Over the past month, new guidance, and resources on the topics of custody, investment adviser compensation, and Form ADV disclosures have been issued. Below we highlight each topic and cite the source for easy reference. We welcome questions from our clients relative to these important matters.
Robert E. Plaze, former Deputy Director of the Division of Investment Management, U.S. Securities and Exchange Commission (“SEC”), and now law partner at Proskauer, was instrumental in writing and subsequently amending the SEC’s custody rule. In October he published a compliance handbook to assist investment advisers in complying with Custody Rule 206(4)-2. The handbook, entitled Regulation of Custodial Practices Under the Investment Advisers Act of 1940 (Rule 206(4)-2), provides succinct and useful guidance to facilitate compliance with this extremely complex and often challenging rule. Although there is nothing new addressed in the handbook, it is a valuable reference guide that all advisers should review.
Custody has been addressed by the Investment Advisers Act of 1940, as amended (“Advisers Act”) since the rule’s inception in 1962 and through periodic amendments thereafter. The rule itself lacked a regualtory definition of custody until 1985 when it was ruled that “an adviser has custody if it directly or indirectly holds client funds or securities, has any authority to obtain possession of them, or has the ability to appropriate them.”
Custody Guidance is Confusing
The Custody Rule was substantially amended in the post-Madoff regulatory era … primarily by providing more explicit direction as to what does and does not entail a custody relationship between an adviser and its client. These amendments further delineated adviser custody scenarios and perhaps most notably, reintroduced the surprise custody audit requirement which had been rescinded decades before.
Since this initial definition was provided by the SEC, the latter has proceeded to issue over 90 no-action letters attempting to clarify and expound upon the definition of custody with only limited success. This ongoing redefinition of the term custody and the prodigious no-action letter process suggest that advisers and the SEC alike lack clarity with regard to this increasingly complex rule.
Custody Failures Can be Costly
According to Plaze, many of the compliance lapses that have been identified by the SEC’s examination staff as well as certain enforcement cases brought by its Enforcement Division have involved advisers that apparently did not recognize that they had custody of client assets. Failure to accurately report custody may lead not only to a violation of the Custody Rule, but also cause the adviser to fail to report that it has custody to the SEC and its clients in violation of other provisions of the Advisers Act.
Key Takeaways from the Custody Handbook
- Newly registered advisers. Newly registered advisers must ensure that, where applicable, the surprise custody audit is executed within the first six months of registration with the SEC.
- Due inquiry. The custody rule requires advisers to affirmatively determine that qualified custodians are providing clients with monthly statements of account, but only when the account is opened by the adviser on a client’s behalf and when changes are made to the custodial arrangements. This provision relies heavily upon the adviser’s ability to “form a reasonable belief” that designated custodians are in fact providing clients with compliant statements of account.
- Inadvertent receipt of client funds or securities. An adviser that inadvertently receives client funds or securities but returns them to the sender within three business days of receiving them does not have custody. This provision of the rule prevents the staff of an adviser that opens the daily mail from discovering that it has custody and is in violation of the rule simply because a client or other person has sent some stock certificates to the adviser. The inadvertent receipt exception does not permit an adviser to forward client funds or securities to a custodian within the three-day period; it must return them to whoever sent them to the adviser. An adviser’s possession of a check drawn by the client and made payable to a third party would typically not mean the adviser has custody of client assets. There are other exceptions to inadvertent custody, as detailed in a 2007 no-action letter issued to the Investment Adviser Association.
- Client address change. An adviser may change a client’s address of record with the qualified client, and still be able to direct the custodian to remit client assets to the client if the adviser has a reasonable belief that the qualified custodian will, upon receiving the adviser’s instruction, send a notice of such change to the client’s old address.
- Standing Letters of Authorization. Ongoing confusion over adviser custody status when utilizing standard letters of authorization (“SLOAs”) is clarified whereby Mr. Plaze opines that “SEC staff views a SLOA as providing the adviser authority to withdraw client funds maintained with a qualified custodian (and thus custody) if the adviser has discretion in determining the amount, payee or timing of transfers.” The handbook then provides context to the seven scenarios whereby the SEC has stated it would not pursue enforcement actions pursuant to failure of the adviser to execute a surprise custody audit for assets retained pursuant to third-party SLOAs.
The handbook addresses other custody scenarios in a clear and concise manner. It is definitely worth a read! Advisers are urged to carefully review the handbook to ensure compliance with all facets of the custody rule. Advisers should further ensure that applicable custody situations are fully and clearly disclosed in Form ADV Part 1A, Item 9 and Part 2A Item 15.
Follow this link to download a copy: https://www.proskauer.com/report/regulation-of-custodial-practices-under-the-investment-advisers-act-of-1940-rule-2064-2.
Frequently Asked Questions Regarding Disclosure of Certain Financial Conflicts
Related to Investment Adviser Compensation
The congruence of adviser compensation and undisclosed or poorly mitigated conflicts is receiving extraordinary SEC scrutiny. Conflicts of interest in general map to the fiduciary duty of loyalty whereby advisers, as fiduciaries, are required to place client interests before all other interests at all times. The fiduciary standard also retains a duty of care whereby advisers must use prudent business practices to develop and execute investment advice in congruence with client objectives.
The SEC’s Office of Compliance Inspections and Examinations has observed, and the Division of Enforcement has pursued enforcement of, cases which entail inadequate identification, disclosure and/or mitigation of conflicts attendant to adviser compensation schemes, thereby undermining the fiduciary duty of loyalty to affected clients.
The fiduciary standard and Form ADV instructions require the investment adviser to disclose in Form ADV (and certain other venues) the conflict of interest that results when it receives compensation, directly or indirectly, in connection with investment advice whereby the adviser executes or recommends buy, hold or sell actions pertaining to securities investments on behalf of its clients.
The SEC declares that Form ADV is “designed to promote effective communication between an adviser and its clients.” The SEC intended Form ADV Part 2A Brochures to be concise, direct, and appropriate to the level of financial sophistication of the adviser’s clients and written in plain English, i.e., longer disclosures may not be better disclosures.
In October, the Commission published “Frequently Asked Questions Regarding Disclosure of Certain Financial Conflicts Related to Investment Adviser Compensation” (“FAQs”) to address investment adviser compensation conflicts and related disclosure/mitigation obligations arising from both the investment adviser’s fiduciary duty and Form ADV instructions.
The SEC states in its FAQs that an adviser that receives, directly or indirectly, compensation in connection with the investments it recommends has a financial incentive to make recommendations that result in the receipt of that compensation. Depending on the nature of the compensation, this financial incentive would give rise to conflicts relating to, for example, the types of investments, the fund families, the particular funds, and the share classes of individual funds that the adviser recommends, as well as the extent of trading it recommends. For instance, when an adviser receives, directly or indirectly, 12b-1 fees in connection with mutual fund recommendations, it has a financial incentive to recommend that a client invest in a share class that pays 12b-1 fees. The resulting conflict of interest is especially pronounced when share classes of the same funds that do not bear these fees are available to the client.
Investment adviser compensation conflicts may include the following scenarios: direct or indirect receipt of service fees from the adviser’s clearing broker-dealer, marketing-support payments from a mutual fund’s investment adviser, transaction fees, or receipt of payments from a mutual fund’s investment adviser to help defray the costs of educating and training its personnel regarding certain investment products. Apart from mutual fund share selection conflicts, advisers may receive compensation from affiliated or unaffiliated private funds whereby licensed personnel of the adviser receive placement fees or other compensation for successfully matriculating investors who are clients of the adviser to a pooled investment vehicle. The SEC directs investment advisers to be proactive in reviewing compensation practices concerning the registrant firm, its affiliates, and/or associated persons relative to compensation received in connection with the investment advice and related services rendered to clients.
Note: The conflict disclosure process must include the means by which the adviser intends to appropriately mitigate the conflict. Failure to mitigate in the manner disclosed will cause the conflict of interest to revert to undisclosed status thereby jeopardizing the fiduciary standard.
- What requirements must an investment adviser consider with respect to disclosure of conflicts of interest related to compensation received in connection with the investments it recommends?
- The adviser must address all general disclosures attendant to its status as a fiduciary and must identify, mitigate, and disclose all conflicts attendant to its compensation scheme that originate with its particular business model.
- Disclosure for both macro and registrant-specific conflicts is generally executed in Form ADV while mitigation will be achieved through effective implementation of the adviser’s compliance policies and Code of Ethics.
- Form ADV provides further direction concerning the information that an adviser must disclose about these types of conflicts. For example:
- Form ADV Part 2, General Instruction 3 reminds an adviser of its fiduciary duty and the related disclosure obligations described above.
- Form ADV Part 2, General Instruction 3 also reminds an adviser that disclosure must include “sufficiently specific facts” to allow clients to understand the adviser’s conflicts and business practices and give informed consent or reject them. This may require an adviser to disclose “information not specifically required by” the Form or more detail than the Form otherwise requires. For example, an adviser disclosing that it “may” have a conflict is not adequate disclosure when the conflict actually exists.
- Form ADV Part 2, General Instruction 2 instructs advisers that, if a conflict or practice exists with respect to only certain classes of clients, advice or transactions, an adviser must indicate as such rather than disclosing that the adviser ‘may’ have a conflict or ‘may’ engage in the practice. For example, if an adviser engages in the practice of recommending share classes with 12b-1 fees for clients in one advisory program, the adviser must fully disclose the practice with respect to that program even if it represents a small portion of the adviser’s assets under management.
- Several items on Form ADV provide additional, relevant instruction. For example:
- Form ADV Part 2A, Item 5.E. instructions state that an adviser must disclose if it or its supervised persons accept sales compensation, including asset-based sales charges or service fees. This item includes several specific disclosures, including information about the conflict, how the adviser addresses the conflict and whether the adviser offsets the compensation against its advisory fees.
- Form ADV Part 2B, Item 4 instructions require an adviser to disclose other business activities of its supervised persons. Under Item 4.A.(2), if an adviser’s supervised person receives commissions, bonuses or other compensation based on the sale of securities or other investment products, including as a broker-dealer or registered representative, and including distribution or service (‘trail’) fees from the sale of mutual funds, the adviser must disclose this fact.
- What are some examples of material facts that an adviser should disclose about its practices related to recommending investments or services with different adviser compensation characteristics?
- Disclosure obligations arising from the availability of multiple mutual fund share classes are well established and provide a good illustration of fiduciary principles which apply to compensation-related conflicts. Advisers face a conflict of interest that must be disclosed when more than one mutual fund share class is available to a client and the adviser upon facilitating the transaction receives, directly or indirectly, compensation based on the share class recommended.
- An adviser that identifies this compensation conflict of interest must consider the material facts that create the conflict. The SEC has stated: “The rate of return of an investment is important to a reasonable investor. In the context of multiple-share-class mutual funds, in which the only bases for the differences in rate of return between classes are the cost structures of investments in the two classes, information about this cost structure would accordingly be important to (disclose to) a reasonable investor. . . .” 
- In its FAQs, the SEC provides useful examples of facts that the SEC believes are material facts to be included in a ‘conflicts’ disclosure related to mutual fund share class selection, addressing:
- The existence and effect of different incentives and resulting conflicts.
- The nature of the conflict.
- How the adviser addresses the conflict.
- Similar to an investment adviser’s receipt of 12b-1 fees, the receipt of revenue-sharing payments creates incentives for investment advisers that, in turn, give rise to conflicts of interest. In addition to the principles and disclosure requirements discussed above, as relevant, what particular Form ADV disclosure requirements relate to an adviser’s receipt of revenue-sharing payments?
- Under Form ADV Part 2A, Item 14.A., the instructions specify that if an entity which is not a client provides an economic benefit to an adviser for providing investment advice or other advisory services to its clients, the adviser must describe the arrangement, explain the conflict of interest, and describe how it mitigates the conflict of interest.
- Note: advisers that receive payments from a custodian based on the value of client assets maintained at that custodian would have to provide disclosure in response to this item.
- Note: Item 9.B of Part 2A, Appendix 1 also requires an adviser’s wrap fee program brochure to respond to Item 14 of Part 2A.
- What are some examples of material facts that an investment adviser should disclose about its practices related to revenue-sharing arrangements, if applicable?
The SEC has cited the following examples of material facts that an adviser should disclose about its practices and conflicts:
- The existence of any incentives provided to the adviser or shared between the adviser and others (e.g., clearing brokers, custodians, funds’ investment advisers or service providers). For example:
- Any agreements to receive payments from a clearing broker for recommending that clients invest in no-transaction-fee mutual fund share classes offered on the clearing broker’s platform, as well as any agreements to receive payments from the clearing broker for recommending that the adviser’s clients invest in 12b-1-fee-paying share classes; and
- Any agreements to receive payments and/or expense offsets from a custodian for recommending that the adviser’s clients maintain assets at the custodian.
- As with the receipt of 12b-1 fees, an adviser disclosing that it ‘may’ have a conflict as the result of receiving revenue-sharing payments is not adequate when the conflict actually exists.
- If an investment adviser materially amends or supplements its disclosures concerning share class recommendations or revenue sharing arrangements in an annual update, is it required to highlight the new disclosure in its Form ADV’s summary of material changes?
Yes. Form ADV Part 2A, Item 2 requires that if an adviser is amending its Brochure for its annual update and the Brochure contains material changes from its last annual update, the adviser must identify and discuss those changes. The adviser may include this disclosure on the cover page of the Brochure, on the page immediately following the cover page, or as a separate document accompanying the Brochure.
Investment advisers are urged to review all benefits received from rendering investment advice and make sure that all conflicts are identified and mitigated. To the extent such conflicts cannot be fully removed, the adviser must make clear and fulsome disclosure of the conflicts and disclose the means by which the adviser manages such conflicts. Advisers are strongly urged to strike the word ‘may’ whenever possible to remove ambiguity.
To read the FAQs in totality, follow this link: https://www.sec.gov/investment/faq-disclosure-conflicts-investment-adviser-compensation.
Form ADV FAQ Update
Drafting an effective Form ADV is often described as more art than science … with the notable exception being when your regulator finds fault with the disclosure. The SEC updated its Form ADV FAQs in October to address many topics including registrant name changes, the confirmation process relative to the annual update, IARD password changes, and soft dollars, among others.
Key Takeaways from Recently Updated Form ADV FAQs
- Name Change. Use Form ADV Part 1, Item 1.c. to report a registrant name change. IARD instructions for this topic include a 7-step protocol to ensure the change is recorded and updated properly.
- Official Books and Records. An adviser holding books and records at a non-primary site which are duplicates of records held at the firm’s primary location are not required to report this non-primary site in Form ADV Part 1A, Section 1.L. of Schedule D. However, if the adviser “holds a complete set” of books and records at another site or sites, these sites should be referenced with a notation of which records are stored at the site(s). If several sites to be referenced retain only a “small part” of the firm’s required records, for example multiple branch offices of the firm, the adviser need not report them on the condition that those books and records are made available to the SEC upon request.
- Wrap Accounts. Advisers are required to count each wrap fee participant in its tabulation used for reporting clients in Form ADV Part 2A, Item 5.
- Soft Dollars. If an adviser receives (without direct expense) research or other products or services other than trade execution from a broker or “third party”, the adviser is required to respond “yes” to Form ADV Part 1A, Item 8.G.(1). There is no exception for affiliated parties or other considerations relative to where the research/eligible soft dollar benefit originated.
- Schedule A. There are two options for reporting an executive officer who has experienced job title changes: (1) list all title changes and the corresponding date when each title change occurred, or (2) list the current title and the date wherein the executive assumed this current job responsibility.
- IARD Password Changes. The FAQs also list five steps for changing a user’s password and specify the complexity parameters required for passwords.
- Miscellaneous. Advisers are urged to use the “Miscellaneous” section of Schedule D to further explain any response on Form ADV Part 1.
To review helpful FAQ guidance on completing Form ADV, follow this link: https://www.sec.gov/divisions/investment/iard/iardfaq.shtml.
 In the Matter of IFGNetworkSecurities, Exchange Act Release No. 54127 (July 11, 2006)