The United States Securities and Exchange Commission (SEC) has proposed a new rule for registered investment advisers that would replace the current “custody rule” with a new “safeguarding rule” and make corresponding amendments to the recordkeeping rule and Form ADV. (Additional information is contained in a related press release and fact sheet.)
In the proposed rule, the SEC would renumber the current custody rule (Rule 206(4)-2 under the Advisers Act) as new Rule 223-1 under the Advisers Act. Among other things, the new “safeguarding” rule would specifically expand the scope of the types of client assets covered under the rule from “funds and securities” to include any client assets of which an adviser has custody. In a significant change from the current custody rule, the new proposed rule would revise the definition of “custody” to include any assets over which an adviser exercises discretionary trading authority. The proposed rule would then include a limited exception from the surprise examination requirement for an adviser whose custody of client assets arises solely from discretionary authority so long as (1) the client assets are maintained with a qualified custodian (e.g., securities not kept with a custodian pursuant to the “privately offered securities” exception would be disqualified from this exception) and (2) the adviser’s trading under discretionary authority is limited to client assets that settle exclusively on a “delivery-versus-payment” (DVP) basis. Because syndicated bank loans generally trade on a non-DVP basis, this exception generally would not be available to CLOs.
In a March 12, 2019, letter (discussed in greater detail in our related Legal Update), the SEC requested specific information regarding the types of assets that are traded non-DVP and regarding other matters, which elicited 10 comment letters, including a letter from the Loan Syndications and Trading Association (LSTA) that discussed how trading loans constituted “authorized trading” and fell outside “custody” under the current custody rule. The LSTA also argued that, due to typical protections and built-in “checks” in the customary trading arrangements for loans (that the letter described in detail), the application of the custody rule to loan trading that is settled non-DVP was not necessary to prevent the loss or misappropriation of client funds.
By proposing to expand “custody” to include assets traded under discretionary trading authority, the proposed rule would require CLO managers to comply with the safeguarding rule, including its surprise examination requirement (or through delivery of annual audited financial statements in lieu of a surprise examination, as permitted under the rule), which has not typically been done by CLO managers and would involve a new potential expense not clearly accounted for in typical CLO indentures.
Our in-depth analysis of the proposed rule will be available in the coming days.
Comments on the proposed rule are due on or before the date that is 60 days following publication in the Federal Register and may be made as described in the proposed rule.