The Evolving Custody Rule: Are You Inadvertently in Violation?
By Derek White, Director, Alternative Investment Group
Rule 206(4)-2 (the “Custody Rule” or the “Rule”) under the Investment Advisers Act of 1940 has been in place for decades, and without major amendment since 2009. Due to its complexity and ambiguous nature, however, the Rule still has the potential to lead an adviser to inadvertent noncompliance.
In February 2017, the Office of Compliance Inspections and Examinations (OCIE), the body charged with conducting the Securities and Exchange Commission’s (SEC) National Exam Program (NEP), issued a risk alert highlighting the five compliance topics most frequently identified in more than 1,000 deficiency letters issued to SEC Registered Investment Advisers over the course of the previous two years. One of the these deficiencies was noted to be the continued unintentional violation of the Custody Rule by registered investment advisers for not identifying the correct population of client accounts over which it has custody. All client accounts over which such advisers are deemed to have custody are subject to a custody examination.
Shortly after the publication of this risk alert, the SEC issued additional guidance including a Division of Investment Management (IM) Guidance Update, an SEC staff no-action letter, and an update to responses in the SEC’s Staff Responses to Questions about the Custody Rule, in an effort to further clarify and address the investment advisers’ duties under the Rule, as well as address “inadvertent custody” violations.
IM Guidance Update
The February 2017 IM Guidance Update No. 2017-01 (the “update”) notes that the IM staff (the “staff”) has concluded that an investment adviser may inadvertently have custody of client assets when provisions in the client’s custodial agreement (entered into between an adviser’s client and a qualified custodian) afford the adviser greater access to a client’s assets than the agreement between the adviser and the client. Depending upon the wording in the related custodial agreements, an adviser may be deemed to have custody over such client assets, which would subject the adviser to either include such accounts as part of the custody exam or be subject to a surprise examination, even though the adviser did not intend to have such access to its clients assets (i.e., inadvertent custody). This scenario is of greatest concern to advisers overseeing separately managed accounts where clients are more likely to select and enter into custodial agreements without the knowledge of the adviser.
Key Custodial Agreement Provisions
The IM Guidance Update highlights staff observations where the terms of an agreement between a client and qualified custodian may permit the adviser to instruct the custodian to disburse or transfer funds or securities, leading to inadvertent custody. The examples given in the IM Guidance Update of such agreements between clients and qualified custodians are as follows:
- A custodial agreement that grants the client’s adviser the right to “receive money, securities and property of every kind and dispose of same.”
- A custodial agreement under which a custodian “may rely on [adviser’s] instructions without any direction from you. You hereby ratify and confirm any and all transaction with [the custodian] made by [adviser] for your account.”
- A custodial agreement that provides authorization for the client’s adviser to “instruct us to disburse cash from your cash account for any purpose.”
The staff reiterated 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 and in instances where 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. It is important to note that the update additionally clarifies that an adviser’s authority to issue instructions to a broker-dealer or custodian to effect or settle trades does not constitute custody where custodians are under instructions to make transfers of funds (or securities) out of a client’s account only upon corresponding transfer of securities (or funds) into the account [delivery versus payment arrangement (DVP)].
In summary, custodial agreements may trigger custody inadvertently. It is important for advisers to be aware of this possibility and implement procedures to ensure that they are in compliance with the Rule. One example given in the update for ensuring compliance is for the adviser to draft a document addressed to the custodian that limits the adviser’s authority to “delivery versus payment” and to have the client and custodian provide written consent of the agreement.
SEC Staff No-Action Letter
In a February 2017 no-action letter (the “letter”) from the SEC to the Investment Adviser Association, the SEC addressed a request for clarification as to whether an SEC-registered investment adviser would be considered to have custody (and therefore be subject to the custody examination requirements) of client assets under the Rule if it acts pursuant to a standing letter of instruction or other similar asset transfer authorization arrangement established by a client with a qualified custodian (“SLOA”). The SEC reiterated in the letter that an investment adviser with the power to dispose of client funds or securities for any purpose other than authorized trading has access to the client’s assets. Additionally, the SEC noted that a SLOA established by an adviser’s client with a qualified custodian would constitute an arrangement under which the investment adviser is authorized to withdraw client funds or securities maintained with a qualified custodian upon its instruction to the qualified custodian; the adviser would therefore have custody and be subject to the Rule and custody examination requirement.
The Division of Investment Management did, however, note that it would not recommend enforcement action to the commission under the Rule against an investment adviser in cases where that adviser does not obtain a surprise examination if it acts pursuant to such a SLOA arrangement under the following circumstances:
- 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 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.
The no-action letter concluded with a statement that beginning with the next annual updating amendment after October 1, 2017, an investment adviser should include client assets that are subject to a SLOA that result in custody, in its response to Item 9 of Form ADV.
SEC’s Staff Responses to Questions about the Custody Rule
In the first quarter of 2017, the SEC also amended its response to a question in section II of the published Staff Responses to Questions about the Custody Rule (the “Q&A”) to clarify and reaffirm its position. The question relates to whether a registered investment adviser has custody of client assets if the client authorizes the adviser to transfer client funds or securities between two or more of the client’s accounts maintained with the same qualified custodian or different qualified custodians. The SEC’s response reiterates the fact that an adviser is deemed to have custody under the Rule if an adviser has the authority to withdraw assets maintained with a qualified custodian upon the instruction of the adviser to a custodian.
The Q&A notes that the SEC, however, does not interpret the authority to withdraw assets to include the limited authority to transfer a client’s assets between the client’s accounts maintained at one or more qualified custodians, providing the following:
- The client must authorize the adviser in writing to make such transfers.
- A copy of that authorization must be provided to the qualified custodians, specifying the client accounts maintained by them.
- The Q&A defines “specifying” as meaning that the written authorization signed by the client and provided to the sending custodian states 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) such that the sending custodian has a record that the client has identified the accounts for which the transfer is being effected as belonging to the client. That authorization does not need to be provided to the receiving custodian.
Additionally, in the Q&A, the SEC notes that an adviser’s authority to transfer client assets between the client’s accounts at the same qualified custodian or between affiliated qualified custodians that both have access to the sending and receiving account numbers and client account name (e.g., to make first-party journal entries) does not constitute custody and does not require further specification of client accounts in the authorization.
Although the Custody Rule has been in place for a significant period of time, due to its complexity and through its evolution, the Rule remains a significant source of anxiety as investment advisers continue to find themselves in violation. The Rule can seem ambiguous, and it is essential that advisers remain abreast of recent developments and interpretations. Taking into consideration recent guidance, advisers must continuously monitor their clients and all client and custodial agreements in place to ensure there are no inconsistencies that could potentially trigger inadvertent custody.
Should you need assistance navigating the Rule, please contact your assurance professional at Marcum LLP.