SEC Proposes New Safeguarding Rule to Replace Custody Rule, With Widespread Implications

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March 6, 2023

On February 15, 2023, the U.S. Securities and Exchange Commission (the “SEC”) issued a proposed rule (the “Proposal”) to significantly amend Rule 206(4)-2 of the Investment Advisers Act of 1940, more commonly known as the custody rule (the “Custody Rule”). The Proposal would replace the Custody Rule with Rule 223-1 safeguarding client assets (the “Safeguarding Rule”).

Beyond a change in nomenclature, the proposed Safeguarding Rule would greatly expand the scope of SEC registered investment advisers’ (RIAs) responsibilities and duties to their clients. Like the Custody Rule, the proposed Safeguarding Rule would not apply to exempt reporting advisers.

The Safeguarding Rule Summarized

The Safeguarding Rule expands key provisions of the existing Custody Rule, summarized below:

Proposed Change	Prior Custody Rule	New Safeguarding Rule
Expanding Scope of Assets	The Custody Rule applies to a client’s funds and securities over which an RIA has custody.	The Safeguarding Rule’s scope applies to all client assets over which an RIA has custody, including other positions held in a client’s account. As noted in the Proposal, this expanded scope potentially would cover digital assets, financial contracts held for investment purposes, and physical assets such as artwork, real estate interests, precious metals, and physical commodities.
Discretionary Authority Deemed Custody	The Custody Rule does not provide that discretionary authority is a dispositive factor in establishing whether an RIA has custody.	The Safeguarding Rule expressly includes discretionary authority within the definition of custody. Specifically, custody would now include any arrangement where an RIA is authorized or permitted to withdraw or transfer beneficial ownership of a client’s assets upon the RIA’s instruction.
Increasing Qualified Custodian Requirements	The Custody Rule generally provides that RIAs with custody of client funds or securities are required to maintain such funds or securities with a “qualified custodian.”	The Safeguarding Rule increases certain qualified custodian requirements, including the following: The Safeguarding Rule provides further requirements for certain entities to be qualified custodians. For banks and savings associations, the Safeguarding Rule would require these entities to hold client assets in an account that is designed to protect such assets from creditors of the bank in case of insolvency or bank failure. Additionally, foreign financial institutions must meet seven new conditions to be a qualified custodian, including being required by law to comply with anti-money laundering provisions of the Bank Secrecy Act, the additional requirements for banks and savings associations above, and not being operated for the purpose of evading the Safeguarding Rule. The Safeguarding Rule would require that a qualified custodian have possession or control of those assets. This requires qualified custodians to participate in any change in beneficial ownership of these assets, including effectuating the transaction and their participation being a condition precedent to the change in beneficial ownership. The Safeguarding Rule would create minimum custodial protections and require an RIA to enter into a written agreement with the qualified custodian. This written agreement would include reasonable assurances from the qualified custodian regarding due care, indemnification, segregation of client assets, and that there will be no liens against client assets unless authorized in writing. In addition, the written agreement must provide that qualified custodians send account statements, at least quarterly, to both the RIA and the client; that the qualified custodian provide the RIA a written internal control report; and provisions that specify the RIA’s level of authority to effect transactions in the custodial account.
Limiting the Privately Offered Securities Exception	The Custody Rule provides an exception for the qualified custodian requirement, specifically for securities that are acquired from the issuer in a transaction not involving any public offering, that are uncertificated, and that are transferable only with the prior consent of the issuer or holders of the outstanding securities of the issuer.	The Safeguarding Rule would limit the exception, stating that the uncertificated securities must 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 RIA’s required records. The RIA would have to determine and document in writing that ownership cannot be recorded and maintained in a manner in which a qualified custodian can maintain possession or control of such assets. This change would reduce the types of assets that can satisfy the exception. As noted in the Proposal, digital assets issued on public, permissionless blockchains would not satisfy the exception. Additionally, physical assets, such as real estate interests or physical commodities, may be excluded from the exception. If the RIA can meet the exception, it must reasonably safeguard the assets; enter into a written agreement with an independent public accountant with several notice requirements regarding the potential purchase, sale, or transfer of such assets; and require such assets to be verified during an annual surprise examination or audit.
Further Segregation of Client Assets	The Custody Rule provides that RIAs must attain a reasonable assurance of segregation of client assets at a qualified custodian.	The Safeguarding Rule provides three additional requirements for client assets over which an RIA has custody: The client asset must be titled or registered in the client’s name or otherwise held for the benefit of that client; The client asset must not be commingled with the adviser’s assets or its related persons’ assets. The client asset must 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 creditor, unless agreed to or authorized in writing by the client.
Further Specificity in Delivery of Notice	The Custody Rule requires an RIA to notify its client in writing promptly upon opening an account with a qualified custodian on its behalf.	The Safeguarding Rule provides the notice must explicitly provide the custodial account number.
Amending Surprise-Examination Requirements	The Custody Rule currently provides that, subject to certain exceptions (such as the exception for audited private funds), RIAs must undergo annual surprise verification by an independent public accountant. If the RIA or related person maintains the client assets as a qualified custodian, the independent public accountant must be registered and subject to regular inspection by PCAOB.	The Safeguarding Rule creates additional requirements for the surprise examination. The RIA must “reasonably believe” that a written agreement has been implemented with an accountant (i.e., that the accountant will perform the surprise examination and comply with the Form ADV-E filing and notification requirements). Notice of any material discrepancies should be sent to the SEC’s Division of Examinations. However, the Safeguarding Rule provides further exceptions to the surprise-examination requirements. Specifically, the Safeguarding Rule expands the current audit-provision exception (from limited partnership, limited liability companies and other types of pooled investment vehicles) to “any advisory client entity whose financial statements are able to be audited in accordance with the rule.” The Safeguarding Rule provides a new exception if an RIA’s sole basis for having custody is discretionary authority with respect to those assets. Additionally, the Safeguarding Rule contain an exception if the RIA has custody of assets solely because of a standing letter of authorization (a “SLOA”) that meets certain requirements.

In addition to its Custody Rule changes, the Proposal has related changes to recordkeeping requirements and Form ADV, summarized below:

Increased Recordkeeping Requirements	The Proposal would amend the recordkeeping requirements under Rule 204-2, specifically to include the following: Retaining copies of all required client notices; Maintaining six categories of records for each client account, including client and custodian identification, SLOAs, and transaction information; Maintaining records of account activity, including copies of account statements and transaction activity; Retaining copies of independent account engagements; and Keeping records of any SLOA issued by a client to the adviser.
Changes to the Form ADV	Part 1A, Schedule D, and the Instructions and Glossary of the Form ADV would be amended. Specifically, Item 9 would be amended as follows: Generally, Item 9 would capture more information about a client’s assets; Item 9.A.(1) would also be amended to require advisers to specify whether they directly or indirectly, through a related person, have custody of client assets. A new Item 9.B. would require advisers to indicate whether they are relying on any exceptions to the Safeguarding Rule; Advisers would be required 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 the approximate amount of client assets maintained with such qualified custodian; Item 9 would require advisers to report information about accountants completing surprise examinations, financial statement audits, or verification of client assets; and Changes to Item 9 would require an other-than-annual-amendment to Form ADV.

Increased Recordkeeping Requirements

The Proposal would amend the recordkeeping requirements under Rule 204-2, specifically to include the following:

Retaining copies of all required client notices;
Maintaining six categories of records for each client account, including client and custodian identification, SLOAs, and transaction information;
Maintaining records of account activity, including copies of account statements and transaction activity;
Retaining copies of independent account engagements; and
Keeping records of any SLOA issued by a client to the adviser.

Changes to the Form ADV

Part 1A, Schedule D, and the Instructions and Glossary of the Form ADV would be amended. Specifically, Item 9 would be amended as follows:

Generally, Item 9 would capture more information about a client’s assets;
Item 9.A.(1) would also be amended to require advisers to specify whether they directly or indirectly, through a related person, have custody of client assets.
A new Item 9.B. would require advisers to indicate whether they are relying on any exceptions to the Safeguarding Rule;
Advisers would be required 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 the approximate amount of client assets maintained with such qualified custodian;
Item 9 would require advisers to report information about accountants completing surprise examinations, financial statement audits, or verification of client assets; and
Changes to Item 9 would require an other-than-annual-amendment to Form ADV.

Impact of the Safeguarding Rule

As summarized above, the proposed Safeguarding Rule is expected to have significant impacts on RIAs, with many new obligations and disclosures. In its justification for these changes, the SEC emphasized the changing nature of various financial sectors and markets. The SEC highlighted that the Custody Rule has been modified several times since its adoption in 1942, and new innovations required an update since its last amendment in 2009.

One major change and innovation highlighted in the Proposal is the rise of the digital asset industry. To that end, the Safeguarding Rule has widespread implications for digital assets. Specifically, changes in the scope of client assets, the role of qualified custodians, and limiting the private-offering exception may bring many digital assets under the SEC’s scrutiny.

In her statement on the Proposal, and as the sole dissenter in the 4-1 vote on the Proposal, Commissioner Hester M. Pierce highlighted these concerns. Commissioner Pierce emphasized the rule’s limited comment period and its workability, given the significant new requirements. Regarding digital assets, Commissioner Pierce stated that more crypto assets may become subject to SEC regulation, while increased requirements would “likely shrink[] the ranks of qualified crypto custodians,” leading to more investor risk. Additionally, Commissioner Pierce stated that the broad inclusion of digital assets overlooks important nuances, and could “encourage investment advisers to back away from advising their clients with respect to crypto.”

Comment Period and Next Steps

The SEC has asked that comments be received on or before the date that is 60 days after the Proposal’s publication in the Federal Register.