The SEC staff recently provided new interpretive guidance addressing two scenarios when an investment adviser would have custody of its client assets, and thus would be required to follow the tricky "custody rule" under the Investment Advisers Act of 1940, as amended. The scenarios include a standing letter of instruction (SLOA) between an investment adviser and its client that provides an adviser with the ability to withdraw client funds from the client's custody account, and custody agreements that contain specific provisions that provide the investment adviser with access to client assets even when the adviser is not a party to the agreement or the adviser’s own agreement with the client contains provisions to the contrary. The staff's guidance follows the SEC's Office of Compliance Examinations and Inspections Risk Alert that identified violations of the custody rule as one of the five most common compliance deficiencies for investment advisers.
SLOA Custody Scenario
The SEC staff, in a formal interpretive letter issued on February 21, 2017, determined that an investment adviser would have custody of its client's assets if an SLOA between the adviser and the client grants the adviser limited power to disburse funds to one or more third parties as specifically designated by the client, even when the client itself instructs the custodian to accept the adviser's instruction on its behalf to move the money to the designee. The SEC staff, notwithstanding that a client under such an SLOA retains full power to revoke instructions and authority, and that the adviser is simply following its client’s instructions, concluded that the SLOA would constitute "an arrangement under which [the] adviser is authorized to withdraw client funds or securities upon its instruction," and results in the adviser having custody of the client’s assets. The SEC staff, however, did acknowledge that SLOAs that limit an adviser's ability to transfer funds solely in connection with authorized trading, or that do not provide an adviser with discretion as to the "amount, payee and timing of transfers," would not implicate the custody rule. Presumably, the type of SLOA that was the focus of the interpretive letter provided the adviser with discretion beyond authorized trading or with respect to amounts and timing of payments.
The crux of the interpretive letter, however, is the onerous provision of the custody rule that requires an adviser to undergo a surprise examination of its client's assets. The SEC staff agreed not to take enforcement action against an adviser that has custody as a result of an SLOA but that does not undergo a surprise examination, so long as the adviser meets certain conditions, including:
- 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.
- 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.
- 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.
- The client has the ability to terminate or change the instruction to the client’s qualified custodian.
- 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.
- 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.
- The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.
Inadvertent Custody via Custody Agreement
The SEC staff also addressed three scenarios with respect to custody agreements under which an investment adviser could be deemed to have custody of its client's assets. The SEC staff observed that custody agreements may provide an adviser with broader access to client funds or securities than the adviser's own advisory agreement with the client, and set out examples of specific provisions permitting the adviser to instruct the custodian to disburse or transfer client funds or securities that might result in custody, including:
- an agreement that grants the investment adviser with the right to receive money, securities and property of every kind and dispose of the same;
- an agreement that provides that the custodian may rely on the adviser’s instructions without any direction from the client; and
- an agreement that provides authorization for the adviser to instruct the custodian to disburse cash from the client’s account for any purpose.
The SEC staff made clear that a separate bilateral restriction between the adviser and the client would not eliminate the adviser’s having custody where the custodian agreement enables the adviser to withdraw or transfer client funds or securities upon instruction to the custodian. The SEC staff did note, however, that "delivery versus payment" (DVP) arrangements would not result in an adviser’s having custody, and suggested that an adviser could avoid having custody if the custody agreements themselves specifically require DVP or the adviser enters into documentation with the custodian that specifies that the adviser’s ability to withdraw client assets is limited to DVP notwithstanding any contrary wording in the custody agreement.
The SEC staff indicated that advisers affected by the SLOA guidance would be permitted "a reasonable period of time to implement the processes and procedures necessary to comply" with the interpretive relief with respect to the surprise audit. The staff did not set out any specific timing, but indicated that an investment adviser should, in its next annual update of its Form ADV after October 1, 2017, include client assets subject to an SLOA that results in custody. The staff, in connection with its guidance on custody agreements, suggested that advisers review their clients' custody agreements to determine whether or not they may result in the adviser having inadvertent custody.