Over the past year and a half, the staff of the SEC’s Division of Investment Management has issued a variety of guidance that modifies or updates the definition of custody and the requirements therefore of registered investment advisers (RIA). These modifications and updates to the “Staff Responses to Questions about the Custody Rule” (the FAQs) have continued a theme of confusion and complexity across the industry for both RIAs and surprise custody examiners alike, most notably with respect to standing letter of authorization agreements (SLOA) and “Inadvertent Custody.”
Per guidance issued in February 2017, an RIA with power to “dispose of client funds or securities for any purpose other than authorized trading” through a SLOA arrangement “would therefore have custody of client assets and would be required to comply with the Custody Rule.” The SEC noted, however, that enforcement action would not be taken against an RIA who did not obtain a surprise examination in the following circumstances:
- The client provides written instruction to the qualified custodian authorizing the adviser to direct transfers, and the frequency of the transfers, to a third party;
- The client’s qualified custodian verifies the instructions, and provides notice to the client after each transfer and annually confirm the instructions; and
- The adviser has no authority or ability to change the client’s instructions, and maintains appropriate records.
While these circumstances listed may provide some regulatory ease for RIAs who have existing SLOA arrangements, we have noted that RIAs with varying demographics and assets under management (AUM) are increasingly electing not to dissect the interpretations of the modifying or updated Custody Rule guidance releases. Instead, RIAs are choosing to reduce the complexity of their compliance, and select the risk averse, albeit more costly and inconvenient, position of including all relevant accounts as under custody on the Form ADV and subject to surprise examination. This is especially evident in regards to other modifying or updated responses by the SEC to the Custody Rule, such as with “Inadvertent Custody.”
Released in February 2017 alongside the SLOA guidance, “Inadvertent Custody” essentially imputes custody to a RIA when a separate custodial agreement with a qualified custodian authorizes the RIA to provide instructions to disburse or transfer funds or securities for a purpose other than trading, even if this authorization directly conflicts with the account authorization stated in the agreement between the RIA and the client. These relationships, regardless of whether an RIA had access to or knew of the custodial agreement terms for a specific client, create a risk that RIAs will unknowingly fail to comply with the Custody Rule, and thereby be subject to possible enforcement action by the SEC.
In June 2018, the SEC clarified the previous guidance to remove some of the compliance headaches of “Inadvertent Custody” when an RIA who does not have a copy of a client’s custodial agreement, and does not know or have reason to know whether the agreement would give the adviser “Inadvertent Custody.” In these cases, the RIA is not required to comply with the custody rule with respect to that client’s account if “Inadvertent Custody” is the sole basis for custody. For many RIAs, however, the issue remains unchanged as the SEC followed up with an exception to the provided clarification noting that this relief is not available where the adviser recommended, requested, or required a client to use a particular custodian.
Ultimately, regardless of the exceptions or clarifications provided by the SEC, the prevalent and continuing themes are an unwillingness from RIAs to subject their clients to further inconvenience, an inability to invest the countless hours in delineating the compliance and disclosure requirements of individual accounts, and the distinct fear of possibly misinterpreting the ever changing Custody Rule guidance. Through this, a growing number of RIAs are taking the compliance position that accounts even remotely resembling an advisory relationship under the Custody Rule be reported and disclosed accordingly on the Form ADV and subject to yearly examination.
For firms taking a conservative compliance position, the result is likely an increased examination cost, and an increased level of scrutiny necessary to effectively and properly attest to management’s compliance with the Custody Rule. In addition, through taking a compliance and disclosure position for accounts to be subject to the Custody Rule that otherwise may not be, an ancillary effect has been that qualified custodians are not willing to communicate with the custody exam auditor, even with client authorization, due to recognizing the RIA as a non-authorized third party.
As the industry has progressed and changed since the last amendment to the Custody Rule in 2009, so has the need for reform or revision of the Custody Rule. Throughout the modifications and updates, it appears that positive change may finally be on the horizon. The SEC’s Division of Investment Management indicated in the 2018 Evolution Revolution report prepared by the Investment Adviser Association and NRS Compliance that “amendments to the custody rules for investment companies and investment advisers were added to the SEC’s Regulatory Flexibility Agenda in the Spring of 2018 as a long term action.” This represents a promising acknowledgment of the need for revision and reform of the Custody Rule that will hopefully provide relief and clarity to RIAs, their clients, and qualified custodians.
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