Proposed Amendments to the Custody Rule – Safeguarding Rule
By John Guerrieri, CPA, Partner, Alternative Investment Group
On February 15, 2023, the U.S. Securities and Exchange Commission (“SEC”) proposed amendments to Rule 206(4)-2 (“Custody Rule”) of the Investment Advisers Act of 1940 (“Advisers Act”) through a new proposed Rule 223-1 (“Safeguarding Rule”), which responds to market innovations through an updated framework. The SEC cited recent industry developments in technology, advisory services, and custodial practices that have provided opportunities for client assets to be placed at “risk of loss, theft, misuse, or misappropriation.” These industry developments have contributed to the following risks:
- The majority of securities are uncertificated, the volume of private capital offered securities has significantly increased, and the custodial market for privately issued securities is less developed.
- Custodians often list assets for which they do not accept “custodial liability” on client account statements. This is done for “accommodation reporting” purposes whereby the custodian does not attest to the holdings in these investments but rather simply reports investments and transactions as reported to it by the adviser.
- Reductions in the level of protection offered by custodians, with retail investors receiving the least protection.
- Developments with crypto assets which present unique risks to advisers and clients, including blockchain technology that, due to the finality of the distributed ledger or blockchain technology, does not provide advisory clients with recourse to reverse transactions that are fraudulent or erroneous, or restore or recover assets in the event key pairings are “lost, forgotten, misappropriated, or destroyed.”
The SEC noted that these industry developments may not be addressed under the current rule, prompting the need for the proposed Rule 223-1.
Scope of Rule
The proposed Rule 223-1 would apply to any investment adviser registered or required to be registered with the SEC under Section 203 of the Advisers Act, that has “custody” of a client’s assets, a concept similar to the current rule. The proposed Rule 223-1 differs from the current rule in that it extends its coverage beyond client “funds and securities” to client “assets.” The proposed Rule 223-1 would also explicitly clarify that the defined term “custody” includes discretionary authority.
Scope of Assets
The proposed Rule 223-1 defines “assets” as “funds, securities, or other positions held in a client’s account.” The “other positions” portion of this definition is an expansion that applies to other positions that are not funds or securities. This forward-looking statement is more encompassing than the current rule as it covers “new investment types as they continue to evolve and multiply to recognize that the protections of the rule should not depend on which type of assets the client entrusts to the adviser.” These “other positions” could include collateral posted on swap contracts, crypto assets, and physical assets, including artwork, real estate, precious metals, or physical commodities. The updated scope definition provides new flexibility for the proposed Rule 223-1 to adapt to industry developments and technologies.
Scope of Activity
The proposed Rule 223-1 continues to apply the definition of custody when an adviser “holds, directly or indirectly, client assets, or has any authority to obtain possession of them.” The concept behind this definition is that an investment adviser who can obtain possession of client assets can subject those assets to “risks of loss, misuse, misappropriation, or theft.” The current rule provides three examples of custody: physical possession, circumstances when the investment adviser acts in certain capacities, and certain arrangements when the investment adviser is authorized or permitted to instruct the client’s custodian. The proposed Rule 223-1 enhances the “arrangements” category to explicitly state that “discretionary trading authority is an arrangement that triggers the rule,” defining discretionary authority as the “authority to decide which assets to purchase and sell for the client.” The proposed custody definition would now include “any arrangement (including, but not limited to, a general power of attorney or discretionary authority) under which the adviser is authorized or permitted to withdraw or transfer beneficial ownership of client assets under the adviser’s instruction.”
Protections by Qualified Custodians
The SEC notes that qualified custodians would continue to act as “key gatekeepers” under the proposed Rule 223-1. Currently, investment advisers with custody of client assets are required to maintain these assets with a qualified custodian.
Banking or savings institutions, registered broker-dealers, registered futures commission merchants, and certain international financial institutions are among the entities expected to act as qualified custodians. The proposed Rule 223-1 requires that such institutions with possession or control of client assets have “a written agreement between the qualified custodian and the investment adviser.” If the qualified custodian is the investment adviser, the written agreement must be between the investment adviser and the client. This written agreement would provide protections and address recordkeeping, client account statements, internal control reports, and the level of authority to transact in the account. Specifically, the written agreement must include the following provisions which are not addressed in the current rule:
- The qualified custodian must promptly provide, upon request, records relating to clients’ assets held in the account at the qualified custodian to the Commission or an independent public accountant engaged for purposes of complying with the safeguarding rule.
- Specify the adviser’s agreed-upon level of authority to effect transactions in the account.
The written agreement also incorporates and expands on the following provisions, which are components of the current rule:
- The written agreement must contain a provision requiring the qualified custodian to deliver account statements to clients and to the adviser, as currently, advisers must have only a reasonable basis for believing this is done.
- The qualified custodian must obtain a written internal control report that includes an opinion from an independent public accountant regarding the adequacy of the qualified custodian’s controls. This provision expands the internal control requirement to all qualified custodians from the current rule’s application to an adviser or related person who acts as a qualified custodian.
Additionally, an investment adviser would be required to obtain “reasonable assurances” from the qualified custodian regarding protections that the qualified custodian will provide to the advisory client. These protections include the following:
- 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 from theft, misuse, misappropriation, or other similar types of loss.
- The qualified custodian will indemnify the client against the risk of loss in the event of the qualified custodian’s negligence, recklessness, or willful misconduct.
- The existence of any sub-custodial, securities depository, or other similar arrangements with regard to the client’s assets will not excuse any of 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 qualified custodian’s proprietary assets and liabilities.
- 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 to the extent agreed to or authorized in writing by the client.
These proposed changes are intended to provide investors with standard protections “that will improve the safeguarding of the assets in the current market as well as in the future as the market for financial products and advisory services continues to evolve.” The SEC notes that while many of these protections may already be provided, the proposed Rule 223-1 is designed to “expand and formalize the minimum standard of protections to advisory clients’ assets held by qualified custodians in a manner that would provide consistent investor protections across all qualified custodians under our proposed rule.”
The proposed Rule 223-1 specifies that a qualified custodian does not “maintain” a client asset for the rule “if it does not have possession or control of that asset.” Possession or control is defined as “holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets.”
This proposed change is intended to “improve account statement integrity and reliability by eliminating an adviser’s ability to request accommodation reporting” from a qualified custodian, whereby the custodian does not attest to the holdings in these investments, but simply includes the investments and transactions as reported to it by the investment adviser.
The proposed Rule 223-1 would also prohibit the account statement from “identifying assets for which the qualified custodian lacks possession or control unless requested by the client, and the qualified custodian clearly indicates that the custodian does not have possession or control over such assets.”
Privately Offered Securities Exception
Investment advisers registered under Section 203 of the Advisers Act must continue to safeguard all client assets of which they have custody through the use of a qualified custodian, with a few exceptions as clarified under the proposed Rule 223-1. The proposed Rule 223-1 provides an exception for privately offered securities and physical assets, allowing investment advisers to self-custody provided the following limited circumstances and conditions are met.
- The investment adviser must 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;
- The investment adviser must reasonably safeguard the assets from loss, theft, misuse, misappropriation, or financial reverses, including insolvency;
- An independent public accountant, pursuant to a written agreement between the investment adviser and the accountant, verifies any purchase, sale, or other transfer of beneficial ownership of such assets promptly upon receiving the notice required in the subsequent paragraph of this section; and notifies the SEC by electronic means directed to the Division of Examinations within one business day upon finding any material discrepancies during the course of performing its procedures;
- The independent public accountant engaged to perform the verification required by the preceding paragraph of this section is notified of any purchase, sale, or other transfer of beneficial ownership of such assets within one business day; and
- 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 a financial statement audit.
The SEC notes that the purpose of this exception is to limit the availability of the exception to “circumstances that truly warrant it,” as in the SEC’s view, qualified custodians can maintain the majority of advisory client assets and, therefore, should be safeguarded in the manner described under the proposed Rule 223-1.
Surprise Examination or Audit
Similar to the previous rule, the proposed Rule 223-1 continues to require investment advisers to undergo an annual surprise examination or obtain an annual audit of financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”). Advisers obtaining and distributing audited financial statements to investors are “deemed to have complied with the surprise examination requirement,” eliminating their need for compliance with account statement requirements.
The proposed Rule 223-1 does, however, require that the existence and ownership of each of the client’s privately offered securities or physical assets not maintained with a qualified custodian be verified as part of the annual independent verification or as part of a financial statement audit.
This proposed change is designed to “address our concerns that a loss of these assets could go undetected for an extended period as a result of not being included within the accountant’s sample to be tested during a surprise examination or verified during an audit if they do not meet the threshold for materiality.” The SEC recognized that while this proposed requirement likely constitutes “a departure from current practice for most surprise examinations and audits, [it believes] that the protective benefits of the surprise examination and annual audit are critical to the safeguarding of client assets, especially where these assets do not have the additional protections afforded by the oversight of a qualified custodian.”
For investment advisers obtaining an annual audit, the proposed Rule 223-1 also requires investment advisers to enter into a written agreement with the independent public accountant performing the audit to notify the SEC upon two events:
- Within one business day upon issuing an audit report to the entity that contains a modified opinion;
- Within four business days of resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed.
The SEC notes that this requirement aligns proposed Rule 223-1 with the current Form ADV-E filing requirement for independent public accountants performing surprise examinations.
Expansion of the Audit Provision Availability
Under the current rule, the audit provision is available to advisers of pooled investment vehicles, generally formed as limited partnerships, limited liability companies, and other types of pooled investment vehicles. Under the proposed Rule 223-1, the SEC would extend the availability of the audit provision and the associated investor protection benefits to any advisory client entity whose financial statements can be audited. The proposed Rule 223-1 would extend the audit provision to a larger number of investors, including pension plans, retirement plans, and 529 plans.
The SEC acknowledged the benefits of audits, noting that “audits provide substantial benefits to pooled investment vehicles and their investors because audits test assertions associated with the investment portfolio” and “provide a check against adviser misrepresentations of performance, fees, and other information about the pool.”
Public Comment Period and Industry Reactions
Public comments were due by May 8, 2023.
Reactions from the investment management industry include comments ranging from consideration of the implementation costs on investment advisers, challenges in providing custodial services for digital assets, potential “loss of competition” for custodians required to provide these services, and concerns over the associated costs of proposed Rule 223-1 being passed on to clients. Additionally, comment letters to the SEC have requested clarification on certain concepts and phrases in proposed Rule 223-1 specific to independent public accountants, including the assurance framework that the “verification procedure” can be performed under, and the definition of “material discrepancies” that require SEC notification.
The SEC’s efforts to increase the safeguarding and protection of client assets through proposed Rule 223-1 will have a significant impact on the investment management industry at large and key gatekeepers. We will continue to provide updates on related developments.