The staff of the Division of Investment Management (Staff) of the U.S. Securities and Exchange Commission (SEC) released three related matters of guidance on February 21, 2017, which provide additional clarity to SEC-registered investment advisers on the topic of Rule 206(4)-2 under the Investment Advisers Act of 1940 (Custody Rule).1 The guidance consists of:
A no-action letter (IAA Letter) to the Investment Adviser Association (IAA), providing relief from the Custody Rule with respect to certain standing letters of authorization or similar arrangements authorizing payments or transfers to third parties (SLOAs);
An update to Custody Rule FAQ II.4 (Updated FAQ), which clarifies prior guidance regarding transfers among multiple accounts of a single client; and
A Guidance Update (IM Guidance) from the Division of Investment Management (Division), which details when certain custody agreement provisions may cause an adviser to be deemed to have custody, even where the adviser did not intend to have custody, and provides a safe harbor from the Custody Rule.
The guidance is in response to industry requests for relief relating to arrangements among a client, its qualified custodian and the adviser that may implicate the Custody Rule. In adopting the Custody Rule in 1962, the SEC intended to protect client assets from “unlawful activities or financial reverses, including insolvency,” of an adviser. Since adoption of the Custody Rule, advisory client assets have typically been held in accounts at independent U.S. banks and broker-dealers. However, even if client assets are held through an independent qualified custodian, an adviser can still be deemed to have custody, depending on the authority the adviser has over the movement of those client assets. Compounding the issue, amendments to the Custody Rule in 2009 imposed additional verification and reporting requirements for advisers.
An adviser that is deemed to have custody, unless otherwise exempt from the Custody Rule, must: maintain client assets with a qualified custodian; conduct due inquiry into whether custodians send account statements to the clients; notify clients of arrangements for custody; and hire an independent public accountant to conduct a surprise examination. Advisers deemed to have custody must also maintain appropriate policies and procedures, Form ADV disclosures and custody-related books and records.
The requirements of the Custody Rule tend to heighten complexity and costs for advisers seeking to offer certain services to their clients, including making payments out of managed assets (e.g., related to bills, tuition or taxes, charitable contributions, or in connection with capital calls by a private fund in which the client has invested). To the extent a client maintains multiple accounts at one or more qualified custodians, the client’s investment and cash management needs across those accounts may necessitate making arrangements with the adviser – for example, by entering into a SLOA pursuant to which the adviser can instruct the custodian to disburse funds to client-designated third parties. However, implementing such arrangements has been a source of confusion and compliance deficiencies for advisers.2
In response to these concerns, the IAA worked with the Staff to provide clearer guidance. In particular, in its letter to the Staff requesting no-action relief, the IAA offered two alternative lines of reasoning. First, the IAA requested confirmation that an adviser acting pursuant to a SLOA does not have custody under the Custody Rule, because such an adviser is not: (1) “holding” client assets; (2) given “authority to obtain possession” of client assets; or (3) authorized to “withdraw client funds” for any purpose. In the alternative, the IAA requested that the Division not recommend enforcement action against an adviser acting pursuant to a SLOA in instances where the adviser does not obtain a surprise examination by its independent public accountant (as otherwise would be required of an adviser deemed to have custody of client assets).
The Staff disagreed with the IAA’s contention that an adviser, relying only on a SLOA and instructing a custodian pursuant to that SLOA, does not have custody under the Custody Rule. However, taking up the IAA’s alternative line of reasoning, the Staff stated that it would not recommend enforcement action if an adviser did not obtain a surprise examination under the Custody Rule where the adviser has custody through a SLOA, provided the following conditions are met:
- The client provides a signed written instruction to the custodian, including specific routing information (i.e., name; address or account number) for the account to which the transfer(s) will be made;
- The client provides a written SLOA to the adviser, which authorizes the adviser to direct transfers to the specified third party according to a stated schedule or from time to time;
- The custodian verifies the SLOA (via a signature review or otherwise) and provides a notice of transfer of funds to the client promptly after each transfer;
- The client retains the ability to terminate or change the instructions to the custodian;
- The adviser does not have any authority to designate or alter instructions related to the third party;
- The adviser maintains records showing the third party is unrelated3 to the adviser and does not share the adviser’s address; and
- The custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.
For advisers, custodians and clients that previously relied on SLOAs, the Staff recognized that it may take a “reasonable period of time” to comply with these conditions. Notably, the Staff also recognized that custody will not be imputed to an adviser in the case of a SLOA under which an adviser has no discretion with respect to the third party or the amount or timing of transfers.4
The Staff stated that if a SLOA results in an adviser being deemed to have custody of certain client assets, the adviser should report the assets that are subject to the SLOA on Item 9 of Form ADV.
The Staff updated Custody Rule FAQ II.4, which addresses transfers between two accounts owned by the same client (first-person transfers) and held at different or unaffiliated qualified custodians. Previously, the FAQ had indicated that an adviser authorized to make first-person transfers would not be deemed to have custody if the client provided written authorization to the adviser and a copy of the authorization was provided to the qualified custodian “specifying the client accounts maintained by the qualified custodian.” However, industry practice varied as to the level of specificity in such written authorizations.
In the Updated FAQ, the Staff explained that “specifying” client accounts means “stat[ing] with particularity the name and account numbers on sending and receiving accounts (including the ABA routing number(s) or name(s) of the receiving custodian).” Further, if the sending custodian is provided with a copy of the written authorization signed by the client, the copy may serve as a record for the custodian that the requested transfer has been identified by, and is associated with, the client.
The Updated FAQ also states the Staff’s view that first-person transfers between accounts at the same qualified custodian or between affiliated qualified custodians, where both custodians have access to the sending and receiving account numbers and client account name, do not constitute custody.
In the IM Guidance, the Staff reiterates and further clarifies its position that an adviser could inadvertently have custody due to the terms of a custody agreement between a client and its custodian, even if the adviser did not intend to have custody and explicitly disclaimed custody in its advisory agreement with the applicable client. The IM Guidance takes the position that the custodial agreement supersedes any agreement between the adviser and client, including the advisory agreement, account agreement or power of attorney.
However, the IM Guidance maintains that a custodial agreement that is structured narrowly to permit the deduction of advisory fees would allow an adviser to forego a surprise examination, so long as the adviser otherwise complies with the exception set forth in Rule 206(4)-2(b)(3) under the Advisers Act.5
Further, the IM Guidance states that “[o]ne way for an adviser to avoid such inadvertent custody” is by sending a letter to its client’s custodian that limits the adviser’s authority to “delivery versus payment” (i.e., trading authority) and by obtaining written consent to such arrangement from the client and custodian.6
Implications for Advisers
The guidance provides a degree of clarity for advisers, custodians and clients as to several aspects of the Custody Rule, as well as a number of challenges. Advisers may wish to review relevant documentation (e.g., custodial agreements, SLOAs and written authorizations) in their records to determine the extent of their authority over client assets and to take steps to address the guidance.
If an adviser determines that it has “standing” authorization from a client to transfer assets, together with discretion as to the timing and amount of payment, the adviser may be deemed to have custody per the IAA Letter. However, if the arrangement provides for payments to a designated third party and the adviser does not have such discretion, the adviser is unlikely to be deemed to have custody. If an adviser chooses to rely on the relief provided in the IAA Letter to avoid the expense of surprise examinations, the adviser, custodian and client will need to bring all, or as many as possible, of its SLOA into compliance with the conditions of the IAA Letter, which could be a significant undertaking. During the IAA Webinar, members of the Staff stated that advisers should be engaged in good faith efforts to revise non-compliant SLOAs.7
If an adviser has authority to make first-person wire transfers between unaffiliated custodians, the adviser may consider whether it needs to obtain additional, more specific written authorizations to comply with the Updated FAQ. For example, a general authorization to transfer “among all my accounts” would fall outside of the guidance. However, first-person transfers at the same qualified custodian, or between affiliated qualified custodians, do not impute custody to an adviser, and no further specificity in an existing authorization would be required.
Advisers may wish to review custodial agreements for their clients’ accounts in their records, to determine whether the custodian has granted authority to the adviser that may result in the adviser having inadvertent custody. However, if a custodian or client will not allow the adviser to review this documentation, the adviser could consider sending a letter to the custodian disclaiming custody and obtaining the written consent of the client and custodian to that letter. It is not yet clear how the custodian community would respond to such requests, since by providing such consent, a custodian may potentially be subject to additional responsibility and liability. During the IAA Webinar, members of the Staff stated that a negative consent process may be insufficient. The Staff also suggested that an industry solution, such as a standard tri-party custodial agreement or a standard form-of amendment, may assist the industry in complying with the guidance. However, the Division does not have jurisdiction over custodians, and thus it is not clear whether the custodian community has an incentive to participate in such a solution. The Staff further expressed its expectation that advisers should explore the issues raised by this guidance as soon as possible, compounding the challenge.
Given the challenges presented by the guidance and that some of its aspects conflict with some industry practices that many believe are reasonable, there are continuing discussions within the industry on how to implement the guidance.