SEC IM Guidance Update 2017-01 Inadvertent Custody: Advisory Contract versus Custodian Contract Authority

By March 9, 2017New in Compliance, SEC

March 9, 2017:  The law of unintended consequences has struck again … this time its target is the investment advisory community wherein advisers who eschew custody and indeed have written policies which prohibit custody, may in fact retain custody and therefore be noncompliant with U.S. Securities and Exchange Commission (“SEC”) Rule 206(4)-2 pursuant to the Investment Advisers Act of 1940, as amended (“Advisers Act”).

The occurrence of unintended custody is a process wherein the custodian and the client, without adviser participation or direct knowledge, execute a custodian agreement which conveys to the adviser access to client funds. Advisers prohibiting client custody under this scenario are now deemed to have client custody.  If you are such an adviser, the SEC wants you to know that your firm has the obligation to fully comply with Custody Rule 206(4)-2.

The SEC issued IM Guidance Update “Inadvertent Custody: Advisory Contract versus Custodian Contract Authority” in February 2017 urging advisers to be aware that they may have custody due to the authority conveyed to the adviser in client custodial agreements (which the adviser may or may not be party to) whereby the authority conveyed to the adviser provides access to client funds and assets. To the extent that custody agreements between a client and qualified custodian include provisions which grant an adviser (unbeknownst to the latter) broader access to client funds or securities, the adviser’s compliance risk profile will adjust accordingly.

This becomes a case of superseding contractual obligation wherein the Commission opines that the custodial agreement supersedes the investment advisory agreement.  Depending on the wording of or rights conferred by these custodial agreements, the adviser may have custody, and may also be subject to the surprise examination requirement among other Rule 206(4)-2 provisions, even though it did not otherwise intend to have or use such access.

The Commission has observed that the terms of an agreement between a client and qualified custodian might permit the client’s adviser to instruct the custodian to disburse, or transfer, funds, or securities. The IM Guidance Update revealed the following examples of custody agreements which contravened the existing adviser agreement:

  • A custodial agreement that grants the client’s adviser the right to “receive money, securities, and property of every kind and dispose of same.”
  • A custodial agreement under which a 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 custodial agreement that provides authorization for the client’s adviser to “instruct us to disburse cash from your cash account for any purpose…”

In the IM Guidance Update, the Commission reminds advisers that the definition of custody turns on whether the adviser is permitted to “withdraw” client funds or securities “upon [the adviser’s] instruction to the qualified custodian.”  The SEC believes that the adviser would have custody if the custodial agreement enables the adviser to withdraw, or transfer, client funds or securities upon instruction to the custodian, regardless of whether the adviser desires such authority, is aware of such authority, or uses such authority.

To this end, the SEC opines that an adviser would have custody when provisions in a custodial agreement and advisory agreement conflict as to an adviser’s authority to withdraw, or transfer, client funds or securities upon instruction to the custodian. For example, the SEC believes an adviser would have custody if the custodial agreement authorizes the adviser to withdraw client funds or securities, notwithstanding a provision in the advisory agreement to the contrary. Moreover, a separate bilateral restriction between the adviser and the client would be insufficient to prevent the adviser from having custody where the custodial agreement enables the adviser to withdraw or transfer client funds or securities upon instruction to the custodian (i.e., the custody agreement supersedes the advisory agreement).  An adviser would have custody, in either case, because from the qualified custodian’s perspective the client has authorized the adviser to withdraw the client’s funds or securities.

While the advisory agreement between the adviser and the client may outline constraints limiting the adviser’s custody authority, the custodian may not be aware of them. If, for example, the adviser attempted to withdraw funds from the account, the custodian would view the adviser as authorized to do so and would release those funds, irrespective of the terms of the advisory agreement. In this regard, however, where a custodial agreement is structured narrowly to permit the deduction of advisory fees (without granting any other rights that would impute custody), an adviser may have custody but not be subject to a surprise examination, provided it otherwise complies with the exception under Rule 206(4)-2(b)(3) available to advisers with limited custody due to fee deduction.

One way for an adviser to avoid such inadvertent custody would be to draft a letter (or other form of document) addressed to the custodian that limits the adviser’s authority to “delivery versus payment,” notwithstanding the wording of the custodial agreement, and to have the client and custodian provide written consent to acknowledge the new arrangement, i.e., without such written consent, the adviser would retain the authority conferred under the original agreement, and the adviser would continue to have custody.

Given the potential and varied risk attendant to the unintended consequences of assuming client custody, we urge our investment advisory clients to request and review each client custody agreement and take appropriate steps to remove the risks associated with unintended custody.

Follow this link to read the full IM Guidance Update:

March 9, 2017

prepared by Horrigan Resources, Ltd.

(724) 934-0129

Not customized advice. Not legal advice.


Author admin

More posts by admin