Custody remains a focus area for SEC and state regulators alike. Firms should review the guidance released by the SEC to learn what steps can be taken to avoid having inadvertent custody requiring an independent surprise examination.
Guidance Issued by the SEC: Inadvertent Contractual Custody
In guidance notice No. 2017-01, “Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority,” the SEC lists examples of problematic statements listed in agreements between clients and qualified custodians. The staff has determined an investment adviser may inadvertently have custody of client funds or securities because of provisions in a separate custodialagreement entered into between its advisory client and a qualified custodian. Depending on the wording of or rights conferred by these custodial agreements, an adviser may have custody, and may also be subject to the surprise examination requirement, even though it did not otherwise intend to have such access.
Examples of such agreements between clients and qualified custodians include:
- 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 . . . .”
It is recommended that you review the guidance found below along with your own agreements to determine whether or not you are inadvertently taking contractual custody over client funds and/or securities.
Updated Frequently Asked Questions Related to Custody: Money Movements
On February 21, 2017, the SEC modified Question II.4 of its Custody Rule FAQs. According to the updated guidance provided by the SEC in their FAQs, advisors with ongoing ‘first-party’ money movement authority may have custody. For an advisor to avoid triggering the custody rule, his/her client must provide the sending custodian a signed authorization listing the receiving account number(s) at outside financial institutions. To date, the industry had generally not considered ongoing ‘first-party’ money movement to be custody because the money never leaves the client’s possession and control. However, the SEC has clarified its interpretation of the Custody Rule when it comes to ongoing ‘first-party’ wire authority granted to an advisor, whether it is exercised or not.
It is recommended, that you review the FAQ below and consider the need to amend your policies and procedures as it relate to money movements to comply with this new guidance.
Q: Does an adviser have custody if it has authority to transfer client funds or securities between two or more of a client’s accounts maintained with the same qualified custodian or different qualified custodians?
A: Under rule 206(4)-2(d)(2)(ii), an adviser has custody if it has the authority to withdraw client assets maintained with a qualified custodian upon the adviser’s instruction to the custodian. We do not interpret the authority to withdraw assets to include the limited authority to transfer a client’s assets between the client’s accounts maintained at one or more qualified custodians if the client has authorized the adviser in writing to make such transfers and a copy of that authorization is provided to the qualified custodians, specifying the client accounts maintained with qualified custodians. In the staff’s view, “specifying” would mean that the written authorization signed by the client and provided to the sending custodian states with particularity the name and account numbers on sending and receiving accounts (including the ABA routing number(s) or name(s) of the receiving custodian) such that the sending custodian has a record that the client has identified the accounts for which the transfer is being effected as belonging to the client. That authorization does not need to be provided to the receiving custodian. Moreover, in the staff’s view, an adviser’s authority to transfer client assets between the client’s accounts at the same qualified custodian or between affiliated qualified custodians that both have access to the sending and receiving account numbers and client account name (e.g., to make first-party journal entries) does not constitute custody and does not require further specification of client accounts in the authorization. (Modified February 21, 2017.)
No-Action Letter: Standing Letters of Authorization
The no-action letter found below outlines a set of conditions that, when followed, allow RIAs to avoid the need for an annual surprise examination requirement. The letter also clarified that a standing letter of authorization (SLOA) granting third-party money movement is custody. Note, if a firm chooses to rely on the set of conditions outlined, the investment adviser will need to include client assets that are subject to a SLOA that result in custody (see note 1 above) in its response to Item 9 of Form ADV. This reporting requirement will begin with the next annual updating amendment after October 1, 2017.
It is recommended, that you review the no-action letter found below and consider the need to amend your policies and procedures as it relate to standing letters of authorizations. An Investment Adviser should consider the ability to readily pull and report this information when making this consideration.