Does a Minnesota-registered RIA have custody if it uses SLOAs?

Feb. 04, 2020

On February 1, 2017, the Securities and Exchange Commission (“SEC”) issued a No Action Letter (the “2017 SEC No Action Letter”) responsive to the question of whether an investment advisor is subject to the SEC’s Custody Rule if the adviser acts pursuant to a Standing Letter of Authorization (“SLOA”) for a client.  In short, the SEC confirmed that advisers utilizing SLOAs have custody, though the SEC agreed to not take action against such an adviser that does not obtain surprise audits of client assets and securities (a requirement typically applicable to advisers with custody under the Custody Rule), so long as the following additional safeguards are met:

  1. The client provides an instruction to the qualified 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.

  2. The client authorizes the investment adviser, in writing, either on the qualified custodian’s form or separately, to direct transfers to the third party either on a specified schedule or from time to time.

  3. The client’s qualified 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.

  4. The client has the ability to terminate or change the instruction to the client’s qualified custodian.

  5. The investment adviser 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.

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

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

To date, the Minnesota Department of Commerce (the “Department”) has not publicized a similar no action determination, nor an interpretive opinion as to whether the SEC’s 2017 No Action Letter applies to advisers registered in Minnesota.  This has led to some confusion about whether Minnesota-registered investment advisers using SLOAs must disclose that they have custody on Item 9 of their Form ADV.  If a Minnesota-registered investment advisor must disclose custody on this basis, there is also confusion as to whether that adviser is then required to obtain an independent audit of its financial statements pursuant to Minn. Rule 2876.4113, obtain yearly surprise audits pursuant to Minn. Rule 2876.4116, and meet certain other state requirements applicable to Minnesota-registered advisers disclosing custody. This article attempts to dispel some of that confusion.

 

Is a MN-registered investment adviser that utilizes standard letters of authorization (SLOAs) with clients required to disclose having custody on its Form ADV?

Probably, yes.   “Custody” is defined under Minnesota Rule 2876.4116, subpart 3(A) to include: (i) possession of client funds or securities; (ii) any arrangement under which an adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon its instruction to the custodian; and (iii) any capacity that gives the adviser or its supervised person legal ownership of or access to client funds or securities. Investment advisers deemed to have custody under this definition are subject to additional safeguards defined in Minnesota law.  For example, the Minnesota Rules require advisers with custody to have their financial statements audited by an independent accountant (see Minn. Rule 287.4113 Subpart 1(B)), and to obtain a surprise examination of client assets by an independent public accountant at least annually (see Minn. Rule 2876.4116, subpart 1(D)(2)(b).

SLOAs are typically used to document a client’s pre-authorization allowing an adviser to withdraw or transfer funds from the client’s account for a specifically designated purpose.  There are many different types of SLOAs in use, and an adviser may be able to effectively argue that a SLOA arrangement that is structured so that the investment adviser does not have discretion as to the amount, payee, and timing of transfers under a SLOA does not cause the adviser to have custody under the above definition.  However, it may be difficult, and risky, to thread that needle.  In the interest of preserving consumer protections, the Department (in my opinion) is more likely than not to take the position that an adviser utilizing SLOAs has custody, as the SEC did in its 2017 No Action Letter.  Minnesota-registered advisers should act accordingly when determining how to complete Item 9 of their Form ADV.


Is a MN-registered investment adviser that discloses having custody due solely to use of SLOAs required to obtain an independent audit of its financials and to obtain surprise audits?

Not necessarily—but be careful.  On at least one occasion I am aware of, the Department informed a Minnesota-registered investment adviser in writing that the adviser was not required to obtain an independent audit of its financial statements, despite disclosing it had custody due to use of SLOAs, so long as the adviser committed to following the seven steps outlined in the SEC’s 2017 No Action Letter.  However, the Department also noted that it considers compliance with the seven steps listed in the SEC’s 2017 No Action Letter as supportive, but not inherently determinative, of an investment advisor’s compliance with Minnesota’s regulations. The Department also noted that it will review this situation on a case-by-case basis, meaning it may take a different approach with an adviser under similar, but slightly different, circumstances.

So what does this mean?  In short, if you use SLOAs, it is good practice to (i) disclose having custody in your Form ADV, and explain why you are making such disclosure (ii)  update (and follow!) your written supervisory procedures such that your firm follows the guidelines provided in the SEC’s 2017 No Action Letter when utilizing SLOAs; and (iii) be proactive and transparent when communicating with the Department on how you approach this issue, particularly if you elect to not obtain an audit of your financial statements, obtain surprise audits of client assets, or otherwise comply with all Minnesota requirements applicable to advisers disclosing having custody.  In this situation, it is likely a better strategy to ask for permission first rather than forgiveness later.  


Written By:
Brian Edstrom

Brian Edstrom is a Shareholder and Attorney at Avisen Legal, P.A. He brings to Avisen clients the ability to “speak regulator,” having spent several years working for federal and state regulators in Washington D.C. and Saint Paul, MN before entering private practice. Brian assists clients in all aspects of working with securities regulators, whether it be to obtain a license or registration, prepare for an audit, or respond to an enforcement investigation.  Brian also regularly advises clients on their general business needs, particularly surrounding raising money through securities offerings.

Megan Hsiang is a 2L student at the University of St. Thomas School of Law.  She is active in Womens Law Student Association (WLSA) as the MWL Liaison, which includes serving on the Board of Minnesota Women Lawyers, and the Nonprofit Organizations Clinic, providing legal services for existing and aspiring nonprofit organizations that promote social justice.

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