Investment Management

Posted on Wednesday, April 5 2017 at 11:50 am by

SEC Issues Custody Rule Guidance

By Paul Foley and John I. Sanders

In February, the Securities and Exchange Commission (SEC) issued two significant pieces of guidance on arrangements that may result in an investment adviser having “custody” of its client assets as that term is defined in Rule 206(4)-2 (Custody Rule)[1] of the Investment Advisers Act of 1940 (Advisers Act).[2] The first piece of guidance was a Guidance Update issued by the SEC’s Division of Investment Management. The second came in the form of a no-action letter (Letter) issued to the Investment Adviser Association (IAA) on February 21, 2017. This article discusses both and offers practical insight into compliance with the Custody Rule.

Background

Under the Custody Rule, an investment adviser is deemed to have custody of client assets when it or a related person “holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services” it provides to its clients.[3] Additionally, the term custody includes any arrangement under which an investment adviser is “authorized or permitted to withdraw client funds or securities maintained with a custodian upon [its] instruction to the custodian.”[4] When an investment adviser is deemed to have “custody,” a number of regulatory requirements are triggered, including an independent verification by an accountant (a “surprise examination”).[5] Accordingly, investment advisers must understand when they have custody of client assets. The SEC’s recent guidance addresses instances in which investment advisers may not know that they have custody and, therefore, are subject to the various regulatory requirements of the Custody Rule.

Guidance Update

An IM Guidance Update published by the SEC’s Division of Investment Management stated that investment advisers may “inadvertently have custody of client funds or securities because of provisions in a separate custodial agreement entered into between its advisory client and a qualified custodian.”[6] The Division of Investment Management found that some custodial agreements grant an adviser the broad power “to instruct the custodian to disburse, or transfer, funds or securities.”[7] Where the adviser has that power, it may be deemed to have custody of the assets even though it did not intend to have such power and its contractual agreement with the client directly prohibits it from taking such action.[8]

The Division of Investment Management found that inadvertent custody arose from some commonly observed custodial agreement provisions:[9]

  • A custodial agreement that grants the client’s adviser the right to “receive money, securities, and property of every kind and dispose of same.”
  • A custodial agreement under which a custodian may rely on the “[adviser’s] instructions without any direction” from the client and asks the client to “ratify and confirm any and all transactions with [the custodian]” made by the adviser.
  • A custodial agreement that provides authorization for the client’s adviser to “instruct us to disburse cash from your cash account for any purpose . . . .”

After describing how advisers might have inadvertent custody of client assets, the SEC cautioned that rectifying inadvertent custody could not be accomplished through a bilateral agreement between the adviser and the client as the custody stems from the custodian’s perception of the adviser’s power.[10] The adviser can alter that perception by: (i) delivering a letter to the custodian that limits the adviser’s authority to “delivery versus payment” notwithstanding a greater grant of power in the custodial agreement; and (ii) obtaining written acknowledgement of the limitation from the client and custodian.[11]

After providing common custodial agreement provisions that may create inadvertent custody, the Guidance Update specified one common provision which does not, in itself, create custody. The SEC stated that where a custodial agreement permits merely the deduction of advisory fees, “an adviser may have custody but not need a surprise examination, provided it otherwise complies with the exception under Rule 206(4)-2(b)(3) available to advisers with limited custody due to fee deduction.”[12] A broader grant of power, however, likely constitutes custody.

We believe the Guidance Update may place a substantial burden on investment advisers. It will not be enough for investment advisers to review their own advisory agreements and other form documents. Instead, an adviser must work with all custodians holding its clients’ assets to obtain and examine any custodial agreement provisions that might create inadvertent custody for the adviser. Moreover, the adviser would need to monitor those agreements for material changes in perpetuity. Of course, the simpler, but still burdensome, path to compliance may be to send letters to all clients and their custodians and obtain their acknowledgement of the adviser’s limited power as a preventative measure.

The IAA No-Action Letter

Dovetailing the Guidance Update, in a letter dated February 15, 2017, the IAA asked the SEC staff to clarify that an investment adviser does not have custody under the Custody Rule “if it acts pursuant to a standing letter of instruction or other similar asset transfer authorization arrangement established by a client with a qualified custodian.”[13] In the alternative, the IAA asked the SEC to state it would not recommend an enforcement action under Section 206(4) of the Act and the Custody Rule against an investment adviser acting pursuant to a standing letter of authorization (SLOA), as described in the Letter, without obtaining a surprise examination of the custodied assets as required by the Custody Rule.[14]

The IAA stated that it is common for an advisory client to grant its registered investment adviser the power, through a SLOA, to disburse funds to specifically-designated third parties. Granting such power to an investment adviser is especially helpful where the client owns multiple accounts with different purposes across multiple custodians. Under such an arrangement, the client grants authority to the adviser, then the client instructs the custodian to transfer assets to the designated third parties on the adviser’s command. After issuing a SLOA, the client retains the power to change or revoke the arrangement, and the adviser’s authority is limited by the specific terms of the SLOA.[15] It was the IAA’s positon that such an arrangement did not constitute custody.[16]

The SEC determined that a SLOA, as described by the IAA may, in fact, lead to an investment adviser having custody of its client assets as contemplated by the Custody Rule. The general rule, as articulated by the SEC, is that an “investment adviser with the power to dispose of client funds or securities for any purpose other than authorized trading has access to the client’s assets” and thus has custody of those assets.[17] Because the SLOA or other similar authorization would permit the investment adviser “to withdraw client funds or securities maintained with a qualified custodian upon its instruction,” an investment adviser entering into an SLOA or similar arrangement would have custody of client assets and would be required to comply with the Custody Rule.

The SEC then stated that it would not recommend enforcement action under Section 206(4) of the Adviser Act or the Custody Rule against an investment adviser that enters into a SLOA that meets the following requirements and does not obtain a surprise examination:[18]

  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.
  7. The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

We believe few SLOAs or similar arrangements currently in place would satisfy these extensive requirements. The SEC seems to agree. It noted that investments advisers, qualified custodians, and their clients would need “a reasonable period of time” to comply with the relief provided by the no-action letter.[19] Further, the SEC stated that any investment adviser that is party to a SLOA that results in custody would not need to include the affected client assets in its response to Item 9 of Form ADV until the next annual updating amendment after October 1, 2017.[20]

The Letter, on its face, could be construed broadly to cover a number of common arrangements. However, the Letter was limited by a SEC statement published the same day.[21] In that statement, the SEC explained that the limited authority to transfer assets between accounts, whether with the same custodian or different custodian, provided that the client has authorized the adviser to make the transfers between specified accounts and has provided the custodians a copy of the authorization, does not constitute custody.[22] The SEC also noted that an adviser’s ability to transfer client assets between accounts at the same custodian or between affiliated custodians that have access to both account numbers and client account name does not amount to custody.[23] Therefore, the Letter seems to directly affect only SLOAs and similar arrangements under which the adviser has the authority to withdraw and disburse clients assets.

Despite the limiting effect of the SEC’s statement, advisers who are currently parties to a SLOA or similar arrangement should carefully review the terms of those arrangements. Where the arrangements do not meet the seven conditions for relief stated in the Letter, the adviser should work to either: (i) change the terms of the arrangement; or (ii) comply with the terms of the Custody Rule and disclose those assets in the next annual amendment to Form ADV after October 1, 2017.

Conclusion

The SEC’s recent guidance may generate significant anxiety among investment advisers concerned about becoming subject to the requirements of the Custody Rule. In particular, the SEC’s recent guidance raises the specter of custody arising from longstanding SLOA arrangements or even from contracts the investment advisers have not seen or do not regularly review. Please feel free to contact us with any questions you may have.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices. John I. Sanders is an associate based in the firm’s Winston-Salem office.

13776971v.4

[1] 17 CFR 275.206(4)-2 (2017).

[2] 15 USC 80b et al (2017).

[3] 17 CFR 275.206(4)-2(d)(2) (2017).

[4] 17 CFR 275.206(4)-2(d)(2)(ii) (2017).

[5] 17 CFR 275.206(4)-2 (2017). Under the Custody Rule, among other things, an investment adviser must: maintain client funds and securities with a “qualified custodian” either under the client’s name or under the investment adviser’s name as agent or trustee for the client; notify its clients promptly upon opening a custodial account on their behalf and when there are changes to the information required in the notification; and have a reasonable basis, after due inquiry, for believing that the qualified custodian sends quarterly account statements directly to the client.

[6] SEC, IM Guidance Update: Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority (Feb. 2017), available at www.sec.gov.

[7] Id.

[8] Id.

[9] Id.

[10] Id.

[11] Id.

[12] Id.

[13] SEC, Investment Advisers Act of 1940 – Section 206(4) and Rule 206(4)-2; Response to the Investment Adviser Association (Feb. 21, 2017), available at https://www.sec.gov/divisions/investment/noaction/2017/investment-adviser-association-022117-206-4.htm.

[14] Id.

[15] Id.

[16] Id.

[17] Id.

[18] Id.

[19] Id.

[20] Id.

[21] SEC, Staff Responses to Questions About the Custody Rule (Feb. 21, 2017), available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.

[22] Id.

[23] Id.

Posted on Thursday, December 15 2016 at 9:28 am by

Supreme Court Confirms Expansive View of Insider Trading

By Paul Foley, Clay Wheeler, and John Sanders

Perhaps the most serious charge that could be leveled against a reader of this blog is that of being engaged in or associated with “insider trading.”  The allegation alone is enough to derail or end a promising career.  Successful compliance requires an understanding of the law and your obligations under it.  In light of recent developments regarding insider trading, including the first Supreme Court decision to address the crime in 20 years,[1] we encourage you to read this article in its entirety and contact us with any questions you may have.

Insider Trading:  The Tradition

Section 10(b) of the Securities Exchange Act of 1934[2] and Rule 10b-5[3] promulgated thereunder prohibit insider trading.  The basic elements of insider trading are:  (i) engaging in a securities transaction, (ii) while in possession of material, non-public information, (iii) in violation of a duty to refrain from doing so.

The paradigm case discussing the so-called “classical” theory of insider trading is Chiarella v. U.S.[4]  In Chiarella, an employee of a publishing firm was charged with insider trading after using advance notice of a takeover bid to trade.  Chiarella’s conviction was reversed by the Supreme Court after the Court focused on the requirement of a duty running from the trader to the shareholders of the corporate entity “owning” the material, non-public information.  Thus, a successful prosecution under the classical theory usually involves a corporate insider trading in shares of his or her employer while in possession of material, non-public information (e.g., advance notice of a merger).

After Chiarella, an important development in the law has been the extension of liability to persons who receive tips from insiders, i.e., individuals whose duty to refrain from trading is derived or inherited from the corporate insider’s duty.  Thus, not only may insiders be liable for insider trading under rule 10b-5, but those to whom they pass tips, either directly (tippees) or through others (remote tippees) may be liable if they trade on such tips.  Because tippee and remote tippee liability is more difficult to grasp and more likely to affect our readers, this article will primarily, but not exclusively, focus on individuals in those circumstances.

In a pattern that has repeated itself over the years, courts broadened the scope of insider trading by developing a second, “complementary”[5] theory of insider trading – the “misappropriation” theory.  This theory “targets person[s] who are not corporate insiders but to whom material non-public information has been entrusted in confidence and who breach a fiduciary duty to the source of the information to gain personal profit in the securities market.”[6]  The seminal case in the articulation of the misappropriation theory is U.S. v. O’Hagan.  In O’Hagan, a partner at a large law firm (but not ours) obtained and traded on information given to attorneys in the firm who were representing a client in a tender offer.  The Supreme Court held that “A person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information, may be held liable for violating § 10(b) and Rule 10b-5.”[7]  In practical terms, under the misappropriation theory, individuals who come into possession of material, non-public information while providing services to corporate clients, such as the attorney in O’Hagan [8] may be held liable.

Joining Chiarella and O’Hagan in making up the traditional core of insider trading law is Dirks v. SEC.[9]  In Dirks, the Supreme Court attempted to set a limit on the scope of insider trading.[10]  Dirks was a securities analyst who learned from a former insurance company insider that the company was committing fraud and was on the verge of financial ruin.[11]  Dirks investigated and disclosed this information to several people, including a reporter and clients who traded on the information.[12]  Dirks was held liable for insider trading, but appealed.[13]  The overturning of Dirks’s liability centered on the fact that the corporate insider had disclosed the fraud to Dirks purely by a desire to expose the fraud, rather than to obtain any financial or other personal benefit.  The Court held:

In determining whether a tippee is under an obligation to disclose or abstain, it is necessary to determine whether the insider’s “tip” constituted a breach of the insider’s fiduciary duty.  Whether disclosure is a breach of duty depends in large part on the personal benefit the insider receives as a result of the disclosure.  Absent an improper purpose, there is no breach of duty to stockholders.  And absent a breach by the insider, there is no derivative breach.[14]

Furthermore, Dirks introduced the idea that a tippee has to be actually aware of the tipper’s breach or presented with sufficient facts so that the tippee will be deemed aware.  In this way, Dirks created a “personal benefit” element related to the tipper.  After Dirks, prosecutors were generally confident they could prove this benefit existed as long as there was a quid pro quo or a moderately close relationship between tipper and tippee.

Newman:  A Disruption

Chiarella, O’Hagan, and Dirks guided the law of insider trading largely uninterrupted for nearly 20 years.  Then came a decision from the Second Circuit, the so-called “Mother Court”[15] of securities law, but an underling of the Supreme Court, called U.S. v. Newman.[16]

Newman involved a hedge fund portfolio manager who was part of an information-sharing cohort of analysts and portfolio managers.[17]  By the time Newman received the tip, he was “four levels removed from the insider tippers,” (i.e., a remote tippee).[18]  The tippers were insiders at technology companies who had provided information to what the court termed “casual acquaintances,” who in turn passed those tips on.  Citing Dirks repeatedly for support, the U.S. 2nd Circuit Court of Appeals emphasized that government must prove the tipper received “a personal benefit” and that the tippee knew of that benefit.[19]

In Newman, the Second Circuit concluded that “the mere fact of friendship” was insufficient to give rise to the required personal benefit to the tipper.  Instead, the court required “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”  Despite the fact that the 2nd Circuit cited its adherence to Dirks in overturning Newman’s conviction, it was clear to all that by raising the bar for the evidence required to meet the Dirks “personal benefit” requirement, the opinion suggested a serious new limitation on insider trading law.  Moreover, the prosecutors were denied a rehearing en banc and a Supreme Court writ of certiorari.  This meant Newman would remain law in the most significant federal circuit for securities law until further notice.

One attorney called Newman “a well-deserved generational setback for the Government.”[20]  The predicted effect of Newman was that the government would be forced to prove that someone charged with insider trading knew that she was trading on non-public, material information and that “the tipper’s goal in disclosing information is to obtain money, property, or something of tangible value.”[21]  This heightened burden led to the reversal of more than a dozen insider trading convictions,[22] and pending cases were dropped.[23]

Salman:  The Expansive View of Insider Trading Strikes Back

Newman’s holding concerning what qualifies as a personal benefit to the tipper was reversed last week when the Supreme Court issued its opinion in Salman v. United States.[24]  Before the Supreme Court issued its opinion, in Salman, only the most ardent securities law gurus followed the case.  So, some background may be helpful.  Salman was convicted after trading on material, non-public information received from a friend, who had received the information from Salman’s brother-in-law.  Thus, Salman was prosecuted as a remote tippee.  He argued that he could not “be held liable as a tippee because the tipper (his brother-in-law, who worked on M&A matters at an investment bank) did not personally receive money or property in exchange for the tips.”[25]

In a strong rebuke, the Supreme Court held, “To the extent that the Second Circuit in Newman held that the tipper must also receive something of a “pecuniary or similarly valuable nature” in exchange for a gift to a trading relative, that rule is inconsistent with Dirks.[26]  Justice Alito succinctly explained “a tippee’s liability for trading on inside information hinges on whether the tipper breached a fiduciary duty” and that duty is breached “when the tipper discloses the inside information for a personal benefit.”[27]  Such a personal benefit can be inferred where the tip is made “to a trading relative or friend.”[28]

Why Salman Matters

By allowing a generous inference of a benefit to the tipper based on a personal relationship alone, the Supreme Court in Salman reestablished the old order of things – an expansive scope for insider trading prosecutions.  We understand that investment advisers are more likely than others to come into contact with corporate insiders, as well as those with whom corporate insiders speak in confidence.  You know these individuals as professionals, former schoolmates, and even friends and family members.  In discussing your work, it is quite possible that non-public, material information may be intentionally or inadvertently tipped to you.  Your livelihood and liberty may depend on how well you understand your legal obligations when that happens.  Fortunately, when you have questions about the rules regarding insider trading, we’re here to assist.

 

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices. Clay Wheeler is a partner in Kilpatrick’s Raleigh and Winston-Salem officesJohn Sanders is an associate based in the firm’s Winston-Salem office.

 

[1] Greg Stohr and Patricia Hurtado, The Supreme Court Will Hear Its First Insider-Trading Case in 20 Years, Bloomberg (Oct. 4, 2016), https://www.bloomberg.com/politics/articles/2016-10-04/wall-street-watching-as-u-s-high-court-tackles-insider-trading.

[2] 15 U.S.C. 78j (2016).

[3] 17 CFR 270.10b-5 (2016).

[4] Chiarella v. U.S., 445 U.S. 222 (1980).

[5] U.S. v. O’Hagan, 521 U.S. 642, 643 (1997).

[6] SEC v. Obus, 693 F.3d 276, 284 (2d Cir. 2012).

[7] O’Hagan, at 642.

[8] Id.

[9] Dirks v. SEC, 463 U.S. 646 (1983).

[10] Id. at 646.

[11] Id.

[12] Id.

[13] Id.

[14] Id. at 647.

[15] James D. Zirin, American Bar Association, The Mother Court: A.K.A., the Southern District Court of New York, http://www.americanbar.org/publications/tyl/topics/legal-history/the-mother-court-aka-southern-district-court-new-york.html

[16] U.S. v. Newman, 773 F.3d 438 (2d Cir. 2014)

[17] Id. at 443.

[18] Id.

[19] Id. at 450.

[20] Jon Eisenberg, How the United States v. Newman Changes the Law, Harvard Law School Forum on Corporate Governance and Financial Regulation (May 3, 2015), https://corpgov.law.harvard.edu/2015/05/03/how-united-states-v-newman-changes-the-law/.

[21] Salman v. U.S., available at https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0ahUKEwihloXYvu_QAhVBjpAKHflsCIIQFggjMAE&url=https%3A%2F%2Fwww.supremecourt.gov%2Fopinions%2F16pdf%2F15-628_m6ho.pdf&usg=AFQjCNGY28IXIk-a-h-Nuvi5EXSHC6XW6g&sig2=Ydo5oy44CzIMDuCxjMluzA&bvm=bv.141320020,d.eWE (The opinion presents and rejects this argument from Salman before stating that the rule from Newman is inconsistent with precedent)

[22] Greg Stohr and Patricia Hurtado, The Supreme Court Will Hear Its First Insider-Trading Case in 20 Years, Bloomberg (Oct. 4, 2016), https://www.bloomberg.com/politics/articles/2016-10-04/wall-street-watching-as-u-s-high-court-tackles-insider-trading.

[23] Patricia Hurtado, SAC Capital’s Steinberg Gets Insider Trading Charges Dropped, Bloomberg (Oct. 23, 2015), https://www.bloomberg.com/news/articles/2015-10-22/u-s-drops-charges-against-sac-capital-s-michael-steinberg.

[24] Salman, supra note 21.

[25] Id.

[26] Id.

[27] Id.

[28] Id.

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