Timothy M. Simons, CFA, CFP, CIPM, CSCP
Senior Managing Member
Focus 1 Associates LLC
September 26, 2016
I want to briefly discuss a topic about which questions have arisen in the last couple of months that we thought had been adequately addressed by the SEC.
We are aware of two custody compliance issues causing concern among Registered Investment Advisers (“RIAs”) because RIAs have been cited by the SEC in deficiency letters for violations of the Custody Rule. The first issue, the more common of the two, is around the ability of an RIA to transfer assets among client accounts with the same name at different custodians. The second issue, which I have only heard of once recently, involves the contract between the RIA’s client and its custodian.
Located on the SEC’s website are Q&A about custody, specifically Question II.4 (at www.sec.gov/divisions/investment/custody_faq_030510.htm):
Q: Does an adviser have custody if it has authority to transfer client funds or securities between two or more of a client’s accounts maintained with the same qualified custodian or different qualified custodians?
A: Under rule 206(4)-2(d)(2)(ii), an adviser has custody if it has the authority to withdraw client assets maintained with a qualified custodian upon the adviser’s instruction to the custodian. We do not interpret the authority to withdraw assets to include the limited authority to transfer a client’s assets between the client’s accounts maintained at one or more qualified custodians if the client has authorized the adviser in writing to make such transfers and a copy of that authorization is provided to the qualified custodians, specifying the client accounts maintained with qualified custodians. (Modified May 20, 2010.) (Italics added.)
This is, of course, “not a rule, regulation, or statement of the SEC and the Commission has neither approved nor disapproved this information.” However, these responses to SEC compliance questions posed by RIAs to the Commission have been prepared by the Division of Investment Management, and are posted on the SEC’s website, which would seem to give them some weight to the RIAs looking to the SEC for answers. This particular question was updated May 20, 2010 and has remained on this site since.
There has been a considerable amount of discussion around RIAs receiving deficiency letters considering them to have custody although they were apparently relying on Question II.4. In my opinion, the real issue was that the RIAs examined were not explicitly following the SEC’s Q&A, as issues cited include
- the adviser having the ability to initiate bank wires without direct instructions from the client that has been filed with both financial institutions;
- the standard custodian paperwork does not specifying the same registration accounts at other financial institutions to where the funds will be transferred; and
- the transferring financial institution is unable to and does not confirm the account registration at the receiving financial institution, thereby relying solely on the RIA for such confirmation.
In the second situation, the SEC cited an RIA because the contract (to which the adviser was not a party) between the client and its custodian gave the adviser the ability to perform the same functions with regard to the client’s account that the client itself was able to perform. Some of you may remember back in the olden days, when the SEC was citing Schwab advisers for exactly the same language in the contract between Schwab (as the custodian) the client and the adviser. At least in that situation the adviser knew what the contract included, which the current adviser did not know. The adviser proposed sending a letter to the client to disregard that portion of its contract with the custodian, but the SEC examiner’s position was that the contract language ruled, the adviser had custody and needed a surprise custody examination for that account and any others in a similar situation, regardless of what the adviser knew.
If the adviser follows the response to Question II.4, gets written authorization from the client identifying the specific accounts maintained with each custodian, and can substantiate sending copies of the authorization to the respective custodians, the registered investment adviser would not be deemed to have custody. It doesn’t seem to me that an adviser following the only information that the SEC has provided on its website, which has not been changed since 2010, and may potentially be followed by thousands of RIAs, would be deemed to be in violation of the rule as specifically addressed in this Q&A. We did note that the Investment Adviser Association has brought this issue to the attention of the SEC.
The custodial agreement issue is an unfortunate situation, in which a qualified custodian, most likely a bank, has not kept up with the federal securities laws and RIA compliance requirements, and an adviser has suffered because of it. My recommendation for every adviser is to become aware of any contract between your clients and their custodians, especially those to which you are not a party, and review them for any obligations of which you might not be aware, before the SEC does.