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Regulation and Compliance > Federal Regulation > SEC

SEC Issues No-Action Letter on Advisors’ ‘Imputed Custody’

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The Securities and Exchange Commission’s Investment Management division opined Tuesday in a no-action letter that an advisor has regulatory custody of client assets where a client grants even limited authority to transfer assets to a designated third party.

Laura Grossman, assistant general counsel at the Investment Adviser Association, asked the agency to clarify that an investment advisor does not have custody as set forth in Rule 206(4)-2, or the custody rule, under the Investment Advisers Act of 1940 if it acts pursuant to a standing letter of instruction (SLOA) or other similar asset transfer authorization arrangement established by a client with a qualified custodian.

The SEC’s no-action letter “is a significant development that should bring much-needed clarity to the investment advisor industry,” Grossman told ThinkAdvisor. “Over the past few years, it became clear that the SEC staff’s view of what constituted imputed custody in the SLOA context differed from that of many in the industry.”

The no-action letter, she continued, “provides a definitive answer to that question – that the [SEC] staff believes there is custody in certain circumstances – but also provides relief from the independent audit requirement, which is one of the most onerous parts of the custody rule, as long as the seven conditions set out in the letter are met.”

The conditions a set forth “will require both advisors and custodians to make changes to their operating protocols,” Grossman explained. “Because many of those representations involve the qualified custodians’ operations, the IAA collaborated closely with four major custodians – Charles Schwab, Fidelity, TD Ameritrade and Pershing – to ensure that the representations would be able to be met. We appreciate the custodians’ willingness to engage with us in this process.”

IAA sent frequently-asked-questions guidance to its members regarding the custody rule and IM staff’s response in the no-action letter.

The SEC issued on Tuesday as well an updated staff responses guide on the custody rule, as well as IM guidance regarding “inadvertent custody.”

That IM guidance states that staff has determined that under the custody rule, an investment advisor may “inadvertently have custody of client funds or securities because of provisions in a separate custodial agreement entered into between its advisory client and a qualified custodian.” The guidance update discusses, among other things, some circumstances the staff has encountered where such inadvertent custody could arise.

(See SEC Waging Enforcement ‘War’ on Advisors: Giachetti)

In its no-action letter, IM staff responded that an advisor who has received SLOAs from one or more clients must report those assets in its response to Item 9 of Form ADV. “The staff will allow such an advisor to dispense with the custody rule’s surprise examination requirement so long as it meets several conditions including ensuring that the third-party custodian appropriately verifies the SLOA, provides transfer of funds notices to the client, and sends the client annual reconfirming notices,” explained Cipperman Compliance Services, in a note about the no-action letter.

Cipperman notes that in companion releases, the staff also provided guidance about transferring assets between custodians and inadvertent custody arising from custodial contracts.

The IM staff, Cipperman said, “continues to take a hard line with respect to its broad view of the custody rule regardless of the underlying policy arguments. The relief from the surprise audit may be cold comfort, as we expect few custodians will be willing to spend the resources and subject themselves to additional liability to accommodate SLOAs (without additional fees).”

Nicolas Morgan, a partner in Paul Hastings’ Los Angeles office, added that “the issue of what constitutes ‘custody’ for investment advisors has important consequences and can trip up even sophisticated parties.”

While advisors and their counsel “may disagree with the staff’s interpretation of the custody rule laid out in the IAA’s request, the no-action letter does provide clarity that, so long as an advisor follows the steps enumerated in the letter, the advisor need not obtain the surprise examination that would otherwise be required,” Morgan said. “It’s not an enormous amount of relief, but the letter is a welcome change from the confusion that preceded it.”

— Check out SEC’s Top 5 Advisor Compliance Failures on ThinkAdvisor.


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