SEC Exempt, Virginia Required: What RIAs with SLOAs Need to Know About Surprise Custody Exams

Virginia’s custody rule may require surprise exams for investment advisers with standing letters of authorization, even when SEC relief applies

Many advisers believe standing letters of authorization (SLOAs) do not trigger a surprise custody exam. At the federal level, that is often true. At the state level, it may not be, and Virginia is a clear example. We are seeing an uptick in Virginia-related custody inquiries and exam requests, including from advisers who follow U.S. Securities and Exchange Commission (SEC) guidance carefully.

What the SEC custody rule requires

Under the SEC Custody Rule (Rule 206(4)-2), an adviser with custody must keep client assets with a qualified custodian. It must also have a reasonable basis to believe the custodian sends clients statements at least quarterly.

The adviser must also have an independent public accountant verify the client assets at least once each calendar year. The accountant picks the date without telling the adviser in advance, and the timing has to vary from year to year. The first exam must happen within six months of the adviser becoming subject to the requirement.

What the SEC says about SLOAs

An SLOA is a written instruction a client gives to their custodian. It authorizes the adviser to send the client’s money to a third party the client has named. The client sets it up, the adviser’s authority is limited by its terms, and the client can change or cancel it at any time.

In its February 21, 2017, no-action letter to the Investment Adviser Association, SEC staff said that an adviser acting under an SLOA has custody and must comply with the custody rule. However, staff said they would not recommend enforcement action against an adviser who does not get a surprise exam, as long as all seven of these conditions are met:

1. The client gives the custodian a signed written instruction that includes the third party’s name and either the third party’s address or account number.
2. The client authorizes the adviser in writing to direct transfers to that third party, either on a schedule or from time to time.
3. The custodian verifies the instruction, for example with a signature review, and notifies the client promptly after each transfer.
4. The client can end or change the instruction.
5. The adviser has no authority to name or change the third party or any of the third party’s details.
6. The adviser keeps records showing the third party isn’t related to the adviser and isn’t at the adviser’s address.
7. The custodian sends the client an initial written notice confirming the instruction and an annual notice reconfirming it.

Advisers relying on this relief still have custody. They must include these assets in their Form ADV, Item 9 response. Some SLOAs do not create custody at all. If the adviser has no discretion over the amount, payee and timing of transfers, the SLOA does not implicate the custody rule.

The letter states SEC staff’s position on enforcement only and doesn’t give a legal conclusion.

How Virginia’s surprise custody exam requirements differ

Virginia has its own custody rule for investment advisers registered or required to be registered in Virginia: 21VAC5-80-146.  (Virginia uses the spelling “advisor”). Like the SEC rule, Virginia defines custody to include any arrangement, including a general power of attorney, that lets the adviser withdraw client funds held at a custodian on the adviser’s instruction. An adviser with custody must have an independent Certified Professional Accountant (CPA) verify client funds and securities at least once each calendar year, through an actual exam on a date the CPA chooses without notice.

The rule lists specific exceptions, such as direct fee deduction (with itemized client invoices), audited pooled vehicles, and certain family-related trustee roles. There is no exception for SLOAs.

The Virginia rule took effect June 3, 2013, before the SEC staff issued its 2017 SLOA letter. The CPA must file Form ADV-E with the Virginia State Corporation Commission within 120 days of the exam date. The CPA must also notify the Commission within one business day of finding any material discrepancy.

Virginia is not alone. State custody rules vary, so advisers registered outside Virginia should check their own state’s requirements.

Who this applies to

Generally, advisers with less than $100 million in regulatory assets under management register with their state, and advisers with more than $110 million register with the SEC. Virginia’s rule applies to Virginia-registered advisers.

What the exam looks like

A surprise exam is less disruptive than many advisers expect. At a high level, the CPA selects a date, confirms client balances with the custodian and, when necessary, directly with clients, and compares the results to your records. After the first year, it becomes a routine part of the annual compliance calendar.

How Keiter can help

Keiter is a PCAOB-registered firm that performs custody exams for SEC- and state-registered RIAs of all sizes, from boutique firms with a few accounts under custody to national firms with thousands. If you have received a custody letter from Virginia or another state or are not sure whether your SLOAs require an exam, contact us. We can usually get you engaged and scheduled quickly. Contact your Keiter Opportunity Advisor or reach out to our Surprise Custody Examination team. Email|Call 804.747.0000.

For more background, see The SEC Custody Rule and Frequently Asked Questions About the SEC Custody Rule.