Inadvertent Custody – SEC Guidance Update

March 07, 2017

In February 2017,  the Division of Investment Management of the U.S. Securities and Exchange Commission (“SEC”) issued a Guidance Update “Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority.” In this Guidance Update, the SEC explained that an investment adviser may have custody of client funds or securities because of provisions in a custodial agreement entered into by the investment advisory client and a qualified custodian.

In essence, the SEC calls to attention the fact that certain verbiage in investment adviser-custodial contracts can lead to the investment adviser having inadvertent custody of client funds and securities. The SEC’s Division of Investment Management identified the following as examples of agreements between an investment advisory client and qualified custodian that result in an investment adviser’s custody of the client’s funds or securities:

  • 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 an adviser’s instructions without direction from you. You hereby ratify and confirm any and all transactions with the custodian made by the 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….”

In accordance with the SEC’s definition of custody which includes “any arrangement . . . under which [an investment adviser is] authorized or permitted to withdraw client funds or securities maintained with a custodian upon [its] instruction to the custodian,”  the SEC explains that an investment adviser would have custody where the custodial agreement enables the investment adviser to withdraw, or transfer, client funds or securities upon instruction to the qualified custodian.  However, the SEC noted that an investment adviser may avoid such inadvertent custody by drafting a letter (or other form of document) addressed to the qualified custodian (and consented to by the client and qualified custodian) that limits the investment adviser’s authority notwithstanding the wording of the custodial agreement.

RIA Compliance Consultants cautions investment advisers to be aware that an investment adviser may have custody due to the authority given to them through custodial-adviser agreements.  A federally registered investment adviser who has custody is subject to an annual surprise verification examination and/or other requirements of the custody rule regardless of its intentions with respect to custody. RIA Compliance Consultants can help assess if your investment adviser firm has inadvertent custody of client funds.  To further discuss your investment adviser’s custody situation, please contact your consultant if you are an existing client of RIA Compliance Consultants or click here to schedule an introductory call if you have not previously worked with RIA Compliance Consultants.

Posted by Grant Parr
Labels: Custody, SEC