INVESTMENT ADVISERS—Comment period reopened on proposal to enhance advisers’ protection of crypto and other assets - 24 August 2023

The initial comment period on changes to the safeguarding rule ended in May, but the Commission feels that additional time is warranted in light of the adoption of the private fund adviser audit rule.

The SEC has reopened the comment period on its controversial plan to amend Investment Company Act Rule 206(4)-2 (the custody rule) to extend an investment adviser’s safeguarding requirements to crypto and other digital assets. The Commission said that the reopening was prompted by the adoption of the private fund adviser audit rule, which requires an adviser to obtain an annual financial statement audit of each private fund it advises in accordance with the audit provision of the existing custody rule. The new comment period will be open for 60 days from the date of the publication of the reopening notice in the Federal Register.

A number of industry organizations wrote to the SEC early in the initial comment period to request more time to comment given the breadth and complexity of the proposal. However, some of them, including the Investment Adviser Association (IAA) and the Investment Company Institute (ICI), still managed to submit comment letters within the initial 60-day period.

The existing custody rule, which has not been amended since 2009, imposes certain safeguarding requirements on advisers to protect clients from the adviser’s insolvency and from the misappropriation or misuse of clients’ funds and securities. Among its primary requirements is that investment advisers must maintain client securities or funds with a qualified custodian to avoid mixing client funds and securities with an adviser’s own assets.

Proposed amendments. The proposed amendments, which were initially issued in February and have garnered more than 150 comment letters to date, would expand the rule to apply to any client assets over which the adviser has custody, including digital assets. The amendments reflect the SEC’s growing concern over the proper handling of digital assets, which have created a new avenue for client assets to be placed at risk.

The Commission reiterated that the proposed changes would expand the custody rule to explicitly include an adviser’s discretionary authority to trade client assets within the definition of custody. The rule would continue to require advisers with custody of client assets to maintain those assets with a qualified custodian, and the custodian would be required to have “possession or control” of advisory client assets. The proposal also includes more robust requirements for an institution to be eligible to serve as a qualified custodian, and further specifies the manner in which qualified custodian banks and savings associations must hold client assets.

Other key provisions of the proposals include:

• Advisers would be required to enter into a written agreement with and obtain certain reasonable assurances from qualified custodians to ensure clients receive certain standard custodial protections when an adviser has custody of their assets;

• The exception to the current custody rule’s exception from the obligation to maintain client assets with a qualified custodian for certain privately offered securities would be modified, including expanding the exception to include certain physical assets; and

• The rule’s requirement for an adviser to undergo a surprise examination by an independent public accountant to verify client assets would be maintained but expanded so that the current custody rule’s audit provision could be used to satisfy the surprise examination requirement.

Objections. The reopening of the comment period may give additional parties the opportunity to provide feedback, but it does not address the widespread pushback the SEC has received so far. Examples include the IAA’s concern at what it views as a dramatic expansion of the concept of custody to include discretionary authority, and the “virtually boundless scope of assets…that the proposal seeks to cover with the same broad-brush requirements.”

It is particularly concerned by the proposed requirements for advisers to enter into written agreements with qualified custodians with respect to duties that custodians primarily or exclusively owe to their customers. The IAA said that by attempting to deputize investment advisers to enforce qualified custodians’ conduct, the Commission is requiring advisers to do indirectly what the SEC is not doing or cannot do directly.

Similarly, the ICI expressed surprise that the Commission would for the first time equate an adviser’s discretionary trading authority over client assets with having custody of those assets, and require advisers, rather than their clients, to enter into a contract with the client’s custodian. ICI believes the proposed changes are unnecessary and will create a significant number of practical difficulties. Equating discretionary trading with custody could cause advisers to be deemed to have custody over thousands of additional client accounts despite no change in the adviser’s relationship with the client, ICI argued.

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