SEC Proposes Safeguarding Rule Amending Custody Rule
The new Rule 223-1, deemed the “safeguarding rule” (the “proposed rule”), would expand the scope of assets and activities covered by the current custody rule and increase the minimum requirements applicable to investment advisors and qualified custodians.
1. The proposed rule would expand the scope of the current custody rule to include any client assets of which an advisor has custody.
The current rule applies to investments that are “funds and securities” that an advisor has custody over. With the increasing diversity of investment opportunities accessible by a wider range of investors, the proposed rule broadens this definition to all “funds, securities, or other positions held in a client’s account.”
The inclusion of “other positions” is intended to keep the definition evergreen and encompass new types and forms of investments as they develop. The SEC explicitly mentions that cryptocurrency assets, short positions, written options, financial contracts held for investment purposes, and even physical assets would all be covered under the proposed rule. This would mean that assets not currently subject to custodial requirements would, with limited exceptions, be required to be maintained by a qualified custodian.
The proposed rule maintains the current rule’s definition of “custody” to apply to assets over which the advisor “holds, directly or indirectly.” However, it clarifies that the term “custody” also includes assets over which the advisor has discretionary authority. Plainly, all assets that an advisor has the ability or authority to effect a change in beneficial ownership would be subject to the proposed rule.
2. The proposed rule would continue to require advisors with custody of client assets to maintain those assets with a qualified custodian, but would slightly alter the qualifications for custodians.
The proposed rule generally maintains the list of acceptable qualified custodians. Banks and savings associations, registered broker-dealers, registered futures commission merchants, and certain foreign financial institutions would continue to be eligible.
However, the proposed rule heightens eligibility requirements for foreign financial institutions (FFIs), meaning that some FFIs that are currently eligible to serve may need to make changes in order to serve if the proposed rule is eventually adopted. Under the proposed rule, for FFIs to serve as a qualified custodian: the FFI must be incorporated under the laws of a country or jurisdiction other than the United States; the investment advisor and the SEC must be able to enforce judgments against the FFI; the FFI must be regulated by a foreign government, agency, or regulatory authority as a banking institution, trust company, or other similar financial institution that customarily holds financial assets; the FFI must be required by law to comply with anti-money laundering and related provisions that are similar to the Bank Secrecy Act; the FFI must segregate customer assets from its own; the FFI must demonstrate the requisite financial strength to serve as a qualified custodian; the FFI must be required by law to implement practices, procedures, and internal controls to ensure due care in holding client assets; and the FFI must not be operated for the purpose of evading the proposed rule.
In addition to the FFI-specific provisions, the proposed rule would require all qualified custodians to obtain possession or control of client assets pursuant to a written agreement between the qualified custodian and investment advisor. This practice is currently not widely followed in the industry. These written agreements would be required to define various requirements related to recordkeeping, providing account statements, developing internal control reports, and observing the advisor's agreed-upon level of authority with the advisory client to effect transactions on the account. Additionally, the investment advisor would be required to obtain reasonable assurances from the qualified custodian related to certain minimum protections provided to the client, discussed further below.
3. The proposed rule would increase the minimum custodial protections provided to advisory clients.
The proposed rule would continue to require investment advisors to maintain client assets with a qualified custodian that has possession or control of those assets. However, the proposed rule would require that possession or control to be of the nature that the qualified custodian is required to participate in, actually effectuate, and be a condition precedent to any change in beneficial ownership of those assets. For many investment advisors and qualified custodians, this would increase the role of the qualified custodian in client services. That said, the SEC has recognized that some types of assets—especially crypto assets—are more difficult to hold in a way that would allow for the requisite level of possession or control over beneficial ownership; the SEC has specifically invited comment on how to handle such assets under the proposed rule.
The proposed rule also defines minimum custodial protections the qualified custodian must provide to the advisory client (those required in the written agreement between the qualified custodian and investment advisor, discussed above). These protections include: the exercise of due care in accordance with reasonable commercial standards; the qualified custodian indemnifying the client against risk of loss due to the qualified custodian’s conduct; the qualified custodian taking responsibility for the client’s assets even in light of sub-custodial like arrangements; maintaining client assets in a segregated custodial account separate from the qualified custodian’s proprietary assets and liabilities; and preventing client assets from being subject to any lien or similar security interest unless agreed to in writing by the client.
Recognizing the uniqueness of privately offered securities, and the complexity and sometimes impossibility of having a qualified custodian maintain custody of such assets, the proposed rule makes an exception to allow an investment advisor to retain custody of the privately offered security so long as it is safeguarded from loss, theft, use and misappropriation, and an independent public accountant can review certain transactions and verify safeguarding during a surprise exam or annual audit. The proposed rule also makes the same exception for physical assets (e.g., precious metals, physical commodities, and real estate) that, due to their nature, are unable to be held by qualified custodians. When an investment advisor retains custody of a client’s assets, the proposed rule would require segregation of assets from the advisors’ own.
4. The proposed rule amends surprise examination and recordkeeping requirements and makes changes to Form ADV.
Recognizing the increased protections the proposed rule intends to offer to investment clients, the proposed rule also makes changes to examination and recordkeeping requirements. The proposed rule maintains an exception to the surprise examination requirement for advisors that obtain an annual audit – but expands the audit provision to be available to “entities,” rather than “pooled investment vehicles,” requires non-US clients to contain information similar to US GAAP, and requires a written agreement between the investment advisor and the auditor that requires the auditor to notify the Commission upon finding discrepancies.
The proposed rule also amends rule 204-2, the Investment Advisor Recordkeeping Rule, to “ensure that a complete custodial record with respect to client assets is maintained and preserved.” The amendments would broaden the scope of records and activities subject to recordkeeping requirements, including retaining copies of client notices, creating records of client account identifying information (e.g., opening records, grants of advisor authority), and retaining records of custodian identifying information.
Finally, the proposed rule updates Form ADV by amending Part 1A, Schedule D, and the Instructions and Glossary.
The SEC is currently accepting public comments on the proposed rule. Public comment will remain open until 60 days after the rule is published in the Federal Register. As of the date of this publication, the proposed rule has not yet been published.
The proposed rule will impact most actors in the client investment industry. All businesses that operate in the investment industry should assess how the proposed rule may impact their business activities and plan accordingly.
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