Compliance Solutions for Investment Advisers

7 Things Advisers Must Do To Avoid Custody

A recent SEC No-Action Letter (Investment Adviser Association, February 21, 2017) clarified how an investment adviser can avoid having custody as a result of having a standing letter of instruction or other similar asset transfer authorization arrangement established by a client with a qualified custodian (SLOA).

It is common for a client to grant its registered investment adviser the limited power in a SLOA to disburse funds to one or more third parties as specifically designated by the client. After granting the investment adviser this limited authorization, the client then instructs the qualified custodian for the client’s account to accept the investment adviser’s direction on the client’s behalf to move money to the third party designated by the client on the SLOA.  The qualified custodian takes that instruction in writing directly from the account holder (the investment adviser’s client), and the investment adviser’s authority is limited by the terms of that instruction.  The investment adviser is authorized to act merely as an agent for the client.  The client retains full power to change or revoke the arrangement.

The SEC believes that a letter of instruction or other similar asset transfer authorization arrangement established by a client with a qualified custodian would constitute an arrangement under which an investment adviser is authorized to withdraw client funds or securities maintained with a qualified custodian upon its instruction to the qualified custodian.  According to the SEC, an investment adviser that enters into such an arrangement with its client would therefore have custody of client assets and would be required to comply with the Custody Rule.

However, an investment adviser can avoid obtaining a surprise examination where it acts pursuant to an SLOA under the following circumstances:

  1. The client provides an instruction to the qualified custodian, in writing, that includes the client’s signature, the third party’s name, and either the third party’s address or the third party’s account number at a custodian to which the transfer should be directed.
  2. The client authorizes the investment adviser, in writing, either on the qualified custodian’s form or separately, to direct transfers to the third party either on a specified schedule or from time to time.
  3. The client’s qualified custodian performs appropriate verification of the instruction, such as a signature review or other method to verify the client’s authorization, and provides a transfer of funds notice to the client promptly after each transfer.
  4. The client has the ability to terminate or change the instruction to the client’s qualified custodian.
  5. The investment adviser has no authority or ability to designate or change the identity of the third party, the address, or any other information about the third party contained in the client’s instruction.
  6. The investment adviser maintains records showing that the third party is not a related party of the investment adviser or located at the same address as the investment adviser.
  7. The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.
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