The SEC’s proposed Safeguarding Rule: What you need to know

By Jennifer Dickinson, Senior Managing Director, U.S.

On February 15, 2023, the U.S. Securities Exchange Commission (SEC) announced proposed rules to significantly expand the remit of the current Custody Rule, and today marks the closing of the comment period. In this article, we highlight the key proposed changes that investment advisers need to be aware of.

More types of assets are included

Renamed the Safeguarding Rule, the proposed amendments bring into scope any client assets of which an adviser has custody – not just funds and securities, as is currently the case. This means that:

• Digital assets, physical commodities and real estate are subject to custody requirements
• Use of the term “other positions” would cover holdings that are not considered assets for accounting purposes, such as short positions and written options
• Assets would also include financial contracts held for investment purposes, collateral posted for a swap contract and other assets that are a gray area under the Custody Rule

In general, any situation in which an adviser has discretion over clients’ assets will have custody, with limited relief from certain requirements. As will be seen, these expansions will materially impact advisers’ operations and compliance programs.

Robust requirements for qualified custodians

The qualified custodian (QC) provision remains in place but will specifically require QCs to hold client assets in an account that is designed to protect them from creditors in the event of the institution’s failure or insolvency. In other words, the client assets must be readily identifiable and segregated from the institution’s assets.

This could present challenges for advisers that manage digital assets or other new/non-traditional investment products. The choices of custodians for these assets is already limited; regulatory burdens may add to or create commercial resistance to custodying those assets.

To be permitted to serve as a QC, foreign financial institutions (FFIs) must meet seven new requirements:

1. Incorporated outside of the U.S., but subject to the ability of the investment adviser and the SEC to enforce judgements and penalties
2. Regulated as a banking institution, trust company or other institution that customarily holds financial assets for clients
3. Legally required to comply with anti-money laundering laws and regulations similar to the U.S. Bank Secrecy Act
4. Holds assets in accounts designed to protect assets from creditors of the FFI in the event of its insolvency or failure
5. Has the requisite financial strength to provide due care for client assets
6. Legally required to implement practices, procedures and internal controls designed to ensure the exercise of due care for the safekeeping of client assets
7. Not operated for the purpose of evading the proposed rule

While sensible at face value, these requirements may further limit advisers’ choice of custodian, even eliminating reputable institutions from consideration due to disconnects between U.S. and local regulatory requirements and business practices.

The proposed rule also establishes three sets of requirements for advisers’ custodial arrangements.

First, QCs must have possession or control of client assets, which essentially means that they are held in such a way that they cannot be moved solely at the discretion of the adviser. Rather, the QC’s participation is necessary to any change of beneficial ownership. The release acknowledges that this requirement will particularly impact digital assets:

• For example, the ability of anyone with the private key to transfer the asset would make it difficult for a custodian to demonstrate exclusive possession or control
• Further, the requirement to maintain assets at a QC at all times may conflict with how these assets are typically traded.

Second, the proposal requires specific provisions in a written agreement between the QC and the adviser that the adviser reasonably believes to have been implemented. Importantly, there is no grandfathering of existing agreements, so custodial arrangements may need to be re-papered.

Agreements must include the following:

• On request, QCs must promptly provide records relating to the clients’ assets to the SEC or an independent public accountant for purposes of complying with the rule
• QCs must send account statements at least quarterly to the client and to the adviser that identify the amount of each asset in the account and state all transactions during the period, including investment advisory fees
• At least annually, QCs must provide a written internal control report to the adviser. The report must include the opinion of an independent public accountant on the controls that have been implemented
• A description of the adviser’s authority to execute transactions in each account, along with any relevant terms or limitations, as well as a mechanism for the adviser and client to reduce that authority

Third, the adviser must obtain reasonable assurances in writing that the QC complies with the following:

• Exercises due care and implements appropriate measures to safeguard client assets from loss
• Indemnifies the client against the risk of loss in the event of the QC’s own negligence, recklessness or willful misconduct
• If applicable, any sub-custodial, securities depository or similar arrangements will not excuse any of the QC’s obligations to the client
• Client assets are clearly identified, held in a custodial account and segregated from the QC’s proprietary assets and liabilities
• Client assets will not be subject to any right, charge, security interest, lien or claim in favor of the QC, its affiliates or creditors, except as may be agreed to in writing by the client

The proposal specifically requires advisers to maintain an ongoing reasonable belief that the QC is in compliance with the above, which again will negatively impact managers of digital asset strategies.

Perhaps more than any other aspect of the proposal, the above three sets of requirements will increase advisers’ initial diligence and ongoing review of their custodial relationships. Depending on an adviser’s strategy, those relationships may be multiplied dramatically if it has to treat swap counterparties as custodians. Undoubtedly, custodians’ costs in upgrading their operations to meet client demand will be passed to their clients.

Advisers must segregate client assets

Under the current Custody Rule, advisers cannot commingle client assets with their own. The proposed Safeguarding Rule adds specificity, requiring that client assets:

• Are titled in the name of the client or otherwise held for the benefit of that client
• Cannot be commingled with those of the adviser or its related persons
• Cannot be subject to any right, charge, security interest, lien or claim in favor of the adviser, its related persons or its creditors, absent agreement in writing by the client

The release notes that these requirements are not intended to prohibit operational practices that involve commingling multiple clients’ assets together, as long as each client’s assets are reasonably identifiable and not subject to increased risk.

Additional notice requirements

In addition to the current requirement to provide notice to clients when custodial accounts are opened, the proposal layers in:

• Including the account number in the notice
• In the case of private funds, notice needs to be sent to the funds’ investors

This requirement applies on a go-forward basis only, i.e. to new accounts opened after the rule’s compliance date.

Expansion of privately offered securities exception

The proposal pivots the existing privately offered securities exception from QC requirements into a broader exception for “assets that are unable to be maintained with a qualified custodian.” For example, along with privately offered securities, physical assets would not need to be held at a QC as long as the adviser meets certain conditions:

• Adviser reasonably determines and documents in writing that ownership cannot be recorded and maintained in the manner that a QC could maintain possession or control transfers
• Adviser reasonably safeguards the assets from loss, theft, misuse, misappropriation or its own financial reversals, including insolvency
• Adviser has a written agreement with an independent public accountant whereby the accountant:
  • Verifies transactions promptly after receiving notice from the adviser that a transaction has occurred (the adviser’s notice must be made within one business day)
  • Notifies the SEC’s Division of Examination within one business day if it finds any material discrepancy
• The existence of all non-custodied assets is verified during either the annual surprise examination of client assets or a financial statement audit

While largely welcome, the expansion of this exception comes at a high operational cost; that is, engaging an accountant to approve each transaction, which of course comes with all of the usual diligence requirements when engaging service providers.

In addition, it is not especially clear that this service is even available at this time, what it will look like, or how much it will cost – not just in terms of advisers, but the accounting firms that will build the offering.

Surprise examinations, audits and exceptions for each

Surprise examinations

The baseline requirement for a surprise examination of client assets remains unchanged, with the additional proviso that advisers must reasonably believe that the accountant is “capable of, and intends to comply with the agreement and the obligations [it] is responsible for under the [requirement].” By way of example, the release notes that advisers should ensure that the accountant has access to IARD so that it can file form ADV-E.

As stated initially, in most cases advisers will be deemed to have custody of client assets if they exercise investment discretion. This means that they will be subject to the surprise examination requirement unless an exception applies. The proposed rule codifies two narrow exceptions:

1. DVP transactions: If an adviser has custody solely because of its discretion to instruct QCs to transact in assets that settle exclusively on a delivery versus payment (DVP) basis AND those assets are maintained with a QC, then the adviser need not arrange for a surprise examination
   • If, however, the adviser has custody on another basis, then this exception is not available
   • Exception to the exception: if the other basis for custody is also subject to similar exceptions (sole basis is fee deduction, or related-person custody for example), then the firm can avoid the surprise examination requirement

It is hard to imagine how many, even conservative/traditional advisers would be able to rely on this exception from the surprise examination requirement.

2. SLOAs: Codifying the 2017 no-action letter, this exception allows advisers to act pursuant to a Standing Letter of Authorization (SLOA) and avoid the surprise examination requirement as long as certain requirements are met. As proposed, the rule requires the SLOA to include:
   • Client’s signature
   • Third party recipient’s name and either their address or account number at the custodian to which the transaction is directed, neither of which can be changed by the adviser

This also comes with very detailed recordkeeping requirements, so it can hardly be considered a safe harbor for the many firms that cannot avail of the DVP or other exception. As we saw in some of last year’s enforcement cases, the message seems to be, “just comply.” Only this time, compliance is costly in the form of a surprise examination or audit of financial statements, in addition to operational burdens.

Audits

With respect to the audit exception, the proposal would codify much of the existing guidance from the Custody Rule FAQ and expand the availability of this exception from only private funds to any entity that is subject to an annual audit and final audit upon liquidation (for example, pension plans).

Advisers that opt for audits instead of surprise examinations are also relieved of the requirement to notify clients when new custodial accounts are opened.

The proposal requires a written agreement between the independent public accountant and the adviser, including a provision that the accountant will notify the SEC:

• Within one business day of issuing a report that contains a modified opinion (a broader term that encompasses qualified, adverse and disclaimer of opinion)
• Within four business days of resigning, being terminated, removing itself, or being removed from consideration for being appointed as an auditor

For private fund managers, the option to separately audit SPVs or combine them with the audit of an affiliated fund remains, with two key adjustments:

• If pursuing the separate audit route, the audited financial statements for the SPV must also be delivered to the fund’s investors
• If an SPV has unaffiliated investors, it must be treated as a separate client and have its own audit

The rule reaffirms existing guidance that if an SPV and related fund have a combined audit, then the SPV’s assets need to be considered within the scope of the audit.

Related items

Finally, the proposal calls for the following related amendments:

• The Investment Adviser Recordkeeping Rule to require advisers to keep additional, more detailed records of trade and transaction activity and position information for each client account of which it has custody
• Form ADV to align advisers’ reporting obligations with the proposed rule’s requirements and to improve the accuracy of custody-related data available to the SEC and the public

In many respects, the proposed rule seems a leap forward in recognizing how our industry currently does business. However, this recognition seems to translate into mandating more traditional operational and compliance procedures that might not comfortably fit. With the comment period closing today, May 8, 2023, we anticipate that industry feedback will be helpful to the SEC as they consider this proposal.

IQ-EQ’s expert U.S. Regulatory Compliance team can work with you to evolve your compliance program to suit your business, the SEC’s exam priorities and other regulatory developments. Find out more about the services we offer.