The Securities and Exchange Commission (“SEC”) is proposing a new rule (“proposed safeguarding rule”) under the Investment Advisers Act of 1940 (“Advisers Act”) to address how investment advisers safeguard client assets. The amendments are intended to enhance investor protections, all of which are consistent with the original intent to protect client assets from the adviser’s own insolvency or bankruptcy, and from the assets being lost, misused, stolen, or misappropriated.
The amendments would also redesignate the current custody rule as Rule 223-1 under the Advisers Act and would be referenced as the “safeguarding rule.” There would also be complementary changes to the Advisers Act books and records rule and Form ADV, which would be designed to align reporting obligations with the proposed rule and to improve the accuracy of custody-related data available to the SEC, its staff, and the public.
Based on the SEC’s belief that the fiduciary duty extends to the entire advisory relationship between the adviser and its client, regardless of whether a specific holding in a client account meets the definition of funds or a security, the proposed amendments would expand the scope of the current custody rule beyond client funds and securities to include any client assets of which an adviser has custody. This proposed change uses more expansive and explicit language to protect client assets when advisers have custody. “Assets” would mean “funds, securities, or other positions held in a client’s account”, and would include all other assets under management by the adviser, including crypto assets, financial contracts, and physical assets such as artwork, precious metals, real estate, or physical commodities such as wheat or lumber. The safeguarding rule would also explicitly include an adviser’s discretionary authority to trade client assets within the definition of custody.
Like the current custody rule, the safeguarding rule would require advisers with custody of client assets to maintain those assets with a qualified custodian, with very limited exceptions. A qualified custodian generally is a federal or state-chartered bank or savings association, certain trust companies, a registered broker-dealer, a registered futures commission merchant, or certain foreign financial institutions. Under the proposal, a qualified custodian would be required to have “possession or control” of advisory client assets. The proposal would also further specify the manner in which qualified custodian banks and savings associations must hold client assets.
The proposed safeguarding rule’s enhanced protections would also:
- Require that an adviser enter into a written agreement with and obtain certain reasonable assurances from qualified custodians to ensure clients receive certain standard custodial protections when an adviser has custody of their assets.
- Modify the current custody rule’s exception from the obligation to maintain client assets with a qualified custodian for certain privately offered securities, including expanding the exception to include certain physical assets.
- Require advisers with custody of client assets, regardless of whether they are maintained by a qualified custodian, to segregate those assets by (a) titling or registering the assets in the client’s name or otherwise holding the assets for the client’s benefit, (b) not commingling the assets with the adviser’s or any of its related persons’ assets, and (c) not subjecting the assets to any right, charge, security interest, lien, or claim of any kind in favor of the investment adviser or its related persons or creditors, except to the extent agreed to or authorized in writing by the client.
- Retain the current custody rule’s requirement for an adviser to undergo a surprise examination by an independent public accountant to verify client assets but expand the availability of the current custody rule’s audit provision as a means of satisfying the surprise examination requirement.
- Amend the investment adviser recordkeeping rule to require advisers to keep additional, more detailed records of trade and transaction activity and position information for each client account of which it has custody.
- Amend Form ADV to align advisers’ reporting obligations with the proposed safeguarding rule’s requirements and to improve the accuracy of custody-related data available to the SEC, its staff, and the public.
Requests for Comment
The SEC is seeking comments on all aspects of the proposed safeguarding rule. Should you have thoughts on this proposed rule, you should act quickly, as the Comment Period ends May 8, 2023.