On February 21, 2017, the Securities and Exchange Commission (SEC) released guidance on the Custody Rule in the form of a no-action letter (“Letter”). The Investment Adviser Association (IAA) submitted a request asking whether an adviser has custody under Rule 206-(4)-2 (“Custody Rule”) of Advisers Act when acting pursuant to a standing letter of authorization (“SLOA”) with a qualified custodian. In an SLOA, a client instructs the qualified custodian to transfer funds from time to time to a designated third party upon the request of the adviser. As pointed out in the request letter, it’s a common practice for retail clients to grant their investment advisers limited authority to disburse funds to one or more third parties. Recently, however, the SEC has been scrutinizing these arrangements during routine examinations, and citing advisers for violations of the Custody Rule for failure to undergo the annual surprise exam. For more information, see our recent blog post.
The IAA requested the no-action relief given the confusion advisers are experiencing in trying to determine whether an SLOA confers custody on advisers. In its response, the SEC stated 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” and therefore has custody. “[W]e believe that a letter of instruction or other similar asset transfer authorization arrangement established by a client with a qualified custodian would constitute an arrangement under which an investment adviser is authorized to withdraw client funds or securities.” In a footnote, however, the SEC stated that “an arrangement that is structured so that the investment adviser does not have discretion as to the amount, payee, and timing of transfers under a SLOA would not implicate the Custody Rule.”
Despite finding that advisers have custody as defined by the rule, the staff provided some relief from the annual surprise examination requirement if certain conditions were met. These conditions include the client providing the custodian with account numbers or name of the third party for such disbursements and the custodian verifying the client’s instructions. The custodian will also be required to provide a transfer of funds notice to the client promptly after each transfer. Additionally, advisers will be required to disclose the amount of assets related to the third party SLOAs resulting in custody in Item 9 on Form ADV beginning October 1, 2017.
What remains to be seen is how qualified custodians will react to this no-action letter. Will they simply charge advisers extra to perform the required verification and customer notifications? The best way to avoid being caught up in custody with third party money movements is to have clients sign one-time only letters of authorization that specify amount, payee, and date of transfer using the custodian’s form.
Check out our Custody-SLOA-Flow-Chart!