Trade Associations United in Criticism of SEC's Proposed IA Custody Rule

Trade associations representing a variety of constituencies urged the SEC not to adopt a proposal that would expand requirements under the Advisers Act Rule 206(4)-2 ("Custody of Funds or Securities of Clients by Investment Advisers").

As previously covered, the proposed changes would 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, not only to ordinary securities, but also to (i) customer assets that are not securities and (ii) digital assets that the SEC has said are securities but that it generally does not permit to be held by a broker-dealer. The proposed rule would cover all "positions held in a client account" to the extent that the adviser has control over the account.

Highlights from the comments include:

• American Bankers Association, Financial Services Forum, and Bank Policy Institute. The trade associations, which effectively represent the custodians that would be indirectly regulated by the SEC's requirements, made clear that they do not support the proposal which would "significantly" change the custody rule to, among other things, restructure a "key relationship" between registered investment advisers ("RIA") and qualified custodians concerning the assets of an RIA client. In addition, the trade associations argued that the proposal would result in a reduction of "financial market access, provider choice, and operational efficiency" by failing to (i) recognize the ways in which banks hold assets and would implement requirements that are "unworkable in practice," (ii) provide evidence for a "monumental shift" in custody banks’ operations and (iii) account for the "risks, costs, and inefficiencies" that would be imposed on the banking system and capital markets.
• SIFMA. SIFMA criticized the proposal’s "substantial departure" from current industry practices and conflict with "well-functioning custodial regulatory frameworks." SIFMA stated that the proposal lacks evidence of any improvements to investor protections, and instead, would greatly hurt clients of investment advisers by (i) reducing the availability of qualified custodians, (ii) reducing access to markets and products and (iii) increasing custodial and advisory fees with minimal additional protections. In addition, SIFMA said that the proposed regulations would hinder qualified custodians’ ability to offer digital asset-related custody services.
• SIFMA Asset Management Group. SIFMA AMG warned that the proposal would "upend[] well-established" industry practices by creating requirements that are "impossible or infeasible to meet for instruments such as private securities and derivatives." In particular, SIFMA AMG expressed concern that the proposal would (i) impose practical challenges for advisers in obtaining the proposed required written assurances from qualified custodians and (ii) impose an "unwarranted expansion" of concept of investment adviser custody. SIFMA AMG added that the proposal also "grossly underestimates" the costs of compliance with the proposal and fails to recognize the "substantial" re-negotiating of contracts should the proposal be adopted.
• Investment Company Institute ("ICI"). ICI, which effectively represents the buy-side, argued that the proposal would, among other things: (i) deprive investors of access to qualified custodians due to custodians’ likely refusal to comply with the proposed written reasonable assurance requirement regarding their use of securities depositories and (ii) create requirements for custody banking entities despite not having the authority to do so, and that the proposal fails to provide reasoning for why custody regulatory regimes for banks should be revised. ICI also urged the SEC to not include "financial contracts" under the proposed amendments as there is no "practical way" for a custodian to control or possess a contract.
• Investment Adviser Association ("IAA"). The IAA stated that it was "deeply concerned" by the SEC's proposed expanded concept of custody to include "discretionary authority and the virtually boundless scope of assets in myriad different markets." The IAA said that the SEC is "attempting to deputize investment advisers to enforce qualified custodians’ conduct" and by doing so is requiring specific business relationships between an adviser and a custodian "where none existed before." This, the IAA stated, forces advisers to do indirectly what the SEC "is not doing or cannot do directly." The IAA called for safeguarding practices that are more "appropriately-targeted, risk-based, and reasonably-designed," saying that the SEC's proposal would be impractical and would "impose significant costs on investment advisers that far exceed any perceived benefits."
• American Investment Council ("AIC"). AIC argued that the proposal "will not facilitate enhanced safeguarding of client assets," calling it "overbroad" and stating the provisions "do not accurately reflect current or even realistic market practices." AIC said that - notwithstanding crypto assets - the SEC failed to explain where further regulation is "necessary to protect against the risk of misappropriation." AIC added that an adviser is already statutorily prohibited from "misdirecting customer assets to its own account." AIC asserted that even if an amendment to the custody rule was warranted, any such change could have been addressed in a "simpler and less costly fashion."