Custody Three Times: SEC Staff Provide Some Rule 206(4)-2 Answers
Few Advisers Act rules are as bedeviling to investment advisers as Rule 206(4)-2, the Custody Rule. In a welcome development, the SEC staff recently provided some clarity in regard to three topics that involve the Rule: standing letters of authorization (SLOAs), first-person transfers, and inadvertent custody.
The Custody Rule is one of several existing rules that many in the asset management community hope the SEC will revisit once a new agency chairman and commissioner are on board. The answers that brought some clarity each came through a different forum: SLOAs were addressed through a Division of Investment Management no-action letter in response to a letter sent by the Investment Adviser Association, first-person transfers were addressed through an SEC staff revision of a frequently asked question, and the issue of inadvertent custody was addressed in an Investment Management Division Guidance Update.
IAA assistant general counsel Laura Grossman, who wrote the no-action request letter to the SEC in regard to SLOAs, suggested that the almost simultaneous release of staff answers to all three matters on February 21 was done intentionally so the information would be available in time for the agency’s annual SEC Speaks conference a few days later.
Following are summaries of just what the staff had to say about the Custody Rule and compliance with it in each of the three areas.
Standing letters of authorization
SLOAs are used when a client grants an adviser limited power to instruct the client’s custodian to disburse funds to one or more client-designated third parties when asked to do so by the client. Once the SLOA is provided, the adviser can instruct the custodian of the client’s account to move money to any of the third parties that the client has designated in the SLOA. In such instances, the adviser is acting as the agent for its client.
The use of SLOAs has raised questions among advisers, qualified custodians, broker-dealers and others as to whether, despite the intention of the SLOA to allow the adviser to act as agent, the SLOA in fact imputes custody to the adviser.
The no-action letter from the SEC staff has both bad news and good news for advisers. The bad news is that the staff makes it clear that it considers the limited authority granted to advisers by SLOAs to constitute custody. The good news in that the no-action letter lays out a path for advisers to follow so that, in such cases, they will not be subject to an enforcement action if they fail to obtain a surprise examination.
"We commend the SEC staff for relieving investment advisers of the unnecessary burden of surprise exams in the case of client-designated third-party transfers," said IAA president and chief executive officer Karen Barr. "This clarification will help advisers understand their obligations under the complex and confusing Custody Rule."
"Before this no-action letter, there was no way for an adviser to direct a third-party disbursement from a client’s account without having to obtain a surprise examination," said Pickard Djinis and Pisarri partner Mari-Anne Pisarri.
The IAA, in its request for the no-action letter, argued that SLOAs should not be viewed as imputing custody to adviser. The IAA’s argument was that the adviser is simply following a client’s instructions to transfer assets pursuant to the limited authority granted by the SLOA, and that this does not result in an investment adviser holding client funds, does not give an investment adviser authority to obtain possession of client funds, and does not permit an investment adviser to withdraw client funds for any purpose contemplated by the Custody Rule.
"We disagree," the SEC staff said in response. "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. . . . An investment adviser that enters into such an arrangement with its client would therefore have custody of client assets and would be required to comply with the Custody Rule."
Fortunately for advisers, however, the no-action letter also provides a way out. SEC staff said that they would not recommend an enforcement action if the adviser fails to obtain a surprise examination, which it would otherwise be required to do under the Custody Rule, if the following seven steps are taken:
The client sends a written instruction to the qualified custodian. That instruction would need to be signed by the client, and include the third party’s name and the address or account number at the custodian to which the transfer will be directed.
The client authorizes the adviser, in writing, to direct transfers to the third party either on a specified schedule or from time to time. That written
authorization would need to be either on the qualified custodian’s form or separately.
The client’s qualified custodian performs "appropriate verification of the instruction." Such verification would need to include a signature review or other method. The custodian must also provide 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 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 obtained in the client’s instruction."
Records are maintained by the adviser showing that the third party is not a related party of the adviser or is located at the adviser’s address.
The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.
The SEC staff, in its no-action letter, indicated that it would show some flexibility as advisers and others comply with these clarifications. "We understand 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." As of the next annual Form ADV update in October 2017, however, the staff said, advisers should include client assets that are subject to an SLOA that result in custody in their response to Item 9.
The SEC staff here clarified, through its revision of an answer to a frequently asked question, the degree of specificity required in the information that advisers must provide when they are granted authority by a client to transfer money between the client’s accounts.
FAQ II.4 under the Custody Rule asks, "Does an adviser have custody if it has authority to transfer client funds or securities between two or more of a client’s accounts maintained with the same qualified custodian or different qualified custodians?"
Until the recent revision, many in the asset management industry operated under the belief that they did not have custody "as long as they had clear authority to initiate first-person transfers, even if account numbers were not specified in the initial authorization signed by the client," the IAA said in comments on these custody developments. In time, however, it became clear through examinations that this was not the case, as a number of advisers received exam deficiency letters after examiners found that accounts were not sufficiently identified.
Unfortunately, in its revised answer to Question II.4, the SEC staff did not provide the answer that many advisers had hoped to hear. "In the staff’s view, ‘specifying’ would mean 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," the new FAQ answer says.
At least the answer provides clarity as to what is required. "While not ideal, the clarification will enable investment advisers and their custodians to adopt their policies and procedures within a reasonable timeframe and avoid further findings of deficiencies by OCIE," the IAA said.
There is no deadline for compliance with this provision in the FAQ, but the IAA said that agency staff understands that advisers will require a reasonable period of time to make the necessary changes. "Our initial conversations with the staff suggested that six to 12 months may be necessary," but that "subsequently, the industry and the staff came to realize that it may take some firms (advisers and custodians), longer based upon their own facts and circumstances."
The Division of Investment Management’s Guidance Update, "Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority," addresses situations where an adviser "may inadvertently have custody of client funds or securities because of provisions in a separate custodial agreement entered into between its advisory client and a qualified custodian."
The staff’s message here appears to be that the agreement between the client and the custodian dominates on questions of custody, even if a separate agreement between the client and the adviser says otherwise. "The custodial agreement between a client and custodian may grant an adviser broader access to client funds or securities than the adviser’s own agreement with the client contemplates," the Guidance states. "Depending on the wording of or rights conferred by these custodial agreements, an adviser may have custody, and may also be subject to the surprise examination requirement, even though it did not otherwise intend to have such access."
What the Guidance makes clear, said Pisarri, is that "the only time when an adviser does not have custody is when it directs disbursements from client accounts in connection with portfolio trades." In making this clear, the Guidance Update provides helpful clarity to advisers, she said.
"Custodial agreements could impute advisers with custody they otherwise did not intend to have," the SEC staff states in the Guidance Update. "The staff cautions advisers to be aware of this possibility and, if applicable, take steps to ensure they comply with the Custody Rule."
There is a way out, however. One way to avoid inadvertent custody, the staff suggests in the Guidance, would be to "draft a letter (or other form of document) addressed to the custodian that limits the adviser’s authority to ‘delivery versus payment,’ notwithstanding the wording of the custodial agreement, and to have the client and custodian provide written consent to acknowledge the new arrangement." Without that written consent, the Guidance states, "the adviser would retain the authority conferred under the original agreement, and the adviser would continue to have custody."