Investor Assets may be at Risk with Investment Advisors

The Securities and Exchange Commission (“SEC”) has issued an investor alert warning about problems with investment advisors improperly handling actual custody of client assets. Under the Investment Advisors Act of 1940, which is still the single most significant legislation governing investment advisors, there is a “custody rule.” According to the rule, an adviser has custody of client assets if the advisor or any related person directly or indirectly holds the client’s money or securities. The advisor also is considered to have custody if the advisor has the authority to obtain possession of them without further authorization from the client.

If the advisor does have custody, there are a number of requirements of how the advisor must act under the law. For example, the advisor is required to put the assets with a “qualified custodian,” which typically means a bank or a broker-dealer. The assets are required to be in a separate account at that custodian either under the name of the client directly, or under the name of the advisor as agent or trustee for that client. The clients are required to be informed of where and how their assets are being held, and the advisor must make reasonable efforts to ensure that the custodian is sending at least quarterly statements to the client. All of these requirements, among others not described, exist to protect clients from fraud and other criminal conduct. So when advisors fail to fulfill these obligations, it is a serious situation which greatly increases the chances that investors will find themselves defrauded of their money.

According to the SEC investigation, roughly one third of the firms reviewed, coming out to around 140 different firms, were not properly identifying and/or maintaining their client custody obligations. The problems identified included: 1) advisors not properly recognizing that they had custody of client assets; 2) advisors improperly comingling, or mixing, client assets with other assets in the same account; and 3) failure to conduct the required surprise examinations of the custodians. As a result of these investigations, Advisors must review their procedures to ensure that custody of customer assets is in compliance with the laws and regulations. In some of these instances, the investigated firm has been referred for disciplinary action or other litigation by the SEC Division of Enforcement.

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