The annual review is one of the three (3) pillars of Rule 206(4)-7 (“the Compliance Rule”) of the Investment Advisers Act of 1940 (“the Advisers Act”).
The rule requires SEC registered investment advisers (“RIAs”) to annually review “the adequacy of the policies and procedures established pursuant to this section and the effectiveness of their implementation.”[i]
Annual reviews have been cited by the Office of Compliance Inspections & Examinations (“OCIE”) as one of the top five (5) “most frequent compliance topics” during SEC exams.
Among their observations, OCIE has found that RIAs have failed to perform annual reviews outright; sufficiently reviewed and tested the adequacy of their policies and procedures (“P&Ps”); and, failed to implement changes or make updates to their P&Ps based on their annual reviews. [ii]
In fact, the SEC has brought enforcement actions against RIAs that failed to conduct annual reviews, including cease-and-desist orders, censure, and civil-monetary penalties, such as the case of Hudson Housing Capital, LLC, wherein the adviser failed to both implement and review their P&Ps as required by the Compliance Rule.[iii]
In consideration of the importance of the Compliance Rule’s requirement for conducting an annual review of your P&Ps, today we focus on custody.
Custody
Custody remains an important topic because a RIA’s ability to move money and other assets on behalf of the client can have a material impact on the client.
Under Rule 206(4)-2 there are specific requirements that have to be met by RIAs including placing client assets with a qualified custodian, verifying that the custodian is a qualified custodian, notifying the clients about the placement of the assets with the custodian, and providing the clients with the custodian’s address.
Additionally, the RIA must verify that a client is receiving quarterly statements from the custodian, and if the adviser is providing statements to the client, to indicate on a legend on their statements that compare the custodian’s statement with the adviser’s statement.
If an RIA has actual custody of client assets including a surprise independent verification (“Surprise Audit”) of assets performed by a certified public accountant on an annual basis as well as filing an ADV-E with the SEC within 120 days of the Surprise Audit.
While not all RIAs have custody of client assets that require them to have a Surprise Audit and file a Form ADV-E, many firms have what’s known as “constructive custody” by virtue of the fact that they can withdraw their quarterly fees from client accounts, and in some cases they can move money to unrelated third-parties because of standing letters of authorization (“SLOAs”) they have with their clients.
When considering reviewing custody at your firm, be sure and evaluate whether the firm has actual or constructive custody and then determine that that the firm is meeting the custody requirements (e.g. a surprise audit in the case of actual custody or meeting the seven-part test for SLOAs to avoid the surprise audit requirement).
Also verify that all steps have been taken to fulfill the custody requirements per your P&Ps including filing of Form ADV-E, delivery of audited financial statements, and verification the custodian is delivering statements.
Conclusion
As you can see there are several of areas of your RIA’s compliance program that need to be taken into consideration when conducting an annual review.
While the task of testing all of the different areas of your firm, analyzing your results, and recording findings and recommendations based on your review might seem difficult, it is not insurmountable. Good planning, working with stakeholders and key employees, and employing a strategic approach to testing your P&Ps will allow you to approach your annual review with confidence.
Jacko Law Group can help your firm with your annual reviews, including providing guidance on how to conduct an annual review, assisting with testing different areas of your compliance program, or conducting the annual review in its entirety on behalf of your firm.
Our team of attorneys will use our extensive experience to assist you with your annual review in order to ensure the successful fulfillment of your annual review obligation under the Compliance Rule.
[i] See 17 CFR § 275.206(4)-7 – Compliance procedures and practices
[ii] Office of Compliance Inspections and Examinations. “Risk Alert: The Five Most Frequent Compliance Topics Identified in OCIE Examinations of Investment Advisers.” SEC.Gov, U.S. Securities and Exchange Commission, 7 Feb. 2017, www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdf.
[iii] See “In the Matter of HUDSON HOUSING CAPITAL LLC, Respondent.”
