Inadvertently Obtaining Custody

The concept behind the custody rule is simple. The adviser needs to hold client assets safely and needs a third -party to verify that the adviser is actually holding the assets. But as it’s been put in place, the Custody Rule is complicated. At times the SEC has needed to provide guidance, and then provide further guidance  to the guidance.

In fairness, part of the problem is that there are so many different business models employed by registered investment advisers that it is hard to have things work for all of them.

The latest guidance under the Custody Rule has to do with some of the arrangements in place between advisers and their custodians. It turns out that some standard custody agreements grant advisers broader access to client funds and securities than the advisers’ agreements with their clients.

The SEC’s Division of Investment Management issued a Guidance Update discussing situations when an investment adviser may inadvertently have “custody” of client assets pursuant to Rule 206(4)-2 under the Advisers Act of 1940.

The Guidance warns advisers to look for custody agreements that permit an adviser to instruct the custodian to disburse or transfer assets. That creates “custody” even if the adviser does not actually give those instructions or the advisory agreement with the client does not permit the adviser to do so.

The fix? The Guidance says to send a letter to the custodian that limits the adviser’s authority and to have the client and custodian provide written consent to acknowledge the arrangement.

The way I read that is to fix the custody agreement.

Staying on the custody theme, the SEC staff issued a no-action letter to the Investment Adviser Association on the use of a standing letter of authorization with a client to transfer assets to a designated third party.

The SEC takes the position that a SLOA grants access to the client’s assets. The transfer instructions come from the client, but the adviser is involved so that invokes custody.

To fix that custody problem, the SEC lays out seven steps that need to be implemented and requires a n update to Form ADV Item 9 next year.

One theme is that the SEC is indicating a willingness to provide relief under the Custody Rule when an adviser has taken steps to mitigate the mitigate potential harms to its clients by these Custody Rule foot-faults.

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