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SEC Staff Issues Guidance on “Inadvertent Custody” of Client Assets

On February 21, 2017, the staff of the SEC’s Division of Investment Management (the Staff) addressed circumstances in which an investment adviser may inadvertently have custody of client assets for purposes of Rule 206(4)-2 under the Advisers Act (the Custody Rule) because of provisions in a separate custodial agreement entered into between its advisory client and a qualified custodian. Noting “widespread confusion and uncertainty” among investment advisers, custodians, broker-dealers, compliance professionals and legal counsel, the Investment Adviser Association (IAA) requested clarification from the Staff that an investment adviser that exercises limited authority to disburse client funds to one or more third parties, as specifically designated by the client pursuant to a standing letter of instruction or other similar asset transfer authorization arrangement established by the client with a qualified custodian (a SLOA) does not have custody under the Custody Rule. The IAA alternatively requested no-action relief if the investment adviser exercises such limited authority pursuant to a SLOA without undergoing an annual surprise exam by an independent public accountant to verify client assets as required by the Custody Rule.

Under the Custody Rule, an investment adviser has “custody” of client funds or securities where it or its related person “holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services [it] provide[s] to clients.”  In addition, “custody” includes “[a]ny arrangement… under which [an investment adviser is] authorized or permitted to withdraw client funds or securities maintained with a custodian upon [its] instruction to the custodian.”  In its letter to the Staff, the IAA asserted that an investment adviser that simply follows a client’s instructions to transfer assets pursuant to a SLOA and the adviser’s corresponding direction to the qualified custodian do not result in an adviser “holding” client funds or give an adviser “authority to obtain possession” of client funds or permit an adviser to “withdraw clients funds,” each as contemplated by the Custody Rule.

The Staff disagreed, stating 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.”  The Staff asserted that a SLOA provides an adviser with such power and thus, an adviser that enters into such an arrangement with its client would have custody of client assets and would be required to comply with the Custody Rule.  Nevertheless, the Staff provided no-action relief with respect to an investment adviser that does not obtain a surprise audit where it acts pursuant to such an arrangement under the following circumstances:

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.
The Staff also advised 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.

The Staff’s letter to the IAA is available at:
https://www.sec.gov/divisions/investment/noaction/2017/investment-adviser-association-022117-206-4.htm.

In addition to its letter to the IAA, the Staff also issued a Guidance Update titled “Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority” (the Guidance Update).  Echoing the view expressed in the letter to the IAA, the Guidance Update cautions advisers to be aware that they may have custody depending on the wording of or rights conferred by custodial agreements, even though advisers did not otherwise intend to have access to client funds or securities triggering application of the Custody Rule.  As examples of agreements between clients andqualified custodians that might permit the client’s adviser to instruct the custodian to disburse, or transfer, funds or securities, the Guidance Update identifies the following:

• 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 transactions 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 Guidance Update advises that the definition of custody turns on whether the adviser is permitted to “withdraw” client funds or securities “upon [the adviser’s] instruction to the qualified custodian,” which may occur even in circumstances in which provisions in a custodial agreement and advisory agreement conflict as to an adviser’s authority in this regard.  As an example, the Staff believes an adviser would have custody if the custodial agreement authorizes the adviser to withdraw client funds or securities, notwithstanding a provision in the advisory agreement to the contrary.  Indeed, according to the Staff, a separate bilateral restriction between the adviser and the client would be insufficient to prevent the adviser from having custody where the custodial agreement enables the adviser to withdraw or transfer client funds or securities upon instruction to the custodian.

© 2017 Vedder Price

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Vedder Price P.C. attorneys provide a full range of services to a diverse financial services clientele. Attorneys practicing in the firm’s Investment Services Group are experienced in all aspects of investment company and investment adviser securities regulations, broker-dealer regulatory and compliance matters, derivatives and financial product matters, and ERISA and tax matters. Clients include mutual fund complexes, hedge and other private funds, money managers, broker-dealers, independent directors, and many other types of institutions such as banks, savings and loans,...

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