Investment Advisers Should Take Note of SEC Updates on Custody Rule

by Pepper Hamilton LLP
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Investment advisers should review their current agreements to identify any potential implications of custody in standing letters of instruction or other similar asset transfer authorizations.

The Securities and Exchange Commission (SEC) recently released additional interpretations of the Custody Rule, Rule 206(4)-2 under the Investment Advisers Act of 1940. Registered investment advisers that have custody of client securities or funds are subject to the Custody Rule. Under the Custody Rule, “custody” means holding, directly or indirectly, client funds or securities or having authority to obtain possession of them. (For example, the general partner and/or investment manager of a private fund ordinarily is deemed to have custody of the fund’s assets due to the general partner’s or manager’s control of the fund). The Custody Rule is designed to protect client funds or securities from being lost, misused, misappropriated or subject to investment advisers’ financial reverses, including insolvency.1 In the last two months, the SEC issued a Guidance Update, a No-Action Letter and a revised FAQ, all available on its website.

Guidance Update

In early February 2017, the SEC’s Division of Investment Management (the Division) surprised many industry professionals when it announced in its Guidance Update2 that “an investment adviser may inadvertently have custody of client funds” if the adviser is permitted by its client to instruct a qualified custodian to direct such funds to a third party.3 The Division went even further and cautioned that custody might be imputed to an adviser without the adviser’s having even agreed to accept such control. The staff explained its position by reasoning that, if an agreement between a custodian and the client grants the adviser the power to access client funds, then the adviser can be deemed to have custody, even when no such power exists in the advisory contract executed by the client and the adviser. The announcement came just weeks after Morgan Stanley was fined millions of dollars, in part for having violated the Custody Rule’s4 “surprise examination” requirement, introducing a new element of complication to a particularly convoluted area of regulatory law.

No-Action Letter

On February 21, 2017, the Division clarified its stance in a No-Action Letter issued to the Investment Adviser Association , mitigating some of the “widespread . . . uncertainty among investment advisers, qualified custodians, broker-dealers [and other legal professionals]” over whether standing letters of instruction and other similar authorizations issued by clients to their advisers (SLOAs) impute to an adviser the custody of its client assets.

Commonly, a client grants its registered investment adviser the limited power in an SLOA to disburse funds to one or more third parties as specifically designated by the client. The staff concluded that “an investment adviser with power to dispose of client funds or securities for any purpose other than authorized trading has access to the client’s assets.” Therefore, an investment adviser that enters into an arrangement to withdraw client funds or securities maintained with a qualified custodian upon its instruction to the qualified custodian would have custody of client assets and would be required to comply with the Custody Rule.5 However, the Division further explained in its letter that it would not recommend enforcement actions against advisers that do not subject themselves to “surprise examinations” if those advisers engage with qualified custodians and other third parties according to a set of seven conditions.

The seven conditions are generally guided by the principle that, in order for investment advisers to avoid “surprise examinations,” the clients of investment advisers must exert independent control over client assets at all times. Insofar as a client permits its investment adviser to direct a custodian to send funds to a third party, the permission must be clear and specific and free of any red flags that would raise questions about the impartiality of the adviser’s actions. The seven conditions are:

  1. 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.
  2. 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.
  3. 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.
  4. The client has the ability to terminate or change the instruction to the client’s qualified custodian.
  5. 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.
  6. 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.
  7. The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.6

Revised FAQ

Also on February 21, 2017, the SEC staff updated its response to a question on its custody FAQs page7 concerning whether custody is imputed when an investment adviser transfers client’s funds or securities between two or more of a client’s accounts maintained with the same qualified custodian or a different qualified custodian. In that case, the investment adviser would not have custody because it does not have the authority to withdraw assets. In the revised response, the staff elaborated on the level of specificity required to be provided in the client’s authorization to the investment adviser.

The written authorization signed by the client and provided to the sending custodian should state “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. Moreover, in the staff’s view, 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.

Pepper Points

  • Investment advisers should review their current agreements to identify any potential implications of custody in standing letters of instruction or other similar asset transfer authorizations.

  • Going forward, investment advisers that chose to forgo surprise examinations will have to be diligent in handling client funds according to the seven conditions enumerated above. These new conditions promise to impact the ways in which investment advisers organize their relationships with their clients and their clients’ custodians. Banks, private funds and other financial institutions would be remiss not to modify their compliance programs accordingly. The SEC staff recognized that “investment advisers, qualified custodians and their clients will require a reasonable period of time to implement the processes and procedures necessary to comply with this relief.” It noted that, beginning with the next annual updating amendment after October 1, 2017, an investment adviser should include client assets that are subject to an SLOA that result in custody in its response to Item 9 of Form ADV. 

  • Investment advisers should have a frank discussion with their clients about what powers should be included in agreements between clients and other parties that might have bearing on the powers and duties of investment advisers.

  • Financial industry professionals of all stripes should pay close attention to developments on the Custody Rule and prepare for any possible revisions as the new administration settles in.

 

 

Endnotes

1 Adoption of Rule 206(4)-2 Under the Investment Advisers Act of 1940, Investment Advisers Act Release No. 123 (Feb. 27, 1962).

2 Guidance Update No. 2017-01

3 Guidance Update No. 2017-01, at 2 (quoting Rule 206(4)-2 under the Investment Advisers Act of 1940).

4 No-Action Letter issued to IAA (Feb. 21, 2017).

5 On the other hand, an arrangement that is structured so that the investment adviser does not have discretion as to the amount, payee and timing of transfers under the SLOA would not implicate the Custody Rule. Id.

6 Id.

7 SEC Division of Investment Management, Staff Responses to Questions About the Custody Rule, Question II.4 (updated Feb. 21, 2017), available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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