SEC Custodial Rule 206(4)-2

[austin3515]

There is some rule affecting RIA's which was in response to Bernie Madoff that increased an RIA's responsibility when they have "custody" of client assets.

I understand the point of the rules with respect to RIA's who have access to their client's money. I have a client who is an RIA who is suggesting that they are subject to these rules with respect to the Trustee of the plan covering the RIA's employees. I tried to explain that in this situation, invoking this rule would involve protecting the Trustee (who happens to be the sole owner) from himself.

The requirements that one must deal with in this situation are quite onerous - either appointing a corporate trustee or engaging an audit firm to conduct "surprise audits."

Can someone point to something where it has been documented that this does NOT apply to RIA firms where the owners of the firm serve as Trustees?

[Peter Gulia]

The Investment Advisers Act of 1940 rule can apply only if the adviser “ha custody of client funds or securities[.]” 17 C.F.R. § 275.206(4)-2(a) [http://www.ecfr.gov/cgi-bin/text-idx?SID=4bca3a6fcc528a39a291f8260cae61c9&mc=true&node=se17.4.275_1206_24_3_62&rgn=div8];Custody of Funds or Securities of Clients by Investment Advisers, 75 Federal Register 1,484 (Jan. 11, 2010); Investment Advisers Act Release IA-2968 (Dec. 30, 2009).

The word client is not specially defined in the rule’s definitions section. But consider this off-rule interpretation:

Question XII.1

Q: A related person of an investment adviser ([for example], an officer or director of the adviser) may act as the trustee of the participant-directed defined contribution plan established for the benefit of the adviser’s employees. As trustee of the plan, the related person selects the service providers for the plan, such as an administrator[,] and may select the investment options available under the plan, [for example], mutual funds. Must the adviser treat the assets of the plan as client assets of which it has custody?

A: The Division will not recommend enforcement action to the Commission against an investment adviser that does not treat the assets of a participant-directed defined contribution plan established for the benefit of adviser’s employees as those of a client of which it has custody in these circumstances solely because a related person of the adviser is trustee which [sic] may select service providers and investment options for the plan, provided that (i) neither the investment adviser nor a related person otherwise acts as an investment adviser to the plan or any investment option available under the plan[,] and (ii) the investment adviser and the related[-]person trustee are, to the extent applicable, in compliance with the Employee Retirement Income Security Act of 1974 (ERISA) and rules and regulations issued thereunder with respect to the plan. (Posted March 5, 2010.)

https://www.sec.gov/divisions/investment/custody_faq_030510.htm

The rule and off-rule interpretation cited above are for an adviser registered (or required to be registered) with the U.S. Securities and Exchange Commission. For an adviser registered (or required to be registered) with a State (or several States), no rule or a different rule might apply.

This general information is not advice to anyone.

[austin3515]

Unbelievable. So I have RIA clients who have pooled accounts. They are all subject to these onerous requirements? I suppose I should suggest a corporate trustee?

[Peter Gulia]

Consider whether such an employer might want the written advice of a lawyer who is experienced with ERISA and the Investment Advisers Act. That advice might be useful if it would conclude that the retirement plan is not a client of the registered investment adviser.

[austin3515]

It seems clear that an in a pooled account they are going way beyond the "safe harbor" role described in the Q&A don't you think?

[Peter Gulia]

A plan that does not provide participant-directed investment is beyond the particular relief that the quoted FAQ states.

But not meeting the conditions for an exception from a general rule does not necessarily mean that a situation is within the general rule.

A lawyer advising an SEC-registered investment adviser about whether it has custody within the meaning of IAA Rule 206(4)-2 because of the adviser's or its associated person's role concerning an in-house retirement plan might consider all of the relevant facts and circumstances, and interpretations about other situations, to render advice about whether the in-house retirement plan is or is not a client of the adviser.

If I can help, please feel free to call me.