On February 15^th 2023, the Securities and Exchange Commission (the “SEC”, or the “Commission”) proposed a new safeguarding rule. Comments must be received by the SEC on or before 60 days after the rule’s publication in the Federal Registrar.

What is the Proposed Safeguarding Rule?

If adopted, the safeguarding rule will be new rule 223-1 under the Investment Advisors Act (the “Advisor’s Act”) and would replace the current custody rule. 

Changes under the New Proposed Safeguarding Rule

Expanded Scope of the Rule:

• The scope of the rule is expanded to include all assets. Under the proposed rule, the scope of the rule will be expanded from client “funds and securities” to client “assets.” The SEC has indicated that assets would include all private fund assets, real estate, loans and derivatives and would expand the scope of included crypto assets.¹ Certain liabilities would also be within the scope.

• Discretionary trading authority explicitly triggers the rule. The new proposed definition would include any arrangement under which the adviser is authorized or permitted to withdraw or transfer client assets upon the adviser’s instruction.

Enhanced Investor Protections:

• Written agreement requirements for certain Qualified Custodians. Under the proposed rule, banks or savings associations, registered broker-dealers, registered future commission merchants, and foreign financial institutions will now need to show that they have “possession or control” of client assets pursuant to a written agreement between the qualified custodian and the investment adviser providing reasonable assurance of asset segregation.

• New conditions for Foreign Financial Institutions (FFIs) to serve as a Qualified Custodian for client assets. The new rule proposes seven new conditions for FFI’s to serve as qualified custodians that are intended to enhance the ability and responsibility of advisers to protect client assets held outside of the United States that are derived from Investment Company Act Rule 17f-5.

New Requirements for Investment Advisors: The new proposed rule includes some new requirements for Investment Advisers seeking to impose terms on qualified custodians and mandating reporting, including:

• Written Reasonable Assurances. Advisers will be required to obtain reasonable assurances in writing from qualified custodians with regards to (i) the exercise of due care and safeguarding measures; (ii) indemnifying the client in the case of the qualified custodian’s own negligence, recklessness, or willful misconduct; (iii) that the existence of any sub-custodial, securities depository, or other similar arrangements with regard to the client’s assets will not excuse an of the qualified custodian’s obligations to the client; (iv) the segregation of client assets in a custodial account that is separate from the qualified custodian’s proprietary assets and liabilities; and (v) that the qualified custodian will not subject client assets to any right, charge, security interest, lien, or claim of the qualified custodian or its related persons or creditors, unless authorized by the client in writing.

• Reporting and Recordkeeping Requirements. The qualified custodian will be required to provide the investment advisor with a written internal control report that includes an opinion of an independent public accountant evaluating the internal controls. The investment adviser will then be required to review the report and take any appropriate actions, as needed. The proposal would also amend the Form ADV and strengthen recordkeeping requirements for advisors to improve the accuracy of custody-related data available to the Commission, its staff, and the public.

Proposed rule 223-1 is grounded in the Advisor’s Act Section 223.  Section 223 makes no mention of written requirements, reasonable assurances, or standards of care. Accordingly, it will be very interesting to follow the comments filed.

Applicable Links:

• The full proposal for the new safeguarding rule can be found here on the Securities and Exchange Commission’s website.

• Comments may be submitted either electronically or by paper.

  • Electronic comments may be submitted using the Commission’s internet comment form or by e-mailing rule-comments@sec.gov. Please be sure to include File Number S7-04-23 in the subject line.

  • Paper comments may be sent to Secretary, Securities and Exchange Commission, 100 F Street, NE Washington, DC 20549-1090.

FOOTNOTES

¹ Ayers, Carl, “SEC Chairmen Gensler lists benefits of custody proposal”, Regulatory Watch, February 15, 2023. https://www.regcompliancewatch.com/sec-chairman-gensler-lists-benefits-of-custody-proposal/ (Subscription only)