Custody Rule: Standing Letter of Authorizations

There has been a level of uncertainty for Registered Investment Advisors (“RIA”) over the past year in regards to the SEC’s position on Rule 206(4)-2 (“Custody Rule”) (see the AdvisorAssist blog post on Custody for additional information) and how it applies to standing letters of authorization (“SLOA”) for a client at a qualified custodian (“Custodian”). It​ has been a common business practice for RIAs and clients to establish a SLOA at the Custodian which authorizes the RIA to instruct the Custodian to disburse client funds to a third party account or payee. Generally speaking, the intent of this practice is to minimize the administrative steps for RIAs to service the money movement requests of their clients. However, there has been much confusion by both RIAs and examiners ​as to​ which ​SLOA scenarios ​constitute custody of client funds and trigger the Custody Rule requirements for the RIA.

On February 21, 2017, the SEC provided clarity to this question through a no-action letter. The SEC confirmed their stance that the business practice of using SLOAs as instructions for payments to third parties fall under the definition of custody. Thereby requiring RIAs to disclose that they have custody of client funds. However, the SEC also provided some relief for RIAs as it relates to the independent surprise examination requirement of the Custody Rule.

The SEC advised that they would not seek enforcement action against RIAs who do​ not obtain a surprise examination as long as the RIA follow the below guidelines:

The client provides an instruction to the 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.

The client authorizes the RIA, in writing, either on the Custodian’s form or separately, to direct transfers to the third party either on a specified schedule or from time to time.

The client’s 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.

The client has the ability to terminate or change the instruction to the client’s Custodian.

The RIA 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.

The RIA maintains records showing that the third party is not a related party of the RIA or located at the same address as the RIA.

The client’s Custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

CCO Best Practices

To ensure that you are properly dealing with custody issues AdvisorAssist recommends the best practices of:

Perform an assessment to determine whether or not you have custody of client assets or securities

Review all current SLOA to identify any that are established to send funds to an account at a different Custodian or to a third party payee.

RIAs have until October 1, 2017 to comply with the above described actions. Also, there will be a new requirement for RIAs to state client assets that are subject to a SLOA on their ADV1, Item 9.

Contributors:
Brian Young
Conor Anderson
Brendan Furey

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CCO Series: Custody

What you need to know

In developing policies and procedures for a registered investment advisor ("RIA") a topic that should be addressed is custody. As stated in their release, the SEC created rule 206(4)-2 under the Advisers Act, “to reflect modern custodial practices and clarify circumstances under which a RIA has custody of assets.” The rule requires a RIA that has custody of client securities or funds to implement a set of controls designed to protect those assets from being lost, misused, or misappropriated. The rule provides that, in general, a RIA should maintain funds and securities with a broker-dealer, bank, or other "qualified custodian" to avoid having custody themselves. Then, if the qualified custodian sends account statements directly to the RIA's clients, the RIA is relieved from undergoing an annual surprise custody audit. Many states have also implemented custody rules similar to 206(4)-2.

Definition of Custody

A RIA has custody when it holds, "directly or indirectly, client funds or securities or [has] any authority to obtain possession of them." The SEC created examples to illustrate circumstances under which a RIA has custody of client funds or securities.

• Holding clients' stock certificates or cash, even temporarily, is custody. However, the rule acknowledges that there may be times of inadvertent receipt of funds or securities. Therefore, to avoid custody, any check or security certificate inadvertently received by a RIA must be returned to the sender or placed with the qualified custodian within three business days of receiving them.
• A RIA has custody if it has the authority to withdraw funds or securities from a client's account, such as a power of attorney, possession of account login credentials or an authorization other than discretionary trading.
• Acting in any capacity that gives it legal ownership of, or access to, the client funds or securities, such as acting as both general partner and investment advisor to a limited partnership is custody. As general partner, the RIA generally has authority to dispose of funds and securities in limited partnership account(s) and thus has custody.
• Collecting prepayment of fees in an amount of $1,200 or more for services to be performed six months or more in advance. In this case, the RIA must include an audited balance sheet with its Form ADV deliveries to clients from whom the RIA has received such prepayments.

Avoiding Custody Issues

There are several steps to take in order to avoid custody issues:

• Due Inquiry. A RIA is required to have a reasonable basis to believe that, after due inquiry, the qualified custodian is delivering an account statement to each of your clients at least quarterly. The account statements must identify the amount of funds and of each security in the account at the end of the period and setting forth all transactions in the account during that period. In SEC Release No. IA-2968, the SEC identified common ways to satisfy due inquiry requirement:
1. Request copies of client account statements be sent to them.
2. Request a written confirmation from the custodian that the account statement was sent to each client.
3. The CCO maintains his or her personal accounts at the same qualified custodian that has all of the RIA’s Client accounts and the CCO ensures that he or she receives statements at least quarterly.
• Deduction of Fees. For a SEC registered RIA documentation of “due inquiry” is the primary safeguard for the deduction of fees to not be deemed custody. However, in addition to “due inquiry”, many states also require that in order to deduct fees from a client’s account without creating custody, the RIA must:
1. Have written authorization from the Client to deduct advisory fees from the account;
2. Each time a fee is directly deducted, the RIA concurrently sends the qualified custodian notice of the amount of the fee to be deducted, and client an invoice itemizing the fee including the formula used to calculate the fee, the amount of assets under management upon which the fee is based, and the time period covered by the fee;
3. Ensure the qualified custodian sends statements, on at least a quarterly basis, to Clients showing all disbursements, including the amount of the advisory fees; and
4. Form ADV states that the Advisor intends to use the safeguards provided in regulation, instead of the requirements for custody.
• Linked Accounts. Since May 20, 2010, the SEC has stated in Question II.4, that the limited authority to transfer a assets between the Client's accounts maintained at one or more qualified custodians is not custody, if:
1. the Client has authorized the RIA in writing to make such transfers and
2. a copy of that authorization is provided to the qualified custodian, specifying the Client accounts maintained with qualified custodian.

For transfers outside of the qualified custodian or recurring transfers, the RIA should have an authorization signed by the Client for each transfer specifying the transfer destination and the dollar amount for each transfer.

Maintaining Custody

For RIAs that have custody of funds or securities there are a number of requirements in order to ensure that the RIA is a “qualified custodian” for those assets.

• Annual audited financials. A RIA with custody of Client funds or securities must have its financials audited annually and then report the balances on Part 1 of Form ADV.
• Annual surprise examinations. The independent verification and audit of the custodied funds must occur at at a time that is chosen by the accountant without prior notice or announcement to you and that is irregular from year to year. The accountant must be registered with the Public Company Accounting Oversight Board.
• Internal controls report. Based on the surprise examination, the accountant must issue a written internal control report with opinions as to whether controls have been placed in operation as of a specific date, and are suitably designed and are operating effectively to meet control objectives relating to custodial services, including the safeguarding of funds and securities held during the year.
• The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
• In addition, many states also require that RIAs with custody also maintain at least a specific amount of net capital or require a surety bond.

What are the next steps for a CCO?

To ensure that you are properly dealing with custody issues AdvisorAssist recommends the best practices of:

• Perform an assessment to determine whether or not you have custody of client assets or securities, and respond appropriately, depending upon your intention to have custody or not.
• Implement controls to ensure the proper handling of client assets and securities to avoid the abuse of the authority granted by your clients to access and manage their assets and securities.
• Perform "due inquiry" on your custodian to ensure that each of your Clients are receiving statements at least quarterly.
• Review your advisory agreements to ensure that you have proper authorization to deduct fees from Client accounts.
• If your RIA receives deposit checks or stock certificates from Clients, maintain a "checks received log" and institute a policy of remitting these checks within 72 hours of receipt to the qualified custodian.
• If your RIA maintains custody, contract with an independent accounting firm to perform surprise custody audits at least annually on the accounts over which you have custody.
• If you are a state registered RIA, review your fee deduction process to ensure that each time a fee is directly deducted, you concurrently send the qualified custodian notice of the amount of the fee to be deducted, and the Client an invoice itemizing the fee including the formula used to calculate the fee, the amount of assets under management upon which the fee is based, and the time period covered by the fee.

The AdvisorAssist CCO Series is a collection of blog posts that cover each of the elements of your RIA's compliance program. Each post will provide an overview of one compliance topic, including our insights on how regulators view each topic as well as some practical steps to help Chief Compliance Officers address this topic. As always, we would welcome your comments and thoughts.

Contributors:
Brendan Furey
Conor Anderson

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