Locke Lord QuickStudy: SEC Staff Provide New Custody Rule Guidance

Locke Lord LLP
February 23, 2017

On February 21, 2017 the Securities and Exchange Commission (the SEC) released new guidance concerning when a registered investment adviser is deemed to have “custody” for purposes of Adviser’s Act Rule 206(4) (the Custody Rule) in a No Action Letter issued to the Investment Adviser Association1, in a new Investment Adviser FAQ regarding the definition of “custody” under the Custody Rule, and in new Division of Investment Management guidance regarding custodial contracts which may result in custody inadvertently being imputed to advisers.

The Custody Rule is designed to protect client assets from being lost, misused, or otherwise misappropriated by investment advisers and, to that end, 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 certain requirements are met. These include the requirement that client accounts where an adviser has custody of client assets be subject to verification by an independent public accountant at least annually.

Custody is defined, under the Custody Rule, as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.”2  The adviser is also deemed to have custody if a related person has custody of client funds or securities in connection with the adviser’s advisory services.

No Action Letter
The No Action Letter is perhaps the most important, and certainly the most helpful to advisers, of the pronouncements. The Division of Investment Management released its No Action Letter on February 21, 2017 in response to a request from the Investment Adviser Association that the Staff provide clarification on whether an investment adviser that exercises limited authority pursuant to a standing letter of authorization or other similar asset transfer authorization arrangement (a SLOA) established by a client with a qualified custodian would have custody of those assets subject to the SLOA. Often, clients desire their adviser to assist them in managing assets held across multiple accounts for investment or cash management purposes, and to this end it is common for the client to grant their adviser standing authorization to disburse funds to third parties or other accounts owned by the client, as designated in the SLOA. Comments and issues raised by the Staff in recent routine examinations of advisers (which comments and issues were widely reported in the industry press) had caused great uncertainty in this area.

In their No Action Letter, the Staff has affirmed the position that an adviser “with power to dispose of client funds or securities for any purpose other than authorized trading has access to the client’s assets”3 (emphasis added). While this clarification results in advisers having custody of client assets that are subject to a SLOA, the Staff has advised that it will not recommend enforcement action against advisers that do not obtain a surprise examination where they act pursuant to a SLOA, if the following requirements are met:
  1. The client provides an instruction to the qualified custodian, in writing, that includes the client’s signature, the third party’s name, and either the third party’s address or the third party’s account number at a custodian to which the transfer should be directed.
  2.  The client authorizes the investment adviser, in writing, either on the qualified custodian’s form or separately, to direct transfers to the third party either on a specified schedule or from time to time.
  3.  The client’s qualified custodian performs appropriate verification of the instruction, such as a signature review or other method to verify the client’s authorization, and provides a transfer of funds notice to the client promptly after each transfer.
  4.  The client has the ability to terminate or change the instruction to the client’s qualified custodian.
  5.  The investment adviser has no authority or ability to designate or change the identity of the third party, the address, or any other information about the third party contained in the client’s instruction.
  6.  The investment adviser maintains records showing that the third party is not a related party of the investment adviser or located at the same address as the investment adviser.
  7.  The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

If an adviser satisfies these requirements it would not be required to obtain a surprise examination, however, it would still be considered to have custody of the client assets subject to the SLOA. This would require that any assets subject to a SLOA be reported in Item 9 of the advisers Form ADV. The Staff has specified that advisers must begin to comply with this reporting requirement starting with the first annual updating amendment after October 1, 2017. We recommend that advisers review their existing SLOA arrangements in light of this new guidance. The October 1 date will likely provide time to alter any arrangements that don’t currently meet the new guidance.

Custody Definition
The Staff has released a new FAQ, Question II.4 on its custody page of FAQs, which clarifies that an adviser will be deemed to have custody if it has the authority to withdraw client assets maintained with a qualified custodian. The adviser will not be deemed to have custody, however, if its authority is limited to directing the transfer of client assets between accounts held at one or more qualified custodians, provided that the client has authorized, in writing, the adviser to make such transfers and a copy of such authorization has been provided to the transferring qualified custodian specifying the client accounts which over which such authority is granted. This should be distinguished from the authority granted under a SLOA to authorize the transfer of client assets to a third party, which would result in the adviser having custody of those client assets, as discussed above.

Importantly, the added text attempts to describe what the Staff means by its reference to “specificity”. “Specificity,” as used here, includes the identification of the accounts by ABA routing number or the name of the receiving custodian. It should be noted that while this specificity is required when transferring client assets between accounts at unaffiliated qualified custodians, the authority of an adviser to transfer assets between client accounts held at the same qualified custodian, or at affiliated qualified custodians that both have access to the sending and receiving account numbers and client account name, is not deemed to constitute “custody” and therefore does not require further specification of client accounts in the authorization.

Inadvertent Custody
In IM Guidance Update No. 2017-01, the Staff discusses the potential for an adviser to have custody of client assets due to the wording of the custodial contract between its client and such clients qualified custodian, even if the contract between the adviser and its client does not contemplate such custody. This can occur when the contract between the client and the custodian grants an adviser broader access to client funds and securities than is contemplated in the advisory contract. 
The Staff has adopted the position that an adviser will be deemed to have custody of client assets if the underlying custodial agreement authorizes it to withdraw client funds, even where the advisory agreement does not permit such withdrawal. This could result in an adviser being deemed to have custody of client assets which it did not otherwise intend to have.
Helpfully, the IM Guidance provides sample language to include in the custody agreement which would allow the adviser to avoid the need for a surprise examination. This language is as follows:
[Custodian name] is permitted to rely upon the authority of the [adviser] to provide instructions to disburse cash from your cash account if [custodian] in good faith believes such instructions to be given in connection with or in accordance with: (a) securities trading activity; or (b) the payment of fees that you owe [adviser]. (2) Any other instructions to disburse cash from your accounts must come from you or other persons whom you have authorized to do so in accordance with the agreement, but excluding your [adviser]. (3) Your [adviser] will not have the authority to provide us with any instruction to disburse cash from your accounts on your behalf except as contemplated above.  

The adviser may also avoid inadvertent custody by drafting a letter addressed to the custodian that limits the adviser’s authority to “delivery versus payment,” notwithstanding the wording of the custodial agreement, and to have the custodian and client provide written consent to such arrangement. Although some custodians may take the initiative to address this potential issue, we believe it is likely best to consider the use of clarifying letters to the custodian as described in the IM Guidance.

We will continue to monitor developments regarding the Custody Rule, and will provide future client updates. If you would like more information on the matters discussed here, please contact the authors.

1  Investment Adviser Association No Action Letter (2/21/2017).
2  17 CFR 275.206(4)-2(d)(2).
3  Investment Adviser Association No Action Letter (2/21/2017).
4  IM Guidance Update No. 2017-01