SEC Proposes Expanded Custody Rule for Investment Advisers

The Securities and Exchange Commission (“SEC”) yesterday announced proposed amendments to Rule 206(4)-2 (the “Custody Rule”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The proposed amendments—which would redesignate the rule as Rule 223-1 (the “Safeguarding Rule”)—would significantly expand the scope of the existing Custody Rule to cover a broader scope of client assets and mandate extensive new contractual relationships between investment advisers and their clients’ custodians.

Material Amendments

Three of the proposed changes will have a material impact on the practices of many advisers, including advisers that presently are not subject to the Custody Rule. The proposed Safeguarding Rule would:

1. ?Explicitly include an investment adviser’s discretionary authority to trade client assets and the ability to transfer client assets within the definition of “custody”;
2. Require that an adviser enter into written agreements with each qualified custodian that maintains possession or control of a client’s assets and obtain reasonable assurances in writing that the custodian will take certain actions; and
3. Expand the scope of the existing Custody Rule beyond “client funds and securities” to include any “funds, securities, or other positions held in the client’s account”.

If adopted as proposed, the first change will greatly expand the universe of investment advisers that are subject to the rule because discretionary investment authority will be considered to confer custody on investment advisers, even if the investment adviser does not have the authority to cause the client’s custodian to transfer assets to third parties.

The second change will require investment advisers to enter into direct contractual agreements with custodians with terms and further assurances regarding reporting, submission to SEC information requests, and asset segregation, among others.?Contracts between adviser and custodian would be required even where clients engage their custodians directly and without regard to the terms in the client’s custodial arrangements.?The practical impediments to establishing or repapering contracts between substantial portions of the investment management industry and the banking industry will be enormous.

The third change would extend the Custody Rule’s reach to real estate, art, and similar physical assets, and would also require that digital assets be custodied with a qualified custodian, even if (as the SEC conceded in the proposing release) the digital assets are neither funds nor securities.

Other Amendments

The proposed Safeguarding Rule also imposes certain technical requirements, including obtaining written assurances from custodians and independent public accountants, that will present practical operational challenges and significant costs in connection with their implementation.?For example, the proposed Safeguarding Rule would:

1. Require that the qualified custodian maintain possession or control of a client’s assets;
2. Broaden the Custody Rule’s exception from the obligation to maintain client assets with a qualified custodian for certain privately offered securities to also include certain physical assets (e.g., real estate), but narrow the utility of the exception by imposing several onerous conditions; and
3. Provide a limited exception from the surprise examination requirement (but not the other requirements of the proposed rule) for client accounts where the adviser has custody solely because they have discretionary authority with respect to those assets if (i) the assets are maintained with a qualified custodian, and (ii) discretionary authority for the account is limited to instructing the qualified custodian to transact in assets that settle exclusively on a delivery versus payment basis.

Next Steps

A more detailed alert regarding the substance and practical impacts of the proposed amendments, including proposed changes to the Recordkeeping Rule and Form ADV, will follow.?The public comment period will remain open for 60 days following publication of the proposal in the Federal Register.?If adopted as proposed, large advisers will have only one year and smaller advisers will have eighteen months to comply, which as noted will require significant coordination and a reworking of existing practices among various market participants.