July 12, 2017 - The staff of the Securities and Exchange Commission has recently taken the position that registered investment advisers that trade loans and other assets (including derivatives) on behalf of separately managed accounts that do not settle “delivery versus payment” (“DVP”), have “custody” of client assets under the Investment Advisers Act (the “Act”) and therefore must comply with the requirements of the custody rule.  (The custody rules do not apply to trades on behalf of CLOs or mutual funds).  This week the LSTA hosted a webinar that focused on this surprising regulatory development which could have very costly consequences.  Amy Doberman, a partner at WilmerHale, was joined by LSTA General Counsel Elliot Ganz to help explain (i) what it means to have custody of client assets under the federal securities laws; (ii) the implications of having custody; (iii) the SEC’s emerging position on custody vis a vis loans and other assets that do not settle DVP; (iv) recent SEC guidance on inadvertent custody and how it may impact the loan market; (v) what the LSTA and others have been doing to date; and (vi) next steps.  This article describes some of the material covered in the webinar.

What is custody?  Rule 206(4)-2 under the Act (the “Rule”) provides that is a fraudulent, deceptive or manipulative act, practice or course of business for a registered investment adviser to have “custody” of client funds or securities unless they are maintained in accordance with the requirements of the rule. The Custody Rule is intended to insulate client assets from misappropriation or other unlawful activities by an adviser or its personnel.

Custody is defined as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.”  It includes physical possession of, the ability to withdraw, or the capacity that gives the adviser legal ownership of or access to, client funds or securities, as well as the investment adviser, directly or indirectly holding client funds or securities, or having any authority to obtain possession of them, in connection with advisory services provided to clients.

What are the implications of having custody?  The Rule has four central safekeeping requirements, the most onerous and relevant of which is the requirement that the adviser engage an independent public accountant to conduct an expensive and burdensome annual surprise audit to verify client assets.

What position has the SEC taken on loan trading and custody?

Last summer, in the course of a routine exam of a loan manager, the SEC staff asserted that the investment adviser had “custody” of client assets because the adviser had the ability to sell and purchase assets – loans – that are traded on a basis other than “delivery versus payment” (“DVP”).  The adviser responded with an extensive analysis of the Rule itself and explained in detail how the loan transfer process prevents the risk of misappropriation. It noted that numerous asset classes do not trade DVP, and that the SEC’s interpretation could subject many advisers to the Rule.  Nevertheless, the staff insisted that the adviser comply with the Rule.  While this appeared to be an isolated incident, the staff in February issued updated guidance where, in an endnote, it clearly and publicly reaffirmed its position that (i) an adviser’s authority to issue instructions to a broker-dealer or a custodian to effect or to settle trades does not constitute custody so long as the transfers are done under a DVP arrangement and, conversely, (ii) custody does arise from trading authority in situations not covered by DPV arrangements.  Notably, the guidance also suggested (but not in the context of the trading authority exclusion) that it might be possible to avoid custody by expressly limiting the adviser’s authority with respect to client assets.

What has the LSTA been doing?  What’s next?

The LSTA has approached the SEC staff in the Division of Investment Management to explain the process of loan settlements and why investment advisers exercising authorized trading authority with respect to loans should not be deemed to have custody.  We have also submitted extensive information about the loan trading and settlement process and all the parties involved therein to illustrate how there is no material risk of misappropriation.  We have proposed to add limiting and protective language to both the advisory agreement as well as the custody agreement to define the adviser’s authority, consistent with the recent guidance described above.  Other industry groups (e.g., the Investment Advisers Association) are also concerned about the SEC’s position on custody in the context of derivatives and other asset classes that do not settle DVP and are joining our efforts.  We expect to engage further with the staff and hope to resolve this issue in a satisfactory manner in the coming months.

The related slides are available by clicking here.

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