SEC Proposes Significant Expansion of the Advisers Act Custody Rule

The SEC proposed to significantly amend and redesignate IAA Rule 206(4)-2 ("Custody of Funds or Securities of Clients by Investment Advisers"), expanding its requirements. The proposal also amends related recordkeeping and reporting obligations.

The SEC stated that the proposed rule changes will better protect customer assets managed by registered investment advisers. One of the proposed changes is to the current rule which covers only "funds and securities." The proposed rule would cover all "positions held in a client account" - thereby bringing in such previously excluded assets such as real estate and other physical assets, digital assets and derivatives - to the extent that the adviser has certain authorities over the account.

Additionally, under the proposed rule the authorities that constitute custody will explicitly include any discretionary trading. While the proposed rule includes some exceptions from certain requirements that could facilitate application of the rule to such asset classes, if adopted in its proposed form it will no longer be the case that certain types of assets are entirely out of scope.

Proposed Rule

The proposed changes are intended to require the safekeeping of virtually all client assets by "qualified custodians" - a term that generally includes U.S. financial institutions and certain foreign financial institutions - at all times (including during the trade settlement process). The rule would apply to (i) customer assets that are not funds or securities, such as commodities and works of art, as well as (ii) assets that the SEC has said are generally securities but that it generally does not permit to be held by a broker-dealer, such as cryptocurrencies.

In order to encourage what the SEC views as sound and investor-friendly custodial practices, the proposed rule would require any adviser that has custody of client assets to enter into an agreement with the clients' custodians. The current practice is generally that the adviser is not a party to client custody arrangements. Such agreements will impose significant burdens on custodians, including:

• an undertaking to provide records to the SEC or to an independent accountant for an audit, examination or control report;
• an undertaking to provide quarterly (or more frequent) account statements to the client and to the adviser;
• an undertaking to hire an independent public accounting firm to prepare a written control report annually;
• specifying the agreed level of authority that the adviser will have over client accounts, and providing the adviser and the client the ability to reduce that authority;
• providing reasonable assurances that the custodian will exercise due care and implement appropriate safeguarding procedures;
• indemnifying clients in the event of the custodian's negligence, recklessness or willful misconduct (and maintaining appropriate insurance);
• retaining responsibility for obligations notwithstanding any sub-custodial, securities depository or similar arrangements;
• identifying and segregating client assets separate from proprietary assets and liabilities; and
• prohibiting any liens or claims in favor of the custodian or its affiliates or creditors, except as agreed to or authorized by the client.

Recognizing there are some assets (e.g., physical assets and uncertificated securities) that cannot be readily subjected to possession or control, the rule will provide an exception from the requirement that such assets be maintained at all times with a qualified custodian.

In order to avail itself of the exemption, an adviser must (i) determine and document that ownership cannot be recorded and maintained in a manner that is consistent with custody by a qualified custodian; (ii) reasonably safeguard the assets from loss or the adviser's insolvency; (iii) inform an independent public accountant of any transfers within one day of transfer and obtain verification of each transfer from that independent public accountant; and (iv) have the existence and ownership of such assets verified through a surprise examination or financial statement audit.

Other notable proposed changes include:

• expansion of the types of entities which can be subject to a financial statement audit in lieu of a surprise examination;
• new recordkeeping requirements; and
• Form ADV amendments to align with the proposed rule and provide more specific custody related data to the SEC, its staff and the public.

Commissioner Statements

SEC Commissioner Caroline A. Crenshaw supported the proposal's effort to align the custody rule with evolving industry practices to better protect investors through (i) expansion of protections to include all types of assets, (ii) enhancement of investor protections to "circumscribe the availability of, the 'privately offered securities' exception, where advisers are not required to custody assets with a qualified custodian," and (iii) improving the gatekeeping function of qualified custodians.

SEC Commissioner Jaime Lizárraga expressed support for the SEC's effort to modernize the custody rule and its related reporting obligations. Mr. Lizárraga said it was most important to know that "the public can invest with the confidence that their assets, whether more traditional or novel, are appropriately safeguarded." He also said "[s]trengthened investor confidence also carries with it the potential for increased retail investor participation in our capital markets."

SEC Commissioner Hester M. Peirce acknowledged the need to update the custody rule, but opposed the proposed changes over concerns regarding:

• the timing for comment periods and implementation;
• the proposed rule's workability, an action that is "a shift away from the long-standing principles of independent custody and protection of customer assets";
• expansion of the reach of the custody requirements to include crypto assets in a way that will likely shrink the ranks of qualified crypto custodians, making investors in crypto assets "more vulnerable to theft or fraud, not less";
• the wording that suggests an immediate shift in custody requirements that may cause investment advisers to back away from advising their clients with respect to crypto until changes can be implemented; and
• a jurisdictional concern that the SEC is again proposing to dictate contract provisions involving entities the SEC does not regulate.

SEC Commissioner Mark T. Uyeda questioned whether the proposed changes could ever be satisfied by investment advisers for crypto assets held by their clients, stating the proposal "takes great pains to paint a 'no-win' scenario for crypto assets." Mr. Uyeda said that crypto assets, by their very nature, trade on platforms that are not qualified custodians. This would create a scenario that an adviser trading on these platforms would violate the rules.