The National Examination Program of the SEC’s Office of Compliance Inspections and Examinations has issued a Risk Alert reporting widespread noncompliance with the custody rule (206(4)-2). The custody rule regulates when an adviser is deemed to have custody of client assets and what steps it must take to protect those assets. The NEP reports that it uncovered custody violations in one-third of recent exams. The deficiencies generally involving advisers’ failure to understand that they had custody of client assets, comply with the surprise exam requirement, engage a qualified custodian, and deliver qualifying financial statements for pooled investment vehicles. In particular, the NEP cited the following violations: adviser personnel with powers of attorney or serving as trustee; check-writing and bill-paying authority; online account access; physical possession of stock certificates; surprise exams that were not a surprise; commingling of client assets in one account; using accountants that were not independent or PCAOB registered; and fund financial statements that were not prepared in accordance with GAAP. The NEP has referred cases to the Enforcement Division and has also ordered remedial measures including allocation of additional resources to custody compliance.
OUR TAKE: We agree with the purpose of the custody rule and some of the safeguards. However, we don’t think 1/3 of advisers are bad people. Instead, we believe 1/3 of advisers have a difficult time understanding and applying the rule. Endemic noncompliance would suggest that the SEC should conduct a re-examination of the Rule.