25 June 2018
The SEC recently updated the Staff Responses to Questions About the Custody Rule (“Custody FAQ”). And this time, it’s a relief!
As you probably recall, in February 2017, the SEC said that advisers may have “Inadvertent Custody” due to language that is in the agreement between the custodian and the client, which caused much angst for some advisers who do not have access to the agreements between their clients and their clients’ custodians.
With the June 5, 2018 amendment to the Custody FAQ, the SEC has made it clear that if the adviser does not have a copy of the client’s custodial agreement or have any other reason to know whether or not the agreement inadvertently gives custody, the adviser would not have to comply with the Custody Rule. The only exception is if the adviser recommends, requests, or requires which custodian the client should use. For these types of arrangements, the adviser has a responsibility to obtain and review the agreements in place to determine whether it imputes custody upon the adviser.
Q: In February 2017, the staff of the Division of Investment Management issued IM Guidance Update 2017-01 “Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority” (“Guidance Update,” available at: https://www.sec.gov/investment/im-guidance-2017-01.pdf) in which the staff expressed its view that, depending on the facts and circumstances, certain custodial agreements could impute investment advisers with custody they otherwise did not intend to have (“Inadvertent Custody”). Specifically, the Guidance Update described circumstances where a custodial agreement between a client and qualified custodian, to which the client’s adviser is not a party, might permit the adviser to instruct the custodian to disburse, or transfer, funds or securities. We are an advisory firm that does not know whether any of our clients’ custodial agreements would give our firm Inadvertent Custody. Are we now required to comply with the custody rule for those client accounts?
A: An adviser that 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, need not comply with the custody rule with respect to that client’s account if Inadvertent Custody would be the sole basis for custody. The Division of Investment Management would not recommend enforcement action to the Commission under the custody rule or under Section 207 of the Advisers Act against any such investment adviser if that adviser neither complied with the requirements of the custody rule nor indicated it has custody in its Form ADV filing. We note, however, that this relief is not available where the adviser recommended, requested, or required a client’s custodian. (Posted June 5, 2018)
Q: We are an advisory firm with 100 clients, and we have check-writing authority on 60 of our clients’ accounts. Of the remaining 40 accounts, we deduct our advisory fee from 10 accounts. We do not know (or have reason to know) whether any of our clients’ custodial agreements would give our firm Inadvertent Custody, as described in Question II.11 above, because, among other things, our firm does not have copies of our clients’ custodial agreements and we did not recommend, request, or require the clients to use their chosen custodians. We have no basis for having custody other than the check-writing authority and fee deduction. We currently comply with the custody rule with respect to the 60 client accounts for which we have check-writing authority, and we rely on the exception from the surprise examination requirement for the 10 accounts from which we deduct our advisory fee. Should we comply with the custody rule for the remaining 30 client accounts?
A: Under the facts you posed, the Division would not recommend enforcement action for not complying with the custody rule or the custody-related ADV reporting requirements for the 30 accounts, consistent with the response to Question II.11 above. The Division would not recommend enforcement action to the Commission under the custody rule or under Section 207 of the Advisers Act if the adviser proceeded to rely on the exception in the custody rule for fee deduction, and completed Form ADV accordingly, for the 10 accounts from which the adviser deducts its advisory fee. In addition, the Division would, therefore, expect you to continue to comply with the custody rule with respect to the 60 client accounts for which you have check-writing authority, and we would expect you to continue to comply with all but the surprise examination requirement with respect to the 10 client accounts from which you deduct fees. (Posted June 5, 2018)