In February 2017, the staff of the SEC’s Division of Investment Management (“IM”) released “tri-part” guidance regarding SEC-registered investment advisers (“Registered Managers”) having “inadvertent custody” through (i) an IM Guidance Update (the “2017 IM Custody Guidance Update”), which can be found here, (ii) a no-action letter issued to the Investment Advisers Association, which can be found here (the “2017 IAA Letter”), and (iii) a modified FAQ II.4, which can be found here (“Modified FAQ II.4”).
The 2017 IAA Letter and Modified FAQ II.4
Under the 2017 IAA Letter, the SEC staff stated that it would not recommend enforcement action against a Registered Manager for violating the Custody Rule solely because the manager has custody by virtue of having limited authority (as described in the letter) to transfer client funds and securities from a client’s account pursuant to a standing letter of instruction (“SLOI”) or similar asset transfer authorization arrangement established by the client with a qualified custodian.
Under the modified FAQ II.4, the SEC staff concluded that a Registered Manager does not have custody of a client’s assets simply by virtue of having the authority to transfer client funds or securities between two or more of a client’s accounts maintained with the same qualified custodian or different qualified custodians, as long as the client has authorized the Registered Manager in writing to make such transfers and a copy of that authorization is provided to the qualified custodians (and as long as, in certain cases, that authorization “specifies” (as described in the modified FAQ II.4) the client accounts maintained with the qualified custodians).
The 2017 IM Custody Guidance
Under the 2017 IM Custody Guidance Update, the SEC staff stated that a Registered Manager would be deemed to have custody over client assets if the client’s agreement with its custodian empowered the Registered Manager to have any form of access to such assets (for example, by disbursing or transferring funds or securities), even though the Registered Manager was not a party to, and might in fact be unaware of the contents of, the client’s agreement with its custodian, and even though the Registered Manager’s agreement with its client prohibited that type of access:
“The definition of custody turns on whether the adviser is permitted to ‘withdraw’ client funds or securities ‘upon [the adviser’s] instruction to the qualified custodian.’…The staff believes that an adviser would have custody where the custodial agreement enables the adviser to withdraw, or transfer, client funds or securities upon instruction to the custodian. An adviser could also have custody when provisions in a custodial agreement and advisory agreement conflict as to an adviser’s authority to withdraw, or transfer, client funds or securities upon instruction to the custodian. For example, the staff believes an adviser would have custody if the custodial agreement authorizes the adviser to withdraw client funds or securities, notwithstanding a provision in the advisory agreement to the contrary.”
The staff acknowledged that one way to avoid “inadvertent custody” arising in these circumstances would be “to draft a letter (or other form of document) 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 client and custodian provide written consent to acknowledge the new arrangement.” The staff suggested this because, it in its view, “[a]n adviser’s authority to issue instructions to a broker-dealer or a custodian to effect or to settle trades does not constitute ‘custody.’ Clients’ custodians are generally under instructions to transfer funds (or securities) out of a client’s account only upon corresponding transfer of securities (or funds) into the account. This ‘delivery versus payment’ [DVP] arrangement minimizes the risk that an adviser could withdraw or misappropriate the funds or securities in its client’s custodial account.” This suggestion posed two major problems for Registered Managers:
- First, it imposed a burdensome requirement on Registered Managers to enter into clarifying agreements with clients and custodians; in some cases, the requirement might not simply be burdensome, but actually impossible for Registered Advisers to comply with because of a possible lack of cooperation from custodians.
- Second, it seemed to imply that, to the extent a Registered Manager trades client funds or securities in a manner that does not involve settlement on a DVP basis, the manager would be deemed to have custody of such assets.
On June 5, 2018, the SEC staff effectively withdrew that portion of the 2017 IM Custody Guidance Update that appeared to impose on Registered Managers the requirement to enter clarifying agreements with clients and custodians, by issuing two new FAQs (II.11 and II.12), which can be found here. New FAQs II.11 and II.12 obviated the first problem discussed above by providing that the Division of Investment Management will not recommend enforcement action under the Custody Rule or Section 207 of the Advisers Act for a Registered Manager’s failure to comply with the Custody Rule with respect to a client’s account in a situation where: (i) the Registered Manager does not have a copy of a client’s custodial agreement, (ii) the Registered Manager does not know, or have reason to know, whether that custodial agreement would give the Registered Manager inadvertent custody, and (iii) the Registered Manager’s custody with respect to that client’s account would arise solely on the basis of inadvertent custody. The relief provided in the FAQ is limited only to circumstances where the Registered Manager has not recommended, requested, or required the client to use a specific custodian.
Unfortunately, the new FAQs did not address the second problem, again leaving the implication that, to the extent a Registered Manager trades client funds or securities in a manner that does not involve settlement on a DVP basis, the manager would be deemed to have custody of such assets.
On March 12, 2019, the SEC staff issued a letter to the Investment Adviser Association, which can be found here (“2019 IAA Letter”), in which it solicited public comment on questions arising under the Custody Rule relating to securities trades that are not processed or settled on a DVP basis. In the 2019 IAA Letter, the staff stated that it:
“is concerned about the risks of misappropriation inherent in Non-DVP arrangements. Where trading or settlement does not occur through a delivery versus payment arrangement, there is a heightened risk that an investment adviser could misappropriate funds or securities in its client’s custodial account. The Commission has noted that ‘[a]n [investment] adviser that holds clients’ stock certificates or cash, even temporarily, puts those assets at risk of misuse or loss.’…The lack of a corresponding transfer of securities or client funds into the custodial account reduces the effectiveness of the custodian as an independent safeguard.”
While the 2019 IAA Letter does not indicate that the SEC is poised to knock down doors with enforcement actions against Registered Managers that do not comply with the Custody Rule with respect to assets traded in non-DVP transactions, it is clear that it did not adopt the position – hoped for by many in the investment management industry – that assets traded in non-DVP transactions should be viewed as being outside the scope of the Custody Rule.
Instead of adopting that position, the SEC staff indicated that, in light of growth in the variety and complexity of the types of securities and other assets commonly utilized by Registered Managers that settle on a non-DVP basis, IM (through its Analytics Office) has launched an initiative to gather information on non-DVP practices and, in that connection, is seeking public comment on several questions relating to those practices. IM indicated in the IAA Letter that answers to the questions will be utilized by IM in formulating “any future recommendations to the Commission with respect to any regulatory action that may be necessary or appropriate.” In this regard, the 2019 IAA Letter states that the staff “believes that questions surrounding Non-DVP trading, as well as additional questions and issues the staff has identified regarding the Custody Rule over the past 15 years, should be considered by the Commission. In this regard, amendments to the Custody Rule are on the Commission’s long-term unified agenda.”
The SEC staff also stated that, “[a]part from the Custody Rule, investment advisers have an obligation to safeguard clients’ assets. Accordingly, registered investment advisers also have an obligation to review internal controls to reduce the risk of misappropriation or loss, and should address this risk in their compliance policies and procedures required by Rule 206(4)-7 under the Advisers Act… In complying with these obligations, investment advisers who issue instructions to a broker-dealer or a custodian to effect or to settle trades through Non-DVP arrangements may find it useful to look to the procedures and controls set forth in the 2009 amendments to the Custody Rule and accompanying interpretive release to reduce the risk of misappropriation described above….”
Three Key Takeaways for Registered Managers
1. Registered Managers should review the 2017 IAA Letter and Modified FAQ II.4 to determine if they could inadvertently have custody of client funds or securities when:
- the Registered Manager has limited authority to transfer client assets pursuant to a standing letter of instruction or similar asset transfer authorization arrangement established by a client with a qualified custodian, or
- the Registered Manager has the authority to move assets between the client’s own accounts.
2. If a Registered Manager either (i) possesses a copy of a client’s custodial agreement, (ii) knows, or has reason to know, that the client’s custodial agreement gives the Registered Manager inadvertent custody over the client’s assets, or (iii) has recommended, requested, or required the client to use a specific custodian, the Registered Manager must review the client’s agreement with the custodian and either
- to the extent necessary, negotiate with the client and the custodian to eliminate all provisions of the custodial agreement that are deemed to give the Registered Manager custody over the client’s assets, or
- accept the fact that the Registered Manager has custody over such assets and comply with the Custody Rule with respect to such assets accordingly (including, without limitation, by verifying that the custodian is a “qualified custodian” for purposes of the Custody Rule).
3. Until the SEC provides clarity on whether the assets traded in non-DVP transactions should be viewed as being inside or outside the scope of the Custody Rule, a Registered Manager should treat them as being inside the scope of the Custody Rule or, after reviewing the procedures and controls set forth in the 2009 amendments to the Custody Rule and accompanying interpretive release (and such other materials as may be relevant), devise appropriate policies and procedures to mitigate the risk of misappropriation arising from such transactions.