On February 15, 2023, the Securities and Exchange Commission (the “SEC”) issued a proposal to enhance investor protections relating to the safeguarding of advisory client assets by amending and redesignating Rule 206(4)-2 (the “custody rule” or the “current rule”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), as new Rule 223-1 (the “safeguarding rule”). Corresponding amendments to Rule 204-2 under the Advisers Act (the “books and records rule”) and to Form ADV are also proposed (collectively with the proposed safeguarding rule, the “Proposed Rules”).

The Proposed Rules, summarized below, are “designed to recognize the evolution in products and services investment advisers offer to their clients and to strengthen and clarify existing custody protections, while also proposing complementary refinements to how advisers report custody information on Form ADV and the books and records they are required to keep that are designed to improve [the SEC’s] oversight and risk-assessment abilities.” The Proposed Rules would apply to investment advisers registered or required to be registered with the SEC under Section 203 of the Advisers Act, as well as any adviser whose related persons have custody of client assets in connection with the adviser’s advisory services.

Background: Current Requirements Under the Custody Rule

Currently, investment advisers who (or whose related persons) have “custody” over client funds or securities are required under the custody rule to take certain steps and adopt certain practices aimed at protecting such funds or securities from loss, theft, misuse, and misappropriation, including: (a) maintaining client funds and securities with a “qualified custodian”, (b) providing written notice to clients of the qualified custodian’s name, address, and the manner in which the funds or securities are maintained, (c) having a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each client for which the custodian maintains funds or securities, (d) verifying, at least annually by surprise examination by an independent public accountant, the client funds and securities of which the adviser has custody, subject to certain limited exceptions, and (e) if the adviser maintains (or if it has custody because a related person maintains) client funds or securities as a qualified custodian, obtaining an annual internal control report prepared by an independent public accountant regarding the suitability and effectiveness of the controls maintained by the adviser relating to its custodial services.

The Proposed Rules would (i) expand and modernize the types of assets and activities subject to the SEC’s custody-related rules, (ii) enhance the requirement that client assets be maintained with a qualified custodian, (iii) require advisers to have a reasonable belief that the independent public accountant engaged to conduct surprise examinations can and will conduct the examination, (iv) provide new limited exceptions to the surprise examination requirement, (v) amend the books and records rule to require advisers to maintain books and records related to the adviser’s obligations under the safeguarding rule and, more generally, to keep additional, more detailed records relating to client accounts over which the adviser has custody, and (vi) amend Form ADV to improve the accuracy and completeness of the custody-related information collected and to ensure that the information collected aligns with the adviser’s obligations under the proposed safeguarding rule.

Client Assets Subject to the Safeguarding Rule

The custody rule currently applies to investment advisers that have (or whose related persons have) custody of client “funds or securities.” The Proposed Rules would expand application of the rule so that it applies to investment advisers (or related persons) having custody of client “assets”, defined as “funds, securities, or other positions held in the client’s account” (emphasis added). Citing its authority under Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which specifically authorized the SEC to prescribe rules requiring investment advisers to safeguard client “assets” over which the adviser has custody, the SEC stated the proposed definition and use of “assets” “is designed to remain evergreen, encompassing 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.”

Examples of “assets” covered by the Proposed Rules would include crypto assets, financial contracts held for investment purposes, collateral posted in connection with a swap contract on behalf of the client, and other assets that, in each case, may or may not qualify as funds or securities currently covered by the custody rule. The SEC also noted that “other positions” within the meaning of the proposed definition of “assets” would include holdings that may not be assets for accounting purposes, reflecting the SEC’s belief that “in the advisory account context . . . the entirety of a client account’s positions, holdings, or investments should receive the protections of the proposed rule regardless of how they may be treated for accounting purposes.”

Activity Subject to the Proposed Rules

The meaning of “custody” under the Proposed Rules would be generally consistent with the meaning under the current rule and would apply when an investment adviser holds, directly or indirectly, client assets, or has any authority to obtain possession of them. The Proposed Rules also generally retain three categories of activity from the current rule that serve as examples of activity qualifying as “custody”: (i) possession of client assets, (ii) any arrangement under which an adviser is authorized or permitted to withdraw client assets upon the adviser’s instruction, and (iii) any capacity that gives an adviser or its supervised person legal ownership of or access to client assets. However, the Proposed Rules would make two enhancements to the activity described in category (ii):

• First, an adviser having authority or permission to transfer beneficial ownership of client assets would be added as an arrangement constituting “custody” under category (ii) (i.e., in addition to an adviser having authority or permission to withdraw client assets).
• Second, discretionary trading authority would be explicitly included as an example of an arrangement of the type described by category (ii) and therefore within the meaning of “custody.” “Discretionary trading authority” is defined under the Proposed Rules as “the authority to decide which assets to purchase and sell for the client” and would include delivery versus payment transactions, although an adviser would be excepted from the surprise examination requirement (discussed below) under the Proposed Rules if the sole basis for having custody is discretionary trading authority, provided such authority is limited to instructing clients’ qualified custodians to transact in assets that settle exclusively on a delivery versus payment basis.

These proposed enhancements reflect the SEC’s view that “[a]n adviser’s ability or authority to effect a change in beneficial ownership of a client’s assets, including for purposes of trading, could place client assets at risk of loss that the rule is designed to address.”

Amendments to Surprise Examination Requirements and Exceptions

Like the current rule, the Proposed Rules would require an adviser to verify the client assets over which it has custody at least annually by surprise examination pursuant to a written agreement between the adviser and an independent public accountant. However, the Proposed Rules add a new explicit requirement that an adviser have a reasonable belief that the written agreement has been implemented, meaning the adviser must have a reasonable belief that the independent public accountant can and will conduct the surprise examination pursuant to the agreement and in accordance with the Proposed Rules.

The Proposed Rules also amend the custody rule’s exceptions to the surprise examination requirement. Currently, advisers who have custody over client assets solely as a result of the adviser’s authority to deduct advisory fees from client accounts, or because an operationally independent related person has custody, are excepted from the surprise examination requirement. The Proposed Rules would retain these exceptions and add a new exception for advisers whose sole basis for having custody is discretionary trading authority, provided such authority is limited to instructing clients’ qualified custodians to transact in assets that settle exclusively on a delivery versus payment basis. A new exception would also be added for advisers who have custody solely as a result of standing letters of authorization issued by a client to the adviser.

Enhanced Qualified Custodian Requirements

Consistent with the custody rule, the Proposed Rules would require advisers to maintain assets over which they have custody with a qualified custodian (i.e., a bank or savings association, registered broker-dealer, registered futures commission merchant, or qualifying foreign financial institution). However, “in light of the evolution of the market for custodial services, financial products, and advisory services over the last decade,” the Proposed Rules would make several amendments aimed at strengthening this requirement:

• To “maintain” client assets under the Proposed Rules, a qualified custodian must have “possession or control” of the assets, meaning the custodian must participate in any change in beneficial ownership of the assets.
• Advisers will be required to enter into written agreements with qualified custodians and the agreement must require the custodian to provide promptly, upon request, records relating to clients’ assets held in the account at the custodian to the SEC or to an independent public accountant engaged for purposes of complying with the safeguarding rule. The Proposed Rules would also require the agreement to specify the adviser’s agreed-upon level of authority to effect transactions in the account.
• Foreign financial institutions (“FFIs”) may continue to serve as qualified custodians under the Proposed Rules, provided they satisfy certain new conditions aimed at enhancing “the ability and responsibility of advisers to protect client assets maintained outside the United States.” Conditions include that the FFI be (i) organized in a jurisdiction in which the adviser and SEC are able to enforce judgments, including civil monetary penalties, against the FFI, (ii) regulated by a foreign governmental or financial regulatory authority as a financial institution that customarily holds financial assets for its customers, and (iii) required by law to comply with anti-money laundering requirements similar to those set forth in the U.S. Bank Secrecy Act, and to have practices, procedures and internal controls in place aimed at ensuring the exercise of due care with respect to the safekeeping of client assets.
• Banks and savings associations may also continue to serve as qualified custodians under the Proposed Rules, provided that client assets are held in an account designed to protect the assets from creditors of the bank or savings association. This new condition currently applies to broker-dealers, futures commission merchants, and FFIs under the custody rule, and the Proposed Rules would apply the requirement to banks and savings associations as well.

Amendments to the Books and Records Rule

The books and records rule under the Advisers Act requires registered advisers to maintain certain books and records relating to the adviser’s investment advisory business. The Proposed Rules would amend the rule to establish additional requirements for maintaining books and records related to the adviser’s obligations under the safeguarding rule. If adopted, an adviser with custody of client assets will be required to maintain true, complete and accurate records of all client notifications and independent public accountant engagements required by the safeguarding rule. Advisers will also be required to create and retain detailed records relating to client accounts, custodians, account statements, trade and transaction activity for each client account, the basis for the adviser having “custody” under the safeguarding rule, and any standing letters of authorization issued by a client to the adviser.

The SEC believes these amendments “would enhance the [SEC’s] oversight of the safeguarding practices of advisers and their compliance with the rule, which will, in turn, promote investor protection.”

Amendments to Form ADV

The Proposed Rules also include several proposed amendments to Form ADV—the application for registration with the SEC that must be filed and maintained by advisers required to register with the SEC and by exempt reporting advisers. Specifically, Item 9 of Part 1A of Form ADV (as well as the corresponding sections of Schedule D and the Instructions and Glossary of Form ADV), which collects information related to an adviser’s custody of client funds and securities, would be amended so that the information collected aligns with the proposed safeguarding rule (e.g., by changing all references to client “funds and securities” to client “assets”, as defined by the safeguarding rule) and to collect additional, more detailed information related to the adviser’s custodial practices, including additional information regarding qualified custodians that maintain client assets for the adviser.

The proposed amendments would also reorganize and clarify Item 9 to remove confusion over the use and meaning of “custody” in both the Form and SEC rules, and, more generally, to improve the accuracy and completeness of the information collected. The SEC noted, for example, that, while advisers may have “custody” of client assets for purposes of the custody rule, there are circumstances where an adviser may be instructed in the current form of Form ADV to report not having custody for purposes of completing Item 9.A.(1), which may in turn lead to inaccurate reporting and/or cause advisers to mistakenly believe they are not subject to the custody rule.

Comments on the Proposed Rules are due 60 days after publication in the Federal Register. For additional information related to anything contained in this Client Alert, please contact one of the authors listed above, or any member of our Securities Law Practice Group.