Safeguarding Advisory Client Assets, 14672-14792 [2023-03681]
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Federal Register / Vol. 88, No. 46 / Thursday, March 9, 2023 / Proposed Rules
• Use the Commission’s internet
comment form (https://www.sec.gov/
rules/submitcomments.html); or
• Send an email to rule-comments@
sec.gov. Please include File Number S7–
04–23 on the subject line.
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FOR FURTHER INFORMATION CONTACT:
Shane Cox, Laura Harper Powell,
Michael Schrader, and Samuel Thomas,
Senior Counsels; Holly H. Miller, Senior
Financial Analyst; Alex Bradford and
Michael Republicano, Assistant Chief
Accountants; Christopher Staley,
Branch Chief; and Melissa Roverts
Harke, Assistant Director at (202) 5516787 or IArules@sec.gov, Investment
Adviser Regulation Office, Division of
Investment Management, Securities and
Exchange Commission, 100 F Street NE,
Washington, DC 20549.
SUPPLEMENTARY INFORMATION: The
Commission is proposing for public
comment to amend and renumber 17
CFR 275.206(4)–2 (rule 206(4)–2) under
the Investment Advisers Act of 1940 [15
U.S.C. 80b–1 et seq.] to redesignate it as
rule 17 CFR 275.223–1 (rule 223–1)
under the Advisers Act, and make
corresponding amendments to 17 CFR
275.204–2 (rule 204–2) and 17 CFR
279.1 (Form ADV) under the Advisers
Act.1
Paper Comments
Table of Contents
SECURITIES AND EXCHANGE
COMMISSION
17 CFR Parts 275 and 279
[Release No. IA–6240; File No. S7–04–23]
RIN 3235–AM32
Safeguarding Advisory Client Assets
Securities and Exchange
Commission.
ACTION: Proposed rule.
AGENCY:
The Securities and Exchange
Commission (‘‘Commission’’ or ‘‘SEC’’)
is proposing a new rule under the
Investment Advisers Act of 1940
(‘‘Advisers Act’’ or ‘‘Act’’) to address
how investment advisers safeguard
client assets. To effect our redesignation
of the current custody rule for the
proposed new safeguarding rule, we are
proposing to renumber the current rule.
In addition we are proposing to amend
certain provisions of the current custody
rule for enhanced investor protections.
We also are proposing corresponding
amendments to the recordkeeping rule
under the Advisers Act and to Form
ADV for investment adviser registration
under the Advisers Act.
DATES: Comments should be received on
or before May 8, 2023.
ADDRESSES: Comments may be
submitted by any of the following
methods:
SUMMARY:
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Electronic Comments
• Send paper comments to Secretary,
Securities and Exchange Commission,
100 F Street NE, Washington, DC
20549–1090.
All submissions should refer to File
Number S7–04–23. This file number
should be included on the subject line
if email is used. To help us process and
review your comments more efficiently,
please use only one method. The
Commission will post all comments on
the Commission’s website (https://
www.sec.gov/rules/proposed.shtml).
Comments are also available for website
viewing and printing in the
Commission’s Public Reference Room,
100 F Street NE, Washington, DC 20549,
on official business days between the
hours of 10 a.m. and 3 p.m. Operating
conditions may limit access to the
Commission’s Public Reference Room.
All comments received will be posted
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I. Introduction
A. Background
B. Overview of the Proposal
II. Discussion
A. Scope of Rule
1. Scope of Assets
2. Scope of Activity Subject to the
Proposed Rule
B. Qualified Custodian Protections
1. Definition of Qualified Custodian
2. Possession or Control
3. Minimum Custodial Protections
C. Certain Assets That Are Unable To Be
Maintained With a Qualified Custodian
1. Definition of Privately Offered Security
and Physical Assets
1 15 U.S.C. 80b. Unless otherwise noted, when we
refer to the Advisers Act, or any section of the
Advisers Act, we are referring to 15 U.S.C. 80b, at
which the Advisers Act is codified, and when we
refer to rules under the Advisers Act, or any section
of these rules, we are referring to title 17, part 275
of the Code of Federal Regulations [17 CFR 275], in
which these rules are published.
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2. Adviser’s Reasonable Determination
3. Adviser Reasonably Safeguards Assets
4. Notification and Prompt Independent
Public Accountant Verification
5. Surprise Examination or Audit
D. Segregation of Client Assets
E. Investment Adviser Delivery of Notice to
Clients
F. Amendments to the Surprise
Examination Requirement
G. Exceptions from the Surprise
Examination
1. Entities Subject to Audit (‘‘Audit
Provision’’)
2. Discretionary Authority
3. Standing Letters of Authorization
H. Amendments to the Investment Adviser
Recordkeeping Rule
1. Client Communications
2. Client Accounts
3. Account Activity
4. Independent Public Accountant
Engagements
5. Standing Letters of Authorization
I. Changes to Form ADV
J. Existing Staff No-Action Letters and
Other Staff Statements
K. Transition Period and Compliance Date
III. Economic Analysis
A. Introduction
B. Broad Economic Considerations
C. Baseline
1. Current Regulation
2. Affected Parties and Industry Statistics
3. Market Practice
D. Benefits and Costs of Proposed Rule and
Form Amendments
1. Scope
2. Qualified Custodian Protections
3. Certain Assets That Are Unable To Be
Maintained With a Qualified Custodian
4. Segregation of Investments
5. Investment Adviser Delivery of Notice to
Clients
6. Exceptions From the Surprise
Examination
7. Amendments to the Investment Adviser
Recordkeeping Rule
8. Changes to Form ADV
E. Efficiency, Competition, and Capital
Formation
F. Reasonable Alternatives
1. Scope of Assets
2. Elimination of Privately Offered
Securities Exception
3. Distribution of Requirements Across
Reasonable Assurances and Written
Agreement
3. Additional Accounting and Client
Notification Requirements for Privately
Offered Securities and Physical Assets
That Are Not Maintained With a
Qualified Custodian
4. Additional Safeguards When Clients
Assets Are Not Maintained With a
Qualified Custodian
5. Designating Clearing Agencies and
Transfer Agents as Qualified Custodians
G. Request for Comment
IV. Paperwork Reduction Act Analysis
A. Introduction
B. Rule 223–1
1. Qualified Custodian Provision
2. Notice to Clients
3. Annual Surprise Examination
C. Exceptions
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Federal Register / Vol. 88, No. 46 / Thursday, March 9, 2023 / Proposed Rules
1. Certain Assets That Are Unable To Be
Maintained With a Qualified Custodian
2. Audit Provision
D. Total Hour Burden Associated With
Proposed Rule 223–1
E. Rule 204–2
F. Form ADV
G. Request for Comments
V. Initial Regulatory Flexibility Analysis
A. Reason for and Objectives of the
Proposed Action
1. Proposed Rule 223–1
2. Proposed Rule 204–2
3. Proposed Amendments to Form ADV
B. Legal Basis
C. Small Entities Subject to the Rule and
Rule Amendments
1. Small Entities Subject to Amendments to
the Custody Rule
D. Projected Reporting, Recordkeeping and
Other Compliance Requirements
1. Proposed Rule 223–1
2. Proposed Amendments to Rule 204–2
3. Proposed Amendments to Form ADV
E. Duplicative, Overlapping, or Conflicting
Federal Rules
F. Significant Alternatives
1. Proposed New Rule 223–1 and
Amendments to Rule 204–2 and Form ADV
G. Solicitation of Comments
VI. Consideration of Impact on the Economy
VII. Statutory Authority
I. Introduction
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A. Background
Rule 206(4)–2 under the Act (the
‘‘custody rule’’ or ‘‘current rule’’)
regulates the custodial practices of
advisers. Although the Commission has
amended the rule over time as custodial
and advisory practices have changed,
since its adoption it has been designed
to safeguard client funds and securities
from the financial reverses, including
insolvency, of an investment adviser
and to prevent client assets from being
lost, misused, stolen, or
misappropriated.2
As originally adopted in 1962, the
rule required all investment advisers
with ‘‘custody’’ (i.e., physical
possession) of client funds and
securities to deposit client funds in a
bank account that was maintained in the
adviser’s name and contained only
client funds.3 Advisers, in addition,
2 See Custody or Possession of Funds or
Securities of Clients, Investment Advisers Act
Release No. 123 (Feb. 27, 1962) [44 FR 2149 (Mar.
6, 1962)] (‘‘1962 Adopting Release’’). See also
Custody of Funds or Securities of Clients by
Investment Advisers, Investment Advisers Act
Release No. 2176 (Sept. 25, 2003) [68 FR 56692
(Oct. 1, 2003)] (‘‘2003 Adopting Release’’); Custody
of Funds or Securities of Clients by Investment
Advisers, Investment Advisers Act Release No.
2044 (Jul. 18, 2002) [67 FR 48579 (Jul. 25, 2002)],
at nn. 3, 15 (‘‘2002 Proposing Release’’).
3 As with the current rule, the proposed
amendments would apply to investment advisers
registered, or required to be registered, with the
Commission. However, the original rule was
broader in scope, applying to ‘‘all investment
advisers,’’ until it was amended in 1997. Rules
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were required to segregate client
securities and hold them in a
‘‘reasonably safe’’ place. In each case,
the rule required investment advisers to
provide their clients notice of these
protocols and to engage an independent
public accountant to conduct an annual
surprise examination 4 to verify client
funds and securities independently.
These requirements were designed to
protect client assets at a time when the
system for owning and transacting in
securities was paper-based.
The Commission amended the rule in
2003 to expand the definition of custody
beyond physical possession to include
situations in which an adviser had any
ability to obtain possession of client
funds or securities. The 2003
amendments made clear that the rule
applied to any investment adviser
‘‘holding, directly or indirectly, client
funds or securities, or having any
Implementing Amendments to the Investment
Advisers Act of 1940, Investment Advisers Act
Release No. 1633 (May 15, 1997) [62 FR 28112 (May
22, 1997)], at section II.I.5. Unless otherwise
indicated, references throughout this release to
‘‘adviser’’ or ‘‘investment adviser’’ refer to
investment advisers registered, or required to be
registered, with the Commission. Further, we have
previously stated, and would continue to take the
position (if these amendments were adopted), that
most of the substantive provisions of the Advisers
Act do not apply with respect to the non-U.S.
clients (including funds) of a registered offshore
adviser. This approach was designed to provide
appropriate flexibility where an adviser has its
principal office and place of business outside of the
United States. We believe it would be appropriate
to continue to apply this approach, including in the
proposed safeguarding rule context (if adopted). For
an adviser whose principal office and place of
business is in the United States (onshore adviser),
the Advisers Act and rules thereunder, including
the proposed safeguarding rule, would apply with
respect to the adviser’s U.S. and non-U.S. clients.
See Exemptions for Advisers to Venture Capital
Funds, Private Fund Advisers With Less Than $150
Million in Assets Under Management, and Foreign
Private Advisers, Release No. IA–3222 (June 22,
2011) [76 FR 39645 (July 6, 2011)] (Most of the
substantive provisions of the Advisers Act do not
apply to the non-U.S. clients of a non-U.S. adviser
registered with the Commission.); Registration
Under the Advisers Act of Certain Hedge Fund
Advisers, Release No. IA–2333 (Dec. 2, 2004) [69 FR
72054, 72072 (Dec. 10, 2004)] (‘‘Hedge Fund
Adviser Release’’) (stating (1) that the following
rules under the Advisers Act would not apply to a
registered offshore adviser, assuming it has no U.S.
clients: compliance rule, custody rule, and proxy
voting rule; (2) stating that the Commission would
not subject an offshore adviser to the rules
governing adviser advertising [17 CFR 275.206(4)–
1] or cash solicitations [17 CFR 275.206(4)–3] with
respect to offshore clients; and (3) noting that U.S.
investors in an offshore fund generally would not
expect the full protection of the U.S. securities laws
and that U.S. investors may be precluded from an
opportunity to invest in an offshore fund if their
participation would result in full application of the
Advisers Act and rules thereunder, but that a
registered offshore adviser would be required to
comply with the Advisers Act and rules thereunder
with respect to any U.S. clients it may have).
4 The terms ‘‘surprise examination’’ and
‘‘independent verification’’ are used throughout the
release and are generally interchangeable.
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14673
authority to obtain possession of
them.’’ 5 It included three illustrative
examples in the rule’s definition of
‘‘custody’’: (1) possession of client funds
or securities, even briefly; (2) authority
to withdraw funds or securities from a
client’s account; and (3) any capacity
that gives the adviser legal ownership
of, or access to, client funds or
securities.6 In the adopting release, the
Commission stated this expansion of the
concept of adviser custody would not
include authorized trading, however,
stating that clients’ custodians are
generally under instructions to transfer
funds or securities out of a client’s
account only upon a corresponding
transfer of securities or funds into the
account.7
In recognition of then-modern
custodial practices, the Commission in
2003 required advisers to keep
securities (not just funds as under the
1962 rule) with a custodian, and it
expanded the types of custodians that
would qualify under the rule.8 The
Commission expressed concern that
some advisers were still keeping
certificates in office files or safety
deposit boxes, which put those
securities at risk.9 The Commission
identified as ‘‘qualified custodians’’ the
types of regulated financial institutions
that customarily provided custodial
services subject to regulatory
examination.10 The Commission also
relied more on the protections of
qualified custodians, eliminating the
adviser’s need to undergo the rule’s
annual surprise examination by an
independent public accountant if the
adviser had a ‘‘reasonable belief’’ that
the qualified custodian would provide
account statements directly to the
adviser’s clients. The Commission
provided an exception, however, from
the requirement to maintain client
securities with a qualified custodian
after commenters had pointed out that,
on occasion, a client may purchase
privately offered securities where the
only evidence of the client’s ownership
was recorded on the issuer’s books and
5 See rule 206(4)–2(a). See also rule 206(4)–
2(d)(v)(2) (defining ‘‘custody’’). The original rule
did not define ‘‘custody,’’ which was
conceptualized at that time as limited to physically
holding securities.
6 See id.
7 See 2003 Adopting Release, supra footnote 2, at
note 10 and accompanying text.
8 See 2003 Adopting Release supra footnote 2, at
section I.
9 See 2002 Proposing Release, supra footnote 2, at
section II.B.
10 The financial institutions identified by the
Commission were broker-dealers, banks and savings
associations, futures commission merchants, and
certain foreign financial institutions. See 2003
Adopting Release at II.B.
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the transfer of ownership requires the
consent of the issuer or the holders of
the issuer’s outstanding securities. As a
result, commenters argued that it was
difficult to maintain certain of these
assets in accounts with qualified
custodians. The Commission noted that
these impediments to transferability
along with the conditions it imposed in
the privately offered securities
exception (‘‘privately offered securities
exception’’), including in some cases
obtaining and distributing audited
financial statements (‘‘the audit
provision’’), provided external
safeguards against the kinds of abuse the
rule seeks to prevent.
The Commission most recently
amended the rule in 2009 after several
enforcement actions against investment
advisers, including actions stemming
from the frauds perpetrated by Bernard
Madoff and Allen Stanford (which also
resulted in criminal convictions),
alleging fraudulent conduct that
included, among other things,
misappropriation or other misuse of
client assets involving certain affiliates
of the adviser.11 These cases underlined
11 See Custody of Funds or Securities of Clients
by Investment Advisers, Investment Advisers Act
Release No. 2968 (Dec. 30, 2009) [75 FR 1455 (Jan.
11, 2010)], at n.1 (‘‘2009 Adopting Release’’)
(referring to the cases cited in Custody of Funds or
Securities of Clients by Investment Advisers,
Investment Advisers Act Release No. 2876 (May 20,
2009) [74 FR 25353 (May 27, 2009)] (‘‘2009
Proposing Release’’)). See also Judgment, ECF Doc
No. 100, 4, United States v. Madoff, No. 09 Cr. 213
(S.D.N.Y. June 29, 2009) (Bernard L. Madoff pled
guilty to eleven felony charges including securities
fraud, investment adviser fraud, mail fraud, wire
fraud, three counts of money laundering, false
statements, perjury, and making false filings with
the SEC); Order Granting Motion for Summary
Judgment, SEC v. Stanford International Bank, Ltd.,
et al., Civil Action No. 3:09–CV0298 (N.D. Tex. Apr.
25, 2013) (the SEC obtained a $5.9 billion judgment
against R. Allen Stanford who was convicted in a
parallel criminal case of conspiracy to commit mail
and wire fraud, four counts of wire fraud, five
counts of mail fraud, one count of conspiracy to
obstruct an SEC investigation, one count of
obstruction of an SEC proceeding, and one count of
conspiracy to commit money laundering and
sentenced to a total of 110 years in prison); SEC v.
WG Trading Investors, L.P., 09–CV–1750 (S.D.N.Y.
July 29, 2010) (involving a broker-dealer and
affiliated registered adviser that orchestrated a
fraudulent investment scheme misappropriating as
much as $554 million and sending clients
misleading account information); Isaac I. Ovid, SEC
Admin. Proceeding No. 3–14313 (Mar. 30 2011)
(registered investment adviser and manager of
purported hedge funds, pled guilty in parallel
criminal proceeding in connection with which he
was required to pay restitution in excess of $12
million); Young and Acorn Capital Management,
LLC, SEC Admin. Proceeding No. 3–14654 (Feb. 28
2012) (registered investment adviser and its
principal convicted of misappropriating $95 million
in a Ponzi scheme in a parallel criminal case
whereupon the SEC issued an order revoking the
adviser’s registration and barred the principal from
association with an investment adviser, broker,
dealer, municipal securities dealer, or transfer
agent); SEC v. The Nutmeg Group, LLC, et al.,
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additional risks both when an adviser
has access to client funds or securities
not explicitly covered within the scope
of the rule, as well as when the qualified
custodian is a related person of the
adviser. In direct response to certain of
these cases, the 2009 amendments
explicitly extended the scope of the rule
to reach an adviser’s ability to access
client funds or securities through its
related persons, expanded the
circumstances in which a surprise
examination is necessary, and required
advisers to obtain an independent
accountant’s report evaluating internal
controls related to custody where the
adviser or its related person serves as
qualified custodian.12
Following the Madoff and Stanford
frauds, and on the heels of the
Commission’s recently adopted 2009
amendments to the custody rule,
Congress expressly vested the
Commission with authority to
promulgate rules requiring registered
advisers to take steps to safeguard client
assets over which advisers have custody
by adding section 223 to the Advisers
Act in the Dodd-Frank Wall Street
Reform and Consumer Protection Act
(‘‘Dodd-Frank Act’’).13 Leading up to the
enactment of the Dodd-Frank Act,
Congress heard testimony that certain
client investments were not covered by
the custody rule because they were
neither funds nor securities, putting
them at greater risk of loss, theft,
misappropriation, or being subject to the
financial reverses of an adviser.14
Litigation Release No. 24677 (Nov. 26, 2019)
(commingled investor funds with his personal
assets, implemented flawed internal systems and
methods for valuing and reporting assets under
management, and transferred millions of dollars out
of the investment pools to himself and companies
controlled by family members).
12 See generally rule 206(4)–2; see also 2009
Adopting Release, supra footnote 11, at sections
II.A and B.
13 See section 411 of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, Public Law
111–203, 124 Stat. 1376 (2010) (adding section 223
to the Advisers Act which provides ‘‘[a]n
investment adviser registered under this subchapter
shall take such steps to safeguard client assets over
which such adviser has custody, including, without
limitation, verification of such assets by an
independent public accountant, as the Commission
may, by rule, prescribe.’’ 15 U.S.C. 80b–18b).
Congress also required the U.S. Government
Accountability Office to study the rule’s
compliance costs. See id. at section 412.
14 See Regulating Hedge Funds and other Private
Investment Pools, Hearing Before the House
Subcommittee on Securities, Insurance, and
Investment, 111 Cong. 50–51 (2009) (Statement of
James S. Chanos, Chairman, Coalition of Private
Investment Companies) (stating that the current
rule’s scope—which was ‘‘funds and securities’’
and with an exception from certain protections for
privately offered securities—excluded assets such
as privately issued uncertificated securities, bank
deposits, real estate assets, swaps, and interests in
other private investment funds leaving a ‘‘gaping
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Congress also heard testimony about the
important role requiring advisers to
maintain client funds and securities
with qualified custodians has in
preventing fraud—a requirement that
applies only if an adviser is subject to
the custody rule and the assets are not
subject to an exception from the
qualified custodian requirement.15
Subsequently, Congress authorized the
Commission to prescribe rules requiring
advisers to take steps to safeguard all
client assets, not just funds and
securities, over which an adviser has
custody.16
In addition to this legislative context,
industry developments prompt us again
to reconsider the important prophylactic
protections of the custody rule and to
address certain gaps in protections—
some of which Congress identified and
gave us the tools to address 13 years
ago.17 We have seen changes in
hole’’ in the rule) (‘‘Dodd Frank Regulating Hedge
Funds and other Private Investment Pools
Testimony by James S. Chanos’’). Congress also
heard testimony about the benefits qualified
custodians provide in preventing fraud. See id.
(‘‘Requiring independence between the function of
managing a private investment fund and controlling
its assets, by requiring that all assets be titled in the
name of a custodian bank or broker-dealer for the
benefit of the private fund and requiring all cash
flows to move through the independent custodian,
would be an important control. Similarly, requiring
an independent check on the records of ownership
of the interests in the private investment fund, as
well as imposing standards for the qualification of
private investment fund auditors—neither of which
currently is required by the Advisers Act—would
also greatly reduce opportunities for mischief.’’).
15 See S. Rep. No. 111–176, at 77 (2010) (‘‘the
custodian requirement largely removes the ability of
an investment adviser to pay the proceeds invested
by new investors to old investors. The custodian
will take the instructions to buy or sell securities,
but not to remit the proceeds of sales to the adviser
or to others (except in return for share redemptions
by investors). At a stroke, this requirement
eliminates the ability of the manager to ‘recycle’
funds from new to old investors.’’ quoting
Testimony of Professor John C. Coffee, Jr.; The
Madoff Investment Securities Fraud: Regulatory and
Oversight Concerns and the Need for Reform:
Testimony before the U.S. Senate Committee on
Banking, Housing and Urban Affairs, 111th
Congress, 1st session, pp. 8, 10 (2009)).
16 Earlier versions of this bill show that Congress
considered retaining the current rule’s funds and
securities formulation. See Investor Protection Act
of 2009, H.R. 3817, 111th Cong section 419 (2009).
17 The current rule has also been the subject of
numerous inquiries and requests for staff views.
See, e.g., Staff Responses to Questions about the
Custody Rule (‘‘Custody Rule FAQs’’), available at
https://www.sec.gov/divisions/investment/custody_
faq_030510.htm; Privately Offered Securities under
the Investment Advisers Act Custody Rule, Division
of Investment Management Guidance Update No.
2013–04 (Aug. 2013) (‘‘2013 IM Guidance’’); Private
Funds and Application of the Custody Rule to
Special Purpose Vehicles and Escrows, Division of
Investment Management Guidance Update No.
2014–07 (June 2014) (‘‘2014 IM Guidance’’). Staff
reports, statistics, and other staff documents
(including those cited herein) represent the views
of Commission staff and are not a rule, regulation,
or statement of the Commission. Furthermore, the
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technology, advisory services, and
custodial practices create new and
different ways for client assets to be
placed at risk of loss, theft, misuse, or
misappropriation that may not be fully
addressed under the current rule.
For example, advisory services have
expanded and developed in recent
years, leading to questions about the
scope of activities that trigger
application of the current rule. More
specifically, nearly 20 years ago when
the Commission interpreted authorized
trading not to be within the definition
of custody, it had stated that clients’
custodians are generally under
instructions to transfer funds or
securities out of a client’s account only
upon corresponding transfer of
securities or funds into the account. At
the time, the Commission’s view was
that such an arrangement would
minimize the risk that an adviser could
withdraw or misappropriate the funds
or securities in its client’s custodial
account.
Discretionary trading practices today,
however, do not necessarily involve a
one-for-one exchange of assets under a
custodian’s oversight. For instance, an
adviser may instruct an issuer or a
transfer agent that recorded ownership
of a client’s privately offered security to
redeem the client’s interest and direct
the proceeds to a particular account.
Because there is no qualified custodian
involved in such a transaction, a client’s
ability to monitor its investments for
suspicious activity is limited (e.g., a
qualified custodian would not attest to
this transaction on the account
statements it provides), and a surprise
examination or an audit may not
discover any misappropriation until the
assets are gone. Moreover, if the security
is not included in the sample over
which an accountant performs its
procedures during a surprise
examination or if the client’s holdings of
the security do not meet the materiality
threshold for a financial statement
audit, misappropriation may go
undetected for an indeterminate amount
of time.
Other times, advisers find themselves
subject to the rule because of authority
Commission has neither approved nor disapproved
these documents and, like all staff statements, they
have no legal force or effect, do not alter or amend
applicable law, and create no new or additional
obligations for any person. The Commission has
expressed no view regarding the analysis, findings,
or conclusions contained therein. As discussed in
section II.J, staff in the Division of Investment
Management is reviewing staff no-action letters and
other staff letters to determine whether any such
letters should be withdrawn in connection with any
adoption of this proposal. If the rule is adopted,
some of the letters and statements may be moot,
superseded, or otherwise inconsistent with the rule
and, therefore, would be withdrawn.
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they do not wish to have. For instance,
we understand that some advisory
clients’ custodial agreements empower
investment advisers with a broad array
of authority that they neither want nor
use.18 Advisers have little to no ability
to eliminate this authority because they
are usually not parties to the custodial
agreements between clients and
qualified custodians, but nonetheless
these arrangements result in an adviser
having custody under the rule.
While these developments suggest a
need to protect clients better and modify
the application of the current rule, other
developments suggest a need to improve
the rule’s efficacy, including
particularly the protections provided by
the qualified custodian, who has long
been the key gatekeeper under this rule.
A growing number of assets are not
receiving custodial protections as a
result of certain of the current rule’s
exceptions from the requirement to
maintain assets with a qualified
custodian, particularly the exception for
privately offered securities.19 That
exception and the exception for mutual
fund shares were adopted at a time
when dematerialized ownership of
securities was still developing, and the
exceptions were envisioned as being
necessary ‘‘at times’’ or ‘‘on occasion.’’
This rarity is no longer the case. We
understand that, today, the
overwhelming majority of securities are
uncertificated, the volume of privately
offered securities has vastly expanded
with the expansion of private capital,
and custodians have developed
safeguarding and reporting practices,
particularly with respect to publicly
traded securities.20 We acknowledge
that the custodial market for privately
issued securities is less developed,21 but
we believe that some custodians
presently custody these assets and we
understand that new custodial services
are being developed.22 What has also
18 We use the term ‘‘custodial agreement’’
throughout the release to refer to a contract between
an advisory client and the qualified custodian. The
adviser usually is not a party.
19 Preqin Global Private Debt Report (2018),
available at https://docs.preqin.com/samples/2018Preqin-Global-Private-Debt-Report-SamplePages.pdf (showing the growth in private capital
assets under management from 2007 to 2017 by the
following asset classes: private equity, private debt,
real estate, infrastructure, natural resources).
20 See discussion in section II.C infra and at text
accompanying footnote 229.
21 We understand that many qualified custodians
will not currently accept custodial liability for
certain instruments including certain crypto assets,
commodities, and privately issued securities. See
Letter to Karen Barr re Engaging on Non-DVP
Custodial Practices and Digital Assets: Investment
Advisers Act of 1940: Rule 206(4)–2 (Mar. 12, 2019)
(‘‘2019 RFI’’).
22 See, e.g., DTCC, Project Whitney Case Study
(May 2020), available at https://www.dtcc.com/∼/
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developed, however, is a practice by
custodians in which the custodian lists
assets for which it does not accept
custodial liability on a client’s account
statement on an accommodation basis
only; the custodian does not attest to the
holdings of or transactions in those
investments or take steps to ensure that
the investments are safeguarded
appropriately (‘‘accommodation
reporting’’). The custodian merely
reports the holdings or transactions as
reported to it by the adviser. This
practice undermines the account
statement’s integrity and utility in
helping to verify that the client owns
the assets and they have not been stolen
or misappropriated. We view the
integrity of custodial account statements
to be critical to the safeguarding of
client assets. Clients should be able to
review their account statements to
evaluate the legitimacy of any
movement within their account,
whether it is a trade, a payment, or a fee
withdrawal. In contrast, the current
exception for mutual fund shares
requires a transfer agent of the mutual
fund to fulfill all of the obligations
assigned to a qualified custodian under
the rule, including sending statements
directly to the client. In our
longstanding experience with the
current rule, this exception has not
raised similar types of investor
protection concerns.
At the same time, the evolution of
financial products and services
discussed above has led to new entrants
and new services in the custodial
marketplace, including newly launched
state-chartered trust companies, as well
as established bank and broker-dealer
custodians seeking to develop new
practices to safeguard assets.23 Our staff
has also observed a general reduction in
the level of protections offered by
custodians, often resulting in advisory
clients with the least amount of
bargaining power (i.e., retail investors)
receiving the most limited protections.
We understand, for instance, that it is
decreasingly common for banks acting
as custodians to do so in a fiduciary
capacity.24 These changes in the
media/Files/Downloads/settlement-asset-services/
user-documentation/Project-Whitney-Paper.pdf.
23 See, e.g., Tomito Geron, Companies Compete to
Be Cryptocurrency Custodians, The Wall Street
Journal (Sept. 17, 2019).
24 See OCC Bulletin 2019–21, April 29, 2019,
‘‘Fiduciary Regulations; Non-Fiduciary Activities;
Advance Notice of Proposed Rulemaking.’’
According to this Bulletin, Bank non-fiduciary
custody activities have increased in asset size since
1996. This Bulletin reports, as of December 2018,
bank non-fiduciary custody assets were about $42
trillion, whereas bank fiduciary custody assets were
about $9 trillion. See also Edward H. Klees, How
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industry have caused us to reconsider
the role of a ‘‘qualified custodian’’
under our rule and what minimum
protections clients should receive.
Finally, since the Commission last
amended the current rule, there have
been significant developments with
respect to crypto assets,25 which
generally use distributed ledger or
blockchain technology (broadly referred
to as ‘‘DLT’’) 26 as a method to record
ownership and transfer assets. While
potentially creating certain efficiencies
in transactions, this technology also
presents technological, legal, and
regulatory risks to advisers and their
clients.27 Unlike mechanisms used to
transact in more traditional assets, this
technology generally requires the use of
public and private cryptographic key
Safe are Institutional Assets in a Custodial Bank’s
Insolvency, 68 Bus. LAW. 103, 110, footnote 46
(2012) (‘‘Klees Article’’). In addition to certain
institutions identified under the Home Owners’
Loan Act and members of the Federal Reserve
System, the Advisers Act generally identifies
‘‘banks’’ as banking institutions or savings
associations a substantial portion of the business of
which consists of receiving deposits or exercising
fiduciary powers similar to those permitted to
national banks. Advisers Act sec. 202(a)(2).
25 There are also digital assets. The term ‘‘digital
asset’’ refers to an asset that is issued and/or
transferred using distributed ledger or blockchain
technology, including, but not limited to, so-called
‘‘virtual currencies,’’ ‘‘coins,’’ and ‘‘tokens.’’ See
Custody of Digital Asset Securities by Special
Purpose Broker-Dealers, Securities Exchange Act
Release No. 90788 (Dec. 23, 2020), 86 FR 11627,
11627 n.1 (Feb. 26, 2021) (‘‘Commission
Statement’’). A digital asset may or may not meet
the definition of a ‘‘security’’ under the Federal
securities laws. See, e.g., Report of Investigation
Pursuant to section 21(a) of the Securities Exchange
Act of 1934: The DAO, Securities Exchange Act
Release No. 81207 (July 25, 2017) (‘‘DAO 21(a)
Report’’), available at https://www.sec.gov/
litigation/investreport/34-81207.pdf; SEC v. W.J.
Howey Co., 328 U.S. 293 (1946). To the extent
digital assets rely on cryptographic protocols, these
types of assets also are commonly referred to as
‘‘crypto assets.’’ For purposes of this release, the
Commission does not distinguish between the terms
‘‘digital asset’’ and ‘‘crypto asset.’’
26 The terms DLT and blockchain, a type of DLT,
generally refer to databases that maintain
information across a network of computers in a
decentralized or distributed manner. Blockchain
networks commonly use cryptographic protocols to
ensure data integrity. See, e.g., World Bank Group,
‘‘Distributed Ledger Technology (DLT) and
Blockchain,’’ FinTech Note No. 1 (2017), available
at: https://openknowledge.worldbank.org/
bitstream/handle/10986/29053/WP-PUBLICDistributed-Ledger-Technology-and-BlockchainFintech-Notes.pdf?sequence=1&isAllowed=y.
27 We note that our staff has expressed a similar
view. See, e.g., SEC Staff Accounting Bulletin No.
121, [87 FR 21016 (Apr. 11, 2022)] (generally
describing risks related to the safeguarding of
crypto assets); Custody of Digital Asset Securities
by Special Purpose Broker-Dealers, supra footnote
25 (generally discussing risks related to brokerdealer custody of crypto asset securities). See also
Joint Statement on Crypto-Asset Risks to Banking
Organizations (Jan 3, 2023), available at https://
occ.treas.gov/news-issuances/news-releases/2023/
nr-ia-2023-1a.pdf (generally discussing risks related
to bank custody of crypto assets).
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pairings, resulting in the inability to
restore or recover many crypto assets in
the event the keys are lost, forgotten,
misappropriated, or destroyed.28 By
design, DLT finality often makes it
difficult or impossible to reverse
erroneous or fraudulent crypto asset
transactions, whereas processes and
protocols exist to reverse erroneous or
fraudulent transactions with respect to
more traditional assets. These specific
characteristics could leave advisory
clients without meaningful recourse to
reverse erroneous or fraudulent
transactions, recover or replace lost
crypto assets, or correct errors that
result from their adviser having custody
of these assets.
Additionally, we understand that
many advisers may be reluctant to
provide a full range of advisory services
to their clients with respect to crypto
assets because of concerns that a market
for custodial services to safeguard these
assets has not yet fully developed. We
understand that other advisers provide
advisory services that would generally
result in an adviser having ‘‘custody’’
within the meaning of the rule (e.g.,
serving as the general partner for a
private fund that holds crypto asset
securities), and therefore are required to
comply with the rule. Some of these
advisers, however, may not maintain
their client’s crypto assets with a
qualified custodian, instead attempting
to safeguard their client’s crypto assets
themselves—a practice that is not
compliant with the custody rule if those
crypto assets are funds or securities and
do not meet an exception from the
qualified custodian requirement. Other
advisers offering similar advisory
services might take the position that
crypto assets are not covered by the
custody rule at all. This, however, is
incorrect because most crypto assets are
likely to be funds or crypto asset
securities covered by the current rule.29
28 See, e.g., Not Your Keys, Not Your Coins:
Unpriced Credit Risk in Cryptocurrency, at section
I, available at https://papers.ssrn.com/sol3/
papers.cfm?abstract_id=4107019.
29 The application of the current rule turns on
whether a particular client investment is a fund or
a security. To the extent there is a question as to
whether a particular crypto asset is an investment
contract that is a security, the analysis is governed
by the test first articulated by the Supreme Court
in SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946).
See, e.g., SEC v. Kik Interactive Inc., 492 F. Supp.
3d 169, 177–180 (S.D.N.Y. 2020) (applying Howey
in granting the Commission’s motion for summary
judgment finding Kik’s sale of Kin tokens to the
public was a sale of a security and required a
registration statement); SEC v. LBRY, No. 21–CV–
260–PB, 2022 WL 16744741 (D.N.H. Nov. 7, 2022)
(applying Howey in granting the Commission’s
motion of summary judgement finding ‘‘no
reasonable trier of fact could reject the SEC’s
contention that LBRY offered LBC [a crypto asset]
as a security.’’ Id. at 21); Report of Investigation
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B. Overview of the Proposal
In the light of these developments and
additional authority that Congress has
given us under the Dodd-Frank Act to
prescribe investment adviser custody
rules, we are redesignating the custody
rule as new rule 223–1 under the
Advisers Act (the ‘‘safeguarding rule’’ or
the ‘‘proposed rule’’) and proposing a
number of amendments to strengthen its
protections.30 The proposal is designed
to recognize the evolution in products
and services investment advisers offer to
their clients and to strengthen and
clarify existing custody protections,
while also proposing complementary
refinements to how advisers report
custody information on Form ADV and
the books and records they are required
to keep that are designed to improve our
oversight and risk-assessment
abilities.31 Importantly, the proposal
maintains the core purpose of protecting
client assets from loss, misuse, theft, or
misappropriation by, and the insolvency
or financial reverses of, the adviser and
maintains the Commission’s ability to
pursue advisers for failing to properly
safeguard client assets under the Act’s
antifraud provisions.32
First, the proposed amendments are
designed to modernize the scope of
assets and activities that would trigger
application of the rule. In today’s
increasingly complex and global
financial markets, this update also
would simplify the rule’s application
and better align the rule with the
Commission’s statutory authority.33
Because investment advisers provide
Pursuant to section 21(a) of the Securities Exchange
Act of 1934: The DAO, Rel. No. 81207 (July 25,
2017) (describing how DAO tokens were securities
under Howey); see also Spotlight on Crypto Assets
and Cyber Enforcement Actions, available at
https://www.sec.gov/spotlight/cybersecurityenforcement-actions. Importantly, even if a
particular crypto asset is not a security, the current
rule also covers funds.
30 We are also renumbering portions of the
custody rule that we are not amending.
31 In a technical, conforming change from the
current rule, the proposed rule would replace, in
certain places, references to ‘‘you’’ with
‘‘investment adviser.’’
32 While we are renumbering the current rule as
rule 223–1, section 206(4) is still available to the
Commission and is also a basis of statutory
authority for this proposed rulemaking. To establish
a violation of section 206(4) for an adviser’s failure
to safeguard client assets, the Commission does not
need to demonstrate that an investment adviser
acted with scienter. See SEC v. Steadman, 967 F.2d
636, 646–7 (D.C. Cir. 1992). As we noted when we
adopted rule 206(4)–8, the court in Steadman
analogized section 206(4) of the Advisers Act to
section 17(a)(3) of the Securities Act, which the
Supreme Court had held did not require a finding
of scienter (citing Aaron v. SEC, 446 U.S. 680
(1980)). See Prohibition of Fraud by Advisers to
Certain Pooled Investment Vehicles, Investment
Advisers Act Rel. 2628, (Aug. 3, 2007), 72 FR 44763
(Aug. 9, 2007). See also Steadman at 643, n.5.
33 See supra note 16 and accompanying text.
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services related to an array of financial
products beyond just funds or
securities, the proposed rule would
require certain minimum protections,
particularly the safeguards of a qualified
custodian, for substantially all types of
client assets held in an advisory
account. Specifically, the safeguarding
rule would specify the types of assets
subject to the safeguarding requirements
of the rule by defining ‘‘assets’’ as
‘‘funds, securities, or other positions
held in a client’s account,’’ as opposed
to the custody rule’s use of ‘‘funds and
securities.’’ 34 This change would
expressly include certain assets that
may not have previously been
categorized as ‘‘funds’’ or ‘‘securities’’
and would accommodate developments
in the market for various investment
types that develop in the future,
irrespective of their status as funds or
securities. By expanding the scope of
the rule to include client assets instead
of only client funds and securities, we
believe we are properly balancing the
desire of investment advisers to provide
advisory services regarding novel or
innovative asset types with the need to
ensure that such assets are properly
safeguarded.
The proposed rule also would
explicitly include discretionary
authority to trade within the definition
of custody.35 When an adviser has
discretion to trade client assets, it has an
arrangement in which it may instruct
the adviser’s custodian to dispose the
client’s assets. An adviser with
discretion may also have broad
authority to direct purchases or sales of
client assets that may not currently
involve a qualified custodian, such as
loan participation interests. An adviser’s
ability or authority to effect a change in
beneficial ownership of a client’s assets,
including for purposes of trading, could
place client assets at risk of loss that the
rule is designed to address.36 This
change would rectify any unintended
34 See 15 U.S.C. 80b–23 (‘‘section 223’’) ‘‘An
investment adviser registered under this subchapter
shall take such steps to safeguard client assets over
which such adviser has custody, including, without
limitation, verification of such assets by an
independent public accountant, as the Commission
may, by rule, prescribe.’’ See proposed rule 223–
1(a).
35 Proposed rule 223–1(d)(3).
36 See section II.A.2. Recognizing that there are
times when an investment adviser neither wants
nor uses the ability or authority that would trigger
the proposed rule and that there are times when an
adviser inadvertently receives client investments,
the proposed rule would provide limited and
tailored exclusions in these circumstances. See
infra, discussion of discretionary trading authority
in section II.G.2.
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consequences of our prior interpretive
position.37
Like the custody rule, the
safeguarding rule would entrust
safekeeping of client assets to a
qualified custodian because we
continue to believe it provides critical
safeguards for those assets. Unlike the
custody rule, however, the safeguarding
rule would specify that a qualified
custodian does not ‘‘maintain’’ a client
asset for purposes of the rule if it does
not have ‘‘possession or control’’ of that
asset. The proposed rule would further
define ‘‘possession or control’’ to mean
holding assets such that the qualified
custodian is required to participate in
any change in beneficial ownership of
those assets.38 This change is designed
to improve account statement integrity
and reliability by eliminating an
adviser’s ability to request
accommodation reporting.39 Further, in
a change from the current rule, the
proposed rule would require an adviser
to enter into a written agreement with
and receive certain assurances from the
qualified custodian to make sure the
qualified custodian provides certain
standard custodial protections when
maintaining client assets.40
Under the proposal, the written
agreement would require two provisions
that are not explicitly addressed by the
current rule. One provision 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
Commission or to an independent
public accountant engaged for purposes
of complying with the safeguarding rule.
The other 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 rule: account statements and
internal control reports. Under the first,
37 When adopting amendments to the custody
rule in 2003, we stated in a footnote: ‘‘An adviser’s
authority to issue instructions to a broker-dealer or
[other] custodian to effect or settle trades does not
constitute ‘custody.’ Clients’ custodians are
generally under instructions to transfer funds (or
securities) out of a client’s account only upon
corresponding transfer of securities (or funds) into
the account. This ‘delivery versus payment’
arrangement minimizes the risk that an adviser
could withdraw or misappropriate the funds or
securities in its client’s custodial account.’’ 2003
Adopting Release, supra footnote 2, at n.10. Absent
this narrowly drawn exception for ‘‘delivery versus
payment’’ transactions, authorized trading comes
within the definition of custody.
38 Proposed rule 223–1(d)(8). For further
discussion of possession or control, please see
discussion infra section II.B.2.
39 See infra discussion section II.B.3.b.ii.
40 Proposed rule 223–1(a)(1).
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the written agreement must contain a
provision requiring the qualified
custodian to deliver account statements
to clients and to the adviser, as
currently advisers must have only a
reasonable basis for believing this is
done. 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. This provision expands the
internal control requirement to all
qualified custodians from the current
rule’s application to an adviser or its
related person 41 that acts as a qualified
custodian.
In addition to the written agreement
requirement, advisers would have to
obtain reasonable assurances that the
qualified custodian satisfies five
additional enumerated items.42 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 subcustodial 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.
We are proposing to modify the
current rule’s privately offered
securities exception from the obligation
to maintain client assets with a qualified
custodian by expanding the exception to
include certain physical assets.43 We are
also proposing refinements to the
definition of privately offered securities
that are designed to ensure appropriate
application and interpretation of this
exception.44 In addition, we are
proposing to modify the conditions for
relying on this exception to improve
investor protections in the absence of
one of the rule’s key gatekeepers.
Specifically, an adviser could rely on
the exception only if it reasonably
41 The term ‘‘related person’’ would have the
same meaning as in the current rule.
42 See proposed rule 223–1(a)(1)(ii).
43 See proposed rule 223–1(b)(2).
44 See proposed rule 223–1(d)(9).
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determines that ownership cannot be
recorded and maintained by a qualified
custodian, the adviser reasonably
safeguards the assets, the adviser
notifies the independent public
accountant performing the verification
of such an asset transfer within one
business day, an independent public
accountant verifies asset transfers and
notifies the Commission upon the
findings of any material discrepancies,
and the existence and ownership of the
assets are verified during an annual
independent verification or as part of a
financial statement audit by an
independent public accountant.45 The
modifications are also designed to limit
availability of the exception to
circumstances that truly warrant it
because we believe the bulk of advisory
client assets are able to be maintained
by qualified custodians and should be
safeguarded in the manner
contemplated under the safeguarding
rule.
Under the proposed rule, advisers
with custody of client assets would be
required to segregate those assets by (1)
titling or registering the assets in the
client’s name or otherwise holding the
assets for the client’s benefit, (2) not
commingling the assets with the
adviser’s or any of its related persons’
assets, and (3) not subjecting the assets
to any right, charge, security interest,
lien, or claim of any kind in favor of the
investment adviser or its related persons
or creditors, except to the extent agreed
to or authorized in writing by the
client.46 This provision, which would
apply regardless of whether the client’s
assets are maintained by a qualified
custodian, is designed to prevent the
adviser, or its related person, from using
client assets for its own purposes or in
a manner not authorized by the client or
in a manner inconsistent with its
fiduciary duty. We believe this will also
help to protect client assets and enable
them to be returned in the event that an
adviser experiences financial hardship.
The proposed rule would continue to
depend on the protections provided by
independent public accountants. We
have long relied on these third-party
gatekeepers to provide ‘‘another set of
eyes’’ on client assets, and we believe
they serve an important role in
safeguarding client assets. In light of the
proposed changes to the rule’s scope,
however, the proposal seeks to balance
better the costs associated with
obtaining a surprise examination with
the investor protections it offers by
providing exceptions to the surprise
examination requirement when the
45 See
46 See
proposed rule 223–1(b)(2).
proposed rule 223–1(a)(3).
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adviser’s sole reason for having custody
is because it has discretionary authority
or because the adviser is acting
according to a standing letter of
authorization, each subject to certain
conditions.47 We believe that the risk to
client assets is lower in these contexts
and the protections offered by the
surprise examination may not justify the
cost of obtaining one. Finally, the
proposed safeguarding rule amendments
would expand the scope of who can
satisfy the rule’s surprise examination
requirement through financial statement
audits by specifying that an entity is not
required to be a limited partnership,
limited liability company, or another
type of pooled investment vehicle to
rely on this provision.48
The proposal also seeks to update and
enhance recordkeeping requirements for
advisers that would work in concert
with the proposed rule. We believe that
these updates would enhance the
Commission’s oversight of the
safeguarding practices of advisers and
their compliance with the rule, which
will, in turn, promote investor
protections.
Finally, we are proposing
amendments to Form ADV to align
reporting obligations with the proposal
and improve the accuracy of custodyrelated data available to the
Commission, its staff, and the public. In
addition, we are improving the structure
of Form ADV Item 9.49 More accurate
and comprehensive information that
aligns with the proposed rule would
inform the Commission’s examination
initiatives and would allow the
Commission and its staff to better assess
risks specific advisers pose to
investors.50
II. Discussion
A. Scope of Rule
Like the current rule, the proposed
rule would apply to any investment
adviser registered or required to be
registered with the Commission under
section 203 of the Act that has
‘‘custody’’ of a client’s assets.51 Also
47 See
proposed rule 223–1(b)(7) and (8).
proposed rule 223–1(b)(4).
49 See infra discussion at section II.I.
50 See infra discussion at section II.J. Because
Form ADV Part 1A is submitted in a structured,
XML-based data language specific to that form, the
information in the proposed amendments to Part 1A
would continue to be structured (i.e., machinereadable).
51 Proposed rule 223–1. As with the current rule,
an adviser would be required to comply with the
proposed rule in circumstances where the adviser
provides advisory services to a person’s assets, even
if uncompensated. ‘‘Although a person is not an
‘investment adviser’ for purposes of the Advisers
Act unless it receives compensation for providing
advice to others, once a person meets that definition
48 See
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consistent with the current rule, the
proposed rule would also apply to any
adviser whose ‘‘related persons’’ have
custody in connection with advisory
services the adviser provides to the
client.52
The proposed rule would change the
current rule’s scope, however, in two
important ways. First, it would expand
the types of investments covered by the
rule. Currently, the rule applies to client
‘‘funds and securities’’ of which an
adviser has custody. The proposed rule
would extend the rule’s coverage
beyond client ‘‘funds and securities’’ to
client ‘‘assets’’ so as to include
additional investments held in a client’s
account. Second, the proposed rule
would make explicit that the current
rule’s defined term ‘‘custody’’ includes
discretionary authority.
1. Scope of Assets
The proposed rule would define
‘‘assets’’ as ‘‘funds, securities, or other
positions held in a client’s account.’’ 53
The proposal, like the current rule,
therefore would apply to a client’s funds
as well as a client’s securities. However,
the proposed rule also would apply to
other positions held in a client’s
account that are not funds or securities.
This proposed change uses the more
expansive and explicit language
employed by Congress in empowering
the Commission to develop rules to
protect client assets when advisers have
custody.54 Congress made this change
following several high profile
enforcement actions relating to
misappropriation of client assets.55 The
proposed amendments also recognize
the continued evolution of the types of
investments held in advisory accounts
since the custody rule was amended in
2009 and since the enactment of section
223. Looking forward, the proposed
definition of assets is designed to
remain evergreen, encompassing new
investment types as they continue to
evolve and multiply to recognize that
the protections of the rule should not
(by receiving compensation from any client to
which it provides advice), the person is an adviser,
and the Act applies to the relationship between the
adviser and any of its clients (whether or not the
adviser receives compensation from them).’’ See
Rules Implementing Amendments to the Investment
Advisers Act of 1940, Investment Advisers Act
Release No. 3221 (June 22, 2011) [76 FR 42,950
(July 19, 2011)], at text accompanying n.74.
52 Consistent with the current rule, under the
proposed rule, the term ‘‘related person’’ would
mean ‘‘any person, directly or indirectly,
controlling or controlled by [the investment
adviser], and any person that is under common
control with [the investment adviser].’’ Proposed
rule 223–1(d)(11).
53 Proposed rule 223–1(d)(1).
54 See section 223, supra footnote 34.
55 See supra footnote 11.
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depend on which type of assets the
client entrusts to the adviser.
The proposed rule’s use of the term
‘‘other positions’’ in the definition of
assets encompasses holdings that may
not necessarily be recorded on a balance
sheet as an asset for accounting
purposes, including, for example, short
positions and written options.56 We
believe, in the advisory account context,
that the entirety of a client account’s
positions, holdings, or investments
should receive the protections of the
proposed rule regardless of how they
may be treated for accounting purposes.
Moreover, the fiduciary duty extends to
the entire relationship between the
adviser and client regardless of whether
a specific holding in a client account
meets the definition of funds or a
security.57 Consequently, the proposed
rule’s definition of assets would include
investments such as all crypto assets,
even in the instances where such assets
are neither funds nor securities.58 Assets
under the rule also would include
financial contracts held for investment
purposes, collateral posted in
connection with a swap contract on
behalf of the client, and other assets that
may not be clearly funds or securities
covered by the current rule.59
Additionally, physical assets, including
artwork, real estate, precious metals, or
physical commodities (e.g., wheat or
lumber), would be within the scope of
the proposed rule. ‘‘Assets’’ also would
encompass investments that would be
accounted for in the liabilities column
of a balance sheet or represented as a
financial obligation of the client
including negative cash, which we
believe would be consistent with the
56 Similarly, rule 6(c)–11 under the Investment
Company Act of 1940 [15 U.S.C. 80a–1 et seq.] (the
‘‘Investment Company Act’’) defines an exchangetraded fund’s portfolio holdings as the securities,
assets, or other positions held by the exchangetraded fund. See 17 CFR 270.6c–11. See Exchange
Traded Funds, Investment Company Act Release
No. 33646 (Sept. 25, 2019) [84 FR 57162 (Oct. 24,
2019)], at n.249 (including within the term ‘‘other
positions’’ short positions in equity, overdrawn or
negative cash balances, written call or put options
(where the other side has the option and can put
or call the underlying instrument to the party who
wrote the contract)).
57 See Commission Interpretation Regarding
Standard of Conduct for Investment Advisers,
Release No. IA–5248 (Jun. 5, 2019) at footnote 17
(discussing the broad scope of the fiduciary duty in
a variety of contexts, including situations where
securities are not specifically involved).
58 Crypto assets that are funds or securities are
subject to the current custody rule, which applies
to all ‘‘funds and securities’’ over which an adviser
has custody. See discussion of whether crypto
assets or digital assets meet the definition of
security at supra footnote 29.
59 Id. Our staff has taken a similar position
regarding collateral for transactions, such as swaps.
See Custody Rule FAQs, supra footnote 17, at
Question II.10.
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purposes of the Act and the
longstanding policy goal of the rule to
prevent potential fraud, misuse, or
misappropriation.60
We also request comment on all
aspects of the proposed definition of
‘‘assets,’’ including the following items:
1. Should the rule apply to client
‘‘assets’’ beyond the scope of the current
rule’s formulation of ‘‘funds or
securities,’’ as proposed? Should the
proposed rule include the term ‘‘other
positions’’ as a catch-all for a client’s
positions subject to the adviser-client
relationship? Should another term, such
as client investments, be used instead?
2. Should we define client ‘‘assets’’ by
referencing other terms, such as
‘‘securities and similar investments’’ or
‘‘any investment,’’ which are used but
not defined in the Investment Company
Act custody rules? 61 Should we instead
incorporate the term ‘‘investment’’ from
the definition of ‘‘qualified purchaser’’
under the Investment Company Act? 62
3. Are there particular types of assets
held in a client’s advisory account that
should or should not be subject to the
proposed rule? If so, what are they and
why should they be included or
excluded? Are there other safeguards
outside of the proposed rule that apply
to these positions that would satisfy the
policy goals of the rule? Does the
answer depend on the type of asset?
4. To the extent that the adviser has
custody of certain physical assets,
should we narrow the proposed
definition to exclude such physical
assets? For example, should the
proposed definition exclude artwork,
real estate, precious metals, or physical
commodities (e.g., wheat or lumber), for
example?
5. It is our understanding that some
advisers treat client assets that may not
be ‘‘funds or securities’’ consistent with
rule 206(4)–2. If so, what types of assets
do they maintain with a qualified
custodian under the current rule? If not,
how do the advisers safeguard these
client assets?
6. Should we provide guidance about
how the proposed rule would apply to
certain asset types? If so, for what types
of assets? Should we provide guidance
for certain assets that would be subject
to exceptions from the proposed rule,
such as privately offered securities or
physical assets?
7. Should the proposed rule apply to
assets that are treated as liabilities from
60 See rule 6c–11, supra footnote 56. The release
discussed that liabilities were contemplated to be
part of ‘‘other positions.’’
61 See rules 17f–1, 17f–2, 17f–5, and 17f–6 under
the Investment Company Act.
62 See rule 2a51–1(b) under the Investment
Company Act.
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an accounting perspective? Is it
sufficiently clear that the proposed rule
would apply to portfolio holdings that
are liabilities on a balance sheet?
Should we provide additional
clarification as to what types of
investments may appear as liabilities
within the scope of the advisory
relationship? What types of holdings
typically appear as liabilities? Are there
any exemptions or provisions required
for such investments if they are
included within the scope of the rule?
2. Scope of Activity Subject to the
Proposed Rule
The proposal generally would
preserve the current rule’s definition of
‘‘custody,’’ and apply when an adviser
‘‘holds, directly or indirectly, client
assets, or has any authority to obtain
possession of them.’’ 63 The general
principle of this definition is to apply
the rule when an adviser has the ability
or authority to effect a change in
beneficial ownership of a client’s
assets.64 An adviser with this ability or
authority can subject a client’s assets to
the risks of loss, misuse,
misappropriation, theft, or financial
reverses of the adviser. Moreover, the
rule would continue to apply when an
adviser’s related person has the ability
to obtain client assets in connection
with advisory services. Like the current
rule, the proposed rule would institute
prophylactic safeguards where there is
this potential for loss or harm to a client
given the adviser’s ability or authority to
deprive the client of ownership and to
obtain possession of the client’s assets.
In addition to this overarching
principle, the current definition of
custody includes three categories that
serve as examples of custody: physical
possession, certain arrangements when
the adviser is authorized or permitted to
instruct the client’s custodian, and
circumstances when the adviser acts in
certain capacities.65 The proposed rule
63 See
proposed rule 223–1(d)(3).
example, an adviser that physically holds
a check drawn by the advisory client and made
payable to a third party is not subject to the rule
solely as a result of holding the check, since the
adviser cannot use the check to change ownership
of the client’s underlying cash holdings. See rule
206(4)–2(d)(2)(i). Similarly, if a stock certificate is
non-transferable (i.e., it cannot be used to effect a
change in beneficial ownership of the client’s
investment), an adviser would not be subject to the
rule as a result of holding it. Our staff previously
took a similar view. See 2013 IM Guidance, supra
footnote 17.
65 Under the current rule, custody includes three
prongs: (i) Possession of client funds or securities
(but not of checks drawn by clients and made
payable to third parties) unless the adviser receives
them inadvertently and returns them to the sender
promptly but in any case within three business days
of receiving them; (ii) Any arrangement (including
64 For
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would retain these categories because,
going forward, we believe this approach
will continue to provide flexibility as
the asset management industry
continues to evolve, introduces novel
investment products, and provides new
services to its advisory clients.
We believe we need to provide
specificity, however, regarding the
arrangement category of the custody
definition to state explicitly that
discretionary trading authority is an
arrangement that triggers the rule.66
Specifically, the amended custody
definition would include any
arrangement (including, but not limited
to, a general power of attorney or
discretionary authority) under which
the adviser is authorized or permitted to
withdraw or transfer beneficial
ownership of client assets upon the
adviser’s instruction.67 In addition, the
proposed discretionary authority
definition is consistent with the
definition in Form ADV and is the
authority to decide which assets to
purchase and sell for the client.68
The Commission previously stated
that an adviser’s authority to issue
instructions to a broker-dealer or a
custodian to effect or to settle trades, or
authorized trading, does not constitute
custody.69 We had explained then that
the risk of an adviser withdrawing or
misappropriating funds and securities
are minimized when a client’s custodian
is under instructions to transfer funds
(or securities) out of a client’s account
only upon corresponding transfer of
securities (or funds) into the account.70
However, while we continue to believe
that there is a more limited risk of loss
a general power of attorney) under which the
adviser is authorized or permitted to withdraw
client funds or securities maintained with a
custodian upon the adviser’s instruction to the
custodian; and (iii) Any capacity (such as general
partner of a limited partnership, managing member
of a limited liability company or a comparable
position for another type of pooled investment
vehicle, or trustee of a trust) that gives the adviser
or its supervised person legal ownership of or
access to client funds or securities.
66 Proposed rule 223–1(d)(3) (proposed custody
definition) and proposed rule 223–
1(d)(4)(discretionary authority definition). The
second prong of the current custody definition
states: ‘‘Any arrangement (including a general
power of attorney) under which you are authorized
or permitted to withdraw client funds or securities
maintained with a custodian upon your instruction
to the custodian.’’ See current rule 206(4)–2(d)(3).
67 The proposed amended definition also removes
the reference ‘‘to the custodian’’ from the
arrangement category. This formulation ensures that
custody is triggered if, for example, an adviser can
instruct a transfer agent or administrator to
withdraw or transfer beneficial ownership of client
assets. See proposed rule 223–1(d)(3).
68 Proposed rule 223–1(d)(4).
69 2003 Adopting Release, supra footnote 2, at
n.10.
70 Id.
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to a client from authorized trading when
a qualified custodian participates in a
one-for-one exchange of assets like this,
we also believe that discretionary
authority presents the types of risks the
rule is designed to address. The adviser,
for instance, could use its discretionary
authority over a client’s assets to
instruct an issuer’s transfer agent or
administrator (e.g., the administrator 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, thereby depriving
the client of ownership, unbeknownst to
the client or its qualified custodian.
Unless a client or its custodian is
required to participate in these
transactions, such as when the client
must sign the subscription agreement to
purchase the security (i.e., the adviser
does not have a power of attorney and
cannot sign for the client in any other
capacity), the client will be unable to
monitor the assets in its account for
potential misuse or misappropriation
effectively.71
We believe it is important to extend
the protections of the rule by explicitly
including ‘‘discretionary authority’’
within the definition of custody.
However, because we continue to
believe more limited risk of loss exists
when a qualified custodian participates
in transactions, we are also proposing a
limited exception to the surprise
examination requirement of the rule.
The exception would generally apply to
client assets that are maintained with a
qualified custodian when the sole basis
for the application of the rule is an
adviser’s discretionary authority that is
limited to instructing the client’s
qualified custodian to transact in assets
that settle only on a delivery versus
payment (‘‘DVP’’) basis.72 In DVP
transactions, clients’ custodians are
under instructions to transfer assets out
of a client’s account only upon
corresponding transfer of assets into the
account. This ‘‘delivery versus
payment’’ arrangement minimizes the
risk that an investment adviser could
withdraw or misappropriate the assets
in its client’s custodial account. In our
view, DVP transactions reduce the risk
that the seller of an asset could deliver
the asset but not receive payment or that
the buyer of an asset could make
payment but not receive delivery of the
asset.73
71 Our staff stated a similar view under the
current rule. See Custody Rule FAQs, supra
footnote 17, at Question VII.3.
72 Proposed rule 223–1(b)(8). See infra at section
II.G.2.
73 For discussion of delivery versus payment
settlement operations, see Bank for International
Settlements, ‘‘Delivery versus Payment in Securities
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We request comment on all aspects of
the proposed application of the rule to
advisers with discretionary authority,
along with the continuing application of
the rule more generally, including the
following items.
8. Should the proposal generally
retain the current rule’s definition of
custody? The proposed rule would
generally retain the three categories that
serve as examples of custody in the
current rule: physical possession,
certain arrangements when the adviser
is authorized or permitted to withdraw
or transfer beneficial ownership of
client assets upon the adviser’s
instructions, and circumstances when
the adviser acts in certain capacities.
Should the proposed rule change the
current definition of custody from these
three categories? What should the
proposal provide alternatively?
9. Should the rule apply to when an
adviser has discretionary authority over
client assets, as proposed? Are there
provisions of the proposed rule that
should or should not apply to advisers
who have custody because they have
discretionary authority?
10. Do advisers with discretionary
authority over a client’s assets
(regardless of settlement method)
currently have safeguards in place that
effectively limit the risks to clients of
loss, misuse, theft, or—in particular—
misappropriation? If so, what are they?
Do these safeguards differ depending on
whether the arrangement involves a
qualified custodian?
11. When a trade settles in a manner
that is not DVP, are there controls that
are or could be established in the event
one leg of the trade does not complete?
If so, how commonly are such controls
utilized? Are there circumstances when
such controls could not be established
or implemented? Should we require
controls or policies and procedures for
advisers and/or the respective
custodians in these circumstances?
12. Should the definition of custody
contain an exception (or should we
interpret the definition of custody not to
include) when the adviser has authority
to instruct the client’s custodian to
remit assets from the custodial account
to the client at his or her mailing
address of record? If so, should such an
exception or interpretation be subject to
any conditions? For example, should
the client be required to grant the
adviser this authority in writing to the
qualified custodian? Should an
exception or interpretation also be
conditioned on the adviser lacking
authority to open an account on behalf
Settlement Systems,’’ Sept. 1992, p. 1 at https://
www.bis.org/cpmi/publ/d06.pdf.
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of the client? Should the adviser also
lack authority to designate or change the
client’s mailing address of record with
the qualified custodian, or if the adviser
has this authority, would it be sufficient
protection for the adviser to have a
reasonable belief that the custodian
would send a notice of any change of
mailing address to the client at the
client’s old address of record upon
receiving the request from the adviser to
change the mailing address? 74 For
example, broker-dealers must send a
customer who is a natural person a
notification of a change of mailing
address to the customer’s old mailing
address.75 Similarly, banks that follow
guidance issued by banking regulators
send confirmation of a customer request
for a change of mailing address to both
the old and new address on record.76 Is
there adequate protection when the
custodian is subject to these regulatory
requirements because the adviser would
be unable to remit its client’s assets to
the client at a mailing address other
than the client’s address of record at the
custodian? Alternatively, should such
an exception or interpretation hinge on
whether advisers design policies and
procedures under rule 206(4)–7 (the
‘‘Compliance Rule’’) that address the
risk to clients of remitting client
investments to non-clients?
13. Should we make clear that an
adviser is subject to the custody rule
and would also be subject to the
proposed rule with respect to its client’s
assets that are held, or accessible, by a
related carrying broker or executed
through a related introducing broker? 77
Conversely, should we make clear that
an adviser would not be subject to the
rule solely due to its related person
acting as the trustee of a participantdirected defined contribution plan
established for the benefit of the
adviser’s employees, provided the
adviser does not provide investment
advisory services to the plan or any
investment option available under the
plan? 78 Similarly, should we clarify the
74 We note that the staff has issued an FAQ on
this topic. See Custody Rule FAQs, supra footnote
17, at FAQ II.5.A. and B.
75 Exchange Act Rule 17a–3(a)(17)(i)(B)(2).
76 See, e.g., Federal Reserve System Supervisory
Letter SR 0–11 (Apr. 26, 2001), Office of
Comptroller of the Currency (‘‘OCC’’) Advisory
Letter 2001–4 (Apr. 30, 2001), Federal Deposit
Insurance Corporation Financial Institution Letter
39–2001 (May 9, 2001), Office of Thrift Supervision
CEO Letter No. 139 (May 4, 2001), and National
Credit Union Administration Letter No. 01–CU–09
(Sept. 2001).
77 We note that the staff has issued an FAQ on
this topic. See Custody Rule FAQs, supra footnote
17, at Question XIV.2–3. See also section II.J, infra.
78 We note that the staff has issued an FAQ on
this topic. Our staff has stated that it would not
consider an adviser to have custody where the
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meaning of ‘‘in connection with
advisory services’’ in the context of
related person custody? 79 For example,
should we make clear that where an
adviser’s client has a bank account with
a bank that is the adviser’s related
person, but does not use the bank
account in connection with the adviser’s
advisory activity, we would not view
the bank’s authority to be ‘‘in
connection with advisory services’’ that
the adviser provides to its client and
that the rule, therefore, would not
apply?
14. Advisers that act as trustee of a
trust would have custody of that trust’s
assets under the proposed rule. Should
we adopt an exception from the
definition of custody for (or should we
interpret the definition of custody not to
include) cases where an adviser acts as
co-trustee of a trust and no single cotrustee is able to effect any change in
control of the beneficial ownership of
the trust’s investments without the prior
written consent of a co-trustee(s) that is
not a related person? 80 In what
circumstances is a co-trustee required
either by law or the trust instrument to
protect the trust beneficiaries from the
actions of a single trustee acting alone?
Similarly, should we adopt an exception
in (or should we interpret the definition
of custody not to include) circumstances
where an adviser has the ability or
authority to effect a change in beneficial
ownership of a trust’s investments,
where an adviser is co-trustee along
with the grantor of a revocable grantor
trust, and the adviser is prohibited by
the trust instrument or by law from
withdrawing any investments from the
trust without the prior written consent
of all of its co-trustees? 81
15. An adviser would have custody
under the proposed rule when it comes
into possession of client assets. The rule
contains an exception from the
definition of custody for possession of
client assets when the adviser receives
investment adviser and the related person trustee
are, to the extent applicable, in compliance with the
Employee Retirement Income Security Act of 1974
(ERISA) and rules and regulations issued
thereunder with respect to the plan. See Custody
Rule FAQs, supra footnote 17, Question XII.1.
79 See proposed rule section 223–1(d)(3).
80 We note that the staff has issued an FAQ on
this topic. See Custody Rule FAQs, supra footnote
17, at Question XII.2.
81 We note that the staff has issued an FAQ on
this topic. See Custody Rule FAQs, supra footnote
17, Question XII.3. See also, 2003 Adopting
Release, supra footnote 2 at note 15 (stating that the
Commission would not view the adviser to have
custody of the funds or securities of the estate,
conservatorship, or trust solely because the
supervised person has been appointed in these
capacities as a result of family or personal
relationship with the decedent, beneficiary or
grantor (and not a result of employment with the
adviser)).
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them inadvertently and returns them to
the sender within three business days.
Should we amend the exception to
accommodate (or interpret the
definition of custody not to include)
other situations in which the adviser
inadvertently receives client assets? 82
For example, should such an exception
or interpretation be conditioned such
that the adviser return the client’s assets
to the sender or forward them to the
client or the client’s custodian within
five days of receipt? Should such an
exception or interpretation be available
only when client assets are received
from senders, such as those identified in
staff statements? Rather than specify
senders in such an exception, should
the exception or interpretation be
available when an adviser determines it
would be unfeasible to return the assets,
or when there is a risk that the client’s
assets could be lost if the adviser
attempted to return them to the sender?
Should such an exception or
interpretation be available only if the
investment adviser’s receipt of its
client’s assets is inadvertent? Should we
condition such an exception or
interpretation on recordkeeping
requirements under proposed rule 204–
2 or on whether advisers design policies
and procedures under rule 206(4)–7?
We understand that for certain private
fund advisers and trustees it is difficult
to avoid temporarily possessing client
checks and physical assets because
there may not be an independent
representative to arrange the movement
of such assets into a qualified custodian.
Are there any particularities to these
contexts that would benefit from an
exception or interpretation? In addition,
are there other circumstances that
involve checks written to third parties,
checks written to clients, and checks
written to advisers where the adviser
has no authority to deposit client assets
into any account other than directed by
the client that would benefit from
exceptions or interpretations? Are there
certain policies and procedures
maintained by advisers that mitigate the
custody risks associated with receiving
checks that may be beneficial to include
in this rulemaking? For example, if the
adviser has policies and procedures
reasonably designed to maintain such
82 We note that the staff has issued a no-action
letter on this topic. The Commission’s staff has
stated that when advisers infrequently receive
specific types of client funds or securities from a
list of enumerated third parties that the staff
identified, the staff would not recommend
enforcement for violation of the current custody
rule if the adviser meets specified conditions. See
Investment Adviser Association, SEC Staff NoAction Letter (Sep. 20, 2007) (‘‘2007 IAA No-Action
Letter’’). See also Custody Rule FAQs, supra
footnote 17, at Question II.1.
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assets with a qualified custodian,
should we provide an exception if an
adviser to a private fund or serving as
a trustee would not be subject to the
rule for the brief handling of client
checks or physical assets?
16. Should we include an exception
from the rule for assets for which the
adviser provides advice in certain subadviser relationships, such as was
described in our staff’s statements? 83 In
what circumstances should such an
exception apply? Would an exception
designed to capture circumstances
where the proposed rule would apply to
the sub-adviser only because its related
person triggers the rule with respect to
the same advisory clients be beneficial?
Such an exception could be conditioned
on the related person being fully subject
to (and in compliance with) the
applicable requirements of the custody
rule. Would such a condition to the
exception work in practice? Should
such exception be conditioned on the
adviser’s related person fully complying
with the requirements of the proposed
rule? If not, why not? If so, how would
advisers determine whether their related
person is fully complying with the rule?
Are there alternative safeguards that
commenters would suggest?
Alternatively, should such sub-advisers
be subject to all or certain requirements
of the rule? If only certain requirements,
which ones and why? Should we
condition such an exception on
recordkeeping requirements under
proposed rule 204–2 or on whether
advisers design policies and procedures
under rule 206(4)–7?
17. Are there are any other
arrangements or circumstances where
an adviser would have custody under
the proposed rules but an exception
would be beneficial and not
inconsistent with the policy goals of the
rule? For example, are there specific
circumstances involving custody at
electronic platforms, investment adviser
aggregators, benefit plans, introducing
broker-dealers, plan sponsors, recordkeepers, or third party administrators
that would benefit from an exception or
interpretation that these arrangements
constitute or do not constitute custody?
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B. Qualified Custodian Protections
Qualified custodians would continue
to serve as key gatekeepers under the
proposed rule. These institutions’
custodial activities are subject to
83 We note that the staff has issued a no-action
letter on this topic. See Investment Adviser
Association, SEC Staff No-Action Letter (Apr. 25,
2016), available at: https://www.sec.gov/divisions/
investment/noaction/2016/investment-adviserassociation-042516-206(4).htm.
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regulation and oversight.84 Accordingly,
as under the current rule, investment
advisers with custody of client assets
would be required to maintain those
assets with a qualified custodian.85 We
are proposing several ways to strengthen
the requirement, however, in light of the
evolution of the market for custodial
services, financial products, and
advisory services over the last decade.
These proposed changes aim to provide
investors with certain standard
custodial protections that will improve
the safeguarding of their assets in the
current market as well as in the future
as the market for financial products and
advisory services continues to evolve.
The proposed rule would continue to
allow banks or savings associations,
registered broker-dealers, registered
futures commission merchants, and
certain foreign financial institutions to
act as qualified custodians, but, in a
change from the current rule, only if
they have ‘‘possession or control’’ of
client assets pursuant to a written
agreement between the qualified
custodian and the investment adviser.86
Also in a change from the current rule,
the proposed rule would modify the
definition of foreign financial institution
and requirements for banks and savings
associations in the definition of
qualified custodian.87 In the case of a
qualified custodian that is the adviser,
the proposed rule would require that the
written agreement be between the
adviser and the client.
The proposed rule would require that
the written agreement contain
contractual provisions that we believe
are critical to providing important
protections for advisory client assets. As
discussed in further detail below, the
contractual terms would address
recordkeeping, client account
statements, internal control reports, and
the adviser’s agreed-upon level of
authority to effect transactions in the
account. In addition, the proposed rule
would require that an adviser obtain
reasonable assurances from a qualified
custodian relating to certain protections
the qualified custodian will provide to
the advisory client, including with
respect to the qualified custodian’s
standard of care, indemnification,
limitation of liability for sub-custodial
84 2002 Proposing Release, supra footnote 2, at n.
30; 2009 Proposing Release, supra footnote 11, at
n. 4.
85 Proposed rule 223–1(a)(1)(i). The proposed rule
would provide an exception, and another means of
compliance with the rule, for certain assets that are
unable to be maintained with a qualified custodian.
See proposed rule 223–1(b)(2).
86 See proposed rule 223–1(a)(1).
87 See proposed rule 223–1(d)(10)(i) and (iv);
section II.B.1.b, infra.
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services, segregation of client assets, and
attachment of liens to client assets. Also
as discussed below, we believe that
many of these important protections are
already provided—through contract or
practice—by certain custodians to
certain custodial customers in the
current market. However, the proposed
rule is designed to expand and
formalize the minimum standard of
protections to advisory clients’ assets
held by qualified custodians in a
manner that would provide consistent
investor protections across all qualified
custodians under our proposed rule. We
believe that the proposed rule leverages
the expertise and regulatory regimes of
qualified custodians with respect to a
wide range of assets, while, at the same
time, tailoring and bolstering the
protections afforded to advisory clients
to improve the safeguarding of client
assets over which advisers have
custody.
1. Definition of Qualified Custodian
Qualified custodians under the
proposed rule would include the types
of financial institutions that clients and
advisers customarily turn to for
custodial services and that have in place
practices that are designed to protect
custodial assets. We continue to believe
that the use of a qualified custodian
would enhance the protections afforded
to client assets.88
The proposed rule, like the current
rule, would define the term ‘‘qualified
custodian’’ to mean a bank or savings
association, registered broker-dealer,
registered futures commission merchant
(‘‘FCM’’), or certain type of foreign
financial institution (‘‘FFI’’) that meets
the specified conditions and
requirements.89 We continue to believe
that these financial institutions should
be permitted to act as qualified
custodians because, as discussed in
more detail below, they operate under
regular government oversight, are
subjected to periodic inspection and
examination, have familiarity with
providing custodial services, and are in
a position to attest to custodial customer
holdings and transactions 90—all critical
88 See 2003 Adopting Release, supra footnote 2;
2009 Adopting Release, supra footnote 11.
89 Proposed rule 223–1(d)(10). Not all registered
broker-dealers and registered FCMs meet the
definition of qualified custodian under the custody
rule or the proposed safeguarding rule. Notably,
only those broker-dealers or FCMs holding client
assets in customer accounts meet this definition.
This would include the broker-dealers subject to the
customer protection rule (Exchange Act Rule 15c3–
3) and FCMs holding futures customers funds
subject to 17 CFR 1.20.
90 See, e.g., 2009 Adopting Release, supra
footnote 11, at section I (describing qualified
custodians under the rule as the types of financial
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components of safeguarding client
assets under the proposed rule. As a
result, with the exception of proposed
amendments to the definition of
qualified custodian relating to banks,
savings associations, and FFIs, we are
not changing the types of institutions
that may serve as qualified custodians
under the rule.91
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a. Bank and Savings Association
Qualified Custodian Proposed
Amendments
The current rule includes in the
definition of qualified custodian a bank
as defined in section 202(a)(2) of the
Advisers Act (15 U.S.C. 80b–2(a)(2)) or
a savings association as defined in
section 3(b)(1) of the Federal Deposit
Insurance Act (12 U.S.C. 1813(b)(1)) that
has deposits insured by the Federal
Deposit Insurance Corporation under
the Federal Deposit Insurance Act (12
U.S.C. 1811). The proposed rule would
largely retain this definition of qualified
custodian relating to banks and savings
associations. However, in connection
with the proposed rule’s focus on
setting certain minimum protections for
client assets, the rule would require that
a qualifying bank or savings association
hold client assets in an account that is
designed to protect such assets from
creditors of the bank or savings
association in the event of the
insolvency or failure of the bank or
savings association (i.e., an account in
which client assets are easily
identifiable and clearly segregated from
the bank’s assets) in order to qualify as
a qualified custodian. We believe that
requiring banks and savings associations
to hold client assets in such an account
brings the requirements for bank and
savings association qualified custodians
in line with the protections required for
broker-dealers, FCMs, and FFIs acting as
qualified custodians under the current
custody rule and under the proposed
safeguarding rule.92
institutions to which clients and advisers
customarily turn for custodial services and as
subject to regulation and oversight).
91 We remind advisers that as additional financial
institutions become available to custody assets,
advisers must continue to exercise their fiduciary
duties to clients in connection with selection and
monitoring of the qualified custodian. See, e.g.,
Standard of Conduct for Investment Advisers
Release, supra note 57, at section II (‘‘The
investment adviser’s fiduciary duty is broad and
applies to the entire adviser-client relationship.’’)
(citations omitted).
92 The current custody rule requires that in order
to be included in the definition of qualified
custodian, a broker-dealer registered under section
15(b)(1) of the Securities Exchange Act of 1934 (15
U.S.C. 78o(b)(1)), must hold the client assets in
customer accounts, a futures commission merchant
registered under section 4f(a) of the Commodity
Exchange Act (7 U.S.C. 6f(a)) must hold the client
assets in customer accounts subject to certain
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We believe that the proposed account
requirement would improve the
safeguarding of client assets. We
understand that, generally, a bank
deposit account creates a debtor-creditor
relationship between the bank and
depositor.93 This debtor-creditor
relationship typically does not create a
special or fiduciary relationship.94
While applicable insolvency law and
procedures vary depending on any
particular bank or savings association’s
regulatory regime,95 we understand that
assets held in accounts of the type
proposed by the rule are more likely to
be returned to clients upon the
insolvency of the qualified custodian
because they may pass outside of a
bank’s insolvency, may be recoverable if
wrongly transferred or converted, and
are not treated as general assets of the
bank.96
We believe that the proposed rule
would provide flexibility to banks and
savings associations to use the
appropriate accounts available to them
under applicable law and offered by
them to customers. Rather than consider
the treatment of custodial customer
assets upon a bank’s failure in all 50
states, and risk the protections of our
rule eroding if state banking law
protections vary or evolve, we are
proposing to establish a consistent and
uniform standard to protect all advisory
clients. The account terms should
identify clearly that the account is
distinguishable from a general deposit
account and clarify the nature of the
relationship between the account holder
and the qualified custodian as a
relationship account that protects the
client assets from creditors of the bank
or savings association in the event of the
additional requirements, and an FFI must
customarily hold financial assets for its customers
and must keep the advisory clients’ assets in
customer accounts segregated from its proprietary
assets. See rule 206(4)–2(d)(6)(ii), (iii), and (iv). See
also proposed rule 223–1(d)(10).
93 See generally, Graham, Heitz, Lapine, et al., 6a
Banking Law section 134.05 (2022) section 134.05
(collecting cases) (‘‘Banking Law’’). We understand
that a deposit in a bank is either general or special
and that a deposit is a general deposit unless there
is an agreement or understanding that it should be
special. See 5C Michie on Banks and Banking,
Deposits section 339 (Sept. 2022) (collecting cases)
(‘‘Michie on Banks & Banking’’); Banking Law,
section 134.05 (‘‘Accounts are either special
accounts or general accounts.’’) (collecting cases).
94 Id.
95 See 3 Michie on Banks & Banking, Insolvency
and Dissolution. section 17. Jurisdiction and Powers
of Courts and Officials in General (discussing stateby state jurisdiction and certain regulatory powers).
96 See Michie on Banks & Banking, Deposits
section 339 (collecting cases under a wide variety
of state laws where a bank may be acting as a
trustee, bailee, or agent in connection with a
customer account that is treated as other than a
general deposit account).
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insolvency or failure of the bank or
savings association.
b. Proposed Enhancements to Definition
of Foreign Financial Institution
Advisory clients often invest in assets
traded on foreign exchanges and their
advisers must, as a practical matter,
maintain those assets with financial
institutions in foreign countries where
the assets are traded. In order to
facilitate these types of holdings, the
current rule includes FFIs that
customarily hold financial assets for
their customers, as qualified custodians,
provided that the FFI keeps the advisory
clients’ assets in customer accounts
segregated from the FFI’s proprietary
assets.97
We are proposing to require that an
FFI satisfy seven new conditions in
order to serve as a qualified custodian
for client assets under the proposed
rule.98 These proposed conditions are
partly drawn from our experience with
the factors relevant to the safekeeping of
‘‘Foreign Assets’’ by the types of foreign
financial entities that can act as an
‘‘Eligible Foreign Custodian’’ as defined
in rule 17f–5 under the Investment
Company Act.99 Such conditions are
also designed to address our
understanding of market developments
since the adoption of rule 17f–5 by
providing enhanced investor protections
for advisory clients and their assets that
97 See rule 206(4)–2(d)(6)(iv). Under the current
rule, when an adviser selects an FFI to hold clients’
assets, we believe the adviser’s fiduciary obligations
require it either to have a reasonable basis for
believing that the FFI satisfies the conditions and
would provide a level of safety for client assets
similar to that which would be provided by a
‘‘qualified custodian’’ in the United States or to
disclose fully to clients any material risks attendant
to maintaining the assets with the foreign
custodian. See 2003 Adopting Release, supra
footnote 2, at note 22.
98 We also propose to eliminate the requirement
under the current definition that the FFI keeps the
advisory clients’ assets in customer accounts
segregated from its proprietary assets because the
proposed rule, more broadly, would require
advisers to obtain reasonable assurances from
qualified custodians that all advisory client assets
are segregated from the qualified custodian’s
proprietary assets and liabilities. See proposed rule
223–1(a)(1)(ii)(D).
99 Rule 17f–5 under the Investment Company Act
defines an Eligible Foreign Custodian as an entity
that is incorporated or organized under the laws of
a country other than the United States and that is
a Qualified Foreign Bank or a majority-owned direct
or indirect subsidiary of a U.S. Bank or bankholding company. For these purposes, a Qualified
Foreign Bank is defined as a banking institution or
trust company, incorporated or organized under the
laws of a country other than the United States, that
is regulated as such by the country’s government or
an agency of the country’s government. See 17 CFR
270.17f–5(a)(1) and (a)(5). Rule 17f–5(c)(1) under
the Investment Company Act lists the factors
relevant to the safekeeping of Foreign Assets, as
defined in rule 17f–5(a)(2). See 17 CFR 270.17f–
5(c)(1) and (a)(2).
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we believe would help promote an FFI
having generally similar protections as a
U.S.-based qualified custodian. Recent
events in crypto assets markets also
have highlighted the need for similarly
enhanced custody safeguards of client
assets held outside the United States.
For an FFI to be a qualified custodian
under the proposed rule, it would need
to be:
• Incorporated or organized under the
laws of a country or jurisdiction other
than the United States, provided that
the adviser and the Commission are able
to enforce judgments, including civil
monetary penalties, against the FFI;
• Regulated by a foreign country’s
government, an agency of a foreign
country’s government, or a foreign
financial regulatory authority 100 as a
banking institution, trust company, or
other financial institution that
customarily holds financial assets for its
customers;
• Required by law to comply with
anti-money laundering and related
provisions similar to those of the Bank
Secrecy Act [31 U.S.C. 5311, et seq.] and
regulations thereunder;
• Holding financial assets for its
customers in an account designed to
protect such assets from creditors of the
foreign financial institution in the event
of the insolvency or failure of the
foreign financial institution;
• Having the requisite financial
strength to provide due care for client
assets;
• Required by law to implement
practices, procedures, and internal
controls designed to ensure the exercise
of due care with respect to the
safekeeping of client assets; and
• Not operated for the purpose of
evading the provisions of the proposed
rule.101
We believe each of these proposed
new conditions would enhance the
ability and responsibility of advisers to
protect client assets maintained outside
the United States for the following
reasons.
Regarding the first condition, we are
proposing to require the adviser to
determine that the adviser and the
Commission are able to enforce
judgments, including civil monetary
penalties, against the FFI. The FFI could
satisfy this condition by such means as
appointing an agent for service of
process in the United States or having
offices in the United States, and the
adviser can request the relevant
documentation for verification
purposes. This condition would thus
100 Defined in section 202(a)(24) of the Advisers
Act [15 U.S.C. 80b–2(a)(24)].
101 Proposed rule 223–1(d)(10)(iv).
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limit the types of foreign financial
entities to those that are subject to or
consent to U.S. jurisdiction.
Regarding the second condition, we
believe requiring an FFI be regulated by
a foreign country’s government, an
agency of a foreign country’s
government, or a foreign financial
regulatory authority, as defined in
section 202(a)(24) of the Advisers Act,
would help ensure that client assets
maintained with an FFI are subject to
regulatory oversight that would better
serve our policy goal of protecting
custodial assets by the use of qualified
custodians that meet our proposed
requirements. In addition to banking
institutions and trust companies, we
would permit foreign-regulated
financial institutions who customarily
hold financial assets for their customers
(e.g., the foreign equivalent of brokerdealers or FCMs) to serve as ‘‘qualified
custodians.’’
We believe the requirement in the
third condition for an FFI to comply
with anti-money laundering (‘‘AML’’)
and related provisions similar to those
of the Bank Secrecy Act (‘‘BSA’’) and
regulations thereunder would help
increase the likelihood that the FFI
would readily identify and investigate
aberrant behavior in a client account,
such as activity that might suggest
misappropriation or some other type of
loss to a client. We generally believe an
FFI would be able to satisfy this
condition if it is required to comply
with the laws and regulations
established by a member or observer
jurisdiction of the Financial Action Task
Force (‘‘FATF’’) and not otherwise listed
on any sanctions list administered by
the Office of Foreign Assets Control of
the U.S. Department of the Treasury
(‘‘OFAC’’),102 or on any special
measures list administered by the
Financial Crimes Enforcement Network
of the U.S. Department of the Treasury
(FinCEN’’).103
102 The
FATF is an inter-governmental body
whose purpose is the development and promotion
of policies, both at the national and international
levels, to combat money laundering and the
financing of terrorism and proliferation. The FATF
monitors members’ progress in implementing AML
measures, reviews money laundering techniques
and counter-measures, and promotes the adoption
and implementation of AML measures globally. See
https://www.fatf-gafi.org/en/the-fatf/what-wedo.html/. To search sanctions lists administered by
OFAC, such as the Specially Designated Nationals
and Blocked Persons list, see https://
sanctionssearch.ofac.treas.gov.
103 See section 311 of the USA PATRIOT Act
[Pub. L. 107–56] (granting the Secretary of the
Treasury the authority to conclude, if reasonable
grounds exist, that a foreign jurisdiction, foreign
financial institution, or an international transaction
or account is of ‘‘primary money laundering
concern,’’ and to require domestic financial
institutions and financial agencies to take certain
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The fourth condition would replace
and strengthen the segregation
requirement for FFIs in the current
definition of qualified custodian in the
custody rule, and it is designed to
complement the proposed segregation
requirements of the safeguarding rule. In
the current rule, an FFI that customarily
holds financial assets for its customers
is permitted to serve as a qualified
custodian, provided that the FFI keeps
the advisory clients’ assets in customer
accounts segregated from its proprietary
assets. The proposed new condition
would require the FFI to hold financial
assets for its customers in accounts
designed to protect such assets from
creditors of the FFI in the event of the
insolvency or failure of the FFI.104 This
condition would thereby impose
investor protections, particularly in the
event of an FFI insolvency or
bankruptcy, that are more comparable to
those we are proposing for assets held
with U.S.-regulated bank or savings
association qualified custodians. We
believe advisers would be able to assess
whether an FFI is holding client assets
in such accounts in the course of
obtaining the reasonable assurances we
are proposing to require advisers obtain
from all qualified custodians, which are
discussed more fully below.105
The fifth condition is designed to
limit the types of FFIs that can serve as
qualified custodians to those that have
the requisite financial strength to meet
the proposed due care standard for
client assets. We believe the
determination of an FFI’s financial
strength could be based on objective
measures and other indicators of
financial health that are reasonably
comparable to those that apply to U.S.
banks and other regulated financial
institutions.106 Given that advisers
would be required to maintain an
ongoing reasonable belief that the FFI
qualified custodian is meeting its due
‘‘special measures,’’ such as additional due
diligence and special attention to particular account
transactions, among other measures, against the
designated entity).
104 Compare rule 204–2(d)(6)(iv) with proposed
rule 223–1(d)(10)(iv)(D).
105 See infra section II.B.3.a.iv (discussing the
adviser’s requirement to obtain reasonable
assurances from qualified custodians regarding the
required account segregation requirements).
106 When the Commission adopted amendments
to rule 17f–5 (17 CFR 270.17f–5) in 1997, its
adopting release offered guidance to evaluate
financial strength by ‘‘assess[ing] the adequacy of
the custodian’s capital with a view of protecting the
fund against the risk of loss from a custodian’s
insolvency.’’ See Custody of Investment Company
Assets Outside the United States, Investment
Company Act Release No. 22658 (May 12, 1997) [62
FR 26923 (May 16, 1997)], at 26928. We understand
that relevant governments and their banking
regulators typically set regulatory capital
requirements for foreign banking institutions.
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care standard, advisers also could
require notifications from the FFI of any
changes, including changes in the
financial strength of the FFI, that would
have an impact on the agreed terms of
the written custodial contract. Such
notifications may provide timely
information to help advisers, as
fiduciaries, to react and respond to
emerging risks of loss of client assets.
Under the sixth condition, FFI
qualified custodians would be required
by law to implement practices,
procedures, and internal controls
designed to ensure the exercise of due
care with respect to the safekeeping of
assets. Since FFIs are subject to a broad
range of regulatory regimes, we believe
this condition would help promote a
minimum level of practices, procedures,
and internal controls across qualified
custodians for safekeeping client assets
under the proposed rule, regardless of
where and how they are held. Further,
we believe this requirement will help to
ensure that an FFI’s practices,
procedures, and internal controls,
including, but not limited to, those with
respect to the safekeeping of certificated
and uncertificated assets, custodial
recordkeeping, and security and data
protection, should not differ in material
ways from those of U.S.-regulated
qualified custodians. Similar to the
fourth condition, advisers should be
able to assess and evaluate an FFI’s
internal controls while obtaining the
reasonable assurances we are proposing
advisers obtain from all qualified
custodians.107
Finally, we have included an antievasion requirement in the seventh
condition for FFI qualified custodians
that is similar to the anti-evasion
provision currently in the definition of
‘‘bank’’ under section 202(a)(2) of the
Advisers Act and in the definition of
‘‘U.S. Bank’’ under rule 17f–5 of the
Investment Company Act.108 Given the
broad scope of foreign financial entities
that we would permit to serve as
qualified custodians, we believe it is
appropriate to apply the anti-evasion
requirement to all types of FFIs, rather
than limiting its application to only
banking institutions or trust companies.
We request comment on all aspects of
the proposed rule’s qualified custodian
requirement, including the following
items.
107 See infra section II.B.3.a.i (discussing the
adviser’s requirement to obtain reasonable
assurances from a qualified custodian regarding the
qualified custodian’s required exercise of due care
and implementation of appropriate measures to
safeguard client assets from theft, misuse,
misappropriation, or other similar type of loss).
108 17 CFR 270.17f–5(a)(7)(iii).
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18. Should we continue to require
that client assets be maintained with
qualified custodians? If not, what
alternative protections for client assets
should we require as part of the rule?
19. Should the rule continue to
include banks as defined in section
202(a)(2) of the Advisers Act or savings
associations as defined in section 3(b)(1)
of the Federal Deposit Insurance Act as
qualified custodians, as proposed?
Should the rule narrow the definition to
include only certain banks and savings
associations as qualified custodians? If
so, how? For example, should the rule
permit only banks or savings
associations that are subject to Federal
regulation and supervision to act as
qualified custodians? Alternatively,
should the rule permit only state banks
and savings association that are
members of the Federal Reserve System
to act as qualified custodians? 109 Would
narrowing of the types of banks and
savings associations that meet the
definition of qualified custodian
provide additional protections to
advisory clients in the event of the
custodian’s insolvency? Is there another
way to achieve our policy goal?
20. Should we require banks and
savings associations to hold client assets
in an account designed to protect such
assets from creditors of the bank or
savings association in the event of the
insolvency or failure of the bank or
savings association as proposed? Is our
understanding correct that requiring
banks and savings associations to hold
client assets in an account of this type
would provide client assets with
enhanced protection from general
creditors in the event of the qualified
custodian’s insolvency and increase the
likelihood of return of client assets to
advisory clients upon a qualified
custodian’s insolvency? Do commenters
agree with our view that this enhanced
protection is especially important in
light of the broad range of regulatory
regimes and insolvency processes to
which a growing number of statechartered trust companies and other
state-chartered, limited purpose banking
entities entering the custodial market
may be subject?
21. Should the rule require the
account terms to identify clearly that the
account is distinguishable from a
general deposit account? Should the
rule require the terms of the account
clarify the nature of the relationship
between the account holder and the
qualified custodian, for example,
whether the account is a special
109 See generally Membership of State Banking
Institutions in the Federal Reserve System
(Regulation H) 12 CFR 208.01 et. seq.
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account,110 a fiduciary account,111 or
whether the bank or savings association
is acting as a trustee, a bailee, or agent
of the account holder?
22. Would requiring banks and
savings associations to hold client assets
in an account designed to protect such
assets from creditors of the bank or
savings association in the event of the
insolvency or failure of the bank or
savings association reduce the
availability of banks or savings
associations that could offer services as
a qualified custodian? Would it increase
costs to advisory clients?
23. Rather than requiring accounts of
this type for all banks and savings
associations, should the rule require
accounts that protect client assets from
creditors of a bank or savings
association in the event of the
insolvency or failure of the bank or
savings association for a subset of these
institutions that are not federally
insured or OCC member banks? For
example, should the rule require
accounts of this type for state banks that
are not members of the Federal Reserve
System?
24. Are there alternative bank and
savings association account safeguards
we should require?
25. Should the rule continue to
include broker-dealers registered under
section 15(b)(1) of the Securities
Exchange Act of 1934 (‘‘Exchange Act’’)
as qualified custodians, as proposed?
Are there additional requirements we
should require when a broker-dealer is
acting as a qualified custodian under the
rule? For example, should we explicitly
clarify that this would include only
registered broker-dealers that carry
customer accounts, or is that already
understood from the current rule?
26. Should the rule continue to
include FCMs as qualified custodians,
as proposed? Should we remove the
condition in the current rule that
prohibits maintaining client securities
with an FCM unless the securities are
‘‘incidental’’ to client futures
transactions? In 2013, the CFTC
enhanced protections afforded to
customers and customer assets held by
FCMs including protections covering,
110 See, e.g., Bank of America, N.A. v. Lehman
Bros. Holdings, Inc. (In re Lehman Bros. Holdings,
Inc.), 439 B.R. 811, 824–825 (Bankr. S.D.N.Y. Nov.
16, 2010) (‘‘Other factors that courts have examined
to ascertain the parties’ mutual intent [to create a
special rather than general account] include: (1)
whether the parties agreed to segregate the funds;
(2) whether the bank paid interest on the funds; (3)
whether the depositor lacked an unfettered right to
withdraw the funds; and (4) whether a third party
possessed an interest in the funds.’’).
111 See, e.g., 12 CFR 9.13 and 12 CFR 150.230
(addressing custody of fiduciary assets for banks
and savings associations, respectively).
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among other things, risk management,
recordkeeping and disclosure, and the
treatment of customer-segregated funds
secured in foreign futures and options
accounts.112 Are the 2013 CFTC
regulatory enhancements sufficient
grounds to eliminate that condition of
the current rule?
27. Should the rule limit the FFIs that
can act as qualified custodians under
this rule, as proposed? Are the proposed
conditions on an FFI sufficiently clear,
and if not, how should they be made
clearer? Should we eliminate any
condition, add any condition, or require
only certain conditions and not others
when an FFI is acting as a qualified
custodian under the rule? For example,
as part of the rule, should we require an
adviser to find that the FFI provides a
level of safety for client assets
equivalent to that which would be
provided by a qualified custodian in the
United States or to fully disclose to
clients any material risks attendant to
maintaining the assets with the foreign
custodian? Should this requirement
apply only when the adviser is involved
in selecting (or assisting a client in
selecting) a qualified custodian? Are
there types of FFIs that currently serve
as qualified custodians that would no
longer be eligible to serve as qualified
custodians under the proposed rule?
Would the proposed changes to the
definition of FFI enhance or inhibit
investor protections? Would the
proposed changes to the definition of
FFI cause any investments that an
investment adviser currently is able to
select on behalf of its clients to become
unavailable for selection by the adviser
due to the lack of the existence of an FFI
that satisfies the conditions of the
proposed rule? Should we only permit
institutions regulated by a specific
foreign financial regulatory authority? If
so, which foreign financial authority
and why? Should we require the adviser
to obtain documentation that identifies
the FFI’s specific financial regulatory
112 The CFTC in 2013 enhanced FCM
requirements surrounding the holding and
investment of customer funds, including the ability
of FCMs to withdraw funds from futures customer
segregated accounts. Under the enhanced
protections, FCMs are required to deposit
proprietary funds (i.e. residual interest) into futures,
cleared swap, and foreign futures customer
accounts for purposes of creating a buffer to ensure
compliance with segregation requirements. In
addition, FCMs are required to file electronically
their segregation calculations with the CFTC and
their self-regulatory organization each business day.
Further, FCMs are required to establish risk
management programs designed to monitor and
manage risks associated with customer funds. See
Enhancing Protections Afforded Customers and
Customer Funds Held by Future Commission
Merchants and Derivatives Clearing Organizations,
(‘‘CFTC Enhanced Protections Release’’) [78 FR
68506 (Nov. 14, 2013)].
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authority or authorities? Should the rule
permit only certain types of FFIs to
qualify as qualified custodians and if so,
which ones? Are there any types of
regulated foreign entities that should
not hold certain types of client assets
outside the United States? Should the
proposed rule account for the country or
jurisdiction where an FFI is primarily
operating, rather than the country or
jurisdiction of incorporation or
organization, as proposed? If so, how
would the adviser determine where the
FFI is primarily operating?
28. Should the proposed rule limit the
types of FFIs that can be qualified
custodians? If so, which institutions
should be included? Only banking
institutions or trust companies? Should
we also specifically include foreign
securities depositories and clearing
agencies or broker-dealer and FCM
equivalents?
29. Is the proposed definition to
include regulated FFIs that customarily
hold financial assets for customers too
broad; would it allow unsound
institutions to act as qualified
custodians under the proposed rule?
30. What, if any, impacts would our
proposed conditions have on the
availability of FFIs that can serve as
qualified custodians? What would be
the positive and negative effects of
requiring FFIs to provide custodial
protections similar to the protections
provided by U.S. qualified custodians?
31. Should the proposed rule require
an FFI to be subject to or consent to U.S.
jurisdiction for judgment enforceability,
as proposed? Alternatively, should
judgment enforceability be a factor
relevant to the adviser’s consideration of
whether client assets will be subject to
the requisite due care standard by an
FFI, similar to the approach in rule 17f–
5(c)(1) under the Investment Company
Act? 113 Should we require the adviser
to obtain the FFI’s consent to service of
process in the United States to verify
that it meets this condition? Should
such consent to service of process be
effected by the FFI’s submission of a
specified form to the Commission,
similar in effect to Form ADV–NR for
the appointment of an agent for service
of process by a non-resident general
partner or a non-resident managing
agent of any investment adviser?
32. Should an FFI be required to
comply with laws and regulations
similar to the BSA to act as a qualified
custodian, as proposed? Do the AML
requirements for FFIs help ensure that
a qualified custodian would more
readily identify and investigate aberrant
behavior in a client’s account?
113 See
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Alternatively, should we specify the
types of AML programs that must be in
place for FFIs?
33. Should we treat an FFI as being
required to comply with laws and
regulations similar to the BSA if the FFI
is required to comply with the laws and
regulations established by a member or
observer jurisdiction of the FATF and
not otherwise listed on any sanctions
list administered by the OFAC or on any
special measures list under section 311
of the USA PATRIOT Act administered
by FinCEN? Alternatively (or in
addition), should we automatically
consider an FFI to not be required to
comply with similar laws and
regulations if it is required to comply
with the laws and regulations of a
country identified by the FATF as a
high-risk or other monitored
jurisdiction? 114
34. Should we require that an FFI
hold financial assets in accounts
designed to protect such assets from
creditors of the FFI in the event of the
FFI’s insolvency or failure, as proposed?
Alternatively, should we require
advisers to obtain reasonable assurances
from an FFI qualified custodian that the
FFI is holding client assets in such
accounts? Should we require an FFI to
have account protections that are
generally similar to those of a U.S. bank
or savings association in the event of its
insolvency or failure? If so, should we
provide guidance around how an
adviser would make such
determinations of general similarity and
to maintain records of these
determinations?
35. Should we provide additional
guidance around how an adviser would
determine that an FFI’s practices,
procedures, and internal controls are
designed to ensure the exercise of due
care with respect to safekeeping of
client assets? Should we require an
FFI’s practices, procedures, and internal
controls to be generally similar to those
of a U.S.-regulated bank or savings
association? If an FFI is not a bank or
savings association, but rather a foreignequivalent to a U.S. broker-dealer or
U.S. FCM, should we require the adviser
to determine that such FFI’s practices,
procedures, and internal controls are
generally similar to those required by
U.S. broker-dealers or FCMs? If so,
should we provide guidance around
how advisers would make such
determinations of general similarity and
114 The FATF identifies jurisdictions with weak
measures to combat money laundering and terrorist
financing in two FATF public documents that are
issued three times a year. See https://www.fatfgafi.org/en/topics/high-risk-and-other-monitoredjurisdictions.html.
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to maintain records of these
determinations?
36. Should we provide additional
guidance around how an adviser would
determine the requisite financial
strength of an FFI qualified custodian?
Should we require advisers to maintain
records of these determinations? Should
we require advisers to have policies and
procedures to determine and monitor
the financial strength of all qualified
custodians, not just FFI custodians?
Should this requirement apply only
when the adviser is involved in
selecting (or assisting a client in
selecting) a qualified custodian?
37. To what extent do advisers or
qualified custodians utilize subcustodians, such as foreign subsidiaries
of a domestic qualified custodian? What
types of sub-custodians are utilized? Do
these sub-custodians have direct
relationships with the adviser or client
or do they only interact directly with
the qualified custodian? How are subcustodians overseen? Is this oversight
performed by the adviser or the
qualified custodian? If it is by the
qualified custodian, how do advisers
ensure that the client assets are
safeguarded properly?
38. Should the rule permit securities
depositories, administrators, or other
intermediaries to be qualified
custodians? Do they offer similar
services to the other types of financial
institutions that meet this definition, for
example, by safeguarding and providing
account statements to advisory clients?
Would they be able to agree to the
contractual terms contained in the
proposed written agreement
requirement? Would advisers be able to
satisfy the reasonable assurances
requirement under the proposed rule if
one of these types of entities were
holding client assets? Do these types of
entities maintain ‘‘possession or
control’’ of client assets, as discussed
below? Do they have similar capital
adequacy requirements under their
respective regulatory regimes to the
other types of financial institutions that
are included in the definition of
qualified custodian? Are there certain
categories of these entities that would
more easily function as qualified
custodians than others?
39. The rule currently excepts
advisers from complying with the
requirement to maintain mutual fund
shares with a qualified custodian,
provided they are maintained with a
transfer agent.115 Should transfer agents
be included in the definition of
qualified custodian in the final rule? Do
they offer similar services to the other
115 Rule
206(4)–2(b)(1).
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types of financial institutions that meet
this definition, for example, by
providing account statements to
advisory clients? Would they be able to
agree to the contractual terms contained
in the proposed written agreement
requirement? Would advisers be able to
satisfy the reasonable assurances
requirement under the proposed rule if
a transfer agent were holding client
assets?
40. Should insurance companies be
included in the definition of qualified
custodian under certain circumstances,
such as in the variable annuity
context? 116 Do they offer services
similar to the other types of financial
institutions that meet this definition, for
example, by safeguarding and providing
account statements to advisory clients?
Would they be able to agree to the
contractual terms contained in the
proposed written agreement
requirement? Would advisers be able to
satisfy the reasonable assurances
requirement under the proposed rule if
an insurance company were holding
client assets? Do insurance companies
maintain ‘‘possession or control’’ of
client assets, as discussed below? Do
insurance companies have similar
capital adequacy requirements to the
other types of financial institutions that
are included in the definition of
qualified custodian? Are there certain
categories or types of insurance
companies that would more easily
function as qualified custodians than
others?
2. Possession or Control
In a change from the current rule, the
proposed rule would require that an
investment adviser maintain client
assets with a qualified custodian that
has possession or control of those assets.
For the purposes of proposed rule,
‘‘possession or control’’ would be
defined to mean holding assets such
that the qualified custodian is required
to participate in any change in
beneficial ownership of those assets, the
qualified custodian’s participation
would effectuate the transaction
involved in the change in beneficial
ownership, and the qualified
custodian’s involvement is a condition
precedent to the change in beneficial
ownership.117 We understand that a
116 Our
staff indicated it would not recommend
enforcement action when an insurance company
served a particular role with respect to variable
annuity contracts similar to the role of a transfer
agent with respect to mutual fund shares. See
American Skandia Life Assurance Corporation, May
16, 2005.
117 See proposed rule 223–1(a)(1)(i) and (d)(2)(8).
Exchange Act Rule 15c3–3(c) prescribes when
securities shall be deemed to be under the control
of a broker-dealer. See 17 CFR 240.15c3–3(c).
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qualified custodian’s participation in a
change in beneficial ownership may
take different forms depending on the
type of asset involved.118 Similarly, we
view participation by a qualified
custodian to require the qualified
custodian to participate in a way that it
is willing to attest to the transaction on
an account statement and for which it
customarily takes custodial liability. By
contrast, we would not view
‘‘accommodation reporting,’’ as
described above, to constitute
‘‘participation.’’ The proposed
requirement and related definition are
designed to achieve several objectives.
First, a critical custodial function is to
prevent loss or unauthorized transfers of
ownership of the client’s assets. It is our
understanding that a custodian will
only provide this safeguarding function,
however, and assume custodial liability
for a custodial customer’s loss, if the
custodian had possession or control of
the asset that is lost. Second, because
the qualified custodian would be
required to participate in any change in
beneficial ownership of a client asset,
the proposed possession or control
definition would provide assurance that
a regulated party who is hired for
safekeeping services by the client to act
for the client is involved in any change
in beneficial ownership of the client’s
asset. Finally, we believe it would help
ensure the integrity of account
statements provided by qualified
custodians because the custodian would
report only on the holdings in its
possession or control (unless the client
requests that the qualified custodian
report on holdings that are not in its
possession or control). As a result, a
client could take comfort that what is
reported on its account statement is an
accurate attestation of holdings and
transactions by that custodian.
The proposed definition of
‘‘possession or control’’ in proposed
rule 223–1 is designed to be consistent
with the laws, rules, or regulations
administered by the qualified
custodian’s functional or primary
financial regulator for purposes of its
custodial activities. Under the existing
regulatory regimes under which
qualified custodians currently operate, a
qualified custodian must generally
118 For example, for certain privately offered
securities, we understand banks will put the
securities in their name as nominee. We also
understand that a change in beneficial ownership
may occur at different points in the transaction
lifecycle based on the type of asset involved. For
example, when purchasing an equity security, the
change in beneficial ownership occurs on trade date
(see, e.g., rule 240.13d–3—Determination of
beneficial owner), but we understand that when
purchasing real property, the change in beneficial
ownership typically occurs on the settlement date.
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maintain assets in its physical
possession or control. We believe our
proposed definition of possession or
control (i.e., being required to
participate in any change of beneficial
ownership) is consistent with how the
concept of possession or control is
understood currently by most qualified
custodians and does not conflict with
the requirements of qualified
custodians’ respective regulatory
regimes. The proposed rule would
formalize that understanding.
For example, under the Exchange Act,
broker-dealers are required promptly to
obtain and maintain in their physical
possession or control all of their
customers’ fully paid and excess margin
securities.119 As a result, a broker-dealer
would necessarily be involved in the
transfer of beneficial ownership of those
securities. In addition, national banks
that offer safeguarding of customer
assets are responsible for maintaining
adequate custody or control of their
customer assets.120 Again, as a result,
119 See
17 CFR 240.15c3–3(b) and (c).
banks that fail to exercise proper
control over customer securities may be subject to
enforcement proceedings by the Comptroller of the
Currency. See 12 U.S.C. 92a(k) (proceeding to
revoke trust powers on account of unlawful or
unsound exercise of powers). See also OCC,
Comptroller’s Handbook on Asset Management
Operations and Control (Jan. 2011), available at
https://www.occ.gov/publications-and-resources/
publications/comptrollers-handbook/files/assetmgmt-ops-controls/index-asset-mgmt-opscontrols.html; OCC regulation 12 CFR 9.13
(requiring, in connection with the custody of
fiduciary assets, among other things, that ‘‘assets of
fiduciary accounts [be placed] in the joint custody
or control’’ of certain fiduciary officers or specially
designated persons). The OCC has issued guidance
relating specifically to custody of crypto assets by
banks and Federal savings associations. See
Interpretive Letter 1170, Authority of a National
Bank to Provide Cryptocurrency Custody Services
for Customers (July 22, 2020), available at https://
www.occ.gov/topics/charters-and-licensing/
interpretations-and-actions/2020/int1170.pdf (‘‘As
with all other activities performed by national
banks and FSAs, a national bank or FSA that
provides cryptocurrency custody services must
conduct these activities in a safe and sound
manner, including having adequate systems in
place to identify, measure, monitor, and control the
risks of its custody services. Such systems should
include policies, procedures, internal controls, and
management information systems governing
custody services. Effective internal controls include
safeguarding assets under custody, producing
reliable financial reports, and complying with laws
and regulations. The OCC has previously described
that custody activities should include dual controls,
segregation of duties and accounting controls. A
custodian’s accounting records and internal
controls should ensure that assets of each custody
account are kept separate from the assets of the
custodian and maintained under joint control to
ensure that that an asset is not lost, destroyed or
misappropriated by internal or external parties.
Other considerations include settlement of
transactions, physical access controls, and security
servicing. Such controls may need to be tailored in
the context of digital custody. Specialized audit
procedures may be necessary to ensure the bank’s
controls are effective for digital custody activities.
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120 National
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national banks would have to relinquish
their custody or control of an asset to
transfer ownership. Similarly, the
protections under section 4d(a)(2) of the
Commodity Exchange Act and
regulations promulgated thereunder,
including, among others, CFTC
regulation 1.20 (Futures customer funds
to be segregated and separately
accounted for), CFTC regulation 1.22
(Use of futures customer funds
restricted), and CFTC regulation 1.25
(Investment of customer funds),121 are
predicated on the acceptance of, and
receipt by, a futures commission
merchant of futures customers money,
securities, or property.122 It is our
understanding that together, these, and
other regulations applicable to FCMs,
holistically serve the same purpose. In
each of the foregoing cases, the
respective custodian is required by its
functional regulator to possess or
control customer assets. While
functional regulators have not defined
possession or control in the custody
context in a manner identical to our
proposed rule (i.e., holding assets such
that the qualified custodian is required
to participate in any change in
beneficial ownership of those assets),
we view the proposed definition to be
crucial to safeguarding client assets and
reflective of the fundamental underlying
principle of the custody industry—a
custodian holds client assets for
safekeeping until directed by the client
or the client’s duly authorized agent to
enter into a transaction with a
For example, procedures for verifying that a bank
maintains access controls for a cryptographic key
will differ from the procedures used for physical
assets. Banks seeking to engage in these activities
should also conduct legal analysis to ensure the
activities are conducted consistent with all
applicable laws.’’).
121 See also section 4d(a)(2) of the Commodity
Exchange Act and CFTC Regulations 1.20–1.30
(Customers’ Money, Securities, and Property); and
see CFTC Regulation 1.32 (Reporting of segregated
account computation and details regarding the
holding of futures customer funds; CFTC Regulation
1.36 (Record of securities and property received
from customers). These regulations address, among
other things, segregation of customer funds,
limitations on institutions in which the FCM may
deposit customer funds, limitations on holding
customer funds outside of the United States,
limitations on the use of customer funds, and
recordkeeping requirements relating to customer
funds.
122 CFTC Regulation 1.3 defines a futures
commission merchant to be ‘‘[a]ny individual,
association, partnership, corporation, or trust
[ . . . ] Who, in connection with any of the[ ]
activities [identified in the regulation] accepts any
money, securities, or property [ . . . .] That
regulation also defines futures customer funds to
mean ‘‘all money, securities, and property received
by a futures commission merchant or by a
derivatives clearing organization from, for, or on
behalf of, futures customers [for the purposes
identified in the regulation]. 17 CFR 1.3 (emphasis
added).
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counterparty resulting in a change of the
client’s beneficial ownership.123
For purposes of an FFI, we believe
that the proposed requirement would
promote the institution’s accountability
for client assets and would thereby help
to promote more comparable investor
protections to those assets held with
U.S. financial institutions.124 Since FFIs
are subject to a broad range of regulatory
regimes, we believe that this
requirement, together with the account
statement contract requirement
discussed below, would formalize and
make more uniform the assets reported
on account statements produced by an
FFI, thereby better informing clients
regarding their holdings and
transactions.
a. Application With Respect to Crypto
Assets
As discussed above, we believe that
under their existing regulatory regimes,
qualified custodians are generally
considered to have ‘‘possession or
control’’ of assets that are in their
exclusive or physical possession or
control. We understand, however, that
proving exclusive control of a crypto
asset may be more challenging than for
assets such as stocks and bonds. For
example, while we understand that it is
possible for a custodian to implement
processes that seek to create exclusive
possession or control of crypto assets
(e.g., private key creation, maintenance,
etc.), it may be difficult actually to
demonstrate exclusive possession or
control of crypto assets due to their
specific characteristics (e.g., being
transferable by anyone in possession of
a private key). Moreover, we are
mindful of crypto asset custody models
in which an advisory client and a
qualified custodian might
simultaneously hold copies of the
advisory client’s private key material to
access the associated wallet with the
client’s crypto assets, and thus both
have authority to change beneficial
ownership of those assets.125
123 Alternatively, a custodian may return the asset
to the customer.
124 See, e.g., the Undertaking for Collective
Investment in Transferable Securities Regulations
2016 (UCITS V) (enhancing the rules on the
responsibilities of UCITS custodians including
making the UCITS custodian liable for the
avoidable loss of a financial instrument held in its
custody).
125 Letter from Anchorage Digital Bank NA re
Custody Rule and Digital Assets (Apr. 13, 2021)
(‘‘Proof of exclusive control can be securely
achieved through a combination of software,
hardware, and operational processes. However,
custody models that rely on private key redundancy
(maintaining multiple physical or electronic copies)
and physical security as a proxy for digital asset
security can’t ever truly prove this.’’).
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As discussed above, the proposed
rule’s definition of possession or control
turns on whether the qualified
custodian is required to participate in a
change in beneficial ownership of a
particular asset. While demonstrating
that a qualified custodian has exclusive
possession or control of an asset would
be one way to demonstrate that the
qualified custodian is required to
participate a change of beneficial
ownership, it is not the only way. For
example, under the proposed rule, a
qualified custodian would have
possession or control of a crypto asset
if it generates and maintains private
keys for the wallets holding advisory
client crypto assets in a manner such
that an adviser is unable to change
beneficial ownership of the crypto asset
without the custodian’s involvement.126
Importantly, however, to comply with
the proposed rule, an adviser with
custody of client crypto assets would
generally need to ensure those assets are
maintained with a qualified custodian
that has possession or control of the
assets at all times in which the adviser
has custody.127 While this is true for
most client assets over which an adviser
has custody, it is particularly relevant
with respect to crypto assets because, as
we understand, much of the crypto asset
trading volume occurs on crypto asset
trading platforms that often directly
settle the trades placed on their
platforms. As a result, many crypto
trading platforms require investors to
pre-fund trades, a process in which
investors transfer their crypto assets,
including crypto asset securities, or fiat
currency to such an exchange prior to
the execution of any trade. Because we
understand that most crypto assets,
including crypto asset securities, trade
on platforms that are not qualified
custodians, this practice would
126 We note that, in the context of crypto asset
securities, the Commission has stated that, ‘‘a
broker-dealer that maintains custody of a fully paid
or excess margin digital asset security for a
customer must hold it in a manner that complies
with Rule 15c3–3, including that the digital asset
security must be in the exclusive possession or
control of the broker-dealer. A digital asset security
that is not in the exclusive possession or control of
the broker-dealer because, for example, an
unauthorized person knows or has access to the
associated private key (and therefore has the ability
to transfer it without the authorization of the
broker-dealer) would not be held in a manner that
complies with the possession or control
requirement of Rule 15c3–3 . . . .]’’ Commission
Statement, supra footnote 25 at 11629 (emphasis
added).
127 This is not only true for crypto assets, but any
client asset for which an adviser has custody,
subject to the exceptions in the proposed rule. See
proposed rule 223–1(b)(1) (Shares of Mutual
Funds), (2) (Certain Assets Unable to be Maintained
with a Qualified Custodian), and (5) (Registered
Investment Companies).
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generally result in an adviser with
custody of a crypto asset security being
in violation of the current custody rule
because custody of the crypto asset
security would not be maintained by a
qualified custodian from the time the
crypto asset security was moved to the
trading platform through the settlement
of the trade.128 In light of our proposal
to expand the rule’s application from
‘‘funds or securities’’ 129 to ‘‘assets,’’ 130
this practice would also constitute a
violation of the proposed rule for an
adviser with custody of client crypto
assets if the adviser trades those assets
on a crypto asset trading platform that
does not satisfy the definition of
‘‘qualified custodian.’’ Alternative
Trading Systems that do not require prefunding of trades and that trade crypto
asset securities following a process that
does not involve the broker-dealer
operator of the Alternative Trading
System providing custodial services for
the crypto asset securities are discussed
further below.131
We request comment on all aspects of
the proposed possession or control
requirement, including the following
items.
41. Should the rule include the
possession or control requirement, as
proposed? Would the proposed
requirement provide additional
protections for clients? Possession or
control would be defined to mean
holding assets such that the qualified
custodian is required to participate in
any change in beneficial ownership of
those assets. Do commenters agree with
our view that the term ‘‘participation’’
would mean that the qualified custodian
would effectuate the transaction and its
involvement would be a condition
precedent to the change in beneficial
ownership? How else would
commenters describe a qualified
custodian’s participation? Should we
instead define possession or control to
mean holding assets such that the
qualified custodian is required to
effectuate any change in beneficial
ownership of those assets? Do
128 This differs from the approach with a U.S.
national securities exchange, which does not
routinely exercise possession or control of the
securities listed on a national securities exchange.
In this scenario, trades are executed on a national
securities exchange, establishing the contract
between buyer and seller. The national securities
exchange then passes transaction details on to a
clearing agency or depository, which steps in to
facilitate and complete settlement between each
party’s custodian, specifically the exchange of cash
and securities per the trade’s contracted terms
agreed on the national securities exchange on a
delivery versus payment basis.
129 See rule 206(4)–2(a).
130 See proposed rule 223–1(a).
131 See infra footnotes 460–461 and
accompanying text.
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commenters agree with our
understanding that a qualified
custodian’s participation in a change in
beneficial ownership may take different
forms depending on the type of asset
involved? Do commenters agree with
our view that participation by a
qualified custodian would require the
qualified custodian be willing to attest
to the transaction on an account
statement? Do commenters agree with
our understanding that a qualified
custodian will customarily take
custodial liability for client assets for
which it participates in beneficial
changes of ownership?
42. Do the types of financial
institutions serving as qualified
custodians under the current rule
maintain client assets in a manner that
would satisfy the proposed definition of
‘‘possession or control’’? Do
commenters agree with our view that
the proposed definition of possession or
control (i.e., being required to
participate in any change of beneficial
ownership) is consistent with how the
concept of possession or control is
understood currently by most qualified
custodians and does not conflict with
the requirements of qualified
custodians’ respective regulatory
regimes?
43. Is our understanding correct that
qualified custodians hold client assets
for safekeeping until directed by the
client or the client’s duly authorized
agent to enter into a transaction with a
counterparty resulting in a change of the
client’s beneficial ownership or until
directed to return the assets to the
client, subject to duly authorized
custodial charges? Is our understanding
correct that this is crucial to
safeguarding client assets and reflective
of a fundamental underlying principle
of the custody industry?
44. Should we have different
possession or control requirements for
different qualified custodians? If so,
what should they be, and why?
45. Are we correct in our
understanding that a custodian will
assume custodial liability for a custodial
customer’s avoidable loss only if the
custodian has possession or control (i.e.,
is required to participate in any change
in beneficial ownership) of the asset that
is lost?
46. Unlike as proposed, should the
rule explicitly state that the qualified
custodian maintain ‘‘physical’’ or
‘‘exclusive’’ possession or control of the
client’s assets? Do commenters agree
with our understanding qualified
custodians may face greater challenges
in their ability to demonstrate
exclusivity with respect to crypto assets
as compared their ability to demonstrate
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exclusive possession or control with
respect to stocks and bonds? Do
custodians for crypto assets routinely
consider the crypto assets they service
to be in their exclusive possession or
control? If so, how would exclusivity be
demonstrated? Are there particular
safeguarding practices with respect to
crypto assets that are better suited to
demonstrating exclusivity than others?
What kind of evidence would be
necessary to demonstrate proof of
exclusive possession or control of
crypto assets? What type of procedures
would a crypto asset custodian need to
have to demonstrate exclusive
possession or control of crypto
assets? 132 Would requiring exclusive
possession or control improve
safeguarding of crypto assets? Given the
nature of crypto assets, is it possible to
demonstrate the exclusive possession or
control of a particular crypto asset? How
important do custodians view
‘‘exclusive’’ possession or control of a
client asset, including a crypto asset, to
be for liability reasons? How do existing
custodians of crypto assets address the
risk of liability for theft, fraud, or
misappropriation of crypto assets when
a client (and potentially others with
whom the client has shared the private
key material) retains the ability to effect
a change in beneficial ownership of the
asset without the involvement of the
custodian?
47. Would a custodian for crypto
assets be able to satisfy the proposed
possession or control requirement?
Would such a custodian be able to
participate in a change of beneficial
ownership for a client’s crypto asset?
What does it mean for a custodian to
‘‘participate’’ in a change of beneficial
ownership for a client’s crypto asset
transaction? Does this involve only the
deployment of the private key or keys
associated with the public address
where the client’s crypto assets are
recorded to transfer, as instructed, the
client’s crypto assets to another person
with a public key? Does this also
include recording or communicating a
change in beneficial ownership?
48. To what extent does a custodian
for crypto assets take custodial liability
for a beneficial change in ownership of
a client’s crypto assets?
132 See Commission Statement, supra footnote 25,
at 11629 (‘‘A digital asset security that is not in the
exclusive physical possession or control of the
broker-dealer because, for example, an
unauthorized person knows or has access to the
associated private key (and therefore has the ability
to transfer it without the authorization of the
broker-dealer) would not be held in a manner that
complies with the possession or control
requirement of Rule 15c3–3 and thus would be
vulnerable to the risks the rule seeks to mitigate.’’).
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49. Is our understanding of how many
crypto asset trading platforms require
investors to pre-fund trades correct?
How many of these trading platforms
require pre-funding trades? How many
rely on other custodial arrangements
and how do those crypto asset trading
platforms operate with such custodial
arrangements? How would the proposed
rule impact advisers who trade on such
trading platforms currently? What, if
any, impacts would the proposed rule
have on the availability of crypto asset
trading platforms that may be able to
serve as qualified custodians? Would
the proposed definition of ‘‘possession
or control’’ enhance or inhibit investor
protections with respect to client assets
traded on crypto asset trading
platforms?
50. Do custodians for crypto assets
permit the customer (and potentially
others with whom the customer has
shared a private key) to retain the ability
to effect a change in beneficial
ownership of the asset without the
involvement of the custodian? In these
cases, do commenters believe that
advisory clients would receive the
benefits of the protections of the
proposed rule if they contractually
required a qualified custodian to be
involved in any beneficial change of
ownership of the crypto asset? Would
crypto asset advisory clients and
custodians be willing to enter into
contractual agreements of that type?
Would requiring that a qualified
custodian have exclusive possession or
control over the crypto asset have an
impact on the crypto asset custody
industry? How big of an impact?
51. Are there asset types other than
crypto assets over which a qualified
custodian may not be able to obtain
‘‘exclusive’’ possession or control?
Please indicate which asset types and
explain why exclusivity may not be
possible.
52. Is our understanding correct that
beneficial ownership change may occur
at different points in the transaction
lifecycle based on asset type? Is there a
customary reference to when a change
in beneficial ownership occurs for each
asset type? For crypto assets, does the
change in beneficial ownership occur
when the transaction is recorded on the
blockchain or when the transaction is
settled off-chain on the internal ledger
system of a crypto asset trading
platform? Are there differences if the
transaction is recorded on a private or
permissioned ledger than on a public or
un-permissioned ledger? Are there
differences if the transaction is settled
on a centralized crypto asset trading
platform versus a so-called
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decentralized crypto asset trading
platform?
53. Many market participants refer
today to ‘‘atomic settlement’’ of crypto
asset trades.133 Is this is commonly
understood and used term? Does it
mean that both legs of the trade settle
simultaneously (similar to a delivery vs.
payment transaction), or that the trade
settles instantly, or both? Which aspect
of crypto asset settlement (simultaneous
settlement or instantaneous settlement)
is preferable from an investor protection
standpoint? Are there drawbacks to
either? Should the Commission require
particular protections related to crypto
asset trades or custody? What about
other crypto asset transactions?
54. Is it possible for an adviser to
execute any trade that settles instantly
and while maintaining the assets at a
qualified custodian throughout the
lifecycle of that trade? If so, how? Could
the adviser do so and still have the
ability to trade with counterparties other
than the qualified custodian? How
would that work?
3. Minimum Custodial Protections
The proposed rule would promote
minimum standard custodial
protections for advisory clients whose
advisers have custody of client assets. It
generally would require that the
investment adviser maintain client
assets with a qualified custodian
pursuant to a written agreement
between the qualified custodian and the
investment adviser (or between the
adviser and client if the adviser is also
the qualified custodian).134 It would
further require the adviser to obtain
reasonable assurances in writing from
the custodian regarding certain vital
protections for the safeguarding of client
assets. We understand that under
existing market practices, advisers are
rarely parties to the custodial
agreement, which is generally between
an advisory client and a qualified
custodian, resulting in an adviser
having limited visibility into the
custodial arrangements of its clients.
This presents several issues under the
current rule and can result in an adviser
being subject to the rule due to what has
become known as inadvertent custody,
which can occur, for example, when the
custodial agreement between a client
and custodian grants an adviser broader
access to client funds or securities than
contemplated by the adviser’s own
agreement with the client and the
133 See Michael Lee, Antoine Martin, and
Benjamin Mu¨ller, What Is Atomic Settlement? (Nov.
7, 2022), available at https://libertystreet
economics.newyorkfed.org/2022/11/what-is-atomicsettlement/.
134 Proposed rule 223–1(a)(1)(i).
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adviser did not intend to have such
access to client assets.135 We
understand that inadvertent custody
often arises because a custodial
agreement grants an adviser expansive
authority to transact in or transfer assets
held in its client custodial accounts
(e.g., the ability to initiate wire
transfers) that are often superfluous to
the advisory services being provided.
However, because advisers are rarely a
party to these agreements, their ability
to repudiate unwanted authority is
limited.
In addition, custodial market
practices have evolved and expanded
since the rule was last amended, as have
the types of assets qualified custodians
hold.136 Some bank qualified custodians
have developed custodial practices for
crypto assets. However, Federal banking
regulators have stated more broadly
regarding crypto asset-related activities
that ‘‘[b]ased on the agencies’ current
understanding and experience to date
[ . . . ] the agencies have significant
safety and soundness concerns with
business models that are concentrated
in crypto-asset-related activities or have
concentrated exposures to the cryptoasset sector.’’ 137 The regulatory
framework to which these institutions
are subject is evolving, in part, to
accommodate new entrants to the
market for custodial services, including
newly launched state-chartered trust
companies that focus on providing
crypto asset custody services.138 In light
135 See Inadvertent Custody: Advisory Contract
Versus Custodial Contract Authority, Division of
Investment Management Guidance Update No.
2017–01 (Feb. 2017) (in which our staff discussed
its views on the application of the current custody
rule to various types of custodial agreements
between a client and a custodian that grant an
adviser broader access to client funds or securities
than the adviser’s own agreement with the client
contemplates).
136 See, e.g., Fiduciary Capacity; Non-Fiduciary
Custody Activities, 84 FR 17967 (Apr. 29, 2019) (the
Office of the Comptroller of Currency estimating
that the size of non-fiduciary custody assets held at
national banks and Federal savings associations has
increased, since it last updated its fiduciary
regulation in 1996, to approximately $41.7 trillion
as of December 21, 2018); Olga Kharif, Fidelity Says
a Third of Big Institutions Own Crypto Assets BNN
Bloomberg (June 9, 2020), available at https://
www.bnnbloomberg.ca/fidelity-says-a-third-of-biginstitutions-own-crypto-assets-1.1447708 (reporting
that, according to a survey by Fidelity Investments,
36 percent of institutional investors in the U.S. and
Europe report holding crypto assets).
137 See Joint Statement on Crypto-Asset Risks to
Banking Organizations, supra footnote 27.
138 See, e.g., Application by Anchorage Trust
Company, Sioux Falls, South Dakota to Convert to
a National Trust Bank; Application for Residency
Waiver (Jan. 13, 2021), available at https://
www.occ.treas.gov/news-issuances/news-releases/
2021/nr-occ-2021-6a.pdf; Application by Protego
Trust Company, Seattle, Washington, to Convert to
a National Trust Bank; Application for Director
Residency Waiver (Feb. 4, 2021), available at
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of this evolution, we must be mindful of
the extent to which many of these new
entrants to the custodial marketplace
offer, and are regulated to provide, the
types of protections we believe a
qualified custodian should provide
under the rule.139
At the same time, we understand that
some existing qualified custodians have
modified their practices to remain
profitable amid these changes, such as
by contractually limiting their liability
to their customers in a variety of ways.
Others have turned to outsourcing less
profitable parts of their custodial
services.140 Our staff has observed that
the clients who are least likely to have
bargaining power are often afforded the
fewest protections. These changes in the
custodial industry have caused us to
reconsider the minimum protections we
believe an adviser who uses a qualified
custodian to maintain possession or
control of client assets should provide.
Consequently, the proposed rule
would require a written agreement
between a qualified custodian and the
investment adviser that incorporates
certain minimum investor protection
https://www.occ.treas.gov/news-issuances/newsreleases/2021/nr-occ-2021-19a.pdf; Application to
charter Paxos National Trust, New York, New York,
OCC Control Number: 2020–NE-Charter-318305,
OCC Charter Number: 25252 (Apr. 23, 2021),
available at https://www.occ.treas.gov/newsissuances/news-releases/2021/nr-occ-2021-49a.pdf;
New York Department of Financial Services,
Financial Services Superintendent Linda A.
Lacewell Announces Grant of DFS Trust Charter to
Bitgo to Engage in New York’s Growing Virtual
Currency Market (Mar. 4, 2021), available at https://
www.dfs.ny.gov/reports_and_publications/press_
releases/pr202103041. See also, New York
Department of Financial Services, Guidance on
Custodial Structures for Customer Protection in the
Event of Insolvency (Jan 23, 2023), https://
www.dfs.ny.gov/industry_guidance/industry_
letters/il20230123_guidance_custodial_structures
(issuing guidance focusing on customer protection
relating to segregation of and separate accounting
for customer virtual currency, custodian’s use of
customer virtual currency, sub-custody
arrangements, and customer disclosure).
139 See, e.g., Financial Stability Oversight
Council, Report on Digital Asset Financial Stability
Risks and Regulation (2022), available at https://
home.treasury.gov/system/files/261/FSOC-DigitalAssets-Report-2022.pdf (‘‘[S]ome platforms
emphasize that they are regulated through MSB
laws. These laws generally are intended to address
consumer protection related to money transmission
and to combat illicit finance. They are not intended
to address funding mismatches outside of money
transmission or risks posed by platforms custodying
crypto-assets internally within omnibus accounts,
particularly when commingled with platform
assets.’’).
140 See Deloitte (2019), The Evolution of a Core
Financial Service: Custodian & Depository Banks,
available at https://www2.deloitte.com/content/
dam/Deloitte/lu/Documents/financial-services/luthe-evolution-of-a-core-financial-service.pdf, at 42–
43 (noting the trend with custodians and
depositories outsourcing operational departments to
low cost labor regions in order to lower costs and
increase margins on core services that have
experienced the largest margin pressures).
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elements for advisory clients.
Additionally, for certain protections in
which the qualified custodian’s duty
runs primarily or exclusively to the
advisory client, it would require the
adviser to obtain reasonable assurances
of certain minimum investor protection
elements for advisory clients. We
believe that this approach would have
direct benefits for advisory clients and
investment advisers. We acknowledge
that an agreement between the
custodian and the adviser would be a
substantial departure from current
industry practice. We also understand
that certain of the protections that the
rule text would promote are not
universally provided to all custodial
customers today. Nonetheless, we
believe it is necessary to help protect
client assets from the harms the custody
rule is designed to address and would
help ensure that they receive certain
standard custodial protections under the
rule.
The proposed requirements do not
prescribe specific safeguarding
procedures or require that client assets
be maintained in a particular manner.
Rather, they are designed to serve as
guardrails that would apply irrespective
of the type of asset or the type of
financial institution acting as a qualified
custodian. The requirements are also
designed to remain evergreen as
methods for safekeeping continue to
evolve to reflect changes in technology,
investment products, and custodial
service best practices. For example,
technical requirements for transacting
and safeguarding crypto assets are likely
to be different from those for traditional
assets, such as stocks, bonds, and
options. Furthermore, the design of
blockchains and other distributed
ledgers that require irreversibility of
crypto asset transactions (without the
consent of all parties to reverse), and the
bearer nature of private keys make it
challenging to recover assets that have
been lost or stolen or to reverse benign
trading errors even if an owner of a
crypto asset wallet may be identified.
This is unlike the traditional securities
infrastructure, which has welldeveloped protocols allowing for the
reversal and cancellation of mistaken or
unauthorized transactions.
These additional risks and nuanced
challenges of safeguarding emerging
assets, such as crypto assets, have
caused us to consider alternatives to the
current rule’s more asset-neutral
approach. In 2020, our staff issued a
statement requesting input on, among
other things, the types of qualities an
adviser seeks when entrusting a client’s
assets to a particular custodian and
whether there are qualities that would
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be important for safeguarding crypto
assets that might not be important for
safeguarding other types of assets.141
Several commenters shared with the
staff their views, advocating for such
things as specifically tailoring the rule
based on how changes in ownership of
the asset are effectuated, including
setting particular standards for qualified
custodians of crypto assets.142 While we
agree that custodial activities may differ
between traditional assets and crypto
assets, we believe that the asset neutral
approach of the current rule has been
and will continue to be more effective
because it relies on the expertise of the
various types of qualified custodians
and allows the rule to remain evergreen
as the types of assets held by custodians
evolve.
Although crypto assets are a relatively
recent and emerging type of asset, this
is not the first time custodians have had
to adapt their practices to safeguard
different types of assets.143 The
proposed rule relies on the expertise of
custodians with a long history of
developing different procedures for
safeguarding a variety of assets. It is also
not the first time custodians have
grappled with a new method of
transacting in or holding assets.144
141 See Staff Statement on WY Division of
Banking’s ‘‘NAL on Custody of Digital Assets and
Qualified Custodian Status’’ (Nov. 9, 2020),
available at https://www.sec.gov/news/publicstatement/statement-im-finhub-wyoming-nalcustody-digital-assets (the Staff Statement used the
term ‘‘digital’’ assets rather than the term ‘‘crypto’’
assets as used in this release).
142 See, e.g., Letter from Coinbase re Custody Rule
and Digital Assets (May 25, 2021) (stating that
qualified custodians for digital assets should, at a
minimum have: institutional technical expertise;
personnel with technical expertise; minimum size;
authority to custody digital assets; robust staffing;
audited control environment; and annual certified
audits); Letter from Anchorage re Custody Rule and
Digital Assets (Apr. 13, 2021) (advocating for
standard requirements for a qualified custodian that
maintains digital assets including proof of exclusive
control, proof of existence of digital assets in
custody, hardware security, and blockchain
monitoring).
143 For example, bank custodians have
traditionally provided safekeeping to a variety of
physical objects, such as valuable papers, rare
coins, and jewelry. See, OCC, Comptroller’s
Handbook on Asset Management Operations and
Control (Jan. 2011), available at https://
www.occ.gov/publications-and-resources/
publications/comptrollers-handbook/files/assetmgmt-ops-controls/index-asset-mgmt-opscontrols.html, at 15. See also Thevenoz, Luc,
Intermediated Securities, Legal Risk, and the
International Harmonization of Commercial Law, 13
Stan. J.L. Bus. & Fin. 384, 386 (Spring 2008)
(‘‘Intermediated Securities’’) (‘‘Immobilization and
dematerialization of securities have made the
physical delivery of certificates nearly irrelevant. In
just a few decades, the issuance of securities has
shifted from the physical to a virtual world, to
which financial intermediaries hold the key.’’).
144 See, James Rogers, Policy Perspectives on
Revised UCC Article 8, 43 UCLA L. Rev. 1431
(1996) (discussing the role large broker-dealers or
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These custodians also have a long
history of innovating and modernizing
their practices as methods of transacting
in or holding client assets have evolved.
Rather, the proposed rule recognizes
that there are certain fundamental
protections that should be provided to
a custodial customer when the adviser
has custody:
• A qualified custodian should
exercise due care and implement
appropriate measures to safeguard the
advisory client’s assets;
• A qualified custodian should
indemnify an advisory client when its
negligence, recklessness, or willful
misconduct results in that client’s loss;
• A qualified custodian should not be
relieved of its responsibilities to an
advisory client as a result of subcustodial arrangements;
• A qualified custodian should
clearly identify an advisory client’s
assets and segregate an advisory client’s
assets from its proprietary assets;
• The client’s assets should remain
free of liens in favor of a qualified
custodian unless authorized in writing
by the client;
• A qualified custodian should keep
certain records relating to those assets;
• A qualified custodian should
cooperate with an independent public
accountant’s efforts to assess its
safeguarding efforts;
• Advisory clients should receive
periodic custodial account statements
directly from the qualified custodian;
• A qualified custodian’s internal
controls relating to its custodial
practices should be evaluated
periodically for effectiveness; and
• A custodial agreement should
reflect an investment adviser’s agreedupon level of authority to effect
transactions in the advisory client’s
account.
We believe that financial institutions
that act as qualified custodians under
the current rule already provide some of
the protections that would be required
under the proposed rule’s requirements,
either to satisfy regulatory requirements,
or pursuant to their existing contracts
with their clients. For example, we
understand that some qualified
custodians usually provide quarterly
account statements to their custodial
customers. We also understand that
banks acting as dealers or custodians played during
the evolution from a manual securities settlement
process focused on the processing of physical
securities certificates to highly automated electronic
settlement centered on processing and transfer of
electronic book-entry securities); Adam Back, Lien
on Me, Uniformity Is Coming to Crypto-Backed
Transactions, 41–12 Am. Bankr. Inst. J. 16 (Dec. 1,
2022) (discussing proposed UCC Article 12
governing property rights in a ‘‘controllable
electronic record’’).
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qualified custodians often obtain
periodic reports of their internal
controls. Further, we understand that
qualified custodians may currently
indemnify their custodial customers
against the risk of loss, but we
understand that the indemnification
standard—for example, ordinary
negligence or gross negligence—often
varies by institution and by customer.
To the extent an element is not typical
for a particular custodian, it may create
practical difficulties (e.g., higher costs of
compliance, or market contraction for
custodial services). On balance,
however, we believe the proposed rule
promotes key protections to which
every custodial customer should be
entitled when the adviser has custody.
Some of these protections are best
promoted via written agreement
between the adviser and custodian;
others are best promoted via the adviser
obtaining reasonable assurances in
writing from the qualified custodian
that the protections will be provided to
the advisory client. We view the
safekeeping protections that would be
required in the proposed written
agreement to be duties owed to both the
client and adviser, while we view the
safekeeping protections in the proposed
reasonable assurances requirements to
be duties owed primarily to the client
and, therefore, are proposing these
protections in a manner that we believe
appropriately reflects the respective
obligations. We are also proposing to
require that the adviser reasonably
believe that the contractual provisions
and reasonable assurances obtained by
the adviser have been implemented by
the qualified custodian.145 We
understand that many of the obligations
under the contractual provisions and
reasonable assurances obtained by the
adviser rest on the qualified custodian,
and that implementation for each
requirement may vary widely
depending on the facts and
circumstances of the parties in interest
and assets in interest. Nonetheless,
advisers should enter into a written
agreement with a qualified custodian
based upon a reasonable belief that the
qualified custodian is capable of, and
intends to, comply with the contractual
provisions. The adviser should have the
same reasonable belief regarding the
reasonable assurances obtained from the
qualified custodian. Further, during the
term of the written agreement and
related advisory relationship, advisers
should have a reasonable belief that the
qualified custodian is complying with
the contractual obligations of the
agreement and continuing to provide
145 See
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the protections to client assets for which
the adviser obtained reasonable
assurances from the qualified custodian.
For example, if the qualified custodian
fails to properly provide the adviser
with the required quarterly account
statement or the required annual
internal control report discussed below,
the adviser could not reasonably believe
that the qualified custodian is
complying with the contractual
obligations of the written agreement.
Finally, as under the custody rule, the
safeguarding rule would continue to
permit an adviser or its related person
to serve as a qualified custodian for
client assets. We continue to believe
that self-custody and related person
safeguarding arrangements provide
practical benefits for advisory clients;
however, we remain wary of the
potential risks of such arrangements that
do not have an independent party
involved in safeguarding client
assets.146 Accordingly, heightened
protections similar to those required
under the custody rule would continue
to be required in such an
arrangement.147 Moreover, the following
elements would all be required to be
part of a written agreement with the
client.148
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a. Reasonable Assurances
We believe that requiring an adviser
to obtain the reasonable assurances in
writing 149 that the custodian will
146 See 2009 Adopting Release, supra footnote 11,
at section II.C.1 (discussing the benefits and
associated risks of maintaining client investments
with advisers or their related persons and
suggesting that the use of an independent custodian
would be an impractical requirement for many
types of advisory accounts).
147 The proposed rule would require a qualified
custodian that is a related person to the adviser to
enter into a written agreement with the adviser.
148 A rulemaking petition submitted to the
Commission requested that we adopt a rule
prohibiting related person custody. We have
considered the petition and share certain of the
petition’s concerns regarding custody arrangements
not involving independent parties. However, we
believe that the protections proposed in the rule
appropriately limit those risks. Kaswell, Stuart J Re:
Petition for Rulemaking; Custody Rule 206(4)(2),
Oct. 30, 2020 [File No. 4–767, Nov. 9, 2020],
available at https://www.sec.gov/rules/petitions/
2020/petn4-767.pdf (‘‘[I]t is my view that the SEC
should take the next step and require the adviser
to use a custodian that is unaffiliated in any way
with the adviser.’’); and see Kaswell, Stuart J.
Supplement to Petition for Rulemaking; Custody
Rule 206(4)(2); File No. 4–767 (Apr. 19, 2021),
available at https://www.sec.gov/comments/4-767/
4767-8685524-235622.pdf (‘‘As indicated in my rule
petition, I respectfully suggest that the Commission
should amend the Custody Rule to require that each
investment adviser use a custodian that is
independent of that adviser.’’).
149 Exchange Act section 13(b)(7) defines
‘‘reasonable assurance’’ and ‘‘reasonable detail’’ as
‘‘such level of detail and degree of assurance as
would satisfy prudent officials in the conduct of
their own affairs.’’ 15 U.S.C. 78m(b)(7). See
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comply with the client protections
required in the proposed rule and
discussed below would improve
safekeeping of client assets. Similarly,
we believe that requiring the adviser to
maintain an ongoing reasonable belief
that the custodian is complying with
such client protection requirements will
improve safekeeping of client assets.150
It is our understanding that many
current custodial agreements address
these issues and, therefore, custodians
are already familiar with these concepts.
For example, we understand that many
custodial agreements address the
attachment of a lien on, or security
interest in, client assets, in some cases
for the protection of the qualified
custodian for nonpayment of fees by a
custodial client. Similarly, many
custodial agreements address
indemnification between the advisory
client and the custodian, but we
understand that the indemnification
standard—for example, ordinary
negligence or gross negligence—often
varies by institution and by customer.
The proposed reasonable assurances
requirements—and the requirement for
the adviser to maintain the ongoing
reasonable belief that the reasonable
assurances provided by the qualified
custodian are being implemented—in
the rule are important protections for
client assets that, together with the
client protections contained in the
written agreement, are designed to
expand and formalize the standard of
protections to advisory clients’ assets
held by qualified custodians in a
manner that would provide consistent
investor protections across all qualified
custodians under our proposed rule.
i. Due Care
The proposed rule would require that
the adviser obtain reasonable assurances
in writing from the qualified custodian
that the qualified custodian will
exercise due care in accordance with
reasonable commercial standards in
discharging its duty as custodian and
will implement appropriate measures to
safeguard client assets from theft,
misuse, misappropriation, or other
similar types of loss.151 The requirement
that the adviser obtain reasonable
assurances that a qualified custodian
will exercise due care in accordance
with reasonable commercial standards
is similar to the standard required of
certain custodians under Investment
Commission Guidance Regarding Management’s
Report on Internal Control Over Financial Reporting
Under section 13(a) or 15(d) of the Securities
Exchange Act of 1934 (Jun. 27, 2007) [72 FR 35323]
(discussing meaning of ‘‘reasonable assurance’’).
150 See proposed rule 223–1(a)(1)(ii).
151 Proposed rule 223–1(a)(1)(ii)(A).
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Company Act rules.152 The Commission
has had experience with the standard of
care under rule 17f–4 under the
Investment Company Act and believes
that advisory clients should receive
protections similar to those afforded
under that rule. In addition, we believe
that this investor protection element
would provide an important standard
for evaluating the qualified custodian’s
custodial practices.
We also believe that it is crucial for
a qualified custodian to implement
appropriate measures to safeguard assets
from theft, misuse, misappropriation, or
other similar types of loss based on the
asset type and manner in which
ownership is evidenced.153 We
recognize that the appropriateness of the
measures required to safeguard assets
varies depending on the asset.154 For
instance, the exercise of due care may
require that a bearer instrument, such as
a physical coupon bond, a physical
security certificate, or a commodity
such as gold, be kept in a vault.
Likewise, an investment that is
evidenced in electronic book-entry
form, such as an exchange-traded note,
could be maintained in line with robust
cybersecurity standards. And the
exercise of due care may require, in
many cases, that crypto assets be stored
in a cold wallet, but depending on the
facts and circumstances, such as when
a client seeks to buy and sell crypto
assets very frequently, due care may
mean the use of hot wallets in
combination with robust policies and
procedures.155 Other facts and
152 See, e.g., rule 17f–4 of the Investment
Company Act.
153 See, e.g., Customer Protection Rules 17 CFR
240.15c3–3 (requiring appropriate measures to
protect and preserve customer property held at
broker-dealers).
154 We also recognize that while the
understanding of appropriate safeguarding
measures is generally expected to be within the
expertise of the qualified custodian, advisers also
generally should seek to become sufficiently
familiar with safeguarding practices to identify
concerns or red flags in order to, among other
things, form an opinion as to whether the assurance
that they receive from the qualified custodian that
the qualified custodian is acting with due care is
reasonable. More broadly, identifying concerns and
red flags is an important factor in the adviser
forming a reasonable belief that the protections in
the proposed written agreement have been
implemented.
155 See, e.g., R. Travis Leppky and Guy Sadeh,
Matthew Bender and Co., Blockchain and Smart
Contract Law: U.S. and International Perspectives;
Ch. 7, Sec. 7 (Security and Custody: Security Issues
for Cryptographic Asset Wallets) (2022) (‘‘[T]he
difference between a hot and cold wallet is whether
or not they are connected to the internet. Generally
speaking, hot wallets are less secure because of
threats that come with being connected to the
internet and additional indirect threats if the
cryptocurrency wallets are held by an external
provider (i.e., hacks, phishing, external provider
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circumstances may require a hybrid of
the two.156 Further, because crypto
assets and distributed ledger technology
are still evolving, we expect the
methods used to safeguard crypto assets
will likewise evolve, which may lead to
reevaluation of best practices in the
future.
The proposed standard of care is not
uncommon in the custodial market and
we believe that financial institutions
acting as qualified custodians are
familiar with it.157 We believe, however,
that the standard of care is not universal
in the custodial market, and that this
requirement may result in some
qualified custodians changing the terms
of their custodial agreements with
advisory clients to incorporate this
standard. We believe that this provision
would promote this important
protection in a consistent manner across
all advisory client assets 158 and would
discourage the qualified custodian from
establishing contractual performance
standards that are less stringent.159
ii. Indemnification
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The proposed rule would require that
the adviser obtain reasonable assurances
in writing from the qualified custodian
that the qualified custodian will
indemnify the client (and will have
insurance arrangements in place that
stability issues, etc.). Hot wallets are generally
better for day-to-day transactions and trading, since
near instant access is provided. Cold wallets,
meanwhile, are stored offline, which provides
additional security. They are generally better for
holding crypto assets for the long term.’’); Deborah
A. Sabalot & Madeleine Yates, Cryptoassets and
custody: an elephant in the room?, 9 Journal of
International Banking and Financial Law 580 (Sept.
24, 2019) (‘‘Hot storage means devices connected
with the internet and generally means that the asset
can be transferred quickly but will also be at greater
risk of loss through hacking. Cold storage devices
are physically offline and disconnected from the
internet but are generally considered less accessible
although are arguably more secure in that they
cannot be attacked in the way that online systems
can. Other arrangements include hybrid systems
which allow the temporary storage of cryptoassets
in a hot facility before being moved to cold
storage.’’); see generally Cryptopedia Staff, Hot
Wallets vs. Cold Wallets, GEMINI (July 4, 2021),
available at https://www.gemini.com/cryptopedia/
crypto-wallets-hot-cold (‘‘A hot wallet is connected
to the internet and could be vulnerable to online
attacks—which could lead to stolen funds—but it’s
faster and makes it easier to trade or spend crypto.
A cold wallet is typically not connected to the
internet, so while it may be more secure, it’s less
convenient.’’).
156 See id.
157 The proposed contractual requirement is the
same as the standard that automatically applies to
custodians under Article 8 of the Uniform
Commercial Code. See UCC sections 8–504(c)(2)
and 8–509 (a) and (b).
158 The requirement of due care, of course, may
impose on a qualified custodian a number of
practices not expressly addressed in this release.
159 See, e.g., UCC section 8–504(c)(2) (allowing
alteration of the standard of care by agreement).
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will adequately protect the client)
against the risk of loss in the event of
the qualified custodian’s own
negligence, recklessness, or willful
misconduct.160 The goal of this
proposed requirement would be for the
client to be compensated in the event of
a loss for which the qualified custodian
is responsible.
Our staff has observed that custodians
often include indemnification clauses in
their custodial agreements with
customers. Generally, the provisions
indemnify custodial customers from
losses arising out of or in connection
with the custodian’s execution or
performance under the agreement to the
extent the loss is caused by, among
other things, the custodian’s negligence,
gross negligence, bad-faith, recklessness,
or willful misconduct. Our staff has
observed that the contractual limitations
on custodial liability vary widely in the
marketplace. Our staff has also observed
that the negotiating power of the
investor appears to play an outsized role
in the type of misconduct for which a
custodian will provide indemnity and
that retail investors appear to have
limited ability to negotiate these terms
effectively.
Custodial misconduct is one of the
primary risks that can undercut or
eliminate the protections of a custody
account.161 The proposed rule seeks to
create a minimum floor of custodial
protection for investors—including
those investors that have little or no
power to negotiate for those
protections—in the event of custodial
misconduct. We question the extent to
which investors, and particularly retail
investors, understand that they may
have limited recourse against the
financial institution that was hired to
safeguard their assets in the event they
suffer a loss because of that institution’s
misconduct.162 As such, we believe that
it is reasonable to require an adviser to
obtain reasonable assurances from a
qualified custodian that it will provide
the required indemnification for
advisory clients.
The current practice in the custodial
marketplace reflects a broad range of
contractual limitations on the qualified
custodian’s liability to its customers to
reduce exposure and may result in suboptimal safeguarding protections for
client assets. While we understand that
custodians, as a gesture of goodwill or
to avoid headline exposure, may cover
losses caused by their own misconduct
rule 223–1(a)(1)(ii)(B).
Article, supra footnote 24, at 106.
162 See, e.g., Klees Article, supra footnote 24, at
103 (‘‘clients bear several significant legal and
operational risks that could limit recovery of their
custodied assets’’).
even if the customer is ineligible for
indemnification under the custodial
agreement, such gestures are at the sole
discretion and ability of the custodian
and we believe that this does not
provide sufficient, consistent, reliable
investor protection.163 Custodians may
not always be willing to extend such
goodwill, such as in the event of an
extremely large loss caused by, for
example, custodial negligence under a
custodial contract providing for
indemnification of the custodial client
only in the event that the custodian’s
misconduct constitutes gross
negligence, during a general downturn
in the economy, or at a time that the
custodian is otherwise not sufficiently
capitalized to easily absorb the loss.
Requiring an adviser to obtain
reasonable assurances from the qualified
custodian that the qualified custodian
will indemnify the client (and will have
insurance arrangements in place that
will adequately protect the client)
against the risk of loss in the event of
the qualified custodian’s own
negligence, recklessness, or willful
misconduct, as proposed, will help
protect clients from custodial
misconduct and reduce the need to rely
on the goodwill of a custodian to make
a client whole in the event of the
custodian’s misconduct.
In our view, the proposed
indemnification requirement would
likely operate as a substantial expansion
in the protections provided by qualified
custodians to advisory clients, in
particular because it would result in
some custodians holding advisory client
assets subject to a simple negligence
standard rather than a gross negligence
standard. We believe that this
requirement is justified because of the
important investor protection benefits it
will provide.
iii. Sub-Custodian or Other Similar
Arrangements
The proposed rule would require that
the adviser obtain reasonable assurances
in writing from the qualified custodian
that the existence of any sub-custodial,
securities depository, or other similar
arrangements with regard to the client’s
assets will not excuse any of the
qualified custodian’s obligations to the
client.164 This requirement is designed
to help ensure that the qualified
custodian would remain responsible in
circumstances where a loss or other
failure to satisfy its obligations to the
client, whether contractual or otherwise,
160 Proposed
161 Klees
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163 We also do not know whether the willingness
of custodians to cover losses for which they may
not be contractually liable depends on whether the
advisory client is retail or institutional.
164 Proposed rule 223–1(a)(1)(ii)(C).
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can be attributed to a sub-custodian or
other third party selected by the
qualified custodian.
As discussed above, outsourcing has
become increasingly common in the
custodial space, whether outsourcing of
back-office functions or the core
function of holding a custodial client’s
assets.165 Additionally, we understand
that the delegation of safeguarding to
sub-custodians can result in opaque
structures, for example involving
several FFI sub-custodians in different
countries.166 Further, our staff has
observed that custodial agreements
addressing the use of sub-custodians
seek to limit contractually the
custodian’s liability for acts or
omissions of the sub-custodian in a
variety of ways, including expressly
limiting the contractual liability of the
custodian for acts of the sub-custodian,
as well as limiting the affirmative steps
the custodian may be required to take in
connection with any loss of client assets
as a result of the sub-custodian’s willful
default or insolvency. We view the
increase in use of sub-custodians to
similarly increase the risk to client
assets because, among other things, an
adviser and a client are not likely to
have a direct contractual relationship
with the sub-custodian and are not
likely to be able to have decisionmaking authority with respect to which
sub-custodian a qualified custodian
uses. The client and adviser, therefore,
are more likely to experience challenges
in recovering losses caused by the subcustodian in the event of a loss of client
165 See, e.g., Deloitte Outsourcing Article, supra
footnote 140; U.S. Bank, 5 questions you should ask
your custodian about outsourcing (May 19, 2022),
available at https://www.usbank.com/financialiq/
plan-your-growth/find-partners/outsourcingquestions-ask-custodian.html (‘‘It’s fairly common
for custody banks to outsource day-to-day securities
processing work to external vendors—both
domestically and overseas.’’); Avantage Reply,
Outsourcing in the Asset Servicing Industry:
Custodian and Depositary Banks, Evolving
regulatory requirements and industry practices in
the Eurozone and the UK (Nov. 2015), available at
https://www.reply.com/en/topics/risk-regulationand-reporting/Shared%20Documents/
Outsourcing%20Working%20Paper.pdf
(‘‘Custodian banks have traditionally outsourced
high-volume operational tasks. While these still
form the bulk of outsourcing, activities that
contribute to the running of banks themselves are
now also being routinely outsourced, including
significant chunks of Customer Services, Human
Resources, Risk and Finance.’’); Geis, George S.,
Traceable Shares and Corporate Law, 113 Nw. U.L.
Rev. 227 (2018), at 233–234 (discussing the largest
custodial banks performing recordkeeping and
information dissemination functions for smaller
custodian banks).
166 See Thomas Droll, Natalia Podlich, and,
Michael Wedow (2015) Out of Sight, Out of Mind?
On the Risk of Sub-Custodian Structures.
Bundesbank Discussion Paper No. 31/2015,
available at SSRN: https://papers.ssrn.com/sol3/
papers.cfm?abstract_id=2797055.
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assets. We similarly believe that this is
true for a securities depository or other
third-party arrangement implemented
by the custodian with respect to client
assets over which the advisory client
has no control.
We believe that requiring the
proposed reasonable assurances
requirement would help reduce the
ability of a qualified custodian to avoid
responsibility for the other important
safeguarding obligations it has to the
advisory client by delegating custodial
responsibility to a sub-custodian,
securities depository, or other similar
arrangements. We believe these
requirements are justified because a
qualified custodian should not be able
to disclaim liability for a third-party it
hires.
iv. Segregation of Client Assets
The proposed rule would require the
adviser to obtain reasonable assurances
in writing from the qualified custodian
that the qualified custodian will clearly
identify the client’s assets as such, hold
them in a custodial account, and
segregate them from the qualified
custodian’s proprietary assets and
liabilities.167 We are proposing this
requirement because we continue to
believe that segregation is a
fundamental element of safeguarding
client assets.168 We believe that some
financial institutions that serve as
qualified custodians, particularly FFIs,
are not required to segregate and
identify their client assets.169 In
addition, for those qualified custodians
that are required to segregate and
identify their client assets, the extent of
those activities varies.170 The proposed
167 Proposed
rule 223–1(a)(1)(ii)(D). In contrast to
the requirements we are proposing to include in the
written agreement, and as with the other reasonable
assurances requirements, we believe this
safekeeping obligation runs primarily to the client.
168 Segregation of client investments has been a
fundamental element of the custody rule since its
inception. See, e.g., 1962 Adopting Release, supra
footnote 2 (requiring advisers to segregate and
identify securities beneficially owned by each
client, and to hold them in a ‘‘reasonably safe’’
place). See also, Klees Article, supra footnote 24
(describing segregation as a pillar of custody that
has generally been recognized in the United States).
169 The custody rule requires a foreign financial
institution to segregate client assets in order to meet
the definition of qualified custodian. As discussed
above and below, we propose to replace and
strengthen the segregation requirement for FFIs in
the custody rule that would complement the
proposed segregation requirements of the
safeguarding rule.
170 See, e.g., 12 U.S.C. 92(c) and 12 U.S.C.
1464(n)(2) (requiring national banks and Federal
savings associations to segregate all assets held in
any fiduciary capacity from their general assets and
to keep a separate set of books and records showing
all transactions in these accounts); section 4d(a)(2)
of the Commodity Exchange Act (requiring FCMs to
segregate from their own assets all money,
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14695
requirement is designed to help ensure
that client assets are at all times readily
identifiable as client property and
remain available to the client even if the
qualified custodian becomes financially
insolvent or if the financial institution’s
creditors assert a lien against the
qualified custodian’s proprietary assets
(or liabilities).171 We believe this
proposed requirement would help
protect client assets from claims by a
third party looking to secure or satisfy
an obligation of the qualified custodian,
including in cases of insolvency or
bankruptcy.172 We believe that the
proposed requirement would help to
identify clearly client assets as
belonging to the appropriate client and,
in the context of an FFI, we believe
these actions would help to preserve the
client’s interests in the event of a
government taking.
We also understand that for
administrative convenience and other
reasons qualified custodians often hold
client assets in omnibus accounts
containing assets of more than one
client or similar commingled-style
accounts. We understand that practice
may be even more common when a
qualified custodian uses a sub-custodian
to hold client assets. We do not intend
the segregation requirement to preclude
traditional operational practices in
which client assets are held in omnibus
accounts or otherwise commingled with
assets of other clients because we
recognize that custodians regularly
maintain assets in a manner that allows
such assets to be identified as held for
a particular client, distinct from assets
of other clients, and not subject to
securities and other property deposited by futures
customers to margin, secure, or guarantee futures
contracts and options on futures contracts traded on
designated contract markets).
171 The proposed segregation requirements are
drawn from rule 15c3–3 of the Exchange Act, which
requires broker-dealers to safeguard their customer
assets and keep customer assets separate from the
firm’s assets, to prevent investor loss or harm in the
event of the broker-dealer’s failure. See Financial
Responsibility Rules of Broker-Dealers, Exchange
Act Release No. 70072 (Jul. 30, 2013) [78 FR 51824
(Aug. 21, 2013)] (‘‘Financial Responsibility
Adopting Release’’). In addition, other regulatory
regimes have adopted similar requirements. See,
e.g., rule 1.20 [17 CFR 1.20] under the Commodity
Exchange Act, which requires a futures commission
merchant to segregate customer assets from its own
assets.
172 See, e.g., Report of the Trustee’s Investigation
and Recommendations, In re MF Global Inc., No.
11–2790 (MG) SIPA (Bankr. S.D.N.Y. June 4, 2012)
(noting that about $1.6 billion in customer funds
were found to be missing after the financial
institution’s bankruptcy). Crypto asset trading
platforms have also experienced failures resulting
in bankruptcy, raising questions as to whether
investors’ funds will be returned. See, e.g., In re
Celsius Network LLC, 2023 Bankr. LEXIS 2, at *60
(Bankr. S.D.N.Y., Jan 4, 2023) (holding that
customer crypto assets in ‘‘Earn Accounts’’ were
property of the bankruptcy estate).
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increased risk of loss arising from a
custodian’s insolvency.
We understand that the current rule’s
account requirements in 206(4)–2(a)(1)
pose certain compliance challenges
when client assets are commingled,
including in the context of sweep
accounts, escrow accounts, and loan
servicing accounts. We believe the
proposed segregation requirements 173
along with the proposed written
agreement and other reasonable
assurances requirements more directly
and comprehensively achieve our policy
goal than the custody rule’s account
requirements in rule 206(4)–2(a)(1). In
light of the proposed segregation
requirements, the safeguarding rule
would not include the custody rule’s
requirement to maintain client funds
and securities with a qualified
custodian (1) in a separate account for
each client under the client’s name; or
(2) in accounts that contain only client
funds and securities under an adviser’s
name as agent or trustee for the
clients.174
We believe that proper identification
of client assets, as required by the
segregation requirement of the proposed
rule, would mitigate concerns regarding
the safety of a client’s assets. Subaccounting of commingled accounts
allows qualified custodians to identify
readily an owner’s commingled assets at
any point in time. Eliminating the
custody rule’s requirement to maintain
accounts that contain only clients’ funds
and securities also should alleviate
certain compliance challenges when
client and non-client assets are
commingled for administrative
convenience and efficiency purposes,
such as in the context of sweep
accounts, escrow accounts, and loan
servicing accounts.175 We understand
that some custodial agreements between
advisory clients and qualified
custodians contain a contractual
provision requiring segregation of client
assets from the custodian’s proprietary
assets and liabilities. We believe that the
reasonable assurances requirement in
the proposed rule may result in
qualified custodians adding such a
contractual provision to custodial
agreements that do not contain this
language. However, we believe that
some custodial agreements already
173 The
safeguarding rule would also require
certain additional segregation requirements related
to, among other things, segregating client assets
from the adviser’s assets, discussed in more detail
in section D, below. See proposed rule 223–1(a)(3).
174 Custody rule 206(4)–2(a)(1).
175 See 2014 IM Guidance, supra footnote 17;
Madison Capital Funding, Inc., SEC Staff No-Action
Letter (Dec. 20, 2018) (‘‘Madison Capital No-Action
Letter’’).
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contain language addressing the
requirement. Moreover, because we
understand that many qualified
custodians are required by their
functional regulator to segregate assets,
we believe that an adviser obtaining
reasonable assurances regarding
segregation as required under the
proposed rule would not result in a
substantial change in the operational
practices of many custodians. More
importantly, we believe that the
proposed rule’s requirement that an
adviser obtain reasonable assurances
from the qualified custodian regarding
the segregation requirement provides
vital protections.
v. No Liens Unless Authorized in
Writing
The proposed rule would require the
adviser to obtain reasonable assurances
in writing from the qualified custodian
that the qualified custodian will 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.176 This requirement is designed
to protect client assets by discouraging
qualified custodians from using those
assets in a manner not authorized by the
client. This provision would help
ensure that client assets maintained
with the qualified custodian are
protected and are free of any claims by
the qualified custodian, or a third party
looking to secure or satisfy an obligation
of the qualified custodian, including in
cases of the qualified custodian’s
insolvency or bankruptcy.
Liens and the other claims addressed
in the proposed rule can arise in favor
of a qualified custodian in a variety of
circumstances. For example, in a margin
account, a type of brokerage account, a
qualified custodian may lend cash to a
client to allow the client to purchase
securities. The qualified custodian’s
loan is typically collateralized by the
securities purchased by the client, other
assets in a client account, and cash, all
of which are typically subject to a
security interest in favor of the qualified
custodian.177 Similarly, qualified
custodians often have contractual or
other rights to liens or similar claims
arising from unpaid client fees. The rule
would not prohibit arrangements like
these. Rather, the rule would require
that the adviser obtain reasonable
176 See
proposed rule 223–1(a)(1)(ii)(E).
Uniform Commercial Code, section 8–504
and cmt. 2 (‘‘Margin accounts are common
examples of arrangements in which an entitlement
holder authorizes the securities intermediary to
grant security interests in the positions held for the
entitlement holder.’’).
177 See
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assurances from the qualified custodian
that the client has authorized in writing
any right, charge, security interest, lien,
or claim in favor of the qualified
custodian or its related persons or
creditors that would arise in connection
with these arrangements or others.
While we recognize that these and
similar arrangements involve some level
of risk to client assets, we recognize that
they can also be beneficial, and should
be permitted when authorized.
We believe that many qualified
custodians maintain their custodial
customer assets free of liens and similar
claims, other than those agreed to or
authorized in writing by the client.
Further, we understand that some
custodial agreements contain
contractual language addressing when a
lien or similar claim will attach to client
assets. Therefore, we believe requiring
an adviser to obtain this reasonable
assurance from the qualified custodian
would provide important client
protections.
b. Written Agreement
As discussed above, the proposed rule
would require an adviser to enter into
a written agreement with a qualified
custodian containing certain terms that
we view as critical to safeguarding
client assets.178 The rule would require
that the written agreement contain the
terms described in more detail below.
i. Provision of Records
The proposed rule would require that
the written agreement with the qualified
custodian include a provision requiring
the qualified custodian promptly, upon
request, to provide records relating to
client assets to the Commission 179 or an
independent public accountant for
purposes of compliance with the
rule.180 Custodial account records
provide information that is critical to an
independent public accountant’s ability
to perform its role under the current
rule, and would be similarly critical
under the proposed rule. We
understand, however, that accountants
often struggle to obtain—or to obtain
timely—information from qualified
custodians when performing surprise
examinations under the current rule
unless the advisory client requests that
178 Proposed
rule 223–1(a)(1)(i).
custodians, including foreign custodians,
must provide records of custody and use of the
securities, deposits, and credits related to an
investment adviser’s client to representatives of the
Commission upon request. Advisers Act section
204(d)(1). The Commission believes that
formalizing this requirement in the written
agreement between a qualified custodian and an
investment adviser will ensure qualified custodians
are aware of the requirements of the Advisers Act.
180 Proposed rule 223–1(a)(1)(i)(A).
179 All
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the qualified custodian share the
information. We realize this is likely
because the qualified custodian has no
contractual agreement with the adviser
or the accountant that has been hired by
the adviser. We believe the proposed
contractual requirement would
substantially mitigate these
complications.
We understand that qualified
custodians do not often provide third
parties access to custodial account
records in light of privacy concerns for
their customers, unless there is
contractual privity with those third
parties or their customers request they
do so. We believe that the proposed
contractual requirement would mitigate
these record access challenges because
the qualified custodian would be in
direct contractual privity with the
adviser and would have a contractual
obligation to provide the records
required by the rule.
ii. Account Statements
The proposed rule would require that
the written agreement with the qualified
custodian provide that the qualified
custodian will send account statements
(unless the client is an entity whose
investors will receive audited financial
statements as part of the financial
statement audit process pursuant to the
audit provision of the proposed rule),181
at least quarterly, to the client and the
investment adviser, identifying the
amount of each client asset in the
custodial account at the end of the
period as well as all transactions in the
account during that period, including
advisory fees.182
The custody rule requires an adviser
to have a reasonable basis, after due
inquiry, for believing that the qualified
custodian sends an account statement,
at least quarterly, to each of the
adviser’s clients for which it maintains
funds or securities, identifying the
amount of funds and of each security in
the account at the end of the period and
setting forth all transactions in the
account during that period.183 We
continue to believe that qualified
custodians’ delivery of account
statements directly to advisory clients—
without involvement of the adviser—
helps provide clients with confidence
that any erroneous or unauthorized
transactions by an adviser would be
reflected in the account statement and,
181 See
proposed rule 223–1(b)(4).
rule 223–1(a)(1)(ii)(B). The proposed
requirement is similar to the approach in the
current rule with regard to the investment adviser
forming a reasonable belief after due inquiry that
the qualified custodian sends account statements, at
least quarterly, to the client. See rule 206(4)–2(a)(3).
183 Custody rule 206(4)–2(a)(3).
182 Proposed
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as a result, would deter advisers from
fraudulent activities. In a change from
the current custody rule, the qualified
custodian would also now be required
to send account statements, at least
quarterly, to the investment adviser,
which would allow the adviser to more
easily perform account reconciliations.
We also believe that, because of custody
rule 206(4)–2(a)(3), the account
statement contract provision is
consistent with longstanding custodial
practices and would easily be
incorporated by qualified custodians
into the written agreement. The account
statements could also be delivered to
the client’s (or pooled investment
vehicle investor’s) independent
representative.
In circumstances where an investor is
itself a pooled vehicle that is
controlling, controlled by, or under
common control with the adviser or its
related persons (a ‘‘control
relationship’’), the contract with the
qualified custodian must require the
quarterly account statement to be
delivered by the qualified custodian to
all of the investors in each pooled
investment vehicle client, which
includes investors in the underlying
pools by looking through that pooled
vehicle (and any pools in a control
relationship with the adviser or its
related persons, such as in a masterfeeder fund structure).184 Advisers to
pooled investment vehicles may from
time to time establish special purpose
vehicles (‘‘SPVs’’) or other pooled
vehicles for a variety of reasons,
including facilitating investments by
one or more private funds that the
advisers manage. If a qualified
custodian did not look through each
pool in a control relationship with the
adviser, the qualified custodian would
be essentially delivering the quarterly
statement to the adviser rather than to
the parties the quarterly statement is
designed to inform. Outside of a control
relationship, such as if a private fund
investor is an unaffiliated fund of funds,
this same concern is not present, and
the qualified custodian would not need
to look through the structure to make
meaningful delivery. The qualified
custodian would just distribute the
quarterly statement to the unaffiliated
fund of funds’ adviser or other
designated party. We believe that this
approach would lead to meaningful
delivery of the quarterly statement to
advisory clients. Also in a change from
the current custody rule, the proposed
rule would require the written
agreement to contain a provision
prohibiting the qualified custodian from
184 See
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identifying assets on account statements
for which the qualified custodian lacks
possession or control, unless requested
by the client. If a client requests such
assets be included on its account
statement, the account statement may
identify the assets, but only if the
account statement clearly indicates that
the custodian does not have possession
or control of the assets.185 Advisers
have, at times, requested a qualified
custodian to include particular holdings
and transactions on the custodial
account statements for a variety of
reasons, including in an attempt to
demonstrate compliance with the
custody rule. For example, it is our
understanding that custodians have
been unwilling or unable to take
possession or control of certain
investments, such as a variety of
privately issued securities. Advisers
sometimes request that custodians
report these securities as an
‘‘accommodation’’ on a custodial
account statement so that the client is
aware of their existence.
We recognize that account statements
provided by a qualified custodian on a
so-called ‘‘accommodation basis’’ may
offer a client the ability to review all of
its investments in a single consolidated
account statement and potentially alert
a client or an auditor to the existence of
an investment.186 We are concerned,
however, that the practice of a qualified
custodian including investments that it
is not safeguarding on an account
statement may be misleading and
confusing to clients. To evaluate the
holdings and transactions reported on
an account statement, a client must have
confidence in the statement’s integrity
and accuracy. Accordingly, we would
prohibit an adviser from participating in
a practice that we believe undermines
that integrity and utility.187
185 To the extent that a client requests that a
qualified custodian report in account statements
holdings and transactions to which the custodian is
not attesting as a custodian and for which the
custodian is disclaiming liability, the proposed rule
would not disrupt this practice, though it would
require them to be clearly identified as such.
186 The rule proposes a process and protections
for certain assets unable to be maintained with a
qualified custodian, thereby making
accommodation reporting unnecessary. See section
II.C, infra.
187 Other regulatory regimes have raised concerns
about this practice including the potential for
communicating inaccurate, confusing or misleading
information to customers, lapses in supervisory
controls, and the use of these reports for fraudulent
or unethical purposes. See, e.g., FINRA’s Regulatory
Notice 10–19 (reminding broker-dealer firms of
their responsibilities to ensure that they comply
with all applicable rules when engaging in
providing customers with consolidated financial
account reporting).
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iii. Internal Control Report
The proposed rule would require that
the written agreement with the qualified
custodian provide that the qualified
custodian, at least annually, will obtain,
and provide to the investment adviser a
written internal control report that
includes an opinion of an independent
public accountant as to whether
controls have been placed in operation
as of a specific date, are suitably
designed, and are operating effectively
to meet control objectives relating to
custodial services (including the
safeguarding of the client assets held by
that qualified custodian during the
year).188 Consistent with an adviser’s
fiduciary duty, an adviser should review
the report for control exceptions and
take appropriate action where
necessary.189
Although the custody rule requires an
internal control report only when the
adviser or its related person acts as a
qualified custodian,190 we believe
expanding this requirement to all
qualified custodians under the proposed
rule would mitigate risks to client assets
regardless of the affiliation of the
qualified custodian.191 We believe the
proposed requirement would help
protect client assets by ensuring that the
qualified custodian’s controls with
respect to its safeguarding practices are
routinely evaluated by a third party that
is independent of the custodian. We
drew the proposed requirement from
our experience with the internal control
report requirement under the custody
rule, understanding of requirements
currently applicable to some types of
qualified custodians, as well as best
practices.192
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188 This
requirement would apply as a control
objective of the internal control report rather than
a requirement in the rule, thereby expanding the
requirement to all qualified custodians, not just a
qualified custodian that is the adviser or its related
person. See generally, Commission Guidance
Regarding Independent Public Accountant
Engagements Performed Pursuant to Rule 206(4)–2
Under the Investment Advisers Act of 1940,
Advisers Act Release No. 2969 (Dec. 30, 2009) [75
FR 1492 (Jan. 11, 2010)] (‘‘Accounting Guidance’’).
189 See supra footnote 57.
190 Current rule 206(4)–2(a)(6).
191 An introducing broker that is also an adviser
or the adviser’s related person would not be
considered as acting as a qualified custodian under
the proposed rule if all client investments are
maintained with a carrying broker (which is not a
related person of the adviser) and thus the
introducing broker would not be subject to the
internal control report requirement.
192 Rule 206(4)–2(a)(6)(ii). See 2009 Proposing
Release, supra footnote 11, at n.88 (noting that
custodians often provide internal control reports to
clients who demand a rigorous evaluation of
internal controls as a condition of obtaining their
business and that obtaining such report is an
‘‘industry best practice.’’). See also United States
Government Accountability Office, Investment
Advisers; Requirements and Costs Associated with
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The objective of the examination
supporting the internal control report is
to obtain reasonable assurance that the
qualified custodian’s controls have been
placed in operation as of a specific date,
and are suitably designed and operating
effectively to meet control objectives
related to safeguarding of client assets
during the period specified.193 Based on
our experience with the custody rule,
we believe that the benefits and
protections that we initially believed
were warranted for a more limited group
of qualified custodians should be
expanded to include all qualified
custodians.194
We understand that not all qualified
custodians obtain internal control
reports, although we believe many do.
We also understand that for those
qualified custodians that currently
obtain internal control reports, the
scope of those reports may not cover the
financial institutions’ safeguarding
activities that this proposed requirement
is designed to cover. Nonetheless, we
believe this requirement is justified
because the proposed internal control
report requirement would provide
meaningful investor protection benefits
by, among other things, providing
advisers with information regarding the
control practices of the qualified
custodian that would enable advisers to
assist advisory clients in making more
informed decisions concerning holding
assets with particular qualified
custodians.
We are not requiring the provision of
a specific type of internal control report
as long as the required objectives are
addressed.195 This flexibility would
permit qualified custodians to leverage
existing audit work to satisfy regulatory
requirements, or work currently
performed as part of internal control
reports prepared to meet client demand.
The proposed rule would define
‘‘independent public accountant’’ to
mean a public accountant that meets the
standards of independence described in
rule 2–01 of Regulation S–X (17 CFR
210.2–01).196 The Commission has long
recognized that an audit by an objective,
impartial, and skilled professional
contributes to both investor protection
and investor confidence.197 We
understand that qualified custodians
currently obtaining internal control
reports voluntarily or pursuant to
requirements of the qualified
custodian’s functional regulator may
need to engage a new accountant if the
qualified custodian’s current accountant
is not independent as defined by the
proposed rule.198 We believe that
adherence to the bedrock principle that
auditors must be independent in fact
and in appearance 199 contributes to
investor protection and investor
confidence in connection with the
relationship between an auditor and the
qualified custodian. We therefore
believe that this requirement is
appropriate.
In connection with our concerns
noted above regarding circumstances in
which an adviser or related person is
the qualified custodian, we are
proposing to retain the current rule’s
approach that if the qualified custodian
is a related person or the adviser, the
independent public accountant that
prepares the internal control report
the Custody Rule (July 2013), available at https://
www.gao.gov/assets/gao-13-569.pdf (stating that
representatives from two industry associations
discussed that institutional investors commonly
require custodians to obtain internal control
reports).
193 See Accounting Guidance, supra footnote 188,
at section III.
194 See rule 206(4)–2(a)(6)(ii).
195 For example, we believe that a report on the
description of controls placed in operation and tests
of operation effectiveness, commonly referred to as
a ‘‘SOC 1 Type 2 Report,’’ would be sufficient to
satisfy the requirements of the internal control
report, provided that the report covers whether the
controls have been placed in operation as of a
specific date, are suitably designed, and are
operating effectively in order to meet control
objectives as required by the rule. A report that
simply provides a report of procedures or controls
a qualified custodian has put in place as of a point
in time, commonly referred to as a ‘‘SOC 1 Type
1 Report,’’ would not satisfy the requirements of the
internal control report because it does not test
operation effectiveness of the controls. In addition,
a report issued in connection with an examination
of internal control conducted in accordance with
AT–C section 315: Compliance Attestation (‘‘AT–C
section 315’’) or AT–C section 320: Reporting on an
Examination of Controls at a Service Organization
Relevant to User Entities’ Internal Control over
Financial Reporting (‘‘AT–C section 320’’) under
the standards of the American Institute of Certified
Public Accountants would also be sufficient
provided that the report covers whether the controls
have been placed in operation as of a specific date,
are suitably designed, and are operating effectively
in order to meet control objectives as required by
the rule. See 2009 Adopting Release, supra footnote
11, at section II.C.1. Similarly, a report based on an
examination in accordance with PCAOB AT–1 of a
broker-dealer’s compliance report prepared
pursuant to rule 17a–5 of the Exchange Act would
be sufficient to satisfy the internal control
requirement. See 17 CFR 240.17a–5; Broker-Dealer
Reports, Exchange Act Release No. 34–70073 (July
30, 2013) [78 FR 51910 (Aug. 21, 2013)].
196 See proposed rule 223–1(d)(5). The definition
in the proposed rule would be amended to
reference Rule 2–01 in its entirety rather than the
more limited reference in the current custody rule
(see rule 206(4)–2(d)(3), referencing 2–01(b) and
(c)), which amendment is designed to clarify that
the entirety of the auditor qualification and
independence requirements in Rule 2–01 apply.
197 See Revision of the Commission’s Auditor
Independence Requirements, Release No. 33–7919
(Nov. 21, 2000) [65 FR 76008 (Dec. 5, 2000)].
198 See proposed rule 223–1(a)(1)(i)(C); 223–
1(d)(5).
199 See Qualifications of Accountants, Release No.
33–10876 (Oct. 16, 2020) [85 FR 80508 (Dec. 11,
2020) (discussing bedrock principles).
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must verify that client assets are
reconciled to a custodian other than you
or your related person. In addition, we
would continue to require that if the
qualified custodian is a related person
or the adviser, the independent public
accountant is registered with and
subject to regular inspection as of the
commencement of the professional
engagement period, and as of each
calendar year-end, by, the Public
Company Accounting Oversight Board
(‘‘PCAOB’’), in accordance with the
rules of the PCAOB.200 We believe that
qualified custodians routinely retain
accountants that satisfy this requirement
because of this requirement under the
custody rule. In light of our experience
with this requirement of the current
rule, we believe that registration and the
periodic PCAOB inspection of an
independent public accountant’s overall
quality control system will provide us
greater confidence in the quality of the
internal control report in the context of
an affiliated adviser and custodian.
iv. Adviser’s Level of Authority
The proposed rule would require that
the written agreement with the qualified
custodian specify the investment
adviser’s agreed-upon level of authority
to effect transactions in the custodial
account as well as any applicable terms
or limitations.201 We are also proposing
that this contract provision permit the
adviser and the client to reduce the
specified level of authority. Our
understanding is that investment
advisers often are given authority over
the custodial account in the custodial
agreement between the custodian and
the client that is broader than what the
adviser and client agreed to in the
advisory agreement. For example, an
adviser may not have authority under its
advisory agreement with a client to
instruct the client’s custodian to
disburse client assets. If, however, the
client’s agreement with its qualified
custodian grants the adviser broad
authority over the client’s account,
including to disburse or transfer assets,
the adviser would be able to effect a
change in beneficial ownership of the
client’s assets.202 In these
circumstances, from the qualified
custodian’s perspective, the client has
authorized the adviser to withdraw the
client’s assets and, while there may be
constraints contained in the advisory
agreement between the adviser and a
client, the custodian may not be aware
of these constraints or may be unwilling
or unable to treat the terms of the
advisory agreement as controlling.203 In
this scenario, believing the adviser to
have authority over the client’s assets,
the custodian could accept the adviser’s
instructions to direct the disposition of
the client’s assets.204 We are concerned
this puts clients at risk, such as in the
event a rogue advisory employee
misuses the authority to direct the
disposition of a client’s assets held by
the custodian. We understand that
advisers have had little success in
modifying or eliminating their
unwanted authority either because a
custodian is reluctant to accept the
adviser’s request to modify its
agreement with its client, or the client
may lack the bargaining power to
negotiate more limited terms on the
adviser’s authority over the client’s
assets because the custodian may refuse
to modify its standard forms.205 This
contractual requirement of the proposed
rule is designed to mitigate these
concerns and empower advisers to
modify this aspect of the custodial
agreement to better reflect client
intentions and to be consistent with the
adviser’s contractual obligations to its
clients.
Our staff has observed that qualified
custodians have been reluctant to
modify or customize the level of
authority investment advisers have with
respect to customer accounts. It
increases their need to monitor
customer accounts, and to accept
liability, for unauthorized transactions
by an adviser and its personnel. We
believe that the risks of inadvertent
custody, the related risk that a custodian
may follow an instruction with respect
to client assets presuming authority that
the adviser does not have under its
advisory contract with the client, and
our staff’s observation of the reluctance
of qualified custodians to modify
adviser authority, warrant the proposed
203 Our
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200 Proposed
rule 223–1(a)(1)(i)(C)(1).
201 Proposed rule 223–1(a)(1)(i)(D).
202 See, e.g., Inadvertent Custody: Advisory
Contract Versus Custodial Contract Authority,
Division of Investment Management Guidance
Update No. 2017–01 (Feb. 2017) (‘‘2017 IM
Guidance’’) in which our staff discussed its views
on the application of the current custody rule to
various types of custodial agreements between a
client and a custodian that grant an adviser broader
access to client funds or securities than the
adviser’s own agreement with the client
contemplates.
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staff took a similar view. See id.
the advisory agreement between the
adviser and its client may constrain the adviser’s
authority, the custodian may not be aware of such
constraints. A separate bilateral restriction between
the adviser and the client is insufficient to prevent
the adviser from having custody where the
custodial agreement enables the adviser to
withdraw or transfer client funds, securities or
similar investments upon instruction to the
custodian. Our staff took a similar view. See 2017
IM Guidance, supra footnote 202.
205 See supra footnote 202 and accompanying
text.
204 While
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14699
requirement. Ultimately, we believe this
requirement would better protect
advisory clients than the current default
broad authority provisions in current
contracts.
We request comment on all aspects of
the proposed reasonable assurances and
written agreement requirement,
including the following:
55. Is our understanding correct that
custodians are familiar with the
concepts addressed by the reasonable
assurances and written agreement
requirements?
56. Should the rule include the due
care reasonable assurances requirement?
Is this standard of care common practice
in the custodial marketplace and, if so,
would custodians be willing to provide
information to an adviser sufficient to
satisfy the proposed rule? Instead of the
proposed approach, should the rule
require generally that an adviser obtain
reasonable assurances that a qualified
custodian meets certain minimum
commercial standards and then specify
some but not all applicable standards?
Would the proposed requirement
provide additional protections for
clients when an adviser has custody of
client assets and further the policy goals
of the rule?
57. Should the rule include the
reasonable assurances requirement that
the qualified custodian will indemnify
the client (and will have insurance
arrangements in place that will
adequately protect the client) against the
risk of loss in the event of the qualified
custodian’s own negligence,
recklessness, or willful misconduct?
Would this requirement provide
additional protections for clients when
an adviser has custody of client assets
and further the policy goals of the rule?
Alternatively, should we require
reasonable assurances of a different
indemnification standard? If so, what
standard and how would that standard
protect investors consistent with the
policy goals of the rule?
58. Would the proposed
indemnification standard be a
substantial departure from current
industry practice? Would it be
expensive for qualified custodians and
would those costs be passed on to
custodial clients? If so, are there less
expensive ways of achieving the policy
goals of the rule? Would this
requirement result in custodians ceasing
operations in the custody business? If
so, what proportion of custodians would
commenters expect to stop providing
custody services as a result of this
proposed rule? Should the safeguarding
rule, instead, require disclosure to
clients that they could lose their assets
in the event of custodian misconduct?
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We understand that retail clients were
often afforded the fewest protections. If
we were to require disclosure, instead of
indemnification, would such retail
clients be able to negotiate with
custodians for better protection?
59. Do commenters agree with our
understanding that custodians may
cover losses caused by their own
misconduct even if the customer is
ineligible for indemnification under the
custodial agreement to avoid headline
exposure or as a gesture of goodwill to
their custodial customers? Do insurers
contribute compensation as part of these
payouts? If so, how frequently? Do
advisers step in to compensate
customers in these circumstances? If so,
how frequently?
60. Should the proposed rule include
the reasonable assurances requirement
requiring the qualified custodian to
provide indemnity and have insurance
arrangements in place to adequately
protect its clients? Should the rule
include additional safeguards regarding
the indemnification requirement, such
as stating that insurance proceeds will
be solely for the benefit of the client,
and will not be considered an asset of
anyone other than the client? Should
the rule include any safeguards around
the type of insurance a qualified
custodian could maintain for those
indemnification purposes? If yes, what
types of safeguards should be imposed?
For example, should the insurance
company be of a certain type or hold a
certain qualification or rating? What
alternatives should we require to
achieve our policy goals? Are there any
particular challenges for FFIs meeting
this requirement? If so, what are they?
61. Should the proposed rule include
the reasonable assurances requirement
that the existence of any sub-custodial,
securities depository, or other similar
arrangements with regard to the client’s
assets will not excuse any of the
qualified custodian’s obligations to the
client? Would that requirement help
ensure that a qualified custodian could
not avoid responsibility for the other
important safeguarding obligations it
owes to the client by delegating
custodial responsibility to a subcustodian or other responsibilities to
other third parties? Would the
requirement provide additional
protections for clients when an adviser
has custody of client assets and further
the policy goals of the rule?
62. Should the rule include the
proposed reasonable assurances of
segregation of client assets
requirements? Are these requirements
sufficiently clear?
63. Would the proposed reasonable
assurances of segregation of client assets
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requirements impose appropriate
limitations to safeguard client assets?
Should we eliminate or modify any of
them? Alternatively, are there other
limitations that would be appropriate?
64. Would the proposed reasonable
assurance of segregation of client assets
requirement increase the likelihood that
client assets will be available to be
returned to clients if a qualified
custodian experiences financial events
such as insolvency or bankruptcy? For
example, do commenters believe the
requirements would help ensure that
client assets are more readily
identifiable as client property?
65. Should certain assets be excluded
from these reasonable assurances of
segregation of client assets
requirements? If so, which assets and
why? Would limiting these
requirements to certain types of assets
present compliance challenges? If so,
which assets and why?
66. In particular, would the proposed
reasonable assurances of segregation of
client assets requirement present
challenges with respect to crypto assets?
Should we address crypto asset
segregation and/or custody with
separate requirements? Do crypto assets
raise specific segregation issues not
presented by other assets? If so, what are
they and why? Would the proposed
requirements offer substantial
protections in the event of a bankruptcy
or financial losses involving a custodian
with custody of crypto assets? Would
the proposed reasonable assurances of
segregation of client assets requirement
present challenges with respect to other
types of assets?
67. Does the proposed reasonable
assurance of segregation requirement
guard against loss, misappropriation,
misuse, theft, and the risk of client
assets being subject to creditor claims in
the insolvency or bankruptcy of the
qualified custodian, while permitting
the flexibility that would address some
of the compliance challenges that the
current rule presents (e.g., commingling
of client and non-client assets)?
68. Should we instead retain the
custody rule’s requirement to maintain
client funds and securities with a
qualified custodian in a separate
account for each client under the
client’s name or in accounts that contain
client funds and securities under the
adviser’s name as agent or trustee? If so,
should any of the custody rule’s
requirements be modified in any way?
If we were to retain the custody rule’s
requirement, should we expand the
scope of the separate account
requirement to assets from funds and
securities?
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69. Is our understanding correct that,
for administrative convenience and
other reasons, qualified custodians often
hold client assets in omnibus accounts
containing assets of more than one
client or similar commingled-style
accounts? Do commenters agree that this
practice may be even more common
when a qualified custodian uses a subcustodian to hold client assets?
70. Should the rule require that an
adviser obtain reasonable assurances
that the qualified custodian will not
commingle client and non-client assets,
similar to the custody rule? 206
Alternatively, should the rule be
modified to permit the commingling of
client and non-client assets for
administrative convenience and
efficiency? If so, what should be
considered ‘‘administrative convenience
and efficiency’’? Does allowing client
and non-client assets to be commingled
(e.g., in the same omnibus account)
increase the risk that client assets will
be lost, misused, stolen, or
misappropriated? Could an advisory
client’s assets be used to satisfy the
debts of someone else in a bankruptcy
event if client and non-client assets are
commingled?
71. Do commenters agree that there
are circumstances when qualified
custodians’ services require them to
commingle advisory client assets and
assets of non-advisory customers? For
example, when a qualified custodian
uses sweep accounts, escrow accounts,
and loan servicing accounts? In these
circumstances, should the rule require
additional protections? Which
protections and why and would they
differ depending on the type of
commingled account?
72. Should the rule require that an
adviser obtain reasonable assurances
from the qualified custodian regarding
the sub-accounting of commingled
accounts? Would such a requirement
provide additional protection to client
assets?
73. Are there instances where
commingling or pooling of certain assets
by qualified custodians may occur via
certain omnibus and sub-accounting
arrangements that may present
compliance challenges under the
reasonable assurances of segregation of
client assets requirement? What are
those instances and what are the
challenges?
74. Do commenters think that
qualified custodians will include
contractual segregation provisions in
their custodial agreements with
advisory clients if they do not already
do so? Should the rule require an
206 See
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express contractual requirement
between the adviser and custodian to
identify and segregate client
investments? Would a contractual
requirement help ensure that advisory
client assets are protected?
75. Do commenters agree with our
belief that not all financial institutions
that serve as qualified custodians,
particularly FFIs, are currently required
to segregate and identify their client
investments? Do commenters agree that
requiring an adviser to obtain
reasonable assurances that a qualified
custodian will segregate client assets
from the custodian’s proprietary assets
and liabilities would be critical to
protecting client investments in the
event of a qualified custodian’s
insolvency as well as in the event of a
taking by a foreign government? Do
commenters believe there may be
reluctance by some financial
institutions to segregate client assets?
Are there circumstances in which
segregation might not be important? If
so, which circumstances?
76. Would this segregation provision
present practical challenges? For
example, would it present practical
challenges in the context of omnibus
accounts or temporary sweep accounts?
Would financial institutions be able to
satisfy the segregation provision? For
example, we know that national banks
and Federal savings associations are
required to segregate all assets held in
any fiduciary capacity from their
general assets. Is this also true of
national banks and Federal savings
associations that hold custodial assets in
a non-fiduciary capacity? Are there
other compliance challenges that this
proposed segregation requirement
would pose? Are there circumstances in
which qualified custodians’ services
require them to commingle advisory
client assets with other assets?
77. In the context of requiring an FFI
to segregate client investments, do
commenters believe that the reasonable
assurances segregation requirement
would help to preserve the client’s
interests in the event of a government
taking?
78. In the event of the insolvency or
bankruptcy of a qualified custodian, do
commenters agree with our
understanding that the sub-accounting
of commingled accounts allows a
qualified custodian to readily identify
the rightful owner of any investment at
any point in time? Are there any
particular assets or services for which
such identification via sub-accounting is
difficult or burdensome? If so, what are
the reasons for these difficulties?
79. Is our approach in requiring a
qualified custodian to maintain client
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assets pursuant to a written agreement
between the qualified custodian and the
investment adviser appropriate? Would
the proposed approach provide
additional protections for clients when
advisers have custody of client assets
and further the policy goals of the rule?
Would this requirement increase costs
to maintain client assets with a qualified
custodian? Would this approach limit
the pool of financial institutions that are
able to serve as qualified custodians?
Would financial institutions currently
acting as qualified custodians exit the
business as a result of the written
agreement requirement? Do commenters
agree that custodial practices, types of
instruments custodians hold, and the
regulatory framework to which these
financial institutions are subject have
evolved, in part to accommodate new
entrants to the market for custodial
services? Do commenters agree that this
evolution, including new custodians
and new custodial practices, has
resulted, in at least some cases, in a
general reduction in the level of
protections offered by custodians, often
resulting in advisory clients with the
least amount of bargaining power (i.e.,
retail investors) receiving the most
limited protections? Are there other
reasons that commenters believe
custodial practices have evolved to
result in a general reduction in the level
of protections offered by custodians?
Would the proposed approach mitigate
some of our concerns with regard to
these custodial market changes?
80. Is our belief correct that financial
institutions that act as qualified
custodians under the current rule
already provide some of the protections
that would be required under the
proposed rule’s contractual
requirements, either to satisfy regulatory
requirements or pursuant to their
existing contracts with their clients? Do
these qualified custodians already
provide the protections that would be
required in the proposed written
agreement to every customer? Are some
protections provided to customers more
often than others? If so, which
protections and why?
81. Should the rule permit an adviser
or its related person to be a qualified
custodian, as under the custody rule, or
should we prohibit the adviser or its
related person from being the qualified
custodian? Do commenters agree that an
adviser or related person acting as the
qualified custodian presents risks to
client assets that are not present when
a qualified custodian is not the adviser
or a related person of the adviser? Do
commenters agree that the proposed
requirements in the rule, including the
proposed internal control report
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14701
requirements applicable to qualified
custodians that are the advisers or a
related person, would help to reduce
those risks? If the rule prohibits the
adviser or its related person from being
the qualified custodian, would it result
in additional costs or operational
burdens on advisory clients? For
example, would the requirement cause
advisory clients to lose access to
services or other efficiencies they
currently receive? Would the
requirement result in higher costs for
advisory clients?
82. Given that the written agreement
and reasonable assurances approach
would be applicable equally to the
different types of qualified custodians,
should the rule identify other financial
institutions such as securities
depositories, transfer agents, credit
unions, insurance companies, or other
intermediaries as qualified custodians?
83. Are the contractual requirements
and reasonable assurances requirements
sufficiently clear? Are there additional
contractual requirements or reasonable
assurances related to the safeguarding of
client investments that should be
included in the written agreement or
obtained by the adviser? If so, what are
they, and why? Should we eliminate
any of the contractual requirements or
reasonable assurances requirements? If
so, which ones, and why? Should all of
the requirements be contractual or
reasonable assurances, rather than a mix
of these two categories as we proposed?
Should any be re-categorized?
84. Are there alternatives to all or any
of the contractual requirements or
reasonable assurances requirements that
would support the policy goals of the
proposed requirements while obviating
the need for one or more specific
contractual provisions or reasonable
assurances? If so, what are the
alternatives? Specifically, would we be
able to achieve the same policy goals by
requiring that an adviser adopt and
implement policies and procedures
reasonably designed to ensure that a
qualified custodian was providing
certain protections to client assets,
rather than requiring a contractual
clause for the protection? For example,
would requiring advisers to adopt and
implement a policy and procedure
reasonably designed to ensure that a
qualified custodian would promptly,
upon request, provide records relating
to the adviser’s clients’ assets held in
the account at the qualified custodian to
the Commission or to an independent
public accountant provide protection
equivalent to the proposed contractual
obligation to provide these records?
What about the proposed internal
control report contractual obligation?
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Would a client be able to obtain
equivalent protection provided by an
adviser’s adoption and implementation
of a policy and procedure reasonably
designed to ensure that the qualified
custodian will provide the internal
control report required in the proposed
contractual requirement? Are there
other alternatives to any of the
contractual requirements, such as
requiring that an adviser obtain
reasonable assurances from the qualified
custodian that the qualified custodian
has contractually agreed to provide
account statements, internal control
reports, or any of the other requirements
we are proposing to be included in the
written agreement? Are there any other
alternatives that we should require?
85. Are there circumstances in which
the written agreement and reasonable
assurances requirements should not be
required? For example, should the
written agreement and reasonable
assurances requirements not apply in
instances where an advisory client has
a custodial relationship with a qualified
custodian that precedes the client’s
engagement of the adviser? If so, how
long should the custodial relationship
precede the advisory relationship in
order for an exception of this type to
apply?
86. Should the proposed rule include
the contractual provision that the
qualified custodian will promptly, upon
request, provide records relating to
client investments to an independent
public accountant for purposes of
compliance with the rule? Are we
correct in our belief that this proposed
provision would facilitate the public
accountant’s ability to obtain custodial
account records? Would this
requirement provide additional
protections when the adviser has
custody of client assets and further the
policy goals of the rule?
87. Should we require a more specific
time period in which a qualified
custodian would be required to provide
records? For example, should we
require that a qualified custodian
provide records within three days of a
request?
88. Is our understanding correct that
qualified custodians do not often
provide third parties access to custodial
account records in light of privacy
concerns for their customers, unless
there is contractual privity with those
third parties or their customers request
they do so? If so, would the proposed
contractual requirement mitigate these
record access challenges because the
qualified custodian would be in direct
contractual privity with the adviser and
would have a contractual obligation to
provide records?
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89. Should the proposed rule include
the contractual requirement that the
qualified custodian will send account
statements, at least quarterly, to the
client and the investment adviser? The
current rule requires an investment
adviser to have a reasonable basis, after
due inquiry, for believing that the
qualified custodian maintaining client
investments sends an account
statement, at least quarterly, to the
client. Is the proposed requirement
regarding sending account statements to
the adviser necessary or helpful? Would
that requirement have a significant cost
impact on qualified custodians and
would those costs be passed on to
advisory clients? Are there alternatives
to the proposed contractual provision
that we should require? For example,
would the client have sufficient
protection when an adviser has custody
of its assets if we were to require that
an adviser must have reasonable
assurance that the qualified custodian
maintaining client assets sends an
account statement, at least quarterly, to
the client?
90. To what extent would the
proposed requirement to provide
custodial account statements to advisers
increase costs to advisory clients?
91. To what extent do commenters
believe that the requirement to provide
custodial account statements to advisers
would have an impact on an adviser’s
duty to monitor? Do commenters believe
that it would increase the frequency at
which some advisers would be required
to monitor activity in client accounts?
Would this enhance protection of client
assets? Could it increase advisory costs?
92. Do commenters agree that
custodians regularly send account
statements to their custodial customers
attesting to the holdings and
transactions in the account during a
particular period? Do commenters agree
that advisory clients use these account
statements to identify erroneous or
unauthorized transactions or
withdrawals in their accounts?
93. Many advisers or their related
persons serve as advisers to pooled
investment vehicles or to other similar
entities (e.g., general partner of a limited
partnership). The proposed rule would
continue to except these advisers from
the requirement to have a qualified
custodian send account statements with
respect to pooled investment vehicles
that are audited annually and distribute
their audited financial statements to the
investors in the pool. Should we
continue to except these advisers from
the account statement requirement?
Would the investors in those pools find
the account statement useful to monitor
the pool’s account activity? Should we
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extend this exception to all entities that
are audited annually and distribute
audited financial statements to investors
in the entities pursuant to the audit
provision, as proposed, provided the
entity complies with all of the
requirements in the proposed audit
provision? 207 Are there other persons
that we should except from this
requirement?
94. In circumstances where an
investor is itself a pooled vehicle that is
controlling, controlled by, or under
common control with the adviser or its
related persons (a ‘‘control
relationship’’), should the contract with
the qualified custodian require the
quarterly account statement to be
delivered by the qualified custodian to
investors in the underlying pools by
looking through that pooled vehicle
(and any pools in a control relationship
with the adviser or its related persons,
such as in a master-feeder fund
structure)? Do commenters agree with
our understanding that if a qualified
custodian did not look through each
pool in a control relationship with the
adviser, the qualified custodian would
be essentially delivering the quarterly
statement to the adviser rather than to
the parties the quarterly statement is
designed to inform? Do commenters
agree with our view that requiring the
qualified custodian to ‘‘look through’’ in
these instances would lead to
meaningful delivery of the quarterly
statement to advisory clients?
95. Is our understanding correct with
respect to current practices of reporting
certain custodial customer holdings for
which the qualified custodian lacks
possession or control on an
accommodation basis?
96. Should the proposed rule prohibit
account statements from identifying
clients’ investments for which the
qualified custodian lacks possession or
control unless the client requests
otherwise? Do commenters agree that
the practice of a qualified custodian
including on an account statement
assets that it is not safeguarding may be
misleading to clients? Are there
challenging practical implications of
this proposed prohibition? For instance,
our staff has previously taken the view
that, under some arrangements, an
adviser that is a qualified custodian may
send its advisory clients account
statements that include assets
maintained with a sub-custodian that is
also a qualified custodian.208 Would the
proposed contract provision preclude
207 See proposed rule 223–1(b)(4) and section
II.G.1, infra.
208 See Custody Rule FAQs, supra footnote 17, at
Question IX.1.
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this type of arrangement? Similarly,
some qualified custodians (regardless of
whether they are related persons of the
adviser) send consolidated account
statements that include the holdings of
sub-custodians. Would the proposed
contract provision disrupt this practice?
Are there ways of improving account
statement integrity without eliminating
qualified custodians’ ability to send
consolidated account statements in
these circumstances? For example,
should we permit an adviser to request
that these assets be included on the
account statement but require that such
request instruct a qualified custodian to
include disclosure on the statement
explaining that the qualified custodian
does not have custodial liability for
those investments? Are there are other
disclosures that would appropriately
distinguish how the qualified custodian
maintains investments?
97. Should we include the contractual
requirement that the qualified
custodian, at least annually, obtain, and
provide to the investment adviser a
written internal control report? Would
the proposed internal control
requirement provide additional
protections where the adviser has
custody? Would the proposed internal
control requirement raise costs for
advisory clients? Should the contractual
requirement require some additional
notification of any material
discrepancies identified in an
examination supporting the internal
control report? For example, should the
contractual requirement require that the
accountant performing the examination
notify the Commission of any material
discrepancies by submitting a form such
as Form ADV–E to the Commission?
Should the contractual requirement
require the accountant to notify the
clients of the material discrepancies?
Should the contractual requirement
include any other provisions with
respect to the written internal control
report?
98. Should we prescribe particular
steps an adviser should take to review
internal control reports for control
exceptions? For example, should we
require an annual review of these
reports by the adviser’s Chief
Compliance Officer or an adviser
personnel with the skill set to review
such reports?
99. Should we specify the internal
control report to be obtained at least
annually, as proposed? Alternatively,
should the internal control report be
obtained more or less frequently?
100. Should the proposed internal
control report be based on an
assessment of the same control
objectives outlined in the 2009
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Accounting Guidance? 209 Are these
control objectives applicable to all
qualified custodians? Should certain of
the control objectives be required only
when the adviser uses a related party
qualified custodian? Have custodial
practices changed since the 2009
Accounting Guidance was published
which would necessitate the addition or
removal of control objectives in order to
meet the policy goals of the proposed
rule? Would additional control
objectives be necessary in order to
appropriately safeguard all client assets
as required under the proposed rule,
compared to funds and securities as
required under the current custody rule?
101. When preparing an internal
control report for a related party
qualified custodian, should an
accountant continue to be required to
verify that client assets are reconciled to
a custodian other than the adviser or its
related person? Should this required
reconciliation be limited to only
securities? Are there custodians (like a
securities depository) unaffiliated with
the adviser that can hold all client assets
when a related party qualified custodian
is utilized? Is further guidance needed
on this reconciliation requirement?
102. Should the contractual provision
require that the independent public
accountant that prepares or issues the
report be registered with the PCAOB
when the adviser serves as, or is a
related person of, the qualified
custodian, as proposed? If so, should the
independent public accountant also be
subject to regular inspection by the
PCAOB, as proposed? Would using
independent public accountants
registered with, and subject to regular
inspection by, the PCAOB increase the
costs to obtain these reports or make it
too difficult to obtain a qualified
accounting firm to provide an internal
control report? Should there be a
different independence standard for
accountants performing the
engagement? Rather than the
independence standard proposed,
should the rule require an accountant to
not be a related person of the qualified
custodian as that term is defined under
the safeguarding rule? 210
103. The current rule 211 and
proposed rule 212 define an independent
public accountant as a public
accountant that meets the standards of
independence described in rule 2–01 of
Regulation S–X (17 CFR 210.2–01). Do
custodians that voluntarily obtain
209 See Accounting Guidance, supra footnote, 188
at section III.
210 Proposed rule 223–1(d)(11).
211 Current rule 206(4)–2(d)(3).
212 Proposed rule 223–1(d)(5).
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internal control reports or obtain them
to satisfy other requirements often
obtain them from independent public
accountants that are independent
according to this standard? If not, do
they have another standard for
determining independence? For
example, do custodians require auditors
to meet the independence standard set
by the Association of International
Certified Professional Accountants? Do
custodians require an independent
public accountant to be unaffiliated
from the custodian?
104. Rather than the contractual
provision requiring that the
independent public accountant that
prepares or issues the report be
registered with the PCAOB when the
adviser serves as, or is a related person
of, the qualified custodian, as proposed,
should this requirement apply to all
qualified custodians, regardless of
whether the qualified custodian is the
adviser or a related person? If so, should
the rule contain different requirements
for a qualified custodian that is the
adviser or a related person?
105. Is it appropriate, as proposed, to
require that an adviser that is also the
qualified custodian include all of the
proposed reasonable assurances
protections in the written agreement
with the client? Should we require
similar protections for any related
person qualified custodian? For
example, should the rule require the
written agreement of any related person
that is the qualified custodian to include
all of the proposed reasonable
assurances requirements? Would doing
so provide enhanced protections for
client assets? Would it result in any
additional burdens on advisers, related
persons, or clients?
106. Do commenters agree with our
proposed requirement that the
accountant who prepares the internal
control report should be ‘‘independent’’
from the qualified custodian? Should it,
instead, require independence from
adviser?
107. Would obtaining or receiving an
internal control report present
additional issues if the qualified
custodian for client assets is located
outside of the United States? Would the
requirement that the independent
public accountant be registered with,
and subject to regular inspection by, the
PCAOB in affiliated or self-custody
situations make it more difficult to
obtain such an internal control report?
108. Instead of making it a term of the
required written agreement, should we
permit an adviser to rely on the
representations of a qualified custodian
that it has obtained the required internal
control report?
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109. Should the proposed rule
include the contractual requirement that
the qualified custodian will specify the
investment adviser’s agreed-upon level
of authority to effect transactions in the
custodial account as well as any
applicable terms or limitations? Are
there other ways in which we could
accomplish our objective to help
empower advisers to modify or
eliminate their unwanted ability in a
custodial agreement to better reflect
their client intentions? Would the
requirement provide additional
protections where the adviser has
custody of client assets and further the
policy goals of the rule?
110. Is it difficult for advisers that
have custody, including inadvertent
custody, pursuant to a client’s custodial
agreement with a qualified custodian, to
reduce or eliminate their authority over
the client’s custodial account? Would
the proposed qualified custodian
contractual requirement make it easier
for advisers to reduce or repudiate this
authority? Do qualified custodians often
reject an adviser’s request to modify its
agreement with its client to reduce or
eliminate the adviser’s authority?
111. Do qualified custodians
sometimes lend, invest, or otherwise use
their custodial customers’ investments?
Do advisers with custody of client assets
have knowledge of these transactions?
Do these transactions present risk to
custodial customers? Do advisers
consider whether a custodian engages in
these transactions, or has sufficient
insurance coverage to cover the risk of
loss arising from these transactions
when involved in selecting a qualified
custodian for an advisory client? Should
we include in the final rule a
contractual requirement requiring
qualified custodians to record a liability
and maintain sufficient capital and/or
insurance when lending, investing, or
otherwise using their custodial
customers’ investments? Would
qualified custodians be able to satisfy
the requirement? If not, what type of
financial institutions would be unable
to satisfy it? Are there other ways of
protecting custodial customers when an
adviser has custody from risk of loss
when those financial institutions lend,
invest, or otherwise use client
investments?
112. Should the proposed rule
include other contractual provisions or
reasonable assurances? For example,
should we require the written agreement
to contain a contractual provision
requiring the qualified custodian to
make and keep adequate records?
Would that provision facilitate
compliance with the contractual
provision requiring that the qualified
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custodian provide records to the
Commission or independent public
accountant? Would this requirement
provide additional protections for
clients where the adviser has custody
and further the policy goals of the rule?
113. Are there other risks that the rule
should require the written agreement to
address? For example, should the rule
require that the written agreement
expressly address the transfer of
custodial assets in the event of the
custodian’s bankruptcy or insolvency?
Should the written agreement be
required to state, or should the adviser
be required to obtain reasonable
assurances, that the intent of parties is
to enter into a custodial relationship,
and under no circumstances should the
relationship be considered a debtorcreditor relationship?
114. Investment companies registered
under the Investment Company Act
(‘‘RICs’’) are subject to a comprehensive
regime for the custody of their assets
under the Investment Company Act and
Commission rules thereunder, with
specific requirements that vary based on
the type of custodian. Should we
continue to except accounts of RICs
under proposed rule 223–1 in light of
this regime for RICs? Should we apply
any of the provisions of proposed rule
223–1 to RIC custodial arrangements,
particularly the proposed contractual
provisions for the qualified custodian
agreement? Should the required
contractual provisions depend on the
type of custodian involved? For
example, should RICs be required to
include some or all of the proposed
contractual provisions in agreements
with bank custodians because the
Commission has not adopted a rule
related to bank custodians specifically?
115. Does the custody rule contain
any safeguards that the safeguarding
rule retains that are not necessary and
which we should not require?
C. Certain Assets That Are Unable To Be
Maintained With a Qualified Custodian
We believe that the bulk of advisory
client assets are able to be maintained
by qualified custodians; however, we
understand that is not universally the
case, particularly for two types of assets:
certain physical assets and certain
privately offered securities.
It is not uncommon for physical
assets, such as precious metals, physical
commodities, and real estate, to be held
in client portfolios, and thus there are
likely circumstances in which advisers
would have custody of these physical
assets as a result of the expanded scope
of the safeguarding rule. We understand
that these assets are sometimes unable
to be maintained by qualified
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custodians, and that some qualified
custodians may refuse to custody such
assets, in part, because the inherent
physical characteristics of the items
increase the expenses associated with
their maintenance and safekeeping.
Some of these assets by their very nature
or size may not easily be subject to theft
or loss, and that may reduce the need
for the safeguarding protections offered
by a qualified custodian, but when an
adviser has an ability or authority to
change beneficial ownership of these
assets, there is still a risk of misuse,
misappropriation, or loss associated
with the adviser’s insolvency or
bankruptcy.
Similarly, it is increasingly common
for advisory clients to have privately
offered securities in their portfolio.213
We understand that advisers with
trading authority of privately offered
securities that do not settle DVP often
have custody of these securities because
of the broad, general power of attorneylike authority required to trade these
securities.214 There are certain
impediments to transferability typically
associated with certain privately offered
securities—specifically, the need to
obtain the consent of the issuer or other
securities holders prior to any transfer
of ownership—that make certain of
these assets less susceptible to some of
the risks the rule is designed to address.
In particular, they would be less likely
to be stolen by a third party or simply
lost. These characteristics reduce the
need for the safeguarding protections
offered by a qualified custodian. These
characteristics, however, do little, if
anything, to protect a client against
misuse, misappropriation, or losses that
213 See, e.g., Form ADV data current as of [Nov.
30, 2021] (showing that there are currently 5,037
registered private fund advisers with over $18
trillion in private fund assets under management);
See also, Vanguard, The role of private equity in
strategic portfolios (Oct. 2020), available at https://
corporate.vanguard.com/content/dam/corp/
research/pdf/Role-of-private-equity-in-strategicportfolios-US-ISGRPE_102020_US_F_online.pdf
(‘‘[T]he asset size of the private equity market has
been gradually growing on an absolute basis and
relative to the public equity market over the last 20
years. Private equity has risen from 2% to 7% of
total investable global equity assets.’’); see also
Scott Bauguess et al., Capital Raising in the U.S.:
An Analysis of the Market for Unregistered
Securities Offerings, 2009- 2017 (2018), available at
https://www.sec.gov/files/dera-white-paper_
regulation-d_082018.pdf (noting that an analysis of
issuer self-reported data through electronic Form D
filings indicates that the number of unregistered
offerings and corresponding amounts raised have
been increasing over the years 2009–2017); Concept
Release on Harmonization of Securities Offering
Exemptions, Release No. 33–10649 (June 18, 2019)
[84 FR 30460 (June 26, 2019)], at n.37 (stating that
the amounts raised in exempt markets have
increased both absolutely and relative to public
markets).
214 See supra footnote 71 and accompanying text.
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may result from the adviser’s insolvency
or bankruptcy.
We understand that the current
market for custodial services of
privately offered securities is fairly thin.
We also understand that, although some
custodians will custody these securities
by holding them in nominee form, many
do not custody them. We similarly
understand that demand for these
services may also be thin. Moreover, we
understand that many advisers with
custody of these assets do not seek to
maintain them with a qualified
custodian—at least in part—because the
custody rule contains the ‘‘privately
offered securities exception’’ 215 from
the qualified custodian requirement.
To qualify for the privately offered
securities exception today, the security
must meet the exception’s description of
‘‘privately offered securities.’’ This
definition includes securities acquired
from the issuer in a transaction or chain
of transactions not involving any public
offering; uncertificated, and ownership
thereof is recorded only on the books of
the issuer or its transfer agent in the
name of the client; and transferable only
with prior consent of the issuer or
holders of the outstanding securities of
the issuer. This custody rule exception
contains one additional condition: for
an adviser to a limited partnership or
similar pooled investment vehicle to
rely on this exception, the adviser must
also comply with the custody rule’s
audit provision. In adopting this
exception, the Commission had
expressed its concern that these
safeguards may be ineffective in the case
of limited partnerships (or other pooled
investment vehicles), noting that
because the private securities are held
in the name of the limited partnership
and the adviser acts for the partnership,
the adviser has apparent authority to
arrange transfers that would be
recognized by the issuer of the
securities.216
However, the Commission adopted
this exception in 2003, following
concerns raised by commenters that a
requirement to maintain certain
privately offered securities with
qualified custodians could pose
difficulties; particularly given that
ownership of such assets generally was
recorded only on the books of the issuer
(e.g., investments in limited
partnerships where clients receive only
a copy of the partnership agreement as
evidence of their investment or
assignment agreements for debt or
equity interests in a private
215 See
216 See
rule 206(4)–2(b)(2).
2003 Adopting Release, supra footnote 2.
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company).217 In support of its decision
to adopt the exception, the Commission
stated that some of the impediments to
transferability typically associated with
certain privately offered securities
provide some external safeguards
against the kinds of abuse the rule seeks
to prevent.218
When this exception was adopted, the
size of the privately held securities
market was much smaller than it is now
on an absolute basis as well as in
relation to the size of the publicly
traded securities market.219 In addition,
the type, nature, structure, and
prevalence of private issues have also
changed and expanded in recent years,
all of which have led the Commission
to reconsider the current rule’s
exception.220 We have become
concerned over the years since its
adoption that this exception may not
adequately protect an advisory client
217 See 2003 Adopting Release, supra footnote 2,
at section II.B. (‘‘Commenters [ ] pointed out that,
on occasion, a client may purchase privatelyoffered securities and that maintaining certain of
these assets in accounts with qualified custodians
poses difficulties because the client’s ownership of
the security is recorded only on the books of the
issuer.’’) (emphasis added).
218 Id. The 2003 Adopting Release identified a
specific and limited range of securities to which
commenters referred. See 2003 Adopting Release,
supra footnote 2, at n.26 (‘‘Commenters specifically
mentioned clients’ investments in limited
partnerships, where clients receive only a copy of
the partnership agreement as evidence of their
investment. Commenters also mentioned
assignment agreements for debt or equity interests
in a private company, or other types of customized
agreements.’’).
219 See Vanguard, The role of private equity in
strategic portfolios (Oct. 2020), available at https://
corporate.vanguard.com/content/dam/corp/
research/pdf/Role-of-private-equity-in-strategicportfolios-US-ISGRPE_102020_US_F_online.pdf
(‘‘[T]he asset size of the private equity market has
been gradually growing on an absolute basis and
relative to the public equity market over the last 20
years. Private equity has risen from 2% to 7% of
total investable global equity assets.’’); see also
Scott Bauguess et al., Capital Raising in the U.S.:
An Analysis of the Market for Unregistered
Securities Offerings, 2009- 2017 (2018), available at
https://www.sec.gov/files/dera-white-paper_
regulation-d_082018.pdf (noting that an analysis of
issuer self-reported data through electronic Form D
filings indicates that the number of unregistered
offerings and corresponding amounts raised have
been increasing over the years 2009–2017); Concept
Release on Harmonization of Securities Offering
Exemptions, Release No. 33–10649 (June 18, 2019)
[84 FR 30460 (June 26, 2019)], at n.37 (stating that
the amounts raised in exempt markets have
increased both absolutely and relative to public
markets).
220 For example, our staff has received several
questions over the years about whether certain
securities would still qualify for the exception if the
securities were not acquired from the issuer but
were transferred, for instance, in a subsequent
private offering, from one owner to the next. Our
staff has also responded to other questions
concerning the application of the exception. See,
e.g., 2013 IM Guidance, supra footnote 17
(providing staff views regarding security evidenced
by a private stock certificate).
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from the broad types of risks the
custody rule is intended to address:
chiefly, misappropriation.221
When an asset cannot be maintained
with a qualified custodian, a client may
not have a full understanding of its
holdings or receive periodic account
statements reflecting transactions in
those assets. This reduces the likelihood
that a client will be able to identify
suspicious activity in its account or
notice that its assets are gone. Moreover,
these assets may not be included in the
sample of assets subject to verification
procedures during a surprise
examination or meet the materiality
threshold for verification during a
financial statement audit. As a result, a
loss could similarly go undetected by an
independent public accountant for a
substantial period.
Ideally, a robust market for custodial
services would develop for physical
assets and privately offered securities.
Absent such a development and the
exception, however, advisers would be
faced with the inability to comply with
a Commission requirement or a need to
transition to providing nondiscretionary
advice or take certain other actions in
221 See 2009 Adopting Release, supra footnote 11,
at section II.B.3 (noting the difficulty for advisory
clients to verify that assets actually exist because
ownership is recorded only on the issuers’ books).
In the 2009 Adopting Release, the Commission
expanded the protections of the surprise
examination to privately offered securities. See id.
The growth of the privately offered securities
market since our 2009 amendments to the custody
rule has increased our concerns regarding the risks
we identified in the 2009 Adopting Release to these
client assets. We have also taken into account
concerns expressed by others. See, e.g., Dodd Frank
Regulating Hedge Funds and other Private
Investment Pools Testimony of James S. Chanos,
supra footnote 14, at 50 (‘‘These instruments are
privately issued uncertificated securities, bank
deposits, real estate assets, swaps, and interests in
other private investment funds, as well as shares of
mutual funds, which, under current law, can
simply be titled in the name of the private
investment fund care of the manager, and the
evidence of ownership held in a file drawer at the
manager of the private investment fund. The issuers
of those assets are permitted to accept instructions
from the manager to transfer cash or other value to
the manager. This gaping hole in current Advisers
Act custody requirements can allow SEC-registered
advisers easily to abscond with money or other
assets and falsify documentation of ownership of
certain categories of assets, and makes it difficult
for auditors, investors and counterparties to verify
the financial condition of advisory accounts and
private investment funds. Requiring independence
between the function of managing a private
investment fund and controlling its assets, by
requiring that all assets be titled in the name of a
custodian bank or broker-dealer for the benefit of
the private fund and requiring all cash flows to
move through the independent custodian, would be
an important control. Similarly, requiring an
independent check on the records of ownership of
the interests in the private investment fund, as well
as imposing standards for the qualification of
private investment fund auditors—neither of which
currently is required by the Advisers Act—would
also greatly reduce opportunities for mischief.’’).
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order to avoid a violation of
Commission rules, which could be
disruptive or result in client harm. We
are therefore proposing to reform the
privately offered securities exception to
address our concerns about the lack of
protections and transparency that could
result when privately offered securities
and physical assets cannot be
maintained by a qualified custodian and
to reduce the likelihood that a loss of
these assets could be undetected for an
indeterminate amount of time. The
safeguarding rule would provide an
exception to the requirement to
maintain client assets with a qualified
custodian where an adviser has custody
of privately offered securities or
physical assets, provided it meets the
following conditions: 222
• The adviser reasonably determines
and documents in writing ownership
cannot be recorded and maintained
(book-entry, digital, or otherwise) in a
manner in which a qualified custodian
can maintain possession, or control
transfers of beneficial ownership, of
such assets;
• The adviser reasonably safeguards
the assets from loss, theft, misuse,
misappropriation, or the adviser’s
financial reverses, including the
adviser’s insolvency;
• An independent public accountant,
pursuant to a written agreement
between the adviser and the accountant,
Æ Verifies any purchase, sale, or other
transfer of beneficial ownership of such
assets promptly upon receiving notice
from the adviser of any purchase, sale,
or other transfer of beneficial ownership
of such assets; and
Æ Notifies the Commission within
one business day upon finding any
material discrepancies during the course
of performing its procedures;
• The adviser notifies the
independent public accountant engaged
to perform the verification of any
purchase, sale, or other transfer of
beneficial ownership of such assets
within one business day; and
• The existence and ownership of
each of the client’s privately offered
securities or physical assets that is not
maintained with a qualified custodian
are verified during the annual surprise
examination or as part of a financial
statement audit.
1. Definition of Privately Offered
Security and Physical Assets
The proposed rule’s definition of
privately offered securities would retain
the elements from the custody rule’s
description that require the securities to
be acquired from the issuer in a
222 See
proposed rule 223–1(b)(2).
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transaction or chain of transactions not
involving any public offering, and
transferable only with prior consent of
the issuer or holders of other
outstanding securities of the issuer.223
Like the custody rule, the safeguarding
rule would also require the securities to
be uncertificated and would require
ownership to be recorded only on the
books of the issuer or its transfer agent
in the name of the client. However, the
safeguarding rule would also require
that the securities be capable of only
being recorded on the non-public books
of the issuer or its transfer agent in the
name of the client as it appears in the
records the adviser is required to keep
under Rule 204–2. This definitional
requirement would enhance the
assurance of the existence of the client
asset provided by the verification
required by proposed 223–1(b)(2)(iii)(A)
and will make the verification process
more efficient. The term
‘‘uncertificated’’ would generally have
the same meaning as set forth in article
8 of the Uniform Commercial Code.224
Additionally, we would not view a
security to be certificated where the
certificate cannot be used to redeem,
transfer, purchase, or otherwise effect a
change in beneficial ownership of the
security for which the certificate is
issued.225 We understand that
transactions and ownership involving
crypto asset securities on public,
permissionless blockchains are
generally evidenced through public keys
or wallet addresses.226 As proposed, in
order for a security to be a privately
offered security under the proposed
safeguarding rule, among other
conditions, it must be uncertificated,
and the ownership can only be recorded
on the non-public books of the issuer or
its transfer agent in the name of the
client as it appears in the adviser’s
required records. As a result, we believe
that such crypto asset securities issued
on public, permissionless blockchains
223 Rule 206(4)–2(b)(2)(i). ‘‘Privately offered
securities’’ are defined by rule 206(4)–2(b)(2) as
securities that are (1) acquired from the issuer in a
transaction or chain of transactions not involving
any public offering, (2) uncertificated, and
ownership thereof is recorded only on the books of
the issuer or its transfer agent in the name of the
client, and (3) transferable only with prior consent
of the issuer or holders of the outstanding securities
of the issuer. See also proposed rule 223–1(d)(9).
224 See UCC Sec. 8–102(a)(18) (‘‘ ‘Uncertificated
security’ means a security that is not represented by
a certificate.’’).
225 Our staff took a similar view. See 2013 IM
Guidance, supra footnote 17.
226 See generally, PwC, Demystifying
cryptocurrency and digital assets (accessed Dec. 5,
2022), available at https://www.pwc.com/us/en/
tech-effect/emerging-tech/understandingcryptocurrency-digital-assets.html (describing
storage, ownership, and transactions, of crypto
assets).
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would not satisfy the conditions of
privately offered securities under the
proposed safeguarding rule.227
We are not providing a definition of
the term ‘‘physical asset’’ or including
specific types of assets in the proposed
rule. Rather, we believe that the plain
language of the phrase, along with a
principles-based facts and
circumstances approach that requires an
adviser to look to the characteristics and
nature of a particular physical asset is
more appropriate. We believe that what
constitutes a ‘‘physical asset’’ is often
self-evident, particularly when
compared to other assets that are
certificated, maintained digitally, or in
book-entry form. For example, real
estate and physical commodities 228
such as, corn, oil, and lumber are
physical assets, while assets like cash,
stocks, bonds, options, futures and
funds are not, even if they provide
exposure to physical assets. Physical
evidence of ownership of non-physical
assets that can be used to transfer
beneficial ownership, like stock
certificates, private keys, and bearer or
registered instruments do not,
themselves, qualify as physical assets
and would not qualify for the exception
from the qualified custodian
requirement. Similarly, certain physical
evidence of physical assets such as a
warehouse receipt for certain
commodities would not qualify for the
exception if they can be used to transfer
beneficial ownership even though the
commodities documented by the
warehouse receipt may qualify for the
exception. Or in the real estate context,
a deed or similar indicia of ownership
that could be used to transfer beneficial
ownership of a property would not
qualify for the exception, but the
physical buildings or land would
qualify.
2. Adviser’s Reasonable Determination
In order to be eligible for the
exception, the rule would require an
adviser to determine, and document in
writing, that ownership cannot be
recorded and maintained (book-entry,
digital, or otherwise) in a manner in
which a qualified custodian can
227 Crypto assets that are not crypto asset
securities would not qualify for the exception
because they do not satisfy the definition of
privately offered security under proposed 223–
1(d)(9).
228 See, e.g., International Organization of
Securities Commissions, Principles for the
Regulation and Supervision of Commodity
Derivatives Markets—Consultation Report at 82
(Nov. 2021), available at https://www.iosco.org/
library/pubdocs/pdf/IOSCOPD689.pdf (defining
physical commodity as ‘‘[a] tangible product or raw
material, as opposed to an instrument which
references a physical commodity.’’).
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maintain possession or control of such
assets. Such a determination necessarily
depends on the facts and circumstances
in issue. Moreover, these determinations
would necessarily evolve over time as
assets and the custodial industry
change, allowing the proposed rule to
remain evergreen.
An adviser’s reasonable determination
of whether a qualified custodian is able
to maintain possession or control of a
particular asset would generally involve
an analysis of the asset and the available
custodial market. An adviser’s
reasonable determination generally
would not require the identification of
every conceivable qualified custodian
and an evaluation of its custodial
services. Fundamentally, to determine
whether an asset can or cannot be
maintained by a qualified custodian
under the proposed rule, an adviser
generally should obtain a reasonable
understanding of the marketplace of
custody services available for each
client asset for which it has custody.
The adviser’s written documentation of
its determination would generally
contain material facts concerning its
understanding of the custodial
marketplace and a description of the
client asset in issue.
The proposed rule does not specify
the frequency with which an adviser
must make this determination. What
frequency would be reasonable for any
determination would depend on the
particular assets and the facts and
circumstances. For example, an adviser
might develop policies and procedures
for conducting this analysis, and those
policies and procedures might
reasonably call for an annual assessment
of one type of asset for which there have
been no indicators of a developing
custodial market. On the other hand, it
would likely be unreasonable for an
adviser to annually assess the custodial
market for an asset for which
developing custodial services are well
publicized as imminent.
As discussed above, we believe that
many privately offered securities are not
currently maintained by qualified
custodians. However, we understand
that a substantial portion of securities—
privately and publicly held—are
uncertificated (i.e., paper stock
certificates are largely a relic from a
prior era, replaced by more modern
methods of recording ownership).229
229 See Paech, Philipp, Securities, Intermediation
and the Blockchain: An Inevitable Choice Between
Liquidity and Legal Certainty? 21(4) Unif. L. Rev.
612 (Dec. 1, 2016) (‘‘The practice of securities
holding, transfer, and collateral has changed
significantly over the past 200 years-moving from
paper certificates and issuer registers, to an
intermediated environment, and from there to
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Particularly as a result of the growth of
uncertificated publicly traded securities,
we understand that custodians have
refined safeguarding and reporting
practices with respect to uncertificated
securities. Therefore, we believe that
this experience has made it increasingly
possible for qualified custodians to
provide custody services for privately
offered securities. Accordingly, while
today it may be reasonable under
appropriate circumstances for an
adviser to determine that a qualified
custodian cannot maintain possession
or control of a particular privately
offered security, we believe that
determination may be more difficult to
support as the custodial industry
continues to evolve.
Whether an adviser can make the
reasonable determination regarding a
particular physical asset necessarily
depends on the asset type and the
availability of custody services. For
example, an adviser could likely
conclude that qualified custodian
services are unavailable for unharvested
wheat or a shopping center. Similarly,
computerization and globalization.’’); Intermediated
Securities, supra footnote 143, at 386
(‘‘Immobilization and dematerialization of
securities have made the physical delivery of
certificates nearly irrelevant. In just a few decades,
the issuance of securities has shifted from the
physical to a virtual world, to which financial
intermediaries hold the key.’’); DTCC, From
Physical to Digital: Advancing the
Dematerialization of U.S. Securities (Sept. 2020),
available at https://www.dtcc.com/∼/media/Files/
PDFs/DTCC-Dematerialization-Whitepaper092020.pdf (‘‘the crushing mountain of paper of the
paperwork crisis in the 1960s and 1970s was
addressed by the two-pronged approach of
immobilization and dematerialization’’). While the
terminology is sometimes used interchangeably,
‘‘dematerialized securities’’ generally refer to
securities, sometimes certificated, that are
represented by entries in securities accounts
maintained by financial intermediaries for
investors, while ‘‘uncertificated securities’’ refer to
securities that are not represented by a certificate
but are registered on an issuer’s books. See
generally, Thevenoz, Intermediated Securities,
supra footnote 143 at 386 (‘‘Certificated securities
do not need to move if they are immobilized in the
custody of reliable depositories and represented by
entries in securities accounts maintained by
financial intermediaries for investors. When
needed, immobilized securities can be transferred
by way of book-entries in investors’ accounts,
which substitute for their physical delivery. Where
corporate law and investor preferences allow,
physical individual securities can become wholly
unnecessary. A whole issue can be replaced by one
global certificate, or it can even be recorded in an
‘issue account’ without the need for any certificate,
against which the dematerialized securities can be
credited to the securities accounts of market
participants and, here again, be transferred by way
of book-entries. Immobilization and
dematerialization of securities have made the
physical delivery of certificates nearly irrelevant. In
just a few decades, the issuance of securities has
shifted from the physical to a virtual world, to
which financial intermediaries hold the key.’’); and
see UCC section 8–102(18) (‘‘ ‘Uncertificated
security’ means a security that is not represented by
a certificate.’’).
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custody of certain tangible agricultural
commodities may be impossible to
insure at a qualified custodian.230 In
these circumstances, an adviser may
reasonably determine that ownership
cannot be recorded and maintained
(book-entry, digital, or otherwise) in a
manner in which a qualified custodian
can maintain possession or control of
such asset. Conversely, it is likely that
a qualified custodian can hold gold
bullion,231 and it would therefore be
difficult for an adviser to make the
determination required to invoke the
proposed exception.
3. Adviser Reasonably Safeguards
Assets
To rely on the exception, the adviser
would be required to reasonably
safeguard any privately offered
securities or physical assets that are not
maintained with a qualified custodian
from loss, theft, misuse,
misappropriation, or the adviser’s
financial reverses, including the
adviser’s insolvency. While the specific
procedures implemented to safeguard
assets may vary depending on the asset,
advisers must satisfy their fiduciary
duty in safeguarding any particular
asset.232
With respect to privately offered
securities, an adviser might ‘‘reasonably
safeguard’’ an asset by looking to
reasonable commercial standards,
which we understand presently may
draw from a variety of protections such
as enhanced recordkeeping, additional
change of control terms in governance
agreements, designation of an agent
required to be involved in transfers of
beneficial ownership, among others. For
230 Though such physical assets may be unable to
be held with a qualified custodian as defined under
the proposed rule, we understand that agricultural
commodities and other physical commodities do
have certain non-qualified custodians, exchangeapproved warehouses or clearing houses that
provide substantial record keeping and
safeguarding protections for such assets. These
often include secure storage facilities, internal
control procedures, and relevant insurance
coverages.
231 It is our understanding that banks are able to
custody gold bullion and other precious metals, but
that other non-bank custodians provide secure
storage and transportation services for gold bullion
and other precious metals, including vault custody
and related transportation services. See, e.g., The
Brinks Company, SEC Staff No-Action Letter (Feb.
3, 2014). We also understand that, from time to
time, bank custodians or others may exit the
precious metals custody business, but that other
custodians may become available to perform those
custody services. See, e.g., Depository Trust
Company of Delaware, LLC, SEC Staff No-Action
Letter (Sept. 12, 2016).
232 The principles-based requirement to
reasonably safeguard a client’s physical assets is
drawn from an adviser’s fiduciary duty including
its duty of care or duty of loyalty under the
Advisers Act, which extends to the entirety of the
adviser-client relationship. See supra footnote 57.
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example, one critical safeguard that
advisers should consider is the types of
internal controls that they can
implement to reasonably safeguard
clients’ privately offered securities. If
possible, an adviser may consider
separating duties of the person
responsible for recording investments in
privately offered securities from the
person responsible for authorizing the
buying and selling of privately offered
securities from the person responsible
for holding certificates or other legal
records evidencing ownership of
privately offered securities.233 An
adviser may also consider implementing
procedures to regularly review and
reconcile the following documents to
the adviser’s records: legal documents
demonstrating evidence of ownership of
privately offered securities, including
any changes year over year; board
meeting minutes, if available, for any
activity that may evidence a change in
a client’s ownership of privately offered
securities; and records of share
ownership maintained by the issuer or
its transfer agent in the name of the
client. An adviser may also consider
periodically reviewing and
documenting that the privately offered
securities are transferable only with the
prior consent of the issuer or its
shareholders. Importantly, the rule
recognizes that the privately offered
securities vary, as do the relationships
between an adviser and its advisory
clients, and the rule retains the
flexibility necessary for advisers to
make reasonable determinations
concerning the safeguarding of those
privately offered securities that are
unable to be maintained with a qualified
custodian.
With respect to physical assets, an
adviser might ‘‘reasonably safeguard’’
such assets by looking to reasonable
commercial standards, which may
include storage in a secure facility or
vault that adheres to exchange, clearing
house, or other licensing requirements
for participation in certain commodities
markets; dual control procedures for
access to assets in safekeeping;
maintenance of records to evidence
movement or transfer of assets
(including details on depositor,
beneficiary and/or the legal owner);
periodic reconciliation of records with
assets held (e.g., vault counts);
separation of duties for movement or
transfer of assets, recordkeeping and
reconciliation; periodic audits; smoke
detection and fire suppression systems;
and insurance coverage for any custody233 We recognize in some smaller organizations it
may be more challenging to separate these
functions.
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related losses incurred by its clients.
Advisers may need to tailor their
standards for safeguarding to each
particular physical asset depending on
the relative common standards for its
market.234 For example, reasonable
commercial standards for safeguarding
and taking delivery of an agricultural
commodity like a bushel of wheat 235
necessarily would be different from the
appropriate maintenance gold
bullion 236 or of personal property like
jewelry, antiques, or art.237 We believe
this approach will give advisers the
flexibility to develop and implement
safeguarding practices with respect to
assets not maintained with a qualified
custodian that are appropriately
tailored, while helping to ensure client
assets receive appropriate protections.
When an adviser has custody of client
physical assets that are not maintained
with a qualified custodian, the ultimate
obligation to safeguard those assets falls
to the adviser. In some circumstances,
an adviser might conclude that it could
safeguard the asset itself, provided it
can do so in accordance with reasonable
commercial standards. In other
circumstances, the adviser could instead
determine that it could permissibly
maintain physical assets with a third
party that the adviser concludes could
234 See, e.g., The Board of the International
Organization of Securities Commissions,
Commodity Storage and Delivery Infrastructures:
Good or Sound Practices (Feb. 2019), available at
https://www.iosco.org/library/pubdocs/pdf/
IOSCOPD622.pdf (encouraging the adoption of
‘‘Good or Sound Practices’’ in member jurisdictions,
but noting that ‘‘[n]ot all of the Practices described
may be relevant to all market participants. It is for
market participants to determine the applicability
of any particular Practice and to apply it as their
circumstances require.’’).
235 For example, in the agricultural context,
clearing members and delivery facilities are subject
to the various rules of the exchange or clearing
house as well as inspection by the exchange and the
Department of Agriculture. See, Chapter 7, Delivery
Facilities and Procedures, Chicago Board of Trade
Rule Book (2022) available at: https://
www.cmegroup.com/rulebook/CBOT/.
236 See Global Previous Metals Code Global
Precious Metals Code available at https://
www.lbma.org.uk/market-standards/globalprecious-metals-code.
237 The OCC notes in its Handbook that
miscellaneous assets (e.g., jewelry, art, coins)
should be maintained in a vault consistent with
applicable law and sound custodial management.
Vault control procedures should ensure physical
security, dual control procedures, maintenance of
records evidencing access to the vault, proper asset
transfer ticketing, and periodic vault counts. See,
Custody Services, Comptrollers Handbook (Jan.
2002) available here: https://www.occ.treas.gov/
publications-and-resources/publications/
comptrollers-handbook/files/custody-services/pubch-custody-services.pdf (‘‘OCC Custody
Handbook’’). See also Inland Marine Underwriters
Association, Evaluating the Risk in the Storage and
Shipping of Fine Art: Insights into the Art Service
Industry at https://www.imua.org/Files/reports/
2019reports/EvaluatingRiskinStorageand
ShippingofFineArtsUpdateFinal1_4_2019.pdf.
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safeguard the assets in accordance with
reasonable commercial standards. The
proposed rule does not require a
particular approach.
More broadly, an adviser might
demonstrate that it is reasonably
safeguarding a client asset itself or
through a third party, by adopting,
implementing, and regularly reassessing
policies and procedures that include
robust due diligence and ongoing
oversight designed to ensure the adviser
has assessed and evaluated the
safeguarding measures put in place by
itself or the third party maintaining
physical assets. Such policies and
procedures might include procedures to
assess whether the person maintaining
the client asset has exercised and is
likely to continue to be able to exercise
due care in accordance with reasonable
commercial standards in safeguarding
the asset.
4. Notification and Prompt Independent
Public Accountant Verification
The exception to the requirement to
maintain assets with a qualified
custodian would also require an adviser
to enter into a written agreement with
an independent public accountant.238
The proposed rule would require the
adviser to notify the independent public
accountant of any purchase, sale, or
other transfer of beneficial ownership of
such assets within one business day.239
The written agreement would require
the independent public accountant to
verify the purchase, sale, or other
transfer promptly upon receiving the
required transfer notice.240 The written
agreement would also require the
accountant to notify the Commission by
electronic means directed to the
Division of Examinations within one
business day upon finding any material
discrepancies during the course of
performing its procedures.241 We
believe that these requirements would
provide advisory clients meaningful and
much-needed protection when their
advisers have custody of assets that are
not maintained with a qualified
custodian.
It has been our longstanding view that
the involvement of independent public
accountants in the review and
verification of client assets of which
advisers have custody is an important
safeguarding tool and reduces the risk of
loss of client assets.242 Consistent with
238 See
proposed rule 223–1(b)(2)(iii).
proposed rule 223–1(b)(2)(iv).
240 See proposed rule 223–1(b)(2)(iii)(A).
241 See proposed rule 223–1(b)(2)(iii)(B).
242 See, e.g., Adoption of Rule 206(4)–2 under the
Investment Advisers Act of 1940, IA Release No.
123 (Feb. 27, 1962) [27 FR 2149 (Mar. 6, 1962)]
(requiring advisers with custody of client securities
239 See
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that view, we believe that an
independent public accountant’s
involvement in the verification and
notification requirements in the
proposed rule enhances the reliability
and integrity of the verification and
would help identify problems that
clients may not, and thus would provide
deterrence against fraudulent conduct
by advisers.
We believe that the timing
requirement for the notice—that the
adviser would be required to provide
notice to an independent public
accountant within one business day of
a transfer of beneficial ownership—is
important to inform an independent
public accountant as soon as practicable
of a transfer of beneficial ownership of
client assets that are not held with a
qualified custodian. This timing will
build a record for the accountant to
review in connection with an annual
surprise examination or financial
statement audit and, therefore, would
reduce the likelihood of loss or
misappropriation of client assets.
Moreover, we anticipate the timing of
these requirements in close proximity to
the timing of a transaction, coupled
with the annual confirmation during a
surprise examination or financial
statement audit, would also reduce the
likelihood that any loss would go
undetected for an extensive time.
Further, we believe that this notice
would not be challenging for any
adviser to provide to the independent
public accountant, especially
considering the limited nature of the
requirement relative to the more
involved aspects of many of the closings
related to privately offered securities or
physical assets such as the preparation
or review of closing memos,
confirmation of receipt of funds,
execution of signature pages, and many
other more time-consuming tasks
related to closings for these types of
assets.
Based on our experience with the
audit provision in the current rule,243
we understand that independent public
accountants are familiar with a wide
variety of transaction verification and
tracing transaction activity as this is a
normal audit procedure. We recognize,
however, that the verification and
or funds to engage an independent public
accountant to conduct an annual surprise
examination); 2009 Adopting Release, supra
footnote 11, at section II.B.1. (‘‘Because advisers
with custody often have authority to access, obtain
and, potentially, misuse client funds or securities,
we believed the additional review provided by an
independent public accountant would help identify
problems that clients may not, and thus would
provide deterrence against fraudulent conduct by
advisers.’’).
243 Rule 206(4)–2(a)(4) and 206(4)–2(b)(4).
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transaction tracing process of any
purchase, sale, or other transfer of
beneficial ownership of the assets
would necessarily vary depending on
the type of asset. For example, for a
privately offered security purchased or
sold by an advisory client, the
independent public accountant could
contact the issuer of the security or its
agent to verify the existence of the asset
and relevant information concerning the
transfer of beneficial ownership of the
client asset. The independent public
accountant may also take a wide array
of additional steps depending on the
nature of the security—and the
transaction—along with other relevant
facts and circumstances. For example,
the independent public accountant may
review a private placement
memorandum, the issuer’s Regulation D
filings,244 or take other steps to assist in
verifying the existence and transfers of
beneficial ownership of the asset.
For a physical asset purchased or sold
by an advisory client, such as a
commercial shopping center, the
independent public accountant may
confirm the existence of the asset
through a variety of reliable means. To
confirm the transfer of beneficial
ownership of the asset, the independent
public accountant may review deeds or
other land recordation materials, or seek
to obtain other reliable information
concerning the transfer of the asset. The
independent public accountant may use
similar methodologies in connection
with the verification of the existence,
and purchase or sale, of physical
commodities. For example, an
independent public accountant may
seek to confirm existence and the
relevant transfers of beneficial
ownership of grain by reviewing a
warehouse receipt for the assets held in
a grain elevator.
The written agreement required by the
proposed rule would require the
accountant to notify the Commission
within one business day upon finding
any material discrepancies during the
course of its examination.245 This
requirement is effectively identical to
the notification requirement for material
discrepancies found during a surprise
examination under the custody rule 246
and would require an effectively
identical decision-making process by
the independent public accountant: the
independent public accountant may
first take reasonable steps to establish
the basis for believing a material
244 See Form D, Notice of Exempt Offering of
Securities, available at https://www.sec.gov/files/
formd.pdf.
245 See proposed rule 223–1(b)(2)(iii).
246 See rule 206(4)–2(a)(4)(ii).
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discrepancy exists. The obligation to
notify the Commission arises once the
accountant has a basis for believing
there is a material discrepancy.
Ordinarily, an accountant should be
able to determine promptly whether it
has a basis for believing there is a
material discrepancy.247 The reporting
by the independent public accountant of
a material discrepancy would provide
the staff with timely notice of a
potential issue with the adviser’s
custodial practices, providing the staff
with an earlier opportunity to examine
an adviser or take other action against
an adviser, as appropriate, in an effort
to help safeguard client assets. This
proposed requirement also bears
similarities to the proposed notification
requirement for an audit under the
proposed safeguarding rule.248
5. Surprise Examination or Audit
Like the custody rule, the
safeguarding rule would require
advisers relying on the exception to
undergo an annual surprise examination
or rely on the audit provision.249 In a
change from the custody rule, however,
the proposed rule would require each
privately offered security or physical
asset not maintained with a qualified
custodian to be verified.250 This change
from the custody rule is designed to
address our concerns that a loss of these
assets could go undetected for an
extended period of time as a result of a
not being included within the
accountant’s sample to be tested during
a surprise examination or verified
during an audit if they do not meet the
threshold for materiality. Moreover, this
proposed requirement would
supplement the proposed requirement
to verify transactions promptly after
they occur, operating similarly to an
annual ‘‘bring down.’’ This would help
ensure the client has some comfort
regarding the status and ultimate
disposition of these assets over time
despite the lack of ability to monitor
quarterly custodial statements. We
247 See 2003 Adopting Release, supra footnote 2,
at note 34; 2009 Proposing Release, supra footnote
11, at note 10.
248 See infra, section II.F.
249 See rule 206(4)–2(a)(4); 2009 Adopting
Release, supra footnote 11, at section II.B.3.
(‘‘Because clients are more dependent on the
adviser with respect to the safeguarding of these
securities, advisory clients may be exposed to
additional risks when their advisers acquire these
securities on their behalf. To mitigate these risks
and to provide assurance that privately offered
securities are properly safeguarded, we believe that
it is appropriate to require an independent thirdparty to verify client ownership with the issuers of
the securities by requiring that these securities be
subject to the surprise examination requirement
under the amended rule.’’).
250 See proposed rule 223–1(b)(2)(v).
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recognize that this proposed
requirement likely constitutes a
departure from current practice for most
surprise examinations and audits, but
believe that the protective benefits of
the surprise examination and annual
audit are critical to the safeguarding of
client assets, especially where these
assets do not have the additional
protections afforded by the oversight of
a qualified custodian.
We request comment on all aspects of
the proposed exception, including the
following:
116. Should the rule retain the
privately offered securities exception of
the custody rule without any
modifications?
117. Do commenters agree with our
understanding that, today, the
overwhelming majority of securities are
uncertificated, that the volume of
privately offered securities has vastly
expanded since 2003, and that
custodians have developed safeguarding
and reporting practices, particularly
with respect to publicly-traded
securities? Are we correct that the
custodial market for privately issued
securities is less developed? Do
commenters also agree that some
custodians will presently custody
privately issued securities and that new
custodial services are being developed?
118. Should the rule eliminate the
current rule’s privately offered
securities exception to the requirement
to maintain securities with a qualified
custodian, as proposed? Rather than
eliminating the custody rule exception
and creating the new safeguarding rule
exception for privately offered securities
and physical assets, should the custody
rule exception be retained, but modified
in a different way? For example, should
it be made available solely to advisers
whose clients’ financial statements are
audited and distributed to investors in
accordance with the requirements of
this rule? If so, what standard of
independence should an auditor be
required to satisfy?
119. Are we correct in our belief that
the privately offered securities
exception may not adequately protect an
advisory client from the broad types of
risks the rule is intended to address? If
not, in what ways does the exception
provide adequate protections? Are there
alternatives to eliminating the exception
and creating the new exception as
proposed that would better serve the
proposed rule’s policy goals?
120. Is our understanding correct that
advisers with trading authority of
privately offered securities that do not
settle DVP often have custody of these
securities because of the broad general
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power of attorney-like authority
required to trade these securities?
121. Are qualified custodians able to
provide custody services for privately
offered securities? If so, what services?
Would maintaining these securities with
qualified custodians be practically
challenging and/or costly? If so, what
are the challenges or cost constraints?
122. Do commenters agree that the
custody rule exception’s restrictions on
transferability of privately offered
securities do not provide comparable
protections to those provided under the
proposed rule? If commenters disagree,
how do these restrictions protect against
misappropriation by the adviser or theft
by a third party? Do issuers and other
holders of outstanding securities
evaluate whether a transaction in the
securities would result in
misappropriation by the adviser or theft
by a third party? Do they have an
incentive to evaluate a transaction for
misappropriation or any of the other
policy goals of the rule?
123. We are proposing to retain the
mutual fund shares exception because,
in our experience, this exception has
not raised similar types of investor
protection concerns that we are seeking
to address in this proposal.251 Do
commenters believe that the mutual
fund shares exception raises investor
protection risks? Should we eliminate
the exception for mutual fund shares?
To what extent do advisory clients
purchase mutual fund shares through
qualified custodians such as brokerdealers such that the exception may not
be necessary?
124. Our understanding is that certain
assets cannot be maintained with a
qualified custodian, but that the bulk of
client assets that advisers service are
able to be held by a qualified custodian.
Do commenters agree with this
understanding? What are some
examples of assets that cannot be held
by a qualified custodian? If an asset
cannot be maintained with a qualified
custodian, should an adviser be
permitted to have custody of the asset,
as that term is defined in the proposed
rule? Should advisers, instead, be
required to relinquish the authority that
triggers the application of the definition
of custody in the context of the asset
that is unable to be maintained with a
qualified custodian? Alternatively,
should they be required to provide
alternative safeguards for the asset, such
as those proposed?
125. Are there currently assets that
qualified custodians will maintain, but
doing so would be cost-prohibitive for
advisers or their clients? If so, what are
some examples of these assets? At what
point does it become cost-prohibitive? Is
it measured based on a percentage of the
value of the asset? Is it based on a
percentage of the adviser’s fee for
providing advisory services with respect
to that asset? Is it the point at which it
becomes unprofitable for the adviser to
provide advice to the client?
126. Should the proposed rule permit
an adviser to conclude that an asset is
eligible for the exception if it would be
prohibitively expensive to custody the
asset with a qualified custodian? What
would be considered prohibitively
expensive?
127. Is the proposed definition of
privately offered securities clear?
Should it include any additional
factors? Should any of the proposed
factors be removed? For example, is the
description of the meaning of
uncertificated clear? Should it be
revised? Are there securities that qualify
for the custody rule’s description of this
term that would be unable to rely on the
proposed exception as a result of the
differences of the proposed definition?
Please explain.
128. Do commenters agree with our
belief that ownership of crypto asset
securities that is evidenced through
public keys or wallet addresses on
public blockchains would not qualify
for the proposed privately offered
securities exception? If not, why? Could
the rationale for the privately offered
securities exception—namely, that
impediments to transferability present
with certain privately offered securities
mitigate some of the risks and provide
some external safeguards against the
kinds of abuse the rule seeks to prevent
(loss and third-party theft) when those
assets cannot be maintained by a
qualified custodian—also apply to the
custody of crypto asset securities, the
ownership of which is evidenced
through public keys or wallet addresses
on public, permissionless
blockchains? 252 If so, how do the
protections work? How do they mitigate
some or all of the risks the rule is
designed to address—loss, theft,
misappropriation, misuse, and adviser
insolvency or bankruptcy?
129. Should we provide a more
prescriptive definition of physical asset?
Do commenters believe that there are
certain physical assets that are unable to
be maintained with a qualified
custodian? If so, do commenters believe
that those assets will remain static as
the custody industry evolves?
251 See rule 206(4)–2(b)(1) and proposed rule
223–1(b)(1).
252 See 2003 Adopting Release, supra footnote 2
at nn. 26–28 and accompanying text.
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130. Is the term ‘‘physical assets’’
sufficiently clear such that advisers will
be able to understand its application
and appropriately utilize the exception?
Should we define the term ‘‘physical
assets’’ or use another term for this
exception, such as ‘‘tangible assets’’? If
so, should such a definition include or
exclude specific asset types? What
assets are commonly considered to be
physical assets that are unable to be
held at a qualified custodian?
131. Should the proposed rule
provide flexibility for advisers to make
a reasonable determination that a
privately offered security or physical
asset is eligible for the exception? Are
there concerns that providing advisers
with the ability to make a reasonable
determination as to whether a privately
offered security or physical asset is
eligible for the exception will allow
some advisers to avoid using qualified
custodians to protect client assets?
Should the Commission take a different
approach instead?
132. Should we limit the exception to
privately offered securities and physical
assets as proposed? Should we expand
the scope of the exception to other types
of assets? If we expanded the scope,
which types of assets should we include
and why? Specifically, are there
impediments to transferability present
with other types of assets that mitigate
some of the risks and provide some
external safeguards against the kinds of
abuse the rule seeks to prevent (loss,
third-party theft, misuse,
misappropriation, adviser insolvency/
bankruptcy) when those assets cannot
be maintained by a qualified custodian?
Please explain your answer.
Alternatively, should we not create an
exception for privately offered securities
and physical assets?
133. Is our understanding correct that
the current market for custodial services
of privately offered securities is limited?
Is our understanding correct that
demand for these services is also
limited? Do commenters agree with our
understanding of the market for
custodial services for physical assets?
Please explain.
134. To be ‘‘reasonable,’’ how
frequently should advisers determine
whether a qualified custodian can
maintain possession or control of an
asset? Should the rule provide
flexibility as proposed? Should it
instead specify intervals, such as
monthly, quarterly, semi-annually, or
annually?
135. If we expanded the scope of the
exception beyond privately offered
securities and physical assets to other
assets that an adviser reasonably
determines cannot be held at a qualified
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custodian what requirements should we
put in place to ensure the assets are
properly safeguarded? Should such
measures include some or all of the
protections for qualified custodians that
we discuss in section II.3.C above?
136. Rule 206(4)–7 requires advisers
to adopt and implement policies and
procedures reasonably designed to
prevent violations of the Advisers Act
and its rules, which will include the
safeguarding rule. Should we,
nonetheless, prescribe specific written
policies and procedures to be adopted
and implemented for determining when
privately offered securities or physical
assets would be eligible for the
exception? For example, should any
such written policies and procedures be
designed to help ensure that any party
involved in maintaining client assets be
required to exercise due care in
accordance with reasonable commercial
standards to safeguard client assets?
Would this requirement improve
safeguarding of client assets not
maintained with a qualified custodian?
137. How do advisers currently
safeguard securities for which they rely
on the privately offered securities
exception under the custody rule? Do
these practices differ from what would
be required under the proposed rule?
Please explain. Should these practices
be prescribed under the final rule?
138. Should we define the term
‘‘reasonably safeguard’’ in the rule text?
Do commenters believe that reasonable
safeguards are generally within
reasonable commercial standards for
particular physical assets or privately
offered securities? Are advisers able to
ascertain what safeguards are within
such reasonable commercial standards
for particular physical assets or
privately offered securities they may
hold on behalf of clients?
139. How would an adviser document
that it is satisfying its fiduciary duty to
an advisory client when maintaining
client assets not with a qualified
custodian under the proposed
exception? How frequently would it be
required to provide this evidence?
140. Should we require a particular
standard of care? Should we require
particular safeguards or practices?
141. Should the rule require an
independent public accountant,
pursuant to a written agreement
between the adviser and the accountant,
to verify transfers of privately offered
securities or physical assets promptly
upon receiving notice from the adviser
of any purchase, sale, or other transfer
of beneficial ownership of such assets?
Would the requirement enhance the
safeguarding of client assets not
maintained with a qualified custodian
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and reduce the risk of loss or
misappropriation?
142. Is the proposed rule’s timing
requirement that the written agreement
require an independent public
accountant to ‘‘promptly’’ verify any
purchase, sale, or other transfer of
beneficial ownership of such assets
sufficiently clear? Is the meaning of the
term ‘‘promptly’’ in this context
sufficiently understood in practice? Is
additional guidance needed? In lieu of
the ‘‘promptly’’ requirement proposed,
should we require an independent
public account to verify any purchase,
sale, or other transfer of beneficial
ownership within a set number of days?
If so, how many days? For example,
within 24 hours of the transfer of
beneficial ownership? Within 24 hours
of receipt of notice from adviser? Within
two days of the transfer of beneficial
ownership or notice from the adviser?
Within one week of the transfer of
beneficial ownership or notice from the
adviser?
143. Are we correct in our
understanding that independent public
accountants are familiar with asset
verification and transaction tracing
procedures? Do commenters believe that
there are alternative procedures that
would achieve the policy goals of the
rule? Should we require the
independent public accountant to be the
same as the independent public
accountant hired to conduct the annual
surprise examination or financial
statement audit? Conversely, should we
prohibit this? Would there be benefits to
using the same accountant, such as an
ability to leverage work papers from the
verification when performing annual
surprise examination or audit
procedures? Would there be benefits to
using a different accountant?
144. Would the 2009 Accounting
Guidance contain sufficient guidance
for an accountant that is engaged to
perform the proposed verification
procedures around privately offered
securities and physical assets that are
not maintained with a qualified
custodian? What changes, if any, do you
believe would be necessary to provide
adequate direction with respect to the
proposed verification procedures?
145. Should we require the
independent public accountant
employed by the adviser under this
exception to verify the transfers to be
registered with and subject to inspection
by the PCAOB?
146. Should the rule require the
adviser to notify the accountant of a
transaction within one business day as
proposed? Should we require these
notices to be in writing? Alternatively,
should the rule require that the written
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agreement between the adviser and the
accountant require the adviser to notify
the accountant of a transaction within
one business day?
147. Do commenters agree with our
view that this notification should occur
as soon as practicable after the closing
of a transfer of beneficial ownership of
assets not custodied with a qualified
custodian? If not, what timeframe do
commenters recommend that would
achieve the policy goals of the proposed
rule? For example, should we require
the notice be no later than a certain
number of hours after the transaction
date? After the settlement date? After
money or asset(s) are sent to a
counterparty? After receipt of proceeds
of a redemption?
148. Do commenters agree with our
belief that it would not be challenging
for advisers to provide the required
notification, as proposed?
149. Is there a way to mitigate the risk
that an adviser intending to
misappropriate client assets does not
comply with the notification
requirement? Should we require other
safeguards that limit the risk that an
adviser intentionally or unintentionally
fails to comply with the notification
requirement?
150. Rather than requiring verification
by an accountant promptly after each
purchase, sale, or other transfer, as
proposed, should we require timely
notification to the auditor and require
the auditor to reconcile each reported
purchase, sale, or other transfer reported
to the books and records subject to the
annual audit or surprise examination?
Would this provide the same level of
protection for client assets not
maintained with a qualified custodian
as the prompt verification requirement
proposed? If not, are there nonetheless
good reasons to require annual
verification rather than prompt
verification? If we were to require only
annual verification, are there other
safeguards that we should require to
mitigate the risk of misappropriation?
151. Rather than requiring verification
by an accountant promptly after each
transfer, as proposed, should the rule
require, as part of the annual surprise
examination or annual audit, an
accountant to verify holdings of
privately offered securities from one
year to the next and evaluate
discrepancies? For example, if a client’s
account held assets X, Y, and Z in one
year, but only X the following year, the
accountant would evaluate the
disposition of assets Y and Z.
152. Should the rule require the
written agreement between the adviser
and the accountant to require the
accountant to notify the Commission
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within one business day upon finding
any material discrepancies during the
course of its examination? Is the
material discrepancy requirement clear
or should we provide further guidance
regarding how accountants should make
the materiality determination? In light
of the fact that the requirement is
effectively identical to the notification
requirement for material discrepancies
found during a surprise examination
under the current custody rule, do
commenters believe that the
requirement for the accountant to notify
the Commission within one business
day upon finding any material
discrepancies would result in ‘‘false
positives’’ or unnecessary notifications
to the Commission as a result of the onebusiness-day reporting timeframe? If so,
do commenters recommend a different
timeframe?
153. Rather than the form of
verification and asset tracing proposed,
should the rule require verification
procedures substantially in the form
used by independent public accountants
under custody rule 206(4)–2(a)(4)?
154. Should the rule require the
independent public accountant to file a
certificate on Form ADV–E stating that
it has verified the transactions and
describing the nature and extent of its
verification? If so, when should the
certificate be filed? Promptly upon
completion of the verification? Within
one business day? Within a certain
period of time after being notified by the
adviser? Would such a requirement
enhance the safeguarding of client assets
not maintained with a qualified
custodian and reduce the risk of loss or
misappropriation?
155. Should the rule permit other
persons or entities to perform the
verification that the rule proposes be
performed by the independent public
accountant? For example, should an
independent representative be
permitted to perform this function? If
so, should the rule retain the
independent representative definition
from the current rule? 253 If not, what
changes should be made? What, if any,
procedures should we require to be
performed to verify the transaction,
especially for the broad array of
physical assets that may be covered by
the rule? Would an independent
representative be equipped to perform
verification? Would such an approach
be more or less burdensome than the
proposed approach?
156. If an independent representative
should be permitted to perform the role
we are proposing for an independent
public accountant, should the rule
253 See
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require or prohibit certain parties from
acting as an independent
representative? What persons and
entities do commenters believe might
act as independent representatives? Do
commenters believe that qualified
custodians would be willing to act as
independent representatives? Do
commenters believe that a client could
serve as its own independent
representative? If so, would that further
the policy goals of the rule? Should
there be limits on which clients could
serve as their own independent
representative? For example, should
those clients be required to be a
qualified purchaser, accredited investor,
or satisfy certain other tests (e.g., net
worth, education, licensing)? Would
there be difficulties in locating a
sufficient number of independent
representatives to perform this function?
157. Should we require that the
proposed verification procedures
provide a certain level of assurance to
investors? If so, what level of assurance
should we require? Should we require
the written agreement specify a required
assurance framework that would be
applied? Should we require a reporting
mechanism requiring the auditor to
communicate the results of the ongoing
verification procedures to the adviser? If
so, how frequently should we require
reports and what information should we
require to be included?
158. As an alternative to the
notification and verification elements of
the proposed rule, should we instead
require periodic examinations for
privately offered securities and physical
assets that are not maintained with a
qualified custodian? If so, should the
procedures be substantially similar as
those required for surprise examinations
under current rule 206(4)–2(a)(4)? How
frequently should these examinations
occur? Would quarterly be sufficient to
reduce the risk of misappropriation and
loss of client assets? Would quarterly
surprise examinations be more or less
expensive than the notification and
verification proposed rules?
159. Are there other challenges with
these aspects of the rule, as proposed?
Would this requirement be expensive
for advisers, and would advisers pass
those costs along to advisory clients?
160. Should the rule require asset
verification of all client assets not
maintained with a qualified custodian?
Would this help reduce the risk of theft,
loss, or misappropriation of client
assets? How common is asset
verification for privately held securities?
For physical assets? Should the
verification requirement permit
sampling of client accounts, as opposed
to verification of assets for all client
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accounts? Should advisers with custody
of assets not maintained with a qualified
custodian be required to obtain more
surprise examinations? If so, how
frequently? Would quarterly or biannual asset verification be more
appropriate? Is 100% asset verification
of assets in all client accounts common
in other contexts or performed for other
purposes unrelated to the requirements
of the custody rule?
161. Should the rule require that the
audit verify all client assets not
maintained with a qualified custodian,
which would thus bar the accountant
engaged by the adviser from performing
asset sampling with respect to such
assets? Would this help reduce the risk
of theft, loss, or misappropriation of
client assets? How common is 100%
asset verification for audits of privately
held securities? For physical assets?
Should advisers with custody of assets
not maintained with a qualified
custodian be required to obtain more
audits? If so, how frequently? Would
quarterly or bi-annual asset audits be
more appropriate? Is 100% asset
verification of client assets common in
other contexts or audits performed for
other purposes unrelated to the
requirements of the custody rule?
162. Do audits provide an appropriate
level of protection for clients where an
adviser is unable to keep certain assets
with a qualified custodian? If not, why
not? In addition to the requirement that
all assets be verified during the annual
audit, should we recommend any
specific audit procedures to test that
client assets not kept at a qualified
custodian are appropriately safeguarded
from loss or misappropriation?
163. If an adviser has any assets not
maintained with a qualified custodian,
should the rule require asset verification
of all assets, including those assets that
are maintained with a qualified
custodian to ensure a complete
accounting of all assets occurs as of the
audit date? Are there other controls that
could be put in place to ensure assets
are not transferred to satisfy an audit
and then returned to their original
location?
164. Are there risks not discussed
above created when an adviser has
custody of privately offered securities or
physical assets that are not maintained
with a qualified custodian? If so, what
are those risks? Would the proposed
rule sufficiently mitigate those risks? If
not, what additional safeguards should
be required?
165. As an alternative or in addition
to any of the safeguards in the proposed
exception, should we require advisers to
promptly deliver a written notice to
each client whose assets are not
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maintained with a qualified custodian
(or the client’s independent
representative) containing certain
specified information regarding the
assets, such as to inform the client that
the assets are not kept by a qualified
custodian and to explain how the client
can verify the existence and ownership
of those holdings? Should the notice be
required to be delivered within a certain
time to allow an adviser to enter into an
agreement with an entity to maintain
the assets? If so, what should that timing
be? Should it be similar to the timing
the proposed exception would require
for the adviser to provide notice to the
accountant? Is there additional
information that should be required to
be included in the notice?
166. As an alternative or in addition
to any of the safeguards in the proposed
rule, should the rule require that an
adviser provide a quarterly summary of
a client’s transactions involving assets
that are not maintained with a qualified
custodian? Should the summary be
more or less frequent? Should the
summary be in a prescribed format or
should certain specific information be
required? If the Commission adopts
requirements to send quarterly
statements to investors in private funds
as recently proposed,254 should that
satisfy the requirement to send these
account statements? Should those
quarterly statements be required to be
audited as an additional or alternative
condition of the proposed exception?
167. As an alternative or in addition
to any of the safeguards in the proposed
rule, should we require the adviser to
obtain an internal control report for
assets not maintained with a qualified
custodian? If so, what type(s) of internal
control report(s) should we require and
why? For example, should it have
similar control objectives to the internal
control report we would require of
qualified custodians? Who should
prepare such internal control report(s)?
For example, should it be an
independent public accountant
registered with and subject to inspection
as of the commencement of the
engagement period by the PCAOB?
Should we require an adviser to obtain
an internal control report covering all of
its internal controls, not just internal
controls relating to the safeguarding of
assets not maintained with a qualified
custodian, or is the proposed exception
sufficient to address our policy goals?
Would requiring an adviser to obtain an
internal control report be sufficient to
254 See, Private Fund Advisers; Documentation of
Registered Investment Adviser Compliance
Reviews, Release No. IA–5955 (Feb. 9, 2022) [87 FR
16886] (Mar. 24, 2022).
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mitigate the risks created when an
adviser has custody of client assets that
are not maintained with a qualified
custodian?
168. As an alternative or in addition
to any of the elements of the proposed
safeguarding rule, should we require
advisers to maintain insurance to
reimburse clients for losses as a result
of the advisers’ misconduct? For
example, should we require fidelity
bonds? Should the insurance policy
limits correspond to the amount of
assets not maintained with a qualified
custodian? Should the insurance policy
limits correspond to the amount of all
of the assets of which the adviser has
custody? Are policies of this nature
common? What costs would be
associated with this kind of insurance?
Who would be the payee of any
claims—the client who suffered the loss
or the adviser? What would be the
advantages or disadvantages of either
approach to payee? Are these policies
occurrence based (the policy that pays
on a claim is the one that is in effect at
the time the incident occurred) or based
on when the claims are made (the policy
that pays on a claim is the one that is
in effect at the time the claim is made
regardless of when the incident
occurred)? What would be the
advantages and disadvantages to
occurrence-based or claims-made
policies in this context? What are
common exclusions under these
policies? Do they cover simple/ordinary
negligence? Does the underwriting
process for these policies involve an
evaluation of the adviser’s internal
controls? Does the underwriting process
take place annually and if so, does it
differ from the initial underwriting
assessment? Should the insurance
policy be obtained from an insurer with
certain credentials or subject to certain
regulatory or other standards? Please
explain.
169. As an alternative or in addition
to any of the elements of the proposed
rule, should we require advisers to have
certain capital requirements? Should
capital requirements be required to
correspond to the amount of assets not
maintained with a qualified custodian?
Should capital requirements correspond
to the amount of all of the assets of
which the adviser has custody? Do
advisers often maintain capital reserves
in the event of a client loss as a result
of their misconduct? If yes, is the capital
maintained in escrow? If we were to
require financial reserves, should the
reserves be maintained in escrow? Who
would be an appropriate escrow agent?
And what would be appropriate terms
of the escrow, particularly for release of
funds? Should the capital be maintained
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in a particular type of bank account? If
yes, what kind of account is commonly
used or would be appropriate for these
purposes? Should such a requirement be
conditioned upon using a particular
type of bank? What type? For example,
should it be chartered by the OCC?
Subject to Federal Deposit Insurance
Corporation oversight? What costs are
associated with escrow accounts and
financial reserve/net capital
requirements?
170. Are there compliance challenges
to this proposed exception? If so, what
are they?
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D. Segregation of Client Assets
Though advisers must attain
reasonable assurance of segregation of
client assets at a qualified custodian,255
the proposed rule also would require
advisers to segregate client assets from
the adviser’s assets and its related
persons’ assets in circumstances where
the adviser has custody. Specifically,
the proposed rule would require that
client assets over which an adviser has
custody:
(1) Be titled or registered in the
client’s name or otherwise held for the
benefit of that client;
(2) Not be commingled with the
adviser’s assets or its related persons’
assets; and
(3) Not be subject to any right, charge,
security interest, lien, or claim of any
kind in favor of the adviser, its related
persons, or its creditors, except to the
extent agreed to or authorized in writing
by the client.256
Segregation of client assets from the
assets of others continues to be a
fundamental element of safeguarding
client assets.257 This aspect of the
proposed rule is designed to ensure the
client’s continued ownership and
authorized use of its assets. This
proposed requirement is intended to
complement, but serves a slightly
different purpose than the proposed
requirement that the adviser obtain
reasonable assurance from the qualified
custodian that the client’s assets are
similarly segregated. This proposed
adviser segregation provision is critical
in light of the fact that some client
assets are not maintained with a
qualified custodian.258 Moreover, we
view it as essential not only for the
custodian, but also for the adviser, to
keep its own proprietary assets and
liabilities segregated from client assets
255 See discussion of qualified custodian
segregation requirements at supra section II.(C)(4).
256 Proposed rule 223–1(a)(1). See also supra
footnote 171.
257 See supra footnote 168.
258 See proposed rule 223–1(a)(1)(ii)(D).
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to prevent misuse or misappropriation
of client assets.
The proposed requirement that a
client’s assets be titled or registered in
the client’s name is designed to ensure
that the client’s assets are clearly
identified as belonging to the
appropriate client, regardless of whether
a qualified custodian is holding the
assets. The proposed rule would also
permit advisers to identify the assets
‘‘for the benefit of’’ a particular client
where assets may not be ‘‘titled or
registered’’ in the client’s name. For
example, an adviser acting as a trustee
would generally maintain client assets
in trust for the benefit of a particular
client for estate planning or other
purposes.259 ‘‘For the benefit of’’ is also
meant to recognize various ways
advisory clients can title or register their
investments. For example, clients may
hold securities in ‘‘street name’’ or
‘‘nominee name’’ through a book-entry
account with a broker-dealer, and the
broker-dealer will keep records showing
the client as the real or ‘‘beneficial’’
owner.260 This requirement would
protect client assets even if the assets
are maintained with a broker-dealer in
such a manner that gives the brokerdealer legal ownership of, or access to,
the assets.
Similarly, if an adviser purchases
privately offered securities that are held
on the books of the issuer or the issuer’s
transfer agent, the adviser should ensure
that the issuer or transfer agent properly
records and registers the adviser’s client
as owner. For example, if the adviser
invests in a private fund or purchases
private debt for a client, the records at
the private fund’s transfer agent or the
private debt issuer should reflect the
client as the owner of the investment.
We believe this requirement would
safeguard the client’s assets from
intentionally or inadvertently becoming
someone else’s property as well as
prevent circumstances that could result
in the misuse or misappropriation of
client assets.
The proposed rule would also require
that client assets not be commingled
with the adviser’s assets, or those of its
related persons. The proposed
requirement is designed to help ensure
that client assets are isolated and more
259 The client would maintain the beneficial
interest in the trust property and the trustee would
hold only legal title without the benefits of
ownership; the trust property is not subject to
personal obligations of the trustee, even if the
trustee becomes insolvent or bankrupt. See section
507 of the Uniform Trust Code (Jan. 2013).
260 See, e.g., Concept Release on the U.S. Proxy
System, Investment Advisers Act Release No. 3052
(July 14, 2010) [75 FR 42981 (July 22, 2010)]
(‘‘Proxy Concept Release’’).
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readily identifiable as client property.261
Consequently, we believe the proposed
prohibition on commingling would help
protect client assets from claims by a
third party looking to secure or satisfy
an obligation of the adviser, including
in cases of insolvency or bankruptcy of
the adviser, or its related persons.262 We
do not intend the prohibition on
commingling to preclude traditional
operational practices in which client
assets are held together with other
clients’ assets. We recognize that some
advisers and custodians regularly
service assets in a manner where such
assets are reasonably identifiable from
other clients’ assets and not subject to
increased risk of loss from adviser
misuse or in the case of adviser
insolvency. Accordingly, we request
comment on some of these practices and
the potential impact of this prohibition
below.
Under the proposed rule, client assets
would also be required to remain free
from any right, charge, security interest,
lien, or claim of any kind in favor of the
adviser, its related persons, or their
creditors. These requirements are
designed to protect client assets by
limiting the ability of an adviser, or its
related persons, to use client assets for
their own purposes or in a manner not
authorized by the client. However, we
do not intend this condition to limit or
prohibit authorized actions by clients.
We are therefore proposing an exception
to these requirements to the extent a
client agrees to or authorizes such
arrangements in writing.263 In our
understanding, some clients authorize
these types of arrangements depending
on the types of assets, products, or
strategies in which they invest resulting
in the subject assets being commingled
and potentially subject to certain claims.
For example, such an authorization
might allow assets to be subject to a
securities lending arrangement
authorized by the client.264 In a typical
securities lending transaction, the legal
title to loaned securities passes to the
borrower for the loan term. The lender
regains title to the securities when the
securities are returned, either upon
demand or at the end of a specified
261 We have taken a similar approach in other
contexts. See, e.g., Financial Responsibility
Adopting Release, supra footnote 171 (discussing
similar requirements under Rule 15c3–3 that would
cause a broker-dealer to keep customer securities
and cash isolated and readily identifiable as
‘‘customer property’’ and, consequently, available
to be distributed to customers in the event that the
broker-dealer is liquidated in a formal proceeding
under the Securities Investor Protection Act of
1970).
262 See, e.g., supra footnote 172.
263 See proposed rule 223–1(b)(7).
264 See proposed rule 223–1(a)(1)(iii).
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term. Similarly, in a margin account,
which is a type of brokerage account, a
broker lends cash to a client to allow the
client to purchase securities. The loan is
collateralized by the securities
purchased, other assets in a client
account, and cash, and the broker
charges a periodic interest rate.265 This
proposed exception would also allow
arrangements in which an adviser
deducts fees directly from client assets
for the payment for services rendered by
the investment adviser or its related
persons, so long as the client authorizes
such payments in writing.
To the extent a client agrees to or
authorizes in writing one of these, or
similar, arrangements, it would be
excepted from the proposed prohibition
against subjecting the client’s assets to
any right, charge, security interest, lien,
or claim in favor of the investment
adviser or a qualified custodian.266
Although these activities may implicate
the types of risks the proposed rule is
designed to address, we believe the
client is aware of, and consents to, the
arrangement for ease or by necessity to
effect a desired activity with respect to
its assets.267 Without the ability to
authorize such arrangements, clients
would be unable to engage in these
potentially beneficial, authorized
activities.
We believe that proper segregation of
client assets, as required by the threepart requirements of the proposed rule,
would mitigate concerns regarding the
safety of a client’s assets, particularly
when coupled with the requirement
described above that the adviser obtain
reasonable assurance from the qualified
custodian that the custodian is similarly
segregating the client’s assets.
We request comment on all aspects of
the proposed rule’s requirements for the
segregation of investments, including
the following items.
171. Should the rule include the
proposed segregation requirements? Are
these requirements sufficiently clear?
172. Do the proposed segregation
requirements properly align with the
proposed qualified custodian contract
provisions and the reasonable assurance
265 See Uniform Commercial Code, section 8–504
and cmt. 2 (‘‘Margin accounts are common
examples of arrangements in which an entitlement
holder authorizes the securities intermediary to
grant security interests in the positions held for the
entitlement holder.’’).
266 Proposed rule 223–1(a)(3)(iii).
267 See also, Standard of Conduct for Investment
Advisers Release, supra footnote 57, page 8 (noting
that although all investment advisers owe each of
their clients a fiduciary duty under the Advisers
Act, that the fiduciary duty must be viewed in the
context of the agreed-upon scope of the relationship
and necessarily depend upon what functions the
adviser, as agent, has agreed to assume for the
client, its principal).
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requirements, especially those proposed
in subsections 223–1(a)(2)(ii)(D) and
(E)?
173. Is the scope of the proposed
segregation requirement’s application to
the adviser and its related persons
appropriate? Should this section also
apply to the qualified custodian, or are
the proposed reasonable assurance
requirements in 223–1(a)(2)(ii) sufficient
to ensure segregation and protection of
assets in a custodial account?
174. Would advisers be able to ensure
that assets are held in the client’s name
or for the client’s benefit in situations
that involve recording of interests at a
transfer agent or in circumstances
involving the custody of privately
offered securities or physical assets?
175. Would the proposed segregation
requirements impose appropriate
limitations to safeguard client assets?
Should we eliminate or modify any of
them? Alternatively, are there other
limitations that would be appropriate?
176. Would the proposed
requirements increase the likelihood
that client assets will be available to be
returned to clients if an adviser or its
related persons experience any financial
reverses, such as insolvency or
bankruptcy? For example, do
commenters believe the requirements
would help ensure that client assets are
more readily identifiable as client
property?
177. Should certain assets be
excluded from these requirements? If so,
which assets and why? Would limiting
these requirements to certain types of
assets present compliance challenges? If
so, what assets and why?
178. In particular, would the
proposed segregation requirements
present challenges with respect to
crypto assets? Should we address crypto
asset segregation and/or custody with
separate requirements? Do crypto assets
raise specific segregation issues not
presented by other assets? If so, what are
they and why? Would the proposed
requirements offer substantial
protections in the event of a bankruptcy
or financial losses involving an adviser
or custodian with custody of crypto
assets? Would the proposed segregation
requirements present challenges with
respect to other types of assets?
179. Would the proposed
requirements ensure that a third party’s
lien against one client’s assets would
not be improperly attached to other
clients’ investments? Are there any
other rights, charges or claims that
should be expressly identified in the
proposed segregation requirements?
180. The proposed requirements
would provide an exception to the
provision that client assets not be
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14715
subject to right, charge, security interest,
lien, or claim of any kind to the extent
it is authorized by the client in writing.
Is this exception appropriate? Is it
sufficiently clear? Would it properly
account for assets that are subject to a
securities lending arrangement or
margin trading agreement? Is the
proposed exception too broad? For
example, should the proposed exception
apply to only certain types of assets or
arrangements? Should we prescribe
specific conditions that must be
included in any client authorization?
181. Is it sufficiently clear from the
rule text that client assets are not to be
subject to any claim except claims for
payment of services rendered by the
investment adviser or related person
that is agreed to or authorized by the
client? Should we explicitly exempt
such claims for certain types of fees?
182. Do the proposed segregation
requirements to be titled in the client’s
name, not to be commingled, and not to
be subject to any right, charge, security
interest, lien or claim guard against loss,
misappropriation, misuse, theft, and the
financial reverses of the adviser, permit
the adviser with reasonable operational
flexibility to use omnibus and other
similar accounts?
183. Should the rule prohibit
commingling client and non-client
assets, as does the current rule?
Alternatively, should it permit the
commingling of client and non-client
assets for administrative convenience
and efficiency? If so, what should be
considered ‘‘administrative convenience
and efficiency’’? Does allowing client
and non-client assets to be commingled
(e.g., in the same escrow account)
increase the risk that client assets will
be lost, misused, stolen, or
misappropriated? Could an advisory
client’s assets be used to satisfy the
debts of someone else in a bankruptcy
event if client and non-client assets are
commingled?
184. Should the rule include express
requirements regarding the subaccounting of commingled accounts if
the rule permits commingling of client
and non-client assets?
185. We recognize there are some
instances where commingling or
pooling of certain assets may occur via
certain omnibus and sub accounting
arrangements that may present
compliance challenges under the
segregation requirements. We also
understand that though such
commingling may occur, the client
assets may still be considered to be
identifiable via omnibus recordkeeping
though they sit among non-client assets.
In what circumstances may such a
requirement restricting commingling
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place burdens on advisers? Are there
certain assets or transaction types for
which such a requirement may be
particularly burdensome? Should we
include any exceptions to the
prohibition on commingling?
186. Do commenters agree that there
are circumstances when advisers’
services require them to commingle
client assets and non-client assets? For
example, when an adviser uses sweep
accounts, escrow accounts, or when an
adviser serves as administrative agent to
a loan syndicate where the lenders
consist of advisory clients and nonadvisory clients? 268 In these
circumstances, should the rule require
additional protections? Which
protections and why and would they
differ depending on the type of
commingled account? For example,
should the rule include specific
requirements to allow an adviser to hold
a percentage of the proceeds from the
sale or merger of a portfolio company
owned by one or more client pooled
investment vehicles (e.g., private equity
funds) and other non-clients for a
limited period? If so, should we limit
the types of proceeds that could be
included in the escrow account or the
period in which the escrow exists?
Should we require the portion of the
escrow attributable to the pooled
investment vehicle client to be included
on financial statements that are audited?
Should we require any contract
governing the escrow or other
commingled account to include certain
terms (such as requiring a seller’s
representative or administrative agent to
distribute the funds in the escrow or
commingled account promptly on a
predetermined formula)? 269
E. Investment Adviser Delivery of Notice
to Clients
The proposed rule, like the custody
rule, would require an investment
adviser to notify its client in writing
promptly upon opening an account with
a qualified custodian on its behalf.270
The notice is designed to alert a client
to the existence of the qualified
custodian that maintains possession or
control of client assets and whom to
contact regarding such assets. Based on
our experience with the custody rule,
we continue to believe it provides
important client protections.
The notice would continue to include
the qualified custodian’s name, address,
and the manner in which the
268 See,
e.g., Madison Capital No-Action Letter.
2014 IM Guidance, supra footnote 17, in
which our staff discussed its views on application
of the current rule to various situations involving
special purposes vehicles SPVs and escrows.
270 See proposed rule 223–1(a)(2).
investments are maintained. The
proposed rule would also explicitly
require that the notice include the
custodial account number to improve
the utility of the notice. If the client is
a pooled investment vehicle, the notice
must be sent to all of the investors in the
pool, provided that, if an investor is a
pooled investment vehicle that is in a
control relationship with the adviser or
the adviser’s related persons, the sender
must look through that pool (and any
pools in a control relationship with the
adviser or its related persons) in order
to send the notice to investors in those
pools.271 As discussed above, this is
intended to promote meaningful
delivery of this important information.
As is permitted under the current rule,
the notice could also be delivered to the
client’s (or pooled investment vehicle
investor’s) independent representative
and the adviser would continue to be
required to provide the notice promptly
when an account is opened and
following any changes in the
information contained in the notice. If
adopted, this provision would require
advisers to send account opening
notices only to clients for which it has
opened new client accounts with a
qualified custodian after the effective
date of the rule. Advisers would not
have to provide new notices to existing
clients for which it has already opened
accounts as these clients are likely
already aware of the location of their
assets at the qualified custodian from
prior notices.
We request comment on all aspects of
the proposed rule’s investment adviser
notice requirement, including the
following items.
187. Should the notice include the
qualified custodian’s account number?
Should we require other types of
information to be included in the
notice? If so, what information, and
why? Should we eliminate any of the
proposed types of information from the
notice? If so, why?
188. If an adviser uses several
qualified custodians for one of its
clients, should the proposed rule permit
the adviser to provide the client a onetime notice for these qualified
custodians rather than providing a new
notice each time the assets move among
the qualified custodians? 272 If yes,
should the rule require the adviser also
to provide the client a new notice
promptly upon using a new qualified
269 See
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proposed rule 223–1(c).
staff has taken a similar view under the
current custody rule. See Custody Rule FAQs, supra
footnote 17, at Question V.1.
custodian to maintain the client’s
investments?
189. Should we require advisers to
provide notice to clients when assets are
not held at a qualified custodian? If yes,
what form should these notices take?
Should they be provided on a one-off or
periodic basis?
F. Amendments to the Surprise
Examination Requirement
We are proposing changes to the
surprise examination requirement.273
Under the current custody rule advisers
with custody, subject to certain
exceptions, must undergo an annual
surprise verification by an independent
public accountant to put ‘‘another set of
eyes’’ on client assets.274 In
circumstances where the adviser or a
related person maintain client assets as
a qualified custodian, the independent
public accountant must be registered
with, and subject to regular inspection
as of the commencement of the
professional engagement period, and as
of each calendar year-end, by the
PCAOB in accordance with its rules.
Currently, the surprise examination
requirement does not require the adviser
explicitly to have a reasonable belief
about the implementation of the written
agreement between the adviser and the
accountant. The surprise examination
requirement would be amended to state
that the adviser must reasonably believe
that a written agreement has been
implemented (i.e., that the accountant
will perform the surprise examination
pursuant to the agreement and comply
with the section’s ADV–E filing and
notification requirements when
required). We are also proposing to
amend the language concerning notice
upon the finding of any material
discrepancies during the course of an
examination that the notice be sent by
electronic means to the newly
designated Division of Examinations as
opposed to the current rule’s
requirement to send to the Director of
the Office of Compliance Inspections
and Examinations.275
In a change from the current rule, we
are proposing an amendment requiring
that an adviser ‘‘must reasonably
believe’’ that the written agreement has
been implemented. We designed this to
address circumstances where, in our
experience, there is an adviser that has
entered into the agreement with the
accountant, but failed to ensure the
surprise examination occurs and the
requirements of the rule are met.
Entering into the contract with the
271 See
272 Our
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273 See
proposed rule 223–1(a)(4).
Adopting Release, supra footnote 11.
275 See proposed rule 223–1(a)(4)(v).
274 2009
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accountant alone would not satisfy the
rule. Accordingly, advisers generally
should enter into a written agreement
with the accountant based upon a
reasonable belief that the accountant is
capable of, and intends to, comply with
the agreement and the obligations the
accountant is responsible for under the
surprise examination requirement. For
example, after securing a written
agreement for the engagement, the
adviser generally should ensure that the
accountant is able to access the
Commission’s filing system so that it
can perform its Form ADV–E filing
functions properly under the rule.
It has been our longstanding view that
the involvement of independent public
accountants in the review and
verification of client assets of which
advisers have custody is an important
safeguarding tool and reduces the risk of
loss of client assets.276 Consistent with
that view, we believe that the adviser
must ensure that the independent
public accountant’s involvement in the
verification and notification
requirements in the proposed rule are
implemented effectively so as to ensure
the reliability and integrity of the
surprise exam.
We request comment on the proposed
rule’s modifications to the surprise
exam requirement, including the
following:
190. Should the rule require that an
adviser must reasonably believe that the
written agreement with the accountant
has been implemented to satisfy the
Form ADV–E and notice requirements
of the provision? Are advisers able to
ensure that an accountant fulfills the
surprise examination requirements, or
are there certain limitations that would
make satisfaction of this requirement
difficult?
191. What difficulties do accountants
have when fulfilling their obligations on
behalf of advisers under this section of
the proposed rule? Should we make
other amendments to this paragraph of
the rule to ensure that accountants are
able to fulfill their duties under the
rule? Does the expansion of the scope of
the rule from funds and securities to
assets raise any problems for advisers
and auditors that would need to comply
with the surprise examination
requirement?
G. Exceptions From the Surprise
Examination
In light of the proposed changes to the
rule’s scope to cover all assets, the
proposal seeks to balance better the
costs associated with obtaining a
surprise examination with the investor
276 See,
2009 Adopting Release, supra note 11.
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protections it offers by providing
exceptions to the surprise examination
requirement when the adviser’s sole
reason for having custody is because it
has discretionary authority or because
the adviser is acting according to a
standing letter of authorization, each
subject to certain conditions. We are
also proposing modifications to the
current rule’s audit provision that we
believe will expand the availability of
its use, enhance investor protection, and
facilitate compliance. These exceptions
are discussed below.
1. Entities Subject to Audit (‘‘Audit
Provision’’)
a. Scope of the Audit Provision
Similar to the custody rule, an adviser
that obtains an audit at least annually
and upon an entity’s liquidation under
the proposed rule would be deemed to
have complied with the surprise
examination requirement and would
eliminate the need for an adviser to
comply with the client notice
requirement.277 Although the
requirement to deliver account
statements to clients would be different
under the proposed rule than under the
custody rule, the audit provision would
still eliminate the adviser’s need to
comply with the account statement
aspect under the proposed rule as well.
Specifically, for the adviser to qualify
for the audit provision under the
proposed rule, its client that is a limited
partnership (or limited liability
company, or another type of pooled
investment vehicle or any other entity)
would need to undergo a financial
statement audit that meets the terms of
the rule at least annually and upon
liquidation.278 Under the proposed rule:
(1) The audit must be performed by an
independent public accountant that
meets the standards of independence 17
CFR 210.2–01 (in rule 2–01 of
Regulation S–X) that is registered with,
and subject to regular inspection as of
the commencement of the professional
engagement period, and as of each
calendar year-end, by, the PCAOB in
accordance with its rules;
(2) The audit meets the definition in
17 CFR 210.1–02(d) (rule 1–02(d) of
Regulation S–X),279 the professional
277 See proposed rule 223–1(b)(4). As under the
custody rule, an adviser that relies on an exception
from the surprise examination requirement, such as
the exception for fee deduction under proposed rule
223–1(b)(3) or the proposed exception for
discretionary trading under proposed rule 223–
1(b)(8) and see Discretionary Authority, infra, need
not rely on the audit provision.
278 See proposed rule 223–1(b)(4).
279 Under the definition in rule 1–02(d) of
Regulation S–X, an ‘‘audit’’ of an entity (such as a
private fund) that is not an issuer as defined in
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engagement period of which shall begin
and end as indicated in Regulation S–
X Rule 2–01(f)(5); 280
(3) Audited financial statements must
be prepared in accordance with U.S.
Generally Accepted Accounting
Principles (‘‘U.S. GAAP’’) or, in the case
of financial statements of entities
organized under non-U.S. law or that
have a general partner or other manager
with a principal place of business
outside the United States, must contain
information substantially similar to
statements prepared in accordance with
U.S. GAAP and material differences
with U.S. GAAP must be reconciled;
(4) Within 120 days (or 180 days in
the case of a fund of funds or 260 days
in the case of a fund of funds of funds)
of an entity’s fiscal year end, the entity’s
audited financial statements, including
any reconciliations to U.S. GAAP or
supplementary U.S. GAAP disclosures,
as applicable, are distributed to
investors in the entity (or their
independent representatives); and
(5) Pursuant to a written agreement
between the auditor and the adviser or
the entity, the auditor notifies the
Commission upon certain events.281
Elements of the proposed rule’s audit
provision are largely unchanged from
the audit provision of the custody
rule.282 Differences include: (1)
expanded availability from ‘‘pooled
investment vehicle’’ clients to
‘‘entities’’; (2) a requirement for the
financial statements of non-U.S. clients
to contain information substantially
similar to statements prepared in
section 2(a)(7) of the Sarbanes-Oxley Act of 2002
means an examination of the financial statements
by an independent accountant performed in
accordance with either the generally accepted
auditing standards of the United States (‘‘U.S.
GAAS’’) or the standards of the PCAOB. When
conducting an audit of financial statements in
accordance with the standards of the PCAOB,
however, the auditor would also be required to
conduct the audit in accordance with U.S. GAAS
because the audit would not be within the
jurisdiction of the PCAOB as defined by the
Sarbanes-Oxley Act of 2002, as amended, (i.e., not
an issuer, broker, or dealer). See AICPA auditing
standards, AU–C section 700.46. We believe most
advisers would choose to perform the audit in
accordance with U.S. GAAS only rather than both
standards, though it would be permissible under
the proposed audit rule to perform the audit in
accordance with both standards.
280 This provision reflects the existing process.
Among other things, rule 2–01(f)(5) of Regulation
S–X indicates that the professional engagement
period begins at the earlier of when the accountant
either signs an initial engagement letter (or other
agreement to review or audit a client’s financial
statements) or begins audit, review, or attest
procedures; and the period ends when the audit
client or the accountant notifies the Commission
that the client is no longer that accountant’s audit
client.
281 Proposed rule 223–1(b)(4).
282 Compare rule 206(4)–2(b)(4) with proposed
rule 223–1(b)(4).
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accordance with U.S. GAAP and
material differences with U.S. GAAP to
be reconciled; and (3) a requirement for
there to be a written agreement between
the adviser or the entity and the auditor
requiring the auditor to notify the
Commission upon the auditor’s
termination or issuance of a modified
opinion.283
We request comment on all aspects of
the proposed rule’s annual audit
provision, including the following:
192. Should the rule continue to
permit an adviser to satisfy certain
elements of the rule by relying on the
audit provision as proposed? Should the
rule require an audit upon an entity’s
liquidation as proposed? Should we
modify either or both of these
requirements? If so, how should we
modify these requirements, and why?
193. Should the rule require audits to
cover a period of 12 months? Would
investors derive value from audits that
cover periods longer or shorter than 12
months? If so, what time periods, and
why?
194. Should the proposed rule allow
newly formed and liquidating entities to
perform an audit less frequently than
annually, provided that the audit period
does not exceed 15 consecutive months,
with no more than three months of such
period occurring immediately before or
after the entity’s fiscal year end? Is 15
months the appropriate audit period
limit for newly formed and/or
liquidating entities? Should we increase
or decrease this limit? If so, what time
period should we require, and why?
Should we include additional
restrictions or requirements for newly
formed entities and/or liquidating
entities under the audit provision? If so,
what restrictions or requirements, and
why? Would allowing for less frequent
auditing during liquidation—for
example, requiring an audit every 18
months or two years in such
circumstances—result in a meaningful
cost reduction to advisers or investors?
195. Should the proposed rule require
investment advisers to provide investors
with a form of interim financial
reporting when an entity’s audit period
will be in excess of 12 months? If so,
what information should be included in
this reporting and who should receive
this reporting? Should the reporting be
audited?
196. Should the rule permit advisers
to satisfy the audit provision by relying
on an audit on an interval other than
annually when an entity is liquidating?
283 See proposed rule 223–1(b)(4)(v). See also
AICPA auditing standard, AU–C section 705, which
establishes three types of modified opinions: a
qualified opinion, an adverse opinion, and a
disclaimer of opinion.
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For example, should we allow advisers
to rely on an audit of an entity every
two years during the liquidation
process? If so, should we modify the
proposed rule to require investment
advisers to create and distribute
alternative financial reporting for the
entity to investors (e.g., cash-flow audit
or asset verification)? Alternatively, or
in addition to alternative financial
reporting, should the rule require
investment advisers to obtain a thirdparty examination of the liquidating
entity? If so, what should the
examination consist of, and why? For
example, an independent auditor could
examine a liquidating entity to confirm
existence of the entity and that cash
flows were appropriate.
197. Would allowing investment
advisers to satisfy the audit provision by
relying on an audit less frequently than
annually during a liquidation raise any
investor protection concerns that
additional requirements could address?
If so, what additional requirements, and
why? For example, should advisers be
required to provide notice to investors
of their intent to liquidate an entity in
these circumstances? Should advisers be
required to obtain investor consent prior
to satisfying the audit requirement by
relying on audits on less than annual
basis?
198. The custody rule does not define
liquidation or liquidating entity for
purposes of the liquidation audit
requirement. Should it? If so, how? For
example, should the definition be based
on (1) a certain percentage of assets
under management of the entity from or
over previous fiscal period(s), (2) a
stated threshold based on an absolute
dollar amount of the entity’s assets
under management, (3) a calculation of
the ratio of the management fees
assessed on assets under management of
the entity, (4) some combination of the
foregoing, or (5) some other basis?
199. Are there risks posed to investors
when an entity is liquidating that the
proposed rule does not address? If so,
please describe those risks and how the
rule should be modified to address such
risks.
200. Are there some types of
investments that pose a greater risk of
misappropriation or loss to investors
during a liquidation that the rule should
specifically address to provide greater
investor protection? If so, please
describe (1) the investment type; (2) the
particular risk poses to investors by the
investment type during liquidation; and
(3) how to modify the proposed rule to
address such investor risk.
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201. Should we define ‘‘fund of
funds’’? 284 If so, how should we define
‘‘fund of funds’’? For example, should
we define a ‘‘fund of funds’’ as a pooled
investment vehicle that invests 10
percent or more of its total assets in
other pooled investment vehicles that
are not, and are not advised by, a related
person of the pool, its general partner,
or its adviser? 285 Are there other
circumstances in which the proposed
180-day deadline might be appropriate?
202. Should we define ‘‘fund of funds
of funds’’? If so, how should we define
‘‘fund of funds of funds’’? For example,
should we define fund of funds of funds
as a fund of funds that invests 10
percent or more of its total assets in one
or more fund of funds that are not, and
are not advised by, a related person of
the fund of funds, its general partner, or
its adviser.286 Are there other
circumstances in which the proposed
260-day deadline might be appropriate?
b. The Expanded Availability of Audit
Provision
The current audit provision is
available only to advisers to a limited
partnership (or limited liability
company or another type of pooled
investment vehicle).287 Historically, we
have relied on financial statement
audits to verify the existence of pooled
investment vehicle investments.288
Based on our experience since
introducing the custody rule’s audit
provision, we have come to believe that
audits provide substantial benefits to
pooled investment vehicles and their
investors because audits test assertions
associated with the investment portfolio
(e.g., completeness, existence, rights and
obligations, valuation, presentation).
Audits may also provide a check against
adviser misrepresentations of
performance, fees, and other
information about the pool. We are thus
proposing to expand the availability of
the audit provision from limited
partnerships, limited liability
companies, and other types of pooled
investment vehicle clients to any
284 For example, we have described funds that
invest in other funds as a ‘‘fund of funds’’
arrangement under rule 12d1–4 under the
Investment Company Act. See Fund of Funds
Arrangements, Release Nos. 33–10871; IC–34045
(Oct. 7, 2020) (Adopting Release).
285 We note that our staff has expressed its views
of what constitutes a fund of funds for purposes of
the custody rule. See Custody Rule FAQs, supra
footnote 17, at Question VI.7.
286 We note that our staff has expressed its views
of what constitutes a fund of funds of funds for
purposes of the custody rule. See Custody Rule
FAQs, supra footnote 17, at Question VI.8B.
287 See rule 206(4)–2(b)(4).
288 See, e.g., rule 206(4)–2(b)(4) under the
Advisers Act; see also 2009 Adopting Release,
supra footnote 11.
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advisory client entity whose financial
statements are able to be audited in
accordance with the rule.289
This aspect of the proposed rule
would also eliminate uncertainty about
the entity types for which the audit
provision is currently available and
extend the investor protection benefits
of an audit to a larger number of
investors, such as pension plans,
retirement plans, college saving plans
(529 plans), and Achieving a Better Life
Experience savings accounts (ABLE
plans or 529 A accounts).290 Because of
uncertainty about the entity types
eligible to use the audit provision, we
believe that some investment advisers
do not use the current rule’s audit
provision.
We believe that financial statement
audits provide additional meaningful
protections to investors as compared to
a surprise examination by increasing the
likelihood that fraudulent activity is
uncovered, thereby providing
deterrence against fraudulent conduct
by advisers. In a financial statement
audit, the accountant performs
procedures beyond those procedures
performed during a surprise
examination. Similar to a surprise
examination, a financial statement audit
involves an accountant verifying the
existence of an entity’s assets. A
financial statement audit, however, also
typically involves an accountant
addressing additional important matters
that are not covered by a surprise
examination, such as tests of valuations
of entity investments, income, operating
expenses, and, if applicable, incentive
fees and allocations that accrue to the
adviser. Thus, an audit includes the
evaluation of amounts and disclosures
within the financial statements that may
be particularly significant to entity
investors.
Moreover, we believe many entities
other than pooled investment vehicles
289 See rule 206(4)–2(b)(4). This provision does
not depend upon a minimum number of investors
in the entity. See also Custody Rule FAQs, supra
footnote 17, at Question X.1, in which our staff
expressed a similar view. Similar to the approach
under the custody rule, under the proposed rule, if
the investors or participants in the legal entity
client that is being audited are also clients of the
adviser, the adviser would have to evaluate
separately whether it has the ability or authority to
effect a change in beneficial ownership of that
investor’s or participant’s investments and comply
with the proposed rule as appropriate. The financial
statement audit of the legal entity whose investors
or participants have invested would not satisfy the
adviser’s obligations under the proposed rule with
respect to the investors or participants. See infra
footnote 307.
290 The staff has previously provided its position
to certain entities that requested clarity about their
eligibility to comply with the current rule’s
exception for audited entities. See, e.g., Investment
Company Institute, SEC Staff No-Action Letter
(Sept. 5, 2012).
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already undergo financial statement
audits. These financial statement audits
of entities may be similar in scope and
offer similar investor protection benefits
as an audit of a pooled investment
vehicle. The proposed expansion of the
availability of the audit provision,
therefore, may reduce costs for these
entities if they no longer must
additionally undergo a surprise
examination.
The account notice and custodial
account statement delivery
requirements are designed to help
ensure the integrity of account
statements and permit clients to identify
any erroneous or unauthorized
transactions or withdrawals by an
adviser.291 A financial statement audit
regularly involves an accountant
confirming bank account balances and
securities holdings as of a point in time
and includes the testing of transactions
that have occurred throughout the year.
We believe that the common types of
audit evidence procedures performed by
accountants during a financial statement
audit—physical examination or
inspection, confirmation,
documentation, inquiry, recalculation,
re-performance, observation, and
analytical procedures—act as an
important check to identify erroneous or
unauthorized transactions or
withdrawals by the adviser, obviating
the need for the account notice and
delivery requirements for entities that
are not pooled investment vehicles.
We request comment on all aspects of
the expanded availability of the audit
provision, including the following
items:
203. Should we expand the
availability of the audit provision
beyond limited partnerships, limited
liability companies, or other types of
pooled investment vehicle to entities as
proposed? If not, explain why. If we
expand the availability of the audit
provision, in what circumstances would
this likely be utilized? Should we
impose any limits on the types of
entities that can make use of the audit
provision? If so, what limits, and why?
It is our understanding that a separate
account cannot be audited. Is our
understanding correct? If not, are
separate accounts currently being
audited, and if so, for what purpose? To
the extent separate accounts can be
audited, should the audit provision be
available for separate account clients in
addition to entities?
204. Do commenters agree that
expanding the scope of entities eligible
291 See generally 2003 Adopting Release, supra
footnote 2; see also discussion supra at section II.B
and II.E.
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for the audit provision, as proposed, is
likely to result in a greater percentage of
client audits?
205. Is the term ‘‘entity’’ the
appropriate term to use to describe the
audit provision client type, or is there
another term we should use? For
example, an adviser may manage a
separate account for a corporate
institutional client that undergoes a
financial statement audit for reasons
unrelated to the custody rule. Although
the financial statements pertain to a
much broader universe of transactions
than just transactions in the account or
the assets the adviser manages for that
client, should the adviser be able to rely
on this audit to comply with the
proposed rule? Would the answer
depend on whether the adviser manages
a non-entity sleeve of the client
corporation’s assets or a subsidiary
entity?
206. Should the proposed rule define
the term ‘‘entity’’? If so, how? Would
using the term ‘‘entity’’ reduce or
eliminate any existing confusion
regarding which entities may make use
of the audit provision?
207. Do other entity client types
currently undergo the type of audit, i.e.,
a full scope audit that is required under
the audit provision? If so, how do the
audit procedures for these entity clients
differ, if at all, from the audit
procedures currently performed during
audits of pooled investment vehicles? If
the audit procedures for these entity
clients differ, do they still offer
substantially similar protections to
investors as the audits currently
performed of pooled investment
vehicles? Why or why not?
208. We understand that certain
entities may undergo audits that are
limited in scope, e.g., an ERISA section
103(a)(3)(C) audit. We understand that
these limited scope audits restrict the
testing of certain investment
information where a qualified
institution has certified to both the
completeness and accuracy of the
required information. These limited
scope audits may be more cost-effective,
but they also do not involve all of the
procedures of a full scope audit. What
audit procedures are performed during
these limited scope engagements? Do
these procedures offer substantially
similar protection to investors as full
scope audits? Why or why not? Should
these limited scope audits be sufficient
to satisfy the requirements of the audit
exception? If so, why?
209. Given the independent public
accountant’s involvement to address the
risks around the existence of
investments and the risk of
misappropriation, should the
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safeguarding rule require full scope—
rather than limited scope—audits as
proposed? Or should the rule require
full scope audits only in certain
circumstances or with respect to certain
entities? If so, what are those
circumstances and why should the
proposed rule require full scope audits
in those circumstances? Would
requiring full scope audits prohibit
certain entities from being able to use
the audit provision? If the rule allowed
limited scope audits in some or all
circumstances, should it impose any
additional requirements on the
investment adviser relying on that audit,
the accountant performing that audit, or
both?
c. PCAOB Inspection
As is the case with the current
custody rule, the proposed rule would
continue to require accountants
performing audits to be registered with
and subject to regular inspection as of
the commencement of the professional
engagement period, and as of each
calendar year-end, by the PCAOB in
accordance with its rules. We believe
that registration and periodic inspection
of an independent public accountant’s
system of quality control by the PCAOB
provides investors with some additional
level of confidence in the quality of
audit produced under the proposed
rule. Under the PCAOB’s current
inspection program, we understand that
the PCAOB selects audit engagements of
audits performed involving U.S. public
companies, other issuers, and brokerdealers, so private fund and certain
other entity audit engagements would
not be selected for review. Even if
private fund and other entity audit
engagements are not selected for review
under the PCAOB’s current inspection
program, we believe that accounting
firms registered with and subject to the
PCAOB’s inspection program would
implement their quality control systems
throughout the accounting firm related
to their assurance engagements.
In light of our proposal to expand the
availability of the audit provision, we
understand that this requirement may
limit the pool of accountants that are
eligible to perform these services
because only those accountants that
currently conduct public company
issuer audits are subject to regular
inspection by the PCAOB. Many of an
adviser’s clients are already undergoing
a financial statement audit; therefore,
the increase in demand for these
services may be limited.292 Nonetheless,
292 For example, more than 90 percent of the total
number of hedge funds and private equity funds
currently undergo a financial statement audit.
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the resulting competition for these
services as a result of our proposed
expanded availability of the audit
provision may result in a limited pool
of accountants eligible to provide the
auditing services, which may increase
costs to investment advisers and
investors.
We also understand that, as part of its
interim inspection program, the PCAOB
inspects accountants auditing brokers
and dealers, and identifies and
addresses with these firms any
significant issues in those audits.293
Similar to the inspection program for
issuer audits, we believe that the
interim inspection program for brokerdealers provides valuable oversight of
these accountants, which may result in
better quality audits. Although the
PCAOB may not disclose which
accounting firms have been inspected
under the interim inspection program
for broker-dealers, we believe that the
PCAOB uses a varied approach for
selecting a particular audit engagement
for review focused on both risk-based
selections and random selections.294
Accordingly, we would also consider an
accountant’s compliance with the
PCAOB’s interim inspection program for
auditors of brokers and dealers to satisfy
the requirement for regular inspection
by the PCAOB under the proposed audit
provision until the effective date of a
permanent program for the inspection of
broker and dealer auditors that is
approved by the Commission.295
An independent public accounting
firm would not be considered to be
‘‘subject to regular inspection,’’
however, if it is included on the list of
firms that is headquartered or has an
office in a foreign jurisdiction that the
PCAOB has determined it is unable to
inspect or investigate completely
because of a position taken by one or
more authorities in that jurisdiction in
accordance with PCAOB Rule 6100.296
293 See PCAOB Adopts Interim Inspection
Program for Broker-Dealer Audits and Broker and
Dealer Funding Rules (June 14, 2011) (‘‘interim
inspection program’’), available at https://
pcaobus.org/News/Releases/Pages/06142011_
OpenBoardMeeting.aspx. See also Dodd-Frank Act
section 982.
294 See, e.g., Annual Report on the Interim
Inspection Program Related to Audits of Brokers
and Dealers, PCAOB Release No. 2022–04 (Aug. 19,
2022) at 7.
295 We note that our staff took a similar position
and has had several years to observe the impact on
the availability of accountants to perform services
and the quality of services produced by these
accountants. See Robert Van Grover Esq., Seward &
Kissel LLP, SEC Staff No-Action Letter (Dec. 11,
2019) (extending the no-action position taken in
prior letters until the date that a PCAOB-adopted
permanent program, having been approved by the
Commission, takes effect).
296 See, e.g., Reports of Board Determinations
Pursuant to Rule 6100, available at https://
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We recognize that there may be a
limited number of PCAOB-registered
and inspected independent public
accountants in certain foreign
jurisdictions. However, we do not
believe that advisers would have
significant difficulty in finding an
accountant that is eligible under the
proposed rule in most jurisdictions
because many PCAOB-registered
independent public accountants who
are subject to regular inspection
currently have practices in various
jurisdictions, which may ease concerns
regarding offshore availability.
We request comment on the all
aspects of the proposed requirement
that accountants be registered with, and
subject to inspection by, the PCAOB,
including the following items:
210. Should the rule require
accountants performing audits under
the rule to be registered with the
PCAOB as proposed? Should the rule
require accountants to be subject to
regular inspection by the PCAOB as
proposed? Do accounting firms
registered with and subject to regular
inspection by the PCAOB implement
their quality control systems throughout
the accounting firm related to their
assurance engagements? Why or why
not?
211. If the rule did not include these
requirements, should the rule impose
any additional licensing, examination,
or inspection requirements on such
accountants? If so, describe these
additional requirements and explain
why they are necessary? For example,
should the rule require accountants to
have a CPA license in good standing?
212. The PCAOB has specific rules
governing regular and special
inspections under its inspection
program.297 We understand, however,
that sometimes advisers may be unsure
whether a registered public accounting
firm is ‘‘subject to regular inspection’’
by the PCAOB. Rather than require the
accountant to be ‘‘subject to regular
inspection,’’ should we instead require
the accountant to be a registered public
accounting firm with either an issuer or
broker dealer audit client (or play a
substantial role in the audit of an issuer
or broker dealer) as of the start of the
engagement period and as of each
calendar year end? If we were to take
this approach, would it significantly
diminish the number of accountants
available to perform audits? How would
this approach affect the cost of audits?
pcaobus.org/oversight/international/boarddeterminations-holding-foreign-companiesaccountable-act-hfcaa.
297 See PCAOB Rule 4000–4003, available at
https://pcaobus.org/about/rules-rulemaking/rules/
section_4.
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Would this have any potential
unintended consequences, including,
for example, adversely affecting smaller
public accounting firms compared to
larger public accounting firms?
213. The PCAOB has explained that it
will inspect at least five percent of the
number of registered public accounting
firms reporting that they have ‘‘played
a substantial role in the preparation or
furnishing of an audit report with
respect to an issuer without having
issued an audit report with respect to an
issuer in that reporting period.’’ 298
Should we define ‘‘subject to regular
inspection’’ for purposes of compliance
with the safeguarding rule to exclude
registered public accounting firms that
‘‘played a substantial role in the
preparation or furnishing of audit report
with respect to an issuer without having
issued an audit report with respect to an
issuer in that reporting period’’? If not,
explain why not? If we defined ‘‘subject
to regular inspection’’ in this way,
would this significantly diminish the
number of accountants available to
perform audits? If so, how would this
affect the cost of audits?
214. By extending the availability of
the audit provision and continuing to
require that the independent
accountants performing audits be
registered with and subject to regular
inspection by the PCAOB, the proposed
rule may narrow the pool of auditors
who would be able to perform services
under the proposed rule. Should the
proposed rule instead require only
PCAOB-registered public accounting
firms to be used to perform certain
services under the proposed rule? If so,
which services and why?
215. Do commenters agree that the
availability of accountants to perform
services for purposes of the proposed
rule is sufficient? If not, please describe
how the proposed rule could provide
greater availability.
216. Do commenters agree that
advisers have reasonable access to
public accountants that are registered
with and subject to inspection by the
PCAOB in the foreign jurisdictions in
which they operate? If not, how should
the proposed rule address this issue?
d. Accounting Standards for Financial
Statements
As is the case with the current
custody rule, the proposed rule would
require audited financial statements to
be prepared in accordance with the
generally accepted accounting
principles.299 Entities that are organized
298 See PCAOB Rule 4003(h), available at https://
pcaobus.org/about/rules-rulemaking/rules/section_
4.
299 See proposed rule 223–1(b)(4)(iii).
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outside of the United States, or that
have a general partner or other manager
with a principal place of business
outside of the United States, may have
their financial statements prepared in
accordance with accounting standards
other than U.S. GAAP.300 We would
consider these financial statements to
meet the requirements of the proposed
rule so long as they contain information
substantially similar to financial
statements prepared in accordance with
U.S. GAAP, material differences with
U.S. GAAP are reconciled, and the
reconciliation, including supplementary
U.S. GAAP disclosures, is distributed to
U.S. investors as part of the audited
financial statements. Requiring that
financial statements comply with U.S.
GAAP or standards substantially similar
to U.S. GAAP along with a
reconciliation to U.S. GAAP in the case
of foreign entities would help assure
that clients receive consistent and
quality financial reporting on their
assets from their adviser.
We believe that this approach
balances the needs of users of the
financial statements with the cost to
prepare financial statements under
separate accounting standards by
allowing advisers the flexibility to
provide clients with financial
statements that are prepared in
accordance with applicable local
accounting standards. We also believe a
reconciliation to U.S. GAAP is
necessary for entity audits because U.S.
GAAP has industry specific accounting
principles for certain pooled vehicles,
including private funds. For example,
U.S. GAAP may require measurement of
trades on trade date as opposed to
settlement date, presentation of a
schedule of investments, and certain
financial highlights that may not be
required under other accounting
standards. Because these differences
may be material, a reconciliation to U.S.
GAAP would enhance investor
protection.
We request comment on all aspects of
the proposed requirements for preparing
financial statements in accordance with
generally accepted accounting
300 This proposed provision is intended to codify
our current approach. For example, we have
previously allowed an adviser to a foreign pooled
investment vehicle to have its financial statements
prepared in accordance with International
Accounting Standards or some other
comprehensive body of accounting standards
provided that the financial statements contain
information that is substantially similar to financial
statements prepared in accordance with U.S. GAAP
and contains a footnote reconciling any material
variations between the comprehensive body of
accounting standards and U.S. GAAP. See 2003
Adopting Release supra footnote 2 at n.41.
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principles, including the following
items:
217. Should the rule continue to
require accountants to prepare audited
financial statements in accordance with
generally accepted accounting
principles as proposed? Should the rule
include any additional requirements
regarding the preparation of financial
statements? If so, what requirements,
and why? For example, should we, as
proposed, consider financial statements
of non-U.S. advisers and non-U.S.
entities to meet the requirements of the
rule provided that they contain
information substantially similar to
statements prepared in accordance with
U.S. GAAP, material differences with
U.S. GAAP are reconciled, and the
reconciliation is distributed to U.S.
clients along with the financial
statements? If so, should we specify
what ‘‘substantially similar’’ means?
What standards should be viewed as
‘‘substantially similar’’ to U.S. GAAP,
and why? Is the requirement to
reconcile financial statements of entities
organized under non-U.S. law or that
have a general partner or other manager
with a principal place of business
outside the U.S. with U.S. GAAP
necessary? Would this reconciliation
requirement present any difficulties?
218. In light of our proposal to make
the audit provision available to advisers
to additional entities (e.g., pension
plans, retirement plans, 529 plans, and
ABLE plans), would these additional
entities be able to meet the proposed
accounting standards? Would they
present any challenges for such entities?
Should we modify this aspect of the
proposal to address these additional
entities? If so, how?
219. It is our understanding that the
financial statement presentation
required under U.S. GAAP may be
different for pooled investment vehicles,
e.g., private funds, compared to other
entities, e.g., 529 plans. Would these
presentation differences have an impact
on investor’s ability to understand the
financial statements?
e. Distribution of Audited Financial
Statements
Under the custody rule, an adviser
must annually distribute its audited
financial statements to all limited
partners (or members or other beneficial
owners) within 120 days of the end of
its fiscal year and promptly upon
completion of the audit in the final year
of liquidation.301 The proposed audit
provision would generally retain this
approach, requiring an adviser to
301 See rule 206(4)–2(b)(4)(i) and rule 206(4)–
2(b)(4)(iii).
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distribute an entity’s audited financial
statements to current investors within
120 days, but would extend the delivery
deadline to 180 days in the case of a
fund of funds or 260 days in the case of
a fund of funds of funds of the entity’s
fiscal year end.302 The audited financial
statements would consist of the
applicable financial statements
(including any required reconciliation
to U.S. GAAP, including supplementary
U.S. GAAP disclosures), related
schedules, accompanying footnotes, and
the audit report. Based on our
experience administering the custody
rule, we believe that a 120-day time
period is appropriate to allow the
financial statements of an entity to be
audited and to provide investors with
timely information. We understand,
however, that preparing audited
financial statements for some
arrangements, such as sub-adviser or
outsourced Chief Investment Officer
(OCIO) arrangements, may require
reliance on third parties, which could
cause an adviser to fail to meet the
current 120-day timing requirements for
distributing audited financial statements
regardless of actions it takes to meet the
requirements. We also recognize there
may be times when an adviser
reasonably believes that an entity’s
audited financial statements would be
distributed within the 120-day
timeframe but fails to have them
distributed within that timeframe
because of unforeseeable circumstances.
For example, during the COVID–19
pandemic, some advisers were unable to
distribute audited financial statements
in the timeframes required under the
custody rule due to logistical
disruptions. Accordingly, the
Commission would take the position
that, if an adviser is unable to deliver
audited financial statements in the
timeframe required under the proposed
safeguarding rule due to reasonably
unforeseeable circumstances, this would
not provide a basis for enforcement
action so long as the adviser reasonably
believed that the audited financial
statements would be distributed by the
applicable deadline.303 We similarly
believe that a 180-day time period
(subject to this position and its
reasonable belief standard) is
appropriate in the context of a fund of
funds and that a 260-day time period
(subject to this position and its
reasonable belief standard) is
appropriate in the context of a fund of
302 See
proposed rule 223–1(b)(4)(iv).
proposed rule 223–1(b)(4)(iv) to rule
206(4)–2(b)(4)(i). Under the proposed rule, we
would still continue to require liquidation audited
financial statements to be distributed ‘‘promptly.’’
303 Compare
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funds of funds because advisers to these
types of pooled investment vehicles
may face practical difficulties
completing their audits before the
completion of audits for the underlying
funds in which they invest.304
Under the proposed audit provision,
the audited financial statements
(including any reconciliation to U.S.
GAAP prepared for a foreign entity, as
applicable) must be sent to all of the
entity’s investors.305 Further, if an
investor is a pooled investment vehicle
that is in a control relationship with the
adviser or the adviser’s related persons,
the sender must look through that pool
(and any pools in a control relationship
with the adviser or its related persons)
in order to send the audited financial
statements to investors in those
pools.306
In addition, an adviser to a pooled
investment vehicle client may utilize an
SPV, organized as a limited liability
company, trust, partnership, corporation
or other similar vehicle, to facilitate
investments for legal, tax, regulatory or
other similar purposes. For example, the
adviser’s pooled investment vehicle
client may invest a portion of its capital
in an SPV, which in turn purchases a
single investment for the pooled
investment vehicle client (‘‘single
purpose vehicle’’). Similarly, an adviser
to multiple pooled investment vehicle
clients may utilize an SPV to purchase
a single investment for multiple pooled
investment vehicle clients (‘‘multi-fund
single purpose vehicle’’). In another
variation, an adviser to one or more
pooled investment vehicle clients may
utilize an SPV to purchase multiple
investments for one or more pooled
investment vehicle clients (‘‘multipurpose vehicle’’). Similar to under the
custody rule,307 an investment adviser
could either treat an SPV as a separate
client, in which case the adviser will
have custody of the SPV’s assets, or treat
the SPV’s assets as assets of the pooled
investment vehicles of which it has
custody indirectly under the
safeguarding rule. If the adviser is
304 See also Custody Rule FAQs, supra footnote
17, at Question VI.8A and VI.8B, in which we note
that our staff expressed a similar view.
305 See proposed rule 223–1(b)(4)(iv).
306 See proposed rule 223–1(c); see supra section
II.B.3.b.ii.
307 Advisers Act Rule 206(4)–2(c) states that
sending an account statement under paragraph
(a)(5) of the custody rule or distributing audited
financial statements under paragraph (b)(4) of the
custody rule shall not satisfy the requirements of
the custody rule if such account statements or
financial statements are sent solely to limited
partners (or members or other beneficial owners)
that themselves are limited partnerships (or limited
liability companies, or another type of pooled
investment vehicle) and are the adviser’s related
persons.
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relying on the audit provision and treats
the SPV as a separate client, the
safeguarding rule would require the
adviser to comply separately with the
safeguarding rule’s audited financial
statement distribution requirements like
the custody rule.308 Accordingly, the
adviser would distribute the SPV’s
audited financial statements to the
pooled investment vehicle’s beneficial
owners. If, however, the adviser is
relying on the audit provision and treats
the SPV’s assets as the pooled
investment vehicle’s assets of which it
has custody indirectly, the SPV’s assets
would be required to be considered
within the scope of the pooled
investment vehicle’s financial statement
audit.309
An adviser would have the choice of
whether to treat the SPV as a separate
client or treat the SPV’s assets as the
pooled investment vehicle’s assets of
which it has custody indirectly,
regardless of whether the SPV is a single
purpose vehicle, multi-fund single
purpose vehicle, or a multi-purpose
vehicle (as applicable), provided that
the SPV’s assets would be considered
within the scope of the financial
statement audit of the pooled
investment vehicle client(s) and
provided that the SPV has no owners
other than the adviser, the adviser’s
related person(s) or the pooled
investment vehicle clients that are
controlled by the adviser or the
adviser’s related person(s). If, however,
the adviser uses an SPV to purchase one
or more investments for one or more
pooled investment vehicle clients and
third parties that are not pooled
investment vehicles controlled by the
adviser or the adviser’s related
person(s), the adviser may not treat the
SPV’s assets as assets of the pooled
investment vehicle clients of which the
adviser or the adviser’s related person(s)
has custody indirectly for purposes of
the safeguarding rule. The adviser
would, instead, be required to treat the
SPV’s assets as a separate client for
purposes of the safeguarding rule
because the SPV has owners other than
the adviser, the adviser’s related
person(s) or pooled investment vehicles
controlled by the adviser or the
adviser’s related person(s).310
We request comment on all aspects of
the proposed rule’s requirements for
distributing audited financial
statements, including the following
items:
308 See
discussion supra at section II.B.3.b.ii.
also id.
310 We note that our staff previously took a
similar view. See 2014 IM Guidance supra footnote
17.
309 See
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220. Should the safeguarding rule
require audited financial statements of
an entity to be distributed to all the
entity’s investors within 120 days (or
180 days in the case of a fund of funds
or 260 days in the case of a fund of
funds of funds) as proposed? Would a
longer or shorter period be appropriate
(e.g., 180 days or 90 days)? Should the
rule expressly allow the statements to be
distributed beyond the prescribed
period of 120 (or 180 or 260) days if a
reasonably unforeseeable circumstance
necessitates a longer period? If so,
should such a longer period have an
outer limit? If so, should other
conditions apply such as requiring the
adviser to retain documentation
supporting the reasons for the delay?
Should it require advisers to notify
investors of the delay and, if so, what
information should be included in the
notice and by when should it be
distributed?
221. If the adviser is unable to deliver
audited financial statements in the
timeframe required under the proposed
safeguarding rule because of reasonably
unforeseeable circumstances but the
adviser reasonably believed that the
audited financial statements would be
distributed by the applicable deadline,
the Commission would take the position
that this would not provide a basis for
enforcement action. Do commenters
believe that this position should be
incorporated into rule text? If so, why?
222. Instead of requiring distribution
of the audited financial statement to
investors, should we require the
statement to be distributed or made
available to investors upon request?
223. For entities, we understand that
audited financial statements are posted
to the entity’s website, e.g., a 529 plan’s
website, along with a written
notification sent to accountholders of
the availability of the financial
statements. The entity also provides a
hardcopy of the financial statements by
mail within three business days upon an
accountholder’s request. Should we
continue to allow this type of electronic
delivery to meet the distribution
requirement? Should we expand the
availability of electronic delivery of
audited financial statements? If so, how?
224. Do commenters agree that funds
of funds or certain funds in masterfeeder structures (including those
advised by related persons) may not be
able to prepare and distribute financial
statements within the current rule’s 120day requirement? Subject to the
qualification above that the Commission
would take the position that an inability
to deliver audited financial statements
in the required timeframe under certain
circumstances would not provide a
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basis for enforcement action, do
commenters agree that distribution
within 180 or 260 days of the fund’s
fiscal year end would be appropriate?
With the proposed expansion of the
audit exception to entities, are there any
types of entities other than fund of
funds that should be permitted
additional time for distribution? If so,
why and what should that limit be?
225. Where an investor is a pooled
investment vehicle that is in a control
relationship with the adviser or the
adviser’s related persons, should we
require the sender to look through that
pool (and any pools in a control
relationship with the adviser or its
related persons) to satisfy the
distribution requirement? If not, why
not?
226. We understand that some
registered fund families have organized
unregistered money market funds for
investment exclusively by their
registered investment companies, in
compliance with rule 12d1–1 under the
Investment Company Act. The financial
statements of the unregistered money
market funds are audited, but delivered
to the registered investment companies,
which may be related persons of the
adviser. Should there be an exception to
the distribution requirements of
proposed rule 223–1(c) under these
circumstances? 311 Are there other
similar circumstances where an
exception would be appropriate? Please
explain.
f. Commission Notification
The proposed rule would require an
adviser to enter into, or cause the entity
to enter into, a written agreement with
the independent public accountant
performing the audit to notify the
Commission (i) within one business day
upon issuing an audit report to the
entity that contains a modified opinion
and (ii) within four business days of
resignation or dismissal from, or other
termination of, the engagement, or upon
removing itself or being removed from
consideration for being reappointed.312
These proposed requirements are drawn
from the current rule’s Form ADV–E
filing requirement for independent
public accountants performing surprise
examinations.313 The accountant
making such a notification would be
required to provide its contact
information and indicate its reason for
sending the notification. The written
311 We note that our staff has stated that it would
not recommend enforcement action to the
Commission under similar circumstances. See
Custody Rule FAQs, supra footnote 17, at Question
VI.10.
312 See proposed rule 223–1(b)(4)(v).
313 See rule 206(4)–2(a)(4).
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agreement must require the independent
public accountant to notify the
Commission by electronic means
directed to the Division of
Examinations. Timely receipt of this
information would enable our staff to
evaluate the need for an examination of
the adviser. We expect the Division of
Examinations would establish a
dedicated email address to receive these
confidential transmissions and would
make the address available on the
Commission’s website in an easily
retrievable location.
Although there is a requirement on
Form ADV for an adviser to a private
fund to report to the Commission
whether it received a qualified audit
opinion and to provide, and update, its
auditor’s identifying information, there
is not a similar obligation for an
accountant to notify the Commission as
there is for a surprise examination
under the current rule.314 Based on our
experience in receiving notifications
from accountants who perform surprise
examinations under the custody rule,
we believe that the timely receipt of this
information—from an independent third
party—would more readily enable our
staff to identify advisers potentially
engaged in harmful misconduct and
who have other compliance issues. This
would bolster the Commission’s efforts
at preventing fraudulent, deceptive, and
manipulative activity and would aid
oversight of investment advisers.
We request comment on all aspects
these notification requirements,
including the following items:
227. Should independent public
accountants completing financial
statement audits under the proposed
rule be required to provide these
proposed notifications? Would the
requirement for an accountant to
comply with the notification
requirement change the approach that
an accountant would take regarding
audits that normally are performed for
purposes of satisfying the custody rule?
If so, how?
228. Are there any privacy concerns
or contractual obligations that could
prohibit or restrict an accountant from
providing this information? If so, what?
229. The regulations in 17 CFR
240.17a–5 (rule 17a–5) require a broker
or dealer to self-report to the
Commission within one business day
and to provide a copy to the accountant.
The accountant must report to the
Commission about any aspects of the
broker’s or dealer’s report with which
the accountant does not agree. If the
314 See rule 206(4)–2(a)(4) compare to rule
206(4)–2(b)(4); see also Form ADV Part 1A,
Schedule D, section 7.B.1, Q.23.
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broker or dealer fails to self-report, the
accountant must report to the
Commission to describe any material
weaknesses or any instances of noncompliance that triggered the
notification requirement. Should the
audit provision under the proposed rule
contain a notification requirement
similar to rule 17a–5? Why or why not?
230. The regulations in 17 CFR
240.17a–5 (rule 17a–5) also require a
broker-dealer, pursuant to a statement
filed with the Commission, to allow
access to the audit documentation
associated with the reports of the
independent public accountant and to
allow the independent public
accountant to discuss the findings
associated with the reports with
representatives of the Commission.
Should the rule include a similar
provision? Specifically, should the rule
require that an investment adviser,
pursuant to a written agreement
between the adviser and the accountant,
allow access to the audit or examination
documentation associated with the
reports of the independent public
accountant, by representatives of the
Commission, if requested in writing for
purposes of an examination of the
adviser? Should the rule require the
investment adviser, pursuant to a
written agreement between the adviser
and the accountant, to require the
independent public accountant to
discuss with representatives of the
Commission, if requested in writing for
purposes of an examination of the
adviser, the findings associated with the
reports of the independent public
accountant?
231. Should the accountant instead be
required to file Form ADV–E in a
similar manner as independent public
accountants who complete surprise
examinations? If so, what types of
information should be included on
Form ADV–E with respect to financial
statement audits? Should a copy of the
audit report or a copy of the audited
financial statements be filed with the
Commission? If so, would there be
issues with making copies of these
reports publicly available, particularly
since the adviser typically is not a party
to the audit engagement agreement
between the audited entity and the
independent public accountant?
232. Is one business day the
appropriate timeframe for notification
upon an accountant issuing a modified
opinion? Should we use a different
timeframe, such as promptly? Why or
why not?
233. Is four business days the
appropriate timeframe for notification
after an accountant’s resignation or
dismissal from, or other termination of,
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the engagement, or upon removing itself
or being removed from consideration for
being reappointed? Should we use a
different timeframe? Why or why not?
234. Should the independent public
accountants completing financial
statement audits under the proposed
rule be required to provide these
proposed notifications of resignation or
dismissal from, or other termination of,
the engagement, or upon removing itself
or being removed from consideration for
being reappointed? Are there any
instances of resignation or dismissal
from, or other termination of, the
engagement, or upon removing itself or
being removed from consideration for
being reappointed that should not be
reported? If so, why? Should we also
amend the instructions to Form ADV–E
in a similar way?
2. Discretionary Authority
The proposed rule would contain an
exception from the surprise examination
requirement for client assets if the
adviser’s sole basis for having custody is
discretionary authority with respect to
those assets, provided this exception
applies only for client assets that are
maintained with a qualified custodian
in accordance with the proposed rule
and for accounts where the adviser’s
discretionary authority is limited to
instructing its client’s qualified
custodian to transact in assets that settle
exclusively on a DVP basis.315 In DVP
transactions, clients’ custodians are
generally under instructions to transfer
assets out of a client’s account only
upon corresponding transfer of assets
into the account.
When a custodian is under
instructions to transfer assets out of a
client’s account only upon
corresponding transfer of assets into the
account, there is a reduced risk that the
adviser could misappropriate the assets,
and when the transaction settles on a
DVP basis there is a reduced risk of theft
of the asset because, on a non-DVP
basis, the seller of an asset could deliver
the asset but not receive payment or the
buyer of an asset could make payment
but not receive delivery of the asset.316
We believe this exception will focus the
requirement to obtain a surprise
315 Proposed
rule 223–1(b)(8).
note that the staff has acknowledged that
limiting the adviser’s authority to transactions that
settle via DVP at a qualified custodian is one way
for an adviser to avoid inadvertent custody. The
staff’s statement noted that an adviser could draft
a letter (or other form of document) addressed to
the custodian that limits the adviser’s authority to
‘‘delivery versus payment,’’ notwithstanding the
wording of the custodial agreement, and have the
client and custodian provide written consent to
acknowledge the new arrangement. See 2017 IM
Guidance, supra footnote 135.
316 We
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examination where the risk of
misappropriation is greatest. As an
example, if the custodian’s instructions
from the client authorize the adviser to
wire cash from the client’s account in
exchange for an equivalent amount of
XYZ stock that is to be received into the
client’s account, the adviser need not
undergo a surprise examination. If,
however, the custodian’s instructions
from the client authorize the adviser to
wire cash from the client’s account
without receipt of a corresponding asset,
the adviser would need to undergo a
surprise examination.
We propose to limit this exception to
instances where this is the adviser’s sole
basis for custody. Accordingly, if an
adviser also has custody of the client’s
assets for additional reasons, such as via
a power of attorney that confers oneway transfer authority, the adviser
cannot rely on the exception.
Conversely, if an adviser also has
custody of the client’s assets for reasons
that are also subject to similar
exceptions (e.g., sole basis is fee
deduction, sole basis is related person
custody),317 the adviser can rely on the
exception. These exceptions from the
surprise examination requirement are
not mutually exclusive of one another
notwithstanding our use of ‘‘solely’’ in
each of them.318
We request comment on all aspects of
the proposed exception for discretionary
authority, including the following items.
235. Should we provide an exception
from the requirement to obtain an
independent verification of client assets
if an adviser’s sole basis for custody is
having discretionary authority with
respect to client assets that are
maintained with a qualified custodian
in accordance with the rule? Does
providing such an exception from asset
verification in these limited
circumstances produce additional risks
for client assets?
236. Are we correct in our assessment
that this proposed exception would
better balance the costs and protections
of the proposed rule?
237. Should we limit the exception to
situations in which the qualified
custodian implements certain policies
and procedures? If so, what should they
include? For example, would a qualified
custodian need to demonstrate that it
has certain systems, confirmations, or
authorizations in place to ensure that an
adviser is unable to initiate any one-way
transactions and that the adviser’s
authority is limited to only trading?
317 See Rule 206(4)–2(b)(3) and (6) and proposed
rule 223–1(b)(6).
318 See proposed rule 223–1(b)(9).
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238. Should we limit the exception to
situations in which the adviser
implements certain policies and
procedures with regard to discretionary
authority? If so, what should those
policies and procedures be? If we were
to rely more heavily on the adviser’s
policies and procedures, should we
require external testing or auditing of
those policies and procedures or
internal controls? For example, should
we require an internal control report
with similar control objectives to the
internal control reports we require
under the custody rule or what we
would require under the safeguarding
rule?
239. Do commenters agree with our
assessment of the risks to client assets
as a result of discretionary authority in
qualified custodian accounts? Do
commenters agree with our assumption
that a one-way transfer of assets from an
account at a qualified custodian is a
riskier form of discretionary authority
than DVP transactions? Are there
circumstances in a discretionary trading
environment at a qualified custodian
where risks of misappropriation or theft
in an account are not mitigated by DVP
settlement or requiring a one-for-one
exchange of assets? If so, please provide
such examples.
240. If an adviser’s authority over an
account with a qualified custodian
includes the ability to transfer assets
free of payment to another account with
the same account title, should such an
account still be eligible for the limited
exception to the surprise examination?
241. Should this exception apply
‘‘solely’’ when the basis for custody is
discretionary authority? Should we
allow use of the exception when the
adviser also qualifies for another
exception that is similarly premised on
an adviser ‘‘solely’’ having custody for
a specifically identified reason, such as
when an adviser has custody of client
assets ‘‘solely’’ as a consequence of its
authority to make withdrawals from
client accounts to pay its advisory fee,
or ‘‘solely’’ because a related person has
custody of them in connection with the
adviser’s advisory services?
Notwithstanding the use of ‘‘solely’’ in
certain exceptions from the surprise
examination requirement, these limited
exceptions are not mutually exclusive;
should they be? 319
3. Standing Letters of Authorization
The proposed rule also contains an
exception from the surprise examination
requirement for client assets if the
adviser has custody of those assets
solely because of a standing letter of
authorization (‘‘SLOA’’).320 The rule
would define SLOA as an arrangement
among the adviser, the client, and the
client’s qualified custodian in which the
adviser is authorized, in writing, to
direct the qualified custodian to transfer
assets to a third-party recipient on a
specified schedule or from time to time.
In such an arrangement the client’s
qualified custodian could not be an
adviser’s related person.321 Such an
authorization must include the client’s
signature, the third party recipient’s
name, and either the third party’s
address or the third party’s account
number at a custodian to which the
transfer should be directed. The
authorization must also provide that the
investment adviser has no ability or
authority to designate or change any
information about the recipient,
including name, address, and account
number.322
Clients increasingly grant their
advisers limited powers to disburse
assets from their accounts to one or
more specifically designated third
parties in a manner that limits the
adviser’s ability to redirect the assets.
For example, a client may grant its
adviser this authority pursuant to a onetime or standing letter of instruction or
other similar asset transfer authorization
arrangement that the client establishes
with qualified custodians. In granting
such authority the client may authorize
the adviser to perform transfers or
disbursements via automated clearing
house (i.e., ACH) transfers, wires,
checks, or other methods. Such
authorizations can be for one-time wires
out of the account or standing
authorization where an adviser is given
ongoing authority by the client to
execute certain asset movements into
and out of a client’s account.
The written instruction and
authorization could be provided to the
adviser on the same form the client
delivers to its qualified custodian, or it
could be provided separately, but it
must be delivered to both parties. The
required signature would ensure that
the instructions and authorizations are
verifiably from the client. We believe
the types of financial institutions
identified as meeting the proposed
definition of qualified custodian are
required by their primary functional
regulator or otherwise to perform
procedures to verify the instruction and
authorization, through a signature
review and, if determined to be
320 Proposed
rule 223–1(b)(7).
term ‘‘related person’’ would have the
same meaning as in the current rule.
322 Proposed rule 223–1(d)(12).
321 The
319 See rule 206(4)–2(b)(3) and (6); proposed rule
223–1(b)(3) and (6).
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necessary, based on the facts and
circumstances, another method of
verification. The required information
could help ensure that the instructions
to the qualified custodian provide
relevant information about the recipient.
These instructions could include a
specified schedule for transfers, or they
could include a more general
instruction for the adviser to direct
transfers to the recipient from time to
time.
Where the arrangement is structured
so that the adviser’s role is limited to
determining the timing and amounts
when disbursing a client’s assets, we
believe that the adviser’s role in
effecting any change in beneficial
ownership is circumscribed and
ministerial, and there is little risk to
clients of loss, misuse,
misappropriation, or theft of its asset.323
We also believe under such
circumstances that a qualified custodian
would be best positioned to ensure that
the required authorizations and
instructions are properly and verifiably
issued by the client (e.g., the client’s
signature is verifiable), provided the
custodian is not a related person of the
adviser to reduce the incentive and
opportunity to collude in such an
arrangement.324 Under these
circumstances, we believe that the
proposed rule’s independent
verification requirement would not be
meaningfully additive to protect a
client’s assets.325
323 We note that the staff has taken a similar
position. See Investment Adviser Association, SEC
Staff No-Action Letter (Feb. 21, 2017) (indicating
the staff would not recommend enforcement action
to the Commission if advisers exercise limited
authority pursuant to a SLOA without undergoing
an annual surprise examination, if the SLOA
arrangement meets certain specified conditions).
324 Each of the types of financial institutions
identified in the proposed rule as meeting the
definition of qualified custodian is subject to antimoney laundering and know your customer
requirements that require the financial institution to
verify signatures. See, e.g., 12 CFR 21.21 (requiring
every national bank and savings association to have
a written, board approved program that is
reasonably designed to assure and monitor
compliance with the Bank Secrecy Act); FINRA
Rule 3310 (setting forth the minimum standards for
broker-dealer firm’s written anti-money laundering
compliance programs); FINRA Rule 2090 (requiring
broker-dealers to use reasonable diligence, in regard
to the opening and maintenance of customer
accounts, to know (and retain) essential facts
concerning its customers and concerning the
authority of each person acting on behalf of such
customers); see also Federal Financial Institutions
Examination Council Bank Secrecy Act/Anti-Money
Laundering Examination Manual, available at
https://bsaaml.ffiec.gov/manual database of BSA/
AML policies and procedures.
325 An adviser would be required to report to the
Commission on Form ADV if it is relying on this
exception. See proposed Form ADV amendment to
Item 9 (Safeguarding). In addition, we are proposing
corresponding amendments to the books and
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Finally, as noted above, this exception
is not mutually exclusive of similar
limited exceptions within the proposed
rule, notwithstanding our use of
‘‘solely’’ in each of them. It would not,
however, be available if the adviser has
custody for another reason outside of
the ones that would qualify the adviser
for an exception as a sole basis for
custody. In our view, the approach
outlined above clarifies that the
initiation of SLOAs means that advisers
have custody under the rule, but also
recognizes the lower risks to client
assets associated with these
arrangements. We request comment on
all aspects of the proposed rule’s SLOA
exception, including the following
items.
242. Do commenters agree that an
adviser should be exempt from the
independent verification requirements if
it has custody solely because of an
SLOA where the client grants its adviser
the limited power for disbursements to
third parties specifically designated by
the client and the adviser can comply
with the conditions of the proposed
exception? Are there other protections
we should require? If so, what
protections?
243. Should this exception be
available when the client’s assets are not
maintained with a qualified custodian?
Does a qualified custodian better protect
client assets subject to limited powers of
attorney (such as by performing
signature verification procedures under
anti-money laundering and know-yourcustomer requirements that require the
financial institution to verify
signatures)?
244. Should this exception be
unavailable when the client’s assets are
at a related qualified custodian, as
proposed? If not, what specific
conditions would safeguard client assets
from the risks of loss, theft, misuse, or
misappropriation in these
circumstances?
245. Would an adviser’s authority be
appropriately limited (and therefore
circumscribed and ministerial) if the
client’s instructions include the name
and either the address or the account
number of the recipient to whom a
transfer of investments should be
directed? Should the instructions and
authorization include different, or
additional, information, and if so, what?
246. Are qualified custodians required
to verify SLOAs, or other limited power
of attorney, instructions under their
governing regulations, such as a
records rule. Proposed rule 204–2(b)(2) would
require advisers to retain true, accurate, and current
copies of, and records relating to, any SLOA issued
by a client to the adviser. Proposed rule 204–
2(b)(2)(vi).
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signature review or other method? If
not, should we require the adviser to
confirm or contract with the qualified
custodian so that it takes these steps?
247. Would it be appropriate to
permit another party, such as an
introducing broker, to perform these
steps for the qualified custodian? Is this
sometimes necessary, such as in the
context of signature verification, if the
introducing broker has a relationship
with the client while a clearing broker
serves as qualified custodian? If yes,
under what conditions? For instance,
should the person performing the steps
be regulated for this activity? Should the
person be prohibited from performing
these steps if it is a related person of the
adviser?
248. Are qualified custodians required
under their governing regulations to
provide a transfer of funds notice to the
client promptly after each transfer under
a power of attorney and/or send the
client, in writing, an initial notice
confirming the instruction and an
annual notice reconfirming the
instruction? If not, should we require
the qualified custodian take these steps
as part of this proposed exception?
Alternatively, should we require the
adviser to include a provision requiring
such notice in its written agreement
with the qualified custodian?
249. Do commenters agree that, in
order to rely on this proposed
exception, the investment adviser must
have no authority or ability to designate
or change the identity of the third party,
the address, or any other information
about the third party contained in the
client’s instruction, as proposed? Are
there other safeguards that an
investment adviser should comply with
in order to rely on this proposed
exception?
250. Are clients that issue limited
powers of attorney able to terminate or
change the instruction to their qualified
custodians? If not, should we require
that the client have this ability as part
of this proposed exception?
251. Are there some types of limited
powers of attorney for which an adviser
cannot satisfy the proposed conditions,
where we should nevertheless permit an
adviser to rely on this proposed
exception? In those cases, is the
adviser’s role in effecting any change in
beneficial ownership of a client’s assets
similarly circumscribed by the client
and ministerial in nature? If so, what are
they?
252. Could online bill pay be
integrated into the proposed framework
for the standing letters of authorization
exception or another exception? Would
there be the difficulties in crafting an
exception for bill pay that offered
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similar protections to those we describe
above?
253. Given the general irreversibility
of crypto asset transactions in the event
of erroneous or fraudulent transactions,
should this proposed exception be
unavailable for crypto assets?
H. Amendments to the Investment
Adviser Recordkeeping Rule
We are proposing to amend rule 204–
2 to set forth requirements for making
and keeping books and records related
to the requirements of the proposed
custody rule. The proposed
amendments to rule 204–2 are designed
to work in concert with the proposed
rule to help ensure that a complete
custodial record with respect to client
assets is maintained and preserved.
The proposed changes to the
recordkeeping rule would help facilitate
the Commission’s inspection and
enforcement capabilities, including
assessing compliance with the
requirements of the proposed rule.
Reviewing client account activity and
holdings is a routine part of most
adviser examinations conducted by
Commission staff. Currently, however,
Commission staff experience challenges
in requesting, receiving, and reconciling
complete and accurate client-level
information from some investment
advisers due to a lack of recordkeeping
and coordination between advisers and
custodians. The proposed recordkeeping
amendments are designed to help
reduce these challenges by making it
easier for examiners to obtain and
review more complete and accurate
advisory client account records. We
believe having more complete records
would facilitate client account
reconciliation of all debits and credits to
and from client accounts. This would
benefit investors directly by virtue of
enhanced detection and deterrence of
possible misappropriation or fraud.
More complete records also would
better enable examiners to identify and
detect potential investment adviser
misappropriation or loss or misuse of
client assets during their examinations,
resulting in more effective investor
protections.
The proposed amendments to rule
204–2 would require an investment
adviser that has custody of client assets
to make and keep true, accurate, and
current records of required client
notifications and independent public
accountant engagements under
proposed rule 223–1, as well as books
and records related to specific types of
client account information, custodian
information, transaction and position
information, and standing letters of
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ddrumheller on DSK120RN23PROD with PROPOSALS2
authorization.326 The proposed
amendments would require a more
detailed and broader scope of records of
trade and transaction activity and
position information for each client
account than the existing requirements
for such records.327 The proposed
amendments also would add new
recordkeeping requirements that
include: (i) retaining copies of required
client notices; 328 (ii) creating and
retaining records documenting client
account identifying information,
including copies of all account opening
records and whether the adviser has
discretionary authority; 329 (iii) creating
and retaining records of custodian
identifying information, including
copies of required qualified custodian
agreements, copies of all records
received from the qualified custodian
relating to client assets, a record of
required reasonable assurances that the
adviser obtains from the qualified
custodian, and if applicable, a copy of
the adviser’s written reasonable
determination that ownership of certain
specified client assets cannot be
recorded and maintained (book-entry,
digital, or otherwise) in a manner in
which a qualified custodian can
maintain possession or control of such
assets; 330 (iv) creating and retaining a
record that indicates the basis of the
adviser’s custody of client assets; 331 (v)
retaining copies of all account
statements; 332 and (vi) retaining copies
of any standing letters of
authorization.333 Lastly, the proposed
amendments would add new
recordkeeping requirements to address
independent public accountant
engagements.334 We believe that all of
326 Advisers would be required to maintain the
proposed records for a period of not less than five
years as required under the current books and
recordkeeping rule. See rule 204–2(e)(1).
327 Compare rules 204–2(b)(1) through (4) with
proposed rule 204–2(b)(2)(v). Advisers would
continue to be required to make and keep a record
describing the basis upon which the adviser has
determined that the presumption that any related
person is not operationally independent has been
overcome, as required under current rule 204–
2(b)(5). This requirement would be renumbered in
the proposed rule with an updated cross-reference
to the definition of ‘‘operationally independent’’ in
proposed rule 223–1(d)(7).
328 Proposed rule 204–2(b)(1).
329 Proposed rule 204–2(b)(2)(i). Given this
proposed client account recordkeeping
requirement, we would eliminate the current
requirement under rule 204–2(a)(8) to keep a list or
other record of all client accounts for which the
investment adviser has any discretionary power.
330 Proposed rule 204–2(b)(2)(ii).
331 Proposed rule 204–2(b)(2)(iii).
332 Proposed rule 204–2(b)(2)(iv).
333 Proposed rule 204–2(b)(2)(vi).
334 Proposed rule 204–2(b)(3). Given that the
proposed independent public accountant
recordkeeping requirements would include a
requirement to retain copies of internal control
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these requirements would enhance the
Commission’s oversight of the
safeguarding practices of advisers and
their compliance with the rule, which
would, in turn, promote investor
protection.
1. Client Communications
The proposed amendments also
would require an adviser to maintain a
copy of all written notices to clients
required under the proposed rule and
any responses thereto.335 Specifically,
this would include notifications
provided by the adviser to each client
upon opening accounts at qualified
custodians on the client’s behalf, along
with notices in writing of any
subsequent changes in the qualified
custodian’s name, address, and account
number, and the manner in which the
client’s assets are maintained.336 Again,
we believe these requirements will
enable our staff to confirm that an
adviser is complying with providing
appropriate client communications
requirements under proposed rule 223–
1.
2. Client Accounts
Additionally, the proposed
amendments would require an adviser
to maintain six categories of records 337
with respect to each client account for
which the adviser has custody of client
assets: (1) client account
identification; 338 (2) custodian
identification; 339 (3) the basis for the
reports under proposed rule 223–1, we would
eliminate the current requirement under rule 204–
2(a)(17)(iii) to keep a copy of any internal control
report obtained or received pursuant to rule 206(4)2(a)(6)(ii). See proposed rule 204–2(b)(3)(ii).
335 See proposed rule 204–2(b)(1).
336 See proposed rule 223–1(a)(2).
337 See generally proposed rule 204–2(b)(2) for
these six categories of records.
338 For each client account, the adviser would
maintain: the advisory account name; client contact
information (including name, mailing address,
phone number, email address); advisory account
number; client type (as identified in Item 5.D. of
Form ADV); or any other identifying information
used by the investment adviser to identify the
account. Further, the provision would require that
the record identify the inception date for the
advisory account, whether the investment adviser
has discretionary authority with respect to any
client assets in the account, whether the investment
adviser has authority to deduct advisory fees from
the account, and, if applicable, the termination date
of the account, asset disposition upon termination,
and the reason for the termination.
339 For each client account, the adviser would
maintain a record that identifies and matches, for
each client of which the adviser has custody of
client assets, the account name and account
number, or any other identifying information, from
any person or entity, including any qualified
custodian, that maintains client assets to the
corresponding advisory account record for each
client required by rule 204–2(b)(2)(i). To the extent
applicable, the record must contain a copy of the
required written agreement with each qualified
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14727
adviser having custody of client assets
in the account, and whether a related
person holds the adviser’s client assets;
(4) any account statements received or
sent by the adviser, including those
delivered by the qualified custodian; (5)
transaction and position information;
and (6) standing letters of authorization.
Included among the proposed
advisory account identification records
an adviser would be required to
maintain is a record indicating whether
the adviser has discretionary authority
with respect to any client assets in the
account.340 This requirement would
inform whether the independent
verification exception applies in the
specific circumstance of the adviser
having custody of client assets solely
because the adviser has discretionary
authority with respect to those assets.341
This requirement also would subsume
and replace the requirement in the
current recordkeeping rule to make and
keep a list or other record of all client
accounts for which the adviser has any
discretionary power.342 The proposed
advisory account identification records
also would require the adviser to
maintain a record indicating whether
the adviser has authority to deduct
advisory fees from the account.343 This
requirement would inform whether the
independent verification exception
applies in the specific circumstance of
the adviser having custody of client
assets solely as a consequence of the
adviser’s authority to make withdrawals
from the account to pay its advisory fee,
and the qualified custodian being an
operationally independent related
person.344
Included among the custodian
identification information an adviser
would be required to maintain are
copies of each contract with a qualified
custodian and copies of all records
received from the qualified custodian
thereunder relating to client assets, if
applicable, and a record that indicates
the basis for the reasonable assurances
the adviser obtains from the qualified
custodian under proposed rule 223–
1(a)(1).345 These aspects of the client
account recordkeeping requirements
generally are designed to specify that
advisers must maintain such records
custodian under proposed rule 223–1(a)(2)(i),
including any amendments thereto. The record
must also reflect the basis for the reasonable
assurances that the investment adviser obtains from
the qualified custodian under proposed rule 223–
1(a)(1)(ii).
340 See proposed rule 204–2(b)(2)(i).
341 See proposed rule 223–1(b)(8).
342 See rule 204–(2)(a)(8).
343 See proposed rule 204–2(b)(2)(i).
344 See proposed rule 223–1(b)(3).
345 See proposed rule 204–2(b)(2)(ii).
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whenever client assets are maintained
by a qualified custodian. These records
also would be necessary for the adviser
to help demonstrate its compliance with
the requisite set of qualified custodian
contractual provisions and reasonable
assurances it must obtain from qualified
custodians in proposed rule 223–1(a)(1).
It would also help the adviser to
identify and match the client custodial
account to the corresponding advisory
account record as discussed above. If
applicable, the custodian identification
information would require the adviser
to maintain a copy of its written
reasonable determination that
ownership of certain specified client
assets cannot be recorded and
maintained in a manner in which a
qualified custodian can maintain
possession or control of such assets.
This recordkeeping obligation would be
required if the adviser wants to rely on
the exception for privately offered
securities and physical assets to be held
at a qualified custodian. It also would
help our examination staff to verify the
reasonableness of the adviser’s
determination and enable both internal
advisory personnel and our examination
staff to readily identify the specified
client assets that are at risk of loss or
misappropriation.
The proposed recordkeeping rule
would also require the adviser to
document the basis for the adviser’s
custody of client assets, including
whether a related person holds the
adviser’s client assets or has any
authority to obtain possession of them
in connection with the adviser’s
advisory services.346 This information
would be essential for internal advisory
personnel and for our examination staff
to be able to readily identify the client
assets that are at risk of loss or
misappropriation. It also would provide
additional explanation in the client
account record to complement the
custodial information discussed above.
3. Account Activity
In addition to client account
identification requirements, the
proposed amendments include corollary
books and records requirements relating
to client account activity that address
account statements, transaction and
position information, and standing
letters of authorization. In order to
demonstrate compliance with the
account statement aspects of the rule,
the proposed amendments would
require an investment adviser to
maintain copies of any account
statement delivered by the qualified
custodian to the client and to the
346 See
proposed rule 204–2(b)(2)(iii).
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adviser under proposed rule. The
adviser also would be required to
maintain copies of any account
statement it delivers to the client,
including copies of any account
statement it delivers to the client
containing the required notification
under proposed rule 223–1(a)(2).347 If
the client is a pooled investment
vehicle, we would require that the
record reflect the delivery of account
statements, notices, or financial
statements, as applicable, to all
investors in such client pursuant to
proposed rule 223–1(c).348
Regarding transaction and position
information in client accounts, we are
proposing several modifications that
would clarify certain obligations of the
current recordkeeping rule’s
requirements.349 First, we are proposing
modifications to the current
recordkeeping rule’s requirement that
the adviser maintain records related to
a client’s position in each security.350
The proposed amendments would
replace the current rule’s references to
‘‘security’’ or ‘‘securities’’ with ‘‘asset’’
or ‘‘assets’’ to align this requirement
with the broader scope of proposed rule
223–1.
Second, we would modify the current
recordkeeping requirement for advisers
to make and keep records of debits and
credits in client accounts, including all
purchases, sales, receipts, and deliveries
of securities for such accounts.351
Specifically, we propose to require that
in addition to trade activity, as required
by rule 204–2, the records should reflect
other transaction activity in client
accounts, which we would interpret
more broadly to include all debits and
credits to or from the account, including
deposits, transfers, and withdrawals as
well as cash flows, corporate action
activity, maturities, expirations,
expenses, and income posted. The
adviser’s records also would be required
to include the date and price or amount
of any purchases, sales, receipts,
deliveries, including any one-way
delivery of assets, and free receipt and
delivery of securities and certificate
numbers, deposits, transfers,
347 See proposed rule 223–1(a)(2). If the adviser
sends account statements to a client to which the
adviser is required to provide the account opening
notice under this section, the adviser must include
in that notice and in any subsequent account
statement it sends to such client, a statement urging
the client to compare the account statements from
the custodian with those from the adviser.
348 See supra section II.B.3.b.ii, for discussion of
proposed rule 223–1(c).
349 Compare rules 204–2(b)(1) through (4) with
proposed rule 204–2(b)(2)(v).
350 See rule 204–2(b)(4).
351 Compare rules 204–2(b)(1) and (2) with
proposed rule 204–2(b)(2)(v)(A).
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withdrawals, cash flows, corporate
action activity, maturities, expirations,
expenses, income posted to the account,
and all other debits and credits.
Although we are not prescribing the
particular form in which the records
must be kept, we would view as
acceptable keeping the records on a
trade blotter, customer account ledger,
or accounting records maintained by the
adviser. We believe that these
modifications would help ensure that an
adviser maintains sufficient information
regarding client account activity when
an adviser has custody of client assets,
and would enhance the ability of our
examination staff to verify the proper
handling of client assets by the adviser
and compliance with the proposed rule
and other applicable provisions of the
Federal securities laws.
We also would modify the current
recordkeeping rule’s requirement that
advisers keep copies of confirmations of
all transactions effected by or for the
client in the client account.352 The
proposed amendments would expressly
provide for trade confirmations that
show the date and price of each trade as
well as any instruction received by the
adviser concerning transacting in the
assets.353 We believe these
modifications are necessary because our
staff has periodically received questions
as to what is required under the current
rule and, particularly, whether the
current rule requires only that the
adviser maintain a record of trade
tickets rather than counterparty
confirmations.
4. Independent Public Accountant
Engagements
The proposed amendments also
would require advisers to retain copies
of documents relating to independent
account engagements.354 Specifically,
these documents include: (1) all audited
financial statements prepared under the
safeguarding rule; 355 (2) a copy of each
internal control report received by the
investment adviser; 356 and (3) a copy of
any written agreement between the
independent public accountant and the
adviser or the client, as applicable,
required under proposed rule 223–1.
352 Compare rule 204–2(b)(3) with proposed rule
204–2(b)(2)(v)(B).
353 As under the current rule, advisers would be
required to retain information about all orders
placed (whether executed or not). See rule 204–
2(a)(3).
354 Proposed rule 204–2(b)(3).
355 Proposed rule 204–2(b)(4).
356 This requirement would subsume and replace
the current recordkeeping requirement to retain a
copy of any internal control report obtained or
received under the current custody rule. See rule
204–2(a)(17)(iii).
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With respect to all three aspects of the
proposed amendments for independent
public accountant engagements, we
believe that maintaining these records
would give our staff critical access to
the findings of the independent public
accountant(s) that perform procedures
to verify the existence of client assets
not maintained with a qualified
custodian and/or the accuracy of an
adviser’s transactions in client assets
using enhanced authority.
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5. Standing Letters of Authorization
Finally, we propose to add a
requirement for advisers to keep copies
of, and records relating to, any standing
letter of authorization issued by a client
to the investment adviser.357 These
records generally should include the
name and either the address or the
account number of each recipient to
whom a transfer of client assets may be
directed, along with any instructions the
adviser has provided to the client’s
qualified custodian to transfer client’s
assets to that recipient. We believe that
this requirement would enhance the
ability of our examinations staff to
verify client-authorized transfers of
assets to designated recipients. This
requirement also would be critical for
our examination staff and internal
compliance personnel to demonstrate
that the adviser is appropriately
safeguarding a client’s assets while
relying on the proposed SLOA
exception from the independent
verification requirements in the
proposed rule.358
We request comment on all aspects of
the proposed books and recordkeeping
amendments, including the following
items.
254. Should we amend rule 204–2 as
proposed? Are there any other records
that an adviser should be required to
maintain? If so, what are they, and why?
255. Are there alternatives to the
proposed amendments to rule 204–2
that would minimize recordkeeping
burdens and the associated costs, while
promoting the goals of facilitating the
inspection and enforcement capabilities
of the Commission and its staff? If so,
what are they, and why?
256. Should we require advisers to
maintain the proposed records in
electronic, text-searchable, machinereadable, and/or structured format?
257. Should we eliminate the
requirement to maintain responses to
any written client communications
required under proposed rule 223–1? If
so, why?
357 See
proposed rule 204–2(b)(vi).
rule 223–1(b)(7).
358 Proposed
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258. The proposed rule would require
an adviser to make and keep records
that identify client accounts for which
the adviser has discretionary authority.
As a result, we are proposing to
eliminate the current rule’s requirement
to keep a list or other record of all client
accounts for which the investment
adviser has any discretionary power
under 204–2(a)(8) as it is no longer
necessary. Do commenters agree?
259. Is the proposed requirement
sufficiently clear regarding account
activity in a client’s account? Should we
require advisers to include additional
information about transactions effected
in a client account in their records? If
so, please explain what additional
information the rule should require and
why it should be required. If the
proposed requirement should require
less information about account activity
in a client account, please identify the
information that should not be required
and why.
260. Would advisers find the
proposed modifications to the current
recordkeeping rule’s requirements
regarding transaction and position
information helpful for account
reconciliation purposes?
261. The proposed rule would require
an adviser to maintain the proposed
records for the same period as required
under the current books and
recordkeeping rule (i.e., 5 years). Should
advisers be required to maintain these
records for a shorter or longer period? If
so, what time period, and why?
262. As proposed in amended rule
204–2, advisers that rely on the audited
financial statements exception in the
safeguarding rule for a pooled
investment vehicle or any other entity
would be required to maintain copies of
such audited financial statements.
Should we also require such advisers to
maintain records verifying the delivery
and distribution of such audited
financial statements to investors in the
entity (or their independent
representatives)?
I. Changes to Form ADV
We are proposing to amend Part 1A,
Schedule D, and the Instructions and
Glossary of Form ADV.359 The
359 This section discusses the Commission’s
proposed rule and form amendments that would
affect advisers registered with the Commission. We
understand that the state securities authorities
intend to consider similar changes that affect
advisers registered with the states, who are also
required to complete Form ADV Part 1A as part of
their state registrations. We will accept any
comments and forward them to the North American
Securities Administrators Association (‘‘NASAA’’)
for consideration by the state securities authorities.
We request that you clearly indicate in your
comment letter which of your comments relate to
these items.
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amendments are designed to help
advisers identify when they may have
custody of client assets, to provide the
Commission with information related to
advisers’ practices to safeguard client
assets, and to provide the Commission
with additional data to improve our
ability to identify compliance risks.
Because Form ADV is publicly
available, these amendments may also
provide clients or investors additional
protection because they will be better
able to discern the reasons why a
particular adviser has custody. Further,
these amendments may offer ancillary
market benefits to the extent that market
participants are better able to analyze
the Form ADV data to assess fraud risk.
The proposed amendments would
continue to collect much of the
information currently reported by
advisers in Item 9 of Form ADV Part 1A
and the corresponding sections of
Schedule D, along with new information
that corresponds with certain aspects of
the proposed rule.360 These proposed
revisions would also streamline the
collection of this information by
reorganizing Item 9 and refining certain
reporting requirements to eliminate
confusion and prevent inaccurate or
incomplete reporting.361
Item 9 currently requires an adviser to
report whether it or a related person has
custody of any advisory client’s cash or
bank accounts or securities, along with
certain additional information if an
adviser reports having custody.
Nonetheless, an adviser is not required
to report having custody if it has
custody solely because it deducts
advisory fees or because a related
person has custody but an adviser has
overcome the presumption that it is not
operationally independent. The adviser
may, however, still be required to
360 Because Form ADV, Part 1A—including the
current Item 9—is submitted in a structured, XMLbased data language specific to that Form, the
information in the amended Item 9 would continue
to be structured (i.e., machine readable) as well.
That is, the Commission is not proposing to change
the structured data language used for Item 9.
361 See proposed Form ADV, Part 1A, Item 9. The
following definitions from the proposed rule would
be added to Form ADV: Assets (for purposes of Item
9 and related sections of Schedule D), Operationally
Independent (for purposes of Item 9 and related
sections of Schedule D), Qualified Custodian, and
Standing Letter of Authorization. Additionally, the
definition of Discretionary Authority or
Discretionary Basis would be expanded to include
Discretionary Trading Authority. See proposed
Form ADV, Part 1A, Glossary and Item 9.C, D, E,
and F, which currently collect information about an
adviser’s methods of compliance with rule 206(4)–
2, whether a related-party acts as a qualified
custodian, whether the adviser was subject to a
surprise examination, and the number of qualified
custodians, respectively, would be deleted or
revised in the proposed Item 9 to reflect the
proposed changes to the rule and to collect similar
information more effectively.
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complete other sections of Item 9. In the
Commission’s experience, advisers often
are confused by these requirements,
because they may have custody under
the rule but are instructed to report not
having custody for purposes of
completing Item 9.A.(1) of Form ADV.
This can result in inaccurate or
incomplete reporting, which in turn,
could limit our staff’s ability to
effectively analyze this important Form
ADV data. Further, not being required to
report having custody on Form ADV
when an adviser in fact has custody
under the rule may result in adviser’s
erroneously believing that it is not
subject to the custody rule. The
proposed amendments to Form ADV are
designed to eliminate this confusion,
improve the information available to the
Commission and the public about how
advisers safeguard clients’ assets, and
promote greater compliance with the
proposed safeguarding rule.
First, consistent with the proposed
rule, we are proposing to capture
information in Item 9 about an adviser’s
custody of its ‘‘client assets’’ including
a client’s funds, securities, and other
positions held in a client’s account. We
are proposing to revise the introductory
language, replace references to funds
and securities in Item 9 with the term
assets (as defined in the proposed rule),
and add a new sub-item to allow
advisers to indicate their reliance on
certain exceptions in the proposed
rule.362 These revisions are designed to
align Form ADV with the proposed rule.
Next, we are also proposing to revise
Item 9.A.(1) to require advisers to
indicate, in a single place, if they
directly, or indirectly through a related
person, have custody of client assets,
including if custody is solely due to an
adviser’s ability to deduct fees from
client accounts or because the adviser
has discretionary authority.363 Form
ADV, Part 1A currently distinguishes
reporting among advisers having direct
custody, advisers subject to the current
rule because a related person has
custody, and advisers having custody of
client funds or securities solely because
of the ability to deduct advisory fees
from client accounts. Further, as noted
above, in certain circumstances advisers
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362 We
would retain the instruction to exclude
reporting information in Item 9 about advisory
clients that are investment companies registered
under the Investment Company Act as this
provision in rule 223–1 is not proposed to be
amended.
363 We are also proposing to include new
instructional language directing advisers to answer
‘‘Yes’’ to Item 9.A.(1) if they have the ability to
deduct advisory fees directly from client accounts,
reported discretionary RAUM in Item 5.F.(2).(a), or
reported having discretionary trading authority in
Item 8.C.(1).
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are currently instructed not to report
having custody in Item 9.A.(1), despite
having custody (i.e., when the basis for
custody is an adviser’s ability to deduct
advisory fees or through an
operationally independent related
person). While these distinctions are
important for evaluating compliance
risks, the current structure of Item 9
makes it difficult to easily analyze this
data. For example, under the current
structure of Item 9, we cannot easily
identify the total number of clients or
the total amount of assets over which an
adviser has custody. The proposed
revisions to Item 9.A.(1) are designed to
increase the quality of the information
reported on Form ADV by reducing
confusion about how and where to
report certain information and make it
easier for the public and the
Commission to understand and analyze.
Third, we are proposing to modify
Item 9.A.(2) to preserve information
currently reported by advisers in Item 9
about the amount of client assets and
number of clients falling into each
category of custody (i.e., direct or
indirect) and to require advisers to
report similar information about client
assets over which they have custody
resulting from (1) having the ability to
deduct advisory fees; (2) having
discretionary trading authority; (3)
serving as a general partner, managing
member, trustee (or equivalent) for
clients that are private funds; (4) serving
as a general partner, managing member,
trustee (or equivalent) for clients that
are not private funds; (5) having a
general power of attorney over client
assets or check-writing authority; (6)
having a standing letter of authorization;
(7) having physical possession of client
assets; (8) acting as a qualified
custodian; (9) a related person with
custody that is operationally
independent; and (10) any other
reason.364 We believe this information
would enhance the quality and utility of
the data reported on the form,
enhancing the Commission’s ability to
exercise oversight of the safeguarding
practices of advisers. We believe this
information may also be beneficial to
clients or investors attempting to
364 Proposed Form ADV, Part 1A, Item 9.A.(2).
Advisers are currently required to report
information with respect to funds and securities
over which their related persons have custody,
including the dollar amount and number of clients
whose funds or securities are in the adviser’s
custody and whether any related person has
custody of any clients’ cash or bank accounts or
securities and the relevant dollar amount and
number of clients. See Form ADV, Part 1A Item
9.A.(2) through, Item 9.B. Based on its responses,
an adviser is also required to report additional
custody-related information in Schedule D of Form
ADV, Part 1A.
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discern the reasons why a particular
adviser has custody. Further, this
updated format may help market
participants to analyze Form ADV data
on an aggregated basis to assess fraud
risk more accurately.
Fourth, we are also proposing new
Item 9.B. requiring an adviser to
indicate whether it is relying on any of
the exceptions from the proposed rule
and, if so, to indicate on which
exception(s) the adviser is relying. This
information would be valuable for
Commission staff to assess compliance
with the proposed rule, and it may also
be beneficial to clients or investors to
assess which exception(s) the adviser is
relying upon.
Fifth, we are proposing to require
advisers to report whether client assets
over which they or a related person
have custody are maintained at a
qualified custodian and the number of
clients and approximate amount of
client assets maintained with a qualified
custodian.365 Advisers also would be
required to report certain identifying
information about the qualified
custodians maintaining client assets.366
Item 9 currently collects only limited
information from advisers about
advisers and their related persons that
act as qualified custodians under the
rule.367 Qualified custodians continue
to serve a critical role in safeguarding
client assets under the proposed rule.
Given this important role, we are
proposing to require advisers to report
the following information for all
qualified custodians maintaining client
assets:
• Full legal name of the qualified
custodian;
• Location of the qualified
custodian’s office responsible for the
services provided;
• Contact information for an
individual to receive regulatory
inquiries;
• Type of entity;
• Legal Entity Identifier (if
applicable);
• Number of clients and approximate
amount of client assets (rounded to the
nearest $1,000) maintained by the
qualified custodian; and
365 See proposed Form ADV, Part 1A, Item
9.C.(1)and proposed Form ADV, Part 1A, Schedule
D, section 9.C.(1).
366 Proposed Form ADV, Part 1A, Schedule D,
section 9.C.(1).
367 See Form ADV, Part 1A, Item 9.D.(2) and Form
ADV, Part 1A, Schedule D, section 7.A. Advisers
are currently required to report more detailed
custodial information about their separately
managed accounts and about the private funds they
advise. See Form ADV, Part 1A, Schedule D, section
5.K.(3); Form ADV, Part 1A, Schedule D, section
7.B.(1)(25).
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• Whether the qualified custodian is
a related person, and if so, the
identifying information for the
independent public accountant engaged
to prepare the proposed internal control
report and verification required under
the proposed safeguarding rule.368
Similarly, we are also proposing
revisions to Item 9 that would require
advisers to report information about
accountants completing surprise
examinations, financial statement
audits, or verification of client assets
under the proposed rule.369 We believe
requiring advisers to disclose more
detailed information about the qualified
custodians maintaining client assets and
the accountants completing these
engagements under the proposed rule
would provide useful information to the
public and facilitate the Commission’s
examination efforts.
Advisers currently are required to file
an other-than-annual-amendment to
Form ADV promptly if certain
information provided in response to
Item 9 becomes inaccurate in any
way.370 Information triggering this
obligation includes whether the adviser
or a related person has custody of client
cash, bank accounts, or securities; 371
the methods by which the adviser
complies with the custody rule; 372 and
whether the adviser or a related person
acts as a qualified custodian.373 Given
the importance of this information, we
continue to believe that advisers should
update this information to the extent it
becomes inaccurate. Thus, we are
proposing to retain the current
requirement that advisers file an otherthan-annual-amendment to Form ADV
promptly if similar information we are
proposing to collect on Form ADV
becomes inaccurate.374 More
specifically, we are proposing to require
368 See proposed Form ADV, Part 1A, Schedule D,
section 9.C.(1). This information is similar to the
information advisers currently report regarding
separately managed accounts and private fund
custodians. See Form ADV, Part 1A, Schedule D,
section 5.K.(3); Form ADV, Part 1A, Schedule D,
section 7.B.(1)(25).
369 See proposed Form ADV, Part 1A, Schedule D,
section 9.C.(3). Advisers report similar information
about the independent public accountants
completing surprise examinations under the current
rule in section 9.C of Form ADV Part 1A Schedule
D.
370 See Form ADV, General Instructions.
Advisers, however, are not required to file an otherthan-annual amendment to update information
provided in response to Items 9.A.(2), 9.B.(2), 9.E,
and 9.F even if that information becomes
inaccurate—though advisers are required to update
this information when filing their next annual
updating amendment. Id.
371 See Form ADV, Item 9.A.(1) and Item 9.B.(1).
372 See Form ADV, Item 9.C.
373 See Form ADV, Item 9.D.
374 See proposed amendments to Form ADV
General Instructions.
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an adviser to file promptly an otherthan-annual amendment to Form ADV if
any of an adviser’s responses regarding
the following becomes inaccurate in any
way: (1) whether the adviser has
custody of client assets either directly or
because a related person has custody of
client assets in connection with
advisory services that the adviser
provides to the client; (2) whether the
adviser is relying on certain exceptions
to the proposed rule; (3) whether client
assets are maintained with a qualified
custodian; (4) whether the adviser or a
related person serves as a qualified
custodian under the proposed rule; (5)
whether client assets are not maintained
by a qualified custodian; (6) whether the
adviser is required to obtain a surprise
examination by an independent public
accountant under the proposed rule; or
(7) whether the adviser is relying on the
audit provision.375 An adviser would be
required to update the other information
reported in Item 9 (e.g., information
about the number of clients and
approximate amount of assets or certain
information about qualified custodians)
only on its annual updating
amendment, which is the same
frequency with which advisers update
similar information on the current
form.376
We request comment on all aspects of
proposed revisions to Form ADV Part
1A, including the following items.
263. Would the proposed
reorganization of Item 9 make it easier
for advisers to complete Item 9 more
accurately and eliminate the confusion
created by the current structure or
wording of Item 9? Are there other
changes to Item 9 that would make the
information reported on that Item more
accurate or less confusing? Is additional
guidance needed to clarify any of the
requirements of the proposed revisions?
264. In proposed Item 9.A.(2), we ask
advisers to identify various ways that
they may have custody, directly or
indirectly, broken out by the
approximate amount of client assets and
number of clients. Based on our
experience, we understand that a client
may have several different advisory
accounts. Should we also ask for
information at the advisory account
level? Should we ask for information on
an account level basis rather than a
client level basis? Would this
information be more meaningful? Why
or why not?
265. In proposed Item 9.B.(2), we ask
advisers about which exception(s) in
375 See generally proposed Form ADV, Items
9.A.(1), 9.B.(1), 9.C., 9.D.(1), and 9.E.
376 See proposed amendments to Form ADV,
General Instructions.
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14731
rule 223–1(b) they are relying upon.
Should we also ask for the approximate
amount of assets and number of clients
under each exception? Should we also
ask for information at the advisory
account level for each exception?
Should we ask for information on an
account level basis rather than a client
level basis for each exception? Would
this information be more meaningful?
Why or why not?
266. Would advisers be able to
provide the information we are
proposing to collect about qualified
custodians? Should we collect
additional or different information from
advisers about qualified custodians? If
so, what types of information should
advisers be required to report? Does the
proposal seek to collect information
about qualified custodians that would
be unnecessary or overly burdensome
for advisers to report? For example, do
advisers keep records of the regulator
for foreign financial institutions acting
as qualified custodians? In particular,
what information should not be
collected and why? For instance, are
there any privacy laws or other legal
barriers that would prohibit or restrict
an adviser from reporting this
information about qualified custodians?
267. Should advisers be required to
file promptly an other-than-annualamendment to Form ADV when the
information provided in response to
certain parts of Item 9 becomes
inaccurate? Should an adviser be
required to update promptly only some
of this information, as proposed, or,
alternatively, all of this information
when it becomes inaccurate? Are there
different items on Form ADV that
advisers should have to update
promptly than those proposed?
268. Is there any additional
information an adviser should be
required to report regarding its practices
to safeguard client assets? If so, what
types of additional information should
advisers be required to report on Form
ADV?
269. Should advisers be required to
report their holdings of physical assets
on Form ADV?
270. Should advisers be required to
report their holdings of privately offered
securities that cannot be recorded and
maintained with a qualified custodian
on Form ADV?
271. Should advisers also be required
to report information about the
independent public accountant where
the adviser cannot maintain assets with
a qualified custodian?
272. Should advisers be required to
disclose information on Form ADV
regarding sub-custodial, securities
depository, or other similar
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arrangements about client assets? Do
advisers often have this information?
273. Should advisers be required to
disclose on Form ADV whether
financial statements distributed to
investors under the audit provision
comply with U.S. GAAP or another
comprehensive body of accounting
standards?
274. Some of the information we are
proposing be reported in section 9.C.(1)
and 9.C.(3) of Schedule D is similar to
the information adviser are required to
report in section 7.B.(1) of Schedule D,
particularly as it relates to whether
reports provided by independent public
accountants contain unqualified,
qualified, or modified opinions. Should
we amend these portions of section
7.B.(1) of Schedule D to conform with
the proposed amendments to section
9.C.(2) and 9.C.(3)?
275. Where a filing adviser files Form
ADV along with a relying adviser, it is
our understanding that some filing
advisers may include the amount of
client funds and securities and total
number of clients for which the filing
adviser has custody in response to Item
9.A.(2) and for which the relying adviser
has custody in response to Item 9.B.(2)
of Form ADV.377 Should we provide
additional guidance in Form ADV about
how we expect filing and relying
advisers to complete Item 9? If so,
please explain.
J. Existing Staff No-Action Letters and
Other Staff Statements
Staff in the Division of Investment
Management is reviewing certain of its
no-action letters and other staff
statements addressing the application of
the custody rule to determine whether
any such letters, statements, or portions
thereof, should be withdrawn in
connection with any adoption of this
proposal. We list below the letters and
other staff statements that are being
reviewed as of the date of any adoption
of the proposed rules or following a
transition period after such adoption. If
interested parties believe that additional
letters or other staff statements, or
portions thereof, should be withdrawn,
they should identify the letter or
statement, state why it is relevant to the
proposed rule, and how it or any
specific portion thereof should be
treated and the reason therefor. To the
extent that a letter listed relates both to
the custody rule and another topic, the
portion unrelated to the custody rule is
not being reviewed in connection with
the adoption of this proposal.
LETTERS TO BE REVIEWED
Name of staff statement
Date issued
All staff statements issued prior to the 2003 Commission Adopting Release .............................
American Bar Association (Question 1, Custody Rule Section, only) .........................................
American Bar Association (Question D only) ...............................................................................
Deloitte & Touche LLP ..................................................................................................................
Investment Adviser Association ....................................................................................................
Investment Company Institute ......................................................................................................
Investment Adviser Association ....................................................................................................
Investment Adviser Association ....................................................................................................
Madison Capital Funding, Inc .......................................................................................................
Robert Van Grover, Esq., Seward and Kissel LLP ......................................................................
Privately Offered Securities Under the Investment Advisers Act Custody Rule, Investment
Management Guidance Update (‘‘IMGU’’) 2013–04.
Private Funds and the Application of the Custody Rule to SPVs and Escrows, IMGU 2014–07
Inadvertent Custody, IMGU 2017–01 ...........................................................................................
Staff Responses to Questions About the Custody Rule (all) .......................................................
K. Transition Period and Compliance
Date
We are proposing a one-year
transition period to provide time for
advisers to come into compliance with
the following if they are adopted:
redesignation of rule 206(4)–2 as new
rule 223–1, and corresponding
amendments to rule 204–2 and Form
ADV, as applicable. Accordingly, we
propose that the compliance date of any
adoption of this proposal would be one
year following the rules’ effective dates
which would be sixty days after the date
of publication of the final rules in the
Federal Register for advisers with more
than $1 billion in regulatory assets
under management (‘‘RAUM’’). For
advisers with up to $1 billion in RAUM,
we propose that the compliance date of
any adoption of this proposal would be
18 months following the rules’ effective
dates which would be sixty days after
the date of publication of the final rules
Number of
advisers
under
threshold
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Threshold
$500 million ......................................................................................................
1 billion .............................................................................................................
1.5 billion ..........................................................................................................
377 See Form ADV and Investment Advisers Act
Rules, Advisers Act Rel. No. 4509 (Aug. 25, 2016)
where the Commission amended Form ADV
instructions, among other items, to allow umbrella
registration for a filing adviser and relying advisers.
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June 2014.
February 2017.
Issued on various dates since 2003.
in the Federal Register. If adopted as
proposed, approximately 10,454
advisers, which represents
approximately 69% of all registered
advisers and 2.5% of the total RAUM of
all advisers, would be subject to the
longer, 18 month transition period.378
The chart below indicates the impact
applying different RAUM threshold
would have on the number of advisers
subject to the proposed 18-month
transition period.379
Percent of
advisers
under
threshold
8,396
10,454
11,448
378 As of June 2022, 15,062 investment advisers
were registered with the Commission and reported
a total of $128.96 trillion in RAUM, while 10,454
advisers reported having less than $1 billion in
RAUM, while the aggregate RAUM reported by
PO 00000
Various Dates.
December 8, 2005.
August 10, 2006.
August 28, 2006.
September 20, 2007.
September 5, 2012.
April 25, 2016.
February 21, 2017.
December 20, 2018.
December 11, 2019.
August 2013.
55.4
69.0
75.5
Total RAUM
of advisers
under
threshold
$1.7
3.2
4.4
Percent of
total RAUM
of advisers
under
threshold
1.3
2.5
3.4
these advisers as of June 2022 was approximately
$3.2 trillion.
379 The data in the table is based upon data
reported by advisers as of June 2022.
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Number of
advisers
under
threshold
Threshold
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2 billion .............................................................................................................
2.5 billion ..........................................................................................................
3 billion .............................................................................................................
3.5 billion ..........................................................................................................
4 billion .............................................................................................................
4.5 billion ..........................................................................................................
5 billion .............................................................................................................
10 billion ...........................................................................................................
Under this proposal, advisers could
continue to rely on current rule 206(4)–
2, rule 204–2, and Form ADV until the
compliance date. We are proposing that
once the rules become effective,
advisers may voluntarily comply with
them in advance of the compliance date.
To promote regulatory consistency,
however, we are proposing that any
adviser that elects to rely, prior to the
compliance date, on the effective rule
223–1 must also comply with, as
applicable, the amended rule 204–2 and
the amended Form ADV beginning at
the same time.
We request comments on the
proposed transition period:
276. Do commenters agree that a oneyear transition period following each
rule’s effective date is appropriate for
advisers with more than $1 billion in
RAUM? Should the period be shorter or
longer? For example, would six months
be an appropriate amount of time?
Alternatively would 18 months be
necessary? Do commenters agree that an
18-month transition period following
each rule’s effective date is appropriate
for advisers with up to $1 billion in
RAUM? Should the period be shorter or
longer? For example, would one year be
an appropriate amount of time?
Alternatively would 24 months be
necessary? Should there be different
compliance dates for different types of
advisers, such as advisers to pooled
investment vehicles or advisers to
separate account clients? Should the $1
billion threshold for the different
compliance groups be higher or lower?
277. Should the transition period be
the same for proposed new rule 223–1
and amendments to rule 204–2 and
Form ADV? Should we permit that once
the rules become effective, advisers may
voluntarily comply with them in
advance of the compliance date, and
require that any adviser that elects to
rely on new rule 223–1 prior to the
compliance date must also comply
beginning at the same time with the
amended rule 204–2 and amended Form
ADV? Does this promote regulatory
consistency, and if not, why not?
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11,987
12,378
12,657
12,859
13,044
13,215
13,357
13,994
278. Should we also require that any
adviser that elects to rely on rule 223–
1 and amended rule 204–2 and
amended Form ADV prior to the
compliance date must also cease to rely
on Commission and staff letters and
other statements that would be
withdrawn on the compliance date?
279. Should the transition period vary
for different rule requirements? For
example, would advisers need 18
months to comply with the proposed
amendments to the qualified custodian
provisions and three months to comply
with the exception from the surprise
examination for SLOAs? Please explain
your answer and suggest transition
period durations.
III. Economic Analysis
A. Introduction
We are mindful of the costs imposed
by, and the benefits obtained from, our
rules. Section 202(c) of the Advisers Act
provides that when the Commission is
engaging in rulemaking under the Act
and is required to consider or determine
whether an action is necessary or
appropriate in the public interest, the
Commission shall also consider whether
the action will promote efficiency,
competition, and capital formation, in
addition to the protection of investors.
The following analysis considers, in
detail, the likely significant economic
effects that may result from the
proposed rule amendments, including
the benefits and costs to investors and
other market participants as well as the
broader implications of the proposed
rule amendments for efficiency,
competition, and capital formation.
Where possible, the Commission
quantifies the likely economic effects of
its proposed amendments and rules.
However, the Commission is unable to
quantify certain economic effects
because it lacks the information
necessary to provide estimates or ranges
of costs. Additionally, in some cases,
quantification would require numerous
assumptions to forecast how investment
advisers and other affected parties
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Percent of
advisers
under
threshold
79.1
81.6
83.5
84.8
86.0
87.2
88.1
92.3
Total RAUM
of advisers
under
threshold
Percent of
total RAUM
of advisers
under
threshold
5.3
6.2
6.9
7.6
8.3
9.0
9.7
14.1
4.1
4.8
5.4
5.9
6.5
7.0
7.6
11.0
would respond to the proposed
amendments, and how those responses
would in turn affect the broader markets
in which they operate. In addition,
many factors determining the economic
effects of the proposed amendments
would vary significantly among
investment advisers. Investment
advisers vary in size and sophistication
as well as the assets on which they
provide advice. As a result, investment
advisers’ existing practices and the
extent to which investment advisers
qualify for exceptions from the rule
varies, making it inherently difficult to
quantify economic effects. Even if it
were possible to calculate a range of
potential quantitative estimates, that
range would be so wide as to not be
informative about the magnitude of the
benefits or costs associated with the
proposed rule. Many parts of the
discussion below are, therefore,
qualitative in nature. As described more
fully below, the Commission is
providing a qualitative assessment and,
where practicable, a quantified estimate
of the economic effects.
B. Broad Economic Considerations
Investors rely on the asset
management industry for a wide variety
of wealth management and financial
planning functions. These services are
critical for investors to plan for the
future and diversify their investment
risks. Investment advisers are a key part
of this industry, as they provide
investment advice to investors and
clients about the value of, or about
investing in, securities and other
investment products.380
When performing services for
investors and clients, an adviser may
frequently have access to client assets,
exposing them to the risk of loss,
misuse, theft, or misappropriation. This
gives rise to a principal-agent problem
between investors and clients (the
principals) on the one hand and their
380 See, e.g., https://www.investor.gov/
introduction-investing/investing-basics/glossary/
investment-adviser.
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investment advisers (the agents) on the
other. This is because, while advisers
face relevant competitive market forces
and therefore have private reputational
incentives to maintain some level of
oversight and internal controls, as
discussed below market failures can
lead their chosen levels of oversight and
control to be sub-optimally low. The
current custody rule, which the
Commission has amended over time,
has been designed to deter such
behavior and alleviate these market
failures in part by relying on a third
party, a qualified custodian, in
safeguarding client assets. While
requiring the use of a qualified
custodians helps mitigate the principalagent problem between investors,
clients, and their advisers, the
introduction of an additional agent—the
custodian—introduces the potential for
additional principal-agent conflicts.
Such principal-agent problems
provide the economic rationale for
revised Commission rules aimed at
further mitigating the underlying market
failures.381 Specifically, in the absence
of targeted regulation, principal-agent
problems can result when investment
advisers and custodians have different
preferences and goals than clients. As a
result, investment advisers and
custodians might take actions that
increase their well-being at the expense
of imposing agency costs on investors
and clients.382 For example, a custodian
may not have sufficient incentive to
provide custodial account records to an
independent public accountant on a
timely basis, to the extent providing a
timely response is burdensome to a
custodian. This would make adviser
compliance with the audit provision,
surprise examination, or Form ADV–E
filing provisions of the rule more
difficult, which would ultimately be to
the disadvantage of clients.
Market forces generally provide some
incentive for principals and agents to
mitigate principal-agent conflicts.
Advisers that effectively mitigate
conflicts, for example, by offering
targeted private contract terms, may, all
else being equal, gain a reputational
advantage that will help them in
retaining and attracting investors and
clients. The assurance provided by such
terms, however, would depend on both
investors’ perception of the costs of
381 As discussed above in section I, there have
been market developments that suggest a need to
better protect client assets by broadening the scope
of the application of the rule and by improving its
efficacy.
382 See, e.g., Michael C. Jensen & William H.
Meckling, Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure, 3 J.Fin.
Econ. 305 (1976).
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enforcing the terms, as well as the
likelihood that disputes would be
resolved in investors’ favor.383 A market
failure may exist to the extent that more
costly enforcement of the contract and
more unpredictable favorable outcomes
reduce the effectiveness of the contract
in mitigating conflicts of interest
between clients and investment
advisers. Factors affecting the cost of
enforcement in the context of
investment advice may include: (1) the
cost of verifying adviser conduct, (2) the
extensiveness and complexity of
services over which the terms apply,
and (3) the ability of investors, who
likely lack specialized knowledge, to
understand how adviser conduct relates
to the terms.384
When the incentives of advisers or
custodians do not sufficiently align with
investors’ or clients’ interests, and
market failures prevent market
participants from effectively resolving
these conflicts of interest via private
contracting, targeted regulatory
requirements can help increase the level
of investor protection. The investor
protection benefits of such regulatory
requirements will depend, however, on
an adviser’s ability and incentive to
comply with the requirements.
Encouraging or requiring independent
oversight and verification of adviser
conduct is one way to incentivize
compliance.385 For example, an adviser
383 See, e.g., Andrei Shleifer, ‘‘Efficient
Regulation’’, (2010), available at https://
www.nber.org/papers/w15651 (‘‘Shleifer paper’’),
for a general discussion of these points.
384 See Shleifer paper for a general discussion of
factors affecting the cost of enforcement of the terms
and the predictability of favorable legal outcomes.
Several factors may also affect an investor’s
assessment of a favorable legal outcome should the
investor believe an adviser to have violated the
contractual terms. First, while investors may
believe an adviser has violated the terms, investors
may be uncertain of their ability to verify such
conduct. Second, given the potentially complex fact
patterns of litigation related to the provision of
investment advice, investors may believe that there
is some chance that courts will simply ‘‘get it
wrong.’’ Third, advisers may have access to
substantially greater financial resources than
investors. Investors may believe that the financial
inequality between themselves and advisers makes
a favorable legal outcome less likely. An investment
adviser’s fiduciary duty to their clients could
mitigate the incentive for an adviser to provide
fewer terms that protect investors. The ability of the
adviser’s fiduciary duty to mitigate the incentive for
an adviser to provide fewer terms that protect
investors will depend on factors affecting the cost
of enforcing that duty. See, Frank H. Easterbrook &
Daniel R. Fischel, ‘‘The Economic Structure of
Corporate Law,’’ 1991, Harvard University Press.
385 Even in the absence of such a regulatory
requirement, an adviser could contractually offer
independent oversight and verification of its
conduct to its investors and clients. However, there
may be practical impediments, such as the lack of
specialized knowledge, which may lead investors to
not seek out such terms. In addition, individual
negotiation of contracts may be less cost effective
than a market-wide regulatory solution.
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is less likely to engage in unauthorized
trading in a client’s account when the
adviser knows that the client will be
receiving an account statement detailing
any trading activity. Similarly, an
adviser is less likely to misappropriate
client assets when it knows that an
independent public accountant is
required to verify client assets.386
There are three ways in which
regulation facilitating clients’ and third
parties’ oversight of advisers’ conduct
through verification of client assets can
reduce potential harm to investors and
clients. First, such regulation can
increase the likelihood that any noncompliant behavior by advisers is
detected. Second, it can increase the
likelihood that any non-compliant
behavior is detected sooner, potentially
mitigating loss to clients. Third, and
perhaps most importantly, facilitating
verification of client assets would likely
have a prophylactic effect, countering
the incentive for non-compliant
behavior by advisers. Indirectly,
regulation that enhances verification of
client assets also reduces potential harm
to clients by facilitating detection of
non-compliant behavior by the qualified
custodians with whom the clients have
custody agreements, potentially
mitigating client losses and deterring
non-compliant behavior by custodians.
This ameliorates principal-agent
problems between the client and the
qualified custodian and facilitates
advisers’ exercise of fiduciary duty over
client assets held by the qualified
custodian.387
Finally, the ability to oversee
investment advisers’ (and custodians’)
conduct through verification of client
assets depends on the quality of the
third party’s verification processes and
the independence of the third party.388
Generally, a higher quality verification
process is one that has an increased
likelihood of detecting misconduct.389
386 See, e.g., Stephen G. Dimmock & William W.
Gerken, ‘‘Predicting fraud by investment
managers,’’ 105 J. Fin. Econ. 153 (Aug. 2011). This
article finds that monitoring is a significant
predictor of investment fraud. For example, large
investors who have stronger incentive and greater
ability to monitor are associated with fewer frauds.
Also see, e.g., Ben Charoenwong, Alan Kwan &
Tarik Umar, ‘‘Does Regulatory Jurisdiction Affect
the Quality of Investment-Adviser Regulation?,’’ 109
Am. Econ. Rev., Am. Econ. Ass’n. 3681 (Oct. 2019).
This article finds that registered investment
advisers that are costlier for state regulators to
supervise, or primarily serve less sophisticated
investors, receive more complaints.
387 For those custodians that are registered brokerdealers, it also facilitates compliance with their
obligations under Exchange Act Rule 15c3–3.
388 See, e.g., Ross L. Watts & Jerold L.
Zimmerman, ‘‘Positive Accounting Theory: A Ten
Year Perspective,’’ 65 Acc. Rev. 131 (Jan. 1990).
389 The use of PCAOB-registered independent
public accountants is required for certain
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Similarly, a more independent third
party is one that is more likely to report
misconduct or violations of regulatory
requirements that it detects.390
Regulation designed to enhance the
quality of third-party verification
processes and/or enhance the
independence of third parties, then,
generally enhances the ability of third
parties to oversee investment advisers’
conduct.
C. Baseline
The Commission assesses the
economic effects of the proposed
amendments relative to the baseline of
existing requirements and practices of
advisers.
1. Current Regulation
a. Custody
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As discussed in greater detail in
section II above, the regulatory
framework regarding safeguarding of
investment adviser client assets is set
forth in rule 206(4)–2, which applies to
any investment adviser registered or
required to be registered with the
Commission under section 203 of the
Act that has custody of client funds or
securities.391 As defined by the current
rule, ‘‘custody’’ means that the
investment adviser, or its related
persons, holds, directly or indirectly,
client funds or securities, or has any
authority to obtain possession of
them.392
engagements under the current rule. In particular,
a PCAOB-registered independent public accountant
is required to perform surprise examinations and
periodically inspect internal controls under the
current rule when an adviser or its related person
serves as a qualified custodian for client assets, and
a PCAOB-registered independent public accountant
must audit the financial statements of a pooled
investment vehicle to be deemed to be in
compliance with the surprise examination
requirement. See current rule 206(4)–2(a)(6) and
(b)(4). As the Commission noted in adopting these
requirements in 2009, the Commission has greater
confidence in the quality of audits conducted by an
independent public accountant registered with, and
subject to regular inspection by, the PCAOB. See
2009 Adopting Release, supra footnote 11, at 17.
390 See, e.g., Ross L. Watts & Jerold L.
Zimmerman, ‘‘Agency Problems, Auditing and the
Theory of the Firm: Some Evidence,’’ 26 J.L. Econ.
613 (1983).
391 See rule 206(4)–2(a). Our exam program
commits significant resources ensuring advisers are
in compliance with the custody rule and verifying
the existence of investor assets at custodians—a
process called asset verification. In FY 2022,
EXAMS verified over 2.1 million investor accounts,
totaling over $2 trillion.
392 Rule 206(4)–2(d)(2). The Commission stated in
2003, however, that because a one-for-one exchange
of assets represents a limited risk of client loss, an
adviser’s authority to issue instructions to a brokerdealer or another custodian to effect or to settle
trades does not constitute ‘‘custody’’ under the
current rule. See 2003 Adopting Release at footnote
10. See also rule 206(4)–2(d)(7), defining ‘‘related
person’’ as ‘‘any person, directly or indirectly,
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The current rule requires such
advisers to maintain all funds and
securities of which the adviser has
custody with a ‘‘qualified custodian’’ in
separate accounts under that client’s
name or in accounts containing only the
funds and securities of such adviser’s
clients, under the adviser’s name as
agent or trustee, subject to certain
exceptions.393 Qualified custodians
generally include banks and savings
associations, broker-dealers, futures
commission merchants, and certain
FFIs 394—all of which are financial
institutions that are currently subject to
regular government oversight and are
subjected to periodic inspection and
examination.395
The current rule generally requires an
adviser with custody of client assets to
obtain an annual surprise examination
from an independent public accountant
to verify client funds and securities
independently.396 With certain
exceptions, the adviser must report on
Form ADV whether it or its related
person has custody of an advisory
client’s cash, bank accounts, and
securities, and disclose the details of the
custodial relationship (including, inter
alia, dollar amounts, total number of
clients, distribution of quarterly account
statements, audits, annual surprise
examinations, and internal control
reports).397
In situations where the adviser or a
related person acts as qualified
custodian, the current rule requires
advisers to obtain, or receive from its
related person, an annual internal
control report with respect to the
adviser’s or related person’s custody
controlling or controlled by [the investment
adviser], and any person that is under common
control with [the investment adviser].’’
393 See rule 206(4)–2(a)(1).
394 See rule 206(4)–2(d)(6).
395 See supra footnote 89.
396 See rule 206(4)–2(a)(4). A 2013 Government
Accountability Office (GAO) study, which
examined 12 average-sized registered advisers,
found that the cost of surprise examinations ranged
from $3,500 to $31,000. The GAO noted that the
costs of surprise examinations vary widely across
advisers and are typically based on the amount of
hours required to conduct the examinations, which
is a function of a number of factors including the
number of client accounts under custody. See Gov’t
Accountability Office, GAO–13–569, Investment
Advisers: Requirements and Costs Associated with
the Custody Rule (2013), https://www.gao.gov/
assets/gao-13-569.pdf.
397 17 CFR 279.1; Form ADV, Part 1A, Item 9; see
also supra notes 268–69, 271, 274–77.297, 303–309.
An adviser must also include a notice in its
brochure concerning its qualified custodian’s
account statement obligations, and a disclosure in
its balance sheet of any financial conditions that are
reasonably likely to impair the adviser’s ability to
meet contractual commitments to clients, when the
adviser has discretionary authority or custody over
client funds or securities. See Form ADV, Part 2A,
Items 15, 18.
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14735
controls, which includes an opinion
from an independent public accountant
that is registered with, and subject to
regular inspection by, the PCAOB.398
The required internal control report
addresses the greater custodial risks
associated with situations where an
adviser, or its related person, acts as a
qualified custodian.399
The current rule’s requirements are,
however, subject to certain exceptions.
Specifically, the current rule provides
an exception to the requirement to
maintain securities with a qualified
custodian for certain ‘‘privately offered
securities’’.400 The current rule also
provides that advisers need not comply
with the requirements of rule 206(4)–2
with respect to the accounts of
registered investment companies,401 and
allows shares of mutual funds to be
maintained with the fund’s transfer
agent in lieu of a qualified custodian.402
In addition, an adviser that has custody
solely because of its authority to deduct
advisory fees, or because a related
person has custody and such related
person is operationally independent of
the adviser, is not required to obtain an
annual surprise examination.403
The current rule also requires that
certain communications be made to
clients. An investment adviser is
required to provide its clients notice if
the adviser establishes an account with
a qualified custodian on a client’s
behalf.404 Advisers must also have a
398 See rule 206(4)–2(a)(6). The surprise
examination must also be conducted by a PCAOBregistered and inspected independent public
accountant. See Custody Rule Amendments
Adopting Release, supra footnote 11 (stating that
the internal control report should address control
objectives and associated controls related to the
areas of client account setup and maintenance,
authorization and processing of client transactions,
security maintenance and setup, processing of
income and corporate action transactions,
reconciliation of funds and security positions to
depositories and other unaffiliated custodians, and
client reporting).
399 As noted in the Custody Rule Amendments
Adopting Release, supra footnote 11, the surprise
examination alone does not adequately address
custodial risks associated with self-custody or
related-person custody because the independent
public accountant seeking to verify client assets
would rely, at least in part, on custodial reports
issued by the adviser or its related person. The
internal control report can significantly strengthen
the utility of the surprise examination when the
adviser or its related person acts as qualified
custodian for client assets because it provides a
basis for the independent accountant performing
the surprise examination to obtain additional
comfort that the confirmations received from the
custodian are reliable.
400 See rule 206(4)–2(b)(2). As discussed in
section II.C, we understand that demand for
custodial services of privately offered may be thin.
401 See rule 206(4)–2(b)(5).
402 Rule 206(4)–2(b)(1).
403 See rule 206(4)–2(b)(3), (6).
404 See rule 206(4)–2(a)(2).
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reasonable basis, after due inquiry, for
believing that the qualified custodian
sends an account statement, at least
quarterly, to each of the adviser’s
applicable clients.405 When an adviser
has custody of funds and securities
belonging to a client that is a pooled
investment vehicle, these account
statements must be sent to each limited
partner, member, or other beneficial
owner if the adviser or its related person
is a general partner of a limited
partnership, managing member of a
limited liability company, or holds a
comparable position for another type of
pooled investment vehicle.406
An adviser is not required to comply
with the notice and account statement
delivery requirements of the rule and
shall be deemed to comply with the
surprise examination requirement with
respect to the account of a limited
partnership or other pooled investment
vehicle that is subject to annual audit,
provided certain conditions are satisfied
(the ‘‘current audit provision’’).407 To
rely on the current audit provision, the
pool’s financial statements must, among
other things, be prepared in accordance
with U.S. GAAP and distributed to all
limited partners (or other beneficial
owners) within 120 days of the end of
the pool’s fiscal year. The current audit
provision also requires the auditor to be
registered with and subject to inspection
by the PCAOB.
ddrumheller on DSK120RN23PROD with PROPOSALS2
b. Recordkeeping
Rule 204–2 applies to any investment
adviser registered or required to be
registered with the Commission under
section 203 of the Act. This rule
requires, among other things, that an
adviser make and keep a list or other
record of all client accounts for which
the adviser has any discretionary
power,408 and copies of internal control
reports obtained or received pursuant to
current rule 206(4)–2.409 Rule 204–2
also currently requires investment
advisers subject to rule 206(4)–2 to
make and keep records regarding all
purchases, sales, receipts and deliveries
of securities for such accounts and all
other debits and credits to such
accounts, separate ledgers for such
accounts, copies of confirmations of all
effected transactions, a record for each
security in which any such client has a
position, and a memorandum describing
the basis upon which the adviser has
determined that the presumption that
405 See
rule 206(4)–2(a)(3).
rule 206(4)–2(a)(5).
407 See rule 206(4)–2(b)(4).
408 See rule 204–2(a)(8).
409 See rule 204–2(a)(17)(iii).
406 See
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any related person is not operationally
independent has been overcome.410
c. Regulation of Qualified Custodians
Finally, other regulations affect
entities’ responsibilities as qualified
custodians, namely, banks and savings
associations, broker-dealers registered
with the Commission, futures
commission merchants registered with
the CFTC, and FFIs. A broker-dealer
acting in the capacity of a custodian is
subject to Exchange Act Rule 15c3–3,
under which customers’ assets must be
segregated from proprietary assets to
permit prompt return in the event of the
firm’s liquidation in a proceeding under
the Securities Investor Protection Act of
1970; 411 and, where applicable, to
FINRA rule 2231, requiring brokerdealers’ statements of assets to be sent
to customers not less than quarterly.
Futures commission merchants are
subject to Commodities Exchange Act
sections 4d(a)(2) and 4d(b) and
regulations issued thereunder, which
require segregation of client funds from
the entities’ funds, and impose related
accounting and recordkeeping
requirements.412 Banks and savings
associations are also subject to
regulation with respect to their
custodial services. For example, under
applicable Treasury regulations,
generally, a depository institution
holding government securities for its
customers must segregate the customer’s
securities from its own assets, free of
any lien, charge, or claim of any third
party granted or created by such
custodian; and it may lend the securities
to a third party only by written
agreement with the customer and in full
compliance with the appropriate
regulatory agency.413 Additionally,
national banks and Federal savings
associations are subject to OCC
410 See
rule 204–2(b).
CFR 240.15c3–3. Specifically, see Rule
15c3–3(b)(1) (requirement for a broker-dealer to
promptly obtain and maintain the physical
possession or control of all fully-paid securities and
excess margin securities carried for the account of
customers); (e)(1) (requiring every broker-dealer to
maintain with a bank a ‘‘Special Reserve Bank
Account for the Exclusive Benefit of Customers’’
and a ‘‘Special Reserve Bank Account for Brokers
and Dealers,’’ separate from each other and from the
broker-dealer’s other bank accounts); and (f)
(requiring written notification that the bank was
informed that cash or securities are being held for
the exclusive benefit of the broker-dealer’s
customers and account holders, separate from the
broker-dealer’s other accounts; and that the brokerdealer must have a written contract with the bank
providing that the cash or securities will not be
used as security for a loan to the broker-dealer by
the bank, and will not be subject to any right,
charge, security interest, lien, or claim in favor of
the bank or any person claiming through the bank).
412 7 U.S.C. 6d(a)(2), 6d(6); 17 CFR 1.20–1.30,
1.32, 1.36.
413 17 CFR 450.4(a)(1), (a)(6).
411 17
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regulations when providing fiduciary
custody services,414 and the OCC has
provided substantial guidance with
respect to these firms’ non-fiduciary
custody services.415 As a result, banks
and savings associations have
developed and deployed comprehensive
custodial service agreements governing
their relationships with their custodial
customers. In addition, depository
institutions are subject to the longstanding, efficient orderly resolution
process deployed by the FDIC and nondepository member banks are subject to
the efficient orderly resolution process
by the OCC. Finally, as noted in part
II.C.1, some FFIs are regulated in their
local jurisdictions and subject to laws
and regulations established by their
national jurisdictions to combat money
laundering and terrorism financing,
consistent with standards and measures
recommended by the FATF.
d. Accredited Investors
Aspects of the proposed rule address
investments in privately offered
securities such as investments in private
companies, and offerings made by
certain hedge funds, private equity
funds, and venture capital funds.416
Congress and the Commission have
provided exemptions for these offerings
based on various factors, including that
the offerings are generally limited to
individuals and entities (e.g., accredited
investors) that do not require the
protection of registration.417 Under
Commission rules, qualifying as an
accredited investor allows an investor to
participate in investment opportunities
that are generally not available to nonaccredited investors, including certain
investments in private companies and
414 See 12 CFR 9.1 et seq. (rules governing
fiduciary powers of national banks); 12 CFR 150.10
et seq. (rules governing fiduciary powers of Federal
savings associations).
415 See generally OCC Custody Handbook, supra
note 237.
416 The Securities Act of 1933 contains a number
of exemptions from its registration requirements
and authorizes the Commission to adopt additional
exemptions.
417 Historically, the Commission has stated that
the accredited investor definition is ‘‘intended to
encompass those persons whose financial
sophistication and ability to sustain the risk of loss
of investment or fend for themselves render the
protections of the Securities Act’s registration
process unnecessary.’’ See Regulation D Revisions;
Exemption for Certain Employee Benefit Plans,
Release No. 33–6683 (Jan. 16, 1987) [52 FR 3015
(Jan. 30, 1987)]. See also SEC v. Ralston Purina Co.,
346 U.S. 119, 125 (1953) (taking the position that
the availability of the section 4(a)(2) exemption
‘‘should turn on whether the particular class of
persons affected needs the protection of the Act. An
offering to those who are shown to be able to fend
for themselves is a transaction ‘not involving any
public offering’ ’’).
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offerings by certain hedge funds, private
equity funds, and venture capital funds.
standards to obtain and maintain the
financial asset.’’ 419
e. Effect of State Law
The relationship between clients and
qualified custodians is also governed by
the common law of agency and
contracts, and—to the extent adopted
under state law—corresponding articles
of the Uniform Commercial Code
(UCC).418 Thus under sections 8–504
and 8–509 of the UCC, unless otherwise
agreed to, and unless duties are
specified otherwise by statute,
regulation, or rule, a custodian ‘‘may not
grant security interests in a financial
asset it is obligated to maintain’’ for the
client and must exercise ‘‘due care in
accordance with reasonable commercial
2. Affected Parties and Industry
Statistics
The proposed amendments would
affect registered investment advisers,
and those required to be registered, as
well as current and prospective clients
of investment advisers, qualified
custodians, and independent public
accountants.
a. Investment Advisers
As of June 2022 there were 15,062
investment advisers registered with the
SEC. Registered investment advisers
reported $128.96 trillion in RAUM with
$117.57 trillion in 47.51 million
14737
accounts over which advisers have
discretionary authority and $11.38
trillion in 14.55 million accounts over
which advisers do not have
discretionary authority.420 The average
RAUM among registered investment
advisers was $8.56 billion and the
median was $427.53 million.
b. Clients
Form ADV requires investment
advisers to indicate the approximate
number of advisory clients and the
amount of total RAUM attributable to
various client types.421 Table 1 provides
information on the number of client
accounts, total RAUM, and the number
of advisers by client type.
TABLE 1—INVESTMENT ADVISER CLIENTS
Number of
clients
(thousands)
Client type
Investment Companies ................................................................................................................
Pooled investment vehicles—Other ............................................................................................
High net worth individuals ...........................................................................................................
Pension Plans ..............................................................................................................................
Insurance Companies ..................................................................................................................
Non-high net worth individuals ....................................................................................................
State/Municipal Entities ...............................................................................................................
Corporations ................................................................................................................................
Foreign Institutions ......................................................................................................................
Charities .......................................................................................................................................
Other Advisers .............................................................................................................................
Banking Institutions ......................................................................................................................
Business Development Companies .............................................................................................
25
95
6,917
431
13
43,824
27
340
2
121
908
11
<1
Total RAUM
(billions)
Registered
investment
advisers
$43,838
34,584
11,832
8,106
7,630
7,093
4,285
3,267
2,209
1,613
1,427
966
211
1,603
5,763
8,989
5,271
1,028
8,286
1,299
4,934
363
5,134
814
432
98
Source: Form ADV, Items 5D.
c. Qualified Custodians
Qualified custodians include state
and federally-chartered trusts, banks
and savings associations, broker-dealers,
FCMs, and certain FFIs.422 The custody
service industry has been characterized
as dominated by a small number of large
market share participants.423 Several
factors contribute to this: (i) economies
of scale, because custodial services
418 See
supra footnotes 157, 159.
8–504(b), (c), 8–509(a) (Am. L. Inst. &
Unif. L. Comm’n 2021).
420 The term ‘‘regulatory assets under
management’’ or ‘‘RAUM’’ refers to an adviser’s
assets under management as reported in response
to Item 5.F. of Part 1A of Form ADV. See Form
ADV: Instructions for Part 1A, instr. 5.b. (setting
forth instructions for calculation of assets under
management for regulatory purposes).
421 If a client fits into more than one category,
Form ADV requires an adviser to select one
category that most accurately represents the client
(to avoid double counting clients and assets).
422 The FDIC reports that as of March 31, 2022,
there were 4,194 FDIC-insured commercial banks
and 602 FDIC-insured savings institutions. See
https://www.fdic.gov/analysis/quarterly-bankingprofile/statistics-at-a-glance/2022mar/industry.pdf.
We do not have data on the number of FDIC-insured
ddrumheller on DSK120RN23PROD with PROPOSALS2
419 U.C.C.
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require a costly infrastructure capable of
processing a large volume of
transactions reliably; (ii) low margins,
which makes it difficult for new
entrants to compete against incumbents;
and (iii) the importance of reputation/
trust.424 Large financial institutions
headquartered in the U.S. dominate the
global custody service industry.425 In
2020, four large U.S. banks serviced
around $114 trillion of global assets
under in their custody.426
commercial banks and FDIC-insured savings
institutions providing custodial services. As of
November 2022, there were 3,530 broker-dealers
registered with the Commission. See https://
www.sec.gov/files/data/broker-dealers/companyinformation-about-active-broker-dealers/
bd110122.txt. The CFTC reports that as of
September 30, 2022, there were 60 FCMs. See
https://www.cftc.gov/sites/default/files/2022-11/
01%20-%20FCM%20webpage%20Update%20%20September%202022.pdf. Out of 3,498 brokerdealers registered with the Commission, 153 were
classified as carrying broker-dealers based on
FOCUS filings as of June 2022. Per EDGAR Form
Custody: A ‘‘Carrying broker-dealer’’ is a brokerdealer that carries customer or broker or dealer
accounts and receives or holds funds or securities
for those customers. We do not have data on the
number of qualifying FFIs.
423 Deloitte, ‘‘The evolution of core financial
service. Custodian & Depository Banks.’’ (2019),
available at https://www2.deloitte.com/content/
dam/Deloitte/lu/Documents/financial-services/luthe-evolution-of-a-core-financial-service.pdf. See
also Congressional Research Service, ‘‘Digital Assets
and SEC Regulation,’’ January 30, 2020. According
to this report, in 2020, four large banks service
around $114 trillion of global assets under custody.
424 Charles-Enguerrand Coste et al., One size fits
some: analyzing profitability, capital and liquidity
constraints of custodian banks through the lens of
the SREP methodology (Eur. Cent. Bank Occasional
Paper No. 256, 2021).
425 Id; see also Congressional Research Service,
‘‘Digital Assets and SEC Regulations,’’ (Jan. 30,
2020.).
426 Congressional Research Service, ‘‘Digital
Assets and SEC Regulations,’’ (Jan. 30, 2020.).
427 See rule 206(4)–2(a)(4).
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d. Independent Public Accountants
As discussed above, the current rule
generally requires an adviser with
custody of client assets to obtain an
annual surprise examination from an
independent public accountant.427 As of
June 2022, 13% of investment advisers
obtain a surprise examination by an
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independent public accountant.428 Not
all advisers with custody, however, are
subject to an annual surprise
examination. For example, as of June
2022, 4,933 investment advisers
satisfied their custody rule obligations
by complying with the current rule’s
audit provision.429 Advisers reported
that 86% of the accountants performing
surprise examinations or conducting
pooled investment vehicle financial
statement audits are subject to regular
inspection by the PCAOB.430
Advisers that are subject to an annual
surprise examination also are required
to obtain (or receive from the relevant
related person) an internal control
report if the adviser or a related person
of the adviser serves as a qualified
custodian for client assets. However, in
the circumstance where an adviser is
deemed to have custody solely because
of a related person custodian and the
related person custodian is
operationally independent of the
adviser, the adviser is not required to
have an annual surprise examination
but is subject to the internal control
requirement.431 As of June 2022, 98
investment advisers have a control
report prepared by an independent
public accountant without being subject
to a surprise examination.432
3. Market Practice
ddrumheller on DSK120RN23PROD with PROPOSALS2
a. Investment Advice
Academic studies have documented a
number of benefits to retail investors
from receiving investment advice,
including, but not limited to: higher
household savings rates, setting longterm goals and calculating retirement
needs, more efficient portfolio
diversification and asset allocation,
increased confidence and peace of
mind, facilitation of small investor
participation, and improved tax
efficiency.433 Investment advisers can
428 Based on advisers’ responses to Item 9.C.(2) of
Part 1A of Form ADV. Comparable numbers for
2019, 2020, and 2021 were 13%, 13%, and 13%,
respectively.
429 Based on advisers’ responses to Item 9.C.(3) of
Part 1A of Form ADV. Comparable numbers for
2019, 2020, and 2021 were 4,460, 4,565, and 4,768,
respectively.
430 These percentages are based on advisers’
responses to Item 9.C.(3) of Part 1A of Form ADV.
Comparable percentages for 2019, 2020, and 2021
were 86%, 86%, and 86%, respectively.
431 See rule 206(4)-2(a)(6) and (b)(6). In these
circumstances, the adviser typically receives the
internal control report from the related person
custodian.
432 Based on advisers’ responses to Item 9.C.(3)
and 9.C.(4) of Part 1A of Form ADV. Comparable
numbers for 2019, 2020, and 2021 were 117, 112,
and 105, respectively.
433 See, e.g., Mitchell Marsden, Catherine D. Zick,
& Robert N. Mayer, The Value of Seeking Financial
Advice, 32 J. Fam. & Econ. Issues 625 (2011); Jinhee
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also help correct potential systematic
errors that retail investors might make,
including limited allocation of savings
to equities, under-diversification, or
investing too little in foreign assets.434
Investor demand for investment
advice, however, may be affected by
Kim, Jasook Kwon & Elaine A. Anderson, Factors
Related to Retirement Confidence: Retirement
Preparation and Workplace Financial Education, 16
J. Fin. Counseling & Plan. 77 (2005); Michael S.
Finke, Sandra J. Huston, & Danielle D. Winchester,
Financial Advice: Who Pays, 22 J. Fin. Counseling
& Plan. 18 (2011); Daniel Bergstresser, John M.R.
Chalmers, & Peter Tufano, Assessing the Costs and
Benefits of Brokers in the Mutual Fund Industry, 22
Rev. Fin. Stud. 4129 (2009); Ralph Bluethgen,
Steffen Meyer & Andreas Hackethal, High-Quality
Financial Advice Wanted! (Working Paper, Feb.
2008), available at https://papers.ssrn.com/sol3/
papers.cfm?abstract_id=1102445; Neal M.
Stoughton, Youchang Wu & Josef Zechner,
Intermediated Investment Management, 66 J. Fin.
947 (2011). Marsden et al. (2011) documents
benefits attributable to hiring a financial
professional, such as better retirement account
diversification and savings goals, but does not find
that hiring a financial professional measurably
increases the amount of overall wealth
accumulation for those investors. See, also, Jeremy
Burke & Angela A. Hung, Do Financial Advisors
Influence Savings Behavior?, RAND Labor and
Population Report Prepared for the Department of
Labor (2015), available at https://www.rand.org/
pubs/research_reports/RR1289; Terrance Martin &
Michael Finke. ‘‘A Comparison of Retirement
Strategies and Financial Planner Value.’’ 27 J. Fin.
Plan. 46 (2014); Crystal R. Hudson L & Lance
Palmer. ‘‘Low-Income Employees: The Relationship
between Information from Formal Advisors and
Financial Behaviors.’’ 23 Fin. Serv. Rev. (2014): 25;
Marc M. Kramer, Financial Literacy,
Overconfidence and Financial Advice Seeking
(Working Paper, Dec. 19, 2014), available at https://
efmaefm.org/0EFMAMEETINGS/EFMA%
20ANNUAL%20MEETINGS/2015-Amsterdam/
papers/EFMA2015_0067_fullpaper.pdf; John R.
Salter, Nathan Harness & Swarn Chatterjee.
‘‘Utilization of Financial Advisors by Affluent
Retirees.’’ 19 Fin. Serv. Rev. 245 (2010), for
additional studies on the causal relation between
the use of a financial professional and wealth
accumulation. Francis M. Kinniry et al., Putting a
Value on Your Value: Quantifying Vanguard
Advisor’s Alpha, Vanguard Research (Sept. 2016),
available at https://advisors.vanguard.com/iwe/pdf/
IARCQAA.pdf, estimates the value to investors
associated with obtaining financial advice of
approximately 3% in net returns to investors,
associated with suitable asset allocation, managing
expense ratios, behavioral coaching, alleviating
home bias, among others.
434 See, e.g., Luigi Guiso, Paolo Sapienza & Luigi
Zingales, People’s Opium? Religion and Economic
Attitudes, 50 J. Monetary Econ. 225 (2003); Laurent
E. Calvet, John Y. Campbell & Paolo Sodini, Down
or Out: Assessing the Welfare Costs of Household
Investment Mistakes, 115 J. Pol. Econ. 707 (2007);
Brad M. Barber & Terrance Odean, ‘‘Trading is
Hazardous to Your Wealth: The Common Stock
Performance of Individual Investors’’, 55 J. Fin. 773
(2000); Karen K. Lewis, Trying to Explain Home
Bias in Equities and Consumption, 37 J. Econ.
Literature 571 (1999). Guiso et al., 2003; Calvet et
al., 2007; Barber and Odean, 2000; Lewis, 1999.
Possible explanations for these investor mistakes
may arise from behavioral biases, such as cognitive
errors, the cost of information acquisition, or the
selection of the financial professional. For example,
investors have been observed to hold too little of
their wealth in foreign assets, which is often called
‘‘home bias.’’
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investor’s assessment of the conflicts
between themselves and investment
advisers. For example, while investors
may benefit from receiving investment
advice, reports have indicated that the
ability to trust the advice of a financial
professional is an important factor in
determining investors’ demand for
investment advice. In particular, one
academic study has shown that trust in
financial institutions is associated with
the propensity to use financial
advice.435 Based on survey data
analysis, this study found that financial
trust is correlated with the likelihood of
seeking financial advice. Using data
from experiments, this study found that
trust is an important predictor of who
takes up advice, even after controlling
for demographic characteristics and
financial literacy.
b. Adviser Custody
As of June 2022, 8,536 advisers
(56.67% of the total number of advisers)
reported on Form ADV that they or their
related persons, in aggregate, had
custody of $45.56 trillion (35.33% of
aggregate RAUM) of client assets.436 437
Advisers reported directly having
custody of approximately $21.28
trillion, and $24.28 trillion resulted
indirectly from custody through a
related person. As of June 2022, 1,904
(12.64% of the total) advisers reported
that an independent public accountant
conducted an annual surprise
examination of client assets.438 4,933
advisers reported that an independent
435 See, e.g., Jeremy Burke & Angela A. Hung,
Trust and Financial Advice (RAND Working Paper
WR–1075, 2015).
436 This analysis is based on advisers’ responses
to Items 9.A. and 9.B. of Part 1A of Form ADV. The
instructions to Item 9.A. of Part 1A of Form ADV
provide that an adviser that has custody solely
because (i) it deducts advisory fees directly from
client accounts, or (ii) an operationally independent
related person has custody of client assets in
connection with advisory services provided to
clients, should answer ‘‘No’’ in response to Item
9.A.(1), which asks whether the adviser has custody
of client assets, meaning the number of advisers
with custody is likely larger.
437 The total number of advisers reporting custody
of client assets or custody by a related person, in
response to Items 9.A. and 9.B. of Part 1A of Form
ADV was 7,424 in 2019, 7,774 in 2020, and 8,180
in 2021. As a percent of the total number of
registered advisers, the percent of advisers reporting
custody of client assets or custody by a related
person in response to Items 9.A. and 9.B. of Part
1A of Form ADV was 55.20% in 2019, 55.88% in
2020, and 55.95% in 2021. As a percent of aggregate
RAUM, advisers reporting custody of client assets
or custody by a related person in response to these
Items of Form ADV, managed 33.92% in 2019,
33.80% in 2020, and 34.44% in 2021.
438 Based on advisers’ responses to Item 9.C.(3) of
Part 1A of Form ADV, the total number of advisers
reporting that an independent public accountant
conducts an annual surprise examination of client
assets was 800 (13.38%) in 2019, 1,834 (13.18%) in
2020, and 1,887 (12.91%) in 2021.
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public accountant annually audits the
pooled investment vehicle(s) the adviser
manages and the audited financial
statements are distributed to investors
in the pools.439 1,405 (9.33% of the
total) advisers reported having a
qualified custodian send quarterly
statements to investors in pooled
investment vehicles.440 As of June 2022,
98 (0.65%) registered advisers reported
that they had an internal control report
prepared by an independent public
accountant but did not report that they
were subject to a surprise
examination.441
As of June 2022, approximately 0.5%
of all registered investment advisers
(6.51% of aggregate RAUM) acted as a
qualified custodian for their clients.
Approximately 0.6% of all registered
investment advisers (23.67% of
aggregate RAUM) had a related person
acting as a qualified custodian.
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c. Market Practice Baseline
In addition to rule 206(4)–2, the 2009
Accounting Guidance, no-action letters,
interpretive letters, and other staff
statements (some of which are
enumerated in section II.K) shape
investment advisers’ custody rule
compliance. For example, staff has
issued 70 FAQs on a wide range of
topics, including the contours of
custody and how custody applies in the
setting of pooled investment vehicles.442
Banks’ practices as qualified
custodians are also shaped by guidance,
such as the Office of the Comptroller of
the Currency’s handbook on custody,
which furnishes guidance to national
banks and savings associations acting as
custodians.443 The OCC guidance
provides that the custodian’s
management has the responsibility to
assess its control environment and
ensure an appropriate system of internal
controls, including separation of duties,
and accounting controls to monitor and
measure transactional workflows and
439 Based on advisers responses to Item 9.C.(2) of
Form ADV. Comparable numbers for 2019, 2020,
and 2021 were 4,460, 4,565, and 4,768, respectively.
In addition, based on advisers’ responses to Items
9.A., 9.B., and 9.F., 8,165 registered advisers had
custody solely because of their authority to deduct
fees in 2020 as of June 2022.
440 Based on advisers’ responses to Item 9.C.(2) of
Form ADV. Comparable numbers for 2019, 2020,
and 2021 were 1,313 (9.76%), 1,328 (9.55%), and
1,348 (9.22%), respectively.
441 These statistics are based on advisers’
responses to Items 9.C.(3) and (4) of Part 1A of Form
ADV. The comparable numbers for 2019, 2020, and
2021 were 117 (0.87%), 112 (0.81%), and 105
(0.72%), respectively.
442 See supra note 17.
443 Off. Of the Comptroller of the Currency,
Comptroller’s Handbook, Custody (2002), available
at https://www.occ.gov/publications-and-resources/
publications/comptrollers-handbook/files/custodyservices/index-custody-services.html.
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their accuracy.444 The custodian’s
management should further ensure that
custody account assets are kept separate
from the custodian’s own assets and
maintained under joint control, and that
securities under custody are not subject
to lending transactions without a
written agreement between the
custodian and the client.445
d. Custody Market Trends
Competition among bank qualified
custodians has been characterized as
fierce, with shrinking profit margins,
and the dominance of a handful of large
entities.446 One report noted that
custodians need to adapt and expand
their service offerings to accommodate
new types of assets, such as crypto
assets, and assets that are now held and
transferred using new technological
methods, such as central bank digital
currencies (also known as CBDCs).447
The industry-reported market
capitalization for crypto assets
experienced a rapid growth from $1
billion in 2018 to $1 trillion in 2021.448
One survey found that 16 percent of
U.S. adults say they personally have
invested in, traded, or otherwise used
‘‘cryptocurrencies.’’ 449 Institutional
investors also invested in
‘‘cryptocurrencies.’’ 450 The Commission
analyzed the extent to which investment
advisers offer various kinds of services
related to digital assets.451 This analysis
444 Comptroller’s
Handbook, Custody at 6–7.
at 14, 30.
446 Id. at 1. See also Deloitte, ‘‘The evolution of
a core financial service. Custodian & Depository
Banks.’’ (2019) available at https://
www2.deloitte.com/content/dam/Deloitte/lu/
Documents/financial-services/lu-the-evolution-of-acore-financial-service.pdf. See also Congressional
Research Service, ‘‘Digital Assets and SEC
Regulations,’’ January (Jan. 30, 2020). According to
this report, in 2020, four large banks service around
$114 trillion of global assets under custody.
447 See, e.g., Deloitte, ‘‘The evolution of a core
financial service. Custodian & Depository Banks.’’
(2019) available at https://www2.deloitte.com/
content/dam/Deloitte/lu/Documents/financialservices/lu-the-evolution-of-a-core-financialservice.pdf.
448 See, e.g., Deloitte, ‘‘Market Manipulation in
Digital Assets’’ (Mar. 2021), available at https://
www2.deloitte.com/content/dam/Deloitte/global/
Documents/Financial-Services/gx-design-marketmanipulation-in-digital-assets-whitepaper-v2-1.pdf.
449 See ‘‘46% of Americans who have invested in
cryptocurrency say it’s done worse than
expected,’’.’’ Pew Research Center, Washington, DC
(Aug. 23, 2022), available at https://
www.pewresearch.org/fact-tank/2022/08/23/46-ofamericans-who-have-invested-in-cryptocurrencysay-its-done-worse-than-expected/. Also, another
study in 2019 estimated about 40 million
Americans owned assets identified as
cryptocurrencies. See Office of the Comptroller of
the Currency, Interpretative Letter #1170, July 2020.
450 See Office of the Comptroller of the Currency,
Interpretative Letter #1170, July 2020.
451 A search of Commission filings, advisers’
websites, and mentions of an adviser’s services
from third-party only news services used the term
445 Id.
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relied on Commission filings, advisers’
websites, and mentions of an adviser’s
services from third-party online news
sources.452 The analysis was conducted
as of June 2022 453 and focuses on the
50 largest investment advisers 454 by
RAUM. The Commission estimates that,
of these 50 largest investment advisers,
(i) 21 are offering or planning on
offering some services related to digital
assets,455 (ii) 9 are giving or planning on
giving investment advice related to
digital assets,456 (iii) 13 provide or are
planning on providing custody of digital
assets or custodial services of digital
assets,457 and (iv) 7 advise or are
planning on advising a pooled
investment vehicle (like a fund or
commodity pool) that holds some digital
assets.458
The market for crypto asset custodial
services continues to develop. Our
understanding is that one OCCregulated national bank, four OCC‘‘digital assets’’ because several of the sources did
not explicitly state that they were strictly referring
to crypto assets.
452 Filings on Form ADV did not, in all cases,
provide sufficient information to determine exactly
the extent to which an adviser offers services
related to digital assets. Therefore, this analysis
relied on supplementary information obtained from
advisers’ websites, online news sources, and in two
cases, other forms filed with the SEC. Both of these
two cases involved funds that held digital assets. In
the case of one adviser, the staff used information
from Form D, in the case of the other the staff used
information from Form S–1. Web pages whose
terms and conditions required citation are: https://
investor.vanguard.com/,
www.franklintempleton.com, www.mufg.jp, https://
www.pimco.com/, and https://citywire.com/.
453 Commission analysis used advisers’ most
recent filings that were submitted during the period
from July 2021 to June 2022. Supplemental data
from websites was evaluated in October 2022.
454 The Commission considered filers that
represent the same firm to be a single adviser. In
aggregate, these 50 investment advisers (i) reflect
49% of total RAUM (as reported in response to
question 5F(2)(c)), (ii) manage 37% of all accounts
(as reported in response to question 5F(2)(f)), (iii)
hold 35% of client funds and securities in
investment adviser firm’s custody or in a related
person’s custody (as reported in response to
questions 9A(2)(a) and 9B(2)(a)), and hold 32% of
client funds and securities in investment adviser
firm’s custody (as reported in response to question
9A(2)(a) only).
455 These investment advisers comprise 67% of
RAUM and manage 66% of accounts of the largest
50 investment advisers.
456 These investment advisers comprise 26% of
RAUM and manage 41% of accounts of the largest
50 investment advisers.
457 These investment advisers comprise 51% of
RAUM and manage 43% of accounts of the largest
50 investment advisers. They further comprise 49%
of client funds and securities in the largest fifty
investment adviser firms’ custody or in related
persons’ custody (as reported in response to
questions 9A(2)(a) and 9B(2)(a)) and 48% of client
funds and securities in the largest fifty investment
adviser firms’ custody (as reported in response to
question 9A(2)(a) only).
458 These investment advisers comprise 67% of
RAUM and manage 66% of accounts of the largest
50 investment advisers.
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regulated trusts, approximately 20 statechartered trust companies and other
state-chartered, limited purpose banking
entities, and at least one FCM currently
offer custodial services for crypto assets.
We also understand that the provision
of custodial services for crypto assets
can arise in the context of the trading of
crypto assets. As discussed above, many
platforms that provide users with the
ability to transact in crypto assets are
not qualified custodians and require
investors to pre-fund trades, a process in
which investors transfer their crypto
assets or fiat currency to such a platform
prior to the execution of any trade.459
Our understanding is that the majority
of crypto asset trading occurs on
platforms requiring pre-funding of
trades, though crypto asset trading also
occurs on so-called decentralized
platforms that may not rely on prefunding. We are aware that a limited
number of SEC-registered crypto asset
securities trade on Alternative Trading
Systems (‘‘ATSs’’) that do not require
pre-funding of trades.460 ATSs that trade
crypto asset securities follow a threestep process or four-step process 461 that
459 See
supra, footnote 128 and accompanying
ddrumheller on DSK120RN23PROD with PROPOSALS2
text.
460 ATSs that do not trade NMS stocks file with
the Commission a Form ATS notice, which the
Commission does not approve. In addition, all
ATSs must file quarterly reports on Form ATS–R
with the Commission. Form ATS–R requires, among
other things, volume information for specified
categories of securities, a list of all securities traded
in the ATS during the quarter, and a list of all
subscribers that were participants. To the extent
that an ATS trades crypto asset securities, the ATS
must disclose information regarding its crypto asset
securities activities as required by Form ATS and
Form ATS–R. Form ATS and Form ATS–R are
deemed confidential when filed with the
Commission. Based on information provided on
these forms, a limited number of ATSs have noticed
on Form ATS their intention to trade certain crypto
asset securities and a subset of those ATSs have
reported transactions in crypto asset securities on
their Form ATS–R.
461 For background on the models, the staff has
noted as follows: A non-custodial ATS four-step
model involves the following steps: Step 1—the
buyer and seller send their respective orders to the
ATS; Step 2—the ATS matches the orders; Step 3—
the ATS notifies the buyer and seller of the matched
trade; and Step 4—the buyer and seller settle the
transaction bilaterally, either directly with each
other or by instructing their respective custodians
to settle the transaction on their behalf. In a noncustodial ATS three-step model involves the
following steps: Step 1—the buyer and seller send
their respective orders to the ATS, notify their
respective custodians of their respective orders
submitted to the ATS, and instruct their respective
custodians to settle transactions in accordance with
the terms of their orders when the ATS notifies the
custodians of a match on the ATS; Step 2—the ATS
matches the orders; and Step 3—the ATS notifies
the buyer and seller and their respective custodians
of the matched trade and the custodians carry out
the conditional instructions. The custodians would
then settle the trade on behalf of the buyer and
seller based on the instructions received in Step 1.
As with the four-step process, the broker-dealer
operator does not guarantee or otherwise have
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does not involve the broker-dealer
operator of the ATS providing custodial
services for the crypto asset
securities.462 We understand, however,
that ATSs do not offer trading of crypto
asset non-securities.
We understand that certain advisers
provide advisory services with respect
to client funds and securities that would
generally result in an adviser having
‘‘custody’’ within the meaning of the
rule (e.g., serving as the general partner
for a private fund that holds crypto asset
securities), and therefore are required to
comply with the rule. Some of these
advisers, however, may not maintain
their client’s crypto assets with a
qualified custodian, instead attempting
to safeguard their client’s crypto assets
themselves—a practice that is not
compliant with the custody rule if those
crypto assets are funds or securities and
do not meet an exception from the
qualified custodian requirement. Other
advisers offering similar advisory
services may take the position that
crypto assets are not covered by the
custody rule at all because they believe
that crypto assets are neither funds nor
securities.463
Assets other than publicly traded
stocks and bonds have increased.464
One investment services industry data
provider forecasted that global assets
under management across alternative
asset classes would grow by 60 percent
between the end of 2020 and the end of
2025.465 For example, capital raised in
the private equity market was less than
$60 billion in 2010. About a decade
later, in 2019, capital raised in the
private equity market was more than
$316 billion.466 Also, investor interest
responsibility for settling the trades and does not
at any time exercise any level of control over the
digital asset securities being sold or the cash being
used to make the purchase (e.g., the ATS does not
place a temporary hold on the seller’s wallet or on
the buyer’s cash to ensure the transaction is
completed) other than by notifying the custodians
for the buyer and seller, and the buyer and seller,
of the match. See finra-ats-role-in-settlement-ofdigital-asset-security-trades-09252020.pdf.
462 Our understanding is that for existing ATSs,
custodial services are typically provided by statechartered trust companies and other state-chartered,
limited purpose banking entities.
463 This, however, is incorrect because most such
assets are likely to be funds or crypto asset
securities covered by the current rule. See infra
footnote 29 and accompanying text.
464 Financial Times, ‘‘Global shift into alternative
assets gathers pace,’’ (July 16, 2017,), available at
https://www.ft.com/content/1167a4b8-6653-11e78526-7b38dcaef614.
465 See, e.g., David Lowery & Preqin Blog, ‘‘Future
of Alternative 2025: Preqin Forecasts Alternative
AUM Growth of 9.8% though to 2025,’’ (Nov. 4,
2020), available athttps://www.preqin.com/insights/
research/blogs/preqin-forecasts-alternative-aumgrowth-of-9-8-percent-through-to-2025.
466 See, e.g., PitchBook, ‘‘Data, Inc., A PE
fundraising record could await in 2021,’’, (Dec. 15,
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in physical assets may have
increased.467 As discussed in section
II.D, safeguarding alternative assets may
involve unique procedures that differ
across each specific asset type and that
substantially differ from safeguarding
practices with respect to more
traditional asset classes (like equities
and fixed income products).
Additionally, physical assets potentially
create more complex challenges with
regard to transaction processing,
monitoring, and reporting services.468
The breadth and variety of alternative
assets diminish an entity’s ability to
scale and automate its safekeeping
services for efficiency and profitability
and, therefore, entities providing
safekeeping services may be reluctant to
expend the resources necessary to
accommodate such assets. As a result,
custodians may outsource the
safekeeping of alternative assets to
entities that specialize in safekeeping
certain asset classes.469
Staff has observed that custodians
often include indemnification clauses in
their custodial agreements with
customers. Generally, the provisions
indemnify custodial customers from
losses arising out of or in connection
with the custodian’s execution or
performance under the agreement to the
extent the loss is caused by, among
other things, the custodian’s negligence,
gross negligence, bad-faith, recklessness,
or willful misconduct.470 Staff has also
observed that the contractual limitations
on custodial liability vary between a
gross negligence standard and a simple
negligence standard. Also, we
understand that some custodial
agreements contain contractual language
addressing when a lien or similar claim
will attach to client assets. Finally, staff
has observed a practice by custodians in
which the custodian lists assets for
which it does not accept custodial
2020), available at https://pitchbook.com/
newsletter/a-pe-fundraising-record-could-await-in2021.
467 For example, the creation of art-market indices
suggests that interest in physical assets, such as fine
art, may have increased. Sotheby’s, ‘‘The Sotheby’s
Mei Moses Indices,’’ available at https://
www.sothebys.com/en/the-sothebys-mei-mosesindices.
468 Deloitte, ‘‘The evolution of core financial
service. Custodian & Depository Banks.’’ (2019)
available at https://www2.deloitte.com/content/
dam/Deloitte/lu/Documents/financial-services/luthe-evolution-of-a-core-financial-service.pdf.
469 See, e.g., Colonnade, ‘‘Alternative Asset
Custody Services, Positive Dynamics Power
Growth,’’ Market Commentary—(Jan. 2015),
available at https://www.coladv.com/wp-content/
uploads/Alt-Asset-Admin-Jan-2015-FINAL.pdf.
470 Custodial agreements are generally between an
advisory client and a qualified custodian. We do
not have data on custodial agreements that would
allow us to characterize the relative frequency of
various agreement provisions.
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liability on a client’s account statement
on an accommodation basis only; the
custodian does not attest to the holdings
of, or transactions in, those investments
or take steps to ensure that the
investments are safeguarded
appropriately. The custodian reports the
holdings or transactions as reported to
it by the adviser.
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e. Compliance Trends
In 2013, the Commission staff issued
a National Exam Program (‘‘NEP’’) Risk
Alert stating that the NEP had observed
widespread and varied non-compliance
with elements of the custody rule.471 In
reviewing examinations that contained
significant deficiencies, the NEP found
that approximately one-third (over 140)
included custody-related issues. The
findings from the examinations resulted
in remedial measures taken by advisers,
including among other things, drafting,
amending or enhancing their written
compliance procedures, policies, or
processes; changing their business
practices; or devoting more resources or
attention to the area of custody.
In 2017, the Commission staff issued
a NEP Risk Alert reporting that
deficiencies or weaknesses related to the
custody rule were among the five most
frequent compliance topics identified
during examinations of investment
advisers.472 Typical examples of
deficiencies or weaknesses with respect
to the custody rule identified by the
staff were: (1) advisers did not recognize
that they may have custody due to
online access to client accounts, (2)
advisers with custody obtained surprise
examinations that did not meet the
requirements of the custody rule, and
(3) advisers did not recognize that they
may have custody as a result of certain
authority over client accounts.
In 2021, the Division of Examinations
issued a Risk Alert stating that in its
experience, a number of activities
related to digital asset securities
presented specific risks to investors.473
Included among the risks identified by
the Division of Examinations were risks
related to advisers’ crypto asset
471 See, e.g., SEC, ‘‘National Exam Program Risk
Alert’’ (Mar. 4, 2013), available at https://
www.sec.gov/about/offices/ocie/custody-riskalert.pdf.
472 See, e.g., SEC, ‘‘National Exam Program Risk
Alert’’ (Feb. 7, 2017), available at https://
www.sec.gov/ocie/Article/risk-alert-5-mostfrequent-ia-compliance-topics.pdfhttps://
www.sec.gov/ocie/Article/risk-alert-5-mostfrequent-ia-compliance-topics.pdf.. https://
www.sec.gov/ocie/Article/risk-alert-5-mostfrequent-ia-compliance-topics.pdf.
473 See Division of Examinations, ‘‘Risk Alert: The
Division of Examinations’ Continued Focus on
Digital Asset Securities’’ (Feb. 26, 2021), available
at https://www.sec.gov/files/digital-assets-riskalert.pdf.
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custodial practices and their compliance
with the custody rule. As discussed
above, the custody rule was designed to
help ensure advisers adequately
safeguard client investments in their
custody by requiring advisers to take
steps to mitigate the risk that client
investments will be lost, misused,
stolen, misappropriated, or subject to
the financial reverses, including
insolvency, of an investment adviser.474
Crypto assets are not exempt from these
risks. Based on that experience, the
Division of Examinations indicated that
it would continue to review the risks
and practices related to crypto asset
custody and examine for compliance
with the custody rule.475
D. Benefits and Costs of Proposed Rule
and Form Amendments
1. Scope
The proposed rule would change the
current rule’s scope in two ways. First,
it would expand the types of
investments covered by the rule beyond
a client’s funds or securities to include
other positions held in a client’s
account that are not funds or securities.
Second, the proposed rule would make
explicit that the current rule’s defined
term ‘‘custody’’ includes discretionary
trading authority. The scope of the rule
determines, in part, the costs and
benefits of the regulatory program set
forth by the other components of the
proposed rule (the ‘‘programmatic
effects’’).
a. Scope of Assets
The proposed rule’s expanded scope
would include all client assets for
which an adviser has custody. The
proposed rule would define ‘‘assets’’ as
‘‘funds, securities, or other positions
held in a client’s account.’’ 476 Assets
under the rule also would include
financial contracts held for investment
purposes, collateral posted in
connection with a swap contract on
behalf of the client, and other assets that
may not clearly be funds or securities
covered by the current rule. ‘‘Other
positions held in the client’s account’’
474 See
section I infra.
the Division of Examinations
stated that staff would review: (i) occurrences of
unauthorized transactions, including theft of digital
assets, (ii) controls around safekeeping of digital
assets (e.g., employee access to private keys and
trading platform accounts), (iii) business continuity
plans where key personnel have exclusive access to
private keys, (iv) how the adviser evaluates harm
due to the loss of private keys, (v) reliability of
software used to interact with relevant digital asset
networks, (vi) storage of digital assets on trading
platform accounts and with third party custodians,
and (vii) security procedures related to software and
hardware wallets.
476 Proposed rule 223–1(d)(1).
475 Specifically
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14741
covers current asset types and asset
types that develop in the future
regardless of their status as funds or
securities. The addition of ‘‘other
positions held in the client’s account’’
would also include crypto assets when
not otherwise covered by the rule’s
references to funds and securities.477
Further, the proposed rule’s use of the
term ‘‘assets’’ would not exclude client
investments that may appear in the
liabilities column of a balance sheet or
that may be represented as a financial
obligation of the client including short
positions, written options, or negative
cash.
We believe that the proposed rule
reduces the risk of loss of client assets
by expanding the types of assets covered
by the rule beyond ‘‘funds and
securities.’’ Bringing more categories of
assets into the scope of the rule’s
requirements will protect investors
because the assets will be subject to
custodial safeguards. Expanding the
scope of the rule will also reduce
uncertainty over the status of assets
under advisement that must be held in
the custody of a qualified custodian,
thereby reducing the legal risk
associated with advisory services and
custodial arrangements for the assets.
This may increase investment
opportunities and the availability of
advisory services for those assets.
Looking forward, the proposed
definition of assets is designed to
remain evergreen, encompassing new
investment types as they continue to
evolve and to recognize that the
protections of the rule should not
depend on which type of assets the
client entrusts to the adviser.
Expanding the scope of the custody
rule to include client assets instead of
only client funds and securities would
also involve costs. We expect that this
expansion in scope would cause
advisers to incur compliance costs in
connection with these newly covered
investment positions. Accordingly,
advisers with custody of such assets
would incur additional costs to ensure
their safeguarding practices with respect
to such assets comply with the custody
rule; for example, the costs associated
with finding a qualified custodian that
is able to take possession or control of
these assets. Rather than incur such
costs, advisers may continue providing
advice with respect to clients’ funds and
securities, but stop providing advice
with respect to clients’ other assets
within the scope of the expanded
477 See
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rule.478 Investment advisers may
accordingly eliminate the aspect of their
services that gives them custody (they
may decline the authority to hold or
take possession of the other assets,
including any discretionary authority to
withdraw or transfer beneficial
ownership of such assets). To the extent
clients benefit from advice on such
other assets—which may be merely
ancillary to advice on funds and
securities—investors would no longer
receive these benefits.479 Also, advisers
would forego any fees associated with
providing such services.
The expanded scope of assets subject
to the proposed rule could create other
costs. For example, as discussed above,
the staff has observed a growing number
of state-chartered trust companies and
other state-chartered, limited purpose
banking entities now offering custodial
services for crypto assets. Also, the staff
has observed an increase in the number
of entities that provide platform users
with the ability to transact in crypto
assets. In connection with these
services, these entities and/or their
agents might safeguard the platform
user’s crypto asset(s) and also maintain
the cryptographic key information
necessary to access the crypto asset.
The expanded scope of assets subject
to the proposed rule could create costs
for those advisers (and their clients)
with custody of crypto assets that are
not funds or securities subject to the
current custody rule. For example, to
the extent advisers have custody of
client crypto assets that are not funds or
securities and those assets are
maintained with state-chartered trust
companies, other state-chartered,
limited purpose banking entities, and
entities providing platform users with
the ability to transact in crypto assets
478 Analysis described in section III.C.3.d
indicates that seven advisers either currently
advise, or are planning to advise, a pooled
investment vehicle (such as a private fund or
commodity pool) that holds some crypto assets. To
the extent these pooled investment vehicles hold
crypto assets that may be outside of the current
rule’s scope (i.e., they are neither funds nor
securities), those assets would be within the scope
of the proposed rule. To the extent that it becomes
cost-prohibitive for advisers to find a qualified
custodian, or otherwise comply with the proposed
rule with respect to these newly covered crypto
assets, we believe that advisers may choose to cease
providing advisory services to pooled investment
vehicles holding such assets, implying these pooled
investment vehicles may no longer be offered to
investors.
479 To the extent competition in the market for
those aspects of services that gives advisers custody
is linked to the number of advisers offering such
services, advisers choosing to eliminate the aspect
of their services that gives them custody could
result in a reduction in competition. A reduction in
competition could result in higher fees for
investors, lower quality services, or some
combination of the two.
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who may choose not to make the
changes necessary to satisfy all of the
requirements to act as a qualified
custodian under the proposed rule, the
proposed rule would require such
crypto assets to be removed from those
entities. Removing assets from those
entities could create costs for investors.
For example, there would be costs
associated with switching from one
entity to another. As we noted in section
II.C.3, the technical requirements for
transacting and safeguarding crypto
assets are likely to differ from those of
traditional assets that include stocks,
bonds, and options. The proposed rule
could cause investors to remove their
assets from an entity that has developed
innovative safeguarding procedures for
those assets, possibly putting those
assets at a greater risk of loss. These
costs would be mitigated, however, to
the extent existing qualified custodians
develop, or otherwise acquire,
innovative safeguarding procedures for
crypto assets, or are able to contract
with specialized sub-custodians, as a
result of the proposed rule.
If investors remove newly scoped-in
assets from entities currently providing
safeguarding services, those entities
providing safeguarding services will
experience a decline in fees because
they would be providing custody for
fewer assets. For example, if investors
remove their crypto assets that are not
funds or securities subject to the current
rule from entities such as state-chartered
trust companies, other state-chartered,
limited-purpose banking entities, and
entities providing platform users with
the ability to transact in crypto assets,
those entities could experience a
decline in fees. The extent of the decline
in fees would depend on investors’
holdings of crypto assets that are not
funds or securities subject to the current
rule, the rates charged by those entities
for safeguarding crypto assets, as well as
the extent to which investors remove
their crypto assets from those entities.
We do not have data that would allow
us to predict accurately investor
holdings of crypto assets or the extent
to which investors would remove crypto
assets from those entities, or the
resulting effect on profitability. A
sufficiently large decline in profitability
could lead such entities to reconsider
their business models or exit the
business altogether.
This aspect of the proposed rule could
create additional costs as well.
Independent public accountants would
have to perform verification procedures
over a larger universe of investments
which could increase the cost of
performing verification procedures.
Absent an increase in the capacity of
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independent public accountants, the
increased demand on the services of
independent public accountants
resulting from having to perform
verification procedures over a larger
universe of assets could result in
increased costs for accountant services
generally. To the extent independent
public accountants reallocate resources
away from other services to meet the
increased demand for asset verification,
other services provided by independent
public accountants could become more
costly. That said, as a result of requiring
that all assets be held in the possession
or control of a qualified custodian,
performing verification procedures may
be less labor-intensive and less costly
than under the current rule.
b. Scope of Activity Subject to the
Proposed Rule
The proposal would generally
preserve the current rule’s definition of
‘‘custody’’. The current definition of
custody includes three categories that
serve as examples of custody including
certain arrangements when the adviser
is authorized or permitted to instruct
the client’s custodian. The proposed
rule would explicitly identify
discretionary trading authority as an
arrangement that triggers the rule. An
adviser with this ability or authority can
subject a client’s assets to the risks of
loss, misuse, misappropriation, theft, or
financial reverses of the adviser. The
proposed rule would also expand the
scope of subject activity by explicitly
identifying discretionary trading
authority as an arrangement that triggers
the rule.
The authority for discretionary
trading presents the kinds of risks to
client assets that the rule is designed to
address. When advisers have this
authority, they have the ability to sell or
purchase assets for the client’s account
without first obtaining client consent.
This creates an opportunity for an
adviser to put those assets at risk of loss,
misuse, misappropriation, theft, or
financial reverses of the adviser. If an
adviser has custody solely because the
adviser has discretionary authority that
is limited to instructing the custodian to
transact in assets that settle on a DVP
basis, the risk of loss is less pronounced,
though not completely eliminated,
when a client’s custodian must
participate in the transaction. In those
cases, the custodian will observe, and
record on a client’s account statement,
that assets are transferred out of a
client’s account only upon
corresponding transfer of other assets of
equal value into the account. Although
the risk of loss is not reduced to zero in
these situations, the client is at least on
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notice via the account statement from
the custodian that a transaction has
occurred. The proposed rule would thus
benefit clients by extending the
protections of the rule, namely the
protections of the qualified custodian
and the account statement reporting, to
instances where an adviser has
discretionary trading authority. The
benefits will be mitigated to the extent
that advisers comply with the rule today
for reasons other than discretionary
trading authority.
Advisers who currently do not need
to comply with the rule for this type of
authority will bear the costs of
compliance with the rule. Those costs
will be mitigated to the extent that
advisers comply with the rule today for
reasons other than discretionary trading
authority. For example, if advisers also
have a general power of attorney with
respect to the same assets, such advisers
already have custody of these assets
under the current rule. For advisers that
will be newly subject to the rule as a
result of this change, the costs of
compliance will be reduced if
discretionary trading authority is their
sole reason for having custody because
they will not have to comply with the
surprise examination requirement.480
Investment advisers with custody of
client assets because of discretionary
trading authority may continue to
provide discretionary trading services to
their clients, or, as discussed above,
they may choose to no longer provide
advice on assets which are not funds or
securities and, accordingly, no longer
exercise custody (including
discretionary trading) for such other
assets as a result of the compliance
costs. If advisers choose to no longer
offer discretionary trading services for
assets other than funds or securities, to
the extent clients benefit from those
discretionary trading services, investors
would bear a cost associated with the
loss of those services or with finding an
investment adviser that provides them.
2. Qualified Custodian Protections
As discussed in section II.B above, the
proposed rule would require investment
advisers to maintain client assets with a
qualified custodian having ‘‘possession
or control’’ of client assets pursuant to
a written agreement between the
qualified custodian and the investment
adviser. The term ‘‘possession or
control’’ would mean holding assets
such that the qualified custodian is
required to participate in any change in
beneficial ownership of those assets, the
qualified custodian’s participation
would effectuate the transaction
involved in the change in beneficial
ownership, and the qualified
custodian’s involvement is a condition
precedent to the change in beneficial
ownership. In the case of a qualified
custodian that is the adviser, the
proposed rule would require that the
written agreement be between the
adviser and the client.481
The proposed rule also would require
the adviser to obtain reasonable
assurances in writing from the
custodian regarding certain vital
protections for the safeguarding of client
assets. If the qualified custodian is the
adviser, the proposed rule would
require that the reasonable assurances
be part of the written agreement
between the adviser and the client,
described above.482
a. Definition of Qualified Custodian
Banks. The current rule includes in
the definition of qualified custodian a
bank as defined in section 202(a)(2) of
the Advisers Act (15 U.S.C. 80b–2(a)(2))
or a savings association as defined in
section 3(b)(1) of the Federal Deposit
Insurance Act (12 U.S.C. 1813(b)(1)) that
has deposits insured by the Federal
Deposit Insurance Corporation under
the Federal Deposit Insurance Act (12
U.S.C. 1811). The proposed rule would
largely retain this definition of qualified
custodian relating to banks and savings
associations. However, in connection
with the proposed rule’s focus on
setting certain minimum protections for
client assets, the rule would require that
a qualifying bank or savings association
hold client assets in an account
designed to protect such assets from
creditors of the bank or savings
association in the event of the
insolvency or failure of the bank or
savings association in order to qualify as
a qualified custodian. While applicable
insolvency law and procedures vary
depending on any particular bank’s
regulatory regime, we understand that
assets held in these accounts are more
likely to be returned to clients upon the
insolvency of the qualified custodian
because they may pass outside of a
bank’s insolvency, may be recoverable if
wrongly transferred or converted, and
are not treated as general assets of the
bank.483
We believe that requiring banks and
savings associations to hold client assets
in an account designed to protect such
assets from creditors of the bank or
savings association in the event of the
insolvency or failure of the bank or
savings association would benefit
rule 223–1(a)(1)(i).
rule 223–1(a)(1)(ii).
483 See supra footnote 96.
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clients by providing client assets with
enhanced protection from general
creditors in the event of the qualified
custodian’s insolvency or failure and
increasing the likelihood of return of
client assets to advisory clients upon a
qualified custodian’s insolvency or
failure. We acknowledge, however, that
the benefit would be limited to the
clients of those qualified custodians that
would not be subject to the resolution
processes deployed by the FDIC or by
the OCC or have not developed and
deployed comprehensive custodial
service agreements governing their
relationships with their custodial
customers. For those custodians that
would not be subject to the resolution
processes deployed by the FDIC or by
the OCC or have not developed and
deployed comprehensive custodial
service agreements governing their
relationships with their custodial
customers, we estimate that changing
the terms of account agreements to
comply with the proposed account
requirement would require 1 hour from
an assistant general counsel ($510/hour)
and 5 hours from a paralegal ($199/
hour), for a total estimated cost of
$1,505 per agreement.
Foreign Financial Institutions. The
proposed definition of qualified
custodian would continue to include
FFIs, but would require an FFI to satisfy
certain additional conditions in order to
serve as a qualified custodian for client
investments. For an FFI to be a qualified
custodian under the proposed rule, it
would need to be:
• Incorporated or organized under the
laws of a country or jurisdiction other
than the United States, provided that
the adviser and the Commission are able
to enforce judgments, including civil
monetary penalties, against the FFI;
• Regulated by a foreign country’s
government, an agency of a foreign
country’s government, or a foreign
financial regulatory authority 484 as a
banking institution, trust company, or
other financial institution that
customarily holds financial assets for its
customers;
• Required by law to comply with
anti-money laundering and related
provisions similar to those of the Bank
Secrecy Act [31 U.S.C. 5311, et seq.] and
regulations thereunder;
• Holding financial assets for its
customers in an account designed to
protect such assets from creditors of the
foreign financial institution in the event
of the insolvency or failure of the
foreign financial institution;
481 Proposed
482 Proposed
480 Proposed
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484 Defined in section 202(a)(24) of the Advisers
Act [15 U.S.C. 80b–2(a)(24)].
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• Having the requisite financial
strength to provide due care for client
assets;
• Required by law to implement
practices, procedures, and internal
controls designed to ensure the exercise
of due care with respect to the
safekeeping of client assets; and
• Not operated for the purpose of
evading the provisions of the proposed
rule.485
As discussed in section II.B.1.b above,
these proposed conditions are partly
drawn from our experience with the
conditions on the types of foreign
financial entities that can act as
‘‘eligible foreign custodians’’ as defined
in rule 17f–5 under the Investment
Company Act.486 Such conditions are
designed to provide enhanced investor
protections for advisory clients and
their assets that we believe would help
promote an FFI having generally similar
protections as a U.S.-based qualified
custodian.
Advisory clients often invest in
securities traded on foreign exchanges
and their advisers must, as a practical
matter, maintain securities with
financial institutions in foreign
countries where the securities are
traded. In order to facilitate these types
of holdings, the current rule includes
any FFI that customarily holds financial
assets for its customers, as qualified
custodian, provided that the FFI keeps
the advisory clients’ assets in customer
accounts segregated from its proprietary
assets. The proposed new conditions
would require that an FFI have similar
protections as a U.S.-based qualified
custodian, thereby enhancing investor
protections for advisory clients by
reducing the risk of loss of their
securities and other financial assets held
outside the United States. For example,
for an FFI to be a qualified custodian
under the proposed rule it would need
to be regulated by a foreign country’s
government, an agency of a foreign
country’s government, or a foreign
financial regulatory authority as a
banking institution, trust company, or
other financial institution that
customarily holds financial assets for its
customers. An FFI also would have to
be required by law to comply with AML
requirements and related requirements
comparable to those of the Bank Secrecy
Act.487 We believe the requirement to
comply with AML and related
485 Proposed
rule 223–1(d)(10)(iv).
the proposed rule would replace
and strengthen the segregation requirement
applicable to FFIs in the current custody rule, and
it is designed to complement the proposed
segregation requirements of the safeguarding rule.
487 Proposed rule 223–1(d)(10)(iv)(C); see also pt.
II.B.1.
486 Furthermore,
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provisions similar to those of the BSA
and regulations thereunder would help
increase the likelihood that the FFI
would readily identify and investigate
aberrant behavior in a client account,
such as activity that might suggest
misappropriation or some other type of
loss to a client. An FFI also would have
to hold financial assets for its customers
in an account designed to protect such
assets from creditors of the foreign
financial institution in the event of the
insolvency or failure of the foreign
financial institution. We believe this
requirement would help to promote
investor protections that are more
comparable, particularly in the event of
an FFI insolvency or bankruptcy, to
those we are proposing for assets held
with U.S.-regulated bank or savings
association qualified custodians.
FFIs that no longer meet the
conditions to be a qualified custodian
would either incur costs to become
compliant, or incur costs in the form of
lost custodial business, and potential
loss of other banking business from the
same clients. Clients of FFIs that incur
costs to become compliant may
experience higher fees. Clients whose
assets were maintained with banks and
savings associations that do not comply
with the proposed requirements would
incur one-time costs related to
switching custodians or, if no financial
institutions qualify as custodians in a
country where securities are traded on
a foreign exchange,488 costs associated
with divestiture, potentially at a loss.
Advisers would incur costs associated
with loss of client assets under
management. The magnitude of these
costs would depend on the number of
client accounts and the quantity of
assets affected.489
b. Possession or Control
Under the custody rule, advisers with
custody of client funds and securities
must maintain them with a qualified
custodian, subject to certain
exceptions.490 The proposed rule would
require that an investment adviser with
custody of client assets maintain those
assets with a qualified custodian that
must maintain possession or control of
those assets.491 The term ‘‘possession or
control’’ would mean holding assets
such that the qualified custodian is
required to participate in any change in
beneficial ownership of those assets, the
488 This could occur if, for example, if the country
does not have a regulatory framework equivalent to
the Bank Secrecy Act requirements for reporting
transactions to financial intelligence authorities.
489 We do not have data on the number of client
accounts and the quantity of assets affected.
490 See rule 206(4)–2(a)(1).
491 See proposed rule 223–1(a)(1)(i).
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qualified custodian’s participation
would effectuate the transaction
involved in the change in beneficial
ownership, and the qualified
custodian’s involvement is a condition
precedent to the change in beneficial
ownership.492
The proposed requirement would
benefit clients in several ways. First, a
critical custodial function is to prevent
loss or unauthorized transfers of
ownership of client assets. It is our
understanding that a custodian will
only provide this safeguarding function
and assume custodial liability for a
custodial customer’s loss if the
custodian has possession or control of
the asset that is lost. Second, because
the qualified custodian would be
required to participate in any change in
beneficial ownership of a client asset,
the qualified custodian’s participation
would effectuate the transaction
involved in the change in beneficial
ownership, and the qualified
custodian’s involvement is a condition
precedent to the change in beneficial
ownership, the proposed possession or
control definition would provide
assurance to the client that a regulated
party who is hired for safekeeping
services by the client to act for the client
is involved in any change in beneficial
ownership of the client’s assets. Further,
clients would be able to review their
account statements to evaluate the
legitimacy of any movement within
their account, whether it is a trade, a
payment, or a fee withdrawal. Finally,
clients could take greater comfort that
what is reported on their account
statements is an accurate attestation of
holdings and transactions because
anything held by a qualified custodian
would be required to be in its
possession or control.
The proposed definition is designed
to be consistent with the laws, rules, or
regulations administered by the
qualified custodian’s functional
regulator for purposes of its custodial
activities. As detailed in section II.C.2
above, this would include Exchange Act
requirements for broker-dealers,
regulatory requirements for national
banks, Commodity Exchange Act
requirements for FCMs, as well as the
broad range of regulatory requirements
for FFIs. Given the proposed definition’s
consistency with the laws, rules, or
regulations administered by a qualified
custodian’s functional regulator, we
believe the additional cost of the
proposed definition of ‘‘possession or
control’’ on qualified custodians would
be minimal.
492 See
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It is our understanding that
custodians have been unwilling or
unable to take possession or control of
certain investments, such as a variety of
privately issued securities. Advisers
sometimes request that custodians
report these securities as an
‘‘accommodation’’ on a custodial
account statement so that the client is
aware of their existence. We
acknowledge, however, that to the
extent account statements provided by a
qualified custodian on an
accommodation basis offer a client the
ability to review all of its investments in
a single consolidated account statement,
and potentially alert a client or an
auditor to the existence of an
investment, the proposed rule’s
elimination of the custodian’s ability to
provide account statements on an
accommodation basis could impose a
cost on investors. Clients would bear
costs to collect information from
multiple sources rather than relying on
a single consolidated account
statement.493 If a client requests such
assets be included on its account
statement, the account statement may
identify the assets, but only if the
account statement clearly indicates that
the custodian does not have possession
or control of the assets.494
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c. Reasonable Assurances
We understand that under existing
market practices, advisers are rarely
parties to the custodial agreement,
which is generally between an advisory
client and a qualified custodian. The
proposed rule would require an adviser
to obtain reasonable assurances in
writing from qualified custodians
regarding certain vital protections for
the safeguarding of client assets and that
the adviser maintain an ongoing
reasonable belief that the custodian is
complying with the client protections
for which the adviser obtains reasonable
assurances.
i. Benefits
Due Care. The proposed rule would
require that the adviser obtain
reasonable assurances from the qualified
custodian that the qualified custodian
will exercise due care in accordance
with reasonable commercial standards
in discharging its duty as custodian and
will implement appropriate measures to
493 It is possible that the requirement could lead
to reduced costs for custodians. Our understanding,
however, is that the custodian merely reports the
holdings or transactions as reported to it by the
adviser—the custodian does not attest to the
holdings of or transactions in those investments or
take steps to ensure that the investments are
safeguarded appropriately. As a result, we would
expect cost savings for custodians to be minimal.
494 See supra note 185.
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safeguard client assets from theft,
misuse, misappropriation, or other
similar types of loss.495 We recognize
that the appropriateness of the measures
required to safeguard assets varies
depending on the asset.496 We believe
such appropriate measures would, in
turn, mitigate the risk to client assets
from theft, misuse, misappropriation, or
other similar types of loss.
Indemnification. The proposed rule
would require the adviser to obtain
reasonable assurances from the qualified
custodian that the qualified custodian
will indemnify the client (and will have
insurance arrangements in place that
will adequately protect the client)
against the risk of loss in the event of
the qualified custodian’s own
negligence, recklessness, or willful
misconduct.497 Our staff has observed
that custodians often include
indemnification clauses in their
custodial agreements with customers.
Staff has also observed that the
contractual limitations on custodial
liability vary widely in the marketplace,
in some instances reducing a qualified
custodian’s liability to such an extent as
to not provide an appropriate level of
investor protection. By requiring
advisers to obtain reasonable assurances
from the qualified custodian that the
qualified custodian will indemnify the
client against the risk of loss in the
event of the qualified custodian’s own
negligence, recklessness, or willful
misconduct, the proposed rule seeks to
create a minimum floor of custodial
protection for investors in the event of
custodial misconduct (i.e., simple
negligence). For those investors whose
qualified custodians indemnify the
client against the risk of loss in the
event of the qualified custodian’s gross
negligence, the proposed requirement
that an adviser obtain reasonable
assurances from the qualified custodian
that the qualified custodian will
indemnify the client against the risk of
loss in the event of the qualified
custodian’s own negligence,
recklessness, or willful misconduct
would likely operate as a substantial
expansion in the protections provided
by qualified custodians to advisory
clients by preventing these custodians
from disclaiming liability for
misconduct that does not rise to the
level of gross negligence.
Sub-custodian or Other Similar
Arrangements. The proposed rule
would require the adviser to obtain
reasonable assurances from the qualified
495 Proposed
rule 223–1(a)(1)(ii)(A).
discussion in section II.B.3.a.i and supra
footnote 154.
497 Proposed rule 223–1(a)(1)(ii)(B).
custodian that the existence of any subcustodial, securities depository, or other
similar arrangements with regard to the
client’s assets will not excuse its
obligations to the client.498
As discussed in section II.B.3.a.3
outsourcing has become increasingly
common in the custodial space, whether
outsourcing of back-office functions or
the core function of safeguarding a
custodial customer’s assets.
Additionally, we understand that the
delegation of safeguarding to subcustodians can result in opaque
structures; for example, involving
several FFI sub-custodians in different
countries. This proposed requirement
would enhance investor protections by
reducing the ability of a qualified
custodian to avoid responsibility for the
other important safeguarding obligations
it has to the advisory client by
delegating custodial responsibility to a
sub-custodian, securities depository, or
other similar arrangements. To the
extent advisory clients are aware of risks
resulting from a qualified custodian
delegating its safeguarding obligations
to a sub-custodian, we believe that this
requirement would give advisory clients
greater confidence that their assets
maintained with a qualified custodian
would not lose protections as a result of
such a delegation.
Segregation of Client Assets. The
proposed rule would require the adviser
to obtain reasonable assurances from the
qualified custodian that the qualified
custodian will clearly identify the
client’s assets as such, hold them in a
custodial account, and segregate them
from the qualified custodian’s
proprietary assets.499 The proposed
requirement would benefit investors by
helping to ensure that client assets are
at all times readily identifiable as client
property and remain available to the
client even if the qualified custodian
becomes financially insolvent. We
believe this proposed requirement
would also benefit clients by helping to
protect client assets from claims by a
qualified custodian’s third-party
creditors looking to secure or satisfy an
obligation of the qualified custodian.
We believe that the proposed
requirement would also benefit clients
by helping to identify clearly client
assets as belonging to the appropriate
client and, in the context of an FFI in
a region facing political risk, we believe
these actions would help to preserve the
client’s interests in the event of a
government taking.
No Liens Unless Authorized in
Writing. The proposed rule would
496 See
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499 Proposed
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require the adviser to obtain reasonable
assurances from the qualified custodian
that the qualified custodian will 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.500 This requirement would
benefit clients by discouraging qualified
custodians from using client assets in a
manner not authorized by the client,
reducing the risk of loss of client assets.
The requirement would also help
reduce the risk of the loss of client
assets to claims by the qualified
custodian, or a third party looking to
secure or satisfy an obligation of the
qualified custodian, including in cases
of the qualified custodian’s insolvency
or bankruptcy. The magnitude of the
benefits will depend on the extent to
which such arrangements may already
be common. As discussed in section
II.B.3.a.v, we believe that many
qualified custodians maintain their
custodial customer assets free of liens
and similar claims, other than those
agreed to or authorized in writing by the
client. Further, we understand that
some custodial agreements contain
contractual language addressing when a
lien or similar claim will attach to client
assets.
ii. Costs
Obtaining Reasonable Assurances.
The proposed rule would require an
adviser to obtain reasonable assurances
in writing from a qualified custodian
regarding certain client protections. As
discussed above, one way that advisers
are likely to satisfy this requirement is
by seeking confirmation from a qualified
custodian that the custodial agreement
with the advisory client contains
contractual language reflecting the
reasonable assurances required by the
rule. The reasonable assurances
requirement could also require
conforming changes in custody
agreements between clients and
qualified custodians. The cost of
obtaining reasonable assurances and
conforming changes in custody
agreements include costs attributable to
attorneys and compliance professionals,
both prior to and at the inception of the
relationship between a client and a
qualified custodian as well as over the
life of the relationship. We describe the
nature of these costs in detail below. For
purposes of the Paperwork Reduction
Act, we estimate that qualified
custodians and advisers will incur
aggregate initial costs of $27,469,680
associated with advisers obtaining
reasonable assurances from qualified
custodians.501 The requirements that an
adviser obtain reasonable assurances
from qualified custodians also will
require due diligence and periodic
monitoring by the adviser. For purposes
of the Paperwork Reduction Act, we
estimate that qualified custodians and
advisers will incur aggregate ongoing
annual costs of $5,493,936 associated
with advisers obtaining reasonable
assurances from qualified custodians.502
Due Care. The proposed due care
requirement is the same as the standard
that generally applies to custodians
under Article 8 of the Uniform
Commercial Code.503 As a result, we
believe the proposed standard of care is
not uncommon in the custodial market,
and that financial institutions acting as
qualified custodians are familiar with it.
We believe, however, that the standard
of care is not universal in the custodial
market. As discussed above, this
requirement may result in certain
qualified custodians incurring costs to
change the terms of their custodial
agreements with advisory clients to
incorporate this standard.504
Indemnification. As discussed above,
staff has observed that the contractual
limitations on custodial liability vary
widely in the marketplace. The
proposed rule seeks to create a
minimum floor of custodial protection
for investors in the event of custodial
misconduct. First, the proposed simple
negligence requirement could impose
operational costs on those custodians
holding advisory client assets subject to
a gross negligence standard. The
operational costs would include the
costs of adapting existing systems and
processes to meet the more stringent
simple negligence standard. Second, the
insurance requirement of the proposed
indemnification requirement would
likely create a substantial increase in the
cost of liability insurance for custodians
that currently do not insure against loss
resulting from simple negligence. We
note, however, that operational costs
and costs of liability insurance would be
mitigated to the extent custodians who
currently hold client assets subject to a
gross negligence standard already have
systems, processes and liability
insurance that are consistent with a
simple negligence standard.
Sub-custodian or Other Similar
Arrangements. As discussed above, staff
has observed custodial agreements
addressing the use of sub-custodians
that seek to contractually limit the
custodian’s liability for acts or
501 See
infra footnote 620.
infra footnote 622.
504 See infra footnote 619.
502 See
500 See
proposed rule 223–1(a)(1)(ii)(E).
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omissions of the sub-custodian in a
variety of ways, including expressly
limiting the contractual liability of the
custodian for acts of the sub-custodian,
as well as limiting the affirmative steps
the custodian may be required to take in
connection with any loss of client assets
as a result of the sub-custodian’s willful
default or insolvency. The proposed
reasonable assurances requirement
could impose operational costs on those
custodians who make use of subcustodial, securities depository, or other
similar arrangements and who would
seek to disclaim responsibility in
circumstances where a loss or other
failure to satisfy its obligations to the
client can be attributed to a subcustodian or other third party selected
by the qualified custodian. The
operational costs would include the
costs of adapting existing systems and
processes to meet the proposed
requirement. We note, however, that the
costs would be mitigated to the extent
custodians who make use of subcustodial, securities depository, or other
similar arrangements already have
systems and processes in place that are
consistent with the proposed
requirement.
Segregation of Client Assets. We
understand that custodial agreements
between advisory clients and qualified
custodians may currently contain a
contractual provision requiring
segregation of client assets from the
custodian’s assets. In addition, we
understand that many qualified
custodians are currently required by
their functional regulator to segregate
assets. The proposed segregation
requirements are drawn from rule 15c3–
3 of the Exchange Act. To the extent
existing regulatory requirements for
qualified custodians are the same or
similar to the requirements of 15c3–3,
the costs of adapting existing systems
may be mitigated for broker-dealers who
act as qualified custodians. For
example, rule 15c3–3 of the Exchange
Act requires broker-dealers to safeguard
their customer assets and keep customer
assets separate from the firm’s assets.
Given their existing regulatory
requirements, we believe custodian
broker-dealers already have systems to
segregate customer assets from their
own and, as a result, the cost of the
proposed requirement for broker-dealer
qualified custodians largely would be
mitigated. Other regulatory regimes
have adopted similar requirements. For
example, under the Commodity
Exchange Act, futures commission
merchants are required to segregate
customer assets from their own
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assets.505 Because futures commission
merchants already have systems to
segregate customer assets from their
own, we believe their cost of meeting
the segregation requirement of the
proposed rule would also largely be
mitigated for futures commission
merchants.
We believe, however, that not all
financial institutions that serve as
qualified custodians are required to
segregate and identify their client assets,
particularly FFIs. In addition, for those
qualified custodians that are required to
segregate and identify their client assets,
the extent of those activities varies.506
To the extent certain custodians
currently do not segregate client assets,
the reasonable assurances requirement
in the proposed rule would result in
qualified custodians adapting existing
systems and processes to meet the
proposed requirement.
No Liens Unless Authorized in
Writing. The rule would not prohibit
liens and the other claims addressed in
the proposed rule, but would require
that the adviser obtain reasonable
assurances from the qualified custodian
that the client has authorized in writing
any right, charge, security interest, lien,
or claim in favor of the qualified
custodian or its related persons or
creditors. The proposed reasonable
assurances requirement could impose
operational costs on those custodians
who make use of liens and the other
claims addressed in the proposed rule.
The operational costs would include the
costs of adapting existing systems and
processes to ensure that qualified
custodians get written client
authorization. The proposed
requirement may also result in qualified
custodians adding a conforming
provision to custodial agreements for
those clients that authorize such claims.
Doing so would result in an additional
burden for those qualified custodians.
We believe that many qualified
custodians maintain their custodial
customer assets free of liens and similar
claims, other than those agreed to or
authorized in writing by the client.
Further, we understand that some
custodial agreements contain
contractual language addressing when a
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505 See
discussion in section III.C.1.
e.g., 12 U.S.C. 92(c) and 12 U.S.C.
1464(n)(2) (requiring national banks and Federal
savings associations to segregate all assets held in
any fiduciary capacity from their general assets and
to keep a separate set of books and records showing
all transactions in these accounts); section 4d(a)(2)
of the Commodity Exchange Act (requiring FCMs to
segregate from their own assets all money,
securities and other property deposited by futures
customers to margin, secure, or guarantee futures
contracts and options on futures contracts traded on
designated contract markets).
506 See,
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lien or similar claim will attach to client
assets. Operational costs and the cost of
adding conforming provisions for those
clients that authorize such claims would
be mitigated to the extent qualified
custodians already have such systems
and provisions in place.
d. Written Agreement
The proposed rule would require
advisers to enter into a written
agreement with a qualified custodian
based upon a reasonable belief that
certain contractual provisions have been
implemented. Further, during the term
of the written agreement and related
advisory relationship, advisers generally
should have a reasonable belief that the
qualified custodian is complying with
the contractual obligations of the
agreement and continuing to provide
the protections to client assets for which
the adviser obtained reasonable
assurances from the qualified custodian.
We discuss the benefits and costs of
the proposed written agreement
requirement below. The magnitude of
both the benefits and costs of the
proposed written agreement
requirement would depend on the
extent to which advisers currently are
party to custodial agreements, and
advisers’ actions to ensure that the
elements of the written agreements are
effective and being met.507
i. Benefits
Under the proposed rule, one
provision 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 Commission
or to an independent public accountant
engaged for purposes of complying with
the rule. Another provision would
specify the adviser’s agreed-upon level
of authority to effect transactions in the
account. A third provision would
require the qualified custodian to
deliver account statements to clients
and to the adviser, whereas currently,
advisers must only have a reasonable
basis for believing that clients are
receiving these account statements upon
due inquiry. The fourth 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.
Record Sharing. The proposed rule
would require that the written
507 While we understand that advisers are rarely
parties to the custodial agreement, which is
generally between an advisory client and its
qualified custodian, we lack quantitative data to
confirm this understanding.
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14747
agreement with the qualified custodian
include a provision requiring the
qualified custodian to provide,
promptly, upon request, records relating
to client assets to the Commission or an
independent public accountant engaged
for purposes of compliance with the
rule.508 We understand, currently, that
accountants often struggle to obtain—or
to obtain timely—information from
qualified custodians when performing
surprise examinations under the current
rule unless the advisory client requests
that the qualified custodian share the
information. We believe that
accountants likely struggle to obtain
information from qualified custodians
because the qualified custodian has no
contractual agreement with the adviser
or the accountant that has been hired by
the adviser. We believe that the
proposed contractual requirement
would mitigate these record access
challenges because the qualified
custodian would be in direct contractual
privity with the adviser and would have
a contractual obligation to provide the
records required by the rule—
potentially reducing the costs
attributable to completing a surprise
examination under the rule.
Account Statements. The proposed
rule would require that the written
agreement provide that the qualified
custodian will send account statements
(unless the client is an entity whose
investors will receive audited financial
statements as part of the financial
statement audit process pursuant to the
proposed rule), at least quarterly, to the
client and the investment adviser,
identifying the amount of each client
asset in the custodial account at the end
of the period as well as all transactions
in the account during that period.509 We
believe that the delivery of quarterly
account statements to the adviser,
which is a new requirement, would
allow the adviser to more easily perform
account statement reconciliations. We
believe that qualified custodians’
delivery of account statements directly
to advisory clients enhances investor
protections by facilitating clients’ ability
to verify adviser conduct as well as
client assets. We also continue to
believe that qualified custodians’
delivery of account statements directly
to advisory clients—without the
involvement of the adviser—helps
provide clients with confidence that any
erroneous or unauthorized transactions
by an adviser would be reflected in the
account statement and, as a result,
508 Proposed
509 Proposed
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would deter advisers from fraudulent
activities.510
The proposed rule would also require
a provision prohibiting the account
statement from identifying assets for
which the qualified custodian lacks
possession or control, unless requested
by the client and the qualified custodian
clearly indicates that the custodian does
not have possession or control over such
assets. We believe the proposed
requirement would enhance investor
protections by enhancing the integrity
and utility of the account statements,
thereby reducing the risk investors are
misled or become confused about those
assets for which the custodian is
responsible in the event of a loss.
Internal Control Report. The proposed
rule would require that the written
agreement with the qualified custodian
provide that the qualified custodian, at
least annually, will obtain, and provide
to the investment adviser a written
internal control report that includes an
opinion of an independent public
accountant as to whether controls have
been placed in operation as of a specific
date, are suitably designed, and are
operating effectively to meet control
objectives relating to custodial services
(including the safeguarding of the client
assets held by that qualified custodian
during the year). The objectives and
scope of the proposed internal control
report are substantially the same as
those of the internal control report
required under the current rule, but
would expand the requirement to all
qualified custodians as opposed to the
current rule, which only requires the
internal control report when the adviser
or its related person acts as a qualified
custodian.
In circumstances where the qualified
custodian is not the adviser or its
related person, we believe the proposed
requirement would help enhance
investor protections by ensuring that the
qualified custodian’s controls with
respect to its safeguarding practices are
routinely evaluated in a timely manner
by an independent third party. Also, in
those circumstances where qualified
custodians currently obtain internal
control reports, the scope of those
reports likely covers the financial
institutions’ safeguarding activities for
‘‘funds and securities’’ rather than all
‘‘assets,’’ as defined in the proposed
amendments. We believe the proposed
requirement would help enhance
investor protection by expanding the
scope of internal control reports to cover
510 Rule 206(4)–2(a)(3) requires the adviser to
have reasonable belief upon due inquiry that the
qualified custodian delivers quarterly account
statements to the client.
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safeguarding actives for ‘‘assets’’ rather
than ‘‘funds and securities.’’ We believe
the requirement that auditors must be
independent in fact and in appearance
contributes to investor protection and
investor confidence in connection with
the relationship between an auditor and
the qualified custodian. Unlike the
current rule that only requires an
internal control report when the adviser
or its related person acts as a qualified
custodian, the proposed rule would
mitigate risks to client assets regardless
of the affiliation of the qualified
custodian.
Under circumstances where the
proposed rule requires the engagement
of a PCAOB-registered and inspected
public accountant, we anticipate that
the proposed rule will have client
protection benefits. As the Commission
noted in adopting the current custody
rule, the Commission has greater
confidence in the quality of the
processes followed by an independent
public accountant registered with, and
subject to regular inspection by, the
PCAOB.511 512 We believe that
registration and the periodic inspection
of an independent public accountant’s
system of quality control by the PCAOB
511 See Custody Rule Amendments Adopting
Release, supra footnote 11, at 17.
512 For example, in response to our 2009
proposed Custody Rule amendments requiring the
use of PCAOB-registered independent public
accountants for annual surprise examinations in
certain circumstances, many commenters agreed
with our belief that PCAOB registration and
inspection provided an important quality check on
the independent accountants providing those
examinations. See comment letter of Investment
Adviser Association (July 24, 2009); comment letter
of The National Association of Active Investment
Managers (July 27, 2009); comment letter of
Timothy P. Turner (July 27, 2009); comment letter
of American Bar Association (Committee on Federal
Regulation of Securities) (July 28, 2009); comment
letter of Curian Capital LLC, Financial Wealth
Management, Inc., LPL Financial Corporation, and
SEI Investments Company (July 28, 2009); comment
letter of Ernst & Young (July 28, 2009); comment
letter of Financial Planning Association (July 28,
2009); comment letter of Coalition of Private
Investment Companies (July 31, 2009); comment
letter of North American Securities Administrators
Association, Inc. (Aug. 5, 2009). Academic research
suggests that PCAOB registration and inspection is
associated with higher quality engagements. See,
e.g., Mark L. DeFond & Clive S. Lennox, Do PCAOB
Inspections Improve the Quality of Internal Control
Audits? (Sept. 2015), available at https://
pcaobus.org//News/Events/Documents/10222015_
CEA/PCAOB-Inspections-Internal-Control-AuditsDeFond_Lennox.pdf. DeFond and Lennox (2015)
posit that auditors are motivated to receive clean
inspection reports from the PCAOB because adverse
inspection outcomes are detrimental to the auditors’
compensation (Johnson, Lindsay, Marsha Keune &
Jennifer Winchel, Auditors’ Perceptions of the
PCAOB Process (2015) working paper, University of
Virginia). They also note that the PCAOB has broad
powers within its jurisdiction to sanction
individual auditors and firms that provide
substandard audits, which provides further
incentive for auditors to perform high quality
audits.
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would provide clients with confidence
in the quality of the reports produced
under the proposed rule.
Adviser’s Level of Authority. The
proposed rule would require that the
adviser’s written agreement with the
qualified custodian specify the
investment adviser’s agreed-upon level
of authority to effect transactions in the
custodial account as well as any
applicable terms or limitations.513 As
discussed in section II.B.3.b.iv above,
our understanding is that custodial
agreements between advisory clients
and qualified custodians often contain
provisions that give investment advisers
authority over their clients’ custodial
accounts that may be broader than what
the adviser and client have agreed to in
their advisory agreements. For example,
an adviser may not have authority under
its advisory agreement with a client to
instruct the client’s custodian to
disburse client assets, or the advisory
agreement may not be entirely clear on
the level of authority granted to the
adviser. If, however, the client’s
agreement with its qualified custodian
grants the adviser broad authority over
the client’s account, the qualified
custodian will accept and act upon
instructions from the adviser to disburse
or transfer assets, for example, without
verifying or confirming those
instructions with the advisory client),
even though the adviser’s agreement
with its client does not give the adviser
the authority to do so.514 This puts
client assets at risk by giving the adviser
access to client assets that the adviser
may not otherwise be authorized to
access. The proposed requirement that
the contract between the adviser and the
qualified custodian specify the adviser’s
agreed upon level of authority would
mitigate these concerns and empower
advisers to tailor custodial arrangements
to better reflect client intentions and to
be consistent with the adviser’s
contractual obligations to its clients.
ii. Costs
The proposed written agreement
requirements would impose costs on
advisers and qualified custodians
related to negotiating, drafting, and
implementing the written agreements.
(a) Negotiating, Drafting, and Forming a
Reasonable Belief the Agreement
Provisions Have Been Implemented
We understand that advisers are
rarely parties to the custodial
agreements. Those advisers who are not
a party to a custodial agreement and
those qualified custodians with whom
513 Proposed
514 See
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they would be contracting would have
to bear costs to negotiate and draft the
written agreement required by the
proposed rule, and the adviser would be
required to form a reasonable belief that
the agreement provisions have been
implemented by the qualified custodian.
This would include costs attributable to
attorneys and compliance professionals,
both prior to and at the inception of the
written agreement, and over the life of
the written agreement. For purposes of
the Paperwork Reduction Act, we
estimate that investment advisers and
qualified custodians would incur
aggregate initial costs of $41,218,464 to
prepare these written agreements,515
and that aggregate annual costs
associated with modifying these
agreements would be $3,503,599.516
Advisers may also incur costs associated
with developing and maintaining a
reasonable belief that the contractual
provisions have been implemented.
These costs would largely depend upon
how each adviser satisfies and
evidences compliance with this
requirement, making them difficult to
quantify. However, the proposed
revisions to the recordkeeping rule
would require an adviser to maintain
records that would likely be useful in
demonstrating an adviser’s reasonable
belief that a qualified custodian has
implemented the proposed contractual
provisions. As a result, we estimate any
additional costs incurred by an adviser
to develop and maintain a reasonable
belief that the proposed contractual
provisions have been implemented
would be marginal.517
(b) Required Provisions
The proposed rule would require a
written agreement between advisers and
qualified custodians that incorporates
certain elements. We believe the cost of
including elements likely varies,
depending on the nature of each
required element. Including certain
elements may involve minimal cost,
while including other elements may
involve more substantial costs.
We understand that qualified
custodians often do not provide
independent public accountants access
to custodial account records in light of
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515 See
infra footnote 593.
infra footnote 595.
517 For example, under the revised recordkeeping
rule, and adviser would be required to maintain
copies of the client account statements it receives
from a qualified custodian. These records could
form the basis of an adviser’s reasonable belief that
a qualified custodian has implemented the
proposed contractual requirement to deliver
account statements. See Proposed rule 204–2(b)(iv).
The costs associated with proposed amendments to
the recordkeeping rule are discussed in more detail
below. See section 3.D.7, infra.
516 See
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privacy concerns for their customers.
The requirement that the written
agreement with the qualified custodian
include a provision requiring the
qualified custodian to promptly, upon
request, provide records relating to
client assets to the Commission or an
independent public accountant for
purposes of compliance with the rule
could impose additional costs on
custodians. We believe these costs
would largely be mitigated because we
believe that providing custodial account
records is consistent with the
longstanding custodial practice of
providing account statements to
clients.518 For purposes of the
Paperwork Reduction Act, we estimate
that qualified custodians would incur
aggregate annual costs of $19,462,024
associated with this record provision
requirement.519
The proposed rule would require that
the written agreement with the qualified
custodian provide that the qualified
custodian will send account statements
(unless the client is an entity whose
investors will receive audited financial
statements as part of the financial
statement audit process pursuant to the
audit provision of the proposed rule), at
least quarterly, to the client and the
investment adviser, identifying the
amount of each client asset in the
custodial account at the end of the
period as well as all transactions in the
account during that period. Because
qualified custodians generally already
send quarterly account statements to
clients, we expect the additional costs
associated with also sending such
statements to advisers to be small. For
purposes of the Paperwork Reduction
Act, we estimate that qualified
custodians would incur aggregate costs
of $4,869,322.50 associated with this
requirement.520
The proposed rule would also require
a provision prohibiting the account
statements from identifying assets for
which the qualified custodian lacks
possession or control, unless requested
by the client and the qualified custodian
clearly indicates that the custodian does
518 Current rule 206(4)–2(a)(3). Qualified
custodians use custodial account records to
produce client account statements.
519 See infra footnote 601, which estimates the
annual burden associated with records provision to
independent public accountants as being 18,422
hours. Using a blended rate of $394 per hour (see
infra footnote 605) produces an estimated annual
burden of (18,422 * $394) = $7,258,268 associated
with records provision to independent public
accountants. See infra footnote 605, which
estimates the annual burden associated with
records provision to the Commission as being
$12,203,756, producing a total annual burden
associated with records provision of ($7,258,268 +
$12,203,756) = $19,462,024.
520 See infra note 609.
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14749
not have possession or control over such
assets. As discussed in section III.D.2.b,
that provision could impose a cost on
clients to the extent account statements
provided by a qualified custodian on an
accommodation basis offer a client the
ability to review all of its investments in
a single consolidated account statement
and potentially alert a client or an
auditor to the existence of an
investment. This provision would also
impose costs on qualified custodians
associated with accommodating
customization requests from clients. For
purposes of the Paperwork Reduction
Act, we estimate that qualified
custodians will incur aggregate annual
costs of $324,621.50 associated with
these customized requests.521
Internal Control Report. The
objectives of the proposed internal
control report are substantially the same
as those of the internal control report
required under the current rule.522 The
internal control report includes an
opinion of an independent public
accountant as to whether controls have
been placed in operation as of a specific
date, are suitably designed, and are
operating effectively to meet control
objectives relating to custodial services.
For those qualified custodians that
currently obtain internal control reports,
the scope of those reports likely do not
cover the financial institutions’
safeguarding activities that this
proposed requirement, which would
expand the scope of the rule to include
all ‘‘assets’’ instead of ‘‘funds and
securities,’’ is designed to cover, thus
potentially creating new costs for those
firms whose report scope would need to
be modified. Any such new cost would
be mitigated, however, to the extent
newly included assets would share
existing controls or implicate controls
similar to those for funds and securities.
We understand, however, that not all
qualified custodians may currently
obtain internal control reports—or may
not be obtaining internal control reports
that meet the requirements of the
proposed rule. While we believe those
financial institutions will be able to
obtain a report that satisfies the
requirements of the proposed rule,
doing so could pose a substantial
financial burden and time commitment.
As discussed above, we are not
requiring that a specific type of internal
control report be provided under the
proposed rule as long as the required
objectives are addressed. For example, a
report on the description of controls
placed in operation and tests of
operation effectiveness, commonly
521 See
infra note 613.
206(4)–2(a)(4)(ii).
522 Rule
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referred to as a ‘‘SOC 1 Type 2 Report,’’
generally should be sufficient to satisfy
the requirements of the proposed
internal control report requirement. For
purposes of the Paperwork Reduction
Act, we estimate that an average internal
control report would cost approximately
$750,000 per year and that qualified
custodians will incur aggregate annual
costs of $35,962,500 associated with
obtaining internal control reports.523
Adviser’s Level of Authority. As
discussed above, our understanding is
that custodial agreements between
advisory clients and qualified
custodians often give advisers authority
over custodial accounts that is broader
than what the adviser and client agreed
to in the advisory agreement. Our staff
has observed that qualified custodians
have been reluctant to modify or
customize the level of authority of
investment advisers with respect to
customer accounts. We believe that
qualified custodians have been reluctant
to modify or customize advisers’ level of
authority because doing so would
increase qualified custodians’ need to
monitor customer accounts, and to
accept liability, for unauthorized
transactions by an adviser and its
personnel. The proposed requirement
could create operational costs for
qualified custodians including the costs
of adapting existing systems and
processes to modify or customize the
level of authority of investment advisers
with respect to customer accounts. Also,
qualified custodians might incur costs
to incorporate new provisions into their
contracts with advisers as well as
amend any inconsistent provisions in
their existing contracts. As a result, we
believe the proposed requirement that
the written agreement contain a
provision addressing the adviser’s
authority, including authority of the
client and adviser to reduce that
authority, may be costly for qualified
custodians.
3. Certain Assets That Are Unable To Be
Maintained With a Qualified Custodian
As discussed in section II.C above, we
believe the bulk of advisory client assets
can be maintained by qualified
custodians. Some assets by their very
nature or size may not easily be subject
to misuse or misappropriation, and that
may reduce the need for the
safeguarding protections offered by a
qualified custodian, but it is also our
understanding that qualified custodians
often refuse to custody such assets for
both advisers and their clients. In
addition, as discussed above, certain
privately offered securities may not be
523 See
infra footnote 617.
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able to be maintained by a qualified
custodian because, in our
understanding, demand for these
services is low and thus there may not
be a ready market.
In circumstances where the
protections of a qualified custodian are
unavailable for certain physical assets
and privately offered securities, the
proposed rule would provide an
exception to the requirement to
maintain client assets with a qualified
custodian, but would also require
additional protections to help ensure
that these assets are properly
safeguarded. In this section, we discuss
the costs and benefits of each of the
proposed rule’s safeguarding
requirements for assets that are unable
to be maintained by a qualified
custodian.
a. Definition of Privately Offered
Security
The proposed rule’s definition of
privately offered securities would retain
the elements from the custody rule’s
description that require the securities to
be acquired from the issuer in a
transaction or chain of transactions not
involving any public offering and
transferable only with prior consent of
the issuer or holders of other
outstanding securities of the issuer.524
Like the custody rule, the safeguarding
rule would also require the securities to
be uncertificated and would require
ownership to be recorded only on the
books of the issuer or its transfer agent
in the name of the client. However, the
safeguarding rule would also require
that the securities be capable of only
being recorded on the non-public books
of the issuer or its transfer agent in the
name of the client as it appears in the
records the adviser is required to keep
under rule 204–2.
To the extent crypto asset securities
may qualify as privately offered
securities under the current rule’s
privately offered securities exception,
advisers with custody of such assets
may not be maintaining them with a
qualified custodian in reliance upon the
exception. However, as discussed above,
we believe crypto asset securities issued
on public, permissionless blockchains
would not satisfy the definition of
privately offered securities.525 As a
result, advisers with custody of such
crypto asset securities generally would
be required to maintain those assets
with a qualified custodian and their
clients would benefit from the enhanced
protections qualified custodians
524 See
supra note 223.
525 See supra note 227 and surrounding
discussion.
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provide.526 To the extent that crypto
asset securities exist or develop that are
able to meet the conditions of the
privately offered securities exception,
the costs and benefits discussed below
with respect to the safeguarding of
privately offered securities would apply
to such assets.
a. Adviser’s Reasonable Determination
In order to be eligible for the
exception, the rule would require an
adviser to reasonably determine, and
document in writing, that ownership
cannot be recorded and maintained
(book-entry, digital, or otherwise) in a
manner in which a qualified custodian
can maintain possession or control of
such assets. Such a determination
necessarily depends on the facts and
circumstances at issue. Moreover, these
determinations would necessarily
evolve over time as assets and the
custodial industry change.
An adviser’s reasonable determination
of whether a qualified custodian is able
to maintain possession or control of a
particular asset would generally involve
an analysis of the asset and the available
custodial market. An adviser’s
reasonable determination generally
would not require the identification of
every conceivable qualified custodian
and an evaluation of its custodial
services. Fundamentally, to determine
whether an asset can or cannot be
maintained by a qualified custodian
under the proposed rule, an adviser
generally should obtain a reasonable
understanding of the marketplace of
custody services available for each
client asset for which it has custody.
The proposed rule’s reasonable
determination requirement would
benefit investors by limiting the scope
of assets eligible for the exception and
helping to ensure that any privately
offered security or physical asset for
which a qualified custodian is available
is held by such custodian, maximizing
the set of assets for which investors
receive the enhanced protections
associated with maintaining possession
or control by a qualified custodian. The
magnitude of this benefit would depend
on the extent to which advisers
currently would not otherwise maintain
assets they have control of with a
qualified custodian despite the
availability of custodial services for
such assets. For example, if the costs
associated with maintaining an asset
with a qualified custodian exceeded the
costs of safeguarding the asset
526 See section III.D.2 for a discussion of the
benefits and costs for assets that do not qualify for
the privately offered security exception and are not
physical assets.
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internally, an adviser with custody of
the asset might choose to safeguard the
asset internally absent this requirement.
Alternatively, in cases where custodial
services are available at prices that are
competitive with the costs of internally
safeguarding an asset, advisers may
have chosen to maintain assets in their
custody with a qualified custodian
regardless of this requirement.
Advisers would incur costs associated
with the proposed rule’s reasonable
determination requirement. For
example, while the rule does not
prescribe exactly how advisers should
comply with the requirement, many
advisers may choose to develop policies
and procedures that establish the
frequency with which the market for
custodial services is reviewed, the
manner in which the availability of
custodial services for an asset should be
assessed, and the manner in which an
ultimate determination is made. The
development and implementation of
such policies and procedures, including
the documentation of each reasonable
determination, would cause advisers to
incur costs that may be passed on to
their clients in the form of higher fees.
The proposed rule does provide
advisers with flexibility in determining
the frequency with which they make the
required reasonable determinations,
which should allow advisers to tailor
these policies and procedures to the
types of asset they hold on behalf of
clients and control the associated costs.
In addition, in cases where custodial
services become available for an asset
but are highly costly, the reasonable
determination requirement would force
advisers to incur such high custodial
costs, which may be passed on to their
clients, whereas they otherwise may
have chosen to forgo custodial services
in such cases. The costs an adviser
incurs as a result of the requirement
would vary depending on factors such
as the types of assets the adviser has
custody of and the heterogeneity in
these asset types. For example, an
adviser that has custody of client assets
that are relatively homogenous may
only have to monitor a single market for
custodial services, whereas an adviser
with custody of many different types of
assets would likely incur higher costs in
monitoring and determining whether
custodial services are available in
multiple markets. We lack precise
information on the degree of
homogeneity versus heterogeneity in the
assets held by advisers, as well as the
eventual costs advisers would pay to
custody assets under the proposed rule,
so we cannot quantify the costs
associated with this requirement.
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b. Adviser Reasonably Safeguards Client
Assets That Are Unable To Be
Maintained With a Qualified Custodian
To rely on the exception, the adviser
would be required to reasonably
safeguard physical assets and privately
offered securities that cannot be
maintained with a qualified custodian.
The proposed rule would not require
that advisers implement any particular
measures to safeguard physical assets or
privately offered securities not
maintained with a qualified custodian.
Instead, the proposed rule would take a
more principles-based approach. If an
adviser has custody of a physical asset
or privately offered security that it has
determined cannot be maintained with
a qualified custodian, the adviser may
decide to safeguard that asset itself,
designing and implementing
safeguarding policies and procedures
accordingly. An adviser must act
consistently with its fiduciary role in
safeguarding any particular asset. For
example, the adviser might ‘‘reasonably
safeguard’’ an asset by looking to
reasonable commercial standards for
safeguarding that asset from theft,
misuse, misappropriation, or other
similar type of loss. Under the rule,
however, an adviser would have the
flexibility to determine the specific
safeguarding measures it puts in place,
which may differ from asset to asset. If
an adviser does not ‘‘self-custody’’
physical assets or privately offered
securities that it has determined cannot
be maintained with a qualified
custodian, and instead maintains those
assets with a third party that is in the
business of safeguarding those assets,
the adviser might implement policies
and procedures reasonably designed to
ensure that the entity directly
maintaining the client’s assets has
implemented appropriate measures to
safeguard them.
Advisers are already obligated to
safeguard client assets as part of their
fiduciary duty. However, to the extent
that the proposed rule would lead
advisers to develop practices that more
effectively safeguard assets that are not
maintained by a qualified custodian, the
proposed rule would benefit investors
by reducing the risk that their assets are
subject to loss, theft, misuse, or
misappropriation by an adviser. Even to
the extent advisers already effectively
safeguard client assets that are not
maintained by a qualified custodian, the
proposed rule may still benefit investors
by establishing a minimum safeguarding
standard which they can expect will be
applied to those assets, increasing
investors’ confidence in the market for
advisory services.
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The proposed rule would not require
advisers to implement any particular
measures to safeguard physical assets or
privately offered securities not
maintained with a qualified custodian.
This principles-based approach would
give advisers the flexibility to safeguard
client assets in a way consistent with
the nature of the assets and each
adviser’s individual facts and
circumstances. If advisers choose to
safeguard client assets themselves, then,
to the extent they do not already
safeguard client assets in accordance
with the proposed requirement, advisers
would bear any costs associated with
developing and implementing effective
safeguarding practices. For example,
some advisers may incur costs designing
and implementing safeguarding policies
and procedures.
If physical assets or privately offered
securities are maintained with a third
party, advisers might comply with the
proposed rule’s safeguarding
requirement by implementing policies
and procedures reasonably designed to
ensure that the third party maintaining
the client’s physical assets has
implemented appropriate measures to
safeguard them. Such policies and
procedures might include robust due
diligence and ongoing oversight
procedures designed to ensure the
adviser has assessed and evaluated the
measures put in place by the third party.
To the extent advisers do not already
employ practices that can ensure that
client assets maintained with a third
party are safeguarded consistently with
the proposed rule, advisers will incur
costs in developing and implementing
such practices in order to comply with
the rule.
c. Notification and Prompt Independent
Public Accountant Verification
The exception to the requirement to
maintain assets with a qualified
custodian would also require an adviser
to enter into a written agreement with
an independent public accountant. The
proposed rule would require the adviser
to notify the independent public
accountant of any purchase, sale, or
other transfer of beneficial ownership of
such assets within one business day.
The proposed rule would require the
written agreement to require the
independent public accountant to verify
the purchase, sale, or other transfer
promptly upon receiving the required
transfer notice. We believe the
involvement of independent public
accountants in the review and
verification of client assets of which
advisers have custody is an important
safeguarding tool. The timing of the
requirement would build a record for
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the accountant to review in connection
with an annual surprise examination or
financial statement audit. The written
agreement would also require the
independent public accountant to notify
the Commission by electronic means
directed to the Division of Examinations
within one business day upon finding
any material discrepancies during the
course of performing its procedures.
The notification and verification
requirement would benefit investors by
reducing the risk that a loss, theft,
misuse, or misappropriation of their
assets goes undetected for a significant
amount of time, which might allow
investors or the Commission to mitigate
losses associated with such events in a
timely manner. Even in cases where an
adviser fails to notify the independent
public accountant of a transaction
because it involves loss, theft, misuse,
or misappropriation, the absence of
such notifications relative to what has
been observed in the past may serve as
a warning sign that is useful in
identifying potential losses during
annual audits or surprise examinations
by the independent public accountant.
Advisers would incur costs associated
with the proposed rule’s notification
and verification requirement. While an
adviser would likely incur some initial
costs associated with designing and
implementing any policies and
procedures necessary to notify the
independent public accountant that a
transaction of client assets has occurred,
the ongoing costs of notifying the
independent public accountant are
likely to be small relative to the more
involved transaction costs associated
with a change of ownership for privately
offered securities or physical assets. For
purposes of the Paperwork Reduction
Act, we estimate that advisers would
incur aggregate ongoing annual costs of
$48,013 associated with notifying
independent public accountants of
transactions.527 Advisers will also incur
one-time costs associated with
negotiating, drafting, and implementing
the written agreement with their
designated independent public
accountant. Advisers may be able to
mitigate these one-time costs if they
already have written agreements
associated with an annual surprise exam
or audit by the same independent public
accountant. In addition, advisers may
incur minimal costs associated with the
occasional modification of these
agreements. For purposes of the
Paperwork Reduction Act, we estimate
that investment advisers would incur
aggregate initial costs of $2,443,194 to
prepare these written agreements,528
and that aggregate annual costs
associated with modifying these
agreements would be $977,514.529
Finally, the adviser will have to pay
the independent public accountant for
its services, the costs of which may be
passed onto investors. Verification costs
would likely vary across advisers
depending on factors such as the type of
client assets they have custody of as
well as the volume of transactions in
which they engage. For example, a
transaction involving a real estate asset
that requires the independent public
accountant to verify titles or deeds in
person is likely to be costlier to verify
than a transaction that can be verified
electronically or via telephone.
Similarly, an adviser that engages in a
high volume of annual transactions
would incur higher costs associated
with transaction verification, which
may ultimately be borne by the advisers’
clients. For purposes of the Paperwork
Reduction Act, we estimate that
advisers would incur aggregate ongoing
annual costs of $21,000,000 associated
with the verification of transactions by
independent public accountants.530
d. Surprise Examination or Audit
Like the existing custody rule, the
proposed safeguarding rule would
require advisers relying on the
exception to undergo an annual surprise
examination or rely on the audit
provision. In a change from the custody
rule, however, the proposed rule would
require each privately offered security
or physical asset not maintained with a
qualified custodian to be verified, rather
than only requiring that a sampling of
assets be verified during a surprise exam
or that only assets meeting the
materiality threshold be verified during
an audit.
The proposed requirement that each
asset be verified in annual surprise
examinations or audits would benefit
investors by reducing the risk that the
loss or theft of client assets is not
detected when those assets are either
not included in a surprise examination’s
sample or do not meet the materiality
threshold when advisers rely on the
audit provision. For clients of advisers
that do not rely on the audit provision,
the magnitude of this benefit depends
on the extent to which the sampling
techniques used in conducting a
surprise examination are likely to omit
assets that have been subject to loss or
theft. To the extent that the sampling
techniques currently used in surprise
528 See
infra note 642.
infra note 644.
530 See infra note 649.
529 See
527 See
infra note 648.
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examinations are effective at capturing
instances of asset loss or theft, or that
the sampling techniques are already a
sufficient deterrent to adviser
misconduct that might result in loss or
theft, the benefit of this requirement
will be more limited with respect to
surprise examinations.
For clients of advisers that rely on the
audit provision, the magnitude of this
benefit depends on the extent to which
loss or theft tend to occur in client
assets that do not meet the materiality
threshold. While the existing custody
rule might not deter adviser misconduct
in assets below the materiality
threshold, the proposed safeguarding
rule would act as more of a deterrent
against such misconduct because those
assets would be subject to regular
verification for advisers that rely on the
audit provision.
Advisers would incur additional costs
as a result of the requirement that, to
rely on the exception, each client asset
be verified in a surprise examination or
annual audit, and these costs may be
passed on to their clients. These costs
will vary with the type of asset subject
to verification and the number of assets
held by an adviser. For example,
verifying a privately offered security
held by an adviser on behalf of its client
might require an independent public
accountant to contact the issuer of the
security or its agent to verify the
existence of the asset, or to review
documents such as private placement
memoranda and the issuer’s Regulation
D filings. For physical assets, an
independent public accountant may be
required to review deeds or other land
recordation materials (e.g., for real estate
assets) or to review other documents,
such as warehouse receipts, that
confirm the existence of a physical
commodity. For both physical assets
and privately offered securities,
incremental verification costs could be
high in cases where the number of
assets held by an adviser is large relative
to the number of assets typically
verified in surprise examinations or
audits under the current custody rule. If
the supply of qualified independent
public accountants is scarce relative to
any increased demand for their services
as a result of this requirement, the
overall cost of their services would also
increase, at least temporarily until those
higher prices attract new entrants into
the public accounting market. For
purposes of the Paperwork Reduction
Act, we estimate that advisers would
incur aggregate ongoing annual costs of
$322,956,000 associated with the
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verification of transactions by
independent public accountants.531
4. Segregation of Investments
In addition to requiring advisers to
attain reasonable assurance of
segregation of client assets from a
qualified custodian’s assets, the
proposed rule also would require
advisers to segregate client assets from
the adviser’s assets and its related
person’s assets in circumstances where
the adviser has custody. Specifically,
the proposed rule would require that
client assets of which an adviser has
custody:
(1) Be titled or registered in the
client’s name or otherwise held for the
benefit of that client;
(2) Not be commingled with the
adviser’s assets or the adviser’s related
persons’ assets; and
(3) Not be subject to any right, charge,
security interest, lien, or claim of any
kind in favor of the adviser, its related
persons, or its creditors, except to the
extent agreed to or authorized in writing
by the client.532
The proposed requirement that a
client’s assets be titled or registered in
the client’s name would help ensure
that the client’s assets are clearly
identified as belonging to the
appropriate client. The proposed rule
would also permit advisers to identify
the assets ‘‘for the benefit of’’ a
particular client where assets may not
be ‘‘titled or registered’’ in the client’s
name. Permitting advisers to identify
assets ‘‘for the benefit of’’ a particular
client benefits investors by recognizing
that advisory clients can title or register
their investments in various ways.
The proposed rule would also require
that client assets not be commingled
with the adviser’s assets or those of its
related persons. The proposed
requirement would help ensure that
client assets are isolated and more
readily identifiable as client property.
We believe isolating client assets and
making them more readily identifiable
as client property would help protect
client assets from claims by a third party
looking to secure or satisfy an obligation
of the adviser, including in cases of
insolvency or bankruptcy of the adviser,
or its related persons.
The proposed rule would also require
client assets to remain free from any
right, charge, security interest, lien, or
claim of any kind in favor of the adviser,
its related persons, or its creditors.
These requirements would protect client
assets by limiting the ability of an
adviser, or its related persons, to use
531 See
infra note 655.
rule 223–1(a)(3).
532 Proposed
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client assets for their own purposes or
in a manner not authorized by the
client. We recognize that some advisers
regularly service assets in a manner
where such assets are reasonably
identifiable from other clients’ assets
and not subject to increased risk of loss
from adviser misuse or in the case of
adviser insolvency, thereby mitigating
the potential benefits of the proposed
requirement. Also, we recognize that,
depending on the types of assets,
products, or strategies in which they
invest, some clients may authorize these
types of arrangements. We do not intend
this condition to limit or prohibit
clients’ ability to authorize such
arrangements.
We recognize that not all advisers
service assets in a manner where such
asserts are reasonably identifiable from
the other clients’ assets and not subject
to increased risk of loss from adviser
misuse or in the case of adviser
insolvency. In addition, for those
advisers that segregate and identify their
client assets, the extent of those
activities varies. To the extent certain
advisers currently do not segregate
client assets, the segregation
requirement in the proposed rule would
result in advisers adapting existing
systems and processes to meet the
proposed requirement.
6. Exceptions From the Surprise
Examination
The proposed rule would create new
exceptions to the surprise examination
requirement in certain limited
circumstances where advisers may have
custody. We believe that in these
circumstances, the subject activities or
arrangements have built-in adequate
preventative safeguards or simply pose
less risk to client assets.
5. Investment Adviser Delivery of
Notice to Clients
The proposed rule, like the custody
rule, would require an investment
adviser to notify its client in writing
promptly upon opening an account with
a qualified custodian on the client’s
behalf. The proposed rule, however,
would require that the notice must
include the custodial account number in
addition to the currently required
qualified custodian’s name and
address.533 The proposed rule would
also continue to allow the notice to be
delivered to the client’s independent
representative. If the client is a pooled
investment vehicle, the notice must be
sent to all of the investors in the pool,
provided that, if an investor is a pooled
investment vehicle that is in a control
relationship with the adviser or the
adviser’s related persons, the sender
must look through that pool (and any
pools in a control relationship with the
adviser or its related persons) in order
to send the notice to investors in those
pools.534
The addition of the custodial account
number would benefit clients by
allowing them to more easily identify
the custodial account. The client would
a. Entities Subject to an Audit
We believe that audits provide
substantial protections to private funds
and their investors both because audits
test assertions associated with the
investment portfolio (e.g., completeness,
existence, rights and obligations,
valuation, presentation) and because
they provide a check against adviser
misrepresentations of performance, fees,
and other information about the fund.
Because of that belief, the proposed
rule’s audit provision would allow
audits to serve as a substitute
mechanism of compliance with certain
aspects of the proposed rule. Elements
of the proposed rule’s audit provision
are largely unchanged from the audit
provision of the current rule.536
Differences include: expanded
availability from ‘‘pooled investment
vehicle’’ clients to ‘‘entities,’’ extending
the current rule’s specific deadlines for
distribution of audited financial
statements to 180 days in the case of
fund of funds or 260 days of a fund of
funds of funds of the entity’s fiscal year
end, and a requirement for there to be
a written agreement between the adviser
or the client and the auditor requiring
the auditor to notify the Commission
533 Proposed
535 See
534 See
536 See
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rule 223–1(a)(2).
proposed rule 223–1(c).
be able to compare the custodial
account number on subsequent account
statements received from the qualified
custodian to the custodial account
number on the notice received from
their investment adviser. Also, if the
client is a pooled investment vehicle,
the look-through requirement on
senders promotes meaningful delivery
of this important information.
We understand that custodial account
numbers are readily available to
qualified custodians and that the cost of
including the custodial account number
in the notice to clients would be
minimal. For purposes of the Paperwork
Reduction Act, we estimate that
advisers would incur aggregate initial
costs of $4,720,044 associated with
ensuring that custodial account
numbers are included in notices to
clients.535
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upon the auditor’s termination or
issuance of a modified opinion.537
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i. The Expanded Availability of Audit
Provision
While the current rule’s audit
provision is only available to an adviser
to clients that are limited partnerships,
limited liability companies, and other
types of pooled investment vehicles, the
proposed audit provision would also be
available to an adviser for any other
client ‘‘entity’’ whose financial
statements can be audited in accordance
with the rule.538
As discussed in section II.G.1.b, this
aspect of the proposed rule would
extend the investor protection benefits
of an audit to a larger number of
investors, such as pension plans,
retirement plans, college saving plans
(529 plans), and Achieving a Better Life
Experience savings accounts (ABLE
plans or 529 A accounts). Investment
advisers do not use the current rule’s
audit provision for clients that are not
pooled investment vehicles, a
consequence that may increase
compliance burdens for advisers and
result in additional costs.
Also, we believe that financial
statement audits provide additional
meaningful protections to investors by
increasing the likelihood that fraudulent
activity is uncovered, thereby providing
deterrence against fraudulent conduct
by advisers. In a financial statement
audit, the accountant performs
procedures beyond those procedures
performed during a surprise
examination. For example, a financial
statement audit typically involves tests
of valuations of entity investments,
income, operating expenses, and, if
applicable, incentive fees and
allocations that accrue to the adviser.
Additionally, a financial statement audit
regularly involves an accountant
confirming bank account balances and
securities holdings as of a point in time,
and a financial statement audit
frequently includes the testing of
transactions that have occurred
throughout the year. These common
types of audit evidence procedures
performed by accountants during a
financial statement audit—physical
examination or inspection,
confirmation, documentation, inquiry,
recalculation, re-performance,
observation, and analytical
procedures—act as an important check
on the adviser obviating the need for the
account notice and delivery
537 See
supra note 283.
rule 206(4)–2(b)(4); proposed rule
223–1(b)(4).
538 Compare
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requirements for pooled investment
vehicles and other entities.
Based on our experience, we estimate
that the party (or parties) that bears the
audit expense would pay an average
audit fee of $60,000 per fund. We
estimate that individual fund audit fees
would tend to vary over an estimated
range from $15,000 to $300,000, and
that some fund audit fees would be
higher or lower than this range. We
noted that the price of a private fund
audit depends on many factors, such as
whether it is a liquid fund or an illiquid
fund, the number of its holdings,
availability of a PCAOB-registered and
-inspected auditor, economies of scale,
and the location and size of the auditor.
We believe that the cost of audit for
client entities whose financial
statements can be audited would be of
a similar magnitude.539 540
ii. Distribution of Audited Financial
Statements
The proposed audit provision would
require an adviser to distribute an
entity’s audited financial statements to
current investors within 120 days (or
180 days in the case of a fund of funds
or 260 days in the case of a fund of
funds of funds) of the entity’s fiscal year
end, instead of the 120-day period
required currently.541 As discussed in
section II.G.1.e above, we understand
that reliance on third parties could
cause an adviser to fail to meet the 120day timing requirements regardless of
an adviser’s actions. We also recognize
539 Although we believe that the procedures
performed by the accountant during the course of
an audit provide meaningful protections to clients
beyond those of a surprise examination, certain
protections provided by surprise examinations
would no longer be provided. The loss of those
protections could create a cost for investors, but we
believe the requirements under the proposed rule
mitigate those potential costs. For example,
although the annual audit is not required to be
performed at a time of the accountant’s choosing (as
is a surprise examination), we believe other
elements of the audit incorporate an element of
uncertainty similar to the surprise element of the
surprise examination, with corresponding benefits
to investors. Specifically, in the course of an annual
audit, the auditor will select transactions to test
during the period that the adviser will not be able
to anticipate.
540 Under the proposed rule, only those
accountants that are subject to regular inspection by
the PCAOB are eligible to perform these services
which limits eligible accountants to those that
currently conduct public company issuer and
broker-dealer audits. The expansion of the
availability of audit provision could result in an
increase in demand for audit services provided by
PCAOB-inspected accountants. Absent an offsetting
increase in the supply of such services, the cost of
audit services for client entities could increase. If
PCAOB-inspected accountants reallocate resources
from other market segments, thereby decreasing the
supply of PCAOB-inspected accountant capacity in
those other market segments, the cost of audit
services, more generally, could increase.
541 See proposed rule 223–1(b)(4)(iv).
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there may be times when an adviser
reasonably believes that an entity’s
audited financial statements would be
distributed within the required
timeframe but fails to have them
distributed in time under certain
unforeseeable circumstances.
By extending the timeframe in which
advisers of certain types of pooled
investment vehicles (i.e., funds of funds
and funds of funds of funds) must
distribute an entity’s audited financial
statements,542 the proposed rule may
reduce any uncertainty advisers to such
pooled investment vehicles face under
the current rule. Because we understand
existing market practices with respect to
these pooled investment vehicles
already follow similar timeframes, we
believe the costs of the proposed
changes to the audit provision with
respect to the distribution of audited
financial statements would be minimal.
For purposes of the Paperwork
Reduction Act, we estimate that
investment advisers would incur an
aggregate annual burden of $1,242,150
associated with delivering audited
financial statements to their clients.543
iii. Commission Notification
The proposed rule would require an
adviser to enter into, or cause the entity
to enter into, a written agreement with
the independent public accountant
performing the audit to notify the
Commission (i) within one business day
upon issuing an audit report to the
entity that contains a modified opinion
and (ii) within four business days of
resignation or dismissal from, or other
termination of, the engagement, or upon
removing itself or being removed from
consideration for being reappointed.544
The written agreement must require the
independent public accountant to notify
the Commission by electronic means
directed to the Division of
Examinations. Although there is a
requirement on Form ADV for an
adviser to a private fund to report to the
Commission whether it received a
qualified audit opinion and to provide
and update its auditor’s identifying
information, there is not a similar
current obligation for an accountant to
notify the Commission under the
current rule.
The proposed requirement to notify
the Commission (i) within one business
day upon issuing an audit report to the
entity that contains a modified opinion
and (ii) within four business days of
resignation or dismissal from, or other
termination of, the engagement, or upon
542 See
supra note 304.
infra note 660.
544 See proposed rule 223–1(b)(4)(v).
543 See
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removing itself or being removed from
consideration for being reappointed
would enable the Commission to receive
more timely, complete, and
independent information in these
circumstances and to evaluate the need
for an examination of the adviser. Based
on our experience in receiving
notifications from accountants who
perform surprise examinations under
the custody rule, we believe that the
timely receipt of this information—from
an independent third party—would
more readily enable our staff to identify
advisers potentially engaged in harmful
misconduct and who have other
compliance issues. This would bolster
the Commission’s efforts at preventing
fraudulent, deceptive, and manipulative
activity and would aid oversight of
investment advisers. This could lead to
a higher rate of detection of activities
that lead to the loss of client assets and
a greater potential for mitigation of such
losses. Anticipating this, advisers would
have stronger incentives to avoid such
harmful activities.
The proposed written agreement
requirement could impose costs on
advisers and accountants related to
negotiating, drafting, and implementing
the written agreements. Based on staff
experience, however, we understand
that written agreements are
commonplace and reflect industry
practice when a person retains the
services of a professional, such as an
accountant, and they are typically
prepared by the independent public
accountant in advance. Also, the
proposed requirements are drawn from
the current rule’s Form ADV–E filing
requirement for independent public
accountants performing surprise
examinations and, as a result, should
not be burdensome for accountants to
include in their written agreements.545
As a result, we do not believe that the
proposed requirement would
significantly increase the costs
attributable to the proposed
requirement. For purposes of the
Paperwork Reduction Act, we estimate
that investment advisers would incur an
initial aggregate burden of 48,735 hours
and an ongoing annual burden of 35,869
hours associated with the written
agreement.546
b. Discretionary Trading Authority
The proposed rule would contain an
exception from the surprise examination
requirement of client assets if the
adviser’s sole basis for having custody is
discretionary authority with respect to
545 Form ADV–E Instructions, pt. 3.ii, https://
www.sec.gov/files/formadv-e.pdf.
546 See infra notes 662 and 664.
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those assets, provided this exception
applies only for client assets that are
maintained with a qualified custodian
and for accounts where the adviser’s
discretionary authority is limited to
instructing its client’s qualified
custodian to transact in assets that settle
exclusively on a delivery versus
payment basis.547 The proposed rule
would limit this exception to instances
where this is the adviser’s sole basis for
custody. Also, if an adviser also has
custody of the client’s assets for reasons
that are also subject to similar
exceptions (e.g., sole basis is fee
deduction, sole basis is related person
custody),548 the adviser can rely on the
exception.
We understand that certain investors
may prefer to give their adviser
discretionary trading authority. In
delivery versus payment transactions,
clients’ custodians are generally under
instructions to transfer assets out of a
client’s account only upon
corresponding transfer of assets into the
account. When a custodian is under
instructions to transfer assets out of a
client’s account only upon
corresponding transfer of assets into the
account, there is a reduced risk that the
adviser could misappropriate the assets,
and when the transaction settles on a
DVP basis there is a reduced risk of theft
of the asset because, on a non-DVP
basis, the seller of an asset could deliver
but not receive payment or that the
buyer of an asset could make payment
but not receive delivery of the asset. The
proposed exception would reduce the
cost of discretionary trading authority in
these instances by not requiring the
adviser to comply with the surprise
examination requirement of the
proposed rule in those circumstances
where the discretionary trading
authority arrangement minimizes the
risk that an investment adviser could
withdraw or misappropriate assets in its
clients’ accounts. We believe this
exception will mitigate the creation of
new burdens for many advisers,
particularly smaller advisers, as a result
of the expanded scope of the definition
of custody in the proposed rule and will
focus the requirement to obtain a
surprise examination where the risk of
misappropriation is greatest. To the
extent advisers pass along cost savings
to clients, clients could realize a benefit
in the form of reduced fees.
c. Standing Letters of Authorization
The proposed rule would provide an
exception from the surprise examination
547 Proposed
rule 223–1(b)(8).
Rule 206(4)–2(b)(3) and (6) and proposed
rule 223–1(b)(3) and (6).
requirement for an investment adviser
that has custody of client assets solely
because of a standing letter of
authorization.549
We understand that certain investors
may prefer to grant their adviser
authority to disburse assets from the
client’s account to one or more
specifically designated third parties in a
manner that limits the adviser’s ability
to redirect the assets, via standing letter
of instruction or other similar asset
transfer authorization arrangement. The
proposed exception would reduce the
cost of granting an adviser such
authority by not requiring the adviser to
comply with the surprise examination
requirement of the proposed rule. To the
extent advisers pass along cost savings
to clients, clients could realize a benefit
in the form of reduced fees.
As discussed in section II.G.3 above,
where an arrangement is structured so
that the adviser’s role is limited to
determining when to disburse a client’s
assets, we believe that the adviser’s role
in effecting any change in beneficial
ownership is circumscribed and
ministerial, and there is little risk to
clients of loss, misuse,
misappropriation, or theft of its asset.
We also believe under such
circumstances that a qualified custodian
would be best positioned to ensure that
the required authorizations and
instructions are properly and verifiably
issued by the client (e.g., the client’s
signature is verifiable). As a result, we
believe the cost of the exception to
clients would be minimal.
The proposed required information
could benefit qualified custodians by
helping ensure that the instructions to
the qualified custodian provide relevant
information about the recipient. The
proposed rule’s requirement could also
impose operational costs on qualified
custodians. As described in section
II.G.3, we believe the types of financial
institutions identified as meeting the
proposed definition of qualified
custodian are required by their primary
functional regulator or otherwise to
perform procedures to verify the
instruction and authorization, through a
signature review and, if determined to
be necessary, based on the facts and
circumstances, another method of
verification. To the extent existing
regulatory requirements for qualified
custodians are the same or similar to the
proposed rule’s requirements, the costs
of adapting existing systems may be
mitigated.
548 See
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7. Amendments to the Investment
Adviser Recordkeeping Rule
The proposed amendments to rule
204–2 would require an investment
adviser that has custody of client assets
to make and keep true, accurate, and
current records of required client
notifications and independent public
accountant engagements under
proposed rule 223–1, as well as books
and records related to specific types of
client account information, custodian
information, transaction and position
information, and standing letters of
authorization.550 The proposed
amendments would require a more
detailed and broader scope of records of
trade and transaction activity and
position information for each client
account than the existing requirements
for such records.551 The proposed
amendments also would add new
recordkeeping requirements that
include: (i) retaining copies of required
client notices; 552 (ii) creating and
retaining records documenting client
account identifying information,
including whether the adviser has
discretionary authority; 553 (iii) creating
and retaining records of custodian
identifying information, including
copies of required qualified custodian
agreements, and a record of required
reasonable assurances that the adviser
obtains from the qualified custodian; 554
(iv) creating and retaining a record that
indicates the basis of the adviser’s
custody of client assets; 555 (v) retaining
copies of all account statements; 556 and
(vi) retaining copies of any standing
letters of authorization.557 Lastly, the
proposed amendments would add new
recordkeeping requirements to address
independent public accountant
engagements.558
The proposed recordkeeping
requirements are designed to work in
concert with the proposed rule to help
ensure that a complete custodial record
with respect to client assets is
maintained and preserved. The
proposed changes to the recordkeeping
rule would benefit clients by helping to
facilitate the Commission’s inspection
and enforcement capabilities, including
assessing compliance with the
550 Advisers would be required to maintain the
proposed records for a period of not less than five
years as required under the current books and
recordkeeping rule. See rule 204–2(e)(1).
551 Compare rule 204–2(b)(1)-(4) with proposed
rule 204–2(b)(2)(v).
552 Proposed rule 204–2(b)(1).
553 Proposed rule 204–2(b)(2)(i).
554 Proposed rule 204–2(b)(2)(ii).
555 Proposed rule 204–2(b)(2)(iii).
556 Proposed rule 204–2(b)(2)(iv).
557 Proposed rule 204–2(b)(2)(vi).
558 Proposed rule 204–2(b)(3).
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requirements of the proposed rule. In
particular, the proposed recordkeeping
requirement would benefit investors by
providing more complete records that
would facilitate client account
reconciliation of all debits and credits to
and from client accounts. More
complete records also would better
enable examiners to identify and detect
potential investment adviser
misappropriation or loss or misuse of
client assets during their examinations,
resulting in more effective investor
protections. More generally, the
recordkeeping requirements would
enhance the transparency of custody of
client assets and enhance the
Commission’s oversight capabilities.
Enhancing the Commission’s oversight
capabilities could benefit clients and
investors through reduced risks of loss
and greater regulatory transparency and
resulting effectiveness of the
Commission’s client and investor
protection efforts.
The proposed recordkeeping
requirements would impose costs on
advisers related to creating and
maintaining the required records. These
costs include those that can be
attributed to compliance professionals
who would review and familiarize
themselves with requirements as
specified in the proposed rule. In
particular, advisers would be required
to make and retain a list of covered
functions and contributing factors,
document their due diligence efforts,
retain any written agreements with
service providers, and document
periodic monitoring of retained service
providers. For purposes of the
Paperwork Reduction Act, we estimate
that advisers would incur aggregate
annual costs of $41,352,853 as a result
of the proposed amendments to rule
204–2.559
8. Changes to Form ADV
We are proposing to amend Part 1A,
Schedule D, and the Instructions and
Glossary of Form ADV.560 The
amendments are designed to categorize
information about advisers’ practices to
safeguard client assets, to provide the
Commission with information related to
these practices, and to provide the
Commission with additional data to
improve our ability to identify
compliance risks. The Commission is
not, however, proposing to change the
structured data language used for Part
1A. Specifically, given that Form ADV
Part 1A currently is submitted in a
structured (i.e., machine-readable),
XML-based data language specific to
559 See
560 See
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that Form, the information in amended
new Item 9 would continue to be
structured in the same manner.
The amendments will provide the
Commission with information related to
these practices, and also provide the
Commission with additional data to
improve our ability to identify
compliance risks. Also, public reporting
of these custodial practices could allow
clients or third parties to assess
potential risks (e.g., concentration of
investments with a small number of
custodians) associated with the market
for custodial services, generally. For
example, these amendments may also
provide clients or investors additional
protection because they will be better
able to discern the reasons why a
particular adviser has custody. Further,
these amendments may offer ancillary
market benefits to the extent that market
participants are better able to analyze
the Form ADV data to assess fraud risk.
These proposed revisions would also
streamline the collection of this
information by reorganizing Item 9 and
refining certain reporting requirements
to eliminate confusion and prevent
inaccurate or incomplete reporting.561
Reporting this additional information
would impose additional costs on
investment advisers, but we believe that
such costs would not be significant
since we understand that much of the
information we propose requesting on
Form ADV would be readily available to
or easily accessible by advisers.562
E. Efficiency, Competition, and Capital
Formation
Efficiency. As discussed above, the
proposed rule should benefit clients and
investors by mitigating risks associated
with the custody of client assets,
thereby enhancing client and investor
protections. The enhancement to client
and investor protections could, in turn,
lead to current clients being willing to
invest a greater portion of their
resources with registered advisers or for
more clients and investors to seek the
advice of registered advisers. Investment
advisers provide investment advice to
investors and clients about the value of,
or about investing in, securities and
other investment products. To the
extent investors benefit from such
advice, we could expect an
improvement in the efficiency of client
investment.
It is possible, however, that the
proposed rule could have the opposite
561 See
proposed Form ADV, Part 1A, Item 9.
infra Table 10 for the revised From ADV
PRA burden that includes incremental changes due
to the proposed amendments as well as adjustments
due to wage inflation and changes in the number
of advisers.
562 See
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effect on efficiency. The costs of the
proposed rule would be borne by
advisers, their clients, and qualified
custodians. It is possible that the costs
borne by advisers may be large enough
to cause some advisers to stop providing
investment advice for certain assets.563
If advisers were to stop providing
investment advice for certain assets,
clients could experience a decrease in
the quality of advisers’ services.
Alternatively, if advisers do try to push
the costs, or some component thereof, to
clients, it is possible that costs will be
large enough to cause some clients to
seek alternatives to registered advisers.
To the extent clients would benefit from
the advice provided by registered
investment advisers, the decreased use
of advisory services could result in a
decline in the efficiency of client
investment including lower realized
returns.
The proposed amendments would
result in a substantive increase in the
information about custodial practices
available to the Commission. That
increased information could, for
example, aid Commission staff in
examinations, increase the likelihood
that non-compliant behavior by
custodians or advisers is detected, and
increase the likelihood that noncompliant behavior is detected sooner.
That increased information should also
allow the Commission to develop a
better understanding custodial
practices, generally. As a result, we
would expect an enhancement in
regulatory efficiency.
Competition. The proposed rule
would enhance protections associated
with the custody of client assets. These
enhancements to client and investor
protection, as well as the additional
information available to current and
potential clients, could lead to an
increased demand for advisory services.
That increase in demand for advisory
services could, in turn, lead to increased
competition among advisers to meet the
increased demand. Alternatively, the
increased demand for advisory services
could lead to an increase in the number
of advisers in the marketplace, also
leading to an increase in competition
among advisers. An increase in
competition could, presumably,
manifest itself in terms of better service,
563 If there are fixed costs associated with the
proposed regulations, then smaller advisers will
generally tend to bear a greater cost, relative to
adviser size, than larger advisers. If there are
material fixed costs associated with the proposed
rule, then we would expect the possible negative
effect on competition to be greater for smaller
advisers because the proposed regulations will tend
to increase their costs more (relative to adviser size)
than for larger advisers.
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better pricing, or some combination of
the two, for clients.
As discussed above, however, it is
possible that the proposed rule could
have the opposite effect on competition.
As noted above, the costs of the
proposed rule would be borne by
advisers, clients, and qualified
custodians. It is possible that the costs
borne by advisers may be large enough
to cause some advisers to stop providing
advice with respect to certain assets. To
the extent the proposed rule would
create new fixed costs of providing
advisory services, those fixed costs
would disproportionately impact small
or newly emerging advisers. As a result,
those fixed costs could discourage entry
of new advisers or cause certain
advisers to exit the market. Rather than
exiting the market, there could be
consolidation among advisers that could
result in fewer options, and potentially
higher costs, for investors. If advisers
were to stop providing advice with
respect to certain assets, competition
among advisers with respect to
providing advice for those assets could
decline. Further, if advisers do try to
push the costs, or some component
thereof, to clients, it is possible that
costs will be large enough to cause some
clients to seek alternatives to the advice
of registered advisers. The decreased
demand for advisory services could
result in a decline in the number of
registered advisers and a decrease in
competition among registered advisers.
Also, we understand that the
requirements of the proposed rule may
result in additional costs for qualified
custodians, particularly the
requirements of a written agreement and
reasonable assurances between the
qualified custodian and the investment
adviser incorporating certain minimum
investor protection elements for
advisory clients. To the extent qualified
custodians are unable to pass these costs
along to advisers and their clients, an
increase in compliance costs could
cause some qualified custodians to exit
the market. A decrease in the number of
qualified custodians could, in turn, lead
to reduced competition, increased
custodial fees, or both.
Capital Formation. As noted above,
the proposed amendments enhance
investor protections by mitigating risks
associated with custody of client assets.
Additionally, the proposed rule would
result in more information about
custodial practices being available to the
public. Those enhancements to client
and investor protection as well as the
additional information available to
potential current clients and potential
investors could lead to greater investor
confidence which could result in
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current investors being willing to invest
more and potential investors being more
willing to invest for the first time. To
the extent that the proposed rule leads
to greater investment, we could expect
greater demand for securities, which
could, in turn, promote capital
formation.
F. Reasonable Alternatives
In this section, reasonable alternatives
to the proposed elements of rule 223–1
are discussed.
1. Scope of Assets
The proposed rule would define
‘‘assets’’ as ‘‘funds, securities, or other
positions held in a client’s account.’’
While, like the current rule, the
proposed rule would apply to a client’s
cash and cash equivalents as well as a
client’s securities, it also would
generally apply to other positions held
in a client’s account that are not funds
or securities. The Commission
alternatively could define the scope of
other positions more narrowly, perhaps
by identifying specific types of other
positions subject to the proposed rule’s
safeguarding requirements.
As discussed above, however, we
observe a continuing evolution of the
types of investments held in advisory
accounts. If the proposed rule were to
identify specific types of assets as
subject to the safeguarding requirements
of the rule, clients may not benefit from
the safeguarding requirements of the
rule if they invest in new asset types
introduced in the future that fall outside
the rule’s scope. We therefore believe a
broad definition of other positions
strikes the correct balance in terms of
investor protections and the cost of
complying with the proposed rule.
2. Elimination of Privately Offered
Securities Exception
The proposed rule would modify the
current rule’s exception to the
requirement to maintain client funds
and securities with a qualified
custodian with respect to certain
privately offered securities.564 As
discussed above, we believe qualified
custodians serve as key gatekeepers to
mitigate loss of client assets. The
Commission alternatively could seek to
enhance investor protections by
eliminating the exception—thus
requiring advisers with custody of
privately offered securities to either
maintain these assets with a qualified
custodian or eliminate having custody—
or retain the current exception without
the proposed modifications.
564 Proposed
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The choice between retaining the
current exception, the exception
modified as proposed, or eliminating
the exception entirely necessarily
involves tradeoffs. Eliminating the
exception and requiring privately
offered securities be maintained with a
qualified custodian would increase the
likelihood that a loss would be
prevented or that non-compliant
behavior is detected earlier, potentially
mitigating loss to clients. Also, to the
extent the likelihood of timely detection
deters non-compliant behavior,
requiring privately offered securities to
be maintained with a qualified
custodian could have an important
prophylactic effect.
While we believe that requiring a
qualified custodian to be involved in
any transfer of ownership of privately
offered securities would best mitigate
the risk of loss of client assets, the
current costs associated with this
approach would be substantial while a
custodial market is still relatively
undeveloped. Although we believe that
this market would be more robust if the
custody rule’s exception for
uncertificated privately offered
securities were eliminated and demand
for custodian services would increase, it
is possible that this market would not
develop as we may expect or would
develop in a way that the costs of
maintaining privately offered securities
with qualified custodians would not be
justified by the benefits of doing so. At
the same time, we believe retaining the
current exception without modification
leaves client assets at risk. In our view,
the proposed modifications strike the
correct balance in terms of investor
protections and the cost of complying
with the proposed rule.
3. Distribution of Requirements Across
Reasonable Assurances and Written
Agreement
The proposed rule would require an
adviser to obtain certain reasonable
assurances regarding the protections
clients receive from the qualified
custodians maintaining their assets. The
proposed rule would also require a
written agreement between advisers and
qualified custodians specifying different
provisions related to the relationship
among an adviser, its client, and a
qualified custodian. Both the proposed
reasonable assurances and written
agreement requirements expand and
formalize the minimum standard
protections to advisory clients’ assets.
The Commission alternatively could
specify a different composition of client
protections realized via reasonable
assurances and written agreements. For
example, the Commission could require
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fewer protections be realized via written
agreements and more be realized via a
reasonable assurances requirement. Or,
the Commission could require more
protections be realized via written
agreements and fewer protections be
realized via a reasonable assurances
requirement.
Under the proposal, the written
agreement covers matters that directly
affect the adviser’s own legal
compliance (i.e., requiring the custodian
to promptly provide records to the
Commission or to an independent
public accountant when required for
compliance; requiring the qualified
custodian to deliver account statements
to the adviser as well as to the client;
requiring the qualified custodian to
assure the adequacy of its internal
controls) and that concern the adviser’s
authority to effect transactions with
funds in the client’s account held by the
custodian. In contrast, the reasonable
assurances requirements cover matters
which—while within the scope of the
adviser’s fiduciary duty—principally
concern the qualified custodian’s direct
obligations to the client (i.e., the
qualified custodian’s standard of due
care to the client, the custodian’s
measures to safeguard the client’s assets,
the custodian’s indemnification of the
client against loss, the custodian’s
obligations to the client when making
sub-custodial arrangements, and the
custodian’s responsibility to identify
and segregate the client’s assets and to
protect the client from liens or thirdparty claims).
Committing more of these
requirements to a written agreement
would have the benefit of establishing a
uniform, predictable set of requirements
for all custodial arrangements and
giving the adviser—as well as the
client—a contractual enforcement
mechanism. The existence of a written
agreement might be a greater deterrent
to misconduct than a reasonable
assurances requirement, and the
agreement might provide useful terms of
reference for examinations. But
committing more of the requirements to
a written agreement could result in
significant contracting costs, potential
loss of flexibility in qualified
custodians’ business practices, a
significant disruption in current
practices, and increased litigation costs.
In contrast, committing more of these
requirements to reasonable assurances
would have the benefit of reducing
contracting costs, but with the added
cost associated with advisers exercising
due diligence and periodic monitoring
of qualified custodians to obtain
reasonable assurances, without the
benefit of an agreement to establish
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basic expectations on matters directly
affecting client advisory services.
Moreover, qualified custodians may
have concerns about implementing
certain protections in the absence of
contractual privity between themselves
and investment advisers. For example,
qualified custodians may have privacy
concerns for their clients in the absence
of an agreement with the adviser
governing provision of records to an
independent public accountant.
Weighing these factors, we believe that
the composition of client protections
realized via reasonable assurances and
written agreements in the proposal
strikes the correct balance in terms of
investor protections and the cost of
complying with the proposed rule.
3. Additional Accounting and Client
Notification Requirements for Privately
Offered Securities and Physical Assets
That Are Not Maintained With a
Qualified Custodian
The proposed rule would require an
investment adviser to implement certain
safeguards for clients’ privately offered
securities and physical assets that
cannot be maintained with a qualified
custodian. The safeguards are designed
to improve protection of these assets
and to create transparency for an
investor as to holdings of and
transactions in these assets, thereby
increasing the likelihood that a loss will
be detected sooner, and misconduct will
be deterred. These include requirements
for the adviser to reasonably determine
that ownership cannot be recorded and
maintained in a manner in which a
qualified custodian can maintain
possession or control of such assets; 565
for the adviser to reasonably safeguard
the assets from loss, theft, misuse,
misappropriation, or the adviser’s
financial reverses, including
insolvency; 566 for the adviser to enter
into a written agreement for an
independent public accountant (‘‘IPA’’)
to verify any purchase, sale, or other
transfer of beneficial ownership of such
assets promptly upon receiving notice
from the adviser, and for the IPA to
notify the Commission within one
business day upon finding any material
discrepancies during the course of
performing its procedures; 567 for the
adviser to notify the IPA of any
purchase, sale, or other transfer of
beneficial ownership of such assets
within one business day; 568 and for
verification of the existence and
ownership of such assets during an
565 Proposed
rule 223–1(b)(2)(i).
rule 223–1(b)(2)(ii).
567 Proposed rule 223–1(b)(2)(iii).
568 Proposed rule 223–1(b)(2)(iv).
566 Proposed
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annual surprise examination or a
financial statement audit.569
We considered whether these
safeguards should be supplemented or
replaced with additional accounting and
client notification requirements,
including periodic examinations of the
assets; prompt delivery to the client of
a written notice that the assets are not
kept by a qualified custodian, with an
explanation of how the client can verify
the existence and ownership of those
holdings; a summary of a client’s
transactions involving assets that are not
maintained with a qualified custodian,
to be issued on a quarterly or other
periodic basis; or for the adviser to
obtain an internal control report for
assets not maintained with a qualified
custodian.570 We also considered
requiring the independent public
accountant engaged to perform the
proposed transaction verifications to be
PCAOB-registered. We believe the
proposed safeguards are sufficient, and
the costs of additional safeguards to
advisers and clients alike may not be
justified.
As previously noted, we lack precise
information on the degree of
homogeneity versus heterogeneity of
assets held by advisers that cannot be
maintained by a qualified custodian,
and more prescriptive accounting and
notification requirements could be more
costly when the assets are more varied
and unique,571 when the custodian must
rely on a third-party service provider to
safeguard and inventory physical assets,
or when the client engages in highvolume transactions.572 Moreover, the
benefits of these additional safeguards
would be limited where the assets are of
such a nature that loss or
misappropriation is readily
detectable.573
4. Additional Safeguards When Clients
Assets Are Not Maintained With a
Qualified Custodian
As discussed above, we recognize that
not all client assets for which an adviser
may have custody can currently be
maintained with qualified
custodians.574 We considered proposing
several alternative additional
protections designed to help protect
client investments when they are not
maintained at a qualified custodian.
One such alternative we considered
would have required advisers to
implement at least one financial
569 Proposed
rule 223–1(b)(2)(v).
part II.D.5, Requests for Comment.
571 See part III.D.3.b.
572 See generally parts III.D.3.c, III.D.3.d.
573 For example, unique, high-value, non-fungible
assets, such as developed real estate.
574 See section II.D, supra.
570 See
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responsibility safeguard. Specifically,
we considered requiring advisers having
custody of client assets that they
determined could not be maintained
with a qualified custodian to either (i)
maintain an insurance policy covering
losses to the investment adviser or its
clients resulting from the loss, misuse,
theft, or misappropriation of
investments not maintained at a
qualified custodian; or (ii) maintain a
reserve bank account containing a
specified amount of cash or certain
qualified securities that could be used
only to compensate clients for violations
of the proposed rule.575
575 In the past—though in different contexts—the
Commission and Congress have considered various
financial responsibility requirements for advisers,
including requiring advisers to maintain insurance
(in the form of fidelity bonds) or satisfy minimum
capital requirements. The Commission most
recently sought comment on these concepts in 2018
in conjunction with its proposed interpretation
regarding the standard of conduct for investment
advisers. See Proposed Commission Interpretation
Regarding Standard of Conduct for Investment
Advisers; Request for Comment on Enhancing
Investment Adviser Regulation, Release No. IA–
4889, at 4 n.8 (Apr. 18, 2018) [83 FR 21203 (May
9, 2018)]. Comments received in response to this
request were still under evaluation at the time the
Commission adopted its final interpretation
regarding the standard of conduct for investment
advisers. See Commission Interpretation Regarding
Standard of Conduct for Investment Advisers, supra
footnote 57. Previously, in 2003, the Commission
requested comment on whether to require a fidelity
bonding requirement for advisers as a way to
increase private sector oversight of the compliance
by funds and advisers with the Federal securities
laws. See Compliance Programs of Investment
Companies and Investment Advisers, Release Nos.
IC–25925 and IA–2107 (Feb. 5, 2003) [68 FR 7037
(Feb. 11, 2003)]. The Commission decided not to
adopt a fidelity bonding requirement at that time,
but noted that it regarded such a requirement as a
viable option should the Commission wish to
further strengthen compliance programs of funds
and advisers. See Compliance Programs of
Investment Companies and Investment Advisers,
Release Nos. IC–26299 and IA–2204 (Dec. 17, 2003)
[68 FR 74714 (Dec. 24, 2003)]. Also, in 1973, a
Commission advisory committee recommended that
Congress authorize the Commission to adopt
minimum financial responsibility requirements for
investment advisers, including minimum capital
requirements. See Report of the Advisory
Committee on Investment Management Services for
Individual Investors, Small Account Investment
Management Services, Fed. Sec. L. Rep. (CCH) No.
465, Pt. III, 64–66 (Jan. 1973). Three years later, in
1976, the Senate Committee on Banking, Housing
and Urban Affairs considered a bill that, among
other things, would have authorized the
Commission to adopt rules requiring investment
advisers with discretionary authority over client
assets, or that advise registered investment
companies, to meet financial responsibility
standards. S. Rep. No. 94–910, 94th Cong. 2d Sess.
(May 20, 1976) (reporting favorably S. 2849). S.2849
was never enacted, however. The issue of adviser
financial responsibility was also considered by
Congress in 1992, with both the Senate and House
of Representatives passing bills that would have
given the Commission the explicit authority to
require investment advisers with custody of client
assets to obtain fidelity bonds. S.226, 102d Cong.,
2d Sess. (Aug. 12, 1992) and H.R. 5726, 102d Cong.
Ed (Sept. 23, 1992). Differences in these two bills
were never reconciled and thus neither became law.
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While this approach is similar to the
types of fidelity bonds that brokerdealers, investment companies, ERISA
fiduciaries, and some state-registered
investment advisers are required to
maintain,576 we considered requiring
advisers to maintain insurance coverage
that would have been more
comprehensive than a typical fidelity
bond in order to address the risks the
proposed rule is designed to mitigate.
For example, we considered requiring
an adviser to maintain an insurance
policy covering losses to the investment
adviser or its clients resulting from the
loss, misuse, theft, or misappropriation
of investments not maintained at a
qualified custodian due to the adviser’s
negligence, recklessness, or intentional
misconduct.
However, we recognize there could be
legal and logistical challenges in
implementing such a requirement. For
example, fidelity bond policies
generally only protect policyholders
from direct losses suffered from a
covered event (e.g., theft of the insured’s
property by an employee), not third
parties such as an adviser’s clients, and
even to the extent fidelity policies are
written to specifically cover third-party
property, there is disagreement as to
whether the money a policyholder uses
to compensate a third party qualifies as
a loss covered under these policies.577
Also, it could be difficult for an adviser
to maintain appropriate coverage
efficiently and effectively as they buy
and sell various investments on behalf
of their clients or as those investments
increase and decrease in value. Finally,
while this approach may provide some
means for recovery if an adviser’s
clients are harmed, requiring this type
of insurance coverage would likely
require advisers to pay significant
premiums, which they would likely
pass along to clients through increased
fees.
We similarly considered requiring an
adviser to maintain a specified level of
reserves based on the value of client
investments not maintained by a
qualified custodian or for which an
adviser has an enhanced ability or
576 See, e.g., FINRA Rule 4360 (broker-dealers); 17
CFR 270.17g–1 (investment companies); 29 CFR
2580.412–1 (ERISA fiduciaries). Many stateregistered investment advisers are required to
maintain fidelity bonds. See, e.g., Ala. Code 1975
section 8–6–3; Ark. Admin. Code 214.00.1–303.2;
Ga. Code Ann., section 10–5–40; see also NASAA
Bonding Requirements for Investment Advisers
Model Rule, available at https://www.nasaa.org/wpcontent/uploads/2011/07/IA-Model-RuleBonding.pdf.
577 See Adam D. Cornett & Andrew S. Kent, Who
Can Recover Under a Fidelity Policy?, XX Fid. L.J.
139, 139–41, 177–180 (2014) (citing Retail Ventures,
Inc. v. Nat’l Union Fire Ins. Co. of Pittsburgh, Pa.,
691 F3d 821, 828–32 (6th Cir. 2012)).
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authority to effect a change in beneficial
ownership. Requiring an adviser to have
sufficient liquid assets to cover these
types of client investments would have
provided a source of recovery when
those client investments are lost,
misused, stolen, or misappropriated due
to the adviser’s failure to adequately
safeguard them. This approach would
have resembled the capitalization
requirements of other financial firms.578
However, because the value of these
client investments would vary based on
market fluctuations as well as client
transactions, designing a reserve
requirement that would ensure that an
adviser maintained adequate reserves to
allow for full recovery at all times could
be operationally challenging and costly.
Further requiring advisers to maintain
reserves sufficient to provide for full—
or even meaningful—client recovery,
may be prohibitively costly because
advisers would need to set aside
significant amounts of capital,
potentially acting as a barrier to entry
for new advisory firms or causing
existing advisers to leave the market.
Another alternative we considered
would have required an adviser to
undergo an enhanced independent
verification of assets not kept with a
qualified custodian or when an adviser
has one-way transfer authority over a
client’s account, irrespective of whether
those assets are maintained with a
qualified custodian. For assets not kept
with a qualified custodian, the surprise
examination would have been required
to verify 100% of a client’s assets, and
it would have required the independent
public accountant to verify the
disposition of assets from one
examination to the next. We have opted,
instead, to propose limiting the assets
an adviser is not required to maintain
assets with a qualified custodian to
shares of mutual funds, and certain
physical assets and privately issued
securities that the adviser has
determined cannot be maintained in the
possession or control of a qualified
custodian. With respect to the latter
category of assets, we are also proposing
to require advisers to implement other
protections to ensure they are
adequately safeguarded, including, for
578 Broker-dealers are subject to minimum
capitalization requirements under the net capital
and customer protection rules. See, e.g., 17 CFR
240.15c3–1 (net capital rule); 17 CFR 240.15c3–3
(customer protection rule). Some state-registered
investment advisers are also subjected to minimum
capitalization requirements. See, e.g., Ark. Admin.
Code 214.00.1–303.2; Ga. Code Ann., section 10–5–
40; see also NASAA Minimum Financial
Requirements for Investment Advisers Model Rule
(2011), available at https://www.nasaa.org/wpcontent/uploads/2011/07/IA-Model-Rule-MinimumFinancial-Requirements.pdf.
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example, more frequent asset
verifications. We believe this approach
is likely to result in more client assets
being maintained by qualified
custodians and better tailoring the
protections for client assets that cannot
be maintained with a qualified
custodian. For one-way transfer
authority, under this alternative, the
surprise examination would have
required the independent public
accountant to evaluate whether each
one-way transfer of client assets was
authorized (e.g., client authorized a cash
withdrawal from the client’s account to
be transferred to a particular recipient).
We were uncertain whether an
independent public accountant would
make such an evaluation, however, and
if so, whether it would be costprohibitive for them to do so. We
determined, instead, to promote
transparency around all transactions for
a client’s evaluation in the proposal’s
approach. The proposed rule would
promote this by eliminating
accommodation reporting on a qualified
custodian account statement, by
limiting the circumstances in which
advisers are not required to maintain
client assets with a qualified custodian,
by requiring an independent public
accountant to verify transactions with
respect to certain assets not maintained
with a qualified custodian more
frequently, and by eliminating the
possibility that assets not kept with a
qualified custodian might not be
included in the sampling of assets
verified under the current rule.
5. Designating Clearing Agencies and
Transfer Agents as Qualified Custodians
The Commission considered
expanding the definition of a qualified
custodian to include clearing agencies
that perform the function, under the
Exchange Act,579 of acting as central
securities depositories (‘‘CSDs’’), as well
as transfer agents.580 Both CSDs and
transfer agents are functionally similar
to qualified custodians in several
respects and are already subject to
regulatory safeguards. These entities
safeguard a significant volume of assets
and are subject to Commission oversight
through regulatory standards,
registration requirements, supervision,
and examination.581 For example,
579 See Exchange Act section 3(a)(23)(A)(i), 15
U.S.C. 78c(a)(23)(A)(i); Rule 17Ad–22(a)(3), 17 CFR
240.17Ad–22(a)(3).
580 See part II.C.1, Requests for Comment.
581 See, e.g., Release No. 34–78963 (Sept. 28,
2016), 81 FR 70744, 70745–47 (Oct. 13, 2016)
(summarizing authorities applicable to clearing
agencies); Release No. 34–76743 (Dec. 22, 2015), 80
FR 81948, 81959–69 (Dec. 31, 2015) (summarizing
authorities applicable to transfer agents).
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among other requirements, CSDs must
establish, implement, maintain, and
enforce written policies and procedures
reasonably designed to ensure the
integrity of securities issues, and
minimize and manage the risks
associated with the safekeeping and
transfer of securities; implement
internal auditing and other controls to
safeguard the rights of securities issuers
and holders and prevent the
unauthorized creation or deletion of
securities, and conduct periodic and at
least daily reconciliation of securities
issues they maintain; and protect assets
against custody risk.582 Similarly,
transfer agents are responsible for
countersigning securities upon issuance,
monitoring to prevent unauthorized
issuance of securities, registering the
transfer of securities, and effecting the
exchange, conversion, and transfer of
securities.583 Expanding the definition
of a qualified custodian to include CSDs
and transfer agents could benefit
investors by increasing the number of
potential entities that provide custodial
services in compliance with the rule,
which could increase competition in the
market for such services and reduce
costs. In addition, different types of
entities may be more or less suited to
providing custodial services for certain
types of assets, such as privately offered
securities, so expanding the definition
of a qualified custodian may reduce the
costs associated with maintaining these
assets with a qualified custodian by
providing additional custodial options.
However, CSDs currently perform
many functions at an aggregate or
omnibus level for institutional
participants, so they might need to build
systems to account for and interact with
individual clients (to, for example,
directly furnish quarterly statements).
The potential costs CSDs would incur
were they to provide services as
qualified custodians under this
alternative might pose a significant
barrier to entry, which could limit the
degree to which expanding the
definition of a qualified custodian
would increase competition in the
market for custodial services. Moreover,
providing custodial services could
significantly alter the risk management
features of CSDs, which have been
tailored for other purposes and are
supported by an architecture that
involves a more limited number of
institutional participants.
While some transfer agents are
currently used by mutual funds in lieu
of a qualified custodian with respect to
582 See
Rule 17Ad–22(e)(11).
Act section 3(a)(25), 15 U.S.C.
78c(a)(25).
583 Exchange
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fund shares,584 they might also have to
develop systems and processes to enable
them to custody assets other than fund
shares. Transfer agents that are used by
mutual funds may also have some
systems and processes in place to
interact with clients, such as those used
to furnish quarterly statements, but
other transfer agents might incur
significant costs building such systems
and processes. Like CSDs, the costs
associated with providing custodial
services might pose a significant barrier
to entry for transfer agents, which could
limit the degree to which expanding the
definition of a qualified custodian
would increase competition in the
market for custodial services. In
addition, while transfer agents are
currently subject to regulatory
safeguards, they are not currently
subject to individual client protections
that are as extensive as the entities we
are including in the definition of a
qualified custodian under the proposed
rule. For example, they are not subject
to the specific safeguarding
requirements of Rule 206(4)–2(a), and
their capitalization and risk
management practices are oriented to
the markets where they operate, not
necessarily to the range and variety of
clients and assets contemplated by the
proposed rule.
G. Request for Comment
The Commission requests comment
on all aspects of this initial economic
analysis, including whether the analysis
has: (i) identified all benefits and costs,
including all effects on efficiency,
competition, and capital formation; (ii)
given due consideration to each benefit
and cost, including each effect on
efficiency, competition, and capital
formation; and (iii) identified and
considered reasonable alternatives to
the proposed rule. We request and
encourage any interested person to
submit comments regarding the
proposed rule, our analysis of the
potential effects of the proposed rule,
and other matters that may have an
effect on the proposed rule. We request
that commenters identify sources of data
and information as well as provide data
and information to assist us in analyzing
the economic consequences of the
proposed rule. We also are interested in
comments on the qualitative benefits
and costs we have identified and any
benefits and costs we may not have
discussed.
280. The proposed rule affects banks
and savings associations, broker-dealers
registered with the Commission, futures
commission merchants registered with
584 See
Rule 206(4)–2(b)(1).
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the CFTC, and FFIs. How do rules and
regulations of other financial regulators
and of self-regulatory organizations
affect these entities in their capacity as
qualified custodians? How do these
existing rules and regulations affect the
benefits of the proposed rule and its
costs?
281. The proposed rule would expand
the scope of assets currently subject to
the custody rule. To what extent do
investors benefit from advisers having
custody of assets newly scoped in under
the proposed rule? What is the nature of
those benefits? To what extent would
those benefits be lost given the
requirements of the proposed rule?
282. The proposed rule would
explicitly identify discretionary trading
authority as an arrangement that triggers
the rule. To what extent do investors
benefit from discretionary trading
services offered by investment advisers?
What is the nature of those benefits? To
what extent would investment advisers
no longer offer discretionary trading
services given the requirements of the
proposed rule?
283. The proposed rule would
generally require that the investment
adviser maintain client assets with a
qualified custodian pursuant to a
written agreement between the qualified
custodian and the investment adviser
(or between the adviser and client if the
adviser is also the qualified custodian).
To what extent are investment advisers
currently party to custodial agreements?
To what extent are the required
provisions similar to, or different from,
provisions in custodial agreements
between investors and qualified
custodians? Have we appropriately
estimated the costs of the reasonable
assurances and written agreement
requirements? Do commenters agree that
qualified custodians will have in
incentive to provide written agreements
that are consistent with the
requirements of the proposed rule? Have
we appropriately identified the costs of
the proposed required provisions?
284. To what extent do entities
maintaining client physical assets
currently enter into written agreements
obligating the entity to comply with
provisions the same as, or similar to, the
provisions required under the proposed
rule?
285. We state that existing regulatory
requirements for qualified custodians
with respect to asset segregation are
similar to the requirements of the
proposed rule and that, as a result, the
costs of the proposed asset segregation
requirements would be mitigated. Is this
an accurate characterization of existing
regulatory requirements? If not, how do
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existing regulatory requirements differ
from those of the proposed rule?
286. We state that for those qualified
custodians indemnifying the client
against the risk of loss in the event of
the qualified custodian’s gross
negligence, the insurance requirement
of the proposed indemnification
requirement would likely create a
substantial increase in the cost of
liability insurance. Is this an accurate
characterization? How costly is
insurance covering loss in the event of
a qualified custodian’s gross negligence?
How costly is insurance covering loss in
the event of a qualified custodian’s
simple negligence? For example, how
much does it cost to insure, per $1,000
of covered assets, losses in the event of
a qualified custodian’s gross negligence?
How much does it cost to insure, per
$1,000 of covered assets, losses in the
event of a qualified custodian’s simple
negligence? Do the per-dollar costs
change as the amount of covered assets
increases? If so, how? What other factor
might affect the cost of liability
insurance for qualified custodians?
What kinds of operational burdens
might be associated with purchasing
and maintaining liability insurance? To
what extent do custodians currently
have systems, processes, and liability
insurance that are consistent with a
simple negligence standard?
IV. Paperwork Reduction Act Analysis
A. Introduction
Certain provisions of our proposal
would result in new ‘‘collection of
information’’ requirements within the
meaning of the Paperwork Reduction
Act of 1995 (‘‘PRA’’).585 The proposed
new rule 223–1 and related
amendments to rules 206(4)–2 and 204–
2 under the Act and Form ADV would
have an impact on current collection of
information burdens. Specifically, we
are proposing new collection of
information requirements under
proposed rule 223–1 and corresponding
amendments to currently approved
collection of information burdens
under: (i) ‘‘Rule 206(4)–2 under the
Investment Advisers Act of 1940—
Custody of Funds or Securities of
Clients by Investment Advisers’’ (OMB
number 3235–0241); (ii) ‘‘Rule 204–2
under the Investment Advisers Act of
1940’’ (OMB control number 3235–
0278); and (iii) ‘‘Form ADV’’ (OMB
control number 3235–0049). The
Commission is submitting these
collections of information to the OMB
for review and approval in accordance
with 44 U.S.C. 3507(d) and 5 CFR
585 44
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1320.11. An agency may not conduct or
sponsor, and a person is not required to
respond to, a collection of information
unless it displays a currently valid OMB
control number.
We discuss below these proposed
amendments and new collection of
information burdens. Responses
provided to the Commission in the
context of its examination and oversight
program concerning the proposed
redesignation of rule 206(4)–2 as new
rule 223–1, and corresponding
amendments to rule 204–2 would be
kept confidential subject to the
provisions of applicable law. Responses
to the disclosure requirements of the
proposed amendments to Form ADV are
not kept confidential.
B. Rule 223–1
Proposed rule 223–1, which will
effectively replace current rule 206(4)–
2 by a redesignation, states that an
adviser registered or required to be
registered under section 203 of the Act,
shall take certain steps to safeguard the
client assets of which the adviser has
custody, and lays out five requirements
with which advisers must comply.586
Paragraph (a)(1) would require advisers
to maintain client’s assets at a qualified
custodian in a specified manner
pursuant to a written contract that
contains enumerated elements.
Paragraph (a)(1)(ii) would require an
adviser to obtain reasonable assurances
in writing from a qualified custodian
that such custodian will exercise due
care over client assets; will indemnify
the client against risk of loss; not excuse
any obligations to the client based upon
the existence of any sub-custodial,
securities depository, or other similar
arrangements with regard to the client’s
assets; clearly identify and segregate
client assets from the custodian’s
proprietary assets and liabilities; and
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. Paragraph
(a)(2) would require an investment
adviser that opens an account with a
qualified custodian on a client’s behalf
to notify the client of the account
details. Paragraph (a)(3) would require
an investment adviser to title or register
a client’s assets in the client’s name or
otherwise hold such assets for the
benefit of that client; prohibit the
commingling of client assets with the
adviser’s (or its related persons’) assets;
and require client assets generally to be
held free of any right, charge, security
interest, lien, or claim in favor of the
adviser and its related persons or
586 Proposed
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creditors. Paragraph (a)(4) would require
an adviser that maintains custody of
client assets to obtain independent
verification from an independent public
accountant at least once during a
calendar year pursuant to a written
agreement that provides for the filing of
Form ADV–E.
Paragraph (b) lays out limited
exceptions from certain requirements of
the proposed rule, some which would
change the current collections of
information burdens of rule 206(4)–2.
These include paragraphs (b)(2)
excepting the requirement to maintain
certain privately offered securities or
physical assets with a qualified
custodian in certain circumstances;
(b)(3) excepting advisers from the
independent verification of client assets
maintained by a qualified custodian if
an adviser has custody solely as a
consequence of the authority to deduct
advisory fees; (b)(4) exempting an
adviser from the account statement and
certain notification requirements, along
with the independent verification
requirement, when the advisory client
undergoes a financial statement audit
annually and upon liquidation in
accordance with the rule; (b)(7) creating
an exemption from the independent
verification requirement if an adviser
has custody of client assets solely
because of a standing letter of
authorization with the client; and (b)(8)
excepting advisers from the
independent verification of assets
requirement under certain
circumstances if custody exists solely
because the adviser has discretionary
authority with respect to those client
assets that are maintained in accounts
with a qualified custodian where the
discretionary authority is limited to
transacting in assets that settle
exclusively on a delivery versus
payment basis.
Each requirement to disclose or obtain
information, deliver communications, or
cause reporting by an independent
public accountant constitutes a
‘‘collection of information’’ requirement
under the PRA and is mandatory.
Advisory clients would use this
information to confirm proper handling
of their accounts. The Commission’s
staff uses the information obtained
through these collections in its
enforcement, regulatory, and
examination programs. The respondents
to these collections of information
requirements would be investment
advisers that are registered or required
to be registered with the Commission
that have custody of client assets. As of
September 2022, there were 15,160
investment advisers registered with the
Commission and 8,724 advisers
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reported to have custody of client assets
in Item 9 of Form ADV. Although not
all investment advisers would be subject
to this rule, we expect that most would
be for two reasons: first, the proposed
rule would be triggered by most services
advisers commonly provide to their
clients, such as trading on a
discretionary basis; and second, the
proposed rule’s application to ‘‘assets’’
would apply to a broad array of client
investments, not just to funds or
securities as under the current rule. We,
therefore, estimate that 13,944 which is
the number of all registered advisers
that currently report having
discretionary authority, would be
subject to the proposed rule.587 The
application of the provisions of the
proposed rule—and thus the extent to
which there are collections of
information and their related burdens—
would be contingent on a number of
factors, such as the types of services the
adviser provides, the number of clients
to whom it provides those services, and
the nature of the relevant assets.
Because of the wide diversity of services
and relationships offered by investment
advisers, we expect that the obligations
imposed by the proposed rule would,
accordingly, vary substantially among
advisers. However, we have made
certain estimates of this data solely for
the purpose of this PRA analysis.
1. Qualified Custodian Provision
a. Written Agreement
Under the proposed rule investment
advisers would be required to enter into
a written agreement with a qualified
custodian to maintain possession or
control of their clients’ assets and to
satisfy certain other requirements
enumerated in the rule, subject to
certain exceptions.588 We estimate that
nearly all of the 13,944 registered
advisers that we estimate would be
subject to the rule will be required to
comply with this requirement.589 We
believe that an investment adviser
587 This estimate is based on the 14,204 advisers
who answer yes to Form ADV Item 8(C)(1) and have
discretionary authority to determine the ‘‘securities
to be bought or sold for a client’s account.’’ For
purposes of this estimate, we have excluded 260
advisers answering yes to Form ADV Item 8(C)(1)
but reporting that they solely advise investment
company clients in response to Form ADV Item
5.D.(1)(d).
588 Proposed rule 223–1(a)(1) (the proposed rule
would require a written agreement between the
adviser and client if the adviser is also the qualified
custodian).
589 While some of these advisers may have
custody of certain client assets that the proposed
rule would except from the requirement to use a
qualified custodian, we assume that these advisers
likely also have at least some client assets that must
be maintained with a qualified custodian under the
proposed rule.
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would enter into a single agreement
with each qualified custodian that
provides custodial services for the
adviser’s clients, regardless of how
many of the adviser’s clients the
qualified custodian provides custodial
services for. Based on the information
currently reported by advisers about
qualified custodians on in Item 9.F of
Form ADV, we estimate that each
adviser would enter into approximately
4 written agreements.590 We therefore
estimate that, initially, advisers would
enter into a total of 55,776 written
agreements.591 We estimate that each
investment adviser and each qualified
custodian that enters into an agreement
would incur an internal burden of 1
hour each to prepare the written
agreement, for a total initial burden
hour estimate of 111,552 592 which we
expect would mostly be attributable to
the requirement to specify the
investment adviser’s agreed-upon level
of authority to effect transactions in the
custodial account as well as any
applicable terms or limitations. Based
on our estimates, there would be an
initial cost to each respondent of this
internal hour burden of $43,951,488 to
draft and finalize these written
agreements.593
Once these agreements are created
they will require little, if any,
modification, except in circumstances
where the adviser’s level of authority
changes (which we estimate would
occur approximately once per year). We
estimate that these changes would take,
on average, 10 minutes per written
agreement. Therefore, we estimate that
590 This estimate is based on responses to Form
ADV, Part 1A, Item 9.F, which requires advisers to
report the number of persons acting as qualified
custodian. For all advisers responding to this
question, the average number of persons acting as
qualified custodians amounted to 4. We believe that
it is possible that the proposed rule could result in
advisers entering into agreements with a greater
number of qualified custodians for custody services
related to assets that advisers may not currently
maintain with a custodian. At the same time, we
believe that it is possible that current custodians
will expand their services in order to provide
custody services for asset types that they do not
currently maintain for advisers. As a result, for the
purposes of this analysis, we will rely on the
average obtained from Form ADV Part 1A, Item 9.F.
data.
591 This estimate is based on the following
calculation: 13,944 advisers × 4 written agreements.
592 This estimate is based on the following
calculation: 55,776 written agreements × 2 hours.
593 This estimate is based on the following
calculation: 111,552 hours (for preparation and
review of draft agreement) × $394 (blended rate for
a compliance manager ($361) and a compliance
attorney ($426)). Unless otherwise indicated in this
section IV, all hourly wages used are from the
Securities Industry and Financial Markets
Association’s Report on Management & Professional
Earnings in the Securities Industry 2013 (‘‘SIFMA
Wage Report’’), updated for 2023, modified to
account for an 1800-hour work-year and inflation.
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the yearly total internal burden of
preparing the written agreement would
be 9,482 hours,594 and there would be
an annual cost of this internal hour
burden of $3,735,908.595
The written agreement proposed by
the rule would require a qualified
custodian to promptly, upon request,
provide records relating to an adviser’s
clients’ assets held in the account at the
qualified custodian to the Commission
or to an independent public accountant
engaged for purposes of complying with
the rule.596 As noted above, we believe
that advisers would enter into
approximately 4 written agreements on
average. We anticipate that 1,842 597 of
the advisers party to these written
agreements would be subject to the
surprise examination requirement. For
these advisers, we estimate that
qualified custodians would be required
to provide information to an
independent public accountant once
annually in connection with each
adviser for which they have a written
agreement under the rule. We estimate
that it would take qualified custodians
approximately 0.5 hours to provide the
required information. Therefore, we
estimate the internal annual hour
burden for qualified custodians to
provide this information to total 3,684
hours.598 Further, we anticipate that
7,018 advisers to these written
agreements would comply with the
proposed rule’s audit exception.599
Because we estimate that 5 percent of
pooled investment vehicles are
liquidated annually at a time other than
their fiscal year-end, for these advisers,
we estimate that qualified custodians
would be required to provide
information to an independent public
accountant 1.05 times annually.
Therefore, we estimate that the total
annual burden for respondents to
provide information to independent
594 This estimate is based on the following
calculation: 55,776 written agreements × .17 hours.
595 This estimate is based on the following
calculation: 9,482 hours × $394 (blended rate for a
compliance manager ($361) and a compliance
attorney ($426)).
596 See proposed rule 223–1(a)(1)(i)(A).
597 See infra footnote 619and accompanying text.
598 This estimate is based on the following
calculation: 1,842 (advisers that we estimate will
obtain a surprise examination) × 4 (average number
of written agreements per adviser) × .5 hours.
599 Advisers to pooled investment vehicles: 4,961.
20% of advisers with custody that have pension
and profit sharing plan clients (3,068 × .20): 614.
20% of advisers with custody that have charitable
organization clients(3,205 × .20): 641. 20% of
advisers with custody that have state or municipal
government entity clients (986 × .20): 197. 20% of
advisers with custody that have corporations and
other business entity clients (3,025 × .20): 605. Total
advisers expected to use the audit provision (4,961
+ 614 + 641 + 197 + 605): 7,018 advisers; See also
infra footnote 654.
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public accountants for the audit related
to these advisers would be 14,738
hours.600 In the aggregate, we estimate
the total annual burden for respondents
to provide information to independent
public accountants for the surprise
examination and audit to amount to
18,422 hours.601
We estimate that the Commission
would examine approximately 2,092 of
the advisers required to enter into a
written agreement under the rule, which
is consistent with the number of
advisers generally examined by
Commission staff over the last three
fiscal years.602 As noted above, because
we estimate that an adviser will on
average maintain client assets with
approximately four qualified
custodians, we estimate that
Commission will issue approximately
8,368 requests to qualified custodians
under the rule. We believe that these
information requests may be more
customized and would take custodians
approximately 1.5 hours to respond to,
slightly longer than it would take a
custodian to provide more standardized
information requested by an
independent public accountant.
Accordingly, the internal burden hours
for respondents to this collection of
information would equal approximately
12,552 hours.603 In total, for the
requirement to provide information to
accountants and the Commission, we
estimate the collection of information
burden on respondents amounts to
30,974 hours annually.604 Accordingly,
we estimate that the annual internal
monetized cost burden amounts to
approximately $12,203,756.605
The proposed rule would require that
the written agreement with the qualified
600 This estimate is based on the following
calculation: 7,018 (number of advisers using the
audit exception) × 4 (average number of qualified
custodians per adviser) × 1.05 (average number of
audits annually) × .5 hours = burden for
respondents to provide information to independent
public accountants for the audit related to these
advisers.
601 3,684 + 14,738 hours.
602 This estimate is based on the following
calculation: 13,944 advisers subject to the rule and
required to enter into a written agreement with a
qualified custodian × 15% (the approximate
number of registered advisers the Commission
examined in each of fiscal years 2019, 2020, and
2021). See U.S. Securities and Exchange
Commission, Division of Examinations, 2022
Examination Priorities at 4 (Mar. 2022), available at
https://www.sec.gov/files/2022-exam-priorities.pdf.
603 This estimate is based on the following
calculation: 8,368 written agreements × 1.5 hours.
604 This estimate is based on the following
calculation: 18,422 (hour burden to provide
information to accountants) + 12,552 (hour burden
to provide information to Commission).
605 This estimate is based on the following
calculation: 30,974 (internal annual burden hours)
× $394 (blended rate for a compliance manager
($361) and a compliance attorney ($426)).
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custodian provide that the qualified
custodian will send account statements
(unless the client is an entity whose
investors will receive audited financial
statements as part of the financial
statement audit process pursuant to the
audit provision of the proposed rule), at
least quarterly, to the client and the
investment adviser, identifying the
amount of each client asset in the
custodial account at the end of the
period as well as all transactions in the
account during that period.606 We
estimate that the average burden for
custodians to provide quarterly
financial statements to advisers is
limited. Because qualified custodians
are already sending quarterly account
statements to clients,607 we estimate
that one additional burden incurred
would be in connection with qualified
custodians adding advisers to their
distribution lists. We estimate this
would aggregate approximately 14,385
hours in initial burden hours.608 We
estimate that this initial internal burden
equates to an initial internal monetized
cost burden of approximately
$4,869,322.50.609
We also believe that this proposed
rule would result in a small additional
burden in terms of modifications to
quarterly statements related to
including, at the client’s request,
information related to assets not
maintained by the qualified
custodian,610 customizing the
statements for any client that requests
such assets to be included, and adding
language that identifies those assets.611
We estimate this would aggregate
approximately 959 hours annually.612
606 Proposed rule 223–1(a)(1)(i)(B). The proposed
requirement is similar to the approach in the
current rule with regard to the investment adviser
forming a reasonable belief after due inquiry that
the qualified custodian sends account statements, at
least quarterly, to the client. See custody rule
206(4)–2(a)(3).
607 See custody rule 206(4)–2(a)(3).
608 15 hours (development of distribution list) ×
959 (estimated number of qualified custodians). We
believe that any ongoing annual burden in
connection with this requirement would be de
minimis.
609 This estimate is based on the following
calculation: 14,385 hours (estimated internal hour
burden of preparing and distributing quarterly
account statements) × $338.50 (blended rate for a
programmer $316 and a compliance manager
$361)).
610 See proposed rule 223–1(a)(1)(i)(B) (‘‘Such
account statements shall not identify assets for
which the qualified custodian lacks possession or
control, unless requested by the client and the
qualified custodian clearly identifies any such
assets that appear on the account statement’’).
611 See id. Since custodians are aware of the
assets for which they are providing accommodation
reporting, we believe that the custodian’s removal
of current accommodation reporting will be de
minimis.
612 1 hour (modifications to account statements)
× 959 (estimated number of qualified custodians).
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We estimate that this annual internal
burden equates to an annual internal
monetized cost burden of approximately
$324,621.50.613
As discussed above, the proposed rule
would require the written agreement to
contain a provision requiring the
qualified custodian, at least annually, to
obtain and provide to the adviser a
written internal control report that
includes an opinion of an independent
public accountant.614 We estimate that
approximately 959 qualified
custodians 615 would have to obtain an
internal control report relating to
custodial services, and would have to
provide the report to the adviser. We
understand that the cost to prepare an
internal control report relating to
custody would vary based on the size
and services offered by the qualified
custodian, but that on average an
internal control report would cost
approximately $750,000 per year.616 We
believe that 95% of custodians currently
obtain internal control reports, and,
therefore, estimate total aggregate
monetized costs attributable to this
section of the proposed rule to be
$35,962,500 annually.617
b. Reasonable Assurances
The proposed rule would require an
adviser to obtain reasonable assurances
in writing from a qualified custodian
regarding certain client protections.618
As discussed above, one way that
advisers are likely to satisfy this
requirement is by seeking confirmation
from a qualified custodian that the
custodial agreement with the advisory
client contains contractual language
reflecting the reasonable assurances
613 This estimate is based on the following
calculation: 959 hours (estimated internal hour
burden of preparing and distributing quarterly
account statements) × $338.50 (blended rate for a
programmer $316 and a compliance manager
$361)).
614 Proposed rule 223–1(a)(1)(i)(C).
615 This estimate was obtained by the following
calculation: 8,724 (advisers reporting that they have
custody)/600 (total number of custodians reported
in Form ADV Part 1A, Question 9.F. = 14.54
(mathematical average number of advisers served by
each custodian obtained solely for the purpose of
performing the calculation); 13,944 (advisers that
we estimate would have to comply with the
proposed rule)/14.54 (average number of advisers
served by each custodian) = 959.
616 We recognize, however, that as a result of the
proposed rule’s expansion to cover all assets, rather
than funds and securities, the internal control
reports currently obtained by qualified custodians
may not fully reflect the type of report that would
be obtained under the proposed rule.
617 This estimate is based on the following
calculation: 959 (estimated number of qualified
custodians operating under written agreements) ×
$750,000 (average cost of obtaining internal control
report) × 5% (percent of custodians that we estimate
are not currently obtaining internal control reports).
618 Proposed rule 223–1(a)(1)(ii).
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required by the rule. We estimate the
amount of time it would take an adviser
to request, and a qualified custodian to
provide, information necessary to satisfy
this requirement to be approximately 15
minutes, and we expect that any related
changes a qualified custodian makes to
a custodial agreement to reflect the
reasonable assurances provided to the
adviser would take approximately 1
hour. We believe this exchange is most
likely to occur in the context of the
negotiation and execution of the written
agreement. Therefore, we estimate that
the initial aggregate time burden for this
collection of information would amount
to 69,720 hours.619 We believe that the
initial monetized costs imposed by the
proposed rule approximate
$27,469,680.620 We believe that most
custodial agreements change very little
from year to year, and therefore, we
estimate the total annual internal hour
burden to be 13,944.621 We believe that
the monetized costs imposed by the
proposed rule would approximate
$5,493,936 annually.622
2. Notice to Clients
The proposed rule, like the current
rule, would require an investment
adviser to notify its client in writing
promptly upon opening an account with
a qualified custodian on its behalf.623
The notice is designed to alert a client
to the existence of the qualified
custodian that maintains possession or
control of client assets and whom to
contact regarding such assets. One
change from the current rule is that the
proposed rule would explicitly require
that the notice include the custodial
account number, an important detail
that is not required under the current
rule. However, we do not believe
including a custodial account number to
the notice would significantly impact
the costs incurred by advisers as they
are already required to provide a nearly
identical notice under the current rule.
Therefore, we estimate that the initial
burden of updating their processes and
systems to ensure account numbers are
included in the relevant notices is 1
hour with a total estimated monetized
cost of $4,720,044.624
hours × 55,776 written agreements.
hours (estimated initial internal hour
burden) × $394 (blended rate for a compliance
manager ($361) and a compliance attorney ($426)).
621 55,776 written agreements × .25 hours.
622 13,944 (estimated annual internal hour
burden) × $394 (blended rate for a compliance
manager ($361) and a compliance attorney ($426)).
623 See proposed rule 223–1(a)(2).
624 The initial burden hours are calculated as
follows (14,204 advisers with discretionary
authority—260 advisers to investment company
clients in response to Form ADV Item 5.D.(1)(d) =
13,944 advisers) × 1 hour × blended rate for a
619 1.25
620 69,720
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3. Annual Surprise Examination
The proposed safeguarding rule does
not change the current rule’s annual
surprise exam requirement, but changes
to other portions of the rule that expand
the application of the rule to certain
advisers or that provide exceptions to
the surprise exam requirement would
impact the number of advisers subject to
this requirement if adopted. The current
rule requires each registered investment
adviser that has custody of client funds
or securities to undergo an annual
surprise examination by an independent
public accountant to verify client assets
pursuant to a written agreement with
the accountant that specifies certain
duties. We estimate that 1,842 advisers
would be subject to the surprise
examination requirement upon its
redesignation under the proposal.625
For purposes of estimating the
collection of information burden, we
have divided the estimated 1,842
advisers into three subgroups. First, we
estimate that 381 advisers have custody
because they serve as qualified
custodians for their clients, or they have
a related person that serves as qualified
custodian for clients, in connection with
advisory services the adviser provides to
the clients.626 We estimate that these
advisers are subject to an annual
surprise examination with respect to
100 percent of their clients (or 9,006
clients per adviser) based on the
assumption that all of their clients
maintain custodial accounts with the
adviser or its related person.627 We
estimate that each adviser will spend an
average of 0.02 hours for each client to
create a client contact list for the
compliance manager ($361) and a programmer
($316) = $338.50) = $4,720,044.
625 Based on data from the Investment Adviser
Registration Depository (‘‘IARD’’) of the advisers
that report having discretion, of the 1,842 advisers
indicated in response to Item 9.C.(3) that an
independent public accountant conducts an annual
surprise examination of client funds and securities.
The calculations in this section regarding the
annual surprise exam represent information as of
June 2022 and incorporate Form ADV filings
received through the (IARD) through August 31,
2022.
626 Based on IARD data, 381 advisers indicated
that an independent public accountant prepares an
internal control report because the adviser or its
affiliate acts as a qualified custodian (in response
to Item 9.C.(4)). Similarly, 76 advisers indicated
that they act as a qualified custodian (in response
to Item 9.D.(1), and 321 advisers indicated that their
related person(s) act as qualified custodian(s) (in
response to Item 9.D.(2)). 76 + 321 = 397.
627 We base our estimate on IARD data of the
average number of clients of all the advisers that
will be subject to the surprise examination
requirement under the rule. To derive our estimate,
we utilized the winsorization method, by setting all
values for advisers (above the 99th percentile of
number of clients) at the number of clients at the
99th percentile. The method lessens the effect of
outliers on client estimates.
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independent public accountant. The
estimated total annual aggregate burden
with respect to the surprise examination
requirement for this group of advisers is
68,626 hours.628
The second group of advisers,
estimated at 835, are those that have
custody because they have broad
authority to access client assets held at
an independent qualified custodian,
such as through a power of attorney or
acting as a trustee for a client’s trust.629
Based on our staff’s experience, advisers
that have access to client assets through
a power of attorney, acting as trustee, or
similar legal authority typically do not
have access to all of their client
accounts, but rather only to a small
percentage of their client accounts
pursuant to these special arrangements.
We estimate that these advisers will be
subject to an annual surprise
examination with respect to 5 percent of
their clients (or 450 clients per adviser)
who have these types of arrangements
with the adviser.630 We estimate that
each adviser will spend an average of
0.02 hours for each client to create a
client contact list for the independent
public accountant. The estimated total
annual aggregate burden with respect to
the surprise examination requirement
for this group of advisers is 7,515
hours.631
A third group of advisers provides
advice to pooled investment vehicles
that are not undergoing an annual audit
and therefore would undergo the
surprise examination with respect to
those pooled investment vehicle clients.
Based on current IARD data, we
estimate that 626 advisers manage
private funds and undergo surprise
examinations.632 We estimate that each
adviser managing private funds has an
average of 6 pooled investment vehicle
clients with an average of 14 investors.
We estimate that advisers to these
pooled investment vehicles will spend 1
hour for the pool and 0.02 hours for
628 381 advisers × 9,006 (average number of
clients subject to the surprise examination
requirement) × 0.02 hour = 68,626 hours.
629 This estimate is based on the total number of
advisers subject to surprise examinations less those
described above in the first group (custody as a
result of serving as, or having a related person
serving as, qualified custodian) less those described
below in the third group (custody as a result of
solely managing private funds). (1,842¥381)¥626
= 835 advisers.
630 Based on the IARD data, we estimate that the
average number of clients of advisers subject to the
surprise examination requirement is 9,006. 9,006 ×
0.05 = 450 clients per adviser.
631 835 advisers × 450 clients × 0.02 hours = 7,
515 hours.
632 Based on IARD data, we estimate that 626
advisers manage private funds and undergo a
surprise examination (responses to Items 7.B. and
9.C.(3)).
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each investor in the pool to create a
contact list for the independent public
accountant, for an estimated total
annual burden with respect to the
surprise examination requirement for
these advisers of 4,808 hours.633
These estimates bring the total annual
aggregate burden with respect to the
surprise examination requirement for all
three groups of advisers to 80,949
hours.634 This estimate does not include
the collection of information discussed
below relating to the written agreement
required by paragraph (a)(4) of the rule.
Related to the surprise exam, the
current custody rule and the
redesignated safeguarding rule require
that an adviser subject to the surprise
examination requirement must enter
into a written agreement with the
independent public accountant engaged
to conduct the surprise examination and
specify certain duties to be performed
by the independent public
accountant.635 We estimate that each
adviser will spend 0.25 hour to add the
required provisions to the written
agreement, with an aggregate of
approximately 461 hours for all advisers
that undergo surprise examinations.636
Therefore the total annual burden in
connection with the surprise
examination is estimated at 81,410
hours under the rule.637 We estimate the
monetized burden related to the
surprise exam is $27,623,345.638
C. Exceptions
The proposal contains several
exceptions that will result in a new
‘‘collection of information’’ requirement
within the meaning of the PRA and
would have an impact on the current
collection of information burdens of
rule 206(4)–2. These exceptions are
discussed below.
1. Certain Assets That Are Unable To Be
Maintained With a Qualified Custodian
We are proposing an exception to the
requirement to maintain client assets
with a qualified custodian where an
adviser has custody of privately offered
securities or physical assets if the
633 ((626 advisers × 6 pools) × 1 hour = 3,756
hours) + ((626 × 6 pools × 14 investors) × .02 hours
= 1,052 hours) = 4,808 hours.
634 68,626 hours + 7,515 hours + 4,808 hours =
80,949 hours.
635 Compare 17 CFR 275.206(4)–2(a)(4) with
proposed rule 223–1(a)(4).
636 1,842 advisers would be required to obtain a
surprise examination × 0.25 = 461.
637 80,949 exam hours + 461 written agreement
hours = 81,410 hours.
638 80,949 exam hours × $338.50 (blended rate for
a compliance manager ($361) and a programmer
($316) = $339) + 461 written agreement hours ×
$394 (blended rate for a compliance manager ($361)
and a compliance attorney ($426) = $393.50) to
amend the written agreement = $27,623,345.
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ownership of such assets cannot be
recorded and maintained (book-entry,
digital, or otherwise) in a manner in
which a qualified custodian can
maintain possession or control of such
assets. This exception will allow
advisers who service client accounts
containing such assets to either
safeguard the assets themselves or
engage another entity to safeguard the
assets subject to certain safeguarding
requirements discussed below. For the
purpose of approximating the average
burden for advisers to comply with the
collections of information that would be
created by this exception, we estimate
that 4,961 advisers currently have
custody of privately offered securities
and physical assets that cannot be
maintained with a qualified
custodian.639
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(a) Written Agreement With
Independent Public Accountant
An adviser relaying on the proposed
exception would be required to enter
into a written agreement with an
independent public accountant that
specifies certain obligations of the
accountant.640 We assume that many
advisers will amend agreements that
they have with accountants to perform
other accounting services for the
adviser, such as a surprise examination,
while some number of advisers will
enter into new agreements with
accountants to perform the services
required by the proposed rule. On
average, we estimate that each adviser
will spend 1.25 hours, initially, to
prepare the written agreement with an
accountant. In the aggregate, we
estimate that advisers will spend 6,201
hours, initially, to enter into these
agreements.641 We estimate the
aggregate initial monetized cost burden
to equal $2,443,194.642
We believe that these agreements will
change minimally from year to year and,
therefore, estimate that advisers will
spend approximately 2,481 aggregate
639 Based on IARD data, 4,961 advisers with
custody of client assets provided advice to pooled
investment vehicles as of June 30, 2022. We believe
that this number is overinclusive of some number
of advisers solely to funds that do not hold
privately offered securities or physical assets. But
we also believe that there may be a small number
of advisers who are not advisers to pooled
investment vehicles who have client assets that
would be subject to the exception. We believe that
the estimate is reasonable based on the data
available.
640 See proposed rule 223–1(b)(2)(iii).
641 4,961 (estimated number of advisers with
custody of privately offered securities and physical
assets that cannot be maintained with a qualified
custodian under the proposed rule) × 1.25 hours.
642 6,201 (estimated internal hour burden) × $394
(blended rate for a compliance manager ($361) and
a compliance attorney ($426)).
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hours annually amending these
agreements or entering into new
agreements.643 The related total
monetized cost burden for these
amendments would equal $977,514.644
(b) Notice to Accountant
The proposed rule would require the
adviser to notify the accountant of any
purchase, sale, or other transfer of
beneficial ownership of such assets
within one business day.645 As
discussed in section II.C.4, above, we
believe that this notice would likely be
provided by the adviser in connection
with the closing of a transaction, and
could be provided to the accountant
without much additional effort beyond
that required in connection with the
closing of the transaction. We estimate
that this notice would take advisers
approximately one minute to deliver to
the accountant. We also estimate that
advisers will send 8,000 of these notices
annually.646 Accordingly, we estimate
that these notices will take advisers
643 This estimate is based on the following
calculation: 4,961 (estimated number of advisers
with custody of privately offered securities and
physical assets that cannot be maintained with a
qualified custodian under the proposed rule) × .5
hours (estimate of average amount of time to amend
agreement).
644 2,481 (estimated internal hour burden) × $394
(blended rate for a compliance manager ($361) and
a compliance attorney ($426)).
645 See proposed rule 223–1(b)(2)(iv).
646 This estimate is based on a review of a number
of sources of private equity transaction data in and
prior to 2021. See generally, S&P Global Market
Intelligence, 2022 Global Private Equity Outlook
(Apr. 20, 2022), available at https://
www.spglobal.com/marketintelligence/en/newsinsights/research/2022-global-private-equityoutlook (‘‘2021 was a record year for the PE
industry as investment activity surpassed the
trillion-dollar mark for the first time. In total,
24,520 deals globally were closed, with an aggregate
deal value worth $1.04 trillion, nearly double the
amount from the year before. At the same time, deal
volume grew by 41.6% over 2020, proving that
investors’ predictions of improved deal-making in
2021 came to fruition.’’); Pitchbook, Data, Inc., 2021
Annual US PE Breakdown, (Jan. 11, 2022), available
at https://pitchbook.com/news/reports/2021annual-us-pe-breakdown (‘‘At over 8,600, [U.S.]
deal count topped 2019’s record by 50%.’’); Statista,
Global private equity (PE) activity from 2002 to
2021 (Mar. 30, 2022) available at https://
www.statista.com/statistics/1292230/private-equitydeal-activity-worldwide/ (‘‘2021 was a recordbreaking year for private equity (PE) activity
worldwide. Investment activity grew nearly twofold
compared to 2020, and reached a value of nearly
1.2 trillion U.S. dollars from 2,616 private equity
deals.’’); Bain & Co., The Private Equity Market in
2021: The Allure of Growth (Mar. 7, 2022),
available at https://www.bain.com/insights/privateequity-market-in-2021-global-private-equity-report2022/ (‘‘While the number of individual [buyout]
deals jumped to nearly 4,300 in 2021, up 16% from
2020 levels, that doesn’t explain the extraordinary
growth in capital deployed.’’). The estimate takes
into account the increasing trend in transaction
volume over the past few years, but also takes into
account that registered advisers are responsible for
only a portion of these total global and total U.S.
transactions.
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approximately 133 hours 647 in the
aggregate to send annually with an
annual monetized cost of $48,013.648
(c) Accountant Verification
The written agreement would require
the independent public accountant to
verify the purchase, sale, or other
transfer promptly upon receiving the
required transfer notice. As discussed in
section II.C.4, above, we believe the
verification process would vary
considerably depending on the asset
involved. Based on our estimate of 8,000
transactions under the proposed
exception annually, we believe that
these verifications will result in an
aggregate monetized cost burden to
advisers of $21,000,000 annually.649
(d) All Assets Verified During Surprise
Examination or Annual Audit
The proposed rule would require that
the existence and ownership of each
privately offered security or physical
asset of a client that is not maintained
with a qualified custodian to be verified
during an adviser’s annual surprise
examination or financial statement audit
under the audit provision.650 We
estimate that 95 percent of advisers
relying on this exception, or 4,713
advisers,651 will obtain a financial
statement audit and 5 percent of
advisers, or 248 advisers, will obtain
surprise examinations.652 For advisers
obtaining an audit under the audit
provision, we estimate the aggregate
annual cost of asset verification to be
$282,780,000.653 We estimate the
647 8,000 (estimated annual transactions)/60
minutes (based on estimate of one minute per
notice).
648 133 (estimated number of hours) × $361
compliance manager.
649 8,000 (estimated number of annual
transactions) × 15 hours (estimated average time to
verify a transaction) × $175 (blended rate for
intermediate accountant ($200), a general
accounting supervisor ($252), and general clerk
($73)). The proposed rule requires that an
accountant report to the Commission any material
discrepancies and our estimate for those notices is
included in the estimated average time to verify a
transaction.
650 See proposed rule 223–1(b)(2)(v).
651 4,961 (advisers relying on exception)/95%
(estimated number of advisers relying on the
exception obtaining audits) = 4,713.
652 4,961 (advisers relying on exception)/5%
(estimated number of advisers relying on the
exception obtaining surprise exams) = 248.
653 4,713 (estimated number of advisers subject to
the exception relying on the audit provision) ×
$60,000 (additive estimated cost of audit). The
additive costs to the audit (and surprise
examination) of full asset verification are mitigated
by proposed rule 223–1(b)(2)(iii), which requires an
accountant to verify any purchase, sale, or other
transfer of beneficial ownership of assets subject to
the exception promptly after receipt of notice from
the adviser. The extent of this mitigation is hard to
estimate with certainty. We estimate that all asset
verification will approximately double the cost of
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The proposed rule would expand the
availability of the audit provision from
limited partnerships, limited liability
companies, and other types of pooled
investment vehicle clients to any
advisory client entity whose financial
statements are able to be audited.
Advisers that seek to comply with the
audit provision would be required to
deliver, promptly after the completion
of the audit, the financial statements of
the entity to all investors.
The collection of information burden
imposed on an adviser relating to the
distribution of audited financial
statements to each investor in a client
entity that the adviser manages should
be minimal, as the financial statements
could be included with account
statements or other mailings or
delivered electronically. Based on our
experience with the audit provision in
the current custody rule, we have
estimated previously that the average
burden for advisers to deliver audited
financial statements to investors in the
client entity is 1 minute per investor.656
Based on our estimate of the number of
advisers to audited pooled investment
vehicles,657 with an adjustment for our
expectation that an increasing number
of advisers will obtain audits of client
entities,658 we estimate that the
aggregate annual hour burden in
connection with the distribution of
audited financial statements is 7,098
hours,659 and there would be an annual
cost of this internal hour burden of
$1,242,150.660
The proposed rule would require an
adviser or the client entity to enter into
a written agreement with the
independent public accountant to
ensure that the independent public
accountant that audits the client entity
notifies the Commission (i) within one
business day of issuing an audit report
to the entity that contains a modified
opinion and (ii) within four business
days of resignation or dismissal from, or
other termination of, the engagement, or
upon removing itself or being removed
from consideration for being
reappointed.661 We assume that,
regardless of whether the adviser or the
client entity enters into the written
agreement, the accountant would incur
the hour burden of preparing the
agreement. We also assume that, if the
client entity was party to the agreement,
the client entity would delegate the task
of reviewing the agreement to the
adviser. This estimate also assumes that
the adviser would enter into a separate
agreement for each client entity, even if
multiple client entities use the same
auditor. We believe that written
agreements are commonplace and
reflect industry practice when a person
retains the services of a professional
such as an accountant, and they are
typically prepared by the independent
public accountant in advance. We
therefore estimate that each adviser will
initially spend 1.25 hours to add the
required provisions to, or confirm that
the required provisions are in, the
written agreement, with an initial
aggregate of 48,735 hours 662 for all
advisers that satisfy the requirements of
the audit engagement. We further
estimate that each adviser will spend
0.92 hours 663 on an annual basis to
reassess current written agreements and
execute new agreements as an adviser
adds entity clients for an annual
aggregate of 35,869 hours 664 and an
annual cost of this internal hour burden
of $19,476,867 665 for all advisers that
satisfy the requirements of the audit
provision.
an audit, estimated at $60,000 per audit. See infra
section IV.C.2.
654 248 (estimated number of advisers subject to
the exception) × $162,000. We previously estimated
that advisers subject to the surprise examination
with respect to 100 percent of their clients will each
spend an average of approximately $162,000
annually. As with the cost of an audit, we estimate
that full asset verification will approximately
double the cost of the surprise examination.
655 $282,780,000 + $40,176,000.
656 2009 Adopting Release, supra note 11.
657 Based on IARD data as of June 30, 2022, 4,961
advisers with custody of client assets provided
advice to pooled investment vehicles. We estimate
that each adviser has an average of 6 pooled
investment vehicle clients with an average of 14
investors.
658 Because the proposed rule expands the types
of entities that can obtain an audit (i.e., is not
limited to pooled investment vehicles as in the
current rule), we expect that an increasing number
of advisers will seek to comply with the proposed
rule by obtaining an audit. To estimate the number
of entities that may utilize the expanded availability
of the audit provision, we selected the following
categories of clients with custody based on IARD
data as of June 30, 2022: Investment advisers with
custody that have pension and profit sharing plan
clients: 3,068 (Average number of pension and
profit sharing clients: (6); Investment advisers with
custody that have charitable organization clients:
3,205 (Average number of charitable organization
clients: (3); Investment advisers with custody that
have state or municipal government entity clients:
986 (Average number of state or municipal
government entity clients: (3); Investment advisers
with custody that have corporations and other
business entity clients: 3,025 (Average number of
corporations and other business entity clients: (5).
We estimate that 20% of advisers to these categories
of clients will utilize the expanded availability of
the audit provision.
659 (4,961 advisers to pooled investment vehicles
× 6 pooled investment vehicle clients × 14 investors
× 1 minute)/60 minutes = 6,945 hours; (3,068
advisers to pension and profit sharing clients × 20%
× 6 clients × 1 minute)/60 minutes = 61 hours;
(3,205 advisers to charitable organization clients ×
20% × 3 clients × 1 minute)/60 minutes = 32 hours;
(986 advisers to state or municipal government
entity clients × 20% × 3 clients × 1 minute)/60
minutes = 10 hours; (3,025 advisers to corporations
and other business entity clients × 20% × 5 clients
× 1 minute)/60 minutes = 50 hours; 6,945 hours +
61 hours +32 hours +10 hours +50 hours = 7,098
hours.
660 This estimate is based on the following
calculation: 7,098 hours × $175 (blended rate for an
intermediate accountant ($200), a general
accounting supervisor ($252), and a general clerk
($73).
661 Proposed rule 223–1(b)(4)(v).
662 4,961 advisers to pooled investment vehicles
× 6 pooled investment vehicle clients = 29,766
client written agreements; 3,068 advisers to pension
and profit sharing clients × 20% × 6 clients = 3,682
client written agreements; 3,205 advisers to
charitable organization clients × 20% × 3 clients =
1,923 client written agreements; 986 advisers to
state or municipal government entity clients × 20%
× 3 clients = 592 client written agreements; 3,025
advisers to corporations and other business entity
clients × 20% × 5 clients = 3,025 client written
agreements; (29,766 + 3,682 + 1,923 + 592 + 3,025)
× 1.25 hours per agreement = 48,735 hours.
663 This includes the internal initial burden
estimate amortized over a three-year period (1.25
hours/3 years) and another 0.5 hours of additional
ongoing burden hours = 0.92 hours.
664 (29,766 + 3,682 + 1,923 + 592 + 3,025) × 0.92
hours per ongoing annual burden = 35,869 hours.
665 This estimate is based on the following
calculation: 35,869 hours × $543 (rate for assistant
general counsel).
666 This estimate is based upon the following
calculations: 111,552 + 9,482 + 12,552 + 18,422 +
14,385 + 959 + 69,720 + 13,944 + 6,201 + 2,481 +
133 + 13,944 + 80,949 + 461 + 7,098 + 35,869 hours
= 398,152 hours.
667 This estimate is based upon the following
calculations: $43,951,488 + $3,735,908 +
$12,203,756 + $4,869,322.50 + $324,621.50 +
$27,469,680 + $5,493,936 + $4,720,044 +
$27,623,345 + $2,443,194 + $977,514 + $48,013 +
$1,242,150 + $19,476,867 = $154,579,839.
668 This estimate is based upon the following
calculations: $35,962,500 + $19,680,000 +
$322,956,000 = $378,598,500.
aggregate annual cost of asset
verification for all assets during a
surprise examination to be
$40,176,000.654 In sum, the total annual
monetized collection of information
burden related to the exception for
privately offered securities and physical
assets is $322,956,000.655
2. Audit Provision
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D. Total Hour Burden Associated With
Proposed Rule 223–1
Accordingly, we estimate investment
advisers that would be subject to the
proposed rule would incur a total
annual hour burden resulting from the
collections of information discussed
above of approximately 398,152
hours,666 at a time cost of
$154,579,839.667 The total external
burden costs would be $378,598,500.668
A chart summarizing the various
proposed components of the total
annual burden for investment advisers
with custody of client assets is below.
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Federal Register / Vol. 88, No. 46 / Thursday, March 9, 2023 / Proposed Rules
Number of
responses
Rule 223–1 description of new requirements
Internal burden hours
External burden
costs
Final Estimates for Qualified Custodian Protections Under 223–1(a)(1)
Initial burden for drafting, negotiating, and executing new written
custodial agreements with required provisions between the adviser and qualified custodian (‘‘QC’’) (IA–QC custodial contract).
Annual burden for drafting, negotiating, and executing new written
custodial agreements with required provisions between the adviser and qualified custodian (IA–QC custodial contract).
Annual burden for QC to provide records relating to clients’ assets to the Commission *.
* This is not broken up into initial and ongoing burden because
the annual burden is estimated to be the same each year.
Annual burden for QC to provide records relating to clients’ assets to an independent public accountant *.
* This is not broken up into initial and ongoing burden because
the annual burden is estimated to be the same each year.
Initial burden for QC to send account statements, at least quarterly, to the client, or its independent representative, and to adviser.
Annual burden for QC to modify and send account statements ....
Annual burden for QC to obtain internal control report ..................
Initial burden for adviser obtaining reasonable assurances from
the QC.
Annual burden for adviser obtaining reasonable assurances from
the QC.
55,776 (4 per ad111,552 (2 per response).
viser with custody).
55,776 (4 per ad9,482 (.17 hour per response).
viser with custody).
8,368 (4 per adviser
examined).
12,552 (1.5 hour per response).
36,844 (4 per adviser obtaining a
surprise examination or audit).
18,422 (.5 hour per response).
959 (estimated
qualified
custodians).
959 (estimated
qualified
custodians).
.................................
55,776 (1 per adviser).
55,776 (1 per adviser).
14,385 hours (15 hours per
qualified custodian).
959 (1 hour per qualified custodian).
....................................................
69,720 (1.25 hours per response).
13,944 (.25 hours per response).
$35,962,500
Final Estimates for Exceptions for Certain Assets that are Unable to be Maintained with a Qualified Custodian Under 223–1(b)(2)
Initial burden for written agreement with independent public accountant (IPA).
Annual burden for written agreement with IPA ...............................
Annual burden to notify the IPA of any purchase, sale, or other
transfer of beneficial ownership of such assets within one business day.
Annual burden to verify the purchase, sale, or other transfer
promptly upon receiving the required transfer notice *.
* This does not contain an internal burden estimate because the
burden under this requirement is solely an external monetary
burden.
Annual burden to verify all assets during a surprise exam or an
annual audit *.
* This does not contain an internal burden estimate because the
burden under this requirement is solely an external monetary
burden.
4,961 (estimated
number of advisers with custody
of privately offered
securities and
physical assets
that cannot be
maintained with a
qualified custodian
under the proposed rule).
4,961 .......................
8,000 (estimated
number of annual
transactions).
.................................
6,201 (1.25 hours per adviser).
....................................................
$19,680,000
.................................
....................................................
$322,956,000
2,481 (.5 hour per adviser).
133 hours (1 minute per transaction).
Final Estimates for Complying with the Notice Requirement Under 223–1(a)(2)
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Initial burden for complying with the notice requirement* ...............
13,944 advisers (1
per adviser).
13,944 hours (1 hour per adviser ).
* This would be a one-time burden to include account numbers in
the notices.
Final Estimates for Independent Verification or Surprise Examination Under 223–1(a)(4)
Annual burden for complying with the independent verification/
surprise examination of client assets by an IPA under a written
agreement between the IPA and the adviser *.
* This is not broken up into initial and ongoing burden because
the annual burden is estimated to be the same each year.
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1,842 advisers are
subject to the surprise exam.
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80,949 hours 1.
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Rule 223–1 description of new requirements
Number of
responses
Annual burden to enter into a written agreement with an IPA engaged to conduct the surprise examination and specify certain
duties to be performed by the independent public accountant *.
* This is not broken up into initial and ongoing burden because
the annual burden is estimated to be the same each year.
1,842 advisers .........
Internal burden hours
14769
External burden
costs
461 hours (.25 per adviser).
Exception for Entities Subject to the Annual Audit 223–1(b)(4)
Annual burden for distributing audited financial statements ...........
Annual burden for drafting, negotiating, and executing the required written agreement between the IPA and adviser regarding notifications from the IPA to the Commission of specified
events.
7,018 advisers .........
7,018 advisers .........
7,098 hours.
35,869 hours.
TOTAL ESTIMATED FINAL BURDEN FOR RULE 223–1
Total estimated burden for rule 223–1 ............................................
Currently approved burden for rule 206(4)–2 .................................
Comparison of proposed rule 223–1 burdens to current rule
206(4)-2 burdens.
319,856 ...................
24,133,429 ..............
(23,813,573) ............
398,152 hours ............................
288,202 hours ............................
109,950 hours ............................
$378,598,500
$174,367,000
$204,231,500
Notes:
1. Advisers can be subject to the surprise exam for several reasons. For a more detailed breakout of the types of advisers and their respective
burdens see section IV.B.3.
ddrumheller on DSK120RN23PROD with PROPOSALS2
E. Rule 204–2
Under section 204 of the Advisers
Act, investment advisers registered or
required to register with the
Commission under section 203 of the
Advisers Act must make and keep for
prescribed periods such records (as
defined in section 3(a)(37) of the
Exchange Act), furnish copies thereof,
and make and disseminate such reports
as the Commission, by rule, may
prescribe as necessary or appropriate in
the public interest or for the protection
of investors. Rule 204–2 sets forth the
requirements for maintaining and
preserving specified books and records.
This collection of information is found
at 17 CFR 275.204–2 and is mandatory.
The Commission staff uses the
collection of information in its
examination and oversight program. As
noted above, responses provided to the
Commission in the context of its
examination and oversight program
concerning the proposed amendments
to rule 204–2 would be kept
confidential subject to the provisions of
applicable law.
We are proposing amendments to rule
204–2 to correspond to proposed new
rule 223–1. Specifically, we are
proposing to require investment
advisers to maintain the following
records for client accounts: (1) client
account identification, (2) custodian
information, including copies of
qualified custodian agreements with the
adviser, a record of required reasonable
assurances from the qualified custodian,
and if applicable, a copy of the adviser’s
written reasonable determination that
ownership of certain specified client
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assets cannot be recorded and
maintained under a qualified
custodian’s possession or control, (3)
the basis for the adviser having custody
of client assets in the account, (4) any
account statements received or sent by
the adviser, (5) transaction and position
information, and (6) any SLOAs and
related records to verify that an adviser
can avail itself of the proposed
exception to the surprise examination
requirement.669 The proposed
amendments also would require an
adviser to maintain copies of all written
notices to clients required under
proposed rule 223–1 and any responses
thereto, and copies of documents
relating to independent public
accountant engagements.
Each of these records would be
required to be maintained in the same
manner, and for the same period of
time, as other books and records
required to be maintained under rule
204–2(a). Specifically, investment
advisers would be required to maintain
and preserve these records in an easily
accessible place for not less than five
years from the end of the fiscal year
during which the last entry was made
on such record, the first two years in an
appropriate office of the investment
adviser. Requiring maintenance of these
records would facilitate the
Commission’s ability to inspect and
enforce compliance with proposed rule
223–1. The information generally is kept
confidential.670
rule 204–2(b)(2)(vi).
section 210(b) of the Advisers Act (15
U.S.C. 80b–10(b)).
The respondents to this collection of
information are investment advisers
registered or required to be registered
with the Commission that have custody
of client assets. As noted above, based
on Form ADV filings, as of June 30,
2022, we estimate that 13,944 registered
investment advisers would have
custody of client assets under proposed
rule 223–1 and would be subject to the
proposed amendments to rule 204–2.
For the proposed retention of SLOAs
and related records, however, we
believe that not every adviser with
custody of client assets will have clients
that issue SLOAs. Thus, such advisers
would not seek to rely on the proposed
SLOA exception. Of the 13,944 advisers
with custody of client assets, we
estimate that approximately 20%, or
approximately 2,789 advisers, will have
clients that issue SLOAs. Because we
believe that many such advisers already
retain copies of client SLOAs in their
books and records, in our view this
particular collection of information
requirement would have a negligible
impact on them. As a result, we estimate
that this collection of information will
result in an increased burden of .25
hours for each adviser seeking to rely on
the proposed SLOA exception.
Therefore, we estimate that the annual
total internal burden of retaining copies
of, and records relating to, client SLOAs
would be approximately 697.25
hours,671 represented by a monetized
cost of $57,174.50.
The approved annual aggregate
burden for rule 204–2 is currently
669 Proposed
670 See
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671 This estimate is based on the following
calculation: .25 hours per adviser × 2,789 advisers.
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2,764,563 hours, based on an estimate of
13,724 registered advisers, or 201.44
hours per registered adviser.672 For the
proposed recordkeeping amendments
that correspond to proposed changes to
the custody rule as discussed in this
release, we estimate that the proposed
amendments would result in an increase
in the collection of information burden
estimate by 21 hours for each of the
estimated 13,944 registered advisers
with custody of client assets. We,
therefore, estimate that the revised
annual aggregate hourly burden for rule
204–2 would be 3,347,352 hours,
represented by a monetized cost of
$217,333,279 based on an estimate of
15,160 registered advisers, of which we
estimate 13,944 would have custody of
client assets under the proposed rule.
This represents an increase of
582,789 673 annual aggregate hours in
the hour burden and an annual
monetized cost increase of $41,352,853
from the currently approved total
aggregate monetized cost for rule 204–
Internal
hour burden
2.674 These increases are attributable to
a larger registered investment adviser
population since the most recent
approval and adjustments for inflation,
as well as the proposed rule 204–2
amendments as discussed in this
proposing release.
A chart summarizing the various
components of the total annual burden
for investment advisers with custody of
client assets is below.
Annual
external
cost burden
Internal
time costs
Wage rate 1
Final Estimates for Rule 204–2 for Client Communications
×
$82 (compliance clerk) .............
$246
....................
3
× 13,944
........
........
...................................................
...................................................
$246
× 13,944
....................
....................
41,832
........
...................................................
$3,430,224
....................
Retention of written client notifications and responses .....................
3
Total burden per adviser ............................................................
Total number of affected advisers ..............................................
Sub-total burden ..................................................................
Final Estimates for Rule 204–2 for Client Accounts
Creation and retention of records documenting client account identifying information, including adviser discretionary authority.
2
×
$73 (general clerk) ....................
$146
1
×
$82 (compliance clerk) .............
$82
....................
Total burden per adviser ............................................................
Total number of affected advisers ..............................................
3
× 13,944
........
........
...................................................
...................................................
$228
× 13,944
....................
....................
Sub-total burden ..................................................................
41,832
........
...................................................
$3,179,232
....................
×
$73 (general clerk) ....................
$146
....................
Creation and retention of records documenting custodian identifying information corresponding to each client account, including
copies of qualified custodian agreements with adviser, a record
of required reasonable assurances from the qualified custodian,
and if applicable, a copy of the adviser’s written reasonable determination that ownership of certain specified client assets cannot be recorded and maintained under a qualified custodian’s
possession or control.
2
×
$82 (compliance clerk) .............
$82
....................
Total burden per adviser ............................................................
Total number of affected advisers ..............................................
3
× 13,944
........
........
...................................................
...................................................
$228
× 13,944
....................
....................
Sub-total burden ..................................................................
41,832
........
...................................................
$3,179,232
....................
2
×
$73 (general clerk) ....................
$146
....................
1
×
$82 (compliance clerk) .............
$82
....................
...................................................
...................................................
$228
× 13,944
....................
....................
1
Creation and retention of records documenting adviser’s basis of
custody of client assets.
Total burden per adviser ............................................................
Total number of affected advisers ..............................................
3
× 13,944
........
........
........
...................................................
$3,179,232
....................
×
$82 (compliance clerk) .............
$164
....................
Sub-total burden ..................................................................
41,832
Retention of copies of account statements .......................................
2
Total burden per adviser ............................................................
Total number of affected advisers ..............................................
2
× 13,944
........
........
...................................................
...................................................
$164
× 13,944
....................
....................
Sub-total burden ..................................................................
27,888
........
...................................................
$2,286,816
....................
×
$82 (compliance clerk) .............
$246
....................
ddrumheller on DSK120RN23PROD with PROPOSALS2
Creation and retention of records of detailed transaction and position information for each client account.
3
Total burden per adviser ............................................................
Total number of advisers ............................................................
3
× 13,944
........
........
...................................................
...................................................
$246
× 13,944
....................
....................
Sub-total burden ..................................................................
41,832
........
...................................................
$3,430,224
....................
.25
×
$82 (compliance clerk) .............
$20.50
....................
.25
........
...................................................
$20.50
....................
Retention of copies of, and records relating to, standing letters of
authorization.
Total burden per adviser ............................................................
672 2,764,563 hours/13,724 registered advisers =
201.44 hours per adviser.
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Internal
hour burden
Annual
external
cost burden
Internal
time costs
Wage rate 1
Total number of advisers ............................................................
× 2,789
........
...................................................
× 2,789
....................
Sub-total burden ..................................................................
697.25
........
...................................................
$57,174.50
....................
Final Estimates for Rule 204–2 for Independent Public Accountant
Retention of copies of all audited financial statements, internal control reports, and required written agreements between independent public accountant and adviser or its client.
3
×
$73 (general clerk) ....................
$219
....................
1
×
$82 (compliance clerk) .............
$82
....................
Total burden per adviser ............................................................
Total number of affected advisers ..............................................
4
× 13,944
........
........
...................................................
...................................................
$301
× 13,944
....................
....................
Sub-total burden ..................................................................
55,776
........
...................................................
$4,197,144
....................
Total Estimated Final Burden for Rule 204–2
Total burden for this rulemaking ........................................................
Previously approved burden plus the additional burden due to the
increase in the number of advisers.
293,521.25
3,053,831
........
........
...................................................
...................................................
$22,939,278.50
$194,394,000
....................
....................
Total burden ...............................................................................
3,347,352
........
...................................................
$217,333,279
....................
Notes:
1 The Commission’s estimates of the relevant wage rates are based on salary information for the securities industry compiled by the Securities Industry and Financial Markets Association’s Office Salaries in the Securities Industry 2013. The estimated figures are modified by firm size, employee benefits, overhead, and adjusted
to account for the effects of inflation. See the SIFMA Wage Report.
ddrumheller on DSK120RN23PROD with PROPOSALS2
F. Form ADV
The proposed amendments to Form
ADV would increase the information
requested in Form ADV Part 1A. More
specifically, we are proposing
amendments to Form ADV Part 1A,
Schedule D, and the Instructions and
Glossary of Form ADV that are designed
to help advisers identify when they may
have custody of client assets, to provide
the Commission with information
related to advisers’ practices to
safeguard client assets information
about advisers’ practices to safeguard
client assets, to provide the Commission
with information related to these
practices, and to provide the
Commission with additional data to
improve our ability to identify
compliance risks.
The estimated new burdens below
also take into account changes in the
numbers of advisers since the last
approved PRA for Form ADV and
increased costs due to inflation. Based
on the prior amendments to Form ADV,
we estimated the annual compliance
burden to comply with the collection of
information requirement of Form ADV
is 433,004 burden hours per year and an
external cost burden estimate of
$14,125,083.675 Compliance with the
disclosure requirements of Form ADV is
mandatory, and the responses to the
disclosure requirements will not be kept
confidential.
We propose the following changes to
our PRA methodology for Form ADV:
• Form ADV Parts 1 and 2. Form
ADV PRA has historically calculated a
per adviser per year hourly burden for
Form ADV Parts 1 and 2 for each of (i)
the initial burden and (ii) the ongoing
burden, which reflects advisers’ filings
of annual and other-than-annual
updating amendments. We noted in
previous PRA amendments that most of
the paperwork burden for Form ADV
Parts 1 and 2 would be incurred in the
initial submissions of Form ADV.
However, recent PRA amendments have
continued to apply the total initial
hourly burden for Parts 1 and 2 to all
currently registered or reporting SECregistered investment advisers (‘‘RIAs’’)
and exempt reporting advisers
(‘‘ERAs’’), respectively, in addition to
the estimated number of new advisers
expected to be registering or reporting
with the Commission annually. We
believe that the total initial hourly
burden for Form ADV Parts 1 and 2
going forward should be applied only to
the estimated number of expected new
675 See Investment Adviser Marketing, Final Rule,
Investment Advisers Act Release No. 5653 (Dec. 22,
2020) [81 FR 60418 (Mar. 5, 2021)] and
corresponding submission to the Office of
Information and Regulatory Affairs at Reginfo.gov
(‘‘2021 Form ADV PRA’’).
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advisers annually. This is because
currently registered or reporting
advisers have generally already incurred
the total initial burden for filing Form
ADV for the first time. On the other
hand, the estimated expected new
advisers will incur the full total burden
of initial filing of Form ADV, and we
believe it is appropriate to apply this
total initial burden to these advisers. We
propose to continue to apply any new
initial burdens resulting from proposed
amendments to Form ADV Parts 1 and
2, as applicable, to all currently
registered or reporting investment
advisers plus all estimated expected
new RIAs and ERAs annually.
• Private fund reporting. We have
previously calculated advisers’ private
fund reporting as a separate initial
burden. The currently approved burden
for all registered and exempt reporting
advisers, including expected new
registered advisers and new exempt
reporting advisers, with respect to
reported private funds, is 1 hour per
private fund reported, which we have
previously amortized over three years
for all private fund advisers. We
propose to continue to calculate
advisers’ private fund reporting as a
separate reporting burden, but we
propose to apply the initial burden only
with respect to the expected new private
funds.
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TABLE 10—FORM ADV PRA ESTIMATES
Internal annual
amendment
burden hours 1
Initial hours per
year
Wage rate 2
Internal time costs
Annual external cost
burden 3
PROPOSED AMENDMENTS TO FORM ADV
RIAs (burden for Parts 1 and 2, not including private fund reporting) 4
Proposed additions (per adviser) to
Part 1A Item 9 and corresponding
schedules.
Current burden per adviser 7 ............
Revised burden per adviser .............
Total revised aggregate burden
estimate.
$318 per hour (blended rate for
senior compliance examiner and
compliance manager) 6.
$273.00 per hour (blended rate for
senior compliance examiner and
compliance manager).
1.4 hours × $318 per
hour = $445.20.
0.4 hours + 11.8
hours = 12.2
hours.
$318 (blended rate for senior compliance examiner and compliance
manager).
(30.72 + 12.2) × $318
= $13,648.56.
191,686.4
hours 13.
Same as above ...............................
(32,177,44 +
191,686.4) × $318 =
$71,169,621.12.
$11,162,546 14.
1 hour for Part
1A.
0.4 hours 5 .........
29.72 hours 8 .....
11.8 hours 9 .......
29.72 hours + 1
hour = 30.72
hours.
32,117.44 12 .......
(29.72 + 11.8) ×
$273.00 =
$11,334.96.
$2,069,250 aggregated
(previously presented
only in the aggregate) 10.
$4,780.50 11.
RIAs (burden for Part 3) 15
No proposed changes
Current burden per RIA ....................
Total updated aggregate burden
estimate.
20 hours, amortized over
three years =
6.67 hours 16.
1.58 hours 17 .....
$273 (blended rate for senior compliance examiner and compliance
manager).
$273 × (6.67 + 1.58) =
$2,249.52.
$2,433.74 per adviser 18.
70,646.67
hours 19.
15,646.74
hours 20.
$318 (blended rate for senior compliance examiner and compliance
manager.
$27,441,303.32 ($318
× (70,646.67 hours
+ 15,646.74 hours).
$9,930,272.08 21.
ERAs (burden for Part 1A, not including private fund reporting) 22
No proposed changes.
Current burden per ERA ..................
Total revised aggregate burden
estimate.
3.60 hours 23 .....
1.5 hours + final
filings 24.
$273 (blended rate for senior compliance examiner and compliance
manager).
.....................................
$0
1,245.60 25 .........
8,777.60 hours 26
$318 (blended rate for senior compliance examiner and compliance
manager.
$3,187,377.60 ($318 ×
(1,245.6 + 8,777.60
hours)).
$0
$273 (blended rate for senior compliance examiner and compliance
manager).
.....................................
$318 (blended rate for senior compliance examiner and compliance
manager).
$5,173,478.40 ($318 ×
16,269 30 hours)).
Cost of $46,865.74 per
fund, applied to 6%
of RIAs that report
private funds 29.
$14,856,439.58 31.
Private Fund Reporting 27
No proposed changes.
Current burden per adviser to private fund.
Total updated aggregate burden estimate.
1 hour per private fund 28.
1,150 hours 30 ...
N/A—included in
the existing
annual amendment burden.
N/A ....................
ddrumheller on DSK120RN23PROD with PROPOSALS2
TOTAL ESTIMATED BURDENS, INCLUDING AMENDMENTS
hours 32.
Current per adviser burden/external
cost per adviser.
23.82
Revised per adviser burden/external
cost per adviser.
15.62 hours 34.
Current aggregate burden estimates
433,004 initial and amendment hours annually 36.
Revised aggregate
mates.
336,389.45 38 Initial and amendment hours annually.
burden
esti-
23.82 hours × $273 =
$6,502.86 per adviser cost of the burden hour.
15.62 hours × $318 =
$4,966.43 per adviser cost of the burden hour.
433,004 × $273 =
$118,210,092 aggregate cost of the burden hour.
336,389.45 × $318 =
$106,971,844.04 aggregate cost of the
burden hour.
$777 33.
$1,669.03 35.
$14,125,083 37.
$35,949,257.66 39.
Notes:
1 This column estimates the hourly burden attributable to annual and other-than-annual updating amendments to Form ADV, plus RIAs’ ongoing obligations to deliver codes of ethics to clients.
2 As with Form ADV generally, and pursuant to the currently approved PRA (see 2021 Form ADV PRA), we expect that for most RIAs and ERAs, the performance
of these functions will most likely be equally allocated between a senior compliance examiner and a compliance manager, or persons performing similar functions.
The Commission’s estimates of the relevant wage rates are based on the SIFMA Wage Report, modified by firm size, employee benefits, overhead, and adjusted to
account for the effects of inflation.
3 External fees are in addition to the projected hour per adviser burden. Form ADV has a one-time initial cost for outside legal and compliance consulting fees in
connection with the initial preparation of Parts 2 and 3 of the form. In addition to the estimated legal and compliance consulting fees, investment advisers of private
funds incur one-time costs with respect to the requirement for investment advisers to report the fair value of private fund assets.
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14773
4 Based on Form ADV data as of June 2022, we estimate that there are 15,160 RIAs (‘‘current RIAs’’) and 552 advisers that are expected to become RIAs annually
(‘‘newly expected RIAs’’).
5 We estimate that 12,570 RIAs (80% of the total of 15,712 combined current and expected RIAs that are required to complete Parts 1 and 2) would incur a burden
of 0.5 hour, and 3,142 RIAs (20% of 15,712 current and expected RIAs that are required to complete Parts 1 and 2) would incur a burden of 0 hours. (12,570 RIAs ×
0.5) + (3,142 RIAs × 0)/15,712 = 0.4 blended average hours per RIA.
6 The $318 wage rate reflects current estimates from the SIFMA Wage Report of the blended hourly rate for a senior compliance examiner ($276) and a compliance manager ($360). ($276 + $360)/2 = $318.
7 Per above, we are proposing to revise the PRA calculation methodology to apply the full initial burden only to expected RIAs, as we believe that current RIAs
have generally already incurred the burden of initially preparing Form ADV.
8 See 2020 Form ADV PRA Renewal (stating that the estimate average collection of information burden per adviser for Parts 1 and 2 is 29.22 hours, prior to the
most recent amendment to Form ADV). See also 2021 Form ADV PRA (adding 0.5 hours to the estimated initial burden for Part 1A in connection with the most recent amendment to Form ADV). Therefore, the current estimated average initial collection of information hourly burden per adviser for Parts 1 and 2 is 29.72 hours
(29.22 + 0.5 = 29.72).
9 The currently approved average total annual burden for RIAs attributable to annual and other-than-annual updating amendments to Form ADV Parts 1 and 2 is
10.5 hours per RIA, plus 1.3 hours per year for each RIA to meet its obligation to deliver codes of ethics to clients (10.5 + 1.3 = 11.8 hours per adviser). See 2020
Form ADV PRA Renewal (these 2020 hourly estimates were not affected by the 2021 amendments to Form ADV). As we explained in previous PRAs, we estimate
that each RIA filing Form ADV Part 1 will amend its form 2 times per year, which consists of one interim updating amendment (at an estimated 0.5 hours per amendment), and one annual updating amendment (at an estimated 8 hours per amendment), each year. We also explained that we estimate in that each RIA will, on average, spend 1 hour per year making interim amendments to brochure supplements, and an additional 1 hour per year to prepare brochure supplements as required by
Form ADV Part 2. See id.
10 See 2020 Form ADV PRA Renewal (the subsequent amendment to Form ADV described in the 2021 Form ADV PRA did not affect that estimate).
11 External cost per RIA includes the external cost for initially preparing Part 2, which we have previously estimated to be approximately 10 hours of outside legal
counsel for a quarter of RIAs, and 8 hours of outside management consulting services for half of RIAs. See 2020 Form ADV Renewal (these estimates were not affected by subsequent amendments to Form ADV). The proposal does not add to this burden. This burden remains 10 hours and 8 hours, respectively, for 1⁄4 and 1⁄2
of RIAs, respectively). (((.25 × 15,160 RIAs) × ($565 × 10 hours)) + ((0.50 × 15,160 RIAs) × ($842 × 8 hours)))/15,160 RIAs = $4,780.50 per adviser.
12 Per above, we are proposing to revise the PRA calculation methodology for current RIAs to not apply the full initial burden to current RIAs, as we believe that
current RIAs have generally already incurred the initial burden of preparing Form ADV. Therefore, we calculate the initial burden associated with complying with the
proposed amendment of 1 initial hours × 15,160 current RIAs = 15,160, initial hours in the first year aggregated for current RIAs. We are not amortizing this burden
because we believe current advisers will incur it in the first year. For expected RIAs, we estimate that they will incur the full revised initial burden, which is 30.72
hours per RIA. Therefore, 30.72 hours × 552 expected RIAs = 16,957.44 aggregate hours for expected RIAs. We do not amortize this burden for expected new RIAs
because we expect a similar number of new RIAs to incur this initial burden each year. Therefore, the total revised aggregate initial burden for current and expected
RIAs is 15,160 hours + 16,957.44 hours = 32,117.44 aggregate initial hours.
13 12.2 amendment hours × (15,160 current RIAs + 552 expected new RIAs) = 191,686 aggregate amendment hours.
14 Per above, for current RIAs, we are proposing to not apply the currently approved external cost for initially preparing Part 2, because we believe that current
RIAs have already incurred that initial external cost. For current RIAs, therefore, we are applying only the external cost we estimate they will incur in complying with
the proposed amendment. Therefore, the revised total burden for current RIAs is (((.25 × 15,160 RIAs) × ($565 × 1 hour)) + ((0.50 × 15,160 RIAs) × ($842 × 1 hour)))
= $8,523,710 aggregated for current RIAs, We do not amortize this cost for current RIAs because we expect current RIAs will incur this initial cost in the first year.
For expected RIAs, we apply the currently approved external cost for initially preparing Part 2 plus the estimated external cost for complying with the proposed
amendment. Therefore, $4,780.50 per expected RIA × 552 = $2,638,836 aggregated for expected RIAs. We do not amortize this cost for expected new RIAs because
we expect a similar number of new RIAs to incur this external cost each year. $8,523,710 aggregated for current RIAs + $2,638,836 aggregated for expected RIAs =
$11,162,546 aggregated external cost for RIAs.
15 Even though we are not proposing amendments to Form ADV Part 3 (‘‘Form CRS’’), the burdens associated with completing Part 3 are included in the PRA for
purposes of updating the overall Form ADV information collection. Based on Form ADV data as of October 31, 2021, we estimate that 8,877 current RIAs provide advice to retail investors and are therefore required to complete Form CRS, and we estimate an average of 347 expected new RIAs to be advising retail advisers and
completing Form CRS for the first time annually.
16 See Form CRS Relationship Summary; Amendments to Form ADV, Investment Advisers Act Release No. 5247 (June 5, 2019) [84 FR 33492 (Sep. 10, 2019)]
(‘‘2019 Form ADV PRA’’). Subsequent PRA amendments for Form ADV have not adjusted the burdens or costs associated with Form CRS. Because Form CRS is
still a new requirement for all applicable RIAs, we have, and are continuing to, apply the total initial burden to all current and expected new RIAs that are required to
file Form CRS, and amortize that initial burden over three years for current RIAs.
17 As reflected in the currently approved PRA burden estimate, we stated that we expect advisers required to prepare and file the relationship summary on Form
ADV Part 3 will spend an average 1 hour per year making amendments to those relationship summaries and will likely amend the disclosure an average of 1.71 times
per year, for approximately 1.58 hours per adviser. See 2019 Form ADV PRA (these estimates were not amended by the 2021 amendments to Form ADV).
18 See 2020 Form ADV PRA Amendment (this cost was not affected by the subsequent amendment to Form ADV and was not updated in connection with that
amendment; while this amendment did not break out a per adviser cost, we calculated this cost from the aggregate total and the number of advisers we estimated
prepared Form CRS). Note, however, that in our 2020 Form ADV PRA Renewal, we applied the external cost only to expected new retail RIAs, whereas we had previously applied the external cost to current and expected retail RIAs. We believe that since Form CRS is still a newly adopted requirement, we should continue to
apply the cost to both current and expected new retail RIAs. See 2019 Form ADV PRA.
19 9,556 current RIAs × 6.67 hours each for initially preparing Form CRS = 63,706.67 aggregate hours for current RIAs initially filing Form CRS. For expected new
RIAs initially filing Form CRS each year, we are not proposing to use the amortized initial burden estimate, because we expect a similar number of new RIAs to incur
the burden of initially preparing Form CRS each year. Therefore, 347 expected new RIAs × 20 initial hours for preparing Form CRS = 6,940 aggregate initial hours for
expected RIAs. 63,706.67 hours + 6,940 hours = 70,646.67 aggregate hours for current and expected RIAs to initially prepare Form CRS.
20 1.58 hours × (9,556 current RIAs updating Form CRS + 347 expected new RIAs updating Form CRS) = 15,646.74 aggregate amendment hours per year for
RIAs updating Form CRS.
21 We have previously estimated the initial preparation of Form CRS would require 5 hours of external legal services for an estimated quarter of advisers that prepare Part 3, and 5 hours of external compliance consulting services for an estimated half of advisers that prepare Part 3. See 2020 PRA Renewal (these estimates
were not amended by the most recent amendment to Form ADV). The hourly cost estimate of $565 and $842 for outside legal services and management consulting
services, respectively, are based on an inflation-adjusted figure in the SIFMA Wage Report. Therefore, (((.25 × 9,556 current RIAs preparing Form CRS) × ($565 × 5
hours)) + ((0.50 × 9,556 current RIAs preparing Form CRS) × ($842 × 5 hours))) = $26,864,305. For current RIAs, since this is still a new requirement, we amortize
this cost over three years for a per year initial external aggregated cost of $8,954,768.33. For expected RIAs that we expect would prepare Form CRS each year, we
use the following formula: (((.25 × 347 expected RIAs preparing Form CRS) × ($565 × 5 hours)) + ((0.50 × 347 expected RIAs preparing Form CRS) × ($842 × 5
hours))) = $975,503.75 aggregated cost for expected RIAs. We are not amortizing this initial cost because we estimate a similar number of new RIAs would incur this
initial cost in preparing Form CRS each year, $8,954,768.33 + $975,503.75 = $9,930,272.08 aggregate external cost for current and expected RIAs to initially prepare
Form CRS.
22 Based on Form ADV data as of June 30, 2022, we estimate that there are 5,481 currently reporting ERAs (‘‘current ERAs’’), and an average of 346 expected
new ERAs annually (‘‘expected ERAs’’).
23 See 2021 Form ADV PRA.
24 The previously approved average per adviser annual burden for ERAs attributable to annual and updating amendments to Form ADV is 1.5 hours. See 2021
Form ADV PRA. As we have done in the past, we add to this burden the burden for ERAs making final filings, which we have previously estimated to be 0.1 hour per
applicable adviser, and we estimate that an expected 371 current ERAs will prepare final filings annually, based on Form ADV data as of December 2020.
25 For current ERAs, we are proposing to not apply the currently approved burden for initially preparing Form ADV, because we believe that current ERAs have already incurred this burden. For expected ERAs, we are applying the initial burden of preparing Form ADV of 3.6 hours. Therefore, 3.6 hours × 346 expected new
ERAs per year = 1,245.60 aggregate initial hours for expected ERAs. For these expected ERAs, we are not proposing to amortize this burden because we expect a
similar number of new ERAs to incur this burden each year. Therefore, we estimate 1,245.60 aggregate initial annual hours for expected ERAs.
26 The previously approved average total annual burden of ERAs attributable to annual and updating amendments to Form ADV is 1.5 hours. See 2020 Form ADV
Renewal (this estimate was not affected by the subsequent amendment to Form ADV). As we have done in the past, we added to this burden the currently approved
burden for ERAs making final filings of 0.1 hour, and multiplied that by the number of final filings we are estimating ERAs would file per year (371 final filings based
on Form ADV data as of December 2020). (1.5 hours × 5,481 currently reporting ERAs) + (0.1 hour × 371 final filings) = 8,258.60 updated aggregated hours for currently reporting ERAs. For expected ERAs, the aggregate burden is 1.5 hours for each ERA attributable to annual and other-than-annual updating amendments to
Form ADV × 346 expected new ERAs = 519 annual aggregated hours for expected new ERAs updating Form ADV (other than for private fund reporting). The total
aggregate amendment burden for ERAs (other than for private fund reporting) is 8,258.60 + 519 = 8,777.60 hours.
27 Based on Form ADV data as of June 30, 2022, we estimate that 5,142 current RIAs advise 50,968 private funds. Previously, based on Form ADV data as of October 31, 2021, we have estimated 136 new RIAs will advise 407 reported private funds per year. We have also estimated that 4,959 current ERAs advise 23,476 private funds, and estimate an expected 372 new ERAs will advise 743 reported private funds per year. Therefore, we estimate that there are 74,444 currently reported
private funds reported by current private fund advisers (50,968 + 23,476), and there will be annually 1,150 new private funds reported by expected private fund advisers (407 + 743). The total number of current and expected new RIAs that report or are expected to report private funds is 5,278 (5,142 current RIAs that report private funds + 136 expected RIAs that would report private funds).
28 See 2020 Form ADV PRA Renewal (this per adviser burden was not affected by subsequent amendments to Form ADV).
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29 We previously estimated that an adviser without the internal capacity to value specific illiquid assets would obtain pricing or valuation services at an estimated
cost of $37,625 each on an annual basis. See Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. IA–
3221 (June 22, 2011) [76 FR 42950 (July 19, 2011)]. However, because we estimated that external cost in 2011, we are proposing to use an inflation-adjusted cost of
$46,865.74, based on the CPI calculator published by the Bureau of Labor Statistics at https://www.bls.gov/data/inflation_calculator.htm. As with previously approved
PRA methodologies, we continue to estimate that 6% of RIAs have at least one private fund client that may not be audited. See 2020 Form ADV PRA Renewal.
30 Per above, for currently reported private funds, we are proposing to not apply the currently approved burden for initially reporting private funds on Form ADV, because we believe that current private fund advisers have already incurred this burden. Therefore, we calculated the burden on current private fund advisers for only
the proposed incremental new additional burden attributable to private fund reporting of 0.2 hours per private fund × 74,444 currently reported private funds = 14,889
aggregate hours for current private fund advisers. We expect advisers to incur the initial burden in the first year and are therefore not amortizing this burden. For the
estimated 1,150 new private funds annually of expected private fund advisers, we calculate the initial burden of both the proposed incremental new additional burden
attributable to private fund reporting of 0.2 hours per private fund and the 1 hour initial burden per private fund. Therefore, 1.2 hours per expected new private fund ×
1,150 expected new private funds = 1,380 aggregate hours for expected new private funds. For these expected new private funds, we are not proposing to amortize
this burden, because we expect new private fund advisers to incur this burden with respect to new private funds each year. 14,889 hours + 1,380 hours = 16,269 aggregate hours for private fund advisers.
31 As with previously approved PRA methodologies, we continue to estimate that 6% of registered advisers have at least one private fund client that may not be audited, therefore we estimate that the total number of audits for current and expected RIAs is 6% × 5,278 current and expected RIAs reporting private funds or expected to report private funds = 316.68 audits. We therefore estimate that approximately 317 registered advisers incur costs of $46,865.74 each on an annual basis
(see note 29 describing the cost per audit), for an aggregate annual total cost of $14,856,439.58.
32 433,004 currently approved burden hours/18,179 advisers (current and expected annually) = 23.82 hours per adviser. See 2021 Form ADV PRA.
33 $14,125,083 currently approved aggregate external cost/18,179 advisers (current and expected annually) = $777 blended average external cost per adviser.
34 336,389.45 aggregate annual hours for current and expected new advisers (see infra note 38)/(15,160 current RIAs + 552 expected RIAs + 5,481 current ERAs
+346 expected ERAs*) = 15.62 blended average hours per adviser. * The parenthetical totals 21,539 current and expected advisers.
35 $35,949,257.66 aggregate external cost for current and expected new advisers (see infra note 39)/(21,539 advisers current and expected annually) = $1,669.03
blended average hours per adviser.
36 See 2021 Form ADV PRA.
37 See 2021 Form ADV PRA.
38 32,117.44 hours (internal initial burden for Parts 1 and 2) + 191,686.40 hours (internal annual amendment burden for Parts 1 and 2) + 70,646.67 hours (internal
initial burden for Part 3) + 15,646.74 hours (internal annual amendment burden for Part 3) + 1,245.60 hours (internal initial burden for ERAs) + 8,777.60 hours (internal annual amendment burden for ERAs)+ 16,269 hours (internal initial burden for private funds) = 336,389.45 aggregate annual hours for current and expected new
advisers.
39 $11,162,546.00 (annual external cost burden for Parts 1 and 2) + $9,930,272.08 (annual external cost burden for Part 3) + $14,856,439.58 (annual external cost
burden for private funds) = $35,949,257.66.
G. Request for Comments
We request comment on whether our
estimates for burden hours and any
external costs as described above are
reasonable. Pursuant to 44 U.S.C.
3506(c)(2)(B), the Commission solicits
comments in order to: (i) evaluate
whether the proposed collections of
information are necessary for the proper
performance of the functions of the
Commission, including whether the
information will have practical utility;
(ii) evaluate the accuracy of the
Commission’s estimate of the burden of
the proposed collections of information;
(iii) determine whether there are ways
to enhance the quality, utility, and
clarity of the information to be
collected; and (iv) determine whether
there are ways to minimize the burden
of the collections of information on
those who are to respond, including
through the use of automated collection
techniques or other forms of information
technology.
In addition to these general requests
for comment, we also request comment
specifically on the following issues:
• Our analysis relies upon certain
assumptions, such as 13,944 advisers
will enter into written agreements as
required by the rule, 959 qualified
custodians will be counterparties to
those written agreements, and 55,776
written agreements will initially be
executed. Do commenters agree with
these assumptions? If not, why not, and
what data would commenters propose?
• Our analysis also relies on the
assumption that a new written
agreement will require approximately
one hour per adviser and per qualified
custodian. Our analysis also assumes
that subsequent annual changes to the
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written agreement require an aggregate
of 10 minutes of adviser and qualified
custodian time per agreement. Do
commenters agree with these
assumptions? If not, why not, and what
data would commenters propose?
• Our analysis also relies on the
assumption that 1,842 of the advisers to
the written agreements would be subject
to the surprise examination requirement
and we estimate that qualified
custodians would be required to provide
information to an independent public
accountant once annually for each
adviser. Further, our analysis relies on
the assumption that it would take
qualified custodians approximately 5
hours to provide the required
information. Do commenters agree with
these assumptions? If not, why not, and
what data would commenters propose?
• Our analysis also relies on the
assumption that 7,018 advisers to the
written agreements would comply with
the proposed rule’s audit exception and
that qualified custodians would be
required to provide information to an
independent public accountant 1.05
times annually for these advisers. Also,
our analysis relies on the assumption
that a qualified custodian will take .5
hours to provide information to the
independent public accountant. Do
commenters agree with these
assumptions? If not, why not, and what
data would commenters propose?
• Our analysis also relies on the
assumption that the Commission would
examine approximately 2,092 of the
advisers required to enter into a written
agreement under the rule and assume
that the Commission will issue
approximately 8,368 requests to
qualified custodians under the rule.
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Additionally, we assume qualified
custodians would take 1.5 hours to
respond to the information requested by
an independent public accountant. Do
commenters agree with these
assumptions? If not, why not, and what
data would commenters propose?
• Our analysis also relies on the
assumption that it would take qualified
custodians 15 hours each to update
distribution lists to add advisers to the
distribution of quarterly statements and
one hour per each qualified custodian to
make modifications and send quarterly
account statements annually. Do
commenters agree with this
assumption? If not, why not, and what
data would commenters propose?
• Our analysis also relies on the
assumption that, on average, an internal
control report for a qualified custodian
costs approximately $750,000. Further,
our analysis relies on the assumption
that 95% of custodians currently obtain
internal control reports. As a result, our
analysis assumes an annual external
cost burden of obtaining internal control
reports to be $35,962,500. Do
commenters agree with this
assumption? If not, why not, and what
data would commenters propose?
• Our analysis also relies on the
assumptions that it would take 15
minutes for an adviser to obtain the
proposed reasonable assurances
requirements from a qualified custodian
and one hour to update any written
agreement, if necessary, to reflect the
reasonable assurances. Further, we
estimate that the exchange is most likely
to occur in the context of the negotiation
and execution of the written agreement.
Additionally, our analysis relies on the
assumption that it will take
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approximately .25 hours to update the
reasonable assurances annually. Do
commenters agree with these
assumptions? If not, why not, and what
data would commenters propose?
• Our analysis relies on the
assumption that each of the 1,842
advisers expected to undergo a surprise
examination under the proposed rule
will spend 0.25 hour to enter into a
written agreement with the independent
public accountant engaged to conduct
the surprise examination. Our analysis
also relies on the assumption that these
advisers can be categorized into three
groups for purposes of the calculation of
the burden. Do commenters agree with
these assumptions? If not, why not, and
what data would commenters propose?
• Our analysis relies on the
assumption that 381 advisers subject to
the surprise examination requirement
have custody because they serve as
qualified custodians for their clients, or
they have a related person that serves as
qualified custodian for clients.
Additionally, our analysis relies on the
assumption that these advisers are
subject to an annual surprise
examination with respect to 100 percent
of their clients (or 9,006 clients per
adviser) based on the assumption that
all of their clients maintain custodial
accounts with the adviser or its related
person. Our analysis assumes that each
adviser will spend an average of 0.02
hours for each client to create a client
contact list for the independent public
accountant to conduct the asset
verification. Do commenters agree with
these assumptions? If not, why not, and
what data would commenters propose?
• Our analysis relies on the
assumption that 834 advisers subject to
the surprise examination requirement
have custody because they have broad
authority to access client assets held at
an independent qualified custodian,
such as through a power of attorney or
acting as a trustee for a client’s trust.
Also, our analysis assumes that these
advisers will be subject to an annual
surprise examination with respect to 5
percent of their clients (or 450 clients
per adviser) who maintain these types of
arrangements with the adviser. In
addition, our analysis assumes that each
adviser will spend an average of 0.02
hours for each client that is subject to
these arrangements to create a client
contact list for the independent public
accountant. Do commenters agree with
these assumptions? If not, why not, and
what data would commenters propose?
• Our analysis relies on the
assumption that 626 advisers manage
private funds and undergo surprise
examinations. For these advisers, our
analysis relies on the assumption that
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each adviser managing private funds has
an average of 6 pooled investment
vehicle clients with an average of 14
investors. Our analysis relies on the
assumption that these advisers will
spend 1 hour for the pool and 0.02
hours for each investor in the pool to
create a contact list for the independent
public accountant. Do commenters agree
with these assumptions? If not, why not,
and what data would commenters
propose?
• Our analysis relies on the
assumption that 4,961 advisers
currently have custody of privately
offered securities and physical assets
that cannot be maintained with a
qualified custodian. Our analysis further
relies on the assumption that there will
be approximately 8,000 purchases,
sales, or other transfers of beneficial
ownership of assets subject to the
exception in proposed rule 223–1(b)(2).
Do commenters agree with these
assumptions? If not, why not, and what
data would commenters propose?
• Our analysis relies on the
assumption that it would take each
adviser 1.25 hours, initially, to prepare
the written agreement with an
accountant for verification of assets
under proposed rule 223–1(b)(2)(iii).
Additionally, our analysis relies on the
assumption that these agreements will
change minimally from year to year and
that advisers will spend approximately
.5 hours annually amending these
agreements or entering into new
agreements. Do commenters agree with
these assumptions? If not, why not, and
what data would commenters propose?
• Our analysis also relies on the
assumption that the adviser’s required
notice to an accountant under proposed
rule 223–1(b)(2)(iv) would likely be
provided by the adviser in connection
with the closing of a transaction, and
would take advisers approximately one
minute to deliver to the accountant. Do
commenters agree with this
assumption? If not, why not, and what
data would commenters propose?
• Our analysis relies on the
assumption that accountant
verifications of transfers of beneficial
ownership will have an annual cost
burden of $19,680,000 to advisers. Do
commenters agree with this
assumption? If not, why not, and what
data would commenters propose?
• Our analysis also relies on the
assumption that the additional cost of
asset verification for all assets during a
surprise examination or audit under the
audit provision aggregates to
$322,956,000 annually. Do commenters
agree with this assumption? If not, why
not, and what data would commenters
propose?
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• Our analysis relies on the
assumption that distributions of audited
financial statements to investors in the
client entity will take advisers
approximately 1 minute per investor.
Our analysis relies on the assumption
that there are 4,961 advisers to audited
pooled investment vehicles, with an
upward adjustment to 7,018 to account
for our expectation that an increasing
number of advisers will obtain audits of
client entities. Do commenters agree
with these assumptions? If not, why not,
and what data would commenters
propose?
• Our analysis relies on the
assumption that each of the 7,018
advisers that rely on the audit provision
will spend 1.25 hours to add the
provisions required under proposed rule
223–1(b)(4)(v) to the written agreement
with the independent public
accountant. Our analysis also relies on
the assumption that each adviser will
spend 0.92 hours on an annual basis to
reassess these written agreements and
execute new agreements as an adviser
adds entity clients. Do commenters
agree with these assumptions? If not,
why not, and what data would
commenters propose?
• Our analysis also relies on the
assumption that of the 13,944 advisers
with custody of client assets, we
estimate that approximately 20%, or
approximately 2,789 advisers, will have
clients that issue SLOAs. Further, our
analysis assumes that many such
advisers already retain copies of client
SLOAs in their books and records and
we assume, therefore, that this
collection of information will result in
an increased burden of only .25 hours
for each adviser seeking to rely on the
proposed SLOA exception. Do
commenters agree with these
assumptions? If not, why not, and what
data would commenters propose?
• Our analysis relies on the
assumption that 12,570 advisers (80% of
the total of 15,712 combined current
and expected advisers that are required
to complete Parts 1 and 2 of the Form
ADV) would incur an additional burden
of 5 hour under the proposed
amendments to Form ADV Part 1A, and
3,142 advisers (20% of 15,712 current
and expected advisers that are required
to complete Parts 1 and 2 of Form ADV)
would incur a burden of 0 hours. Do
commenters agree with these
assumptions? If not, why not, and what
data would commenters propose?
The agency is submitting the
proposed collections of information to
OMB for approval. Persons wishing to
submit comments on the collection of
information requirements of the
proposed amendments should direct
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them to the Office of Management and
Budget, Attention Desk Officer for the
Securities and Exchange Commission,
Office of Information and Regulatory
Affairs, Washington, DC 20503, and
should send a copy to Vanessa A.
Countryman, Secretary, Securities and
Exchange Commission, 100 F Street NE,
Washington, DC 20549 1090, with
reference to File S7–04–23. OMB is
required to make a decision concerning
the collections of information between
30 and 60 days after publication of this
release; therefore, a comment to OMB is
best assured of having its full effect if
OMB receives it within 30 days after
publication of this release. Requests for
materials submitted to OMB by the
Commission with regard to these
collections of information should be in
writing, refer to File S7–04–23, and be
submitted to the Securities and
Exchange Commission, Office of FOIA
Services, 100 F Street NE, Washington,
DC 20549–2736.
V. Initial Regulatory Flexibility
Analysis
The Commission has prepared the
following Initial Regulatory Flexibility
Analysis (‘‘IRFA’’) in accordance with
section 3(a) of the Regulatory Flexibility
Act (‘‘RFA’’).676 It relates to: (i) new rule
223–1 under the Advisers Act; (ii)
proposed rule 204(d)–1; (iii) proposed
amendments to rule 204–2; and (iv)
proposed amendments to Form ADV
Part 1A.
ddrumheller on DSK120RN23PROD with PROPOSALS2
A. Reason for and Objectives of the
Proposed Action
1. Proposed Rule 223–1
We are proposing amendments to the
custody rule, which we adopted in 1962
and amended in 2003 and 2009. The
current custody rule generally requires
an adviser to:
• Maintain client funds and securities
with a qualified custodian (brokerdealers, banks or savings associations,
futures commission merchants, and
certain foreign financial institutions);
• Have a reasonable basis upon due
inquiry for believing qualified
custodians send account statements
directly to advisory clients;
• Undergo an annual surprise
examination by an independent public
accountant to verify that a sampling of
client funds and securities exists or
have the audited financial statements of
a pooled investment vehicle prepared in
accordance with generally accepted
accounting principles and distributed to
investors in the pool; and
• Obtain a report of the internal
controls of related person qualified
676 5
U.S.C. 603(a).
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custodians relating to custody from an
independent public accountant.
The proposed changes to the custody
rule are designed to recognize the
expansion in products and services
investment advisers offer to their
clients, evolution in the types of
investments and ways of evidencing
their ownership, and developments in
the market for custodial services. We
have accounted for these advancements
by clarifying the rule’s scope and
implementing more impactful and
tailored protections. Specifically, the
rule would subject investment advisers
to requirements pertaining to the use of
a qualified custodian, delivery of
notices to clients, segregation of client
assets, and independent public
accountant assessments. The rule would
also subject investment advisers to
requirements relating to the
safeguarding of client assets that are not
able to be maintained by a qualified
custodian. Importantly, the proposal
maintains the core purpose of protecting
client assets from loss, misuse, theft,
misappropriation, and the insolvency or
financial reverses of the adviser. We
believe that modernized rules would
help advisers better recognize and
protect against vulnerabilities to
advisory client assets and would
improve our oversight and riskassessment abilities. The reasons for,
and objectives of, the proposed
amendments are discussed in more
detail in sections I and II, above. The
burdens of these requirements on small
advisers are discussed below as well as
above in sections III and IV, which
discuss the burdens on all advisers. The
professional skills required to meet
these specific burdens are also
discussed in section IV.
2. Proposed Rule 204–2
We also are proposing amendments to
rule 204–2 to correspond to proposed
rule 223–1. Specifically, we are
proposing to require investment
advisers to maintain the following
records for client accounts: (1) client
account identification, (2) custodian
identification, (3) the basis for the
adviser having custody of client assets
in the account, (4) any account
statements received or sent by the
adviser, (5) transaction and position
information, and (6) any standing letters
of authorization and records relating
thereto. The proposed amendments also
would require an adviser to maintain
copies of all written notices to clients
required under proposed rule 223–1 and
any responses thereto, and copies of
documents relating to independent
account engagements.
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Although the current rule requires
certain recordkeeping relating to
investment advisers’ custody rule
compliance, the proposal would align
the recordkeeping requirements with
proposed rule 223–1. We are proposing
to amend the current rule to require
advisers to retain documentation that
would allow the Commission
examination staff to verify advisers’
compliance with proposed rule 223–1,
particularly in the categories of client
communications, client accounts, and
independent public account
engagements, and reliance on the
proposed rule’s exceptions. The
proposed recordkeeping rules are
designed to work in concert with
proposed rule 223–1 so that a complete
custodial record with respect to client
assets is maintained and preserved. This
would help facilitate the Commission’s
inspection and enforcement capabilities,
including assessing compliance with
rules, and therefore, it would provide
important investor protections.
3. Proposed Amendments to Form ADV
We are also proposing to amend Item
9 of Part 1A, Schedule D, and the
Instructions and Glossary of Form ADV
to improve information available to us
and to the general public about advisers’
practices in safeguarding client assets.
We are proposing amendments to Form
ADV to align reporting obligations with
the proposed changes to the custody
rule and to help advisers identify when
they may have custody of client assets,
to provide the Commission with
information related to advisers’
practices to safeguard client assets, and
to provide the Commission with
additional data to improve our ability to
identify compliance risks. More
accurate and comprehensive
information would inform the
Commission’s examination initiatives
and would allow the Commission and
its staff to better assess risks specific
advisers pose to investors.
The proposed revisions would require
an adviser to report the amount and
number of clients falling into each
category of custody (i.e., direct or
indirect) and to require advisers to
report similar information about client
assets over which they have custody
resulting from (1) having the ability to
deduct advisory fees; (2) having
discretionary trading authority; (3)
serving as a general partner, managing
member, trustee (or equivalent) for
clients that are private funds; (4) serving
as a general partner, managing member,
trustee (or equivalent) for clients that
are not private funds; (5) having a
general power of attorney over client
assets or check-writing authority; (6)
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having a standing letter of authorization;
(7) having physical possession of client
assets; (8) acting as a qualified
custodian; (9) a related person with
custody that is operationally
independent; and (10) any other
reason.677 Amendments to the form
would require an adviser to indicate
whether it is relying on any of the
exceptions from the safeguarding rule
and, if so, to indicate on which
exception(s) the adviser is relying. We
are also proposing to require advisers to
report whether client assets for which
the adviser triggers the rule are
maintained at a qualified custodian and
the number of clients and approximate
amount of assets not maintained with a
qualified custodian. Advisers would
also be required to report certain
identifying information about the
qualified custodians and independent
public accountants. The reasons for and
objectives of, the proposed amendments
to Form ADV are discussed in more
detail in section II.I above. The burdens
of these requirements on small advisers
are discussed below as well as above in
our Economic Analysis and Paperwork
Reduction Act Analysis, which discuss
the burdens on all advisers. The
professional skills required to meet
these specific burdens are also
discussed in section IV.
B. Legal Basis
ddrumheller on DSK120RN23PROD with PROPOSALS2
The Commission is proposing new
rule 223–1 and to redesignate rule
206(4)–2 pursuant to the authority set
forth in sections 206(4), 211(a), and 223
of the Advisers Act [15 U.S.C. 80b–6(4),
80b–11(a), and 80b–23]; to proposed
rule 204(d)–1 pursuant to authority set
forth in sections 204, 211(a), and 223 of
the Advisers Act [15 U.S.C. 80b–4 and
80b–11(a)]; to amend rule 204–2
pursuant to the authority set forth in
sections 204, 211, and 223 of the
Advisers Act [15 U.S.C. 80b–4, 80b–11,
80b–23]; and to amend Form ADV
pursuant to the authority set forth in
sections 203(c)(1), 204, 211(a), and 223
of the Advisers Act [15 U.S.C. 80b–
3(c)(1), 80b–4, 80b–11(a), and 80b–23].
677 Proposed Form ADV, Part 1A, Item 9.A.(2).
Advisers are currently required to report
information with respect to funds and securities
over which their related persons have custody,
including the dollar amount and number of clients
whose funds or securities are in the adviser’s
custody and whether any related person has
custody of any clients’ cash or bank accounts or
securities and the relevant dollar amount and
number of clients. See Form ADV, Part 1A Item
9.A.(2) through, Item 9.B. Based on its responses,
an adviser is also required to report additional
custody-related information in Schedule D of Form
ADV, Part 1A.
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C. Small Entities Subject to the Rule and
Rule Amendments
subject to the requirements of the
proposed rule.681
In developing these proposals, we
have considered their potential impact
on small entities that would be subject
to the proposed amendments. The
proposed amendments would affect
many, but not all, investment advisers
registered with the Commission,
including some small entities.
Under Commission rules, for the
purposes of the Advisers Act and the
RFA, an investment adviser generally is
a small entity if it: (1) has assets under
management having a total value of less
than $25 million; (2) did not have total
assets of $5 million or more on the last
day of the most recent fiscal year; and
(3) does not control, is not controlled
by, and is not under common control
with another investment adviser that
has assets under management of $25
million or more, or any person (other
than a natural person) that had total
assets of $5 million or more on the last
day of its most recent fiscal year.678 Our
proposed new rules and amendments
would not affect most investment
advisers that are small entities (‘‘small
advisers’’) because they are generally
registered with one or more state
securities authorities and not with the
Commission. Under section 203A of the
Advisers Act, most small advisers are
prohibited from registering with the
Commission and are regulated by state
regulators. Based on IARD data, we
estimate that as of June 30, 2022,
approximately 522 SEC-registered
advisers are small entities under the
RFA.679
D. Projected Reporting, Recordkeeping
and Other Compliance Requirements
1. Small Entities Subject to
Amendments to the Custody Rule
As discussed above in section III (the
Economic Analysis), the Commission
estimates that based on IARD data as of
June 30, 2022, approximately 13,944
investment advisers would be subject to
the new rule 223–1 under the Advisers
Act, the related proposed amendments
to rule 204–2 under the Advisers Act,
and the related proposed amendments
to Form ADV.680
Of the approximately 522 SECregistered advisers that are small
entities under the RFA, 321 would be
subject to the new rule 223–1, the
corresponding amendments to rule 204–
2, and the amendments to Form ADV.
This is because, as discussed above in
the PRA, we estimate that all small
entities that have custody would be
1. Proposed Rule 223–1
Proposed rule 223–1 would impose
certain reporting and compliance
requirements on certain investment
advisers, including those that are small
entities. All registered investment
advisers that have custody of client
assets, which we estimate to be 13,944
advisers, would be required to comply
with the proposed safeguarding rule’s
segregation, qualified custodian
protection, notice to client, and
independent verification requirements.
Although all of these advisers would
also be subject to the qualified
custodian requirements, some would
satisfy these requirements by entering
into contracts with qualified custodians,
while others would satisfy them by
satisfying conditions of a limited
exception for investments in privately
offered securities and physical assets.
The proposed requirements and rule
amendments, including compliance,
reporting, and recordkeeping
requirements, are summarized in this
IRFA (section V.A., above). All of these
proposed requirements are also
discussed in detail, above, in sections I
and II, and these requirements and the
burdens on respondents, including
those that are small entities, are
discussed above in sections III and IV
(the Economic Analysis and Paperwork
Reduction Act Analysis, respectively)
and below. The professional skills
required to meet these specific burdens
are also discussed in section IV.
As discussed above, there are
approximately 522 small advisers
currently registered with us, and we
estimate that 480 of those small advisers
registered with us would be subject to
amendments to the safeguarding rule
(92% of all registered small advisers).682
As discussed above in our Paperwork
Reduction Act Analysis in section IV
above, the proposed amendments to rule
223–1 under the Advisers Act would
create a new annual burden of
approximately 28.4 hours per adviser, or
9,116 hours in aggregate for small
advisers.683 We therefore expect the
annual monetized aggregate cost to
681 See
678 Advisers
Act rule 0–7(a).
679 Based on SEC-registered investment adviser
responses to Items 5.F. and 12 of Form ADV.
680 See supra note 553.
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PRA discussion supra section IV.
supra note 587and accompanying text.
683 396,041 hours/13,944 advisers subject to the
proposed rule = 28.4 hours per adviser. 28.4 hours
× 480 small advisers = 13,632 hours.
682 See
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small advisers associated with our
proposed amendments to the
safeguarding rule would be
$5,371,008.684
2. Proposed Amendments to Rule
204–2
Proposed amendments to rule 204–2
would require investment advisers to
maintain the following records for client
accounts: (1) client account
identification, (2) custodian
identification, (3) the basis for the
adviser having custody of client assets
in the account, (4) any account
statements received or sent by the
adviser, (5) transaction and position
information, and (6) any standing letters
of authorization and records relating
thereto. The proposed amendments also
would require an adviser to maintain
copies of all written notices to clients
required under proposed rule 223–1 and
any responses thereto, and copies of
documents relating to independent
account engagements. Each of these
records would correspond to proposed
rule 223–1, and also would be required
to be maintained in the same manner,
and for the same period of time, as other
books and records required to be
maintained under rule 204–2(a).
As discussed above, there are
approximately 522 small advisers
currently registered with us. We
estimate that 92% percent of all advisers
registered with us that have investment
discretion over client assets (and thus
deemed custody of such assets) 685
would be subject to proposed rule 223–
1 and corresponding amendments to the
books and records rule. As discussed
above in our Paperwork Reduction Act
Analysis in section IV.E above, the
proposed amendments to rule 204–2
under the Advisers Act would increase
the annual burden by approximately 21
hours per affected adviser, or 10,080
hours in aggregate for small advisers
with custody of client assets.686 We
therefore believe the annual monetized
aggregate cost to small advisers
associated with our proposed
amendments would be $3,971,520.687
3. Proposed Amendments to Form ADV
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Proposed amendments to Form ADV
would impose certain reporting and
compliance requirements on certain
684 13,632 aggregate small adviser hours × $394
(blended rate for a compliance manager ($361) and
a compliance attorney ($426)) = $5,371,008.
685 522 small advisers × 92% = 480 small advisers
with custody.
686 21 hours × 480 small advisers with custody =
10,080 hours.
687 10,080 aggregate small adviser hours × $394
(blended rate for a compliance manager ($361) and
a compliance attorney ($426)) = $3,971,520.
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investment advisers, including those
that are small entities, requiring them to
provide information about their
practices in safeguarding client assets.
The proposed requirements and rule
amendments, including recordkeeping
requirements, are summarized above in
this IRFA (section V.A). All of these
proposed requirements are also
discussed in detail, above, in section II,
and these requirements and the burdens
on respondents, including those that are
small entities, are discussed above in
sections III and IV (the Economic
Analysis and Paperwork Reduction Act
Analysis) and below. The professional
skills required to meet these specific
burdens are also discussed in section IV.
Our Economic Analysis (section III
above) discusses these costs and
burdens for respondents, which include
small advisers. As discussed above in
our Paperwork Reduction Act Analysis
in section IV.F above, the proposed
amendments to Form ADV would
increase the annual burden for advisers
(other than exempt reporting advisers,
who would not be required to respond
to the new Form ADV questions we are
proposing) by approximately 1.4 hours
per adviser, or 730.8 hours in aggregate
for small advisers (other than exempt
reporting advisers).688 We therefore
expect the annual monetized aggregate
cost to small advisers (other than
exempt reporting advisers, for whom
there would be no additional cost)
associated with our proposed
amendments would be $232,394.40.689
E. Duplicative, Overlapping, or
Conflicting Federal Rules
The Commission believes that there
are no rules that duplicate, overlap, or
conflict with the proposed rule
amendments.
F. Significant Alternatives
1. Proposed New Rule 223–1 and
Amendments to Rule 204–2 and Form
ADV
The RFA directs the Commission to
consider significant alternatives that
would accomplish our stated objectives,
while minimizing any significant
adverse impact on small entities. We
considered the following alternatives for
small entities in relation to proposed
new rule 223–1 and the corresponding
proposed amendments to rule 204–2
under the Advisers Act and to Form
ADV: (i) differing compliance or
reporting requirements that take into
hours × 522 small advisers = 730.8 hours.
hours × $318 = $232,394.40. See supra
Table 10 for a discussion of who we believe would
perform this function, and the applicable blended
rate.
688 1.4
689 730.8
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account the resources available to small
entities; (ii) the clarification,
consolidation, or simplification of
compliance and reporting requirements
under the proposed rule for such small
entities; (iii) the use of performance
rather than design standards; and (iv) an
exemption from coverage of the
proposals, or any part thereof, for such
small entities.
Regarding the first and fourth
alternatives, the Commission believes
that establishing different compliance or
reporting requirements for small
advisers, or exempting small advisers
from the proposed rule, or any part
thereof, would be inappropriate under
these circumstances. Because the
protections of the Advisers Act are
intended to apply equally to clients of
both large and small firms, it would be
inconsistent with the purposes of the
Advisers Act to specify differences for
small entities under proposed rule 223–
1 and corresponding changes to rule
204–2 and Form ADV. As discussed
above, we believe that the proposed
safeguarding rule would result in
multiple benefits to clients. For
example, segregation requirements and
the imposition of certain minimum
standard requirements for assets
maintained at a qualified custodian
would provide investors with additional
safeguards to protect their assets from
the financial reverses, including
insolvency, of an investment adviser
and to prevent client assets from being
lost, misused, stolen, or
misappropriated. We believe that these
benefits should apply to clients of
smaller firms as well as larger firms. In
addition, as discussed above, our staff
would use the corresponding
information that advisers would report
on the proposed amended Form ADV
for risk-assessment and to help prepare
for examinations of investment advisers.
Establishing different conditions for
large and small advisers that have
custody of client assets would negate
these benefits. Though we are not
exempting small advisers from portions
of the proposals, we believe that the
exception from the surprise examination
requirement for discretionary authority
for client assets that settle exclusively
on a DVP basis will mitigate the creation
of new burdens for many advisers,
particularly smaller advisers. We also
have requested comment on whether we
should provide different compliance
dates for differing types of advisers
including smaller advisers.
Regarding the second alternative, we
believe the current proposal is clear and
that further clarification, consolidation,
or simplification of the compliance
requirements is not necessary. As
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discussed above: the proposed rule
would provide a requirement to
segregate client assets to prevent them
from potential misuse or
misappropriation; would require that
advisers maintain a written agreement
with or obtain reasonable assurances
from qualified custodians concerning
certain minimal safeguarding
requirements that we believe are critical
to providing important protections for
advisory client assets; and would
provide certain limited exceptions from
requirements to maintain assets with a
qualified custodian or obtain an
independent verification of assets.
These provisions would address a
number of safeguarding risks for assets
maintained at a qualified custodian that
the current rule does not address while
extending the protections of the rule
from ‘‘funds and securities’’ to ‘‘assets’’
to account for new and evolving
financial products that may be
maintained in client accounts. The
proposed provisions would strengthen
investment advisers’ safeguarding
practices, which we believe currently
has gaps.
Further, we believe our proposal
would allow the Commission
examination staff to verify all advisers’
compliance with the proposed
amendments to rule 204–2, particularly
in the categories of client
communications, client accounts, and
independent public account
engagements, and reliance on the
exceptions to proposed new rule 223–1.
The proposed recordkeeping rules are
designed to work in concert with
proposed new rule 223–1 so that a
complete custodial record with respect
to client assets is maintained and
preserved. This would help facilitate the
Commission’s inspection and
enforcement capabilities, including
assessing compliance with rules, and
therefore, it would provide important
investor protections.
Regarding the third alternative, we
determined to use a combination of
performance and design standards in
the current proposal. The general
requirement to maintain assets with a
qualified custodian would apply to all
advisers to establish certain minimum
standard requirements under the
proposed safeguarding rule, subject to
narrowly tailored exemptions and
exceptions from certain requirements
(e.g., the surprise exam) if certain
conditions are met. By design, these
exemptions and exceptions address
specific circumstances to ensure
safekeeping of client assets, but also to
provide relief from certain requirements
in circumstances where an adviser’s
ability to misuse or misappropriate
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client assets are limited. The
corresponding changes to rule 204–2
and Form ADV also are narrowly
tailored to address proposed new rule
223–1.
G. Solicitation of Comments
We encourage written comments on
the matters discussed in this IRFA. We
solicit comment on the number of small
entities subject to proposed new rule
223–1 and related amendments to rules
206(4)–2 and 204–2, and Form ADV, as
well as the potential impacts discussed
in this analysis; and whether the
proposal could have an effect on small
entities that has not been considered.
We request that commenters describe
the nature of any impact on small
entities and provide empirical data to
support the extent of such impact.
VI. Consideration of Impact on the
Economy
For purposes of the Small Business
Regulatory Enforcement Fairness Act of
1996, or ‘‘SBREFA,’’ 690 we must advise
OMB whether a proposed regulation
constitutes a ‘‘major’’ rule. Under
SBREFA, a rule is considered ‘‘major’’
where, if adopted, it results in or is
likely to result in (1) an annual effect on
the economy of $100 million or more;
(2) a major increase in costs or prices for
consumers or individual industries; or
(3) significant adverse effects on
competition, investment or innovation.
We request comment on the potential
effect of the proposed amendments on
the U.S. economy on an annual basis;
any potential increase in costs or prices
for consumers or individual industries;
and any potential effect on competition,
investment or innovation. Commenters
are requested to provide empirical data
and other factual support for their views
to the extent possible.
VII. Statutory Authority
The Commission is proposing new
rule 223–1 by a redesignation of rule
206(4)–2 of the Advisers Act under the
authority set forth in sections 206(4),
211(a), and 223 of the Advisers Act [15
U.S.C. 80b–6(4), 80b–11(a), and 80b–
23]. The Commission is proposing
corresponding amendments to rule 204–
2 under the Advisers Act under the
authority set forth in 206(4), 211(a), and
223 of the Advisers Act [15 U.S.C. 80b–
6(4), 80b–11(a), and 80b–23]. The
Commission is proposing to amend
Form ADV pursuant to the authority set
forth in sections 203(c)(1), 204, 211(a),
and 223 of the Advisers Act [15 U.S.C.
690 Public Law 104–121, Title II, 110 Stat. 857
(1996) (codified in various sections of 5 U.S.C., 15
U.S.C. and as a note to 5 U.S.C. 601).
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80b–3(c)(1), 80b–4, 80b–11(a), and 80b–
23].
List of Subjects in 17 CFR Parts 275 and
279
Reporting and recordkeeping
requirements; Securities.
Text of Proposed Rules and Rule and
Form Amendments
For the reasons set out in the
preamble, title 17, chapter II of the Code
of Federal Regulations is proposed to be
amended as follows:
PART 275—RULES AND
REGULATIONS, INVESTMENT
ADVISERS ACT OF 1940
1. The authority citation for part 275
is revised to read, in part, as follows:
■
Authority: 15 U.S.C. 80b–2(a)(11)(G), 80b–
2(a)(11)(H), 80b–2(a)(17), 80b–3, 80b–4, 80b–
4a, 80b–6(4), 80b–6a, and 80b–11, unless
otherwise noted.
*
*
*
*
*
Section 275.204–2 is also issued under 15
U.S.C. 80b–6.
*
*
*
*
*
Section 275.223–1 is also issued under 15
U.S.C. 80b–18b.
2. Amend § 275.204–2 by:
a. Removing and reserving paragraphs
(a)(8) and (a)(17)(iii).
■ b. Revising paragraph (b).
The revisions read as follows:
■
■
§ 275.204–2 Books and records to be
maintained by investment advisers.
*
*
*
*
*
(b) If an investment adviser subject to
paragraph (a) of this section is subject to
§ 275.223–1 (Rule 223–1) of this
chapter, the investment adviser shall
make and keep true, accurate, and
current the following books and records:
(1) Client communications. A copy of
all written client notifications required
under § 275.223–1(a)(2) (Rule 223–
1(a)(2)), and any responses thereto.
(2) Client accounts. For each client
account:
(i) Account identification. A record of
the advisory account name, client
contact information (including name,
mailing address, phone number, email
address), and advisory account number,
client type (as identified in Item 5.D of
Form ADV), or other identifying
information used by the investment
adviser to identify the account, and
copies of all account opening records.
The record must show the advisory
account inception date, whether the
investment adviser has discretionary
authority (as defined by § 275.223–
1(d)(4) (Rule 223–1(d)(4)) with respect
to any client assets in the account,
whether the investment adviser has
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authority to deduct advisory fees from
the account, and, if applicable, the
termination date of the account, asset
disposition upon termination, and the
reason for the termination.
(ii) Custodian identification. A record
that identifies and matches, for each
client of which the adviser has custody
of client assets, the account name and
account number, or any other
identifying information, from any
person or entity, including any qualified
custodian, that maintains client assets to
the corresponding advisory account
record for each client required by
paragraph (b)(2)(i) of this section. To the
extent applicable, the record must
contain a copy of the required written
agreement with each qualified custodian
under § 275.223–1(a)(1)(i) (Rule 223–
1(a)(1)(i)), including any amendments
thereto, and copies of all records
received from the qualified custodian
thereunder relating to client assets. The
record must also reflect the basis for the
reasonable assurances that the
investment adviser obtains from the
qualified custodian under § 275.223–
1(a)(1)(ii) (Rule 223–1(a)(1)(ii)). To the
extent applicable, the record must
contain a copy of the investment
adviser’s required written reasonable
determination that ownership of certain
specified client assets cannot be
recorded and maintained (book-entry,
digital, or otherwise) in a manner in
which a qualified custodian can
maintain possession or control (as
defined by § 275.223–1(d)(8) (Rule 223–
1(d)(8)) of such assets, as required under
§ 275.223–1(b)(2) (Rule 223–1(b)(2)).
(iii) Basis for being subject to Rule
223–1. A memorandum or other record
that indicates the basis of the
investment adviser’s custody (as defined
in § 275.223–1(d)(3) (Rule 223–1(d)(3))
of the client’s assets (as defined by
§ 275.223–1(d)(1) (Rule 223–1(d)(1)),
including whether a related person (as
defined by § 275.223–1(d)(11) (Rule
223–1(d)(11)) holds the investment
adviser’s client assets (or has any
authority to obtain possession of them)
in connection with the investment
adviser’s advisory services.
(iv) Account statements. Copies of
each account statement delivered by the
qualified custodian to the client and to
the investment adviser pursuant to
§ 275.223–1(a)(1)(i)(B) (Rule 223–
1(a)(1)(i)(B)), copies of any account
statement delivered by the investment
adviser to the client, including copies of
any account statement delivered by the
investment adviser to the client
containing the required notification
under § 275.223–1(a)(2) (Rule 223–
1(a)(2)). If the client is a pooled
investment vehicle, the record must also
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reflect the delivery of account
statements, notices, or financial
statements (as applicable) to all
investors in such client pursuant to
§ 275.223–1(c) (Rule 223–1(c)).
(v) Transaction and position
information.
(A) A detailed record of all trade and
transaction activity for each such client
account that includes the date and price
or amount of all purchases, sales,
receipts, deliveries (including one-way
delivery of assets, and free receipt and
delivery of securities and certificate
numbers, as applicable), deposits,
transfers, withdrawals, cash flows,
corporate action activity, maturities,
expirations, expenses, income posted to
the account, and all other debits and
credits to or from the account.
(B) Copies of confirmations of all
trades effected by or for the account of
each client that show the date and price
of each trade, and any instruction
received by the investment adviser
concerning transacting in the client’s
assets (as defined by Rule 223–1(d)(1)).
(C) A record for each asset (as defined
by Rule 223–1(d)(1)) in which each
client has a position, which record shall
show the name of such client having
any interest in such asset, the amount or
interest of such client, and the location
of such asset.
(D) A memorandum describing the
basis upon which the adviser has
determined that the presumption that
any related person is not operationally
independent under § 275.223–1(d)(7)
has been overcome.
(vi) Standing letters of authorization.
Copies of, and records relating to, any
standing letter of authorization (as
defined in § 275.223–1(d)(12) (Rule
223–1(d)(12)) issued by a client to the
investment adviser.
(2) Independent public accountant.
(i) Copies of all audited financial
statements prepared pursuant to
§ 275.223–1(b)(4) (Rule 223–1(b)(4)).
(ii) A copy of any internal control
report:
(A) Obtained by a qualified custodian
and received by an investment adviser
pursuant to § 275.223–1(a)(1)(i)(C) (Rule
223–1(a)(1)(i)(C)); and
(B) Obtained by the investment
adviser if the investment adviser is also
the client’s qualified custodian.
(iii) A copy of any written agreement
between the independent public
accountant and the investment adviser
or its client, as applicable, required
under Rule 223–1.
*
*
*
*
*
§ 275.206(4)–2
■
[Removed]
3. Section 275.206(4)–2 is removed.
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4. Section 275.223–1 is added to read
as follows:
■
§ 275.223–1
Safeguarding client assets.
(a) Safekeeping required. If you are an
investment adviser registered or
required to be registered under section
203 of the Act (15 U.S.C. 80b–3), you
shall take the following steps to
safeguard client assets of which you
have custody:
(1) Qualified custodian.
(i) Written agreement. A qualified
custodian must maintain possession or
control of your client’s assets pursuant
to a written agreement between you and
the qualified custodian (or between you
and the client if you are also the
qualified custodian) that must provide
the following provisions, which you
must reasonably believe have been
implemented:
(A) The qualified custodian will
promptly, upon request, provide records
relating to your clients’ assets held in
the account at the qualified custodian to
the Commission or to an independent
public accountant engaged for purposes
of complying with paragraph (a)(4),
(b)(1), or (b)(4) of this section;
(B) The qualified custodian will send
account statements, at least quarterly, to
the client, or its independent
representative, and to you, identifying
the amount of each client asset in the
account at the end of the period and
setting forth all transactions in the
account during that period, including
investment advisory fees. Such account
statements shall not identify assets for
which the qualified custodian lacks
possession or control, unless requested
by the client and the qualified custodian
clearly identifies any such assets that
appear on the account statement;
(C) At least annually, the qualified
custodian will obtain, and provide to
you a written internal control report that
includes an opinion of an independent
public accountant as to whether
controls have been placed in operation
as of a specific date, are suitably
designed, and are operating effectively
to meet control objectives relating to
custodial services (including the
safeguarding of the client assets held by
that qualified custodian during the
year), and
(1) If you are the qualified custodian,
or if the qualified custodian is a related
person, the independent public
accountant that prepares the internal
control report must verify that client
assets are reconciled to a custodian
other than you or your related person
and be registered with, and subject to
regular inspection as of the
commencement of the professional
engagement period, and as of each
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calendar year-end, by, the Public
Company Accounting Oversight Board
in accordance with its rules;
(D) Specifies your agreed-upon level
of authority to effect transactions in the
account as well as any applicable terms
or limitations, and permits you and the
client to reduce that authority; and
(ii) Reasonable assurances obtained
by adviser. You must obtain reasonable
assurances in writing from the qualified
custodian (or, if you are also the
qualified custodian, the written
agreement required by paragraph
(a)(1)(i) of this section must provide)
that the custodian will comply with the
following requirements, and you must
maintain an ongoing reasonable belief
that the custodian is complying with
these requirements:
(A) The qualified custodian will
exercise due care in accordance with
reasonable commercial standards in
discharging its duty as custodian and
will implement appropriate measures to
safeguard client assets from theft,
misuse, misappropriation, or other
similar type of loss;
(B) The qualified custodian will
indemnify the client (and will have
insurance arrangements in place that
will adequately protect the client)
against the risk of loss of the client’s
assets maintained with the qualified
custodian in the event of the qualified
custodian’s own negligence,
recklessness, or willful misconduct;
(C) The existence of any subcustodial, securities depository, or other
similar arrangements with regard to the
client’s assets will not excuse any of the
qualified custodian’s obligations to the
client;
(D) The qualified custodian will
clearly identify the client’s assets as
such, hold them in a custodial account,
and will segregate all client assets from
the qualified custodian’s proprietary
assets and liabilities; and
(E) The qualified custodian will 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.
(2) Notice to clients. If you open an
account with a qualified custodian on
your client’s behalf, you must promptly
notify the client, or its independent
representative, in writing of the
qualified custodian’s name, address,
and account number, and the manner in
which the client’s assets are maintained,
when the account is opened and
following any changes to this
information. If you send account
statements to a client to which you are
required to provide this notice, include
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in the notification provided to that
client and in any subsequent account
statement you send that client a
statement urging the client to compare
the account statements from the
custodian with those from the adviser.
(3) Segregation of client assets. The
client’s assets must:
(i) Be titled or registered in the
client’s name or otherwise held for the
benefit of that client;
(ii) Not be commingled with your
assets or your related persons’ assets;
and
(iii) Not be subject to any right,
charge, security interest, lien, or claim
of any kind in favor of you, your related
persons, or your creditors, except to the
extent agreed to or authorized in writing
by the client.
(4) Independent verification. The
client assets of which you have custody
are verified by actual examination at
least once during each calendar year by
an independent public accountant,
provided that, if you, or a related person
in connection with advisory services
you provide to clients, maintain client
assets pursuant to this section as a
qualified custodian, the independent
public accountant must be registered
with, and subject to regular inspection
as of the commencement of the
professional engagement period, and as
of each calendar year-end, by, the Public
Company Accounting Oversight Board
in accordance with its rules. The
independent verification must be
performed pursuant to a written
agreement between you and the
accountant, at a time that is chosen by
the accountant without prior notice or
announcement to you and that is
irregular from year to year. The written
agreement must provide for the first
examination to occur within six months
of becoming subject to this paragraph,
except that, if you maintain client assets
pursuant to this section as a qualified
custodian, the agreement must provide
for the first examination to occur no
later than six months after obtaining
your internal control report. The written
agreement, which you must reasonably
believe has been implemented, must
require the accountant to:
(i) File a certificate on Form ADV–E
(17 CFR 279.8) with the Commission
within 120 days of the time chosen by
the accountant in paragraph (a)(4) of
this section, stating that it has examined
the assets and describing the nature and
extent of the examination;
(ii) Upon finding any material
discrepancies during the course of the
examination, notify the Commission
within one business day of the finding,
by electronic means directed to the
Division of Examinations; and
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14781
(iii) Upon resignation or dismissal
from, or other termination of, the
engagement, or upon removing itself or
being removed from consideration for
being reappointed, file within four
business days Form ADV–E
accompanied by a statement that
includes:
(A) The date of such resignation,
dismissal, removal, or other
termination, and the name, address, and
contact information of the accountant;
and
(B) An explanation of any problems
relating to examination scope or
procedure that contributed to such
resignation, dismissal, removal, or other
termination.
(b) Exceptions.
(1) Shares of mutual funds. With
respect to shares of an open-end
company as defined in section 5(a)(1) of
the Investment Company Act of 1940
(15 U.S.C. 80a–5(a)(1)) (‘‘mutual fund’’),
you may use the mutual fund’s transfer
agent in lieu of a qualified custodian for
purposes of complying with paragraph
(a) of this section.
(2) Certain assets unable to be
maintained with a qualified custodian.
You are not required to comply with
paragraph (a)(1) of this section with
respect to client assets that are privately
offered securities or physical assets,
provided:
(i) You reasonably determine, and
document in writing, that ownership
cannot be recorded and maintained
(book-entry, digital, or otherwise) in a
manner in which a qualified custodian
can maintain possession or control of
such assets;
(ii) You reasonably safeguard the
assets from loss, theft, misuse,
misappropriation, or your financial
reverses, including your insolvency;
(iii) An independent public
accountant, pursuant to a written
agreement between you and the
accountant,
(A) verifies any purchase, sale, or
other transfer of beneficial ownership of
such assets, promptly, upon receiving
the notice required by paragraph
(b)(2)(iv) of this section; and
(B) notifies the Commission by
electronic means directed to the
Division of Examinations within one
business day upon finding any material
discrepancies during the course of
performing its procedures;
(iv) You notify the independent
public accountant engaged to perform
the verification required by paragraph
(b)(2)(iii) of this section of any purchase,
sale, or other transfer of beneficial
ownership of such assets within one
business day; and
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(v) The existence and ownership of
each of the client’s privately offered
securities or physical assets that are not
maintained with a qualified custodian
are verified during the annual
independent verification conducted
pursuant to paragraph (a)(4) of this
section or as part of a financial
statement audit performed pursuant to
paragraph (b)(4) of this section.
(3) Fee deduction. Notwithstanding
paragraph (a)(4) of this section, you are
not required to obtain an independent
verification of client assets maintained
by a qualified custodian if:
(i) You have custody of the client
assets solely as a consequence of your
authority to make withdrawals from
client accounts to pay your advisory fee;
(ii) If the qualified custodian is a
related person, you can rely on
paragraph (b)(6) of this section.
(4) Entities subject to annual audit.
You are not required to comply with
paragraphs (a)(1)(i)(B) and (a)(2) of this
section and you shall be deemed to have
complied with paragraphs (a)(4) of this
section with respect to the account of a
limited partnership (or limited liability
company, or another type of pooled
investment vehicle or any other entity)
if it undergoes a financial statement
audit as follows at least annually and
upon liquidation:
(i) The audit is performed by an
independent public accountant that is
registered with, and subject to regular
inspection as of the commencement of
the professional engagement period, and
as of each calendar year-end, by, the
Public Company Accounting Oversight
Board in accordance with its rules;
(ii) The audit meets the definition in
17 CFR 210.1–02(d) (Rule 1–02(d) of
Regulation S–X), the professional
engagement period of which shall begin
and end as indicated in Regulation S–
X Rule 2–01(f)(5); and
(iii) Audited financial statements are
prepared in accordance with U.S.
Generally Accepted Accounting
Principles (‘‘U.S. GAAP’’) or, in the case
of financial statements of entities
organized under non-U.S. law or that
have a general partner or other manager
with a principal place of business
outside the United States, contain
information substantially similar to
statements prepared in accordance with
U.S. GAAP and material differences
with U.S. GAAP are reconciled;
(iv) Within 120 days (or 180 days in
the case of a fund of funds or 260 days
in the case of a fund of funds of funds)
of an entity’s fiscal year end, the entity’s
audited financial statements, including
any reconciliations to U.S. GAAP or
supplementary U.S. GAAP disclosures,
as applicable, are distributed to
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investors in the entity (or their
independent representatives); and
(v) Pursuant to a written agreement
between the independent public
accountant and the adviser or the entity,
the independent public accountant that
completes the audit notifies the
Commission by electronic means
directed to the Division of
Examinations:
(A) Within one business day of
issuing an audit report to the entity that
contains a modified opinion, and
(B) Within four business days of
resignation or dismissal from, or other
termination of, the engagement, or upon
removing itself or being removed from
consideration for being reappointed.
(5) Registered investment companies.
You are not required to comply with
this section [(17 CFR 275.223–1)] with
respect to the account of an investment
company registered under the
Investment Company Act of 1940 (15
U.S.C. 80a–1 to 80a–64).
(6) Certain related persons.
Notwithstanding paragraph (a)(4) of this
section, you are not required to obtain
an independent verification of client
assets if:
(i) You have custody under this rule
solely because a related person holds,
directly or indirectly, client assets, or
has any authority to obtain possession
of them, in connection with advisory
services you provide to clients; and
(ii) Your related person is
operationally independent of you.
(7) Standing letters of authorization.
Notwithstanding paragraph (a)(4) of this
section, you are not required to obtain
an independent verification of client
assets if you have custody of client
assets solely because of a standing letter
of authorization.
(8) Discretionary authority.
Notwithstanding paragraph (a)(4) of this
section, you are not required to obtain
an independent verification of client
assets if you have custody of client
assets solely because you have
discretionary authority with respect to
those assets, provided this exception
applies only for client assets that are
maintained with a qualified custodian
in accordance with paragraph (a)(1) of
this rule and for accounts where your
discretionary authority is limited to
instructing your client’s qualified
custodian to transact in assets that settle
exclusively on a delivery versus
payment basis.
(9) Reliance on multiple exceptions.
Notwithstanding the use of ‘‘solely’’ in
paragraphs (b)(3), (b)(6), (b)(7), and
(b)(8) of this section, the exceptions in
paragraphs (b)(3), (b)(6), (b)(7), and
(b)(8) of this section are not mutually
exclusive.
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(c) Delivery to pooled investment
vehicle clients. To satisfy the
requirements of paragraph (a)(1), (a)(2),
(b)(1), or (b)(4), the account statements,
notices, or financial statements (as
applicable) must be sent to all of the
investors in each pooled investment
vehicle client, provided that, if an
investor is a pooled investment vehicle
that is controlling, controlled by, or
under common control with (‘‘a control
relationship’’) you or your related
persons, the sender must look through
that pool (and any pools in a control
relationship with you or your related
persons) in order to send to investors in
those pools.
(d) Definitions. For the purposes of
this section:
(1) Assets means funds, securities, or
other positions held in the client’s
account.
(2) Control means the power, directly
or indirectly, to direct the management
or policies of a person, whether through
ownership of securities, by contract, or
otherwise. Control includes:
(i) Each of your firm’s officers,
partners, or directors exercising
executive responsibility (or persons
having similar status or functions) is
presumed to control your firm;
(ii) A person is presumed to control
a corporation if the person:
(A) Directly or indirectly has the right
to vote 25 percent or more of a class of
the corporation’s voting securities; or
(B) Has the power to sell or direct the
sale of 25 percent or more of a class of
the corporation’s voting securities;
(C) A person is presumed to control
a partnership if the person has the right
to receive upon dissolution, or has
contributed, 25 percent or more of the
capital of the partnership;
(D) A person is presumed to control
a limited liability company if the
person:
(1) Directly or indirectly has the right
to vote 25 percent or more of a class of
the interests of the limited liability
company;
(2) Has the right to receive upon
dissolution, or has contributed, 25
percent or more of the capital of the
limited liability company; or
(3) Is an elected manager of the
limited liability company; or
(E) A person is presumed to control a
trust if the person is a trustee or
managing agent of the trust.
(3) Custody means holding, directly or
indirectly, client assets, or having any
authority to obtain possession of them.
You have custody if a related person
holds, directly or indirectly, client
assets, or has any authority to obtain
possession of them, in connection with
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advisory services you provide to clients.
Custody includes:
(i) Possession of client assets (but not
of checks drawn by clients and made
payable to third parties) unless you
receive them inadvertently and you
return them to the sender promptly but
in any case within three business days
of receiving them;
(ii) 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; and
(iii) Any capacity (such as general
partner of a limited partnership,
managing member of a limited liability
company or a comparable position for
another type of pooled investment
vehicle, or trustee of a trust) that gives
you or your supervised person legal
ownership of or access to client assets.
(4) Discretionary authority means the
authority to decide which assets to
purchase and sell for the client.
(5) Independent public accountant
means a public accountant that meets
the standards of independence
described in 17 CFR 210.2–01 (rule 2–
01 of Regulation S–X).
(6) Independent representative means
a person that:
(i) Acts as agent for an advisory client,
including in the case of a pooled
investment vehicle, for limited partners
of a limited partnership (or members of
a limited liability company, or other
beneficial owners of another type of
pooled investment vehicle) and by law
or contract is obliged to act in the best
interest of the advisory client or the
limited partners (or members, or other
beneficial owners);
(ii) Does not control, is not controlled
by, and is not under common control
with you; and
(iii) Does not have, and has not had
within the past two years, a material
business relationship with you.
(7) Operationally independent: for
purposes of paragraph (b)(6) of this
section, a related person is presumed
not to be operationally independent
unless each of the following conditions
is met and no other circumstances can
reasonably be expected to compromise
the operational independence of the
related person:
(i) Client assets in the custody of the
related person are not subject to claims
of the adviser’s creditors;
(ii) Advisory personnel do not have
custody or possession of, or direct or
indirect access to client assets of which
the related person has custody, or the
power to control the disposition of such
client assets to third parties for the
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benefit of the adviser or its related
persons, or otherwise have the
opportunity to misappropriate such
client assets;
(iii) Advisory personnel and
personnel of the related person who
have access to advisory client assets are
not under common supervision; and
(iv) Advisory personnel do not hold
any position with the related person or
share premises with the related person.
(8) Possession or control means
holding assets such that the qualified
custodian is required to participate in
any change in beneficial ownership of
those assets, the qualified custodian’s
participation would effectuate the
transaction involved in the change in
beneficial ownership, and the qualified
custodian’s involvement is a condition
precedent to the change in beneficial
ownership.
(9) Privately offered securities means
securities:
(i) Acquired from the issuer in a
transaction or chain of transactions not
involving any public offering;
(ii) That are uncertificated; and the
ownership of which can only be
recorded on the non-public books of the
issuer or its transfer agent in the name
of the client as it appears in the records
you are required to keep under Rule
204–2; and
(iii) That are transferable only with
prior consent of the issuer or holders of
the outstanding securities of the issuer.
(10) Qualified custodian means:
(i) A bank as defined in section
202(a)(2) of the Advisers Act (15 U.S.C.
80b–2(a)(2)) or a savings association as
defined in section 3(b)(1) of the Federal
Deposit Insurance Act (12 U.S.C.
1813(b)(1)) that has deposits insured by
the Federal Deposit Insurance
Corporation under the Federal Deposit
Insurance Act (12 U.S.C. 1811),
provided that the bank or savings
association holds the client assets in an
account designed to protect such assets
from creditors of the bank or savings
association in the event of the
insolvency or failure of the bank or
savings association;
(ii) A broker-dealer registered under
section 15(b)(1) of the Securities
Exchange Act of 1934 (15 U.S.C.
78o(b)(1)), holding the client assets in
customer accounts;
(iii) A futures commission merchant
registered under section 4f(a) of the
Commodity Exchange Act (7 U.S.C.
6f(a)), holding the client assets in
customer accounts, but only with
respect to clients’ funds and security
futures, or other securities incidental to
transactions in contracts for the
purchase or sale of a commodity for
future delivery and options thereon; and
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(iv) A foreign financial institution
that:
(A) Is incorporated or organized under
the laws of a country or jurisdiction
other than the United States, provided
that you and the Commission are able to
enforce judgments, including civil
monetary penalties, against the foreign
financial institution;
(B) Is regulated by a foreign country’s
government, an agency of a foreign
country’s government, or a foreign
financial regulatory authority as defined
in section 202(a)(24) of the Investment
Advisers Act of 1940 [15 U.S.C. 80b–
2(a)(24)] as a banking institution, trust
company, or other financial institution
that customarily holds financial assets
for its customers;
(C) Is required by law to comply with
anti-money laundering and related
provisions similar to those of the Bank
Secrecy Act [31 U.S.C. 5311, et seq.] and
regulations thereunder;
(D) Holds financial assets for its
customers in an account designed to
protect such assets from creditors of the
foreign financial institution in the event
of the insolvency or failure of the
foreign financial institution;
(E) Has the requisite financial strength
to provide due care for client assets;
(F) Is required by law to implement
practices, procedures, and internal
controls designed to ensure the exercise
of due care with respect to the
safekeeping of client assets; and
(G) Is not operated for the purpose of
evading the provisions of this rule 223–
1.
(11) Related person means any
person, directly or indirectly,
controlling or controlled by you, and
any person that is under common
control with you.
(12) Standing letter of authorization
means an arrangement among you, the
client, and the client’s qualified
custodian in which you are authorized,
in writing, to direct the qualified
custodian to transfer assets to a thirdparty recipient on a specified schedule
or from time to time, provided:
(i) The client’s qualified custodian is
not your related person;
(ii) The client’s authorization includes
the client’s signature, the third-party
recipient’s name, and either its address
or account number at a custodian to
which the transfer should be directed;
and
(iii) You have no ability or authority
to designate or change any information
about the third-party recipient,
including name, address, and account
number.
(13) U.S. generally accepted
accounting principles (U.S. GAAP)
means accounting principles recognized
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by the Commission as generally
accepted in accordance with section
19(b) of the Securities Act of 1933 (15
U.S.C. 77s).
PART 279—FORMS PRESCRIBED
UNDER THE INVESTMENT ADVISERS
ACT OF 1940
5. The authority citation for part 279
continues to read as follows:
■
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Authority: The Investment Advisers Act of
1940, 15 U.S.C. 80b–1, et seq., Pub. L. 111–
203, 124 Stat. 1376.
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6. Amend Form ADV (referenced in
§ 279.1) by:
■ a. In General Instructions, revising the
second sub-bullet point paragraph to the
first bullet point paragraph under
Instruction 4 related to Other-thanannual amendments;
■ b. In Glossary of Terms, revising the
definitions of items 12 (Custody) and 13
(Discretionary Authority or
Discretionary Basis);
■ c. In Glossary of Terms, add new
items defining the terms Assets,
■
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Operationally Independent, Qualified
Custodian, and Standing Letter of
Authorization and redesignating the
items accordingly;
■ d. In Part 1A, revising Item 9;
■ e. In Schedule D, adding section 9.C.1;
and revising section 9.C.3.
The additions and revisions read as
follows:
Note: The text of Form ADV does not, and
this amendment will not, appear in the Code
of Federal Regulations.
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*
*
Federal Register / Vol. 88, No. 46 / Thursday, March 9, 2023 / Proposed Rules
*
*
Dated: February 15, 2023.
Vanessa A. Countryman,
Secretary.
*
By the Commission.
[FR Doc. 2023–03681 Filed 3–8–23; 8:45 am]
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BILLING CODE 8011–01–P
]]>Agencies
[Federal Register Volume 88, Number 46 (Thursday, March 9, 2023)]
[Proposed Rules]
[Pages 14672-14792]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2023-03681]
[[Page 14671]]
Vol. 88
Thursday,
No. 46
March 9, 2023
Part II
Securities and Exchange Commission
-----------------------------------------------------------------------
17 CFR Parts 275 and 279
Safeguarding Advisory Client Assets; Proposed Rule
Federal Register / Vol. 88 , No. 46 / Thursday, March 9, 2023 /
Proposed Rules
[[Page 14672]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 275 and 279
[Release No. IA-6240; File No. S7-04-23]
RIN 3235-AM32
Safeguarding Advisory Client Assets
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
-----------------------------------------------------------------------
SUMMARY: The Securities and Exchange Commission (``Commission'' or
``SEC'') is proposing a new rule under the Investment Advisers Act of
1940 (``Advisers Act'' or ``Act'') to address how investment advisers
safeguard client assets. To effect our redesignation of the current
custody rule for the proposed new safeguarding rule, we are proposing
to renumber the current rule. In addition we are proposing to amend
certain provisions of the current custody rule for enhanced investor
protections. We also are proposing corresponding amendments to the
recordkeeping rule under the Advisers Act and to Form ADV for
investment adviser registration under the Advisers Act.
DATES: Comments should be received on or before May 8, 2023.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (https://www.sec.gov/rules/submitcomments.html); or
Send an email to [email protected]. Please include
File Number S7-04-23 on the subject line.
Paper Comments
Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-1090.
All submissions should refer to File Number S7-04-23. This file number
should be included on the subject line if email is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
website (https://www.sec.gov/rules/proposed.shtml). Comments are also
available for website viewing and printing in the Commission's Public
Reference Room, 100 F Street NE, Washington, DC 20549, on official
business days between the hours of 10 a.m. and 3 p.m. Operating
conditions may limit access to the Commission's Public Reference Room.
All comments received will be posted without change. Persons submitting
comments are cautioned that the Commission does not redact or edit
personal identifying information from comment submissions. You should
submit only information that you wish to make available publicly.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: Shane Cox, Laura Harper Powell,
Michael Schrader, and Samuel Thomas, Senior Counsels; Holly H. Miller,
Senior Financial Analyst; Alex Bradford and Michael Republicano,
Assistant Chief Accountants; Christopher Staley, Branch Chief; and
Melissa Roverts Harke, Assistant Director at (202) 551- 6787 or
[email protected], Investment Adviser Regulation Office, Division of
Investment Management, Securities and Exchange Commission, 100 F Street
NE, Washington, DC 20549.
SUPPLEMENTARY INFORMATION: The Commission is proposing for public
comment to amend and renumber 17 CFR 275.206(4)-2 (rule 206(4)-2) under
the Investment Advisers Act of 1940 [15 U.S.C. 80b-1 et seq.] to
redesignate it as rule 17 CFR 275.223-1 (rule 223-1) under the Advisers
Act, and make corresponding amendments to 17 CFR 275.204-2 (rule 204-2)
and 17 CFR 279.1 (Form ADV) under the Advisers Act.\1\
---------------------------------------------------------------------------
\1\ 15 U.S.C. 80b. Unless otherwise noted, when we refer to the
Advisers Act, or any section of the Advisers Act, we are referring
to 15 U.S.C. 80b, at which the Advisers Act is codified, and when we
refer to rules under the Advisers Act, or any section of these
rules, we are referring to title 17, part 275 of the Code of Federal
Regulations [17 CFR 275], in which these rules are published.
---------------------------------------------------------------------------
Table of Contents
I. Introduction
A. Background
B. Overview of the Proposal
II. Discussion
A. Scope of Rule
1. Scope of Assets
2. Scope of Activity Subject to the Proposed Rule
B. Qualified Custodian Protections
1. Definition of Qualified Custodian
2. Possession or Control
3. Minimum Custodial Protections
C. Certain Assets That Are Unable To Be Maintained With a
Qualified Custodian
1. Definition of Privately Offered Security and Physical Assets
2. Adviser's Reasonable Determination
3. Adviser Reasonably Safeguards Assets
4. Notification and Prompt Independent Public Accountant
Verification
5. Surprise Examination or Audit
D. Segregation of Client Assets
E. Investment Adviser Delivery of Notice to Clients
F. Amendments to the Surprise Examination Requirement
G. Exceptions from the Surprise Examination
1. Entities Subject to Audit (``Audit Provision'')
2. Discretionary Authority
3. Standing Letters of Authorization
H. Amendments to the Investment Adviser Recordkeeping Rule
1. Client Communications
2. Client Accounts
3. Account Activity
4. Independent Public Accountant Engagements
5. Standing Letters of Authorization
I. Changes to Form ADV
J. Existing Staff No-Action Letters and Other Staff Statements
K. Transition Period and Compliance Date
III. Economic Analysis
A. Introduction
B. Broad Economic Considerations
C. Baseline
1. Current Regulation
2. Affected Parties and Industry Statistics
3. Market Practice
D. Benefits and Costs of Proposed Rule and Form Amendments
1. Scope
2. Qualified Custodian Protections
3. Certain Assets That Are Unable To Be Maintained With a
Qualified Custodian
4. Segregation of Investments
5. Investment Adviser Delivery of Notice to Clients
6. Exceptions From the Surprise Examination
7. Amendments to the Investment Adviser Recordkeeping Rule
8. Changes to Form ADV
E. Efficiency, Competition, and Capital Formation
F. Reasonable Alternatives
1. Scope of Assets
2. Elimination of Privately Offered Securities Exception
3. Distribution of Requirements Across Reasonable Assurances and
Written Agreement
3. Additional Accounting and Client Notification Requirements
for Privately Offered Securities and Physical Assets That Are Not
Maintained With a Qualified Custodian
4. Additional Safeguards When Clients Assets Are Not Maintained
With a Qualified Custodian
5. Designating Clearing Agencies and Transfer Agents as
Qualified Custodians
G. Request for Comment
IV. Paperwork Reduction Act Analysis
A. Introduction
B. Rule 223-1
1. Qualified Custodian Provision
2. Notice to Clients
3. Annual Surprise Examination
C. Exceptions
[[Page 14673]]
1. Certain Assets That Are Unable To Be Maintained With a
Qualified Custodian
2. Audit Provision
D. Total Hour Burden Associated With Proposed Rule 223-1
E. Rule 204-2
F. Form ADV
G. Request for Comments
V. Initial Regulatory Flexibility Analysis
A. Reason for and Objectives of the Proposed Action
1. Proposed Rule 223-1
2. Proposed Rule 204-2
3. Proposed Amendments to Form ADV
B. Legal Basis
C. Small Entities Subject to the Rule and Rule Amendments
1. Small Entities Subject to Amendments to the Custody Rule
D. Projected Reporting, Recordkeeping and Other Compliance
Requirements
1. Proposed Rule 223-1
2. Proposed Amendments to Rule 204-2
3. Proposed Amendments to Form ADV
E. Duplicative, Overlapping, or Conflicting Federal Rules
F. Significant Alternatives
1. Proposed New Rule 223-1 and Amendments to Rule 204-2 and Form
ADV
G. Solicitation of Comments
VI. Consideration of Impact on the Economy
VII. Statutory Authority
I. Introduction
A. Background
Rule 206(4)-2 under the Act (the ``custody rule'' or ``current
rule'') regulates the custodial practices of advisers. Although the
Commission has amended the rule over time as custodial and advisory
practices have changed, since its adoption it has been designed to
safeguard client funds and securities from the financial reverses,
including insolvency, of an investment adviser and to prevent client
assets from being lost, misused, stolen, or misappropriated.\2\
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\2\ See Custody or Possession of Funds or Securities of Clients,
Investment Advisers Act Release No. 123 (Feb. 27, 1962) [44 FR 2149
(Mar. 6, 1962)] (``1962 Adopting Release''). See also Custody of
Funds or Securities of Clients by Investment Advisers, Investment
Advisers Act Release No. 2176 (Sept. 25, 2003) [68 FR 56692 (Oct. 1,
2003)] (``2003 Adopting Release''); Custody of Funds or Securities
of Clients by Investment Advisers, Investment Advisers Act Release
No. 2044 (Jul. 18, 2002) [67 FR 48579 (Jul. 25, 2002)], at nn. 3, 15
(``2002 Proposing Release'').
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As originally adopted in 1962, the rule required all investment
advisers with ``custody'' (i.e., physical possession) of client funds
and securities to deposit client funds in a bank account that was
maintained in the adviser's name and contained only client funds.\3\
Advisers, in addition, were required to segregate client securities and
hold them in a ``reasonably safe'' place. In each case, the rule
required investment advisers to provide their clients notice of these
protocols and to engage an independent public accountant to conduct an
annual surprise examination \4\ to verify client funds and securities
independently. These requirements were designed to protect client
assets at a time when the system for owning and transacting in
securities was paper-based.
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\3\ As with the current rule, the proposed amendments would
apply to investment advisers registered, or required to be
registered, with the Commission. However, the original rule was
broader in scope, applying to ``all investment advisers,'' until it
was amended in 1997. Rules Implementing Amendments to the Investment
Advisers Act of 1940, Investment Advisers Act Release No. 1633 (May
15, 1997) [62 FR 28112 (May 22, 1997)], at section II.I.5. Unless
otherwise indicated, references throughout this release to
``adviser'' or ``investment adviser'' refer to investment advisers
registered, or required to be registered, with the Commission.
Further, we have previously stated, and would continue to take the
position (if these amendments were adopted), that most of the
substantive provisions of the Advisers Act do not apply with respect
to the non-U.S. clients (including funds) of a registered offshore
adviser. This approach was designed to provide appropriate
flexibility where an adviser has its principal office and place of
business outside of the United States. We believe it would be
appropriate to continue to apply this approach, including in the
proposed safeguarding rule context (if adopted). For an adviser
whose principal office and place of business is in the United States
(onshore adviser), the Advisers Act and rules thereunder, including
the proposed safeguarding rule, would apply with respect to the
adviser's U.S. and non-U.S. clients. See Exemptions for Advisers to
Venture Capital Funds, Private Fund Advisers With Less Than $150
Million in Assets Under Management, and Foreign Private Advisers,
Release No. IA-3222 (June 22, 2011) [76 FR 39645 (July 6, 2011)]
(Most of the substantive provisions of the Advisers Act do not apply
to the non-U.S. clients of a non-U.S. adviser registered with the
Commission.); Registration Under the Advisers Act of Certain Hedge
Fund Advisers, Release No. IA-2333 (Dec. 2, 2004) [69 FR 72054,
72072 (Dec. 10, 2004)] (``Hedge Fund Adviser Release'') (stating (1)
that the following rules under the Advisers Act would not apply to a
registered offshore adviser, assuming it has no U.S. clients:
compliance rule, custody rule, and proxy voting rule; (2) stating
that the Commission would not subject an offshore adviser to the
rules governing adviser advertising [17 CFR 275.206(4)-1] or cash
solicitations [17 CFR 275.206(4)-3] with respect to offshore
clients; and (3) noting that U.S. investors in an offshore fund
generally would not expect the full protection of the U.S.
securities laws and that U.S. investors may be precluded from an
opportunity to invest in an offshore fund if their participation
would result in full application of the Advisers Act and rules
thereunder, but that a registered offshore adviser would be required
to comply with the Advisers Act and rules thereunder with respect to
any U.S. clients it may have).
\4\ The terms ``surprise examination'' and ``independent
verification'' are used throughout the release and are generally
interchangeable.
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The Commission amended the rule in 2003 to expand the definition of
custody beyond physical possession to include situations in which an
adviser had any ability to obtain possession of client funds or
securities. The 2003 amendments made clear that the rule applied to any
investment adviser ``holding, directly or indirectly, client funds or
securities, or having any authority to obtain possession of them.'' \5\
It included three illustrative examples in the rule's definition of
``custody'': (1) possession of client funds or securities, even
briefly; (2) authority to withdraw funds or securities from a client's
account; and (3) any capacity that gives the adviser legal ownership
of, or access to, client funds or securities.\6\ In the adopting
release, the Commission stated this expansion of the concept of adviser
custody would not include authorized trading, however, stating that
clients' custodians are generally under instructions to transfer funds
or securities out of a client's account only upon a corresponding
transfer of securities or funds into the account.\7\
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\5\ See rule 206(4)-2(a). See also rule 206(4)-2(d)(v)(2)
(defining ``custody''). The original rule did not define
``custody,'' which was conceptualized at that time as limited to
physically holding securities.
\6\ See id.
\7\ See 2003 Adopting Release, supra footnote 2, at note 10 and
accompanying text.
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In recognition of then-modern custodial practices, the Commission
in 2003 required advisers to keep securities (not just funds as under
the 1962 rule) with a custodian, and it expanded the types of
custodians that would qualify under the rule.\8\ The Commission
expressed concern that some advisers were still keeping certificates in
office files or safety deposit boxes, which put those securities at
risk.\9\ The Commission identified as ``qualified custodians'' the
types of regulated financial institutions that customarily provided
custodial services subject to regulatory examination.\10\ The
Commission also relied more on the protections of qualified custodians,
eliminating the adviser's need to undergo the rule's annual surprise
examination by an independent public accountant if the adviser had a
``reasonable belief'' that the qualified custodian would provide
account statements directly to the adviser's clients. The Commission
provided an exception, however, from the requirement to maintain client
securities with a qualified custodian after commenters had pointed out
that, on occasion, a client may purchase privately offered securities
where the only evidence of the client's ownership was recorded on the
issuer's books and
[[Page 14674]]
the transfer of ownership requires the consent of the issuer or the
holders of the issuer's outstanding securities. As a result, commenters
argued that it was difficult to maintain certain of these assets in
accounts with qualified custodians. The Commission noted that these
impediments to transferability along with the conditions it imposed in
the privately offered securities exception (``privately offered
securities exception''), including in some cases obtaining and
distributing audited financial statements (``the audit provision''),
provided external safeguards against the kinds of abuse the rule seeks
to prevent.
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\8\ See 2003 Adopting Release supra footnote 2, at section I.
\9\ See 2002 Proposing Release, supra footnote 2, at section
II.B.
\10\ The financial institutions identified by the Commission
were broker-dealers, banks and savings associations, futures
commission merchants, and certain foreign financial institutions.
See 2003 Adopting Release at II.B.
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The Commission most recently amended the rule in 2009 after several
enforcement actions against investment advisers, including actions
stemming from the frauds perpetrated by Bernard Madoff and Allen
Stanford (which also resulted in criminal convictions), alleging
fraudulent conduct that included, among other things, misappropriation
or other misuse of client assets involving certain affiliates of the
adviser.\11\ These cases underlined additional risks both when an
adviser has access to client funds or securities not explicitly covered
within the scope of the rule, as well as when the qualified custodian
is a related person of the adviser. In direct response to certain of
these cases, the 2009 amendments explicitly extended the scope of the
rule to reach an adviser's ability to access client funds or securities
through its related persons, expanded the circumstances in which a
surprise examination is necessary, and required advisers to obtain an
independent accountant's report evaluating internal controls related to
custody where the adviser or its related person serves as qualified
custodian.\12\
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\11\ See Custody of Funds or Securities of Clients by Investment
Advisers, Investment Advisers Act Release No. 2968 (Dec. 30, 2009)
[75 FR 1455 (Jan. 11, 2010)], at n.1 (``2009 Adopting Release'')
(referring to the cases cited in Custody of Funds or Securities of
Clients by Investment Advisers, Investment Advisers Act Release No.
2876 (May 20, 2009) [74 FR 25353 (May 27, 2009)] (``2009 Proposing
Release'')). See also Judgment, ECF Doc No. 100, 4, United States v.
Madoff, No. 09 Cr. 213 (S.D.N.Y. June 29, 2009) (Bernard L. Madoff
pled guilty to eleven felony charges including securities fraud,
investment adviser fraud, mail fraud, wire fraud, three counts of
money laundering, false statements, perjury, and making false
filings with the SEC); Order Granting Motion for Summary Judgment,
SEC v. Stanford International Bank, Ltd., et al., Civil Action No.
3:09-CV0298 (N.D. Tex. Apr. 25, 2013) (the SEC obtained a $5.9
billion judgment against R. Allen Stanford who was convicted in a
parallel criminal case of conspiracy to commit mail and wire fraud,
four counts of wire fraud, five counts of mail fraud, one count of
conspiracy to obstruct an SEC investigation, one count of
obstruction of an SEC proceeding, and one count of conspiracy to
commit money laundering and sentenced to a total of 110 years in
prison); SEC v. WG Trading Investors, L.P., 09-CV-1750 (S.D.N.Y.
July 29, 2010) (involving a broker-dealer and affiliated registered
adviser that orchestrated a fraudulent investment scheme
misappropriating as much as $554 million and sending clients
misleading account information); Isaac I. Ovid, SEC Admin.
Proceeding No. 3-14313 (Mar. 30 2011) (registered investment adviser
and manager of purported hedge funds, pled guilty in parallel
criminal proceeding in connection with which he was required to pay
restitution in excess of $12 million); Young and Acorn Capital
Management, LLC, SEC Admin. Proceeding No. 3-14654 (Feb. 28 2012)
(registered investment adviser and its principal convicted of
misappropriating $95 million in a Ponzi scheme in a parallel
criminal case whereupon the SEC issued an order revoking the
adviser's registration and barred the principal from association
with an investment adviser, broker, dealer, municipal securities
dealer, or transfer agent); SEC v. The Nutmeg Group, LLC, et al.,
Litigation Release No. 24677 (Nov. 26, 2019) (commingled investor
funds with his personal assets, implemented flawed internal systems
and methods for valuing and reporting assets under management, and
transferred millions of dollars out of the investment pools to
himself and companies controlled by family members).
\12\ See generally rule 206(4)-2; see also 2009 Adopting
Release, supra footnote 11, at sections II.A and B.
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Following the Madoff and Stanford frauds, and on the heels of the
Commission's recently adopted 2009 amendments to the custody rule,
Congress expressly vested the Commission with authority to promulgate
rules requiring registered advisers to take steps to safeguard client
assets over which advisers have custody by adding section 223 to the
Advisers Act in the Dodd-Frank Wall Street Reform and Consumer
Protection Act (``Dodd-Frank Act'').\13\ Leading up to the enactment of
the Dodd-Frank Act, Congress heard testimony that certain client
investments were not covered by the custody rule because they were
neither funds nor securities, putting them at greater risk of loss,
theft, misappropriation, or being subject to the financial reverses of
an adviser.\14\ Congress also heard testimony about the important role
requiring advisers to maintain client funds and securities with
qualified custodians has in preventing fraud--a requirement that
applies only if an adviser is subject to the custody rule and the
assets are not subject to an exception from the qualified custodian
requirement.\15\ Subsequently, Congress authorized the Commission to
prescribe rules requiring advisers to take steps to safeguard all
client assets, not just funds and securities, over which an adviser has
custody.\16\
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\13\ See section 411 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010)
(adding section 223 to the Advisers Act which provides ``[a]n
investment adviser registered under this subchapter shall take such
steps to safeguard client assets over which such adviser has
custody, including, without limitation, verification of such assets
by an independent public accountant, as the Commission may, by rule,
prescribe.'' 15 U.S.C. 80b-18b). Congress also required the U.S.
Government Accountability Office to study the rule's compliance
costs. See id. at section 412.
\14\ See Regulating Hedge Funds and other Private Investment
Pools, Hearing Before the House Subcommittee on Securities,
Insurance, and Investment, 111 Cong. 50-51 (2009) (Statement of
James S. Chanos, Chairman, Coalition of Private Investment
Companies) (stating that the current rule's scope--which was ``funds
and securities'' and with an exception from certain protections for
privately offered securities--excluded assets such as privately
issued uncertificated securities, bank deposits, real estate assets,
swaps, and interests in other private investment funds leaving a
``gaping hole'' in the rule) (``Dodd Frank Regulating Hedge Funds
and other Private Investment Pools Testimony by James S. Chanos'').
Congress also heard testimony about the benefits qualified
custodians provide in preventing fraud. See id. (``Requiring
independence between the function of managing a private investment
fund and controlling its assets, by requiring that all assets be
titled in the name of a custodian bank or broker-dealer for the
benefit of the private fund and requiring all cash flows to move
through the independent custodian, would be an important control.
Similarly, requiring an independent check on the records of
ownership of the interests in the private investment fund, as well
as imposing standards for the qualification of private investment
fund auditors--neither of which currently is required by the
Advisers Act--would also greatly reduce opportunities for
mischief.'').
\15\ See S. Rep. No. 111-176, at 77 (2010) (``the custodian
requirement largely removes the ability of an investment adviser to
pay the proceeds invested by new investors to old investors. The
custodian will take the instructions to buy or sell securities, but
not to remit the proceeds of sales to the adviser or to others
(except in return for share redemptions by investors). At a stroke,
this requirement eliminates the ability of the manager to `recycle'
funds from new to old investors.'' quoting Testimony of Professor
John C. Coffee, Jr.; The Madoff Investment Securities Fraud:
Regulatory and Oversight Concerns and the Need for Reform: Testimony
before the U.S. Senate Committee on Banking, Housing and Urban
Affairs, 111th Congress, 1st session, pp. 8, 10 (2009)).
\16\ Earlier versions of this bill show that Congress considered
retaining the current rule's funds and securities formulation. See
Investor Protection Act of 2009, H.R. 3817, 111th Cong section 419
(2009).
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In addition to this legislative context, industry developments
prompt us again to reconsider the important prophylactic protections of
the custody rule and to address certain gaps in protections--some of
which Congress identified and gave us the tools to address 13 years
ago.\17\ We have seen changes in
[[Page 14675]]
technology, advisory services, and custodial practices create new and
different ways for client assets to be placed at risk of loss, theft,
misuse, or misappropriation that may not be fully addressed under the
current rule.
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\17\ The current rule has also been the subject of numerous
inquiries and requests for staff views. See, e.g., Staff Responses
to Questions about the Custody Rule (``Custody Rule FAQs''),
available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm; Privately Offered Securities under the
Investment Advisers Act Custody Rule, Division of Investment
Management Guidance Update No. 2013-04 (Aug. 2013) (``2013 IM
Guidance''); Private Funds and Application of the Custody Rule to
Special Purpose Vehicles and Escrows, Division of Investment
Management Guidance Update No. 2014-07 (June 2014) (``2014 IM
Guidance''). Staff reports, statistics, and other staff documents
(including those cited herein) represent the views of Commission
staff and are not a rule, regulation, or statement of the
Commission. Furthermore, the Commission has neither approved nor
disapproved these documents and, like all staff statements, they
have no legal force or effect, do not alter or amend applicable law,
and create no new or additional obligations for any person. The
Commission has expressed no view regarding the analysis, findings,
or conclusions contained therein. As discussed in section II.J,
staff in the Division of Investment Management is reviewing staff
no-action letters and other staff letters to determine whether any
such letters should be withdrawn in connection with any adoption of
this proposal. If the rule is adopted, some of the letters and
statements may be moot, superseded, or otherwise inconsistent with
the rule and, therefore, would be withdrawn.
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For example, advisory services have expanded and developed in
recent years, leading to questions about the scope of activities that
trigger application of the current rule. More specifically, nearly 20
years ago when the Commission interpreted authorized trading not to be
within the definition of custody, it had stated that clients'
custodians are generally under instructions to transfer funds or
securities out of a client's account only upon corresponding transfer
of securities or funds into the account. At the time, the Commission's
view was that such an arrangement would minimize the risk that an
adviser could withdraw or misappropriate the funds or securities in its
client's custodial account.
Discretionary trading practices today, however, do not necessarily
involve a one-for-one exchange of assets under a custodian's oversight.
For instance, an adviser may instruct an issuer or a transfer agent
that recorded ownership of a client's privately offered security to
redeem the client's interest and direct the proceeds to a particular
account. Because there is no qualified custodian involved in such a
transaction, a client's ability to monitor its investments for
suspicious activity is limited (e.g., a qualified custodian would not
attest to this transaction on the account statements it provides), and
a surprise examination or an audit may not discover any
misappropriation until the assets are gone. Moreover, if the security
is not included in the sample over which an accountant performs its
procedures during a surprise examination or if the client's holdings of
the security do not meet the materiality threshold for a financial
statement audit, misappropriation may go undetected for an
indeterminate amount of time.
Other times, advisers find themselves subject to the rule because
of authority they do not wish to have. For instance, we understand that
some advisory clients' custodial agreements empower investment advisers
with a broad array of authority that they neither want nor use.\18\
Advisers have little to no ability to eliminate this authority because
they are usually not parties to the custodial agreements between
clients and qualified custodians, but nonetheless these arrangements
result in an adviser having custody under the rule.
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\18\ We use the term ``custodial agreement'' throughout the
release to refer to a contract between an advisory client and the
qualified custodian. The adviser usually is not a party.
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While these developments suggest a need to protect clients better
and modify the application of the current rule, other developments
suggest a need to improve the rule's efficacy, including particularly
the protections provided by the qualified custodian, who has long been
the key gatekeeper under this rule. A growing number of assets are not
receiving custodial protections as a result of certain of the current
rule's exceptions from the requirement to maintain assets with a
qualified custodian, particularly the exception for privately offered
securities.\19\ That exception and the exception for mutual fund shares
were adopted at a time when dematerialized ownership of securities was
still developing, and the exceptions were envisioned as being necessary
``at times'' or ``on occasion.'' This rarity is no longer the case. We
understand that, today, the overwhelming majority of securities are
uncertificated, the volume of privately offered securities has vastly
expanded with the expansion of private capital, and custodians have
developed safeguarding and reporting practices, particularly with
respect to publicly traded securities.\20\ We acknowledge that the
custodial market for privately issued securities is less developed,\21\
but we believe that some custodians presently custody these assets and
we understand that new custodial services are being developed.\22\ What
has also developed, however, is a practice by custodians in which the
custodian lists assets for which it does not accept custodial liability
on a client's account statement on an accommodation basis only; the
custodian does not attest to the holdings of or transactions in those
investments or take steps to ensure that the investments are
safeguarded appropriately (``accommodation reporting''). The custodian
merely reports the holdings or transactions as reported to it by the
adviser. This practice undermines the account statement's integrity and
utility in helping to verify that the client owns the assets and they
have not been stolen or misappropriated. We view the integrity of
custodial account statements to be critical to the safeguarding of
client assets. Clients should be able to review their account
statements to evaluate the legitimacy of any movement within their
account, whether it is a trade, a payment, or a fee withdrawal. In
contrast, the current exception for mutual fund shares requires a
transfer agent of the mutual fund to fulfill all of the obligations
assigned to a qualified custodian under the rule, including sending
statements directly to the client. In our longstanding experience with
the current rule, this exception has not raised similar types of
investor protection concerns.
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\19\ Preqin Global Private Debt Report (2018), available at
https://docs.preqin.com/samples/2018-Preqin-Global-Private-Debt-Report-Sample-Pages.pdf (showing the growth in private capital
assets under management from 2007 to 2017 by the following asset
classes: private equity, private debt, real estate, infrastructure,
natural resources).
\20\ See discussion in section II.C infra and at text
accompanying footnote 229.
\21\ We understand that many qualified custodians will not
currently accept custodial liability for certain instruments
including certain crypto assets, commodities, and privately issued
securities. See Letter to Karen Barr re Engaging on Non-DVP
Custodial Practices and Digital Assets: Investment Advisers Act of
1940: Rule 206(4)-2 (Mar. 12, 2019) (``2019 RFI'').
\22\ See, e.g., DTCC, Project Whitney Case Study (May 2020),
available at https://www.dtcc.com/~/media/Files/Downloads/
settlement-asset-services/user-documentation/Project-Whitney-
Paper.pdf.
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At the same time, the evolution of financial products and services
discussed above has led to new entrants and new services in the
custodial marketplace, including newly launched state-chartered trust
companies, as well as established bank and broker-dealer custodians
seeking to develop new practices to safeguard assets.\23\ Our staff has
also observed a general reduction in the level of protections offered
by custodians, often resulting in advisory clients with the least
amount of bargaining power (i.e., retail investors) receiving the most
limited protections. We understand, for instance, that it is
decreasingly common for banks acting as custodians to do so in a
fiduciary capacity.\24\ These changes in the
[[Page 14676]]
industry have caused us to reconsider the role of a ``qualified
custodian'' under our rule and what minimum protections clients should
receive.
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\23\ See, e.g., Tomito Geron, Companies Compete to Be
Cryptocurrency Custodians, The Wall Street Journal (Sept. 17, 2019).
\24\ See OCC Bulletin 2019-21, April 29, 2019, ``Fiduciary
Regulations; Non-Fiduciary Activities; Advance Notice of Proposed
Rulemaking.'' According to this Bulletin, Bank non-fiduciary custody
activities have increased in asset size since 1996. This Bulletin
reports, as of December 2018, bank non-fiduciary custody assets were
about $42 trillion, whereas bank fiduciary custody assets were about
$9 trillion. See also Edward H. Klees, How Safe are Institutional
Assets in a Custodial Bank's Insolvency, 68 Bus. LAW. 103, 110,
footnote 46 (2012) (``Klees Article''). In addition to certain
institutions identified under the Home Owners' Loan Act and members
of the Federal Reserve System, the Advisers Act generally identifies
``banks'' as banking institutions or savings associations a
substantial portion of the business of which consists of receiving
deposits or exercising fiduciary powers similar to those permitted
to national banks. Advisers Act sec. 202(a)(2).
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Finally, since the Commission last amended the current rule, there
have been significant developments with respect to crypto assets,\25\
which generally use distributed ledger or blockchain technology
(broadly referred to as ``DLT'') \26\ as a method to record ownership
and transfer assets. While potentially creating certain efficiencies in
transactions, this technology also presents technological, legal, and
regulatory risks to advisers and their clients.\27\ Unlike mechanisms
used to transact in more traditional assets, this technology generally
requires the use of public and private cryptographic key pairings,
resulting in the inability to restore or recover many crypto assets in
the event the keys are lost, forgotten, misappropriated, or
destroyed.\28\ By design, DLT finality often makes it difficult or
impossible to reverse erroneous or fraudulent crypto asset
transactions, whereas processes and protocols exist to reverse
erroneous or fraudulent transactions with respect to more traditional
assets. These specific characteristics could leave advisory clients
without meaningful recourse to reverse erroneous or fraudulent
transactions, recover or replace lost crypto assets, or correct errors
that result from their adviser having custody of these assets.
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\25\ There are also digital assets. The term ``digital asset''
refers to an asset that is issued and/or transferred using
distributed ledger or blockchain technology, including, but not
limited to, so-called ``virtual currencies,'' ``coins,'' and
``tokens.'' See Custody of Digital Asset Securities by Special
Purpose Broker-Dealers, Securities Exchange Act Release No. 90788
(Dec. 23, 2020), 86 FR 11627, 11627 n.1 (Feb. 26, 2021)
(``Commission Statement''). A digital asset may or may not meet the
definition of a ``security'' under the Federal securities laws. See,
e.g., Report of Investigation Pursuant to section 21(a) of the
Securities Exchange Act of 1934: The DAO, Securities Exchange Act
Release No. 81207 (July 25, 2017) (``DAO 21(a) Report''), available
at https://www.sec.gov/litigation/investreport/34-81207.pdf; SEC v.
W.J. Howey Co., 328 U.S. 293 (1946). To the extent digital assets
rely on cryptographic protocols, these types of assets also are
commonly referred to as ``crypto assets.'' For purposes of this
release, the Commission does not distinguish between the terms
``digital asset'' and ``crypto asset.''
\26\ The terms DLT and blockchain, a type of DLT, generally
refer to databases that maintain information across a network of
computers in a decentralized or distributed manner. Blockchain
networks commonly use cryptographic protocols to ensure data
integrity. See, e.g., World Bank Group, ``Distributed Ledger
Technology (DLT) and Blockchain,'' FinTech Note No. 1 (2017),
available at: https://openknowledge.worldbank.org/bitstream/handle/10986/29053/WP-PUBLIC-Distributed-Ledger-Technology-and-Blockchain-Fintech-Notes.pdf?sequence=1&isAllowed=y.
\27\ We note that our staff has expressed a similar view. See,
e.g., SEC Staff Accounting Bulletin No. 121, [87 FR 21016 (Apr. 11,
2022)] (generally describing risks related to the safeguarding of
crypto assets); Custody of Digital Asset Securities by Special
Purpose Broker-Dealers, supra footnote 25 (generally discussing
risks related to broker-dealer custody of crypto asset securities).
See also Joint Statement on Crypto-Asset Risks to Banking
Organizations (Jan 3, 2023), available at https://occ.treas.gov/news-issuances/news-releases/2023/nr-ia-2023-1a.pdf (generally
discussing risks related to bank custody of crypto assets).
\28\ See, e.g., Not Your Keys, Not Your Coins: Unpriced Credit
Risk in Cryptocurrency, at section I, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4107019.
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Additionally, we understand that many advisers may be reluctant to
provide a full range of advisory services to their clients with respect
to crypto assets because of concerns that a market for custodial
services to safeguard these assets has not yet fully developed. We
understand that other advisers provide advisory services that would
generally result in an adviser having ``custody'' within the meaning of
the rule (e.g., serving as the general partner for a private fund that
holds crypto asset securities), and therefore are required to comply
with the rule. Some of these advisers, however, may not maintain their
client's crypto assets with a qualified custodian, instead attempting
to safeguard their client's crypto assets themselves--a practice that
is not compliant with the custody rule if those crypto assets are funds
or securities and do not meet an exception from the qualified custodian
requirement. Other advisers offering similar advisory services might
take the position that crypto assets are not covered by the custody
rule at all. This, however, is incorrect because most crypto assets are
likely to be funds or crypto asset securities covered by the current
rule.\29\
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\29\ The application of the current rule turns on whether a
particular client investment is a fund or a security. To the extent
there is a question as to whether a particular crypto asset is an
investment contract that is a security, the analysis is governed by
the test first articulated by the Supreme Court in SEC v. W.J. Howey
Co., 328 U.S. 293, 301 (1946). See, e.g., SEC v. Kik Interactive
Inc., 492 F. Supp. 3d 169, 177-180 (S.D.N.Y. 2020) (applying Howey
in granting the Commission's motion for summary judgment finding
Kik's sale of Kin tokens to the public was a sale of a security and
required a registration statement); SEC v. LBRY, No. 21-CV-260-PB,
2022 WL 16744741 (D.N.H. Nov. 7, 2022) (applying Howey in granting
the Commission's motion of summary judgement finding ``no reasonable
trier of fact could reject the SEC's contention that LBRY offered
LBC [a crypto asset] as a security.'' Id. at 21); Report of
Investigation Pursuant to section 21(a) of the Securities Exchange
Act of 1934: The DAO, Rel. No. 81207 (July 25, 2017) (describing how
DAO tokens were securities under Howey); see also Spotlight on
Crypto Assets and Cyber Enforcement Actions, available at https://www.sec.gov/spotlight/cybersecurity-enforcement-actions.
Importantly, even if a particular crypto asset is not a security,
the current rule also covers funds.
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B. Overview of the Proposal
In the light of these developments and additional authority that
Congress has given us under the Dodd-Frank Act to prescribe investment
adviser custody rules, we are redesignating the custody rule as new
rule 223-1 under the Advisers Act (the ``safeguarding rule'' or the
``proposed rule'') and proposing a number of amendments to strengthen
its protections.\30\ The proposal is designed to recognize the
evolution in products and services investment advisers offer to their
clients and to strengthen and clarify existing custody protections,
while also proposing complementary refinements to how advisers report
custody information on Form ADV and the books and records they are
required to keep that are designed to improve our oversight and risk-
assessment abilities.\31\ Importantly, the proposal maintains the core
purpose of protecting client assets from loss, misuse, theft, or
misappropriation by, and the insolvency or financial reverses of, the
adviser and maintains the Commission's ability to pursue advisers for
failing to properly safeguard client assets under the Act's antifraud
provisions.\32\
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\30\ We are also renumbering portions of the custody rule that
we are not amending.
\31\ In a technical, conforming change from the current rule,
the proposed rule would replace, in certain places, references to
``you'' with ``investment adviser.''
\32\ While we are renumbering the current rule as rule 223-1,
section 206(4) is still available to the Commission and is also a
basis of statutory authority for this proposed rulemaking. To
establish a violation of section 206(4) for an adviser's failure to
safeguard client assets, the Commission does not need to demonstrate
that an investment adviser acted with scienter. See SEC v. Steadman,
967 F.2d 636, 646-7 (D.C. Cir. 1992). As we noted when we adopted
rule 206(4)-8, the court in Steadman analogized section 206(4) of
the Advisers Act to section 17(a)(3) of the Securities Act, which
the Supreme Court had held did not require a finding of scienter
(citing Aaron v. SEC, 446 U.S. 680 (1980)). See Prohibition of Fraud
by Advisers to Certain Pooled Investment Vehicles, Investment
Advisers Act Rel. 2628, (Aug. 3, 2007), 72 FR 44763 (Aug. 9, 2007).
See also Steadman at 643, n.5.
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First, the proposed amendments are designed to modernize the scope
of assets and activities that would trigger application of the rule. In
today's increasingly complex and global financial markets, this update
also would simplify the rule's application and better align the rule
with the Commission's statutory authority.\33\ Because investment
advisers provide
[[Page 14677]]
services related to an array of financial products beyond just funds or
securities, the proposed rule would require certain minimum
protections, particularly the safeguards of a qualified custodian, for
substantially all types of client assets held in an advisory account.
Specifically, the safeguarding rule would specify the types of assets
subject to the safeguarding requirements of the rule by defining
``assets'' as ``funds, securities, or other positions held in a
client's account,'' as opposed to the custody rule's use of ``funds and
securities.'' \34\ This change would expressly include certain assets
that may not have previously been categorized as ``funds'' or
``securities'' and would accommodate developments in the market for
various investment types that develop in the future, irrespective of
their status as funds or securities. By expanding the scope of the rule
to include client assets instead of only client funds and securities,
we believe we are properly balancing the desire of investment advisers
to provide advisory services regarding novel or innovative asset types
with the need to ensure that such assets are properly safeguarded.
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\33\ See supra note 16 and accompanying text.
\34\ See 15 U.S.C. 80b-23 (``section 223'') ``An investment
adviser registered under this subchapter shall take such steps to
safeguard client assets over which such adviser has custody,
including, without limitation, verification of such assets by an
independent public accountant, as the Commission may, by rule,
prescribe.'' See proposed rule 223-1(a).
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The proposed rule also would explicitly include discretionary
authority to trade within the definition of custody.\35\ When an
adviser has discretion to trade client assets, it has an arrangement in
which it may instruct the adviser's custodian to dispose the client's
assets. An adviser with discretion may also have broad authority to
direct purchases or sales of client assets that may not currently
involve a qualified custodian, such as loan participation interests. An
adviser's ability or authority to effect a change in beneficial
ownership of a client's assets, including for purposes of trading,
could place client assets at risk of loss that the rule is designed to
address.\36\ This change would rectify any unintended consequences of
our prior interpretive position.\37\
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\35\ Proposed rule 223-1(d)(3).
\36\ See section II.A.2. Recognizing that there are times when
an investment adviser neither wants nor uses the ability or
authority that would trigger the proposed rule and that there are
times when an adviser inadvertently receives client investments, the
proposed rule would provide limited and tailored exclusions in these
circumstances. See infra, discussion of discretionary trading
authority in section II.G.2.
\37\ When adopting amendments to the custody rule in 2003, we
stated in a footnote: ``An adviser's authority to issue instructions
to a broker-dealer or [other] custodian to effect or settle trades
does not constitute `custody.' Clients' custodians are generally
under instructions to transfer funds (or securities) out of a
client's account only upon corresponding transfer of securities (or
funds) into the account. This `delivery versus payment' arrangement
minimizes the risk that an adviser could withdraw or misappropriate
the funds or securities in its client's custodial account.'' 2003
Adopting Release, supra footnote 2, at n.10. Absent this narrowly
drawn exception for ``delivery versus payment'' transactions,
authorized trading comes within the definition of custody.
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Like the custody rule, the safeguarding rule would entrust
safekeeping of client assets to a qualified custodian because we
continue to believe it provides critical safeguards for those assets.
Unlike the custody rule, however, the safeguarding rule would specify
that a qualified custodian does not ``maintain'' a client asset for
purposes of the rule if it does not have ``possession or control'' of
that asset. The proposed rule would further define ``possession or
control'' to mean holding assets such that the qualified custodian is
required to participate in any change in beneficial ownership of those
assets.\38\ This change is designed to improve account statement
integrity and reliability by eliminating an adviser's ability to
request accommodation reporting.\39\ Further, in a change from the
current rule, the proposed rule would require an adviser to enter into
a written agreement with and receive certain assurances from the
qualified custodian to make sure the qualified custodian provides
certain standard custodial protections when maintaining client
assets.\40\
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\38\ Proposed rule 223-1(d)(8). For further discussion of
possession or control, please see discussion infra section II.B.2.
\39\ See infra discussion section II.B.3.b.ii.
\40\ Proposed rule 223-1(a)(1).
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Under the proposal, the written agreement would require two
provisions that are not explicitly addressed by the current rule. One
provision 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 Commission or to an independent
public accountant engaged for purposes of complying with the
safeguarding rule. The other 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 rule: account statements and
internal control reports. Under the first, the written agreement must
contain a provision requiring the qualified custodian to deliver
account statements to clients and to the adviser, as currently advisers
must have only a reasonable basis for believing this is done. 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. This provision expands the internal control requirement to
all qualified custodians from the current rule's application to an
adviser or its related person \41\ that acts as a qualified custodian.
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\41\ The term ``related person'' would have the same meaning as
in the current rule.
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In addition to the written agreement requirement, advisers would
have to obtain reasonable assurances that the qualified custodian
satisfies five additional enumerated items.\42\ 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.
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\42\ See proposed rule 223-1(a)(1)(ii).
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We are proposing to modify the current rule's privately offered
securities exception from the obligation to maintain client assets with
a qualified custodian by expanding the exception to include certain
physical assets.\43\ We are also proposing refinements to the
definition of privately offered securities that are designed to ensure
appropriate application and interpretation of this exception.\44\ In
addition, we are proposing to modify the conditions for relying on this
exception to improve investor protections in the absence of one of the
rule's key gatekeepers. Specifically, an adviser could rely on the
exception only if it reasonably
[[Page 14678]]
determines that ownership cannot be recorded and maintained by a
qualified custodian, the adviser reasonably safeguards the assets, the
adviser notifies the independent public accountant performing the
verification of such an asset transfer within one business day, an
independent public accountant verifies asset transfers and notifies the
Commission upon the findings of any material discrepancies, and the
existence and ownership of the assets are verified during an annual
independent verification or as part of a financial statement audit by
an independent public accountant.\45\ The modifications are also
designed to limit availability of the exception to circumstances that
truly warrant it because we believe the bulk of advisory client assets
are able to be maintained by qualified custodians and should be
safeguarded in the manner contemplated under the safeguarding rule.
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\43\ See proposed rule 223-1(b)(2).
\44\ See proposed rule 223-1(d)(9).
\45\ See proposed rule 223-1(b)(2).
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Under the proposed rule, advisers with custody of client assets
would be required to segregate those assets by (1) titling or
registering the assets in the client's name or otherwise holding the
assets for the client's benefit, (2) not commingling the assets with
the adviser's or any of its related persons' assets, and (3) not
subjecting the assets to any right, charge, security interest, lien, or
claim of any kind in favor of the investment adviser or its related
persons or creditors, except to the extent agreed to or authorized in
writing by the client.\46\ This provision, which would apply regardless
of whether the client's assets are maintained by a qualified custodian,
is designed to prevent the adviser, or its related person, from using
client assets for its own purposes or in a manner not authorized by the
client or in a manner inconsistent with its fiduciary duty. We believe
this will also help to protect client assets and enable them to be
returned in the event that an adviser experiences financial hardship.
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\46\ See proposed rule 223-1(a)(3).
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The proposed rule would continue to depend on the protections
provided by independent public accountants. We have long relied on
these third-party gatekeepers to provide ``another set of eyes'' on
client assets, and we believe they serve an important role in
safeguarding client assets. In light of the proposed changes to the
rule's scope, however, the proposal seeks to balance better the costs
associated with obtaining a surprise examination with the investor
protections it offers by providing exceptions to the surprise
examination requirement when the adviser's sole reason for having
custody is because it has discretionary authority or because the
adviser is acting according to a standing letter of authorization, each
subject to certain conditions.\47\ We believe that the risk to client
assets is lower in these contexts and the protections offered by the
surprise examination may not justify the cost of obtaining one.
Finally, the proposed safeguarding rule amendments would expand the
scope of who can satisfy the rule's surprise examination requirement
through financial statement audits by specifying that an entity is not
required to be a limited partnership, limited liability company, or
another type of pooled investment vehicle to rely on this
provision.\48\
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\47\ See proposed rule 223-1(b)(7) and (8).
\48\ See proposed rule 223-1(b)(4).
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The proposal also seeks to update and enhance recordkeeping
requirements for advisers that would work in concert with the proposed
rule. We believe that these updates would enhance the Commission's
oversight of the safeguarding practices of advisers and their
compliance with the rule, which will, in turn, promote investor
protections.
Finally, we are proposing amendments to Form ADV to align reporting
obligations with the proposal and improve the accuracy of custody-
related data available to the Commission, its staff, and the public. In
addition, we are improving the structure of Form ADV Item 9.\49\ More
accurate and comprehensive information that aligns with the proposed
rule would inform the Commission's examination initiatives and would
allow the Commission and its staff to better assess risks specific
advisers pose to investors.\50\
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\49\ See infra discussion at section II.I.
\50\ See infra discussion at section II.J. Because Form ADV Part
1A is submitted in a structured, XML-based data language specific to
that form, the information in the proposed amendments to Part 1A
would continue to be structured (i.e., machine-readable).
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II. Discussion
A. Scope of Rule
Like the current rule, the proposed rule would apply to any
investment adviser registered or required to be registered with the
Commission under section 203 of the Act that has ``custody'' of a
client's assets.\51\ Also consistent with the current rule, the
proposed rule would also apply to any adviser whose ``related persons''
have custody in connection with advisory services the adviser provides
to the client.\52\
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\51\ Proposed rule 223-1. As with the current rule, an adviser
would be required to comply with the proposed rule in circumstances
where the adviser provides advisory services to a person's assets,
even if uncompensated. ``Although a person is not an `investment
adviser' for purposes of the Advisers Act unless it receives
compensation for providing advice to others, once a person meets
that definition (by receiving compensation from any client to which
it provides advice), the person is an adviser, and the Act applies
to the relationship between the adviser and any of its clients
(whether or not the adviser receives compensation from them).'' See
Rules Implementing Amendments to the Investment Advisers Act of
1940, Investment Advisers Act Release No. 3221 (June 22, 2011) [76
FR 42,950 (July 19, 2011)], at text accompanying n.74.
\52\ Consistent with the current rule, under the proposed rule,
the term ``related person'' would mean ``any person, directly or
indirectly, controlling or controlled by [the investment adviser],
and any person that is under common control with [the investment
adviser].'' Proposed rule 223-1(d)(11).
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The proposed rule would change the current rule's scope, however,
in two important ways. First, it would expand the types of investments
covered by the rule. Currently, the rule applies to client ``funds and
securities'' of which an adviser has custody. The proposed rule would
extend the rule's coverage beyond client ``funds and securities'' to
client ``assets'' so as to include additional investments held in a
client's account. Second, the proposed rule would make explicit that
the current rule's defined term ``custody'' includes discretionary
authority.
1. Scope of Assets
The proposed rule would define ``assets'' as ``funds, securities,
or other positions held in a client's account.'' \53\ The proposal,
like the current rule, therefore would apply to a client's funds as
well as a client's securities. However, the proposed rule also would
apply to other positions held in a client's account that are not funds
or securities. This proposed change uses the more expansive and
explicit language employed by Congress in empowering the Commission to
develop rules to protect client assets when advisers have custody.\54\
Congress made this change following several high profile enforcement
actions relating to misappropriation of client assets.\55\ The proposed
amendments also recognize the continued evolution of the types of
investments held in advisory accounts since the custody rule was
amended in 2009 and since the enactment of section 223. Looking
forward, the proposed definition of assets is designed to remain
evergreen, encompassing new investment types as they continue to evolve
and multiply to recognize that the protections of the rule should not
[[Page 14679]]
depend on which type of assets the client entrusts to the adviser.
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\53\ Proposed rule 223-1(d)(1).
\54\ See section 223, supra footnote 34.
\55\ See supra footnote 11.
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The proposed rule's use of the term ``other positions'' in the
definition of assets encompasses holdings that may not necessarily be
recorded on a balance sheet as an asset for accounting purposes,
including, for example, short positions and written options.\56\ We
believe, in the advisory account context, that the entirety of a client
account's positions, holdings, or investments should receive the
protections of the proposed rule regardless of how they may be treated
for accounting purposes. Moreover, the fiduciary duty extends to the
entire relationship between the adviser and client regardless of
whether a specific holding in a client account meets the definition of
funds or a security.\57\ Consequently, the proposed rule's definition
of assets would include investments such as all crypto assets, even in
the instances where such assets are neither funds nor securities.\58\
Assets under the rule also would include financial contracts held for
investment purposes, collateral posted in connection with a swap
contract on behalf of the client, and other assets that may not be
clearly funds or securities covered by the current rule.\59\
Additionally, physical assets, including artwork, real estate, precious
metals, or physical commodities (e.g., wheat or lumber), would be
within the scope of the proposed rule. ``Assets'' also would encompass
investments that would be accounted for in the liabilities column of a
balance sheet or represented as a financial obligation of the client
including negative cash, which we believe would be consistent with the
purposes of the Act and the longstanding policy goal of the rule to
prevent potential fraud, misuse, or misappropriation.\60\
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\56\ Similarly, rule 6(c)-11 under the Investment Company Act of
1940 [15 U.S.C. 80a-1 et seq.] (the ``Investment Company Act'')
defines an exchange-traded fund's portfolio holdings as the
securities, assets, or other positions held by the exchange-traded
fund. See 17 CFR 270.6c-11. See Exchange Traded Funds, Investment
Company Act Release No. 33646 (Sept. 25, 2019) [84 FR 57162 (Oct.
24, 2019)], at n.249 (including within the term ``other positions''
short positions in equity, overdrawn or negative cash balances,
written call or put options (where the other side has the option and
can put or call the underlying instrument to the party who wrote the
contract)).
\57\ See Commission Interpretation Regarding Standard of Conduct
for Investment Advisers, Release No. IA-5248 (Jun. 5, 2019) at
footnote 17 (discussing the broad scope of the fiduciary duty in a
variety of contexts, including situations where securities are not
specifically involved).
\58\ Crypto assets that are funds or securities are subject to
the current custody rule, which applies to all ``funds and
securities'' over which an adviser has custody. See discussion of
whether crypto assets or digital assets meet the definition of
security at supra footnote 29.
\59\ Id. Our staff has taken a similar position regarding
collateral for transactions, such as swaps. See Custody Rule FAQs,
supra footnote 17, at Question II.10.
\60\ See rule 6c-11, supra footnote 56. The release discussed
that liabilities were contemplated to be part of ``other
positions.''
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We also request comment on all aspects of the proposed definition
of ``assets,'' including the following items:
1. Should the rule apply to client ``assets'' beyond the scope of
the current rule's formulation of ``funds or securities,'' as proposed?
Should the proposed rule include the term ``other positions'' as a
catch-all for a client's positions subject to the adviser-client
relationship? Should another term, such as client investments, be used
instead?
2. Should we define client ``assets'' by referencing other terms,
such as ``securities and similar investments'' or ``any investment,''
which are used but not defined in the Investment Company Act custody
rules? \61\ Should we instead incorporate the term ``investment'' from
the definition of ``qualified purchaser'' under the Investment Company
Act? \62\
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\61\ See rules 17f-1, 17f-2, 17f-5, and 17f-6 under the
Investment Company Act.
\62\ See rule 2a51-1(b) under the Investment Company Act.
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3. Are there particular types of assets held in a client's advisory
account that should or should not be subject to the proposed rule? If
so, what are they and why should they be included or excluded? Are
there other safeguards outside of the proposed rule that apply to these
positions that would satisfy the policy goals of the rule? Does the
answer depend on the type of asset?
4. To the extent that the adviser has custody of certain physical
assets, should we narrow the proposed definition to exclude such
physical assets? For example, should the proposed definition exclude
artwork, real estate, precious metals, or physical commodities (e.g.,
wheat or lumber), for example?
5. It is our understanding that some advisers treat client assets
that may not be ``funds or securities'' consistent with rule 206(4)-2.
If so, what types of assets do they maintain with a qualified custodian
under the current rule? If not, how do the advisers safeguard these
client assets?
6. Should we provide guidance about how the proposed rule would
apply to certain asset types? If so, for what types of assets? Should
we provide guidance for certain assets that would be subject to
exceptions from the proposed rule, such as privately offered securities
or physical assets?
7. Should the proposed rule apply to assets that are treated as
liabilities from an accounting perspective? Is it sufficiently clear
that the proposed rule would apply to portfolio holdings that are
liabilities on a balance sheet? Should we provide additional
clarification as to what types of investments may appear as liabilities
within the scope of the advisory relationship? What types of holdings
typically appear as liabilities? Are there any exemptions or provisions
required for such investments if they are included within the scope of
the rule?
2. Scope of Activity Subject to the Proposed Rule
The proposal generally would preserve the current rule's definition
of ``custody,'' and apply when an adviser ``holds, directly or
indirectly, client assets, or has any authority to obtain possession of
them.'' \63\ The general principle of this definition is to apply the
rule when an adviser has the ability or authority to effect a change in
beneficial ownership of a client's assets.\64\ An adviser with this
ability or authority can subject a client's assets to the risks of
loss, misuse, misappropriation, theft, or financial reverses of the
adviser. Moreover, the rule would continue to apply when an adviser's
related person has the ability to obtain client assets in connection
with advisory services. Like the current rule, the proposed rule would
institute prophylactic safeguards where there is this potential for
loss or harm to a client given the adviser's ability or authority to
deprive the client of ownership and to obtain possession of the
client's assets.
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\63\ See proposed rule 223-1(d)(3).
\64\ For example, an adviser that physically holds a check drawn
by the advisory client and made payable to a third party is not
subject to the rule solely as a result of holding the check, since
the adviser cannot use the check to change ownership of the client's
underlying cash holdings. See rule 206(4)-2(d)(2)(i). Similarly, if
a stock certificate is non-transferable (i.e., it cannot be used to
effect a change in beneficial ownership of the client's investment),
an adviser would not be subject to the rule as a result of holding
it. Our staff previously took a similar view. See 2013 IM Guidance,
supra footnote 17.
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In addition to this overarching principle, the current definition
of custody includes three categories that serve as examples of custody:
physical possession, certain arrangements when the adviser is
authorized or permitted to instruct the client's custodian, and
circumstances when the adviser acts in certain capacities.\65\ The
proposed rule
[[Page 14680]]
would retain these categories because, going forward, we believe this
approach will continue to provide flexibility as the asset management
industry continues to evolve, introduces novel investment products, and
provides new services to its advisory clients.
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\65\ Under the current rule, custody includes three prongs: (i)
Possession of client funds or securities (but not of checks drawn by
clients and made payable to third parties) unless the adviser
receives them inadvertently and returns them to the sender promptly
but in any case within three business days of receiving them; (ii)
Any arrangement (including a general power of attorney) under which
the adviser is authorized or permitted to withdraw client funds or
securities maintained with a custodian upon the adviser's
instruction to the custodian; and (iii) Any capacity (such as
general partner of a limited partnership, managing member of a
limited liability company or a comparable position for another type
of pooled investment vehicle, or trustee of a trust) that gives the
adviser or its supervised person legal ownership of or access to
client funds or securities.
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We believe we need to provide specificity, however, regarding the
arrangement category of the custody definition to state explicitly that
discretionary trading authority is an arrangement that triggers the
rule.\66\ Specifically, the amended custody definition would include
any arrangement (including, but not limited to, a general power of
attorney or discretionary authority) under which the adviser is
authorized or permitted to withdraw or transfer beneficial ownership of
client assets upon the adviser's instruction.\67\ In addition, the
proposed discretionary authority definition is consistent with the
definition in Form ADV and is the authority to decide which assets to
purchase and sell for the client.\68\
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\66\ Proposed rule 223-1(d)(3) (proposed custody definition) and
proposed rule 223-1(d)(4)(discretionary authority definition). The
second prong of the current custody definition states: ``Any
arrangement (including a general power of attorney) under which you
are authorized or permitted to withdraw client funds or securities
maintained with a custodian upon your instruction to the
custodian.'' See current rule 206(4)-2(d)(3).
\67\ The proposed amended definition also removes the reference
``to the custodian'' from the arrangement category. This formulation
ensures that custody is triggered if, for example, an adviser can
instruct a transfer agent or administrator to withdraw or transfer
beneficial ownership of client assets. See proposed rule 223-
1(d)(3).
\68\ Proposed rule 223-1(d)(4).
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The Commission previously stated that an adviser's authority to
issue instructions to a broker-dealer or a custodian to effect or to
settle trades, or authorized trading, does not constitute custody.\69\
We had explained then that the risk of an adviser withdrawing or
misappropriating funds and securities are minimized when a client's
custodian is under instructions to transfer funds (or securities) out
of a client's account only upon corresponding transfer of securities
(or funds) into the account.\70\ However, while we continue to believe
that there is a more limited risk of loss to a client from authorized
trading when a qualified custodian participates in a one-for-one
exchange of assets like this, we also believe that discretionary
authority presents the types of risks the rule is designed to address.
The adviser, for instance, could use its discretionary authority over a
client's assets to instruct an issuer's transfer agent or administrator
(e.g., the administrator 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, thereby depriving the client of
ownership, unbeknownst to the client or its qualified custodian. Unless
a client or its custodian is required to participate in these
transactions, such as when the client must sign the subscription
agreement to purchase the security (i.e., the adviser does not have a
power of attorney and cannot sign for the client in any other
capacity), the client will be unable to monitor the assets in its
account for potential misuse or misappropriation effectively.\71\
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\69\ 2003 Adopting Release, supra footnote 2, at n.10.
\70\ Id.
\71\ Our staff stated a similar view under the current rule. See
Custody Rule FAQs, supra footnote 17, at Question VII.3.
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We believe it is important to extend the protections of the rule by
explicitly including ``discretionary authority'' within the definition
of custody. However, because we continue to believe more limited risk
of loss exists when a qualified custodian participates in transactions,
we are also proposing a limited exception to the surprise examination
requirement of the rule. The exception would generally apply to client
assets that are maintained with a qualified custodian when the sole
basis for the application of the rule is an adviser's discretionary
authority that is limited to instructing the client's qualified
custodian to transact in assets that settle only on a delivery versus
payment (``DVP'') basis.\72\ In DVP transactions, clients' custodians
are under instructions to transfer assets out of a client's account
only upon corresponding transfer of assets into the account. This
``delivery versus payment'' arrangement minimizes the risk that an
investment adviser could withdraw or misappropriate the assets in its
client's custodial account. In our view, DVP transactions reduce the
risk that the seller of an asset could deliver the asset but not
receive payment or that the buyer of an asset could make payment but
not receive delivery of the asset.\73\
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\72\ Proposed rule 223-1(b)(8). See infra at section II.G.2.
\73\ For discussion of delivery versus payment settlement
operations, see Bank for International Settlements, ``Delivery
versus Payment in Securities Settlement Systems,'' Sept. 1992, p. 1
at https://www.bis.org/cpmi/publ/d06.pdf.
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We request comment on all aspects of the proposed application of
the rule to advisers with discretionary authority, along with the
continuing application of the rule more generally, including the
following items.
8. Should the proposal generally retain the current rule's
definition of custody? The proposed rule would generally retain the
three categories that serve as examples of custody in the current rule:
physical possession, certain arrangements when the adviser is
authorized or permitted to withdraw or transfer beneficial ownership of
client assets upon the adviser's instructions, and circumstances when
the adviser acts in certain capacities. Should the proposed rule change
the current definition of custody from these three categories? What
should the proposal provide alternatively?
9. Should the rule apply to when an adviser has discretionary
authority over client assets, as proposed? Are there provisions of the
proposed rule that should or should not apply to advisers who have
custody because they have discretionary authority?
10. Do advisers with discretionary authority over a client's assets
(regardless of settlement method) currently have safeguards in place
that effectively limit the risks to clients of loss, misuse, theft,
or--in particular--misappropriation? If so, what are they? Do these
safeguards differ depending on whether the arrangement involves a
qualified custodian?
11. When a trade settles in a manner that is not DVP, are there
controls that are or could be established in the event one leg of the
trade does not complete? If so, how commonly are such controls
utilized? Are there circumstances when such controls could not be
established or implemented? Should we require controls or policies and
procedures for advisers and/or the respective custodians in these
circumstances?
12. Should the definition of custody contain an exception (or
should we interpret the definition of custody not to include) when the
adviser has authority to instruct the client's custodian to remit
assets from the custodial account to the client at his or her mailing
address of record? If so, should such an exception or interpretation be
subject to any conditions? For example, should the client be required
to grant the adviser this authority in writing to the qualified
custodian? Should an exception or interpretation also be conditioned on
the adviser lacking authority to open an account on behalf
[[Page 14681]]
of the client? Should the adviser also lack authority to designate or
change the client's mailing address of record with the qualified
custodian, or if the adviser has this authority, would it be sufficient
protection for the adviser to have a reasonable belief that the
custodian would send a notice of any change of mailing address to the
client at the client's old address of record upon receiving the request
from the adviser to change the mailing address? \74\ For example,
broker-dealers must send a customer who is a natural person a
notification of a change of mailing address to the customer's old
mailing address.\75\ Similarly, banks that follow guidance issued by
banking regulators send confirmation of a customer request for a change
of mailing address to both the old and new address on record.\76\ Is
there adequate protection when the custodian is subject to these
regulatory requirements because the adviser would be unable to remit
its client's assets to the client at a mailing address other than the
client's address of record at the custodian? Alternatively, should such
an exception or interpretation hinge on whether advisers design
policies and procedures under rule 206(4)-7 (the ``Compliance Rule'')
that address the risk to clients of remitting client investments to
non-clients?
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\74\ We note that the staff has issued an FAQ on this topic. See
Custody Rule FAQs, supra footnote 17, at FAQ II.5.A. and B.
\75\ Exchange Act Rule 17a-3(a)(17)(i)(B)(2).
\76\ See, e.g., Federal Reserve System Supervisory Letter SR 0-
11 (Apr. 26, 2001), Office of Comptroller of the Currency (``OCC'')
Advisory Letter 2001-4 (Apr. 30, 2001), Federal Deposit Insurance
Corporation Financial Institution Letter 39-2001 (May 9, 2001),
Office of Thrift Supervision CEO Letter No. 139 (May 4, 2001), and
National Credit Union Administration Letter No. 01-CU-09 (Sept.
2001).
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13. Should we make clear that an adviser is subject to the custody
rule and would also be subject to the proposed rule with respect to its
client's assets that are held, or accessible, by a related carrying
broker or executed through a related introducing broker? \77\
Conversely, should we make clear that an adviser would not be subject
to the rule solely due to its related person acting as the trustee of a
participant-directed defined contribution plan established for the
benefit of the adviser's employees, provided the adviser does not
provide investment advisory services to the plan or any investment
option available under the plan? \78\ Similarly, should we clarify the
meaning of ``in connection with advisory services'' in the context of
related person custody? \79\ For example, should we make clear that
where an adviser's client has a bank account with a bank that is the
adviser's related person, but does not use the bank account in
connection with the adviser's advisory activity, we would not view the
bank's authority to be ``in connection with advisory services'' that
the adviser provides to its client and that the rule, therefore, would
not apply?
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\77\ We note that the staff has issued an FAQ on this topic. See
Custody Rule FAQs, supra footnote 17, at Question XIV.2-3. See also
section II.J, infra.
\78\ We note that the staff has issued an FAQ on this topic. Our
staff has stated that it would not consider an adviser to have
custody where the investment adviser and the related person trustee
are, to the extent applicable, in compliance with the Employee
Retirement Income Security Act of 1974 (ERISA) and rules and
regulations issued thereunder with respect to the plan. See Custody
Rule FAQs, supra footnote 17, Question XII.1.
\79\ See proposed rule section 223-1(d)(3).
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14. Advisers that act as trustee of a trust would have custody of
that trust's assets under the proposed rule. Should we adopt an
exception from the definition of custody for (or should we interpret
the definition of custody not to include) cases where an adviser acts
as co-trustee of a trust and no single co-trustee is able to effect any
change in control of the beneficial ownership of the trust's
investments without the prior written consent of a co-trustee(s) that
is not a related person? \80\ In what circumstances is a co-trustee
required either by law or the trust instrument to protect the trust
beneficiaries from the actions of a single trustee acting alone?
Similarly, should we adopt an exception in (or should we interpret the
definition of custody not to include) circumstances where an adviser
has the ability or authority to effect a change in beneficial ownership
of a trust's investments, where an adviser is co-trustee along with the
grantor of a revocable grantor trust, and the adviser is prohibited by
the trust instrument or by law from withdrawing any investments from
the trust without the prior written consent of all of its co-trustees?
\81\
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\80\ We note that the staff has issued an FAQ on this topic. See
Custody Rule FAQs, supra footnote 17, at Question XII.2.
\81\ We note that the staff has issued an FAQ on this topic. See
Custody Rule FAQs, supra footnote 17, Question XII.3. See also, 2003
Adopting Release, supra footnote 2 at note 15 (stating that the
Commission would not view the adviser to have custody of the funds
or securities of the estate, conservatorship, or trust solely
because the supervised person has been appointed in these capacities
as a result of family or personal relationship with the decedent,
beneficiary or grantor (and not a result of employment with the
adviser)).
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15. An adviser would have custody under the proposed rule when it
comes into possession of client assets. The rule contains an exception
from the definition of custody for possession of client assets when the
adviser receives them inadvertently and returns them to the sender
within three business days. Should we amend the exception to
accommodate (or interpret the definition of custody not to include)
other situations in which the adviser inadvertently receives client
assets? \82\ For example, should such an exception or interpretation be
conditioned such that the adviser return the client's assets to the
sender or forward them to the client or the client's custodian within
five days of receipt? Should such an exception or interpretation be
available only when client assets are received from senders, such as
those identified in staff statements? Rather than specify senders in
such an exception, should the exception or interpretation be available
when an adviser determines it would be unfeasible to return the assets,
or when there is a risk that the client's assets could be lost if the
adviser attempted to return them to the sender? Should such an
exception or interpretation be available only if the investment
adviser's receipt of its client's assets is inadvertent? Should we
condition such an exception or interpretation on recordkeeping
requirements under proposed rule 204-2 or on whether advisers design
policies and procedures under rule 206(4)-7? We understand that for
certain private fund advisers and trustees it is difficult to avoid
temporarily possessing client checks and physical assets because there
may not be an independent representative to arrange the movement of
such assets into a qualified custodian. Are there any particularities
to these contexts that would benefit from an exception or
interpretation? In addition, are there other circumstances that involve
checks written to third parties, checks written to clients, and checks
written to advisers where the adviser has no authority to deposit
client assets into any account other than directed by the client that
would benefit from exceptions or interpretations? Are there certain
policies and procedures maintained by advisers that mitigate the
custody risks associated with receiving checks that may be beneficial
to include in this rulemaking? For example, if the adviser has policies
and procedures reasonably designed to maintain such
[[Page 14682]]
assets with a qualified custodian, should we provide an exception if an
adviser to a private fund or serving as a trustee would not be subject
to the rule for the brief handling of client checks or physical assets?
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\82\ We note that the staff has issued a no-action letter on
this topic. The Commission's staff has stated that when advisers
infrequently receive specific types of client funds or securities
from a list of enumerated third parties that the staff identified,
the staff would not recommend enforcement for violation of the
current custody rule if the adviser meets specified conditions. See
Investment Adviser Association, SEC Staff No-Action Letter (Sep. 20,
2007) (``2007 IAA No-Action Letter''). See also Custody Rule FAQs,
supra footnote 17, at Question II.1.
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16. Should we include an exception from the rule for assets for
which the adviser provides advice in certain sub-adviser relationships,
such as was described in our staff's statements? \83\ In what
circumstances should such an exception apply? Would an exception
designed to capture circumstances where the proposed rule would apply
to the sub-adviser only because its related person triggers the rule
with respect to the same advisory clients be beneficial? Such an
exception could be conditioned on the related person being fully
subject to (and in compliance with) the applicable requirements of the
custody rule. Would such a condition to the exception work in practice?
Should such exception be conditioned on the adviser's related person
fully complying with the requirements of the proposed rule? If not, why
not? If so, how would advisers determine whether their related person
is fully complying with the rule? Are there alternative safeguards that
commenters would suggest? Alternatively, should such sub-advisers be
subject to all or certain requirements of the rule? If only certain
requirements, which ones and why? Should we condition such an exception
on recordkeeping requirements under proposed rule 204-2 or on whether
advisers design policies and procedures under rule 206(4)-7?
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\83\ We note that the staff has issued a no-action letter on
this topic. See Investment Adviser Association, SEC Staff No-Action
Letter (Apr. 25, 2016), available at: https://www.sec.gov/divisions/investment/noaction/2016/investment-adviser-association-042516-206(4).htm.
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17. Are there are any other arrangements or circumstances where an
adviser would have custody under the proposed rules but an exception
would be beneficial and not inconsistent with the policy goals of the
rule? For example, are there specific circumstances involving custody
at electronic platforms, investment adviser aggregators, benefit plans,
introducing broker-dealers, plan sponsors, record-keepers, or third
party administrators that would benefit from an exception or
interpretation that these arrangements constitute or do not constitute
custody?
B. Qualified Custodian Protections
Qualified custodians would continue to serve as key gatekeepers
under the proposed rule. These institutions' custodial activities are
subject to regulation and oversight.\84\ Accordingly, as under the
current rule, investment advisers with custody of client assets would
be required to maintain those assets with a qualified custodian.\85\ We
are proposing several ways to strengthen the requirement, however, in
light of the evolution of the market for custodial services, financial
products, and advisory services over the last decade. These proposed
changes aim to provide investors with certain standard custodial
protections that will improve the safeguarding of their assets in the
current market as well as in the future as the market for financial
products and advisory services continues to evolve.
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\84\ 2002 Proposing Release, supra footnote 2, at n. 30; 2009
Proposing Release, supra footnote 11, at n. 4.
\85\ Proposed rule 223-1(a)(1)(i). The proposed rule would
provide an exception, and another means of compliance with the rule,
for certain assets that are unable to be maintained with a qualified
custodian. See proposed rule 223-1(b)(2).
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The proposed rule would continue to allow banks or savings
associations, registered broker-dealers, registered futures commission
merchants, and certain foreign financial institutions to act as
qualified custodians, but, in a change from the current rule, only if
they have ``possession or control'' of client assets pursuant to a
written agreement between the qualified custodian and the investment
adviser.\86\ Also in a change from the current rule, the proposed rule
would modify the definition of foreign financial institution and
requirements for banks and savings associations in the definition of
qualified custodian.\87\ In the case of a qualified custodian that is
the adviser, the proposed rule would require that the written agreement
be between the adviser and the client.
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\86\ See proposed rule 223-1(a)(1).
\87\ See proposed rule 223-1(d)(10)(i) and (iv); section
II.B.1.b, infra.
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The proposed rule would require that the written agreement contain
contractual provisions that we believe are critical to providing
important protections for advisory client assets. As discussed in
further detail below, the contractual terms would address
recordkeeping, client account statements, internal control reports, and
the adviser's agreed-upon level of authority to effect transactions in
the account. In addition, the proposed rule would require that an
adviser obtain reasonable assurances from a qualified custodian
relating to certain protections the qualified custodian will provide to
the advisory client, including with respect to the qualified
custodian's standard of care, indemnification, limitation of liability
for sub-custodial services, segregation of client assets, and
attachment of liens to client assets. Also as discussed below, we
believe that many of these important protections are already provided--
through contract or practice--by certain custodians to certain
custodial customers in the current market. However, the proposed rule
is designed to expand and formalize the minimum standard of protections
to advisory clients' assets held by qualified custodians in a manner
that would provide consistent investor protections across all qualified
custodians under our proposed rule. We believe that the proposed rule
leverages the expertise and regulatory regimes of qualified custodians
with respect to a wide range of assets, while, at the same time,
tailoring and bolstering the protections afforded to advisory clients
to improve the safeguarding of client assets over which advisers have
custody.
1. Definition of Qualified Custodian
Qualified custodians under the proposed rule would include the
types of financial institutions that clients and advisers customarily
turn to for custodial services and that have in place practices that
are designed to protect custodial assets. We continue to believe that
the use of a qualified custodian would enhance the protections afforded
to client assets.\88\
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\88\ See 2003 Adopting Release, supra footnote 2; 2009 Adopting
Release, supra footnote 11.
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The proposed rule, like the current rule, would define the term
``qualified custodian'' to mean a bank or savings association,
registered broker-dealer, registered futures commission merchant
(``FCM''), or certain type of foreign financial institution (``FFI'')
that meets the specified conditions and requirements.\89\ We continue
to believe that these financial institutions should be permitted to act
as qualified custodians because, as discussed in more detail below,
they operate under regular government oversight, are subjected to
periodic inspection and examination, have familiarity with providing
custodial services, and are in a position to attest to custodial
customer holdings and transactions \90\--all critical
[[Page 14683]]
components of safeguarding client assets under the proposed rule. As a
result, with the exception of proposed amendments to the definition of
qualified custodian relating to banks, savings associations, and FFIs,
we are not changing the types of institutions that may serve as
qualified custodians under the rule.\91\
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\89\ Proposed rule 223-1(d)(10). Not all registered broker-
dealers and registered FCMs meet the definition of qualified
custodian under the custody rule or the proposed safeguarding rule.
Notably, only those broker-dealers or FCMs holding client assets in
customer accounts meet this definition. This would include the
broker-dealers subject to the customer protection rule (Exchange Act
Rule 15c3-3) and FCMs holding futures customers funds subject to 17
CFR 1.20.
\90\ See, e.g., 2009 Adopting Release, supra footnote 11, at
section I (describing qualified custodians under the rule as the
types of financial institutions to which clients and advisers
customarily turn for custodial services and as subject to regulation
and oversight).
\91\ We remind advisers that as additional financial
institutions become available to custody assets, advisers must
continue to exercise their fiduciary duties to clients in connection
with selection and monitoring of the qualified custodian. See, e.g.,
Standard of Conduct for Investment Advisers Release, supra note 57,
at section II (``The investment adviser's fiduciary duty is broad
and applies to the entire adviser-client relationship.'') (citations
omitted).
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a. Bank and Savings Association Qualified Custodian Proposed Amendments
The current rule includes in the definition of qualified custodian
a bank as defined in section 202(a)(2) of the Advisers Act (15 U.S.C.
80b-2(a)(2)) or a savings association as defined in section 3(b)(1) of
the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has
deposits insured by the Federal Deposit Insurance Corporation under the
Federal Deposit Insurance Act (12 U.S.C. 1811). The proposed rule would
largely retain this definition of qualified custodian relating to banks
and savings associations. However, in connection with the proposed
rule's focus on setting certain minimum protections for client assets,
the rule would require that a qualifying bank or savings association
hold client assets in an account that is designed to protect such
assets from creditors of the bank or savings association in the event
of the insolvency or failure of the bank or savings association (i.e.,
an account in which client assets are easily identifiable and clearly
segregated from the bank's assets) in order to qualify as a qualified
custodian. We believe that requiring banks and savings associations to
hold client assets in such an account brings the requirements for bank
and savings association qualified custodians in line with the
protections required for broker-dealers, FCMs, and FFIs acting as
qualified custodians under the current custody rule and under the
proposed safeguarding rule.\92\
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\92\ The current custody rule requires that in order to be
included in the definition of qualified custodian, a broker-dealer
registered under section 15(b)(1) of the Securities Exchange Act of
1934 (15 U.S.C. 78o(b)(1)), must hold the client assets in customer
accounts, a futures commission merchant registered under section
4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)) must hold the
client assets in customer accounts subject to certain additional
requirements, and an FFI must customarily hold financial assets for
its customers and must keep the advisory clients' assets in customer
accounts segregated from its proprietary assets. See rule 206(4)-
2(d)(6)(ii), (iii), and (iv). See also proposed rule 223-1(d)(10).
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We believe that the proposed account requirement would improve the
safeguarding of client assets. We understand that, generally, a bank
deposit account creates a debtor-creditor relationship between the bank
and depositor.\93\ This debtor-creditor relationship typically does not
create a special or fiduciary relationship.\94\ While applicable
insolvency law and procedures vary depending on any particular bank or
savings association's regulatory regime,\95\ we understand that assets
held in accounts of the type proposed by the rule are more likely to be
returned to clients upon the insolvency of the qualified custodian
because they may pass outside of a bank's insolvency, may be
recoverable if wrongly transferred or converted, and are not treated as
general assets of the bank.\96\
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\93\ See generally, Graham, Heitz, Lapine, et al., 6a Banking
Law section 134.05 (2022) section 134.05 (collecting cases)
(``Banking Law''). We understand that a deposit in a bank is either
general or special and that a deposit is a general deposit unless
there is an agreement or understanding that it should be special.
See 5C Michie on Banks and Banking, Deposits section 339 (Sept.
2022) (collecting cases) (``Michie on Banks & Banking''); Banking
Law, section 134.05 (``Accounts are either special accounts or
general accounts.'') (collecting cases).
\94\ Id.
\95\ See 3 Michie on Banks & Banking, Insolvency and
Dissolution. section 17. Jurisdiction and Powers of Courts and
Officials in General (discussing state-by state jurisdiction and
certain regulatory powers).
\96\ See Michie on Banks & Banking, Deposits section 339
(collecting cases under a wide variety of state laws where a bank
may be acting as a trustee, bailee, or agent in connection with a
customer account that is treated as other than a general deposit
account).
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We believe that the proposed rule would provide flexibility to
banks and savings associations to use the appropriate accounts
available to them under applicable law and offered by them to
customers. Rather than consider the treatment of custodial customer
assets upon a bank's failure in all 50 states, and risk the protections
of our rule eroding if state banking law protections vary or evolve, we
are proposing to establish a consistent and uniform standard to protect
all advisory clients. The account terms should identify clearly that
the account is distinguishable from a general deposit account and
clarify the nature of the relationship between the account holder and
the qualified custodian as a relationship account that protects the
client assets from creditors of the bank or savings association in the
event of the insolvency or failure of the bank or savings association.
b. Proposed Enhancements to Definition of Foreign Financial Institution
Advisory clients often invest in assets traded on foreign exchanges
and their advisers must, as a practical matter, maintain those assets
with financial institutions in foreign countries where the assets are
traded. In order to facilitate these types of holdings, the current
rule includes FFIs that customarily hold financial assets for their
customers, as qualified custodians, provided that the FFI keeps the
advisory clients' assets in customer accounts segregated from the FFI's
proprietary assets.\97\
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\97\ See rule 206(4)-2(d)(6)(iv). Under the current rule, when
an adviser selects an FFI to hold clients' assets, we believe the
adviser's fiduciary obligations require it either to have a
reasonable basis for believing that the FFI satisfies the conditions
and would provide a level of safety for client assets similar to
that which would be provided by a ``qualified custodian'' in the
United States or to disclose fully to clients any material risks
attendant to maintaining the assets with the foreign custodian. See
2003 Adopting Release, supra footnote 2, at note 22.
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We are proposing to require that an FFI satisfy seven new
conditions in order to serve as a qualified custodian for client assets
under the proposed rule.\98\ These proposed conditions are partly drawn
from our experience with the factors relevant to the safekeeping of
``Foreign Assets'' by the types of foreign financial entities that can
act as an ``Eligible Foreign Custodian'' as defined in rule 17f-5 under
the Investment Company Act.\99\ Such conditions are also designed to
address our understanding of market developments since the adoption of
rule 17f-5 by providing enhanced investor protections for advisory
clients and their assets that
[[Page 14684]]
we believe would help promote an FFI having generally similar
protections as a U.S.-based qualified custodian. Recent events in
crypto assets markets also have highlighted the need for similarly
enhanced custody safeguards of client assets held outside the United
States.
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\98\ We also propose to eliminate the requirement under the
current definition that the FFI keeps the advisory clients' assets
in customer accounts segregated from its proprietary assets because
the proposed rule, more broadly, would require advisers to obtain
reasonable assurances from qualified custodians that all advisory
client assets are segregated from the qualified custodian's
proprietary assets and liabilities. See proposed rule 223-
1(a)(1)(ii)(D).
\99\ Rule 17f-5 under the Investment Company Act defines an
Eligible Foreign Custodian as an entity that is incorporated or
organized under the laws of a country other than the United States
and that is a Qualified Foreign Bank or a majority-owned direct or
indirect subsidiary of a U.S. Bank or bank-holding company. For
these purposes, a Qualified Foreign Bank is defined as a banking
institution or trust company, incorporated or organized under the
laws of a country other than the United States, that is regulated as
such by the country's government or an agency of the country's
government. See 17 CFR 270.17f-5(a)(1) and (a)(5). Rule 17f-5(c)(1)
under the Investment Company Act lists the factors relevant to the
safekeeping of Foreign Assets, as defined in rule 17f-5(a)(2). See
17 CFR 270.17f-5(c)(1) and (a)(2).
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For an FFI to be a qualified custodian under the proposed rule, it
would need to be:
Incorporated or organized under the laws of a country or
jurisdiction other than the United States, provided that the adviser
and the Commission are able to enforce judgments, including civil
monetary penalties, against the FFI;
Regulated by a foreign country's government, an agency of
a foreign country's government, or a foreign financial regulatory
authority \100\ as a banking institution, trust company, or other
financial institution that customarily holds financial assets for its
customers;
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\100\ Defined in section 202(a)(24) of the Advisers Act [15
U.S.C. 80b-2(a)(24)].
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Required by law to comply with anti-money laundering and
related provisions similar to those of the Bank Secrecy Act [31 U.S.C.
5311, et seq.] and regulations thereunder;
Holding financial assets for its customers in an account
designed to protect such assets from creditors of the foreign financial
institution in the event of the insolvency or failure of the foreign
financial institution;
Having the requisite financial strength to provide due
care for client assets;
Required by law to implement practices, procedures, and
internal controls designed to ensure the exercise of due care with
respect to the safekeeping of client assets; and
Not operated for the purpose of evading the provisions of
the proposed rule.\101\
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\101\ Proposed rule 223-1(d)(10)(iv).
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We believe each of these proposed new conditions would enhance the
ability and responsibility of advisers to protect client assets
maintained outside the United States for the following reasons.
Regarding the first condition, we are proposing to require the
adviser to determine that the adviser and the Commission are able to
enforce judgments, including civil monetary penalties, against the FFI.
The FFI could satisfy this condition by such means as appointing an
agent for service of process in the United States or having offices in
the United States, and the adviser can request the relevant
documentation for verification purposes. This condition would thus
limit the types of foreign financial entities to those that are subject
to or consent to U.S. jurisdiction.
Regarding the second condition, we believe requiring an FFI be
regulated by a foreign country's government, an agency of a foreign
country's government, or a foreign financial regulatory authority, as
defined in section 202(a)(24) of the Advisers Act, would help ensure
that client assets maintained with an FFI are subject to regulatory
oversight that would better serve our policy goal of protecting
custodial assets by the use of qualified custodians that meet our
proposed requirements. In addition to banking institutions and trust
companies, we would permit foreign-regulated financial institutions who
customarily hold financial assets for their customers (e.g., the
foreign equivalent of broker-dealers or FCMs) to serve as ``qualified
custodians.''
We believe the requirement in the third condition for an FFI to
comply with anti-money laundering (``AML'') and related provisions
similar to those of the Bank Secrecy Act (``BSA'') and regulations
thereunder would help increase the likelihood that the FFI would
readily identify and investigate aberrant behavior in a client account,
such as activity that might suggest misappropriation or some other type
of loss to a client. We generally believe an FFI would be able to
satisfy this condition if it is required to comply with the laws and
regulations established by a member or observer jurisdiction of the
Financial Action Task Force (``FATF'') and not otherwise listed on any
sanctions list administered by the Office of Foreign Assets Control of
the U.S. Department of the Treasury (``OFAC''),\102\ or on any special
measures list administered by the Financial Crimes Enforcement Network
of the U.S. Department of the Treasury (FinCEN'').\103\
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\102\ The FATF is an inter-governmental body whose purpose is
the development and promotion of policies, both at the national and
international levels, to combat money laundering and the financing
of terrorism and proliferation. The FATF monitors members' progress
in implementing AML measures, reviews money laundering techniques
and counter-measures, and promotes the adoption and implementation
of AML measures globally. See https://www.fatf-gafi.org/en/the-fatf/what-we-do.html/. To search sanctions lists administered by OFAC,
such as the Specially Designated Nationals and Blocked Persons list,
see https://sanctionssearch.ofac.treas.gov.
\103\ See section 311 of the USA PATRIOT Act [Pub. L. 107-56]
(granting the Secretary of the Treasury the authority to conclude,
if reasonable grounds exist, that a foreign jurisdiction, foreign
financial institution, or an international transaction or account is
of ``primary money laundering concern,'' and to require domestic
financial institutions and financial agencies to take certain
``special measures,'' such as additional due diligence and special
attention to particular account transactions, among other measures,
against the designated entity).
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The fourth condition would replace and strengthen the segregation
requirement for FFIs in the current definition of qualified custodian
in the custody rule, and it is designed to complement the proposed
segregation requirements of the safeguarding rule. In the current rule,
an FFI that customarily holds financial assets for its customers is
permitted to serve as a qualified custodian, provided that the FFI
keeps the advisory clients' assets in customer accounts segregated from
its proprietary assets. The proposed new condition would require the
FFI to hold financial assets for its customers in accounts designed to
protect such assets from creditors of the FFI in the event of the
insolvency or failure of the FFI.\104\ This condition would thereby
impose investor protections, particularly in the event of an FFI
insolvency or bankruptcy, that are more comparable to those we are
proposing for assets held with U.S.-regulated bank or savings
association qualified custodians. We believe advisers would be able to
assess whether an FFI is holding client assets in such accounts in the
course of obtaining the reasonable assurances we are proposing to
require advisers obtain from all qualified custodians, which are
discussed more fully below.\105\
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\104\ Compare rule 204-2(d)(6)(iv) with proposed rule 223-
1(d)(10)(iv)(D).
\105\ See infra section II.B.3.a.iv (discussing the adviser's
requirement to obtain reasonable assurances from qualified
custodians regarding the required account segregation requirements).
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The fifth condition is designed to limit the types of FFIs that can
serve as qualified custodians to those that have the requisite
financial strength to meet the proposed due care standard for client
assets. We believe the determination of an FFI's financial strength
could be based on objective measures and other indicators of financial
health that are reasonably comparable to those that apply to U.S. banks
and other regulated financial institutions.\106\ Given that advisers
would be required to maintain an ongoing reasonable belief that the FFI
qualified custodian is meeting its due
[[Page 14685]]
care standard, advisers also could require notifications from the FFI
of any changes, including changes in the financial strength of the FFI,
that would have an impact on the agreed terms of the written custodial
contract. Such notifications may provide timely information to help
advisers, as fiduciaries, to react and respond to emerging risks of
loss of client assets.
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\106\ When the Commission adopted amendments to rule 17f-5 (17
CFR 270.17f-5) in 1997, its adopting release offered guidance to
evaluate financial strength by ``assess[ing] the adequacy of the
custodian's capital with a view of protecting the fund against the
risk of loss from a custodian's insolvency.'' See Custody of
Investment Company Assets Outside the United States, Investment
Company Act Release No. 22658 (May 12, 1997) [62 FR 26923 (May 16,
1997)], at 26928. We understand that relevant governments and their
banking regulators typically set regulatory capital requirements for
foreign banking institutions.
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Under the sixth condition, FFI qualified custodians would be
required by law to implement practices, procedures, and internal
controls designed to ensure the exercise of due care with respect to
the safekeeping of assets. Since FFIs are subject to a broad range of
regulatory regimes, we believe this condition would help promote a
minimum level of practices, procedures, and internal controls across
qualified custodians for safekeeping client assets under the proposed
rule, regardless of where and how they are held. Further, we believe
this requirement will help to ensure that an FFI's practices,
procedures, and internal controls, including, but not limited to, those
with respect to the safekeeping of certificated and uncertificated
assets, custodial recordkeeping, and security and data protection,
should not differ in material ways from those of U.S.-regulated
qualified custodians. Similar to the fourth condition, advisers should
be able to assess and evaluate an FFI's internal controls while
obtaining the reasonable assurances we are proposing advisers obtain
from all qualified custodians.\107\
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\107\ See infra section II.B.3.a.i (discussing the adviser's
requirement to obtain reasonable assurances from a qualified
custodian regarding the qualified custodian's required exercise of
due care and implementation of appropriate measures to safeguard
client assets from theft, misuse, misappropriation, or other similar
type of loss).
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Finally, we have included an anti-evasion requirement in the
seventh condition for FFI qualified custodians that is similar to the
anti-evasion provision currently in the definition of ``bank'' under
section 202(a)(2) of the Advisers Act and in the definition of ``U.S.
Bank'' under rule 17f-5 of the Investment Company Act.\108\ Given the
broad scope of foreign financial entities that we would permit to serve
as qualified custodians, we believe it is appropriate to apply the
anti-evasion requirement to all types of FFIs, rather than limiting its
application to only banking institutions or trust companies.
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\108\ 17 CFR 270.17f-5(a)(7)(iii).
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We request comment on all aspects of the proposed rule's qualified
custodian requirement, including the following items.
18. Should we continue to require that client assets be maintained
with qualified custodians? If not, what alternative protections for
client assets should we require as part of the rule?
19. Should the rule continue to include banks as defined in section
202(a)(2) of the Advisers Act or savings associations as defined in
section 3(b)(1) of the Federal Deposit Insurance Act as qualified
custodians, as proposed? Should the rule narrow the definition to
include only certain banks and savings associations as qualified
custodians? If so, how? For example, should the rule permit only banks
or savings associations that are subject to Federal regulation and
supervision to act as qualified custodians? Alternatively, should the
rule permit only state banks and savings association that are members
of the Federal Reserve System to act as qualified custodians? \109\
Would narrowing of the types of banks and savings associations that
meet the definition of qualified custodian provide additional
protections to advisory clients in the event of the custodian's
insolvency? Is there another way to achieve our policy goal?
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\109\ See generally Membership of State Banking Institutions in
the Federal Reserve System (Regulation H) 12 CFR 208.01 et. seq.
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20. Should we require banks and savings associations to hold client
assets in an account designed to protect such assets from creditors of
the bank or savings association in the event of the insolvency or
failure of the bank or savings association as proposed? Is our
understanding correct that requiring banks and savings associations to
hold client assets in an account of this type would provide client
assets with enhanced protection from general creditors in the event of
the qualified custodian's insolvency and increase the likelihood of
return of client assets to advisory clients upon a qualified
custodian's insolvency? Do commenters agree with our view that this
enhanced protection is especially important in light of the broad range
of regulatory regimes and insolvency processes to which a growing
number of state-chartered trust companies and other state-chartered,
limited purpose banking entities entering the custodial market may be
subject?
21. Should the rule require the account terms to identify clearly
that the account is distinguishable from a general deposit account?
Should the rule require the terms of the account clarify the nature of
the relationship between the account holder and the qualified
custodian, for example, whether the account is a special account,\110\
a fiduciary account,\111\ or whether the bank or savings association is
acting as a trustee, a bailee, or agent of the account holder?
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\110\ See, e.g., Bank of America, N.A. v. Lehman Bros. Holdings,
Inc. (In re Lehman Bros. Holdings, Inc.), 439 B.R. 811, 824-825
(Bankr. S.D.N.Y. Nov. 16, 2010) (``Other factors that courts have
examined to ascertain the parties' mutual intent [to create a
special rather than general account] include: (1) whether the
parties agreed to segregate the funds; (2) whether the bank paid
interest on the funds; (3) whether the depositor lacked an
unfettered right to withdraw the funds; and (4) whether a third
party possessed an interest in the funds.'').
\111\ See, e.g., 12 CFR 9.13 and 12 CFR 150.230 (addressing
custody of fiduciary assets for banks and savings associations,
respectively).
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22. Would requiring banks and savings associations to hold client
assets in an account designed to protect such assets from creditors of
the bank or savings association in the event of the insolvency or
failure of the bank or savings association reduce the availability of
banks or savings associations that could offer services as a qualified
custodian? Would it increase costs to advisory clients?
23. Rather than requiring accounts of this type for all banks and
savings associations, should the rule require accounts that protect
client assets from creditors of a bank or savings association in the
event of the insolvency or failure of the bank or savings association
for a subset of these institutions that are not federally insured or
OCC member banks? For example, should the rule require accounts of this
type for state banks that are not members of the Federal Reserve
System?
24. Are there alternative bank and savings association account
safeguards we should require?
25. Should the rule continue to include broker-dealers registered
under section 15(b)(1) of the Securities Exchange Act of 1934
(``Exchange Act'') as qualified custodians, as proposed? Are there
additional requirements we should require when a broker-dealer is
acting as a qualified custodian under the rule? For example, should we
explicitly clarify that this would include only registered broker-
dealers that carry customer accounts, or is that already understood
from the current rule?
26. Should the rule continue to include FCMs as qualified
custodians, as proposed? Should we remove the condition in the current
rule that prohibits maintaining client securities with an FCM unless
the securities are ``incidental'' to client futures transactions? In
2013, the CFTC enhanced protections afforded to customers and customer
assets held by FCMs including protections covering,
[[Page 14686]]
among other things, risk management, recordkeeping and disclosure, and
the treatment of customer-segregated funds secured in foreign futures
and options accounts.\112\ Are the 2013 CFTC regulatory enhancements
sufficient grounds to eliminate that condition of the current rule?
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\112\ The CFTC in 2013 enhanced FCM requirements surrounding the
holding and investment of customer funds, including the ability of
FCMs to withdraw funds from futures customer segregated accounts.
Under the enhanced protections, FCMs are required to deposit
proprietary funds (i.e. residual interest) into futures, cleared
swap, and foreign futures customer accounts for purposes of creating
a buffer to ensure compliance with segregation requirements. In
addition, FCMs are required to file electronically their segregation
calculations with the CFTC and their self-regulatory organization
each business day. Further, FCMs are required to establish risk
management programs designed to monitor and manage risks associated
with customer funds. See Enhancing Protections Afforded Customers
and Customer Funds Held by Future Commission Merchants and
Derivatives Clearing Organizations, (``CFTC Enhanced Protections
Release'') [78 FR 68506 (Nov. 14, 2013)].
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27. Should the rule limit the FFIs that can act as qualified
custodians under this rule, as proposed? Are the proposed conditions on
an FFI sufficiently clear, and if not, how should they be made clearer?
Should we eliminate any condition, add any condition, or require only
certain conditions and not others when an FFI is acting as a qualified
custodian under the rule? For example, as part of the rule, should we
require an adviser to find that the FFI provides a level of safety for
client assets equivalent to that which would be provided by a qualified
custodian in the United States or to fully disclose to clients any
material risks attendant to maintaining the assets with the foreign
custodian? Should this requirement apply only when the adviser is
involved in selecting (or assisting a client in selecting) a qualified
custodian? Are there types of FFIs that currently serve as qualified
custodians that would no longer be eligible to serve as qualified
custodians under the proposed rule? Would the proposed changes to the
definition of FFI enhance or inhibit investor protections? Would the
proposed changes to the definition of FFI cause any investments that an
investment adviser currently is able to select on behalf of its clients
to become unavailable for selection by the adviser due to the lack of
the existence of an FFI that satisfies the conditions of the proposed
rule? Should we only permit institutions regulated by a specific
foreign financial regulatory authority? If so, which foreign financial
authority and why? Should we require the adviser to obtain
documentation that identifies the FFI's specific financial regulatory
authority or authorities? Should the rule permit only certain types of
FFIs to qualify as qualified custodians and if so, which ones? Are
there any types of regulated foreign entities that should not hold
certain types of client assets outside the United States? Should the
proposed rule account for the country or jurisdiction where an FFI is
primarily operating, rather than the country or jurisdiction of
incorporation or organization, as proposed? If so, how would the
adviser determine where the FFI is primarily operating?
28. Should the proposed rule limit the types of FFIs that can be
qualified custodians? If so, which institutions should be included?
Only banking institutions or trust companies? Should we also
specifically include foreign securities depositories and clearing
agencies or broker-dealer and FCM equivalents?
29. Is the proposed definition to include regulated FFIs that
customarily hold financial assets for customers too broad; would it
allow unsound institutions to act as qualified custodians under the
proposed rule?
30. What, if any, impacts would our proposed conditions have on the
availability of FFIs that can serve as qualified custodians? What would
be the positive and negative effects of requiring FFIs to provide
custodial protections similar to the protections provided by U.S.
qualified custodians?
31. Should the proposed rule require an FFI to be subject to or
consent to U.S. jurisdiction for judgment enforceability, as proposed?
Alternatively, should judgment enforceability be a factor relevant to
the adviser's consideration of whether client assets will be subject to
the requisite due care standard by an FFI, similar to the approach in
rule 17f-5(c)(1) under the Investment Company Act? \113\ Should we
require the adviser to obtain the FFI's consent to service of process
in the United States to verify that it meets this condition? Should
such consent to service of process be effected by the FFI's submission
of a specified form to the Commission, similar in effect to Form ADV-NR
for the appointment of an agent for service of process by a non-
resident general partner or a non-resident managing agent of any
investment adviser?
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\113\ See 17 CFR 270.17f-5(c)(1)((iv).
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32. Should an FFI be required to comply with laws and regulations
similar to the BSA to act as a qualified custodian, as proposed? Do the
AML requirements for FFIs help ensure that a qualified custodian would
more readily identify and investigate aberrant behavior in a client's
account? Alternatively, should we specify the types of AML programs
that must be in place for FFIs?
33. Should we treat an FFI as being required to comply with laws
and regulations similar to the BSA if the FFI is required to comply
with the laws and regulations established by a member or observer
jurisdiction of the FATF and not otherwise listed on any sanctions list
administered by the OFAC or on any special measures list under section
311 of the USA PATRIOT Act administered by FinCEN? Alternatively (or in
addition), should we automatically consider an FFI to not be required
to comply with similar laws and regulations if it is required to comply
with the laws and regulations of a country identified by the FATF as a
high-risk or other monitored jurisdiction? \114\
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\114\ The FATF identifies jurisdictions with weak measures to
combat money laundering and terrorist financing in two FATF public
documents that are issued three times a year. See https://www.fatf-gafi.org/en/topics/high-risk-and-other-monitored-jurisdictions.html.
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34. Should we require that an FFI hold financial assets in accounts
designed to protect such assets from creditors of the FFI in the event
of the FFI's insolvency or failure, as proposed? Alternatively, should
we require advisers to obtain reasonable assurances from an FFI
qualified custodian that the FFI is holding client assets in such
accounts? Should we require an FFI to have account protections that are
generally similar to those of a U.S. bank or savings association in the
event of its insolvency or failure? If so, should we provide guidance
around how an adviser would make such determinations of general
similarity and to maintain records of these determinations?
35. Should we provide additional guidance around how an adviser
would determine that an FFI's practices, procedures, and internal
controls are designed to ensure the exercise of due care with respect
to safekeeping of client assets? Should we require an FFI's practices,
procedures, and internal controls to be generally similar to those of a
U.S.-regulated bank or savings association? If an FFI is not a bank or
savings association, but rather a foreign-equivalent to a U.S. broker-
dealer or U.S. FCM, should we require the adviser to determine that
such FFI's practices, procedures, and internal controls are generally
similar to those required by U.S. broker-dealers or FCMs? If so, should
we provide guidance around how advisers would make such determinations
of general similarity and
[[Page 14687]]
to maintain records of these determinations?
36. Should we provide additional guidance around how an adviser
would determine the requisite financial strength of an FFI qualified
custodian? Should we require advisers to maintain records of these
determinations? Should we require advisers to have policies and
procedures to determine and monitor the financial strength of all
qualified custodians, not just FFI custodians? Should this requirement
apply only when the adviser is involved in selecting (or assisting a
client in selecting) a qualified custodian?
37. To what extent do advisers or qualified custodians utilize sub-
custodians, such as foreign subsidiaries of a domestic qualified
custodian? What types of sub-custodians are utilized? Do these sub-
custodians have direct relationships with the adviser or client or do
they only interact directly with the qualified custodian? How are sub-
custodians overseen? Is this oversight performed by the adviser or the
qualified custodian? If it is by the qualified custodian, how do
advisers ensure that the client assets are safeguarded properly?
38. Should the rule permit securities depositories, administrators,
or other intermediaries to be qualified custodians? Do they offer
similar services to the other types of financial institutions that meet
this definition, for example, by safeguarding and providing account
statements to advisory clients? Would they be able to agree to the
contractual terms contained in the proposed written agreement
requirement? Would advisers be able to satisfy the reasonable
assurances requirement under the proposed rule if one of these types of
entities were holding client assets? Do these types of entities
maintain ``possession or control'' of client assets, as discussed
below? Do they have similar capital adequacy requirements under their
respective regulatory regimes to the other types of financial
institutions that are included in the definition of qualified
custodian? Are there certain categories of these entities that would
more easily function as qualified custodians than others?
39. The rule currently excepts advisers from complying with the
requirement to maintain mutual fund shares with a qualified custodian,
provided they are maintained with a transfer agent.\115\ Should
transfer agents be included in the definition of qualified custodian in
the final rule? Do they offer similar services to the other types of
financial institutions that meet this definition, for example, by
providing account statements to advisory clients? Would they be able to
agree to the contractual terms contained in the proposed written
agreement requirement? Would advisers be able to satisfy the reasonable
assurances requirement under the proposed rule if a transfer agent were
holding client assets?
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\115\ Rule 206(4)-2(b)(1).
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40. Should insurance companies be included in the definition of
qualified custodian under certain circumstances, such as in the
variable annuity context? \116\ Do they offer services similar to the
other types of financial institutions that meet this definition, for
example, by safeguarding and providing account statements to advisory
clients? Would they be able to agree to the contractual terms contained
in the proposed written agreement requirement? Would advisers be able
to satisfy the reasonable assurances requirement under the proposed
rule if an insurance company were holding client assets? Do insurance
companies maintain ``possession or control'' of client assets, as
discussed below? Do insurance companies have similar capital adequacy
requirements to the other types of financial institutions that are
included in the definition of qualified custodian? Are there certain
categories or types of insurance companies that would more easily
function as qualified custodians than others?
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\116\ Our staff indicated it would not recommend enforcement
action when an insurance company served a particular role with
respect to variable annuity contracts similar to the role of a
transfer agent with respect to mutual fund shares. See American
Skandia Life Assurance Corporation, May 16, 2005.
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2. Possession or Control
In a change from the current rule, the proposed rule would require
that an investment adviser maintain client assets with a qualified
custodian that has possession or control of those assets. For the
purposes of proposed rule, ``possession or control'' would be defined
to mean holding assets such that the qualified custodian is required to
participate in any change in beneficial ownership of those assets, the
qualified custodian's participation would effectuate the transaction
involved in the change in beneficial ownership, and the qualified
custodian's involvement is a condition precedent to the change in
beneficial ownership.\117\ We understand that a qualified custodian's
participation in a change in beneficial ownership may take different
forms depending on the type of asset involved.\118\ Similarly, we view
participation by a qualified custodian to require the qualified
custodian to participate in a way that it is willing to attest to the
transaction on an account statement and for which it customarily takes
custodial liability. By contrast, we would not view ``accommodation
reporting,'' as described above, to constitute ``participation.'' The
proposed requirement and related definition are designed to achieve
several objectives. First, a critical custodial function is to prevent
loss or unauthorized transfers of ownership of the client's assets. It
is our understanding that a custodian will only provide this
safeguarding function, however, and assume custodial liability for a
custodial customer's loss, if the custodian had possession or control
of the asset that is lost. Second, because the qualified custodian
would be required to participate in any change in beneficial ownership
of a client asset, the proposed possession or control definition would
provide assurance that a regulated party who is hired for safekeeping
services by the client to act for the client is involved in any change
in beneficial ownership of the client's asset. Finally, we believe it
would help ensure the integrity of account statements provided by
qualified custodians because the custodian would report only on the
holdings in its possession or control (unless the client requests that
the qualified custodian report on holdings that are not in its
possession or control). As a result, a client could take comfort that
what is reported on its account statement is an accurate attestation of
holdings and transactions by that custodian.
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\117\ See proposed rule 223-1(a)(1)(i) and (d)(2)(8). Exchange
Act Rule 15c3-3(c) prescribes when securities shall be deemed to be
under the control of a broker-dealer. See 17 CFR 240.15c3-3(c).
\118\ For example, for certain privately offered securities, we
understand banks will put the securities in their name as nominee.
We also understand that a change in beneficial ownership may occur
at different points in the transaction lifecycle based on the type
of asset involved. For example, when purchasing an equity security,
the change in beneficial ownership occurs on trade date (see, e.g.,
rule 240.13d-3--Determination of beneficial owner), but we
understand that when purchasing real property, the change in
beneficial ownership typically occurs on the settlement date.
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The proposed definition of ``possession or control'' in proposed
rule 223-1 is designed to be consistent with the laws, rules, or
regulations administered by the qualified custodian's functional or
primary financial regulator for purposes of its custodial activities.
Under the existing regulatory regimes under which qualified custodians
currently operate, a qualified custodian must generally
[[Page 14688]]
maintain assets in its physical possession or control. We believe our
proposed definition of possession or control (i.e., being required to
participate in any change of beneficial ownership) is consistent with
how the concept of possession or control is understood currently by
most qualified custodians and does not conflict with the requirements
of qualified custodians' respective regulatory regimes. The proposed
rule would formalize that understanding.
For example, under the Exchange Act, broker-dealers are required
promptly to obtain and maintain in their physical possession or control
all of their customers' fully paid and excess margin securities.\119\
As a result, a broker-dealer would necessarily be involved in the
transfer of beneficial ownership of those securities. In addition,
national banks that offer safeguarding of customer assets are
responsible for maintaining adequate custody or control of their
customer assets.\120\ Again, as a result, national banks would have to
relinquish their custody or control of an asset to transfer ownership.
Similarly, the protections under section 4d(a)(2) of the Commodity
Exchange Act and regulations promulgated thereunder, including, among
others, CFTC regulation 1.20 (Futures customer funds to be segregated
and separately accounted for), CFTC regulation 1.22 (Use of futures
customer funds restricted), and CFTC regulation 1.25 (Investment of
customer funds),\121\ are predicated on the acceptance of, and receipt
by, a futures commission merchant of futures customers money,
securities, or property.\122\ It is our understanding that together,
these, and other regulations applicable to FCMs, holistically serve the
same purpose. In each of the foregoing cases, the respective custodian
is required by its functional regulator to possess or control customer
assets. While functional regulators have not defined possession or
control in the custody context in a manner identical to our proposed
rule (i.e., holding assets such that the qualified custodian is
required to participate in any change in beneficial ownership of those
assets), we view the proposed definition to be crucial to safeguarding
client assets and reflective of the fundamental underlying principle of
the custody industry--a custodian holds client assets for safekeeping
until directed by the client or the client's duly authorized agent to
enter into a transaction with a counterparty resulting in a change of
the client's beneficial ownership.\123\
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\119\ See 17 CFR 240.15c3-3(b) and (c).
\120\ National banks that fail to exercise proper control over
customer securities may be subject to enforcement proceedings by the
Comptroller of the Currency. See 12 U.S.C. 92a(k) (proceeding to
revoke trust powers on account of unlawful or unsound exercise of
powers). See also OCC, Comptroller's Handbook on Asset Management
Operations and Control (Jan. 2011), available at https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html; OCC regulation 12 CFR 9.13 (requiring, in connection
with the custody of fiduciary assets, among other things, that
``assets of fiduciary accounts [be placed] in the joint custody or
control'' of certain fiduciary officers or specially designated
persons). The OCC has issued guidance relating specifically to
custody of crypto assets by banks and Federal savings associations.
See Interpretive Letter 1170, Authority of a National Bank to
Provide Cryptocurrency Custody Services for Customers (July 22,
2020), available at https://www.occ.gov/topics/charters-and-licensing/interpretations-and-actions/2020/int1170.pdf (``As with
all other activities performed by national banks and FSAs, a
national bank or FSA that provides cryptocurrency custody services
must conduct these activities in a safe and sound manner, including
having adequate systems in place to identify, measure, monitor, and
control the risks of its custody services. Such systems should
include policies, procedures, internal controls, and management
information systems governing custody services. Effective internal
controls include safeguarding assets under custody, producing
reliable financial reports, and complying with laws and regulations.
The OCC has previously described that custody activities should
include dual controls, segregation of duties and accounting
controls. A custodian's accounting records and internal controls
should ensure that assets of each custody account are kept separate
from the assets of the custodian and maintained under joint control
to ensure that that an asset is not lost, destroyed or
misappropriated by internal or external parties. Other
considerations include settlement of transactions, physical access
controls, and security servicing. Such controls may need to be
tailored in the context of digital custody. Specialized audit
procedures may be necessary to ensure the bank's controls are
effective for digital custody activities. For example, procedures
for verifying that a bank maintains access controls for a
cryptographic key will differ from the procedures used for physical
assets. Banks seeking to engage in these activities should also
conduct legal analysis to ensure the activities are conducted
consistent with all applicable laws.'').
\121\ See also section 4d(a)(2) of the Commodity Exchange Act
and CFTC Regulations 1.20-1.30 (Customers' Money, Securities, and
Property); and see CFTC Regulation 1.32 (Reporting of segregated
account computation and details regarding the holding of futures
customer funds; CFTC Regulation 1.36 (Record of securities and
property received from customers). These regulations address, among
other things, segregation of customer funds, limitations on
institutions in which the FCM may deposit customer funds,
limitations on holding customer funds outside of the United States,
limitations on the use of customer funds, and recordkeeping
requirements relating to customer funds.
\122\ CFTC Regulation 1.3 defines a futures commission merchant
to be ``[a]ny individual, association, partnership, corporation, or
trust [ . . . ] Who, in connection with any of the[ ] activities
[identified in the regulation] accepts any money, securities, or
property [ . . . .] That regulation also defines futures customer
funds to mean ``all money, securities, and property received by a
futures commission merchant or by a derivatives clearing
organization from, for, or on behalf of, futures customers [for the
purposes identified in the regulation]. 17 CFR 1.3 (emphasis added).
\123\ Alternatively, a custodian may return the asset to the
customer.
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For purposes of an FFI, we believe that the proposed requirement
would promote the institution's accountability for client assets and
would thereby help to promote more comparable investor protections to
those assets held with U.S. financial institutions.\124\ Since FFIs are
subject to a broad range of regulatory regimes, we believe that this
requirement, together with the account statement contract requirement
discussed below, would formalize and make more uniform the assets
reported on account statements produced by an FFI, thereby better
informing clients regarding their holdings and transactions.
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\124\ See, e.g., the Undertaking for Collective Investment in
Transferable Securities Regulations 2016 (UCITS V) (enhancing the
rules on the responsibilities of UCITS custodians including making
the UCITS custodian liable for the avoidable loss of a financial
instrument held in its custody).
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a. Application With Respect to Crypto Assets
As discussed above, we believe that under their existing regulatory
regimes, qualified custodians are generally considered to have
``possession or control'' of assets that are in their exclusive or
physical possession or control. We understand, however, that proving
exclusive control of a crypto asset may be more challenging than for
assets such as stocks and bonds. For example, while we understand that
it is possible for a custodian to implement processes that seek to
create exclusive possession or control of crypto assets (e.g., private
key creation, maintenance, etc.), it may be difficult actually to
demonstrate exclusive possession or control of crypto assets due to
their specific characteristics (e.g., being transferable by anyone in
possession of a private key). Moreover, we are mindful of crypto asset
custody models in which an advisory client and a qualified custodian
might simultaneously hold copies of the advisory client's private key
material to access the associated wallet with the client's crypto
assets, and thus both have authority to change beneficial ownership of
those assets.\125\
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\125\ Letter from Anchorage Digital Bank NA re Custody Rule and
Digital Assets (Apr. 13, 2021) (``Proof of exclusive control can be
securely achieved through a combination of software, hardware, and
operational processes. However, custody models that rely on private
key redundancy (maintaining multiple physical or electronic copies)
and physical security as a proxy for digital asset security can't
ever truly prove this.'').
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[[Page 14689]]
As discussed above, the proposed rule's definition of possession or
control turns on whether the qualified custodian is required to
participate in a change in beneficial ownership of a particular asset.
While demonstrating that a qualified custodian has exclusive possession
or control of an asset would be one way to demonstrate that the
qualified custodian is required to participate a change of beneficial
ownership, it is not the only way. For example, under the proposed
rule, a qualified custodian would have possession or control of a
crypto asset if it generates and maintains private keys for the wallets
holding advisory client crypto assets in a manner such that an adviser
is unable to change beneficial ownership of the crypto asset without
the custodian's involvement.\126\
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\126\ We note that, in the context of crypto asset securities,
the Commission has stated that, ``a broker-dealer that maintains
custody of a fully paid or excess margin digital asset security for
a customer must hold it in a manner that complies with Rule 15c3-3,
including that the digital asset security must be in the exclusive
possession or control of the broker-dealer. A digital asset security
that is not in the exclusive possession or control of the broker-
dealer because, for example, an unauthorized person knows or has
access to the associated private key (and therefore has the ability
to transfer it without the authorization of the broker-dealer) would
not be held in a manner that complies with the possession or control
requirement of Rule 15c3-3 . . . .]'' Commission Statement, supra
footnote 25 at 11629 (emphasis added).
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Importantly, however, to comply with the proposed rule, an adviser
with custody of client crypto assets would generally need to ensure
those assets are maintained with a qualified custodian that has
possession or control of the assets at all times in which the adviser
has custody.\127\ While this is true for most client assets over which
an adviser has custody, it is particularly relevant with respect to
crypto assets because, as we understand, much of the crypto asset
trading volume occurs on crypto asset trading platforms that often
directly settle the trades placed on their platforms. As a result, many
crypto trading platforms require investors to pre-fund trades, a
process in which investors transfer their crypto assets, including
crypto asset securities, or fiat currency to such an exchange prior to
the execution of any trade. Because we understand that most crypto
assets, including crypto asset securities, trade on platforms that are
not qualified custodians, this practice would generally result in an
adviser with custody of a crypto asset security being in violation of
the current custody rule because custody of the crypto asset security
would not be maintained by a qualified custodian from the time the
crypto asset security was moved to the trading platform through the
settlement of the trade.\128\ In light of our proposal to expand the
rule's application from ``funds or securities'' \129\ to ``assets,''
\130\ this practice would also constitute a violation of the proposed
rule for an adviser with custody of client crypto assets if the adviser
trades those assets on a crypto asset trading platform that does not
satisfy the definition of ``qualified custodian.'' Alternative Trading
Systems that do not require pre-funding of trades and that trade crypto
asset securities following a process that does not involve the broker-
dealer operator of the Alternative Trading System providing custodial
services for the crypto asset securities are discussed further
below.\131\
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\127\ This is not only true for crypto assets, but any client
asset for which an adviser has custody, subject to the exceptions in
the proposed rule. See proposed rule 223-1(b)(1) (Shares of Mutual
Funds), (2) (Certain Assets Unable to be Maintained with a Qualified
Custodian), and (5) (Registered Investment Companies).
\128\ This differs from the approach with a U.S. national
securities exchange, which does not routinely exercise possession or
control of the securities listed on a national securities exchange.
In this scenario, trades are executed on a national securities
exchange, establishing the contract between buyer and seller. The
national securities exchange then passes transaction details on to a
clearing agency or depository, which steps in to facilitate and
complete settlement between each party's custodian, specifically the
exchange of cash and securities per the trade's contracted terms
agreed on the national securities exchange on a delivery versus
payment basis.
\129\ See rule 206(4)-2(a).
\130\ See proposed rule 223-1(a).
\131\ See infra footnotes 460-461 and accompanying text.
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We request comment on all aspects of the proposed possession or
control requirement, including the following items.
41. Should the rule include the possession or control requirement,
as proposed? Would the proposed requirement provide additional
protections for clients? Possession or control would be defined to mean
holding assets such that the qualified custodian is required to
participate in any change in beneficial ownership of those assets. Do
commenters agree with our view that the term ``participation'' would
mean that the qualified custodian would effectuate the transaction and
its involvement would be a condition precedent to the change in
beneficial ownership? How else would commenters describe a qualified
custodian's participation? Should we instead define possession or
control to mean holding assets such that the qualified custodian is
required to effectuate any change in beneficial ownership of those
assets? Do commenters agree with our understanding that a qualified
custodian's participation in a change in beneficial ownership may take
different forms depending on the type of asset involved? Do commenters
agree with our view that participation by a qualified custodian would
require the qualified custodian be willing to attest to the transaction
on an account statement? Do commenters agree with our understanding
that a qualified custodian will customarily take custodial liability
for client assets for which it participates in beneficial changes of
ownership?
42. Do the types of financial institutions serving as qualified
custodians under the current rule maintain client assets in a manner
that would satisfy the proposed definition of ``possession or
control''? Do commenters agree with our view that the proposed
definition of possession or control (i.e., being required to
participate in any change of beneficial ownership) is consistent with
how the concept of possession or control is understood currently by
most qualified custodians and does not conflict with the requirements
of qualified custodians' respective regulatory regimes?
43. Is our understanding correct that qualified custodians hold
client assets for safekeeping until directed by the client or the
client's duly authorized agent to enter into a transaction with a
counterparty resulting in a change of the client's beneficial ownership
or until directed to return the assets to the client, subject to duly
authorized custodial charges? Is our understanding correct that this is
crucial to safeguarding client assets and reflective of a fundamental
underlying principle of the custody industry?
44. Should we have different possession or control requirements for
different qualified custodians? If so, what should they be, and why?
45. Are we correct in our understanding that a custodian will
assume custodial liability for a custodial customer's avoidable loss
only if the custodian has possession or control (i.e., is required to
participate in any change in beneficial ownership) of the asset that is
lost?
46. Unlike as proposed, should the rule explicitly state that the
qualified custodian maintain ``physical'' or ``exclusive'' possession
or control of the client's assets? Do commenters agree with our
understanding qualified custodians may face greater challenges in their
ability to demonstrate exclusivity with respect to crypto assets as
compared their ability to demonstrate
[[Page 14690]]
exclusive possession or control with respect to stocks and bonds? Do
custodians for crypto assets routinely consider the crypto assets they
service to be in their exclusive possession or control? If so, how
would exclusivity be demonstrated? Are there particular safeguarding
practices with respect to crypto assets that are better suited to
demonstrating exclusivity than others? What kind of evidence would be
necessary to demonstrate proof of exclusive possession or control of
crypto assets? What type of procedures would a crypto asset custodian
need to have to demonstrate exclusive possession or control of crypto
assets? \132\ Would requiring exclusive possession or control improve
safeguarding of crypto assets? Given the nature of crypto assets, is it
possible to demonstrate the exclusive possession or control of a
particular crypto asset? How important do custodians view ``exclusive''
possession or control of a client asset, including a crypto asset, to
be for liability reasons? How do existing custodians of crypto assets
address the risk of liability for theft, fraud, or misappropriation of
crypto assets when a client (and potentially others with whom the
client has shared the private key material) retains the ability to
effect a change in beneficial ownership of the asset without the
involvement of the custodian?
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\132\ See Commission Statement, supra footnote 25, at 11629 (``A
digital asset security that is not in the exclusive physical
possession or control of the broker-dealer because, for example, an
unauthorized person knows or has access to the associated private
key (and therefore has the ability to transfer it without the
authorization of the broker-dealer) would not be held in a manner
that complies with the possession or control requirement of Rule
15c3-3 and thus would be vulnerable to the risks the rule seeks to
mitigate.'').
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47. Would a custodian for crypto assets be able to satisfy the
proposed possession or control requirement? Would such a custodian be
able to participate in a change of beneficial ownership for a client's
crypto asset? What does it mean for a custodian to ``participate'' in a
change of beneficial ownership for a client's crypto asset transaction?
Does this involve only the deployment of the private key or keys
associated with the public address where the client's crypto assets are
recorded to transfer, as instructed, the client's crypto assets to
another person with a public key? Does this also include recording or
communicating a change in beneficial ownership?
48. To what extent does a custodian for crypto assets take
custodial liability for a beneficial change in ownership of a client's
crypto assets?
49. Is our understanding of how many crypto asset trading platforms
require investors to pre-fund trades correct? How many of these trading
platforms require pre-funding trades? How many rely on other custodial
arrangements and how do those crypto asset trading platforms operate
with such custodial arrangements? How would the proposed rule impact
advisers who trade on such trading platforms currently? What, if any,
impacts would the proposed rule have on the availability of crypto
asset trading platforms that may be able to serve as qualified
custodians? Would the proposed definition of ``possession or control''
enhance or inhibit investor protections with respect to client assets
traded on crypto asset trading platforms?
50. Do custodians for crypto assets permit the customer (and
potentially others with whom the customer has shared a private key) to
retain the ability to effect a change in beneficial ownership of the
asset without the involvement of the custodian? In these cases, do
commenters believe that advisory clients would receive the benefits of
the protections of the proposed rule if they contractually required a
qualified custodian to be involved in any beneficial change of
ownership of the crypto asset? Would crypto asset advisory clients and
custodians be willing to enter into contractual agreements of that
type? Would requiring that a qualified custodian have exclusive
possession or control over the crypto asset have an impact on the
crypto asset custody industry? How big of an impact?
51. Are there asset types other than crypto assets over which a
qualified custodian may not be able to obtain ``exclusive'' possession
or control? Please indicate which asset types and explain why
exclusivity may not be possible.
52. Is our understanding correct that beneficial ownership change
may occur at different points in the transaction lifecycle based on
asset type? Is there a customary reference to when a change in
beneficial ownership occurs for each asset type? For crypto assets,
does the change in beneficial ownership occur when the transaction is
recorded on the blockchain or when the transaction is settled off-chain
on the internal ledger system of a crypto asset trading platform? Are
there differences if the transaction is recorded on a private or
permissioned ledger than on a public or un-permissioned ledger? Are
there differences if the transaction is settled on a centralized crypto
asset trading platform versus a so-called decentralized crypto asset
trading platform?
53. Many market participants refer today to ``atomic settlement''
of crypto asset trades.\133\ Is this is commonly understood and used
term? Does it mean that both legs of the trade settle simultaneously
(similar to a delivery vs. payment transaction), or that the trade
settles instantly, or both? Which aspect of crypto asset settlement
(simultaneous settlement or instantaneous settlement) is preferable
from an investor protection standpoint? Are there drawbacks to either?
Should the Commission require particular protections related to crypto
asset trades or custody? What about other crypto asset transactions?
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\133\ See Michael Lee, Antoine Martin, and Benjamin M[uuml]ller,
What Is Atomic Settlement? (Nov. 7, 2022), available at https://libertystreeteconomics.newyorkfed.org/2022/11/what-is-atomic-settlement/.
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54. Is it possible for an adviser to execute any trade that settles
instantly and while maintaining the assets at a qualified custodian
throughout the lifecycle of that trade? If so, how? Could the adviser
do so and still have the ability to trade with counterparties other
than the qualified custodian? How would that work?
3. Minimum Custodial Protections
The proposed rule would promote minimum standard custodial
protections for advisory clients whose advisers have custody of client
assets. It generally would require that the investment adviser maintain
client assets with a qualified custodian pursuant to a written
agreement between the qualified custodian and the investment adviser
(or between the adviser and client if the adviser is also the qualified
custodian).\134\ It would further require the adviser to obtain
reasonable assurances in writing from the custodian regarding certain
vital protections for the safeguarding of client assets. We understand
that under existing market practices, advisers are rarely parties to
the custodial agreement, which is generally between an advisory client
and a qualified custodian, resulting in an adviser having limited
visibility into the custodial arrangements of its clients. This
presents several issues under the current rule and can result in an
adviser being subject to the rule due to what has become known as
inadvertent custody, which can occur, for example, when the custodial
agreement between a client and custodian grants an adviser broader
access to client funds or securities than contemplated by the adviser's
own agreement with the client and the
[[Page 14691]]
adviser did not intend to have such access to client assets.\135\ We
understand that inadvertent custody often arises because a custodial
agreement grants an adviser expansive authority to transact in or
transfer assets held in its client custodial accounts (e.g., the
ability to initiate wire transfers) that are often superfluous to the
advisory services being provided. However, because advisers are rarely
a party to these agreements, their ability to repudiate unwanted
authority is limited.
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\134\ Proposed rule 223-1(a)(1)(i).
\135\ See Inadvertent Custody: Advisory Contract Versus
Custodial Contract Authority, Division of Investment Management
Guidance Update No. 2017-01 (Feb. 2017) (in which our staff
discussed its views on the application of the current custody rule
to various types of custodial agreements between a client and a
custodian that grant an adviser broader access to client funds or
securities than the adviser's own agreement with the client
contemplates).
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In addition, custodial market practices have evolved and expanded
since the rule was last amended, as have the types of assets qualified
custodians hold.\136\ Some bank qualified custodians have developed
custodial practices for crypto assets. However, Federal banking
regulators have stated more broadly regarding crypto asset-related
activities that ``[b]ased on the agencies' current understanding and
experience to date [ . . . ] the agencies have significant safety and
soundness concerns with business models that are concentrated in
crypto-asset-related activities or have concentrated exposures to the
crypto-asset sector.'' \137\ The regulatory framework to which these
institutions are subject is evolving, in part, to accommodate new
entrants to the market for custodial services, including newly launched
state-chartered trust companies that focus on providing crypto asset
custody services.\138\ In light of this evolution, we must be mindful
of the extent to which many of these new entrants to the custodial
marketplace offer, and are regulated to provide, the types of
protections we believe a qualified custodian should provide under the
rule.\139\
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\136\ See, e.g., Fiduciary Capacity; Non-Fiduciary Custody
Activities, 84 FR 17967 (Apr. 29, 2019) (the Office of the
Comptroller of Currency estimating that the size of non-fiduciary
custody assets held at national banks and Federal savings
associations has increased, since it last updated its fiduciary
regulation in 1996, to approximately $41.7 trillion as of December
21, 2018); Olga Kharif, Fidelity Says a Third of Big Institutions
Own Crypto Assets BNN Bloomberg (June 9, 2020), available at https://www.bnnbloomberg.ca/fidelity-says-a-third-of-big-institutions-own-crypto-assets-1.1447708 (reporting that, according to a survey by
Fidelity Investments, 36 percent of institutional investors in the
U.S. and Europe report holding crypto assets).
\137\ See Joint Statement on Crypto-Asset Risks to Banking
Organizations, supra footnote 27.
\138\ See, e.g., Application by Anchorage Trust Company, Sioux
Falls, South Dakota to Convert to a National Trust Bank; Application
for Residency Waiver (Jan. 13, 2021), available at https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-6a.pdf; Application by Protego Trust Company, Seattle, Washington,
to Convert to a National Trust Bank; Application for Director
Residency Waiver (Feb. 4, 2021), available at https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-19a.pdf; Application to charter Paxos National Trust, New York, New
York, OCC Control Number: 2020-NE-Charter-318305, OCC Charter
Number: 25252 (Apr. 23, 2021), available at https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-49a.pdf; New York Department of Financial Services, Financial
Services Superintendent Linda A. Lacewell Announces Grant of DFS
Trust Charter to Bitgo to Engage in New York's Growing Virtual
Currency Market (Mar. 4, 2021), available at https://www.dfs.ny.gov/reports_and_publications/press_releases/pr202103041. See also, New
York Department of Financial Services, Guidance on Custodial
Structures for Customer Protection in the Event of Insolvency (Jan
23, 2023), https://www.dfs.ny.gov/industry_guidance/industry_letters/il20230123_guidance_custodial_structures (issuing
guidance focusing on customer protection relating to segregation of
and separate accounting for customer virtual currency, custodian's
use of customer virtual currency, sub-custody arrangements, and
customer disclosure).
\139\ See, e.g., Financial Stability Oversight Council, Report
on Digital Asset Financial Stability Risks and Regulation (2022),
available at https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf (``[S]ome platforms emphasize that
they are regulated through MSB laws. These laws generally are
intended to address consumer protection related to money
transmission and to combat illicit finance. They are not intended to
address funding mismatches outside of money transmission or risks
posed by platforms custodying crypto-assets internally within
omnibus accounts, particularly when commingled with platform
assets.'').
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At the same time, we understand that some existing qualified
custodians have modified their practices to remain profitable amid
these changes, such as by contractually limiting their liability to
their customers in a variety of ways. Others have turned to outsourcing
less profitable parts of their custodial services.\140\ Our staff has
observed that the clients who are least likely to have bargaining power
are often afforded the fewest protections. These changes in the
custodial industry have caused us to reconsider the minimum protections
we believe an adviser who uses a qualified custodian to maintain
possession or control of client assets should provide.
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\140\ See Deloitte (2019), The Evolution of a Core Financial
Service: Custodian & Depository Banks, available at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf, at 42-43
(noting the trend with custodians and depositories outsourcing
operational departments to low cost labor regions in order to lower
costs and increase margins on core services that have experienced
the largest margin pressures).
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Consequently, the proposed rule would require a written agreement
between a qualified custodian and the investment adviser that
incorporates certain minimum investor protection elements for advisory
clients. Additionally, for certain protections in which the qualified
custodian's duty runs primarily or exclusively to the advisory client,
it would require the adviser to obtain reasonable assurances of certain
minimum investor protection elements for advisory clients. We believe
that this approach would have direct benefits for advisory clients and
investment advisers. We acknowledge that an agreement between the
custodian and the adviser would be a substantial departure from current
industry practice. We also understand that certain of the protections
that the rule text would promote are not universally provided to all
custodial customers today. Nonetheless, we believe it is necessary to
help protect client assets from the harms the custody rule is designed
to address and would help ensure that they receive certain standard
custodial protections under the rule.
The proposed requirements do not prescribe specific safeguarding
procedures or require that client assets be maintained in a particular
manner. Rather, they are designed to serve as guardrails that would
apply irrespective of the type of asset or the type of financial
institution acting as a qualified custodian. The requirements are also
designed to remain evergreen as methods for safekeeping continue to
evolve to reflect changes in technology, investment products, and
custodial service best practices. For example, technical requirements
for transacting and safeguarding crypto assets are likely to be
different from those for traditional assets, such as stocks, bonds, and
options. Furthermore, the design of blockchains and other distributed
ledgers that require irreversibility of crypto asset transactions
(without the consent of all parties to reverse), and the bearer nature
of private keys make it challenging to recover assets that have been
lost or stolen or to reverse benign trading errors even if an owner of
a crypto asset wallet may be identified. This is unlike the traditional
securities infrastructure, which has well-developed protocols allowing
for the reversal and cancellation of mistaken or unauthorized
transactions.
These additional risks and nuanced challenges of safeguarding
emerging assets, such as crypto assets, have caused us to consider
alternatives to the current rule's more asset-neutral approach. In
2020, our staff issued a statement requesting input on, among other
things, the types of qualities an adviser seeks when entrusting a
client's assets to a particular custodian and whether there are
qualities that would
[[Page 14692]]
be important for safeguarding crypto assets that might not be important
for safeguarding other types of assets.\141\ Several commenters shared
with the staff their views, advocating for such things as specifically
tailoring the rule based on how changes in ownership of the asset are
effectuated, including setting particular standards for qualified
custodians of crypto assets.\142\ While we agree that custodial
activities may differ between traditional assets and crypto assets, we
believe that the asset neutral approach of the current rule has been
and will continue to be more effective because it relies on the
expertise of the various types of qualified custodians and allows the
rule to remain evergreen as the types of assets held by custodians
evolve.
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\141\ See Staff Statement on WY Division of Banking's ``NAL on
Custody of Digital Assets and Qualified Custodian Status'' (Nov. 9,
2020), available at https://www.sec.gov/news/public-statement/statement-im-finhub-wyoming-nal-custody-digital-assets (the Staff
Statement used the term ``digital'' assets rather than the term
``crypto'' assets as used in this release).
\142\ See, e.g., Letter from Coinbase re Custody Rule and
Digital Assets (May 25, 2021) (stating that qualified custodians for
digital assets should, at a minimum have: institutional technical
expertise; personnel with technical expertise; minimum size;
authority to custody digital assets; robust staffing; audited
control environment; and annual certified audits); Letter from
Anchorage re Custody Rule and Digital Assets (Apr. 13, 2021)
(advocating for standard requirements for a qualified custodian that
maintains digital assets including proof of exclusive control, proof
of existence of digital assets in custody, hardware security, and
blockchain monitoring).
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Although crypto assets are a relatively recent and emerging type of
asset, this is not the first time custodians have had to adapt their
practices to safeguard different types of assets.\143\ The proposed
rule relies on the expertise of custodians with a long history of
developing different procedures for safeguarding a variety of assets.
It is also not the first time custodians have grappled with a new
method of transacting in or holding assets.\144\ These custodians also
have a long history of innovating and modernizing their practices as
methods of transacting in or holding client assets have evolved.
Rather, the proposed rule recognizes that there are certain fundamental
protections that should be provided to a custodial customer when the
adviser has custody:
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\143\ For example, bank custodians have traditionally provided
safekeeping to a variety of physical objects, such as valuable
papers, rare coins, and jewelry. See, OCC, Comptroller's Handbook on
Asset Management Operations and Control (Jan. 2011), available at
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html, at 15. See also Thevenoz, Luc, Intermediated
Securities, Legal Risk, and the International Harmonization of
Commercial Law, 13 Stan. J.L. Bus. & Fin. 384, 386 (Spring 2008)
(``Intermediated Securities'') (``Immobilization and
dematerialization of securities have made the physical delivery of
certificates nearly irrelevant. In just a few decades, the issuance
of securities has shifted from the physical to a virtual world, to
which financial intermediaries hold the key.'').
\144\ See, James Rogers, Policy Perspectives on Revised UCC
Article 8, 43 UCLA L. Rev. 1431 (1996) (discussing the role large
broker-dealers or banks acting as dealers or custodians played
during the evolution from a manual securities settlement process
focused on the processing of physical securities certificates to
highly automated electronic settlement centered on processing and
transfer of electronic book-entry securities); Adam Back, Lien on
Me, Uniformity Is Coming to Crypto-Backed Transactions, 41-12 Am.
Bankr. Inst. J. 16 (Dec. 1, 2022) (discussing proposed UCC Article
12 governing property rights in a ``controllable electronic
record'').
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A qualified custodian should exercise due care and
implement appropriate measures to safeguard the advisory client's
assets;
A qualified custodian should indemnify an advisory client
when its negligence, recklessness, or willful misconduct results in
that client's loss;
A qualified custodian should not be relieved of its
responsibilities to an advisory client as a result of sub-custodial
arrangements;
A qualified custodian should clearly identify an advisory
client's assets and segregate an advisory client's assets from its
proprietary assets;
The client's assets should remain free of liens in favor
of a qualified custodian unless authorized in writing by the client;
A qualified custodian should keep certain records relating
to those assets;
A qualified custodian should cooperate with an independent
public accountant's efforts to assess its safeguarding efforts;
Advisory clients should receive periodic custodial account
statements directly from the qualified custodian;
A qualified custodian's internal controls relating to its
custodial practices should be evaluated periodically for effectiveness;
and
A custodial agreement should reflect an investment
adviser's agreed-upon level of authority to effect transactions in the
advisory client's account.
We believe that financial institutions that act as qualified
custodians under the current rule already provide some of the
protections that would be required under the proposed rule's
requirements, either to satisfy regulatory requirements, or pursuant to
their existing contracts with their clients. For example, we understand
that some qualified custodians usually provide quarterly account
statements to their custodial customers. We also understand that
qualified custodians often obtain periodic reports of their internal
controls. Further, we understand that qualified custodians may
currently indemnify their custodial customers against the risk of loss,
but we understand that the indemnification standard--for example,
ordinary negligence or gross negligence--often varies by institution
and by customer. To the extent an element is not typical for a
particular custodian, it may create practical difficulties (e.g.,
higher costs of compliance, or market contraction for custodial
services). On balance, however, we believe the proposed rule promotes
key protections to which every custodial customer should be entitled
when the adviser has custody.
Some of these protections are best promoted via written agreement
between the adviser and custodian; others are best promoted via the
adviser obtaining reasonable assurances in writing from the qualified
custodian that the protections will be provided to the advisory client.
We view the safekeeping protections that would be required in the
proposed written agreement to be duties owed to both the client and
adviser, while we view the safekeeping protections in the proposed
reasonable assurances requirements to be duties owed primarily to the
client and, therefore, are proposing these protections in a manner that
we believe appropriately reflects the respective obligations. We are
also proposing to require that the adviser reasonably believe that the
contractual provisions and reasonable assurances obtained by the
adviser have been implemented by the qualified custodian.\145\ We
understand that many of the obligations under the contractual
provisions and reasonable assurances obtained by the adviser rest on
the qualified custodian, and that implementation for each requirement
may vary widely depending on the facts and circumstances of the parties
in interest and assets in interest. Nonetheless, advisers should enter
into a written agreement with a qualified custodian based upon a
reasonable belief that the qualified custodian is capable of, and
intends to, comply with the contractual provisions. The adviser should
have the same reasonable belief regarding the reasonable assurances
obtained from the qualified custodian. Further, during the term of the
written agreement and related advisory relationship, advisers should
have a reasonable belief that the qualified custodian is complying with
the contractual obligations of the agreement and continuing to provide
[[Page 14693]]
the protections to client assets for which the adviser obtained
reasonable assurances from the qualified custodian. For example, if the
qualified custodian fails to properly provide the adviser with the
required quarterly account statement or the required annual internal
control report discussed below, the adviser could not reasonably
believe that the qualified custodian is complying with the contractual
obligations of the written agreement.
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\145\ See proposed rule 223-1(a)(1)(i), (ii).
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Finally, as under the custody rule, the safeguarding rule would
continue to permit an adviser or its related person to serve as a
qualified custodian for client assets. We continue to believe that
self-custody and related person safeguarding arrangements provide
practical benefits for advisory clients; however, we remain wary of the
potential risks of such arrangements that do not have an independent
party involved in safeguarding client assets.\146\ Accordingly,
heightened protections similar to those required under the custody rule
would continue to be required in such an arrangement.\147\ Moreover,
the following elements would all be required to be part of a written
agreement with the client.\148\
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\146\ See 2009 Adopting Release, supra footnote 11, at section
II.C.1 (discussing the benefits and associated risks of maintaining
client investments with advisers or their related persons and
suggesting that the use of an independent custodian would be an
impractical requirement for many types of advisory accounts).
\147\ The proposed rule would require a qualified custodian that
is a related person to the adviser to enter into a written agreement
with the adviser.
\148\ A rulemaking petition submitted to the Commission
requested that we adopt a rule prohibiting related person custody.
We have considered the petition and share certain of the petition's
concerns regarding custody arrangements not involving independent
parties. However, we believe that the protections proposed in the
rule appropriately limit those risks. Kaswell, Stuart J Re: Petition
for Rulemaking; Custody Rule 206(4)(2), Oct. 30, 2020 [File No. 4-
767, Nov. 9, 2020], available at https://www.sec.gov/rules/petitions/2020/petn4-767.pdf (``[I]t is my view that the SEC should
take the next step and require the adviser to use a custodian that
is unaffiliated in any way with the adviser.''); and see Kaswell,
Stuart J. Supplement to Petition for Rulemaking; Custody Rule
206(4)(2); File No. 4-767 (Apr. 19, 2021), available at https://www.sec.gov/comments/4-767/4767-8685524-235622.pdf (``As indicated
in my rule petition, I respectfully suggest that the Commission
should amend the Custody Rule to require that each investment
adviser use a custodian that is independent of that adviser.'').
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a. Reasonable Assurances
We believe that requiring an adviser to obtain the reasonable
assurances in writing \149\ that the custodian will comply with the
client protections required in the proposed rule and discussed below
would improve safekeeping of client assets. Similarly, we believe that
requiring the adviser to maintain an ongoing reasonable belief that the
custodian is complying with such client protection requirements will
improve safekeeping of client assets.\150\ It is our understanding that
many current custodial agreements address these issues and, therefore,
custodians are already familiar with these concepts. For example, we
understand that many custodial agreements address the attachment of a
lien on, or security interest in, client assets, in some cases for the
protection of the qualified custodian for nonpayment of fees by a
custodial client. Similarly, many custodial agreements address
indemnification between the advisory client and the custodian, but we
understand that the indemnification standard--for example, ordinary
negligence or gross negligence--often varies by institution and by
customer. The proposed reasonable assurances requirements--and the
requirement for the adviser to maintain the ongoing reasonable belief
that the reasonable assurances provided by the qualified custodian are
being implemented--in the rule are important protections for client
assets that, together with the client protections contained in the
written agreement, are designed to expand and formalize the standard of
protections to advisory clients' assets held by qualified custodians in
a manner that would provide consistent investor protections across all
qualified custodians under our proposed rule.
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\149\ Exchange Act section 13(b)(7) defines ``reasonable
assurance'' and ``reasonable detail'' as ``such level of detail and
degree of assurance as would satisfy prudent officials in the
conduct of their own affairs.'' 15 U.S.C. 78m(b)(7). See Commission
Guidance Regarding Management's Report on Internal Control Over
Financial Reporting Under section 13(a) or 15(d) of the Securities
Exchange Act of 1934 (Jun. 27, 2007) [72 FR 35323] (discussing
meaning of ``reasonable assurance'').
\150\ See proposed rule 223-1(a)(1)(ii).
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i. Due Care
The proposed rule would require that the adviser obtain reasonable
assurances in writing from the qualified custodian that the qualified
custodian will exercise due care in accordance with reasonable
commercial standards in discharging its duty as custodian and will
implement appropriate measures to safeguard client assets from theft,
misuse, misappropriation, or other similar types of loss.\151\ The
requirement that the adviser obtain reasonable assurances that a
qualified custodian will exercise due care in accordance with
reasonable commercial standards is similar to the standard required of
certain custodians under Investment Company Act rules.\152\ The
Commission has had experience with the standard of care under rule 17f-
4 under the Investment Company Act and believes that advisory clients
should receive protections similar to those afforded under that rule.
In addition, we believe that this investor protection element would
provide an important standard for evaluating the qualified custodian's
custodial practices.
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\151\ Proposed rule 223-1(a)(1)(ii)(A).
\152\ See, e.g., rule 17f-4 of the Investment Company Act.
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We also believe that it is crucial for a qualified custodian to
implement appropriate measures to safeguard assets from theft, misuse,
misappropriation, or other similar types of loss based on the asset
type and manner in which ownership is evidenced.\153\ We recognize that
the appropriateness of the measures required to safeguard assets varies
depending on the asset.\154\ For instance, the exercise of due care may
require that a bearer instrument, such as a physical coupon bond, a
physical security certificate, or a commodity such as gold, be kept in
a vault. Likewise, an investment that is evidenced in electronic book-
entry form, such as an exchange-traded note, could be maintained in
line with robust cybersecurity standards. And the exercise of due care
may require, in many cases, that crypto assets be stored in a cold
wallet, but depending on the facts and circumstances, such as when a
client seeks to buy and sell crypto assets very frequently, due care
may mean the use of hot wallets in combination with robust policies and
procedures.\155\ Other facts and
[[Page 14694]]
circumstances may require a hybrid of the two.\156\ Further, because
crypto assets and distributed ledger technology are still evolving, we
expect the methods used to safeguard crypto assets will likewise
evolve, which may lead to reevaluation of best practices in the future.
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\153\ See, e.g., Customer Protection Rules 17 CFR 240.15c3-3
(requiring appropriate measures to protect and preserve customer
property held at broker-dealers).
\154\ We also recognize that while the understanding of
appropriate safeguarding measures is generally expected to be within
the expertise of the qualified custodian, advisers also generally
should seek to become sufficiently familiar with safeguarding
practices to identify concerns or red flags in order to, among other
things, form an opinion as to whether the assurance that they
receive from the qualified custodian that the qualified custodian is
acting with due care is reasonable. More broadly, identifying
concerns and red flags is an important factor in the adviser forming
a reasonable belief that the protections in the proposed written
agreement have been implemented.
\155\ See, e.g., R. Travis Leppky and Guy Sadeh, Matthew Bender
and Co., Blockchain and Smart Contract Law: U.S. and International
Perspectives; Ch. 7, Sec. 7 (Security and Custody: Security Issues
for Cryptographic Asset Wallets) (2022) (``[T]he difference between
a hot and cold wallet is whether or not they are connected to the
internet. Generally speaking, hot wallets are less secure because of
threats that come with being connected to the internet and
additional indirect threats if the cryptocurrency wallets are held
by an external provider (i.e., hacks, phishing, external provider
stability issues, etc.). Hot wallets are generally better for day-
to-day transactions and trading, since near instant access is
provided. Cold wallets, meanwhile, are stored offline, which
provides additional security. They are generally better for holding
crypto assets for the long term.''); Deborah A. Sabalot & Madeleine
Yates, Cryptoassets and custody: an elephant in the room?, 9 Journal
of International Banking and Financial Law 580 (Sept. 24, 2019)
(``Hot storage means devices connected with the internet and
generally means that the asset can be transferred quickly but will
also be at greater risk of loss through hacking. Cold storage
devices are physically offline and disconnected from the internet
but are generally considered less accessible although are arguably
more secure in that they cannot be attacked in the way that online
systems can. Other arrangements include hybrid systems which allow
the temporary storage of cryptoassets in a hot facility before being
moved to cold storage.''); see generally Cryptopedia Staff, Hot
Wallets vs. Cold Wallets, GEMINI (July 4, 2021), available at
https://www.gemini.com/cryptopedia/crypto-wallets-hot-cold (``A hot
wallet is connected to the internet and could be vulnerable to
online attacks--which could lead to stolen funds--but it's faster
and makes it easier to trade or spend crypto. A cold wallet is
typically not connected to the internet, so while it may be more
secure, it's less convenient.'').
\156\ See id.
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The proposed standard of care is not uncommon in the custodial
market and we believe that financial institutions acting as qualified
custodians are familiar with it.\157\ We believe, however, that the
standard of care is not universal in the custodial market, and that
this requirement may result in some qualified custodians changing the
terms of their custodial agreements with advisory clients to
incorporate this standard. We believe that this provision would promote
this important protection in a consistent manner across all advisory
client assets \158\ and would discourage the qualified custodian from
establishing contractual performance standards that are less
stringent.\159\
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\157\ The proposed contractual requirement is the same as the
standard that automatically applies to custodians under Article 8 of
the Uniform Commercial Code. See UCC sections 8-504(c)(2) and 8-509
(a) and (b).
\158\ The requirement of due care, of course, may impose on a
qualified custodian a number of practices not expressly addressed in
this release.
\159\ See, e.g., UCC section 8-504(c)(2) (allowing alteration of
the standard of care by agreement).
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ii. Indemnification
The proposed rule would require that the adviser obtain reasonable
assurances in writing from the qualified custodian that the qualified
custodian will indemnify the client (and will have insurance
arrangements in place that will adequately protect the client) against
the risk of loss in the event of the qualified custodian's own
negligence, recklessness, or willful misconduct.\160\ The goal of this
proposed requirement would be for the client to be compensated in the
event of a loss for which the qualified custodian is responsible.
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\160\ Proposed rule 223-1(a)(1)(ii)(B).
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Our staff has observed that custodians often include
indemnification clauses in their custodial agreements with customers.
Generally, the provisions indemnify custodial customers from losses
arising out of or in connection with the custodian's execution or
performance under the agreement to the extent the loss is caused by,
among other things, the custodian's negligence, gross negligence, bad-
faith, recklessness, or willful misconduct. Our staff has observed that
the contractual limitations on custodial liability vary widely in the
marketplace. Our staff has also observed that the negotiating power of
the investor appears to play an outsized role in the type of misconduct
for which a custodian will provide indemnity and that retail investors
appear to have limited ability to negotiate these terms effectively.
Custodial misconduct is one of the primary risks that can undercut
or eliminate the protections of a custody account.\161\ The proposed
rule seeks to create a minimum floor of custodial protection for
investors--including those investors that have little or no power to
negotiate for those protections--in the event of custodial misconduct.
We question the extent to which investors, and particularly retail
investors, understand that they may have limited recourse against the
financial institution that was hired to safeguard their assets in the
event they suffer a loss because of that institution's misconduct.\162\
As such, we believe that it is reasonable to require an adviser to
obtain reasonable assurances from a qualified custodian that it will
provide the required indemnification for advisory clients.
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\161\ Klees Article, supra footnote 24, at 106.
\162\ See, e.g., Klees Article, supra footnote 24, at 103
(``clients bear several significant legal and operational risks that
could limit recovery of their custodied assets'').
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The current practice in the custodial marketplace reflects a broad
range of contractual limitations on the qualified custodian's liability
to its customers to reduce exposure and may result in sub-optimal
safeguarding protections for client assets. While we understand that
custodians, as a gesture of goodwill or to avoid headline exposure, may
cover losses caused by their own misconduct even if the customer is
ineligible for indemnification under the custodial agreement, such
gestures are at the sole discretion and ability of the custodian and we
believe that this does not provide sufficient, consistent, reliable
investor protection.\163\ Custodians may not always be willing to
extend such goodwill, such as in the event of an extremely large loss
caused by, for example, custodial negligence under a custodial contract
providing for indemnification of the custodial client only in the event
that the custodian's misconduct constitutes gross negligence, during a
general downturn in the economy, or at a time that the custodian is
otherwise not sufficiently capitalized to easily absorb the loss.
Requiring an adviser to obtain reasonable assurances from the qualified
custodian that the qualified custodian will indemnify the client (and
will have insurance arrangements in place that will adequately protect
the client) against the risk of loss in the event of the qualified
custodian's own negligence, recklessness, or willful misconduct, as
proposed, will help protect clients from custodial misconduct and
reduce the need to rely on the goodwill of a custodian to make a client
whole in the event of the custodian's misconduct.
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\163\ We also do not know whether the willingness of custodians
to cover losses for which they may not be contractually liable
depends on whether the advisory client is retail or institutional.
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In our view, the proposed indemnification requirement would likely
operate as a substantial expansion in the protections provided by
qualified custodians to advisory clients, in particular because it
would result in some custodians holding advisory client assets subject
to a simple negligence standard rather than a gross negligence
standard. We believe that this requirement is justified because of the
important investor protection benefits it will provide.
iii. Sub-Custodian or Other Similar Arrangements
The proposed rule would require that the adviser obtain reasonable
assurances in writing from the qualified custodian that the existence
of any sub-custodial, securities depository, or other similar
arrangements with regard to the client's assets will not excuse any of
the qualified custodian's obligations to the client.\164\ This
requirement is designed to help ensure that the qualified custodian
would remain responsible in circumstances where a loss or other failure
to satisfy its obligations to the client, whether contractual or
otherwise,
[[Page 14695]]
can be attributed to a sub-custodian or other third party selected by
the qualified custodian.
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\164\ Proposed rule 223-1(a)(1)(ii)(C).
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As discussed above, outsourcing has become increasingly common in
the custodial space, whether outsourcing of back-office functions or
the core function of holding a custodial client's assets.\165\
Additionally, we understand that the delegation of safeguarding to sub-
custodians can result in opaque structures, for example involving
several FFI sub-custodians in different countries.\166\ Further, our
staff has observed that custodial agreements addressing the use of sub-
custodians seek to limit contractually the custodian's liability for
acts or omissions of the sub-custodian in a variety of ways, including
expressly limiting the contractual liability of the custodian for acts
of the sub-custodian, as well as limiting the affirmative steps the
custodian may be required to take in connection with any loss of client
assets as a result of the sub-custodian's willful default or
insolvency. We view the increase in use of sub-custodians to similarly
increase the risk to client assets because, among other things, an
adviser and a client are not likely to have a direct contractual
relationship with the sub-custodian and are not likely to be able to
have decision-making authority with respect to which sub-custodian a
qualified custodian uses. The client and adviser, therefore, are more
likely to experience challenges in recovering losses caused by the sub-
custodian in the event of a loss of client assets. We similarly believe
that this is true for a securities depository or other third-party
arrangement implemented by the custodian with respect to client assets
over which the advisory client has no control.
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\165\ See, e.g., Deloitte Outsourcing Article, supra footnote
140; U.S. Bank, 5 questions you should ask your custodian about
outsourcing (May 19, 2022), available at https://www.usbank.com/financialiq/plan-your-growth/find-partners/outsourcing-questions-ask-custodian.html (``It's fairly common for custody banks to
outsource day-to-day securities processing work to external
vendors--both domestically and overseas.''); Avantage Reply,
Outsourcing in the Asset Servicing Industry: Custodian and
Depositary Banks, Evolving regulatory requirements and industry
practices in the Eurozone and the UK (Nov. 2015), available at
https://www.reply.com/en/topics/risk-regulation-and-reporting/Shared%20Documents/Outsourcing%20Working%20Paper.pdf (``Custodian
banks have traditionally outsourced high-volume operational tasks.
While these still form the bulk of outsourcing, activities that
contribute to the running of banks themselves are now also being
routinely outsourced, including significant chunks of Customer
Services, Human Resources, Risk and Finance.''); Geis, George S.,
Traceable Shares and Corporate Law, 113 Nw. U.L. Rev. 227 (2018), at
233-234 (discussing the largest custodial banks performing
recordkeeping and information dissemination functions for smaller
custodian banks).
\166\ See Thomas Droll, Natalia Podlich, and, Michael Wedow
(2015) Out of Sight, Out of Mind? On the Risk of Sub-Custodian
Structures. Bundesbank Discussion Paper No. 31/2015, available at
SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2797055.
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We believe that requiring the proposed reasonable assurances
requirement would help reduce the ability of a qualified custodian to
avoid responsibility for the other important safeguarding obligations
it has to the advisory client by delegating custodial responsibility to
a sub-custodian, securities depository, or other similar arrangements.
We believe these requirements are justified because a qualified
custodian should not be able to disclaim liability for a third-party it
hires.
iv. Segregation of Client Assets
The proposed rule would require the adviser to obtain reasonable
assurances in writing from the qualified custodian that the qualified
custodian will clearly identify the client's assets as such, hold them
in a custodial account, and segregate them from the qualified
custodian's proprietary assets and liabilities.\167\ We are proposing
this requirement because we continue to believe that segregation is a
fundamental element of safeguarding client assets.\168\ We believe that
some financial institutions that serve as qualified custodians,
particularly FFIs, are not required to segregate and identify their
client assets.\169\ In addition, for those qualified custodians that
are required to segregate and identify their client assets, the extent
of those activities varies.\170\ The proposed requirement is designed
to help ensure that client assets are at all times readily identifiable
as client property and remain available to the client even if the
qualified custodian becomes financially insolvent or if the financial
institution's creditors assert a lien against the qualified custodian's
proprietary assets (or liabilities).\171\ We believe this proposed
requirement would help protect client assets from claims by a third
party looking to secure or satisfy an obligation of the qualified
custodian, including in cases of insolvency or bankruptcy.\172\ We
believe that the proposed requirement would help to identify clearly
client assets as belonging to the appropriate client and, in the
context of an FFI, we believe these actions would help to preserve the
client's interests in the event of a government taking.
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\167\ Proposed rule 223-1(a)(1)(ii)(D). In contrast to the
requirements we are proposing to include in the written agreement,
and as with the other reasonable assurances requirements, we believe
this safekeeping obligation runs primarily to the client.
\168\ Segregation of client investments has been a fundamental
element of the custody rule since its inception. See, e.g., 1962
Adopting Release, supra footnote 2 (requiring advisers to segregate
and identify securities beneficially owned by each client, and to
hold them in a ``reasonably safe'' place). See also, Klees Article,
supra footnote 24 (describing segregation as a pillar of custody
that has generally been recognized in the United States).
\169\ The custody rule requires a foreign financial institution
to segregate client assets in order to meet the definition of
qualified custodian. As discussed above and below, we propose to
replace and strengthen the segregation requirement for FFIs in the
custody rule that would complement the proposed segregation
requirements of the safeguarding rule.
\170\ See, e.g., 12 U.S.C. 92(c) and 12 U.S.C. 1464(n)(2)
(requiring national banks and Federal savings associations to
segregate all assets held in any fiduciary capacity from their
general assets and to keep a separate set of books and records
showing all transactions in these accounts); section 4d(a)(2) of the
Commodity Exchange Act (requiring FCMs to segregate from their own
assets all money, securities and other property deposited by futures
customers to margin, secure, or guarantee futures contracts and
options on futures contracts traded on designated contract markets).
\171\ The proposed segregation requirements are drawn from rule
15c3-3 of the Exchange Act, which requires broker-dealers to
safeguard their customer assets and keep customer assets separate
from the firm's assets, to prevent investor loss or harm in the
event of the broker-dealer's failure. See Financial Responsibility
Rules of Broker-Dealers, Exchange Act Release No. 70072 (Jul. 30,
2013) [78 FR 51824 (Aug. 21, 2013)] (``Financial Responsibility
Adopting Release''). In addition, other regulatory regimes have
adopted similar requirements. See, e.g., rule 1.20 [17 CFR 1.20]
under the Commodity Exchange Act, which requires a futures
commission merchant to segregate customer assets from its own
assets.
\172\ See, e.g., Report of the Trustee's Investigation and
Recommendations, In re MF Global Inc., No. 11-2790 (MG) SIPA (Bankr.
S.D.N.Y. June 4, 2012) (noting that about $1.6 billion in customer
funds were found to be missing after the financial institution's
bankruptcy). Crypto asset trading platforms have also experienced
failures resulting in bankruptcy, raising questions as to whether
investors' funds will be returned. See, e.g., In re Celsius Network
LLC, 2023 Bankr. LEXIS 2, at *60 (Bankr. S.D.N.Y., Jan 4, 2023)
(holding that customer crypto assets in ``Earn Accounts'' were
property of the bankruptcy estate).
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We also understand that for administrative convenience and other
reasons qualified custodians often hold client assets in omnibus
accounts containing assets of more than one client or similar
commingled-style accounts. We understand that practice may be even more
common when a qualified custodian uses a sub-custodian to hold client
assets. We do not intend the segregation requirement to preclude
traditional operational practices in which client assets are held in
omnibus accounts or otherwise commingled with assets of other clients
because we recognize that custodians regularly maintain assets in a
manner that allows such assets to be identified as held for a
particular client, distinct from assets of other clients, and not
subject to
[[Page 14696]]
increased risk of loss arising from a custodian's insolvency.
We understand that the current rule's account requirements in
206(4)-2(a)(1) pose certain compliance challenges when client assets
are commingled, including in the context of sweep accounts, escrow
accounts, and loan servicing accounts. We believe the proposed
segregation requirements \173\ along with the proposed written
agreement and other reasonable assurances requirements more directly
and comprehensively achieve our policy goal than the custody rule's
account requirements in rule 206(4)-2(a)(1). In light of the proposed
segregation requirements, the safeguarding rule would not include the
custody rule's requirement to maintain client funds and securities with
a qualified custodian (1) in a separate account for each client under
the client's name; or (2) in accounts that contain only client funds
and securities under an adviser's name as agent or trustee for the
clients.\174\
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\173\ The safeguarding rule would also require certain
additional segregation requirements related to, among other things,
segregating client assets from the adviser's assets, discussed in
more detail in section D, below. See proposed rule 223-1(a)(3).
\174\ Custody rule 206(4)-2(a)(1).
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We believe that proper identification of client assets, as required
by the segregation requirement of the proposed rule, would mitigate
concerns regarding the safety of a client's assets. Sub-accounting of
commingled accounts allows qualified custodians to identify readily an
owner's commingled assets at any point in time. Eliminating the custody
rule's requirement to maintain accounts that contain only clients'
funds and securities also should alleviate certain compliance
challenges when client and non-client assets are commingled for
administrative convenience and efficiency purposes, such as in the
context of sweep accounts, escrow accounts, and loan servicing
accounts.\175\ We understand that some custodial agreements between
advisory clients and qualified custodians contain a contractual
provision requiring segregation of client assets from the custodian's
proprietary assets and liabilities. We believe that the reasonable
assurances requirement in the proposed rule may result in qualified
custodians adding such a contractual provision to custodial agreements
that do not contain this language. However, we believe that some
custodial agreements already contain language addressing the
requirement. Moreover, because we understand that many qualified
custodians are required by their functional regulator to segregate
assets, we believe that an adviser obtaining reasonable assurances
regarding segregation as required under the proposed rule would not
result in a substantial change in the operational practices of many
custodians. More importantly, we believe that the proposed rule's
requirement that an adviser obtain reasonable assurances from the
qualified custodian regarding the segregation requirement provides
vital protections.
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\175\ See 2014 IM Guidance, supra footnote 17; Madison Capital
Funding, Inc., SEC Staff No-Action Letter (Dec. 20, 2018) (``Madison
Capital No-Action Letter'').
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v. No Liens Unless Authorized in Writing
The proposed rule would require the adviser to obtain reasonable
assurances in writing from the qualified custodian that the qualified
custodian will 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.\176\ This requirement is designed
to protect client assets by discouraging qualified custodians from
using those assets in a manner not authorized by the client. This
provision would help ensure that client assets maintained with the
qualified custodian are protected and are free of any claims by the
qualified custodian, or a third party looking to secure or satisfy an
obligation of the qualified custodian, including in cases of the
qualified custodian's insolvency or bankruptcy.
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\176\ See proposed rule 223-1(a)(1)(ii)(E).
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Liens and the other claims addressed in the proposed rule can arise
in favor of a qualified custodian in a variety of circumstances. For
example, in a margin account, a type of brokerage account, a qualified
custodian may lend cash to a client to allow the client to purchase
securities. The qualified custodian's loan is typically collateralized
by the securities purchased by the client, other assets in a client
account, and cash, all of which are typically subject to a security
interest in favor of the qualified custodian.\177\ Similarly, qualified
custodians often have contractual or other rights to liens or similar
claims arising from unpaid client fees. The rule would not prohibit
arrangements like these. Rather, the rule would require that the
adviser obtain reasonable assurances from the qualified custodian that
the client has authorized in writing any right, charge, security
interest, lien, or claim in favor of the qualified custodian or its
related persons or creditors that would arise in connection with these
arrangements or others. While we recognize that these and similar
arrangements involve some level of risk to client assets, we recognize
that they can also be beneficial, and should be permitted when
authorized.
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\177\ See Uniform Commercial Code, section 8-504 and cmt. 2
(``Margin accounts are common examples of arrangements in which an
entitlement holder authorizes the securities intermediary to grant
security interests in the positions held for the entitlement
holder.'').
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We believe that many qualified custodians maintain their custodial
customer assets free of liens and similar claims, other than those
agreed to or authorized in writing by the client. Further, we
understand that some custodial agreements contain contractual language
addressing when a lien or similar claim will attach to client assets.
Therefore, we believe requiring an adviser to obtain this reasonable
assurance from the qualified custodian would provide important client
protections.
b. Written Agreement
As discussed above, the proposed rule would require an adviser to
enter into a written agreement with a qualified custodian containing
certain terms that we view as critical to safeguarding client
assets.\178\ The rule would require that the written agreement contain
the terms described in more detail below.
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\178\ Proposed rule 223-1(a)(1)(i).
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i. Provision of Records
The proposed rule would require that the written agreement with the
qualified custodian include a provision requiring the qualified
custodian promptly, upon request, to provide records relating to client
assets to the Commission \179\ or an independent public accountant for
purposes of compliance with the rule.\180\ Custodial account records
provide information that is critical to an independent public
accountant's ability to perform its role under the current rule, and
would be similarly critical under the proposed rule. We understand,
however, that accountants often struggle to obtain--or to obtain
timely--information from qualified custodians when performing surprise
examinations under the current rule unless the advisory client requests
that
[[Page 14697]]
the qualified custodian share the information. We realize this is
likely because the qualified custodian has no contractual agreement
with the adviser or the accountant that has been hired by the adviser.
We believe the proposed contractual requirement would substantially
mitigate these complications.
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\179\ All custodians, including foreign custodians, must provide
records of custody and use of the securities, deposits, and credits
related to an investment adviser's client to representatives of the
Commission upon request. Advisers Act section 204(d)(1). The
Commission believes that formalizing this requirement in the written
agreement between a qualified custodian and an investment adviser
will ensure qualified custodians are aware of the requirements of
the Advisers Act.
\180\ Proposed rule 223-1(a)(1)(i)(A).
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We understand that qualified custodians do not often provide third
parties access to custodial account records in light of privacy
concerns for their customers, unless there is contractual privity with
those third parties or their customers request they do so. We believe
that the proposed contractual requirement would mitigate these record
access challenges because the qualified custodian would be in direct
contractual privity with the adviser and would have a contractual
obligation to provide the records required by the rule.
ii. Account Statements
The proposed rule would require that the written agreement with the
qualified custodian provide that the qualified custodian will send
account statements (unless the client is an entity whose investors will
receive audited financial statements as part of the financial statement
audit process pursuant to the audit provision of the proposed
rule),\181\ at least quarterly, to the client and the investment
adviser, identifying the amount of each client asset in the custodial
account at the end of the period as well as all transactions in the
account during that period, including advisory fees.\182\
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\181\ See proposed rule 223-1(b)(4).
\182\ Proposed rule 223-1(a)(1)(ii)(B). The proposed requirement
is similar to the approach in the current rule with regard to the
investment adviser forming a reasonable belief after due inquiry
that the qualified custodian sends account statements, at least
quarterly, to the client. See rule 206(4)-2(a)(3).
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The custody rule requires an adviser to have a reasonable basis,
after due inquiry, for believing that the qualified custodian sends an
account statement, at least quarterly, to each of the adviser's clients
for which it maintains funds or securities, identifying the amount of
funds and of each security in the account at the end of the period and
setting forth all transactions in the account during that period.\183\
We continue to believe that qualified custodians' delivery of account
statements directly to advisory clients--without involvement of the
adviser--helps provide clients with confidence that any erroneous or
unauthorized transactions by an adviser would be reflected in the
account statement and, as a result, would deter advisers from
fraudulent activities. In a change from the current custody rule, the
qualified custodian would also now be required to send account
statements, at least quarterly, to the investment adviser, which would
allow the adviser to more easily perform account reconciliations. We
also believe that, because of custody rule 206(4)-2(a)(3), the account
statement contract provision is consistent with longstanding custodial
practices and would easily be incorporated by qualified custodians into
the written agreement. The account statements could also be delivered
to the client's (or pooled investment vehicle investor's) independent
representative.
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\183\ Custody rule 206(4)-2(a)(3).
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In circumstances where an investor is itself a pooled vehicle that
is controlling, controlled by, or under common control with the adviser
or its related persons (a ``control relationship''), the contract with
the qualified custodian must require the quarterly account statement to
be delivered by the qualified custodian to all of the investors in each
pooled investment vehicle client, which includes investors in the
underlying pools by looking through that pooled vehicle (and any pools
in a control relationship with the adviser or its related persons, such
as in a master-feeder fund structure).\184\ Advisers to pooled
investment vehicles may from time to time establish special purpose
vehicles (``SPVs'') or other pooled vehicles for a variety of reasons,
including facilitating investments by one or more private funds that
the advisers manage. If a qualified custodian did not look through each
pool in a control relationship with the adviser, the qualified
custodian would be essentially delivering the quarterly statement to
the adviser rather than to the parties the quarterly statement is
designed to inform. Outside of a control relationship, such as if a
private fund investor is an unaffiliated fund of funds, this same
concern is not present, and the qualified custodian would not need to
look through the structure to make meaningful delivery. The qualified
custodian would just distribute the quarterly statement to the
unaffiliated fund of funds' adviser or other designated party. We
believe that this approach would lead to meaningful delivery of the
quarterly statement to advisory clients. Also in a change from the
current custody rule, the proposed rule would require the written
agreement to contain a provision prohibiting the qualified custodian
from identifying assets on account statements for which the qualified
custodian lacks possession or control, unless requested by the client.
If a client requests such assets be included on its account statement,
the account statement may identify the assets, but only if the account
statement clearly indicates that the custodian does not have possession
or control of the assets.\185\ Advisers have, at times, requested a
qualified custodian to include particular holdings and transactions on
the custodial account statements for a variety of reasons, including in
an attempt to demonstrate compliance with the custody rule. For
example, it is our understanding that custodians have been unwilling or
unable to take possession or control of certain investments, such as a
variety of privately issued securities. Advisers sometimes request that
custodians report these securities as an ``accommodation'' on a
custodial account statement so that the client is aware of their
existence.
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\184\ See proposed rule 223-1(c).
\185\ To the extent that a client requests that a qualified
custodian report in account statements holdings and transactions to
which the custodian is not attesting as a custodian and for which
the custodian is disclaiming liability, the proposed rule would not
disrupt this practice, though it would require them to be clearly
identified as such.
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We recognize that account statements provided by a qualified
custodian on a so-called ``accommodation basis'' may offer a client the
ability to review all of its investments in a single consolidated
account statement and potentially alert a client or an auditor to the
existence of an investment.\186\ We are concerned, however, that the
practice of a qualified custodian including investments that it is not
safeguarding on an account statement may be misleading and confusing to
clients. To evaluate the holdings and transactions reported on an
account statement, a client must have confidence in the statement's
integrity and accuracy. Accordingly, we would prohibit an adviser from
participating in a practice that we believe undermines that integrity
and utility.\187\
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\186\ The rule proposes a process and protections for certain
assets unable to be maintained with a qualified custodian, thereby
making accommodation reporting unnecessary. See section II.C, infra.
\187\ Other regulatory regimes have raised concerns about this
practice including the potential for communicating inaccurate,
confusing or misleading information to customers, lapses in
supervisory controls, and the use of these reports for fraudulent or
unethical purposes. See, e.g., FINRA's Regulatory Notice 10-19
(reminding broker-dealer firms of their responsibilities to ensure
that they comply with all applicable rules when engaging in
providing customers with consolidated financial account reporting).
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[[Page 14698]]
iii. Internal Control Report
The proposed rule would require that the written agreement with the
qualified custodian provide that the qualified custodian, at least
annually, will obtain, and provide to the investment adviser a written
internal control report that includes an opinion of an independent
public accountant as to whether controls have been placed in operation
as of a specific date, are suitably designed, and are operating
effectively to meet control objectives relating to custodial services
(including the safeguarding of the client assets held by that qualified
custodian during the year).\188\ Consistent with an adviser's fiduciary
duty, an adviser should review the report for control exceptions and
take appropriate action where necessary.\189\
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\188\ This requirement would apply as a control objective of the
internal control report rather than a requirement in the rule,
thereby expanding the requirement to all qualified custodians, not
just a qualified custodian that is the adviser or its related
person. See generally, Commission Guidance Regarding Independent
Public Accountant Engagements Performed Pursuant to Rule 206(4)-2
Under the Investment Advisers Act of 1940, Advisers Act Release No.
2969 (Dec. 30, 2009) [75 FR 1492 (Jan. 11, 2010)] (``Accounting
Guidance'').
\189\ See supra footnote 57.
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Although the custody rule requires an internal control report only
when the adviser or its related person acts as a qualified
custodian,\190\ we believe expanding this requirement to all qualified
custodians under the proposed rule would mitigate risks to client
assets regardless of the affiliation of the qualified custodian.\191\
We believe the proposed requirement would help protect client assets by
ensuring that the qualified custodian's controls with respect to its
safeguarding practices are routinely evaluated by a third party that is
independent of the custodian. We drew the proposed requirement from our
experience with the internal control report requirement under the
custody rule, understanding of requirements currently applicable to
some types of qualified custodians, as well as best practices.\192\
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\190\ Current rule 206(4)-2(a)(6).
\191\ An introducing broker that is also an adviser or the
adviser's related person would not be considered as acting as a
qualified custodian under the proposed rule if all client
investments are maintained with a carrying broker (which is not a
related person of the adviser) and thus the introducing broker would
not be subject to the internal control report requirement.
\192\ Rule 206(4)-2(a)(6)(ii). See 2009 Proposing Release, supra
footnote 11, at n.88 (noting that custodians often provide internal
control reports to clients who demand a rigorous evaluation of
internal controls as a condition of obtaining their business and
that obtaining such report is an ``industry best practice.''). See
also United States Government Accountability Office, Investment
Advisers; Requirements and Costs Associated with the Custody Rule
(July 2013), available at https://www.gao.gov/assets/gao-13-569.pdf
(stating that representatives from two industry associations
discussed that institutional investors commonly require custodians
to obtain internal control reports).
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The objective of the examination supporting the internal control
report is to obtain reasonable assurance that the qualified custodian's
controls have been placed in operation as of a specific date, and are
suitably designed and operating effectively to meet control objectives
related to safeguarding of client assets during the period
specified.\193\ Based on our experience with the custody rule, we
believe that the benefits and protections that we initially believed
were warranted for a more limited group of qualified custodians should
be expanded to include all qualified custodians.\194\
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\193\ See Accounting Guidance, supra footnote 188, at section
III.
\194\ See rule 206(4)-2(a)(6)(ii).
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We understand that not all qualified custodians obtain internal
control reports, although we believe many do. We also understand that
for those qualified custodians that currently obtain internal control
reports, the scope of those reports may not cover the financial
institutions' safeguarding activities that this proposed requirement is
designed to cover. Nonetheless, we believe this requirement is
justified because the proposed internal control report requirement
would provide meaningful investor protection benefits by, among other
things, providing advisers with information regarding the control
practices of the qualified custodian that would enable advisers to
assist advisory clients in making more informed decisions concerning
holding assets with particular qualified custodians.
We are not requiring the provision of a specific type of internal
control report as long as the required objectives are addressed.\195\
This flexibility would permit qualified custodians to leverage existing
audit work to satisfy regulatory requirements, or work currently
performed as part of internal control reports prepared to meet client
demand.
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\195\ For example, we believe that a report on the description
of controls placed in operation and tests of operation
effectiveness, commonly referred to as a ``SOC 1 Type 2 Report,''
would be sufficient to satisfy the requirements of the internal
control report, provided that the report covers whether the controls
have been placed in operation as of a specific date, are suitably
designed, and are operating effectively in order to meet control
objectives as required by the rule. A report that simply provides a
report of procedures or controls a qualified custodian has put in
place as of a point in time, commonly referred to as a ``SOC 1 Type
1 Report,'' would not satisfy the requirements of the internal
control report because it does not test operation effectiveness of
the controls. In addition, a report issued in connection with an
examination of internal control conducted in accordance with AT-C
section 315: Compliance Attestation (``AT-C section 315'') or AT-C
section 320: Reporting on an Examination of Controls at a Service
Organization Relevant to User Entities' Internal Control over
Financial Reporting (``AT-C section 320'') under the standards of
the American Institute of Certified Public Accountants would also be
sufficient provided that the report covers whether the controls have
been placed in operation as of a specific date, are suitably
designed, and are operating effectively in order to meet control
objectives as required by the rule. See 2009 Adopting Release, supra
footnote 11, at section II.C.1. Similarly, a report based on an
examination in accordance with PCAOB AT-1 of a broker-dealer's
compliance report prepared pursuant to rule 17a-5 of the Exchange
Act would be sufficient to satisfy the internal control requirement.
See 17 CFR 240.17a-5; Broker-Dealer Reports, Exchange Act Release
No. 34-70073 (July 30, 2013) [78 FR 51910 (Aug. 21, 2013)].
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The proposed rule would define ``independent public accountant'' to
mean a public accountant that meets the standards of independence
described in rule 2-01 of Regulation S-X (17 CFR 210.2-01).\196\ The
Commission has long recognized that an audit by an objective,
impartial, and skilled professional contributes to both investor
protection and investor confidence.\197\ We understand that qualified
custodians currently obtaining internal control reports voluntarily or
pursuant to requirements of the qualified custodian's functional
regulator may need to engage a new accountant if the qualified
custodian's current accountant is not independent as defined by the
proposed rule.\198\ We believe that adherence to the bedrock principle
that auditors must be independent in fact and in appearance \199\
contributes to investor protection and investor confidence in
connection with the relationship between an auditor and the qualified
custodian. We therefore believe that this requirement is appropriate.
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\196\ See proposed rule 223-1(d)(5). The definition in the
proposed rule would be amended to reference Rule 2-01 in its
entirety rather than the more limited reference in the current
custody rule (see rule 206(4)-2(d)(3), referencing 2-01(b) and (c)),
which amendment is designed to clarify that the entirety of the
auditor qualification and independence requirements in Rule 2-01
apply.
\197\ See Revision of the Commission's Auditor Independence
Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec.
5, 2000)].
\198\ See proposed rule 223-1(a)(1)(i)(C); 223-1(d)(5).
\199\ See Qualifications of Accountants, Release No. 33-10876
(Oct. 16, 2020) [85 FR 80508 (Dec. 11, 2020) (discussing bedrock
principles).
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In connection with our concerns noted above regarding circumstances
in which an adviser or related person is the qualified custodian, we
are proposing to retain the current rule's approach that if the
qualified custodian is a related person or the adviser, the independent
public accountant that prepares the internal control report
[[Page 14699]]
must verify that client assets are reconciled to a custodian other than
you or your related person. In addition, we would continue to require
that if the qualified custodian is a related person or the adviser, the
independent public accountant is registered with and subject to regular
inspection as of the commencement of the professional engagement
period, and as of each calendar year-end, by, the Public Company
Accounting Oversight Board (``PCAOB''), in accordance with the rules of
the PCAOB.\200\ We believe that qualified custodians routinely retain
accountants that satisfy this requirement because of this requirement
under the custody rule. In light of our experience with this
requirement of the current rule, we believe that registration and the
periodic PCAOB inspection of an independent public accountant's overall
quality control system will provide us greater confidence in the
quality of the internal control report in the context of an affiliated
adviser and custodian.
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\200\ Proposed rule 223-1(a)(1)(i)(C)(1).
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iv. Adviser's Level of Authority
The proposed rule would require that the written agreement with the
qualified custodian specify the investment adviser's agreed-upon level
of authority to effect transactions in the custodial account as well as
any applicable terms or limitations.\201\ We are also proposing that
this contract provision permit the adviser and the client to reduce the
specified level of authority. Our understanding is that investment
advisers often are given authority over the custodial account in the
custodial agreement between the custodian and the client that is
broader than what the adviser and client agreed to in the advisory
agreement. For example, an adviser may not have authority under its
advisory agreement with a client to instruct the client's custodian to
disburse client assets. If, however, the client's agreement with its
qualified custodian grants the adviser broad authority over the
client's account, including to disburse or transfer assets, the adviser
would be able to effect a change in beneficial ownership of the
client's assets.\202\ In these circumstances, from the qualified
custodian's perspective, the client has authorized the adviser to
withdraw the client's assets and, while there may be constraints
contained in the advisory agreement between the adviser and a client,
the custodian may not be aware of these constraints or may be unwilling
or unable to treat the terms of the advisory agreement as
controlling.\203\ In this scenario, believing the adviser to have
authority over the client's assets, the custodian could accept the
adviser's instructions to direct the disposition of the client's
assets.\204\ We are concerned this puts clients at risk, such as in the
event a rogue advisory employee misuses the authority to direct the
disposition of a client's assets held by the custodian. We understand
that advisers have had little success in modifying or eliminating their
unwanted authority either because a custodian is reluctant to accept
the adviser's request to modify its agreement with its client, or the
client may lack the bargaining power to negotiate more limited terms on
the adviser's authority over the client's assets because the custodian
may refuse to modify its standard forms.\205\ This contractual
requirement of the proposed rule is designed to mitigate these concerns
and empower advisers to modify this aspect of the custodial agreement
to better reflect client intentions and to be consistent with the
adviser's contractual obligations to its clients.
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\201\ Proposed rule 223-1(a)(1)(i)(D).
\202\ See, e.g., Inadvertent Custody: Advisory Contract Versus
Custodial Contract Authority, Division of Investment Management
Guidance Update No. 2017-01 (Feb. 2017) (``2017 IM Guidance'') in
which our staff discussed its views on the application of the
current custody rule to various types of custodial agreements
between a client and a custodian that grant an adviser broader
access to client funds or securities than the adviser's own
agreement with the client contemplates.
\203\ Our staff took a similar view. See id.
\204\ While the advisory agreement between the adviser and its
client may constrain the adviser's authority, the custodian may not
be aware of such constraints. A separate bilateral restriction
between the adviser and the client is insufficient to prevent the
adviser from having custody where the custodial agreement enables
the adviser to withdraw or transfer client funds, securities or
similar investments upon instruction to the custodian. Our staff
took a similar view. See 2017 IM Guidance, supra footnote 202.
\205\ See supra footnote 202 and accompanying text.
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Our staff has observed that qualified custodians have been
reluctant to modify or customize the level of authority investment
advisers have with respect to customer accounts. It increases their
need to monitor customer accounts, and to accept liability, for
unauthorized transactions by an adviser and its personnel. We believe
that the risks of inadvertent custody, the related risk that a
custodian may follow an instruction with respect to client assets
presuming authority that the adviser does not have under its advisory
contract with the client, and our staff's observation of the reluctance
of qualified custodians to modify adviser authority, warrant the
proposed requirement. Ultimately, we believe this requirement would
better protect advisory clients than the current default broad
authority provisions in current contracts.
We request comment on all aspects of the proposed reasonable
assurances and written agreement requirement, including the following:
55. Is our understanding correct that custodians are familiar with
the concepts addressed by the reasonable assurances and written
agreement requirements?
56. Should the rule include the due care reasonable assurances
requirement? Is this standard of care common practice in the custodial
marketplace and, if so, would custodians be willing to provide
information to an adviser sufficient to satisfy the proposed rule?
Instead of the proposed approach, should the rule require generally
that an adviser obtain reasonable assurances that a qualified custodian
meets certain minimum commercial standards and then specify some but
not all applicable standards? Would the proposed requirement provide
additional protections for clients when an adviser has custody of
client assets and further the policy goals of the rule?
57. Should the rule include the reasonable assurances requirement
that the qualified custodian will indemnify the client (and will have
insurance arrangements in place that will adequately protect the
client) against the risk of loss in the event of the qualified
custodian's own negligence, recklessness, or willful misconduct? Would
this requirement provide additional protections for clients when an
adviser has custody of client assets and further the policy goals of
the rule? Alternatively, should we require reasonable assurances of a
different indemnification standard? If so, what standard and how would
that standard protect investors consistent with the policy goals of the
rule?
58. Would the proposed indemnification standard be a substantial
departure from current industry practice? Would it be expensive for
qualified custodians and would those costs be passed on to custodial
clients? If so, are there less expensive ways of achieving the policy
goals of the rule? Would this requirement result in custodians ceasing
operations in the custody business? If so, what proportion of
custodians would commenters expect to stop providing custody services
as a result of this proposed rule? Should the safeguarding rule,
instead, require disclosure to clients that they could lose their
assets in the event of custodian misconduct?
[[Page 14700]]
We understand that retail clients were often afforded the fewest
protections. If we were to require disclosure, instead of
indemnification, would such retail clients be able to negotiate with
custodians for better protection?
59. Do commenters agree with our understanding that custodians may
cover losses caused by their own misconduct even if the customer is
ineligible for indemnification under the custodial agreement to avoid
headline exposure or as a gesture of goodwill to their custodial
customers? Do insurers contribute compensation as part of these
payouts? If so, how frequently? Do advisers step in to compensate
customers in these circumstances? If so, how frequently?
60. Should the proposed rule include the reasonable assurances
requirement requiring the qualified custodian to provide indemnity and
have insurance arrangements in place to adequately protect its clients?
Should the rule include additional safeguards regarding the
indemnification requirement, such as stating that insurance proceeds
will be solely for the benefit of the client, and will not be
considered an asset of anyone other than the client? Should the rule
include any safeguards around the type of insurance a qualified
custodian could maintain for those indemnification purposes? If yes,
what types of safeguards should be imposed? For example, should the
insurance company be of a certain type or hold a certain qualification
or rating? What alternatives should we require to achieve our policy
goals? Are there any particular challenges for FFIs meeting this
requirement? If so, what are they?
61. Should the proposed rule include the reasonable assurances
requirement that the existence of any sub-custodial, securities
depository, or other similar arrangements with regard to the client's
assets will not excuse any of the qualified custodian's obligations to
the client? Would that requirement help ensure that a qualified
custodian could not avoid responsibility for the other important
safeguarding obligations it owes to the client by delegating custodial
responsibility to a sub-custodian or other responsibilities to other
third parties? Would the requirement provide additional protections for
clients when an adviser has custody of client assets and further the
policy goals of the rule?
62. Should the rule include the proposed reasonable assurances of
segregation of client assets requirements? Are these requirements
sufficiently clear?
63. Would the proposed reasonable assurances of segregation of
client assets requirements impose appropriate limitations to safeguard
client assets? Should we eliminate or modify any of them?
Alternatively, are there other limitations that would be appropriate?
64. Would the proposed reasonable assurance of segregation of
client assets requirement increase the likelihood that client assets
will be available to be returned to clients if a qualified custodian
experiences financial events such as insolvency or bankruptcy? For
example, do commenters believe the requirements would help ensure that
client assets are more readily identifiable as client property?
65. Should certain assets be excluded from these reasonable
assurances of segregation of client assets requirements? If so, which
assets and why? Would limiting these requirements to certain types of
assets present compliance challenges? If so, which assets and why?
66. In particular, would the proposed reasonable assurances of
segregation of client assets requirement present challenges with
respect to crypto assets? Should we address crypto asset segregation
and/or custody with separate requirements? Do crypto assets raise
specific segregation issues not presented by other assets? If so, what
are they and why? Would the proposed requirements offer substantial
protections in the event of a bankruptcy or financial losses involving
a custodian with custody of crypto assets? Would the proposed
reasonable assurances of segregation of client assets requirement
present challenges with respect to other types of assets?
67. Does the proposed reasonable assurance of segregation
requirement guard against loss, misappropriation, misuse, theft, and
the risk of client assets being subject to creditor claims in the
insolvency or bankruptcy of the qualified custodian, while permitting
the flexibility that would address some of the compliance challenges
that the current rule presents (e.g., commingling of client and non-
client assets)?
68. Should we instead retain the custody rule's requirement to
maintain client funds and securities with a qualified custodian in a
separate account for each client under the client's name or in accounts
that contain client funds and securities under the adviser's name as
agent or trustee? If so, should any of the custody rule's requirements
be modified in any way? If we were to retain the custody rule's
requirement, should we expand the scope of the separate account
requirement to assets from funds and securities?
69. Is our understanding correct that, for administrative
convenience and other reasons, qualified custodians often hold client
assets in omnibus accounts containing assets of more than one client or
similar commingled-style accounts? Do commenters agree that this
practice may be even more common when a qualified custodian uses a sub-
custodian to hold client assets?
70. Should the rule require that an adviser obtain reasonable
assurances that the qualified custodian will not commingle client and
non-client assets, similar to the custody rule? \206\ Alternatively,
should the rule be modified to permit the commingling of client and
non-client assets for administrative convenience and efficiency? If so,
what should be considered ``administrative convenience and
efficiency''? Does allowing client and non-client assets to be
commingled (e.g., in the same omnibus account) increase the risk that
client assets will be lost, misused, stolen, or misappropriated? Could
an advisory client's assets be used to satisfy the debts of someone
else in a bankruptcy event if client and non-client assets are
commingled?
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\206\ See rule 206(4)-2(a)(1)(i).
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71. Do commenters agree that there are circumstances when qualified
custodians' services require them to commingle advisory client assets
and assets of non-advisory customers? For example, when a qualified
custodian uses sweep accounts, escrow accounts, and loan servicing
accounts? In these circumstances, should the rule require additional
protections? Which protections and why and would they differ depending
on the type of commingled account?
72. Should the rule require that an adviser obtain reasonable
assurances from the qualified custodian regarding the sub-accounting of
commingled accounts? Would such a requirement provide additional
protection to client assets?
73. Are there instances where commingling or pooling of certain
assets by qualified custodians may occur via certain omnibus and sub-
accounting arrangements that may present compliance challenges under
the reasonable assurances of segregation of client assets requirement?
What are those instances and what are the challenges?
74. Do commenters think that qualified custodians will include
contractual segregation provisions in their custodial agreements with
advisory clients if they do not already do so? Should the rule require
an
[[Page 14701]]
express contractual requirement between the adviser and custodian to
identify and segregate client investments? Would a contractual
requirement help ensure that advisory client assets are protected?
75. Do commenters agree with our belief that not all financial
institutions that serve as qualified custodians, particularly FFIs, are
currently required to segregate and identify their client investments?
Do commenters agree that requiring an adviser to obtain reasonable
assurances that a qualified custodian will segregate client assets from
the custodian's proprietary assets and liabilities would be critical to
protecting client investments in the event of a qualified custodian's
insolvency as well as in the event of a taking by a foreign government?
Do commenters believe there may be reluctance by some financial
institutions to segregate client assets? Are there circumstances in
which segregation might not be important? If so, which circumstances?
76. Would this segregation provision present practical challenges?
For example, would it present practical challenges in the context of
omnibus accounts or temporary sweep accounts? Would financial
institutions be able to satisfy the segregation provision? For example,
we know that national banks and Federal savings associations are
required to segregate all assets held in any fiduciary capacity from
their general assets. Is this also true of national banks and Federal
savings associations that hold custodial assets in a non-fiduciary
capacity? Are there other compliance challenges that this proposed
segregation requirement would pose? Are there circumstances in which
qualified custodians' services require them to commingle advisory
client assets with other assets?
77. In the context of requiring an FFI to segregate client
investments, do commenters believe that the reasonable assurances
segregation requirement would help to preserve the client's interests
in the event of a government taking?
78. In the event of the insolvency or bankruptcy of a qualified
custodian, do commenters agree with our understanding that the sub-
accounting of commingled accounts allows a qualified custodian to
readily identify the rightful owner of any investment at any point in
time? Are there any particular assets or services for which such
identification via sub-accounting is difficult or burdensome? If so,
what are the reasons for these difficulties?
79. Is our approach in requiring a qualified custodian to maintain
client assets pursuant to a written agreement between the qualified
custodian and the investment adviser appropriate? Would the proposed
approach provide additional protections for clients when advisers have
custody of client assets and further the policy goals of the rule?
Would this requirement increase costs to maintain client assets with a
qualified custodian? Would this approach limit the pool of financial
institutions that are able to serve as qualified custodians? Would
financial institutions currently acting as qualified custodians exit
the business as a result of the written agreement requirement? Do
commenters agree that custodial practices, types of instruments
custodians hold, and the regulatory framework to which these financial
institutions are subject have evolved, in part to accommodate new
entrants to the market for custodial services? Do commenters agree that
this evolution, including new custodians and new custodial practices,
has resulted, in at least some cases, in a general reduction in the
level of protections offered by custodians, often resulting in advisory
clients with the least amount of bargaining power (i.e., retail
investors) receiving the most limited protections? Are there other
reasons that commenters believe custodial practices have evolved to
result in a general reduction in the level of protections offered by
custodians? Would the proposed approach mitigate some of our concerns
with regard to these custodial market changes?
80. Is our belief correct that financial institutions that act as
qualified custodians under the current rule already provide some of the
protections that would be required under the proposed rule's
contractual requirements, either to satisfy regulatory requirements or
pursuant to their existing contracts with their clients? Do these
qualified custodians already provide the protections that would be
required in the proposed written agreement to every customer? Are some
protections provided to customers more often than others? If so, which
protections and why?
81. Should the rule permit an adviser or its related person to be a
qualified custodian, as under the custody rule, or should we prohibit
the adviser or its related person from being the qualified custodian?
Do commenters agree that an adviser or related person acting as the
qualified custodian presents risks to client assets that are not
present when a qualified custodian is not the adviser or a related
person of the adviser? Do commenters agree that the proposed
requirements in the rule, including the proposed internal control
report requirements applicable to qualified custodians that are the
advisers or a related person, would help to reduce those risks? If the
rule prohibits the adviser or its related person from being the
qualified custodian, would it result in additional costs or operational
burdens on advisory clients? For example, would the requirement cause
advisory clients to lose access to services or other efficiencies they
currently receive? Would the requirement result in higher costs for
advisory clients?
82. Given that the written agreement and reasonable assurances
approach would be applicable equally to the different types of
qualified custodians, should the rule identify other financial
institutions such as securities depositories, transfer agents, credit
unions, insurance companies, or other intermediaries as qualified
custodians?
83. Are the contractual requirements and reasonable assurances
requirements sufficiently clear? Are there additional contractual
requirements or reasonable assurances related to the safeguarding of
client investments that should be included in the written agreement or
obtained by the adviser? If so, what are they, and why? Should we
eliminate any of the contractual requirements or reasonable assurances
requirements? If so, which ones, and why? Should all of the
requirements be contractual or reasonable assurances, rather than a mix
of these two categories as we proposed? Should any be re-categorized?
84. Are there alternatives to all or any of the contractual
requirements or reasonable assurances requirements that would support
the policy goals of the proposed requirements while obviating the need
for one or more specific contractual provisions or reasonable
assurances? If so, what are the alternatives? Specifically, would we be
able to achieve the same policy goals by requiring that an adviser
adopt and implement policies and procedures reasonably designed to
ensure that a qualified custodian was providing certain protections to
client assets, rather than requiring a contractual clause for the
protection? For example, would requiring advisers to adopt and
implement a policy and procedure reasonably designed to ensure that a
qualified custodian would promptly, upon request, provide records
relating to the adviser's clients' assets held in the account at the
qualified custodian to the Commission or to an independent public
accountant provide protection equivalent to the proposed contractual
obligation to provide these records? What about the proposed internal
control report contractual obligation?
[[Page 14702]]
Would a client be able to obtain equivalent protection provided by an
adviser's adoption and implementation of a policy and procedure
reasonably designed to ensure that the qualified custodian will provide
the internal control report required in the proposed contractual
requirement? Are there other alternatives to any of the contractual
requirements, such as requiring that an adviser obtain reasonable
assurances from the qualified custodian that the qualified custodian
has contractually agreed to provide account statements, internal
control reports, or any of the other requirements we are proposing to
be included in the written agreement? Are there any other alternatives
that we should require?
85. Are there circumstances in which the written agreement and
reasonable assurances requirements should not be required? For example,
should the written agreement and reasonable assurances requirements not
apply in instances where an advisory client has a custodial
relationship with a qualified custodian that precedes the client's
engagement of the adviser? If so, how long should the custodial
relationship precede the advisory relationship in order for an
exception of this type to apply?
86. Should the proposed rule include the contractual provision that
the qualified custodian will promptly, upon request, provide records
relating to client investments to an independent public accountant for
purposes of compliance with the rule? Are we correct in our belief that
this proposed provision would facilitate the public accountant's
ability to obtain custodial account records? Would this requirement
provide additional protections when the adviser has custody of client
assets and further the policy goals of the rule?
87. Should we require a more specific time period in which a
qualified custodian would be required to provide records? For example,
should we require that a qualified custodian provide records within
three days of a request?
88. Is our understanding correct that qualified custodians do not
often provide third parties access to custodial account records in
light of privacy concerns for their customers, unless there is
contractual privity with those third parties or their customers request
they do so? If so, would the proposed contractual requirement mitigate
these record access challenges because the qualified custodian would be
in direct contractual privity with the adviser and would have a
contractual obligation to provide records?
89. Should the proposed rule include the contractual requirement
that the qualified custodian will send account statements, at least
quarterly, to the client and the investment adviser? The current rule
requires an investment adviser to have a reasonable basis, after due
inquiry, for believing that the qualified custodian maintaining client
investments sends an account statement, at least quarterly, to the
client. Is the proposed requirement regarding sending account
statements to the adviser necessary or helpful? Would that requirement
have a significant cost impact on qualified custodians and would those
costs be passed on to advisory clients? Are there alternatives to the
proposed contractual provision that we should require? For example,
would the client have sufficient protection when an adviser has custody
of its assets if we were to require that an adviser must have
reasonable assurance that the qualified custodian maintaining client
assets sends an account statement, at least quarterly, to the client?
90. To what extent would the proposed requirement to provide
custodial account statements to advisers increase costs to advisory
clients?
91. To what extent do commenters believe that the requirement to
provide custodial account statements to advisers would have an impact
on an adviser's duty to monitor? Do commenters believe that it would
increase the frequency at which some advisers would be required to
monitor activity in client accounts? Would this enhance protection of
client assets? Could it increase advisory costs?
92. Do commenters agree that custodians regularly send account
statements to their custodial customers attesting to the holdings and
transactions in the account during a particular period? Do commenters
agree that advisory clients use these account statements to identify
erroneous or unauthorized transactions or withdrawals in their
accounts?
93. Many advisers or their related persons serve as advisers to
pooled investment vehicles or to other similar entities (e.g., general
partner of a limited partnership). The proposed rule would continue to
except these advisers from the requirement to have a qualified
custodian send account statements with respect to pooled investment
vehicles that are audited annually and distribute their audited
financial statements to the investors in the pool. Should we continue
to except these advisers from the account statement requirement? Would
the investors in those pools find the account statement useful to
monitor the pool's account activity? Should we extend this exception to
all entities that are audited annually and distribute audited financial
statements to investors in the entities pursuant to the audit
provision, as proposed, provided the entity complies with all of the
requirements in the proposed audit provision? \207\ Are there other
persons that we should except from this requirement?
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\207\ See proposed rule 223-1(b)(4) and section II.G.1, infra.
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94. In circumstances where an investor is itself a pooled vehicle
that is controlling, controlled by, or under common control with the
adviser or its related persons (a ``control relationship''), should the
contract with the qualified custodian require the quarterly account
statement to be delivered by the qualified custodian to investors in
the underlying pools by looking through that pooled vehicle (and any
pools in a control relationship with the adviser or its related
persons, such as in a master-feeder fund structure)? Do commenters
agree with our understanding that if a qualified custodian did not look
through each pool in a control relationship with the adviser, the
qualified custodian would be essentially delivering the quarterly
statement to the adviser rather than to the parties the quarterly
statement is designed to inform? Do commenters agree with our view that
requiring the qualified custodian to ``look through'' in these
instances would lead to meaningful delivery of the quarterly statement
to advisory clients?
95. Is our understanding correct with respect to current practices
of reporting certain custodial customer holdings for which the
qualified custodian lacks possession or control on an accommodation
basis?
96. Should the proposed rule prohibit account statements from
identifying clients' investments for which the qualified custodian
lacks possession or control unless the client requests otherwise? Do
commenters agree that the practice of a qualified custodian including
on an account statement assets that it is not safeguarding may be
misleading to clients? Are there challenging practical implications of
this proposed prohibition? For instance, our staff has previously taken
the view that, under some arrangements, an adviser that is a qualified
custodian may send its advisory clients account statements that include
assets maintained with a sub-custodian that is also a qualified
custodian.\208\ Would the proposed contract provision preclude
[[Page 14703]]
this type of arrangement? Similarly, some qualified custodians
(regardless of whether they are related persons of the adviser) send
consolidated account statements that include the holdings of sub-
custodians. Would the proposed contract provision disrupt this
practice? Are there ways of improving account statement integrity
without eliminating qualified custodians' ability to send consolidated
account statements in these circumstances? For example, should we
permit an adviser to request that these assets be included on the
account statement but require that such request instruct a qualified
custodian to include disclosure on the statement explaining that the
qualified custodian does not have custodial liability for those
investments? Are there are other disclosures that would appropriately
distinguish how the qualified custodian maintains investments?
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\208\ See Custody Rule FAQs, supra footnote 17, at Question
IX.1.
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97. Should we include the contractual requirement that the
qualified custodian, at least annually, obtain, and provide to the
investment adviser a written internal control report? Would the
proposed internal control requirement provide additional protections
where the adviser has custody? Would the proposed internal control
requirement raise costs for advisory clients? Should the contractual
requirement require some additional notification of any material
discrepancies identified in an examination supporting the internal
control report? For example, should the contractual requirement require
that the accountant performing the examination notify the Commission of
any material discrepancies by submitting a form such as Form ADV-E to
the Commission? Should the contractual requirement require the
accountant to notify the clients of the material discrepancies? Should
the contractual requirement include any other provisions with respect
to the written internal control report?
98. Should we prescribe particular steps an adviser should take to
review internal control reports for control exceptions? For example,
should we require an annual review of these reports by the adviser's
Chief Compliance Officer or an adviser personnel with the skill set to
review such reports?
99. Should we specify the internal control report to be obtained at
least annually, as proposed? Alternatively, should the internal control
report be obtained more or less frequently?
100. Should the proposed internal control report be based on an
assessment of the same control objectives outlined in the 2009
Accounting Guidance? \209\ Are these control objectives applicable to
all qualified custodians? Should certain of the control objectives be
required only when the adviser uses a related party qualified
custodian? Have custodial practices changed since the 2009 Accounting
Guidance was published which would necessitate the addition or removal
of control objectives in order to meet the policy goals of the proposed
rule? Would additional control objectives be necessary in order to
appropriately safeguard all client assets as required under the
proposed rule, compared to funds and securities as required under the
current custody rule?
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\209\ See Accounting Guidance, supra footnote, 188 at section
III.
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101. When preparing an internal control report for a related party
qualified custodian, should an accountant continue to be required to
verify that client assets are reconciled to a custodian other than the
adviser or its related person? Should this required reconciliation be
limited to only securities? Are there custodians (like a securities
depository) unaffiliated with the adviser that can hold all client
assets when a related party qualified custodian is utilized? Is further
guidance needed on this reconciliation requirement?
102. Should the contractual provision require that the independent
public accountant that prepares or issues the report be registered with
the PCAOB when the adviser serves as, or is a related person of, the
qualified custodian, as proposed? If so, should the independent public
accountant also be subject to regular inspection by the PCAOB, as
proposed? Would using independent public accountants registered with,
and subject to regular inspection by, the PCAOB increase the costs to
obtain these reports or make it too difficult to obtain a qualified
accounting firm to provide an internal control report? Should there be
a different independence standard for accountants performing the
engagement? Rather than the independence standard proposed, should the
rule require an accountant to not be a related person of the qualified
custodian as that term is defined under the safeguarding rule? \210\
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\210\ Proposed rule 223-1(d)(11).
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103. The current rule \211\ and proposed rule \212\ define an
independent public accountant as a public accountant that meets the
standards of independence described in rule 2-01 of Regulation S-X (17
CFR 210.2-01). Do custodians that voluntarily obtain internal control
reports or obtain them to satisfy other requirements often obtain them
from independent public accountants that are independent according to
this standard? If not, do they have another standard for determining
independence? For example, do custodians require auditors to meet the
independence standard set by the Association of International Certified
Professional Accountants? Do custodians require an independent public
accountant to be unaffiliated from the custodian?
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\211\ Current rule 206(4)-2(d)(3).
\212\ Proposed rule 223-1(d)(5).
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104. Rather than the contractual provision requiring that the
independent public accountant that prepares or issues the report be
registered with the PCAOB when the adviser serves as, or is a related
person of, the qualified custodian, as proposed, should this
requirement apply to all qualified custodians, regardless of whether
the qualified custodian is the adviser or a related person? If so,
should the rule contain different requirements for a qualified
custodian that is the adviser or a related person?
105. Is it appropriate, as proposed, to require that an adviser
that is also the qualified custodian include all of the proposed
reasonable assurances protections in the written agreement with the
client? Should we require similar protections for any related person
qualified custodian? For example, should the rule require the written
agreement of any related person that is the qualified custodian to
include all of the proposed reasonable assurances requirements? Would
doing so provide enhanced protections for client assets? Would it
result in any additional burdens on advisers, related persons, or
clients?
106. Do commenters agree with our proposed requirement that the
accountant who prepares the internal control report should be
``independent'' from the qualified custodian? Should it, instead,
require independence from adviser?
107. Would obtaining or receiving an internal control report
present additional issues if the qualified custodian for client assets
is located outside of the United States? Would the requirement that the
independent public accountant be registered with, and subject to
regular inspection by, the PCAOB in affiliated or self-custody
situations make it more difficult to obtain such an internal control
report?
108. Instead of making it a term of the required written agreement,
should we permit an adviser to rely on the representations of a
qualified custodian that it has obtained the required internal control
report?
[[Page 14704]]
109. Should the proposed rule include the contractual requirement
that the qualified custodian will specify the investment adviser's
agreed-upon level of authority to effect transactions in the custodial
account as well as any applicable terms or limitations? Are there other
ways in which we could accomplish our objective to help empower
advisers to modify or eliminate their unwanted ability in a custodial
agreement to better reflect their client intentions? Would the
requirement provide additional protections where the adviser has
custody of client assets and further the policy goals of the rule?
110. Is it difficult for advisers that have custody, including
inadvertent custody, pursuant to a client's custodial agreement with a
qualified custodian, to reduce or eliminate their authority over the
client's custodial account? Would the proposed qualified custodian
contractual requirement make it easier for advisers to reduce or
repudiate this authority? Do qualified custodians often reject an
adviser's request to modify its agreement with its client to reduce or
eliminate the adviser's authority?
111. Do qualified custodians sometimes lend, invest, or otherwise
use their custodial customers' investments? Do advisers with custody of
client assets have knowledge of these transactions? Do these
transactions present risk to custodial customers? Do advisers consider
whether a custodian engages in these transactions, or has sufficient
insurance coverage to cover the risk of loss arising from these
transactions when involved in selecting a qualified custodian for an
advisory client? Should we include in the final rule a contractual
requirement requiring qualified custodians to record a liability and
maintain sufficient capital and/or insurance when lending, investing,
or otherwise using their custodial customers' investments? Would
qualified custodians be able to satisfy the requirement? If not, what
type of financial institutions would be unable to satisfy it? Are there
other ways of protecting custodial customers when an adviser has
custody from risk of loss when those financial institutions lend,
invest, or otherwise use client investments?
112. Should the proposed rule include other contractual provisions
or reasonable assurances? For example, should we require the written
agreement to contain a contractual provision requiring the qualified
custodian to make and keep adequate records? Would that provision
facilitate compliance with the contractual provision requiring that the
qualified custodian provide records to the Commission or independent
public accountant? Would this requirement provide additional
protections for clients where the adviser has custody and further the
policy goals of the rule?
113. Are there other risks that the rule should require the written
agreement to address? For example, should the rule require that the
written agreement expressly address the transfer of custodial assets in
the event of the custodian's bankruptcy or insolvency? Should the
written agreement be required to state, or should the adviser be
required to obtain reasonable assurances, that the intent of parties is
to enter into a custodial relationship, and under no circumstances
should the relationship be considered a debtor-creditor relationship?
114. Investment companies registered under the Investment Company
Act (``RICs'') are subject to a comprehensive regime for the custody of
their assets under the Investment Company Act and Commission rules
thereunder, with specific requirements that vary based on the type of
custodian. Should we continue to except accounts of RICs under proposed
rule 223-1 in light of this regime for RICs? Should we apply any of the
provisions of proposed rule 223-1 to RIC custodial arrangements,
particularly the proposed contractual provisions for the qualified
custodian agreement? Should the required contractual provisions depend
on the type of custodian involved? For example, should RICs be required
to include some or all of the proposed contractual provisions in
agreements with bank custodians because the Commission has not adopted
a rule related to bank custodians specifically?
115. Does the custody rule contain any safeguards that the
safeguarding rule retains that are not necessary and which we should
not require?
C. Certain Assets That Are Unable To Be Maintained With a Qualified
Custodian
We believe that the bulk of advisory client assets are able to be
maintained by qualified custodians; however, we understand that is not
universally the case, particularly for two types of assets: certain
physical assets and certain privately offered securities.
It is not uncommon for physical assets, such as precious metals,
physical commodities, and real estate, to be held in client portfolios,
and thus there are likely circumstances in which advisers would have
custody of these physical assets as a result of the expanded scope of
the safeguarding rule. We understand that these assets are sometimes
unable to be maintained by qualified custodians, and that some
qualified custodians may refuse to custody such assets, in part,
because the inherent physical characteristics of the items increase the
expenses associated with their maintenance and safekeeping. Some of
these assets by their very nature or size may not easily be subject to
theft or loss, and that may reduce the need for the safeguarding
protections offered by a qualified custodian, but when an adviser has
an ability or authority to change beneficial ownership of these assets,
there is still a risk of misuse, misappropriation, or loss associated
with the adviser's insolvency or bankruptcy.
Similarly, it is increasingly common for advisory clients to have
privately offered securities in their portfolio.\213\ We understand
that advisers with trading authority of privately offered securities
that do not settle DVP often have custody of these securities because
of the broad, general power of attorney-like authority required to
trade these securities.\214\ There are certain impediments to
transferability typically associated with certain privately offered
securities--specifically, the need to obtain the consent of the issuer
or other securities holders prior to any transfer of ownership--that
make certain of these assets less susceptible to some of the risks the
rule is designed to address. In particular, they would be less likely
to be stolen by a third party or simply lost. These characteristics
reduce the need for the safeguarding protections offered by a qualified
custodian. These characteristics, however, do little, if anything, to
protect a client against misuse, misappropriation, or losses that
[[Page 14705]]
may result from the adviser's insolvency or bankruptcy.
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\213\ See, e.g., Form ADV data current as of [Nov. 30, 2021]
(showing that there are currently 5,037 registered private fund
advisers with over $18 trillion in private fund assets under
management); See also, Vanguard, The role of private equity in
strategic portfolios (Oct. 2020), available at https://corporate.vanguard.com/content/dam/corp/research/pdf/Role-of-private-equity-in-strategic-portfolios-US-ISGRPE_102020_US_F_online.pdf (``[T]he asset size of the private
equity market has been gradually growing on an absolute basis and
relative to the public equity market over the last 20 years. Private
equity has risen from 2% to 7% of total investable global equity
assets.''); see also Scott Bauguess et al., Capital Raising in the
U.S.: An Analysis of the Market for Unregistered Securities
Offerings, 2009- 2017 (2018), available at https://www.sec.gov/files/dera-white-paper_regulation-d_082018.pdf (noting that an
analysis of issuer self-reported data through electronic Form D
filings indicates that the number of unregistered offerings and
corresponding amounts raised have been increasing over the years
2009-2017); Concept Release on Harmonization of Securities Offering
Exemptions, Release No. 33-10649 (June 18, 2019) [84 FR 30460 (June
26, 2019)], at n.37 (stating that the amounts raised in exempt
markets have increased both absolutely and relative to public
markets).
\214\ See supra footnote 71 and accompanying text.
---------------------------------------------------------------------------
We understand that the current market for custodial services of
privately offered securities is fairly thin. We also understand that,
although some custodians will custody these securities by holding them
in nominee form, many do not custody them. We similarly understand that
demand for these services may also be thin. Moreover, we understand
that many advisers with custody of these assets do not seek to maintain
them with a qualified custodian--at least in part--because the custody
rule contains the ``privately offered securities exception'' \215\ from
the qualified custodian requirement.
---------------------------------------------------------------------------
\215\ See rule 206(4)-2(b)(2).
---------------------------------------------------------------------------
To qualify for the privately offered securities exception today,
the security must meet the exception's description of ``privately
offered securities.'' This definition includes securities acquired from
the issuer in a transaction or chain of transactions not involving any
public offering; uncertificated, and ownership thereof is recorded only
on the books of the issuer or its transfer agent in the name of the
client; and transferable only with prior consent of the issuer or
holders of the outstanding securities of the issuer. This custody rule
exception contains one additional condition: for an adviser to a
limited partnership or similar pooled investment vehicle to rely on
this exception, the adviser must also comply with the custody rule's
audit provision. In adopting this exception, the Commission had
expressed its concern that these safeguards may be ineffective in the
case of limited partnerships (or other pooled investment vehicles),
noting that because the private securities are held in the name of the
limited partnership and the adviser acts for the partnership, the
adviser has apparent authority to arrange transfers that would be
recognized by the issuer of the securities.\216\
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\216\ See 2003 Adopting Release, supra footnote 2.
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However, the Commission adopted this exception in 2003, following
concerns raised by commenters that a requirement to maintain certain
privately offered securities with qualified custodians could pose
difficulties; particularly given that ownership of such assets
generally was recorded only on the books of the issuer (e.g.,
investments in limited partnerships where clients receive only a copy
of the partnership agreement as evidence of their investment or
assignment agreements for debt or equity interests in a private
company).\217\ In support of its decision to adopt the exception, the
Commission stated that some of the impediments to transferability
typically associated with certain privately offered securities provide
some external safeguards against the kinds of abuse the rule seeks to
prevent.\218\
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\217\ See 2003 Adopting Release, supra footnote 2, at section
II.B. (``Commenters [ ] pointed out that, on occasion, a client may
purchase privately-offered securities and that maintaining certain
of these assets in accounts with qualified custodians poses
difficulties because the client's ownership of the security is
recorded only on the books of the issuer.'') (emphasis added).
\218\ Id. The 2003 Adopting Release identified a specific and
limited range of securities to which commenters referred. See 2003
Adopting Release, supra footnote 2, at n.26 (``Commenters
specifically mentioned clients' investments in limited partnerships,
where clients receive only a copy of the partnership agreement as
evidence of their investment. Commenters also mentioned assignment
agreements for debt or equity interests in a private company, or
other types of customized agreements.'').
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When this exception was adopted, the size of the privately held
securities market was much smaller than it is now on an absolute basis
as well as in relation to the size of the publicly traded securities
market.\219\ In addition, the type, nature, structure, and prevalence
of private issues have also changed and expanded in recent years, all
of which have led the Commission to reconsider the current rule's
exception.\220\ We have become concerned over the years since its
adoption that this exception may not adequately protect an advisory
client from the broad types of risks the custody rule is intended to
address: chiefly, misappropriation.\221\
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\219\ See Vanguard, The role of private equity in strategic
portfolios (Oct. 2020), available at https://corporate.vanguard.com/content/dam/corp/research/pdf/Role-of-private-equity-in-strategic-portfolios-US-ISGRPE_102020_US_F_online.pdf (``[T]he asset size of
the private equity market has been gradually growing on an absolute
basis and relative to the public equity market over the last 20
years. Private equity has risen from 2% to 7% of total investable
global equity assets.''); see also Scott Bauguess et al., Capital
Raising in the U.S.: An Analysis of the Market for Unregistered
Securities Offerings, 2009- 2017 (2018), available at https://www.sec.gov/files/dera-white-paper_regulation-d_082018.pdf (noting
that an analysis of issuer self-reported data through electronic
Form D filings indicates that the number of unregistered offerings
and corresponding amounts raised have been increasing over the years
2009-2017); Concept Release on Harmonization of Securities Offering
Exemptions, Release No. 33-10649 (June 18, 2019) [84 FR 30460 (June
26, 2019)], at n.37 (stating that the amounts raised in exempt
markets have increased both absolutely and relative to public
markets).
\220\ For example, our staff has received several questions over
the years about whether certain securities would still qualify for
the exception if the securities were not acquired from the issuer
but were transferred, for instance, in a subsequent private
offering, from one owner to the next. Our staff has also responded
to other questions concerning the application of the exception. See,
e.g., 2013 IM Guidance, supra footnote 17 (providing staff views
regarding security evidenced by a private stock certificate).
\221\ See 2009 Adopting Release, supra footnote 11, at section
II.B.3 (noting the difficulty for advisory clients to verify that
assets actually exist because ownership is recorded only on the
issuers' books). In the 2009 Adopting Release, the Commission
expanded the protections of the surprise examination to privately
offered securities. See id. The growth of the privately offered
securities market since our 2009 amendments to the custody rule has
increased our concerns regarding the risks we identified in the 2009
Adopting Release to these client assets. We have also taken into
account concerns expressed by others. See, e.g., Dodd Frank
Regulating Hedge Funds and other Private Investment Pools Testimony
of James S. Chanos, supra footnote 14, at 50 (``These instruments
are privately issued uncertificated securities, bank deposits, real
estate assets, swaps, and interests in other private investment
funds, as well as shares of mutual funds, which, under current law,
can simply be titled in the name of the private investment fund care
of the manager, and the evidence of ownership held in a file drawer
at the manager of the private investment fund. The issuers of those
assets are permitted to accept instructions from the manager to
transfer cash or other value to the manager. This gaping hole in
current Advisers Act custody requirements can allow SEC-registered
advisers easily to abscond with money or other assets and falsify
documentation of ownership of certain categories of assets, and
makes it difficult for auditors, investors and counterparties to
verify the financial condition of advisory accounts and private
investment funds. Requiring independence between the function of
managing a private investment fund and controlling its assets, by
requiring that all assets be titled in the name of a custodian bank
or broker-dealer for the benefit of the private fund and requiring
all cash flows to move through the independent custodian, would be
an important control. Similarly, requiring an independent check on
the records of ownership of the interests in the private investment
fund, as well as imposing standards for the qualification of private
investment fund auditors--neither of which currently is required by
the Advisers Act--would also greatly reduce opportunities for
mischief.'').
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When an asset cannot be maintained with a qualified custodian, a
client may not have a full understanding of its holdings or receive
periodic account statements reflecting transactions in those assets.
This reduces the likelihood that a client will be able to identify
suspicious activity in its account or notice that its assets are gone.
Moreover, these assets may not be included in the sample of assets
subject to verification procedures during a surprise examination or
meet the materiality threshold for verification during a financial
statement audit. As a result, a loss could similarly go undetected by
an independent public accountant for a substantial period.
Ideally, a robust market for custodial services would develop for
physical assets and privately offered securities. Absent such a
development and the exception, however, advisers would be faced with
the inability to comply with a Commission requirement or a need to
transition to providing nondiscretionary advice or take certain other
actions in
[[Page 14706]]
order to avoid a violation of Commission rules, which could be
disruptive or result in client harm. We are therefore proposing to
reform the privately offered securities exception to address our
concerns about the lack of protections and transparency that could
result when privately offered securities and physical assets cannot be
maintained by a qualified custodian and to reduce the likelihood that a
loss of these assets could be undetected for an indeterminate amount of
time. The safeguarding rule would provide an exception to the
requirement to maintain client assets with a qualified custodian where
an adviser has custody of privately offered securities or physical
assets, provided it meets the following conditions: \222\
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\222\ See proposed rule 223-1(b)(2).
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The adviser reasonably determines and documents in writing
ownership cannot be recorded and maintained (book-entry, digital, or
otherwise) in a manner in which a qualified custodian can maintain
possession, or control transfers of beneficial ownership, of such
assets;
The adviser reasonably safeguards the assets from loss,
theft, misuse, misappropriation, or the adviser's financial reverses,
including the adviser's insolvency;
An independent public accountant, pursuant to a written
agreement between the adviser and the accountant,
[cir] Verifies any purchase, sale, or other transfer of beneficial
ownership of such assets promptly upon receiving notice from the
adviser of any purchase, sale, or other transfer of beneficial
ownership of such assets; and
[cir] Notifies the Commission within one business day upon finding
any material discrepancies during the course of performing its
procedures;
The adviser notifies the independent public accountant
engaged to perform the verification of any purchase, sale, or other
transfer of beneficial ownership of such assets within one business
day; and
The existence and ownership of each of the client's
privately offered securities or physical assets that is not maintained
with a qualified custodian are verified during the annual surprise
examination or as part of a financial statement audit.
1. Definition of Privately Offered Security and Physical Assets
The proposed rule's definition of privately offered securities
would retain the elements from the custody rule's description that
require the securities to be acquired from the issuer in a transaction
or chain of transactions not involving any public offering, and
transferable only with prior consent of the issuer or holders of other
outstanding securities of the issuer.\223\ Like the custody rule, the
safeguarding rule would also require the securities to be
uncertificated and would require ownership to be recorded only on the
books of the issuer or its transfer agent in the name of the client.
However, the safeguarding rule would also require that the securities
be capable of only being recorded on the non-public books of the issuer
or its transfer agent in the name of the client as it appears in the
records the adviser is required to keep under Rule 204-2. This
definitional requirement would enhance the assurance of the existence
of the client asset provided by the verification required by proposed
223-1(b)(2)(iii)(A) and will make the verification process more
efficient. The term ``uncertificated'' would generally have the same
meaning as set forth in article 8 of the Uniform Commercial Code.\224\
Additionally, we would not view a security to be certificated where the
certificate cannot be used to redeem, transfer, purchase, or otherwise
effect a change in beneficial ownership of the security for which the
certificate is issued.\225\ We understand that transactions and
ownership involving crypto asset securities on public, permissionless
blockchains are generally evidenced through public keys or wallet
addresses.\226\ As proposed, in order for a security to be a privately
offered security under the proposed safeguarding rule, among other
conditions, it must be uncertificated, and the ownership can only be
recorded on the non-public books of the issuer or its transfer agent in
the name of the client as it appears in the adviser's required records.
As a result, we believe that such crypto asset securities issued on
public, permissionless blockchains would not satisfy the conditions of
privately offered securities under the proposed safeguarding rule.\227\
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\223\ Rule 206(4)-2(b)(2)(i). ``Privately offered securities''
are defined by rule 206(4)-2(b)(2) as securities that are (1)
acquired from the issuer in a transaction or chain of transactions
not involving any public offering, (2) uncertificated, and ownership
thereof is recorded only on the books of the issuer or its transfer
agent in the name of the client, and (3) transferable only with
prior consent of the issuer or holders of the outstanding securities
of the issuer. See also proposed rule 223-1(d)(9).
\224\ See UCC Sec. 8-102(a)(18) (`` `Uncertificated security'
means a security that is not represented by a certificate.'').
\225\ Our staff took a similar view. See 2013 IM Guidance, supra
footnote 17.
\226\ See generally, PwC, Demystifying cryptocurrency and
digital assets (accessed Dec. 5, 2022), available at https://www.pwc.com/us/en/tech-effect/emerging-tech/understanding-cryptocurrency-digital-assets.html (describing storage, ownership,
and transactions, of crypto assets).
\227\ Crypto assets that are not crypto asset securities would
not qualify for the exception because they do not satisfy the
definition of privately offered security under proposed 223-1(d)(9).
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We are not providing a definition of the term ``physical asset'' or
including specific types of assets in the proposed rule. Rather, we
believe that the plain language of the phrase, along with a principles-
based facts and circumstances approach that requires an adviser to look
to the characteristics and nature of a particular physical asset is
more appropriate. We believe that what constitutes a ``physical asset''
is often self-evident, particularly when compared to other assets that
are certificated, maintained digitally, or in book-entry form. For
example, real estate and physical commodities \228\ such as, corn, oil,
and lumber are physical assets, while assets like cash, stocks, bonds,
options, futures and funds are not, even if they provide exposure to
physical assets. Physical evidence of ownership of non-physical assets
that can be used to transfer beneficial ownership, like stock
certificates, private keys, and bearer or registered instruments do
not, themselves, qualify as physical assets and would not qualify for
the exception from the qualified custodian requirement. Similarly,
certain physical evidence of physical assets such as a warehouse
receipt for certain commodities would not qualify for the exception if
they can be used to transfer beneficial ownership even though the
commodities documented by the warehouse receipt may qualify for the
exception. Or in the real estate context, a deed or similar indicia of
ownership that could be used to transfer beneficial ownership of a
property would not qualify for the exception, but the physical
buildings or land would qualify.
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\228\ See, e.g., International Organization of Securities
Commissions, Principles for the Regulation and Supervision of
Commodity Derivatives Markets--Consultation Report at 82 (Nov.
2021), available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD689.pdf (defining physical commodity as ``[a] tangible
product or raw material, as opposed to an instrument which
references a physical commodity.'').
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2. Adviser's Reasonable Determination
In order to be eligible for the exception, the rule would require
an adviser to determine, and document in writing, that ownership cannot
be recorded and maintained (book-entry, digital, or otherwise) in a
manner in which a qualified custodian can
[[Page 14707]]
maintain possession or control of such assets. Such a determination
necessarily depends on the facts and circumstances in issue. Moreover,
these determinations would necessarily evolve over time as assets and
the custodial industry change, allowing the proposed rule to remain
evergreen.
An adviser's reasonable determination of whether a qualified
custodian is able to maintain possession or control of a particular
asset would generally involve an analysis of the asset and the
available custodial market. An adviser's reasonable determination
generally would not require the identification of every conceivable
qualified custodian and an evaluation of its custodial services.
Fundamentally, to determine whether an asset can or cannot be
maintained by a qualified custodian under the proposed rule, an adviser
generally should obtain a reasonable understanding of the marketplace
of custody services available for each client asset for which it has
custody. The adviser's written documentation of its determination would
generally contain material facts concerning its understanding of the
custodial marketplace and a description of the client asset in issue.
The proposed rule does not specify the frequency with which an
adviser must make this determination. What frequency would be
reasonable for any determination would depend on the particular assets
and the facts and circumstances. For example, an adviser might develop
policies and procedures for conducting this analysis, and those
policies and procedures might reasonably call for an annual assessment
of one type of asset for which there have been no indicators of a
developing custodial market. On the other hand, it would likely be
unreasonable for an adviser to annually assess the custodial market for
an asset for which developing custodial services are well publicized as
imminent.
As discussed above, we believe that many privately offered
securities are not currently maintained by qualified custodians.
However, we understand that a substantial portion of securities--
privately and publicly held--are uncertificated (i.e., paper stock
certificates are largely a relic from a prior era, replaced by more
modern methods of recording ownership).\229\ Particularly as a result
of the growth of uncertificated publicly traded securities, we
understand that custodians have refined safeguarding and reporting
practices with respect to uncertificated securities. Therefore, we
believe that this experience has made it increasingly possible for
qualified custodians to provide custody services for privately offered
securities. Accordingly, while today it may be reasonable under
appropriate circumstances for an adviser to determine that a qualified
custodian cannot maintain possession or control of a particular
privately offered security, we believe that determination may be more
difficult to support as the custodial industry continues to evolve.
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\229\ See Paech, Philipp, Securities, Intermediation and the
Blockchain: An Inevitable Choice Between Liquidity and Legal
Certainty? 21(4) Unif. L. Rev. 612 (Dec. 1, 2016) (``The practice of
securities holding, transfer, and collateral has changed
significantly over the past 200 years-moving from paper certificates
and issuer registers, to an intermediated environment, and from
there to computerization and globalization.''); Intermediated
Securities, supra footnote 143, at 386 (``Immobilization and
dematerialization of securities have made the physical delivery of
certificates nearly irrelevant. In just a few decades, the issuance
of securities has shifted from the physical to a virtual world, to
which financial intermediaries hold the key.''); DTCC, From Physical
to Digital: Advancing the Dematerialization of U.S. Securities
(Sept. 2020), available at https://www.dtcc.com/~/media/Files/PDFs/
DTCC-Dematerialization-Whitepaper-092020.pdf (``the crushing
mountain of paper of the paperwork crisis in the 1960s and 1970s was
addressed by the two-pronged approach of immobilization and
dematerialization''). While the terminology is sometimes used
interchangeably, ``dematerialized securities'' generally refer to
securities, sometimes certificated, that are represented by entries
in securities accounts maintained by financial intermediaries for
investors, while ``uncertificated securities'' refer to securities
that are not represented by a certificate but are registered on an
issuer's books. See generally, Thevenoz, Intermediated Securities,
supra footnote 143 at 386 (``Certificated securities do not need to
move if they are immobilized in the custody of reliable depositories
and represented by entries in securities accounts maintained by
financial intermediaries for investors. When needed, immobilized
securities can be transferred by way of book-entries in investors'
accounts, which substitute for their physical delivery. Where
corporate law and investor preferences allow, physical individual
securities can become wholly unnecessary. A whole issue can be
replaced by one global certificate, or it can even be recorded in an
`issue account' without the need for any certificate, against which
the dematerialized securities can be credited to the securities
accounts of market participants and, here again, be transferred by
way of book-entries. Immobilization and dematerialization of
securities have made the physical delivery of certificates nearly
irrelevant. In just a few decades, the issuance of securities has
shifted from the physical to a virtual world, to which financial
intermediaries hold the key.''); and see UCC section 8-102(18) (``
`Uncertificated security' means a security that is not represented
by a certificate.'').
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Whether an adviser can make the reasonable determination regarding
a particular physical asset necessarily depends on the asset type and
the availability of custody services. For example, an adviser could
likely conclude that qualified custodian services are unavailable for
unharvested wheat or a shopping center. Similarly, custody of certain
tangible agricultural commodities may be impossible to insure at a
qualified custodian.\230\ In these circumstances, an adviser may
reasonably determine that ownership cannot be recorded and maintained
(book-entry, digital, or otherwise) in a manner in which a qualified
custodian can maintain possession or control of such asset. Conversely,
it is likely that a qualified custodian can hold gold bullion,\231\ and
it would therefore be difficult for an adviser to make the
determination required to invoke the proposed exception.
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\230\ Though such physical assets may be unable to be held with
a qualified custodian as defined under the proposed rule, we
understand that agricultural commodities and other physical
commodities do have certain non-qualified custodians, exchange-
approved warehouses or clearing houses that provide substantial
record keeping and safeguarding protections for such assets. These
often include secure storage facilities, internal control
procedures, and relevant insurance coverages.
\231\ It is our understanding that banks are able to custody
gold bullion and other precious metals, but that other non-bank
custodians provide secure storage and transportation services for
gold bullion and other precious metals, including vault custody and
related transportation services. See, e.g., The Brinks Company, SEC
Staff No-Action Letter (Feb. 3, 2014). We also understand that, from
time to time, bank custodians or others may exit the precious metals
custody business, but that other custodians may become available to
perform those custody services. See, e.g., Depository Trust Company
of Delaware, LLC, SEC Staff No-Action Letter (Sept. 12, 2016).
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3. Adviser Reasonably Safeguards Assets
To rely on the exception, the adviser would be required to
reasonably safeguard any privately offered securities or physical
assets that are not maintained with a qualified custodian from loss,
theft, misuse, misappropriation, or the adviser's financial reverses,
including the adviser's insolvency. While the specific procedures
implemented to safeguard assets may vary depending on the asset,
advisers must satisfy their fiduciary duty in safeguarding any
particular asset.\232\
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\232\ The principles-based requirement to reasonably safeguard a
client's physical assets is drawn from an adviser's fiduciary duty
including its duty of care or duty of loyalty under the Advisers
Act, which extends to the entirety of the adviser-client
relationship. See supra footnote 57.
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With respect to privately offered securities, an adviser might
``reasonably safeguard'' an asset by looking to reasonable commercial
standards, which we understand presently may draw from a variety of
protections such as enhanced recordkeeping, additional change of
control terms in governance agreements, designation of an agent
required to be involved in transfers of beneficial ownership, among
others. For
[[Page 14708]]
example, one critical safeguard that advisers should consider is the
types of internal controls that they can implement to reasonably
safeguard clients' privately offered securities. If possible, an
adviser may consider separating duties of the person responsible for
recording investments in privately offered securities from the person
responsible for authorizing the buying and selling of privately offered
securities from the person responsible for holding certificates or
other legal records evidencing ownership of privately offered
securities.\233\ An adviser may also consider implementing procedures
to regularly review and reconcile the following documents to the
adviser's records: legal documents demonstrating evidence of ownership
of privately offered securities, including any changes year over year;
board meeting minutes, if available, for any activity that may evidence
a change in a client's ownership of privately offered securities; and
records of share ownership maintained by the issuer or its transfer
agent in the name of the client. An adviser may also consider
periodically reviewing and documenting that the privately offered
securities are transferable only with the prior consent of the issuer
or its shareholders. Importantly, the rule recognizes that the
privately offered securities vary, as do the relationships between an
adviser and its advisory clients, and the rule retains the flexibility
necessary for advisers to make reasonable determinations concerning the
safeguarding of those privately offered securities that are unable to
be maintained with a qualified custodian.
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\233\ We recognize in some smaller organizations it may be more
challenging to separate these functions.
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With respect to physical assets, an adviser might ``reasonably
safeguard'' such assets by looking to reasonable commercial standards,
which may include storage in a secure facility or vault that adheres to
exchange, clearing house, or other licensing requirements for
participation in certain commodities markets; dual control procedures
for access to assets in safekeeping; maintenance of records to evidence
movement or transfer of assets (including details on depositor,
beneficiary and/or the legal owner); periodic reconciliation of records
with assets held (e.g., vault counts); separation of duties for
movement or transfer of assets, recordkeeping and reconciliation;
periodic audits; smoke detection and fire suppression systems; and
insurance coverage for any custody-related losses incurred by its
clients. Advisers may need to tailor their standards for safeguarding
to each particular physical asset depending on the relative common
standards for its market.\234\ For example, reasonable commercial
standards for safeguarding and taking delivery of an agricultural
commodity like a bushel of wheat \235\ necessarily would be different
from the appropriate maintenance gold bullion \236\ or of personal
property like jewelry, antiques, or art.\237\ We believe this approach
will give advisers the flexibility to develop and implement
safeguarding practices with respect to assets not maintained with a
qualified custodian that are appropriately tailored, while helping to
ensure client assets receive appropriate protections.
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\234\ See, e.g., The Board of the International Organization of
Securities Commissions, Commodity Storage and Delivery
Infrastructures: Good or Sound Practices (Feb. 2019), available at
https://www.iosco.org/library/pubdocs/pdf/IOSCOPD622.pdf
(encouraging the adoption of ``Good or Sound Practices'' in member
jurisdictions, but noting that ``[n]ot all of the Practices
described may be relevant to all market participants. It is for
market participants to determine the applicability of any particular
Practice and to apply it as their circumstances require.'').
\235\ For example, in the agricultural context, clearing members
and delivery facilities are subject to the various rules of the
exchange or clearing house as well as inspection by the exchange and
the Department of Agriculture. See, Chapter 7, Delivery Facilities
and Procedures, Chicago Board of Trade Rule Book (2022) available
at: https://www.cmegroup.com/rulebook/CBOT/.
\236\ See Global Previous Metals Code Global Precious Metals
Code available at https://www.lbma.org.uk/market-standards/global-precious-metals-code.
\237\ The OCC notes in its Handbook that miscellaneous assets
(e.g., jewelry, art, coins) should be maintained in a vault
consistent with applicable law and sound custodial management. Vault
control procedures should ensure physical security, dual control
procedures, maintenance of records evidencing access to the vault,
proper asset transfer ticketing, and periodic vault counts. See,
Custody Services, Comptrollers Handbook (Jan. 2002) available here:
https://www.occ.treas.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/pub-ch-custody-services.pdf (``OCC Custody Handbook''). See also Inland Marine
Underwriters Association, Evaluating the Risk in the Storage and
Shipping of Fine Art: Insights into the Art Service Industry at
https://www.imua.org/Files/reports/2019reports/EvaluatingRiskinStorageandShippingofFineArtsUpdateFinal1_4_2019.pdf.
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When an adviser has custody of client physical assets that are not
maintained with a qualified custodian, the ultimate obligation to
safeguard those assets falls to the adviser. In some circumstances, an
adviser might conclude that it could safeguard the asset itself,
provided it can do so in accordance with reasonable commercial
standards. In other circumstances, the adviser could instead determine
that it could permissibly maintain physical assets with a third party
that the adviser concludes could safeguard the assets in accordance
with reasonable commercial standards. The proposed rule does not
require a particular approach.
More broadly, an adviser might demonstrate that it is reasonably
safeguarding a client asset itself or through a third party, by
adopting, implementing, and regularly reassessing policies and
procedures that include robust due diligence and ongoing oversight
designed to ensure the adviser has assessed and evaluated the
safeguarding measures put in place by itself or the third party
maintaining physical assets. Such policies and procedures might include
procedures to assess whether the person maintaining the client asset
has exercised and is likely to continue to be able to exercise due care
in accordance with reasonable commercial standards in safeguarding the
asset.
4. Notification and Prompt Independent Public Accountant Verification
The exception to the requirement to maintain assets with a
qualified custodian would also require an adviser to enter into a
written agreement with an independent public accountant.\238\ The
proposed rule would require the adviser to notify the independent
public accountant of any purchase, sale, or other transfer of
beneficial ownership of such assets within one business day.\239\ The
written agreement would require the independent public accountant to
verify the purchase, sale, or other transfer promptly upon receiving
the required transfer notice.\240\ The written agreement would also
require the accountant to notify the Commission by electronic means
directed to the Division of Examinations within one business day upon
finding any material discrepancies during the course of performing its
procedures.\241\ We believe that these requirements would provide
advisory clients meaningful and much-needed protection when their
advisers have custody of assets that are not maintained with a
qualified custodian.
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\238\ See proposed rule 223-1(b)(2)(iii).
\239\ See proposed rule 223-1(b)(2)(iv).
\240\ See proposed rule 223-1(b)(2)(iii)(A).
\241\ See proposed rule 223-1(b)(2)(iii)(B).
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It has been our longstanding view that the involvement of
independent public accountants in the review and verification of client
assets of which advisers have custody is an important safeguarding tool
and reduces the risk of loss of client assets.\242\ Consistent with
[[Page 14709]]
that view, we believe that an independent public accountant's
involvement in the verification and notification requirements in the
proposed rule enhances the reliability and integrity of the
verification and would help identify problems that clients may not, and
thus would provide deterrence against fraudulent conduct by advisers.
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\242\ See, e.g., Adoption of Rule 206(4)-2 under the Investment
Advisers Act of 1940, IA Release No. 123 (Feb. 27, 1962) [27 FR 2149
(Mar. 6, 1962)] (requiring advisers with custody of client
securities or funds to engage an independent public accountant to
conduct an annual surprise examination); 2009 Adopting Release,
supra footnote 11, at section II.B.1. (``Because advisers with
custody often have authority to access, obtain and, potentially,
misuse client funds or securities, we believed the additional review
provided by an independent public accountant would help identify
problems that clients may not, and thus would provide deterrence
against fraudulent conduct by advisers.'').
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We believe that the timing requirement for the notice--that the
adviser would be required to provide notice to an independent public
accountant within one business day of a transfer of beneficial
ownership--is important to inform an independent public accountant as
soon as practicable of a transfer of beneficial ownership of client
assets that are not held with a qualified custodian. This timing will
build a record for the accountant to review in connection with an
annual surprise examination or financial statement audit and,
therefore, would reduce the likelihood of loss or misappropriation of
client assets. Moreover, we anticipate the timing of these requirements
in close proximity to the timing of a transaction, coupled with the
annual confirmation during a surprise examination or financial
statement audit, would also reduce the likelihood that any loss would
go undetected for an extensive time. Further, we believe that this
notice would not be challenging for any adviser to provide to the
independent public accountant, especially considering the limited
nature of the requirement relative to the more involved aspects of many
of the closings related to privately offered securities or physical
assets such as the preparation or review of closing memos, confirmation
of receipt of funds, execution of signature pages, and many other more
time-consuming tasks related to closings for these types of assets.
Based on our experience with the audit provision in the current
rule,\243\ we understand that independent public accountants are
familiar with a wide variety of transaction verification and tracing
transaction activity as this is a normal audit procedure. We recognize,
however, that the verification and transaction tracing process of any
purchase, sale, or other transfer of beneficial ownership of the assets
would necessarily vary depending on the type of asset. For example, for
a privately offered security purchased or sold by an advisory client,
the independent public accountant could contact the issuer of the
security or its agent to verify the existence of the asset and relevant
information concerning the transfer of beneficial ownership of the
client asset. The independent public accountant may also take a wide
array of additional steps depending on the nature of the security--and
the transaction--along with other relevant facts and circumstances. For
example, the independent public accountant may review a private
placement memorandum, the issuer's Regulation D filings,\244\ or take
other steps to assist in verifying the existence and transfers of
beneficial ownership of the asset.
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\243\ Rule 206(4)-2(a)(4) and 206(4)-2(b)(4).
\244\ See Form D, Notice of Exempt Offering of Securities,
available at https://www.sec.gov/files/formd.pdf.
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For a physical asset purchased or sold by an advisory client, such
as a commercial shopping center, the independent public accountant may
confirm the existence of the asset through a variety of reliable means.
To confirm the transfer of beneficial ownership of the asset, the
independent public accountant may review deeds or other land
recordation materials, or seek to obtain other reliable information
concerning the transfer of the asset. The independent public accountant
may use similar methodologies in connection with the verification of
the existence, and purchase or sale, of physical commodities. For
example, an independent public accountant may seek to confirm existence
and the relevant transfers of beneficial ownership of grain by
reviewing a warehouse receipt for the assets held in a grain elevator.
The written agreement required by the proposed rule would require
the accountant to notify the Commission within one business day upon
finding any material discrepancies during the course of its
examination.\245\ This requirement is effectively identical to the
notification requirement for material discrepancies found during a
surprise examination under the custody rule \246\ and would require an
effectively identical decision-making process by the independent public
accountant: the independent public accountant may first take reasonable
steps to establish the basis for believing a material discrepancy
exists. The obligation to notify the Commission arises once the
accountant has a basis for believing there is a material discrepancy.
Ordinarily, an accountant should be able to determine promptly whether
it has a basis for believing there is a material discrepancy.\247\ The
reporting by the independent public accountant of a material
discrepancy would provide the staff with timely notice of a potential
issue with the adviser's custodial practices, providing the staff with
an earlier opportunity to examine an adviser or take other action
against an adviser, as appropriate, in an effort to help safeguard
client assets. This proposed requirement also bears similarities to the
proposed notification requirement for an audit under the proposed
safeguarding rule.\248\
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\245\ See proposed rule 223-1(b)(2)(iii).
\246\ See rule 206(4)-2(a)(4)(ii).
\247\ See 2003 Adopting Release, supra footnote 2, at note 34;
2009 Proposing Release, supra footnote 11, at note 10.
\248\ See infra, section II.F.
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5. Surprise Examination or Audit
Like the custody rule, the safeguarding rule would require advisers
relying on the exception to undergo an annual surprise examination or
rely on the audit provision.\249\ In a change from the custody rule,
however, the proposed rule would require each privately offered
security or physical asset not maintained with a qualified custodian to
be verified.\250\ This change from the custody rule is designed to
address our concerns that a loss of these assets could go undetected
for an extended period of time as a result of a not being included
within the accountant's sample to be tested during a surprise
examination or verified during an audit if they do not meet the
threshold for materiality. Moreover, this proposed requirement would
supplement the proposed requirement to verify transactions promptly
after they occur, operating similarly to an annual ``bring down.'' This
would help ensure the client has some comfort regarding the status and
ultimate disposition of these assets over time despite the lack of
ability to monitor quarterly custodial statements. We
[[Page 14710]]
recognize that this proposed requirement likely constitutes a departure
from current practice for most surprise examinations and audits, but
believe that the protective benefits of the surprise examination and
annual audit are critical to the safeguarding of client assets,
especially where these assets do not have the additional protections
afforded by the oversight of a qualified custodian.
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\249\ See rule 206(4)-2(a)(4); 2009 Adopting Release, supra
footnote 11, at section II.B.3. (``Because clients are more
dependent on the adviser with respect to the safeguarding of these
securities, advisory clients may be exposed to additional risks when
their advisers acquire these securities on their behalf. To mitigate
these risks and to provide assurance that privately offered
securities are properly safeguarded, we believe that it is
appropriate to require an independent third-party to verify client
ownership with the issuers of the securities by requiring that these
securities be subject to the surprise examination requirement under
the amended rule.'').
\250\ See proposed rule 223-1(b)(2)(v).
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We request comment on all aspects of the proposed exception,
including the following:
116. Should the rule retain the privately offered securities
exception of the custody rule without any modifications?
117. Do commenters agree with our understanding that, today, the
overwhelming majority of securities are uncertificated, that the volume
of privately offered securities has vastly expanded since 2003, and
that custodians have developed safeguarding and reporting practices,
particularly with respect to publicly-traded securities? Are we correct
that the custodial market for privately issued securities is less
developed? Do commenters also agree that some custodians will presently
custody privately issued securities and that new custodial services are
being developed?
118. Should the rule eliminate the current rule's privately offered
securities exception to the requirement to maintain securities with a
qualified custodian, as proposed? Rather than eliminating the custody
rule exception and creating the new safeguarding rule exception for
privately offered securities and physical assets, should the custody
rule exception be retained, but modified in a different way? For
example, should it be made available solely to advisers whose clients'
financial statements are audited and distributed to investors in
accordance with the requirements of this rule? If so, what standard of
independence should an auditor be required to satisfy?
119. Are we correct in our belief that the privately offered
securities exception may not adequately protect an advisory client from
the broad types of risks the rule is intended to address? If not, in
what ways does the exception provide adequate protections? Are there
alternatives to eliminating the exception and creating the new
exception as proposed that would better serve the proposed rule's
policy goals?
120. Is our understanding correct that advisers with trading
authority of privately offered securities that do not settle DVP often
have custody of these securities because of the broad general power of
attorney-like authority required to trade these securities?
121. Are qualified custodians able to provide custody services for
privately offered securities? If so, what services? Would maintaining
these securities with qualified custodians be practically challenging
and/or costly? If so, what are the challenges or cost constraints?
122. Do commenters agree that the custody rule exception's
restrictions on transferability of privately offered securities do not
provide comparable protections to those provided under the proposed
rule? If commenters disagree, how do these restrictions protect against
misappropriation by the adviser or theft by a third party? Do issuers
and other holders of outstanding securities evaluate whether a
transaction in the securities would result in misappropriation by the
adviser or theft by a third party? Do they have an incentive to
evaluate a transaction for misappropriation or any of the other policy
goals of the rule?
123. We are proposing to retain the mutual fund shares exception
because, in our experience, this exception has not raised similar types
of investor protection concerns that we are seeking to address in this
proposal.\251\ Do commenters believe that the mutual fund shares
exception raises investor protection risks? Should we eliminate the
exception for mutual fund shares? To what extent do advisory clients
purchase mutual fund shares through qualified custodians such as
broker-dealers such that the exception may not be necessary?
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\251\ See rule 206(4)-2(b)(1) and proposed rule 223-1(b)(1).
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124. Our understanding is that certain assets cannot be maintained
with a qualified custodian, but that the bulk of client assets that
advisers service are able to be held by a qualified custodian. Do
commenters agree with this understanding? What are some examples of
assets that cannot be held by a qualified custodian? If an asset cannot
be maintained with a qualified custodian, should an adviser be
permitted to have custody of the asset, as that term is defined in the
proposed rule? Should advisers, instead, be required to relinquish the
authority that triggers the application of the definition of custody in
the context of the asset that is unable to be maintained with a
qualified custodian? Alternatively, should they be required to provide
alternative safeguards for the asset, such as those proposed?
125. Are there currently assets that qualified custodians will
maintain, but doing so would be cost-prohibitive for advisers or their
clients? If so, what are some examples of these assets? At what point
does it become cost-prohibitive? Is it measured based on a percentage
of the value of the asset? Is it based on a percentage of the adviser's
fee for providing advisory services with respect to that asset? Is it
the point at which it becomes unprofitable for the adviser to provide
advice to the client?
126. Should the proposed rule permit an adviser to conclude that an
asset is eligible for the exception if it would be prohibitively
expensive to custody the asset with a qualified custodian? What would
be considered prohibitively expensive?
127. Is the proposed definition of privately offered securities
clear? Should it include any additional factors? Should any of the
proposed factors be removed? For example, is the description of the
meaning of uncertificated clear? Should it be revised? Are there
securities that qualify for the custody rule's description of this term
that would be unable to rely on the proposed exception as a result of
the differences of the proposed definition? Please explain.
128. Do commenters agree with our belief that ownership of crypto
asset securities that is evidenced through public keys or wallet
addresses on public blockchains would not qualify for the proposed
privately offered securities exception? If not, why? Could the
rationale for the privately offered securities exception--namely, that
impediments to transferability present with certain privately offered
securities mitigate some of the risks and provide some external
safeguards against the kinds of abuse the rule seeks to prevent (loss
and third-party theft) when those assets cannot be maintained by a
qualified custodian--also apply to the custody of crypto asset
securities, the ownership of which is evidenced through public keys or
wallet addresses on public, permissionless blockchains? \252\ If so,
how do the protections work? How do they mitigate some or all of the
risks the rule is designed to address--loss, theft, misappropriation,
misuse, and adviser insolvency or bankruptcy?
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\252\ See 2003 Adopting Release, supra footnote 2 at nn. 26-28
and accompanying text.
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129. Should we provide a more prescriptive definition of physical
asset? Do commenters believe that there are certain physical assets
that are unable to be maintained with a qualified custodian? If so, do
commenters believe that those assets will remain static as the custody
industry evolves?
[[Page 14711]]
130. Is the term ``physical assets'' sufficiently clear such that
advisers will be able to understand its application and appropriately
utilize the exception? Should we define the term ``physical assets'' or
use another term for this exception, such as ``tangible assets''? If
so, should such a definition include or exclude specific asset types?
What assets are commonly considered to be physical assets that are
unable to be held at a qualified custodian?
131. Should the proposed rule provide flexibility for advisers to
make a reasonable determination that a privately offered security or
physical asset is eligible for the exception? Are there concerns that
providing advisers with the ability to make a reasonable determination
as to whether a privately offered security or physical asset is
eligible for the exception will allow some advisers to avoid using
qualified custodians to protect client assets? Should the Commission
take a different approach instead?
132. Should we limit the exception to privately offered securities
and physical assets as proposed? Should we expand the scope of the
exception to other types of assets? If we expanded the scope, which
types of assets should we include and why? Specifically, are there
impediments to transferability present with other types of assets that
mitigate some of the risks and provide some external safeguards against
the kinds of abuse the rule seeks to prevent (loss, third-party theft,
misuse, misappropriation, adviser insolvency/bankruptcy) when those
assets cannot be maintained by a qualified custodian? Please explain
your answer. Alternatively, should we not create an exception for
privately offered securities and physical assets?
133. Is our understanding correct that the current market for
custodial services of privately offered securities is limited? Is our
understanding correct that demand for these services is also limited?
Do commenters agree with our understanding of the market for custodial
services for physical assets? Please explain.
134. To be ``reasonable,'' how frequently should advisers determine
whether a qualified custodian can maintain possession or control of an
asset? Should the rule provide flexibility as proposed? Should it
instead specify intervals, such as monthly, quarterly, semi-annually,
or annually?
135. If we expanded the scope of the exception beyond privately
offered securities and physical assets to other assets that an adviser
reasonably determines cannot be held at a qualified custodian what
requirements should we put in place to ensure the assets are properly
safeguarded? Should such measures include some or all of the
protections for qualified custodians that we discuss in section II.3.C
above?
136. Rule 206(4)-7 requires advisers to adopt and implement
policies and procedures reasonably designed to prevent violations of
the Advisers Act and its rules, which will include the safeguarding
rule. Should we, nonetheless, prescribe specific written policies and
procedures to be adopted and implemented for determining when privately
offered securities or physical assets would be eligible for the
exception? For example, should any such written policies and procedures
be designed to help ensure that any party involved in maintaining
client assets be required to exercise due care in accordance with
reasonable commercial standards to safeguard client assets? Would this
requirement improve safeguarding of client assets not maintained with a
qualified custodian?
137. How do advisers currently safeguard securities for which they
rely on the privately offered securities exception under the custody
rule? Do these practices differ from what would be required under the
proposed rule? Please explain. Should these practices be prescribed
under the final rule?
138. Should we define the term ``reasonably safeguard'' in the rule
text? Do commenters believe that reasonable safeguards are generally
within reasonable commercial standards for particular physical assets
or privately offered securities? Are advisers able to ascertain what
safeguards are within such reasonable commercial standards for
particular physical assets or privately offered securities they may
hold on behalf of clients?
139. How would an adviser document that it is satisfying its
fiduciary duty to an advisory client when maintaining client assets not
with a qualified custodian under the proposed exception? How frequently
would it be required to provide this evidence?
140. Should we require a particular standard of care? Should we
require particular safeguards or practices?
141. Should the rule require an independent public accountant,
pursuant to a written agreement between the adviser and the accountant,
to verify transfers of privately offered securities or physical assets
promptly upon receiving notice from the adviser of any purchase, sale,
or other transfer of beneficial ownership of such assets? Would the
requirement enhance the safeguarding of client assets not maintained
with a qualified custodian and reduce the risk of loss or
misappropriation?
142. Is the proposed rule's timing requirement that the written
agreement require an independent public accountant to ``promptly''
verify any purchase, sale, or other transfer of beneficial ownership of
such assets sufficiently clear? Is the meaning of the term ``promptly''
in this context sufficiently understood in practice? Is additional
guidance needed? In lieu of the ``promptly'' requirement proposed,
should we require an independent public account to verify any purchase,
sale, or other transfer of beneficial ownership within a set number of
days? If so, how many days? For example, within 24 hours of the
transfer of beneficial ownership? Within 24 hours of receipt of notice
from adviser? Within two days of the transfer of beneficial ownership
or notice from the adviser? Within one week of the transfer of
beneficial ownership or notice from the adviser?
143. Are we correct in our understanding that independent public
accountants are familiar with asset verification and transaction
tracing procedures? Do commenters believe that there are alternative
procedures that would achieve the policy goals of the rule? Should we
require the independent public accountant to be the same as the
independent public accountant hired to conduct the annual surprise
examination or financial statement audit? Conversely, should we
prohibit this? Would there be benefits to using the same accountant,
such as an ability to leverage work papers from the verification when
performing annual surprise examination or audit procedures? Would there
be benefits to using a different accountant?
144. Would the 2009 Accounting Guidance contain sufficient guidance
for an accountant that is engaged to perform the proposed verification
procedures around privately offered securities and physical assets that
are not maintained with a qualified custodian? What changes, if any, do
you believe would be necessary to provide adequate direction with
respect to the proposed verification procedures?
145. Should we require the independent public accountant employed
by the adviser under this exception to verify the transfers to be
registered with and subject to inspection by the PCAOB?
146. Should the rule require the adviser to notify the accountant
of a transaction within one business day as proposed? Should we require
these notices to be in writing? Alternatively, should the rule require
that the written
[[Page 14712]]
agreement between the adviser and the accountant require the adviser to
notify the accountant of a transaction within one business day?
147. Do commenters agree with our view that this notification
should occur as soon as practicable after the closing of a transfer of
beneficial ownership of assets not custodied with a qualified
custodian? If not, what timeframe do commenters recommend that would
achieve the policy goals of the proposed rule? For example, should we
require the notice be no later than a certain number of hours after the
transaction date? After the settlement date? After money or asset(s)
are sent to a counterparty? After receipt of proceeds of a redemption?
148. Do commenters agree with our belief that it would not be
challenging for advisers to provide the required notification, as
proposed?
149. Is there a way to mitigate the risk that an adviser intending
to misappropriate client assets does not comply with the notification
requirement? Should we require other safeguards that limit the risk
that an adviser intentionally or unintentionally fails to comply with
the notification requirement?
150. Rather than requiring verification by an accountant promptly
after each purchase, sale, or other transfer, as proposed, should we
require timely notification to the auditor and require the auditor to
reconcile each reported purchase, sale, or other transfer reported to
the books and records subject to the annual audit or surprise
examination? Would this provide the same level of protection for client
assets not maintained with a qualified custodian as the prompt
verification requirement proposed? If not, are there nonetheless good
reasons to require annual verification rather than prompt verification?
If we were to require only annual verification, are there other
safeguards that we should require to mitigate the risk of
misappropriation?
151. Rather than requiring verification by an accountant promptly
after each transfer, as proposed, should the rule require, as part of
the annual surprise examination or annual audit, an accountant to
verify holdings of privately offered securities from one year to the
next and evaluate discrepancies? For example, if a client's account
held assets X, Y, and Z in one year, but only X the following year, the
accountant would evaluate the disposition of assets Y and Z.
152. Should the rule require the written agreement between the
adviser and the accountant to require the accountant to notify the
Commission within one business day upon finding any material
discrepancies during the course of its examination? Is the material
discrepancy requirement clear or should we provide further guidance
regarding how accountants should make the materiality determination? In
light of the fact that the requirement is effectively identical to the
notification requirement for material discrepancies found during a
surprise examination under the current custody rule, do commenters
believe that the requirement for the accountant to notify the
Commission within one business day upon finding any material
discrepancies would result in ``false positives'' or unnecessary
notifications to the Commission as a result of the one-business-day
reporting timeframe? If so, do commenters recommend a different
timeframe?
153. Rather than the form of verification and asset tracing
proposed, should the rule require verification procedures substantially
in the form used by independent public accountants under custody rule
206(4)-2(a)(4)?
154. Should the rule require the independent public accountant to
file a certificate on Form ADV-E stating that it has verified the
transactions and describing the nature and extent of its verification?
If so, when should the certificate be filed? Promptly upon completion
of the verification? Within one business day? Within a certain period
of time after being notified by the adviser? Would such a requirement
enhance the safeguarding of client assets not maintained with a
qualified custodian and reduce the risk of loss or misappropriation?
155. Should the rule permit other persons or entities to perform
the verification that the rule proposes be performed by the independent
public accountant? For example, should an independent representative be
permitted to perform this function? If so, should the rule retain the
independent representative definition from the current rule? \253\ If
not, what changes should be made? What, if any, procedures should we
require to be performed to verify the transaction, especially for the
broad array of physical assets that may be covered by the rule? Would
an independent representative be equipped to perform verification?
Would such an approach be more or less burdensome than the proposed
approach?
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\253\ See rule 223-1(d)(4).
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156. If an independent representative should be permitted to
perform the role we are proposing for an independent public accountant,
should the rule require or prohibit certain parties from acting as an
independent representative? What persons and entities do commenters
believe might act as independent representatives? Do commenters believe
that qualified custodians would be willing to act as independent
representatives? Do commenters believe that a client could serve as its
own independent representative? If so, would that further the policy
goals of the rule? Should there be limits on which clients could serve
as their own independent representative? For example, should those
clients be required to be a qualified purchaser, accredited investor,
or satisfy certain other tests (e.g., net worth, education, licensing)?
Would there be difficulties in locating a sufficient number of
independent representatives to perform this function?
157. Should we require that the proposed verification procedures
provide a certain level of assurance to investors? If so, what level of
assurance should we require? Should we require the written agreement
specify a required assurance framework that would be applied? Should we
require a reporting mechanism requiring the auditor to communicate the
results of the ongoing verification procedures to the adviser? If so,
how frequently should we require reports and what information should we
require to be included?
158. As an alternative to the notification and verification
elements of the proposed rule, should we instead require periodic
examinations for privately offered securities and physical assets that
are not maintained with a qualified custodian? If so, should the
procedures be substantially similar as those required for surprise
examinations under current rule 206(4)-2(a)(4)? How frequently should
these examinations occur? Would quarterly be sufficient to reduce the
risk of misappropriation and loss of client assets? Would quarterly
surprise examinations be more or less expensive than the notification
and verification proposed rules?
159. Are there other challenges with these aspects of the rule, as
proposed? Would this requirement be expensive for advisers, and would
advisers pass those costs along to advisory clients?
160. Should the rule require asset verification of all client
assets not maintained with a qualified custodian? Would this help
reduce the risk of theft, loss, or misappropriation of client assets?
How common is asset verification for privately held securities? For
physical assets? Should the verification requirement permit sampling of
client accounts, as opposed to verification of assets for all client
[[Page 14713]]
accounts? Should advisers with custody of assets not maintained with a
qualified custodian be required to obtain more surprise examinations?
If so, how frequently? Would quarterly or bi-annual asset verification
be more appropriate? Is 100% asset verification of assets in all client
accounts common in other contexts or performed for other purposes
unrelated to the requirements of the custody rule?
161. Should the rule require that the audit verify all client
assets not maintained with a qualified custodian, which would thus bar
the accountant engaged by the adviser from performing asset sampling
with respect to such assets? Would this help reduce the risk of theft,
loss, or misappropriation of client assets? How common is 100% asset
verification for audits of privately held securities? For physical
assets? Should advisers with custody of assets not maintained with a
qualified custodian be required to obtain more audits? If so, how
frequently? Would quarterly or bi-annual asset audits be more
appropriate? Is 100% asset verification of client assets common in
other contexts or audits performed for other purposes unrelated to the
requirements of the custody rule?
162. Do audits provide an appropriate level of protection for
clients where an adviser is unable to keep certain assets with a
qualified custodian? If not, why not? In addition to the requirement
that all assets be verified during the annual audit, should we
recommend any specific audit procedures to test that client assets not
kept at a qualified custodian are appropriately safeguarded from loss
or misappropriation?
163. If an adviser has any assets not maintained with a qualified
custodian, should the rule require asset verification of all assets,
including those assets that are maintained with a qualified custodian
to ensure a complete accounting of all assets occurs as of the audit
date? Are there other controls that could be put in place to ensure
assets are not transferred to satisfy an audit and then returned to
their original location?
164. Are there risks not discussed above created when an adviser
has custody of privately offered securities or physical assets that are
not maintained with a qualified custodian? If so, what are those risks?
Would the proposed rule sufficiently mitigate those risks? If not, what
additional safeguards should be required?
165. As an alternative or in addition to any of the safeguards in
the proposed exception, should we require advisers to promptly deliver
a written notice to each client whose assets are not maintained with a
qualified custodian (or the client's independent representative)
containing certain specified information regarding the assets, such as
to inform the client that the assets are not kept by a qualified
custodian and to explain how the client can verify the existence and
ownership of those holdings? Should the notice be required to be
delivered within a certain time to allow an adviser to enter into an
agreement with an entity to maintain the assets? If so, what should
that timing be? Should it be similar to the timing the proposed
exception would require for the adviser to provide notice to the
accountant? Is there additional information that should be required to
be included in the notice?
166. As an alternative or in addition to any of the safeguards in
the proposed rule, should the rule require that an adviser provide a
quarterly summary of a client's transactions involving assets that are
not maintained with a qualified custodian? Should the summary be more
or less frequent? Should the summary be in a prescribed format or
should certain specific information be required? If the Commission
adopts requirements to send quarterly statements to investors in
private funds as recently proposed,\254\ should that satisfy the
requirement to send these account statements? Should those quarterly
statements be required to be audited as an additional or alternative
condition of the proposed exception?
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\254\ See, Private Fund Advisers; Documentation of Registered
Investment Adviser Compliance Reviews, Release No. IA-5955 (Feb. 9,
2022) [87 FR 16886] (Mar. 24, 2022).
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167. As an alternative or in addition to any of the safeguards in
the proposed rule, should we require the adviser to obtain an internal
control report for assets not maintained with a qualified custodian? If
so, what type(s) of internal control report(s) should we require and
why? For example, should it have similar control objectives to the
internal control report we would require of qualified custodians? Who
should prepare such internal control report(s)? For example, should it
be an independent public accountant registered with and subject to
inspection as of the commencement of the engagement period by the
PCAOB? Should we require an adviser to obtain an internal control
report covering all of its internal controls, not just internal
controls relating to the safeguarding of assets not maintained with a
qualified custodian, or is the proposed exception sufficient to address
our policy goals? Would requiring an adviser to obtain an internal
control report be sufficient to mitigate the risks created when an
adviser has custody of client assets that are not maintained with a
qualified custodian?
168. As an alternative or in addition to any of the elements of the
proposed safeguarding rule, should we require advisers to maintain
insurance to reimburse clients for losses as a result of the advisers'
misconduct? For example, should we require fidelity bonds? Should the
insurance policy limits correspond to the amount of assets not
maintained with a qualified custodian? Should the insurance policy
limits correspond to the amount of all of the assets of which the
adviser has custody? Are policies of this nature common? What costs
would be associated with this kind of insurance? Who would be the payee
of any claims--the client who suffered the loss or the adviser? What
would be the advantages or disadvantages of either approach to payee?
Are these policies occurrence based (the policy that pays on a claim is
the one that is in effect at the time the incident occurred) or based
on when the claims are made (the policy that pays on a claim is the one
that is in effect at the time the claim is made regardless of when the
incident occurred)? What would be the advantages and disadvantages to
occurrence-based or claims-made policies in this context? What are
common exclusions under these policies? Do they cover simple/ordinary
negligence? Does the underwriting process for these policies involve an
evaluation of the adviser's internal controls? Does the underwriting
process take place annually and if so, does it differ from the initial
underwriting assessment? Should the insurance policy be obtained from
an insurer with certain credentials or subject to certain regulatory or
other standards? Please explain.
169. As an alternative or in addition to any of the elements of the
proposed rule, should we require advisers to have certain capital
requirements? Should capital requirements be required to correspond to
the amount of assets not maintained with a qualified custodian? Should
capital requirements correspond to the amount of all of the assets of
which the adviser has custody? Do advisers often maintain capital
reserves in the event of a client loss as a result of their misconduct?
If yes, is the capital maintained in escrow? If we were to require
financial reserves, should the reserves be maintained in escrow? Who
would be an appropriate escrow agent? And what would be appropriate
terms of the escrow, particularly for release of funds? Should the
capital be maintained
[[Page 14714]]
in a particular type of bank account? If yes, what kind of account is
commonly used or would be appropriate for these purposes? Should such a
requirement be conditioned upon using a particular type of bank? What
type? For example, should it be chartered by the OCC? Subject to
Federal Deposit Insurance Corporation oversight? What costs are
associated with escrow accounts and financial reserve/net capital
requirements?
170. Are there compliance challenges to this proposed exception? If
so, what are they?
D. Segregation of Client Assets
Though advisers must attain reasonable assurance of segregation of
client assets at a qualified custodian,\255\ the proposed rule also
would require advisers to segregate client assets from the adviser's
assets and its related persons' assets in circumstances where the
adviser has custody. Specifically, the proposed rule would require that
client assets over which an adviser has custody:
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\255\ See discussion of qualified custodian segregation
requirements at supra section II.(C)(4).
---------------------------------------------------------------------------
(1) Be titled or registered in the client's name or otherwise held
for the benefit of that client;
(2) Not be commingled with the adviser's assets or its related
persons' assets; and
(3) Not be subject to any right, charge, security interest, lien,
or claim of any kind in favor of the adviser, its related persons, or
its creditors, except to the extent agreed to or authorized in writing
by the client.\256\
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\256\ Proposed rule 223-1(a)(1). See also supra footnote 171.
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Segregation of client assets from the assets of others continues to
be a fundamental element of safeguarding client assets.\257\ This
aspect of the proposed rule is designed to ensure the client's
continued ownership and authorized use of its assets. This proposed
requirement is intended to complement, but serves a slightly different
purpose than the proposed requirement that the adviser obtain
reasonable assurance from the qualified custodian that the client's
assets are similarly segregated. This proposed adviser segregation
provision is critical in light of the fact that some client assets are
not maintained with a qualified custodian.\258\ Moreover, we view it as
essential not only for the custodian, but also for the adviser, to keep
its own proprietary assets and liabilities segregated from client
assets to prevent misuse or misappropriation of client assets.
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\257\ See supra footnote 168.
\258\ See proposed rule 223-1(a)(1)(ii)(D).
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The proposed requirement that a client's assets be titled or
registered in the client's name is designed to ensure that the client's
assets are clearly identified as belonging to the appropriate client,
regardless of whether a qualified custodian is holding the assets. The
proposed rule would also permit advisers to identify the assets ``for
the benefit of'' a particular client where assets may not be ``titled
or registered'' in the client's name. For example, an adviser acting as
a trustee would generally maintain client assets in trust for the
benefit of a particular client for estate planning or other
purposes.\259\ ``For the benefit of'' is also meant to recognize
various ways advisory clients can title or register their investments.
For example, clients may hold securities in ``street name'' or
``nominee name'' through a book-entry account with a broker-dealer, and
the broker-dealer will keep records showing the client as the real or
``beneficial'' owner.\260\ This requirement would protect client assets
even if the assets are maintained with a broker-dealer in such a manner
that gives the broker-dealer legal ownership of, or access to, the
assets.
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\259\ The client would maintain the beneficial interest in the
trust property and the trustee would hold only legal title without
the benefits of ownership; the trust property is not subject to
personal obligations of the trustee, even if the trustee becomes
insolvent or bankrupt. See section 507 of the Uniform Trust Code
(Jan. 2013).
\260\ See, e.g., Concept Release on the U.S. Proxy System,
Investment Advisers Act Release No. 3052 (July 14, 2010) [75 FR
42981 (July 22, 2010)] (``Proxy Concept Release'').
---------------------------------------------------------------------------
Similarly, if an adviser purchases privately offered securities
that are held on the books of the issuer or the issuer's transfer
agent, the adviser should ensure that the issuer or transfer agent
properly records and registers the adviser's client as owner. For
example, if the adviser invests in a private fund or purchases private
debt for a client, the records at the private fund's transfer agent or
the private debt issuer should reflect the client as the owner of the
investment. We believe this requirement would safeguard the client's
assets from intentionally or inadvertently becoming someone else's
property as well as prevent circumstances that could result in the
misuse or misappropriation of client assets.
The proposed rule would also require that client assets not be
commingled with the adviser's assets, or those of its related persons.
The proposed requirement is designed to help ensure that client assets
are isolated and more readily identifiable as client property.\261\
Consequently, we believe the proposed prohibition on commingling would
help protect client assets from claims by a third party looking to
secure or satisfy an obligation of the adviser, including in cases of
insolvency or bankruptcy of the adviser, or its related persons.\262\
We do not intend the prohibition on commingling to preclude traditional
operational practices in which client assets are held together with
other clients' assets. We recognize that some advisers and custodians
regularly service assets in a manner where such assets are reasonably
identifiable from other clients' assets and not subject to increased
risk of loss from adviser misuse or in the case of adviser insolvency.
Accordingly, we request comment on some of these practices and the
potential impact of this prohibition below.
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\261\ We have taken a similar approach in other contexts. See,
e.g., Financial Responsibility Adopting Release, supra footnote 171
(discussing similar requirements under Rule 15c3-3 that would cause
a broker-dealer to keep customer securities and cash isolated and
readily identifiable as ``customer property'' and, consequently,
available to be distributed to customers in the event that the
broker-dealer is liquidated in a formal proceeding under the
Securities Investor Protection Act of 1970).
\262\ See, e.g., supra footnote 172.
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Under the proposed rule, client assets would also be required to
remain free from any right, charge, security interest, lien, or claim
of any kind in favor of the adviser, its related persons, or their
creditors. These requirements are designed to protect client assets by
limiting the ability of an adviser, or its related persons, to use
client assets for their own purposes or in a manner not authorized by
the client. However, we do not intend this condition to limit or
prohibit authorized actions by clients. We are therefore proposing an
exception to these requirements to the extent a client agrees to or
authorizes such arrangements in writing.\263\ In our understanding,
some clients authorize these types of arrangements depending on the
types of assets, products, or strategies in which they invest resulting
in the subject assets being commingled and potentially subject to
certain claims. For example, such an authorization might allow assets
to be subject to a securities lending arrangement authorized by the
client.\264\ In a typical securities lending transaction, the legal
title to loaned securities passes to the borrower for the loan term.
The lender regains title to the securities when the securities are
returned, either upon demand or at the end of a specified
[[Page 14715]]
term. Similarly, in a margin account, which is a type of brokerage
account, a broker lends cash to a client to allow the client to
purchase securities. The loan is collateralized by the securities
purchased, other assets in a client account, and cash, and the broker
charges a periodic interest rate.\265\ This proposed exception would
also allow arrangements in which an adviser deducts fees directly from
client assets for the payment for services rendered by the investment
adviser or its related persons, so long as the client authorizes such
payments in writing.
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\263\ See proposed rule 223-1(b)(7).
\264\ See proposed rule 223-1(a)(1)(iii).
\265\ See Uniform Commercial Code, section 8-504 and cmt. 2
(``Margin accounts are common examples of arrangements in which an
entitlement holder authorizes the securities intermediary to grant
security interests in the positions held for the entitlement
holder.'').
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To the extent a client agrees to or authorizes in writing one of
these, or similar, arrangements, it would be excepted from the proposed
prohibition against subjecting the client's assets to any right,
charge, security interest, lien, or claim in favor of the investment
adviser or a qualified custodian.\266\ Although these activities may
implicate the types of risks the proposed rule is designed to address,
we believe the client is aware of, and consents to, the arrangement for
ease or by necessity to effect a desired activity with respect to its
assets.\267\ Without the ability to authorize such arrangements,
clients would be unable to engage in these potentially beneficial,
authorized activities.
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\266\ Proposed rule 223-1(a)(3)(iii).
\267\ See also, Standard of Conduct for Investment Advisers
Release, supra footnote 57, page 8 (noting that although all
investment advisers owe each of their clients a fiduciary duty under
the Advisers Act, that the fiduciary duty must be viewed in the
context of the agreed-upon scope of the relationship and necessarily
depend upon what functions the adviser, as agent, has agreed to
assume for the client, its principal).
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We believe that proper segregation of client assets, as required by
the three-part requirements of the proposed rule, would mitigate
concerns regarding the safety of a client's assets, particularly when
coupled with the requirement described above that the adviser obtain
reasonable assurance from the qualified custodian that the custodian is
similarly segregating the client's assets.
We request comment on all aspects of the proposed rule's
requirements for the segregation of investments, including the
following items.
171. Should the rule include the proposed segregation requirements?
Are these requirements sufficiently clear?
172. Do the proposed segregation requirements properly align with
the proposed qualified custodian contract provisions and the reasonable
assurance requirements, especially those proposed in subsections 223-
1(a)(2)(ii)(D) and (E)?
173. Is the scope of the proposed segregation requirement's
application to the adviser and its related persons appropriate? Should
this section also apply to the qualified custodian, or are the proposed
reasonable assurance requirements in 223-1(a)(2)(ii) sufficient to
ensure segregation and protection of assets in a custodial account?
174. Would advisers be able to ensure that assets are held in the
client's name or for the client's benefit in situations that involve
recording of interests at a transfer agent or in circumstances
involving the custody of privately offered securities or physical
assets?
175. Would the proposed segregation requirements impose appropriate
limitations to safeguard client assets? Should we eliminate or modify
any of them? Alternatively, are there other limitations that would be
appropriate?
176. Would the proposed requirements increase the likelihood that
client assets will be available to be returned to clients if an adviser
or its related persons experience any financial reverses, such as
insolvency or bankruptcy? For example, do commenters believe the
requirements would help ensure that client assets are more readily
identifiable as client property?
177. Should certain assets be excluded from these requirements? If
so, which assets and why? Would limiting these requirements to certain
types of assets present compliance challenges? If so, what assets and
why?
178. In particular, would the proposed segregation requirements
present challenges with respect to crypto assets? Should we address
crypto asset segregation and/or custody with separate requirements? Do
crypto assets raise specific segregation issues not presented by other
assets? If so, what are they and why? Would the proposed requirements
offer substantial protections in the event of a bankruptcy or financial
losses involving an adviser or custodian with custody of crypto assets?
Would the proposed segregation requirements present challenges with
respect to other types of assets?
179. Would the proposed requirements ensure that a third party's
lien against one client's assets would not be improperly attached to
other clients' investments? Are there any other rights, charges or
claims that should be expressly identified in the proposed segregation
requirements?
180. The proposed requirements would provide an exception to the
provision that client assets not be subject to right, charge, security
interest, lien, or claim of any kind to the extent it is authorized by
the client in writing. Is this exception appropriate? Is it
sufficiently clear? Would it properly account for assets that are
subject to a securities lending arrangement or margin trading
agreement? Is the proposed exception too broad? For example, should the
proposed exception apply to only certain types of assets or
arrangements? Should we prescribe specific conditions that must be
included in any client authorization?
181. Is it sufficiently clear from the rule text that client assets
are not to be subject to any claim except claims for payment of
services rendered by the investment adviser or related person that is
agreed to or authorized by the client? Should we explicitly exempt such
claims for certain types of fees?
182. Do the proposed segregation requirements to be titled in the
client's name, not to be commingled, and not to be subject to any
right, charge, security interest, lien or claim guard against loss,
misappropriation, misuse, theft, and the financial reverses of the
adviser, permit the adviser with reasonable operational flexibility to
use omnibus and other similar accounts?
183. Should the rule prohibit commingling client and non-client
assets, as does the current rule? Alternatively, should it permit the
commingling of client and non-client assets for administrative
convenience and efficiency? If so, what should be considered
``administrative convenience and efficiency''? Does allowing client and
non-client assets to be commingled (e.g., in the same escrow account)
increase the risk that client assets will be lost, misused, stolen, or
misappropriated? Could an advisory client's assets be used to satisfy
the debts of someone else in a bankruptcy event if client and non-
client assets are commingled?
184. Should the rule include express requirements regarding the
sub-accounting of commingled accounts if the rule permits commingling
of client and non-client assets?
185. We recognize there are some instances where commingling or
pooling of certain assets may occur via certain omnibus and sub
accounting arrangements that may present compliance challenges under
the segregation requirements. We also understand that though such
commingling may occur, the client assets may still be considered to be
identifiable via omnibus recordkeeping though they sit among non-client
assets. In what circumstances may such a requirement restricting
commingling
[[Page 14716]]
place burdens on advisers? Are there certain assets or transaction
types for which such a requirement may be particularly burdensome?
Should we include any exceptions to the prohibition on commingling?
186. Do commenters agree that there are circumstances when
advisers' services require them to commingle client assets and non-
client assets? For example, when an adviser uses sweep accounts, escrow
accounts, or when an adviser serves as administrative agent to a loan
syndicate where the lenders consist of advisory clients and non-
advisory clients? \268\ In these circumstances, should the rule require
additional protections? Which protections and why and would they differ
depending on the type of commingled account? For example, should the
rule include specific requirements to allow an adviser to hold a
percentage of the proceeds from the sale or merger of a portfolio
company owned by one or more client pooled investment vehicles (e.g.,
private equity funds) and other non-clients for a limited period? If
so, should we limit the types of proceeds that could be included in the
escrow account or the period in which the escrow exists? Should we
require the portion of the escrow attributable to the pooled investment
vehicle client to be included on financial statements that are audited?
Should we require any contract governing the escrow or other commingled
account to include certain terms (such as requiring a seller's
representative or administrative agent to distribute the funds in the
escrow or commingled account promptly on a predetermined formula)?
\269\
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\268\ See, e.g., Madison Capital No-Action Letter.
\269\ See 2014 IM Guidance, supra footnote 17, in which our
staff discussed its views on application of the current rule to
various situations involving special purposes vehicles SPVs and
escrows.
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E. Investment Adviser Delivery of Notice to Clients
The proposed rule, like the custody rule, would require an
investment adviser to notify its client in writing promptly upon
opening an account with a qualified custodian on its behalf.\270\ The
notice is designed to alert a client to the existence of the qualified
custodian that maintains possession or control of client assets and
whom to contact regarding such assets. Based on our experience with the
custody rule, we continue to believe it provides important client
protections.
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\270\ See proposed rule 223-1(a)(2).
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The notice would continue to include the qualified custodian's
name, address, and the manner in which the investments are maintained.
The proposed rule would also explicitly require that the notice include
the custodial account number to improve the utility of the notice. If
the client is a pooled investment vehicle, the notice must be sent to
all of the investors in the pool, provided that, if an investor is a
pooled investment vehicle that is in a control relationship with the
adviser or the adviser's related persons, the sender must look through
that pool (and any pools in a control relationship with the adviser or
its related persons) in order to send the notice to investors in those
pools.\271\ As discussed above, this is intended to promote meaningful
delivery of this important information. As is permitted under the
current rule, the notice could also be delivered to the client's (or
pooled investment vehicle investor's) independent representative and
the adviser would continue to be required to provide the notice
promptly when an account is opened and following any changes in the
information contained in the notice. If adopted, this provision would
require advisers to send account opening notices only to clients for
which it has opened new client accounts with a qualified custodian
after the effective date of the rule. Advisers would not have to
provide new notices to existing clients for which it has already opened
accounts as these clients are likely already aware of the location of
their assets at the qualified custodian from prior notices.
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\271\ See proposed rule 223-1(c).
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We request comment on all aspects of the proposed rule's investment
adviser notice requirement, including the following items.
187. Should the notice include the qualified custodian's account
number? Should we require other types of information to be included in
the notice? If so, what information, and why? Should we eliminate any
of the proposed types of information from the notice? If so, why?
188. If an adviser uses several qualified custodians for one of its
clients, should the proposed rule permit the adviser to provide the
client a one-time notice for these qualified custodians rather than
providing a new notice each time the assets move among the qualified
custodians? \272\ If yes, should the rule require the adviser also to
provide the client a new notice promptly upon using a new qualified
custodian to maintain the client's investments?
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\272\ Our staff has taken a similar view under the current
custody rule. See Custody Rule FAQs, supra footnote 17, at Question
V.1.
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189. Should we require advisers to provide notice to clients when
assets are not held at a qualified custodian? If yes, what form should
these notices take? Should they be provided on a one-off or periodic
basis?
F. Amendments to the Surprise Examination Requirement
We are proposing changes to the surprise examination
requirement.\273\ Under the current custody rule advisers with custody,
subject to certain exceptions, must undergo an annual surprise
verification by an independent public accountant to put ``another set
of eyes'' on client assets.\274\ In circumstances where the adviser or
a related person maintain client assets as a qualified custodian, the
independent public accountant must be registered with, and subject to
regular inspection as of the commencement of the professional
engagement period, and as of each calendar year-end, by the PCAOB in
accordance with its rules. Currently, the surprise examination
requirement does not require the adviser explicitly to have a
reasonable belief about the implementation of the written agreement
between the adviser and the accountant. The surprise examination
requirement would be amended to state that the adviser must reasonably
believe that a written agreement has been implemented (i.e., that the
accountant will perform the surprise examination pursuant to the
agreement and comply with the section's ADV-E filing and notification
requirements when required). We are also proposing to amend the
language concerning notice upon the finding of any material
discrepancies during the course of an examination that the notice be
sent by electronic means to the newly designated Division of
Examinations as opposed to the current rule's requirement to send to
the Director of the Office of Compliance Inspections and
Examinations.\275\
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\273\ See proposed rule 223-1(a)(4).
\274\ 2009 Adopting Release, supra footnote 11.
\275\ See proposed rule 223-1(a)(4)(v).
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In a change from the current rule, we are proposing an amendment
requiring that an adviser ``must reasonably believe'' that the written
agreement has been implemented. We designed this to address
circumstances where, in our experience, there is an adviser that has
entered into the agreement with the accountant, but failed to ensure
the surprise examination occurs and the requirements of the rule are
met. Entering into the contract with the
[[Page 14717]]
accountant alone would not satisfy the rule. Accordingly, advisers
generally should enter into a written agreement with the accountant
based upon a reasonable belief that the accountant is capable of, and
intends to, comply with the agreement and the obligations the
accountant is responsible for under the surprise examination
requirement. For example, after securing a written agreement for the
engagement, the adviser generally should ensure that the accountant is
able to access the Commission's filing system so that it can perform
its Form ADV-E filing functions properly under the rule.
It has been our longstanding view that the involvement of
independent public accountants in the review and verification of client
assets of which advisers have custody is an important safeguarding tool
and reduces the risk of loss of client assets.\276\ Consistent with
that view, we believe that the adviser must ensure that the independent
public accountant's involvement in the verification and notification
requirements in the proposed rule are implemented effectively so as to
ensure the reliability and integrity of the surprise exam.
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\276\ See, 2009 Adopting Release, supra note 11.
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We request comment on the proposed rule's modifications to the
surprise exam requirement, including the following:
190. Should the rule require that an adviser must reasonably
believe that the written agreement with the accountant has been
implemented to satisfy the Form ADV-E and notice requirements of the
provision? Are advisers able to ensure that an accountant fulfills the
surprise examination requirements, or are there certain limitations
that would make satisfaction of this requirement difficult?
191. What difficulties do accountants have when fulfilling their
obligations on behalf of advisers under this section of the proposed
rule? Should we make other amendments to this paragraph of the rule to
ensure that accountants are able to fulfill their duties under the
rule? Does the expansion of the scope of the rule from funds and
securities to assets raise any problems for advisers and auditors that
would need to comply with the surprise examination requirement?
G. Exceptions From the Surprise Examination
In light of the proposed changes to the rule's scope to cover all
assets, the proposal seeks to balance better the costs associated with
obtaining a surprise examination with the investor protections it
offers by providing exceptions to the surprise examination requirement
when the adviser's sole reason for having custody is because it has
discretionary authority or because the adviser is acting according to a
standing letter of authorization, each subject to certain conditions.
We are also proposing modifications to the current rule's audit
provision that we believe will expand the availability of its use,
enhance investor protection, and facilitate compliance. These
exceptions are discussed below.
1. Entities Subject to Audit (``Audit Provision'')
a. Scope of the Audit Provision
Similar to the custody rule, an adviser that obtains an audit at
least annually and upon an entity's liquidation under the proposed rule
would be deemed to have complied with the surprise examination
requirement and would eliminate the need for an adviser to comply with
the client notice requirement.\277\ Although the requirement to deliver
account statements to clients would be different under the proposed
rule than under the custody rule, the audit provision would still
eliminate the adviser's need to comply with the account statement
aspect under the proposed rule as well. Specifically, for the adviser
to qualify for the audit provision under the proposed rule, its client
that is a limited partnership (or limited liability company, or another
type of pooled investment vehicle or any other entity) would need to
undergo a financial statement audit that meets the terms of the rule at
least annually and upon liquidation.\278\ Under the proposed rule:
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\277\ See proposed rule 223-1(b)(4). As under the custody rule,
an adviser that relies on an exception from the surprise examination
requirement, such as the exception for fee deduction under proposed
rule 223-1(b)(3) or the proposed exception for discretionary trading
under proposed rule 223-1(b)(8) and see Discretionary Authority,
infra, need not rely on the audit provision.
\278\ See proposed rule 223-1(b)(4).
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(1) The audit must be performed by an independent public accountant
that meets the standards of independence 17 CFR 210.2-01 (in rule 2-01
of Regulation S-X) that is registered with, and subject to regular
inspection as of the commencement of the professional engagement
period, and as of each calendar year-end, by, the PCAOB in accordance
with its rules;
(2) The audit meets the definition in 17 CFR 210.1-02(d) (rule 1-
02(d) of Regulation S-X),\279\ the professional engagement period of
which shall begin and end as indicated in Regulation S-X Rule 2-
01(f)(5); \280\
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\279\ Under the definition in rule 1-02(d) of Regulation S-X, an
``audit'' of an entity (such as a private fund) that is not an
issuer as defined in section 2(a)(7) of the Sarbanes-Oxley Act of
2002 means an examination of the financial statements by an
independent accountant performed in accordance with either the
generally accepted auditing standards of the United States (``U.S.
GAAS'') or the standards of the PCAOB. When conducting an audit of
financial statements in accordance with the standards of the PCAOB,
however, the auditor would also be required to conduct the audit in
accordance with U.S. GAAS because the audit would not be within the
jurisdiction of the PCAOB as defined by the Sarbanes-Oxley Act of
2002, as amended, (i.e., not an issuer, broker, or dealer). See
AICPA auditing standards, AU-C section 700.46. We believe most
advisers would choose to perform the audit in accordance with U.S.
GAAS only rather than both standards, though it would be permissible
under the proposed audit rule to perform the audit in accordance
with both standards.
\280\ This provision reflects the existing process. Among other
things, rule 2-01(f)(5) of Regulation S-X indicates that the
professional engagement period begins at the earlier of when the
accountant either signs an initial engagement letter (or other
agreement to review or audit a client's financial statements) or
begins audit, review, or attest procedures; and the period ends when
the audit client or the accountant notifies the Commission that the
client is no longer that accountant's audit client.
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(3) Audited financial statements must be prepared in accordance
with U.S. Generally Accepted Accounting Principles (``U.S. GAAP'') or,
in the case of financial statements of entities organized under non-
U.S. law or that have a general partner or other manager with a
principal place of business outside the United States, must contain
information substantially similar to statements prepared in accordance
with U.S. GAAP and material differences with U.S. GAAP must be
reconciled;
(4) Within 120 days (or 180 days in the case of a fund of funds or
260 days in the case of a fund of funds of funds) of an entity's fiscal
year end, the entity's audited financial statements, including any
reconciliations to U.S. GAAP or supplementary U.S. GAAP disclosures, as
applicable, are distributed to investors in the entity (or their
independent representatives); and
(5) Pursuant to a written agreement between the auditor and the
adviser or the entity, the auditor notifies the Commission upon certain
events.\281\
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\281\ Proposed rule 223-1(b)(4).
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Elements of the proposed rule's audit provision are largely
unchanged from the audit provision of the custody rule.\282\
Differences include: (1) expanded availability from ``pooled investment
vehicle'' clients to ``entities''; (2) a requirement for the financial
statements of non-U.S. clients to contain information substantially
similar to statements prepared in
[[Page 14718]]
accordance with U.S. GAAP and material differences with U.S. GAAP to be
reconciled; and (3) a requirement for there to be a written agreement
between the adviser or the entity and the auditor requiring the auditor
to notify the Commission upon the auditor's termination or issuance of
a modified opinion.\283\
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\282\ Compare rule 206(4)-2(b)(4) with proposed rule 223-
1(b)(4).
\283\ See proposed rule 223-1(b)(4)(v). See also AICPA auditing
standard, AU-C section 705, which establishes three types of
modified opinions: a qualified opinion, an adverse opinion, and a
disclaimer of opinion.
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We request comment on all aspects of the proposed rule's annual
audit provision, including the following:
192. Should the rule continue to permit an adviser to satisfy
certain elements of the rule by relying on the audit provision as
proposed? Should the rule require an audit upon an entity's liquidation
as proposed? Should we modify either or both of these requirements? If
so, how should we modify these requirements, and why?
193. Should the rule require audits to cover a period of 12 months?
Would investors derive value from audits that cover periods longer or
shorter than 12 months? If so, what time periods, and why?
194. Should the proposed rule allow newly formed and liquidating
entities to perform an audit less frequently than annually, provided
that the audit period does not exceed 15 consecutive months, with no
more than three months of such period occurring immediately before or
after the entity's fiscal year end? Is 15 months the appropriate audit
period limit for newly formed and/or liquidating entities? Should we
increase or decrease this limit? If so, what time period should we
require, and why? Should we include additional restrictions or
requirements for newly formed entities and/or liquidating entities
under the audit provision? If so, what restrictions or requirements,
and why? Would allowing for less frequent auditing during liquidation--
for example, requiring an audit every 18 months or two years in such
circumstances--result in a meaningful cost reduction to advisers or
investors?
195. Should the proposed rule require investment advisers to
provide investors with a form of interim financial reporting when an
entity's audit period will be in excess of 12 months? If so, what
information should be included in this reporting and who should receive
this reporting? Should the reporting be audited?
196. Should the rule permit advisers to satisfy the audit provision
by relying on an audit on an interval other than annually when an
entity is liquidating? For example, should we allow advisers to rely on
an audit of an entity every two years during the liquidation process?
If so, should we modify the proposed rule to require investment
advisers to create and distribute alternative financial reporting for
the entity to investors (e.g., cash-flow audit or asset verification)?
Alternatively, or in addition to alternative financial reporting,
should the rule require investment advisers to obtain a third-party
examination of the liquidating entity? If so, what should the
examination consist of, and why? For example, an independent auditor
could examine a liquidating entity to confirm existence of the entity
and that cash flows were appropriate.
197. Would allowing investment advisers to satisfy the audit
provision by relying on an audit less frequently than annually during a
liquidation raise any investor protection concerns that additional
requirements could address? If so, what additional requirements, and
why? For example, should advisers be required to provide notice to
investors of their intent to liquidate an entity in these
circumstances? Should advisers be required to obtain investor consent
prior to satisfying the audit requirement by relying on audits on less
than annual basis?
198. The custody rule does not define liquidation or liquidating
entity for purposes of the liquidation audit requirement. Should it? If
so, how? For example, should the definition be based on (1) a certain
percentage of assets under management of the entity from or over
previous fiscal period(s), (2) a stated threshold based on an absolute
dollar amount of the entity's assets under management, (3) a
calculation of the ratio of the management fees assessed on assets
under management of the entity, (4) some combination of the foregoing,
or (5) some other basis?
199. Are there risks posed to investors when an entity is
liquidating that the proposed rule does not address? If so, please
describe those risks and how the rule should be modified to address
such risks.
200. Are there some types of investments that pose a greater risk
of misappropriation or loss to investors during a liquidation that the
rule should specifically address to provide greater investor
protection? If so, please describe (1) the investment type; (2) the
particular risk poses to investors by the investment type during
liquidation; and (3) how to modify the proposed rule to address such
investor risk.
201. Should we define ``fund of funds''? \284\ If so, how should we
define ``fund of funds''? For example, should we define a ``fund of
funds'' as a pooled investment vehicle that invests 10 percent or more
of its total assets in other pooled investment vehicles that are not,
and are not advised by, a related person of the pool, its general
partner, or its adviser? \285\ Are there other circumstances in which
the proposed 180-day deadline might be appropriate?
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\284\ For example, we have described funds that invest in other
funds as a ``fund of funds'' arrangement under rule 12d1-4 under the
Investment Company Act. See Fund of Funds Arrangements, Release Nos.
33-10871; IC-34045 (Oct. 7, 2020) (Adopting Release).
\285\ We note that our staff has expressed its views of what
constitutes a fund of funds for purposes of the custody rule. See
Custody Rule FAQs, supra footnote 17, at Question VI.7.
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202. Should we define ``fund of funds of funds''? If so, how should
we define ``fund of funds of funds''? For example, should we define
fund of funds of funds as a fund of funds that invests 10 percent or
more of its total assets in one or more fund of funds that are not, and
are not advised by, a related person of the fund of funds, its general
partner, or its adviser.\286\ Are there other circumstances in which
the proposed 260-day deadline might be appropriate?
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\286\ We note that our staff has expressed its views of what
constitutes a fund of funds of funds for purposes of the custody
rule. See Custody Rule FAQs, supra footnote 17, at Question VI.8B.
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b. The Expanded Availability of Audit Provision
The current audit provision is available only to advisers to a
limited partnership (or limited liability company or another type of
pooled investment vehicle).\287\ Historically, we have relied on
financial statement audits to verify the existence of pooled investment
vehicle investments.\288\ Based on our experience since introducing the
custody rule's audit provision, we have come to believe that audits
provide substantial benefits to pooled investment vehicles and their
investors because audits test assertions associated with the investment
portfolio (e.g., completeness, existence, rights and obligations,
valuation, presentation). Audits may also provide a check against
adviser misrepresentations of performance, fees, and other information
about the pool. We are thus proposing to expand the availability of the
audit provision from limited partnerships, limited liability companies,
and other types of pooled investment vehicle clients to any
[[Page 14719]]
advisory client entity whose financial statements are able to be
audited in accordance with the rule.\289\
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\287\ See rule 206(4)-2(b)(4).
\288\ See, e.g., rule 206(4)-2(b)(4) under the Advisers Act; see
also 2009 Adopting Release, supra footnote 11.
\289\ See rule 206(4)-2(b)(4). This provision does not depend
upon a minimum number of investors in the entity. See also Custody
Rule FAQs, supra footnote 17, at Question X.1, in which our staff
expressed a similar view. Similar to the approach under the custody
rule, under the proposed rule, if the investors or participants in
the legal entity client that is being audited are also clients of
the adviser, the adviser would have to evaluate separately whether
it has the ability or authority to effect a change in beneficial
ownership of that investor's or participant's investments and comply
with the proposed rule as appropriate. The financial statement audit
of the legal entity whose investors or participants have invested
would not satisfy the adviser's obligations under the proposed rule
with respect to the investors or participants. See infra footnote
307.
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This aspect of the proposed rule would also eliminate uncertainty
about the entity types for which the audit provision is currently
available and extend the investor protection benefits of an audit to a
larger number of investors, such as pension plans, retirement plans,
college saving plans (529 plans), and Achieving a Better Life
Experience savings accounts (ABLE plans or 529 A accounts).\290\
Because of uncertainty about the entity types eligible to use the audit
provision, we believe that some investment advisers do not use the
current rule's audit provision.
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\290\ The staff has previously provided its position to certain
entities that requested clarity about their eligibility to comply
with the current rule's exception for audited entities. See, e.g.,
Investment Company Institute, SEC Staff No-Action Letter (Sept. 5,
2012).
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We believe that financial statement audits provide additional
meaningful protections to investors as compared to a surprise
examination by increasing the likelihood that fraudulent activity is
uncovered, thereby providing deterrence against fraudulent conduct by
advisers. In a financial statement audit, the accountant performs
procedures beyond those procedures performed during a surprise
examination. Similar to a surprise examination, a financial statement
audit involves an accountant verifying the existence of an entity's
assets. A financial statement audit, however, also typically involves
an accountant addressing additional important matters that are not
covered by a surprise examination, such as tests of valuations of
entity investments, income, operating expenses, and, if applicable,
incentive fees and allocations that accrue to the adviser. Thus, an
audit includes the evaluation of amounts and disclosures within the
financial statements that may be particularly significant to entity
investors.
Moreover, we believe many entities other than pooled investment
vehicles already undergo financial statement audits. These financial
statement audits of entities may be similar in scope and offer similar
investor protection benefits as an audit of a pooled investment
vehicle. The proposed expansion of the availability of the audit
provision, therefore, may reduce costs for these entities if they no
longer must additionally undergo a surprise examination.
The account notice and custodial account statement delivery
requirements are designed to help ensure the integrity of account
statements and permit clients to identify any erroneous or unauthorized
transactions or withdrawals by an adviser.\291\ A financial statement
audit regularly involves an accountant confirming bank account balances
and securities holdings as of a point in time and includes the testing
of transactions that have occurred throughout the year. We believe that
the common types of audit evidence procedures performed by accountants
during a financial statement audit--physical examination or inspection,
confirmation, documentation, inquiry, recalculation, re-performance,
observation, and analytical procedures--act as an important check to
identify erroneous or unauthorized transactions or withdrawals by the
adviser, obviating the need for the account notice and delivery
requirements for entities that are not pooled investment vehicles.
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\291\ See generally 2003 Adopting Release, supra footnote 2; see
also discussion supra at section II.B and II.E.
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We request comment on all aspects of the expanded availability of
the audit provision, including the following items:
203. Should we expand the availability of the audit provision
beyond limited partnerships, limited liability companies, or other
types of pooled investment vehicle to entities as proposed? If not,
explain why. If we expand the availability of the audit provision, in
what circumstances would this likely be utilized? Should we impose any
limits on the types of entities that can make use of the audit
provision? If so, what limits, and why? It is our understanding that a
separate account cannot be audited. Is our understanding correct? If
not, are separate accounts currently being audited, and if so, for what
purpose? To the extent separate accounts can be audited, should the
audit provision be available for separate account clients in addition
to entities?
204. Do commenters agree that expanding the scope of entities
eligible for the audit provision, as proposed, is likely to result in a
greater percentage of client audits?
205. Is the term ``entity'' the appropriate term to use to describe
the audit provision client type, or is there another term we should
use? For example, an adviser may manage a separate account for a
corporate institutional client that undergoes a financial statement
audit for reasons unrelated to the custody rule. Although the financial
statements pertain to a much broader universe of transactions than just
transactions in the account or the assets the adviser manages for that
client, should the adviser be able to rely on this audit to comply with
the proposed rule? Would the answer depend on whether the adviser
manages a non-entity sleeve of the client corporation's assets or a
subsidiary entity?
206. Should the proposed rule define the term ``entity''? If so,
how? Would using the term ``entity'' reduce or eliminate any existing
confusion regarding which entities may make use of the audit provision?
207. Do other entity client types currently undergo the type of
audit, i.e., a full scope audit that is required under the audit
provision? If so, how do the audit procedures for these entity clients
differ, if at all, from the audit procedures currently performed during
audits of pooled investment vehicles? If the audit procedures for these
entity clients differ, do they still offer substantially similar
protections to investors as the audits currently performed of pooled
investment vehicles? Why or why not?
208. We understand that certain entities may undergo audits that
are limited in scope, e.g., an ERISA section 103(a)(3)(C) audit. We
understand that these limited scope audits restrict the testing of
certain investment information where a qualified institution has
certified to both the completeness and accuracy of the required
information. These limited scope audits may be more cost-effective, but
they also do not involve all of the procedures of a full scope audit.
What audit procedures are performed during these limited scope
engagements? Do these procedures offer substantially similar protection
to investors as full scope audits? Why or why not? Should these limited
scope audits be sufficient to satisfy the requirements of the audit
exception? If so, why?
209. Given the independent public accountant's involvement to
address the risks around the existence of investments and the risk of
misappropriation, should the
[[Page 14720]]
safeguarding rule require full scope--rather than limited scope--audits
as proposed? Or should the rule require full scope audits only in
certain circumstances or with respect to certain entities? If so, what
are those circumstances and why should the proposed rule require full
scope audits in those circumstances? Would requiring full scope audits
prohibit certain entities from being able to use the audit provision?
If the rule allowed limited scope audits in some or all circumstances,
should it impose any additional requirements on the investment adviser
relying on that audit, the accountant performing that audit, or both?
c. PCAOB Inspection
As is the case with the current custody rule, the proposed rule
would continue to require accountants performing audits to be
registered with and subject to regular inspection as of the
commencement of the professional engagement period, and as of each
calendar year-end, by the PCAOB in accordance with its rules. We
believe that registration and periodic inspection of an independent
public accountant's system of quality control by the PCAOB provides
investors with some additional level of confidence in the quality of
audit produced under the proposed rule. Under the PCAOB's current
inspection program, we understand that the PCAOB selects audit
engagements of audits performed involving U.S. public companies, other
issuers, and broker-dealers, so private fund and certain other entity
audit engagements would not be selected for review. Even if private
fund and other entity audit engagements are not selected for review
under the PCAOB's current inspection program, we believe that
accounting firms registered with and subject to the PCAOB's inspection
program would implement their quality control systems throughout the
accounting firm related to their assurance engagements.
In light of our proposal to expand the availability of the audit
provision, we understand that this requirement may limit the pool of
accountants that are eligible to perform these services because only
those accountants that currently conduct public company issuer audits
are subject to regular inspection by the PCAOB. Many of an adviser's
clients are already undergoing a financial statement audit; therefore,
the increase in demand for these services may be limited.\292\
Nonetheless, the resulting competition for these services as a result
of our proposed expanded availability of the audit provision may result
in a limited pool of accountants eligible to provide the auditing
services, which may increase costs to investment advisers and
investors.
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\292\ For example, more than 90 percent of the total number of
hedge funds and private equity funds currently undergo a financial
statement audit.
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We also understand that, as part of its interim inspection program,
the PCAOB inspects accountants auditing brokers and dealers, and
identifies and addresses with these firms any significant issues in
those audits.\293\ Similar to the inspection program for issuer audits,
we believe that the interim inspection program for broker-dealers
provides valuable oversight of these accountants, which may result in
better quality audits. Although the PCAOB may not disclose which
accounting firms have been inspected under the interim inspection
program for broker-dealers, we believe that the PCAOB uses a varied
approach for selecting a particular audit engagement for review focused
on both risk-based selections and random selections.\294\ Accordingly,
we would also consider an accountant's compliance with the PCAOB's
interim inspection program for auditors of brokers and dealers to
satisfy the requirement for regular inspection by the PCAOB under the
proposed audit provision until the effective date of a permanent
program for the inspection of broker and dealer auditors that is
approved by the Commission.\295\
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\293\ See PCAOB Adopts Interim Inspection Program for Broker-
Dealer Audits and Broker and Dealer Funding Rules (June 14, 2011)
(``interim inspection program''), available at https://pcaobus.org/News/Releases/Pages/06142011_OpenBoardMeeting.aspx. See also Dodd-
Frank Act section 982.
\294\ See, e.g., Annual Report on the Interim Inspection Program
Related to Audits of Brokers and Dealers, PCAOB Release No. 2022-04
(Aug. 19, 2022) at 7.
\295\ We note that our staff took a similar position and has had
several years to observe the impact on the availability of
accountants to perform services and the quality of services produced
by these accountants. See Robert Van Grover Esq., Seward & Kissel
LLP, SEC Staff No-Action Letter (Dec. 11, 2019) (extending the no-
action position taken in prior letters until the date that a PCAOB-
adopted permanent program, having been approved by the Commission,
takes effect).
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An independent public accounting firm would not be considered to be
``subject to regular inspection,'' however, if it is included on the
list of firms that is headquartered or has an office in a foreign
jurisdiction that the PCAOB has determined it is unable to inspect or
investigate completely because of a position taken by one or more
authorities in that jurisdiction in accordance with PCAOB Rule
6100.\296\ We recognize that there may be a limited number of PCAOB-
registered and inspected independent public accountants in certain
foreign jurisdictions. However, we do not believe that advisers would
have significant difficulty in finding an accountant that is eligible
under the proposed rule in most jurisdictions because many PCAOB-
registered independent public accountants who are subject to regular
inspection currently have practices in various jurisdictions, which may
ease concerns regarding offshore availability.
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\296\ See, e.g., Reports of Board Determinations Pursuant to
Rule 6100, available at https://pcaobus.org/oversight/international/board-determinations-holding-foreign-companies-accountable-act-hfcaa.
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We request comment on the all aspects of the proposed requirement
that accountants be registered with, and subject to inspection by, the
PCAOB, including the following items:
210. Should the rule require accountants performing audits under
the rule to be registered with the PCAOB as proposed? Should the rule
require accountants to be subject to regular inspection by the PCAOB as
proposed? Do accounting firms registered with and subject to regular
inspection by the PCAOB implement their quality control systems
throughout the accounting firm related to their assurance engagements?
Why or why not?
211. If the rule did not include these requirements, should the
rule impose any additional licensing, examination, or inspection
requirements on such accountants? If so, describe these additional
requirements and explain why they are necessary? For example, should
the rule require accountants to have a CPA license in good standing?
212. The PCAOB has specific rules governing regular and special
inspections under its inspection program.\297\ We understand, however,
that sometimes advisers may be unsure whether a registered public
accounting firm is ``subject to regular inspection'' by the PCAOB.
Rather than require the accountant to be ``subject to regular
inspection,'' should we instead require the accountant to be a
registered public accounting firm with either an issuer or broker
dealer audit client (or play a substantial role in the audit of an
issuer or broker dealer) as of the start of the engagement period and
as of each calendar year end? If we were to take this approach, would
it significantly diminish the number of accountants available to
perform audits? How would this approach affect the cost of audits?
[[Page 14721]]
Would this have any potential unintended consequences, including, for
example, adversely affecting smaller public accounting firms compared
to larger public accounting firms?
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\297\ See PCAOB Rule 4000-4003, available at https://pcaobus.org/about/rules-rulemaking/rules/section_4.
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213. The PCAOB has explained that it will inspect at least five
percent of the number of registered public accounting firms reporting
that they have ``played a substantial role in the preparation or
furnishing of an audit report with respect to an issuer without having
issued an audit report with respect to an issuer in that reporting
period.'' \298\ Should we define ``subject to regular inspection'' for
purposes of compliance with the safeguarding rule to exclude registered
public accounting firms that ``played a substantial role in the
preparation or furnishing of audit report with respect to an issuer
without having issued an audit report with respect to an issuer in that
reporting period''? If not, explain why not? If we defined ``subject to
regular inspection'' in this way, would this significantly diminish the
number of accountants available to perform audits? If so, how would
this affect the cost of audits?
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\298\ See PCAOB Rule 4003(h), available at https://pcaobus.org/about/rules-rulemaking/rules/section_4.
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214. By extending the availability of the audit provision and
continuing to require that the independent accountants performing
audits be registered with and subject to regular inspection by the
PCAOB, the proposed rule may narrow the pool of auditors who would be
able to perform services under the proposed rule. Should the proposed
rule instead require only PCAOB-registered public accounting firms to
be used to perform certain services under the proposed rule? If so,
which services and why?
215. Do commenters agree that the availability of accountants to
perform services for purposes of the proposed rule is sufficient? If
not, please describe how the proposed rule could provide greater
availability.
216. Do commenters agree that advisers have reasonable access to
public accountants that are registered with and subject to inspection
by the PCAOB in the foreign jurisdictions in which they operate? If
not, how should the proposed rule address this issue?
d. Accounting Standards for Financial Statements
As is the case with the current custody rule, the proposed rule
would require audited financial statements to be prepared in accordance
with the generally accepted accounting principles.\299\ Entities that
are organized outside of the United States, or that have a general
partner or other manager with a principal place of business outside of
the United States, may have their financial statements prepared in
accordance with accounting standards other than U.S. GAAP.\300\ We
would consider these financial statements to meet the requirements of
the proposed rule so long as they contain information substantially
similar to financial statements prepared in accordance with U.S. GAAP,
material differences with U.S. GAAP are reconciled, and the
reconciliation, including supplementary U.S. GAAP disclosures, is
distributed to U.S. investors as part of the audited financial
statements. Requiring that financial statements comply with U.S. GAAP
or standards substantially similar to U.S. GAAP along with a
reconciliation to U.S. GAAP in the case of foreign entities would help
assure that clients receive consistent and quality financial reporting
on their assets from their adviser.
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\299\ See proposed rule 223-1(b)(4)(iii).
\300\ This proposed provision is intended to codify our current
approach. For example, we have previously allowed an adviser to a
foreign pooled investment vehicle to have its financial statements
prepared in accordance with International Accounting Standards or
some other comprehensive body of accounting standards provided that
the financial statements contain information that is substantially
similar to financial statements prepared in accordance with U.S.
GAAP and contains a footnote reconciling any material variations
between the comprehensive body of accounting standards and U.S.
GAAP. See 2003 Adopting Release supra footnote 2 at n.41.
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We believe that this approach balances the needs of users of the
financial statements with the cost to prepare financial statements
under separate accounting standards by allowing advisers the
flexibility to provide clients with financial statements that are
prepared in accordance with applicable local accounting standards. We
also believe a reconciliation to U.S. GAAP is necessary for entity
audits because U.S. GAAP has industry specific accounting principles
for certain pooled vehicles, including private funds. For example, U.S.
GAAP may require measurement of trades on trade date as opposed to
settlement date, presentation of a schedule of investments, and certain
financial highlights that may not be required under other accounting
standards. Because these differences may be material, a reconciliation
to U.S. GAAP would enhance investor protection.
We request comment on all aspects of the proposed requirements for
preparing financial statements in accordance with generally accepted
accounting principles, including the following items:
217. Should the rule continue to require accountants to prepare
audited financial statements in accordance with generally accepted
accounting principles as proposed? Should the rule include any
additional requirements regarding the preparation of financial
statements? If so, what requirements, and why? For example, should we,
as proposed, consider financial statements of non-U.S. advisers and
non-U.S. entities to meet the requirements of the rule provided that
they contain information substantially similar to statements prepared
in accordance with U.S. GAAP, material differences with U.S. GAAP are
reconciled, and the reconciliation is distributed to U.S. clients along
with the financial statements? If so, should we specify what
``substantially similar'' means? What standards should be viewed as
``substantially similar'' to U.S. GAAP, and why? Is the requirement to
reconcile financial statements of entities organized under non-U.S. law
or that have a general partner or other manager with a principal place
of business outside the U.S. with U.S. GAAP necessary? Would this
reconciliation requirement present any difficulties?
218. In light of our proposal to make the audit provision available
to advisers to additional entities (e.g., pension plans, retirement
plans, 529 plans, and ABLE plans), would these additional entities be
able to meet the proposed accounting standards? Would they present any
challenges for such entities? Should we modify this aspect of the
proposal to address these additional entities? If so, how?
219. It is our understanding that the financial statement
presentation required under U.S. GAAP may be different for pooled
investment vehicles, e.g., private funds, compared to other entities,
e.g., 529 plans. Would these presentation differences have an impact on
investor's ability to understand the financial statements?
e. Distribution of Audited Financial Statements
Under the custody rule, an adviser must annually distribute its
audited financial statements to all limited partners (or members or
other beneficial owners) within 120 days of the end of its fiscal year
and promptly upon completion of the audit in the final year of
liquidation.\301\ The proposed audit provision would generally retain
this approach, requiring an adviser to
[[Page 14722]]
distribute an entity's audited financial statements to current
investors within 120 days, but would extend the delivery deadline to
180 days in the case of a fund of funds or 260 days in the case of a
fund of funds of funds of the entity's fiscal year end.\302\ The
audited financial statements would consist of the applicable financial
statements (including any required reconciliation to U.S. GAAP,
including supplementary U.S. GAAP disclosures), related schedules,
accompanying footnotes, and the audit report. Based on our experience
administering the custody rule, we believe that a 120-day time period
is appropriate to allow the financial statements of an entity to be
audited and to provide investors with timely information. We
understand, however, that preparing audited financial statements for
some arrangements, such as sub-adviser or outsourced Chief Investment
Officer (OCIO) arrangements, may require reliance on third parties,
which could cause an adviser to fail to meet the current 120-day timing
requirements for distributing audited financial statements regardless
of actions it takes to meet the requirements. We also recognize there
may be times when an adviser reasonably believes that an entity's
audited financial statements would be distributed within the 120-day
timeframe but fails to have them distributed within that timeframe
because of unforeseeable circumstances. For example, during the COVID-
19 pandemic, some advisers were unable to distribute audited financial
statements in the timeframes required under the custody rule due to
logistical disruptions. Accordingly, the Commission would take the
position that, if an adviser is unable to deliver audited financial
statements in the timeframe required under the proposed safeguarding
rule due to reasonably unforeseeable circumstances, this would not
provide a basis for enforcement action so long as the adviser
reasonably believed that the audited financial statements would be
distributed by the applicable deadline.\303\ We similarly believe that
a 180-day time period (subject to this position and its reasonable
belief standard) is appropriate in the context of a fund of funds and
that a 260-day time period (subject to this position and its reasonable
belief standard) is appropriate in the context of a fund of funds of
funds because advisers to these types of pooled investment vehicles may
face practical difficulties completing their audits before the
completion of audits for the underlying funds in which they
invest.\304\
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\301\ See rule 206(4)-2(b)(4)(i) and rule 206(4)-2(b)(4)(iii).
\302\ See proposed rule 223-1(b)(4)(iv).
\303\ Compare proposed rule 223-1(b)(4)(iv) to rule 206(4)-
2(b)(4)(i). Under the proposed rule, we would still continue to
require liquidation audited financial statements to be distributed
``promptly.''
\304\ See also Custody Rule FAQs, supra footnote 17, at Question
VI.8A and VI.8B, in which we note that our staff expressed a similar
view.
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Under the proposed audit provision, the audited financial
statements (including any reconciliation to U.S. GAAP prepared for a
foreign entity, as applicable) must be sent to all of the entity's
investors.\305\ Further, if an investor is a pooled investment vehicle
that is in a control relationship with the adviser or the adviser's
related persons, the sender must look through that pool (and any pools
in a control relationship with the adviser or its related persons) in
order to send the audited financial statements to investors in those
pools.\306\
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\305\ See proposed rule 223-1(b)(4)(iv).
\306\ See proposed rule 223-1(c); see supra section II.B.3.b.ii.
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In addition, an adviser to a pooled investment vehicle client may
utilize an SPV, organized as a limited liability company, trust,
partnership, corporation or other similar vehicle, to facilitate
investments for legal, tax, regulatory or other similar purposes. For
example, the adviser's pooled investment vehicle client may invest a
portion of its capital in an SPV, which in turn purchases a single
investment for the pooled investment vehicle client (``single purpose
vehicle''). Similarly, an adviser to multiple pooled investment vehicle
clients may utilize an SPV to purchase a single investment for multiple
pooled investment vehicle clients (``multi-fund single purpose
vehicle''). In another variation, an adviser to one or more pooled
investment vehicle clients may utilize an SPV to purchase multiple
investments for one or more pooled investment vehicle clients (``multi-
purpose vehicle''). Similar to under the custody rule,\307\ an
investment adviser could either treat an SPV as a separate client, in
which case the adviser will have custody of the SPV's assets, or treat
the SPV's assets as assets of the pooled investment vehicles of which
it has custody indirectly under the safeguarding rule. If the adviser
is relying on the audit provision and treats the SPV as a separate
client, the safeguarding rule would require the adviser to comply
separately with the safeguarding rule's audited financial statement
distribution requirements like the custody rule.\308\ Accordingly, the
adviser would distribute the SPV's audited financial statements to the
pooled investment vehicle's beneficial owners. If, however, the adviser
is relying on the audit provision and treats the SPV's assets as the
pooled investment vehicle's assets of which it has custody indirectly,
the SPV's assets would be required to be considered within the scope of
the pooled investment vehicle's financial statement audit.\309\
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\307\ Advisers Act Rule 206(4)-2(c) states that sending an
account statement under paragraph (a)(5) of the custody rule or
distributing audited financial statements under paragraph (b)(4) of
the custody rule shall not satisfy the requirements of the custody
rule if such account statements or financial statements are sent
solely to limited partners (or members or other beneficial owners)
that themselves are limited partnerships (or limited liability
companies, or another type of pooled investment vehicle) and are the
adviser's related persons.
\308\ See discussion supra at section II.B.3.b.ii.
\309\ See also id.
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An adviser would have the choice of whether to treat the SPV as a
separate client or treat the SPV's assets as the pooled investment
vehicle's assets of which it has custody indirectly, regardless of
whether the SPV is a single purpose vehicle, multi-fund single purpose
vehicle, or a multi-purpose vehicle (as applicable), provided that the
SPV's assets would be considered within the scope of the financial
statement audit of the pooled investment vehicle client(s) and provided
that the SPV has no owners other than the adviser, the adviser's
related person(s) or the pooled investment vehicle clients that are
controlled by the adviser or the adviser's related person(s). If,
however, the adviser uses an SPV to purchase one or more investments
for one or more pooled investment vehicle clients and third parties
that are not pooled investment vehicles controlled by the adviser or
the adviser's related person(s), the adviser may not treat the SPV's
assets as assets of the pooled investment vehicle clients of which the
adviser or the adviser's related person(s) has custody indirectly for
purposes of the safeguarding rule. The adviser would, instead, be
required to treat the SPV's assets as a separate client for purposes of
the safeguarding rule because the SPV has owners other than the
adviser, the adviser's related person(s) or pooled investment vehicles
controlled by the adviser or the adviser's related person(s).\310\
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\310\ We note that our staff previously took a similar view. See
2014 IM Guidance supra footnote 17.
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We request comment on all aspects of the proposed rule's
requirements for distributing audited financial statements, including
the following items:
[[Page 14723]]
220. Should the safeguarding rule require audited financial
statements of an entity to be distributed to all the entity's investors
within 120 days (or 180 days in the case of a fund of funds or 260 days
in the case of a fund of funds of funds) as proposed? Would a longer or
shorter period be appropriate (e.g., 180 days or 90 days)? Should the
rule expressly allow the statements to be distributed beyond the
prescribed period of 120 (or 180 or 260) days if a reasonably
unforeseeable circumstance necessitates a longer period? If so, should
such a longer period have an outer limit? If so, should other
conditions apply such as requiring the adviser to retain documentation
supporting the reasons for the delay? Should it require advisers to
notify investors of the delay and, if so, what information should be
included in the notice and by when should it be distributed?
221. If the adviser is unable to deliver audited financial
statements in the timeframe required under the proposed safeguarding
rule because of reasonably unforeseeable circumstances but the adviser
reasonably believed that the audited financial statements would be
distributed by the applicable deadline, the Commission would take the
position that this would not provide a basis for enforcement action. Do
commenters believe that this position should be incorporated into rule
text? If so, why?
222. Instead of requiring distribution of the audited financial
statement to investors, should we require the statement to be
distributed or made available to investors upon request?
223. For entities, we understand that audited financial statements
are posted to the entity's website, e.g., a 529 plan's website, along
with a written notification sent to accountholders of the availability
of the financial statements. The entity also provides a hardcopy of the
financial statements by mail within three business days upon an
accountholder's request. Should we continue to allow this type of
electronic delivery to meet the distribution requirement? Should we
expand the availability of electronic delivery of audited financial
statements? If so, how?
224. Do commenters agree that funds of funds or certain funds in
master-feeder structures (including those advised by related persons)
may not be able to prepare and distribute financial statements within
the current rule's 120-day requirement? Subject to the qualification
above that the Commission would take the position that an inability to
deliver audited financial statements in the required timeframe under
certain circumstances would not provide a basis for enforcement action,
do commenters agree that distribution within 180 or 260 days of the
fund's fiscal year end would be appropriate? With the proposed
expansion of the audit exception to entities, are there any types of
entities other than fund of funds that should be permitted additional
time for distribution? If so, why and what should that limit be?
225. Where an investor is a pooled investment vehicle that is in a
control relationship with the adviser or the adviser's related persons,
should we require the sender to look through that pool (and any pools
in a control relationship with the adviser or its related persons) to
satisfy the distribution requirement? If not, why not?
226. We understand that some registered fund families have
organized unregistered money market funds for investment exclusively by
their registered investment companies, in compliance with rule 12d1-1
under the Investment Company Act. The financial statements of the
unregistered money market funds are audited, but delivered to the
registered investment companies, which may be related persons of the
adviser. Should there be an exception to the distribution requirements
of proposed rule 223-1(c) under these circumstances? \311\ Are there
other similar circumstances where an exception would be appropriate?
Please explain.
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\311\ We note that our staff has stated that it would not
recommend enforcement action to the Commission under similar
circumstances. See Custody Rule FAQs, supra footnote 17, at Question
VI.10.
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f. Commission Notification
The proposed rule would require an adviser to enter into, or cause
the entity to enter into, a written agreement with the independent
public accountant performing the audit to notify the Commission (i)
within one business day upon issuing an audit report to the entity that
contains a modified opinion and (ii) within four business days of
resignation or dismissal from, or other termination of, the engagement,
or upon removing itself or being removed from consideration for being
reappointed.\312\ These proposed requirements are drawn from the
current rule's Form ADV-E filing requirement for independent public
accountants performing surprise examinations.\313\ The accountant
making such a notification would be required to provide its contact
information and indicate its reason for sending the notification. The
written agreement must require the independent public accountant to
notify the Commission by electronic means directed to the Division of
Examinations. Timely receipt of this information would enable our staff
to evaluate the need for an examination of the adviser. We expect the
Division of Examinations would establish a dedicated email address to
receive these confidential transmissions and would make the address
available on the Commission's website in an easily retrievable
location.
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\312\ See proposed rule 223-1(b)(4)(v).
\313\ See rule 206(4)-2(a)(4).
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Although there is a requirement on Form ADV for an adviser to a
private fund to report to the Commission whether it received a
qualified audit opinion and to provide, and update, its auditor's
identifying information, there is not a similar obligation for an
accountant to notify the Commission as there is for a surprise
examination under the current rule.\314\ Based on our experience in
receiving notifications from accountants who perform surprise
examinations under the custody rule, we believe that the timely receipt
of this information--from an independent third party--would more
readily enable our staff to identify advisers potentially engaged in
harmful misconduct and who have other compliance issues. This would
bolster the Commission's efforts at preventing fraudulent, deceptive,
and manipulative activity and would aid oversight of investment
advisers.
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\314\ See rule 206(4)-2(a)(4) compare to rule 206(4)-2(b)(4);
see also Form ADV Part 1A, Schedule D, section 7.B.1, Q.23.
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We request comment on all aspects these notification requirements,
including the following items:
227. Should independent public accountants completing financial
statement audits under the proposed rule be required to provide these
proposed notifications? Would the requirement for an accountant to
comply with the notification requirement change the approach that an
accountant would take regarding audits that normally are performed for
purposes of satisfying the custody rule? If so, how?
228. Are there any privacy concerns or contractual obligations that
could prohibit or restrict an accountant from providing this
information? If so, what?
229. The regulations in 17 CFR 240.17a-5 (rule 17a-5) require a
broker or dealer to self-report to the Commission within one business
day and to provide a copy to the accountant. The accountant must report
to the Commission about any aspects of the broker's or dealer's report
with which the accountant does not agree. If the
[[Page 14724]]
broker or dealer fails to self-report, the accountant must report to
the Commission to describe any material weaknesses or any instances of
non-compliance that triggered the notification requirement. Should the
audit provision under the proposed rule contain a notification
requirement similar to rule 17a-5? Why or why not?
230. The regulations in 17 CFR 240.17a-5 (rule 17a-5) also require
a broker-dealer, pursuant to a statement filed with the Commission, to
allow access to the audit documentation associated with the reports of
the independent public accountant and to allow the independent public
accountant to discuss the findings associated with the reports with
representatives of the Commission. Should the rule include a similar
provision? Specifically, should the rule require that an investment
adviser, pursuant to a written agreement between the adviser and the
accountant, allow access to the audit or examination documentation
associated with the reports of the independent public accountant, by
representatives of the Commission, if requested in writing for purposes
of an examination of the adviser? Should the rule require the
investment adviser, pursuant to a written agreement between the adviser
and the accountant, to require the independent public accountant to
discuss with representatives of the Commission, if requested in writing
for purposes of an examination of the adviser, the findings associated
with the reports of the independent public accountant?
231. Should the accountant instead be required to file Form ADV-E
in a similar manner as independent public accountants who complete
surprise examinations? If so, what types of information should be
included on Form ADV-E with respect to financial statement audits?
Should a copy of the audit report or a copy of the audited financial
statements be filed with the Commission? If so, would there be issues
with making copies of these reports publicly available, particularly
since the adviser typically is not a party to the audit engagement
agreement between the audited entity and the independent public
accountant?
232. Is one business day the appropriate timeframe for notification
upon an accountant issuing a modified opinion? Should we use a
different timeframe, such as promptly? Why or why not?
233. Is four business days the appropriate timeframe for
notification after an accountant's resignation or dismissal from, or
other termination of, the engagement, or upon removing itself or being
removed from consideration for being reappointed? Should we use a
different timeframe? Why or why not?
234. Should the independent public accountants completing financial
statement audits under the proposed rule be required to provide these
proposed notifications of resignation or dismissal from, or other
termination of, the engagement, or upon removing itself or being
removed from consideration for being reappointed? Are there any
instances of resignation or dismissal from, or other termination of,
the engagement, or upon removing itself or being removed from
consideration for being reappointed that should not be reported? If so,
why? Should we also amend the instructions to Form ADV-E in a similar
way?
2. Discretionary Authority
The proposed rule would contain an exception from the surprise
examination requirement for client assets if the adviser's sole basis
for having custody is discretionary authority with respect to those
assets, provided this exception applies only for client assets that are
maintained with a qualified custodian in accordance with the proposed
rule and for accounts where the adviser's discretionary authority is
limited to instructing its client's qualified custodian to transact in
assets that settle exclusively on a DVP basis.\315\ In DVP
transactions, clients' custodians are generally under instructions to
transfer assets out of a client's account only upon corresponding
transfer of assets into the account.
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\315\ Proposed rule 223-1(b)(8).
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When a custodian is under instructions to transfer assets out of a
client's account only upon corresponding transfer of assets into the
account, there is a reduced risk that the adviser could misappropriate
the assets, and when the transaction settles on a DVP basis there is a
reduced risk of theft of the asset because, on a non-DVP basis, the
seller of an asset could deliver the asset but not receive payment or
the buyer of an asset could make payment but not receive delivery of
the asset.\316\ We believe this exception will focus the requirement to
obtain a surprise examination where the risk of misappropriation is
greatest. As an example, if the custodian's instructions from the
client authorize the adviser to wire cash from the client's account in
exchange for an equivalent amount of XYZ stock that is to be received
into the client's account, the adviser need not undergo a surprise
examination. If, however, the custodian's instructions from the client
authorize the adviser to wire cash from the client's account without
receipt of a corresponding asset, the adviser would need to undergo a
surprise examination.
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\316\ We note that the staff has acknowledged that limiting the
adviser's authority to transactions that settle via DVP at a
qualified custodian is one way for an adviser to avoid inadvertent
custody. The staff's statement noted that an adviser could draft a
letter (or other form of document) addressed to the custodian that
limits the adviser's authority to ``delivery versus payment,''
notwithstanding the wording of the custodial agreement, and have the
client and custodian provide written consent to acknowledge the new
arrangement. See 2017 IM Guidance, supra footnote 135.
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We propose to limit this exception to instances where this is the
adviser's sole basis for custody. Accordingly, if an adviser also has
custody of the client's assets for additional reasons, such as via a
power of attorney that confers one-way transfer authority, the adviser
cannot rely on the exception. Conversely, if an adviser also has
custody of the client's assets for reasons that are also subject to
similar exceptions (e.g., sole basis is fee deduction, sole basis is
related person custody),\317\ the adviser can rely on the exception.
These exceptions from the surprise examination requirement are not
mutually exclusive of one another notwithstanding our use of ``solely''
in each of them.\318\
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\317\ See Rule 206(4)-2(b)(3) and (6) and proposed rule 223-
1(b)(6).
\318\ See proposed rule 223-1(b)(9).
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We request comment on all aspects of the proposed exception for
discretionary authority, including the following items.
235. Should we provide an exception from the requirement to obtain
an independent verification of client assets if an adviser's sole basis
for custody is having discretionary authority with respect to client
assets that are maintained with a qualified custodian in accordance
with the rule? Does providing such an exception from asset verification
in these limited circumstances produce additional risks for client
assets?
236. Are we correct in our assessment that this proposed exception
would better balance the costs and protections of the proposed rule?
237. Should we limit the exception to situations in which the
qualified custodian implements certain policies and procedures? If so,
what should they include? For example, would a qualified custodian need
to demonstrate that it has certain systems, confirmations, or
authorizations in place to ensure that an adviser is unable to initiate
any one-way transactions and that the adviser's authority is limited to
only trading?
[[Page 14725]]
238. Should we limit the exception to situations in which the
adviser implements certain policies and procedures with regard to
discretionary authority? If so, what should those policies and
procedures be? If we were to rely more heavily on the adviser's
policies and procedures, should we require external testing or auditing
of those policies and procedures or internal controls? For example,
should we require an internal control report with similar control
objectives to the internal control reports we require under the custody
rule or what we would require under the safeguarding rule?
239. Do commenters agree with our assessment of the risks to client
assets as a result of discretionary authority in qualified custodian
accounts? Do commenters agree with our assumption that a one-way
transfer of assets from an account at a qualified custodian is a
riskier form of discretionary authority than DVP transactions? Are
there circumstances in a discretionary trading environment at a
qualified custodian where risks of misappropriation or theft in an
account are not mitigated by DVP settlement or requiring a one-for-one
exchange of assets? If so, please provide such examples.
240. If an adviser's authority over an account with a qualified
custodian includes the ability to transfer assets free of payment to
another account with the same account title, should such an account
still be eligible for the limited exception to the surprise
examination?
241. Should this exception apply ``solely'' when the basis for
custody is discretionary authority? Should we allow use of the
exception when the adviser also qualifies for another exception that is
similarly premised on an adviser ``solely'' having custody for a
specifically identified reason, such as when an adviser has custody of
client assets ``solely'' as a consequence of its authority to make
withdrawals from client accounts to pay its advisory fee, or ``solely''
because a related person has custody of them in connection with the
adviser's advisory services? Notwithstanding the use of ``solely'' in
certain exceptions from the surprise examination requirement, these
limited exceptions are not mutually exclusive; should they be? \319\
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\319\ See rule 206(4)-2(b)(3) and (6); proposed rule 223-1(b)(3)
and (6).
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3. Standing Letters of Authorization
The proposed rule also contains an exception from the surprise
examination requirement for client assets if the adviser has custody of
those assets solely because of a standing letter of authorization
(``SLOA'').\320\ The rule would define SLOA as an arrangement among the
adviser, the client, and the client's qualified custodian in which the
adviser is authorized, in writing, to direct the qualified custodian to
transfer assets to a third-party recipient on a specified schedule or
from time to time. In such an arrangement the client's qualified
custodian could not be an adviser's related person.\321\ Such an
authorization must include the client's signature, the third party
recipient's name, and either the third party's address or the third
party's account number at a custodian to which the transfer should be
directed. The authorization must also provide that the investment
adviser has no ability or authority to designate or change any
information about the recipient, including name, address, and account
number.\322\
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\320\ Proposed rule 223-1(b)(7).
\321\ The term ``related person'' would have the same meaning as
in the current rule.
\322\ Proposed rule 223-1(d)(12).
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Clients increasingly grant their advisers limited powers to
disburse assets from their accounts to one or more specifically
designated third parties in a manner that limits the adviser's ability
to redirect the assets. For example, a client may grant its adviser
this authority pursuant to a one-time or standing letter of instruction
or other similar asset transfer authorization arrangement that the
client establishes with qualified custodians. In granting such
authority the client may authorize the adviser to perform transfers or
disbursements via automated clearing house (i.e., ACH) transfers,
wires, checks, or other methods. Such authorizations can be for one-
time wires out of the account or standing authorization where an
adviser is given ongoing authority by the client to execute certain
asset movements into and out of a client's account.
The written instruction and authorization could be provided to the
adviser on the same form the client delivers to its qualified
custodian, or it could be provided separately, but it must be delivered
to both parties. The required signature would ensure that the
instructions and authorizations are verifiably from the client. We
believe the types of financial institutions identified as meeting the
proposed definition of qualified custodian are required by their
primary functional regulator or otherwise to perform procedures to
verify the instruction and authorization, through a signature review
and, if determined to be necessary, based on the facts and
circumstances, another method of verification. The required information
could help ensure that the instructions to the qualified custodian
provide relevant information about the recipient. These instructions
could include a specified schedule for transfers, or they could include
a more general instruction for the adviser to direct transfers to the
recipient from time to time.
Where the arrangement is structured so that the adviser's role is
limited to determining the timing and amounts when disbursing a
client's assets, we believe that the adviser's role in effecting any
change in beneficial ownership is circumscribed and ministerial, and
there is little risk to clients of loss, misuse, misappropriation, or
theft of its asset.\323\ We also believe under such circumstances that
a qualified custodian would be best positioned to ensure that the
required authorizations and instructions are properly and verifiably
issued by the client (e.g., the client's signature is verifiable),
provided the custodian is not a related person of the adviser to reduce
the incentive and opportunity to collude in such an arrangement.\324\
Under these circumstances, we believe that the proposed rule's
independent verification requirement would not be meaningfully additive
to protect a client's assets.\325\
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\323\ We note that the staff has taken a similar position. See
Investment Adviser Association, SEC Staff No-Action Letter (Feb. 21,
2017) (indicating the staff would not recommend enforcement action
to the Commission if advisers exercise limited authority pursuant to
a SLOA without undergoing an annual surprise examination, if the
SLOA arrangement meets certain specified conditions).
\324\ Each of the types of financial institutions identified in
the proposed rule as meeting the definition of qualified custodian
is subject to anti-money laundering and know your customer
requirements that require the financial institution to verify
signatures. See, e.g., 12 CFR 21.21 (requiring every national bank
and savings association to have a written, board approved program
that is reasonably designed to assure and monitor compliance with
the Bank Secrecy Act); FINRA Rule 3310 (setting forth the minimum
standards for broker-dealer firm's written anti-money laundering
compliance programs); FINRA Rule 2090 (requiring broker-dealers to
use reasonable diligence, in regard to the opening and maintenance
of customer accounts, to know (and retain) essential facts
concerning its customers and concerning the authority of each person
acting on behalf of such customers); see also Federal Financial
Institutions Examination Council Bank Secrecy Act/Anti-Money
Laundering Examination Manual, available at https://bsaaml.ffiec.gov/manual database of BSA/AML policies and procedures.
\325\ An adviser would be required to report to the Commission
on Form ADV if it is relying on this exception. See proposed Form
ADV amendment to Item 9 (Safeguarding). In addition, we are
proposing corresponding amendments to the books and records rule.
Proposed rule 204-2(b)(2) would require advisers to retain true,
accurate, and current copies of, and records relating to, any SLOA
issued by a client to the adviser. Proposed rule 204-2(b)(2)(vi).
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[[Page 14726]]
Finally, as noted above, this exception is not mutually exclusive
of similar limited exceptions within the proposed rule, notwithstanding
our use of ``solely'' in each of them. It would not, however, be
available if the adviser has custody for another reason outside of the
ones that would qualify the adviser for an exception as a sole basis
for custody. In our view, the approach outlined above clarifies that
the initiation of SLOAs means that advisers have custody under the
rule, but also recognizes the lower risks to client assets associated
with these arrangements. We request comment on all aspects of the
proposed rule's SLOA exception, including the following items.
242. Do commenters agree that an adviser should be exempt from the
independent verification requirements if it has custody solely because
of an SLOA where the client grants its adviser the limited power for
disbursements to third parties specifically designated by the client
and the adviser can comply with the conditions of the proposed
exception? Are there other protections we should require? If so, what
protections?
243. Should this exception be available when the client's assets
are not maintained with a qualified custodian? Does a qualified
custodian better protect client assets subject to limited powers of
attorney (such as by performing signature verification procedures under
anti-money laundering and know-your-customer requirements that require
the financial institution to verify signatures)?
244. Should this exception be unavailable when the client's assets
are at a related qualified custodian, as proposed? If not, what
specific conditions would safeguard client assets from the risks of
loss, theft, misuse, or misappropriation in these circumstances?
245. Would an adviser's authority be appropriately limited (and
therefore circumscribed and ministerial) if the client's instructions
include the name and either the address or the account number of the
recipient to whom a transfer of investments should be directed? Should
the instructions and authorization include different, or additional,
information, and if so, what?
246. Are qualified custodians required to verify SLOAs, or other
limited power of attorney, instructions under their governing
regulations, such as a signature review or other method? If not, should
we require the adviser to confirm or contract with the qualified
custodian so that it takes these steps?
247. Would it be appropriate to permit another party, such as an
introducing broker, to perform these steps for the qualified custodian?
Is this sometimes necessary, such as in the context of signature
verification, if the introducing broker has a relationship with the
client while a clearing broker serves as qualified custodian? If yes,
under what conditions? For instance, should the person performing the
steps be regulated for this activity? Should the person be prohibited
from performing these steps if it is a related person of the adviser?
248. Are qualified custodians required under their governing
regulations to provide a transfer of funds notice to the client
promptly after each transfer under a power of attorney and/or send the
client, in writing, an initial notice confirming the instruction and an
annual notice reconfirming the instruction? If not, should we require
the qualified custodian take these steps as part of this proposed
exception? Alternatively, should we require the adviser to include a
provision requiring such notice in its written agreement with the
qualified custodian?
249. Do commenters agree that, in order to rely on this proposed
exception, the investment adviser must have no authority or ability to
designate or change the identity of the third party, the address, or
any other information about the third party contained in the client's
instruction, as proposed? Are there other safeguards that an investment
adviser should comply with in order to rely on this proposed exception?
250. Are clients that issue limited powers of attorney able to
terminate or change the instruction to their qualified custodians? If
not, should we require that the client have this ability as part of
this proposed exception?
251. Are there some types of limited powers of attorney for which
an adviser cannot satisfy the proposed conditions, where we should
nevertheless permit an adviser to rely on this proposed exception? In
those cases, is the adviser's role in effecting any change in
beneficial ownership of a client's assets similarly circumscribed by
the client and ministerial in nature? If so, what are they?
252. Could online bill pay be integrated into the proposed
framework for the standing letters of authorization exception or
another exception? Would there be the difficulties in crafting an
exception for bill pay that offered similar protections to those we
describe above?
253. Given the general irreversibility of crypto asset transactions
in the event of erroneous or fraudulent transactions, should this
proposed exception be unavailable for crypto assets?
H. Amendments to the Investment Adviser Recordkeeping Rule
We are proposing to amend rule 204-2 to set forth requirements for
making and keeping books and records related to the requirements of the
proposed custody rule. The proposed amendments to rule 204-2 are
designed to work in concert with the proposed rule to help ensure that
a complete custodial record with respect to client assets is maintained
and preserved.
The proposed changes to the recordkeeping rule would help
facilitate the Commission's inspection and enforcement capabilities,
including assessing compliance with the requirements of the proposed
rule. Reviewing client account activity and holdings is a routine part
of most adviser examinations conducted by Commission staff. Currently,
however, Commission staff experience challenges in requesting,
receiving, and reconciling complete and accurate client-level
information from some investment advisers due to a lack of
recordkeeping and coordination between advisers and custodians. The
proposed recordkeeping amendments are designed to help reduce these
challenges by making it easier for examiners to obtain and review more
complete and accurate advisory client account records. We believe
having more complete records would facilitate client account
reconciliation of all debits and credits to and from client accounts.
This would benefit investors directly by virtue of enhanced detection
and deterrence of possible misappropriation or fraud. More complete
records also would better enable examiners to identify and detect
potential investment adviser misappropriation or loss or misuse of
client assets during their examinations, resulting in more effective
investor protections.
The proposed amendments to rule 204-2 would require an investment
adviser that has custody of client assets to make and keep true,
accurate, and current records of required client notifications and
independent public accountant engagements under proposed rule 223-1, as
well as books and records related to specific types of client account
information, custodian information, transaction and position
information, and standing letters of
[[Page 14727]]
authorization.\326\ The proposed amendments would require a more
detailed and broader scope of records of trade and transaction activity
and position information for each client account than the existing
requirements for such records.\327\ The proposed amendments also would
add new recordkeeping requirements that include: (i) retaining copies
of required client notices; \328\ (ii) creating and retaining records
documenting client account identifying information, including copies of
all account opening records and whether the adviser has discretionary
authority; \329\ (iii) creating and retaining records of custodian
identifying information, including copies of required qualified
custodian agreements, copies of all records received from the qualified
custodian relating to client assets, a record of required reasonable
assurances that the adviser obtains from the qualified custodian, and
if applicable, a copy of the adviser's written reasonable determination
that ownership of certain specified client assets cannot be recorded
and maintained (book-entry, digital, or otherwise) in a manner in which
a qualified custodian can maintain possession or control of such
assets; \330\ (iv) creating and retaining a record that indicates the
basis of the adviser's custody of client assets; \331\ (v) retaining
copies of all account statements; \332\ and (vi) retaining copies of
any standing letters of authorization.\333\ Lastly, the proposed
amendments would add new recordkeeping requirements to address
independent public accountant engagements.\334\ We believe that all of
these requirements would enhance the Commission's oversight of the
safeguarding practices of advisers and their compliance with the rule,
which would, in turn, promote investor protection.
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\326\ Advisers would be required to maintain the proposed
records for a period of not less than five years as required under
the current books and recordkeeping rule. See rule 204-2(e)(1).
\327\ Compare rules 204-2(b)(1) through (4) with proposed rule
204-2(b)(2)(v). Advisers would continue to be required to make and
keep a record describing the basis upon which the adviser has
determined that the presumption that any related person is not
operationally independent has been overcome, as required under
current rule 204-2(b)(5). This requirement would be renumbered in
the proposed rule with an updated cross-reference to the definition
of ``operationally independent'' in proposed rule 223-1(d)(7).
\328\ Proposed rule 204-2(b)(1).
\329\ Proposed rule 204-2(b)(2)(i). Given this proposed client
account recordkeeping requirement, we would eliminate the current
requirement under rule 204-2(a)(8) to keep a list or other record of
all client accounts for which the investment adviser has any
discretionary power.
\330\ Proposed rule 204-2(b)(2)(ii).
\331\ Proposed rule 204-2(b)(2)(iii).
\332\ Proposed rule 204-2(b)(2)(iv).
\333\ Proposed rule 204-2(b)(2)(vi).
\334\ Proposed rule 204-2(b)(3). Given that the proposed
independent public accountant recordkeeping requirements would
include a requirement to retain copies of internal control reports
under proposed rule 223-1, we would eliminate the current
requirement under rule 204-2(a)(17)(iii) to keep a copy of any
internal control report obtained or received pursuant to rule
206(4)-2(a)(6)(ii). See proposed rule 204-2(b)(3)(ii).
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1. Client Communications
The proposed amendments also would require an adviser to maintain a
copy of all written notices to clients required under the proposed rule
and any responses thereto.\335\ Specifically, this would include
notifications provided by the adviser to each client upon opening
accounts at qualified custodians on the client's behalf, along with
notices in writing of any subsequent changes in the qualified
custodian's name, address, and account number, and the manner in which
the client's assets are maintained.\336\ Again, we believe these
requirements will enable our staff to confirm that an adviser is
complying with providing appropriate client communications requirements
under proposed rule 223-1.
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\335\ See proposed rule 204-2(b)(1).
\336\ See proposed rule 223-1(a)(2).
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2. Client Accounts
Additionally, the proposed amendments would require an adviser to
maintain six categories of records \337\ with respect to each client
account for which the adviser has custody of client assets: (1) client
account identification; \338\ (2) custodian identification; \339\ (3)
the basis for the adviser having custody of client assets in the
account, and whether a related person holds the adviser's client
assets; (4) any account statements received or sent by the adviser,
including those delivered by the qualified custodian; (5) transaction
and position information; and (6) standing letters of authorization.
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\337\ See generally proposed rule 204-2(b)(2) for these six
categories of records.
\338\ For each client account, the adviser would maintain: the
advisory account name; client contact information (including name,
mailing address, phone number, email address); advisory account
number; client type (as identified in Item 5.D. of Form ADV); or any
other identifying information used by the investment adviser to
identify the account. Further, the provision would require that the
record identify the inception date for the advisory account, whether
the investment adviser has discretionary authority with respect to
any client assets in the account, whether the investment adviser has
authority to deduct advisory fees from the account, and, if
applicable, the termination date of the account, asset disposition
upon termination, and the reason for the termination.
\339\ For each client account, the adviser would maintain a
record that identifies and matches, for each client of which the
adviser has custody of client assets, the account name and account
number, or any other identifying information, from any person or
entity, including any qualified custodian, that maintains client
assets to the corresponding advisory account record for each client
required by rule 204-2(b)(2)(i). To the extent applicable, the
record must contain a copy of the required written agreement with
each qualified custodian under proposed rule 223-1(a)(2)(i),
including any amendments thereto. The record must also reflect the
basis for the reasonable assurances that the investment adviser
obtains from the qualified custodian under proposed rule 223-
1(a)(1)(ii).
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Included among the proposed advisory account identification records
an adviser would be required to maintain is a record indicating whether
the adviser has discretionary authority with respect to any client
assets in the account.\340\ This requirement would inform whether the
independent verification exception applies in the specific circumstance
of the adviser having custody of client assets solely because the
adviser has discretionary authority with respect to those assets.\341\
This requirement also would subsume and replace the requirement in the
current recordkeeping rule to make and keep a list or other record of
all client accounts for which the adviser has any discretionary
power.\342\ The proposed advisory account identification records also
would require the adviser to maintain a record indicating whether the
adviser has authority to deduct advisory fees from the account.\343\
This requirement would inform whether the independent verification
exception applies in the specific circumstance of the adviser having
custody of client assets solely as a consequence of the adviser's
authority to make withdrawals from the account to pay its advisory fee,
and the qualified custodian being an operationally independent related
person.\344\
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\340\ See proposed rule 204-2(b)(2)(i).
\341\ See proposed rule 223-1(b)(8).
\342\ See rule 204-(2)(a)(8).
\343\ See proposed rule 204-2(b)(2)(i).
\344\ See proposed rule 223-1(b)(3).
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Included among the custodian identification information an adviser
would be required to maintain are copies of each contract with a
qualified custodian and copies of all records received from the
qualified custodian thereunder relating to client assets, if
applicable, and a record that indicates the basis for the reasonable
assurances the adviser obtains from the qualified custodian under
proposed rule 223-1(a)(1).\345\ These aspects of the client account
recordkeeping requirements generally are designed to specify that
advisers must maintain such records
[[Page 14728]]
whenever client assets are maintained by a qualified custodian. These
records also would be necessary for the adviser to help demonstrate its
compliance with the requisite set of qualified custodian contractual
provisions and reasonable assurances it must obtain from qualified
custodians in proposed rule 223-1(a)(1). It would also help the adviser
to identify and match the client custodial account to the corresponding
advisory account record as discussed above. If applicable, the
custodian identification information would require the adviser to
maintain a copy of its written reasonable determination that ownership
of certain specified client assets cannot be recorded and maintained in
a manner in which a qualified custodian can maintain possession or
control of such assets. This recordkeeping obligation would be required
if the adviser wants to rely on the exception for privately offered
securities and physical assets to be held at a qualified custodian. It
also would help our examination staff to verify the reasonableness of
the adviser's determination and enable both internal advisory personnel
and our examination staff to readily identify the specified client
assets that are at risk of loss or misappropriation.
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\345\ See proposed rule 204-2(b)(2)(ii).
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The proposed recordkeeping rule would also require the adviser to
document the basis for the adviser's custody of client assets,
including whether a related person holds the adviser's client assets or
has any authority to obtain possession of them in connection with the
adviser's advisory services.\346\ This information would be essential
for internal advisory personnel and for our examination staff to be
able to readily identify the client assets that are at risk of loss or
misappropriation. It also would provide additional explanation in the
client account record to complement the custodial information discussed
above.
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\346\ See proposed rule 204-2(b)(2)(iii).
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3. Account Activity
In addition to client account identification requirements, the
proposed amendments include corollary books and records requirements
relating to client account activity that address account statements,
transaction and position information, and standing letters of
authorization. In order to demonstrate compliance with the account
statement aspects of the rule, the proposed amendments would require an
investment adviser to maintain copies of any account statement
delivered by the qualified custodian to the client and to the adviser
under proposed rule. The adviser also would be required to maintain
copies of any account statement it delivers to the client, including
copies of any account statement it delivers to the client containing
the required notification under proposed rule 223-1(a)(2).\347\ If the
client is a pooled investment vehicle, we would require that the record
reflect the delivery of account statements, notices, or financial
statements, as applicable, to all investors in such client pursuant to
proposed rule 223-1(c).\348\
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\347\ See proposed rule 223-1(a)(2). If the adviser sends
account statements to a client to which the adviser is required to
provide the account opening notice under this section, the adviser
must include in that notice and in any subsequent account statement
it sends to such client, a statement urging the client to compare
the account statements from the custodian with those from the
adviser.
\348\ See supra section II.B.3.b.ii, for discussion of proposed
rule 223-1(c).
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Regarding transaction and position information in client accounts,
we are proposing several modifications that would clarify certain
obligations of the current recordkeeping rule's requirements.\349\
First, we are proposing modifications to the current recordkeeping
rule's requirement that the adviser maintain records related to a
client's position in each security.\350\ The proposed amendments would
replace the current rule's references to ``security'' or ``securities''
with ``asset'' or ``assets'' to align this requirement with the broader
scope of proposed rule 223-1.
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\349\ Compare rules 204-2(b)(1) through (4) with proposed rule
204-2(b)(2)(v).
\350\ See rule 204-2(b)(4).
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Second, we would modify the current recordkeeping requirement for
advisers to make and keep records of debits and credits in client
accounts, including all purchases, sales, receipts, and deliveries of
securities for such accounts.\351\ Specifically, we propose to require
that in addition to trade activity, as required by rule 204-2, the
records should reflect other transaction activity in client accounts,
which we would interpret more broadly to include all debits and credits
to or from the account, including deposits, transfers, and withdrawals
as well as cash flows, corporate action activity, maturities,
expirations, expenses, and income posted. The adviser's records also
would be required to include the date and price or amount of any
purchases, sales, receipts, deliveries, including any one-way delivery
of assets, and free receipt and delivery of securities and certificate
numbers, deposits, transfers, withdrawals, cash flows, corporate action
activity, maturities, expirations, expenses, income posted to the
account, and all other debits and credits. Although we are not
prescribing the particular form in which the records must be kept, we
would view as acceptable keeping the records on a trade blotter,
customer account ledger, or accounting records maintained by the
adviser. We believe that these modifications would help ensure that an
adviser maintains sufficient information regarding client account
activity when an adviser has custody of client assets, and would
enhance the ability of our examination staff to verify the proper
handling of client assets by the adviser and compliance with the
proposed rule and other applicable provisions of the Federal securities
laws.
---------------------------------------------------------------------------
\351\ Compare rules 204-2(b)(1) and (2) with proposed rule 204-
2(b)(2)(v)(A).
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We also would modify the current recordkeeping rule's requirement
that advisers keep copies of confirmations of all transactions effected
by or for the client in the client account.\352\ The proposed
amendments would expressly provide for trade confirmations that show
the date and price of each trade as well as any instruction received by
the adviser concerning transacting in the assets.\353\ We believe these
modifications are necessary because our staff has periodically received
questions as to what is required under the current rule and,
particularly, whether the current rule requires only that the adviser
maintain a record of trade tickets rather than counterparty
confirmations.
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\352\ Compare rule 204-2(b)(3) with proposed rule 204-
2(b)(2)(v)(B).
\353\ As under the current rule, advisers would be required to
retain information about all orders placed (whether executed or
not). See rule 204-2(a)(3).
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4. Independent Public Accountant Engagements
The proposed amendments also would require advisers to retain
copies of documents relating to independent account engagements.\354\
Specifically, these documents include: (1) all audited financial
statements prepared under the safeguarding rule; \355\ (2) a copy of
each internal control report received by the investment adviser; \356\
and (3) a copy of any written agreement between the independent public
accountant and the adviser or the client, as applicable, required under
proposed rule 223-1.
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\354\ Proposed rule 204-2(b)(3).
\355\ Proposed rule 204-2(b)(4).
\356\ This requirement would subsume and replace the current
recordkeeping requirement to retain a copy of any internal control
report obtained or received under the current custody rule. See rule
204-2(a)(17)(iii).
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[[Page 14729]]
With respect to all three aspects of the proposed amendments for
independent public accountant engagements, we believe that maintaining
these records would give our staff critical access to the findings of
the independent public accountant(s) that perform procedures to verify
the existence of client assets not maintained with a qualified
custodian and/or the accuracy of an adviser's transactions in client
assets using enhanced authority.
5. Standing Letters of Authorization
Finally, we propose to add a requirement for advisers to keep
copies of, and records relating to, any standing letter of
authorization issued by a client to the investment adviser.\357\ These
records generally should include the name and either the address or the
account number of each recipient to whom a transfer of client assets
may be directed, along with any instructions the adviser has provided
to the client's qualified custodian to transfer client's assets to that
recipient. We believe that this requirement would enhance the ability
of our examinations staff to verify client-authorized transfers of
assets to designated recipients. This requirement also would be
critical for our examination staff and internal compliance personnel to
demonstrate that the adviser is appropriately safeguarding a client's
assets while relying on the proposed SLOA exception from the
independent verification requirements in the proposed rule.\358\
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\357\ See proposed rule 204-2(b)(vi).
\358\ Proposed rule 223-1(b)(7).
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We request comment on all aspects of the proposed books and
recordkeeping amendments, including the following items.
254. Should we amend rule 204-2 as proposed? Are there any other
records that an adviser should be required to maintain? If so, what are
they, and why?
255. Are there alternatives to the proposed amendments to rule 204-
2 that would minimize recordkeeping burdens and the associated costs,
while promoting the goals of facilitating the inspection and
enforcement capabilities of the Commission and its staff? If so, what
are they, and why?
256. Should we require advisers to maintain the proposed records in
electronic, text-searchable, machine-readable, and/or structured
format?
257. Should we eliminate the requirement to maintain responses to
any written client communications required under proposed rule 223-1?
If so, why?
258. The proposed rule would require an adviser to make and keep
records that identify client accounts for which the adviser has
discretionary authority. As a result, we are proposing to eliminate the
current rule's requirement to keep a list or other record of all client
accounts for which the investment adviser has any discretionary power
under 204-2(a)(8) as it is no longer necessary. Do commenters agree?
259. Is the proposed requirement sufficiently clear regarding
account activity in a client's account? Should we require advisers to
include additional information about transactions effected in a client
account in their records? If so, please explain what additional
information the rule should require and why it should be required. If
the proposed requirement should require less information about account
activity in a client account, please identify the information that
should not be required and why.
260. Would advisers find the proposed modifications to the current
recordkeeping rule's requirements regarding transaction and position
information helpful for account reconciliation purposes?
261. The proposed rule would require an adviser to maintain the
proposed records for the same period as required under the current
books and recordkeeping rule (i.e., 5 years). Should advisers be
required to maintain these records for a shorter or longer period? If
so, what time period, and why?
262. As proposed in amended rule 204-2, advisers that rely on the
audited financial statements exception in the safeguarding rule for a
pooled investment vehicle or any other entity would be required to
maintain copies of such audited financial statements. Should we also
require such advisers to maintain records verifying the delivery and
distribution of such audited financial statements to investors in the
entity (or their independent representatives)?
I. Changes to Form ADV
We are proposing to amend Part 1A, Schedule D, and the Instructions
and Glossary of Form ADV.\359\ The amendments are designed to help
advisers identify when they may have custody of client assets, to
provide the Commission with information related to advisers' practices
to safeguard client assets, and to provide the Commission with
additional data to improve our ability to identify compliance risks.
Because Form ADV is publicly available, these amendments may also
provide clients or investors additional protection because they will be
better able to discern the reasons why a particular adviser has
custody. Further, these amendments may offer ancillary market benefits
to the extent that market participants are better able to analyze the
Form ADV data to assess fraud risk. The proposed amendments would
continue to collect much of the information currently reported by
advisers in Item 9 of Form ADV Part 1A and the corresponding sections
of Schedule D, along with new information that corresponds with certain
aspects of the proposed rule.\360\ These proposed revisions would also
streamline the collection of this information by reorganizing Item 9
and refining certain reporting requirements to eliminate confusion and
prevent inaccurate or incomplete reporting.\361\
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\359\ This section discusses the Commission's proposed rule and
form amendments that would affect advisers registered with the
Commission. We understand that the state securities authorities
intend to consider similar changes that affect advisers registered
with the states, who are also required to complete Form ADV Part 1A
as part of their state registrations. We will accept any comments
and forward them to the North American Securities Administrators
Association (``NASAA'') for consideration by the state securities
authorities. We request that you clearly indicate in your comment
letter which of your comments relate to these items.
\360\ Because Form ADV, Part 1A--including the current Item 9--
is submitted in a structured, XML-based data language specific to
that Form, the information in the amended Item 9 would continue to
be structured (i.e., machine readable) as well. That is, the
Commission is not proposing to change the structured data language
used for Item 9.
\361\ See proposed Form ADV, Part 1A, Item 9. The following
definitions from the proposed rule would be added to Form ADV:
Assets (for purposes of Item 9 and related sections of Schedule D),
Operationally Independent (for purposes of Item 9 and related
sections of Schedule D), Qualified Custodian, and Standing Letter of
Authorization. Additionally, the definition of Discretionary
Authority or Discretionary Basis would be expanded to include
Discretionary Trading Authority. See proposed Form ADV, Part 1A,
Glossary and Item 9.C, D, E, and F, which currently collect
information about an adviser's methods of compliance with rule
206(4)-2, whether a related-party acts as a qualified custodian,
whether the adviser was subject to a surprise examination, and the
number of qualified custodians, respectively, would be deleted or
revised in the proposed Item 9 to reflect the proposed changes to
the rule and to collect similar information more effectively.
---------------------------------------------------------------------------
Item 9 currently requires an adviser to report whether it or a
related person has custody of any advisory client's cash or bank
accounts or securities, along with certain additional information if an
adviser reports having custody. Nonetheless, an adviser is not required
to report having custody if it has custody solely because it deducts
advisory fees or because a related person has custody but an adviser
has overcome the presumption that it is not operationally independent.
The adviser may, however, still be required to
[[Page 14730]]
complete other sections of Item 9. In the Commission's experience,
advisers often are confused by these requirements, because they may
have custody under the rule but are instructed to report not having
custody for purposes of completing Item 9.A.(1) of Form ADV. This can
result in inaccurate or incomplete reporting, which in turn, could
limit our staff's ability to effectively analyze this important Form
ADV data. Further, not being required to report having custody on Form
ADV when an adviser in fact has custody under the rule may result in
adviser's erroneously believing that it is not subject to the custody
rule. The proposed amendments to Form ADV are designed to eliminate
this confusion, improve the information available to the Commission and
the public about how advisers safeguard clients' assets, and promote
greater compliance with the proposed safeguarding rule.
First, consistent with the proposed rule, we are proposing to
capture information in Item 9 about an adviser's custody of its
``client assets'' including a client's funds, securities, and other
positions held in a client's account. We are proposing to revise the
introductory language, replace references to funds and securities in
Item 9 with the term assets (as defined in the proposed rule), and add
a new sub-item to allow advisers to indicate their reliance on certain
exceptions in the proposed rule.\362\ These revisions are designed to
align Form ADV with the proposed rule.
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\362\ We would retain the instruction to exclude reporting
information in Item 9 about advisory clients that are investment
companies registered under the Investment Company Act as this
provision in rule 223-1 is not proposed to be amended.
---------------------------------------------------------------------------
Next, we are also proposing to revise Item 9.A.(1) to require
advisers to indicate, in a single place, if they directly, or
indirectly through a related person, have custody of client assets,
including if custody is solely due to an adviser's ability to deduct
fees from client accounts or because the adviser has discretionary
authority.\363\ Form ADV, Part 1A currently distinguishes reporting
among advisers having direct custody, advisers subject to the current
rule because a related person has custody, and advisers having custody
of client funds or securities solely because of the ability to deduct
advisory fees from client accounts. Further, as noted above, in certain
circumstances advisers are currently instructed not to report having
custody in Item 9.A.(1), despite having custody (i.e., when the basis
for custody is an adviser's ability to deduct advisory fees or through
an operationally independent related person). While these distinctions
are important for evaluating compliance risks, the current structure of
Item 9 makes it difficult to easily analyze this data. For example,
under the current structure of Item 9, we cannot easily identify the
total number of clients or the total amount of assets over which an
adviser has custody. The proposed revisions to Item 9.A.(1) are
designed to increase the quality of the information reported on Form
ADV by reducing confusion about how and where to report certain
information and make it easier for the public and the Commission to
understand and analyze.
---------------------------------------------------------------------------
\363\ We are also proposing to include new instructional
language directing advisers to answer ``Yes'' to Item 9.A.(1) if
they have the ability to deduct advisory fees directly from client
accounts, reported discretionary RAUM in Item 5.F.(2).(a), or
reported having discretionary trading authority in Item 8.C.(1).
---------------------------------------------------------------------------
Third, we are proposing to modify Item 9.A.(2) to preserve
information currently reported by advisers in Item 9 about the amount
of client assets and number of clients falling into each category of
custody (i.e., direct or indirect) and to require advisers to report
similar information about client assets over which they have custody
resulting from (1) having the ability to deduct advisory fees; (2)
having discretionary trading authority; (3) serving as a general
partner, managing member, trustee (or equivalent) for clients that are
private funds; (4) serving as a general partner, managing member,
trustee (or equivalent) for clients that are not private funds; (5)
having a general power of attorney over client assets or check-writing
authority; (6) having a standing letter of authorization; (7) having
physical possession of client assets; (8) acting as a qualified
custodian; (9) a related person with custody that is operationally
independent; and (10) any other reason.\364\ We believe this
information would enhance the quality and utility of the data reported
on the form, enhancing the Commission's ability to exercise oversight
of the safeguarding practices of advisers. We believe this information
may also be beneficial to clients or investors attempting to discern
the reasons why a particular adviser has custody. Further, this updated
format may help market participants to analyze Form ADV data on an
aggregated basis to assess fraud risk more accurately.
---------------------------------------------------------------------------
\364\ Proposed Form ADV, Part 1A, Item 9.A.(2). Advisers are
currently required to report information with respect to funds and
securities over which their related persons have custody, including
the dollar amount and number of clients whose funds or securities
are in the adviser's custody and whether any related person has
custody of any clients' cash or bank accounts or securities and the
relevant dollar amount and number of clients. See Form ADV, Part 1A
Item 9.A.(2) through, Item 9.B. Based on its responses, an adviser
is also required to report additional custody-related information in
Schedule D of Form ADV, Part 1A.
---------------------------------------------------------------------------
Fourth, we are also proposing new Item 9.B. requiring an adviser to
indicate whether it is relying on any of the exceptions from the
proposed rule and, if so, to indicate on which exception(s) the adviser
is relying. This information would be valuable for Commission staff to
assess compliance with the proposed rule, and it may also be beneficial
to clients or investors to assess which exception(s) the adviser is
relying upon.
Fifth, we are proposing to require advisers to report whether
client assets over which they or a related person have custody are
maintained at a qualified custodian and the number of clients and
approximate amount of client assets maintained with a qualified
custodian.\365\ Advisers also would be required to report certain
identifying information about the qualified custodians maintaining
client assets.\366\ Item 9 currently collects only limited information
from advisers about advisers and their related persons that act as
qualified custodians under the rule.\367\ Qualified custodians continue
to serve a critical role in safeguarding client assets under the
proposed rule. Given this important role, we are proposing to require
advisers to report the following information for all qualified
custodians maintaining client assets:
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\365\ See proposed Form ADV, Part 1A, Item 9.C.(1)and proposed
Form ADV, Part 1A, Schedule D, section 9.C.(1).
\366\ Proposed Form ADV, Part 1A, Schedule D, section 9.C.(1).
\367\ See Form ADV, Part 1A, Item 9.D.(2) and Form ADV, Part 1A,
Schedule D, section 7.A. Advisers are currently required to report
more detailed custodial information about their separately managed
accounts and about the private funds they advise. See Form ADV, Part
1A, Schedule D, section 5.K.(3); Form ADV, Part 1A, Schedule D,
section 7.B.(1)(25).
---------------------------------------------------------------------------
Full legal name of the qualified custodian;
Location of the qualified custodian's office responsible
for the services provided;
Contact information for an individual to receive
regulatory inquiries;
Type of entity;
Legal Entity Identifier (if applicable);
Number of clients and approximate amount of client assets
(rounded to the nearest $1,000) maintained by the qualified custodian;
and
[[Page 14731]]
Whether the qualified custodian is a related person, and
if so, the identifying information for the independent public
accountant engaged to prepare the proposed internal control report and
verification required under the proposed safeguarding rule.\368\
---------------------------------------------------------------------------
\368\ See proposed Form ADV, Part 1A, Schedule D, section
9.C.(1). This information is similar to the information advisers
currently report regarding separately managed accounts and private
fund custodians. See Form ADV, Part 1A, Schedule D, section 5.K.(3);
Form ADV, Part 1A, Schedule D, section 7.B.(1)(25).
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Similarly, we are also proposing revisions to Item 9 that would
require advisers to report information about accountants completing
surprise examinations, financial statement audits, or verification of
client assets under the proposed rule.\369\ We believe requiring
advisers to disclose more detailed information about the qualified
custodians maintaining client assets and the accountants completing
these engagements under the proposed rule would provide useful
information to the public and facilitate the Commission's examination
efforts.
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\369\ See proposed Form ADV, Part 1A, Schedule D, section
9.C.(3). Advisers report similar information about the independent
public accountants completing surprise examinations under the
current rule in section 9.C of Form ADV Part 1A Schedule D.
---------------------------------------------------------------------------
Advisers currently are required to file an other-than-annual-
amendment to Form ADV promptly if certain information provided in
response to Item 9 becomes inaccurate in any way.\370\ Information
triggering this obligation includes whether the adviser or a related
person has custody of client cash, bank accounts, or securities; \371\
the methods by which the adviser complies with the custody rule; \372\
and whether the adviser or a related person acts as a qualified
custodian.\373\ Given the importance of this information, we continue
to believe that advisers should update this information to the extent
it becomes inaccurate. Thus, we are proposing to retain the current
requirement that advisers file an other-than-annual-amendment to Form
ADV promptly if similar information we are proposing to collect on Form
ADV becomes inaccurate.\374\ More specifically, we are proposing to
require an adviser to file promptly an other-than-annual amendment to
Form ADV if any of an adviser's responses regarding the following
becomes inaccurate in any way: (1) whether the adviser has custody of
client assets either directly or because a related person has custody
of client assets in connection with advisory services that the adviser
provides to the client; (2) whether the adviser is relying on certain
exceptions to the proposed rule; (3) whether client assets are
maintained with a qualified custodian; (4) whether the adviser or a
related person serves as a qualified custodian under the proposed rule;
(5) whether client assets are not maintained by a qualified custodian;
(6) whether the adviser is required to obtain a surprise examination by
an independent public accountant under the proposed rule; or (7)
whether the adviser is relying on the audit provision.\375\ An adviser
would be required to update the other information reported in Item 9
(e.g., information about the number of clients and approximate amount
of assets or certain information about qualified custodians) only on
its annual updating amendment, which is the same frequency with which
advisers update similar information on the current form.\376\
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\370\ See Form ADV, General Instructions. Advisers, however, are
not required to file an other-than-annual amendment to update
information provided in response to Items 9.A.(2), 9.B.(2), 9.E, and
9.F even if that information becomes inaccurate--though advisers are
required to update this information when filing their next annual
updating amendment. Id.
\371\ See Form ADV, Item 9.A.(1) and Item 9.B.(1).
\372\ See Form ADV, Item 9.C.
\373\ See Form ADV, Item 9.D.
\374\ See proposed amendments to Form ADV General Instructions.
\375\ See generally proposed Form ADV, Items 9.A.(1), 9.B.(1),
9.C., 9.D.(1), and 9.E.
\376\ See proposed amendments to Form ADV, General Instructions.
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We request comment on all aspects of proposed revisions to Form ADV
Part 1A, including the following items.
263. Would the proposed reorganization of Item 9 make it easier for
advisers to complete Item 9 more accurately and eliminate the confusion
created by the current structure or wording of Item 9? Are there other
changes to Item 9 that would make the information reported on that Item
more accurate or less confusing? Is additional guidance needed to
clarify any of the requirements of the proposed revisions?
264. In proposed Item 9.A.(2), we ask advisers to identify various
ways that they may have custody, directly or indirectly, broken out by
the approximate amount of client assets and number of clients. Based on
our experience, we understand that a client may have several different
advisory accounts. Should we also ask for information at the advisory
account level? Should we ask for information on an account level basis
rather than a client level basis? Would this information be more
meaningful? Why or why not?
265. In proposed Item 9.B.(2), we ask advisers about which
exception(s) in rule 223-1(b) they are relying upon. Should we also ask
for the approximate amount of assets and number of clients under each
exception? Should we also ask for information at the advisory account
level for each exception? Should we ask for information on an account
level basis rather than a client level basis for each exception? Would
this information be more meaningful? Why or why not?
266. Would advisers be able to provide the information we are
proposing to collect about qualified custodians? Should we collect
additional or different information from advisers about qualified
custodians? If so, what types of information should advisers be
required to report? Does the proposal seek to collect information about
qualified custodians that would be unnecessary or overly burdensome for
advisers to report? For example, do advisers keep records of the
regulator for foreign financial institutions acting as qualified
custodians? In particular, what information should not be collected and
why? For instance, are there any privacy laws or other legal barriers
that would prohibit or restrict an adviser from reporting this
information about qualified custodians?
267. Should advisers be required to file promptly an other-than-
annual-amendment to Form ADV when the information provided in response
to certain parts of Item 9 becomes inaccurate? Should an adviser be
required to update promptly only some of this information, as proposed,
or, alternatively, all of this information when it becomes inaccurate?
Are there different items on Form ADV that advisers should have to
update promptly than those proposed?
268. Is there any additional information an adviser should be
required to report regarding its practices to safeguard client assets?
If so, what types of additional information should advisers be required
to report on Form ADV?
269. Should advisers be required to report their holdings of
physical assets on Form ADV?
270. Should advisers be required to report their holdings of
privately offered securities that cannot be recorded and maintained
with a qualified custodian on Form ADV?
271. Should advisers also be required to report information about
the independent public accountant where the adviser cannot maintain
assets with a qualified custodian?
272. Should advisers be required to disclose information on Form
ADV regarding sub-custodial, securities depository, or other similar
[[Page 14732]]
arrangements about client assets? Do advisers often have this
information?
273. Should advisers be required to disclose on Form ADV whether
financial statements distributed to investors under the audit provision
comply with U.S. GAAP or another comprehensive body of accounting
standards?
274. Some of the information we are proposing be reported in
section 9.C.(1) and 9.C.(3) of Schedule D is similar to the information
adviser are required to report in section 7.B.(1) of Schedule D,
particularly as it relates to whether reports provided by independent
public accountants contain unqualified, qualified, or modified
opinions. Should we amend these portions of section 7.B.(1) of Schedule
D to conform with the proposed amendments to section 9.C.(2) and
9.C.(3)?
275. Where a filing adviser files Form ADV along with a relying
adviser, it is our understanding that some filing advisers may include
the amount of client funds and securities and total number of clients
for which the filing adviser has custody in response to Item 9.A.(2)
and for which the relying adviser has custody in response to Item
9.B.(2) of Form ADV.\377\ Should we provide additional guidance in Form
ADV about how we expect filing and relying advisers to complete Item 9?
If so, please explain.
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\377\ See Form ADV and Investment Advisers Act Rules, Advisers
Act Rel. No. 4509 (Aug. 25, 2016) where the Commission amended Form
ADV instructions, among other items, to allow umbrella registration
for a filing adviser and relying advisers.
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J. Existing Staff No-Action Letters and Other Staff Statements
Staff in the Division of Investment Management is reviewing certain
of its no-action letters and other staff statements addressing the
application of the custody rule to determine whether any such letters,
statements, or portions thereof, should be withdrawn in connection with
any adoption of this proposal. We list below the letters and other
staff statements that are being reviewed as of the date of any adoption
of the proposed rules or following a transition period after such
adoption. If interested parties believe that additional letters or
other staff statements, or portions thereof, should be withdrawn, they
should identify the letter or statement, state why it is relevant to
the proposed rule, and how it or any specific portion thereof should be
treated and the reason therefor. To the extent that a letter listed
relates both to the custody rule and another topic, the portion
unrelated to the custody rule is not being reviewed in connection with
the adoption of this proposal.
Letters To Be Reviewed
----------------------------------------------------------------------------------------------------------------
Name of staff statement Date issued
----------------------------------------------------------------------------------------------------------------
All staff statements issued prior to the Various Dates.
2003 Commission Adopting Release.
American Bar Association (Question 1, December 8, 2005.
Custody Rule Section, only).
American Bar Association (Question D August 10, 2006.
only).
Deloitte & Touche LLP................... August 28, 2006.
Investment Adviser Association.......... September 20, 2007.
Investment Company Institute............ September 5, 2012.
Investment Adviser Association.......... April 25, 2016.
Investment Adviser Association.......... February 21, 2017.
Madison Capital Funding, Inc............ December 20, 2018.
Robert Van Grover, Esq., Seward and December 11, 2019.
Kissel LLP.
Privately Offered Securities Under the August 2013.
Investment Advisers Act Custody Rule,
Investment Management Guidance Update
(``IMGU'') 2013-04.
Private Funds and the Application of the June 2014.
Custody Rule to SPVs and Escrows, IMGU
2014-07.
Inadvertent Custody, IMGU 2017-01....... February 2017.
Staff Responses to Questions About the Issued on various dates since 2003.
Custody Rule (all).
----------------------------------------------------------------------------------------------------------------
K. Transition Period and Compliance Date
We are proposing a one-year transition period to provide time for
advisers to come into compliance with the following if they are
adopted: redesignation of rule 206(4)-2 as new rule 223-1, and
corresponding amendments to rule 204-2 and Form ADV, as applicable.
Accordingly, we propose that the compliance date of any adoption of
this proposal would be one year following the rules' effective dates
which would be sixty days after the date of publication of the final
rules in the Federal Register for advisers with more than $1 billion in
regulatory assets under management (``RAUM''). For advisers with up to
$1 billion in RAUM, we propose that the compliance date of any adoption
of this proposal would be 18 months following the rules' effective
dates which would be sixty days after the date of publication of the
final rules in the Federal Register. If adopted as proposed,
approximately 10,454 advisers, which represents approximately 69% of
all registered advisers and 2.5% of the total RAUM of all advisers,
would be subject to the longer, 18 month transition period.\378\ The
chart below indicates the impact applying different RAUM threshold
would have on the number of advisers subject to the proposed 18-month
transition period.\379\
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\378\ As of June 2022, 15,062 investment advisers were
registered with the Commission and reported a total of $128.96
trillion in RAUM, while 10,454 advisers reported having less than $1
billion in RAUM, while the aggregate RAUM reported by these advisers
as of June 2022 was approximately $3.2 trillion.
\379\ The data in the table is based upon data reported by
advisers as of June 2022.
----------------------------------------------------------------------------------------------------------------
Percent of
Number of Percent of Total RAUM of total RAUM of
Threshold advisers under advisers under advisers under advisers under
threshold threshold threshold threshold
----------------------------------------------------------------------------------------------------------------
$500 million.................................... 8,396 55.4 $1.7 1.3
1 billion....................................... 10,454 69.0 3.2 2.5
1.5 billion..................................... 11,448 75.5 4.4 3.4
[[Page 14733]]
2 billion....................................... 11,987 79.1 5.3 4.1
2.5 billion..................................... 12,378 81.6 6.2 4.8
3 billion....................................... 12,657 83.5 6.9 5.4
3.5 billion..................................... 12,859 84.8 7.6 5.9
4 billion....................................... 13,044 86.0 8.3 6.5
4.5 billion..................................... 13,215 87.2 9.0 7.0
5 billion....................................... 13,357 88.1 9.7 7.6
10 billion...................................... 13,994 92.3 14.1 11.0
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Under this proposal, advisers could continue to rely on current
rule 206(4)-2, rule 204-2, and Form ADV until the compliance date. We
are proposing that once the rules become effective, advisers may
voluntarily comply with them in advance of the compliance date. To
promote regulatory consistency, however, we are proposing that any
adviser that elects to rely, prior to the compliance date, on the
effective rule 223-1 must also comply with, as applicable, the amended
rule 204-2 and the amended Form ADV beginning at the same time.
We request comments on the proposed transition period:
276. Do commenters agree that a one-year transition period
following each rule's effective date is appropriate for advisers with
more than $1 billion in RAUM? Should the period be shorter or longer?
For example, would six months be an appropriate amount of time?
Alternatively would 18 months be necessary? Do commenters agree that an
18-month transition period following each rule's effective date is
appropriate for advisers with up to $1 billion in RAUM? Should the
period be shorter or longer? For example, would one year be an
appropriate amount of time? Alternatively would 24 months be necessary?
Should there be different compliance dates for different types of
advisers, such as advisers to pooled investment vehicles or advisers to
separate account clients? Should the $1 billion threshold for the
different compliance groups be higher or lower?
277. Should the transition period be the same for proposed new rule
223-1 and amendments to rule 204-2 and Form ADV? Should we permit that
once the rules become effective, advisers may voluntarily comply with
them in advance of the compliance date, and require that any adviser
that elects to rely on new rule 223-1 prior to the compliance date must
also comply beginning at the same time with the amended rule 204-2 and
amended Form ADV? Does this promote regulatory consistency, and if not,
why not?
278. Should we also require that any adviser that elects to rely on
rule 223-1 and amended rule 204-2 and amended Form ADV prior to the
compliance date must also cease to rely on Commission and staff letters
and other statements that would be withdrawn on the compliance date?
279. Should the transition period vary for different rule
requirements? For example, would advisers need 18 months to comply with
the proposed amendments to the qualified custodian provisions and three
months to comply with the exception from the surprise examination for
SLOAs? Please explain your answer and suggest transition period
durations.
III. Economic Analysis
A. Introduction
We are mindful of the costs imposed by, and the benefits obtained
from, our rules. Section 202(c) of the Advisers Act provides that when
the Commission is engaging in rulemaking under the Act and is required
to consider or determine whether an action is necessary or appropriate
in the public interest, the Commission shall also consider whether the
action will promote efficiency, competition, and capital formation, in
addition to the protection of investors. The following analysis
considers, in detail, the likely significant economic effects that may
result from the proposed rule amendments, including the benefits and
costs to investors and other market participants as well as the broader
implications of the proposed rule amendments for efficiency,
competition, and capital formation.
Where possible, the Commission quantifies the likely economic
effects of its proposed amendments and rules. However, the Commission
is unable to quantify certain economic effects because it lacks the
information necessary to provide estimates or ranges of costs.
Additionally, in some cases, quantification would require numerous
assumptions to forecast how investment advisers and other affected
parties would respond to the proposed amendments, and how those
responses would in turn affect the broader markets in which they
operate. In addition, many factors determining the economic effects of
the proposed amendments would vary significantly among investment
advisers. Investment advisers vary in size and sophistication as well
as the assets on which they provide advice. As a result, investment
advisers' existing practices and the extent to which investment
advisers qualify for exceptions from the rule varies, making it
inherently difficult to quantify economic effects. Even if it were
possible to calculate a range of potential quantitative estimates, that
range would be so wide as to not be informative about the magnitude of
the benefits or costs associated with the proposed rule. Many parts of
the discussion below are, therefore, qualitative in nature. As
described more fully below, the Commission is providing a qualitative
assessment and, where practicable, a quantified estimate of the
economic effects.
B. Broad Economic Considerations
Investors rely on the asset management industry for a wide variety
of wealth management and financial planning functions. These services
are critical for investors to plan for the future and diversify their
investment risks. Investment advisers are a key part of this industry,
as they provide investment advice to investors and clients about the
value of, or about investing in, securities and other investment
products.\380\
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\380\ See, e.g., https://www.investor.gov/introduction-investing/investing-basics/glossary/investment-adviser.
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When performing services for investors and clients, an adviser may
frequently have access to client assets, exposing them to the risk of
loss, misuse, theft, or misappropriation. This gives rise to a
principal-agent problem between investors and clients (the principals)
on the one hand and their
[[Page 14734]]
investment advisers (the agents) on the other. This is because, while
advisers face relevant competitive market forces and therefore have
private reputational incentives to maintain some level of oversight and
internal controls, as discussed below market failures can lead their
chosen levels of oversight and control to be sub-optimally low. The
current custody rule, which the Commission has amended over time, has
been designed to deter such behavior and alleviate these market
failures in part by relying on a third party, a qualified custodian, in
safeguarding client assets. While requiring the use of a qualified
custodians helps mitigate the principal-agent problem between
investors, clients, and their advisers, the introduction of an
additional agent--the custodian--introduces the potential for
additional principal-agent conflicts.
Such principal-agent problems provide the economic rationale for
revised Commission rules aimed at further mitigating the underlying
market failures.\381\ Specifically, in the absence of targeted
regulation, principal-agent problems can result when investment
advisers and custodians have different preferences and goals than
clients. As a result, investment advisers and custodians might take
actions that increase their well-being at the expense of imposing
agency costs on investors and clients.\382\ For example, a custodian
may not have sufficient incentive to provide custodial account records
to an independent public accountant on a timely basis, to the extent
providing a timely response is burdensome to a custodian. This would
make adviser compliance with the audit provision, surprise examination,
or Form ADV-E filing provisions of the rule more difficult, which would
ultimately be to the disadvantage of clients.
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\381\ As discussed above in section I, there have been market
developments that suggest a need to better protect client assets by
broadening the scope of the application of the rule and by improving
its efficacy.
\382\ See, e.g., Michael C. Jensen & William H. Meckling, Theory
of the Firm: Managerial Behavior, Agency Costs and Ownership
Structure, 3 J.Fin. Econ. 305 (1976).
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Market forces generally provide some incentive for principals and
agents to mitigate principal-agent conflicts. Advisers that effectively
mitigate conflicts, for example, by offering targeted private contract
terms, may, all else being equal, gain a reputational advantage that
will help them in retaining and attracting investors and clients. The
assurance provided by such terms, however, would depend on both
investors' perception of the costs of enforcing the terms, as well as
the likelihood that disputes would be resolved in investors'
favor.\383\ A market failure may exist to the extent that more costly
enforcement of the contract and more unpredictable favorable outcomes
reduce the effectiveness of the contract in mitigating conflicts of
interest between clients and investment advisers. Factors affecting the
cost of enforcement in the context of investment advice may include:
(1) the cost of verifying adviser conduct, (2) the extensiveness and
complexity of services over which the terms apply, and (3) the ability
of investors, who likely lack specialized knowledge, to understand how
adviser conduct relates to the terms.\384\
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\383\ See, e.g., Andrei Shleifer, ``Efficient Regulation'',
(2010), available at https://www.nber.org/papers/w15651 (``Shleifer
paper''), for a general discussion of these points.
\384\ See Shleifer paper for a general discussion of factors
affecting the cost of enforcement of the terms and the
predictability of favorable legal outcomes. Several factors may also
affect an investor's assessment of a favorable legal outcome should
the investor believe an adviser to have violated the contractual
terms. First, while investors may believe an adviser has violated
the terms, investors may be uncertain of their ability to verify
such conduct. Second, given the potentially complex fact patterns of
litigation related to the provision of investment advice, investors
may believe that there is some chance that courts will simply ``get
it wrong.'' Third, advisers may have access to substantially greater
financial resources than investors. Investors may believe that the
financial inequality between themselves and advisers makes a
favorable legal outcome less likely. An investment adviser's
fiduciary duty to their clients could mitigate the incentive for an
adviser to provide fewer terms that protect investors. The ability
of the adviser's fiduciary duty to mitigate the incentive for an
adviser to provide fewer terms that protect investors will depend on
factors affecting the cost of enforcing that duty. See, Frank H.
Easterbrook & Daniel R. Fischel, ``The Economic Structure of
Corporate Law,'' 1991, Harvard University Press.
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When the incentives of advisers or custodians do not sufficiently
align with investors' or clients' interests, and market failures
prevent market participants from effectively resolving these conflicts
of interest via private contracting, targeted regulatory requirements
can help increase the level of investor protection. The investor
protection benefits of such regulatory requirements will depend,
however, on an adviser's ability and incentive to comply with the
requirements. Encouraging or requiring independent oversight and
verification of adviser conduct is one way to incentivize
compliance.\385\ For example, an adviser is less likely to engage in
unauthorized trading in a client's account when the adviser knows that
the client will be receiving an account statement detailing any trading
activity. Similarly, an adviser is less likely to misappropriate client
assets when it knows that an independent public accountant is required
to verify client assets.\386\
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\385\ Even in the absence of such a regulatory requirement, an
adviser could contractually offer independent oversight and
verification of its conduct to its investors and clients. However,
there may be practical impediments, such as the lack of specialized
knowledge, which may lead investors to not seek out such terms. In
addition, individual negotiation of contracts may be less cost
effective than a market-wide regulatory solution.
\386\ See, e.g., Stephen G. Dimmock & William W. Gerken,
``Predicting fraud by investment managers,'' 105 J. Fin. Econ. 153
(Aug. 2011). This article finds that monitoring is a significant
predictor of investment fraud. For example, large investors who have
stronger incentive and greater ability to monitor are associated
with fewer frauds. Also see, e.g., Ben Charoenwong, Alan Kwan &
Tarik Umar, ``Does Regulatory Jurisdiction Affect the Quality of
Investment-Adviser Regulation?,'' 109 Am. Econ. Rev., Am. Econ.
Ass'n. 3681 (Oct. 2019). This article finds that registered
investment advisers that are costlier for state regulators to
supervise, or primarily serve less sophisticated investors, receive
more complaints.
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There are three ways in which regulation facilitating clients' and
third parties' oversight of advisers' conduct through verification of
client assets can reduce potential harm to investors and clients.
First, such regulation can increase the likelihood that any non-
compliant behavior by advisers is detected. Second, it can increase the
likelihood that any non-compliant behavior is detected sooner,
potentially mitigating loss to clients. Third, and perhaps most
importantly, facilitating verification of client assets would likely
have a prophylactic effect, countering the incentive for non-compliant
behavior by advisers. Indirectly, regulation that enhances verification
of client assets also reduces potential harm to clients by facilitating
detection of non-compliant behavior by the qualified custodians with
whom the clients have custody agreements, potentially mitigating client
losses and deterring non-compliant behavior by custodians. This
ameliorates principal-agent problems between the client and the
qualified custodian and facilitates advisers' exercise of fiduciary
duty over client assets held by the qualified custodian.\387\
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\387\ For those custodians that are registered broker-dealers,
it also facilitates compliance with their obligations under Exchange
Act Rule 15c3-3.
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Finally, the ability to oversee investment advisers' (and
custodians') conduct through verification of client assets depends on
the quality of the third party's verification processes and the
independence of the third party.\388\ Generally, a higher quality
verification process is one that has an increased likelihood of
detecting misconduct.\389\
[[Page 14735]]
Similarly, a more independent third party is one that is more likely to
report misconduct or violations of regulatory requirements that it
detects.\390\ Regulation designed to enhance the quality of third-party
verification processes and/or enhance the independence of third
parties, then, generally enhances the ability of third parties to
oversee investment advisers' conduct.
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\388\ See, e.g., Ross L. Watts & Jerold L. Zimmerman, ``Positive
Accounting Theory: A Ten Year Perspective,'' 65 Acc. Rev. 131 (Jan.
1990).
\389\ The use of PCAOB-registered independent public accountants
is required for certain engagements under the current rule. In
particular, a PCAOB-registered independent public accountant is
required to perform surprise examinations and periodically inspect
internal controls under the current rule when an adviser or its
related person serves as a qualified custodian for client assets,
and a PCAOB-registered independent public accountant must audit the
financial statements of a pooled investment vehicle to be deemed to
be in compliance with the surprise examination requirement. See
current rule 206(4)-2(a)(6) and (b)(4). As the Commission noted in
adopting these requirements in 2009, the Commission has greater
confidence in the quality of audits conducted by an independent
public accountant registered with, and subject to regular inspection
by, the PCAOB. See 2009 Adopting Release, supra footnote 11, at 17.
\390\ See, e.g., Ross L. Watts & Jerold L. Zimmerman, ``Agency
Problems, Auditing and the Theory of the Firm: Some Evidence,'' 26
J.L. Econ. 613 (1983).
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C. Baseline
The Commission assesses the economic effects of the proposed
amendments relative to the baseline of existing requirements and
practices of advisers.
1. Current Regulation
a. Custody
As discussed in greater detail in section II above, the regulatory
framework regarding safeguarding of investment adviser client assets is
set forth in rule 206(4)-2, which applies to any investment adviser
registered or required to be registered with the Commission under
section 203 of the Act that has custody of client funds or
securities.\391\ As defined by the current rule, ``custody'' means that
the investment adviser, or its related persons, holds, directly or
indirectly, client funds or securities, or has any authority to obtain
possession of them.\392\
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\391\ See rule 206(4)-2(a). Our exam program commits significant
resources ensuring advisers are in compliance with the custody rule
and verifying the existence of investor assets at custodians--a
process called asset verification. In FY 2022, EXAMS verified over
2.1 million investor accounts, totaling over $2 trillion.
\392\ Rule 206(4)-2(d)(2). The Commission stated in 2003,
however, that because a one-for-one exchange of assets represents a
limited risk of client loss, an adviser's authority to issue
instructions to a broker-dealer or another custodian to effect or to
settle trades does not constitute ``custody'' under the current
rule. See 2003 Adopting Release at footnote 10. See also rule
206(4)-2(d)(7), defining ``related person'' as ``any person,
directly or indirectly, controlling or controlled by [the investment
adviser], and any person that is under common control with [the
investment adviser].''
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The current rule requires such advisers to maintain all funds and
securities of which the adviser has custody with a ``qualified
custodian'' in separate accounts under that client's name or in
accounts containing only the funds and securities of such adviser's
clients, under the adviser's name as agent or trustee, subject to
certain exceptions.\393\ Qualified custodians generally include banks
and savings associations, broker-dealers, futures commission merchants,
and certain FFIs \394\--all of which are financial institutions that
are currently subject to regular government oversight and are subjected
to periodic inspection and examination.\395\
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\393\ See rule 206(4)-2(a)(1).
\394\ See rule 206(4)-2(d)(6).
\395\ See supra footnote 89.
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The current rule generally requires an adviser with custody of
client assets to obtain an annual surprise examination from an
independent public accountant to verify client funds and securities
independently.\396\ With certain exceptions, the adviser must report on
Form ADV whether it or its related person has custody of an advisory
client's cash, bank accounts, and securities, and disclose the details
of the custodial relationship (including, inter alia, dollar amounts,
total number of clients, distribution of quarterly account statements,
audits, annual surprise examinations, and internal control
reports).\397\
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\396\ See rule 206(4)-2(a)(4). A 2013 Government Accountability
Office (GAO) study, which examined 12 average-sized registered
advisers, found that the cost of surprise examinations ranged from
$3,500 to $31,000. The GAO noted that the costs of surprise
examinations vary widely across advisers and are typically based on
the amount of hours required to conduct the examinations, which is a
function of a number of factors including the number of client
accounts under custody. See Gov't Accountability Office, GAO-13-569,
Investment Advisers: Requirements and Costs Associated with the
Custody Rule (2013), https://www.gao.gov/assets/gao-13-569.pdf.
\397\ 17 CFR 279.1; Form ADV, Part 1A, Item 9; see also supra
notes 268-69, 271, 274-77.297, 303-309. An adviser must also include
a notice in its brochure concerning its qualified custodian's
account statement obligations, and a disclosure in its balance sheet
of any financial conditions that are reasonably likely to impair the
adviser's ability to meet contractual commitments to clients, when
the adviser has discretionary authority or custody over client funds
or securities. See Form ADV, Part 2A, Items 15, 18.
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In situations where the adviser or a related person acts as
qualified custodian, the current rule requires advisers to obtain, or
receive from its related person, an annual internal control report with
respect to the adviser's or related person's custody controls, which
includes an opinion from an independent public accountant that is
registered with, and subject to regular inspection by, the PCAOB.\398\
The required internal control report addresses the greater custodial
risks associated with situations where an adviser, or its related
person, acts as a qualified custodian.\399\
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\398\ See rule 206(4)-2(a)(6). The surprise examination must
also be conducted by a PCAOB-registered and inspected independent
public accountant. See Custody Rule Amendments Adopting Release,
supra footnote 11 (stating that the internal control report should
address control objectives and associated controls related to the
areas of client account setup and maintenance, authorization and
processing of client transactions, security maintenance and setup,
processing of income and corporate action transactions,
reconciliation of funds and security positions to depositories and
other unaffiliated custodians, and client reporting).
\399\ As noted in the Custody Rule Amendments Adopting Release,
supra footnote 11, the surprise examination alone does not
adequately address custodial risks associated with self-custody or
related-person custody because the independent public accountant
seeking to verify client assets would rely, at least in part, on
custodial reports issued by the adviser or its related person. The
internal control report can significantly strengthen the utility of
the surprise examination when the adviser or its related person acts
as qualified custodian for client assets because it provides a basis
for the independent accountant performing the surprise examination
to obtain additional comfort that the confirmations received from
the custodian are reliable.
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The current rule's requirements are, however, subject to certain
exceptions. Specifically, the current rule provides an exception to the
requirement to maintain securities with a qualified custodian for
certain ``privately offered securities''.\400\ The current rule also
provides that advisers need not comply with the requirements of rule
206(4)-2 with respect to the accounts of registered investment
companies,\401\ and allows shares of mutual funds to be maintained with
the fund's transfer agent in lieu of a qualified custodian.\402\ In
addition, an adviser that has custody solely because of its authority
to deduct advisory fees, or because a related person has custody and
such related person is operationally independent of the adviser, is not
required to obtain an annual surprise examination.\403\
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\400\ See rule 206(4)-2(b)(2). As discussed in section II.C, we
understand that demand for custodial services of privately offered
may be thin.
\401\ See rule 206(4)-2(b)(5).
\402\ Rule 206(4)-2(b)(1).
\403\ See rule 206(4)-2(b)(3), (6).
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The current rule also requires that certain communications be made
to clients. An investment adviser is required to provide its clients
notice if the adviser establishes an account with a qualified custodian
on a client's behalf.\404\ Advisers must also have a
[[Page 14736]]
reasonable basis, after due inquiry, for believing that the qualified
custodian sends an account statement, at least quarterly, to each of
the adviser's applicable clients.\405\ When an adviser has custody of
funds and securities belonging to a client that is a pooled investment
vehicle, these account statements must be sent to each limited partner,
member, or other beneficial owner if the adviser or its related person
is a general partner of a limited partnership, managing member of a
limited liability company, or holds a comparable position for another
type of pooled investment vehicle.\406\
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\404\ See rule 206(4)-2(a)(2).
\405\ See rule 206(4)-2(a)(3).
\406\ See rule 206(4)-2(a)(5).
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An adviser is not required to comply with the notice and account
statement delivery requirements of the rule and shall be deemed to
comply with the surprise examination requirement with respect to the
account of a limited partnership or other pooled investment vehicle
that is subject to annual audit, provided certain conditions are
satisfied (the ``current audit provision'').\407\ To rely on the
current audit provision, the pool's financial statements must, among
other things, be prepared in accordance with U.S. GAAP and distributed
to all limited partners (or other beneficial owners) within 120 days of
the end of the pool's fiscal year. The current audit provision also
requires the auditor to be registered with and subject to inspection by
the PCAOB.
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\407\ See rule 206(4)-2(b)(4).
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b. Recordkeeping
Rule 204-2 applies to any investment adviser registered or required
to be registered with the Commission under section 203 of the Act. This
rule requires, among other things, that an adviser make and keep a list
or other record of all client accounts for which the adviser has any
discretionary power,\408\ and copies of internal control reports
obtained or received pursuant to current rule 206(4)-2.\409\ Rule 204-2
also currently requires investment advisers subject to rule 206(4)-2 to
make and keep records regarding all purchases, sales, receipts and
deliveries of securities for such accounts and all other debits and
credits to such accounts, separate ledgers for such accounts, copies of
confirmations of all effected transactions, a record for each security
in which any such client has a position, and a memorandum describing
the basis upon which the adviser has determined that the presumption
that any related person is not operationally independent has been
overcome.\410\
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\408\ See rule 204-2(a)(8).
\409\ See rule 204-2(a)(17)(iii).
\410\ See rule 204-2(b).
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c. Regulation of Qualified Custodians
Finally, other regulations affect entities' responsibilities as
qualified custodians, namely, banks and savings associations, broker-
dealers registered with the Commission, futures commission merchants
registered with the CFTC, and FFIs. A broker-dealer acting in the
capacity of a custodian is subject to Exchange Act Rule 15c3-3, under
which customers' assets must be segregated from proprietary assets to
permit prompt return in the event of the firm's liquidation in a
proceeding under the Securities Investor Protection Act of 1970; \411\
and, where applicable, to FINRA rule 2231, requiring broker-dealers'
statements of assets to be sent to customers not less than quarterly.
Futures commission merchants are subject to Commodities Exchange Act
sections 4d(a)(2) and 4d(b) and regulations issued thereunder, which
require segregation of client funds from the entities' funds, and
impose related accounting and recordkeeping requirements.\412\ Banks
and savings associations are also subject to regulation with respect to
their custodial services. For example, under applicable Treasury
regulations, generally, a depository institution holding government
securities for its customers must segregate the customer's securities
from its own assets, free of any lien, charge, or claim of any third
party granted or created by such custodian; and it may lend the
securities to a third party only by written agreement with the customer
and in full compliance with the appropriate regulatory agency.\413\
Additionally, national banks and Federal savings associations are
subject to OCC regulations when providing fiduciary custody
services,\414\ and the OCC has provided substantial guidance with
respect to these firms' non-fiduciary custody services.\415\ As a
result, banks and savings associations have developed and deployed
comprehensive custodial service agreements governing their
relationships with their custodial customers. In addition, depository
institutions are subject to the long-standing, efficient orderly
resolution process deployed by the FDIC and non-depository member banks
are subject to the efficient orderly resolution process by the OCC.
Finally, as noted in part II.C.1, some FFIs are regulated in their
local jurisdictions and subject to laws and regulations established by
their national jurisdictions to combat money laundering and terrorism
financing, consistent with standards and measures recommended by the
FATF.
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\411\ 17 CFR 240.15c3-3. Specifically, see Rule 15c3-3(b)(1)
(requirement for a broker-dealer to promptly obtain and maintain the
physical possession or control of all fully-paid securities and
excess margin securities carried for the account of customers);
(e)(1) (requiring every broker-dealer to maintain with a bank a
``Special Reserve Bank Account for the Exclusive Benefit of
Customers'' and a ``Special Reserve Bank Account for Brokers and
Dealers,'' separate from each other and from the broker-dealer's
other bank accounts); and (f) (requiring written notification that
the bank was informed that cash or securities are being held for the
exclusive benefit of the broker-dealer's customers and account
holders, separate from the broker-dealer's other accounts; and that
the broker-dealer must have a written contract with the bank
providing that the cash or securities will not be used as security
for a loan to the broker-dealer by the bank, and will not be subject
to any right, charge, security interest, lien, or claim in favor of
the bank or any person claiming through the bank).
\412\ 7 U.S.C. 6d(a)(2), 6d(6); 17 CFR 1.20-1.30, 1.32, 1.36.
\413\ 17 CFR 450.4(a)(1), (a)(6).
\414\ See 12 CFR 9.1 et seq. (rules governing fiduciary powers
of national banks); 12 CFR 150.10 et seq. (rules governing fiduciary
powers of Federal savings associations).
\415\ See generally OCC Custody Handbook, supra note 237.
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d. Accredited Investors
Aspects of the proposed rule address investments in privately
offered securities such as investments in private companies, and
offerings made by certain hedge funds, private equity funds, and
venture capital funds.\416\ Congress and the Commission have provided
exemptions for these offerings based on various factors, including that
the offerings are generally limited to individuals and entities (e.g.,
accredited investors) that do not require the protection of
registration.\417\ Under Commission rules, qualifying as an accredited
investor allows an investor to participate in investment opportunities
that are generally not available to non-accredited investors, including
certain investments in private companies and
[[Page 14737]]
offerings by certain hedge funds, private equity funds, and venture
capital funds.
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\416\ The Securities Act of 1933 contains a number of exemptions
from its registration requirements and authorizes the Commission to
adopt additional exemptions.
\417\ Historically, the Commission has stated that the
accredited investor definition is ``intended to encompass those
persons whose financial sophistication and ability to sustain the
risk of loss of investment or fend for themselves render the
protections of the Securities Act's registration process
unnecessary.'' See Regulation D Revisions; Exemption for Certain
Employee Benefit Plans, Release No. 33-6683 (Jan. 16, 1987) [52 FR
3015 (Jan. 30, 1987)]. See also SEC v. Ralston Purina Co., 346 U.S.
119, 125 (1953) (taking the position that the availability of the
section 4(a)(2) exemption ``should turn on whether the particular
class of persons affected needs the protection of the Act. An
offering to those who are shown to be able to fend for themselves is
a transaction `not involving any public offering' '').
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e. Effect of State Law
The relationship between clients and qualified custodians is also
governed by the common law of agency and contracts, and--to the extent
adopted under state law--corresponding articles of the Uniform
Commercial Code (UCC).\418\ Thus under sections 8-504 and 8-509 of the
UCC, unless otherwise agreed to, and unless duties are specified
otherwise by statute, regulation, or rule, a custodian ``may not grant
security interests in a financial asset it is obligated to maintain''
for the client and must exercise ``due care in accordance with
reasonable commercial standards to obtain and maintain the financial
asset.'' \419\
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\418\ See supra footnotes 157, 159.
\419\ U.C.C. 8-504(b), (c), 8-509(a) (Am. L. Inst. & Unif. L.
Comm'n 2021).
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2. Affected Parties and Industry Statistics
The proposed amendments would affect registered investment
advisers, and those required to be registered, as well as current and
prospective clients of investment advisers, qualified custodians, and
independent public accountants.
a. Investment Advisers
As of June 2022 there were 15,062 investment advisers registered
with the SEC. Registered investment advisers reported $128.96 trillion
in RAUM with $117.57 trillion in 47.51 million accounts over which
advisers have discretionary authority and $11.38 trillion in 14.55
million accounts over which advisers do not have discretionary
authority.\420\ The average RAUM among registered investment advisers
was $8.56 billion and the median was $427.53 million.
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\420\ The term ``regulatory assets under management'' or
``RAUM'' refers to an adviser's assets under management as reported
in response to Item 5.F. of Part 1A of Form ADV. See Form ADV:
Instructions for Part 1A, instr. 5.b. (setting forth instructions
for calculation of assets under management for regulatory purposes).
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b. Clients
Form ADV requires investment advisers to indicate the approximate
number of advisory clients and the amount of total RAUM attributable to
various client types.\421\ Table 1 provides information on the number
of client accounts, total RAUM, and the number of advisers by client
type.
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\421\ If a client fits into more than one category, Form ADV
requires an adviser to select one category that most accurately
represents the client (to avoid double counting clients and assets).
Table 1--Investment Adviser Clients
----------------------------------------------------------------------------------------------------------------
Number of Registered
Client type clients Total RAUM investment
(thousands) (billions) advisers
----------------------------------------------------------------------------------------------------------------
Investment Companies............................................ 25 $43,838 1,603
Pooled investment vehicles--Other............................... 95 34,584 5,763
High net worth individuals...................................... 6,917 11,832 8,989
Pension Plans................................................... 431 8,106 5,271
Insurance Companies............................................. 13 7,630 1,028
Non-high net worth individuals.................................. 43,824 7,093 8,286
State/Municipal Entities........................................ 27 4,285 1,299
Corporations.................................................... 340 3,267 4,934
Foreign Institutions............................................ 2 2,209 363
Charities....................................................... 121 1,613 5,134
Other Advisers.................................................. 908 1,427 814
Banking Institutions............................................ 11 966 432
Business Development Companies.................................. <1 211 98
----------------------------------------------------------------------------------------------------------------
Source: Form ADV, Items 5D.
c. Qualified Custodians
Qualified custodians include state and federally-chartered trusts,
banks and savings associations, broker-dealers, FCMs, and certain
FFIs.\422\ The custody service industry has been characterized as
dominated by a small number of large market share participants.\423\
Several factors contribute to this: (i) economies of scale, because
custodial services require a costly infrastructure capable of
processing a large volume of transactions reliably; (ii) low margins,
which makes it difficult for new entrants to compete against
incumbents; and (iii) the importance of reputation/trust.\424\ Large
financial institutions headquartered in the U.S. dominate the global
custody service industry.\425\ In 2020, four large U.S. banks serviced
around $114 trillion of global assets under in their custody.\426\
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\422\ The FDIC reports that as of March 31, 2022, there were
4,194 FDIC-insured commercial banks and 602 FDIC-insured savings
institutions. See https://www.fdic.gov/analysis/quarterly-banking-profile/statistics-at-a-glance/2022mar/industry.pdf. We do not have
data on the number of FDIC-insured commercial banks and FDIC-insured
savings institutions providing custodial services. As of November
2022, there were 3,530 broker-dealers registered with the
Commission. See https://www.sec.gov/files/data/broker-dealers/company-information-about-active-broker-dealers/bd110122.txt. The
CFTC reports that as of September 30, 2022, there were 60 FCMs. See
https://www.cftc.gov/sites/default/files/2022-11/01%20-%20FCM%20webpage%20Update%20-%20September%202022.pdf. Out of 3,498
broker-dealers registered with the Commission, 153 were classified
as carrying broker-dealers based on FOCUS filings as of June 2022.
Per EDGAR Form Custody: A ``Carrying broker-dealer'' is a broker-
dealer that carries customer or broker or dealer accounts and
receives or holds funds or securities for those customers. We do not
have data on the number of qualifying FFIs.
\423\ Deloitte, ``The evolution of core financial service.
Custodian & Depository Banks.'' (2019), available at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf. See also
Congressional Research Service, ``Digital Assets and SEC
Regulation,'' January 30, 2020. According to this report, in 2020,
four large banks service around $114 trillion of global assets under
custody.
\424\ Charles-Enguerrand Coste et al., One size fits some:
analyzing profitability, capital and liquidity constraints of
custodian banks through the lens of the SREP methodology (Eur. Cent.
Bank Occasional Paper No. 256, 2021).
\425\ Id; see also Congressional Research Service, ``Digital
Assets and SEC Regulations,'' (Jan. 30, 2020.).
\426\ Congressional Research Service, ``Digital Assets and SEC
Regulations,'' (Jan. 30, 2020.).
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d. Independent Public Accountants
As discussed above, the current rule generally requires an adviser
with custody of client assets to obtain an annual surprise examination
from an independent public accountant.\427\ As of June 2022, 13% of
investment advisers obtain a surprise examination by an
[[Page 14738]]
independent public accountant.\428\ Not all advisers with custody,
however, are subject to an annual surprise examination. For example, as
of June 2022, 4,933 investment advisers satisfied their custody rule
obligations by complying with the current rule's audit provision.\429\
Advisers reported that 86% of the accountants performing surprise
examinations or conducting pooled investment vehicle financial
statement audits are subject to regular inspection by the PCAOB.\430\
---------------------------------------------------------------------------
\427\ See rule 206(4)-2(a)(4).
\428\ Based on advisers' responses to Item 9.C.(2) of Part 1A of
Form ADV. Comparable numbers for 2019, 2020, and 2021 were 13%, 13%,
and 13%, respectively.
\429\ Based on advisers' responses to Item 9.C.(3) of Part 1A of
Form ADV. Comparable numbers for 2019, 2020, and 2021 were 4,460,
4,565, and 4,768, respectively.
\430\ These percentages are based on advisers' responses to Item
9.C.(3) of Part 1A of Form ADV. Comparable percentages for 2019,
2020, and 2021 were 86%, 86%, and 86%, respectively.
---------------------------------------------------------------------------
Advisers that are subject to an annual surprise examination also
are required to obtain (or receive from the relevant related person) an
internal control report if the adviser or a related person of the
adviser serves as a qualified custodian for client assets. However, in
the circumstance where an adviser is deemed to have custody solely
because of a related person custodian and the related person custodian
is operationally independent of the adviser, the adviser is not
required to have an annual surprise examination but is subject to the
internal control requirement.\431\ As of June 2022, 98 investment
advisers have a control report prepared by an independent public
accountant without being subject to a surprise examination.\432\
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\431\ See rule 206(4)-2(a)(6) and (b)(6). In these
circumstances, the adviser typically receives the internal control
report from the related person custodian.
\432\ Based on advisers' responses to Item 9.C.(3) and 9.C.(4)
of Part 1A of Form ADV. Comparable numbers for 2019, 2020, and 2021
were 117, 112, and 105, respectively.
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3. Market Practice
a. Investment Advice
Academic studies have documented a number of benefits to retail
investors from receiving investment advice, including, but not limited
to: higher household savings rates, setting long-term goals and
calculating retirement needs, more efficient portfolio diversification
and asset allocation, increased confidence and peace of mind,
facilitation of small investor participation, and improved tax
efficiency.\433\ Investment advisers can also help correct potential
systematic errors that retail investors might make, including limited
allocation of savings to equities, under-diversification, or investing
too little in foreign assets.\434\
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\433\ See, e.g., Mitchell Marsden, Catherine D. Zick, & Robert
N. Mayer, The Value of Seeking Financial Advice, 32 J. Fam. & Econ.
Issues 625 (2011); Jinhee Kim, Jasook Kwon & Elaine A. Anderson,
Factors Related to Retirement Confidence: Retirement Preparation and
Workplace Financial Education, 16 J. Fin. Counseling & Plan. 77
(2005); Michael S. Finke, Sandra J. Huston, & Danielle D.
Winchester, Financial Advice: Who Pays, 22 J. Fin. Counseling &
Plan. 18 (2011); Daniel Bergstresser, John M.R. Chalmers, & Peter
Tufano, Assessing the Costs and Benefits of Brokers in the Mutual
Fund Industry, 22 Rev. Fin. Stud. 4129 (2009); Ralph Bluethgen,
Steffen Meyer & Andreas Hackethal, High-Quality Financial Advice
Wanted! (Working Paper, Feb. 2008), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1102445; Neal M.
Stoughton, Youchang Wu & Josef Zechner, Intermediated Investment
Management, 66 J. Fin. 947 (2011). Marsden et al. (2011) documents
benefits attributable to hiring a financial professional, such as
better retirement account diversification and savings goals, but
does not find that hiring a financial professional measurably
increases the amount of overall wealth accumulation for those
investors. See, also, Jeremy Burke & Angela A. Hung, Do Financial
Advisors Influence Savings Behavior?, RAND Labor and Population
Report Prepared for the Department of Labor (2015), available at
https://www.rand.org/pubs/research_reports/RR1289; Terrance Martin &
Michael Finke. ``A Comparison of Retirement Strategies and Financial
Planner Value.'' 27 J. Fin. Plan. 46 (2014); Crystal R. Hudson L &
Lance Palmer. ``Low-Income Employees: The Relationship between
Information from Formal Advisors and Financial Behaviors.'' 23 Fin.
Serv. Rev. (2014): 25; Marc M. Kramer, Financial Literacy,
Overconfidence and Financial Advice Seeking (Working Paper, Dec. 19,
2014), available at https://efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2015-Amsterdam/papers/EFMA2015_0067_fullpaper.pdf; John R. Salter, Nathan Harness & Swarn
Chatterjee. ``Utilization of Financial Advisors by Affluent
Retirees.'' 19 Fin. Serv. Rev. 245 (2010), for additional studies on
the causal relation between the use of a financial professional and
wealth accumulation. Francis M. Kinniry et al., Putting a Value on
Your Value: Quantifying Vanguard Advisor's Alpha, Vanguard Research
(Sept. 2016), available at https://advisors.vanguard.com/iwe/pdf/IARCQAA.pdf, estimates the value to investors associated with
obtaining financial advice of approximately 3% in net returns to
investors, associated with suitable asset allocation, managing
expense ratios, behavioral coaching, alleviating home bias, among
others.
\434\ See, e.g., Luigi Guiso, Paolo Sapienza & Luigi Zingales,
People's Opium? Religion and Economic Attitudes, 50 J. Monetary
Econ. 225 (2003); Laurent E. Calvet, John Y. Campbell & Paolo
Sodini, Down or Out: Assessing the Welfare Costs of Household
Investment Mistakes, 115 J. Pol. Econ. 707 (2007); Brad M. Barber &
Terrance Odean, ``Trading is Hazardous to Your Wealth: The Common
Stock Performance of Individual Investors'', 55 J. Fin. 773 (2000);
Karen K. Lewis, Trying to Explain Home Bias in Equities and
Consumption, 37 J. Econ. Literature 571 (1999). Guiso et al., 2003;
Calvet et al., 2007; Barber and Odean, 2000; Lewis, 1999. Possible
explanations for these investor mistakes may arise from behavioral
biases, such as cognitive errors, the cost of information
acquisition, or the selection of the financial professional. For
example, investors have been observed to hold too little of their
wealth in foreign assets, which is often called ``home bias.''
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Investor demand for investment advice, however, may be affected by
investor's assessment of the conflicts between themselves and
investment advisers. For example, while investors may benefit from
receiving investment advice, reports have indicated that the ability to
trust the advice of a financial professional is an important factor in
determining investors' demand for investment advice. In particular, one
academic study has shown that trust in financial institutions is
associated with the propensity to use financial advice.\435\ Based on
survey data analysis, this study found that financial trust is
correlated with the likelihood of seeking financial advice. Using data
from experiments, this study found that trust is an important predictor
of who takes up advice, even after controlling for demographic
characteristics and financial literacy.
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\435\ See, e.g., Jeremy Burke & Angela A. Hung, Trust and
Financial Advice (RAND Working Paper WR-1075, 2015).
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b. Adviser Custody
As of June 2022, 8,536 advisers (56.67% of the total number of
advisers) reported on Form ADV that they or their related persons, in
aggregate, had custody of $45.56 trillion (35.33% of aggregate RAUM) of
client assets.436 437 Advisers reported directly having
custody of approximately $21.28 trillion, and $24.28 trillion resulted
indirectly from custody through a related person. As of June 2022,
1,904 (12.64% of the total) advisers reported that an independent
public accountant conducted an annual surprise examination of client
assets.\438\ 4,933 advisers reported that an independent
[[Page 14739]]
public accountant annually audits the pooled investment vehicle(s) the
adviser manages and the audited financial statements are distributed to
investors in the pools.\439\ 1,405 (9.33% of the total) advisers
reported having a qualified custodian send quarterly statements to
investors in pooled investment vehicles.\440\ As of June 2022, 98
(0.65%) registered advisers reported that they had an internal control
report prepared by an independent public accountant but did not report
that they were subject to a surprise examination.\441\
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\436\ This analysis is based on advisers' responses to Items
9.A. and 9.B. of Part 1A of Form ADV. The instructions to Item 9.A.
of Part 1A of Form ADV provide that an adviser that has custody
solely because (i) it deducts advisory fees directly from client
accounts, or (ii) an operationally independent related person has
custody of client assets in connection with advisory services
provided to clients, should answer ``No'' in response to Item
9.A.(1), which asks whether the adviser has custody of client
assets, meaning the number of advisers with custody is likely
larger.
\437\ The total number of advisers reporting custody of client
assets or custody by a related person, in response to Items 9.A. and
9.B. of Part 1A of Form ADV was 7,424 in 2019, 7,774 in 2020, and
8,180 in 2021. As a percent of the total number of registered
advisers, the percent of advisers reporting custody of client assets
or custody by a related person in response to Items 9.A. and 9.B. of
Part 1A of Form ADV was 55.20% in 2019, 55.88% in 2020, and 55.95%
in 2021. As a percent of aggregate RAUM, advisers reporting custody
of client assets or custody by a related person in response to these
Items of Form ADV, managed 33.92% in 2019, 33.80% in 2020, and
34.44% in 2021.
\438\ Based on advisers' responses to Item 9.C.(3) of Part 1A of
Form ADV, the total number of advisers reporting that an independent
public accountant conducts an annual surprise examination of client
assets was 800 (13.38%) in 2019, 1,834 (13.18%) in 2020, and 1,887
(12.91%) in 2021.
\439\ Based on advisers responses to Item 9.C.(2) of Form ADV.
Comparable numbers for 2019, 2020, and 2021 were 4,460, 4,565, and
4,768, respectively.
In addition, based on advisers' responses to Items 9.A., 9.B.,
and 9.F., 8,165 registered advisers had custody solely because of
their authority to deduct fees in 2020 as of June 2022.
\440\ Based on advisers' responses to Item 9.C.(2) of Form ADV.
Comparable numbers for 2019, 2020, and 2021 were 1,313 (9.76%),
1,328 (9.55%), and 1,348 (9.22%), respectively.
\441\ These statistics are based on advisers' responses to Items
9.C.(3) and (4) of Part 1A of Form ADV. The comparable numbers for
2019, 2020, and 2021 were 117 (0.87%), 112 (0.81%), and 105 (0.72%),
respectively.
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As of June 2022, approximately 0.5% of all registered investment
advisers (6.51% of aggregate RAUM) acted as a qualified custodian for
their clients. Approximately 0.6% of all registered investment advisers
(23.67% of aggregate RAUM) had a related person acting as a qualified
custodian.
c. Market Practice Baseline
In addition to rule 206(4)-2, the 2009 Accounting Guidance, no-
action letters, interpretive letters, and other staff statements (some
of which are enumerated in section II.K) shape investment advisers'
custody rule compliance. For example, staff has issued 70 FAQs on a
wide range of topics, including the contours of custody and how custody
applies in the setting of pooled investment vehicles.\442\
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\442\ See supra note 17.
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Banks' practices as qualified custodians are also shaped by
guidance, such as the Office of the Comptroller of the Currency's
handbook on custody, which furnishes guidance to national banks and
savings associations acting as custodians.\443\ The OCC guidance
provides that the custodian's management has the responsibility to
assess its control environment and ensure an appropriate system of
internal controls, including separation of duties, and accounting
controls to monitor and measure transactional workflows and their
accuracy.\444\ The custodian's management should further ensure that
custody account assets are kept separate from the custodian's own
assets and maintained under joint control, and that securities under
custody are not subject to lending transactions without a written
agreement between the custodian and the client.\445\
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\443\ Off. Of the Comptroller of the Currency, Comptroller's
Handbook, Custody (2002), available at https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/index-custody-services.html.
\444\ Comptroller's Handbook, Custody at 6-7.
\445\ Id. at 14, 30.
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d. Custody Market Trends
Competition among bank qualified custodians has been characterized
as fierce, with shrinking profit margins, and the dominance of a
handful of large entities.\446\ One report noted that custodians need
to adapt and expand their service offerings to accommodate new types of
assets, such as crypto assets, and assets that are now held and
transferred using new technological methods, such as central bank
digital currencies (also known as CBDCs).\447\
---------------------------------------------------------------------------
\446\ Id. at 1. See also Deloitte, ``The evolution of a core
financial service. Custodian & Depository Banks.'' (2019) available
at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf.
See also Congressional Research Service, ``Digital Assets and SEC
Regulations,'' January (Jan. 30, 2020). According to this report, in
2020, four large banks service around $114 trillion of global assets
under custody.
\447\ See, e.g., Deloitte, ``The evolution of a core financial
service. Custodian & Depository Banks.'' (2019) available at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf.
---------------------------------------------------------------------------
The industry-reported market capitalization for crypto assets
experienced a rapid growth from $1 billion in 2018 to $1 trillion in
2021.\448\ One survey found that 16 percent of U.S. adults say they
personally have invested in, traded, or otherwise used
``cryptocurrencies.'' \449\ Institutional investors also invested in
``cryptocurrencies.'' \450\ The Commission analyzed the extent to which
investment advisers offer various kinds of services related to digital
assets.\451\ This analysis relied on Commission filings, advisers'
websites, and mentions of an adviser's services from third-party online
news sources.\452\ The analysis was conducted as of June 2022 \453\ and
focuses on the 50 largest investment advisers \454\ by RAUM. The
Commission estimates that, of these 50 largest investment advisers, (i)
21 are offering or planning on offering some services related to
digital assets,\455\ (ii) 9 are giving or planning on giving investment
advice related to digital assets,\456\ (iii) 13 provide or are planning
on providing custody of digital assets or custodial services of digital
assets,\457\ and (iv) 7 advise or are planning on advising a pooled
investment vehicle (like a fund or commodity pool) that holds some
digital assets.\458\
---------------------------------------------------------------------------
\448\ See, e.g., Deloitte, ``Market Manipulation in Digital
Assets'' (Mar. 2021), available at https://www2.deloitte.com/content/dam/Deloitte/global/Documents/Financial-Services/gx-design-market-manipulation-in-digital-assets-whitepaper-v2-1.pdf.
\449\ See ``46% of Americans who have invested in cryptocurrency
say it's done worse than expected,''.'' Pew Research Center,
Washington, DC (Aug. 23, 2022), available at https://www.pewresearch.org/fact-tank/2022/08/23/46-of-americans-who-have-invested-in-cryptocurrency-say-its-done-worse-than-expected/. Also,
another study in 2019 estimated about 40 million Americans owned
assets identified as cryptocurrencies. See Office of the Comptroller
of the Currency, Interpretative Letter #1170, July 2020.
\450\ See Office of the Comptroller of the Currency,
Interpretative Letter #1170, July 2020.
\451\ A search of Commission filings, advisers' websites, and
mentions of an adviser's services from third-party only news
services used the term ``digital assets'' because several of the
sources did not explicitly state that they were strictly referring
to crypto assets.
\452\ Filings on Form ADV did not, in all cases, provide
sufficient information to determine exactly the extent to which an
adviser offers services related to digital assets. Therefore, this
analysis relied on supplementary information obtained from advisers'
websites, online news sources, and in two cases, other forms filed
with the SEC. Both of these two cases involved funds that held
digital assets. In the case of one adviser, the staff used
information from Form D, in the case of the other the staff used
information from Form S-1. Web pages whose terms and conditions
required citation are: https://investor.vanguard.com/,
www.franklintempleton.com, www.mufg.jp, https://www.pimco.com/, and
https://citywire.com/.
\453\ Commission analysis used advisers' most recent filings
that were submitted during the period from July 2021 to June 2022.
Supplemental data from websites was evaluated in October 2022.
\454\ The Commission considered filers that represent the same
firm to be a single adviser. In aggregate, these 50 investment
advisers (i) reflect 49% of total RAUM (as reported in response to
question 5F(2)(c)), (ii) manage 37% of all accounts (as reported in
response to question 5F(2)(f)), (iii) hold 35% of client funds and
securities in investment adviser firm's custody or in a related
person's custody (as reported in response to questions 9A(2)(a) and
9B(2)(a)), and hold 32% of client funds and securities in investment
adviser firm's custody (as reported in response to question 9A(2)(a)
only).
\455\ These investment advisers comprise 67% of RAUM and manage
66% of accounts of the largest 50 investment advisers.
\456\ These investment advisers comprise 26% of RAUM and manage
41% of accounts of the largest 50 investment advisers.
\457\ These investment advisers comprise 51% of RAUM and manage
43% of accounts of the largest 50 investment advisers. They further
comprise 49% of client funds and securities in the largest fifty
investment adviser firms' custody or in related persons' custody (as
reported in response to questions 9A(2)(a) and 9B(2)(a)) and 48% of
client funds and securities in the largest fifty investment adviser
firms' custody (as reported in response to question 9A(2)(a) only).
\458\ These investment advisers comprise 67% of RAUM and manage
66% of accounts of the largest 50 investment advisers.
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The market for crypto asset custodial services continues to
develop. Our understanding is that one OCC-regulated national bank,
four OCC-
[[Page 14740]]
regulated trusts, approximately 20 state-chartered trust companies and
other state-chartered, limited purpose banking entities, and at least
one FCM currently offer custodial services for crypto assets. We also
understand that the provision of custodial services for crypto assets
can arise in the context of the trading of crypto assets. As discussed
above, many platforms that provide users with the ability to transact
in crypto assets are not qualified custodians and require investors to
pre-fund trades, a process in which investors transfer their crypto
assets or fiat currency to such a platform prior to the execution of
any trade.\459\ Our understanding is that the majority of crypto asset
trading occurs on platforms requiring pre-funding of trades, though
crypto asset trading also occurs on so-called decentralized platforms
that may not rely on pre-funding. We are aware that a limited number of
SEC-registered crypto asset securities trade on Alternative Trading
Systems (``ATSs'') that do not require pre-funding of trades.\460\ ATSs
that trade crypto asset securities follow a three-step process or four-
step process \461\ that does not involve the broker-dealer operator of
the ATS providing custodial services for the crypto asset
securities.\462\ We understand, however, that ATSs do not offer trading
of crypto asset non-securities.
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\459\ See supra, footnote 128 and accompanying text.
\460\ ATSs that do not trade NMS stocks file with the Commission
a Form ATS notice, which the Commission does not approve. In
addition, all ATSs must file quarterly reports on Form ATS-R with
the Commission. Form ATS-R requires, among other things, volume
information for specified categories of securities, a list of all
securities traded in the ATS during the quarter, and a list of all
subscribers that were participants. To the extent that an ATS trades
crypto asset securities, the ATS must disclose information regarding
its crypto asset securities activities as required by Form ATS and
Form ATS-R. Form ATS and Form ATS-R are deemed confidential when
filed with the Commission. Based on information provided on these
forms, a limited number of ATSs have noticed on Form ATS their
intention to trade certain crypto asset securities and a subset of
those ATSs have reported transactions in crypto asset securities on
their Form ATS-R.
\461\ For background on the models, the staff has noted as
follows: A non-custodial ATS four-step model involves the following
steps: Step 1--the buyer and seller send their respective orders to
the ATS; Step 2--the ATS matches the orders; Step 3--the ATS
notifies the buyer and seller of the matched trade; and Step 4--the
buyer and seller settle the transaction bilaterally, either directly
with each other or by instructing their respective custodians to
settle the transaction on their behalf. In a non-custodial ATS
three-step model involves the following steps: Step 1--the buyer and
seller send their respective orders to the ATS, notify their
respective custodians of their respective orders submitted to the
ATS, and instruct their respective custodians to settle transactions
in accordance with the terms of their orders when the ATS notifies
the custodians of a match on the ATS; Step 2--the ATS matches the
orders; and Step 3--the ATS notifies the buyer and seller and their
respective custodians of the matched trade and the custodians carry
out the conditional instructions. The custodians would then settle
the trade on behalf of the buyer and seller based on the
instructions received in Step 1. As with the four-step process, the
broker-dealer operator does not guarantee or otherwise have
responsibility for settling the trades and does not at any time
exercise any level of control over the digital asset securities
being sold or the cash being used to make the purchase (e.g., the
ATS does not place a temporary hold on the seller's wallet or on the
buyer's cash to ensure the transaction is completed) other than by
notifying the custodians for the buyer and seller, and the buyer and
seller, of the match. See finra-ats-role-in-settlement-of-digital-
asset-security-trades-09252020.pdf.
\462\ Our understanding is that for existing ATSs, custodial
services are typically provided by state-chartered trust companies
and other state-chartered, limited purpose banking entities.
---------------------------------------------------------------------------
We understand that certain advisers provide advisory services with
respect to client funds and securities that would generally result in
an adviser having ``custody'' within the meaning of the rule (e.g.,
serving as the general partner for a private fund that holds crypto
asset securities), and therefore are required to comply with the rule.
Some of these advisers, however, may not maintain their client's crypto
assets with a qualified custodian, instead attempting to safeguard
their client's crypto assets themselves--a practice that is not
compliant with the custody rule if those crypto assets are funds or
securities and do not meet an exception from the qualified custodian
requirement. Other advisers offering similar advisory services may take
the position that crypto assets are not covered by the custody rule at
all because they believe that crypto assets are neither funds nor
securities.\463\
---------------------------------------------------------------------------
\463\ This, however, is incorrect because most such assets are
likely to be funds or crypto asset securities covered by the current
rule. See infra footnote 29 and accompanying text.
---------------------------------------------------------------------------
Assets other than publicly traded stocks and bonds have
increased.\464\ One investment services industry data provider
forecasted that global assets under management across alternative asset
classes would grow by 60 percent between the end of 2020 and the end of
2025.\465\ For example, capital raised in the private equity market was
less than $60 billion in 2010. About a decade later, in 2019, capital
raised in the private equity market was more than $316 billion.\466\
Also, investor interest in physical assets may have increased.\467\ As
discussed in section II.D, safeguarding alternative assets may involve
unique procedures that differ across each specific asset type and that
substantially differ from safeguarding practices with respect to more
traditional asset classes (like equities and fixed income products).
Additionally, physical assets potentially create more complex
challenges with regard to transaction processing, monitoring, and
reporting services.\468\ The breadth and variety of alternative assets
diminish an entity's ability to scale and automate its safekeeping
services for efficiency and profitability and, therefore, entities
providing safekeeping services may be reluctant to expend the resources
necessary to accommodate such assets. As a result, custodians may
outsource the safekeeping of alternative assets to entities that
specialize in safekeeping certain asset classes.\469\
---------------------------------------------------------------------------
\464\ Financial Times, ``Global shift into alternative assets
gathers pace,'' (July 16, 2017,), available at https://www.ft.com/content/1167a4b8-6653-11e7-8526-7b38dcaef614.
\465\ See, e.g., David Lowery & Preqin Blog, ``Future of
Alternative 2025: Preqin Forecasts Alternative AUM Growth of 9.8%
though to 2025,'' (Nov. 4, 2020), available athttps://
www.preqin.com/insights/research/blogs/preqin-forecasts-alternative-aum-growth-of-9-8-percent-through-to-2025.
\466\ See, e.g., PitchBook, ``Data, Inc., A PE fundraising
record could await in 2021,'', (Dec. 15, 2020), available at https://pitchbook.com/newsletter/a-pe-fundraising-record-could-await-in-2021.
\467\ For example, the creation of art-market indices suggests
that interest in physical assets, such as fine art, may have
increased. Sotheby's, ``The Sotheby's Mei Moses Indices,'' available
at https://www.sothebys.com/en/the-sothebys-mei-moses-indices.
\468\ Deloitte, ``The evolution of core financial service.
Custodian & Depository Banks.'' (2019) available at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf.
\469\ See, e.g., Colonnade, ``Alternative Asset Custody
Services, Positive Dynamics Power Growth,'' Market Commentary--(Jan.
2015), available at https://www.coladv.com/wp-content/uploads/Alt-Asset-Admin-Jan-2015-FINAL.pdf.
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Staff has observed that custodians often include indemnification
clauses in their custodial agreements with customers. Generally, the
provisions indemnify custodial customers from losses arising out of or
in connection with the custodian's execution or performance under the
agreement to the extent the loss is caused by, among other things, the
custodian's negligence, gross negligence, bad-faith, recklessness, or
willful misconduct.\470\ Staff has also observed that the contractual
limitations on custodial liability vary between a gross negligence
standard and a simple negligence standard. Also, we understand that
some custodial agreements contain contractual language addressing when
a lien or similar claim will attach to client assets. Finally, staff
has observed a practice by custodians in which the custodian lists
assets for which it does not accept custodial
[[Page 14741]]
liability on a client's account statement on an accommodation basis
only; the custodian does not attest to the holdings of, or transactions
in, those investments or take steps to ensure that the investments are
safeguarded appropriately. The custodian reports the holdings or
transactions as reported to it by the adviser.
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\470\ Custodial agreements are generally between an advisory
client and a qualified custodian. We do not have data on custodial
agreements that would allow us to characterize the relative
frequency of various agreement provisions.
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e. Compliance Trends
In 2013, the Commission staff issued a National Exam Program
(``NEP'') Risk Alert stating that the NEP had observed widespread and
varied non-compliance with elements of the custody rule.\471\ In
reviewing examinations that contained significant deficiencies, the NEP
found that approximately one-third (over 140) included custody-related
issues. The findings from the examinations resulted in remedial
measures taken by advisers, including among other things, drafting,
amending or enhancing their written compliance procedures, policies, or
processes; changing their business practices; or devoting more
resources or attention to the area of custody.
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\471\ See, e.g., SEC, ``National Exam Program Risk Alert'' (Mar.
4, 2013), available at https://www.sec.gov/about/offices/ocie/custody-risk-alert.pdf.
---------------------------------------------------------------------------
In 2017, the Commission staff issued a NEP Risk Alert reporting
that deficiencies or weaknesses related to the custody rule were among
the five most frequent compliance topics identified during examinations
of investment advisers.\472\ Typical examples of deficiencies or
weaknesses with respect to the custody rule identified by the staff
were: (1) advisers did not recognize that they may have custody due to
online access to client accounts, (2) advisers with custody obtained
surprise examinations that did not meet the requirements of the custody
rule, and (3) advisers did not recognize that they may have custody as
a result of certain authority over client accounts.
---------------------------------------------------------------------------
\472\ See, e.g., SEC, ``National Exam Program Risk Alert'' (Feb.
7, 2017), available at https://www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdfhttps://www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdf..
https://www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdf.
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In 2021, the Division of Examinations issued a Risk Alert stating
that in its experience, a number of activities related to digital asset
securities presented specific risks to investors.\473\ Included among
the risks identified by the Division of Examinations were risks related
to advisers' crypto asset custodial practices and their compliance with
the custody rule. As discussed above, the custody rule was designed to
help ensure advisers adequately safeguard client investments in their
custody by requiring advisers to take steps to mitigate the risk that
client investments will be lost, misused, stolen, misappropriated, or
subject to the financial reverses, including insolvency, of an
investment adviser.\474\ Crypto assets are not exempt from these risks.
Based on that experience, the Division of Examinations indicated that
it would continue to review the risks and practices related to crypto
asset custody and examine for compliance with the custody rule.\475\
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\473\ See Division of Examinations, ``Risk Alert: The Division
of Examinations' Continued Focus on Digital Asset Securities'' (Feb.
26, 2021), available at https://www.sec.gov/files/digital-assets-risk-alert.pdf.
\474\ See section I infra.
\475\ Specifically the Division of Examinations stated that
staff would review: (i) occurrences of unauthorized transactions,
including theft of digital assets, (ii) controls around safekeeping
of digital assets (e.g., employee access to private keys and trading
platform accounts), (iii) business continuity plans where key
personnel have exclusive access to private keys, (iv) how the
adviser evaluates harm due to the loss of private keys, (v)
reliability of software used to interact with relevant digital asset
networks, (vi) storage of digital assets on trading platform
accounts and with third party custodians, and (vii) security
procedures related to software and hardware wallets.
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D. Benefits and Costs of Proposed Rule and Form Amendments
1. Scope
The proposed rule would change the current rule's scope in two
ways. First, it would expand the types of investments covered by the
rule beyond a client's funds or securities to include other positions
held in a client's account that are not funds or securities. Second,
the proposed rule would make explicit that the current rule's defined
term ``custody'' includes discretionary trading authority. The scope of
the rule determines, in part, the costs and benefits of the regulatory
program set forth by the other components of the proposed rule (the
``programmatic effects'').
a. Scope of Assets
The proposed rule's expanded scope would include all client assets
for which an adviser has custody. The proposed rule would define
``assets'' as ``funds, securities, or other positions held in a
client's account.'' \476\ Assets under the rule also would include
financial contracts held for investment purposes, collateral posted in
connection with a swap contract on behalf of the client, and other
assets that may not clearly be funds or securities covered by the
current rule. ``Other positions held in the client's account'' covers
current asset types and asset types that develop in the future
regardless of their status as funds or securities. The addition of
``other positions held in the client's account'' would also include
crypto assets when not otherwise covered by the rule's references to
funds and securities.\477\ Further, the proposed rule's use of the term
``assets'' would not exclude client investments that may appear in the
liabilities column of a balance sheet or that may be represented as a
financial obligation of the client including short positions, written
options, or negative cash.
---------------------------------------------------------------------------
\476\ Proposed rule 223-1(d)(1).
\477\ See Part II.A, supra.
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We believe that the proposed rule reduces the risk of loss of
client assets by expanding the types of assets covered by the rule
beyond ``funds and securities.'' Bringing more categories of assets
into the scope of the rule's requirements will protect investors
because the assets will be subject to custodial safeguards. Expanding
the scope of the rule will also reduce uncertainty over the status of
assets under advisement that must be held in the custody of a qualified
custodian, thereby reducing the legal risk associated with advisory
services and custodial arrangements for the assets. This may increase
investment opportunities and the availability of advisory services for
those assets. Looking forward, the proposed definition of assets is
designed to remain evergreen, encompassing new investment types as they
continue to evolve and to recognize that the protections of the rule
should not depend on which type of assets the client entrusts to the
adviser.
Expanding the scope of the custody rule to include client assets
instead of only client funds and securities would also involve costs.
We expect that this expansion in scope would cause advisers to incur
compliance costs in connection with these newly covered investment
positions. Accordingly, advisers with custody of such assets would
incur additional costs to ensure their safeguarding practices with
respect to such assets comply with the custody rule; for example, the
costs associated with finding a qualified custodian that is able to
take possession or control of these assets. Rather than incur such
costs, advisers may continue providing advice with respect to clients'
funds and securities, but stop providing advice with respect to
clients' other assets within the scope of the expanded
[[Page 14742]]
rule.\478\ Investment advisers may accordingly eliminate the aspect of
their services that gives them custody (they may decline the authority
to hold or take possession of the other assets, including any
discretionary authority to withdraw or transfer beneficial ownership of
such assets). To the extent clients benefit from advice on such other
assets--which may be merely ancillary to advice on funds and
securities--investors would no longer receive these benefits.\479\
Also, advisers would forego any fees associated with providing such
services.
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\478\ Analysis described in section III.C.3.d indicates that
seven advisers either currently advise, or are planning to advise, a
pooled investment vehicle (such as a private fund or commodity pool)
that holds some crypto assets. To the extent these pooled investment
vehicles hold crypto assets that may be outside of the current
rule's scope (i.e., they are neither funds nor securities), those
assets would be within the scope of the proposed rule. To the extent
that it becomes cost-prohibitive for advisers to find a qualified
custodian, or otherwise comply with the proposed rule with respect
to these newly covered crypto assets, we believe that advisers may
choose to cease providing advisory services to pooled investment
vehicles holding such assets, implying these pooled investment
vehicles may no longer be offered to investors.
\479\ To the extent competition in the market for those aspects
of services that gives advisers custody is linked to the number of
advisers offering such services, advisers choosing to eliminate the
aspect of their services that gives them custody could result in a
reduction in competition. A reduction in competition could result in
higher fees for investors, lower quality services, or some
combination of the two.
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The expanded scope of assets subject to the proposed rule could
create other costs. For example, as discussed above, the staff has
observed a growing number of state-chartered trust companies and other
state-chartered, limited purpose banking entities now offering
custodial services for crypto assets. Also, the staff has observed an
increase in the number of entities that provide platform users with the
ability to transact in crypto assets. In connection with these
services, these entities and/or their agents might safeguard the
platform user's crypto asset(s) and also maintain the cryptographic key
information necessary to access the crypto asset.
The expanded scope of assets subject to the proposed rule could
create costs for those advisers (and their clients) with custody of
crypto assets that are not funds or securities subject to the current
custody rule. For example, to the extent advisers have custody of
client crypto assets that are not funds or securities and those assets
are maintained with state-chartered trust companies, other state-
chartered, limited purpose banking entities, and entities providing
platform users with the ability to transact in crypto assets who may
choose not to make the changes necessary to satisfy all of the
requirements to act as a qualified custodian under the proposed rule,
the proposed rule would require such crypto assets to be removed from
those entities. Removing assets from those entities could create costs
for investors. For example, there would be costs associated with
switching from one entity to another. As we noted in section II.C.3,
the technical requirements for transacting and safeguarding crypto
assets are likely to differ from those of traditional assets that
include stocks, bonds, and options. The proposed rule could cause
investors to remove their assets from an entity that has developed
innovative safeguarding procedures for those assets, possibly putting
those assets at a greater risk of loss. These costs would be mitigated,
however, to the extent existing qualified custodians develop, or
otherwise acquire, innovative safeguarding procedures for crypto
assets, or are able to contract with specialized sub-custodians, as a
result of the proposed rule.
If investors remove newly scoped-in assets from entities currently
providing safeguarding services, those entities providing safeguarding
services will experience a decline in fees because they would be
providing custody for fewer assets. For example, if investors remove
their crypto assets that are not funds or securities subject to the
current rule from entities such as state-chartered trust companies,
other state-chartered, limited-purpose banking entities, and entities
providing platform users with the ability to transact in crypto assets,
those entities could experience a decline in fees. The extent of the
decline in fees would depend on investors' holdings of crypto assets
that are not funds or securities subject to the current rule, the rates
charged by those entities for safeguarding crypto assets, as well as
the extent to which investors remove their crypto assets from those
entities. We do not have data that would allow us to predict accurately
investor holdings of crypto assets or the extent to which investors
would remove crypto assets from those entities, or the resulting effect
on profitability. A sufficiently large decline in profitability could
lead such entities to reconsider their business models or exit the
business altogether.
This aspect of the proposed rule could create additional costs as
well. Independent public accountants would have to perform verification
procedures over a larger universe of investments which could increase
the cost of performing verification procedures. Absent an increase in
the capacity of independent public accountants, the increased demand on
the services of independent public accountants resulting from having to
perform verification procedures over a larger universe of assets could
result in increased costs for accountant services generally. To the
extent independent public accountants reallocate resources away from
other services to meet the increased demand for asset verification,
other services provided by independent public accountants could become
more costly. That said, as a result of requiring that all assets be
held in the possession or control of a qualified custodian, performing
verification procedures may be less labor-intensive and less costly
than under the current rule.
b. Scope of Activity Subject to the Proposed Rule
The proposal would generally preserve the current rule's definition
of ``custody''. The current definition of custody includes three
categories that serve as examples of custody including certain
arrangements when the adviser is authorized or permitted to instruct
the client's custodian. The proposed rule would explicitly identify
discretionary trading authority as an arrangement that triggers the
rule. An adviser with this ability or authority can subject a client's
assets to the risks of loss, misuse, misappropriation, theft, or
financial reverses of the adviser. The proposed rule would also expand
the scope of subject activity by explicitly identifying discretionary
trading authority as an arrangement that triggers the rule.
The authority for discretionary trading presents the kinds of risks
to client assets that the rule is designed to address. When advisers
have this authority, they have the ability to sell or purchase assets
for the client's account without first obtaining client consent. This
creates an opportunity for an adviser to put those assets at risk of
loss, misuse, misappropriation, theft, or financial reverses of the
adviser. If an adviser has custody solely because the adviser has
discretionary authority that is limited to instructing the custodian to
transact in assets that settle on a DVP basis, the risk of loss is less
pronounced, though not completely eliminated, when a client's custodian
must participate in the transaction. In those cases, the custodian will
observe, and record on a client's account statement, that assets are
transferred out of a client's account only upon corresponding transfer
of other assets of equal value into the account. Although the risk of
loss is not reduced to zero in these situations, the client is at least
on
[[Page 14743]]
notice via the account statement from the custodian that a transaction
has occurred. The proposed rule would thus benefit clients by extending
the protections of the rule, namely the protections of the qualified
custodian and the account statement reporting, to instances where an
adviser has discretionary trading authority. The benefits will be
mitigated to the extent that advisers comply with the rule today for
reasons other than discretionary trading authority.
Advisers who currently do not need to comply with the rule for this
type of authority will bear the costs of compliance with the rule.
Those costs will be mitigated to the extent that advisers comply with
the rule today for reasons other than discretionary trading authority.
For example, if advisers also have a general power of attorney with
respect to the same assets, such advisers already have custody of these
assets under the current rule. For advisers that will be newly subject
to the rule as a result of this change, the costs of compliance will be
reduced if discretionary trading authority is their sole reason for
having custody because they will not have to comply with the surprise
examination requirement.\480\
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\480\ Proposed rule 223-1(b)(9).
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Investment advisers with custody of client assets because of
discretionary trading authority may continue to provide discretionary
trading services to their clients, or, as discussed above, they may
choose to no longer provide advice on assets which are not funds or
securities and, accordingly, no longer exercise custody (including
discretionary trading) for such other assets as a result of the
compliance costs. If advisers choose to no longer offer discretionary
trading services for assets other than funds or securities, to the
extent clients benefit from those discretionary trading services,
investors would bear a cost associated with the loss of those services
or with finding an investment adviser that provides them.
2. Qualified Custodian Protections
As discussed in section II.B above, the proposed rule would require
investment advisers to maintain client assets with a qualified
custodian having ``possession or control'' of client assets pursuant to
a written agreement between the qualified custodian and the investment
adviser. The term ``possession or control'' would mean holding assets
such that the qualified custodian is required to participate in any
change in beneficial ownership of those assets, the qualified
custodian's participation would effectuate the transaction involved in
the change in beneficial ownership, and the qualified custodian's
involvement is a condition precedent to the change in beneficial
ownership. In the case of a qualified custodian that is the adviser,
the proposed rule would require that the written agreement be between
the adviser and the client.\481\
---------------------------------------------------------------------------
\481\ Proposed rule 223-1(a)(1)(i).
---------------------------------------------------------------------------
The proposed rule also would require the adviser to obtain
reasonable assurances in writing from the custodian regarding certain
vital protections for the safeguarding of client assets. If the
qualified custodian is the adviser, the proposed rule would require
that the reasonable assurances be part of the written agreement between
the adviser and the client, described above.\482\
---------------------------------------------------------------------------
\482\ Proposed rule 223-1(a)(1)(ii).
---------------------------------------------------------------------------
a. Definition of Qualified Custodian
Banks. The current rule includes in the definition of qualified
custodian a bank as defined in section 202(a)(2) of the Advisers Act
(15 U.S.C. 80b-2(a)(2)) or a savings association as defined in section
3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1))
that has deposits insured by the Federal Deposit Insurance Corporation
under the Federal Deposit Insurance Act (12 U.S.C. 1811). The proposed
rule would largely retain this definition of qualified custodian
relating to banks and savings associations. However, in connection with
the proposed rule's focus on setting certain minimum protections for
client assets, the rule would require that a qualifying bank or savings
association hold client assets in an account designed to protect such
assets from creditors of the bank or savings association in the event
of the insolvency or failure of the bank or savings association in
order to qualify as a qualified custodian. While applicable insolvency
law and procedures vary depending on any particular bank's regulatory
regime, we understand that assets held in these accounts are more
likely to be returned to clients upon the insolvency of the qualified
custodian because they may pass outside of a bank's insolvency, may be
recoverable if wrongly transferred or converted, and are not treated as
general assets of the bank.\483\
---------------------------------------------------------------------------
\483\ See supra footnote 96.
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We believe that requiring banks and savings associations to hold
client assets in an account designed to protect such assets from
creditors of the bank or savings association in the event of the
insolvency or failure of the bank or savings association would benefit
clients by providing client assets with enhanced protection from
general creditors in the event of the qualified custodian's insolvency
or failure and increasing the likelihood of return of client assets to
advisory clients upon a qualified custodian's insolvency or failure. We
acknowledge, however, that the benefit would be limited to the clients
of those qualified custodians that would not be subject to the
resolution processes deployed by the FDIC or by the OCC or have not
developed and deployed comprehensive custodial service agreements
governing their relationships with their custodial customers. For those
custodians that would not be subject to the resolution processes
deployed by the FDIC or by the OCC or have not developed and deployed
comprehensive custodial service agreements governing their
relationships with their custodial customers, we estimate that changing
the terms of account agreements to comply with the proposed account
requirement would require 1 hour from an assistant general counsel
($510/hour) and 5 hours from a paralegal ($199/hour), for a total
estimated cost of $1,505 per agreement.
Foreign Financial Institutions. The proposed definition of
qualified custodian would continue to include FFIs, but would require
an FFI to satisfy certain additional conditions in order to serve as a
qualified custodian for client investments. For an FFI to be a
qualified custodian under the proposed rule, it would need to be:
Incorporated or organized under the laws of a country or
jurisdiction other than the United States, provided that the adviser
and the Commission are able to enforce judgments, including civil
monetary penalties, against the FFI;
Regulated by a foreign country's government, an agency of
a foreign country's government, or a foreign financial regulatory
authority \484\ as a banking institution, trust company, or other
financial institution that customarily holds financial assets for its
customers;
---------------------------------------------------------------------------
\484\ Defined in section 202(a)(24) of the Advisers Act [15
U.S.C. 80b-2(a)(24)].
---------------------------------------------------------------------------
Required by law to comply with anti-money laundering and
related provisions similar to those of the Bank Secrecy Act [31 U.S.C.
5311, et seq.] and regulations thereunder;
Holding financial assets for its customers in an account
designed to protect such assets from creditors of the foreign financial
institution in the event of the insolvency or failure of the foreign
financial institution;
[[Page 14744]]
Having the requisite financial strength to provide due
care for client assets;
Required by law to implement practices, procedures, and
internal controls designed to ensure the exercise of due care with
respect to the safekeeping of client assets; and
Not operated for the purpose of evading the provisions of
the proposed rule.\485\
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\485\ Proposed rule 223-1(d)(10)(iv).
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As discussed in section II.B.1.b above, these proposed conditions
are partly drawn from our experience with the conditions on the types
of foreign financial entities that can act as ``eligible foreign
custodians'' as defined in rule 17f-5 under the Investment Company
Act.\486\ Such conditions are designed to provide enhanced investor
protections for advisory clients and their assets that we believe would
help promote an FFI having generally similar protections as a U.S.-
based qualified custodian.
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\486\ Furthermore, the proposed rule would replace and
strengthen the segregation requirement applicable to FFIs in the
current custody rule, and it is designed to complement the proposed
segregation requirements of the safeguarding rule.
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Advisory clients often invest in securities traded on foreign
exchanges and their advisers must, as a practical matter, maintain
securities with financial institutions in foreign countries where the
securities are traded. In order to facilitate these types of holdings,
the current rule includes any FFI that customarily holds financial
assets for its customers, as qualified custodian, provided that the FFI
keeps the advisory clients' assets in customer accounts segregated from
its proprietary assets. The proposed new conditions would require that
an FFI have similar protections as a U.S.-based qualified custodian,
thereby enhancing investor protections for advisory clients by reducing
the risk of loss of their securities and other financial assets held
outside the United States. For example, for an FFI to be a qualified
custodian under the proposed rule it would need to be regulated by a
foreign country's government, an agency of a foreign country's
government, or a foreign financial regulatory authority as a banking
institution, trust company, or other financial institution that
customarily holds financial assets for its customers. An FFI also would
have to be required by law to comply with AML requirements and related
requirements comparable to those of the Bank Secrecy Act.\487\ We
believe the requirement to comply with AML and related provisions
similar to those of the BSA and regulations thereunder would help
increase the likelihood that the FFI would readily identify and
investigate aberrant behavior in a client account, such as activity
that might suggest misappropriation or some other type of loss to a
client. An FFI also would have to hold financial assets for its
customers in an account designed to protect such assets from creditors
of the foreign financial institution in the event of the insolvency or
failure of the foreign financial institution. We believe this
requirement would help to promote investor protections that are more
comparable, particularly in the event of an FFI insolvency or
bankruptcy, to those we are proposing for assets held with U.S.-
regulated bank or savings association qualified custodians.
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\487\ Proposed rule 223-1(d)(10)(iv)(C); see also pt. II.B.1.
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FFIs that no longer meet the conditions to be a qualified custodian
would either incur costs to become compliant, or incur costs in the
form of lost custodial business, and potential loss of other banking
business from the same clients. Clients of FFIs that incur costs to
become compliant may experience higher fees. Clients whose assets were
maintained with banks and savings associations that do not comply with
the proposed requirements would incur one-time costs related to
switching custodians or, if no financial institutions qualify as
custodians in a country where securities are traded on a foreign
exchange,\488\ costs associated with divestiture, potentially at a
loss. Advisers would incur costs associated with loss of client assets
under management. The magnitude of these costs would depend on the
number of client accounts and the quantity of assets affected.\489\
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\488\ This could occur if, for example, if the country does not
have a regulatory framework equivalent to the Bank Secrecy Act
requirements for reporting transactions to financial intelligence
authorities.
\489\ We do not have data on the number of client accounts and
the quantity of assets affected.
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b. Possession or Control
Under the custody rule, advisers with custody of client funds and
securities must maintain them with a qualified custodian, subject to
certain exceptions.\490\ The proposed rule would require that an
investment adviser with custody of client assets maintain those assets
with a qualified custodian that must maintain possession or control of
those assets.\491\ The term ``possession or control'' would mean
holding assets such that the qualified custodian is required to
participate in any change in beneficial ownership of those assets, the
qualified custodian's participation would effectuate the transaction
involved in the change in beneficial ownership, and the qualified
custodian's involvement is a condition precedent to the change in
beneficial ownership.\492\
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\490\ See rule 206(4)-2(a)(1).
\491\ See proposed rule 223-1(a)(1)(i).
\492\ See proposed rule 223-1(d)(8).
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The proposed requirement would benefit clients in several ways.
First, a critical custodial function is to prevent loss or unauthorized
transfers of ownership of client assets. It is our understanding that a
custodian will only provide this safeguarding function and assume
custodial liability for a custodial customer's loss if the custodian
has possession or control of the asset that is lost. Second, because
the qualified custodian would be required to participate in any change
in beneficial ownership of a client asset, the qualified custodian's
participation would effectuate the transaction involved in the change
in beneficial ownership, and the qualified custodian's involvement is a
condition precedent to the change in beneficial ownership, the proposed
possession or control definition would provide assurance to the client
that a regulated party who is hired for safekeeping services by the
client to act for the client is involved in any change in beneficial
ownership of the client's assets. Further, clients would be able to
review their account statements to evaluate the legitimacy of any
movement within their account, whether it is a trade, a payment, or a
fee withdrawal. Finally, clients could take greater comfort that what
is reported on their account statements is an accurate attestation of
holdings and transactions because anything held by a qualified
custodian would be required to be in its possession or control.
The proposed definition is designed to be consistent with the laws,
rules, or regulations administered by the qualified custodian's
functional regulator for purposes of its custodial activities. As
detailed in section II.C.2 above, this would include Exchange Act
requirements for broker-dealers, regulatory requirements for national
banks, Commodity Exchange Act requirements for FCMs, as well as the
broad range of regulatory requirements for FFIs. Given the proposed
definition's consistency with the laws, rules, or regulations
administered by a qualified custodian's functional regulator, we
believe the additional cost of the proposed definition of ``possession
or control'' on qualified custodians would be minimal.
[[Page 14745]]
It is our understanding that custodians have been unwilling or
unable to take possession or control of certain investments, such as a
variety of privately issued securities. Advisers sometimes request that
custodians report these securities as an ``accommodation'' on a
custodial account statement so that the client is aware of their
existence. We acknowledge, however, that to the extent account
statements provided by a qualified custodian on an accommodation basis
offer a client the ability to review all of its investments in a single
consolidated account statement, and potentially alert a client or an
auditor to the existence of an investment, the proposed rule's
elimination of the custodian's ability to provide account statements on
an accommodation basis could impose a cost on investors. Clients would
bear costs to collect information from multiple sources rather than
relying on a single consolidated account statement.\493\ If a client
requests such assets be included on its account statement, the account
statement may identify the assets, but only if the account statement
clearly indicates that the custodian does not have possession or
control of the assets.\494\
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\493\ It is possible that the requirement could lead to reduced
costs for custodians. Our understanding, however, is that the
custodian merely reports the holdings or transactions as reported to
it by the adviser--the custodian does not attest to the holdings of
or transactions in those investments or take steps to ensure that
the investments are safeguarded appropriately. As a result, we would
expect cost savings for custodians to be minimal.
\494\ See supra note 185.
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c. Reasonable Assurances
We understand that under existing market practices, advisers are
rarely parties to the custodial agreement, which is generally between
an advisory client and a qualified custodian. The proposed rule would
require an adviser to obtain reasonable assurances in writing from
qualified custodians regarding certain vital protections for the
safeguarding of client assets and that the adviser maintain an ongoing
reasonable belief that the custodian is complying with the client
protections for which the adviser obtains reasonable assurances.
i. Benefits
Due Care. The proposed rule would require that the adviser obtain
reasonable assurances from the qualified custodian that the qualified
custodian will exercise due care in accordance with reasonable
commercial standards in discharging its duty as custodian and will
implement appropriate measures to safeguard client assets from theft,
misuse, misappropriation, or other similar types of loss.\495\ We
recognize that the appropriateness of the measures required to
safeguard assets varies depending on the asset.\496\ We believe such
appropriate measures would, in turn, mitigate the risk to client assets
from theft, misuse, misappropriation, or other similar types of loss.
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\495\ Proposed rule 223-1(a)(1)(ii)(A).
\496\ See discussion in section II.B.3.a.i and supra footnote
154.
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Indemnification. The proposed rule would require the adviser to
obtain reasonable assurances from the qualified custodian that the
qualified custodian will indemnify the client (and will have insurance
arrangements in place that will adequately protect the client) against
the risk of loss in the event of the qualified custodian's own
negligence, recklessness, or willful misconduct.\497\ Our staff has
observed that custodians often include indemnification clauses in their
custodial agreements with customers. Staff has also observed that the
contractual limitations on custodial liability vary widely in the
marketplace, in some instances reducing a qualified custodian's
liability to such an extent as to not provide an appropriate level of
investor protection. By requiring advisers to obtain reasonable
assurances from the qualified custodian that the qualified custodian
will indemnify the client against the risk of loss in the event of the
qualified custodian's own negligence, recklessness, or willful
misconduct, the proposed rule seeks to create a minimum floor of
custodial protection for investors in the event of custodial misconduct
(i.e., simple negligence). For those investors whose qualified
custodians indemnify the client against the risk of loss in the event
of the qualified custodian's gross negligence, the proposed requirement
that an adviser obtain reasonable assurances from the qualified
custodian that the qualified custodian will indemnify the client
against the risk of loss in the event of the qualified custodian's own
negligence, recklessness, or willful misconduct would likely operate as
a substantial expansion in the protections provided by qualified
custodians to advisory clients by preventing these custodians from
disclaiming liability for misconduct that does not rise to the level of
gross negligence.
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\497\ Proposed rule 223-1(a)(1)(ii)(B).
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Sub-custodian or Other Similar Arrangements. The proposed rule
would require the adviser to obtain reasonable assurances from the
qualified custodian that the existence of any sub-custodial, securities
depository, or other similar arrangements with regard to the client's
assets will not excuse its obligations to the client.\498\
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\498\ Proposed rule 223-1(a)(1)(ii)(C).
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As discussed in section II.B.3.a.3 outsourcing has become
increasingly common in the custodial space, whether outsourcing of
back-office functions or the core function of safeguarding a custodial
customer's assets. Additionally, we understand that the delegation of
safeguarding to sub-custodians can result in opaque structures; for
example, involving several FFI sub-custodians in different countries.
This proposed requirement would enhance investor protections by
reducing the ability of a qualified custodian to avoid responsibility
for the other important safeguarding obligations it has to the advisory
client by delegating custodial responsibility to a sub-custodian,
securities depository, or other similar arrangements. To the extent
advisory clients are aware of risks resulting from a qualified
custodian delegating its safeguarding obligations to a sub-custodian,
we believe that this requirement would give advisory clients greater
confidence that their assets maintained with a qualified custodian
would not lose protections as a result of such a delegation.
Segregation of Client Assets. The proposed rule would require the
adviser to obtain reasonable assurances from the qualified custodian
that the qualified custodian will clearly identify the client's assets
as such, hold them in a custodial account, and segregate them from the
qualified custodian's proprietary assets.\499\ The proposed requirement
would benefit investors by helping to ensure that client assets are at
all times readily identifiable as client property and remain available
to the client even if the qualified custodian becomes financially
insolvent. We believe this proposed requirement would also benefit
clients by helping to protect client assets from claims by a qualified
custodian's third-party creditors looking to secure or satisfy an
obligation of the qualified custodian. We believe that the proposed
requirement would also benefit clients by helping to identify clearly
client assets as belonging to the appropriate client and, in the
context of an FFI in a region facing political risk, we believe these
actions would help to preserve the client's interests in the event of a
government taking.
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\499\ Proposed rule 223-1(a)(1)(ii)(D).
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No Liens Unless Authorized in Writing. The proposed rule would
[[Page 14746]]
require the adviser to obtain reasonable assurances from the qualified
custodian that the qualified custodian will 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.\500\ This
requirement would benefit clients by discouraging qualified custodians
from using client assets in a manner not authorized by the client,
reducing the risk of loss of client assets. The requirement would also
help reduce the risk of the loss of client assets to claims by the
qualified custodian, or a third party looking to secure or satisfy an
obligation of the qualified custodian, including in cases of the
qualified custodian's insolvency or bankruptcy. The magnitude of the
benefits will depend on the extent to which such arrangements may
already be common. As discussed in section II.B.3.a.v, we believe that
many qualified custodians maintain their custodial customer assets free
of liens and similar claims, other than those agreed to or authorized
in writing by the client. Further, we understand that some custodial
agreements contain contractual language addressing when a lien or
similar claim will attach to client assets.
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\500\ See proposed rule 223-1(a)(1)(ii)(E).
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ii. Costs
Obtaining Reasonable Assurances. The proposed rule would require an
adviser to obtain reasonable assurances in writing from a qualified
custodian regarding certain client protections. As discussed above, one
way that advisers are likely to satisfy this requirement is by seeking
confirmation from a qualified custodian that the custodial agreement
with the advisory client contains contractual language reflecting the
reasonable assurances required by the rule. The reasonable assurances
requirement could also require conforming changes in custody agreements
between clients and qualified custodians. The cost of obtaining
reasonable assurances and conforming changes in custody agreements
include costs attributable to attorneys and compliance professionals,
both prior to and at the inception of the relationship between a client
and a qualified custodian as well as over the life of the relationship.
We describe the nature of these costs in detail below. For purposes of
the Paperwork Reduction Act, we estimate that qualified custodians and
advisers will incur aggregate initial costs of $27,469,680 associated
with advisers obtaining reasonable assurances from qualified
custodians.\501\ The requirements that an adviser obtain reasonable
assurances from qualified custodians also will require due diligence
and periodic monitoring by the adviser. For purposes of the Paperwork
Reduction Act, we estimate that qualified custodians and advisers will
incur aggregate ongoing annual costs of $5,493,936 associated with
advisers obtaining reasonable assurances from qualified
custodians.\502\
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\501\ See infra footnote 620.
\502\ See infra footnote 622.
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Due Care. The proposed due care requirement is the same as the
standard that generally applies to custodians under Article 8 of the
Uniform Commercial Code.\503\ As a result, we believe the proposed
standard of care is not uncommon in the custodial market, and that
financial institutions acting as qualified custodians are familiar with
it. We believe, however, that the standard of care is not universal in
the custodial market. As discussed above, this requirement may result
in certain qualified custodians incurring costs to change the terms of
their custodial agreements with advisory clients to incorporate this
standard.\504\
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\504\ See infra footnote 619.
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Indemnification. As discussed above, staff has observed that the
contractual limitations on custodial liability vary widely in the
marketplace. The proposed rule seeks to create a minimum floor of
custodial protection for investors in the event of custodial
misconduct. First, the proposed simple negligence requirement could
impose operational costs on those custodians holding advisory client
assets subject to a gross negligence standard. The operational costs
would include the costs of adapting existing systems and processes to
meet the more stringent simple negligence standard. Second, the
insurance requirement of the proposed indemnification requirement would
likely create a substantial increase in the cost of liability insurance
for custodians that currently do not insure against loss resulting from
simple negligence. We note, however, that operational costs and costs
of liability insurance would be mitigated to the extent custodians who
currently hold client assets subject to a gross negligence standard
already have systems, processes and liability insurance that are
consistent with a simple negligence standard.
Sub-custodian or Other Similar Arrangements. As discussed above,
staff has observed custodial agreements addressing the use of sub-
custodians that seek to contractually limit the custodian's liability
for acts or omissions of the sub-custodian in a variety of ways,
including expressly limiting the contractual liability of the custodian
for acts of the sub-custodian, as well as limiting the affirmative
steps the custodian may be required to take in connection with any loss
of client assets as a result of the sub-custodian's willful default or
insolvency. The proposed reasonable assurances requirement could impose
operational costs on those custodians who make use of sub-custodial,
securities depository, or other similar arrangements and who would seek
to disclaim responsibility in circumstances where a loss or other
failure to satisfy its obligations to the client can be attributed to a
sub-custodian or other third party selected by the qualified custodian.
The operational costs would include the costs of adapting existing
systems and processes to meet the proposed requirement. We note,
however, that the costs would be mitigated to the extent custodians who
make use of sub-custodial, securities depository, or other similar
arrangements already have systems and processes in place that are
consistent with the proposed requirement.
Segregation of Client Assets. We understand that custodial
agreements between advisory clients and qualified custodians may
currently contain a contractual provision requiring segregation of
client assets from the custodian's assets. In addition, we understand
that many qualified custodians are currently required by their
functional regulator to segregate assets. The proposed segregation
requirements are drawn from rule 15c3-3 of the Exchange Act. To the
extent existing regulatory requirements for qualified custodians are
the same or similar to the requirements of 15c3-3, the costs of
adapting existing systems may be mitigated for broker-dealers who act
as qualified custodians. For example, rule 15c3-3 of the Exchange Act
requires broker-dealers to safeguard their customer assets and keep
customer assets separate from the firm's assets. Given their existing
regulatory requirements, we believe custodian broker-dealers already
have systems to segregate customer assets from their own and, as a
result, the cost of the proposed requirement for broker-dealer
qualified custodians largely would be mitigated. Other regulatory
regimes have adopted similar requirements. For example, under the
Commodity Exchange Act, futures commission merchants are required to
segregate customer assets from their own
[[Page 14747]]
assets.\505\ Because futures commission merchants already have systems
to segregate customer assets from their own, we believe their cost of
meeting the segregation requirement of the proposed rule would also
largely be mitigated for futures commission merchants.
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\505\ See discussion in section III.C.1.
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We believe, however, that not all financial institutions that serve
as qualified custodians are required to segregate and identify their
client assets, particularly FFIs. In addition, for those qualified
custodians that are required to segregate and identify their client
assets, the extent of those activities varies.\506\ To the extent
certain custodians currently do not segregate client assets, the
reasonable assurances requirement in the proposed rule would result in
qualified custodians adapting existing systems and processes to meet
the proposed requirement.
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\506\ See, e.g., 12 U.S.C. 92(c) and 12 U.S.C. 1464(n)(2)
(requiring national banks and Federal savings associations to
segregate all assets held in any fiduciary capacity from their
general assets and to keep a separate set of books and records
showing all transactions in these accounts); section 4d(a)(2) of the
Commodity Exchange Act (requiring FCMs to segregate from their own
assets all money, securities and other property deposited by futures
customers to margin, secure, or guarantee futures contracts and
options on futures contracts traded on designated contract markets).
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No Liens Unless Authorized in Writing. The rule would not prohibit
liens and the other claims addressed in the proposed rule, but would
require that the adviser obtain reasonable assurances from the
qualified custodian that the client has authorized in writing any
right, charge, security interest, lien, or claim in favor of the
qualified custodian or its related persons or creditors. The proposed
reasonable assurances requirement could impose operational costs on
those custodians who make use of liens and the other claims addressed
in the proposed rule. The operational costs would include the costs of
adapting existing systems and processes to ensure that qualified
custodians get written client authorization. The proposed requirement
may also result in qualified custodians adding a conforming provision
to custodial agreements for those clients that authorize such claims.
Doing so would result in an additional burden for those qualified
custodians. We believe that many qualified custodians maintain their
custodial customer assets free of liens and similar claims, other than
those agreed to or authorized in writing by the client. Further, we
understand that some custodial agreements contain contractual language
addressing when a lien or similar claim will attach to client assets.
Operational costs and the cost of adding conforming provisions for
those clients that authorize such claims would be mitigated to the
extent qualified custodians already have such systems and provisions in
place.
d. Written Agreement
The proposed rule would require advisers to enter into a written
agreement with a qualified custodian based upon a reasonable belief
that certain contractual provisions have been implemented. Further,
during the term of the written agreement and related advisory
relationship, advisers generally should have a reasonable belief that
the qualified custodian is complying with the contractual obligations
of the agreement and continuing to provide the protections to client
assets for which the adviser obtained reasonable assurances from the
qualified custodian.
We discuss the benefits and costs of the proposed written agreement
requirement below. The magnitude of both the benefits and costs of the
proposed written agreement requirement would depend on the extent to
which advisers currently are party to custodial agreements, and
advisers' actions to ensure that the elements of the written agreements
are effective and being met.\507\
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\507\ While we understand that advisers are rarely parties to
the custodial agreement, which is generally between an advisory
client and its qualified custodian, we lack quantitative data to
confirm this understanding.
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i. Benefits
Under the proposed rule, one provision 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
Commission or to an independent public accountant engaged for purposes
of complying with the rule. Another provision would specify the
adviser's agreed-upon level of authority to effect transactions in the
account. A third provision would require the qualified custodian to
deliver account statements to clients and to the adviser, whereas
currently, advisers must only have a reasonable basis for believing
that clients are receiving these account statements upon due inquiry.
The fourth 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.
Record Sharing. The proposed rule would require that the written
agreement with the qualified custodian include a provision requiring
the qualified custodian to provide, promptly, upon request, records
relating to client assets to the Commission or an independent public
accountant engaged for purposes of compliance with the rule.\508\ We
understand, currently, that accountants often struggle to obtain--or to
obtain timely--information from qualified custodians when performing
surprise examinations under the current rule unless the advisory client
requests that the qualified custodian share the information. We believe
that accountants likely struggle to obtain information from qualified
custodians because the qualified custodian has no contractual agreement
with the adviser or the accountant that has been hired by the adviser.
We believe that the proposed contractual requirement would mitigate
these record access challenges because the qualified custodian would be
in direct contractual privity with the adviser and would have a
contractual obligation to provide the records required by the rule--
potentially reducing the costs attributable to completing a surprise
examination under the rule.
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\508\ Proposed rule 223-1(a)(1)(i)(A).
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Account Statements. The proposed rule would require that the
written agreement provide that the qualified custodian will send
account statements (unless the client is an entity whose investors will
receive audited financial statements as part of the financial statement
audit process pursuant to the proposed rule), at least quarterly, to
the client and the investment adviser, identifying the amount of each
client asset in the custodial account at the end of the period as well
as all transactions in the account during that period.\509\ We believe
that the delivery of quarterly account statements to the adviser, which
is a new requirement, would allow the adviser to more easily perform
account statement reconciliations. We believe that qualified
custodians' delivery of account statements directly to advisory clients
enhances investor protections by facilitating clients' ability to
verify adviser conduct as well as client assets. We also continue to
believe that qualified custodians' delivery of account statements
directly to advisory clients--without the involvement of the adviser--
helps provide clients with confidence that any erroneous or
unauthorized transactions by an adviser would be reflected in the
account statement and, as a result,
[[Page 14748]]
would deter advisers from fraudulent activities.\510\
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\509\ Proposed rules 223-1(a)(1)(i)(B), 223-1(b)(4).
\510\ Rule 206(4)-2(a)(3) requires the adviser to have
reasonable belief upon due inquiry that the qualified custodian
delivers quarterly account statements to the client.
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The proposed rule would also require a provision prohibiting the
account statement from identifying assets for which the qualified
custodian lacks possession or control, unless requested by the client
and the qualified custodian clearly indicates that the custodian does
not have possession or control over such assets. We believe the
proposed requirement would enhance investor protections by enhancing
the integrity and utility of the account statements, thereby reducing
the risk investors are misled or become confused about those assets for
which the custodian is responsible in the event of a loss.
Internal Control Report. The proposed rule would require that the
written agreement with the qualified custodian provide that the
qualified custodian, at least annually, will obtain, and provide to the
investment adviser a written internal control report that includes an
opinion of an independent public accountant as to whether controls have
been placed in operation as of a specific date, are suitably designed,
and are operating effectively to meet control objectives relating to
custodial services (including the safeguarding of the client assets
held by that qualified custodian during the year). The objectives and
scope of the proposed internal control report are substantially the
same as those of the internal control report required under the current
rule, but would expand the requirement to all qualified custodians as
opposed to the current rule, which only requires the internal control
report when the adviser or its related person acts as a qualified
custodian.
In circumstances where the qualified custodian is not the adviser
or its related person, we believe the proposed requirement would help
enhance investor protections by ensuring that the qualified custodian's
controls with respect to its safeguarding practices are routinely
evaluated in a timely manner by an independent third party. Also, in
those circumstances where qualified custodians currently obtain
internal control reports, the scope of those reports likely covers the
financial institutions' safeguarding activities for ``funds and
securities'' rather than all ``assets,'' as defined in the proposed
amendments. We believe the proposed requirement would help enhance
investor protection by expanding the scope of internal control reports
to cover safeguarding actives for ``assets'' rather than ``funds and
securities.'' We believe the requirement that auditors must be
independent in fact and in appearance contributes to investor
protection and investor confidence in connection with the relationship
between an auditor and the qualified custodian. Unlike the current rule
that only requires an internal control report when the adviser or its
related person acts as a qualified custodian, the proposed rule would
mitigate risks to client assets regardless of the affiliation of the
qualified custodian.
Under circumstances where the proposed rule requires the engagement
of a PCAOB-registered and inspected public accountant, we anticipate
that the proposed rule will have client protection benefits. As the
Commission noted in adopting the current custody rule, the Commission
has greater confidence in the quality of the processes followed by an
independent public accountant registered with, and subject to regular
inspection by, the PCAOB.511 512 We believe that
registration and the periodic inspection of an independent public
accountant's system of quality control by the PCAOB would provide
clients with confidence in the quality of the reports produced under
the proposed rule.
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\511\ See Custody Rule Amendments Adopting Release, supra
footnote 11, at 17.
\512\ For example, in response to our 2009 proposed Custody Rule
amendments requiring the use of PCAOB-registered independent public
accountants for annual surprise examinations in certain
circumstances, many commenters agreed with our belief that PCAOB
registration and inspection provided an important quality check on
the independent accountants providing those examinations. See
comment letter of Investment Adviser Association (July 24, 2009);
comment letter of The National Association of Active Investment
Managers (July 27, 2009); comment letter of Timothy P. Turner (July
27, 2009); comment letter of American Bar Association (Committee on
Federal Regulation of Securities) (July 28, 2009); comment letter of
Curian Capital LLC, Financial Wealth Management, Inc., LPL Financial
Corporation, and SEI Investments Company (July 28, 2009); comment
letter of Ernst & Young (July 28, 2009); comment letter of Financial
Planning Association (July 28, 2009); comment letter of Coalition of
Private Investment Companies (July 31, 2009); comment letter of
North American Securities Administrators Association, Inc. (Aug. 5,
2009). Academic research suggests that PCAOB registration and
inspection is associated with higher quality engagements. See, e.g.,
Mark L. DeFond & Clive S. Lennox, Do PCAOB Inspections Improve the
Quality of Internal Control Audits? (Sept. 2015), available at
https://pcaobus.org//News/Events/Documents/10222015_CEA/PCAOB-Inspections-Internal-Control-Audits-DeFond_Lennox.pdf. DeFond and
Lennox (2015) posit that auditors are motivated to receive clean
inspection reports from the PCAOB because adverse inspection
outcomes are detrimental to the auditors' compensation (Johnson,
Lindsay, Marsha Keune & Jennifer Winchel, Auditors' Perceptions of
the PCAOB Process (2015) working paper, University of Virginia).
They also note that the PCAOB has broad powers within its
jurisdiction to sanction individual auditors and firms that provide
substandard audits, which provides further incentive for auditors to
perform high quality audits.
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Adviser's Level of Authority. The proposed rule would require that
the adviser's written agreement with the qualified custodian specify
the investment adviser's agreed-upon level of authority to effect
transactions in the custodial account as well as any applicable terms
or limitations.\513\ As discussed in section II.B.3.b.iv above, our
understanding is that custodial agreements between advisory clients and
qualified custodians often contain provisions that give investment
advisers authority over their clients' custodial accounts that may be
broader than what the adviser and client have agreed to in their
advisory agreements. For example, an adviser may not have authority
under its advisory agreement with a client to instruct the client's
custodian to disburse client assets, or the advisory agreement may not
be entirely clear on the level of authority granted to the adviser. If,
however, the client's agreement with its qualified custodian grants the
adviser broad authority over the client's account, the qualified
custodian will accept and act upon instructions from the adviser to
disburse or transfer assets, for example, without verifying or
confirming those instructions with the advisory client), even though
the adviser's agreement with its client does not give the adviser the
authority to do so.\514\ This puts client assets at risk by giving the
adviser access to client assets that the adviser may not otherwise be
authorized to access. The proposed requirement that the contract
between the adviser and the qualified custodian specify the adviser's
agreed upon level of authority would mitigate these concerns and
empower advisers to tailor custodial arrangements to better reflect
client intentions and to be consistent with the adviser's contractual
obligations to its clients.
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\513\ Proposed rule 223-1(a)(1)(i)(D).
\514\ See supra note 202.
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ii. Costs
The proposed written agreement requirements would impose costs on
advisers and qualified custodians related to negotiating, drafting, and
implementing the written agreements.
(a) Negotiating, Drafting, and Forming a Reasonable Belief the
Agreement Provisions Have Been Implemented
We understand that advisers are rarely parties to the custodial
agreements. Those advisers who are not a party to a custodial agreement
and those qualified custodians with whom
[[Page 14749]]
they would be contracting would have to bear costs to negotiate and
draft the written agreement required by the proposed rule, and the
adviser would be required to form a reasonable belief that the
agreement provisions have been implemented by the qualified custodian.
This would include costs attributable to attorneys and compliance
professionals, both prior to and at the inception of the written
agreement, and over the life of the written agreement. For purposes of
the Paperwork Reduction Act, we estimate that investment advisers and
qualified custodians would incur aggregate initial costs of $41,218,464
to prepare these written agreements,\515\ and that aggregate annual
costs associated with modifying these agreements would be
$3,503,599.\516\ Advisers may also incur costs associated with
developing and maintaining a reasonable belief that the contractual
provisions have been implemented. These costs would largely depend upon
how each adviser satisfies and evidences compliance with this
requirement, making them difficult to quantify. However, the proposed
revisions to the recordkeeping rule would require an adviser to
maintain records that would likely be useful in demonstrating an
adviser's reasonable belief that a qualified custodian has implemented
the proposed contractual provisions. As a result, we estimate any
additional costs incurred by an adviser to develop and maintain a
reasonable belief that the proposed contractual provisions have been
implemented would be marginal.\517\
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\515\ See infra footnote 593.
\516\ See infra footnote 595.
\517\ For example, under the revised recordkeeping rule, and
adviser would be required to maintain copies of the client account
statements it receives from a qualified custodian. These records
could form the basis of an adviser's reasonable belief that a
qualified custodian has implemented the proposed contractual
requirement to deliver account statements. See Proposed rule 204-
2(b)(iv). The costs associated with proposed amendments to the
recordkeeping rule are discussed in more detail below. See section
3.D.7, infra.
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(b) Required Provisions
The proposed rule would require a written agreement between
advisers and qualified custodians that incorporates certain elements.
We believe the cost of including elements likely varies, depending on
the nature of each required element. Including certain elements may
involve minimal cost, while including other elements may involve more
substantial costs.
We understand that qualified custodians often do not provide
independent public accountants access to custodial account records in
light of privacy concerns for their customers. The requirement that the
written agreement with the qualified custodian include a provision
requiring the qualified custodian to promptly, upon request, provide
records relating to client assets to the Commission or an independent
public accountant for purposes of compliance with the rule could impose
additional costs on custodians. We believe these costs would largely be
mitigated because we believe that providing custodial account records
is consistent with the longstanding custodial practice of providing
account statements to clients.\518\ For purposes of the Paperwork
Reduction Act, we estimate that qualified custodians would incur
aggregate annual costs of $19,462,024 associated with this record
provision requirement.\519\
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\518\ Current rule 206(4)-2(a)(3). Qualified custodians use
custodial account records to produce client account statements.
\519\ See infra footnote 601, which estimates the annual burden
associated with records provision to independent public accountants
as being 18,422 hours. Using a blended rate of $394 per hour (see
infra footnote 605) produces an estimated annual burden of (18,422 *
$394) = $7,258,268 associated with records provision to independent
public accountants. See infra footnote 605, which estimates the
annual burden associated with records provision to the Commission as
being $12,203,756, producing a total annual burden associated with
records provision of ($7,258,268 + $12,203,756) = $19,462,024.
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The proposed rule would require that the written agreement with the
qualified custodian provide that the qualified custodian will send
account statements (unless the client is an entity whose investors will
receive audited financial statements as part of the financial statement
audit process pursuant to the audit provision of the proposed rule), at
least quarterly, to the client and the investment adviser, identifying
the amount of each client asset in the custodial account at the end of
the period as well as all transactions in the account during that
period. Because qualified custodians generally already send quarterly
account statements to clients, we expect the additional costs
associated with also sending such statements to advisers to be small.
For purposes of the Paperwork Reduction Act, we estimate that qualified
custodians would incur aggregate costs of $4,869,322.50 associated with
this requirement.\520\
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\520\ See infra note 609.
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The proposed rule would also require a provision prohibiting the
account statements from identifying assets for which the qualified
custodian lacks possession or control, unless requested by the client
and the qualified custodian clearly indicates that the custodian does
not have possession or control over such assets. As discussed in
section III.D.2.b, that provision could impose a cost on clients to the
extent account statements provided by a qualified custodian on an
accommodation basis offer a client the ability to review all of its
investments in a single consolidated account statement and potentially
alert a client or an auditor to the existence of an investment. This
provision would also impose costs on qualified custodians associated
with accommodating customization requests from clients. For purposes of
the Paperwork Reduction Act, we estimate that qualified custodians will
incur aggregate annual costs of $324,621.50 associated with these
customized requests.\521\
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\521\ See infra note 613.
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Internal Control Report. The objectives of the proposed internal
control report are substantially the same as those of the internal
control report required under the current rule.\522\ The internal
control report includes an opinion of an independent public accountant
as to whether controls have been placed in operation as of a specific
date, are suitably designed, and are operating effectively to meet
control objectives relating to custodial services. For those qualified
custodians that currently obtain internal control reports, the scope of
those reports likely do not cover the financial institutions'
safeguarding activities that this proposed requirement, which would
expand the scope of the rule to include all ``assets'' instead of
``funds and securities,'' is designed to cover, thus potentially
creating new costs for those firms whose report scope would need to be
modified. Any such new cost would be mitigated, however, to the extent
newly included assets would share existing controls or implicate
controls similar to those for funds and securities. We understand,
however, that not all qualified custodians may currently obtain
internal control reports--or may not be obtaining internal control
reports that meet the requirements of the proposed rule. While we
believe those financial institutions will be able to obtain a report
that satisfies the requirements of the proposed rule, doing so could
pose a substantial financial burden and time commitment. As discussed
above, we are not requiring that a specific type of internal control
report be provided under the proposed rule as long as the required
objectives are addressed. For example, a report on the description of
controls placed in operation and tests of operation effectiveness,
commonly
[[Page 14750]]
referred to as a ``SOC 1 Type 2 Report,'' generally should be
sufficient to satisfy the requirements of the proposed internal control
report requirement. For purposes of the Paperwork Reduction Act, we
estimate that an average internal control report would cost
approximately $750,000 per year and that qualified custodians will
incur aggregate annual costs of $35,962,500 associated with obtaining
internal control reports.\523\
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\522\ Rule 206(4)-2(a)(4)(ii).
\523\ See infra footnote 617.
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Adviser's Level of Authority. As discussed above, our understanding
is that custodial agreements between advisory clients and qualified
custodians often give advisers authority over custodial accounts that
is broader than what the adviser and client agreed to in the advisory
agreement. Our staff has observed that qualified custodians have been
reluctant to modify or customize the level of authority of investment
advisers with respect to customer accounts. We believe that qualified
custodians have been reluctant to modify or customize advisers' level
of authority because doing so would increase qualified custodians' need
to monitor customer accounts, and to accept liability, for unauthorized
transactions by an adviser and its personnel. The proposed requirement
could create operational costs for qualified custodians including the
costs of adapting existing systems and processes to modify or customize
the level of authority of investment advisers with respect to customer
accounts. Also, qualified custodians might incur costs to incorporate
new provisions into their contracts with advisers as well as amend any
inconsistent provisions in their existing contracts. As a result, we
believe the proposed requirement that the written agreement contain a
provision addressing the adviser's authority, including authority of
the client and adviser to reduce that authority, may be costly for
qualified custodians.
3. Certain Assets That Are Unable To Be Maintained With a Qualified
Custodian
As discussed in section II.C above, we believe the bulk of advisory
client assets can be maintained by qualified custodians. Some assets by
their very nature or size may not easily be subject to misuse or
misappropriation, and that may reduce the need for the safeguarding
protections offered by a qualified custodian, but it is also our
understanding that qualified custodians often refuse to custody such
assets for both advisers and their clients. In addition, as discussed
above, certain privately offered securities may not be able to be
maintained by a qualified custodian because, in our understanding,
demand for these services is low and thus there may not be a ready
market.
In circumstances where the protections of a qualified custodian are
unavailable for certain physical assets and privately offered
securities, the proposed rule would provide an exception to the
requirement to maintain client assets with a qualified custodian, but
would also require additional protections to help ensure that these
assets are properly safeguarded. In this section, we discuss the costs
and benefits of each of the proposed rule's safeguarding requirements
for assets that are unable to be maintained by a qualified custodian.
a. Definition of Privately Offered Security
The proposed rule's definition of privately offered securities
would retain the elements from the custody rule's description that
require the securities to be acquired from the issuer in a transaction
or chain of transactions not involving any public offering and
transferable only with prior consent of the issuer or holders of other
outstanding securities of the issuer.\524\ Like the custody rule, the
safeguarding rule would also require the securities to be
uncertificated and would require ownership to be recorded only on the
books of the issuer or its transfer agent in the name of the client.
However, the safeguarding rule would also require that the securities
be capable of only being recorded on the non-public books of the issuer
or its transfer agent in the name of the client as it appears in the
records the adviser is required to keep under rule 204-2.
---------------------------------------------------------------------------
\524\ See supra note 223.
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To the extent crypto asset securities may qualify as privately
offered securities under the current rule's privately offered
securities exception, advisers with custody of such assets may not be
maintaining them with a qualified custodian in reliance upon the
exception. However, as discussed above, we believe crypto asset
securities issued on public, permissionless blockchains would not
satisfy the definition of privately offered securities.\525\ As a
result, advisers with custody of such crypto asset securities generally
would be required to maintain those assets with a qualified custodian
and their clients would benefit from the enhanced protections qualified
custodians provide.\526\ To the extent that crypto asset securities
exist or develop that are able to meet the conditions of the privately
offered securities exception, the costs and benefits discussed below
with respect to the safeguarding of privately offered securities would
apply to such assets.
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\525\ See supra note 227 and surrounding discussion.
\526\ See section III.D.2 for a discussion of the benefits and
costs for assets that do not qualify for the privately offered
security exception and are not physical assets.
---------------------------------------------------------------------------
a. Adviser's Reasonable Determination
In order to be eligible for the exception, the rule would require
an adviser to reasonably determine, and document in writing, that
ownership cannot be recorded and maintained (book-entry, digital, or
otherwise) in a manner in which a qualified custodian can maintain
possession or control of such assets. Such a determination necessarily
depends on the facts and circumstances at issue. Moreover, these
determinations would necessarily evolve over time as assets and the
custodial industry change.
An adviser's reasonable determination of whether a qualified
custodian is able to maintain possession or control of a particular
asset would generally involve an analysis of the asset and the
available custodial market. An adviser's reasonable determination
generally would not require the identification of every conceivable
qualified custodian and an evaluation of its custodial services.
Fundamentally, to determine whether an asset can or cannot be
maintained by a qualified custodian under the proposed rule, an adviser
generally should obtain a reasonable understanding of the marketplace
of custody services available for each client asset for which it has
custody.
The proposed rule's reasonable determination requirement would
benefit investors by limiting the scope of assets eligible for the
exception and helping to ensure that any privately offered security or
physical asset for which a qualified custodian is available is held by
such custodian, maximizing the set of assets for which investors
receive the enhanced protections associated with maintaining possession
or control by a qualified custodian. The magnitude of this benefit
would depend on the extent to which advisers currently would not
otherwise maintain assets they have control of with a qualified
custodian despite the availability of custodial services for such
assets. For example, if the costs associated with maintaining an asset
with a qualified custodian exceeded the costs of safeguarding the asset
[[Page 14751]]
internally, an adviser with custody of the asset might choose to
safeguard the asset internally absent this requirement. Alternatively,
in cases where custodial services are available at prices that are
competitive with the costs of internally safeguarding an asset,
advisers may have chosen to maintain assets in their custody with a
qualified custodian regardless of this requirement.
Advisers would incur costs associated with the proposed rule's
reasonable determination requirement. For example, while the rule does
not prescribe exactly how advisers should comply with the requirement,
many advisers may choose to develop policies and procedures that
establish the frequency with which the market for custodial services is
reviewed, the manner in which the availability of custodial services
for an asset should be assessed, and the manner in which an ultimate
determination is made. The development and implementation of such
policies and procedures, including the documentation of each reasonable
determination, would cause advisers to incur costs that may be passed
on to their clients in the form of higher fees. The proposed rule does
provide advisers with flexibility in determining the frequency with
which they make the required reasonable determinations, which should
allow advisers to tailor these policies and procedures to the types of
asset they hold on behalf of clients and control the associated costs.
In addition, in cases where custodial services become available for
an asset but are highly costly, the reasonable determination
requirement would force advisers to incur such high custodial costs,
which may be passed on to their clients, whereas they otherwise may
have chosen to forgo custodial services in such cases. The costs an
adviser incurs as a result of the requirement would vary depending on
factors such as the types of assets the adviser has custody of and the
heterogeneity in these asset types. For example, an adviser that has
custody of client assets that are relatively homogenous may only have
to monitor a single market for custodial services, whereas an adviser
with custody of many different types of assets would likely incur
higher costs in monitoring and determining whether custodial services
are available in multiple markets. We lack precise information on the
degree of homogeneity versus heterogeneity in the assets held by
advisers, as well as the eventual costs advisers would pay to custody
assets under the proposed rule, so we cannot quantify the costs
associated with this requirement.
b. Adviser Reasonably Safeguards Client Assets That Are Unable To Be
Maintained With a Qualified Custodian
To rely on the exception, the adviser would be required to
reasonably safeguard physical assets and privately offered securities
that cannot be maintained with a qualified custodian. The proposed rule
would not require that advisers implement any particular measures to
safeguard physical assets or privately offered securities not
maintained with a qualified custodian. Instead, the proposed rule would
take a more principles-based approach. If an adviser has custody of a
physical asset or privately offered security that it has determined
cannot be maintained with a qualified custodian, the adviser may decide
to safeguard that asset itself, designing and implementing safeguarding
policies and procedures accordingly. An adviser must act consistently
with its fiduciary role in safeguarding any particular asset. For
example, the adviser might ``reasonably safeguard'' an asset by looking
to reasonable commercial standards for safeguarding that asset from
theft, misuse, misappropriation, or other similar type of loss. Under
the rule, however, an adviser would have the flexibility to determine
the specific safeguarding measures it puts in place, which may differ
from asset to asset. If an adviser does not ``self-custody'' physical
assets or privately offered securities that it has determined cannot be
maintained with a qualified custodian, and instead maintains those
assets with a third party that is in the business of safeguarding those
assets, the adviser might implement policies and procedures reasonably
designed to ensure that the entity directly maintaining the client's
assets has implemented appropriate measures to safeguard them.
Advisers are already obligated to safeguard client assets as part
of their fiduciary duty. However, to the extent that the proposed rule
would lead advisers to develop practices that more effectively
safeguard assets that are not maintained by a qualified custodian, the
proposed rule would benefit investors by reducing the risk that their
assets are subject to loss, theft, misuse, or misappropriation by an
adviser. Even to the extent advisers already effectively safeguard
client assets that are not maintained by a qualified custodian, the
proposed rule may still benefit investors by establishing a minimum
safeguarding standard which they can expect will be applied to those
assets, increasing investors' confidence in the market for advisory
services.
The proposed rule would not require advisers to implement any
particular measures to safeguard physical assets or privately offered
securities not maintained with a qualified custodian. This principles-
based approach would give advisers the flexibility to safeguard client
assets in a way consistent with the nature of the assets and each
adviser's individual facts and circumstances. If advisers choose to
safeguard client assets themselves, then, to the extent they do not
already safeguard client assets in accordance with the proposed
requirement, advisers would bear any costs associated with developing
and implementing effective safeguarding practices. For example, some
advisers may incur costs designing and implementing safeguarding
policies and procedures.
If physical assets or privately offered securities are maintained
with a third party, advisers might comply with the proposed rule's
safeguarding requirement by implementing policies and procedures
reasonably designed to ensure that the third party maintaining the
client's physical assets has implemented appropriate measures to
safeguard them. Such policies and procedures might include robust due
diligence and ongoing oversight procedures designed to ensure the
adviser has assessed and evaluated the measures put in place by the
third party. To the extent advisers do not already employ practices
that can ensure that client assets maintained with a third party are
safeguarded consistently with the proposed rule, advisers will incur
costs in developing and implementing such practices in order to comply
with the rule.
c. Notification and Prompt Independent Public Accountant Verification
The exception to the requirement to maintain assets with a
qualified custodian would also require an adviser to enter into a
written agreement with an independent public accountant. The proposed
rule would require the adviser to notify the independent public
accountant of any purchase, sale, or other transfer of beneficial
ownership of such assets within one business day. The proposed rule
would require the written agreement to require the independent public
accountant to verify the purchase, sale, or other transfer promptly
upon receiving the required transfer notice. We believe the involvement
of independent public accountants in the review and verification of
client assets of which advisers have custody is an important
safeguarding tool. The timing of the requirement would build a record
for
[[Page 14752]]
the accountant to review in connection with an annual surprise
examination or financial statement audit. The written agreement would
also require the independent public accountant to notify the Commission
by electronic means directed to the Division of Examinations within one
business day upon finding any material discrepancies during the course
of performing its procedures.
The notification and verification requirement would benefit
investors by reducing the risk that a loss, theft, misuse, or
misappropriation of their assets goes undetected for a significant
amount of time, which might allow investors or the Commission to
mitigate losses associated with such events in a timely manner. Even in
cases where an adviser fails to notify the independent public
accountant of a transaction because it involves loss, theft, misuse, or
misappropriation, the absence of such notifications relative to what
has been observed in the past may serve as a warning sign that is
useful in identifying potential losses during annual audits or surprise
examinations by the independent public accountant.
Advisers would incur costs associated with the proposed rule's
notification and verification requirement. While an adviser would
likely incur some initial costs associated with designing and
implementing any policies and procedures necessary to notify the
independent public accountant that a transaction of client assets has
occurred, the ongoing costs of notifying the independent public
accountant are likely to be small relative to the more involved
transaction costs associated with a change of ownership for privately
offered securities or physical assets. For purposes of the Paperwork
Reduction Act, we estimate that advisers would incur aggregate ongoing
annual costs of $48,013 associated with notifying independent public
accountants of transactions.\527\ Advisers will also incur one-time
costs associated with negotiating, drafting, and implementing the
written agreement with their designated independent public accountant.
Advisers may be able to mitigate these one-time costs if they already
have written agreements associated with an annual surprise exam or
audit by the same independent public accountant. In addition, advisers
may incur minimal costs associated with the occasional modification of
these agreements. For purposes of the Paperwork Reduction Act, we
estimate that investment advisers would incur aggregate initial costs
of $2,443,194 to prepare these written agreements,\528\ and that
aggregate annual costs associated with modifying these agreements would
be $977,514.\529\
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\527\ See infra note 648.
\528\ See infra note 642.
\529\ See infra note 644.
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Finally, the adviser will have to pay the independent public
accountant for its services, the costs of which may be passed onto
investors. Verification costs would likely vary across advisers
depending on factors such as the type of client assets they have
custody of as well as the volume of transactions in which they engage.
For example, a transaction involving a real estate asset that requires
the independent public accountant to verify titles or deeds in person
is likely to be costlier to verify than a transaction that can be
verified electronically or via telephone. Similarly, an adviser that
engages in a high volume of annual transactions would incur higher
costs associated with transaction verification, which may ultimately be
borne by the advisers' clients. For purposes of the Paperwork Reduction
Act, we estimate that advisers would incur aggregate ongoing annual
costs of $21,000,000 associated with the verification of transactions
by independent public accountants.\530\
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\530\ See infra note 649.
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d. Surprise Examination or Audit
Like the existing custody rule, the proposed safeguarding rule
would require advisers relying on the exception to undergo an annual
surprise examination or rely on the audit provision. In a change from
the custody rule, however, the proposed rule would require each
privately offered security or physical asset not maintained with a
qualified custodian to be verified, rather than only requiring that a
sampling of assets be verified during a surprise exam or that only
assets meeting the materiality threshold be verified during an audit.
The proposed requirement that each asset be verified in annual
surprise examinations or audits would benefit investors by reducing the
risk that the loss or theft of client assets is not detected when those
assets are either not included in a surprise examination's sample or do
not meet the materiality threshold when advisers rely on the audit
provision. For clients of advisers that do not rely on the audit
provision, the magnitude of this benefit depends on the extent to which
the sampling techniques used in conducting a surprise examination are
likely to omit assets that have been subject to loss or theft. To the
extent that the sampling techniques currently used in surprise
examinations are effective at capturing instances of asset loss or
theft, or that the sampling techniques are already a sufficient
deterrent to adviser misconduct that might result in loss or theft, the
benefit of this requirement will be more limited with respect to
surprise examinations.
For clients of advisers that rely on the audit provision, the
magnitude of this benefit depends on the extent to which loss or theft
tend to occur in client assets that do not meet the materiality
threshold. While the existing custody rule might not deter adviser
misconduct in assets below the materiality threshold, the proposed
safeguarding rule would act as more of a deterrent against such
misconduct because those assets would be subject to regular
verification for advisers that rely on the audit provision.
Advisers would incur additional costs as a result of the
requirement that, to rely on the exception, each client asset be
verified in a surprise examination or annual audit, and these costs may
be passed on to their clients. These costs will vary with the type of
asset subject to verification and the number of assets held by an
adviser. For example, verifying a privately offered security held by an
adviser on behalf of its client might require an independent public
accountant to contact the issuer of the security or its agent to verify
the existence of the asset, or to review documents such as private
placement memoranda and the issuer's Regulation D filings. For physical
assets, an independent public accountant may be required to review
deeds or other land recordation materials (e.g., for real estate
assets) or to review other documents, such as warehouse receipts, that
confirm the existence of a physical commodity. For both physical assets
and privately offered securities, incremental verification costs could
be high in cases where the number of assets held by an adviser is large
relative to the number of assets typically verified in surprise
examinations or audits under the current custody rule. If the supply of
qualified independent public accountants is scarce relative to any
increased demand for their services as a result of this requirement,
the overall cost of their services would also increase, at least
temporarily until those higher prices attract new entrants into the
public accounting market. For purposes of the Paperwork Reduction Act,
we estimate that advisers would incur aggregate ongoing annual costs of
$322,956,000 associated with the
[[Page 14753]]
verification of transactions by independent public accountants.\531\
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\531\ See infra note 655.
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4. Segregation of Investments
In addition to requiring advisers to attain reasonable assurance of
segregation of client assets from a qualified custodian's assets, the
proposed rule also would require advisers to segregate client assets
from the adviser's assets and its related person's assets in
circumstances where the adviser has custody. Specifically, the proposed
rule would require that client assets of which an adviser has custody:
(1) Be titled or registered in the client's name or otherwise held
for the benefit of that client;
(2) Not be commingled with the adviser's assets or the adviser's
related persons' assets; and
(3) Not be subject to any right, charge, security interest, lien,
or claim of any kind in favor of the adviser, its related persons, or
its creditors, except to the extent agreed to or authorized in writing
by the client.\532\
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\532\ Proposed rule 223-1(a)(3).
---------------------------------------------------------------------------
The proposed requirement that a client's assets be titled or
registered in the client's name would help ensure that the client's
assets are clearly identified as belonging to the appropriate client.
The proposed rule would also permit advisers to identify the assets
``for the benefit of'' a particular client where assets may not be
``titled or registered'' in the client's name. Permitting advisers to
identify assets ``for the benefit of'' a particular client benefits
investors by recognizing that advisory clients can title or register
their investments in various ways.
The proposed rule would also require that client assets not be
commingled with the adviser's assets or those of its related persons.
The proposed requirement would help ensure that client assets are
isolated and more readily identifiable as client property. We believe
isolating client assets and making them more readily identifiable as
client property would help protect client assets from claims by a third
party looking to secure or satisfy an obligation of the adviser,
including in cases of insolvency or bankruptcy of the adviser, or its
related persons.
The proposed rule would also require client assets to remain free
from any right, charge, security interest, lien, or claim of any kind
in favor of the adviser, its related persons, or its creditors. These
requirements would protect client assets by limiting the ability of an
adviser, or its related persons, to use client assets for their own
purposes or in a manner not authorized by the client. We recognize that
some advisers regularly service assets in a manner where such assets
are reasonably identifiable from other clients' assets and not subject
to increased risk of loss from adviser misuse or in the case of adviser
insolvency, thereby mitigating the potential benefits of the proposed
requirement. Also, we recognize that, depending on the types of assets,
products, or strategies in which they invest, some clients may
authorize these types of arrangements. We do not intend this condition
to limit or prohibit clients' ability to authorize such arrangements.
We recognize that not all advisers service assets in a manner where
such asserts are reasonably identifiable from the other clients' assets
and not subject to increased risk of loss from adviser misuse or in the
case of adviser insolvency. In addition, for those advisers that
segregate and identify their client assets, the extent of those
activities varies. To the extent certain advisers currently do not
segregate client assets, the segregation requirement in the proposed
rule would result in advisers adapting existing systems and processes
to meet the proposed requirement.
5. Investment Adviser Delivery of Notice to Clients
The proposed rule, like the custody rule, would require an
investment adviser to notify its client in writing promptly upon
opening an account with a qualified custodian on the client's behalf.
The proposed rule, however, would require that the notice must include
the custodial account number in addition to the currently required
qualified custodian's name and address.\533\ The proposed rule would
also continue to allow the notice to be delivered to the client's
independent representative. If the client is a pooled investment
vehicle, the notice must be sent to all of the investors in the pool,
provided that, if an investor is a pooled investment vehicle that is in
a control relationship with the adviser or the adviser's related
persons, the sender must look through that pool (and any pools in a
control relationship with the adviser or its related persons) in order
to send the notice to investors in those pools.\534\
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\533\ Proposed rule 223-1(a)(2).
\534\ See proposed rule 223-1(c).
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The addition of the custodial account number would benefit clients
by allowing them to more easily identify the custodial account. The
client would be able to compare the custodial account number on
subsequent account statements received from the qualified custodian to
the custodial account number on the notice received from their
investment adviser. Also, if the client is a pooled investment vehicle,
the look-through requirement on senders promotes meaningful delivery of
this important information.
We understand that custodial account numbers are readily available
to qualified custodians and that the cost of including the custodial
account number in the notice to clients would be minimal. For purposes
of the Paperwork Reduction Act, we estimate that advisers would incur
aggregate initial costs of $4,720,044 associated with ensuring that
custodial account numbers are included in notices to clients.\535\
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\535\ See infra note 624.
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6. Exceptions From the Surprise Examination
The proposed rule would create new exceptions to the surprise
examination requirement in certain limited circumstances where advisers
may have custody. We believe that in these circumstances, the subject
activities or arrangements have built-in adequate preventative
safeguards or simply pose less risk to client assets.
a. Entities Subject to an Audit
We believe that audits provide substantial protections to private
funds and their investors both because audits test assertions
associated with the investment portfolio (e.g., completeness,
existence, rights and obligations, valuation, presentation) and because
they provide a check against adviser misrepresentations of performance,
fees, and other information about the fund. Because of that belief, the
proposed rule's audit provision would allow audits to serve as a
substitute mechanism of compliance with certain aspects of the proposed
rule. Elements of the proposed rule's audit provision are largely
unchanged from the audit provision of the current rule.\536\
Differences include: expanded availability from ``pooled investment
vehicle'' clients to ``entities,'' extending the current rule's
specific deadlines for distribution of audited financial statements to
180 days in the case of fund of funds or 260 days of a fund of funds of
funds of the entity's fiscal year end, and a requirement for there to
be a written agreement between the adviser or the client and the
auditor requiring the auditor to notify the Commission
[[Page 14754]]
upon the auditor's termination or issuance of a modified opinion.\537\
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\536\ See supra note 282.
\537\ See supra note 283.
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i. The Expanded Availability of Audit Provision
While the current rule's audit provision is only available to an
adviser to clients that are limited partnerships, limited liability
companies, and other types of pooled investment vehicles, the proposed
audit provision would also be available to an adviser for any other
client ``entity'' whose financial statements can be audited in
accordance with the rule.\538\
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\538\ Compare rule 206(4)-2(b)(4); proposed rule 223-1(b)(4).
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As discussed in section II.G.1.b, this aspect of the proposed rule
would extend the investor protection benefits of an audit to a larger
number of investors, such as pension plans, retirement plans, college
saving plans (529 plans), and Achieving a Better Life Experience
savings accounts (ABLE plans or 529 A accounts). Investment advisers do
not use the current rule's audit provision for clients that are not
pooled investment vehicles, a consequence that may increase compliance
burdens for advisers and result in additional costs.
Also, we believe that financial statement audits provide additional
meaningful protections to investors by increasing the likelihood that
fraudulent activity is uncovered, thereby providing deterrence against
fraudulent conduct by advisers. In a financial statement audit, the
accountant performs procedures beyond those procedures performed during
a surprise examination. For example, a financial statement audit
typically involves tests of valuations of entity investments, income,
operating expenses, and, if applicable, incentive fees and allocations
that accrue to the adviser. Additionally, a financial statement audit
regularly involves an accountant confirming bank account balances and
securities holdings as of a point in time, and a financial statement
audit frequently includes the testing of transactions that have
occurred throughout the year. These common types of audit evidence
procedures performed by accountants during a financial statement
audit--physical examination or inspection, confirmation, documentation,
inquiry, recalculation, re-performance, observation, and analytical
procedures--act as an important check on the adviser obviating the need
for the account notice and delivery requirements for pooled investment
vehicles and other entities.
Based on our experience, we estimate that the party (or parties)
that bears the audit expense would pay an average audit fee of $60,000
per fund. We estimate that individual fund audit fees would tend to
vary over an estimated range from $15,000 to $300,000, and that some
fund audit fees would be higher or lower than this range. We noted that
the price of a private fund audit depends on many factors, such as
whether it is a liquid fund or an illiquid fund, the number of its
holdings, availability of a PCAOB-registered and -inspected auditor,
economies of scale, and the location and size of the auditor. We
believe that the cost of audit for client entities whose financial
statements can be audited would be of a similar
magnitude.539 540
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\539\ Although we believe that the procedures performed by the
accountant during the course of an audit provide meaningful
protections to clients beyond those of a surprise examination,
certain protections provided by surprise examinations would no
longer be provided. The loss of those protections could create a
cost for investors, but we believe the requirements under the
proposed rule mitigate those potential costs. For example, although
the annual audit is not required to be performed at a time of the
accountant's choosing (as is a surprise examination), we believe
other elements of the audit incorporate an element of uncertainty
similar to the surprise element of the surprise examination, with
corresponding benefits to investors. Specifically, in the course of
an annual audit, the auditor will select transactions to test during
the period that the adviser will not be able to anticipate.
\540\ Under the proposed rule, only those accountants that are
subject to regular inspection by the PCAOB are eligible to perform
these services which limits eligible accountants to those that
currently conduct public company issuer and broker-dealer audits.
The expansion of the availability of audit provision could result in
an increase in demand for audit services provided by PCAOB-inspected
accountants. Absent an offsetting increase in the supply of such
services, the cost of audit services for client entities could
increase. If PCAOB-inspected accountants reallocate resources from
other market segments, thereby decreasing the supply of PCAOB-
inspected accountant capacity in those other market segments, the
cost of audit services, more generally, could increase.
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ii. Distribution of Audited Financial Statements
The proposed audit provision would require an adviser to distribute
an entity's audited financial statements to current investors within
120 days (or 180 days in the case of a fund of funds or 260 days in the
case of a fund of funds of funds) of the entity's fiscal year end,
instead of the 120-day period required currently.\541\ As discussed in
section II.G.1.e above, we understand that reliance on third parties
could cause an adviser to fail to meet the 120-day timing requirements
regardless of an adviser's actions. We also recognize there may be
times when an adviser reasonably believes that an entity's audited
financial statements would be distributed within the required timeframe
but fails to have them distributed in time under certain unforeseeable
circumstances.
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\541\ See proposed rule 223-1(b)(4)(iv).
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By extending the timeframe in which advisers of certain types of
pooled investment vehicles (i.e., funds of funds and funds of funds of
funds) must distribute an entity's audited financial statements,\542\
the proposed rule may reduce any uncertainty advisers to such pooled
investment vehicles face under the current rule. Because we understand
existing market practices with respect to these pooled investment
vehicles already follow similar timeframes, we believe the costs of the
proposed changes to the audit provision with respect to the
distribution of audited financial statements would be minimal.
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\542\ See supra note 304.
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For purposes of the Paperwork Reduction Act, we estimate that
investment advisers would incur an aggregate annual burden of
$1,242,150 associated with delivering audited financial statements to
their clients.\543\
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\543\ See infra note 660.
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iii. Commission Notification
The proposed rule would require an adviser to enter into, or cause
the entity to enter into, a written agreement with the independent
public accountant performing the audit to notify the Commission (i)
within one business day upon issuing an audit report to the entity that
contains a modified opinion and (ii) within four business days of
resignation or dismissal from, or other termination of, the engagement,
or upon removing itself or being removed from consideration for being
reappointed.\544\ The written agreement must require the independent
public accountant to notify the Commission by electronic means directed
to the Division of Examinations. Although there is a requirement on
Form ADV for an adviser to a private fund to report to the Commission
whether it received a qualified audit opinion and to provide and update
its auditor's identifying information, there is not a similar current
obligation for an accountant to notify the Commission under the current
rule.
---------------------------------------------------------------------------
\544\ See proposed rule 223-1(b)(4)(v).
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The proposed requirement to notify the Commission (i) within one
business day upon issuing an audit report to the entity that contains a
modified opinion and (ii) within four business days of resignation or
dismissal from, or other termination of, the engagement, or upon
[[Page 14755]]
removing itself or being removed from consideration for being
reappointed would enable the Commission to receive more timely,
complete, and independent information in these circumstances and to
evaluate the need for an examination of the adviser. Based on our
experience in receiving notifications from accountants who perform
surprise examinations under the custody rule, we believe that the
timely receipt of this information--from an independent third party--
would more readily enable our staff to identify advisers potentially
engaged in harmful misconduct and who have other compliance issues.
This would bolster the Commission's efforts at preventing fraudulent,
deceptive, and manipulative activity and would aid oversight of
investment advisers. This could lead to a higher rate of detection of
activities that lead to the loss of client assets and a greater
potential for mitigation of such losses. Anticipating this, advisers
would have stronger incentives to avoid such harmful activities.
The proposed written agreement requirement could impose costs on
advisers and accountants related to negotiating, drafting, and
implementing the written agreements. Based on staff experience,
however, we understand that written agreements are commonplace and
reflect industry practice when a person retains the services of a
professional, such as an accountant, and they are typically prepared by
the independent public accountant in advance. Also, the proposed
requirements are drawn from the current rule's Form ADV-E filing
requirement for independent public accountants performing surprise
examinations and, as a result, should not be burdensome for accountants
to include in their written agreements.\545\ As a result, we do not
believe that the proposed requirement would significantly increase the
costs attributable to the proposed requirement. For purposes of the
Paperwork Reduction Act, we estimate that investment advisers would
incur an initial aggregate burden of 48,735 hours and an ongoing annual
burden of 35,869 hours associated with the written agreement.\546\
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\545\ Form ADV-E Instructions, pt. 3.ii, https://www.sec.gov/files/formadv-e.pdf.
\546\ See infra notes 662 and 664.
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b. Discretionary Trading Authority
The proposed rule would contain an exception from the surprise
examination requirement of client assets if the adviser's sole basis
for having custody is discretionary authority with respect to those
assets, provided this exception applies only for client assets that are
maintained with a qualified custodian and for accounts where the
adviser's discretionary authority is limited to instructing its
client's qualified custodian to transact in assets that settle
exclusively on a delivery versus payment basis.\547\ The proposed rule
would limit this exception to instances where this is the adviser's
sole basis for custody. Also, if an adviser also has custody of the
client's assets for reasons that are also subject to similar exceptions
(e.g., sole basis is fee deduction, sole basis is related person
custody),\548\ the adviser can rely on the exception.
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\547\ Proposed rule 223-1(b)(8).
\548\ See Rule 206(4)-2(b)(3) and (6) and proposed rule 223-
1(b)(3) and (6).
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We understand that certain investors may prefer to give their
adviser discretionary trading authority. In delivery versus payment
transactions, clients' custodians are generally under instructions to
transfer assets out of a client's account only upon corresponding
transfer of assets into the account. When a custodian is under
instructions to transfer assets out of a client's account only upon
corresponding transfer of assets into the account, there is a reduced
risk that the adviser could misappropriate the assets, and when the
transaction settles on a DVP basis there is a reduced risk of theft of
the asset because, on a non-DVP basis, the seller of an asset could
deliver but not receive payment or that the buyer of an asset could
make payment but not receive delivery of the asset. The proposed
exception would reduce the cost of discretionary trading authority in
these instances by not requiring the adviser to comply with the
surprise examination requirement of the proposed rule in those
circumstances where the discretionary trading authority arrangement
minimizes the risk that an investment adviser could withdraw or
misappropriate assets in its clients' accounts. We believe this
exception will mitigate the creation of new burdens for many advisers,
particularly smaller advisers, as a result of the expanded scope of the
definition of custody in the proposed rule and will focus the
requirement to obtain a surprise examination where the risk of
misappropriation is greatest. To the extent advisers pass along cost
savings to clients, clients could realize a benefit in the form of
reduced fees.
c. Standing Letters of Authorization
The proposed rule would provide an exception from the surprise
examination requirement for an investment adviser that has custody of
client assets solely because of a standing letter of
authorization.\549\
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\549\ Proposed rule 223-1(b)(7).
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We understand that certain investors may prefer to grant their
adviser authority to disburse assets from the client's account to one
or more specifically designated third parties in a manner that limits
the adviser's ability to redirect the assets, via standing letter of
instruction or other similar asset transfer authorization arrangement.
The proposed exception would reduce the cost of granting an adviser
such authority by not requiring the adviser to comply with the surprise
examination requirement of the proposed rule. To the extent advisers
pass along cost savings to clients, clients could realize a benefit in
the form of reduced fees.
As discussed in section II.G.3 above, where an arrangement is
structured so that the adviser's role is limited to determining when to
disburse a client's assets, we believe that the adviser's role in
effecting any change in beneficial ownership is circumscribed and
ministerial, and there is little risk to clients of loss, misuse,
misappropriation, or theft of its asset. We also believe under such
circumstances that a qualified custodian would be best positioned to
ensure that the required authorizations and instructions are properly
and verifiably issued by the client (e.g., the client's signature is
verifiable). As a result, we believe the cost of the exception to
clients would be minimal.
The proposed required information could benefit qualified
custodians by helping ensure that the instructions to the qualified
custodian provide relevant information about the recipient. The
proposed rule's requirement could also impose operational costs on
qualified custodians. As described in section II.G.3, we believe the
types of financial institutions identified as meeting the proposed
definition of qualified custodian are required by their primary
functional regulator or otherwise to perform procedures to verify the
instruction and authorization, through a signature review and, if
determined to be necessary, based on the facts and circumstances,
another method of verification. To the extent existing regulatory
requirements for qualified custodians are the same or similar to the
proposed rule's requirements, the costs of adapting existing systems
may be mitigated.
[[Page 14756]]
7. Amendments to the Investment Adviser Recordkeeping Rule
The proposed amendments to rule 204-2 would require an investment
adviser that has custody of client assets to make and keep true,
accurate, and current records of required client notifications and
independent public accountant engagements under proposed rule 223-1, as
well as books and records related to specific types of client account
information, custodian information, transaction and position
information, and standing letters of authorization.\550\ The proposed
amendments would require a more detailed and broader scope of records
of trade and transaction activity and position information for each
client account than the existing requirements for such records.\551\
The proposed amendments also would add new recordkeeping requirements
that include: (i) retaining copies of required client notices; \552\
(ii) creating and retaining records documenting client account
identifying information, including whether the adviser has
discretionary authority; \553\ (iii) creating and retaining records of
custodian identifying information, including copies of required
qualified custodian agreements, and a record of required reasonable
assurances that the adviser obtains from the qualified custodian; \554\
(iv) creating and retaining a record that indicates the basis of the
adviser's custody of client assets; \555\ (v) retaining copies of all
account statements; \556\ and (vi) retaining copies of any standing
letters of authorization.\557\ Lastly, the proposed amendments would
add new recordkeeping requirements to address independent public
accountant engagements.\558\
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\550\ Advisers would be required to maintain the proposed
records for a period of not less than five years as required under
the current books and recordkeeping rule. See rule 204-2(e)(1).
\551\ Compare rule 204-2(b)(1)-(4) with proposed rule 204-
2(b)(2)(v).
\552\ Proposed rule 204-2(b)(1).
\553\ Proposed rule 204-2(b)(2)(i).
\554\ Proposed rule 204-2(b)(2)(ii).
\555\ Proposed rule 204-2(b)(2)(iii).
\556\ Proposed rule 204-2(b)(2)(iv).
\557\ Proposed rule 204-2(b)(2)(vi).
\558\ Proposed rule 204-2(b)(3).
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The proposed recordkeeping requirements are designed to work in
concert with the proposed rule to help ensure that a complete custodial
record with respect to client assets is maintained and preserved. The
proposed changes to the recordkeeping rule would benefit clients by
helping to facilitate the Commission's inspection and enforcement
capabilities, including assessing compliance with the requirements of
the proposed rule. In particular, the proposed recordkeeping
requirement would benefit investors by providing more complete records
that would facilitate client account reconciliation of all debits and
credits to and from client accounts. More complete records also would
better enable examiners to identify and detect potential investment
adviser misappropriation or loss or misuse of client assets during
their examinations, resulting in more effective investor protections.
More generally, the recordkeeping requirements would enhance the
transparency of custody of client assets and enhance the Commission's
oversight capabilities. Enhancing the Commission's oversight
capabilities could benefit clients and investors through reduced risks
of loss and greater regulatory transparency and resulting effectiveness
of the Commission's client and investor protection efforts.
The proposed recordkeeping requirements would impose costs on
advisers related to creating and maintaining the required records.
These costs include those that can be attributed to compliance
professionals who would review and familiarize themselves with
requirements as specified in the proposed rule. In particular, advisers
would be required to make and retain a list of covered functions and
contributing factors, document their due diligence efforts, retain any
written agreements with service providers, and document periodic
monitoring of retained service providers. For purposes of the Paperwork
Reduction Act, we estimate that advisers would incur aggregate annual
costs of $41,352,853 as a result of the proposed amendments to rule
204-2.\559\
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\559\ See infra footnote 674.
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8. Changes to Form ADV
We are proposing to amend Part 1A, Schedule D, and the Instructions
and Glossary of Form ADV.\560\ The amendments are designed to
categorize information about advisers' practices to safeguard client
assets, to provide the Commission with information related to these
practices, and to provide the Commission with additional data to
improve our ability to identify compliance risks. The Commission is
not, however, proposing to change the structured data language used for
Part 1A. Specifically, given that Form ADV Part 1A currently is
submitted in a structured (i.e., machine-readable), XML-based data
language specific to that Form, the information in amended new Item 9
would continue to be structured in the same manner.
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\560\ See supra note 359.
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The amendments will provide the Commission with information related
to these practices, and also provide the Commission with additional
data to improve our ability to identify compliance risks. Also, public
reporting of these custodial practices could allow clients or third
parties to assess potential risks (e.g., concentration of investments
with a small number of custodians) associated with the market for
custodial services, generally. For example, these amendments may also
provide clients or investors additional protection because they will be
better able to discern the reasons why a particular adviser has
custody. Further, these amendments may offer ancillary market benefits
to the extent that market participants are better able to analyze the
Form ADV data to assess fraud risk. These proposed revisions would also
streamline the collection of this information by reorganizing Item 9
and refining certain reporting requirements to eliminate confusion and
prevent inaccurate or incomplete reporting.\561\
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\561\ See proposed Form ADV, Part 1A, Item 9.
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Reporting this additional information would impose additional costs
on investment advisers, but we believe that such costs would not be
significant since we understand that much of the information we propose
requesting on Form ADV would be readily available to or easily
accessible by advisers.\562\
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\562\ See infra Table 10 for the revised From ADV PRA burden
that includes incremental changes due to the proposed amendments as
well as adjustments due to wage inflation and changes in the number
of advisers.
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E. Efficiency, Competition, and Capital Formation
Efficiency. As discussed above, the proposed rule should benefit
clients and investors by mitigating risks associated with the custody
of client assets, thereby enhancing client and investor protections.
The enhancement to client and investor protections could, in turn, lead
to current clients being willing to invest a greater portion of their
resources with registered advisers or for more clients and investors to
seek the advice of registered advisers. Investment advisers provide
investment advice to investors and clients about the value of, or about
investing in, securities and other investment products. To the extent
investors benefit from such advice, we could expect an improvement in
the efficiency of client investment.
It is possible, however, that the proposed rule could have the
opposite
[[Page 14757]]
effect on efficiency. The costs of the proposed rule would be borne by
advisers, their clients, and qualified custodians. It is possible that
the costs borne by advisers may be large enough to cause some advisers
to stop providing investment advice for certain assets.\563\ If
advisers were to stop providing investment advice for certain assets,
clients could experience a decrease in the quality of advisers'
services. Alternatively, if advisers do try to push the costs, or some
component thereof, to clients, it is possible that costs will be large
enough to cause some clients to seek alternatives to registered
advisers. To the extent clients would benefit from the advice provided
by registered investment advisers, the decreased use of advisory
services could result in a decline in the efficiency of client
investment including lower realized returns.
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\563\ If there are fixed costs associated with the proposed
regulations, then smaller advisers will generally tend to bear a
greater cost, relative to adviser size, than larger advisers. If
there are material fixed costs associated with the proposed rule,
then we would expect the possible negative effect on competition to
be greater for smaller advisers because the proposed regulations
will tend to increase their costs more (relative to adviser size)
than for larger advisers.
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The proposed amendments would result in a substantive increase in
the information about custodial practices available to the Commission.
That increased information could, for example, aid Commission staff in
examinations, increase the likelihood that non-compliant behavior by
custodians or advisers is detected, and increase the likelihood that
non-compliant behavior is detected sooner. That increased information
should also allow the Commission to develop a better understanding
custodial practices, generally. As a result, we would expect an
enhancement in regulatory efficiency.
Competition. The proposed rule would enhance protections associated
with the custody of client assets. These enhancements to client and
investor protection, as well as the additional information available to
current and potential clients, could lead to an increased demand for
advisory services. That increase in demand for advisory services could,
in turn, lead to increased competition among advisers to meet the
increased demand. Alternatively, the increased demand for advisory
services could lead to an increase in the number of advisers in the
marketplace, also leading to an increase in competition among advisers.
An increase in competition could, presumably, manifest itself in terms
of better service, better pricing, or some combination of the two, for
clients.
As discussed above, however, it is possible that the proposed rule
could have the opposite effect on competition. As noted above, the
costs of the proposed rule would be borne by advisers, clients, and
qualified custodians. It is possible that the costs borne by advisers
may be large enough to cause some advisers to stop providing advice
with respect to certain assets. To the extent the proposed rule would
create new fixed costs of providing advisory services, those fixed
costs would disproportionately impact small or newly emerging advisers.
As a result, those fixed costs could discourage entry of new advisers
or cause certain advisers to exit the market. Rather than exiting the
market, there could be consolidation among advisers that could result
in fewer options, and potentially higher costs, for investors. If
advisers were to stop providing advice with respect to certain assets,
competition among advisers with respect to providing advice for those
assets could decline. Further, if advisers do try to push the costs, or
some component thereof, to clients, it is possible that costs will be
large enough to cause some clients to seek alternatives to the advice
of registered advisers. The decreased demand for advisory services
could result in a decline in the number of registered advisers and a
decrease in competition among registered advisers.
Also, we understand that the requirements of the proposed rule may
result in additional costs for qualified custodians, particularly the
requirements of a written agreement and reasonable assurances between
the qualified custodian and the investment adviser incorporating
certain minimum investor protection elements for advisory clients. To
the extent qualified custodians are unable to pass these costs along to
advisers and their clients, an increase in compliance costs could cause
some qualified custodians to exit the market. A decrease in the number
of qualified custodians could, in turn, lead to reduced competition,
increased custodial fees, or both.
Capital Formation. As noted above, the proposed amendments enhance
investor protections by mitigating risks associated with custody of
client assets. Additionally, the proposed rule would result in more
information about custodial practices being available to the public.
Those enhancements to client and investor protection as well as the
additional information available to potential current clients and
potential investors could lead to greater investor confidence which
could result in current investors being willing to invest more and
potential investors being more willing to invest for the first time. To
the extent that the proposed rule leads to greater investment, we could
expect greater demand for securities, which could, in turn, promote
capital formation.
F. Reasonable Alternatives
In this section, reasonable alternatives to the proposed elements
of rule 223-1 are discussed.
1. Scope of Assets
The proposed rule would define ``assets'' as ``funds, securities,
or other positions held in a client's account.'' While, like the
current rule, the proposed rule would apply to a client's cash and cash
equivalents as well as a client's securities, it also would generally
apply to other positions held in a client's account that are not funds
or securities. The Commission alternatively could define the scope of
other positions more narrowly, perhaps by identifying specific types of
other positions subject to the proposed rule's safeguarding
requirements.
As discussed above, however, we observe a continuing evolution of
the types of investments held in advisory accounts. If the proposed
rule were to identify specific types of assets as subject to the
safeguarding requirements of the rule, clients may not benefit from the
safeguarding requirements of the rule if they invest in new asset types
introduced in the future that fall outside the rule's scope. We
therefore believe a broad definition of other positions strikes the
correct balance in terms of investor protections and the cost of
complying with the proposed rule.
2. Elimination of Privately Offered Securities Exception
The proposed rule would modify the current rule's exception to the
requirement to maintain client funds and securities with a qualified
custodian with respect to certain privately offered securities.\564\ As
discussed above, we believe qualified custodians serve as key
gatekeepers to mitigate loss of client assets. The Commission
alternatively could seek to enhance investor protections by eliminating
the exception--thus requiring advisers with custody of privately
offered securities to either maintain these assets with a qualified
custodian or eliminate having custody--or retain the current exception
without the proposed modifications.
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\564\ Proposed rule 223-1(b)(2).
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[[Page 14758]]
The choice between retaining the current exception, the exception
modified as proposed, or eliminating the exception entirely necessarily
involves tradeoffs. Eliminating the exception and requiring privately
offered securities be maintained with a qualified custodian would
increase the likelihood that a loss would be prevented or that non-
compliant behavior is detected earlier, potentially mitigating loss to
clients. Also, to the extent the likelihood of timely detection deters
non-compliant behavior, requiring privately offered securities to be
maintained with a qualified custodian could have an important
prophylactic effect.
While we believe that requiring a qualified custodian to be
involved in any transfer of ownership of privately offered securities
would best mitigate the risk of loss of client assets, the current
costs associated with this approach would be substantial while a
custodial market is still relatively undeveloped. Although we believe
that this market would be more robust if the custody rule's exception
for uncertificated privately offered securities were eliminated and
demand for custodian services would increase, it is possible that this
market would not develop as we may expect or would develop in a way
that the costs of maintaining privately offered securities with
qualified custodians would not be justified by the benefits of doing
so. At the same time, we believe retaining the current exception
without modification leaves client assets at risk. In our view, the
proposed modifications strike the correct balance in terms of investor
protections and the cost of complying with the proposed rule.
3. Distribution of Requirements Across Reasonable Assurances and
Written Agreement
The proposed rule would require an adviser to obtain certain
reasonable assurances regarding the protections clients receive from
the qualified custodians maintaining their assets. The proposed rule
would also require a written agreement between advisers and qualified
custodians specifying different provisions related to the relationship
among an adviser, its client, and a qualified custodian. Both the
proposed reasonable assurances and written agreement requirements
expand and formalize the minimum standard protections to advisory
clients' assets. The Commission alternatively could specify a different
composition of client protections realized via reasonable assurances
and written agreements. For example, the Commission could require fewer
protections be realized via written agreements and more be realized via
a reasonable assurances requirement. Or, the Commission could require
more protections be realized via written agreements and fewer
protections be realized via a reasonable assurances requirement.
Under the proposal, the written agreement covers matters that
directly affect the adviser's own legal compliance (i.e., requiring the
custodian to promptly provide records to the Commission or to an
independent public accountant when required for compliance; requiring
the qualified custodian to deliver account statements to the adviser as
well as to the client; requiring the qualified custodian to assure the
adequacy of its internal controls) and that concern the adviser's
authority to effect transactions with funds in the client's account
held by the custodian. In contrast, the reasonable assurances
requirements cover matters which--while within the scope of the
adviser's fiduciary duty--principally concern the qualified custodian's
direct obligations to the client (i.e., the qualified custodian's
standard of due care to the client, the custodian's measures to
safeguard the client's assets, the custodian's indemnification of the
client against loss, the custodian's obligations to the client when
making sub-custodial arrangements, and the custodian's responsibility
to identify and segregate the client's assets and to protect the client
from liens or third-party claims).
Committing more of these requirements to a written agreement would
have the benefit of establishing a uniform, predictable set of
requirements for all custodial arrangements and giving the adviser--as
well as the client--a contractual enforcement mechanism. The existence
of a written agreement might be a greater deterrent to misconduct than
a reasonable assurances requirement, and the agreement might provide
useful terms of reference for examinations. But committing more of the
requirements to a written agreement could result in significant
contracting costs, potential loss of flexibility in qualified
custodians' business practices, a significant disruption in current
practices, and increased litigation costs. In contrast, committing more
of these requirements to reasonable assurances would have the benefit
of reducing contracting costs, but with the added cost associated with
advisers exercising due diligence and periodic monitoring of qualified
custodians to obtain reasonable assurances, without the benefit of an
agreement to establish basic expectations on matters directly affecting
client advisory services. Moreover, qualified custodians may have
concerns about implementing certain protections in the absence of
contractual privity between themselves and investment advisers. For
example, qualified custodians may have privacy concerns for their
clients in the absence of an agreement with the adviser governing
provision of records to an independent public accountant. Weighing
these factors, we believe that the composition of client protections
realized via reasonable assurances and written agreements in the
proposal strikes the correct balance in terms of investor protections
and the cost of complying with the proposed rule.
3. Additional Accounting and Client Notification Requirements for
Privately Offered Securities and Physical Assets That Are Not
Maintained With a Qualified Custodian
The proposed rule would require an investment adviser to implement
certain safeguards for clients' privately offered securities and
physical assets that cannot be maintained with a qualified custodian.
The safeguards are designed to improve protection of these assets and
to create transparency for an investor as to holdings of and
transactions in these assets, thereby increasing the likelihood that a
loss will be detected sooner, and misconduct will be deterred. These
include requirements for the adviser to reasonably determine that
ownership cannot be recorded and maintained in a manner in which a
qualified custodian can maintain possession or control of such assets;
\565\ for the adviser to reasonably safeguard the assets from loss,
theft, misuse, misappropriation, or the adviser's financial reverses,
including insolvency; \566\ for the adviser to enter into a written
agreement for an independent public accountant (``IPA'') to verify any
purchase, sale, or other transfer of beneficial ownership of such
assets promptly upon receiving notice from the adviser, and for the IPA
to notify the Commission within one business day upon finding any
material discrepancies during the course of performing its procedures;
\567\ for the adviser to notify the IPA of any purchase, sale, or other
transfer of beneficial ownership of such assets within one business
day; \568\ and for verification of the existence and ownership of such
assets during an
[[Page 14759]]
annual surprise examination or a financial statement audit.\569\
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\565\ Proposed rule 223-1(b)(2)(i).
\566\ Proposed rule 223-1(b)(2)(ii).
\567\ Proposed rule 223-1(b)(2)(iii).
\568\ Proposed rule 223-1(b)(2)(iv).
\569\ Proposed rule 223-1(b)(2)(v).
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We considered whether these safeguards should be supplemented or
replaced with additional accounting and client notification
requirements, including periodic examinations of the assets; prompt
delivery to the client of a written notice that the assets are not kept
by a qualified custodian, with an explanation of how the client can
verify the existence and ownership of those holdings; a summary of a
client's transactions involving assets that are not maintained with a
qualified custodian, to be issued on a quarterly or other periodic
basis; or for the adviser to obtain an internal control report for
assets not maintained with a qualified custodian.\570\ We also
considered requiring the independent public accountant engaged to
perform the proposed transaction verifications to be PCAOB-registered.
We believe the proposed safeguards are sufficient, and the costs of
additional safeguards to advisers and clients alike may not be
justified.
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\570\ See part II.D.5, Requests for Comment.
---------------------------------------------------------------------------
As previously noted, we lack precise information on the degree of
homogeneity versus heterogeneity of assets held by advisers that cannot
be maintained by a qualified custodian, and more prescriptive
accounting and notification requirements could be more costly when the
assets are more varied and unique,\571\ when the custodian must rely on
a third-party service provider to safeguard and inventory physical
assets, or when the client engages in high-volume transactions.\572\
Moreover, the benefits of these additional safeguards would be limited
where the assets are of such a nature that loss or misappropriation is
readily detectable.\573\
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\571\ See part III.D.3.b.
\572\ See generally parts III.D.3.c, III.D.3.d.
\573\ For example, unique, high-value, non-fungible assets, such
as developed real estate.
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4. Additional Safeguards When Clients Assets Are Not Maintained With a
Qualified Custodian
As discussed above, we recognize that not all client assets for
which an adviser may have custody can currently be maintained with
qualified custodians.\574\ We considered proposing several alternative
additional protections designed to help protect client investments when
they are not maintained at a qualified custodian. One such alternative
we considered would have required advisers to implement at least one
financial responsibility safeguard. Specifically, we considered
requiring advisers having custody of client assets that they determined
could not be maintained with a qualified custodian to either (i)
maintain an insurance policy covering losses to the investment adviser
or its clients resulting from the loss, misuse, theft, or
misappropriation of investments not maintained at a qualified
custodian; or (ii) maintain a reserve bank account containing a
specified amount of cash or certain qualified securities that could be
used only to compensate clients for violations of the proposed
rule.\575\
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\574\ See section II.D, supra.
\575\ In the past--though in different contexts--the Commission
and Congress have considered various financial responsibility
requirements for advisers, including requiring advisers to maintain
insurance (in the form of fidelity bonds) or satisfy minimum capital
requirements. The Commission most recently sought comment on these
concepts in 2018 in conjunction with its proposed interpretation
regarding the standard of conduct for investment advisers. See
Proposed Commission Interpretation Regarding Standard of Conduct for
Investment Advisers; Request for Comment on Enhancing Investment
Adviser Regulation, Release No. IA-4889, at 4 n.8 (Apr. 18, 2018)
[83 FR 21203 (May 9, 2018)]. Comments received in response to this
request were still under evaluation at the time the Commission
adopted its final interpretation regarding the standard of conduct
for investment advisers. See Commission Interpretation Regarding
Standard of Conduct for Investment Advisers, supra footnote 57.
Previously, in 2003, the Commission requested comment on whether to
require a fidelity bonding requirement for advisers as a way to
increase private sector oversight of the compliance by funds and
advisers with the Federal securities laws. See Compliance Programs
of Investment Companies and Investment Advisers, Release Nos. IC-
25925 and IA-2107 (Feb. 5, 2003) [68 FR 7037 (Feb. 11, 2003)]. The
Commission decided not to adopt a fidelity bonding requirement at
that time, but noted that it regarded such a requirement as a viable
option should the Commission wish to further strengthen compliance
programs of funds and advisers. See Compliance Programs of
Investment Companies and Investment Advisers, Release Nos. IC-26299
and IA-2204 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)]. Also, in
1973, a Commission advisory committee recommended that Congress
authorize the Commission to adopt minimum financial responsibility
requirements for investment advisers, including minimum capital
requirements. See Report of the Advisory Committee on Investment
Management Services for Individual Investors, Small Account
Investment Management Services, Fed. Sec. L. Rep. (CCH) No. 465, Pt.
III, 64-66 (Jan. 1973). Three years later, in 1976, the Senate
Committee on Banking, Housing and Urban Affairs considered a bill
that, among other things, would have authorized the Commission to
adopt rules requiring investment advisers with discretionary
authority over client assets, or that advise registered investment
companies, to meet financial responsibility standards. S. Rep. No.
94-910, 94th Cong. 2d Sess. (May 20, 1976) (reporting favorably S.
2849). S.2849 was never enacted, however. The issue of adviser
financial responsibility was also considered by Congress in 1992,
with both the Senate and House of Representatives passing bills that
would have given the Commission the explicit authority to require
investment advisers with custody of client assets to obtain fidelity
bonds. S.226, 102d Cong., 2d Sess. (Aug. 12, 1992) and H.R. 5726,
102d Cong. Ed (Sept. 23, 1992). Differences in these two bills were
never reconciled and thus neither became law.
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While this approach is similar to the types of fidelity bonds that
broker-dealers, investment companies, ERISA fiduciaries, and some
state-registered investment advisers are required to maintain,\576\ we
considered requiring advisers to maintain insurance coverage that would
have been more comprehensive than a typical fidelity bond in order to
address the risks the proposed rule is designed to mitigate. For
example, we considered requiring an adviser to maintain an insurance
policy covering losses to the investment adviser or its clients
resulting from the loss, misuse, theft, or misappropriation of
investments not maintained at a qualified custodian due to the
adviser's negligence, recklessness, or intentional misconduct.
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\576\ See, e.g., FINRA Rule 4360 (broker-dealers); 17 CFR
270.17g-1 (investment companies); 29 CFR 2580.412-1 (ERISA
fiduciaries). Many state-registered investment advisers are required
to maintain fidelity bonds. See, e.g., Ala. Code 1975 section 8-6-3;
Ark. Admin. Code 214.00.1-303.2; Ga. Code Ann., section 10-5-40; see
also NASAA Bonding Requirements for Investment Advisers Model Rule,
available at https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Bonding.pdf.
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However, we recognize there could be legal and logistical
challenges in implementing such a requirement. For example, fidelity
bond policies generally only protect policyholders from direct losses
suffered from a covered event (e.g., theft of the insured's property by
an employee), not third parties such as an adviser's clients, and even
to the extent fidelity policies are written to specifically cover
third-party property, there is disagreement as to whether the money a
policyholder uses to compensate a third party qualifies as a loss
covered under these policies.\577\ Also, it could be difficult for an
adviser to maintain appropriate coverage efficiently and effectively as
they buy and sell various investments on behalf of their clients or as
those investments increase and decrease in value. Finally, while this
approach may provide some means for recovery if an adviser's clients
are harmed, requiring this type of insurance coverage would likely
require advisers to pay significant premiums, which they would likely
pass along to clients through increased fees.
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\577\ See Adam D. Cornett & Andrew S. Kent, Who Can Recover
Under a Fidelity Policy?, XX Fid. L.J. 139, 139-41, 177-180 (2014)
(citing Retail Ventures, Inc. v. Nat'l Union Fire Ins. Co. of
Pittsburgh, Pa., 691 F3d 821, 828-32 (6th Cir. 2012)).
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We similarly considered requiring an adviser to maintain a
specified level of reserves based on the value of client investments
not maintained by a qualified custodian or for which an adviser has an
enhanced ability or
[[Page 14760]]
authority to effect a change in beneficial ownership. Requiring an
adviser to have sufficient liquid assets to cover these types of client
investments would have provided a source of recovery when those client
investments are lost, misused, stolen, or misappropriated due to the
adviser's failure to adequately safeguard them. This approach would
have resembled the capitalization requirements of other financial
firms.\578\ However, because the value of these client investments
would vary based on market fluctuations as well as client transactions,
designing a reserve requirement that would ensure that an adviser
maintained adequate reserves to allow for full recovery at all times
could be operationally challenging and costly. Further requiring
advisers to maintain reserves sufficient to provide for full--or even
meaningful--client recovery, may be prohibitively costly because
advisers would need to set aside significant amounts of capital,
potentially acting as a barrier to entry for new advisory firms or
causing existing advisers to leave the market.
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\578\ Broker-dealers are subject to minimum capitalization
requirements under the net capital and customer protection rules.
See, e.g., 17 CFR 240.15c3-1 (net capital rule); 17 CFR 240.15c3-3
(customer protection rule). Some state-registered investment
advisers are also subjected to minimum capitalization requirements.
See, e.g., Ark. Admin. Code 214.00.1-303.2; Ga. Code Ann., section
10-5-40; see also NASAA Minimum Financial Requirements for
Investment Advisers Model Rule (2011), available at https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Minimum-Financial-Requirements.pdf.
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Another alternative we considered would have required an adviser to
undergo an enhanced independent verification of assets not kept with a
qualified custodian or when an adviser has one-way transfer authority
over a client's account, irrespective of whether those assets are
maintained with a qualified custodian. For assets not kept with a
qualified custodian, the surprise examination would have been required
to verify 100% of a client's assets, and it would have required the
independent public accountant to verify the disposition of assets from
one examination to the next. We have opted, instead, to propose
limiting the assets an adviser is not required to maintain assets with
a qualified custodian to shares of mutual funds, and certain physical
assets and privately issued securities that the adviser has determined
cannot be maintained in the possession or control of a qualified
custodian. With respect to the latter category of assets, we are also
proposing to require advisers to implement other protections to ensure
they are adequately safeguarded, including, for example, more frequent
asset verifications. We believe this approach is likely to result in
more client assets being maintained by qualified custodians and better
tailoring the protections for client assets that cannot be maintained
with a qualified custodian. For one-way transfer authority, under this
alternative, the surprise examination would have required the
independent public accountant to evaluate whether each one-way transfer
of client assets was authorized (e.g., client authorized a cash
withdrawal from the client's account to be transferred to a particular
recipient). We were uncertain whether an independent public accountant
would make such an evaluation, however, and if so, whether it would be
cost-prohibitive for them to do so. We determined, instead, to promote
transparency around all transactions for a client's evaluation in the
proposal's approach. The proposed rule would promote this by
eliminating accommodation reporting on a qualified custodian account
statement, by limiting the circumstances in which advisers are not
required to maintain client assets with a qualified custodian, by
requiring an independent public accountant to verify transactions with
respect to certain assets not maintained with a qualified custodian
more frequently, and by eliminating the possibility that assets not
kept with a qualified custodian might not be included in the sampling
of assets verified under the current rule.
5. Designating Clearing Agencies and Transfer Agents as Qualified
Custodians
The Commission considered expanding the definition of a qualified
custodian to include clearing agencies that perform the function, under
the Exchange Act,\579\ of acting as central securities depositories
(``CSDs''), as well as transfer agents.\580\ Both CSDs and transfer
agents are functionally similar to qualified custodians in several
respects and are already subject to regulatory safeguards. These
entities safeguard a significant volume of assets and are subject to
Commission oversight through regulatory standards, registration
requirements, supervision, and examination.\581\ For example, among
other requirements, CSDs must establish, implement, maintain, and
enforce written policies and procedures reasonably designed to ensure
the integrity of securities issues, and minimize and manage the risks
associated with the safekeeping and transfer of securities; implement
internal auditing and other controls to safeguard the rights of
securities issuers and holders and prevent the unauthorized creation or
deletion of securities, and conduct periodic and at least daily
reconciliation of securities issues they maintain; and protect assets
against custody risk.\582\ Similarly, transfer agents are responsible
for countersigning securities upon issuance, monitoring to prevent
unauthorized issuance of securities, registering the transfer of
securities, and effecting the exchange, conversion, and transfer of
securities.\583\ Expanding the definition of a qualified custodian to
include CSDs and transfer agents could benefit investors by increasing
the number of potential entities that provide custodial services in
compliance with the rule, which could increase competition in the
market for such services and reduce costs. In addition, different types
of entities may be more or less suited to providing custodial services
for certain types of assets, such as privately offered securities, so
expanding the definition of a qualified custodian may reduce the costs
associated with maintaining these assets with a qualified custodian by
providing additional custodial options.
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\579\ See Exchange Act section 3(a)(23)(A)(i), 15 U.S.C.
78c(a)(23)(A)(i); Rule 17Ad-22(a)(3), 17 CFR 240.17Ad-22(a)(3).
\580\ See part II.C.1, Requests for Comment.
\581\ See, e.g., Release No. 34-78963 (Sept. 28, 2016), 81 FR
70744, 70745-47 (Oct. 13, 2016) (summarizing authorities applicable
to clearing agencies); Release No. 34-76743 (Dec. 22, 2015), 80 FR
81948, 81959-69 (Dec. 31, 2015) (summarizing authorities applicable
to transfer agents).
\582\ See Rule 17Ad-22(e)(11).
\583\ Exchange Act section 3(a)(25), 15 U.S.C. 78c(a)(25).
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However, CSDs currently perform many functions at an aggregate or
omnibus level for institutional participants, so they might need to
build systems to account for and interact with individual clients (to,
for example, directly furnish quarterly statements). The potential
costs CSDs would incur were they to provide services as qualified
custodians under this alternative might pose a significant barrier to
entry, which could limit the degree to which expanding the definition
of a qualified custodian would increase competition in the market for
custodial services. Moreover, providing custodial services could
significantly alter the risk management features of CSDs, which have
been tailored for other purposes and are supported by an architecture
that involves a more limited number of institutional participants.
While some transfer agents are currently used by mutual funds in
lieu of a qualified custodian with respect to
[[Page 14761]]
fund shares,\584\ they might also have to develop systems and processes
to enable them to custody assets other than fund shares. Transfer
agents that are used by mutual funds may also have some systems and
processes in place to interact with clients, such as those used to
furnish quarterly statements, but other transfer agents might incur
significant costs building such systems and processes. Like CSDs, the
costs associated with providing custodial services might pose a
significant barrier to entry for transfer agents, which could limit the
degree to which expanding the definition of a qualified custodian would
increase competition in the market for custodial services. In addition,
while transfer agents are currently subject to regulatory safeguards,
they are not currently subject to individual client protections that
are as extensive as the entities we are including in the definition of
a qualified custodian under the proposed rule. For example, they are
not subject to the specific safeguarding requirements of Rule 206(4)-
2(a), and their capitalization and risk management practices are
oriented to the markets where they operate, not necessarily to the
range and variety of clients and assets contemplated by the proposed
rule.
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\584\ See Rule 206(4)-2(b)(1).
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G. Request for Comment
The Commission requests comment on all aspects of this initial
economic analysis, including whether the analysis has: (i) identified
all benefits and costs, including all effects on efficiency,
competition, and capital formation; (ii) given due consideration to
each benefit and cost, including each effect on efficiency,
competition, and capital formation; and (iii) identified and considered
reasonable alternatives to the proposed rule. We request and encourage
any interested person to submit comments regarding the proposed rule,
our analysis of the potential effects of the proposed rule, and other
matters that may have an effect on the proposed rule. We request that
commenters identify sources of data and information as well as provide
data and information to assist us in analyzing the economic
consequences of the proposed rule. We also are interested in comments
on the qualitative benefits and costs we have identified and any
benefits and costs we may not have discussed.
280. The proposed rule affects banks and savings associations,
broker-dealers registered with the Commission, futures commission
merchants registered with the CFTC, and FFIs. How do rules and
regulations of other financial regulators and of self-regulatory
organizations affect these entities in their capacity as qualified
custodians? How do these existing rules and regulations affect the
benefits of the proposed rule and its costs?
281. The proposed rule would expand the scope of assets currently
subject to the custody rule. To what extent do investors benefit from
advisers having custody of assets newly scoped in under the proposed
rule? What is the nature of those benefits? To what extent would those
benefits be lost given the requirements of the proposed rule?
282. The proposed rule would explicitly identify discretionary
trading authority as an arrangement that triggers the rule. To what
extent do investors benefit from discretionary trading services offered
by investment advisers? What is the nature of those benefits? To what
extent would investment advisers no longer offer discretionary trading
services given the requirements of the proposed rule?
283. The proposed rule would generally require that the investment
adviser maintain client assets with a qualified custodian pursuant to a
written agreement between the qualified custodian and the investment
adviser (or between the adviser and client if the adviser is also the
qualified custodian). To what extent are investment advisers currently
party to custodial agreements? To what extent are the required
provisions similar to, or different from, provisions in custodial
agreements between investors and qualified custodians? Have we
appropriately estimated the costs of the reasonable assurances and
written agreement requirements? Do commenters agree that qualified
custodians will have in incentive to provide written agreements that
are consistent with the requirements of the proposed rule? Have we
appropriately identified the costs of the proposed required provisions?
284. To what extent do entities maintaining client physical assets
currently enter into written agreements obligating the entity to comply
with provisions the same as, or similar to, the provisions required
under the proposed rule?
285. We state that existing regulatory requirements for qualified
custodians with respect to asset segregation are similar to the
requirements of the proposed rule and that, as a result, the costs of
the proposed asset segregation requirements would be mitigated. Is this
an accurate characterization of existing regulatory requirements? If
not, how do existing regulatory requirements differ from those of the
proposed rule?
286. We state that for those qualified custodians indemnifying the
client against the risk of loss in the event of the qualified
custodian's gross negligence, the insurance requirement of the proposed
indemnification requirement would likely create a substantial increase
in the cost of liability insurance. Is this an accurate
characterization? How costly is insurance covering loss in the event of
a qualified custodian's gross negligence? How costly is insurance
covering loss in the event of a qualified custodian's simple
negligence? For example, how much does it cost to insure, per $1,000 of
covered assets, losses in the event of a qualified custodian's gross
negligence? How much does it cost to insure, per $1,000 of covered
assets, losses in the event of a qualified custodian's simple
negligence? Do the per-dollar costs change as the amount of covered
assets increases? If so, how? What other factor might affect the cost
of liability insurance for qualified custodians? What kinds of
operational burdens might be associated with purchasing and maintaining
liability insurance? To what extent do custodians currently have
systems, processes, and liability insurance that are consistent with a
simple negligence standard?
IV. Paperwork Reduction Act Analysis
A. Introduction
Certain provisions of our proposal would result in new ``collection
of information'' requirements within the meaning of the Paperwork
Reduction Act of 1995 (``PRA'').\585\ The proposed new rule 223-1 and
related amendments to rules 206(4)-2 and 204-2 under the Act and Form
ADV would have an impact on current collection of information burdens.
Specifically, we are proposing new collection of information
requirements under proposed rule 223-1 and corresponding amendments to
currently approved collection of information burdens under: (i) ``Rule
206(4)-2 under the Investment Advisers Act of 1940--Custody of Funds or
Securities of Clients by Investment Advisers'' (OMB number 3235-0241);
(ii) ``Rule 204-2 under the Investment Advisers Act of 1940'' (OMB
control number 3235-0278); and (iii) ``Form ADV'' (OMB control number
3235-0049). The Commission is submitting these collections of
information to the OMB for review and approval in accordance with 44
U.S.C. 3507(d) and 5 CFR
[[Page 14762]]
1320.11. An agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless it displays
a currently valid OMB control number.
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\585\ 44 U.S.C. 3501 et seq.
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We discuss below these proposed amendments and new collection of
information burdens. Responses provided to the Commission in the
context of its examination and oversight program concerning the
proposed redesignation of rule 206(4)-2 as new rule 223-1, and
corresponding amendments to rule 204-2 would be kept confidential
subject to the provisions of applicable law. Responses to the
disclosure requirements of the proposed amendments to Form ADV are not
kept confidential.
B. Rule 223-1
Proposed rule 223-1, which will effectively replace current rule
206(4)-2 by a redesignation, states that an adviser registered or
required to be registered under section 203 of the Act, shall take
certain steps to safeguard the client assets of which the adviser has
custody, and lays out five requirements with which advisers must
comply.\586\ Paragraph (a)(1) would require advisers to maintain
client's assets at a qualified custodian in a specified manner pursuant
to a written contract that contains enumerated elements. Paragraph
(a)(1)(ii) would require an adviser to obtain reasonable assurances in
writing from a qualified custodian that such custodian will exercise
due care over client assets; will indemnify the client against risk of
loss; not excuse any obligations to the client based upon the existence
of any sub-custodial, securities depository, or other similar
arrangements with regard to the client's assets; clearly identify and
segregate client assets from the custodian's proprietary assets and
liabilities; and 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. Paragraph (a)(2) would require an
investment adviser that opens an account with a qualified custodian on
a client's behalf to notify the client of the account details.
Paragraph (a)(3) would require an investment adviser to title or
register a client's assets in the client's name or otherwise hold such
assets for the benefit of that client; prohibit the commingling of
client assets with the adviser's (or its related persons') assets; and
require client assets generally to be held free of any right, charge,
security interest, lien, or claim in favor of the adviser and its
related persons or creditors. Paragraph (a)(4) would require an adviser
that maintains custody of client assets to obtain independent
verification from an independent public accountant at least once during
a calendar year pursuant to a written agreement that provides for the
filing of Form ADV-E.
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\586\ Proposed rule 223-1.
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Paragraph (b) lays out limited exceptions from certain requirements
of the proposed rule, some which would change the current collections
of information burdens of rule 206(4)-2. These include paragraphs
(b)(2) excepting the requirement to maintain certain privately offered
securities or physical assets with a qualified custodian in certain
circumstances; (b)(3) excepting advisers from the independent
verification of client assets maintained by a qualified custodian if an
adviser has custody solely as a consequence of the authority to deduct
advisory fees; (b)(4) exempting an adviser from the account statement
and certain notification requirements, along with the independent
verification requirement, when the advisory client undergoes a
financial statement audit annually and upon liquidation in accordance
with the rule; (b)(7) creating an exemption from the independent
verification requirement if an adviser has custody of client assets
solely because of a standing letter of authorization with the client;
and (b)(8) excepting advisers from the independent verification of
assets requirement under certain circumstances if custody exists solely
because the adviser has discretionary authority with respect to those
client assets that are maintained in accounts with a qualified
custodian where the discretionary authority is limited to transacting
in assets that settle exclusively on a delivery versus payment basis.
Each requirement to disclose or obtain information, deliver
communications, or cause reporting by an independent public accountant
constitutes a ``collection of information'' requirement under the PRA
and is mandatory. Advisory clients would use this information to
confirm proper handling of their accounts. The Commission's staff uses
the information obtained through these collections in its enforcement,
regulatory, and examination programs. The respondents to these
collections of information requirements would be investment advisers
that are registered or required to be registered with the Commission
that have custody of client assets. As of September 2022, there were
15,160 investment advisers registered with the Commission and 8,724
advisers reported to have custody of client assets in Item 9 of Form
ADV. Although not all investment advisers would be subject to this
rule, we expect that most would be for two reasons: first, the proposed
rule would be triggered by most services advisers commonly provide to
their clients, such as trading on a discretionary basis; and second,
the proposed rule's application to ``assets'' would apply to a broad
array of client investments, not just to funds or securities as under
the current rule. We, therefore, estimate that 13,944 which is the
number of all registered advisers that currently report having
discretionary authority, would be subject to the proposed rule.\587\
The application of the provisions of the proposed rule--and thus the
extent to which there are collections of information and their related
burdens--would be contingent on a number of factors, such as the types
of services the adviser provides, the number of clients to whom it
provides those services, and the nature of the relevant assets. Because
of the wide diversity of services and relationships offered by
investment advisers, we expect that the obligations imposed by the
proposed rule would, accordingly, vary substantially among advisers.
However, we have made certain estimates of this data solely for the
purpose of this PRA analysis.
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\587\ This estimate is based on the 14,204 advisers who answer
yes to Form ADV Item 8(C)(1) and have discretionary authority to
determine the ``securities to be bought or sold for a client's
account.'' For purposes of this estimate, we have excluded 260
advisers answering yes to Form ADV Item 8(C)(1) but reporting that
they solely advise investment company clients in response to Form
ADV Item 5.D.(1)(d).
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1. Qualified Custodian Provision
a. Written Agreement
Under the proposed rule investment advisers would be required to
enter into a written agreement with a qualified custodian to maintain
possession or control of their clients' assets and to satisfy certain
other requirements enumerated in the rule, subject to certain
exceptions.\588\ We estimate that nearly all of the 13,944 registered
advisers that we estimate would be subject to the rule will be required
to comply with this requirement.\589\ We believe that an investment
adviser
[[Page 14763]]
would enter into a single agreement with each qualified custodian that
provides custodial services for the adviser's clients, regardless of
how many of the adviser's clients the qualified custodian provides
custodial services for. Based on the information currently reported by
advisers about qualified custodians on in Item 9.F of Form ADV, we
estimate that each adviser would enter into approximately 4 written
agreements.\590\ We therefore estimate that, initially, advisers would
enter into a total of 55,776 written agreements.\591\ We estimate that
each investment adviser and each qualified custodian that enters into
an agreement would incur an internal burden of 1 hour each to prepare
the written agreement, for a total initial burden hour estimate of
111,552 \592\ which we expect would mostly be attributable to the
requirement to specify the investment adviser's agreed-upon level of
authority to effect transactions in the custodial account as well as
any applicable terms or limitations. Based on our estimates, there
would be an initial cost to each respondent of this internal hour
burden of $43,951,488 to draft and finalize these written
agreements.\593\
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\588\ Proposed rule 223-1(a)(1) (the proposed rule would require
a written agreement between the adviser and client if the adviser is
also the qualified custodian).
\589\ While some of these advisers may have custody of certain
client assets that the proposed rule would except from the
requirement to use a qualified custodian, we assume that these
advisers likely also have at least some client assets that must be
maintained with a qualified custodian under the proposed rule.
\590\ This estimate is based on responses to Form ADV, Part 1A,
Item 9.F, which requires advisers to report the number of persons
acting as qualified custodian. For all advisers responding to this
question, the average number of persons acting as qualified
custodians amounted to 4. We believe that it is possible that the
proposed rule could result in advisers entering into agreements with
a greater number of qualified custodians for custody services
related to assets that advisers may not currently maintain with a
custodian. At the same time, we believe that it is possible that
current custodians will expand their services in order to provide
custody services for asset types that they do not currently maintain
for advisers. As a result, for the purposes of this analysis, we
will rely on the average obtained from Form ADV Part 1A, Item 9.F.
data.
\591\ This estimate is based on the following calculation:
13,944 advisers x 4 written agreements.
\592\ This estimate is based on the following calculation:
55,776 written agreements x 2 hours.
\593\ This estimate is based on the following calculation:
111,552 hours (for preparation and review of draft agreement) x $394
(blended rate for a compliance manager ($361) and a compliance
attorney ($426)). Unless otherwise indicated in this section IV, all
hourly wages used are from the Securities Industry and Financial
Markets Association's Report on Management & Professional Earnings
in the Securities Industry 2013 (``SIFMA Wage Report''), updated for
2023, modified to account for an 1800-hour work-year and inflation.
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Once these agreements are created they will require little, if any,
modification, except in circumstances where the adviser's level of
authority changes (which we estimate would occur approximately once per
year). We estimate that these changes would take, on average, 10
minutes per written agreement. Therefore, we estimate that the yearly
total internal burden of preparing the written agreement would be 9,482
hours,\594\ and there would be an annual cost of this internal hour
burden of $3,735,908.\595\
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\594\ This estimate is based on the following calculation:
55,776 written agreements x .17 hours.
\595\ This estimate is based on the following calculation: 9,482
hours x $394 (blended rate for a compliance manager ($361) and a
compliance attorney ($426)).
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The written agreement proposed by the rule would require a
qualified custodian to promptly, upon request, provide records relating
to an adviser's clients' assets held in the account at the qualified
custodian to the Commission or to an independent public accountant
engaged for purposes of complying with the rule.\596\ As noted above,
we believe that advisers would enter into approximately 4 written
agreements on average. We anticipate that 1,842 \597\ of the advisers
party to these written agreements would be subject to the surprise
examination requirement. For these advisers, we estimate that qualified
custodians would be required to provide information to an independent
public accountant once annually in connection with each adviser for
which they have a written agreement under the rule. We estimate that it
would take qualified custodians approximately 0.5 hours to provide the
required information. Therefore, we estimate the internal annual hour
burden for qualified custodians to provide this information to total
3,684 hours.\598\ Further, we anticipate that 7,018 advisers to these
written agreements would comply with the proposed rule's audit
exception.\599\ Because we estimate that 5 percent of pooled investment
vehicles are liquidated annually at a time other than their fiscal
year-end, for these advisers, we estimate that qualified custodians
would be required to provide information to an independent public
accountant 1.05 times annually. Therefore, we estimate that the total
annual burden for respondents to provide information to independent
public accountants for the audit related to these advisers would be
14,738 hours.\600\ In the aggregate, we estimate the total annual
burden for respondents to provide information to independent public
accountants for the surprise examination and audit to amount to 18,422
hours.\601\
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\596\ See proposed rule 223-1(a)(1)(i)(A).
\597\ See infra footnote 619and accompanying text.
\598\ This estimate is based on the following calculation: 1,842
(advisers that we estimate will obtain a surprise examination) x 4
(average number of written agreements per adviser) x .5 hours.
\599\ Advisers to pooled investment vehicles: 4,961. 20% of
advisers with custody that have pension and profit sharing plan
clients (3,068 x .20): 614. 20% of advisers with custody that have
charitable organization clients(3,205 x .20): 641. 20% of advisers
with custody that have state or municipal government entity clients
(986 x .20): 197. 20% of advisers with custody that have
corporations and other business entity clients (3,025 x .20): 605.
Total advisers expected to use the audit provision (4,961 + 614 +
641 + 197 + 605): 7,018 advisers; See also infra footnote 654.
\600\ This estimate is based on the following calculation: 7,018
(number of advisers using the audit exception) x 4 (average number
of qualified custodians per adviser) x 1.05 (average number of
audits annually) x .5 hours = burden for respondents to provide
information to independent public accountants for the audit related
to these advisers.
\601\ 3,684 + 14,738 hours.
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We estimate that the Commission would examine approximately 2,092
of the advisers required to enter into a written agreement under the
rule, which is consistent with the number of advisers generally
examined by Commission staff over the last three fiscal years.\602\ As
noted above, because we estimate that an adviser will on average
maintain client assets with approximately four qualified custodians, we
estimate that Commission will issue approximately 8,368 requests to
qualified custodians under the rule. We believe that these information
requests may be more customized and would take custodians approximately
1.5 hours to respond to, slightly longer than it would take a custodian
to provide more standardized information requested by an independent
public accountant. Accordingly, the internal burden hours for
respondents to this collection of information would equal approximately
12,552 hours.\603\ In total, for the requirement to provide information
to accountants and the Commission, we estimate the collection of
information burden on respondents amounts to 30,974 hours
annually.\604\ Accordingly, we estimate that the annual internal
monetized cost burden amounts to approximately $12,203,756.\605\
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\602\ This estimate is based on the following calculation:
13,944 advisers subject to the rule and required to enter into a
written agreement with a qualified custodian x 15% (the approximate
number of registered advisers the Commission examined in each of
fiscal years 2019, 2020, and 2021). See U.S. Securities and Exchange
Commission, Division of Examinations, 2022 Examination Priorities at
4 (Mar. 2022), available at https://www.sec.gov/files/2022-exam-priorities.pdf.
\603\ This estimate is based on the following calculation: 8,368
written agreements x 1.5 hours.
\604\ This estimate is based on the following calculation:
18,422 (hour burden to provide information to accountants) + 12,552
(hour burden to provide information to Commission).
\605\ This estimate is based on the following calculation:
30,974 (internal annual burden hours) x $394 (blended rate for a
compliance manager ($361) and a compliance attorney ($426)).
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The proposed rule would require that the written agreement with the
qualified
[[Page 14764]]
custodian provide that the qualified custodian will send account
statements (unless the client is an entity whose investors will receive
audited financial statements as part of the financial statement audit
process pursuant to the audit provision of the proposed rule), at least
quarterly, to the client and the investment adviser, identifying the
amount of each client asset in the custodial account at the end of the
period as well as all transactions in the account during that
period.\606\ We estimate that the average burden for custodians to
provide quarterly financial statements to advisers is limited. Because
qualified custodians are already sending quarterly account statements
to clients,\607\ we estimate that one additional burden incurred would
be in connection with qualified custodians adding advisers to their
distribution lists. We estimate this would aggregate approximately
14,385 hours in initial burden hours.\608\ We estimate that this
initial internal burden equates to an initial internal monetized cost
burden of approximately $4,869,322.50.\609\
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\606\ Proposed rule 223-1(a)(1)(i)(B). The proposed requirement
is similar to the approach in the current rule with regard to the
investment adviser forming a reasonable belief after due inquiry
that the qualified custodian sends account statements, at least
quarterly, to the client. See custody rule 206(4)-2(a)(3).
\607\ See custody rule 206(4)-2(a)(3).
\608\ 15 hours (development of distribution list) x 959
(estimated number of qualified custodians). We believe that any
ongoing annual burden in connection with this requirement would be
de minimis.
\609\ This estimate is based on the following calculation:
14,385 hours (estimated internal hour burden of preparing and
distributing quarterly account statements) x $338.50 (blended rate
for a programmer $316 and a compliance manager $361)).
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We also believe that this proposed rule would result in a small
additional burden in terms of modifications to quarterly statements
related to including, at the client's request, information related to
assets not maintained by the qualified custodian,\610\ customizing the
statements for any client that requests such assets to be included, and
adding language that identifies those assets.\611\ We estimate this
would aggregate approximately 959 hours annually.\612\ We estimate that
this annual internal burden equates to an annual internal monetized
cost burden of approximately $324,621.50.\613\
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\610\ See proposed rule 223-1(a)(1)(i)(B) (``Such account
statements shall not identify assets for which the qualified
custodian lacks possession or control, unless requested by the
client and the qualified custodian clearly identifies any such
assets that appear on the account statement'').
\611\ See id. Since custodians are aware of the assets for which
they are providing accommodation reporting, we believe that the
custodian's removal of current accommodation reporting will be de
minimis.
\612\ 1 hour (modifications to account statements) x 959
(estimated number of qualified custodians).
\613\ This estimate is based on the following calculation: 959
hours (estimated internal hour burden of preparing and distributing
quarterly account statements) x $338.50 (blended rate for a
programmer $316 and a compliance manager $361)).
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As discussed above, the proposed rule would require the written
agreement to contain a provision requiring the qualified custodian, at
least annually, to obtain and provide to the adviser a written internal
control report that includes an opinion of an independent public
accountant.\614\ We estimate that approximately 959 qualified
custodians \615\ would have to obtain an internal control report
relating to custodial services, and would have to provide the report to
the adviser. We understand that the cost to prepare an internal control
report relating to custody would vary based on the size and services
offered by the qualified custodian, but that on average an internal
control report would cost approximately $750,000 per year.\616\ We
believe that 95% of custodians currently obtain internal control
reports, and, therefore, estimate total aggregate monetized costs
attributable to this section of the proposed rule to be $35,962,500
annually.\617\
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\614\ Proposed rule 223-1(a)(1)(i)(C).
\615\ This estimate was obtained by the following calculation:
8,724 (advisers reporting that they have custody)/600 (total number
of custodians reported in Form ADV Part 1A, Question 9.F. = 14.54
(mathematical average number of advisers served by each custodian
obtained solely for the purpose of performing the calculation);
13,944 (advisers that we estimate would have to comply with the
proposed rule)/14.54 (average number of advisers served by each
custodian) = 959.
\616\ We recognize, however, that as a result of the proposed
rule's expansion to cover all assets, rather than funds and
securities, the internal control reports currently obtained by
qualified custodians may not fully reflect the type of report that
would be obtained under the proposed rule.
\617\ This estimate is based on the following calculation: 959
(estimated number of qualified custodians operating under written
agreements) x $750,000 (average cost of obtaining internal control
report) x 5% (percent of custodians that we estimate are not
currently obtaining internal control reports).
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b. Reasonable Assurances
The proposed rule would require an adviser to obtain reasonable
assurances in writing from a qualified custodian regarding certain
client protections.\618\ As discussed above, one way that advisers are
likely to satisfy this requirement is by seeking confirmation from a
qualified custodian that the custodial agreement with the advisory
client contains contractual language reflecting the reasonable
assurances required by the rule. We estimate the amount of time it
would take an adviser to request, and a qualified custodian to provide,
information necessary to satisfy this requirement to be approximately
15 minutes, and we expect that any related changes a qualified
custodian makes to a custodial agreement to reflect the reasonable
assurances provided to the adviser would take approximately 1 hour. We
believe this exchange is most likely to occur in the context of the
negotiation and execution of the written agreement. Therefore, we
estimate that the initial aggregate time burden for this collection of
information would amount to 69,720 hours.\619\ We believe that the
initial monetized costs imposed by the proposed rule approximate
$27,469,680.\620\ We believe that most custodial agreements change very
little from year to year, and therefore, we estimate the total annual
internal hour burden to be 13,944.\621\ We believe that the monetized
costs imposed by the proposed rule would approximate $5,493,936
annually.\622\
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\618\ Proposed rule 223-1(a)(1)(ii).
\619\ 1.25 hours x 55,776 written agreements.
\620\ 69,720 hours (estimated initial internal hour burden) x
$394 (blended rate for a compliance manager ($361) and a compliance
attorney ($426)).
\621\ 55,776 written agreements x .25 hours.
\622\ 13,944 (estimated annual internal hour burden) x $394
(blended rate for a compliance manager ($361) and a compliance
attorney ($426)).
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2. Notice to Clients
The proposed rule, like the current rule, would require an
investment adviser to notify its client in writing promptly upon
opening an account with a qualified custodian on its behalf.\623\ The
notice is designed to alert a client to the existence of the qualified
custodian that maintains possession or control of client assets and
whom to contact regarding such assets. One change from the current rule
is that the proposed rule would explicitly require that the notice
include the custodial account number, an important detail that is not
required under the current rule. However, we do not believe including a
custodial account number to the notice would significantly impact the
costs incurred by advisers as they are already required to provide a
nearly identical notice under the current rule. Therefore, we estimate
that the initial burden of updating their processes and systems to
ensure account numbers are included in the relevant notices is 1 hour
with a total estimated monetized cost of $4,720,044.\624\
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\623\ See proposed rule 223-1(a)(2).
\624\ The initial burden hours are calculated as follows (14,204
advisers with discretionary authority--260 advisers to investment
company clients in response to Form ADV Item 5.D.(1)(d) = 13,944
advisers) x 1 hour x blended rate for a compliance manager ($361)
and a programmer ($316) = $338.50) = $4,720,044.
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[[Page 14765]]
3. Annual Surprise Examination
The proposed safeguarding rule does not change the current rule's
annual surprise exam requirement, but changes to other portions of the
rule that expand the application of the rule to certain advisers or
that provide exceptions to the surprise exam requirement would impact
the number of advisers subject to this requirement if adopted. The
current rule requires each registered investment adviser that has
custody of client funds or securities to undergo an annual surprise
examination by an independent public accountant to verify client assets
pursuant to a written agreement with the accountant that specifies
certain duties. We estimate that 1,842 advisers would be subject to the
surprise examination requirement upon its redesignation under the
proposal.\625\
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\625\ Based on data from the Investment Adviser Registration
Depository (``IARD'') of the advisers that report having discretion,
of the 1,842 advisers indicated in response to Item 9.C.(3) that an
independent public accountant conducts an annual surprise
examination of client funds and securities. The calculations in this
section regarding the annual surprise exam represent information as
of June 2022 and incorporate Form ADV filings received through the
(IARD) through August 31, 2022.
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For purposes of estimating the collection of information burden, we
have divided the estimated 1,842 advisers into three subgroups. First,
we estimate that 381 advisers have custody because they serve as
qualified custodians for their clients, or they have a related person
that serves as qualified custodian for clients, in connection with
advisory services the adviser provides to the clients.\626\ We estimate
that these advisers are subject to an annual surprise examination with
respect to 100 percent of their clients (or 9,006 clients per adviser)
based on the assumption that all of their clients maintain custodial
accounts with the adviser or its related person.\627\ We estimate that
each adviser will spend an average of 0.02 hours for each client to
create a client contact list for the independent public accountant. The
estimated total annual aggregate burden with respect to the surprise
examination requirement for this group of advisers is 68,626
hours.\628\
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\626\ Based on IARD data, 381 advisers indicated that an
independent public accountant prepares an internal control report
because the adviser or its affiliate acts as a qualified custodian
(in response to Item 9.C.(4)). Similarly, 76 advisers indicated that
they act as a qualified custodian (in response to Item 9.D.(1), and
321 advisers indicated that their related person(s) act as qualified
custodian(s) (in response to Item 9.D.(2)). 76 + 321 = 397.
\627\ We base our estimate on IARD data of the average number of
clients of all the advisers that will be subject to the surprise
examination requirement under the rule. To derive our estimate, we
utilized the winsorization method, by setting all values for
advisers (above the 99th percentile of number of clients) at the
number of clients at the 99th percentile. The method lessens the
effect of outliers on client estimates.
\628\ 381 advisers x 9,006 (average number of clients subject to
the surprise examination requirement) x 0.02 hour = 68,626 hours.
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The second group of advisers, estimated at 835, are those that have
custody because they have broad authority to access client assets held
at an independent qualified custodian, such as through a power of
attorney or acting as a trustee for a client's trust.\629\ Based on our
staff's experience, advisers that have access to client assets through
a power of attorney, acting as trustee, or similar legal authority
typically do not have access to all of their client accounts, but
rather only to a small percentage of their client accounts pursuant to
these special arrangements. We estimate that these advisers will be
subject to an annual surprise examination with respect to 5 percent of
their clients (or 450 clients per adviser) who have these types of
arrangements with the adviser.\630\ We estimate that each adviser will
spend an average of 0.02 hours for each client to create a client
contact list for the independent public accountant. The estimated total
annual aggregate burden with respect to the surprise examination
requirement for this group of advisers is 7,515 hours.\631\
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\629\ This estimate is based on the total number of advisers
subject to surprise examinations less those described above in the
first group (custody as a result of serving as, or having a related
person serving as, qualified custodian) less those described below
in the third group (custody as a result of solely managing private
funds). (1,842-381)-626 = 835 advisers.
\630\ Based on the IARD data, we estimate that the average
number of clients of advisers subject to the surprise examination
requirement is 9,006. 9,006 x 0.05 = 450 clients per adviser.
\631\ 835 advisers x 450 clients x 0.02 hours = 7, 515 hours.
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A third group of advisers provides advice to pooled investment
vehicles that are not undergoing an annual audit and therefore would
undergo the surprise examination with respect to those pooled
investment vehicle clients. Based on current IARD data, we estimate
that 626 advisers manage private funds and undergo surprise
examinations.\632\ We estimate that each adviser managing private funds
has an average of 6 pooled investment vehicle clients with an average
of 14 investors. We estimate that advisers to these pooled investment
vehicles will spend 1 hour for the pool and 0.02 hours for each
investor in the pool to create a contact list for the independent
public accountant, for an estimated total annual burden with respect to
the surprise examination requirement for these advisers of 4,808
hours.\633\
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\632\ Based on IARD data, we estimate that 626 advisers manage
private funds and undergo a surprise examination (responses to Items
7.B. and 9.C.(3)).
\633\ ((626 advisers x 6 pools) x 1 hour = 3,756 hours) + ((626
x 6 pools x 14 investors) x .02 hours = 1,052 hours) = 4,808 hours.
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These estimates bring the total annual aggregate burden with
respect to the surprise examination requirement for all three groups of
advisers to 80,949 hours.\634\ This estimate does not include the
collection of information discussed below relating to the written
agreement required by paragraph (a)(4) of the rule.
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\634\ 68,626 hours + 7,515 hours + 4,808 hours = 80,949 hours.
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Related to the surprise exam, the current custody rule and the
redesignated safeguarding rule require that an adviser subject to the
surprise examination requirement must enter into a written agreement
with the independent public accountant engaged to conduct the surprise
examination and specify certain duties to be performed by the
independent public accountant.\635\ We estimate that each adviser will
spend 0.25 hour to add the required provisions to the written
agreement, with an aggregate of approximately 461 hours for all
advisers that undergo surprise examinations.\636\ Therefore the total
annual burden in connection with the surprise examination is estimated
at 81,410 hours under the rule.\637\ We estimate the monetized burden
related to the surprise exam is $27,623,345.\638\
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\635\ Compare 17 CFR 275.206(4)-2(a)(4) with proposed rule 223-
1(a)(4).
\636\ 1,842 advisers would be required to obtain a surprise
examination x 0.25 = 461.
\637\ 80,949 exam hours + 461 written agreement hours = 81,410
hours.
\638\ 80,949 exam hours x $338.50 (blended rate for a compliance
manager ($361) and a programmer ($316) = $339) + 461 written
agreement hours x $394 (blended rate for a compliance manager ($361)
and a compliance attorney ($426) = $393.50) to amend the written
agreement = $27,623,345.
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C. Exceptions
The proposal contains several exceptions that will result in a new
``collection of information'' requirement within the meaning of the PRA
and would have an impact on the current collection of information
burdens of rule 206(4)-2. These exceptions are discussed below.
1. Certain Assets That Are Unable To Be Maintained With a Qualified
Custodian
We are proposing an exception to the requirement to maintain client
assets with a qualified custodian where an adviser has custody of
privately offered securities or physical assets if the
[[Page 14766]]
ownership of such assets cannot be recorded and maintained (book-entry,
digital, or otherwise) in a manner in which a qualified custodian can
maintain possession or control of such assets. This exception will
allow advisers who service client accounts containing such assets to
either safeguard the assets themselves or engage another entity to
safeguard the assets subject to certain safeguarding requirements
discussed below. For the purpose of approximating the average burden
for advisers to comply with the collections of information that would
be created by this exception, we estimate that 4,961 advisers currently
have custody of privately offered securities and physical assets that
cannot be maintained with a qualified custodian.\639\
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\639\ Based on IARD data, 4,961 advisers with custody of client
assets provided advice to pooled investment vehicles as of June 30,
2022. We believe that this number is overinclusive of some number of
advisers solely to funds that do not hold privately offered
securities or physical assets. But we also believe that there may be
a small number of advisers who are not advisers to pooled investment
vehicles who have client assets that would be subject to the
exception. We believe that the estimate is reasonable based on the
data available.
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(a) Written Agreement With Independent Public Accountant
An adviser relaying on the proposed exception would be required to
enter into a written agreement with an independent public accountant
that specifies certain obligations of the accountant.\640\ We assume
that many advisers will amend agreements that they have with
accountants to perform other accounting services for the adviser, such
as a surprise examination, while some number of advisers will enter
into new agreements with accountants to perform the services required
by the proposed rule. On average, we estimate that each adviser will
spend 1.25 hours, initially, to prepare the written agreement with an
accountant. In the aggregate, we estimate that advisers will spend
6,201 hours, initially, to enter into these agreements.\641\ We
estimate the aggregate initial monetized cost burden to equal
$2,443,194.\642\
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\640\ See proposed rule 223-1(b)(2)(iii).
\641\ 4,961 (estimated number of advisers with custody of
privately offered securities and physical assets that cannot be
maintained with a qualified custodian under the proposed rule) x
1.25 hours.
\642\ 6,201 (estimated internal hour burden) x $394 (blended
rate for a compliance manager ($361) and a compliance attorney
($426)).
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We believe that these agreements will change minimally from year to
year and, therefore, estimate that advisers will spend approximately
2,481 aggregate hours annually amending these agreements or entering
into new agreements.\643\ The related total monetized cost burden for
these amendments would equal $977,514.\644\
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\643\ This estimate is based on the following calculation: 4,961
(estimated number of advisers with custody of privately offered
securities and physical assets that cannot be maintained with a
qualified custodian under the proposed rule) x .5 hours (estimate of
average amount of time to amend agreement).
\644\ 2,481 (estimated internal hour burden) x $394 (blended
rate for a compliance manager ($361) and a compliance attorney
($426)).
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(b) Notice to Accountant
The proposed rule would require the adviser to notify the
accountant of any purchase, sale, or other transfer of beneficial
ownership of such assets within one business day.\645\ As discussed in
section II.C.4, above, we believe that this notice would likely be
provided by the adviser in connection with the closing of a
transaction, and could be provided to the accountant without much
additional effort beyond that required in connection with the closing
of the transaction. We estimate that this notice would take advisers
approximately one minute to deliver to the accountant. We also estimate
that advisers will send 8,000 of these notices annually.\646\
Accordingly, we estimate that these notices will take advisers
approximately 133 hours \647\ in the aggregate to send annually with an
annual monetized cost of $48,013.\648\
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\645\ See proposed rule 223-1(b)(2)(iv).
\646\ This estimate is based on a review of a number of sources
of private equity transaction data in and prior to 2021. See
generally, S&P Global Market Intelligence, 2022 Global Private
Equity Outlook (Apr. 20, 2022), available at https://www.spglobal.com/marketintelligence/en/news-insights/research/2022-global-private-equity-outlook (``2021 was a record year for the PE
industry as investment activity surpassed the trillion-dollar mark
for the first time. In total, 24,520 deals globally were closed,
with an aggregate deal value worth $1.04 trillion, nearly double the
amount from the year before. At the same time, deal volume grew by
41.6% over 2020, proving that investors' predictions of improved
deal-making in 2021 came to fruition.''); Pitchbook, Data, Inc.,
2021 Annual US PE Breakdown, (Jan. 11, 2022), available at https://pitchbook.com/news/reports/2021-annual-us-pe-breakdown (``At over
8,600, [U.S.] deal count topped 2019's record by 50%.''); Statista,
Global private equity (PE) activity from 2002 to 2021 (Mar. 30,
2022) available at https://www.statista.com/statistics/1292230/private-equity-deal-activity-worldwide/ (``2021 was a record-
breaking year for private equity (PE) activity worldwide. Investment
activity grew nearly twofold compared to 2020, and reached a value
of nearly 1.2 trillion U.S. dollars from 2,616 private equity
deals.''); Bain & Co., The Private Equity Market in 2021: The Allure
of Growth (Mar. 7, 2022), available at https://www.bain.com/insights/private-equity-market-in-2021-global-private-equity-report-2022/ (``While the number of individual [buyout] deals jumped to
nearly 4,300 in 2021, up 16% from 2020 levels, that doesn't explain
the extraordinary growth in capital deployed.''). The estimate takes
into account the increasing trend in transaction volume over the
past few years, but also takes into account that registered advisers
are responsible for only a portion of these total global and total
U.S. transactions.
\647\ 8,000 (estimated annual transactions)/60 minutes (based on
estimate of one minute per notice).
\648\ 133 (estimated number of hours) x $361 compliance manager.
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(c) Accountant Verification
The written agreement would require the independent public
accountant to verify the purchase, sale, or other transfer promptly
upon receiving the required transfer notice. As discussed in section
II.C.4, above, we believe the verification process would vary
considerably depending on the asset involved. Based on our estimate of
8,000 transactions under the proposed exception annually, we believe
that these verifications will result in an aggregate monetized cost
burden to advisers of $21,000,000 annually.\649\
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\649\ 8,000 (estimated number of annual transactions) x 15 hours
(estimated average time to verify a transaction) x $175 (blended
rate for intermediate accountant ($200), a general accounting
supervisor ($252), and general clerk ($73)). The proposed rule
requires that an accountant report to the Commission any material
discrepancies and our estimate for those notices is included in the
estimated average time to verify a transaction.
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(d) All Assets Verified During Surprise Examination or Annual Audit
The proposed rule would require that the existence and ownership of
each privately offered security or physical asset of a client that is
not maintained with a qualified custodian to be verified during an
adviser's annual surprise examination or financial statement audit
under the audit provision.\650\ We estimate that 95 percent of advisers
relying on this exception, or 4,713 advisers,\651\ will obtain a
financial statement audit and 5 percent of advisers, or 248 advisers,
will obtain surprise examinations.\652\ For advisers obtaining an audit
under the audit provision, we estimate the aggregate annual cost of
asset verification to be $282,780,000.\653\ We estimate the
[[Page 14767]]
aggregate annual cost of asset verification for all assets during a
surprise examination to be $40,176,000.\654\ In sum, the total annual
monetized collection of information burden related to the exception for
privately offered securities and physical assets is $322,956,000.\655\
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\650\ See proposed rule 223-1(b)(2)(v).
\651\ 4,961 (advisers relying on exception)/95% (estimated
number of advisers relying on the exception obtaining audits) =
4,713.
\652\ 4,961 (advisers relying on exception)/5% (estimated number
of advisers relying on the exception obtaining surprise exams) =
248.
\653\ 4,713 (estimated number of advisers subject to the
exception relying on the audit provision) x $60,000 (additive
estimated cost of audit). The additive costs to the audit (and
surprise examination) of full asset verification are mitigated by
proposed rule 223-1(b)(2)(iii), which requires an accountant to
verify any purchase, sale, or other transfer of beneficial ownership
of assets subject to the exception promptly after receipt of notice
from the adviser. The extent of this mitigation is hard to estimate
with certainty. We estimate that all asset verification will
approximately double the cost of an audit, estimated at $60,000 per
audit. See infra section IV.C.2.
\654\ 248 (estimated number of advisers subject to the
exception) x $162,000. We previously estimated that advisers subject
to the surprise examination with respect to 100 percent of their
clients will each spend an average of approximately $162,000
annually. As with the cost of an audit, we estimate that full asset
verification will approximately double the cost of the surprise
examination.
\655\ $282,780,000 + $40,176,000.
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2. Audit Provision
The proposed rule would expand the availability of the audit
provision from limited partnerships, limited liability companies, and
other types of pooled investment vehicle clients to any advisory client
entity whose financial statements are able to be audited. Advisers that
seek to comply with the audit provision would be required to deliver,
promptly after the completion of the audit, the financial statements of
the entity to all investors.
The collection of information burden imposed on an adviser relating
to the distribution of audited financial statements to each investor in
a client entity that the adviser manages should be minimal, as the
financial statements could be included with account statements or other
mailings or delivered electronically. Based on our experience with the
audit provision in the current custody rule, we have estimated
previously that the average burden for advisers to deliver audited
financial statements to investors in the client entity is 1 minute per
investor.\656\ Based on our estimate of the number of advisers to
audited pooled investment vehicles,\657\ with an adjustment for our
expectation that an increasing number of advisers will obtain audits of
client entities,\658\ we estimate that the aggregate annual hour burden
in connection with the distribution of audited financial statements is
7,098 hours,\659\ and there would be an annual cost of this internal
hour burden of $1,242,150.\660\
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\656\ 2009 Adopting Release, supra note 11.
\657\ Based on IARD data as of June 30, 2022, 4,961 advisers
with custody of client assets provided advice to pooled investment
vehicles. We estimate that each adviser has an average of 6 pooled
investment vehicle clients with an average of 14 investors.
\658\ Because the proposed rule expands the types of entities
that can obtain an audit (i.e., is not limited to pooled investment
vehicles as in the current rule), we expect that an increasing
number of advisers will seek to comply with the proposed rule by
obtaining an audit. To estimate the number of entities that may
utilize the expanded availability of the audit provision, we
selected the following categories of clients with custody based on
IARD data as of June 30, 2022: Investment advisers with custody that
have pension and profit sharing plan clients: 3,068 (Average number
of pension and profit sharing clients: (6); Investment advisers with
custody that have charitable organization clients: 3,205 (Average
number of charitable organization clients: (3); Investment advisers
with custody that have state or municipal government entity clients:
986 (Average number of state or municipal government entity clients:
(3); Investment advisers with custody that have corporations and
other business entity clients: 3,025 (Average number of corporations
and other business entity clients: (5). We estimate that 20% of
advisers to these categories of clients will utilize the expanded
availability of the audit provision.
\659\ (4,961 advisers to pooled investment vehicles x 6 pooled
investment vehicle clients x 14 investors x 1 minute)/60 minutes =
6,945 hours; (3,068 advisers to pension and profit sharing clients x
20% x 6 clients x 1 minute)/60 minutes = 61 hours; (3,205 advisers
to charitable organization clients x 20% x 3 clients x 1 minute)/60
minutes = 32 hours; (986 advisers to state or municipal government
entity clients x 20% x 3 clients x 1 minute)/60 minutes = 10 hours;
(3,025 advisers to corporations and other business entity clients x
20% x 5 clients x 1 minute)/60 minutes = 50 hours; 6,945 hours + 61
hours +32 hours +10 hours +50 hours = 7,098 hours.
\660\ This estimate is based on the following calculation: 7,098
hours x $175 (blended rate for an intermediate accountant ($200), a
general accounting supervisor ($252), and a general clerk ($73).
---------------------------------------------------------------------------
The proposed rule would require an adviser or the client entity to
enter into a written agreement with the independent public accountant
to ensure that the independent public accountant that audits the client
entity notifies the Commission (i) within one business day of issuing
an audit report to the entity that contains a modified opinion and (ii)
within four business days of resignation or dismissal from, or other
termination of, the engagement, or upon removing itself or being
removed from consideration for being reappointed.\661\ We assume that,
regardless of whether the adviser or the client entity enters into the
written agreement, the accountant would incur the hour burden of
preparing the agreement. We also assume that, if the client entity was
party to the agreement, the client entity would delegate the task of
reviewing the agreement to the adviser. This estimate also assumes that
the adviser would enter into a separate agreement for each client
entity, even if multiple client entities use the same auditor. We
believe that written agreements are commonplace and reflect industry
practice when a person retains the services of a professional such as
an accountant, and they are typically prepared by the independent
public accountant in advance. We therefore estimate that each adviser
will initially spend 1.25 hours to add the required provisions to, or
confirm that the required provisions are in, the written agreement,
with an initial aggregate of 48,735 hours \662\ for all advisers that
satisfy the requirements of the audit engagement. We further estimate
that each adviser will spend 0.92 hours \663\ on an annual basis to
reassess current written agreements and execute new agreements as an
adviser adds entity clients for an annual aggregate of 35,869 hours
\664\ and an annual cost of this internal hour burden of $19,476,867
\665\ for all advisers that satisfy the requirements of the audit
provision.
---------------------------------------------------------------------------
\661\ Proposed rule 223-1(b)(4)(v).
\662\ 4,961 advisers to pooled investment vehicles x 6 pooled
investment vehicle clients = 29,766 client written agreements; 3,068
advisers to pension and profit sharing clients x 20% x 6 clients =
3,682 client written agreements; 3,205 advisers to charitable
organization clients x 20% x 3 clients = 1,923 client written
agreements; 986 advisers to state or municipal government entity
clients x 20% x 3 clients = 592 client written agreements; 3,025
advisers to corporations and other business entity clients x 20% x 5
clients = 3,025 client written agreements; (29,766 + 3,682 + 1,923 +
592 + 3,025) x 1.25 hours per agreement = 48,735 hours.
\663\ This includes the internal initial burden estimate
amortized over a three-year period (1.25 hours/3 years) and another
0.5 hours of additional ongoing burden hours = 0.92 hours.
\664\ (29,766 + 3,682 + 1,923 + 592 + 3,025) x 0.92 hours per
ongoing annual burden = 35,869 hours.
\665\ This estimate is based on the following calculation:
35,869 hours x $543 (rate for assistant general counsel).
---------------------------------------------------------------------------
D. Total Hour Burden Associated With Proposed Rule 223-1
Accordingly, we estimate investment advisers that would be subject
to the proposed rule would incur a total annual hour burden resulting
from the collections of information discussed above of approximately
398,152 hours,\666\ at a time cost of $154,579,839.\667\ The total
external burden costs would be $378,598,500.\668\
---------------------------------------------------------------------------
\666\ This estimate is based upon the following calculations:
111,552 + 9,482 + 12,552 + 18,422 + 14,385 + 959 + 69,720 + 13,944 +
6,201 + 2,481 + 133 + 13,944 + 80,949 + 461 + 7,098 + 35,869 hours =
398,152 hours.
\667\ This estimate is based upon the following calculations:
$43,951,488 + $3,735,908 + $12,203,756 + $4,869,322.50 + $324,621.50
+ $27,469,680 + $5,493,936 + $4,720,044 + $27,623,345 + $2,443,194 +
$977,514 + $48,013 + $1,242,150 + $19,476,867 = $154,579,839.
\668\ This estimate is based upon the following calculations:
$35,962,500 + $19,680,000 + $322,956,000 = $378,598,500.
---------------------------------------------------------------------------
A chart summarizing the various proposed components of the total
annual burden for investment advisers with custody of client assets is
below.
[[Page 14768]]
----------------------------------------------------------------------------------------------------------------
Rule 223-1 description of new External burden
requirements Number of responses Internal burden hours costs
----------------------------------------------------------------------------------------------------------------
Final Estimates for Qualified Custodian Protections Under 223-1(a)(1)
----------------------------------------------------------------------------------------------------------------
Initial burden for drafting, 55,776 (4 per adviser with 111,552 (2 per
negotiating, and executing new custody). response).
written custodial agreements with
required provisions between the
adviser and qualified custodian
(``QC'') (IA-QC custodial
contract).
Annual burden for drafting, 55,776 (4 per adviser with 9,482 (.17 hour per
negotiating, and executing new custody). response).
written custodial agreements with
required provisions between the
adviser and qualified custodian
(IA-QC custodial contract).
Annual burden for QC to provide 8,368 (4 per adviser examined).. 12,552 (1.5 hour per
records relating to clients' response).
assets to the Commission *.
* This is not broken up into
initial and ongoing burden because
the annual burden is estimated to
be the same each year.
Annual burden for QC to provide 36,844 (4 per adviser obtaining 18,422 (.5 hour per
records relating to clients' a surprise examination or response).
assets to an independent public audit).
accountant *.
* This is not broken up into
initial and ongoing burden because
the annual burden is estimated to
be the same each year.
Initial burden for QC to send 959 (estimated qualified 14,385 hours (15 hours
account statements, at least custodians). per qualified
quarterly, to the client, or its custodian).
independent representative, and to
adviser.
Annual burden for QC to modify and 959 (estimated qualified 959 (1 hour per
send account statements. custodians). qualified custodian).
Annual burden for QC to obtain ................................ ...................... $35,962,500
internal control report.
Initial burden for adviser 55,776 (1 per adviser).......... 69,720 (1.25 hours per
obtaining reasonable assurances response).
from the QC.
Annual burden for adviser obtaining 55,776 (1 per adviser).......... 13,944 (.25 hours per
reasonable assurances from the QC. response).
----------------------------------------------------------------------------------------------------------------
Final Estimates for Exceptions for Certain Assets that are Unable to be Maintained with a Qualified Custodian
Under 223-1(b)(2)
----------------------------------------------------------------------------------------------------------------
Initial burden for written 4,961 (estimated number of 6,201 (1.25 hours per
agreement with independent public advisers with custody of adviser).
accountant (IPA). privately offered securities
and physical assets that cannot
be maintained with a qualified
custodian under the proposed
rule).
Annual burden for written agreement 4,961........................... 2,481 (.5 hour per
with IPA. adviser).
Annual burden to notify the IPA of 8,000 (estimated number of 133 hours (1 minute
any purchase, sale, or other annual transactions). per transaction).
transfer of beneficial ownership
of such assets within one business
day.
Annual burden to verify the ................................ ...................... $19,680,000
purchase, sale, or other transfer
promptly upon receiving the
required transfer notice *.
* This does not contain an internal
burden estimate because the burden
under this requirement is solely
an external monetary burden.
Annual burden to verify all assets ................................ ...................... $322,956,000
during a surprise exam or an
annual audit *.
* This does not contain an internal
burden estimate because the burden
under this requirement is solely
an external monetary burden.
----------------------------------------------------------------------------------------------------------------
Final Estimates for Complying with the Notice Requirement Under 223-1(a)(2)
----------------------------------------------------------------------------------------------------------------
Initial burden for complying with 13,944 advisers (1 per adviser). 13,944 hours (1 hour
the notice requirement*. per adviser ).
* This would be a one-time burden
to include account numbers in the
notices.
----------------------------------------------------------------------------------------------------------------
Final Estimates for Independent Verification or Surprise Examination Under 223-1(a)(4)
----------------------------------------------------------------------------------------------------------------
Annual burden for complying with 1,842 advisers are subject to 80,949 hours \1\......
the independent verification/ the surprise exam.
surprise examination of client
assets by an IPA under a written
agreement between the IPA and the
adviser *.
* This is not broken up into
initial and ongoing burden because
the annual burden is estimated to
be the same each year.
[[Page 14769]]
Annual burden to enter into a 1,842 advisers.................. 461 hours (.25 per
written agreement with an IPA adviser).
engaged to conduct the surprise
examination and specify certain
duties to be performed by the
independent public accountant *.
* This is not broken up into
initial and ongoing burden because
the annual burden is estimated to
be the same each year.
----------------------------------------------------------------------------------------------------------------
Exception for Entities Subject to the Annual Audit 223-1(b)(4)
----------------------------------------------------------------------------------------------------------------
Annual burden for distributing 7,018 advisers.................. 7,098 hours...........
audited financial statements.
Annual burden for drafting, 7,018 advisers.................. 35,869 hours..........
negotiating, and executing the
required written agreement between
the IPA and adviser regarding
notifications from the IPA to the
Commission of specified events.
----------------------------------------------------------------------------------------------------------------
TOTAL ESTIMATED FINAL BURDEN FOR RULE 223-1
----------------------------------------------------------------------------------------------------------------
Total estimated burden for rule 223- 319,856......................... 398,152 hours......... $378,598,500
1.
Currently approved burden for rule 24,133,429...................... 288,202 hours......... $174,367,000
206(4)-2.
Comparison of proposed rule 223-1 (23,813,573).................... 109,950 hours......... $204,231,500
burdens to current rule 206(4)-2
burdens.
----------------------------------------------------------------------------------------------------------------
Notes:
1. Advisers can be subject to the surprise exam for several reasons. For a more detailed breakout of the types
of advisers and their respective burdens see section IV.B.3.
E. Rule 204-2
Under section 204 of the Advisers Act, investment advisers
registered or required to register with the Commission under section
203 of the Advisers Act must make and keep for prescribed periods such
records (as defined in section 3(a)(37) of the Exchange Act), furnish
copies thereof, and make and disseminate such reports as the
Commission, by rule, may prescribe as necessary or appropriate in the
public interest or for the protection of investors. Rule 204-2 sets
forth the requirements for maintaining and preserving specified books
and records. This collection of information is found at 17 CFR 275.204-
2 and is mandatory. The Commission staff uses the collection of
information in its examination and oversight program. As noted above,
responses provided to the Commission in the context of its examination
and oversight program concerning the proposed amendments to rule 204-2
would be kept confidential subject to the provisions of applicable law.
We are proposing amendments to rule 204-2 to correspond to proposed
new rule 223-1. Specifically, we are proposing to require investment
advisers to maintain the following records for client accounts: (1)
client account identification, (2) custodian information, including
copies of qualified custodian agreements with the adviser, a record of
required reasonable assurances from the qualified custodian, and if
applicable, a copy of the adviser's written reasonable determination
that ownership of certain specified client assets cannot be recorded
and maintained under a qualified custodian's possession or control, (3)
the basis for the adviser having custody of client assets in the
account, (4) any account statements received or sent by the adviser,
(5) transaction and position information, and (6) any SLOAs and related
records to verify that an adviser can avail itself of the proposed
exception to the surprise examination requirement.\669\ The proposed
amendments also would require an adviser to maintain copies of all
written notices to clients required under proposed rule 223-1 and any
responses thereto, and copies of documents relating to independent
public accountant engagements.
---------------------------------------------------------------------------
\669\ Proposed rule 204-2(b)(2)(vi).
---------------------------------------------------------------------------
Each of these records would be required to be maintained in the
same manner, and for the same period of time, as other books and
records required to be maintained under rule 204-2(a). Specifically,
investment advisers would be required to maintain and preserve these
records in an easily accessible place for not less than five years from
the end of the fiscal year during which the last entry was made on such
record, the first two years in an appropriate office of the investment
adviser. Requiring maintenance of these records would facilitate the
Commission's ability to inspect and enforce compliance with proposed
rule 223-1. The information generally is kept confidential.\670\
---------------------------------------------------------------------------
\670\ See section 210(b) of the Advisers Act (15 U.S.C. 80b-
10(b)).
---------------------------------------------------------------------------
The respondents to this collection of information are investment
advisers registered or required to be registered with the Commission
that have custody of client assets. As noted above, based on Form ADV
filings, as of June 30, 2022, we estimate that 13,944 registered
investment advisers would have custody of client assets under proposed
rule 223-1 and would be subject to the proposed amendments to rule 204-
2.
For the proposed retention of SLOAs and related records, however,
we believe that not every adviser with custody of client assets will
have clients that issue SLOAs. Thus, such advisers would not seek to
rely on the proposed SLOA exception. Of the 13,944 advisers with
custody of client assets, we estimate that approximately 20%, or
approximately 2,789 advisers, will have clients that issue SLOAs.
Because we believe that many such advisers already retain copies of
client SLOAs in their books and records, in our view this particular
collection of information requirement would have a negligible impact on
them. As a result, we estimate that this collection of information will
result in an increased burden of .25 hours for each adviser seeking to
rely on the proposed SLOA exception. Therefore, we estimate that the
annual total internal burden of retaining copies of, and records
relating to, client SLOAs would be approximately 697.25 hours,\671\
represented by a monetized cost of $57,174.50.
---------------------------------------------------------------------------
\671\ This estimate is based on the following calculation: .25
hours per adviser x 2,789 advisers.
---------------------------------------------------------------------------
The approved annual aggregate burden for rule 204-2 is currently
[[Page 14770]]
2,764,563 hours, based on an estimate of 13,724 registered advisers, or
201.44 hours per registered adviser.\672\ For the proposed
recordkeeping amendments that correspond to proposed changes to the
custody rule as discussed in this release, we estimate that the
proposed amendments would result in an increase in the collection of
information burden estimate by 21 hours for each of the estimated
13,944 registered advisers with custody of client assets. We,
therefore, estimate that the revised annual aggregate hourly burden for
rule 204-2 would be 3,347,352 hours, represented by a monetized cost of
$217,333,279 based on an estimate of 15,160 registered advisers, of
which we estimate 13,944 would have custody of client assets under the
proposed rule. This represents an increase of 582,789 \673\ annual
aggregate hours in the hour burden and an annual monetized cost
increase of $41,352,853 from the currently approved total aggregate
monetized cost for rule 204-2.\674\ These increases are attributable to
a larger registered investment adviser population since the most recent
approval and adjustments for inflation, as well as the proposed rule
204-2 amendments as discussed in this proposing release.
---------------------------------------------------------------------------
\672\ 2,764,563 hours/13,724 registered advisers = 201.44 hours
per adviser.
\673\ 3,347,352 hours-2,764,563 hours = 582,789 hours.
\674\ $217,333,279-$175,980,426 = $41,352,853.
---------------------------------------------------------------------------
A chart summarizing the various components of the total annual
burden for investment advisers with custody of client assets is below.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Annual
Internal hour Wage rate \1\ Internal time external
burden costs cost burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Final Estimates for Rule 204-2 for Client Communications
--------------------------------------------------------------------------------------------------------------------------------------------------------
Retention of written client notifications 3 x $82 (compliance clerk).......................... $246 ...........
and responses.
------------------------------------------------------------------------------------------------------------
Total burden per adviser............... 3 ...... ................................................ $246 ...........
Total number of affected advisers...... x 13,944 ...... ................................................ x 13,944 ...........
------------------------------------------------------------------------------------------------------------
Sub-total burden................... 41,832 ...... ................................................ $3,430,224 ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Final Estimates for Rule 204-2 for Client Accounts
--------------------------------------------------------------------------------------------------------------------------------------------------------
Creation and retention of records 2 x $73 (general clerk)............................. $146
documenting client account identifying
information, including adviser
discretionary authority.
1 x $82 (compliance clerk).......................... $82 ...........
------------------------------------------------------------------------------------------------------------
Total burden per adviser............... 3 ...... ................................................ $228 ...........
Total number of affected advisers...... x 13,944 ...... ................................................ x 13,944 ...........
------------------------------------------------------------------------------------------------------------
Sub-total burden................... 41,832 ...... ................................................ $3,179,232 ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Creation and retention of records 2 x $73 (general clerk)............................. $146 ...........
documenting custodian identifying
information corresponding to each client
account, including copies of qualified
custodian agreements with adviser, a
record of required reasonable assurances
from the qualified custodian, and if
applicable, a copy of the adviser's
written reasonable determination that
ownership of certain specified client
assets cannot be recorded and maintained
under a qualified custodian's possession
or control.
1 x $82 (compliance clerk).......................... $82 ...........
------------------------------------------------------------------------------------------------------------
Total burden per adviser............... 3 ...... ................................................ $228 ...........
Total number of affected advisers...... x 13,944 ...... ................................................ x 13,944 ...........
------------------------------------------------------------------------------------------------------------
Sub-total burden................... 41,832 ...... ................................................ $3,179,232 ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Creation and retention of records 2 x $73 (general clerk)............................. $146 ...........
documenting adviser's basis of custody of
client assets.
1 x $82 (compliance clerk).......................... $82 ...........
------------------------------------------------------------------------------------------------------------
Total burden per adviser............... 3 ...... ................................................ $228 ...........
Total number of affected advisers...... x 13,944 ...... ................................................ x 13,944 ...........
------------------------------------------------------------------------------------------------------------
Sub-total burden................... 41,832 ...... ................................................ $3,179,232 ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Retention of copies of account statements.. 2 x $82 (compliance clerk).......................... $164 ...........
------------------------------------------------------------------------------------------------------------
Total burden per adviser............... 2 ...... ................................................ $164 ...........
Total number of affected advisers...... x 13,944 ...... ................................................ x 13,944 ...........
------------------------------------------------------------------------------------------------------------
Sub-total burden................... 27,888 ...... ................................................ $2,286,816 ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Creation and retention of records of 3 x $82 (compliance clerk).......................... $246 ...........
detailed transaction and position
information for each client account.
------------------------------------------------------------------------------------------------------------
Total burden per adviser............... 3 ...... ................................................ $246 ...........
Total number of advisers............... x 13,944 ...... ................................................ x 13,944 ...........
------------------------------------------------------------------------------------------------------------
Sub-total burden................... 41,832 ...... ................................................ $3,430,224 ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Retention of copies of, and records .25 x $82 (compliance clerk).......................... $20.50 ...........
relating to, standing letters of
authorization.
------------------------------------------------------------------------------------------------------------
Total burden per adviser............... .25 ...... ................................................ $20.50 ...........
[[Page 14771]]
Total number of advisers............... x 2,789 ...... ................................................ x 2,789 ...........
------------------------------------------------------------------------------------------------------------
Sub-total burden................... 697.25 ...... ................................................ $57,174.50 ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Final Estimates for Rule 204-2 for Independent Public Accountant
--------------------------------------------------------------------------------------------------------------------------------------------------------
Retention of copies of all audited 3 x $73 (general clerk)............................. $219 ...........
financial statements, internal control
reports, and required written agreements
between independent public accountant and
adviser or its client.
1 x $82 (compliance clerk).......................... $82 ...........
------------------------------------------------------------------------------------------------------------
Total burden per adviser............... 4 ...... ................................................ $301 ...........
Total number of affected advisers...... x 13,944 ...... ................................................ x 13,944 ...........
------------------------------------------------------------------------------------------------------------
Sub-total burden................... 55,776 ...... ................................................ $4,197,144 ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total Estimated Final Burden for Rule 204-2
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total burden for this rulemaking........... 293,521.25 ...... ................................................ $22,939,278.50 ...........
Previously approved burden plus the 3,053,831 ...... ................................................ $194,394,000 ...........
additional burden due to the increase in
the number of advisers.
------------------------------------------------------------------------------------------------------------
Total burden........................... 3,347,352 ...... ................................................ $217,333,279 ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ The Commission's estimates of the relevant wage rates are based on salary information for the securities industry compiled by the Securities
Industry and Financial Markets Association's Office Salaries in the Securities Industry 2013. The estimated figures are modified by firm size,
employee benefits, overhead, and adjusted to account for the effects of inflation. See the SIFMA Wage Report.
F. Form ADV
The proposed amendments to Form ADV would increase the information
requested in Form ADV Part 1A. More specifically, we are proposing
amendments to Form ADV Part 1A, Schedule D, and the Instructions and
Glossary of Form ADV that are designed to help advisers identify when
they may have custody of client assets, to provide the Commission with
information related to advisers' practices to safeguard client assets
information about advisers' practices to safeguard client assets, to
provide the Commission with information related to these practices, and
to provide the Commission with additional data to improve our ability
to identify compliance risks.
The estimated new burdens below also take into account changes in
the numbers of advisers since the last approved PRA for Form ADV and
increased costs due to inflation. Based on the prior amendments to Form
ADV, we estimated the annual compliance burden to comply with the
collection of information requirement of Form ADV is 433,004 burden
hours per year and an external cost burden estimate of
$14,125,083.\675\ Compliance with the disclosure requirements of Form
ADV is mandatory, and the responses to the disclosure requirements will
not be kept confidential.
---------------------------------------------------------------------------
\675\ See Investment Adviser Marketing, Final Rule, Investment
Advisers Act Release No. 5653 (Dec. 22, 2020) [81 FR 60418 (Mar. 5,
2021)] and corresponding submission to the Office of Information and
Regulatory Affairs at Reginfo.gov (``2021 Form ADV PRA'').
---------------------------------------------------------------------------
We propose the following changes to our PRA methodology for Form
ADV:
Form ADV Parts 1 and 2. Form ADV PRA has historically
calculated a per adviser per year hourly burden for Form ADV Parts 1
and 2 for each of (i) the initial burden and (ii) the ongoing burden,
which reflects advisers' filings of annual and other-than-annual
updating amendments. We noted in previous PRA amendments that most of
the paperwork burden for Form ADV Parts 1 and 2 would be incurred in
the initial submissions of Form ADV. However, recent PRA amendments
have continued to apply the total initial hourly burden for Parts 1 and
2 to all currently registered or reporting SEC-registered investment
advisers (``RIAs'') and exempt reporting advisers (``ERAs''),
respectively, in addition to the estimated number of new advisers
expected to be registering or reporting with the Commission annually.
We believe that the total initial hourly burden for Form ADV Parts 1
and 2 going forward should be applied only to the estimated number of
expected new advisers annually. This is because currently registered or
reporting advisers have generally already incurred the total initial
burden for filing Form ADV for the first time. On the other hand, the
estimated expected new advisers will incur the full total burden of
initial filing of Form ADV, and we believe it is appropriate to apply
this total initial burden to these advisers. We propose to continue to
apply any new initial burdens resulting from proposed amendments to
Form ADV Parts 1 and 2, as applicable, to all currently registered or
reporting investment advisers plus all estimated expected new RIAs and
ERAs annually.
Private fund reporting. We have previously calculated
advisers' private fund reporting as a separate initial burden. The
currently approved burden for all registered and exempt reporting
advisers, including expected new registered advisers and new exempt
reporting advisers, with respect to reported private funds, is 1 hour
per private fund reported, which we have previously amortized over
three years for all private fund advisers. We propose to continue to
calculate advisers' private fund reporting as a separate reporting
burden, but we propose to apply the initial burden only with respect to
the expected new private funds.
[[Page 14772]]
Table 10--Form ADV PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Internal annual
Initial hours per year amendment burden Wage rate \2\ Internal time costs Annual external
hours \1\ cost burden \3\
--------------------------------------------------------------------------------------------------------------------------------------------------------
PROPOSED AMENDMENTS TO FORM ADV
RIAs (burden for Parts 1 and 2, not including private fund reporting) \4\
--------------------------------------------------------------------------------------------------------------------------------------------------------
Proposed additions (per adviser) 1 hour for Part 1A.... 0.4 hours \5\......... $318 per hour 1.4 hours x $318 per hour =
to Part 1A Item 9 and (blended rate for $445.20.
corresponding schedules. senior compliance
examiner and
compliance
manager) \6\.
Current burden per adviser \7\.. 29.72 hours \8\....... 11.8 hours \9\........ $273.00 per hour (29.72 + 11.8) x $273.00 = $2,069,250
(blended rate for $11,334.96. aggregated
senior compliance (previously
examiner and presented only in
compliance the aggregate)
manager). \10\.
Revised burden per adviser...... 29.72 hours + 1 hour = 0.4 hours + 11.8 hours $318 (blended rate (30.72 + 12.2) x $318 = $4,780.50 \11\.
30.72 hours. = 12.2 hours. for senior $13,648.56.
compliance
examiner and
compliance
manager).
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total revised aggregate 32,117.44 \12\........ 191,686.4 hours \13\.. Same as above...... (32,177,44 + 191,686.4) x $11,162,546 \14\.
burden estimate. $318 = $71,169,621.12.
--------------------------------------------------------------------------------------------------------------------------------------------------------
RIAs (burden for Part 3) \15\
--------------------------------------------------------------------------------------------------------------------------------------------------------
No proposed changes
Current burden per RIA.......... 20 hours, amortized 1.58 hours \17\....... $273 (blended rate $273 x (6.67 + 1.58) = $2,433.74 per
over three years = for senior $2,249.52. adviser \18\.
6.67 hours \16\. compliance
examiner and
compliance
manager).
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total updated aggregate 70,646.67 hours \19\.. 15,646.74 hours \20\.. $318 (blended rate $27,441,303.32 ($318 x $9,930,272.08 \21\.
burden estimate. for senior (70,646.67 hours +
compliance 15,646.74 hours).
examiner and
compliance manager.
--------------------------------------------------------------------------------------------------------------------------------------------------------
ERAs (burden for Part 1A, not including private fund reporting) \22\
--------------------------------------------------------------------------------------------------------------------------------------------------------
No proposed changes.............
Current burden per ERA.......... 3.60 hours \23\....... 1.5 hours + final $273 (blended rate ............................ $0
filings \24\. for senior
compliance
examiner and
compliance
manager).
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total revised aggregate 1,245.60 \25\......... 8,777.60 hours \26\... $318 (blended rate $3,187,377.60 ($318 x $0
burden estimate. for senior (1,245.6 + 8,777.60 hours)).
compliance
examiner and
compliance manager.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Private Fund Reporting \27\
--------------------------------------------------------------------------------------------------------------------------------------------------------
No proposed changes.............
Current burden per adviser to 1 hour per private N/A--included in the $273 (blended rate ............................ Cost of $46,865.74
private fund. fund \28\. existing annual for senior per fund, applied
amendment burden. compliance to 6% of RIAs that
examiner and report private
compliance funds \29\.
manager).
Total updated aggregate burden 1,150 hours \30\...... N/A................... $318 (blended rate $5,173,478.40 ($318 x 16,269 $14,856,439.58
estimate. for senior \30\ hours)). \31\.
compliance
examiner and
compliance
manager).
--------------------------------------------------------------------------------------------------------------------------------------------------------
TOTAL ESTIMATED BURDENS, INCLUDING AMENDMENTS
--------------------------------------------------------------------------------------------------------------------------------------------------------
Current per adviser burden/ 23.82 hours \32\. 23.82 hours x $273 = $777 \33\.
external cost per adviser. $6,502.86 per adviser cost
of the burden hour.
Revised per adviser burden/ 15.62 hours \34\. 15.62 hours x $318 = $1,669.03 \35\.
external cost per adviser. $4,966.43 per adviser cost
of the burden hour.
Current aggregate burden 433,004 initial and amendment hours annually \36\. 433,004 x $273 = $14,125,083 \37\.
estimates. $118,210,092 aggregate cost
of the burden hour.
Revised aggregate burden 336,389.45 \38\ Initial and amendment hours annually. 336,389.45 x $318 = $35,949,257.66
estimates. $106,971,844.04 aggregate \39\.
cost of the burden hour.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ This column estimates the hourly burden attributable to annual and other-than-annual updating amendments to Form ADV, plus RIAs' ongoing obligations
to deliver codes of ethics to clients.
\2\ As with Form ADV generally, and pursuant to the currently approved PRA (see 2021 Form ADV PRA), we expect that for most RIAs and ERAs, the
performance of these functions will most likely be equally allocated between a senior compliance examiner and a compliance manager, or persons
performing similar functions. The Commission's estimates of the relevant wage rates are based on the SIFMA Wage Report, modified by firm size,
employee benefits, overhead, and adjusted to account for the effects of inflation.
\3\ External fees are in addition to the projected hour per adviser burden. Form ADV has a one-time initial cost for outside legal and compliance
consulting fees in connection with the initial preparation of Parts 2 and 3 of the form. In addition to the estimated legal and compliance consulting
fees, investment advisers of private funds incur one-time costs with respect to the requirement for investment advisers to report the fair value of
private fund assets.
[[Page 14773]]
\4\ Based on Form ADV data as of June 2022, we estimate that there are 15,160 RIAs (``current RIAs'') and 552 advisers that are expected to become RIAs
annually (``newly expected RIAs'').
\5\ We estimate that 12,570 RIAs (80% of the total of 15,712 combined current and expected RIAs that are required to complete Parts 1 and 2) would incur
a burden of 0.5 hour, and 3,142 RIAs (20% of 15,712 current and expected RIAs that are required to complete Parts 1 and 2) would incur a burden of 0
hours. (12,570 RIAs x 0.5) + (3,142 RIAs x 0)/15,712 = 0.4 blended average hours per RIA.
\6\ The $318 wage rate reflects current estimates from the SIFMA Wage Report of the blended hourly rate for a senior compliance examiner ($276) and a
compliance manager ($360). ($276 + $360)/2 = $318.
\7\ Per above, we are proposing to revise the PRA calculation methodology to apply the full initial burden only to expected RIAs, as we believe that
current RIAs have generally already incurred the burden of initially preparing Form ADV.
\8\ See 2020 Form ADV PRA Renewal (stating that the estimate average collection of information burden per adviser for Parts 1 and 2 is 29.22 hours,
prior to the most recent amendment to Form ADV). See also 2021 Form ADV PRA (adding 0.5 hours to the estimated initial burden for Part 1A in
connection with the most recent amendment to Form ADV). Therefore, the current estimated average initial collection of information hourly burden per
adviser for Parts 1 and 2 is 29.72 hours (29.22 + 0.5 = 29.72).
\9\ The currently approved average total annual burden for RIAs attributable to annual and other-than-annual updating amendments to Form ADV Parts 1 and
2 is 10.5 hours per RIA, plus 1.3 hours per year for each RIA to meet its obligation to deliver codes of ethics to clients (10.5 + 1.3 = 11.8 hours
per adviser). See 2020 Form ADV PRA Renewal (these 2020 hourly estimates were not affected by the 2021 amendments to Form ADV). As we explained in
previous PRAs, we estimate that each RIA filing Form ADV Part 1 will amend its form 2 times per year, which consists of one interim updating amendment
(at an estimated 0.5 hours per amendment), and one annual updating amendment (at an estimated 8 hours per amendment), each year. We also explained
that we estimate in that each RIA will, on average, spend 1 hour per year making interim amendments to brochure supplements, and an additional 1 hour
per year to prepare brochure supplements as required by Form ADV Part 2. See id.
\10\ See 2020 Form ADV PRA Renewal (the subsequent amendment to Form ADV described in the 2021 Form ADV PRA did not affect that estimate).
\11\ External cost per RIA includes the external cost for initially preparing Part 2, which we have previously estimated to be approximately 10 hours of
outside legal counsel for a quarter of RIAs, and 8 hours of outside management consulting services for half of RIAs. See 2020 Form ADV Renewal (these
estimates were not affected by subsequent amendments to Form ADV). The proposal does not add to this burden. This burden remains 10 hours and 8 hours,
respectively, for \1/4\ and \1/2\ of RIAs, respectively). (((.25 x 15,160 RIAs) x ($565 x 10 hours)) + ((0.50 x 15,160 RIAs) x ($842 x 8 hours)))/
15,160 RIAs = $4,780.50 per adviser.
\12\ Per above, we are proposing to revise the PRA calculation methodology for current RIAs to not apply the full initial burden to current RIAs, as we
believe that current RIAs have generally already incurred the initial burden of preparing Form ADV. Therefore, we calculate the initial burden
associated with complying with the proposed amendment of 1 initial hours x 15,160 current RIAs = 15,160, initial hours in the first year aggregated
for current RIAs. We are not amortizing this burden because we believe current advisers will incur it in the first year. For expected RIAs, we
estimate that they will incur the full revised initial burden, which is 30.72 hours per RIA. Therefore, 30.72 hours x 552 expected RIAs = 16,957.44
aggregate hours for expected RIAs. We do not amortize this burden for expected new RIAs because we expect a similar number of new RIAs to incur this
initial burden each year. Therefore, the total revised aggregate initial burden for current and expected RIAs is 15,160 hours + 16,957.44 hours =
32,117.44 aggregate initial hours.
\13\ 12.2 amendment hours x (15,160 current RIAs + 552 expected new RIAs) = 191,686 aggregate amendment hours.
\14\ Per above, for current RIAs, we are proposing to not apply the currently approved external cost for initially preparing Part 2, because we believe
that current RIAs have already incurred that initial external cost. For current RIAs, therefore, we are applying only the external cost we estimate
they will incur in complying with the proposed amendment. Therefore, the revised total burden for current RIAs is (((.25 x 15,160 RIAs) x ($565 x 1
hour)) + ((0.50 x 15,160 RIAs) x ($842 x 1 hour))) = $8,523,710 aggregated for current RIAs, We do not amortize this cost for current RIAs because we
expect current RIAs will incur this initial cost in the first year. For expected RIAs, we apply the currently approved external cost for initially
preparing Part 2 plus the estimated external cost for complying with the proposed amendment. Therefore, $4,780.50 per expected RIA x 552 = $2,638,836
aggregated for expected RIAs. We do not amortize this cost for expected new RIAs because we expect a similar number of new RIAs to incur this external
cost each year. $8,523,710 aggregated for current RIAs + $2,638,836 aggregated for expected RIAs = $11,162,546 aggregated external cost for RIAs.
\15\ Even though we are not proposing amendments to Form ADV Part 3 (``Form CRS''), the burdens associated with completing Part 3 are included in the
PRA for purposes of updating the overall Form ADV information collection. Based on Form ADV data as of October 31, 2021, we estimate that 8,877
current RIAs provide advice to retail investors and are therefore required to complete Form CRS, and we estimate an average of 347 expected new RIAs
to be advising retail advisers and completing Form CRS for the first time annually.
\16\ See Form CRS Relationship Summary; Amendments to Form ADV, Investment Advisers Act Release No. 5247 (June 5, 2019) [84 FR 33492 (Sep. 10, 2019)]
(``2019 Form ADV PRA''). Subsequent PRA amendments for Form ADV have not adjusted the burdens or costs associated with Form CRS. Because Form CRS is
still a new requirement for all applicable RIAs, we have, and are continuing to, apply the total initial burden to all current and expected new RIAs
that are required to file Form CRS, and amortize that initial burden over three years for current RIAs.
\17\ As reflected in the currently approved PRA burden estimate, we stated that we expect advisers required to prepare and file the relationship summary
on Form ADV Part 3 will spend an average 1 hour per year making amendments to those relationship summaries and will likely amend the disclosure an
average of 1.71 times per year, for approximately 1.58 hours per adviser. See 2019 Form ADV PRA (these estimates were not amended by the 2021
amendments to Form ADV).
\18\ See 2020 Form ADV PRA Amendment (this cost was not affected by the subsequent amendment to Form ADV and was not updated in connection with that
amendment; while this amendment did not break out a per adviser cost, we calculated this cost from the aggregate total and the number of advisers we
estimated prepared Form CRS). Note, however, that in our 2020 Form ADV PRA Renewal, we applied the external cost only to expected new retail RIAs,
whereas we had previously applied the external cost to current and expected retail RIAs. We believe that since Form CRS is still a newly adopted
requirement, we should continue to apply the cost to both current and expected new retail RIAs. See 2019 Form ADV PRA.
\19\ 9,556 current RIAs x 6.67 hours each for initially preparing Form CRS = 63,706.67 aggregate hours for current RIAs initially filing Form CRS. For
expected new RIAs initially filing Form CRS each year, we are not proposing to use the amortized initial burden estimate, because we expect a similar
number of new RIAs to incur the burden of initially preparing Form CRS each year. Therefore, 347 expected new RIAs x 20 initial hours for preparing
Form CRS = 6,940 aggregate initial hours for expected RIAs. 63,706.67 hours + 6,940 hours = 70,646.67 aggregate hours for current and expected RIAs to
initially prepare Form CRS.
\20\ 1.58 hours x (9,556 current RIAs updating Form CRS + 347 expected new RIAs updating Form CRS) = 15,646.74 aggregate amendment hours per year for
RIAs updating Form CRS.
\21\ We have previously estimated the initial preparation of Form CRS would require 5 hours of external legal services for an estimated quarter of
advisers that prepare Part 3, and 5 hours of external compliance consulting services for an estimated half of advisers that prepare Part 3. See 2020
PRA Renewal (these estimates were not amended by the most recent amendment to Form ADV). The hourly cost estimate of $565 and $842 for outside legal
services and management consulting services, respectively, are based on an inflation-adjusted figure in the SIFMA Wage Report. Therefore, (((.25 x
9,556 current RIAs preparing Form CRS) x ($565 x 5 hours)) + ((0.50 x 9,556 current RIAs preparing Form CRS) x ($842 x 5 hours))) = $26,864,305. For
current RIAs, since this is still a new requirement, we amortize this cost over three years for a per year initial external aggregated cost of
$8,954,768.33. For expected RIAs that we expect would prepare Form CRS each year, we use the following formula: (((.25 x 347 expected RIAs preparing
Form CRS) x ($565 x 5 hours)) + ((0.50 x 347 expected RIAs preparing Form CRS) x ($842 x 5 hours))) = $975,503.75 aggregated cost for expected RIAs.
We are not amortizing this initial cost because we estimate a similar number of new RIAs would incur this initial cost in preparing Form CRS each
year, $8,954,768.33 + $975,503.75 = $9,930,272.08 aggregate external cost for current and expected RIAs to initially prepare Form CRS.
\22\ Based on Form ADV data as of June 30, 2022, we estimate that there are 5,481 currently reporting ERAs (``current ERAs''), and an average of 346
expected new ERAs annually (``expected ERAs'').
\23\ See 2021 Form ADV PRA.
\24\ The previously approved average per adviser annual burden for ERAs attributable to annual and updating amendments to Form ADV is 1.5 hours. See
2021 Form ADV PRA. As we have done in the past, we add to this burden the burden for ERAs making final filings, which we have previously estimated to
be 0.1 hour per applicable adviser, and we estimate that an expected 371 current ERAs will prepare final filings annually, based on Form ADV data as
of December 2020.
\25\ For current ERAs, we are proposing to not apply the currently approved burden for initially preparing Form ADV, because we believe that current
ERAs have already incurred this burden. For expected ERAs, we are applying the initial burden of preparing Form ADV of 3.6 hours. Therefore, 3.6 hours
x 346 expected new ERAs per year = 1,245.60 aggregate initial hours for expected ERAs. For these expected ERAs, we are not proposing to amortize this
burden because we expect a similar number of new ERAs to incur this burden each year. Therefore, we estimate 1,245.60 aggregate initial annual hours
for expected ERAs.
\26\ The previously approved average total annual burden of ERAs attributable to annual and updating amendments to Form ADV is 1.5 hours. See 2020 Form
ADV Renewal (this estimate was not affected by the subsequent amendment to Form ADV). As we have done in the past, we added to this burden the
currently approved burden for ERAs making final filings of 0.1 hour, and multiplied that by the number of final filings we are estimating ERAs would
file per year (371 final filings based on Form ADV data as of December 2020). (1.5 hours x 5,481 currently reporting ERAs) + (0.1 hour x 371 final
filings) = 8,258.60 updated aggregated hours for currently reporting ERAs. For expected ERAs, the aggregate burden is 1.5 hours for each ERA
attributable to annual and other-than-annual updating amendments to Form ADV x 346 expected new ERAs = 519 annual aggregated hours for expected new
ERAs updating Form ADV (other than for private fund reporting). The total aggregate amendment burden for ERAs (other than for private fund reporting)
is 8,258.60 + 519 = 8,777.60 hours.
\27\ Based on Form ADV data as of June 30, 2022, we estimate that 5,142 current RIAs advise 50,968 private funds. Previously, based on Form ADV data as
of October 31, 2021, we have estimated 136 new RIAs will advise 407 reported private funds per year. We have also estimated that 4,959 current ERAs
advise 23,476 private funds, and estimate an expected 372 new ERAs will advise 743 reported private funds per year. Therefore, we estimate that there
are 74,444 currently reported private funds reported by current private fund advisers (50,968 + 23,476), and there will be annually 1,150 new private
funds reported by expected private fund advisers (407 + 743). The total number of current and expected new RIAs that report or are expected to report
private funds is 5,278 (5,142 current RIAs that report private funds + 136 expected RIAs that would report private funds).
\28\ See 2020 Form ADV PRA Renewal (this per adviser burden was not affected by subsequent amendments to Form ADV).
[[Page 14774]]
\29\ We previously estimated that an adviser without the internal capacity to value specific illiquid assets would obtain pricing or valuation services
at an estimated cost of $37,625 each on an annual basis. See Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers
Act Release No. IA-3221 (June 22, 2011) [76 FR 42950 (July 19, 2011)]. However, because we estimated that external cost in 2011, we are proposing to
use an inflation-adjusted cost of $46,865.74, based on the CPI calculator published by the Bureau of Labor Statistics at https://www.bls.gov/data/inflation_calculator.htm. As with previously approved PRA methodologies, we continue to estimate that 6% of RIAs have at least one private fund client
that may not be audited. See 2020 Form ADV PRA Renewal.
\30\ Per above, for currently reported private funds, we are proposing to not apply the currently approved burden for initially reporting private funds
on Form ADV, because we believe that current private fund advisers have already incurred this burden. Therefore, we calculated the burden on current
private fund advisers for only the proposed incremental new additional burden attributable to private fund reporting of 0.2 hours per private fund x
74,444 currently reported private funds = 14,889 aggregate hours for current private fund advisers. We expect advisers to incur the initial burden in
the first year and are therefore not amortizing this burden. For the estimated 1,150 new private funds annually of expected private fund advisers, we
calculate the initial burden of both the proposed incremental new additional burden attributable to private fund reporting of 0.2 hours per private
fund and the 1 hour initial burden per private fund. Therefore, 1.2 hours per expected new private fund x 1,150 expected new private funds = 1,380
aggregate hours for expected new private funds. For these expected new private funds, we are not proposing to amortize this burden, because we expect
new private fund advisers to incur this burden with respect to new private funds each year. 14,889 hours + 1,380 hours = 16,269 aggregate hours for
private fund advisers.
\31\ As with previously approved PRA methodologies, we continue to estimate that 6% of registered advisers have at least one private fund client that
may not be audited, therefore we estimate that the total number of audits for current and expected RIAs is 6% x 5,278 current and expected RIAs
reporting private funds or expected to report private funds = 316.68 audits. We therefore estimate that approximately 317 registered advisers incur
costs of $46,865.74 each on an annual basis (see note 29 describing the cost per audit), for an aggregate annual total cost of $14,856,439.58.
\32\ 433,004 currently approved burden hours/18,179 advisers (current and expected annually) = 23.82 hours per adviser. See 2021 Form ADV PRA.
\33\ $14,125,083 currently approved aggregate external cost/18,179 advisers (current and expected annually) = $777 blended average external cost per
adviser.
\34\ 336,389.45 aggregate annual hours for current and expected new advisers (see infra note 38)/(15,160 current RIAs + 552 expected RIAs + 5,481
current ERAs +346 expected ERAs*) = 15.62 blended average hours per adviser. * The parenthetical totals 21,539 current and expected advisers.
\35\ $35,949,257.66 aggregate external cost for current and expected new advisers (see infra note 39)/(21,539 advisers current and expected annually) =
$1,669.03 blended average hours per adviser.
\36\ See 2021 Form ADV PRA.
\37\ See 2021 Form ADV PRA.
\38\ 32,117.44 hours (internal initial burden for Parts 1 and 2) + 191,686.40 hours (internal annual amendment burden for Parts 1 and 2) + 70,646.67
hours (internal initial burden for Part 3) + 15,646.74 hours (internal annual amendment burden for Part 3) + 1,245.60 hours (internal initial burden
for ERAs) + 8,777.60 hours (internal annual amendment burden for ERAs)+ 16,269 hours (internal initial burden for private funds) = 336,389.45
aggregate annual hours for current and expected new advisers.
\39\ $11,162,546.00 (annual external cost burden for Parts 1 and 2) + $9,930,272.08 (annual external cost burden for Part 3) + $14,856,439.58 (annual
external cost burden for private funds) = $35,949,257.66.
G. Request for Comments
We request comment on whether our estimates for burden hours and
any external costs as described above are reasonable. Pursuant to 44
U.S.C. 3506(c)(2)(B), the Commission solicits comments in order to: (i)
evaluate whether the proposed collections of information are necessary
for the proper performance of the functions of the Commission,
including whether the information will have practical utility; (ii)
evaluate the accuracy of the Commission's estimate of the burden of the
proposed collections of information; (iii) determine whether there are
ways to enhance the quality, utility, and clarity of the information to
be collected; and (iv) determine whether there are ways to minimize the
burden of the collections of information on those who are to respond,
including through the use of automated collection techniques or other
forms of information technology.
In addition to these general requests for comment, we also request
comment specifically on the following issues:
Our analysis relies upon certain assumptions, such as
13,944 advisers will enter into written agreements as required by the
rule, 959 qualified custodians will be counterparties to those written
agreements, and 55,776 written agreements will initially be executed.
Do commenters agree with these assumptions? If not, why not, and what
data would commenters propose?
Our analysis also relies on the assumption that a new
written agreement will require approximately one hour per adviser and
per qualified custodian. Our analysis also assumes that subsequent
annual changes to the written agreement require an aggregate of 10
minutes of adviser and qualified custodian time per agreement. Do
commenters agree with these assumptions? If not, why not, and what data
would commenters propose?
Our analysis also relies on the assumption that 1,842 of
the advisers to the written agreements would be subject to the surprise
examination requirement and we estimate that qualified custodians would
be required to provide information to an independent public accountant
once annually for each adviser. Further, our analysis relies on the
assumption that it would take qualified custodians approximately 5
hours to provide the required information. Do commenters agree with
these assumptions? If not, why not, and what data would commenters
propose?
Our analysis also relies on the assumption that 7,018
advisers to the written agreements would comply with the proposed
rule's audit exception and that qualified custodians would be required
to provide information to an independent public accountant 1.05 times
annually for these advisers. Also, our analysis relies on the
assumption that a qualified custodian will take .5 hours to provide
information to the independent public accountant. Do commenters agree
with these assumptions? If not, why not, and what data would commenters
propose?
Our analysis also relies on the assumption that the
Commission would examine approximately 2,092 of the advisers required
to enter into a written agreement under the rule and assume that the
Commission will issue approximately 8,368 requests to qualified
custodians under the rule. Additionally, we assume qualified custodians
would take 1.5 hours to respond to the information requested by an
independent public accountant. Do commenters agree with these
assumptions? If not, why not, and what data would commenters propose?
Our analysis also relies on the assumption that it would
take qualified custodians 15 hours each to update distribution lists to
add advisers to the distribution of quarterly statements and one hour
per each qualified custodian to make modifications and send quarterly
account statements annually. Do commenters agree with this assumption?
If not, why not, and what data would commenters propose?
Our analysis also relies on the assumption that, on
average, an internal control report for a qualified custodian costs
approximately $750,000. Further, our analysis relies on the assumption
that 95% of custodians currently obtain internal control reports. As a
result, our analysis assumes an annual external cost burden of
obtaining internal control reports to be $35,962,500. Do commenters
agree with this assumption? If not, why not, and what data would
commenters propose?
Our analysis also relies on the assumptions that it would
take 15 minutes for an adviser to obtain the proposed reasonable
assurances requirements from a qualified custodian and one hour to
update any written agreement, if necessary, to reflect the reasonable
assurances. Further, we estimate that the exchange is most likely to
occur in the context of the negotiation and execution of the written
agreement. Additionally, our analysis relies on the assumption that it
will take
[[Page 14775]]
approximately .25 hours to update the reasonable assurances annually.
Do commenters agree with these assumptions? If not, why not, and what
data would commenters propose?
Our analysis relies on the assumption that each of the
1,842 advisers expected to undergo a surprise examination under the
proposed rule will spend 0.25 hour to enter into a written agreement
with the independent public accountant engaged to conduct the surprise
examination. Our analysis also relies on the assumption that these
advisers can be categorized into three groups for purposes of the
calculation of the burden. Do commenters agree with these assumptions?
If not, why not, and what data would commenters propose?
Our analysis relies on the assumption that 381 advisers
subject to the surprise examination requirement have custody because
they serve as qualified custodians for their clients, or they have a
related person that serves as qualified custodian for clients.
Additionally, our analysis relies on the assumption that these advisers
are subject to an annual surprise examination with respect to 100
percent of their clients (or 9,006 clients per adviser) based on the
assumption that all of their clients maintain custodial accounts with
the adviser or its related person. Our analysis assumes that each
adviser will spend an average of 0.02 hours for each client to create a
client contact list for the independent public accountant to conduct
the asset verification. Do commenters agree with these assumptions? If
not, why not, and what data would commenters propose?
Our analysis relies on the assumption that 834 advisers
subject to the surprise examination requirement have custody because
they have broad authority to access client assets held at an
independent qualified custodian, such as through a power of attorney or
acting as a trustee for a client's trust. Also, our analysis assumes
that these advisers will be subject to an annual surprise examination
with respect to 5 percent of their clients (or 450 clients per adviser)
who maintain these types of arrangements with the adviser. In addition,
our analysis assumes that each adviser will spend an average of 0.02
hours for each client that is subject to these arrangements to create a
client contact list for the independent public accountant. Do
commenters agree with these assumptions? If not, why not, and what data
would commenters propose?
Our analysis relies on the assumption that 626 advisers
manage private funds and undergo surprise examinations. For these
advisers, our analysis relies on the assumption that each adviser
managing private funds has an average of 6 pooled investment vehicle
clients with an average of 14 investors. Our analysis relies on the
assumption that these advisers will spend 1 hour for the pool and 0.02
hours for each investor in the pool to create a contact list for the
independent public accountant. Do commenters agree with these
assumptions? If not, why not, and what data would commenters propose?
Our analysis relies on the assumption that 4,961 advisers
currently have custody of privately offered securities and physical
assets that cannot be maintained with a qualified custodian. Our
analysis further relies on the assumption that there will be
approximately 8,000 purchases, sales, or other transfers of beneficial
ownership of assets subject to the exception in proposed rule 223-
1(b)(2). Do commenters agree with these assumptions? If not, why not,
and what data would commenters propose?
Our analysis relies on the assumption that it would take
each adviser 1.25 hours, initially, to prepare the written agreement
with an accountant for verification of assets under proposed rule 223-
1(b)(2)(iii). Additionally, our analysis relies on the assumption that
these agreements will change minimally from year to year and that
advisers will spend approximately .5 hours annually amending these
agreements or entering into new agreements. Do commenters agree with
these assumptions? If not, why not, and what data would commenters
propose?
Our analysis also relies on the assumption that the
adviser's required notice to an accountant under proposed rule 223-
1(b)(2)(iv) would likely be provided by the adviser in connection with
the closing of a transaction, and would take advisers approximately one
minute to deliver to the accountant. Do commenters agree with this
assumption? If not, why not, and what data would commenters propose?
Our analysis relies on the assumption that accountant
verifications of transfers of beneficial ownership will have an annual
cost burden of $19,680,000 to advisers. Do commenters agree with this
assumption? If not, why not, and what data would commenters propose?
Our analysis also relies on the assumption that the
additional cost of asset verification for all assets during a surprise
examination or audit under the audit provision aggregates to
$322,956,000 annually. Do commenters agree with this assumption? If
not, why not, and what data would commenters propose?
Our analysis relies on the assumption that distributions
of audited financial statements to investors in the client entity will
take advisers approximately 1 minute per investor. Our analysis relies
on the assumption that there are 4,961 advisers to audited pooled
investment vehicles, with an upward adjustment to 7,018 to account for
our expectation that an increasing number of advisers will obtain
audits of client entities. Do commenters agree with these assumptions?
If not, why not, and what data would commenters propose?
Our analysis relies on the assumption that each of the
7,018 advisers that rely on the audit provision will spend 1.25 hours
to add the provisions required under proposed rule 223-1(b)(4)(v) to
the written agreement with the independent public accountant. Our
analysis also relies on the assumption that each adviser will spend
0.92 hours on an annual basis to reassess these written agreements and
execute new agreements as an adviser adds entity clients. Do commenters
agree with these assumptions? If not, why not, and what data would
commenters propose?
Our analysis also relies on the assumption that of the
13,944 advisers with custody of client assets, we estimate that
approximately 20%, or approximately 2,789 advisers, will have clients
that issue SLOAs. Further, our analysis assumes that many such advisers
already retain copies of client SLOAs in their books and records and we
assume, therefore, that this collection of information will result in
an increased burden of only .25 hours for each adviser seeking to rely
on the proposed SLOA exception. Do commenters agree with these
assumptions? If not, why not, and what data would commenters propose?
Our analysis relies on the assumption that 12,570 advisers
(80% of the total of 15,712 combined current and expected advisers that
are required to complete Parts 1 and 2 of the Form ADV) would incur an
additional burden of 5 hour under the proposed amendments to Form ADV
Part 1A, and 3,142 advisers (20% of 15,712 current and expected
advisers that are required to complete Parts 1 and 2 of Form ADV) would
incur a burden of 0 hours. Do commenters agree with these assumptions?
If not, why not, and what data would commenters propose?
The agency is submitting the proposed collections of information to
OMB for approval. Persons wishing to submit comments on the collection
of information requirements of the proposed amendments should direct
[[Page 14776]]
them to the Office of Management and Budget, Attention Desk Officer for
the Securities and Exchange Commission, Office of Information and
Regulatory Affairs, Washington, DC 20503, and should send a copy to
Vanessa A. Countryman, Secretary, Securities and Exchange Commission,
100 F Street NE, Washington, DC 20549 1090, with reference to File S7-
04-23. OMB is required to make a decision concerning the collections of
information between 30 and 60 days after publication of this release;
therefore, a comment to OMB is best assured of having its full effect
if OMB receives it within 30 days after publication of this release.
Requests for materials submitted to OMB by the Commission with regard
to these collections of information should be in writing, refer to File
S7-04-23, and be submitted to the Securities and Exchange Commission,
Office of FOIA Services, 100 F Street NE, Washington, DC 20549-2736.
V. Initial Regulatory Flexibility Analysis
The Commission has prepared the following Initial Regulatory
Flexibility Analysis (``IRFA'') in accordance with section 3(a) of the
Regulatory Flexibility Act (``RFA'').\676\ It relates to: (i) new rule
223-1 under the Advisers Act; (ii) proposed rule 204(d)-1; (iii)
proposed amendments to rule 204-2; and (iv) proposed amendments to Form
ADV Part 1A.
---------------------------------------------------------------------------
\676\ 5 U.S.C. 603(a).
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A. Reason for and Objectives of the Proposed Action
1. Proposed Rule 223-1
We are proposing amendments to the custody rule, which we adopted
in 1962 and amended in 2003 and 2009. The current custody rule
generally requires an adviser to:
Maintain client funds and securities with a qualified
custodian (broker-dealers, banks or savings associations, futures
commission merchants, and certain foreign financial institutions);
Have a reasonable basis upon due inquiry for believing
qualified custodians send account statements directly to advisory
clients;
Undergo an annual surprise examination by an independent
public accountant to verify that a sampling of client funds and
securities exists or have the audited financial statements of a pooled
investment vehicle prepared in accordance with generally accepted
accounting principles and distributed to investors in the pool; and
Obtain a report of the internal controls of related person
qualified custodians relating to custody from an independent public
accountant.
The proposed changes to the custody rule are designed to recognize
the expansion in products and services investment advisers offer to
their clients, evolution in the types of investments and ways of
evidencing their ownership, and developments in the market for
custodial services. We have accounted for these advancements by
clarifying the rule's scope and implementing more impactful and
tailored protections. Specifically, the rule would subject investment
advisers to requirements pertaining to the use of a qualified
custodian, delivery of notices to clients, segregation of client
assets, and independent public accountant assessments. The rule would
also subject investment advisers to requirements relating to the
safeguarding of client assets that are not able to be maintained by a
qualified custodian. Importantly, the proposal maintains the core
purpose of protecting client assets from loss, misuse, theft,
misappropriation, and the insolvency or financial reverses of the
adviser. We believe that modernized rules would help advisers better
recognize and protect against vulnerabilities to advisory client assets
and would improve our oversight and risk-assessment abilities. The
reasons for, and objectives of, the proposed amendments are discussed
in more detail in sections I and II, above. The burdens of these
requirements on small advisers are discussed below as well as above in
sections III and IV, which discuss the burdens on all advisers. The
professional skills required to meet these specific burdens are also
discussed in section IV.
2. Proposed Rule 204-2
We also are proposing amendments to rule 204-2 to correspond to
proposed rule 223-1. Specifically, we are proposing to require
investment advisers to maintain the following records for client
accounts: (1) client account identification, (2) custodian
identification, (3) the basis for the adviser having custody of client
assets in the account, (4) any account statements received or sent by
the adviser, (5) transaction and position information, and (6) any
standing letters of authorization and records relating thereto. The
proposed amendments also would require an adviser to maintain copies of
all written notices to clients required under proposed rule 223-1 and
any responses thereto, and copies of documents relating to independent
account engagements.
Although the current rule requires certain recordkeeping relating
to investment advisers' custody rule compliance, the proposal would
align the recordkeeping requirements with proposed rule 223-1. We are
proposing to amend the current rule to require advisers to retain
documentation that would allow the Commission examination staff to
verify advisers' compliance with proposed rule 223-1, particularly in
the categories of client communications, client accounts, and
independent public account engagements, and reliance on the proposed
rule's exceptions. The proposed recordkeeping rules are designed to
work in concert with proposed rule 223-1 so that a complete custodial
record with respect to client assets is maintained and preserved. This
would help facilitate the Commission's inspection and enforcement
capabilities, including assessing compliance with rules, and therefore,
it would provide important investor protections.
3. Proposed Amendments to Form ADV
We are also proposing to amend Item 9 of Part 1A, Schedule D, and
the Instructions and Glossary of Form ADV to improve information
available to us and to the general public about advisers' practices in
safeguarding client assets. We are proposing amendments to Form ADV to
align reporting obligations with the proposed changes to the custody
rule and to help advisers identify when they may have custody of client
assets, to provide the Commission with information related to advisers'
practices to safeguard client assets, and to provide the Commission
with additional data to improve our ability to identify compliance
risks. More accurate and comprehensive information would inform the
Commission's examination initiatives and would allow the Commission and
its staff to better assess risks specific advisers pose to investors.
The proposed revisions would require an adviser to report the
amount and number of clients falling into each category of custody
(i.e., direct or indirect) and to require advisers to report similar
information about client assets over which they have custody resulting
from (1) having the ability to deduct advisory fees; (2) having
discretionary trading authority; (3) serving as a general partner,
managing member, trustee (or equivalent) for clients that are private
funds; (4) serving as a general partner, managing member, trustee (or
equivalent) for clients that are not private funds; (5) having a
general power of attorney over client assets or check-writing
authority; (6)
[[Page 14777]]
having a standing letter of authorization; (7) having physical
possession of client assets; (8) acting as a qualified custodian; (9) a
related person with custody that is operationally independent; and (10)
any other reason.\677\ Amendments to the form would require an adviser
to indicate whether it is relying on any of the exceptions from the
safeguarding rule and, if so, to indicate on which exception(s) the
adviser is relying. We are also proposing to require advisers to report
whether client assets for which the adviser triggers the rule are
maintained at a qualified custodian and the number of clients and
approximate amount of assets not maintained with a qualified custodian.
Advisers would also be required to report certain identifying
information about the qualified custodians and independent public
accountants. The reasons for and objectives of, the proposed amendments
to Form ADV are discussed in more detail in section II.I above. The
burdens of these requirements on small advisers are discussed below as
well as above in our Economic Analysis and Paperwork Reduction Act
Analysis, which discuss the burdens on all advisers. The professional
skills required to meet these specific burdens are also discussed in
section IV.
---------------------------------------------------------------------------
\677\ Proposed Form ADV, Part 1A, Item 9.A.(2). Advisers are
currently required to report information with respect to funds and
securities over which their related persons have custody, including
the dollar amount and number of clients whose funds or securities
are in the adviser's custody and whether any related person has
custody of any clients' cash or bank accounts or securities and the
relevant dollar amount and number of clients. See Form ADV, Part 1A
Item 9.A.(2) through, Item 9.B. Based on its responses, an adviser
is also required to report additional custody-related information in
Schedule D of Form ADV, Part 1A.
---------------------------------------------------------------------------
B. Legal Basis
The Commission is proposing new rule 223-1 and to redesignate rule
206(4)-2 pursuant to the authority set forth in sections 206(4),
211(a), and 223 of the Advisers Act [15 U.S.C. 80b-6(4), 80b-11(a), and
80b-23]; to proposed rule 204(d)-1 pursuant to authority set forth in
sections 204, 211(a), and 223 of the Advisers Act [15 U.S.C. 80b-4 and
80b-11(a)]; to amend rule 204-2 pursuant to the authority set forth in
sections 204, 211, and 223 of the Advisers Act [15 U.S.C. 80b-4, 80b-
11, 80b-23]; and to amend Form ADV pursuant to the authority set forth
in sections 203(c)(1), 204, 211(a), and 223 of the Advisers Act [15
U.S.C. 80b-3(c)(1), 80b-4, 80b-11(a), and 80b-23].
C. Small Entities Subject to the Rule and Rule Amendments
In developing these proposals, we have considered their potential
impact on small entities that would be subject to the proposed
amendments. The proposed amendments would affect many, but not all,
investment advisers registered with the Commission, including some
small entities.
Under Commission rules, for the purposes of the Advisers Act and
the RFA, an investment adviser generally is a small entity if it: (1)
has assets under management having a total value of less than $25
million; (2) did not have total assets of $5 million or more on the
last day of the most recent fiscal year; and (3) does not control, is
not controlled by, and is not under common control with another
investment adviser that has assets under management of $25 million or
more, or any person (other than a natural person) that had total assets
of $5 million or more on the last day of its most recent fiscal
year.\678\ Our proposed new rules and amendments would not affect most
investment advisers that are small entities (``small advisers'')
because they are generally registered with one or more state securities
authorities and not with the Commission. Under section 203A of the
Advisers Act, most small advisers are prohibited from registering with
the Commission and are regulated by state regulators. Based on IARD
data, we estimate that as of June 30, 2022, approximately 522 SEC-
registered advisers are small entities under the RFA.\679\
---------------------------------------------------------------------------
\678\ Advisers Act rule 0-7(a).
\679\ Based on SEC-registered investment adviser responses to
Items 5.F. and 12 of Form ADV.
---------------------------------------------------------------------------
1. Small Entities Subject to Amendments to the Custody Rule
As discussed above in section III (the Economic Analysis), the
Commission estimates that based on IARD data as of June 30, 2022,
approximately 13,944 investment advisers would be subject to the new
rule 223-1 under the Advisers Act, the related proposed amendments to
rule 204-2 under the Advisers Act, and the related proposed amendments
to Form ADV.\680\
---------------------------------------------------------------------------
\680\ See supra note 553.
---------------------------------------------------------------------------
Of the approximately 522 SEC-registered advisers that are small
entities under the RFA, 321 would be subject to the new rule 223-1, the
corresponding amendments to rule 204-2, and the amendments to Form ADV.
This is because, as discussed above in the PRA, we estimate that all
small entities that have custody would be subject to the requirements
of the proposed rule.\681\
---------------------------------------------------------------------------
\681\ See PRA discussion supra section IV.
---------------------------------------------------------------------------
D. Projected Reporting, Recordkeeping and Other Compliance Requirements
1. Proposed Rule 223-1
Proposed rule 223-1 would impose certain reporting and compliance
requirements on certain investment advisers, including those that are
small entities. All registered investment advisers that have custody of
client assets, which we estimate to be 13,944 advisers, would be
required to comply with the proposed safeguarding rule's segregation,
qualified custodian protection, notice to client, and independent
verification requirements. Although all of these advisers would also be
subject to the qualified custodian requirements, some would satisfy
these requirements by entering into contracts with qualified
custodians, while others would satisfy them by satisfying conditions of
a limited exception for investments in privately offered securities and
physical assets. The proposed requirements and rule amendments,
including compliance, reporting, and recordkeeping requirements, are
summarized in this IRFA (section V.A., above). All of these proposed
requirements are also discussed in detail, above, in sections I and II,
and these requirements and the burdens on respondents, including those
that are small entities, are discussed above in sections III and IV
(the Economic Analysis and Paperwork Reduction Act Analysis,
respectively) and below. The professional skills required to meet these
specific burdens are also discussed in section IV.
As discussed above, there are approximately 522 small advisers
currently registered with us, and we estimate that 480 of those small
advisers registered with us would be subject to amendments to the
safeguarding rule (92% of all registered small advisers).\682\ As
discussed above in our Paperwork Reduction Act Analysis in section IV
above, the proposed amendments to rule 223-1 under the Advisers Act
would create a new annual burden of approximately 28.4 hours per
adviser, or 9,116 hours in aggregate for small advisers.\683\ We
therefore expect the annual monetized aggregate cost to
---------------------------------------------------------------------------
\682\ See supra note 587and accompanying text.
\683\ 396,041 hours/13,944 advisers subject to the proposed rule
= 28.4 hours per adviser. 28.4 hours x 480 small advisers = 13,632
hours.
---------------------------------------------------------------------------
[[Page 14778]]
small advisers associated with our proposed amendments to the
safeguarding rule would be $5,371,008.\684\
---------------------------------------------------------------------------
\684\ 13,632 aggregate small adviser hours x $394 (blended rate
for a compliance manager ($361) and a compliance attorney ($426)) =
$5,371,008.
---------------------------------------------------------------------------
2. Proposed Amendments to Rule 204-2
Proposed amendments to rule 204-2 would require investment advisers
to maintain the following records for client accounts: (1) client
account identification, (2) custodian identification, (3) the basis for
the adviser having custody of client assets in the account, (4) any
account statements received or sent by the adviser, (5) transaction and
position information, and (6) any standing letters of authorization and
records relating thereto. The proposed amendments also would require an
adviser to maintain copies of all written notices to clients required
under proposed rule 223-1 and any responses thereto, and copies of
documents relating to independent account engagements. Each of these
records would correspond to proposed rule 223-1, and also would be
required to be maintained in the same manner, and for the same period
of time, as other books and records required to be maintained under
rule 204-2(a).
As discussed above, there are approximately 522 small advisers
currently registered with us. We estimate that 92% percent of all
advisers registered with us that have investment discretion over client
assets (and thus deemed custody of such assets) \685\ would be subject
to proposed rule 223-1 and corresponding amendments to the books and
records rule. As discussed above in our Paperwork Reduction Act
Analysis in section IV.E above, the proposed amendments to rule 204-2
under the Advisers Act would increase the annual burden by
approximately 21 hours per affected adviser, or 10,080 hours in
aggregate for small advisers with custody of client assets.\686\ We
therefore believe the annual monetized aggregate cost to small advisers
associated with our proposed amendments would be $3,971,520.\687\
---------------------------------------------------------------------------
\685\ 522 small advisers x 92% = 480 small advisers with
custody.
\686\ 21 hours x 480 small advisers with custody = 10,080 hours.
\687\ 10,080 aggregate small adviser hours x $394 (blended rate
for a compliance manager ($361) and a compliance attorney ($426)) =
$3,971,520.
---------------------------------------------------------------------------
3. Proposed Amendments to Form ADV
Proposed amendments to Form ADV would impose certain reporting and
compliance requirements on certain investment advisers, including those
that are small entities, requiring them to provide information about
their practices in safeguarding client assets. The proposed
requirements and rule amendments, including recordkeeping requirements,
are summarized above in this IRFA (section V.A). All of these proposed
requirements are also discussed in detail, above, in section II, and
these requirements and the burdens on respondents, including those that
are small entities, are discussed above in sections III and IV (the
Economic Analysis and Paperwork Reduction Act Analysis) and below. The
professional skills required to meet these specific burdens are also
discussed in section IV.
Our Economic Analysis (section III above) discusses these costs and
burdens for respondents, which include small advisers. As discussed
above in our Paperwork Reduction Act Analysis in section IV.F above,
the proposed amendments to Form ADV would increase the annual burden
for advisers (other than exempt reporting advisers, who would not be
required to respond to the new Form ADV questions we are proposing) by
approximately 1.4 hours per adviser, or 730.8 hours in aggregate for
small advisers (other than exempt reporting advisers).\688\ We
therefore expect the annual monetized aggregate cost to small advisers
(other than exempt reporting advisers, for whom there would be no
additional cost) associated with our proposed amendments would be
$232,394.40.\689\
---------------------------------------------------------------------------
\688\ 1.4 hours x 522 small advisers = 730.8 hours.
\689\ 730.8 hours x $318 = $232,394.40. See supra Table 10 for a
discussion of who we believe would perform this function, and the
applicable blended rate.
---------------------------------------------------------------------------
E. Duplicative, Overlapping, or Conflicting Federal Rules
The Commission believes that there are no rules that duplicate,
overlap, or conflict with the proposed rule amendments.
F. Significant Alternatives
1. Proposed New Rule 223-1 and Amendments to Rule 204-2 and Form ADV
The RFA directs the Commission to consider significant alternatives
that would accomplish our stated objectives, while minimizing any
significant adverse impact on small entities. We considered the
following alternatives for small entities in relation to proposed new
rule 223-1 and the corresponding proposed amendments to rule 204-2
under the Advisers Act and to Form ADV: (i) differing compliance or
reporting requirements that take into account the resources available
to small entities; (ii) the clarification, consolidation, or
simplification of compliance and reporting requirements under the
proposed rule for such small entities; (iii) the use of performance
rather than design standards; and (iv) an exemption from coverage of
the proposals, or any part thereof, for such small entities.
Regarding the first and fourth alternatives, the Commission
believes that establishing different compliance or reporting
requirements for small advisers, or exempting small advisers from the
proposed rule, or any part thereof, would be inappropriate under these
circumstances. Because the protections of the Advisers Act are intended
to apply equally to clients of both large and small firms, it would be
inconsistent with the purposes of the Advisers Act to specify
differences for small entities under proposed rule 223-1 and
corresponding changes to rule 204-2 and Form ADV. As discussed above,
we believe that the proposed safeguarding rule would result in multiple
benefits to clients. For example, segregation requirements and the
imposition of certain minimum standard requirements for assets
maintained at a qualified custodian would provide investors with
additional safeguards to protect their assets from the financial
reverses, including insolvency, of an investment adviser and to prevent
client assets from being lost, misused, stolen, or misappropriated. We
believe that these benefits should apply to clients of smaller firms as
well as larger firms. In addition, as discussed above, our staff would
use the corresponding information that advisers would report on the
proposed amended Form ADV for risk-assessment and to help prepare for
examinations of investment advisers. Establishing different conditions
for large and small advisers that have custody of client assets would
negate these benefits. Though we are not exempting small advisers from
portions of the proposals, we believe that the exception from the
surprise examination requirement for discretionary authority for client
assets that settle exclusively on a DVP basis will mitigate the
creation of new burdens for many advisers, particularly smaller
advisers. We also have requested comment on whether we should provide
different compliance dates for differing types of advisers including
smaller advisers.
Regarding the second alternative, we believe the current proposal
is clear and that further clarification, consolidation, or
simplification of the compliance requirements is not necessary. As
[[Page 14779]]
discussed above: the proposed rule would provide a requirement to
segregate client assets to prevent them from potential misuse or
misappropriation; would require that advisers maintain a written
agreement with or obtain reasonable assurances from qualified
custodians concerning certain minimal safeguarding requirements that we
believe are critical to providing important protections for advisory
client assets; and would provide certain limited exceptions from
requirements to maintain assets with a qualified custodian or obtain an
independent verification of assets. These provisions would address a
number of safeguarding risks for assets maintained at a qualified
custodian that the current rule does not address while extending the
protections of the rule from ``funds and securities'' to ``assets'' to
account for new and evolving financial products that may be maintained
in client accounts. The proposed provisions would strengthen investment
advisers' safeguarding practices, which we believe currently has gaps.
Further, we believe our proposal would allow the Commission
examination staff to verify all advisers' compliance with the proposed
amendments to rule 204-2, particularly in the categories of client
communications, client accounts, and independent public account
engagements, and reliance on the exceptions to proposed new rule 223-1.
The proposed recordkeeping rules are designed to work in concert with
proposed new rule 223-1 so that a complete custodial record with
respect to client assets is maintained and preserved. This would help
facilitate the Commission's inspection and enforcement capabilities,
including assessing compliance with rules, and therefore, it would
provide important investor protections.
Regarding the third alternative, we determined to use a combination
of performance and design standards in the current proposal. The
general requirement to maintain assets with a qualified custodian would
apply to all advisers to establish certain minimum standard
requirements under the proposed safeguarding rule, subject to narrowly
tailored exemptions and exceptions from certain requirements (e.g., the
surprise exam) if certain conditions are met. By design, these
exemptions and exceptions address specific circumstances to ensure
safekeeping of client assets, but also to provide relief from certain
requirements in circumstances where an adviser's ability to misuse or
misappropriate client assets are limited. The corresponding changes to
rule 204-2 and Form ADV also are narrowly tailored to address proposed
new rule 223-1.
G. Solicitation of Comments
We encourage written comments on the matters discussed in this
IRFA. We solicit comment on the number of small entities subject to
proposed new rule 223-1 and related amendments to rules 206(4)-2 and
204-2, and Form ADV, as well as the potential impacts discussed in this
analysis; and whether the proposal could have an effect on small
entities that has not been considered. We request that commenters
describe the nature of any impact on small entities and provide
empirical data to support the extent of such impact.
VI. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \690\ we must advise OMB whether a proposed
regulation constitutes a ``major'' rule. Under SBREFA, a rule is
considered ``major'' where, if adopted, it results in or is likely to
result in (1) an annual effect on the economy of $100 million or more;
(2) a major increase in costs or prices for consumers or individual
industries; or (3) significant adverse effects on competition,
investment or innovation. We request comment on the potential effect of
the proposed amendments on the U.S. economy on an annual basis; any
potential increase in costs or prices for consumers or individual
industries; and any potential effect on competition, investment or
innovation. Commenters are requested to provide empirical data and
other factual support for their views to the extent possible.
---------------------------------------------------------------------------
\690\ Public Law 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
---------------------------------------------------------------------------
VII. Statutory Authority
The Commission is proposing new rule 223-1 by a redesignation of
rule 206(4)-2 of the Advisers Act under the authority set forth in
sections 206(4), 211(a), and 223 of the Advisers Act [15 U.S.C. 80b-
6(4), 80b-11(a), and 80b-23]. The Commission is proposing corresponding
amendments to rule 204-2 under the Advisers Act under the authority set
forth in 206(4), 211(a), and 223 of the Advisers Act [15 U.S.C. 80b-
6(4), 80b-11(a), and 80b-23]. The Commission is proposing to amend Form
ADV pursuant to the authority set forth in sections 203(c)(1), 204,
211(a), and 223 of the Advisers Act [15 U.S.C. 80b-3(c)(1), 80b-4, 80b-
11(a), and 80b-23].
List of Subjects in 17 CFR Parts 275 and 279
Reporting and recordkeeping requirements; Securities.
Text of Proposed Rules and Rule and Form Amendments
For the reasons set out in the preamble, title 17, chapter II of
the Code of Federal Regulations is proposed to be amended as follows:
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
0
1. The authority citation for part 275 is revised to read, in part, as
follows:
Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless
otherwise noted.
* * * * *
Section 275.204-2 is also issued under 15 U.S.C. 80b-6.
* * * * *
Section 275.223-1 is also issued under 15 U.S.C. 80b-18b.
0
2. Amend Sec. 275.204-2 by:
0
a. Removing and reserving paragraphs (a)(8) and (a)(17)(iii).
0
b. Revising paragraph (b).
The revisions read as follows:
Sec. 275.204-2 Books and records to be maintained by investment
advisers.
* * * * *
(b) If an investment adviser subject to paragraph (a) of this
section is subject to Sec. 275.223-1 (Rule 223-1) of this chapter, the
investment adviser shall make and keep true, accurate, and current the
following books and records:
(1) Client communications. A copy of all written client
notifications required under Sec. 275.223-1(a)(2) (Rule 223-1(a)(2)),
and any responses thereto.
(2) Client accounts. For each client account:
(i) Account identification. A record of the advisory account name,
client contact information (including name, mailing address, phone
number, email address), and advisory account number, client type (as
identified in Item 5.D of Form ADV), or other identifying information
used by the investment adviser to identify the account, and copies of
all account opening records. The record must show the advisory account
inception date, whether the investment adviser has discretionary
authority (as defined by Sec. 275.223-1(d)(4) (Rule 223-1(d)(4)) with
respect to any client assets in the account, whether the investment
adviser has
[[Page 14780]]
authority to deduct advisory fees from the account, and, if applicable,
the termination date of the account, asset disposition upon
termination, and the reason for the termination.
(ii) Custodian identification. A record that identifies and
matches, for each client of which the adviser has custody of client
assets, the account name and account number, or any other identifying
information, from any person or entity, including any qualified
custodian, that maintains client assets to the corresponding advisory
account record for each client required by paragraph (b)(2)(i) of this
section. To the extent applicable, the record must contain a copy of
the required written agreement with each qualified custodian under
Sec. 275.223-1(a)(1)(i) (Rule 223-1(a)(1)(i)), including any
amendments thereto, and copies of all records received from the
qualified custodian thereunder relating to client assets. The record
must also reflect the basis for the reasonable assurances that the
investment adviser obtains from the qualified custodian under Sec.
275.223-1(a)(1)(ii) (Rule 223-1(a)(1)(ii)). To the extent applicable,
the record must contain a copy of the investment adviser's required
written reasonable determination that ownership of certain specified
client assets cannot be recorded and maintained (book-entry, digital,
or otherwise) in a manner in which a qualified custodian can maintain
possession or control (as defined by Sec. 275.223-1(d)(8) (Rule 223-
1(d)(8)) of such assets, as required under Sec. 275.223-1(b)(2) (Rule
223-1(b)(2)).
(iii) Basis for being subject to Rule 223-1. A memorandum or other
record that indicates the basis of the investment adviser's custody (as
defined in Sec. 275.223-1(d)(3) (Rule 223-1(d)(3)) of the client's
assets (as defined by Sec. 275.223-1(d)(1) (Rule 223-1(d)(1)),
including whether a related person (as defined by Sec. 275.223-
1(d)(11) (Rule 223-1(d)(11)) holds the investment adviser's client
assets (or has any authority to obtain possession of them) in
connection with the investment adviser's advisory services.
(iv) Account statements. Copies of each account statement delivered
by the qualified custodian to the client and to the investment adviser
pursuant to Sec. 275.223-1(a)(1)(i)(B) (Rule 223-1(a)(1)(i)(B)),
copies of any account statement delivered by the investment adviser to
the client, including copies of any account statement delivered by the
investment adviser to the client containing the required notification
under Sec. 275.223-1(a)(2) (Rule 223-1(a)(2)). If the client is a
pooled investment vehicle, the record must also reflect the delivery of
account statements, notices, or financial statements (as applicable) to
all investors in such client pursuant to Sec. 275.223-1(c) (Rule 223-
1(c)).
(v) Transaction and position information.
(A) A detailed record of all trade and transaction activity for
each such client account that includes the date and price or amount of
all purchases, sales, receipts, deliveries (including one-way delivery
of assets, and free receipt and delivery of securities and certificate
numbers, as applicable), deposits, transfers, withdrawals, cash flows,
corporate action activity, maturities, expirations, expenses, income
posted to the account, and all other debits and credits to or from the
account.
(B) Copies of confirmations of all trades effected by or for the
account of each client that show the date and price of each trade, and
any instruction received by the investment adviser concerning
transacting in the client's assets (as defined by Rule 223-1(d)(1)).
(C) A record for each asset (as defined by Rule 223-1(d)(1)) in
which each client has a position, which record shall show the name of
such client having any interest in such asset, the amount or interest
of such client, and the location of such asset.
(D) A memorandum describing the basis upon which the adviser has
determined that the presumption that any related person is not
operationally independent under Sec. 275.223-1(d)(7) has been
overcome.
(vi) Standing letters of authorization. Copies of, and records
relating to, any standing letter of authorization (as defined in Sec.
275.223-1(d)(12) (Rule 223-1(d)(12)) issued by a client to the
investment adviser.
(2) Independent public accountant.
(i) Copies of all audited financial statements prepared pursuant to
Sec. 275.223-1(b)(4) (Rule 223-1(b)(4)).
(ii) A copy of any internal control report:
(A) Obtained by a qualified custodian and received by an investment
adviser pursuant to Sec. 275.223-1(a)(1)(i)(C) (Rule 223-
1(a)(1)(i)(C)); and
(B) Obtained by the investment adviser if the investment adviser is
also the client's qualified custodian.
(iii) A copy of any written agreement between the independent
public accountant and the investment adviser or its client, as
applicable, required under Rule 223-1.
* * * * *
Sec. 275.206(4)-2 [Removed]
0
3. Section 275.206(4)-2 is removed.
0
4. Section 275.223-1 is added to read as follows:
Sec. 275.223-1 Safeguarding client assets.
(a) Safekeeping required. If you are an investment adviser
registered or required to be registered under section 203 of the Act
(15 U.S.C. 80b-3), you shall take the following steps to safeguard
client assets of which you have custody:
(1) Qualified custodian.
(i) Written agreement. A qualified custodian must maintain
possession or control of your client's assets pursuant to a written
agreement between you and the qualified custodian (or between you and
the client if you are also the qualified custodian) that must provide
the following provisions, which you must reasonably believe have been
implemented:
(A) The qualified custodian will promptly, upon request, provide
records relating to your clients' assets held in the account at the
qualified custodian to the Commission or to an independent public
accountant engaged for purposes of complying with paragraph (a)(4),
(b)(1), or (b)(4) of this section;
(B) The qualified custodian will send account statements, at least
quarterly, to the client, or its independent representative, and to
you, identifying the amount of each client asset in the account at the
end of the period and setting forth all transactions in the account
during that period, including investment advisory fees. Such account
statements shall not identify assets for which the qualified custodian
lacks possession or control, unless requested by the client and the
qualified custodian clearly identifies any such assets that appear on
the account statement;
(C) At least annually, the qualified custodian will obtain, and
provide to you a written internal control report that includes an
opinion of an independent public accountant as to whether controls have
been placed in operation as of a specific date, are suitably designed,
and are operating effectively to meet control objectives relating to
custodial services (including the safeguarding of the client assets
held by that qualified custodian during the year), and
(1) If you are the qualified custodian, or if the qualified
custodian is a related person, the independent public accountant that
prepares the internal control report must verify that client assets are
reconciled to a custodian other than you or your related person and be
registered with, and subject to regular inspection as of the
commencement of the professional engagement period, and as of each
[[Page 14781]]
calendar year-end, by, the Public Company Accounting Oversight Board in
accordance with its rules;
(D) Specifies your agreed-upon level of authority to effect
transactions in the account as well as any applicable terms or
limitations, and permits you and the client to reduce that authority;
and
(ii) Reasonable assurances obtained by adviser. You must obtain
reasonable assurances in writing from the qualified custodian (or, if
you are also the qualified custodian, the written agreement required by
paragraph (a)(1)(i) of this section must provide) that the custodian
will comply with the following requirements, and you must maintain an
ongoing reasonable belief that the custodian is complying with these
requirements:
(A) The qualified custodian will exercise due care in accordance
with reasonable commercial standards in discharging its duty as
custodian and will implement appropriate measures to safeguard client
assets from theft, misuse, misappropriation, or other similar type of
loss;
(B) The qualified custodian will indemnify the client (and will
have insurance arrangements in place that will adequately protect the
client) against the risk of loss of the client's assets maintained with
the qualified custodian in the event of the qualified custodian's own
negligence, recklessness, or willful misconduct;
(C) The existence of any sub-custodial, securities depository, or
other similar arrangements with regard to the client's assets will not
excuse any of the qualified custodian's obligations to the client;
(D) The qualified custodian will clearly identify the client's
assets as such, hold them in a custodial account, and will segregate
all client assets from the qualified custodian's proprietary assets and
liabilities; and
(E) The qualified custodian will 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.
(2) Notice to clients. If you open an account with a qualified
custodian on your client's behalf, you must promptly notify the client,
or its independent representative, in writing of the qualified
custodian's name, address, and account number, and the manner in which
the client's assets are maintained, when the account is opened and
following any changes to this information. If you send account
statements to a client to which you are required to provide this
notice, include in the notification provided to that client and in any
subsequent account statement you send that client a statement urging
the client to compare the account statements from the custodian with
those from the adviser.
(3) Segregation of client assets. The client's assets must:
(i) Be titled or registered in the client's name or otherwise held
for the benefit of that client;
(ii) Not be commingled with your assets or your related persons'
assets; and
(iii) Not be subject to any right, charge, security interest, lien,
or claim of any kind in favor of you, your related persons, or your
creditors, except to the extent agreed to or authorized in writing by
the client.
(4) Independent verification. The client assets of which you have
custody are verified by actual examination at least once during each
calendar year by an independent public accountant, provided that, if
you, or a related person in connection with advisory services you
provide to clients, maintain client assets pursuant to this section as
a qualified custodian, the independent public accountant must be
registered with, and subject to regular inspection as of the
commencement of the professional engagement period, and as of each
calendar year-end, by, the Public Company Accounting Oversight Board in
accordance with its rules. The independent verification must be
performed pursuant to a written agreement between you and the
accountant, at a time that is chosen by the accountant without prior
notice or announcement to you and that is irregular from year to year.
The written agreement must provide for the first examination to occur
within six months of becoming subject to this paragraph, except that,
if you maintain client assets pursuant to this section as a qualified
custodian, the agreement must provide for the first examination to
occur no later than six months after obtaining your internal control
report. The written agreement, which you must reasonably believe has
been implemented, must require the accountant to:
(i) File a certificate on Form ADV-E (17 CFR 279.8) with the
Commission within 120 days of the time chosen by the accountant in
paragraph (a)(4) of this section, stating that it has examined the
assets and describing the nature and extent of the examination;
(ii) Upon finding any material discrepancies during the course of
the examination, notify the Commission within one business day of the
finding, by electronic means directed to the Division of Examinations;
and
(iii) Upon resignation or dismissal from, or other termination of,
the engagement, or upon removing itself or being removed from
consideration for being reappointed, file within four business days
Form ADV-E accompanied by a statement that includes:
(A) The date of such resignation, dismissal, removal, or other
termination, and the name, address, and contact information of the
accountant; and
(B) An explanation of any problems relating to examination scope or
procedure that contributed to such resignation, dismissal, removal, or
other termination.
(b) Exceptions.
(1) Shares of mutual funds. With respect to shares of an open-end
company as defined in section 5(a)(1) of the Investment Company Act of
1940 (15 U.S.C. 80a-5(a)(1)) (``mutual fund''), you may use the mutual
fund's transfer agent in lieu of a qualified custodian for purposes of
complying with paragraph (a) of this section.
(2) Certain assets unable to be maintained with a qualified
custodian. You are not required to comply with paragraph (a)(1) of this
section with respect to client assets that are privately offered
securities or physical assets, provided:
(i) You reasonably determine, and document in writing, that
ownership cannot be recorded and maintained (book-entry, digital, or
otherwise) in a manner in which a qualified custodian can maintain
possession or control of such assets;
(ii) You reasonably safeguard the assets from loss, theft, misuse,
misappropriation, or your financial reverses, including your
insolvency;
(iii) An independent public accountant, pursuant to a written
agreement between you and the accountant,
(A) verifies any purchase, sale, or other transfer of beneficial
ownership of such assets, promptly, upon receiving the notice required
by paragraph (b)(2)(iv) of this section; and
(B) notifies the Commission by electronic means directed to the
Division of Examinations within one business day upon finding any
material discrepancies during the course of performing its procedures;
(iv) You notify the independent public accountant engaged to
perform the verification required by paragraph (b)(2)(iii) of this
section of any purchase, sale, or other transfer of beneficial
ownership of such assets within one business day; and
[[Page 14782]]
(v) The existence and ownership of each of the client's privately
offered securities or physical assets that are not maintained with a
qualified custodian are verified during the annual independent
verification conducted pursuant to paragraph (a)(4) of this section or
as part of a financial statement audit performed pursuant to paragraph
(b)(4) of this section.
(3) Fee deduction. Notwithstanding paragraph (a)(4) of this
section, you are not required to obtain an independent verification of
client assets maintained by a qualified custodian if:
(i) You have custody of the client assets solely as a consequence
of your authority to make withdrawals from client accounts to pay your
advisory fee;
(ii) If the qualified custodian is a related person, you can rely
on paragraph (b)(6) of this section.
(4) Entities subject to annual audit. You are not required to
comply with paragraphs (a)(1)(i)(B) and (a)(2) of this section and you
shall be deemed to have complied with paragraphs (a)(4) of this section
with respect to the account of a limited partnership (or limited
liability company, or another type of pooled investment vehicle or any
other entity) if it undergoes a financial statement audit as follows at
least annually and upon liquidation:
(i) The audit is performed by an independent public accountant that
is registered with, and subject to regular inspection as of the
commencement of the professional engagement period, and as of each
calendar year-end, by, the Public Company Accounting Oversight Board in
accordance with its rules;
(ii) The audit meets the definition in 17 CFR 210.1-02(d) (Rule 1-
02(d) of Regulation S-X), the professional engagement period of which
shall begin and end as indicated in Regulation S-X Rule 2-01(f)(5); and
(iii) Audited financial statements are prepared in accordance with
U.S. Generally Accepted Accounting Principles (``U.S. GAAP'') or, in
the case of financial statements of entities organized under non-U.S.
law or that have a general partner or other manager with a principal
place of business outside the United States, contain information
substantially similar to statements prepared in accordance with U.S.
GAAP and material differences with U.S. GAAP are reconciled;
(iv) Within 120 days (or 180 days in the case of a fund of funds or
260 days in the case of a fund of funds of funds) of an entity's fiscal
year end, the entity's audited financial statements, including any
reconciliations to U.S. GAAP or supplementary U.S. GAAP disclosures, as
applicable, are distributed to investors in the entity (or their
independent representatives); and
(v) Pursuant to a written agreement between the independent public
accountant and the adviser or the entity, the independent public
accountant that completes the audit notifies the Commission by
electronic means directed to the Division of Examinations:
(A) Within one business day of issuing an audit report to the
entity that contains a modified opinion, and
(B) Within four business days of resignation or dismissal from, or
other termination of, the engagement, or upon removing itself or being
removed from consideration for being reappointed.
(5) Registered investment companies. You are not required to comply
with this section [(17 CFR 275.223-1)] with respect to the account of
an investment company registered under the Investment Company Act of
1940 (15 U.S.C. 80a-1 to 80a-64).
(6) Certain related persons. Notwithstanding paragraph (a)(4) of
this section, you are not required to obtain an independent
verification of client assets if:
(i) You have custody under this rule solely because a related
person holds, directly or indirectly, client assets, or has any
authority to obtain possession of them, in connection with advisory
services you provide to clients; and
(ii) Your related person is operationally independent of you.
(7) Standing letters of authorization. Notwithstanding paragraph
(a)(4) of this section, you are not required to obtain an independent
verification of client assets if you have custody of client assets
solely because of a standing letter of authorization.
(8) Discretionary authority. Notwithstanding paragraph (a)(4) of
this section, you are not required to obtain an independent
verification of client assets if you have custody of client assets
solely because you have discretionary authority with respect to those
assets, provided this exception applies only for client assets that are
maintained with a qualified custodian in accordance with paragraph
(a)(1) of this rule and for accounts where your discretionary authority
is limited to instructing your client's qualified custodian to transact
in assets that settle exclusively on a delivery versus payment basis.
(9) Reliance on multiple exceptions. Notwithstanding the use of
``solely'' in paragraphs (b)(3), (b)(6), (b)(7), and (b)(8) of this
section, the exceptions in paragraphs (b)(3), (b)(6), (b)(7), and
(b)(8) of this section are not mutually exclusive.
(c) Delivery to pooled investment vehicle clients. To satisfy the
requirements of paragraph (a)(1), (a)(2), (b)(1), or (b)(4), the
account statements, notices, or financial statements (as applicable)
must be sent to all of the investors in each pooled investment vehicle
client, provided that, if an investor is a pooled investment vehicle
that is controlling, controlled by, or under common control with (``a
control relationship'') you or your related persons, the sender must
look through that pool (and any pools in a control relationship with
you or your related persons) in order to send to investors in those
pools.
(d) Definitions. For the purposes of this section:
(1) Assets means funds, securities, or other positions held in the
client's account.
(2) Control means the power, directly or indirectly, to direct the
management or policies of a person, whether through ownership of
securities, by contract, or otherwise. Control includes:
(i) Each of your firm's officers, partners, or directors exercising
executive responsibility (or persons having similar status or
functions) is presumed to control your firm;
(ii) A person is presumed to control a corporation if the person:
(A) Directly or indirectly has the right to vote 25 percent or more
of a class of the corporation's voting securities; or
(B) Has the power to sell or direct the sale of 25 percent or more
of a class of the corporation's voting securities;
(C) A person is presumed to control a partnership if the person has
the right to receive upon dissolution, or has contributed, 25 percent
or more of the capital of the partnership;
(D) A person is presumed to control a limited liability company if
the person:
(1) Directly or indirectly has the right to vote 25 percent or more
of a class of the interests of the limited liability company;
(2) Has the right to receive upon dissolution, or has contributed,
25 percent or more of the capital of the limited liability company; or
(3) Is an elected manager of the limited liability company; or
(E) A person is presumed to control a trust if the person is a
trustee or managing agent of the trust.
(3) Custody means holding, directly or indirectly, client assets,
or having any authority to obtain possession of them. You have custody
if a related person holds, directly or indirectly, client assets, or
has any authority to obtain possession of them, in connection with
[[Page 14783]]
advisory services you provide to clients. Custody includes:
(i) Possession of client assets (but not of checks drawn by clients
and made payable to third parties) unless you receive them
inadvertently and you return them to the sender promptly but in any
case within three business days of receiving them;
(ii) 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; and
(iii) Any capacity (such as general partner of a limited
partnership, managing member of a limited liability company or a
comparable position for another type of pooled investment vehicle, or
trustee of a trust) that gives you or your supervised person legal
ownership of or access to client assets.
(4) Discretionary authority means the authority to decide which
assets to purchase and sell for the client.
(5) Independent public accountant means a public accountant that
meets the standards of independence described in 17 CFR 210.2-01 (rule
2-01 of Regulation S-X).
(6) Independent representative means a person that:
(i) Acts as agent for an advisory client, including in the case of
a pooled investment vehicle, for limited partners of a limited
partnership (or members of a limited liability company, or other
beneficial owners of another type of pooled investment vehicle) and by
law or contract is obliged to act in the best interest of the advisory
client or the limited partners (or members, or other beneficial
owners);
(ii) Does not control, is not controlled by, and is not under
common control with you; and
(iii) Does not have, and has not had within the past two years, a
material business relationship with you.
(7) Operationally independent: for purposes of paragraph (b)(6) of
this section, a related person is presumed not to be operationally
independent unless each of the following conditions is met and no other
circumstances can reasonably be expected to compromise the operational
independence of the related person:
(i) Client assets in the custody of the related person are not
subject to claims of the adviser's creditors;
(ii) Advisory personnel do not have custody or possession of, or
direct or indirect access to client assets of which the related person
has custody, or the power to control the disposition of such client
assets to third parties for the benefit of the adviser or its related
persons, or otherwise have the opportunity to misappropriate such
client assets;
(iii) Advisory personnel and personnel of the related person who
have access to advisory client assets are not under common supervision;
and
(iv) Advisory personnel do not hold any position with the related
person or share premises with the related person.
(8) Possession or control means holding assets such that the
qualified custodian is required to participate in any change in
beneficial ownership of those assets, the qualified custodian's
participation would effectuate the transaction involved in the change
in beneficial ownership, and the qualified custodian's involvement is a
condition precedent to the change in beneficial ownership.
(9) Privately offered securities means securities:
(i) Acquired from the issuer in a transaction or chain of
transactions not involving any public offering;
(ii) That are uncertificated; and the ownership of which can only
be recorded on the non-public books of the issuer or its transfer agent
in the name of the client as it appears in the records you are required
to keep under Rule 204-2; and
(iii) That are transferable only with prior consent of the issuer
or holders of the outstanding securities of the issuer.
(10) Qualified custodian means:
(i) A bank as defined in section 202(a)(2) of the Advisers Act (15
U.S.C. 80b-2(a)(2)) or a savings association as defined in section
3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1))
that has deposits insured by the Federal Deposit Insurance Corporation
under the Federal Deposit Insurance Act (12 U.S.C. 1811), provided that
the bank or savings association holds the client assets in an account
designed to protect such assets from creditors of the bank or savings
association in the event of the insolvency or failure of the bank or
savings association;
(ii) A broker-dealer registered under section 15(b)(1) of the
Securities Exchange Act of 1934 (15 U.S.C. 78o(b)(1)), holding the
client assets in customer accounts;
(iii) A futures commission merchant registered under section 4f(a)
of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client
assets in customer accounts, but only with respect to clients' funds
and security futures, or other securities incidental to transactions in
contracts for the purchase or sale of a commodity for future delivery
and options thereon; and
(iv) A foreign financial institution that:
(A) Is incorporated or organized under the laws of a country or
jurisdiction other than the United States, provided that you and the
Commission are able to enforce judgments, including civil monetary
penalties, against the foreign financial institution;
(B) Is regulated by a foreign country's government, an agency of a
foreign country's government, or a foreign financial regulatory
authority as defined in section 202(a)(24) of the Investment Advisers
Act of 1940 [15 U.S.C. 80b-2(a)(24)] as a banking institution, trust
company, or other financial institution that customarily holds
financial assets for its customers;
(C) Is required by law to comply with anti-money laundering and
related provisions similar to those of the Bank Secrecy Act [31 U.S.C.
5311, et seq.] and regulations thereunder;
(D) Holds financial assets for its customers in an account designed
to protect such assets from creditors of the foreign financial
institution in the event of the insolvency or failure of the foreign
financial institution;
(E) Has the requisite financial strength to provide due care for
client assets;
(F) Is required by law to implement practices, procedures, and
internal controls designed to ensure the exercise of due care with
respect to the safekeeping of client assets; and
(G) Is not operated for the purpose of evading the provisions of
this rule 223-1.
(11) Related person means any person, directly or indirectly,
controlling or controlled by you, and any person that is under common
control with you.
(12) Standing letter of authorization means an arrangement among
you, the client, and the client's qualified custodian in which you are
authorized, in writing, to direct the qualified custodian to transfer
assets to a third-party recipient on a specified schedule or from time
to time, provided:
(i) The client's qualified custodian is not your related person;
(ii) The client's authorization includes the client's signature,
the third-party recipient's name, and either its address or account
number at a custodian to which the transfer should be directed; and
(iii) You have no ability or authority to designate or change any
information about the third-party recipient, including name, address,
and account number.
(13) U.S. generally accepted accounting principles (U.S. GAAP)
means accounting principles recognized
[[Page 14784]]
by the Commission as generally accepted in accordance with section
19(b) of the Securities Act of 1933 (15 U.S.C. 77s).
PART 279--FORMS PRESCRIBED UNDER THE INVESTMENT ADVISERS ACT OF
1940
0
5. The authority citation for part 279 continues to read as follows:
Authority: The Investment Advisers Act of 1940, 15 U.S.C. 80b-1,
et seq., Pub. L. 111-203, 124 Stat. 1376.
0
6. Amend Form ADV (referenced in Sec. 279.1) by:
0
a. In General Instructions, revising the second sub-bullet point
paragraph to the first bullet point paragraph under Instruction 4
related to Other-than-annual amendments;
0
b. In Glossary of Terms, revising the definitions of items 12 (Custody)
and 13 (Discretionary Authority or Discretionary Basis);
0
c. In Glossary of Terms, add new items defining the terms Assets,
Operationally Independent, Qualified Custodian, and Standing Letter of
Authorization and redesignating the items accordingly;
0
d. In Part 1A, revising Item 9;
0
e. In Schedule D, adding section 9.C.1; and revising section 9.C.3.
The additions and revisions read as follows:
Note: The text of Form ADV does not, and this amendment will
not, appear in the Code of Federal Regulations.
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* * * * *
By the Commission.
Dated: February 15, 2023.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2023-03681 Filed 3-8-23; 8:45 am]
BILLING CODE 8011-01-P
