Apr 26, 2017 | News

Investment Advisor Custodial Agreements could mean “surprise exams” by SEC

When they say the devil is in the details, take it to heart; especially investment advisors who have separate custodial agreements with a client and a qualified custodian. Because custodian agreements come in different shapes and sizes, the contract could inadvertently give custody of client funds or securities to the IA, which could lead to a “surprise examination” by the SEC.

The SEC has found under the Investment Advisors Act of 1940 custody Rule 206(4)-2, some custodial agreements may grant “an advisor broader access to client funds or securities than the advisor’s own agreement with the client contemplates.”  Thus, in some instances, they may permit an IA to “disburse, or transfer funds or securities.” Here are some examples:

  • Custodial agreements that grant an IA the right to “receive money, securities, and property of every kind and dispose of the same.”
  • A custodial agreement that relies only on instructions from the IA, and not from the client, who gave up rights to the IA.
  • A custodial agreement that provides authorization to an IA that allows them to “disburse cash from the client account for any purpose.”

The SEC states that the “definition of custody turns on whether the advisor is permitted to ‘withdraw’ client funds or securities ‘upon [the IA’s] instruction to the qualified custodian.” A custodian agreement could conflict with an advisory client agreement as to the IA’s ability to withdraw or transfer funds.  In that case, the SEC states the custodial agreement might take precedence over the client agreement.

And though there might be “constraints” within the client agreement, the custodian might not be aware of them. It would follow its own agreement with the IA. That said, narrowly constructed custodial agreements could allow deduction of fees instructions from an IA and would not subject them to “surprise examination.”

The SEC cautions IAs to be aware of these potential custodial agreement conflicts, and suggests that one an advisor can avoid these issues by drafting a letter or document to the custodian that would limit the IA’s authority to “delivery versus payment,” despite wording of custodial agreement, and have the custodian and client “acknowledge the new arrangement.”

For further guidance, click here.

For clarification and the no action letter from the SEC, click here.