On February 15, 2022 the US Securities and Exchange Commission (SEC) proposed sweeping changes to Rule 206(4)-2 (the Custody Rule) under the Investment Advisers Act of 1940 (Advisers Act), which would be redesignated as Rule 223-1 under the Advisers Act and retitled “Safeguarding Client Assets” (the Proposed Rule), as well as companion amendments to Rule 204-2 under the Advisers Act (the Recordkeeping Rule) and Form ADV under the Advisers Act (collectively, the Safeguarding Proposal).¹ While the SEC’s treatment of digital assets in the Safeguarding Proposal has attracted much of the public’s focus, the Safeguarding Proposal would have far broader impacts upon registered investment advisers, custodians, and auditors if enacted. Among other things, the Safeguarding Proposal would:

• expand the scope of assets subject to the Proposed Rule to encompass all assets regardless of whether they are funds or securities, including crypto assets, derivatives, and physical assets;
• greatly increase the number of investment advisers deemed to have custody of client assets by treating discretionary authority as a form of custody;
• require investment advisers to enter into contracts with qualified custodians holding their clients’ assets (qualified custodians) that include various specified terms;
• require investment advisers to obtain “reasonable assurances” in writing that qualified custodians will provide for certain “minimum investor protection elements” for their clients;
• require custodians to obtain internal control reports from independent auditors annually (regardless of whether they have related person custody) and provide them to the investment advisers who have custody of the client assets they maintain;
• narrow the scope of the Custody Rule’s exception for so-called “privately offered securities,” but also allow physical assets to qualify as “privately offered securities”;
• require investment advisers to maintain a host of new records relating to the custody of their clients’ assets pursuant to certain amendments to the Recordkeeping Rule; and
• require advisers to disclose additional information on Form ADV relating to their custody practices, including, among other things, their basis for having custody of client assets.

BACKGROUND

Since the SEC initially adopted the Custody Rule in 1962, it has amended the Custody Rule to expand the definition of custody to include situations in which an adviser has any ability to obtain possession of client funds or securities, as well as to cover instances in which an adviser is able to access client funds and securities through its related persons. After the SEC’s most recent amendments of the Custody Rule in 2009, Congress enacted the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Among other things, Dodd-Frank added new Section 223 to the Advisers Act, which granted the SEC explicit authority to promulgate rules requiring registered investment advisers to take steps to safeguard client assets over which advisers have custody, including assets other than funds and securities.

Since then, the SEC and its staff have focused on the application of the Custody Rule to certain practices and arrangements that, in their view, provide an investment adviser with the ability to access client assets, and have expressed their views as to whether those practices and arrangements amount to custody under the Custody Rule, including:

• standing letters of authorization (SLOAs); and
• agreements between custodians and clients that purport to provide an investment adviser with broader authority to access client assets than the authority granted in the client’s investment advisory agreement (so-called inadvertent custody).

The SEC staff has also solicited public comment on custody issues relating to transactions not settled on a delivery-versus-payment (DVP) basis and custody of digital assets. The staff noted that it was soliciting public comment in advance of proposing amendments to the Custody Rule. However, as we discuss below, the scope of the Safeguarding Proposal is far broader than SLOAs, inadvertent custody, digital assets and non-DVP settlement.

New Rule 223-1: Proposed Safeguarding Rule

In addition to re-designating the Custody Rule as new Rule 223-1, the Proposed Rule seeks to substantially revise many aspects of the current custody regime.

If adopted, the Proposed Rule would apply to all investment advisers registered or required to be registered with the SEC, and would significantly impact the qualified custodians and independent public accountants involved in the custody process with such investment advisers. Exempt reporting advisers, investment advisers otherwise exempt from registering with the SEC and the accounts of the non-US clients of registered offshore SEC-registered advisers (as well as State registered advisers) would continue to fall outside of the scope of the Advisers Act custody rules.

Expanded Scope of Assets Subject to the Proposed Rule’s Provisions

The Proposed Rule would expand the scope of assets subject to safekeeping with a qualified custodian, beyond the “client funds and securities” contemplated in the current Custody Rule to include “funds, securities, or other positions held in a client’s account.”² In discussing this potential expansion, the SEC indicated its desire to include “novel or innovative asset types” in the scope of custody, thus incorporating a growing number of assets that currently fall outside the Custody Rule’s scope (including cryptocurrency, bank deposits, real estate assets, physical commodities, artwork, and swaps, among others).³ The proposal would even encompass holdings that clients would not record as an asset on their balance sheets, such as short positions and certain options, as well as holdings that would be recorded as liabilities, such as negative cash.⁴

Revisions to Privately Offered Securities Exception

The Safeguarding Proposal seeks to acknowledge the difficulties arising from technological changes in custodial practices as they pertain to uncertificated securities. The SEC argues that market developments – particularly the expansion of uncertificated securities and custodians’ development of enhanced safeguarding and reporting practices – mean that there is no longer a need to categorically exclude privately offered securities from the requirement that they be maintained with a qualified custodian.⁵ Instead, the Proposed Rule would limit the exception to only those assets that the adviser “reasonably determines . . . cannot be recorded and maintained by a qualified custodian.”⁶ As proposed, should the adviser affirmatively make this threshold determination, it must then reasonably safeguard the asset(s) and notify its independent public accountant within one business day.⁷ The independent public accountant must then confirm that the transfer occurred, and if any discrepancy is found, notify the SEC.⁸ Also notable, the Proposed Rule’s privately offered securities exception would also be made available in connection with physical assets that cannot be maintained with a qualified custodian, such as real estate, artwork and commodities.

“Discretionary Authority to Trade” As Custody

In addition to expanding the scope of assets subject to safekeeping with a qualified custodian, the Proposed Rule also seeks to expand the definition of custody to encompass “any arrangement (including, but not limited to, a general power of attorney or discretionary authority) under which [an] adviser is authorized or permitted to withdraw or transfer beneficial ownership of client assets upon the adviser’s instruction.”⁹ The Proposed Rule would define “discretionary authority” or “discretionary authority to trade” as the authority to decide which assets to purchase and sell for the client. The SEC’s historical position is that an adviser’s authority to decide what securities to buy and sell or even issue instructions to a broker-dealer or custodian to make or settle trades does not constitute “custody” for purposes of the Custody Rule.

The Proposed Rule provides that the surprise audit requirements would not apply in connection with client assets over which an adviser has discretionary authority, but which settle on a DVP basis.

Exceptions from the Surprise Examination Requirement – Entities Subject to Audit

The Custody Rule currently exempts from the scope of the surprise audit requirement limited partnerships, limited liability companies, or other types of pooled investment vehicles that obtain a financial statement audit from a PCAOB-registered independent public accountant at least annually, and that distribute their US GAAP-audited financial statements to their investors at least annually. The Proposed Rule would expand this exemption to encompass all entities. Financial statements would be required to be distributed to investors or their representatives within 120 days (or 180 days in the case of a fund of funds or 260 days in the case of a fund of funds of funds) of an entity’s fiscal year-end. The Proposed Rule would also require the auditor and the entity to enter into a written agreement requiring the auditor to notify the SEC upon the auditor’s termination or issuance of a modified opinion.

Amendments to Qualified Custodian Practice Standards

In addition to new requirements that would apply to investment advisers, the Proposed Rule would indirectly impose new requirements on qualified custodians. While those institutions that currently serve as qualified custodians could continue to do so under the Proposed Rule, the Proposed Rule would impose new requirements on foreign financial institutions in order to serve as qualified custodians and would restrict the practice of “accommodation reporting” of assets not held by the qualified custodian.

Foreign Financial Institution Qualification Requirements

The Custody Rule provides that a foreign financial institution (FFI) may serve as a “qualified custodian” on the condition that the FFI keeps the advisory clients’ funds and securities in accounts that are segregated from the FFI’s proprietary assets.¹⁰ The Proposed Rule would impose seven new conditions on FFIs to qualify as “qualified custodians,” drawing from the conditions applicable to “eligible foreign custodians” under Rule 17f-5 under the Investment Company Act of 1940, as amended. Under the Proposed Rule, an FFI would be able to operate as a “qualified custodian” only if it:

• is incorporated or organized under the laws of a country or jurisdiction other than the United States, provided that the investment adviser and the SEC are able to enforce judgments, including civil monetary penalties, against the FFI;
• is regulated by a foreign country’s government, an agency of a foreign country’s government, or a foreign financial regulatory authority as a banking institution, trust company, or other financial institution that customarily holds financial assets for its customers;
• is required by law to comply with anti-money laundering and related provisions similar to those of the Bank Secrecy Act and the regulations promulgated thereunder;
• holds financial assets for its customers in an account designed to protect such assets from creditors of the FFI in the event of its insolvency or failure;
• has the requisite financial strength to provide due care for client assets;
• is required by law to implement practices, procedures, and internal controls designed to ensure the exercise of due care with respect to the safekeeping of client assets; and
• is not operated for the purpose of evading the provisions of the Proposed Rule.

Maintaining Custody

The Proposed Rule highlights the practice of “accommodation reporting,” a growing custodial practice of including client assets on client statements without the qualified custodian retaining actual possession or control. If a client requests such assets be included on its account statement, the account statement may identify the assets, but only if the account statement clearly indicates that the custodian does not have possession or control of the assets. Otherwise, these assets would not be permitted to be included on an account statement.

The Proposed Rule would deem a qualified custodian to “maintain” custody only over assets it possesses or controls, which is further defined to mean “holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets.”¹¹ The Proposed Rule notes this definition “would formalize [the commonly held] understanding” of what it means to maintain assets with a qualified custodian while also addressing concerns related to custody of crypto assets, which frequently trade on platforms that require investors to pre-fund their trades.¹²

Minimum Custodial Protection Provisions

In a departure from the current regulatory regime, the Proposed Rule would require investment advisers to maintain their clients’ assets with a qualified custodian pursuant to a written agreement with the custodian. This would also represent a departure from current market practice, where an adviser is often not a party to the custody agreements between the custodian and the investment adviser’s clients. Additionally, while the current Custody Rule and the guidance promulgated thereunder do not address required provisions in custody agreements, the Proposed Rule would require that custody agreements contain four provisions:

• a requirement  that the custodian “provide promptly, upon request, records relating to the clients’ assets held in the account at the qualified custodian” to the SEC or auditors conducting examinations in keeping with the Proposed Rule;
• a specification regarding the investment adviser’s level of authority to effectuate transactions in its client’s account;
• a requirement that the custodian provide account statements to both the investment adviser and its client on whose behalf the custodial account is kept; and
• a requirement that the custodian annually obtain and provide to the adviser a written internal control report containing the opinion of an independent public accountant regarding the adequacy of the custodian’s controls.

The Proposed Rule would also require the investment adviser to arrive at a reasonable belief that the qualified custodian has implemented these provisions from the required agreement.

Beyond these provisions, the Proposed Rule would also require an investment adviser to obtain from the qualified custodian “reasonable assurances” in writing, and maintain an ongoing reasonable belief of compliance with such reasonable assurances, that the qualified custodian responsible for maintaining the client’s assets will provide for certain “minimum investor protection elements” for advisory clients, including that the custodian will:

• exercise due care (in accordance with reasonable commercial standards) in discharging its duty as custodian, and implement appropriate measures to safeguard client assets from theft, misuse, misappropriation, or other, similar types of losses;
• indemnify the client against losses caused by the qualified custodian’s negligence, recklessness, or willful misconduct;
• not be excused from its obligations to the client as a result of any sub-custodial or other similar arrangement;
• clearly identify and segregate client assets from the custodian’s assets and liabilities;
• not subject client assets to any right, charge, security interest, lien, or claim in favor of the qualified custodian or its related persons or creditors, except to the extent agreed upon or authorized by the client in writing; and
• keep records related to the client’s assets.

Rule 204-2: Proposed Revisions to Recordkeeping Requirements

In addition to the amendments set forth in the Proposed Rule, the proposal sets forth amendments to the Recordkeeping Rule that would require investment advisers to maintain certain records related to custody of client accounts. These records include the following:

• client account identification;
• custodian information, including copies of qualified custodian agreements with the adviser, a record of required reasonable assurances from the qualified custodian, and, if applicable, a copy of the adviser’s written reasonable determination that ownership of certain specified client assets cannot be recorded and maintained under a qualified custodian’s possession or control;
• the basis for the adviser having custody of client assets in the account;
• any account statements received or sent by the adviser;
• transaction and position information; and
• any SLOAs and related records to verify that an adviser can avail itself of the proposed exception to the surprise examination requirement contained in the current Custody Rule.

In addition to the above, the amendments would require the investment adviser to maintain copies of all written notices to clients required under the Proposed Rule, as well as any responses thereto. Each document would be required to be maintained in the same manner and for the same duration as all other books and records which are kept pursuant to Rule 204-2(a).

Form ADV

Finally, the proposal also seeks to amend Form ADV to align investment advisers’ reporting obligations with custodial practices, as well as to improve the accuracy of custody-related data available to the public. Specifically, the proposal would amend Form ADV Part 1A, Schedule D, as well as the Instructions and Glossary of Form ADV, to conform the language contained in the Form ADV to that of the Proposed Rule. The proposal would require investment advisers to indicate the reason(s) that they have custody and would require advisers to report on Form ADV if they are relying on any exceptions to the Proposed Rule in their maintenance of client assets with a qualified custodian (e.g., the privately offered securities exception) and, if so, to identify the applicable exception.

CONCLUSION

The Safeguarding Proposal, if adopted as proposed, would have far-reaching impacts – some of which the SEC appears to have intended and others of which the SEC may not have intended.

• The expansion of the definition of custody to encompass discretionary authority would markedly increase the number of investment advisers who are deemed to have custody of client assets.
• There is no evidence that custodians will be willing to enter into agreements or provide investment advisers with the assurances contemplated in the Proposed Rule.
• There does not appear to be a workable solution for the custody of digital assets.
• The role of independent accountants would significantly increase.

Comments on the Proposed Rule and related proposed amendments are due May 8.

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