Custody Rule Vigilance

Custody Rule Vigilance

In a recent settlement order, the SEC reminded the investment advisory community that the SEC remains vigilant in enforcing the Custody Rule, Rule 206(4)-2 of the Investment Advisers Act of 1940. The SEC also again telegraphed that it will institute enforcement proceedings even when there has been no client harm, in fact, even when it appears that clients financially benefitted.

Although the facts provided are minimal, the Order states that the adviser had separately managed account clients, whose securities were appropriately custodied at a Qualified Custodian. However, things went askew when the adviser’s president/majority owner implemented an opportunity for some clients without proper custodial controls. The Order states that a client owned and controlled company was seeking additional capital; the adviser’s president/majority owner suggested to this client that some of the adviser’s other high net worth clients could lend funds to that client’s company if at a favorable interest rate. The president/majority owner went to several of the advisory clients, and, following agreement, promissory notes were issued (paying rates of 9 or 10%).

The notes were held outside of the clients’ advisory accounts, although it appears that possibly there were some lines of credit to fund the notes, secured by some of the advisory accounts held at the Qualified Custodian. At the direction of the president/majority owner, the adviser placed copies of the notes in each client’s online ‘drop box’ associated with the advisory accounts. However, the clients’ account statements from the Qualified Custodian did not reflect the investments. The adviser’s chief compliance officer and chief investment officer were not aware of the notes, and thus they did not have the ability to monitor or evaluate the investments as required by the adviser’s written policies and procedures.

Based on these facts, the SEC found that the adviser had custody of the notes. The Order states that the adviser violated the Custody Rule because the adviser “failed to comply with the custody rule requirements, including ensuring that a qualified custodian maintained the client assets.”

Neither the adviser nor its president/majority owner received any compensation in connection with the promissory notes. Within the year of the notes’ issuance (2019), the company repaid, early and in full, all of the advisory clients. The Order clearly states “no [advisory] client lost money in the promissory note investments.”

Understanding and fulfilling the requirements of the Custody Rule can be more cumbersome than one may initially think. The Rule does not address directly many scenarios, so each adviser must regularly assess conduct to determine first if there is custody under the Custody Rule—which is much more than physical possession—and, secondly, if there is custody, if the many Custody Rule requirements are being met. To the SEC, “misuse of client assets” has wider meaning than financially harming clients, just as ‘custody’ has wider meaning than ‘possession.’  We have heard that the SEC soon may be revising the Custody Rule to provide clarity to the advisory community, but, until then, please remain vigilant in meeting the Custody Rule requirements.

Additionally, there is a sub-story to this case. The adviser was not registered with the Commission at the time of the conduct, although it “was required to be registered then” due to the amount of assets under management. This statement alone is a reminder that correctly calculating regulatory assets under management (“RAUM”) is critical, and that enforcement is not avoided by not registering where the Commission has jurisdiction.

As we approach this year end, this case serves as a timely prompt. Now is a good time to review all forms of authority over client assets and implementation of all provisions of the Custody Rule. Additionally, and in coordination with the mandatory Form ADV Annual Updating Amendment (for those advisers with a December 31 fiscal year end), now is the time to review how one calculates the RAUM, the accuracy of the RAUM calculation, and the impact of RAUM to jurisdiction and Form ADV disclosures.  

For more information or to speak with a regulatory expert, please email


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