April 10, 2023

In-Depth: US SEC Proposes New Safeguarding Rule for Investment Advisers


Additional Author: James Alford

On February 15, the US Securities and Exchange Commission (the “SEC” or the “Commission”) proposed rule changes (the “Proposal”) to enhance protections of client assets managed by investment advisers registered with the SEC (“RIAs”).1 If adopted, the changes would amend Rule 206(4)-2, the “Custody Rule,” under the Investment Advisers Act of 1940 (the “Advisers Act”), and redesignate it as new Rule 223-1, the “Safeguarding Rule,” under the Advisers Act. The proposed Safeguarding Rule would have significant repercussions on industry participants, requiring RIAs to enter into agreements with qualified custodians and imposing a wide array of new requirements on such qualified custodians. The Proposal acknowledges that certain of its components are major departures from current market practices and that the new requirements for qualified custodians will create higher barriers to entry, potentially causing the market for qualified custodians to shrink and increasing costs for RIAs, particularly small and mid-sized firms. Nevertheless, the SEC believes that these updates are necessary given certain industry developments since the last time the rule was amended in 2009. In particular, the Proposal is intended to address what the Commission views as a general reduction in the level of protection offered by custodians to the general public and requires a higher baseline of services and protections that can currently only be obtained by counterparties with considerable leverage and, generally, not by retail investors.

The Proposal devotes considerable attention to crypto assets and the custodial arrangements of such assets; however, the scope of the Safeguarding Rule would have consequences to a much broader segment of the market, imposing additional burdens on all RIAs and creating complications for a variety of asset classes, including real estate, collateralized loan obligations (“CLOs”) and even ordinary cash deposits in custodial relationships. Moreover, at various points throughout the Proposal, the SEC goes out of its way to create new interpretations or endorse SEC staff views of the existing Custody Rule. In other words, before the Safeguarding Rule is finalized (and even if it is not ultimately adopted), advisers may be required to adjust their activities in order to comply with the SEC’s new interpretations of the Custody Rule in the Proposal.

I. Significantly Increased Scope

A. Any “Assets,” from Funds and Securities to Land, Wheat, and Lumber

Under the Custody Rule, any investment adviser registered with, or required to be registered with, the SEC under Section 203 of the Advisers Act that has “custody” of a client’s “funds or securities” is subject to the Custody Rule. The SEC is now proposing to dramatically expand the scope of the Safeguarding Rule from “funds and securities” to any client “assets” over which the RIA is deemed to have custody. This expansion would therefore include a wide variety of assets not currently subject to the Custody Rule, including certain crypto and digital assets,2 artwork, real estate, precious metals and physical commodities (e.g., wheat and lumber). The definition of assets also encompasses holdings that are not necessarily recorded on a balance sheet as an asset for accounting purposes, such as short positions and written options, as well as items that would be accounted for as a liability, such as negative cash. The expanded scope has significant implications because of the general requirement that all client assets over which an RIA has custody must be maintained with a qualified custodian, subject to a limited exception discussed below.

B. Discretionary Authority is Custody

The Proposal leaves largely unmodified the threshold definition of “custody” from the existing Custody Rule (i.e., “holding, directly or indirectly, client assets, or having authority to obtain possession of them”), but would significantly expand the scope of the definition through a modification of the examples of custody provided in the rule. Specifically, custody under the Safeguarding Rule is proposed to include “any arrangement (including, but not limited to, a general power of attorney or discretionary authority) under which you are authorized or permitted to withdraw or transfer beneficial ownership of client assets upon your instruction” (emphasis added).3 “Discretionary authority” is then further defined as the “authority to decide which assets to purchase and sell for the client.”4

1. SMA and CLO Advisers Generally within Scope

This expanded scope would have a significant impact on RIAs to separately managed accounts (“SMAs”) and CLOs. Many SMA advisers and CLO managers have taken great pains to avoid being imputed with “custody” by carefully drafting their authority provisions under investment management or similar agreements and through the mechanics of CLO indentures, but the proposed Safeguarding Rule would render these precautions largely moot, causing all RIAs acting with “discretion” over the client assets to have custody of those assets and therefore be subject to the Safeguarding Rule’s requirements. This change will, however, have little impact on most RIAs to commingled funds, as they typically already have custody under the current Custody Rule because a related person serves as the fund’s general partner, managing member, or equivalent, which would be unchanged under the Safeguarding Rule.5

As drafted, the Safeguarding Rule does not address issues related to sub-advisory arrangements, including those involving affiliated advisers. Historically, such arrangements, particularly those involving non-US commingled funds sub-advised by an affiliated US adviser, have caused significant friction under the Custody Rule where the non-US primary adviser is deemed to have custody.6 The SEC has, however, solicited comments on the impact on sub-advisory arrangements. Clearly, the prior SEC staff guidance regarding certain sub-advisory arrangements involving affiliated advisers would need to be significantly expanded to be workable under the proposed Safeguarding Rule.7

2. New Interpretation of Existing Custody Rule

More troubling is the statement by the Commission that RIAs acting with discretionary authority are already in scope of the existing Custody Rule if their discretionary authority applies to funds and securities that do not trade on a “delivery-versus-payment” (“DVP”) basis. In the Proposal, the SEC explicitly states that “authorized trading” for any transactions other than those that settle on a DVP basis come within the current definition of custody,8 noting that for non-DVP transactions, an adviser could have authority to instruct an issuer’s transfer agent or administrator (such as for a loan syndicate) “to sell its client’s interest and to direct the cash proceeds of the sale to an account that the adviser owns and controls.” The SEC Staff implied this view in interpretative guidance published in 2017; however, the position remained subject to significant uncertainty and was never officially adopted by the Commission.9 This interpretation of an existing rule, tucked away in a new rule proposal, may come as a surprise to even careful industry observers. Accordingly, even before the Safeguarding Rule is finalized, RIAs might consider re-evaluating their current practices in light of these statements.

3. Extremely Limited Relief from Surprise Examinations

As part of the Safeguarding Rule, the SEC would provide relief from the surprise examination (or audited financial statement) requirement for advisers that have “custody” arising solely out of this discretionary authority (i) with respect to assets that are maintained with a qualified custodian, and (ii) where the discretionary authority is limited to assets that settle exclusively on a DVP basis. This relief is extremely limited given these two requirements and would not be available with respect to any assets that qualify for the exemption from being maintained with a qualified custodian.10 Further, the requirement that assets trade exclusively on a DVP basis would appear to make this relief unavailable for many asset classes, including loans.

II. New Requirements for “Qualified Custodians”

Consistent with the Custody Rule, RIAs with custody of client assets would be required to maintain those assets with a qualified custodian. The definition of qualified custodian remains largely the same: a bank or savings association, registered broker-dealer, registered futures commission merchant, or a foreign financial institution (“FFI”) that meets specified conditions and requirements. However, the SEC would effectively engage in indirect regulation of these qualified custodians by imposing new requirements on, and new required “findings” by investment advisers related to, these custodians.

In addition, many of these proposed changes appear designed to limit the ability of registered advisers to hold crypto and digital assets in client portfolios, particularly with respect to assets that might be held at state-chartered trust companies following the failure of several crypto firms, but will have significant repercussions for many more market participants The Proposal pre-dates the recent receivership of Silicon Valley Bank and Signature Bank; it remains to be seen whether the Commission will alter the Proposal in response to such events.11

A. New Requirements on Assets Held by Banks and Savings Associations

A qualifying bank or savings association (for simplicity, we refer to these simply as “banks”) would be required to hold client assets in an easily identifiable account segregated from its own assets and liabilities so that they are protected from creditors in the event of the insolvency or failure of such bank. Although already substantially required for FFIs under the current Custody Rule, this is a new requirement for domestic entities and, as noted above, predates the recent regional bank failures.

One of the most significant impacts of this change is the effect on cash deposits at banks. As a general matter, bank deposit accounts create a debtor-creditor relationship between the bank and the depositor. Furthermore, most deposits of cash are, by default, treated as “general deposits” and are not protected from other depositors and creditors in the event of a bank’s insolvency, meaning they would not satisfy this requirement.

If cash cannot be held in a general deposit, clients would likely need to renegotiate their deposit agreements with bank custodians to explicitly create a “special” deposit that may be protected from creditors. “Special” deposits have other significant complications that are not fully addressed in the Proposal. Notably, even under bankruptcy and bank receivership law, the “special” determination is determined by state law.12 Moreover, a special deposit’s existence is based on the intent of the parties as reflected in explicit terms dating to the creation of the relationship. Courts have disfavored special deposits since 1936,13 and there is uncertainty whether custodied cash will be kept separate from a bank’s receivership estate. What is clear is that such arrangements would likely result in an increase in custody fees paid by advisory clients, as banks would need to put limits around how they would hold “special” deposits, if at all. This requirement, when coupled with the reasonable assurances advisers will need to obtain from qualified custodians further discussed in Section II.D below, will have a particularly odd result for advisers providing services to institutional investors (like state pension plans) who typically have their own custody relationships, often with large custodial banks. In such circumstances, the adviser—who is not a party to the custodial agreement and has not been involved in its negotiation—will be unable to provide investment advisory services unless the third-party custodian agrees to hold cash deposits in a special custody arrangement. Even in arrangements where the adviser has a direct role in selection of the custodian, such as for most commingled funds, the direct result is likely to be increased costs borne by the client.

B. More Robust Requirements for FFIs

The Safeguarding Rule would also add a more robust set of requirements for an institution to be an FFI that is eligible to serve as a qualified custodian, including that the FFI:

    1. is organized under the laws of a non-US jurisdiction, provided that the adviser and the SEC (though notably not the client) are able to enforce judgments, including civil money penalties, on the FFI;
    2. is regulated by a foreign country’s government or governmental agency as a banking institution, trust company, or other financial institution that customarily holds financial assets for customers (e.g., foreign equivalents of brokers and FCMs);
    3. is required to comply with anti-money laundering provisions “similar to those of the Bank Secrecy Act and regulations thereunder”;
    4. holds financial assets for customers in an account designed to protect such assets from creditors of the FFI in the event of its insolvency or failure (see similar requirement for banks discussed above);
    5. “has the requisite financial strength to provide due care for client assets”;
    6. 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
    7. is not operated for the purpose of evading the Safeguarding Rule.

An FFI could satisfy the first condition by simply appointing an agent for service of process in the United States or having offices in the United States. The Proposal noted that an FFI would be able to satisfy the third condition if it is required to comply with the laws and regulations established by a member or observer jurisdiction of the Financial Action Task Force (“FATF”) and not otherwise listed on any sanctions list administered and not otherwise listed on any sanctions list administered by the Office of Foreign Assets Control of the US Department of the Treasury (“OFAC”), or on any special measures list administered by the Financial Crimes Enforcement Network of the US Department of the Treasury. The Proposal’s provided example appears to be illustrative rather than exhaustive. It is unclear how the Commission will interpret this requirement with respect to custodians organized under the laws of FATF “grey list” jurisdictions (notably, the Cayman Islands). Finally, although there is not much discussion devoted to the fifth requirement, the Proposal suggests that advisers could assess an FFI’s financial strength based on “objective measures,”14 and could require notifications from an FFI of changes in financial strength to help advisers, as fiduciaries, to respond to emerging risks of loss of client assets.

C. Custodians Must Have Possession or Control Over Client Assets

The Safeguarding Rule would require a qualified custodian to have “possession or control” over all client assets (other than those subject to the exception below), which would be defined to mean holding assets such that (1) the qualified custodian is required to participate in any change in beneficial ownership of those assets, (2) the qualified custodian’s participation would effectuate the transaction involved in the change in beneficial ownership, and (3) the qualified custodian’s involvement is a condition precedent to the change in beneficial ownership. The Proposal states that this requirement will prevent loss or unauthorized transfers of the client’s assets and ensure the integrity of account statements provided by qualified custodians, as they would only report on holdings in their possession or control. “Accommodation reporting,” where a custodian lists assets for which it does not accept custodial liability on a client’s account statement for reporting purposes, would not constitute participation for purposes of this possession or control standard.

As other portions of the Proposal, this requirement appears to be targeted, at least in part, at crypto and digital assets over which it is difficult or impossible for a custodian to demonstrate possession or control. In addition, the Proposal notes that many digital assets are traded over platforms that directly settle trades (i.e., crypto exchanges) where investors are required to pre-fund trades by transferring currency and digital assets prior to executing a trade. The Proposal was explicit that such assets are squarely within the purview of the Safeguarding Rule and will not be compliant with the possession or control requirement. Moreover, the Proposal states that the SEC views these pre-funded transactions on crypto exchanges to not be in compliance with the current Custody Rule because most such exchanges are not “qualified custodians,” and trading on such exchanges therefore necessarily involves client assets not being maintained with a qualified custodian during the period they are on the exchange. This requirement will also impact other assets that the Commission may not have considered—for example, loans or certain derivatives where third parties are responsible for transferring ownership of assets or collecting payments.

D. Adviser Agreements with and Oversight of Qualified Custodians

Acknowledging that this is a “substantial departure from current industry practice,” the Safeguarding Rule would require an adviser to enter into a written agreement with its custodian that contains terms addressing “minimum custodial protections” for client assets. Further, the Safeguarding Rule would require that an adviser obtain reasonable assurances from a qualified custodian relating to certain protections the qualified custodian will provide to the advisory client. The Proposal noted these requirements are in response to evolving custody practices, including the contractual limitation of liability by custodians and outsourcing of less profitable workstreams.

The Proposal noted that these new requirements may cause the custodial market to shrink. However, it is not clear whether custodians (whether domestic or foreign) would be willing or able to such an agreement at all, or at what cost.  Further, these requirements will be particularly challenging to implement for funds investing in foreign assets. The custodial services provided by large banks are generally regarded as a low margin, high volume business; accordingly, banks may decide the revenue is not worth the added liability imposed by the Proposal, especially when combined with the additional potential costs related to “special” deposits discussed above. To the extent custodians take on these new responsibilities, it is almost certain that there will be increased costs passed down to clients and investors.

1. Required Contractual Terms

Under the Proposal, the written agreement between a qualified custodian and an adviser must contain the following terms requiring the qualified custodian to:

  1. promptly, upon request, provide records relating to client assets to the SEC or an independent public accountant for purposes of compliance with the Safeguarding Rule;
  2. at least quarterly, send account statements to the client and the investment adviser (unless the client is an entity whose investors will receive audited financial statements as part of the financial statement audit process) identifying the amount of each client asset in the custodial account at the end of the period, as well as all transactions in the account during that period, including advisory fees;
  3. at least annually, obtain and provide to the 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 (i.e., making the current internal control report under the Custody Rule universally applicable to all qualified custodians, not just the adviser and its related persons); and
  4. specify the investment adviser’s agreed-upon level of authority to effect transactions in the custodial account as well as any applicable terms or limitations (and thereby addressing concerns raised by the SEC staff related to so-called “inadvertent custody”15).

2. RIAs to Obtain “Reasonable Assurances” and Monitor Compliance

Further, the adviser will be required to obtain reasonable assurances in writing from the custodian that the qualified custodian will:

  1. exercise due care in accordance with reasonable commercial standards in discharging its duty as a custodian and will implement appropriate measures to safeguard client assets from theft, misuse, misappropriation or other similar types of loss;16
  2. indemnify the advisory client (and will have insurance arrangements in place that will adequately protect the client) against the risk of loss in the event of the qualified custodian’s own negligence, recklessness, or willful misconduct;17
  3. not be excused from any obligations to the client by the existence of any sub-custodial, securities depository, or other similar arrangements;
  4. clearly identify the client’s assets as such, hold them in a custodial account, and segregate them from the qualified custodian’s proprietary assets and liabilities;18 and
  5. 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 to the extent agreed to or authorized in writing by the client.

The Commission is viewing the safekeeping protections required in the proposed written agreement as duties owed both to the investment adviser and the advisory client, and the safekeeping protections in the proposed reasonable assurances as duties owed primarily to the client. In entering the agreement, RIAs will be required to reasonably believe that the qualified custodian is capable of and intends to comply with the contractual provisions and reasonable assurances obtained by the adviser.

Further, during the term of the agreement, RIAs will be required to have a reasonable belief that the qualified custodian is actually complying with its contractual obligations; accordingly, if an adviser comes to believe that a custodian is not complying with any requirement (e.g., because the adviser does not receive a copy of an account statement sent to a client), it would no longer be in compliance with these requirements under the Safeguarding Rule.

These aspects of the proposal appear to be woven from the same cloth as the foreign custody rules under the Investment Company Act of 1940 (“Investment Company Act”). The proposed required written assurances are similar to the required terms for foreign custodians under Investment Company Act Rule 17f-5.  In addition, the proposed requirements for RIA findings and oversight are similar to the requirements imposed on foreign custody managers under the Investment Company Act (although most foreign custody managers are sophisticated domestic banks that are subject matter experts regarding custodial arrangements, whereas most RIAs are certainly not).

We see the potential for significant pushback against these proposed requirements from custodial banks and other custodians, reminiscent of the protracted rulemaking process related to foreign custody relationships under the Investment Company Act in the 1990s.  

E. “Expanded” Exception for Privately Offered Securities

As discussed in Section I.A above, the Safeguarding Rule would significantly expand the scope of the types of assets required to be maintained with a qualified custodian. At the same time, the Proposal would both expand the scope of the current exception from this requirement for certain “privately offered securities,” but also impose significant new requirements on its use. In the Proposal, the Commission explained that it had originally intended the privately offered securities exception to be only occasionally used, but the significant growth in private assets over the last 20 years has led to a significant increase in the use of this exception. The SEC expressed concern that clients whose advisers rely on this exception are not fully protected from risk of misuse, misappropriation, or losses that could result from the adviser’s insolvency or bankruptcy.19 Nonetheless, the Commission, recognizing that a “robust” market for custodial services has not developed for many assets that would be subject to the Safeguarding Rule, is maintaining the exception, and expanding its scope to include both privately offered securities and physical assets, subject to the following conditions:

  1. The adviser reasonably determines and documents in writing that ownership cannot be recorded and maintained in a manner in which a qualified custodian can maintain possession, or control transfers of beneficial ownership, of such assets;
  2. The adviser reasonably safeguards the assets from loss, theft, misuse, misappropriation, or the adviser’s financial reverses, including the adviser’s insolvency;
  3. An independent public accountant, pursuant to a written agreement with the adviser, verifies any purchase, sale, or other transfer of beneficial ownership of such assets promptly after receiving notice from the adviser of any such purchase, sale, or transfer (with such notice provided within one business day of the purchase, sale, or transfer), and the accountant notifies the Commission within one business day upon finding any material discrepancies during the course of performing its procedures; and
  4. The existence and ownership of each privately offered security or physical asset not maintained with a qualified custodian is verified during the annual surprise examination or as part of a financial statement audit.

Several aspects of the proposed exception are notable. First, with respect to scope, although the Commission is proposing to limit the availability of this exception to uncertificated privately offered securities (using substantially the same wording as under the current rule), it would interpret “uncertificated” to include securities that have a nominal certificate, but where the certificate “cannot be used to redeem, transfer, purchase, or otherwise effect a change in beneficial ownership of the security.”20 The Commission explicitly states that (i) crypto securities transferred via a public, permissionless blockchain evidenced through public keys or wallet addresses would not qualify under this interpretation, and (ii) crypto assets that are not securities would not qualify because they are neither privately offered securities nor physical assets.21 With respect to physical assets, the Commission has declined to define the term in the Proposal, but notes that it would include real estate and physical commodities, but would not include physical evidence of ownership of non-physical assets (including stock certificates, private keys, and bearer instruments).22 Even with respect to real estate, the Proposal explains that a deed or similar indicia of ownership that can be used to transfer beneficial ownership would not qualify, but the physical buildings or land would qualify.23

Second, the standard for the adviser’s reasonable determination and documentation is that ownership cannot be recorded and maintained with a qualified custodian. The Proposal explains that an adviser would have an obligation to periodically review and update this determination as the market for custodial services evolves over time. While an adviser would not be expected to identify every conceivable custodian for a given asset or asset class, the Commission does expect advisers to “obtain a reasonable understanding of the marketplace of custodial services,” and re-assess its findings on an annual or other basis—noting that where new custodial services are “well publicized,” even such an annual assessment may be insufficient.

Third, with respect to an adviser’s “reasonable safeguards,” the Commission would expect advisers to implement internal controls to safeguard the client assets not kept with a qualified custodian, including segregation of duties of personnel, regular review and reconciliation of documents, and documentation of transferability restrictions. Moreover, with respect to physical assets, the Commission indicated that advisers could look to comply with “reasonable commercial standards,” including use of secure facilities, vaults that adhere to exchange, clearing house, or licensing requirements, dual control procedures, reconciliation procedures, and periodic audits, among other measures.

Lastly, the Safeguarding Rule would impose a wholly new verification system for an independent public accountant to promptly review every purchase, sale, or transfer. We expect that this requirement would impose substantial new costs on advisers utilizing this exception (which may ultimately be borne by clients), as well as increasing the costs of financial statement audits and surprise examinations.

III. Amendments to the Surprise Examination Requirement, Audited Financial Statement Exception, and SLOAs

Under the Custody Rule, advisers with custody who do not rely on certain exceptions (notably, obtaining audited financial statements) must undergo an annual surprise verification by an independent public accountant to put “another set of eyes” on client assets. The Safeguarding Rule, like the Custody Rule, will retain this general requirement, and will require advisers (or their related persons) who self-custody to get such annual surprise verification by an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board in accordance with its rules. In a more significant change from the current rule, under the Safeguarding Rule the adviser must not only enter into an agreement with an accountant, but also “must reasonably believe” that the written agreement has been implemented. The Proposal explains that this change was made in recognition of situations where an adviser has properly engaged an accountant, but has failed to ensure that the surprise examination actually occurs in accordance with the Custody Rule’s requirements (e.g., due to failure to file a Form ADV-E).

With respect to the “audit exception,” the proposed Safeguarding Rule would substantially keep the current audit exception, with some welcome modifications incorporating SEC staff guidance. The modified exception would (i) more clearly be available to clients in the form of any entity for which financial statements can be prepared; (ii) incorporate longer delivery windows for annual audited financial statements for funds of funds (and funds of funds of funds) of 180 days (or 260 days) after the entity’s fiscal year-end, rather than 120 days; and (iii) incorporate guidance regarding the financial statements of entities organized under non-US law (or that have a general partner or other manager located outside the United States) that are prepared under standards other than US Generally Accepted Accounting Principles, subject to disclosure of reconciliation of material differences to US GAAP. The Proposal would retain, without modification, the SEC staff’s existing positions related to special purpose vehicles and multi-layered structures, including “Scenario #4” under the staff’s 2014 Guidance Update, which relates to SPVs held, in part, by third parties that are not pooled investment vehicles controlled by the adviser or the adviser’s related persons, and therefore requiring separate audited financial statements for such entity.24

In one change that will be less welcome by industry participants, the Commission would add a new requirement for the auditor’s engagement letter to require the auditor to notify the SEC upon the auditor’s termination or the issuance of a modified opinion (i.e., a qualified opinion, an adverse opinion, or a disclaimer of opinion).

As noted in Section I.B above, the SEC would also provide relief from the surprise examination (or audited financial statement) requirement for advisers that have “custody” arising solely out of this discretionary authority in limited circumstances.

The Proposal solicits comments on whether the Safeguarding Rule should permit financial statement periods longer than one year or on a less frequent basis for newly formed entities (e.g., 15 months) or for liquidating entities (e.g., every two years). Both modifications would likely be welcomed by advisers and by many fund investors, recognizing the expenses associated with an initial stub period audit for a newly formed fund or in the waning days of a fund’s liquidation often outweigh the benefits of the audit.

Finally, the Safeguarding Rule would substantially incorporate the SEC staff’s guidance regarding “standing letters of authorization” (“SLOAs”) into the rule.25

IV. Amendments to Form ADV and Recordkeeping Requirements

The Safeguarding Rule would also amend Item 9 of Part 1A, Schedule D, and the Instructions and Glossary of Form ADV to align reporting obligations with the proposed changes to the Custody Rule and to help advisers identify when they may have custody of client assets, and to provide the SEC with additional data to identify compliance risks and inform its examination initiatives. The proposed revisions would require an adviser to report the amount and number of clients falling into each category of custody (i.e., direct or indirect) and require advisers to report similar information about client assets over which they have custody. Advisers will be required to indicate which, if any, exceptions from the Safeguarding Rule they are relying on, providing a clear “road map” for both advisers and SEC examiners to how an adviser is applying the Safeguarding Rule to its business. Advisers would also be required to report certain identifying information about their use of qualified custodians and independent public accountants.

In addition, the Proposal would amend Rule 204-2 under the Advisers Act to enhance recordkeeping requirements related to client notifications, accountant engagements, custodian information, transactions, and SLOAs, in keeping with the various requirements under the Safeguarding Rule.

V. Conclusion

The SEC is proposing that the Safeguarding Rule would have a staggered transition period of one year following the rule’s effective date for advisers with more than $1 billion in regulatory assets under management, or 18 months for advisers with up to $1 billion in regulatory assets under management. Given many of the significant changes discussed above, this does not provide much leeway even for medium- and larger-sized advisers to overhaul their custodial arrangements with clients, try to put in place new agreements with custodians and accountants, and make and document many of the new required findings. Taken as a whole, while the proposed Safeguarding Rule does include some welcome changes, it certainly does not simplify one of the most complicated rules under the Advisers Act, and indeed seems likely to increase the number of inadvertent violations.

Overall, the proposal appears to establish a “trickle down” approach to responsibility and liability, putting pressure first on qualified custodians, which may not be willing to accept those responsibilities at all or only for increased costs and which, as recently experienced, are not themselves insulated from disruption.   The next stop is the RIAs, which are not experts in matters of custodial arrangements (particularly foreign custody arrangements), but will need to become experts under the Proposal.  And the final stop is the accounting firms, which have been the subject of continuous SEC regulatory focus, particularly regarding independence.  The Proposal, or at least certain aspects of it, appear to be modeled after the Investment Company Act’s regulatory requirements for foreign custody arrangements.  We have recently seen similar convergence toward the Investment Company Act in other areas of SEC regulation, from the private fund proposal to the securitization conflicts proposal, narrowing the regulatory distinctions between registered funds and other types of clients and issuers. 

At minimum, even before any further SEC action is taken with respect to the Proposal, RIAs might consider the guidance the SEC has provided regarding the current Custody Rule, including: (i) the imputation of custody for discretionary trading arrangements not involving assets that trade and settle on a DVP basis, (ii) the suggestion that most digital and crypto assets are already subject to the Custody Rule, and (iii) the assertion that pre-funding such digital and crypto assets, or currency, for trading on an exchange that is not itself a qualified custodian, would violate the current Custody Rule. RIAs also might consider mapping out a plan for compliance with the Proposal by, for example, engaging in dialogue with qualified custodians regarding the portions of the Proposal that would impact those stakeholders.

Comments on the Proposal are due May 8, 2023.

1 Safeguarding Advisory Client Assets, Advisers Act Release No. 6240 (Feb. 15, 2023) (Release), available at https://www.sec.gov/rules/proposed/2023/ia-6240.pdf (the “Proposal”).

2 Certain crypto and digital assets are “securities,” and therefore already in scope of the Custody Rule, but other such assets could potentially fall outside the scope of the current rule, so long as they are not “funds” (a term which has not historically been defined). Notably, in the Proposal, the SEC takes the view that “most crypto assets are likely to be funds or [securities] covered by the current rule.” See Proposal at n.29 and accompanying text.

3 Proposed Rule 223-1(d)(3)(ii).

4 Proposed Rule 223-1(d)(4).

5 Notably, this could impact advisers to funds organized as Cayman exempted companies, series trusts, Irish ICAVs or similar structures, where no general partner or managing member typically exists. Many RIA managers of such funds have historically concluded that they do not have “custody,” but also typically have discretionary trading authority.

6 Helpfully, the Commission did indicate that it intends to continue its existing interpretive position that substantive provisions of the Advisers Act and the rules thereunder, including the proposed Safeguarding Rule, do not apply to non-US clients of a registered offshore adviser. Issues arise, however, when a US-based affiliate is retained as a sub-adviser, because the US-based affiliate does not receive the same treatment.

7 C.f. Investment Adviser Association, SEC Staff No-Action Letter (Apr. 25, 2016).

8 See Proposal at n.37.

9 See Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority No. 2017-01 (Feb. 2017) (SEC, Division of Investment Management Guidance Update), available at https://www.sec.gov/investment/im-guidance-2017-01.pdf.

10 For example, an SMA may generally invest in publicly traded securities but also make investments in a small amount of illiquid, privately offered securities (e.g., “private equity”-style investments, or interests in special purpose vehicles (SPVs) established solely to facilitate investments by multiple clients in complex assets such as loans, real estate, etc.). Currently, under the Custody Rule, all the public securities may be kept with SMA client’s custodian but the interest in the SPV would likely satisfy the “privately offered security” exception, and therefore not need to be kept with a qualified custodian. Under the Safeguarding Rule, because the interest in the SPV is (properly) not kept with a qualified custodian, the RIA to this SMA would lose the ability use the surprise examination exception because the discretionary authority is not solely with respect to assets maintained with a qualified custodian.

11 For Mayer Brown’s full coverage of these developments, please see: Silicon Valley Bank (SVB) Response and Emerging Legal Issues.

12 See Merrill Lynch Mortgage Capital, Inc. v. FDIC, 293 F. Supp. 2d 98 (D.D.C. 2003).

13 See, e.g., Joseph H. Sommer, Special Deposits, The Business Lawyer, Vol. 76, 842-888 (Summer 2021).

14 See Proposal at n.106 citing Custody of Investment Company Assets Outside the United States, Investment Company Act Release No. 22658 (May 12, 1997) [62 FR 26923 (May 16, 1997)], at 26928 (“The amended rule requires the Foreign Custody Manager to consider whether the foreign custodian has the requisite financial strength to provide reasonable care for fund assets. Particular emphasis should be placed on evaluating the custodian’s financial strength, since the amended rule no longer requires the foreign custodian to have a specified minimum shareholders’ equity… in considering financial strength, the Foreign Custody Manager should assess the adequacy of the custodian’s capital with a view of protecting the fund against the risk of loss from a custodian’s insolvency. In addition, consideration must be given to the custodian’s reputation and standing generally.”)

15 See, e.g., Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority No. 2017-01 (Feb. 2017) (SEC, Division of Investment Management Guidance Update), available at https://www.sec.gov/investment/im-guidance-2017-01.pdf.

16 The Proposal notes that this could include, for example, the use of vaults to safeguard bearer instruments; implementation of robust cybersecurity standards for safekeeping book-entry assets; and the use of cold wallets and hot wallets for holding crypto assets, in combination with robust procedures. The Proposal indicates that advisers will have a responsibility to “become sufficiently familiar with safeguarding practices” for various assets in order to enable them to identify red flags or other concerns, in connection with its obligation to form an opinion regarding the required “reasonable assurances.”

17 The Proposal notes that while some clients may already receive indemnification for simple negligence from custodians, the Commission believes that custodians’ willingness to grant this term is a function of negotiating power. Under the Safeguarding Rule, this benefit would be extended to all advisory clients; as was the case with the private fund rule proposal from last year, the Commission has not been hesitant to dictate commercial terms when they believe doing so is in the interests of investors. Seeour alert on that proposal: SEC Proposal Significantly Impacts Private Fund Advisers and Investors.

18 Notably, this requirement would not preclude use of “omnibus” accounts, nor would it prohibit certain types of “commingled” accounts that are problematic under the current Custody Rule, such as sweep accounts, escrow accounts, and loan servicing accounts, which may commingle assets of clients and non-clients. See, e.g., Madison Capital Funding, Inc., SEC Staff No-Action Letter (Dec. 20, 2018).

19 See Proposal at n.217 and accompanying text.

20 See Proposal at n.225 and accompanying text. This largely incorporates the existing SEC staff guidance regarding certain types of “certificated” securities. See also Privately Offered Securities under the Investment Advisers Act Custody Rule No. 2013-04 (Aug. 2013) (SEC, Division of Investment Management Guidance Update), available https://www.sec.gov/divisions/investment/guidance/im-guidance-2013-04.pdf.

21 See Proposal at n.227 and accompanying text.

22 The Proposal further notes that physical evidence of physical assets, such as warehouse receipts for certain commodities, would not qualify for the exception if they can be used to transfer beneficial ownership (even though the underlying assets could qualify).

23 It is helpful that land and physical buildings will not need to be custodied as such assets cannot be kept with a qualified custodian. However, the Commission’s statements regarding real estate deeds raise a number of interpretive questions.  Among other things, it is unclear if this is intended to apply only to unrecorded deeds, or to recorded deeds as well.  Customarily, a prudent or sophisticated investor will record a deed with a local registrar or clerk’s office in connection with a transfer of title in order to establish its interest in the real property.  To the extent that the Safeguarding Rule would require unrecorded signed deeds to be maintained with a qualified custodian (and therefore not be sent for recordation), the Safeguarding Rule could create significant tension with the adviser’s fiduciary duty to clients to protect their interest in the real property.  Moreover, recorded deeds are often returned to counsel for the purchaser (who would not meet the definition of a “qualified custodian”), and therefore if the Commission’s statement extends to recorded deeds, such practice would run afoul of the rule’s requirements, even where there is no residual purpose of such a recorded deed, as they cannot be further novated or endorsed to a third party.

24 See Private Funds and the Application of the Custody Rule to Special Purpose Vehicles and Escrows No. 2014-07 (June 2014) (SEC, Division of Investment Management Guidance Update), available at https://www.sec.gov/investment/im-guidance-2014-07.pdf.

25 See Investment Adviser Association, SEC Staff No-Action Letter (Feb. 21, 2017).

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