I n 2009 and 2010, when the Dodd-Frank Wall Street Reform and Consumer Protection Act “Dodd-Frank Act”, and other rules were adopted or amended by the Securities Exchange Commissions “SEC”, investment advisors and advisors of private funds became subject to the amended “Custody Rule” Rule 206(4)-2 under the Investment Advisors Act. The Custody Rule is intended to provide additional protections for customer cash and securities held by investment advisors.
What is “Custody”?
Under the provisions of the Custody Rule, custody is defined as holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. The Custody Rule states that “custody” includes: (i) Possession of client funds or securities; (ii) Any arrangement under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and (iii) Any capacity that gives you or your supervised person legal ownership of or access to client funds or securities.
Advisors that are deemed to have custody are required to undergo independent verification, a “surprise examination”, on an annual basis, subject to certain requirements.
Common occurrences that trigger custody:
General partner of a private investment fund is “related” advisor for the fund
Direct access to customer third-party accounts (employer 401(k) and similar accounts) through customers’ usernames and passwords
Power of attorney over customer accounts
Check-writing or bill-paying authority over customer accounts
Standing letters of authorization (SLOAs) from customer accounts to transfer funds to third-party accounts*
Advisors should reassess the services they are providing to their customers in light of the SEC letter and identify if custody is triggered. This assessment may indicate a need to update documentation in customer files or engage an independent public accountant to perform a surprise examination in order to maintain compliance with the Custody Rule.
*On February 21, 2017, the SEC issued a letter to the IAA clarifying its interpretation of the Custody Rule regarding in particular SLOAs. Under this letter, the SEC indicated that SLOAs may give advisors custody; however the staff agreed not to recommend enforcement action if an advisor acts pursuant to a SLOA without obtaining the surprise exam, as long as certain representations outlined in their letter were met.