For many people, the term "inadvertent custody" might describe the feeling a parent has upon finding someone else's child in the family room a half hour after the birthday party has ended.
In the world of investments, the term "inadvertent custody" may raise a feeling of unease as well. The Securities and Exchange Commission treats a money manager or adviser as possessing inadvertent custody of client assets when the manager does not hold the assets but has authority in certain situations to direct those assets to improper purposes. The SEC will treat the adviser as having custody for purposes of the SEC's custody rule, which requires advisers to protect client assets from theft or mishandling.
The custody rule is immensely important, and the SEC deserves credit for offering guidance aimed at blocking unscrupulous advisers from stealing assets through indirect means. However, the rule as applied here puts unnecessary burdens on both the adviser and the client.
In February, the SEC's Investment Management Division warned that an adviser may have inadvertent custody if its client has hired a custodian bank or broker under a contract that grants all advisers broad authority over client assets, even if the contract directly between an individual adviser and the client is much narrower in scope. This means the adviser is on the hook under a contract to which it is not a party and indeed may not be allowed to see (as custody agreements often provide). The SEC offers the adviser a way out of inadvertent custody if its client can obtain a clarifying letter from the custodian that the custodian will not implement terms from its contract that could ensnare the adviser.
This means the adviser has to ask the client for a favor, something many advisers are reluctant ever to do. But even if they do and the client agrees to ask the custodian for a letter, we are doubtful the custodian will comply. Many custodian banks and many brokers require all clients to sign the same custody form. As such, every client in this entire segment of their businesses will want one. Also, custodian counsel might recommend not doing so if there is any possibility that issuing the letter if may create some sort of risk or exposure.
The problem for the adviser comes from the contract between the client and the custodian, something that the adviser is not a party to and may have no knowledge of the contents. However, clients often send the custodian a copy of the advisory agreement to facilitate implementation of the trading program. If the custodian gets a copy of the adviser-client contract, there would seem greater fairness and efficiency in enforcing compliance of the custody rule against the custodian here rather than the adviser, especially under general principles of the law of agency. Once a custodian has received and read the client's advisory contract, the custodian ought to be deemed to know the adviser's "actual authority" under the advisory contract. It should not matter that the custodian's contract grants broader authority to the adviser, especially when the custodian knows how both contracts line up but the adviser does not.
In addition, the SEC has other topics affecting the safety of client assets to consider at the custodian rather than the adviser level. For example, many custody agreements broadly exculpate the custodian and may exclude minimal legal language to protect client assets in the event of custodial insolvency. In other words, while the SEC's effort to protect client assets is immensely important and widely appreciated, there are additional avenues it could consider to add substantive protections to guard against theft or loss of client assets and that do not require the adviser and the client to renegotiate the client's deal with its custodian.
Edward H. Klees is a partner at Hirschler Fleischer and leads its Endowments, Foundations and Outsourced CIO Practice Group. James W. Van Horn Jr. is a partner at Hirschler Fleischer and co-chair of its Investment Management and Private Funds Practice Group.