Investment Adviser Guide
For the most part, the Division rules follow the Securities and Exchange Commission's "Custody Rule" - SEC Rule 204(4)-2. Advisers that take custody of client funds or securities are subject to additional regulations designed to protect these client assets. The Custody Rule sets guidelines for segregating client funds and securities, including some additional recordkeeping requirements.
Custody typically refers to “having possession” of something. In dealing with investment advisers and the client funds that they manage, the definition is expanded somewhat to include “having access to” client assets. In this case, it means “having possession of, ” or “having access to,” client funds or securities. This can be broken down into two broad categories: physical custody and constructive custody.
Physical custody: Physical custody is where the adviser physically possesses the client funds or securities. This would include such things as storing clients’ stock certificates, accepting checks made out to the adviser for deposit into the clients’ accounts, and accepting cash from the client to purchase investments or to deposit into the clients’ accounts. The adviser typically uses a clearing firm, bank, or brokerage firm to actually house clients’ funds and securities, commonly referred to as the “custodian.” Custodians are required to keep client funds and securities segregated from those of other clients and they must follow special rules. If the adviser has physical custody as noted above, then the adviser becomes a custodian and is subject to those same custodial requirements.
There are examples of physical custody that are labeled “inadvertent” and “transitory.” § DFI-5.035(4)(a)(1)
Inadvertent custody is when the client inadvertently sends the adviser funds or securities that are intended for deposit into the client’s account. In order to avoid having to comply with the safekeeping, audit, and net worth requirements of having physical custody, the adviser must return those funds or securities to the client within 3 business days as well as document that receipt and return. § DFI-5.035(3)
Transitory custody situations occur when the client sends the adviser a check made payable to the custodian (clearing firm, bank or brokerage firm, not the adviser) for deposit into the client’s account. In order to avoid having to comply with the safekeeping, audit, and net worth requirements of having physical custody, the adviser must forward such checks to the custodian within 24 hours of receiving them and keep a record detailing the receipt and forwarding. § DFI-5.035(3)
An adviser who has custody of client funds and securities must comply with the following:
1. The adviser must notify the Division in writing via Form ADV that the adviser has custody. § DFI-5.035(1)(a)
2. Client funds and securities must be maintained in a separate account for each client under the client's name or the adviser's name as agent or trustee for the client. Client funds and securities must be kept with a “qualified custodian”. A qualified custodian includes a broker-dealer registered under ch. 551, Wis. Stats., a bank or savings association whose deposits are insured by a federal deposit insurance corporation, a registered futures commission merchant registered under section 4f(a) of the Commodity Exchange Act, or a foreign financial institution that customarily holds financial assets for its customers. § DFI-5.035(1)(b)
3. The adviser must notify the client in writing of the name and address of the custodian where their funds or securities are maintained and the manner in which the funds or securities are maintained, promptly when the account is opened and following any changes in the custodian or its location. § DFI-5.035(1)(c)
4. Account statements must be sent to clients in compliance with the following:
a. If held at a qualified custodian, the adviser needs to verify that the qualified custodian sends an account statement, at least quarterly, to each client, identifying the amount of funds, each security in the account and the transaction details for that statement period. § DFI-5.035(1)(d)(1) If the adviser is a general partner of a pooled investment, the statements should be sent to each limited partner, member or other beneficial owner. § DFI-5.035(1)(d)(3)
b. If the funds or securities are held by the adviser, the adviser must send an account statement to the client at least quarterly, identifying the amount of funds, each security in the account and transaction details for that statement period. § DFI-5.035(1)(d)(2)a The adviser must engage an independent certified public accountant to verify all client funds and securities by examination at least once each calendar year at a time chosen by the accountant without prior notice or announcement to the adviser. The times must be irregular from year to year. The accountant must file a copy of the examination report with the Division within 30 days after the completion of the exam, stating that it has examined the funds and securities and describing the nature and extent of the exam. § DFI-5.035(1)(d)(2)b If the accountant finds any material discrepancies during the examination, the accountant must notify the Division within one day of finding the discrepancy by facsimile transmission or electronic mail, followed by first class mail directed to the Division. § DFI-5.035(1)(d)(2)c
BOOKS AND RECORDS
1. If the adviser is permitted to withdraw client funds or securities maintained at a qualified custodian, the adviser must keep copies of all written authorizations from clients allowing such withdrawals, copies of the notice to the custodian of fees to be deducted as well as the invoice sent to the client. § DFI-5.035(3)(b)(1)
2. A journal or other records showing all purchases, sales, receipts and deliveries of securities, including certificate numbers, for all accounts and all other debits and credits to the account. § DFI-5.035(3)(b)(2)
3. A separate ledger for each client showing all purchases, sales, receipts and deliveries of securities, the date and price of each purchase and sale and all debits and credits. § DFI-5.035(3)(b)(3)
4. Copies of confirmations of all transactions effected for the account of any client. § DFI-5.035(3)(b)(4)
5. A record by security showing the name of each client holding such security, the amount being held and the location of the security. § DFI-5.035(3)(b)(5)
6. Copies of the quarterly statements generated by the custodian as well as any statements generated by the adviser and the date they were sent to the client. § DFI-5.035(3)(b)(6)
7. If applicable to the adviser's situation, a copy of the auditor's report and financial statements, and a copy of the letter verifying the independent certified public accountant's examination that was provided to the Division. § DFI-5.035(3)(b)(7)
8. A record of any material discrepancies found by the independent certified public accountant during the exam. § DFI-5.035(3)(b)(8)
9. If applicable, evidence of the client's designation of an independent representative. § DFI-5.035(3)(b)(9)
NET WORTH REQUIREMENT
Advisers with custody must also maintain at all times a net worth of $35,000. § DFI-5.02(2)
If the adviser is an individual, an amount sufficient to satisfy the net worth requirement must be segregated from the adviser’s personal capital, and must be designated solely for the advisory business.
“Net Worth” for this section is defined as an excess of assets over liabilities, determined by generally accepted accounting principles but may not include the following assets:
a. Prepaid expenses, deferred charges, goodwill, franchise rights, organizational expenses, patents, copyrights, marketing rights, unamortized debt discount and expense, and all other assets of an intangible nature.
b. Home, home furnishings, automobiles and any other personal items not readily marketable, if the adviser is an individual.
c. Advances or loans to stockholders and officers, if the adviser is a corporation.
d. Advances or loans to partners, if the adviser is a partnership.
Constructive custody: An adviser can have custody of client funds and securities even without having physical possession of the funds or securities, by “having access to” them. Examples of constructive custody include the following: general power of attorney, direct fee deduction, advisor to a mutual fund, general partner, trustee or executor.
General Power of Attorney. § DFI-5.035(4)(a)(2)
An adviser with a full power of attorney over the client's account including having the ability to withdraw client funds and securities is deemed to have custody. An adviser could have a limited power of attorney without having custody as long as it is clear that the adviser does not have the power to withdraw client funds or securities. If the adviser has signatory authority on a client's account, for example a checking or savings account, the adviser would have custody.
An adviser having custody through a general power of attorney or as a signatory on client accounts is not required to meet the net worth requirement or additional books and records requirements of custody, if the adviser complies with all of the safekeeping requirements. § DFI-5.035(1)(f)(4)
Direct fee deduction. § DFI-5.035(4)(a)(2)
Many advisers offer the service of having their advisory fees deducted directly from the client's custodial account as a matter of convenience so the client does not have to write a check to the adviser each quarter. This constitutes custody, but some relief from the additional books and records and net worth requirements is available, if the adviser complies with the following: § DFI-5.035(1)(f)(1)-(2)
a. The adviser must obtain written authorization from the client to deduct advisory fees from the account held with the qualified custodian.
b. Each time the advisory fee is to be deducted the adviser must send the qualified custodian notice of the amount to be deducted and at the same time send the client an invoice itemizing the fee to include the formula used to calculate the fee, the amount of assets under management the fee is based on, and the time period covered by the fee.
c. The adviser must notify the Division on Form ADV of its intention to comply with a. and b. above.
d. As long as the adviser complies with the above invoice procedure and complies with all of the safekeeping requirements, the adviser will not be required to meet the net worth requirement.
Mutual Fund: § DFI-5.035(2)
If an adviser's clients hold shares of an open-end investment company as defined in section 5(a)(1) of the Investment Company Act of 1940, the adviser may use the transfer agent instead of a "qualified custodian" to meet the safekeeping requirements. An adviser would not have to meet the safekeeping requirements under the following circumstances:
The account is held by an investment company registered under the investment company act of 1940.
Or, the securities meet the following requirements:
a. The securities are obtained from the issuer without being part of a public offering. § DFI-5.035(2)(b)(1)a.
b. The securities are not in certificate form and ownership is recorded only on the records of the issuer or its transfer agent in the client's name. § DFI-5.035(2)(b)(1)b.
c. The securities are transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer. § DFI-5.035(2)(b)(1)c.
General Partner. § DFI-5.035(4)(a)(3)
Some advisers manage client assets by forming a partnership for the purpose of pooling investors' funds. Each client contributes money to the partnership and is entitled to his or her share of the whole. This operates like a mini-mutual fund. The adviser serves as general partner and manages the pooled assets as one account. The adviser would have custody if it has the ability to withdraw account assets to pay itself advisory or management fees as general partner.
An adviser acting 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 must comply with the following, if it does not distribute its financial statements because of the exception in. § DFI-5.035(2)(c) [§ DFI-Sec 5.035(1)(g)]:
a. The adviser must hire an independent party to review all
fees, expenses and capital withdrawals from the pooled accounts.
b. The adviser must send invoices or receipts to the independent party, detailing the amount of the fee, expenses or capital withdrawal, and the method of calculation so that the independent party can do the following:
1. Determine that the payment is in accordance with the standards set forth in the partnership agreement or membership agreement.
2. Forward to the qualified custodian, written approval for payment of the fee, expense or capital withdrawal, and provide a copy to the adviser.
3. The adviser through Form ADV must advise the Division that a. and b. above will be complied with.
4. As long as the adviser does the above and complies with the safekeeping requirements , the adviser will not be required to meet the financial requirements of custody.
The adviser does not have to provide clients with quarterly account statements as prescribed by rule § DFI-5.035(1)(d), if the account is subject to audit at least annually and distributes annually its audited financial statements prepared in accordance with general accepted accounting principles to all limited partners, members or other beneficial owners within 120 days of the end of its fiscal year. The adviser must also notify the Division of its intent to comply with this rule on Form ADV. § DFI-Sec 5.035(2)(c)
An adviser is not required to comply with the safekeeping requirements with respect to securities held for the account of a limited partnership, limited liability company, or other type of pooled investment vehicle, only if the entity has audited financial statements that are distributed in compliance with § DFI-5.035(2)(c) and the adviser notified the division on Form ADV that the adviser intends to distribute the audited financial statements and the account holds securities that meet the following:
a. The securities are obtained from the issuer without being part of a public offering. § DFI-5.035(2)(b)(1)a
b. The securities are not in certificate form and ownership is recorded only on the records of the issuer or its transfer agent in the client’s name. § DFI-5.035(2)(b)(1)b
c. The securities are transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer. § DFI-5.035(2)(b)(1)c
Trustee or Executor. § DFI-5.035(4)(a)(3)
An adviser acting as a trustee or executor for clients’ accounts may have the authority to pay bills, taxes, etc…. from the account on behalf of the client. When an adviser has such authority, it has custody.
An adviser does not have to comply with the safekeeping requirements
or the net capital requirements if the custody is only because the adviser
is the trustee of a beneficial trust as long as the following are met:
a. The beneficial owner of the trust is a parent, grandparent, spouse, sibling, child or grandchild of the adviser. Those relationships include “step” relationships.
b. For each account that meets the above, the adviser must do the following:
1. Provide a written statement to each beneficial owner of the account explaining the safekeeping requirements and the reason why the adviser will not be complying with those requirements.3. Maintain copies of the documents from a. and b. above, until the account is closed or the adviser is no longer the trustee.
2. Obtain a signed and dated statement acknowledging the receipt of the above written statement.
If the adviser is acting in any capacity such as a trustee of a trust that provides the adviser or a representative of the adviser with legal ownership of, or access to client funds and securities and does not meet the exemption noted above, the adviser must comply with the custody safekeeping requirements, net capital requirements, books and records requirements, as well as the following additional books and records:
a. True, accurate and current account statements.
b. If the adviser complies with providing the annual audited financials as required by § DFI-5.035(2)(c), the following records must be maintained:
1. A record of the date of the audit.
2. A copy of the audited financial statements.
3. A record evidencing the mailing by the issuer of its audited financial statements to all limited partners, members or other beneficial owners within 120 days of the end of the fiscal year.