Recently, the staff (the “Staff”) of the SEC’s Division of Investment Management issued guidance on three scenarios in which a registered investment adviser is deemed to have custody of clients assets under Rule 206(4)-2 (the “Custody Rule”) of the Investment Advisers Act of 1940 (the “Advisers Act”) and therefore is required to comply with the provisions of the Custody Rule, including the requirement to undergo an annual surprise examination by an independent public accountant to verify client assets.1 Specifically, the Staff clarified that an investment adviser is deemed to have custody of client assets by virtue of:
(1) Standing letters of instruction established by a client with a qualified custodian that grant the investment adviser the authority to disburse client assets to one or more third parties specifically designated by the client (“SLOAs”);
(2) Arrangements that grant the investment adviser the authority to transfer a client’s assets between the client’s accounts maintained at one or more qualified custodians (unless the client has authorized the investment 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) (“First-Person Transfers”); or
(3) Provisions in a custodial agreement between a client and a qualified custodian that grant the investment adviser access to client assets even though the investment adviser did not otherwise intend to have such access (“Inadvertent Custody”).
The following is a brief summary of the Staff’s guidance with respect to each of these situations.
The SEC issued a letter in response to the Investment Adviser Association’s (“IAA”) no-action request letter, dated February 15, 2017, seeking clarification that an investment adviser does not have custody as set forth in the Custody Rule if it acts pursuant to an SLOA.2 Under this arrangement, the client instructs the qualified custodian in writing to accept the investment adviser’s direction on the client’s behalf to move funds to a third party designated by the client. The investment adviser’s authority is limited by the terms of the client’s instruction to the custodian. The investment adviser is authorized to act merely as an agent for the client and the client retains full power to change or revoke the authorization.
The Staff disagreed, stating that the investment adviser has custody because the SLOA would constitute an arrangement under which an investment adviser is authorized to withdraw client funds or securities maintained with a qualified custodian upon its instruction to the qualified custodian.3
Notwithstanding its position, the Staff stated it would not recommend enforcement action against an adviser that does not obtain a surprise annual examination as required by the Custody Rule where the investment adviser acts pursuant to an SLOA under the following circumstances:
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 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.
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 or 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.
2. First-Person Transfers
The Staff updated its frequently asked questions about the Custody Rule to respond to a question about the applicability of the Custody Rule with respect to certain First-Person Transfers.4 The Staff clarified that an adviser does not have custody if it has the limited authority to transfer a client’s assets between the client’s accounts maintained at one or more qualified custodians provided that the client has authorized the investment 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.5 Moreover, the Staff stated that 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.
3. Inadvertent Custody
In an Investment Management Guidance Update, the Staff discussed certain circumstances under which an investment adviser may inadvertently have custody of a client’s assets through a separate custodial agreement entered into between the client and a qualified custodian.6 The Staff cautioned that a custodial agreement between a client and custodian may grant an investment adviser broader access to client funds or securities than contemplated by the investment adviser’s agreement with the client, thereby inadvertently giving the investment adviser custody of client assets.
The Staff provided the following examples in which the terms of an agreement between a client and qualified custodian might permit the client’s investment adviser to instruct the custodian to disburse or transfer funds or securities:
1. A custodial agreement that grants the client’s adviser the right to “receive money, securities, and property of every kind and dispose of same.”
2. 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.”
3. A custodial agreement that provides authorization for the client’s adviser to “instruct us to disburse cash from your cash account for any purpose….”
The Staff noted that, while an investment adviser may have custody in the context of a custodial agreement that is structured narrowly to permit the deduction of advisory fees (without granting any other rights that would impute custody), it would not need to obtain a surprise examination provided it complies with the exception under Rule 206(4)-2(b)(3) of the Advisers Act available to advisers with limited custody due to fee deduction.7
Additionally, the Staff stated that one way an adviser can avoid such inadvertent custody would be to draft a letter (or other form of document) addressed to the custodian that limits the investment adviser’s authority to “delivery versus payment,” notwithstanding the wording of the custodial agreement, and to have the client and custodian provide written consent to acknowledge the new arrangement.
In light of the Staff’s guidance on the Custody Rule, registered investment advisers should carefully review any client instructions or arrangements that authorize the investment adviser to disburse or transfer client assets and custodial agreements between clients and their qualified custodians to determine whether they could be deemed to have custody of client assets. In order to avoid having custody of client assets, investment advisers may wish to adopt the measures described in the Staff’s guidance, including the steps outlined in the Staff’s response to the IAA’s no-action letter and Custody Rule FAQs, and the written acknowledgement of “delivery versus payment” described in the Staff’s Guidance Update.
1 See Rule 206(4)-2(a)(4) under the Advisers Act. Investment advisers are not required to undergo an annual surprise examination with respect to the accounts of pooled investment vehicles that comply with the annual audit exception provided in Rule 206(4)-2(b)(4) under the Advisers Act.
2 Investment Adviser Association, SEC No-Action Letter (Feb. 21, 2017)
3 The Staff noted that an adviser should include client assets that are subject to an SLOA that results in custody in its response to Item 9 of Form ADV Part 1A.
4 Staff Responses to Questions About the Custody Rule, Question II.4, U.S. SEC. & EXCHANGE COMMISSION, (last updated Feb. 21, 2017).
5 In the Staff’s view, “specifying” would mean that the written authorization states with particularity the name and account numbers on sending and receiving accounts (e.g., 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.
6 U.S. Sec. & Exc. Comm’n Div. of Inv. Mgmt., Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority, IM GUIDANCE UPDATE (Feb. 2017),
7 The Staff provided sample language for such a narrowly structured custodial agreement: “(1) [Custodian name] is permitted to rely upon the authority of the [adviser] to provide instructions to disburse cash from your cash account if [custodian] in good faith believes such instructions to be given in connection with or in accordance with: (a) securities trading activity; or (b) the payment of fees that you owe [adviser]. (2) Any other instructions to disburse cash from your accounts must come from you or other persons whom you have authorized to do so in accordance with the agreement, but excluding your [adviser]. (3) Your [adviser] will not have the authority to provide us with any instruction to disburse cash from your accounts on your behalf except as contemplated above.”
If you have any questions regarding the matters covered in this memo, please contact any of the partners and counsel listed below or your primary attorney in Seward & Kissel’s Investment Management Group.