State of Connecticut Department of Banking

Statement of Policy Regarding Custody Requirements for Investment Advisers With Standing Letters of Authorization and Similar Arrangements 

November, 2022

Introduction

Section 36b-5(c) of Chapter 672a of the Connecticut Uniform Securities Act (the “Act”)  prohibits any investment adviser that is registered or required to be registered in Connecticut from taking or having custody of client funds or securities if the Commissioner by regulation prohibits custody or, in the absence of a regulation, the investment adviser fails to notify the Commissioner that it may have custody. 

Section 36b-31-5b of the Regulations under the Act makes it a fraudulent, deceptive or misleading act, practice or course of business for an investment adviser having custody or possession of client funds or securities to take any action regarding those funds or securities unless certain conditions are met.  These conditions involve 1) the segregation and safekeeping of custodied funds or securities in earmarked accounts; 2) notice to the client regarding the place and manner in which the custodied funds or securities will be maintained; 3) the sending of quarterly itemized statements to the client; and 4) an annual “surprise” verification of the custodied funds and securities by an independent public accountant.  Section 36b-31-5b of the Regulations was patterned after Securities and Exchange Commission (“SEC”) Rule 206(4)-2, 17 C.F.R. § 275.206(4)-2, promulgated under the Investment Advisers Act of 1940. 

On February 4, 2005, the Banking Commissioner, responding to the SEC's amendments to Rule 206(4)-2, issued an Order Updating Custody Requirements For State-Registered Investment Advisers (the “Custody Order”) that reflected modern custodial practices.  In essence, the Custody Order exempted advisers with custody from the surprise verification requirement in Section 36b-31-5b of the Regulations if certain safeguards were observed.  These included use of a “qualified custodian” - typically a bank or securities broker-dealer – notice to the Commissioner and notice to the affected clients.

The Custody Order defined custody to mean “holding, directly or indirectly, client funds or securities, having any authority to obtain possession of them, or having the ability to appropriate them” and included “any arrangement, including a general power of attorney, under which the investment adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the investment adviser’s instruction to the custodian” as well as “any capacity, such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust, that gives the investment adviser or its investment adviser agent legal ownership of or access to client funds or securities.” 

Neither the Regulations nor the Custody Order specifically addressed Standing Letters of Authorization. 

Standing Letters of Authorization and Custody

Some investment advisory clients establish a Standing Letter of Authorization (or Standing Letter of Instruction) (collectively, “SLOA”) with the adviser and its Qualified Custodian.1  The SLOA typically authorizes the investment adviser to instruct the Qualified Custodian to disburse funds or transfer securities to third parties on the client’s behalf.  The actual terms of the SLOA limit the investment adviser’s authority, and the investment adviser essentially acts as the client’s agent, with the client retaining full power to modify or revoke the SLOA. 

As a general proposition, investment advisers have custody if they are authorized, pursuant to SLOAs or similar arrangements, to withdraw client funds or securities upon instruction to the Qualified Custodian.  Therefore, they would be required to comply with 36b-31-5b of the Regulations, including the surprise verification requirement.

Significantly, there is no standardized format for a SLOA and usage varies from firm to firm.  SLOAs may involve first-party transfers or third-party transfers.  There may also be instances, for example, where the investment adviser does not have discretion as to the amount, payee, and timing of transfers under a SLOA.  In that case, the Securities and Exchange Commission in its February 21, 2017 no-action letter to the Investment Adviser Association took the position that this type of SLOA did not implicate the custody rule.  Other states have followed suit.2  Therefore, Connecticut would not consider a SLOA arrangement to involve “custody” within the meaning of Sections 36b-5(c) and 36b-14(d) of the Act and Section 36b-31-5b of the Regulations where the client’s SLOA with the Qualified Custodian specifies the amount, the payee and the timing of the transfers and the investment adviser cannot provide any instructions to the Qualified Custodian. 

Other types of SLOAs would, by contrast, involve custody.  However, pursuant to Section 36b-31(f) of the Act, the Division will take no enforcement action at the present time if investment advisers using such SLOA arrangements do not observe the requirements in Section 36b-5(c) of the Act, Section 36b-31-5b of the Regulations or Section 36b-31-14d of the Regulations (requirement that annual financial statements filed by investment advisers having custody be audited) provided that the following conditions 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; and
  7. The client’s Qualified Custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

Connecticut-registered investment advisers should report client assets that are subject to a SLOA or similar arrangement resulting in custody on Item 9 of Form ADV, with an explanatory note included on Schedule D. 

This Policy Statement, which shall remain in effect until modified, superseded or vacated, represents the Division’s position on enforcement only, and extends solely to investment advisers having custody of client funds or securities solely as a result of a third-party SLOA arrangement with a client.

1 For purposes of this analysis, “Qualified Custodian” has the same meaning as in paragraph 1.(d) of the Custody Order. 
2 In evaluating the risk of harm to the client, one can draw a parallel to the Custody Order's treatment of client checks forwarded by the adviser to an unrelated third party - a scenario that the Connecticut Custody Order specifically excepts from the definition of “custody” and hence the coverage of Section 36b-31-5b of the Regulations.