On February 15, 2023, the U.S. Securities and Exchange Commission (the “SEC”) proposed massive changes to the custody rule for registered investment advisers. Public comments to this proposal can be submitted to the SEC until May 8, 2023. If these rules are implemented as is, registered investment advisers with at least $1 billion in regulatory assets under management would have 12 months to comply and registered investment advisers with $1 billion or less in regulatory assets under management would have 18 months to comply. Notably, this rule change would not affect exempt reporting advisers or unregistered investment advisers. While not yet in effect, these changes include:
Expanding Rule Coverage to Other Assets: The current custody rule only applies to “funds and securities”, but the SEC wants to also include “other positions held in [a] client’s account”. This additional language is intended to cover assets, such as financial contracts held for investment purposes; short positions; written options and collateral posted in connection with swap contracts; uncertificated privately offered securities; physical assets, including artwork, real estate, precious metals, physical commodities (e.g., wheat and lumber); liabilities on a client’s balance sheet (e.g., negative cash); and digital assets (including bitcoin and other cryptocurrencies, NFTs, etc.).
Custody to Include Discretionary Trading Authority: The proposed rule would newly define custody to include discretionary trading authority. The SEC intends to apply the rule to investment advisers with custody over their client’s accounts, and will not be applicable to advisers with a purely advisory role.
New Qualified Custodian Requirements: Under the proposal, qualified custodians are required to maintain possession or control of a client’s assets, including transactions that require a change in beneficial ownership. Notably, this change would create complications for custodians of digital assets.
Required Written Custodian Agreements: The new rule would require investment advisers to have written agreements with custodians that have control of client assets. These written agreements would require certain custodian representations, such as: agreeing to promptly provide records of a client’s assets to the SEC when requested; agreeing to provide quarterly account statements to the client and the investment adviser; agreeing to provide an annual internal control report to the investment adviser; and specifying the investment adviser’s level of authority over the account.
Required Written Reasonable Assurances from Custodians: Similarly, the proposed rule would require investment advisers to receive written reasonable assurances from qualified custodians and maintain an ongoing belief that a custodian will: exercise due care and safeguard client assets; indemnify the client from risk of loss due to custodian negligence, recklessness, and willful misconduct; be responsible for its obligations regardless of sub-custodial arrangements; segregate client assets from the liabilities of a custodian; and not subject the client’s assets to the custodian’s liens or claims.
New Exception Parameters, Including Exclusion of Physical Assets: The proposed rule would also permit physical assets to qualify under the new custody rule parameters. However, there would need to be accompanying documentation that specifies why a physical asset or privately-offered security cannot be maintained with a custodian. Additionally, these new parameters would require notifying an independent public accountant within one business day of a purchase or sale of the asset, along with a verification of the transaction from the accountant.
All Entities Subject to Audit: Currently, the custody rule subjects only pooled investment vehicles to audits, but the proposed safeguarding rule would broaden the scope to all entities. This expansion intends to include pension plans, retirement plans, college savings plans, and more.
New Exceptions to Surprise Examination Requirement: The new rule would create additional exceptions to the surprise examination requirement for investment advisers. The new exceptions would include: investment advisers that have custody pursuant to a standing letter of authorization; or the assets are with a qualified custodian and the investment adviser only has discretionary authority limited to instructing the qualified custodian to settle on a delivery versus payment basis.
New Recordkeeping Requirements and Form ADV Disclosures: The new rule proposes investment advisers keep more detailed transaction records and, on their Form ADV, provide more details on their safeguarding of assets and other information.
If you have any questions about this alert or any other regulatory matters, do not hesitate to reach out to: Daniel G. Viola at 212.573.8038, dviola@sadis.com.