1. Custody

2. Definition of Custody NASAA vs. SEC Eight Safekeeping Requirements Exam Items

3. Custody Definition Having possession of or having access to client funds or securities

4. Custody – So What? Client funds are at much greater risk from an insolvent or unscrupulous adviser. Advisers are prohibited from having custody unless they follow certain Safekeeping Requirements. Failure to follow Safekeeping Requirements may be considered a fraudulent business practice. Adviser is usually required to maintain a significantly higher net worth and/or surety bond. Adviser usually has additional financial reporting requirements. Adviser usually has additional recordkeeping and disclosure requirements.

5. Custody Deficiencies In the 2009 NASAA Coordinated IA Exams of 423 advisers, 11.8% of all exams noted deficiencies related to custody.

6. >$500, >6 months fees Annual Audit of PIV Notice to Administrator PIN to Client Account 11.8% of all advisers had at least one deficiency.

7. NASAA vs. SEC Custody SEC amended custody rules in 2010 Did not change the definitions of custody

8. NASAA vs. SEC Custody Definition NASAA MODEL RULE 102(e)(1)-1(c)(1) “Custody” means holding directly or indirectly, client funds or securities, or having any authority to obtain possession of them [or has the ability to appropriate them]. Custody includes: IA Act Rule 206(4)- 2(c)1 "Custody" means holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. Custody includes:

9. NASAA 4 Custody Scenarios 1.Possession of client funds or securities unless received inadvertently and returned to the sender promptly, but in any case within three business days of receiving them; 2.Receipt of checks drawn by clients and made payable to unrelated third parties will not meet the definition of custody if forwarded to the third party within 24 hours of receipt and the adviser maintains the records required under Rule 203(a)2-22; SEC 3 Custody Scenarios 1.Possession of client funds or securities, (but not of checks drawn by clients and made payable to third parties,) unless you receive them inadvertently and you return them to the sender promptly but in any case within three business days of receiving them; These are the only “It’s custody, unless...” scenarios

10. 3.Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and 4.Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities. 2.Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and 3.Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities. NASAASEC

11. NASAA Custody Scenario #1 Possession of client funds or securities unless received inadvertently and returned to the sender promptly, but in any case within three business days of receiving them Examples: 1.Adviser receives stock certificates from client 2.Adviser receives cash from client for deposit into client’s account 3.Adviser receives a check made payable to the adviser for deposit into the client’s account In order to not have custody... Clock starts ticking...The adviser has 3 business days to return to the sender and document the return

12. NASAA Custody Scenario #2 Receipt of checks drawn by clients and made payable to unrelated third parties will not meet the definition of custody if forwarded to the third party within 24 hours of receipt and the adviser maintains the records required under Rule 203(a)2-22 Examples: 1.Adviser receives check from client made payable to client’s Schwab account In order to not have custody... Clock starts ticking...The adviser has 24 hours to forward to Schwab plus document the forwarding

13. Wait...Document What? Securities received and returned, or Checks forwarded NASAA Model Rule 230(a)-2(a)(22) –Issuer (Payor) –Type of security and series (Type of Check) –Date of issue (Date of Check) –For debt instruments, the denomination, interest rate, maturity date (Amount of Check) –Certificate number, including alphabetical prefix or suffix (Check Number) –Name in which registered (Payee) –Date given to adviser –Date sent to client or sender, or date forwarded –Form of delivery, or copy of form of delivery –Mail confirmation number, or confirmation of delivery

14. NASAA Custody Scenario #3 Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian Examples: 1.Direct fee deduction 2.General POA to withdraw funds from custodian

15. NASAA Custody Scenario #4 Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities Examples: 1.Adviser is General Partner of pooled investment 2.Adviser is a Trustee for client 3.Adviser is Executor for client’s estate

16. OK, So what’s an adviser to do? Eight Safekeeping Requirements Serious violation of anti-fraud provisions These do not provide relief from custody definition May provide relief from increased net worth, bonding, and financial reporting requirements if jurisdiction grants waiver

17. Eight Safekeeping Requirements #1 Notice to Administrator #2 Qualified Custodian #3 Notice to Clients #4 Account Statements #5 Independent Representative (more of a definition) #6 Direct Fee Deduction #7 General Partner of Investment Partnership (with or without annual audits) #8 Trustee or Executor for a client

18. Safekeeping Requirement #1 Notice to Administrator –An investment adviser with custody must notify the State securities administrator i.e. Secretary of State’s office, Securities Commission, etc… that the adviser has or may have custody. Such notification is required to be given on Form ADV part 1A Item 9 and part 1B Item 2(I)

19. Safekeeping Requirement #2 Must use a Qualified Custodian –bank or savings association insured by FDIC –registered broker-dealer holding client assets in customer accounts –registered futures commission merchant holding client assets in customer accounts –foreign financial institution customarily holding financial assets for its customers Customer Accounts must be –Segregated in separate accounts under client’s name, or –In accounts that contain only the adviser’s clients’ funds and securities, under the adviser’s name as agent or trustee for the clients

20. Safekeeping Requirement #3 Notice to Clients –At time of account opening –Any time the custodian changes –Custodian’s name, address, and the manner in which the funds or securities are maintained Adviser’s responsibility Usually found in client’s advisory contract or in adviser’s ADV

21. Safekeeping Requirement #4 Account Statements from Custodian –At least Quarterly –Shows all funds, each security and amounts, and all transactions during the period If Adviser holds client funds and securities and provides statements –Independent CPA audit (yearly, unannounced, reported to Administrator –Discrepancies reported to Administrator

22. #6 Direct Fee Deduction Notify Administrator (on ADV) Obtain written authorization from client Dual invoice client and custodian –Client invoice must show Amount of fee Time period covered Fee formula Assets for which fee applied –Custodian invoice must only show Amount of fee and who it’s for

23. #7 GP of Investment Partnership (That has annual audits) Notify Administrator (on ADV) Has annual audit (minimally) Audit prepared in accordance with GAAP Audited Financial Statements distributed to all partners, owners, or members within 120 days of fiscal year end

24. #7 GP of Investment Partnership (That doesn’t have annual audits) Notify Administrator (on ADV) Hire an independent “Gatekeeper” Send gatekeeper all invoices and receipts for fees, expenses, capital withdrawals –Gatekeeper will Determine if appropriate Approve fee Forward to custodian for payment –Gatekeeper is “independent” if No control relationship with adviser No material business relationship within two years

25. #8 Adviser as Trustee (or Executor) Notify Administrator (on ADV) Invoice Requirement –Dual invoice grantor and custodian just like direct fee deduction Written Agreement with Custodian for –Payment of Fees to Adviser Grantor must authorize custodian to pay fees to adviser Must be a detailed invoice for advisory fee Custodian must send detailed quarterly statement to grantor –Distribution of Assets By instruction from authorized signatory only Distributed only to –Trust company, bank, or broker-dealer –Grantors or beneficiaries of the trust –Independent 3 rd persons (attorneys, taxes, etc...)

26. Adviser as Trustee for Relative Gives relief from all Custody Requirements (Including Safekeeping) Gives relief from increased net worth, bonding, financial reporting Owner of trust must be a parent, grandparent, spouse, sibling, child or grandchild (includes “step” relations) The adviser must –Provide a written statement to each owner of the trust listing the four Safekeeping Requirements and why the adviser will not be complying with them –Obtain a signed acknowledgement for that statement from each owner of the trust –Maintain a copy of both documents until account is closed or adviser is no longer trustee

27. Examination Time Keep in mind that the adviser may not understand if it has custody or not. Exam Module interview questions address custody scenarios. The Main IA Module lists custody and potential custody scenarios and provides questions to determine if adviser is in compliance with the safekeeping requirements for that particular type of custody scenario. Get help from an experienced accounting person for examining an adviser acting as custodian

28. The Three “I”s… Identify custody situations Independence of custodian, CPA, auditors, and gatekeepers Investigate the flow of funds –Trace a customer’s purchase, deposit, securities transfer, etc… from the customer to the custodian, ESPECIALLY if it passes through the adviser, asset verification