The 2017 Guidance Update indicated that a separate and clear written understanding between the RIA and the custodian limiting the RIA’s authority to “delivery versus payment” (DVP) trading, notwithstanding the language in the custodial agreement, was one way an RIA could avoid Inadvertent Custody. This suggested approach has been widely criticized within the industry as unworkable because the custodian has little incentive to accept or acknowledge the RIA’s limitations on its own authority where the RIA has no contractual relationship with the custodian. Adviser industry groups have engaged the SEC staff in extensive discussions regarding this issue, and the industry has awaited additional guidance.
FAQ II.11 states that 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.3 Further, FAQ II.11 indicates that the Division of Investment Management would not recommend enforcement action to the SEC under the Custody Rule or Advisers Act Section 207 against any such RIA due to Inadvertent Custody if that RIA neither complied with the requirements of the Custody Rule with respect to the pertinent client account nor indicated it has custody regarding the pertinent client assets in its Form ADV filing. The relief is not available, however, where the adviser recommended, requested or required a client to engage the particular custodian. Notably, FAQ II.11 does not address the requirements for RIAs who, but for performing due diligence in response to the 2017 Guidance Update, would not have known or have had reason to know whether a client’s custodial agreement would give the RIA Inadvertent Custody.
FAQ II.12 clarifies SEC treatment of an RIA that has the authority to deduct fees from a client account and/or check-writing authority under the same circumstances presented in FAQ II.11 (i.e., where the RIA is reasonably unaware of provisions in the client’s custodial agreement that would give the RIA custody). Such RIA may (i) rely on the fee deduction exception (i.e., not obtain a surprise examination for the account) and (ii) complete its Form ADV accordingly (i.e., not report the account as one for which the RIA has custody). The RIA must comply with all other aspects of the Custody Rule. FAQ II.12 also reiterates that an RIA must comply fully with the Custody Rule (including obtaining a surprise examination) with respect to any accounts for which it has check-writing authority.
The tripart February 2017 guidance included an update to an existing FAQ regarding an RIA’s authority to transfer client assets from a client’s custodial account to another of the client’s accounts4 and an SEC staff no-action letter addressing an RIA’s authority to transfer a client’s assets from its custodial account to a third party.5 The New FAQs do not address or have any impact on either of these pieces of guidance.
Some industry participants have noted that language in an endnote to the 2017 Guidance Update could be read as raising possible questions regarding whether all transactions must settle on a DVP basis in order for an adviser to rely on the SEC staff’s position that “authorized trading” does not itself constitute custody. Such an interpretation would be problematic for many advisers, as certain types of securities commonly traded in client accounts (e.g., bank loans and private fund interests) do not settle on a DVP basis. The New FAQs do not address the issue, and the intent of the language in the 2017 Guidance Update remains unclear.
The SEC has indicated informally that it may release additional guidance regarding Inadvertent Custody and/or other custody-related questions and has added the Custody Rule to its list of long-term priorities. The SEC recently updated its Agency Rule List agenda to reflect its prioritization of the matter.6 As reflected in the updated agenda, clarifying the Custody Rule is a long-term priority, and the Division of Investment Management may recommend that the SEC propose amendments to the rules concerning custody under the Investment Company Act of 1940 and the Advisers Act.7
1 SEC Division of Investment Management, “Staff Responses to Questions About the Custody Rule,” Questions II.11 and II.12 (June 5, 2018), click here to read.
2 SEC Division of Investment Management, IM Guidance Update: “Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority,”
No. 2017-01 (February 2017), click here to read.
3 See note 1 above.
4 See note 2 above.
5 Investment Adviser Association, SEC Staff No-Action Letter (Feb. 21, 2017), click here to read. See also Sidley Update, “SEC Publishes Important Guidance on the Custody Rule, Participating Affiliate Arrangements, Robo-Advisers, Form PF and Certain Compliance Topics” (May 8, 2017), click here to read.
6 Office of Information and Regulatory Affairs, “Agency Rule List — Spring 2018: Securities and Exchange Commission” (last modified 2018), click here to read.
7 Office of Information and Regulatory Affairs, “Agency Rule List — Spring 2018: Securities and Exchange Commission,” Rule 3235-AM32 (Spring 2018), click here to read.
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