Section 146. Custody of client funds or securities by investment advisors

Part III. Investment Advisor, Federal Covered Advisor, and Investment Advisor Representative Regulations

A. For purposes of this section the following definitions shall apply:

"Control" means the power, directly or indirectly, to direct the management or policies of a person whether through ownership of securities, by contract, or otherwise. Control includes:

1. Each of the investment advisor's officers, partners, or directors exercising executive responsibility (or persons having similar status or functions) is presumed to control the investment advisor.

2. A person is presumed to control a corporation if the person:

a. Directly or indirectly has the right to vote 25% or more of a class of the corporation's voting securities; or

b. Has the power to sell or direct the sale of 25% or more of a class of the corporation's voting securities;

3. A person is presumed to control a partnership if the person has the right to receive upon dissolution, or has contributed, 25% or more of the capital of the partnership;

4. A person is presumed to control a limited liability company if the person:

a. Directly or indirectly has the right to vote 25% or more of a class of the interests of the limited liability company;

b. Has the right to receive upon dissolution, or has contributed, 25% or more of the capital of the limited liability company;

c. Is an elected manager of the limited liability company; or

5. A person is presumed to control a trust if the person is a trustee or managing agent of the trust.

"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. The investment advisor has custody if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services the investment advisor provides to clients.

1. Custody includes:

a. Possession of client funds or securities unless the investment advisor receives them inadvertently and returns them to the sender promptly but in any case within three business days of receiving them;

b. Any arrangement (including general power of attorney) under which the investment advisor is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the investment advisor's instruction to the custodian; and

c. 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 the investment advisor or its supervised person legal ownership of or access to client funds or securities.

2. Receipt of checks drawn by clients and made payable to third parties will not meet the definition of custody if forwarded to the third party within three business days of receipt and the investment advisor maintains the records required under 21VAC5-80-160 A 23;

"Independent certified public accountant" means a certified public accountant that meets the standards of independence described in Rule 2-01(b) and (c) of Regulation S-X (17 CFR 210.2-01(b) and (c)).

"Independent party" means a person that:

1. Is engaged by the investment advisor to act as a gatekeeper for the payment of fees, expenses, and capital withdrawals from the pooled investment;

2. Does not control and is not controlled by and is not under common control with the investment advisor;

3. Does not have, and has not had within the past two years, a material business relationship with the investment advisor; and

4. Shall not negotiate or agree to have material business relations or commonly controlled relations with an investment advisor for a period of two years after serving as the person engaged in an independent party agreement.

"Independent representative" means a person who:

1. Acts as agent for an advisory client, including in the case of a pooled investment vehicle, for limited partners of a limited partnership, members of a limited liability company, or other beneficial owners of another type of pooled investment vehicle and by law or contract is obliged to act in the best interest of the advisory client or the limited partners, members, or other beneficial owners;

2. Does not control, is not controlled by, and is not under common control with investment advisor; and

3. Does not have, and has not had within the past two years, a material business relationship with the investment advisor.

"Qualified custodian" means:

1. A bank or savings association that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act;

2. A broker-dealer registered in this jurisdiction and with the SEC holding the client assets in customer accounts;

3. A registered futures commission merchant registered under Section 4f(a) of the Commodity Exchange Act, holding the client assets in customer accounts, but only with respect to clients' funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon; and

4. A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients' assets in customer accounts segregated from its proprietary assets.

"Related person" means any person, directly or indirectly, controlling or controlled by the investment advisor, and any person that is under common control with the investment advisor.

B. Requirements: It is unlawful and deemed to be a fraudulent, deceptive, or manipulative act, practice, or course of business for an investment advisor, registered or required to be registered, to have custody of client funds or securities unless:

1. The investment advisor notifies the commission promptly in writing that the investment advisor has or may have custody. Such notification is required to be given on Form ADV.

2. A qualified custodian maintains those funds and securities:

a. In a separate account for each client under that client's name; or

b. In accounts that contain only the investment advisor's clients' funds and securities, under the investment advisor's name as agent or trustee for the clients, or, in the case of a pooled investment vehicle that the investment advisor manages, in the name of the pooled investment vehicle.

3. If an investment advisor opens an account with a qualified custodian on its client's behalf, under the client's name, under the name of the investment advisor as agent, or under the name of a pooled investment vehicle, the investment advisor must notify the client in writing of the qualified custodian's name, address, and the manner in which the funds or securities are maintained, promptly when the account is opened and following any changes to this information. If the investment advisor sends account statements to a client to which the investment advisor is required to provide this notice, and the investment advisor must include in the notification provided to that client and in any subsequent account statement the investment advisor sends that client a statement urging the client to compare the account statements from the custodian with those from the investment advisor.

4. The investment advisor has a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each client for which it maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions in the account during that period.

5. If the investment advisor or a related person is a general partner of a limited partnership (or managing member of a limited liability company, or holds a comparable position for another type of pooled investment vehicle):

a. The account statements required under subdivision 4 of this subsection must be sent to each limited partner (or member or other beneficial owner), and

b. The investment advisor must:

(1) Enter into a written agreement with an independent party who is obliged to act in the best interest of the limited partners, members, or other beneficial owners to review all fees, expenses and capital withdrawals from the pooled accounts;

(2) Send all invoices or receipts to the independent party, detailing the amount of the fee, expenses or capital withdrawal and the method of calculation such that the independent party can:

(a) Determine that the payment is in accordance with the pooled investment vehicle standards (generally the partnership agreement or membership agreement); and

(b) Forward, to the qualified custodian, approval for payment of the invoice with a copy to the investment advisor.

6. An independent certified public accountant, pursuant to a written agreement between the investment advisor and the independent certified public accountant, verifies by actual examination at least once during each calendar year the client funds and securities of which the investment advisor has custody. The time will be chosen by the independent certified public accountant without prior notice or announcement to the investment advisor and will be irregular from year to year. The written agreement must provide for the first examination to occur within six months of becoming subject to this subdivision, except that, if the investment advisor maintains client funds or securities pursuant to this section as a qualified custodian, the agreement must provide for the first examination to occur no later than six months after obtaining the internal control report. The written agreement must require the independent certified public accountant to:

a. File a certificate on Form ADV-E with the commission within 120 days of the time chosen by the independent certified public accountant in subdivision 6 of this subsection, stating that it has examined the funds and securities and describing the nature and extent of the examination;

b. Upon finding any material discrepancies during the course of the examination, notify the commission within one business day of the finding, by means of a facsimile transmission or electronic mail, followed by first class mail, directed to the attention of the commission; and

c. Upon resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed, file within four business days Form ADV-E accompanied by a statement that includes:

(1) The date of such resignation, dismissal, removal, or other termination, and the name, address, and contact information of the independent certified public accountant; and

(2) An explanation of any problems relating to examination scope or procedure that contributed to such resignation, dismissal, removal, or other termination.

7. If the investment advisor maintains, or if the investment advisor has custody because a related person maintains, client funds or securities pursuant to this section as a qualified custodian in connection with advisory services the investment advisor provides to clients:

a. The independent certified public accountant the investment advisor retains to perform the independent verification required by subdivision 6 of this subsection must be registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by the Public Company Accounting Oversight Board in accordance with its rules; and

b. The investment advisor must obtain, or receive from its related person, within six months of becoming subject to this subdivision and thereafter no less frequently than once each calendar year a written internal control report prepared by an independent certified public accountant:

(1) The internal control report must include an opinion of an independent certified public accountant as to whether controls have been placed in operation as of a specific date, are suitably designed, and are operating effectively to meet control objectives relating to custodial services, including the safeguarding of funds and securities held by either the investment advisor or a related person on behalf of the investment advisors clients, during the year;

(2) The independent certified public accountant must verify that the funds and securities are reconciled to a custodian other than the investment advisor or the investment advisors related person; and

(3) The independent certified public accountant must be registered with and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by the Public Company Accounting Oversight Board in accordance with its rules.

8. A client may designate an independent representative to receive on his behalf notices and account statements as required under subdivisions 3 and 4 of this subsection.

C. Exceptions:

1. With respect to shares of an open-end company as defined in Section 5(a)(1) of the Investment Company Act of 1940 ("mutual fund"), the investment advisor may use the mutual fund's transfer agent in lieu of a qualified custodian for purposes of complying with subsection B of this section;

2. Certain privately offered securities are exempt, including:

a. The investment advisor is not required to comply with subdivision B 2 of this section with respect to securities that are:

(1) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;

(2) Uncertificated and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and

(3) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

b. Notwithstanding subdivision 2 a of this subsection, the provisions of this subdivision 2 are available with respect to securities held for the account of a limited partnership (or limited liability company, or other type of pooled investment vehicle) only if the limited partnership is audited, and the audited financial statements are distributed, as described in subdivision 4 of this subsection and the investment advisor notifies the commission in writing that the investment advisor intends to provide audited financial statements as described above. Such notification is required to be provided on Form ADV.

3. Notwithstanding subdivision B 6 of this section, an investment advisor is not required to obtain an independent verification of client funds and securities maintained by a qualified custodian if all of the following are met:

a. The investment advisor has custody of the funds and securities solely as a consequence of its authority to make withdrawals from client accounts to pay its advisory fee;

b. The investment advisor has written authorization from the client to deduct advisory fees from the account held with the qualified custodian;

c. Each time a fee is directly deducted from a client account, the investment advisor concurrently:

(1) Sends the qualified custodian or if subdivision B 5 of this section applies sends the independent party designated pursuant to subdivision B 5 b (2) of this section, an invoice or statement of the amount of the fee to be deducted from the client's account; and

(2) Sends the client an invoice or statement itemizing the fee. Itemization includes 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. The invoice will notify the client that the custodian will not be checking the accuracy of the fees and this responsibility is the client's.

d. The investment advisor notifies the commission in writing that the investment advisor intends to use the safeguards provided above. Such notification is required to be given on Form ADV.

Check Item 9.A. on Form ADV Part 1A as "No" if the only reason the investment advisors have custody is because they engage in direct fee deduction. Item 2.I. of Form ADV Part 1B asks detailed questions that are more useful in determining associated risk.

4. An investment advisor is not required to comply with subdivisions B 3 and B 4 of this section and shall be deemed to have complied with subdivision B 6 of this section with respect to the account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) if each of the following conditions are met:

a. The advisor sends to all limited partners (or members or other beneficial owners) at least quarterly, a statement, showing:

(1) The total amount of all additions to and withdrawals from the fund as a whole as well as the opening and closing value of the fund at the end of the quarter based on the custodian's records;

(2) A listing of all long and short positions on the closing date of the statement in accordance with FASB Rule Accounting Standards Codification (ASC) 946-210-50; and

(3) The total amount of additions to and withdrawals from the fund by the investor as well as the total value of the investor's interest in the fund at the end of the quarter.

The listing in subdivision 4 a (2) of this subsection follows FASB Rule Accounting Standards Codification (ASC) 946-210-50-6 whereby long and short positions representing more than 5.0% of the net assets of the fund must be reported as outlined in subsection 50-6 of the FASB Rule. All provisions of subsection 50-6 in the FASB Rule apply to the position disclosure required on the quarterly customer statement. This is the same reporting format required by Rule 13F under the Securities Exchange Act of 1934 for investment managers' annual reports.

b. At least annually the fund is subject to an audit and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) and the commission within 120 days of the end of its fiscal year;

c. The audit is performed by an independent certified public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by the Public Company Accounting Oversight Board in accordance with its rules;

d. Upon liquidation, the advisor distributes the fund's final audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) and the commission promptly after the completion of such audit;

e. The written agreement with the independent certified public accountant must require the independent certified public accountant to, upon resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed, notify the commission within four business days accompanied by a statement that includes:

(1) The date of such resignation, dismissal, removal, or other termination, and the name, address, and contact information of the independent certified public accountant; and

(2) An explanation of any problems relating to audit scope or procedure that contributed to such resignation, dismissal, removal, or other termination.

f. The investment advisor must also notify the commission in writing that the investment advisor intends to employ the use of the statement delivery and audit safeguards described above. Such notification is required to be given on Form ADV.

5. The investment advisor is not required to comply with this section with respect to the account of an investment company registered under the Investment Company Act of 1940.

6. When a supervised person of an advisor serves as the executor, conservator, or trustee for an estate, conservatorship, or personal trust solely because the supervised person has been appointed in these capacities as a result of a family or personal relationship with the decedent, beneficiary, or grantor (but not a relationship resulting from a past or present client relationship with the advisor), the advisor will not be required to comply with the requirements of subsection B of this section if the advisor complies with the following:

a. Provides a written statement to each beneficial owner of the account setting forth a description of the requirements of subsection B of this section and includes the reasons why the investment advisor will not be required to comply with those requirements.

b. Obtains from each beneficial owner a signed and dated statement acknowledging the receipt of the written statement required under subdivision 6 a of this subsection.

c. Maintains a copy of both documents described in subdivisions 6 a and b of this subsection until the account is closed or the investment advisor is no longer executor, conservator, or trustee.

D. Delivery to related persons. Sending an account statement under subdivision B 5 of this section or distributing audited financial statements under subdivision C 4 of this section shall not satisfy the requirements of this section if such account statements or financial statements are sent solely to limited partners (or members or other beneficial owners) that themselves are limited partnerships (or limited liability companies, or another type of pooled investment vehicle) and are related persons.

Historical Notes

Derived from Volume 29, Issue 20, eff. June 3, 2013.

Statutory Authority

§ 12.1-13 and 13.1-523 of the Code of Virginia.