SEC Addresses Two Scenarios That May Result in RIA Custody: SLOAs and Custodial Contract Authority

The Securities and Exchange Commission (SEC) recently issued new guidance regarding the Custody Rule and inadvertent custody of client assets in the form of a No-Action Letter on standing letters of authorization (SLOAs) and a Guidance Update on custodial contract authority. This guidance comes in the wake of the recent SEC Risk Alert identifying most frequent compliance issues found in examinations of registered investment advisers and listing custody as one of these most frequent compliance issues.

The Custody Rule, or Rule 206(4)-2, provides that it is a fraudulent, deceptive, or manipulative act within the meaning of section 206(4) of the Investment Advisers Act of 1940 for a registered investment adviser to have custody of client assets unless certain requirements are met. One of these requirements is an annual surprise examination requirement, although this requirement does not apply if the investment adviser solely has custody as a result of its authority to make advisory fee deductions.

Custody is defined in Rule 206(4)-2 as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them,” and includes any arrangements under which the adviser is authorized to withdraw client funds or securities upon instruction to the custodian.

In the No-Action Letter issued to the Investment Adviser Association, the SEC makes clear that SLOAs that grant advisers with authority to disburse client funds to third parties designated by the client on behalf of the client upon the adviser’s instruction to the custodian amount to custody of client funds. They reasoned that this type of authority amounts to an arrangement under which the adviser is authorized to “withdraw client funds or securities” upon the adviser’s “instruction to the qualified custodian” within the definition of custody in Rule 206(4)-2. In the SEC’s view, advisers who have the authority to dispose of client funds or securities for any purpose other than authorized trading have access to the client’s assets, and therefore custody. The SEC notes that arrangements that are structured such that the adviser does not have discretion as to the amount, payee, and timing of transfers under an SLOA would not amount to custody.

Investment advisers that have third-party SLOAs with clients therefore have custody of client assets. However, the SEC stated that advisers are not required to comply with the annual surprise examination if the following requirements were met: 1) client provides specific instructions to custodian regarding third party’s name, address, and account number; 2) client authorizes adviser to direct transfers to the third party on a specified schedule or from time to time; 3) custodian performs appropriate verification of the instruction and provides a transfer of funds notice to the client promptly after each transfer; 4) client has ability to terminate or change instruction to custodian; 5) adviser has no authority or ability to designate or change the third party or any information about the third party; 6) adviser maintains records showing the third party is not a related party of the adviser or located at the same address; and 7) client’s qualified custodian sends client an initial and annual notice confirming the instruction.

The SEC has noted previously in Custody Rule FAQ II.4 that SLOAs or other forms of authorization that only authorize advisers to transfer funds between two or more of a client’s accounts maintained with different custodians do not amount to custody, provided the authorization is given to the sending custodian “specifying” the client accounts maintained with the qualified custodians. Along with their new No-Action Letter, the SEC also revised this FAQ to further clarify that the authorization must state with particularity the name and account number on sending and receiving accounts in order to verify that the client has identified those accounts as belonging to the client. This specification is not required for authorizations to transfer funds between client’s accounts at the same or affiliated custodians, as these arrangements do not amount to custody.

In the Guidance Update the SEC warned advisers that they may have inadvertent custody of client funds due to authority resulting from the custodial agreement between the client and the custodian, particularly where the terms of the agreement permit the client’s adviser to instruct the custodian to disburse or transfer funds or securities, because this amounts to authority to “withdraw client funds or securities” upon the adviser’s “instruction to the qualified custodian” within the definition of custody in Rule 206(4)-2.

The SEC states that this custody concern would still be there even if there is a conflicting provision in the advisory agreement as to the adviser’s authority to withdraw client funds or securities because the custodian may not be aware of this restriction. From the custodian’s perspective, the client has authorized the adviser to withdraw client funds or securities. This problem can be avoided by structuring the custodial agreement narrowly to permit only deduction of advisory fees, without granting any other rights that could impute custody. In those cases the adviser would only have limited custody due to fee deduction and could rely on the exception under Rule 206(4)-2(b)(3) to avoid the annual surprise examination requirement.

Furthermore, the SEC notes that advisers whose clients have custodial agreements that grant advisers authority to withdraw client funds or securities can avoid having this custody imputed to them by providing a letter to the custodian that “limits the adviser’s authority to ‘delivery versus payment,’ notwithstanding the wording of the custodial agreement,” and having the client and custodian provide written consent to acknowledge this new arrangement.

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