The SEC’s Division of Investment Management (IM) just issued new guidance on the Custody Rule 206(4)-2. Most likely this new guidance is a result of the special custody exams conducted by OCIE in 2016. It appears that the examination Staff observed several instances of inadvertent custody via special arrangements between advisory clients and client custodians. Earlier this month, IM issued a no-action letter on the Custody Rule (see Investment Adviser Association, SEC No-Action letter, February 21, 2017). This new guidance clarifies the types of arrangements that may give rise to an adviser having custody of client funds or securities, thus requiring a surprise audit under the Custody Rule.
Examples of these arrangements are as follows:
- Client custodial agreement grants the adviser the right to “receive money, securities, and property of every kind and dispose of same.”
- The client custodial agreement states that the 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.”
- A client custodial agreement that provides authorization for the adviser to “instruct us to disburse cash from your cash account for any purpose…”
All the above scenarios would give rise to an adviser maintaining custody and therefore, the need to comply with the surprise audit requirement. A separate clause in another document, such as the advisory agreement that limits the adviser’s authority regarding access to client funds, would not absolve the adviser from maintaining custody since the custodian will defer to its own agreement with the client when it comes to accepting instructions.
Those custodial agreements that limit the adviser’s authority to the deduction of advisory fees still fall under the limited custody provisions of Rule 206(4)-2(b)(3). In addition, other very narrow arrangements whereby the custodian, client, and adviser all agree in writing to the adviser’s limited access may also be exempt from the surprise audit requirement if certain conditions are met (see IAA no-action letter referenced above). The Staff also stated that a letter to a client’s custodian that limits the adviser’s authority to access funds to “delivery versus payment” and signed by both the client and custodian would also suffice.
View SEC IM Guidance Update, “Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority,” February 2017.