The SEC’s Division of Investment Management recently issued a no-action letter (Investment Adviser Association, February 21, 2017) that provides clarification regarding whether an investment advisor acting on a standing letter of authorization (“SLOA”) has custody under Rule 206(4)-2 of the Advisers Act (“the Custody Rule”). The Investment Adviser Association (“IAA”) had requested assurance from the SEC that an investment advisor would not be deemed to be “holding” or have “authority to obtain possession” of client funds or be authorized or permitted to “withdraw client funds,” as contemplated by the Custody Rule, if it was granted limited power by a client to transfer assets to one or more third parties designated by a client upon the advisor’s direction to the qualified custodian pursuant to a letter of instruction or other similar asset transfer authorization arrangement.
The Division of Investment Management disagreed with the IAA and stated that it believed that an investment advisor that entered into a letter of instruction or similar arrangement established by a client would result in that advisor having custody and therefore require compliance with the Custody Rule. According to the SEC, the advisor would have custody in this situation because it would be authorized to withdraw client funds or securities maintained with a qualified custodian upon its instruction to the qualified custodian.
The SEC, however, does provide advisors a roadmap for avoiding the surprise examination requirement under the Custody Rule when acting upon a client’s SLOA or similar asset transfer arrangement. Specifically, the Division of Investment Management stated that it would not recommend enforcement action under Section 206(4) and Rule 206(4)-2 for an investment advisor that does not obtain the surprise examination pursuant to such an arrangement if the following conditions are met:
- 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.
- The client authorizes the investment advisor, 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.
- 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 advisor 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 advisor maintains records showing that the third party is not a related party of the investment advisor or located at the same address as the investment advisor.
- The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.
Due to the fact that investment advisors, custodians, and clients will need time to implement the necessary processes and procedures, as described above, the SEC appears to be giving such parties “a reasonable period of time” to comply with the relief from the surprise examination requirement.
Also of note is the fact that beginning with the next annual Form ADV amendment after October 1, 2017, the SEC will be requiring registered investment advisors to include client assets subject to a SLOA that results in custody in their response to Item 9 of Part 1A.
For more information about whether a surprise examination may be needed in your particular situation or for other compliance questions, please contact NCA Compliance.
Hayley Nelson is the President and Principal Consultant of NCA Compliance, Inc., a compliance consulting firm providing a wide range of customized compliance solutions for investment advisors. Ms. Nelson previously worked for the Securities and Exchange Commission and a large investment manager in New York.
