CUSTODY RULE UPDATES; RECENT SEC STAFF GUIDANCE FOR INVESTMENT ADVISERS

Posted on October 16, 2017

Recent guidance from the SEC Staff has addressed the Custody Rule in connection with standing letters or instructions or other similar authorization arrangements established by a client with its qualified custodian (SLOA).  As a result advisers should review their current practices to determine whether they may be deemed to have “custody”.

              The Custody Rule, Advisers Act Rule 206(4)-2, protects client funds from misuse by an adviser with custody of client funds or securities.  An adviser has “custody” under the Custody Rule where it holds client funds, has authority to obtain possession of them in connection with its advisory services, or is authorized to withdraw client funds held at a custodian upon the client’s instruction.  Having “custody” may require the adviser to obtain a surprise examination from an independent public accountant.

              Clients commonly grant their advisers limited power to transfer assets to specifically designated third parties, and subsequently instruct their qualified custodian to accept the adviser’s direction (on the client’s behalf) to move the money to the third party designated on the SLOA.  In a recent No-Action letter,[1] the SEC Staff stated that, under these circumstances, an adviser would generally have custody under the Custody Rule.  However, the Staff carved out conditions where it would not recommend an enforcement action for not obtaining a surprise examination:

  1. The client provides a signed, written instruction to the qualified custodian with the third party’s name, and address or account number at a custodian to which the transfer should be directed.
  2. The client authorizes the adviser in writing to direct transfers to the third party on a schedule or from time-to-time.
  3. The custodian appropriately verifies the instruction (e.g., by signature review) to authenticate the client’s authorization, and provides the client with a transfer of funds notice promptly after each transfer.
  4. The client is able to terminate or change the instruction to the qualified custodian.
  5. The adviser has no authority to change the identity of the third party or any information about the third party in the client’s instruction.
  6. The adviser maintains records showing the third party is not a related party or located at the same address.
  7. The client’s qualified custodian sends the client an initial written notice confirming the instruction and an annual written notice reconfirming the instruction.

            The Staff also provided similar guidance for transfers between custodial accounts of the same client under an SLOA.  Here, the Staff stated that an adviser would not be deemed to have “custody” under the Custody Rule in such circumstances if the client provides a copy of a written authorization to the qualified custodians.  The authorization must clearly specify the name and accounts numbers on the sending and receiving accounts, and identifying the accounts as belonging to the client.[2]

           A few things that advisers should consider in addressing compliance with this guidance:

  • Review outstanding SLOAs to confirm whether you are deemed to have custody;
  • Take appropriate steps to avoid custody or comply with the guidance for having custody;
  • Update your compliance policies and procedures to address this guidance; 
  • Update your Form ADV to reflect any deemed custody of assets subject to an SLOA, beginning with annual amendments filed on or after October 1, 2017; and 
  • Include a review of compliance with this guidance in your annual compliance reviews.

            This article has been prepared for general information purposes only and is not intended as legal advice, nor does it create an attorney-client relationship. These materials may be considered Attorney Advertising in some states.  If you should have questions regarding how these new rules may impact your firm, please contact Greg Gribben at 585-987-2875, or Steven Suozzi at 585-445-2753, or another member of the Firm’s Investment Management practice group.

[1] See U.S. Securities and Exchange Commission No-Action Letter, dated February 21, 2017, available at https://www.sec.gov/divisions/investment/noaction/2017/investment-adviser-association-022117-206-4.htm

[2] See “Staff Responses to Questions About the Custody Rule”, Question II.4 (modified February 21, 2017), available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.

Steven A. Suozzi

Gregory W. Gribben