ADVANCED

SEC Issues Custody Rule Guidance on SLOAs, First-Person Transfers and Inadvertent Custody

Published on: Feb 23rd, 2017

The U.S. Securities and Exchange Commission (“SEC”) has issued three pieces of guidance on SEC-registered investment advisers’ compliance with the Custody Rule (Rule 206(4)-2 under the Investment Advisers Act of 1940). The SEC issued a No-Action Letter regarding standing letters of instruction or other similar asset transfer authorization arrangements established by a client with a qualified custodian (“SLOAs”) where the client gives the adviser limited power to disburse funds to one or more client-designated third parties. In addition, the SEC posted a revised FAQ about a client’s authorization of the adviser to transfer funds or securities between two or more of the client’s accounts at a single qualified custodian or at different qualified custodians (“first-person transfers”). Finally, the Division of Investment Management issued a Guidance Update on inadvertent custody that may result from provisions in a client’s custodial agreement with the qualified custodian. SEC-registered investment advisers should review the issues raised in this Regulatory Update, the SEC guidance and the FAQs that the Investment Adviser Association has made available to the public (here), and consider any changes they may want to make as a result of the guidance.

Cordium notes that the SEC’s Office of Compliance Inspections and Examination’s National Exam Program issued a Risk Alert earlier this month covering the five most frequent compliance topics identified in deficiency letters sent to investment advisers. The Custody Rule was one of these five topics. One typical Custody Rule deficiency was that advisers did not recognize that they could have custody as a result of certain authority over client accounts. The guidance addressed in this Regulatory Update provides investment advisers with additional insight into the situations where such authority may give rise to custody.

The Custody Rule. The goal of the Custody Rule is to safeguard clients’ assets and prevent theft, misappropriation, loss or misuse. Under the Custody Rule, when an adviser has custody it must generally meet the following requirements: (i) the client assets must be held at a “qualified custodian” (i.e., a bank, registered broker-dealer, futures commission merchant or certain foreign entities); (ii) the adviser must give clients written notice detailing how and where their assets are being held; (iii) the adviser must reasonably believe that the qualified custodian is sending account statements to the client at least quarterly; and (iv) the adviser must enter into a written agreement with an independent public accountant to perform an annual surprise exam to test the safety of those assets. There are circumstances in which the Custody Rule provides variations on these requirements (e.g., Pooled Vehicle Annual Audit Exception).

No-Action Letter on SLOAs. The SEC issued a No-Action Letter to the Investment Adviser Association (“IAA”) addressing the question of how SLOAs should be treated under the Custody Rule. The SEC states that an SLOA will generally result in the adviser having custody; however, an adviser required to have an annual surprise exam will not need to do so if the conditions specified in the No-Action Letter are met. As discussed below, the SEC does note that there may be situations where an SLOA would not fall under the Custody Rule. The No-Action Letter, issued to the Investment Adviser Association (the “IAA”), may be found here.

Form ADV. If it is determined that the adviser does have custody under an SLOA, the adviser should make sure to include client assets that are subject to such SLOA in its response to Item 9 of Form ADV. This will apply starting with the next annual updating amendment after October 1, 2017.

No surprise exam necessary – conditions to be met. Where an SLOA does result in custody, no surprise exam will be necessary (i.e., the SEC will not bring an enforcement action if no surprise exam is performed) if the conditions set out below are met. The IAA ‘s letter requesting no-action relief suggested these conditions and explained how each of these requirements helps to meet the Custody Rule’s goal of safeguarding client assets.

  1. Written instruction to qualified custodian. The client provides written instruction to the qualified custodian.
    • The instruction must include 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.
      • Note that the third party cannot be a related party of the investment adviser or located at the same address as the investment adviser.
    • The client must have the ability to terminate or change the instruction.
  2. Written authorization of investment adviser. The client provides written authorization of the investment adviser 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.
    • The authorization should make clear that the investment adviser does not have the 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.
  3. Qualified custodian procedures. The qualified custodian must follow the following procedures:
    • Verification. The qualified custodian must perform “appropriate verification” of the instruction – such as a signature review or another method to verify the authorization.
    • Notices to client. The qualified custodian must send the client (i) an initial written notice confirming the instruction; (ii) a transfer of funds notice promptly after each transfer; and (iii) an annual notice reconfirming the instruction.
  4. Investment adviser recordkeeping. The investment adviser must maintain 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.

SLOAs that would not fall under the Custody Rule. The SEC notes that there are different types of SLOAs for third party transfers and whether or not they result in custody depends on “the extent of the adviser’s discretion to act.” An SLOA arrangement under which the adviser has no discretion as to the amount, payee or timing of the transfers would not fall under the Custody Rule. (See No-Action Letter footnote 1).

Time to comply. The SEC acknowledges that “investment advisers, qualified custodians and their clients will require a reasonable period of time to implement the processes and procedures necessary to comply with this relief.” The IAA’s FAQs state that advisers wishing to take advantage of this relief should make a good faith effort to comply within six months, but note that the SEC staff views the timing with some flexibility.

Revision to Custody Rule FAQ II.4 – First-person transfers. Another issue that has come up in exams has been that examiners have told advisers that transfers where the client has given the adviser authority to move assets between the client’s own accounts cause the adviser to have custody and, in some cases, this issue has been included in deficiency letters. These advisers had concluded that they did not have custody on the basis of the SEC’s FAQ which stated that no custody results where the client’s authorization specifies the client accounts. The examiners disagreed on whether or not the accounts were sufficiently specified, for example where the client had not specified the account numbers. The revised FAQ clarifies that “specifying” requires that the client’s written authorization that is provided to the sending custodian must set out the name and account numbers on the sending and receiving accounts (including the ABA routing number(s) or name(s) of the receiving custodian). The sending custodian must have a record that the client has identified these accounts as belonging to the client. Cordium notes that the transfers between a client’s own accounts in the same qualified custodian or between affiliated qualified custodians do not constitute custody and that any related authorizations do not need to meet those specification requirements. Although the SEC does not specify a time frame within which it expects advisers to have these more specific authorizations in place, the IAA’s FAQs state that their discussions with the SEC staff indicate that the staff will be flexible about implementation time but suggest that advisers make a good faith effort to comply within six to 12 months. The revised Custody Rule FAQ may be found here.

IM Guidance Update – Inadvertent Custody: Advisory Contract versus Custodial Contract Authority. The Division of Investment Management has determined that there are certain provisions in a client’s custodial agreement with a qualified custodian that inadvertently may give advisers custody where they otherwise would not have had custody. The SEC notes they are not addressing the situation where the adviser has authority to give instructions to a broker-dealer or custodian to effect or settle trades where there is a “delivery versus payment” arrangement, i.e., where the client’s custodian has instructions to transfer assets out of a client’s account only where there is a corresponding transfer of assets into the account. Such an arrangement does not give rise to custody.

The IM Guidance Update addresses custodial agreements which may give the adviser greater access to client assets than the adviser has under its own agreement with the client and allow the adviser to give the custodian instructions to disburse, or transfer, such assets in such a way that would rise to the level of the right to “withdraw” client assets. That right is one of the indications of custody under the Custody Rule’s definition. The IM Guidance Update includes excerpts of the type of problematic provisions which may appear in such agreements. It would be difficult for the adviser to ensure that clients avoid or strike such language from their custodial agreements. The Division suggests that one way for the adviser to avoid inadvertent custody is for the adviser to put in place a document addressed to the custodian which limits the adviser’s authority to “delivery versus payment” despite the custodial agreement. The adviser should have both the custodian and the client acknowledge this limitation. It would not be sufficient to have an agreement between the adviser and the client only setting out such a restriction. The Division does not specify a time frame within which it expects advisers to comply with this guidance. The IM Guidance Update may be found here.

Takeaways. There are takeaways from each of the three pieces of guidance that were issued. SEC-registered investment advisers will want to review the arrangements and documentation they currently have in place to determine if they need to add or revise certain policies and procedures and documentation or change other relevant aspects of their operations.

With respect to SLOAs, if a client has an SLOA in place that would result in custody or intends to enter into one and the adviser does not want to have a surprise exam and so plans to rely on the No-Action Letter, the adviser will need to put certain policies and procedures in place. These include policies and procedures to confirm that (i) the requirements regarding the client’s authorization of the investment adviser are met; (ii) the adviser is meeting its recordkeeping requirements; (iii) the requirements regarding the client’s instruction to the qualified custodian are met; and (iv) the qualified custodian is performing the required verification and fulfilling the various notice requirements. In addition, as the IAA notes, the adviser may need to revise its documentation (including its Form ADV, as noted above), obtain additional information from clients, train personnel, explain the new procedures to clients and obtain records regarding third parties. Although the IAA’s letter suggests that the investment adviser’s obligation vis-à-vis requirements with respect to the qualified custodian is to have a “reasonable basis, after due inquiry, for reasonably believing” the qualified custodian is taking the required actions, the SEC does not include that concept in the No-Action Letter. As noted above, advisers should make a good faith effort to comply with these requirements within the six month period suggested by the IAA.

In the wake of the revision of the FAQ, the adviser should review any authorization it has from a client to transfer assets between the client’s own accounts that are housed at different unaffiliated qualified custodians. The adviser should confirm that the authorization is sufficiently specific in accordance with the guidance described above. If it is not, the adviser should have the client provide an updated authorization. If the adviser has a form of such an authorization, the adviser should review and revise as necessary to include the data required by the SEC. As the IAA suggests, advisers should make a good faith effort to comply with this guidance within six to twelve months.

Pursuant to the IM Guidance Update, if an adviser does not wish to accept custody, it should take steps to ensure that it will not have inadvertent custody as a result of language in an agreement between a client and the qualified custodian. Putting in place the document described by the Update which limits authority to “delivery versus payment” is a solution that advisers may want to consider.

As mentioned above, the Custody Rule was one of the five topics named in the National Exam Program’s recent Risk Alert on frequent investment adviser deficiencies. In addition to the Custody Rule, most deficiencies are found with respect to compliance with the Compliance Rule, required regulatory filings, the Code of Ethics Rule and the Books and Records Rule.

Cordium will monitor the SEC’s website for any further guidance on the Custody Rule and the other topics identified in the Risk Alert. In addition to focusing on how the three pieces of guidance covered in this Regulatory Update may affect their practices, advisers should consider reviewing their compliance programs and practices in light of all five of these topics and sample deficiencies identified in the Risk Alert and making and implementing any changes that are indicated.

For our Regulatory Update disclaimer, click here.

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