Natalie A. Roberts, J.D., LL.M.
Natalie A. Roberts, J.D., LL.M.

Advisors Take Note: SEC Proposes Sweeping Changes to Custody Rule

By Natalie Roberts

On the horizon is a potentially cataclysmic shift in the rules for custody of investments managed by investment advisers.

On February 15, 2023, the Securities and Exchange Commission (“the Commission”) issued  Release IA-6240 (the “Issuing Release”), announcing it proposes to amend Rule 206(4)-2 of the Investment Advisers Act of 1940 (“Advisers Act”), commonly referred to as the “Custody Rule”. The new  proposed rule will be redesignated as Rule 223-1(a)(1),[1] a new “Safeguarding Rule.” Regarding a period within which advisers would be required to comply, the Commission is suggesting one year following the rule’s effective date. Advisers with RAUM below $1 billion would have 18 months to comply.

In its release, the Commission requests comments on all aspects of the proposed rule, with a deadline for submission of such comments within 60 days.  The Commission expressly requests comments regarding the impact of the proposed rule on smaller firms.[2]

Significant Proposed Changes

The most significant proposed changes to the existing Custody Rule include the following:

  • Expanding the rule to cover not only funds and securities, but “all assets” in an adviser’s client’s account, including investments that, until now, have not been considered to be within the auspices of the  Custody Rule, such as digital assets, art, real estate, precious metals, physical commodities, financial contracts held for investment purposes, and collateral posted in connection with a swap contract. 
  • Applying the rule to physical assets that traditionally were deemed non-custodiable, if they are subject to transfer via a document, such as a warehouse receipt.
  • Redefining “custody” to include discretionary trading authority.
  • Enhancing the standards for custodians to serve as “qualified custodians,” by requiring that qualified custodians maintain “possession or control” of client assets, hold them in accounts segregated from the custodian’s proprietary assets and liabilities, and agree to indemnify the client in the event of loss caused by the custodian’s negligence.
  • Changing the definition of “possession and control” to mean holding assets under terms requiring the qualified custodian to participate in any change in beneficial ownership of the advisory clients’ assets.
  • Requiring advisers to enter into written agreements with qualified custodians that allow the adviser to obtain “reasonable assurances” that the custodians will provide “vital protections” for safeguarding clients’ assets, whether those assets consist of crypto assets or physical assets.
  • Allowing advisers and their related persons to serve as qualified custodians, with certain heightened protections as conditions that must be met.
  • Limiting the exception from the rule for privately offered securities to those that:
    • acquired from the issuer;
    • are uncertificated;
    • the ownership of which can only be recorded on the non-public books of the issuer or its transfer agent, in the name of the client as it appear in the adviser’s records;
    • transferable only with the prior consent of the issuer; and
    • in the case of an adviser to a limited partnership or similar pooled investment vehicle, the adviser must comply with the rule’s audit provisions.

From, its inception, the Custody Rule was designed to safeguard client funds and securities from the financial reverses, including insolvency, of an investment adviser, and to prevent client assets from being lost, misused, stolen, or misappropriated.  The proposed rule, according to the release, represents the Commission’s attempt to close gaps in the current rule, which must be addressed based on the basic recognition that custodians are the key gatekeepers to mitigate loss of client assets.

While the safeguards proposed in the new rule improve investor protects, the proposed rule arguably represents a preemptive attempt by the Commission to exert regulatory authority over digital assets, including cryptocurrency and NFTs, using its right to regulate investment advisers as a portal to such expanded jurisdiction. This claim of extended authority will doubtlessly be challenged, first by commentators and, subsequently, if the proposed rule is adopted in its present form, in court.

[1] Securities and Exchange Commission Release No. IA-6240, File No. S7-04-23, RIN 3235-AM32, Safeguarding Advisory Client Assets, 17 CFR Parts 275 and 279, issued 2/15/2023. In the Issuing Release, the SEC proposes to effect corresponding amendments to the recordkeeping rules and to Form ADV under the Adviser’s Act.

[2] Issuing Release, p. 405

Natalie A. Roberts, J.D., LL.M.

Natalie A. Roberts, J.D., LL.M.

Natalie Roberts is licensed to practice in both Florida and Minnesota. She is dedicated to providing honest, exceptional and deeply personalized legal counsel to her clients.

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