SEC No-Action Letter Offers Clarity Into ‘Custody Rule’ Interpretation

On Feb. 21, 2017, the Securities and Exchange Commission (the “SEC”) published a highly anticipated no-action letter in response to a request from the Investment Adviser Association regarding Rule 206(4)-2 of the Investment Advisers Act of 1940 (the “Act”), commonly known as the “custody rule.” The regulator’s statement provided what the association called “much-needed clarity” to investment advisers, who will benefit from the added certainty in their compliance efforts.

The association wrote to the SEC in an attempt to address the “widespread confusion and uncertainty” within the industry as to whether an adviser is considered to have custody if it “acts pursuant to a standing letter of instruction or other similar asset transfer authorization arrangement established by a client with a qualified custodian (“SLOA”).” Further, the association asked whether the SEC would bring an enforcement action against an adviser if it acted pursuant to a SLOA without obtaining a surprise independent verification (a “surprise examination”) of client assets by an independent public accountant, as required by the custody rule.

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,” such as in a SLOA, has access to the client’s assets and, as such, has custody of such assets for purposes of the custody rule. However, the SEC specified that its Division of Investment Management would not recommend enforcement action under Section 206(4) and Rule 206(4)-2 of the Act against an investment adviser if that adviser did not obtain a surprise examination, provided each of the following requirements is met:

• The client provides an instruction to the qualified custodian,¹ 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.
   
• The client authorizes the investment adviser, in writing, either on the qualified custodian’s form or separately, to direct transfers to the third party on a specified schedule or from time to time.
   
• The client’s qualified custodian performs appropriate verification of the instruction, such as a signature review or other method to verify the client’s authorization, and provides a transfer of funds notice to the client promptly after each transfer.
   
• The client has the ability to terminate or change the instruction to the client’s qualified custodian.
   
• The investment adviser has 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.
   
• The investment adviser maintains 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.
   
• The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

In providing this guidance, the SEC acknowledged that no standardized format for a SLOA exists, as investment advisers, qualified custodians and their clients have developed a wide variety of formats for third-party transfers. Any one of these could implicate the custody rule, the SEC notes, depending on the extent of the adviser’s discretion to act under such SLOA. For example, an arrangement structured so the adviser does not have discretion as to the amount, payee and timing of transfers under a SLOA would not implicate the custody rule.

The SEC further recognized that investment advisers, qualified custodians and their clients will need “a reasonable period of time to implement the processes and procedures” to ensure compliance with the guidance set forth in the no-action letter. In addition, the SEC indicated that investment advisers should include client assets subject to a SLOA that result in custody in response to Item 9 of Form ADV beginning with the next annual updating amendment after Oct. 1, 2017.

Although it provided much-needed clarity, the no-action letter also demonstrates the intricacies involved in interpreting the custody rule. As a result, investment advisers should review all of their applicable arrangements in light of this new guidance to ensure compliance by the October deadline.

¹ The custody rule requires that client assets be custodied by a qualified custodian. In general, a “qualified custodian” includes entities such as banks, savings associations, futures commission merchants, broker-dealers and non-U.S. financial institutions that customarily hold financial assets for their customers, all as specified in more detail in the custody rule.