March 13, 2019 - As we have previously discussed, in February 2017 the SEC’s Division of Investment Management staff took the position that registered investment advisers that trade loans and other assets 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, including the implementation of annual surprise audits.  Since that time the LSTA has been engaged with the staff in ongoing efforts to obtain “no-action” relief with respect to loans while at the same time working with other trade associations to reach a broader consensus on all non-DVP assets.  After more than two years of back and forth with no conclusive results, the staff recently identified another possible path forward.

On Tuesday, the staff launched an initiative to gather information on trading practices for non-DVP assets. In a letter issued to the Investment Adviser Association (“IAA”), the staff stated that it welcomes industry input on a list of questions, including those relating to the risks of misappropriation or loss, controls and independent checks, and surprise exam challenges associated with non-DVP assets.

Importantly, the letter states, “The staff believes that questions surrounding Non-DVP trading, as well as additional questions and issues the staff has identified regarding the Custody Rule over the past 15 years, should be considered by the Commission. In this regard, amendments to the Custody Rule are on the Commission’s long-term unified agenda.” This signals that the staff believes that rulemaking by the Commission — rather than staff guidance — is needed to address the non-DVP issues that impact custody.  What does this mean for managers of loans?  It’s complicated, but we take a stab at unpacking the staff’s initiative.

First, some background.

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?

In the summer of 2016, 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?

The LSTA has had many meetings and calls with the staff 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 the staff that they provide no-action relief for managers of loans so long as they follow standard compliance and settlement protocols. None of these efforts has resulted in a workable solution.

What are the implications of the staff’s new initiative?

There are a number of important takeaways from the staff’s letter:  First, it is clear that their intent is to resolve the custody issue through a rulemaking rather than staff guidance.  While there are important advantages to that, most particularly clarity and finality, there are also downsides.  Given the SEC’s long list of priorities, a rulemaking on custody is probably far off, perhaps even years, in the future.  Moreover, the letter forecloses any possibility that syndicated loans will get no-action relief in the meantime.  Second, it appears that the staff has taken a half-step back from their position that trading non-DVP assets results in custody.  While they don’t say this expressly, it seems inherent from their statements and questions.  Relatedly, the staff seems to be signaling that they will not enforce the custody rule in the context of non-DVP trading for now.  However, they reiterate their view that trading non-DVP assets is inherently more risky and admonish advisers to “review internal controls to reduce the risk of misappropriation or loss, and should address this risk in their compliance policies and procedures” and further suggest that they look to the procedures and controls set forth in the 2009 amendments to the Custody Rule.  So, while the Custody Rule may not be enforced, the staff will be focusing on compliance practices for non-DVP assets.

What’s Next?

The staff asks the IAA and other market participants for their written views on a series of questions related to non-DVP assets and custody.  Interestingly, they do not offer a deadline for responses and note that the answers will assist them to “inform future steps” and not as part of a rulemaking.  Ironically, the LSTA, in its ongoing dialogue with the staff over the past two years, has already answered most of these questions in the context of syndicated loans, supported by a substantial amount of supporting materials and data.  Nevertheless, the LSTA intends to respond to the letter in due course.  We may know more on Friday when Gail Bernstein, the general counsel of the IAA, gets a chance to talk to Dalia Blass, the Director of the SEC’s Division of Investment Management at its Compliance Conference in Washington, DC.

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