IM Guidance Update
Advisory Contract versus Custodial Contract Authority
The U.S. Securities and Exchange Commission’s Division of Investment Management recently released guidance to alert investment advisers that they
“may inadvertently have custody of client funds or securities because of provisions in a separate custodial agreement entered into between its advisory client and a qualified custodian”
[emphasis added], which an adviser may not even be aware of.
The guidance cautions advisers that various custodial agreements may grant an adviser broader access to client funds or securities than the adviser’s own agreement, thereby causing an adviser to have custody and be subject to the surprise examination requirement, even though it did not otherwise intend to have such access. Examples provided of language contained in the custodial agreement between the custodian and client that would cause the adviser to have custody include:
- 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….”
Further, the guidance states that 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.” The Staff believes an adviser would have custody, in such cases, because, from the qualified custodian’s perspective, the client has authorized the adviser to withdraw the client’s funds or securities, and while there may be constraints contained in the advisory agreement between the adviser and its client(s), the custodian may not be aware of them.
The guidance clarifies that this type of provision grants the adviser custody, which in turn requires compliance with the custody rule (surprise custody examination), and disclosure of custody in Form ADV. Staff cautions advisers to be aware of this possibility and, if applicable, take steps to ensure compliance with the custody rule. An adviser can avoid such inadvertent custody by drafting a letter (or document) addressed to the custodian that:
- Limits the adviser’s authority to “delivery versus payment,” notwithstanding the wording of the custodial agreement, and
- Have the client and custodian provide written consent to acknowledge the new arrangement. Without written consent, the adviser would continue to have custody.
IM Guidance Update