also mention that state [x] does not have a rule per se on the matter. Additionally, the regulator may notify you whether the state has issued a policy statement on the issue of custody.
In my experience, I have found that state examiners are happy to answer questions, but they will not provide you legal advice. With that said, it is important that questions are worded carefully, or an examiner may not answer them at all. In our scenario, I suggest wording the question, “Does the State of [X] have its own custody rule, and if so, would you mind telling me which rule that is?” Here, you are only asking for the applicable rule, rather than asking the regulator to help you determine if you have custody or not. Although some states do not have enough resources to answer every call that comes in, you will likely have the opportunity to leave a voicemail describing your inquiry.
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