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SEC Grants Limited Relief from the Custody Rule for Advisers Relying on Clients’ Standing Letters of Instruction

Posted in Investment Adviser Regulation, SEC Enforcement

In a letter to the Investment Adviser Association (IAA), the Staff of the Division of Investment Management said that investment advisers acting pursuant to a standing letter of instruction or other similar asset transfer authorization (SLOA) established by a client with a qualified custodian would be deemed to have custody of client assets for purposes of Rule 206(4)-2 (the “Custody Rule”).  Nonetheless, the Staff said it would not recommend enforcement action if an adviser, acting pursuant to a SLOA, did not obtain a surprise examination of custody accounts under certain circumstances.  The no-action relief does not extend to investment advisers who are deemed to have custody of client assets because they have the ability to authorize payment of their own advisory fees.

The IAA argued that an adviser that exercises only limited authority pursuant to a SLOA should not be deemed to have custody of a client’s assets.

According to the IAA, many clients provide their registered investment adviser with a SLOA giving the adviser limited authority to disburse funds to one or more identified third parties.  Such clients also instruct the qualified custodian for their accounts to accept the investment adviser’s direction on the client’s behalf to move money only to the designated third party.  Because the qualified custodian takes that instruction in writing directly from a client, and the investment adviser’s authority is limited by the terms of the SLOA, the IAA argued that the investment adviser is merely acting as an agent for its client and should not be deemed to have constructive custody of client assets.

The Staff disagreed, stating that an investment adviser with the “power to dispose of client funds or securities for any purpose other than authorized trading has access to the client’s assets.”  The Staff said that an investment adviser that enters into a SLOA or similar asset transfer authorization with its client would therefore have custody of client assets and would be required to comply with the Custody Rule.

Notwithstanding this view, the Staff said that it would not recommend enforcement action to the SEC if an investment adviser operating pursuant to a SLOA does not obtain a surprise examination and the adviser complies with the following:

  1. The client must provide 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.
  1. The client must authorize 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.
  1. The client’s qualified custodian must perform appropriate verification of the instruction, such as a signature review or other method to verify the client’s authorization, and must provide a transfer of funds notice to the client promptly after each transfer.
  1. The client must retain the ability to terminate or change the instruction to the qualified custodian.
  1. The investment adviser can have 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 to the qualified custodian.
  1. The investment adviser must maintain 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.
  1. The client’s qualified custodian must send the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

The Staff also said 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.  For most investment advisers, this disclosure will be required for their annual filing in the first quarter of 2018.

Our Take.  Given continuing confusion about “constructive custody,” any clarity regarding the Custody Rule is welcome.  Moreover, giving clients the ability to instruct their advisers and qualified custodians to make regular transfers to identified third parties should be a welcome client service.  That said, implementation of the Staff’s instructions will take some time.  Qualified custodians must develop forms for client instructions, ensure that their systems are able to accommodate such instructions, and establish procedures for the required client notices.  Likewise, investment advisers will need to review their compliance policies and procedures and update their compliance manuals to implement the Staff’s instructions and to ensure that appropriate records are maintained.  What’s more, the Staff just gave most investment advisers one more thing to consider in connection with their next annual update to their Form ADV; previously announced amendments to Form ADV must also be implemented in filings made after October 1, 2017.