On February 15, 2023, the US Securities and Exchange Commission (the 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 Safeguarding Proposal). The Safeguarding Proposal, if adopted, would have broad and far-reaching impacts on registered investment advisers and custodians – with provisions that would fundamentally alter the typical custodial relationship.

The narrative surrounding the Safeguarding Proposal has focused on the SEC’s continuing attempts to bring digital assets, and the entities that interact with them, under the umbrella of the SEC’s jurisdiction. Despite this narrative, certain of the Safeguarding Proposal’s provisions present a different, and perhaps more broadly impactful jurisdictional grab by the SEC over qualified custodians, such as federal and state chartered banks and trust companies, that are not subject to its jurisdiction.

Proposed written agreement and reasonable assurances requirements

The SEC’s jurisdictional grab over entities such as banks and trust companies emanates from proposed requirements for those registered investment advisers deemed to have custody of client assets, to enter into a written agreement with certain specified terms with the custodian of those assets, and receive certain “reasonable assurances” from the custodian. These provisions represent a substantial departure from the current regulatory regime, where a registered investment adviser is not required to enter into a written agreement with a custodian, and current market practice, where the adviser is often not a party to the custody agreements between the custodian and the investment adviser’s clients.

Under the Safeguarding Proposal, custodial agreements between an investment adviser and a custodian would be required to 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.

Beyond these provisions, the Safeguarding Proposal 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.

Jurisdictional overreach

The SEC derives its authority for rulemaking concerning the custody of client assets from Section 223 of the Advisers Act, which was adopted in 2009 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Section 223 states, “[a]n investment adviser registered under this subchapter shall take such steps to safeguard client assets over which the adviser has custody, including, without limitation, verification of such assets by an independent public accountant, as the Commission may, by rule, prescribe.” Even given this broad mandate, the Safeguarding Proposal appears to overstep the authority granted by Congress in Section 223 by attempting to indirectly regulate entities outside of the SEC’s jurisdictional purview.

The primary example of the SEC overstepping its authority comes from the written agreement and reasonable assurances requirements, which represent the SEC’s attempt to exert influence over entities outside of its jurisdictional scope (i.e., banks and trust companies) by mandating that those entities enter into contracts with entities within its jurisdictional scope (i.e., registered investment advisers). The SEC mandating that two private parties, who have historically not been in contractual privity, enter into a contractual agreement with certain specified terms is, by itself, remarkable. It is even more remarkable considering that many entities that operate as “qualified custodians” do not operate under the jurisdiction of the SEC and, instead, are subject to robust regulation by other federal and state regulatory bodies.

For example, a large portion of custodied assets are held by federally chartered banks and trust companies, which are regulated by the Office of the Comptroller of the Currency (OCC). The OCC has a well-developed and stringent regulatory regime that governs federally chartered banks and trust companies. On the subject of custody, the OCC has issued a “Comptroller’s Handbook” titled “Custody Services” (the OCC Custody Handbook), which provides substantial guidance to OCC-regulated entities providing custody services. OCC examiners use this handbook in connection with their regular examination of OCC-regulated entities’ custody services.

The Proposing Release to the Safeguarding Proposal acknowledges some of the regulations that federally chartered banks and trust companies are subjected to under the purview of the OCC, including requirements that they: (1) exercise proper control over custodied securities; (2) have adequate systems in place to identify, measure, monitor, and control the risks of custody services; (3) maintain policies, procedures, internal controls, and management information systems governing custody services; and (4) maintain controls to ensure that assets of each custody account are kept separate from the assets of the custodian and maintained under joint control to ensure that assets are not lost, destroyed, or misappropriated by internal or external parties.

It should be noted that through amendments to the Advisers Act enacted as part of Dodd-Frank, Congress provided the SEC with limited authority to examine and/or make document requests of persons having “custody or use of the securities, deposits, or credits of a client.” This authority, found in Section 204(d) of the Advisers Act, is limited by the fact that custodians subject to regulation by other regulatory agencies (such as federally chartered banks) can satisfy “any examination request, information request, or document request” by providing the SEC with a “detailed listing, in writing, of the securities, deposits, or credits of the client within the custody” of the custodian. While Section 204(d) of the Advisers Act provides the SEC with a toehold into institutions outside of its jurisdictional purview, it falls far short of the type of regulatory authority that the SEC is attempting to assert through the Safeguarding Proposal.

Takeaways

While the precise impacts of the Safeguarding Proposal are impossible to predict, it is highly likely that the inclusion of the written agreement and reasonable assurances requirements would have a substantial and detrimental impact on the custody market. Chief among these impacts is higher custodial fees, which will be passed on directly to the investor. As one example of many as to why custodial fees would likely rise, the proposal would require qualified custodians to provide reasonable assurances to advisers that the qualified custodian would indemnify advisory clients against losses caused by the qualified custodian’s negligence, recklessness, or willful misconduct.

Providing this written “reasonable assurance” would require qualified custodians to incur costs to review their current custody agreements with their clients to consider whether the indemnification “reasonable assurance” conflicts with those agreements. Further, by expressly agreeing to indemnify clients, qualified custodians would be taking on additional risk – which would likely cause them to charge higher custodial fees to account for that risk. Finally, some custodians could decide to forego providing custody services entirely, or to smaller clients, as a result of the increase in risk. The Proposing Release acknowledges this consequence, noting that the written agreement and reasonable assurances requirements could “increase compliance costs” which “could cause some qualified custodians to exit the market.” It further notes that “[a] decrease in the number of qualified custodians could, in turn, lead to reduced competition, increased custodial fees, or both.”

Further, there is an inherent problem with a regulatory body such as the SEC mandating that two parties, who have not historically been in contractual privity, enter into a contract that contains certain, specified contractual provisions. These problems are heightened when the parties are subject to different regulatory regimes (such as is the case, for example, with a registered investment adviser and a federally chartered bank).

By way of example, to consider just one potential issue - among the “reasonable assurances” requirements, a qualified custodian would be required to “exercise due care in discharging its duty as custodian, and implement appropriate measures to safeguard client assets from theft, misuse, misappropriation, or other, similar types of losses.” What is “due care”? What are “appropriate measures to safeguard client assets?”

The OCC has its own interpretation of these requirements, which are laid out in detail in the OCC Custody Handbook. What will happen when the SEC issues interpretive guidance and/or brings an enforcement action against an adviser, in which it opines that “due care” in this context means something different than is currently mandated by the OCC? The SEC will have no mechanism to enforce its interpretation against an entity that it does not regulate. Does an adviser have to reconsider its custody arrangements each time the SEC brings an enforcement action under the proposed safeguarding rule?

Conclusion

The Safeguarding Proposal, if adopted, would fundamentally change the relationship between registered investment advisers and custodians. The SEC’s proposed indirect imposition of the “written agreement” and “reasonable assurances” requirements on custodians outside of its jurisdictional scope (such as federally chartered banks and trust companies) would likely have many unintended consequences – such as less competition in the custodial market and higher custodial fees for customers. While the exact implications are impossible to predict, custodians should monitor the rulemaking closely as it moves through the comment and review period.

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