SEC Proposes Extensive Amendments to the Custody Rule
Client memorandum | March 10, 2023
Authors: Jessica Forbes, Philip Heimowitz, Michael L. Sherman, and Joanna Rosenberg
On February 15, 2023, the Securities and Exchange Commission (“SEC”) voted 4-1 in favor of proposed rule changes under the Investment Advisers Act of 1940 (the “Advisers Act”) that would replace the current “custody rule” (“Custody Rule”) with a new “safeguarding rule” (“Proposed Safeguarding Rule”) and make corresponding amendments to the Advisers Act recordkeeping rule and Form ADV. The Proposed Safeguarding Rule, if adopted as proposed, would apply much more broadly in terms of covered assets and authorities that constitute custody than the Custody Rule and would impose significant additional and more burdensome requirements on registered investment advisers and, indirectly, on custodians. If the Proposed Safeguarding Rule is adopted as proposed, we expect that compliance with the rule would involve substantial additional costs for both registered advisers and their clients, including additional fees to accountants and a likely increase in the cost of custodial services. In light of the many significant changes and potential economic impact of the proposal should it be adopted, we expect significant industry comment on many aspects of the proposal. Key elements of the Proposed Safeguarding Rule and the corresponding amendments to the recordkeeping rule and Form ADV are summarized below.
Proposed Safeguarding Rule
- Scope of the Rule.
- Covered Asset Types. The Custody Rule applies to client “funds and securities” (i.e., cash and stock, notes, and bonds, among others). The Proposed Safeguarding Rule would extend the rule’s coverage to include, in addition to funds and securities, “any other positions held in the client’s account.” The Proposing Release states that the definition of “assets” would encompass: (a) holdings that may not necessarily be recorded on a balance sheet as an asset for accounting purposes, including short positions and written options; (b) all crypto assets, even where such assets are neither funds nor securities; (c) financial contracts held for investment purposes; (d) collateral posted in connection with a swap contract; (e) physical assets including real estate, precious metals, physical commodities, and artwork; and (f) investments that would be accounted for in the liabilities column of a balance sheet or represented as a financial obligation of the client, including negative cash.
- Definition of Custody. The Proposed Safeguarding Rule would expand the current definition of custody under the Custody Rule to also include arrangements pursuant to which a registered adviser has the authority to decide which assets to purchase and sell for the client and is authorized or permitted to transfer beneficial ownership of client assets upon its instruction (i.e., discretionary authority). If a registered adviser has custody of client assets solely because it has discretionary authority with respect to assets that settle exclusively on a delivery versus payment basis, an exception from the surprise examination requirement is available.
- Qualified Custodian Requirements.
- Definition of Qualified Custodian. Like the Custody Rule, the Proposed Safeguarding Rule would define “qualified custodian” to mean a bank or savings association, registered broker-dealer, registered futures commission merchant, and certain types of foreign financial institutions that meet the specified conditions and requirements in the rule. The Proposed Safeguarding Rule would impose certain new requirements and conditions for qualifying banks and savings associations and foreign financial institutions.
- Possession or Control. The Proposed Safeguarding Rule would require a registered adviser to enter into a written agreement with each qualified custodian that holds client assets over which the adviser has custody. That agreement must provide that the qualified custodian will maintain “possession or control” of the clients’ assets. “Possession or control” would be defined to mean “holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets, the qualified custodian’s participation would effectuate the transaction involved in the change in beneficial ownership, and the qualified custodian’s involvement is a condition precedent to the change in beneficial ownership.” With respect to an advisory client’s crypto assets, the Proposing Release states that a qualified custodian would have possession or control if it generates and maintains private keys for the wallets holding the assets in a manner such that an adviser is unable to change beneficial ownership of the crypto asset without the custodian’s involvement. The Proposing Release notes that many crypto asset trades are settled directly on crypto asset trading platforms that are not qualified custodians, which would be a violation of the Proposed Safeguarding Rule, and that, to the extent a registered adviser has custody of a client’s crypto asset securities, settlement of trades in those securities directly on any such platform that is not a qualified custodian would be a violation of the Custody Rule.
- Written Agreement with the Qualified Custodian. The written agreement between the registered adviser and each qualified custodian that would be required under the Proposed Safeguarding Rule would also need to require the qualified custodian to (i) promptly provide, upon request, records relating to client assets held in the account at the qualified custodian to the SEC or an accountant engaged to conduct a surprise exam or annual audit; (ii) at least quarterly, send account statements to the client or the client’s independent representative and the registered adviser; and (iii) at least annually, obtain and provide to the registered adviser a written internal control report that includes an opinion of an independent public accountant as to whether controls have been placed in operation as of a specific date, are suitably designed, and are operating effectively to meet control objectives relating to custodial services. The written agreement would also be required to specify the agreed-upon level of the registered adviser’s authority to effect transactions in the account as well as any applicable terms or limitations, and permit the registered adviser and the client to reduce that authority. If the registered adviser or a related person is the qualified custodian, the independent public accountant that prepares the internal control report must verify that client assets are reconciled to a custodian other than the registered adviser or its related person and be registered with, and subject to, regular inspection by the Public Company Accounting Oversight Board.
- Reasonable Assurances from the Qualified Custodian. The Proposed Safeguarding Rule would require a registered adviser to obtain reasonable assurances in writing from the qualified custodian that:
- The qualified custodian will exercise due care in accordance with reasonable commercial standards in discharging its duty as custodian and will implement appropriate measures to safeguard client assets;
- The qualified custodian will indemnify the client (and will have insurance arrangements in place that will adequately protect the client) against risk of loss in the event of the qualified custodian’s negligence, recklessness, or willful misconduct;
- Any sub-custodial, securities depository, or similar arrangement will not excuse the qualified custodian’s obligations to the client;
- The qualified custodian will clearly identify the client’s assets as such, hold them in a custodial account, and segregate them from the custodian’s assets/liabilities; and
- The qualified custodian will not subject client assets to any right, charge, security, interest, lien, or claim in favor of the qualified custodian (or its related persons or creditors), except as agreed with or authorized by the client.
- Exception for Assets that are Unable to be Maintained with a Qualified Custodian.
- Assets Eligible for the Exception. The Proposed Safeguarding Rule would provide an exception to the requirement to maintain client assets with a qualified custodian for privately offered securities and physical assets.
- Privately Offered Securities. The Proposed Safeguarding Rule would retain the definition of privately offered securities under the Custody Rule, including the requirement that such securities be uncertificated. The Proposed Safeguarding Rule would also require that such securities be capable of only being recorded on the nonpublic books of the issuer or its transfer agent in the name of the client.
- Physical Assets. The term “physical assets” is not defined in the Proposed Safeguarding Rule, but the Proposing Release states that this term would include real estate and physical commodities and also indicates that art, antiques, jewelry, and other personal property would be physical assets. While the physical asset itself would be subject to the exception, the Proposing Release states that certain types of physical evidence of physical assets (e.g., warehouse receipts or deeds) that could be used to transfer beneficial ownership would not qualify and would therefore be subject to the qualified custodian requirement.
- Conditions Required to Qualify for the Exception. The exception would require registered advisers to meet the following conditions:
- Reasonably determine, and document in writing, that ownership cannot be recorded and maintained (book-entry, digital, or otherwise) in a manner in which a qualified custodian can maintain possession or control of such assets;
- Reasonably safeguard the assets from loss, theft, misuse, misappropriation, or the adviser’s financial reverses, including the adviser’s insolvency;
- Enter into an agreement with an independent public accountant that requires the accountant to:
- verify any purchase, sale, or other transfer of beneficial ownership of such assets, promptly, upon receiving notice from the registered adviser; and
- notify the SEC within one business day upon finding any material discrepancies during the course of performing its verification; and
- Notify the independent public accountant engaged to perform the verification of any purchase, sale, or other transfer of beneficial ownership of such assets within one business day.
The exception would also require that the existence and ownership of each of the client’s privately offered securities or physical assets that are not maintained with a qualified custodian are verified during the annual independent verification or as part of the annual audit.
Additionally, as is the case with the current rule, the Proposed Rule would permit a mutual fund’s transfer agent to act in lieu of a qualified custodian with respect to a client’s investment in shares issued by the mutual fund.
- Segregation of Client Assets. In addition to requiring registered advisers to obtain reasonable assurances of segregation of client assets as a qualified custodian, the Proposed Safeguarding Rule would explicitly require registered advisers with custody of client assets to segregate those client assets from its own assets (and the assets of its related persons). Specifically, the Proposed Safeguarding Rule would require that client assets over which an adviser has custody (a) be titled or registered in the client’s name or otherwise held for the benefit of that client; (b) not be commingled with the assets of the registered adviser or its related persons; and (c) not be subject to any right, charge, security interest, lien, or claim of any kind in favor of the adviser, its related persons, or its creditors, except to the extent agreed to or authorized in writing by the client. Although these requirements are consistent with the spirit of the current Custody Rule, they are not required by the plain text of the current rule.
- Delivery of Notice to Clients. The Proposed Safeguarding Rule would retain the requirement that a registered adviser notify its client in writing promptly upon opening an account with a qualified custodian on the client’s behalf and, additionally, would require the notice to include the custodial account number. The Proposing Release notes that if the Proposed Safeguarding Rule is adopted, the proposed rule’s notice requirement would apply only to clients for which a registered adviser has opened new accounts with a qualified custodian after the effective date of the rule; registered advisers would not have to provide new notices to existing clients for which it has already opened accounts. Similar to the current Custody Rule, the Proposed Safeguarding Rule would (i) require that, with respect to pooled investment vehicle clients, the notice be sent to all investors in the pooled investment vehicle, and, if any investor is itself a pooled vehicle in a control relationship with the registered adviser or its related persons, the investors in such pooled vehicle, and (ii) encourage clients to compare statements received from the custodian with statements received from the adviser.
- Amendments to the Surprise Examination Requirement. The Proposed Safeguarding Rule includes two changes to the surprise examination requirement under the Custody Rule. First, the Proposed Safeguarding Rule would require a registered adviser to have a reasonable belief that the accountant engaged to perform the surprise examination will perform such surprise examination and meet its other obligations under the rule. Second, the Proposed Safeguarding Rule would require the written agreement between the registered adviser and the accountant engaged to conduct the surprise examination to provide that the accountant must notify the SEC by electronic means to the Division of Examinations upon the finding of any material discrepancies during the course of a surprise examination, as opposed to the Custody Rule’s requirement to notify the Director of the Office of Compliance Inspections and Examinations via facsimile transmission or electronic mail, followed by first class mail.
- Exceptions from the Surprise Examination Requirement.
- Audit Provision. The Proposed Safeguarding Rule would make three changes to the audit provision under the Custody Rule. First, the proposed rule would expand the availability of the exception from pooled investment vehicle clients to any advisory client entity whose financial statements are able to be audited in accordance with the rule. The Proposing Release states that this aspect of the proposed rule would extend the benefits of the provision to entities such as pension plans, retirement plans, and college savings plans, among others. Second, the Proposed Safeguarding Rule would explicitly allow for the financial statements of entities organized under non-U.S. law or that have a general partner or other manager with a principal place of business outside the United States to be prepared in a manner consistent with local principles, so long as such financial statements contain information substantially similar to statements prepared in accordance with U.S. GAAP and any material differences are reconciled to U.S. GAAP. Third, the Proposed Safeguarding Rule would require a written agreement between the auditor and the registered adviser or the audited entity that would require the auditor to notify the SEC upon the auditor’s termination or issuance of a modified opinion.
- Discretionary Authority; Standing Letter of Authorization. Under the Proposed Safeguarding Rule, if a registered adviser has custody of client assets solely because (i) the adviser has discretionary authority to instruct a client’s custodian to transact in assets that settle exclusively on a delivery versus payment basis or (ii) of a standing letter of authorization, an exception from the surprise examination requirement would be available.
Proposed Amendments to the Recordkeeping Rule and Form ADV
- Recordkeeping Rule Amendments. The SEC also proposes to amend Advisers Act rule 204-2 (“Recordkeeping Rule”) to set forth requirements for making and keeping books and records related to the requirements of the Proposed Safeguarding Rule. The proposed amendments to the Recordkeeping Rule would require a registered adviser to (i) retain copies of required client notices and responses thereto; (ii) create and retain records documenting client account identifying information; (iii) create and retain records of custodian identifying information, including copies of required qualified custodian agreements, copies of all records received from the qualified custodian relating to client assets, a record of required reasonable assurances that the adviser obtains from the qualified custodian, and, if applicable, a copy of the adviser’s written reasonable determination that ownership of certain specified client assets cannot be recorded and maintained (book-entry, digital, or otherwise) in a manner in which a qualified custodian can maintain possession or control of such assets; (iv) create and retain a record that indicates the basis of the adviser’s custody of client assets; (v) retain copies of all account statements; (vi) create and retain a detailed record of all trade and transaction activity of client accounts; (vii) retain copies of any standing letters of authorization; and (viii) retain copies of certain documentation relating to independent public accountant engagements under the Proposed Safeguarding Rule. Registered advisers would be required to maintain these proposed records for not less than five years, and in the same place and manner as is required under the current Recordkeeping Rule.
- Form ADV Amendments. The SEC proposes to amend Form ADV to align the form with the Proposed Safeguarding Rule. The amendments would, among other things, require a registered adviser to report more detailed information regarding its basis for having custody of client assets and its reliance on certain exceptions in the Proposed Safeguarding Rule.
Comment Period, Transition Period and Compliance Date
The SEC requests comments on all aspects of the Proposal, which will be due on May 8, 2023 (60 days after the Proposing Release was published in the Federal Register). The SEC proposes: (i) a one-year transition period for registered advisers with more than $1 billion of regulatory assets under management and (ii) an 18-month transition period for registered advisers with up to $1 billion of regulatory assets under management, in each case to provide time for registered advisers to come into compliance with the Proposed Safeguarding Rule and related amendments to the recordkeeping rule and Form ADV, if they are adopted. Accordingly, the proposed compliance dates of any adoption of the proposed rules and amendments would be, depending on a registered adviser’s regulatory assets under management, one year or 18 months following the rules’ effective dates, which would be 60 days after the date of publication of the adopted rules in the Federal Register.
 Advisers Act Rule 206(4)-2.
 Safeguarding Advisory Client Assets, Release No. IA-6240, (Feb. 15, 2023) (“Proposing Release”). The Proposing Release was published in the Federal Register on March 9, 2023. 88 Fed. Reg. 14672 (Mar. 9, 2023). All citations in this memorandum correspond to the page numbers in the pre-Federal Register version
 Proposed rule 223-1(d)(1).
 Proposing Release at 27-28.
 Proposed rule 223-1(d)(3)(ii), (d)(4).
 Proposed rule 223-1(b)(8).
 A qualifying bank or savings association would be required to hold client assets in an account designed to protect such assets from creditors of the bank or savings association in the event of insolvency or failure. Proposed rule 223-1(d)(10)(i).
 A foreign financial institution would be a qualified custodian under the Proposed Safeguarding Rule if it: (a) is incorporated or organized under the laws of a country or jurisdiction other than the United States, provided that the registered adviser and the SEC are able to enforce judgments, including civil monetary penalties, against the foreign financial institution; (b) is regulated by a foreign country’s government, an agency of a foreign country’s government, or a foreign financial regulatory authority as defined in section 202(a)(24) of the Advisers Act as a banking institution, trust company, or other financial institution that customarily holds financial assets for its customers; (c) is required by law to comply with anti-money laundering and related provisions similar to those of the Bank Secrecy Act and regulations thereunder; (d) has the requisite financial strength to provide due care for client assets; (e) is required by law to implement practices, procedures, and internal controls designed to ensure the exercise of due care with respect to the safekeeping of client assets; and (f) is not operated for the purpose of evading the provisions of the Proposed Safeguarding Rule. Proposed rule 223-1(d)(10)(iv). In addition, similar to the requirement under the Custody Rule that a foreign financial institution keep its advisory clients’ assets in customer accounts segregated from its proprietary assets, the Proposed Safeguarding Rule would require a foreign financial institution to hold financial assets for its customers in an account designed to protect such assets from creditors of the foreign financial institution in the event of the insolvency or failure of the foreign financial institution. Id.
 Proposed rule 223-1(a)(1)(i). This agreement, which is discussed in further detail below, would be separate from, and in addition to, the agreement between the client and its custodian. As noted below, where the adviser itself serves as qualified custodian, the required provisions discussed herein and in section 2(c), and the assurances described in section 2(d), would instead be required to be in an agreement between the adviser and its client.
 Proposed rule 223-1(d)(8).
 Proposed rule 223-1(a)(1)(i).
 In the Proposing Release, the SEC states that this requirement is not intended to preclude traditional operational practices in which client assets are held in omnibus accounts or otherwise commingled with assets of other clients. Proposing Release at 93.
 Proposed rule 223-1(a)(1)(ii).
 Proposed rule 223-1(b)(2).
 The Proposing Release states that the SEC would not consider a privately offered security to be certificated if “the certificate cannot be used to redeem, transfer, purchase or otherwise effect a change in beneficial ownership of the security for which the certificate is issued.” Proposed Release at 135.
 Proposed rule 223-1(d)(9)(ii).
 Proposing Release at 135.
 Proposed rule 223-1(b)(2).
 Proposed Rule 223-1(b)(1). This exception is available only for shares of registered, open-end companies. Also as is the case with the current rule, the Proposed Safeguarding Rule would not apply to the assets of a client that is a registered investment company, as such clients are subject to custody requirements under the Investment Company Act of 1940.
 Proposed rule 223-1(a)(3).
 Proposed rule 223-1(a)(2). The Proposed Safeguarding Rule would retain the requirement in the current Custody Rule that the notice include the qualified custodian’s name, address, and the manner in which the investments are maintained. Id.
 Proposing Release at 175.
 Proposed rule 223-1(a)(4).
 Proposed rule 223-1(b)(4); Proposing Release at 185-86.
 Proposing Release at 186.
 Proposed rule 223-1(b)(4)(iii).
 Proposed rule 223-1(b)(4)(v).
 “Standing letter of authorization” would be defined to mean an arrangement among the registered adviser, the client, and the client’s qualified custodian in which the registered adviser is authorized, in writing, to direct the qualified custodian to transfer assets to a third-party recipient on a specified schedule or from time to time, provided: (i) the client’s qualified custodian is not a related person of the registered adviser; (ii) the client’s authorization includes the client’s signature, the third-party recipient’s name, and either its address or account number at a custodian to which the transfer should be directed; and (iii) the registered adviser has no ability or authority to designate or change any information about the third-party recipient, including name, address, and account number. Proposed rule 223-1(d)(12).
 Proposed rule 223-1(b)(7), (8). Exceptions would also be provided for fee deduction and custody by a related person that is operationally independent. Proposed Rule 223-1(b)(3), (6). Registered advisers would be permitted to rely on multiple exceptions, notwithstanding that each is cast as being available when custody is “solely” due to the particular reason covered by the relevant exception. Proposed Rule 223-1(b)(9).
 Proposed Form ADV, Part 1A, Item 9, and Schedule D, Section 9.
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