- An adviser can avoid inadvertent custody if it does not recommend, request or require that clients use a particular custodian and does not know or have reason to know if a client’s custodial agreement would give the firm inadvertent custody.
Securities and Exchange Commission (SEC) staff on June 5, 2018 issued additional guidance on Rule 206(4)-2 under the Investment Advisers Act of 1940 (Advisers Act), commonly known as the Custody Rule. In Staff Responses to Questions About the Custody Rule (FAQ), the staff states in new Questions II.11 and II.12 that an adviser need not comply with the Custody Rule if inadvertent custody would be the sole basis for custody.
In February 2017, Division of Investment Management staff issued IM Guidance Update 2017-01, which addresses inadvertent custody. In it, the staff indicates that under the Custody Rule, an investment adviser may be deemed to have custody of client funds or securities if the custodial agreement between the client and the custodian permits the adviser to instruct the custodian to disburse or transfer funds or securities, even though the advisory agreement does not permit this and the adviser does not otherwise intend to have access to client assets. The Guidance Update states that “an adviser could also have custody when provisions of the custodial agreement and the advisory agreement conflict as to the adviser’s authority to withdraw or transfer client assets … “ Thus, an adviser could be deemed to have custody of assets without knowledge of the custodial designation.
This can be very significant to advisers, particularly those that use unaffiliated custodians or allow advisory clients to choose their own. In those cases, the custodian’s standard agreement could confer custody on the adviser without the adviser’s knowledge. To avoid the Custody Rule’s requirements, the staff suggests that an adviser notify custodians in writing that the adviser’s authority is limited to “delivery versus payment” notwithstanding the custodial agreement’s wording and that it obtain the client’s and custodian’s written consent acknowledging the arrangement. This suggestion is impractical in that it assumes the custodian’s and client’s timely cooperation and adequate resources at advisory firms to administer this procedure.
In the FAQ, the staff was presented with the following fact pattern: An advisory firm does not have copies of its clients’ custodial agreements and does not recommend, request or require that clients use a particular custodian. As a result, the firm does not know or have reason to know whether any of its clients’ custodial agreements would give the firm inadvertent custody, as described in IM Guidance Update 2017-01.
In its response, the staff states that an adviser that does not have a copy of a client’s custodial agreement and does not know or have reason to know whether the agreement would give the adviser inadvertent custody need not comply with the Custody Rule with respect to that client’s account if inadvertent custody would be the sole basis for custody. Consequently, the staff would not recommend SEC enforcement action under the Custody Rule or Section 207 of the Advisers Act against the investment adviser if that adviser neither complied with the Custody Rule’s requirements nor indicated it had custody in its Form ADV filing.