The Custody Rule provides that “it is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the [Advisers] Act … for [a registered investment adviser] to have custody of client funds or securities unless” the adviser implements an enumerated set of requirements to prevent loss, misuse, or misappropriation of those funds and securities.[1] The purpose of the Custody Rule is to protect investment advisory clients from, among other things, the loss, misuse, or misappropriation of their funds and securities.
Under the rule, an investment adviser has custody if it holds, directly or indirectly, client funds or securities, or if it has the ability to obtain possession of those funds and securities.[2] Custody is defined to include, among other things, “[a]ny arrangement … under which [the adviser is] authorized or permitted to withdraw client funds or securities maintained with a custodian upon [its] instruction to the custodian” and “[a]ny capacity (such as … trustee of a trust) that gives [the adviser or its] supervised person legal ownership of or access to client funds or securities.”[3] A “related person” is defined as any person, directly or indirectly, controlling or controlled by the adviser, and any person that is under common control with the adviser.[4]
Under the Custody Rule, an investment adviser who has custody of client funds and securities must, among other things: (i) ensure that a qualified custodian maintains the client funds and securities; (ii) notify the client in writing of accounts opened by the adviser at a qualified custodian on the client’s behalf; (iii) have a reasonable basis for believing that the qualified custodian sends account statements at least quarterly to clients; and (iv) ensure that client funds and securities are verified by actual examination each year by an independent public accountant pursuant to a written agreement at a time chosen by the accountant without prior notice or announcement to the adviser (i.e., the “surprise examination” requirement).[5] The written agreement with the accountant must provide for the first examination to occur within six months of becoming subject to the requirement and require, among other things, that the accountant file a Form ADV-E with the SEC within 120 days of the date chosen by the accountant to perform the examination, which states that the accountant has examined the client funds and securities and describes the nature and extent of the examination.[6]
Today, we examine In the Matter of Munakata Associates LLC (here), an administrative action that was settled in anticipation of the institution of enforcement proceedings involving the alleged violation of the Custody Rule.
According to the SEC, from at least 2018 to 2024 (the “Relevant Period”), respondent’s president, sole principal, and chief compliance officer (the “Munakata’s President”) served as a co-trustee of two trusts that were advisory clients of Munakata. The trust agreements granted each co-trustee “broad investment and other powers under the trust agreement and applicable law to enter into transactions and to trade, buy, sell, sell short or otherwise acquire, receive, deliver, assign, endorse for transfer, hold or dispose of all manner of securities, futures, currencies and commodities …” as well as “broad powers under the trust agreements and applicable law to engage in borrowing and other loan and credit transactions ….” The trust agreements further stated that each co-trustee could act independently. As a result, respondent had access to and/or the ability to obtain possession of trust funds and securities without the consent of the respective co-trustees.
During the Relevant Period, said the SEC, Munakata’s President had signatory authority on four client accounts. Pursuant to this authority, explained the SEC, Munakata’s President had the same ability to instruct the broker about the delivery of the accounts’ funds and securities as did the beneficial owner of the account. Thus, said the SEC, respondent had access to and/or the ability to obtain possession of client funds and securities.
During the Relevant Period, said the SEC, Munakata’s President acted as an authorized agent with power of attorney on five client accounts. Pursuant to the power of attorney, explained the SEC, Munakata’s President had “the power to place orders in an account, request disbursements and make inquiries concerning the account such as obtaining account balances” as well as the power “to make gifts or other transfers of … money or other property from [the client’s] account during [the client’s] lifetime, without restriction, to any one or more persons, including the agent himself or herself.” (Orig’l emphasis). Thus, said the SEC, respondent had access to and/or the ability to obtain possession of client funds and securities.
As a result, said the SEC, during the Relevant Period, respondent had custody of client funds and securities under the Custody Rule. Accordingly, noted the SEC, respondent was required to obtain surprise examinations in accordance with Rule 206(4)-2(a)(4) during the Relevant Period. According to the SEC, at no time during the Relevant Period, however, did respondent arrange for the required surprise examinations for the client accounts.
As a result, the SEC alleged that, during the Relevant Period, respondent violated Section 206(4) of the Investment Advisers Act and Rule 206(4)-2 thereunder.
Without admitting or denying the findings in the SEC’s order instituting cease-and-desist proceedings (here), respondent agreed to cease and desist from committing or causing any violations and any future violations of Section 206(4) of the Advisers Act and Rule 206(4)-2 thereunder, and to pay a civil penalty in the amount of $50,000.
Takeaway:
Over recent years, the SEC has actively enforced the Custody Rule:
- In September 2022, the SEC resolved nine enforcement proceedings alleging violations of the Custody Rule and associated requirements for amending Form ADV to provide accurate information about fund audits.
- In September 2023, the SEC resolved five additional enforcement proceedings arising out of the Custody Rule.
- In December 2023, the SEC settled charges with an investment adviser who allegedly failed, among other things, to conduct surprise examinations of its client funds or securities.
- In August 2024, the SEC settled charges against an investment advisory firm for failing to deliver required audited financial statements in a timely manner and failing to promptly file an annual updating amendment to its Form ADV.
- In September 2024, the SEC settled charges against a Florida-based (former) registered investment adviser for a private fund that primarily invested in crypto assets, for failing to comply with requirements related to the safeguarding of client assets, including crypto assets being offered and sold as securities.
Munakata stands as another recent example of the SEC’s active enforcement of, and commitment to, enforcing the Custody Rule.
Munakata also underscores the SEC’s emphasis on compliance even in the absence of client loss. As discussed, there was no allegation of investor loss in Munakata.
[1] Rule 206(4)-2(a).
[2] Rule 206(4)-2(d)(2).
[3] Id.
[4] Rule 206(4)-2(d)(7).
[5] Rule 206(4)-2(a)(1) – (4).
[6] Rule 206(4)-2(a)(4).
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