The short answer: if your firm can direct client money to a third party under a standing letter of authorization, the SEC generally treats that as custody — which means it belongs on your Form ADV, and it can carry the Custody Rule’s most burdensome requirements.
On the Form ADV — the registration and disclosure form investment advisers file with the SEC — there are two sections where a firm must declare whether or not they have custody, and if so, how much custody the firm has. Specifically, this is a part of Item 9 of Form ADV Part 1 – the number of assets and the number of clients for which they’re deemed to have custody.
While it’s generally clear when a firm has custody in many cases (including the situation where a firm has dually registered as a broker-dealer and has physical custody), what has not been so clear in the past is how custody is viewed by the SEC in situations where a firm has non-physical custody and an SLOA (Standing Letter of Authorization) — a client’s written instruction authorizing the adviser to move funds from their account to a third party — is involved.
In fact, the lack of clarity around this issue has persisted for years, leading to a request by the IAA for clarity on the issue. This was part of the SEC’s response:
“An investment adviser with power to dispose of client funds or securities for any purpose other than authorized trading has access to the client’s assets.”
You can read more about the IAA’s request and the SEC’s full response. With the recent updates to Form ADV in October 2017, investment advisors now need to list client assets that are subject to SLOA agreements. Every situation is unique, and there are many variables involved in determining whether or not your firm has custody and how to report it. Seeking outside help from a compliance consultant is often recommended to analyze your firm’s specific situation.
While this blog will attempt to cover some of the ways that SLOAs may impact custody, it’s a complex topic. Even if your situation isn’t covered in this blog, you may still have custody to include on your Form ADV. If you’re unsure, we highly recommend seeking the help of a third-party compliance consultant.
Do Standing Letters of Authorization (SLOAs) Create Inadvertent Custody?
In the SEC’s view, yes — a standing letter of authorization generally gives an adviser “access” to client assets and therefore triggers custody under the Custody Rule (Rule 206(4)-2), even when the adviser only moves money at the client’s direction. But confirming it in any given case is rarely simple.
The difficulty of discussing SLOAs and inadvertent custody is the inherent complexity of trying to determine custody in the first place — truly, it requires an examination of each situation individually to be able to say, one way or the other if custody exists. It’s one of the many ways advisers can end up with inadvertent custody without realizing it.
Why all the fuss about custody in the first place?
Besides the obvious dangers of regulatory sanctions being levied if the requirements of the Custody Rule are not being adhered to, many firms would like to avoid having custody entirely. This is because those firms would then find themselves under a significant burden — namely, firms with custody must implement onerous (and sometimes quite expensive) risk management controls.
The main encumbrance most firms want to avoid is the requirement to obtain independent annual surprise examinations, which not only take up a large amount of time and resources but may also cost quite a bit of money.
These surprise examinations, as the name suggests, are completely random and must take place annually through third-party accounting firms. If you’ve ever had to utilize the services of these firms, they can be quite expensive, so it is certainly worth the time and cost of working with third-party consultants. They can work with you in determining if custody exists and what can be done, if anything, to remove that risk.
Fortunately, there are risk mitigation protocols that firms can follow to alleviate the need for surprise audits when deemed with custody due to having SLOAs. The SEC has outlined the steps firms can take in its no-action letter — a specific set of seven conditions an adviser must satisfy to avoid the annual surprise examination. For more information, we encourage you to read our breakdown of the SLOA no-action letter, which walks through those steps and includes a link to the no-action letter itself.
Keep Your Form ADV Custody Reporting Up to Date
Ultimately, it is up to each advisory firm to ensure that they remain in compliance with applicable custody regulations and that their Form ADV is kept up to date — including reporting any SLOA-related custody in Item 9 of Form ADV Part 1.
As firms approach the deadline to file their Form ADV annual updating amendment — due within 90 days of the firm’s fiscal year-end — now is the time to review the Custody Rule, speak with a compliance consultant about any potential custody or compliance issues, and confirm that this year’s filing reflects the disclosures that belong in your Form ADV amendment. Getting the right Form ADV filing and registration support in place before the deadline is far easier than untangling a custody misstatement after the fact.
SLOAs and the Custody Rule: Frequently Asked Questions
Does a SLOA create custody? Generally, yes. The SEC has stated that an adviser with the power to move client funds to a third party — even solely at the client’s instruction under a standing letter of authorization — has access to client assets and is therefore deemed to have custody under Rule 206(4)-2.
What is inadvertent custody? Inadvertent custody is custody a firm has without realizing it — often through arrangements like SLOAs, or through certain language in custodial agreements — rather than by physically holding client assets. Because it is easy to miss, many advisers only discover it during a compliance review or an exam.
Do SLOA assets have to be reported on Form ADV? Yes. Since October 1, 2017, advisers have been required to include client assets subject to SLOA arrangements in their response to Item 9 of Form ADV Part 1.
How can a firm avoid the annual surprise examination for SLOA custody? The SEC’s no-action letter allows an adviser with SLOA-based custody to forgo the surprise examination if it meets the seven specific conditions the letter sets out. Because those conditions are fact-specific, many firms work with a compliance consultant to confirm they qualify.
Contact Core Compliance today to discuss how we can help your firm file in a timely manner and navigate any potential custody issues.
