A common complaint that I hear from broker-dealers and investment advisors is that it is nearly impossible anymore to obtain informal guidance from their regulators. Where it was once possible, even normal, to make a call and get casual advice how to comply with a particularly tricky rule, nowadays, regulators routinely decline to respond to such requests. Moreover, even if you are lucky enough to find some examiner willing to go out on a limb and offer his or her opinion on something, the law is frighteningly clear that reliance on that advice provides absolutely zero protection from subsequent regulatory action. In other words, one relies on informal guidance at one’s own peril.
Given this unfortunate fact, my advice to clients who are hell-bent on asking permission rather than forgiveness is to seek formal guidance. From FINRA, that would be an Interpretive Letter; from the SEC, that would be a no-action letter. The problem with this approach is obvious, however: you don’t always get the answer you were hoping for. And, you are showing your hand to your regulator, thereby inviting their scrutiny anyway.
But, sometimes, it works the way you hope, and you get an answer, and it’s actually helpful. That happened recently when an investment advisor asked the SEC for a no-action letter regarding the custody rule, a deceptively simple rule that can get advisor into trouble, even when they think they’re doing the right thing. When an advisor has actual custody of client funds or securities, several things have to happen. The client assets have to be held securely, of course, it must be disclosed on Form ADV, and you have to subject the client assets to a surprise exam by a public accountant. If you mess up any one of these elements, you’re in violation. Intent is not required, so it’s basically a strict liability situation.
This gets further complicated by the fact that what constitutes custody is not always obvious. Specifically, in addition to actually holding funds or securities, an advisor is deemed to have custody if it “has any authority to obtain possession of [client funds or securities], in connection with advisory services [it] provide[s] to clients.” Given that rule, the advisor in question here asked the SEC to agree that if the sole authority granted to the advisor was to instruct the third-party custodian of the client assets to transfer those assets in accordance with the client’s express direction, this would not constitute “custody” under the rule.
Interestingly, the SEC would not agree, and it concluded that this is, in fact, custody. But, at least in this instance, the SEC both tooketh and gaveth. While it said this was custody, it also stated that if an advisor jumps through each of several specific hoops, it would not recommend that any enforcement action be taken, even absent a surprise audit. The hoops are as follows:
- 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.
- 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.
- 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.
- The client has the ability to terminate or change the instruction to the client’s qualified custodian.
- 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.
- 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.
- The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.
This may seem overly simplistic, but it is difficult to complain too loudly when a regulator supplies a detailed blueprint for compliance. The lesson is clear: as long as you’re willing to risk not getting the answer you want, seeking formal guidance can be the best way to steer clear of regulatory quicksand.
 To be clear, and remarkably enough, according to FINRA, it isn’t even safe to rely on an Interpretive Letter. FINRA’s website states, “All interpretive positions are staff position, unless otherwise indicated. Staff-issued interpretive letters express staff views and opinions only and are not binding on FINRA and its Board; any representation to the contrary is expressly disclaimed.” I mean, what’s the point if the supposedly “official” advice isn’t binding?