On February 15, the US Securities and Exchange Commission (the “SEC” or the “Commission”) proposed rule changes (the “Proposal”) to enhance protections of client assets managed by investment advisers registered with the SEC (“RIAs”).1 If adopted, the changes would amend Rule 206(4)-2, the “Custody Rule,” under the Investment Advisers Act of 1940 (the “Advisers Act”), and redesignate it as new Rule 223-1, the “Safeguarding Rule,” under the Advisers Act. The proposed Safeguarding Rule would have significant repercussions on industry participants, requiring RIAs to enter into agreements with qualified custodians and imposing a wide array of new requirements on such qualified custodians. The Proposal acknowledges that certain of its components are major departures from current market practices and that the new requirements for qualified custodians will create higher barriers to entry, potentially causing the market for qualified custodians to shrink and increasing costs for RIAs, particularly small and mid-sized firms. Nevertheless, the SEC believes that these updates are necessary given certain industry developments since the last time the rule was amended in 2009. In particular, the Proposal is intended to address what the Commission views as a general reduction in the level of protection offered by custodians to the general public and requires a higher baseline of services and protections that can currently only be obtained by counterparties with considerable leverage and, generally, not by retail investors.
The Proposal devotes considerable attention to crypto assets and the custodial arrangements of such assets; however, the scope of the Safeguarding Rule would have consequences to a much broader segment of the market, imposing additional burdens on all RIAs and creating complications for a variety of asset classes, including real estate, collateralized loan obligations (“CLOs”) and even ordinary cash deposits in custodial relationships. Moreover, at various points throughout the Proposal, the SEC goes out of its way to create new interpretations or endorse SEC staff views of the existing Custody Rule. In other words, before the Safeguarding Rule is finalized (and even if it is not ultimately adopted), advisers may be required to adjust their activities in order to comply with the SEC’s new interpretations of the Custody Rule in the Proposal.
I. Significantly Increased Scope
A. Any “Assets,” from Funds and Securities to Land, Wheat, and Lumber
Under the Custody Rule, any investment adviser registered with, or required to be registered with, the SEC under Section 203 of the Advisers Act that has “custody” of a client’s “funds or securities” is subject to the Custody Rule. The SEC is now proposing to dramatically expand the scope of the Safeguarding Rule from “funds and securities” to any client “assets” over which the RIA is deemed to have custody. This expansion would therefore include a wide variety of assets not currently subject to the Custody Rule, including certain crypto and digital assets,2 artwork, real estate, precious metals and physical commodities (e.g., wheat and lumber). The definition of assets also encompasses holdings that are not necessarily recorded on a balance sheet as an asset for accounting purposes, such as short positions and written options, as well as items that would be accounted for as a liability, such as negative cash. The expanded scope has significant implications because of the general requirement that all client assets over which an RIA has custody must be maintained with a qualified custodian, subject to a limited exception discussed below.
B. Discretionary Authority is Custody
The Proposal leaves largely unmodified the threshold definition of “custody” from the existing Custody Rule (i.e., “holding, directly or indirectly, client assets, or having authority to obtain possession of them”), but would significantly expand the scope of the definition through a modification of the examples of custody provided in the rule. Specifically, custody under the Safeguarding Rule is proposed to include “any arrangement (including, but not limited to, a general power of attorney or discretionary authority) under which you are authorized or permitted to withdraw or transfer beneficial ownership of client assets upon your instruction” (emphasis added).3 “Discretionary authority” is then further defined as the “authority to decide which assets to purchase and sell for the client.”4
- SMA and CLO Advisers Generally within Scope
This expanded scope would have a significant impact on RIAs to separately managed accounts (“SMAs”) and CLOs. Many SMA advisers and CLO managers have taken great pains to avoid being imputed with “custody” by carefully drafting their authority provisions under investment management or similar agreements and through the mechanics of CLO indentures, but the proposed Safeguarding Rule would render these precautions largely moot, causing all RIAs acting with “discretion” over the client assets to have custody of those assets and therefore be subject to the Safeguarding Rule’s requirements. This change will, however, have little impact on most RIAs to commingled funds, as they typically already have custody under the current Custody Rule because a related person serves as the fund’s general partner, managing member, or equivalent, which would be unchanged under the Safeguarding Rule.5
As drafted, the Safeguarding Rule does not address issues related to sub-advisory arrangements, including those involving affiliated advisers. Historically, such arrangements, particularly those involving non-US commingled funds sub-advised by an affiliated US adviser, have caused significant friction under the Custody Rule where the non-US primary adviser is deemed to have custody.6 The SEC has, however, solicited comments on the impact on sub-advisory arrangements. Clearly, the prior SEC staff guidance regarding certain sub-advisory arrangements involving affiliated advisers would need to be significantly expanded to be workable under the proposed Safeguarding Rule.7
- New Interpretation of Existing Custody Rule
More troubling is the statement by the Commission that RIAs acting with discretionary authority are already in scope of the existing Custody Rule if their discretionary authority applies to funds and securities that do not trade on a “delivery-versus-payment” (“DVP”) basis. In the Proposal, the SEC explicitly states that “authorized trading” for any transactions other than those that settle on a DVP basis come within the current definition of custody,8 noting that for non-DVP transactions, an adviser could have authority to instruct an issuer’s transfer agent or administrator (such as for a loan syndicate) “to sell its client’s interest and to direct the cash proceeds of the sale to an account that the adviser owns and controls.” The SEC Staff implied this view in interpretative guidance published in 2017; however, the position remained subject to significant uncertainty and was never officially adopted by the Commission.9 This interpretation of an existing rule, tucked away in a new rule proposal, may come as a surprise to even careful industry observers. Accordingly, even before the Safeguarding Rule is finalized, RIAs might consider re-evaluating their current practices in light of these statements.
- Extremely Limited Relief from Surprise Examinations
As part of the Safeguarding Rule, the SEC would provide relief from the surprise examination (or audited financial statement) requirement for advisers that have “custody” arising solely out of this discretionary authority (i) with respect to assets that are maintained with a qualified custodian, and (ii) where the discretionary authority is limited to assets that settle exclusively on a DVP basis. This relief is extremely limited given these two requirements and would not be available with respect to any assets that qualify for the exemption from being maintained with a qualified custodian.10 Further, the requirement that assets trade exclusively on a DVP basis would appear to make this relief unavailable for many asset classes, including loans.
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