Clarification on the Custody Rule

It wasn't long ago that a good number of investment advisers and industry professionals had the belief, based on the then-current regulatory guidance, that standard letters of authorization (SLOA) and other similar forms of client fund disbursement authorization did not trigger custody under Rule 206(4)-2 (Custody Rule). Some investment advisers, however, found themselves with exam deficiencies for not complying with the Securities and Exchange Commission's (SEC) Custody Rule for having such authorization. The uncertainty associated with the Custody Rule was clarified in a recent no-action letter where the SEC provided clarity on SLOAs and authorization granted to investment advisers to effectuate money transfers between a client's own accounts.

In the SEC's no-action letter, dated February 21, 2017, the SEC more clearly established their position that an investment adviser's authority to disburse or otherwise transfer client assets for "any purpose other than authorized trading" constitutes an arrangement requiring compliance with the Custody Rule. In the no-action letter, however, the SEC represented that they would not recommend enforcement action against an investment advisor having client fund transfer authorization so long as the investment adviser (and acting qualified custodian) satisfied the following requirements:

1. The client provides 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.
2. The client authorizes 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.
3. The client's qualified custodian performs appropriate verification of the instruction, such as 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.
4. The client has the ability to terminate or change the instruction to the client's qualified custodian.
5. 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.
6. The investment adviser maintains records showing that the third party is not a related party of the investment adviser nor located at the same address as the investment adviser.
7. The client's qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

Where an investment adviser believes its disbursement authority over client accounts constitutes custody under this new guidance, the investment adviser will need to ensure that it has proper disclosures on Form ADV.  Additionally, investment advisers will need to examine the no-action letter's representations and determine whether the Adviser will need to satisfy the annual surprise audit requirement set forth in the Custody Rule. Investment Advisers with disbursement authorization should also inquire with their client's acting custodian(s) as to any documentation showing that the custodian has implemented processes and procedures compliant with the SEC's representations in the no-action letter.

Based on the guidance in the no-action letter, the SEC indicated that investment advisers should make a good faith effort to implement the processes and procedures necessary to comply with the no-action letter's representations within a "reasonable period of time," which is believed to be within six months from the date of the no-action letter, depending on the investment adviser's individual facts and circumstances.

As part of its recent guidance, the SEC also updated one of its Custody Rule frequently asked question (FAQ) responses pertaining to an investment adviser's authority to transfer funds between a client's own accounts (see Question II.4). Specifically, the SEC clarified in FAQ II.4 that authorization for such transfers will not require compliance with the Custody Rule so long as the client instructs the sending custodian, in writing, as to the name and account number(s) on the sending and receiving account(s), including ABA routing number(s). Similar to the SLOA guidance, the SEC did not provide a hard deadline for compliance with this interpretation but investment advisers should act in good faith and aim to be compliant within six to twelve months.

If you have any questions as to how this new guidance affects your practice, or how you might comply with the SEC's no action letter representations, please contact your NCS Regulatory Compliance Consultant. NCS Regulatory Compliance is ready to help.  You can call us at  (800) 800-3204 or email us at info@ncsregcomp.com.

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