By Marc B. Minor

Investment advisers, rightly, focus much of their attention on satisfying their fiduciary duty through careful investment recommendations. However, advisers’ duties also include ensuring that client cash and securities are transferred for investment, and held, safely by the custodian of those assets.

For robo-advisers, client onboarding, facilitating the transfer of funds and securities, and trading are, nearly exclusively, conducted electronically through third-party vendors and partners. Robo-adviser, then, do not hold client assets during these steps, but enter arrangements with the brokerage, clearing and custodial partners that do. Thus, where client funds are deposited awaiting investment, where securities are held, and where liquidated positions reside, are all important factors in determining, and avoiding, custody.

Custody obligations are governed by Rule 206(4)-2 of the Investment Advisers Act (the “Custody Rule”), which states that an adviser is regarded to have ‘custody of client assets subject to the Custody Rule when it holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them.

This broad rule provides that investment advisers that are deemed to have custody must ensure that following conditions are met, including that:

(1) A qualified custodian (typically a bank or savings association, broker-dealer, or futures commission merchant) maintain client funds and securities in separate accounts held either in the client’s name or, under the adviser’s name as agent or trustee for the client;

(2) Clients are notified at account opening of the qualified custodian’s name, address, and the manner of the assets’ maintenance. Any adviser account statements sent to the client should urge clients to compare the adviser statements with those from the custodian;

(3) Advisers have a reasonable basis, after due inquiry, for believing that the qualified custodian sends clients account statements, at least quarterly, identifying the amount of funds and of each security in the account, including all transactions in the account; and

(4) Client funds and securities must be verified by surprise examination of the adviser, at least once during each calendar year by an independent public accountant, or if by a qualified custodian, no later than 6 months after obtaining an internal control report.

Importantly, however, as further described in the example below, an adviser which would otherwise be deeded to have custody solely based on its authority to make withdrawals from client accounts to pay advisory fees will not be subject to the surprise examination requirement.

The SEC has issued specific guidance to robo-advisers regarding custody, including risks inherent to robo platforms. Robo-adviser operations not carefully structured and monitored, run the risk of creating unintended custody issues.  Here are a few examples:

-Holding client assets.

Holding client assets, even briefly, may still be deemed custody. For robo-advisers, platform design and order routing systems typically prevent such scenarios. But for hybrids, or even fully digital robo-advisers, clients will occasionally forward funds or physical checks for investment or the payment of fees. While it may be tempting to facilitate customer intentions and save time by accepting and forwarding funds to the appropriate account(s), regulators may disagree. The SEC has held that intentionally holding clients’ assets even temporarily invokes the Custody Rule. An adviser that is accidently sent client assets, can return them to the sender within 3 days and avoid custody. Also, merely receiving a client’s check that is payable to a third party is not custody if promptly forwarded to the payee. Conversely, advisers depositing such assets in their own accounts, even solely for the purpose of forwarding them to an intended third party, will likely be deemed custody.

-Having client authorizations.

Generally, any authority to withdraw funds or securities from a client’s account will be presumed to be custody. However, this should be distinguished from the common robo-adviser practice of having clients grant advisers authority to instruct broker-dealers or custodians to effect or to settle trades in an account, or take an advisory fee, which, generally, do not constitute “custody.”

The SEC has stated that authorizations allowing robo-advisers access to client accounts may constitute custody. Having password access to clients’ online accounts which include the ability to withdraw assets that are not in the name of qualified custodians may constitute custody, whether that access is used or not. Further, advisers may have unintended custody if agreements between the qualified custodian and advisory client allow the adviser to instruct the custodian to effectuate withdrawals or transfers. To avoid this, robo-advisers should determine whether such passwords or rights are available, and to whom, and have an agreement with custodians that limits any such advisory authority, notwithstanding client agreements to the contrary.

The selection of a qualified custodian, and satisfaction of the Custody Rule for those with affiliated custodians, require clear understanding of an adviser’s asset handling policies and practices in order to avoid the issues that the Custody Rule can create.

Next, the Robo Blog will be tackling the basic yet essential function of Recordkeeping.