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How to keep the SEC happy without going out of business ...

While advisors frequently discuss best execution and proxy voting, the regulation currently attracting the most attention is the SEC's new ruling on custody of client assets. Effective Nov. 5, 2003, the SEC adopted long-awaited amendments to Rule 206(4)-2 intended to modernize the Investment Advisor Act of 1940 custody rule to enhance protections for advisory clients' assets, harmonize the rule with current custodial practices, and clarify when advisors have custody. What many advisors don't realize is that--for most advisors--the new rule is a liberalization of the rule previously in effect.

Essentially, if you keep your clients' assets at an "approved custodian" that provides at least a quarterly statement directly to your client, this relieves the advisors from sending clients quarterly account statements and undergoing an annual surprise examination. If you turn over to custodians within three days any stock certificates a client may give you, you don't receive client payments of more than $500 more than six months in advance of service, and you don't hold power of attorney to sign checks on a client's behalf, then you probably don't have custody. The good news: you aren't subject to the requirement of giving clients audited financial statements, and you don't have to pay for surprise accounting firm audits.

One exception is that the SEC deems an advisor to have custody if (s)he has the ability to debit the client's account for payment of advisory fees. However, you will not be required to undergo an annual surprise CPA examination, or provide an audited financial statement based upon this one factor.


What's the bottom line to the custody rule? Matters will be easier for most advisors because they now have the option of declining to send clients quarterly investment reports if their custodian is already doing it. All you really need to do is have a page in your compliance manual that spells out where you custody client funds, when and what kind of investment report your clients receive, how and when you charge client fees, and that you do not directly hold client funds or securities.

Advisors now should have a better idea of what is required and how to develop procedures and documentation. Even with this roadmap, however, these new regulations will still seem to most advisors and sole practitioners (who make up a huge percentage of our industry) to be an added burden.

The SEC will frown on sole practitioners wearing all hats: it's the fox guarding the hen house thing. The SEC will look for third-party relationships with attorneys or consultants specializing in compliance issues, as well as a culture of compliance. This culture underpins your business, along with the decisions and choices you make every day, such as how you handle customers' complaints, correct minor errors in pricing or in net asset value, and deal with disclosure issues. These decisions must be made in the context of your firm's compliance culture.

Phyllis Bernstein, CPA/PFS, is president of Phyllis Bernstein Consulting, Inc, in New York City. Contact her at or through

Investment Advisors, Part II

This is Part II of a two-part article; Part I was published in the August/September issue.
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Author:Bernstein, Phyllis
Publication:The National Public Accountant
Geographic Code:1USA
Date:Nov 1, 2004
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