SEC proposes rule changes on safeguarding of client assets

Written on Mar 7, 2023

The SEC has proposed rule changes to enhance how investment advisers safeguard client assets. The proposal would expand the scope of assets covered under the current custody rule to all client assets held in an advisory account, including crypto assets and any physical assets, and impose new custodial protections on client assets held by qualified custodians.

If adopted, the changes would amend Rule 206(4)-2, the “Custody Rule,” under the Investment Advisers Act of 1940 (the Advisers Act), and redesignate it as new Rule 223-1, the “Safeguarding Rule,” under the Advisers Act.

The proposal would expand the scope of assets covered by the Custody Rule as well as the recordkeeping and reporting requirements for advisers. It would also significantly expand the responsibilities for qualified custodians, by enhancing representations to clients and advisers, eliminating accommodation reporting, and narrowing the definition of “possession or control.” Finally, the proposal would increase the involvement of independent public accountants in certain circumstances.

The proposal would expand the scope of the assets covered under the Custody Rule from “funds and securities” to “funds, securities, or other positions held in a client’s account.” This would apply to all client assets held in an advisory account, including crypto assets and physical assets, which may not have previously been in scope of the Custody Rule. The new Safeguarding Rule would explicitly include assets over which an adviser has discretionary authority (i.e., the authority to decide which assets to purchase and sell for a client) as assets for which the adviser has custody.

In addition, the proposal specifies that a qualified custodian would have to have “possession or control” of advisory client assets, meaning that the qualified custodian would be required to participate in any change in beneficial ownership of those assets, to “maintain” them. This is intended to improve the integrity of custody account statements, such that a qualified custodian would only report the assets in its possession or control.

An adviser would be required to enter into a written agreement with and receive certain assurances from the qualified custodian holding customer assets. This written agreement would require the custodian to (1) provide promptly (upon request) records related to client assets held at the qualified custodian to the SEC or to an independent public accountant engaged to comply with the Safeguarding Rule; (2) deliver account statements at least quarterly to clients and to the adviser; and (3) obtain a written internal control report that includes an opinion of an independent public accountant regarding the adequacy of the qualified custodian’s controls. Currently, this requirement applies only when the adviser or its affiliate is acting as a qualified custodian. The written agreement would also specify the adviser’s agreed-upon level of authority to affect transactions in the account.

Advisers would also be required to obtain reasonable assurances that the qualified custodian will:

Exercise due care in accordance with reasonable commercial standards in discharging its duty as custodian and implement appropriate measures to safeguard client assets from loss

Indemnify the client against losses caused by the qualified custodian’s negligence, recklessness, or willful misconduct
Not be excused from its obligations to the client as a result of any sub-custodial or other similar arrangements
Clearly identify and segregate client assets from the custodian’s assets and liabilities
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

The proposal would expand the availability of the audit provision from pooled investment vehicles to other entities, such as pension plans, retirement plans, and college saving plans. It would also require the adviser or entity to enter into a written agreement with the independent public accountant, which would require the auditor to notify the SEC (1) promptly upon issuing an audit report to a private fund that contains a modified opinion and (2) within four business days upon termination of an engagement.

The proposal would modify the Custody Rule’s existing exemption for privately offered securities to be held by a qualified custodian to include certain physical assets and add new provisions, including the requirement for the adviser to notify its independent public accountant of any transfer of ownership within one day of the transaction. The adviser’s written agreement with the independent public accountant would require the accountant to then verify the transfer promptly upon receiving the transfer notice and notify the SEC within one business day if it identifies any material discrepancies.

As proposed, the rule would also require each privately offered security or physical asset not maintained with a qualified custodian to be verified as part of the adviser’s surprise examination, or as part of the audit when the adviser is relying on the audit provision for the entity that owns the asset.

The proposal would add new recordkeeping requirements and make corresponding amendments to Form ADV to improve the accuracy of custody-related data available to the SEC and the public.

Public comments on the proposal will be due 60 days after it is published in the Federal Register.