July 31, 2019 - Last week was a busy one for the LSTA in its continuing engagement with the SEC’s Division of Investment Management (“IM”) on the issue of whether registered investment advisers that trade loans and other assets 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. Why do we care? The custody rule has four central safekeeping requirements, the most onerous and relevant of which is the requirement that advisers that have custody engage an independent public accountant to conduct an expensive and burdensome annual surprise audit to verify client assets.
On Monday, the LSTA submitted a comment letter in response to a letter issued by IM in March and, later in the week, met with the IM staff together with the Investment Adviser Association and SIFMA’s Asset Management Division. While the issue has not been resolved, a number of things have become a bit clearer (including that a final resolution is still a far ways off).
The LSTA comment letter responds to an initiative launched by the IM staff to gather information on trading practices for non-DVP assets (which we covered in an earlier post).
The LSTA’s comment begins by noting that the IM staff’s guidance regarding the Custody Rule relating to instruments that do not settle on a delivery-versus-payment (“DVP”) basis has caused confusion, as LSTA’s members understood until relatively recently that investing in bank loans as authorized by clients would constitute “authorized trading” and thus would fall outside the definition of “custody” under the Rule. Nevertheless, the letter then responds to a number of questions asked by IM designed to elicit information regarding the trading and settlement process for non-DVP instruments, as well as the controls around such processes that serve to mitigate the risk of loss or misappropriation of a client’s assets. The rest of the LSTA’s letter explains in detail the process by which loan interests trade and settle and the extensive documentation and controls associated with the process to prevent loss and misappropriation of client assets.
At the meeting with the IM staff the LSTA and the other trade associations stressed that the issue of whether instruments settle DVP or not is not germane and that IM’s focus instead should be on the risks of misappropriation of client assets that are traded under “authorized trading” authority and the controls in place that mitigate those risks. What is the bottom line? The issue of custody for loans will not be resolved until a final rulemaking is completed which is likely to take many months if not longer. In the meantime, the IM staff continues to signal that no enforcement action will be taken against advisers that trade non-DVP assets and do not comply with the custody rule until such a rulemaking is completed.