Earlier this year, we outlined a number of common scenarios which an registered investment adviser (RIA) firm may be deemed to have custody of client funds or securities. One of the key SEC investment adviser compliance requirements for a RIA firm deemed to have custody is the independent surprise examination requirement performed by an accounting firm which is outlined in Rule 275.206(4)-2(a)(4) as follows:
The client funds and securities of which you have custody are verified by actual examination at least once during each calendar year, except as provided below, by an independent public accountant, pursuant to a written agreement between you and the accountant, at a time that is chosen by the accountant without prior notice or announcement to you and that is irregular from year to year. The written agreement must provide for the first examination to occur within six months of becoming subject to this paragraph, except that, if you maintain client funds or securities pursuant to this section as a qualified custodian, the agreement must provide for the first examination to occur no later than six months after obtaining the internal control report.
Some investment adviser custody situations may also require that the independent public accountant retained by the advisory firm must be registered and subject to regular inspection by the Public Company Accounting Oversight Board (PCAOB) in accordance with its rules. The American Institute of CPAs (AICPA) has compiled an overview document with a few illustrative examples to provide investment advisers and accounting firms with more guidance on how to meet the RIA compliance annual surprise audit requirements.
As RIA compliance consultants, we strongly recommend that your investment advisory firm's Chief Compliance Officer (CCO) carefully review your firm's business activities. The CCO should look to identify any situations or scenarios for which your firm may be deemed to have custody. The CCO should also ensure that the firm's Form ADV filing documents properly disclose these custody situations, as required. Additional guidance for meeting the SEC's custody rules may also be found in the SEC Staff Responses to Questions About the Custody Rule.
State requirements may vary from the SEC requirements, so it's also very important that any state-registered RIA firm review its relevant RIA compliance custody requirements. The North American Securities Administrators Association (NASAA) model custody rule, variations of which have been adopted by some states, includes many of the same safeguards that the SEC rule contains including the surprise independent verification and some additional safeguards for RIA firms that deduct advisory fees directly from clients' accounts. In these situations, some advisory firms may be exempt from the independent verification requirement but will have the additional requirement of sending itemized invoices to clients.
In 2013, according to NASAA, coordinated state exams of 1,130 investment advisory firms found that 16.6% of RIA firms had at least one custody-related compliance deficiency. Custody and compliance with the safeguards required by the SEC or state rules and statutes, continues to be an area of focus for both SEC and state investment adviser examiners.