In February, the SEC announced a proposal to significantly revise Rule 206(4)-2 (the “Custody Rule”) to help provide additional protections to client assets. Specifically, under the proposal, the Custody Rule would be replaced by a proposed Rule 223-1 (the “Safeguarding Rule”).
CLIENT ASSETS
The new Safeguarding Rule would apply to all client assets, including real estate, crypto assets, and derivatives, rather than just client “funds and securities.” With regard to “privately offered securities,” however, an exception from the requirement to maintain these securities at a qualified custodian would be kept in place, provided that the investment adviser documents that a qualified custodian is not able to record and maintain the assets, the adviser reasonably safeguards the assets, and the adviser meets certain other conditions.
DISCRETIONARY AUTHORITY
Another significant change would be that an adviser with discretionary authority to trade client assets, even without access to the funds and securities of that client, would be considered to have “custody.” However, an exception to the independent accountant surprise examination requirement would be provided if the adviser’s sole reason for having custody is because it has discretionary authority (or because the adviser is deducting advisory fees from the custodian or acting according to a standing letter of authorization), subject to certain conditions. Nevertheless, an adviser with custody because it has discretionary authority would still need to comply with other requirements of the Safeguarding Rule, including the need to maintain assets with a qualified custodian.
WRITTEN AGREEMENT WITH CUSTODIAN
The proposed rule would also require an adviser to enter into a written agreement with and receive certain assurances from the qualified custodian to make sure that the qualified custodian is providing certain standard custodial protections while maintaining client assets. One provision of this written agreement would require the qualified custodian to provide promptly, upon request, records relating to clients’ assets held in the account at the qualified custodian to the SEC or to an independent public accountant engaged for purposes of complying with the Safeguarding rule. The other required provision of the agreement between the adviser and the qualified custodian would specify the adviser’s agreed upon level of authority to effect transactions in the account. The proposed rule’s written agreement requirement would also incorporate, and expand, two components of the current Custody Rule. First, the written agreement would have to contain a provision requiring the qualified custodian to deliver account statements to clients and to the adviser. The other provision would require the qualified custodian to obtain a written internal control report that includes an opinion of an independent public accountant regarding the adequacy of the qualified custodian’s controls.
REASONABLE ASSURANCES
In addition to the written agreement requirement above, advisers would have to obtain reasonable assurances that the qualified custodian satisfies five additional items. These include assurances that the custodian will: (1) exercise due care in accordance with reasonable commercial standards in discharging its duty as custodian and implement appropriate measures to safeguard client assets from theft, misuse, misappropriation, or other similar type of loss; (2) indemnify the client against losses caused by the qualified custodian’s negligence, recklessness, or willful misconduct; (3) not be excused from its obligations to the client as a result of any sub-custodial or other similar arrangements; (4) clearly identify and segregate client assets from the custodian’s assets and liabilities; and (5) 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.
FORM ADV AND RECORDKEEPING REQUIREMENTS
Finally, advisers’ recordkeeping requirements and reporting requirements in Form ADV would also be amended to bring the changes to the Custody Rule in line with the new Safeguarding Rule.
Next Steps
The SEC’s proposal will be subject to a comment period, which will remain open for 60 days after publication in the Federal Register. A copy of the proposed rule can be found here.
For more information about the proposed changes discussed above, please contact NCA Compliance.Hayley Nelson is the President and Principal Consultant of NCA Compliance, Inc., a compliance consulting firm providing a wide range of customized compliance solutions for investment advisors. Ms. Nelson previously worked for the Securities and Exchange Commission and a large investment manager in New York.
