(Article from Registered Funds Regulatory Update, April 2023)
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In a 4-1 vote on February 15, 2023, the SEC proposed amendments to existing Rule 206(4)-2, the so-called “Custody Rule,” under the Advisers Act. The proposal, if adopted, would redesignate the Custody Rule as new Rule 223-1 and rename it the “Safeguarding Rule.” The SEC’s proposal seeks to modernize certain aspects of the existing Custody Rule and enhance investor protection relating to advisory client assets over which registered investment advisers have custody. The SEC proposed a staggered implementation timeline, with a 12-month compliance period for large advisers and 18 months for smaller advisers.
Summary of the Proposal
Qualified Custodian Agreements and Assurances. The proposal would require advisers to enter into new written agreements with each client’s “Qualified Custodian” and obtain several written assurances from that Qualified Custodian. Among these are an assurance that the Qualified Custodian will indemnify the client against losses resulting from the Qualified Custodian’s negligence, recklessness or willful misconduct and that the existence of any sub-custodial or similar arrangement will not excuse any of the Qualified Custodian’s obligations to the client. The Qualified Custodian also would need to assure the adviser that it will exercise due care, in accordance with reasonable commercial standards, in discharging its duty as custodian and will segregate client assets from the Qualified Custodian’s proprietary assets and liabilities. The SEC acknowledged that these requirements are a substantial departure from current practice.
New Conditions to a Key Exception for Private Securities. The proposal would continue to except certain privately offered securities from the requirement they be held with a Qualified Custodian; however, the proposal would add two significant new requirements to rely on the exception:
- First, the adviser must reasonably determine, and document in writing, that such securities cannot be recorded and maintained by a Qualified Custodian. This would be a significant departure from the current exemption. The SEC release acknowledges that an adviser’s reasonableness determination necessarily depends on the facts and circumstances at issue, including an analysis of the security and the available custodial market for the security. However, the release does not clarify how impracticable it must be for the Qualified Custodian to maintain the asset.
- Second, the proposal would require that an independent public accountant verify promptly any purchase, sale, or other transfer of any privately offered securities relying on the exception.
All Assets Coverage. The proposed rule would apply to all assets in a client’s account, while the current Custody Rule only applies to “funds and securities.” As statements from several SEC Commissioners made clear, this aspect of the proposed rule was intended to cover investments in crypto assets (although it also would apply to other assets that are not securities, such as real estate).
New Requirement on Qualified Custodians. The proposal would require Qualified Custodians to have possession or control of assets in order to be viewed as “maintaining” the assets for purposes of meeting the Safeguarding Rule requirements. One challenge with this requirement is how and whether the adviser, which is the only party subject to Rule 223-1, can determine whether the Qualified Custodian has such possession and control.
Broadened Advisory Activities. The proposal would broaden the types of advisory activities that could be deemed to confer custody to an adviser. These new circumstances include the authority to engage in discretionary trading without the ability to otherwise direct assets out of an account.
Implications
There is widespread consensus that safeguarding client assets is vitally important, and at the heart of the SEC’s responsibility for investor protection. As proposed, the amendments would only apply to investment advisers subject to the Advisers Act but not to registered funds or business development companies. Nonetheless, the release may be indicative of the SEC’s broader thoughts on issues that would otherwise impact the protection of advisory clients’ assets.
Comments on the proposals are due 60 days after the release is published in the Federal Register.
Safeguarding Advisory Client Assets, SEC Release No. IA-6240 (Feb. 15, 2023), available at: https://www.sec.gov/rules/proposed/2023/ia-6240.pdf.