Articles & Alerts
SEC Proposes Sweeping Changes to the Custody Rule for Investment Advisers
On February 15, 2023, the SEC voted 4 to 1 to propose to amend and redesignate Rule 206(4)-2 (the current “Custody Rule”) as new Rule 223-1 (the Proposed Rule) under the Investment Advisers Act of 1940. Last amended in 2009, the Custody Rule is designed to protect advisory clients from the misuse or misappropriation of their funds and securities. The Custody Rule requires registered investment advisers who have custody of client funds or securities to implement an enumerated set of requirements, including, among other things, generally maintaining client funds and securities with a qualified custodian.
The new proposed “Safeguarding Rule” introduces a number of significant amendments that the SEC characterizes as designed to enhance investor protections and account for changes in technology, advisory services and custodial practices in the years since the current Custody Rule was last amended. A summary of key changes of the Proposed Rule are listed below.
Expand the current Custody Rule to apply to all client “assets” and not only client “funds and securities.”
Currently, the Custody Rule applies to a client’s “funds and securities” held in an advisory account. The Proposed Rule would expand the scope of the current Custody Rule beyond client “funds and securities” to include “other positions held in the client’s account,” thus capturing the entirety of a client account’s positions, holdings, and investments including crypto assets as well as physical assets such as real estate, artwork, and physical commodities. By expanding the scope of the rule to include client assets instead of only client funds and securities, the SEC believes that the Proposed Rule provides the proper balance, enabling investment advisers to provide advisory services regarding novel or innovative asset types with the need to ensure that such assets are properly safeguarded.
Create extensive new requirements for advisers and qualified custodians (including entry into written agreements with prescriptive requirements).
Currently, the Custody Rule requires an adviser with custody over client assets to ensure that a qualified custodian “maintains” the assets of their clients. The Proposed Rule clarifies what it means for an adviser to “maintain” assets with a qualified custodian. While the Proposed Rule, like the Custody Rule, “entrusts the safekeeping of client assets to a qualified custodian,” it would deviate from the existing Custody Rule in that “a qualified custodian does not ‘maintain’ a client asset for purposes of the rule if it does not have ‘possession or control’ of that asset.” The Proposed Rule would further define “possession or control” to mean holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets. It would also require written agreements with, and receive certain assurances from, the qualified custodian.
Require minimum contractual protections for advisory clients in required written agreements
In a change from the current Custody Rule, the Proposed Rule would require an adviser to enter into a written agreement with, and obtain assurances in writing from, the qualified custodian to ensure the qualified custodian provides certain standard custodial protections when maintaining client assets. It would specifically require the adherence to two new provisions, one requiring the qualified custodian to provide client records promptly to the commission or independent public accountant. The second provision would require the qualified custodian to specify the level of authority in effect for transactions in an account. The SEC indicated that these requirements “do not prescribe specific safeguarding procedures or require that client assets be maintained in a particular manner.” Rather, they are designed to serve as guardrails that would apply irrespective of the type of asset or the type of financial institution acting as a qualified custodian.
Introduce significant new requirements to the exception for privately offered securities and extend the exception to certain physical assets that would be covered under the Proposed Rule’s expanded scope.
The Proposed Rule would modify the current Custody Rule’s exception from the obligation to maintain client assets with a qualified custodian for certain privately offered securities. First, it would be expanded to include certain physical assets. Second, it would be narrowed so that the adviser could rely on the exception only if (1) the adviser reasonably determines that ownership cannot be recorded and maintained by a qualified custodian, (2) the adviser reasonably safeguards the assets, (3) the adviser notifies the independent public accountant engaged to perform the verification of any asset transfer within one business day, (4) the independent public accountant verifies asset transfers and notifies the SEC upon the finding of any material discrepancies, and (5) the existence and ownership of the assets are verified during an annual independent verification or as part of an independent financial statement audit.
Expand the definition of “custody” to include discretionary authority
The Proposed Rule would explicitly include discretionary authority within the definition of “custody.” Under the current Custody Rule, a registered investment adviser does not have “custody” over the assets of its clients if it merely possesses the “authority to issue instructions to a broker-dealer or a custodian to effect or to settle trades.” Based on this, an adviser currently has broad authority to effect direct purchases or sales of client assets that may not involve a qualified custodian, such as loan participation interests. The Proposed Rule would, however, continue to provide exceptions to the surprise examination requirements when the adviser’s sole reason for having custody is because it has discretionary authority or because the adviser is acting according to a standing letter of authorization, each subject to certain conditions. It would also expand the scope of who can avail themselves of the exception by expanding the type of entities covered.
The proposal also includes related amendments to the rule governing books and records required to be maintained by advisers, and to Form ADV regarding advisers’ reporting obligations in line with the proposed Safeguarding Rule’s requirements. The proposed compliance transition period following adoption of the rule would be one year for large advisers, or 18 months for advisers with under $1 billion in regulatory assets under management.