The SEC Proposes Big Changes to the Custody Rule
Although many financial professionals would agree that the Advisers Act Custody Rule (Rule 206(4)-2) could use revision, the U.S Securities and Exchange Commission’s (SEC's) latest proposal is probably not what they hoped for. Responding to changes in "technology, advisory services, and custodial practices," the SEC’s proposal expands the current rule’s coverage to all client assets where the adviser has custody, including crypto and digital assets, real estate, loans, and derivatives. The proposed rule, if adopted, applies to registered investment advisers. Exempt reporting advisers and the accounts of non-U.S. clients of registered offshore advisers are excluded.
Custodians must provide greater protections
The proposal redesignates Rule 206(4)-(2) as Rule 223-1 and renames it the “Safeguarding Rule.” Like the existing rule, the Safeguarding Rule requires that investment advisers maintain client assets with a qualified custodian, and the custodian must have “possession or control” of the assets. The types of institutions traditionally serving as qualified custodians will not change; however, those institutions must hold client assets in segregated accounts "designed to protect such assets from creditors" of the custodian in the event of insolvency or failure. Additionally, foreign financial institutions can only serve as qualified custodians if they meet more robust requirements, such as oversight by governmental regulatory authorities, the ability to segregate custodied assets, submission to U.S. jurisdiction, and compliance with anti-money laundering regulations. These new requirements are similar to those required under Rule 17f-5 of the Investment Company Act.
Crypto assets left between a rock and a hard place
As Commission Chair Gary Gensler noted, the proposal "would cover all crypto assets—including those that currently are covered as funds and securities and those that are not funds or securities." By including all crypto assets, the new rule prevents advisers from trading crypto assets on existing platforms since many do not meet the requirements to act as qualified custodians. Gensler stated, “these platforms have commingled those assets with their own crypto or other investors' crypto. When these platforms go bankrupt—something we've seen time and again recently—investors' assets often have become property of the failed company, leaving investors in line at the bankruptcy court.”
But the rule proposal also imposes additional requirements on "qualified custodians," including having exclusive possession and control over assets. This can be a problem with crypto assets since, in some cases, the client and the custodian have access to the private key and can both affect transactions. The SEC did not address this issue in the proposal.
Agreements between custodians and advisers
But the SEC did not stop with crypto. The proposal imposes an unprecedented condition for compliance that advisers enter into written agreements with qualified custodians. The agreement must (i) require the custodian to provide client records promptly to the SEC or an independent public accountant conducting an annual audit, (ii) require the custodian to provide the adviser with an internal control report annually, and (iii) specify the adviser's authority to effect transactions in the account. Custodians must also provide “reasonable assurances” that they will comply with the client protections required under the proposed role, including keeping custodial assets in accounts segregated from the custodian’s proprietary assets and liabilities. The custodian will also have to agree to indemnify the client for losses resulting from the custodian’s negligence. Interestingly, the SEC estimated that "each investment adviser and each qualified custodian that enters into an agreement would incur an internal burden of 1 hour each to prepare the written agreement.”
More work for independent public accountants
The proposal also expanded the definition of custody by explicitly stating that an adviser with discretionary trading authority has custody. Consequently, advisers with discretion must undergo an annual surprise examination by an independent public accountant to verify client assets. The proposed rule, however, provides a limited exemption from the surprise examination requirement for advisers whose discretionary authority is limited to trading in assets that settle exclusively on a delivery versus payment (DVP) basis and are maintained with a qualified custodian. The proposal does not include an exception for advisers with separately managed accounts that hold non-DVP assets such as loans or privately offered securities. These advisers will need a surprise examination or annual audit of these assets. Interestingly, the proposal does not address prime brokerage arrangements, which work similarly to DVP arrangements.
For private fund advisers, the audit exception is still available. Under the proposal, however, the audit provision is available for "entities" and private funds (e.g., separately managed accounts). Moreover, there is a new requirement that the auditors must agree to promptly notify the SEC of an audit report that contains a modified opinion, resignation or dismissal or other termination of the engagement of the accountant.
As previously discussed, the proposal states that an adviser with "discretionary authority" to trade client assets has custody. But discretionary advisers can rely on an exception from the surprise examination requirement if (i) the client assets are maintained with a qualified custodian and (ii) their authority is limited to instructing the custodian to trade assets to settle exclusively on a DVP basis. The proposal also retains the Custody Rule's exceptions from the surprise examination requirement for firms that have custody solely because they deduct fees from client accounts and where an adviser’s related person has custody but is operationally independent. But can an adviser have more than one “sole basis” for custody and still rely on the exemption from a surprise examination, or are they mutually exclusive? For example, the adviser has discretionary authority to trade DVP securities and deducts its fees directly from the client's accounts. According to the proposal, the adviser can do both and rely on the surprise examination exemption.
Similarly, advisers that have custody because of a standing letter of authorization (SLOA) could also claim an exemption from the surprise examination requirement under the proposal. The exemption requires that the SLOA meet certain requirements, including the client’s written authorization allowing the adviser to direct the qualified custodian to transfer assets to a third-party recipient on a specified schedule.
Exemptions for privately offered securities and physical assets
In the proposal, the SEC acknowledges that some assets cannot be maintained with a qualified custodian, including privately offered securities and physical assets. Accordingly, the proposed rule provides an exception to the qualified custodian requirement for those types of assets, provided that the adviser can “reasonably determine” and document that asset ownership cannot be recorded and maintained by a qualified custodian. To make this determination, the SEC suggests that the adviser "obtain a reasonable understanding of the marketplace of custody services available for each client asset for which it has custody." Of course, at the same time, the SEC recognizes that the marketplace for custodying such assets may be underdeveloped.
The proposal leaves many open questions for investment advisers about how they can "reasonably determine" that a qualified custodian is incapable of maintaining custody of such assets since the proposal does not discuss how to achieve custody. For example, in the case of real assets or uncertificated private securities, would custody be achieved by holding evidence of the original ownership documentation (such as a real estate deed or LLC operating agreements) with a qualifying custodian? The SEC has historically approved this approach under the custody rule (FAQ, Question VII.2,) where the SEC said that an adviser could satisfy the Custody Rule by keeping the originally signed subscription agreement (instead of the security itself) with a qualified custodian or having the custodian act as nominee for the limited partnership.
For the assets not being held by a qualified custodian, the adviser must safeguard them from theft, misuse, misappropriation, or financial reversals, including the adviser's insolvency. Finally, the adviser must also engage an independent public accountant to verify the existence of the assets by either a surprise examination or audit. As part of the engagement, the adviser must notify the accountant of any asset purchase, sale, or transfer of beneficial ownership within one business day. The adviser must also notify the independent public accountant of any purchase, sale, or other transfer of beneficial ownership of these assets within one business day so the accountant can verify the transaction. In addition, the independent public accountant must notify the Division of Examinations within one business day after finding any "material discrepancies" while performing its procedures.
The proposal also includes amendments to Advisers Act Rule 204-2, the books and records rule, requiring advisers to maintain more detailed records of trade and transaction activity and Form ADV.
The SEC will accept comments on the rule proposal for 60 days after its publication in the Federal Register.
How we help
We can help you to navigate the evolving regulatory landscape while considering the complexity of your firm’s unique compliance requirements. Our advisory team can assist you with developing and maintaining your compliance manual, policies, and procedures for a range of topical challenges.
For more information about the SEC’s proposed changes to the Custody Rule, or how ACA can help you comply with the updated requirements, please contact your ACA consultant or contact us here.