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SEC Proposes Amendments to Custody Rule and Targets Digital Assets

February 28, 2023

On February 15, 2023, the SEC released Rule 223-1 (the “Safeguarding Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”), proposing amendments to Advisers Act Rule 206(4)-2 (the “Custody Rule”). The Safeguarding Rule would greatly broaden the reach of the Custody Rule and captures a wide range of assets, including digital assets, real estate, loans, and other emerging asset classes, in addition to physical assets. Should the proposal be adopted in its current form, it will significantly impact how registered investment advisers manage and protect their clients’ assets.

Below is a brief overview of some of the more notable changes under the Safeguarding Rule.

      I. Minimum Custodial Protections

The Safeguarding Rule, among other things, outlines minimum custodial protections which would require an adviser to enter into a written agreement with qualified custodians to provide fundamental protections. The proposed requirements are “designed to serve as guardrails” and do not prescribe specific procedures. Some changes include:

  • the Custody Rule would be expanded to apply to all client assets held in advisory accounts, not just client “funds and securities,” explicitly including digital assets;
  • advisers with custody of client assets would be required to maintain them with a qualified custodian. The qualified custodian must have “possession or control” of client assets and participate in any change of beneficial ownership of the 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 clearly identify an advisory client’s assets and segregate them from the custodian’s proprietary assets;
  • the client’s assets should remain free of liens in favor of a qualified custodian unless authorized in writing by the client;
  • the exception for “privately offered securities” would be rescinded in favor of a new exception from the requirement to maintain certain assets with a qualified custodian, provided that the adviser meets certain conditions; and
  • a custodial agreement would need to reflect an adviser’s agreed-upon level of authority to effect transactions in the advisory client’s account.

      II. Qualified Custodian

There are not material changes to what types of entities could serve as qualified custodians, though there are additional compliance requirements. Banks or savings associations (including trust companies); registered broker-dealers; registered futures commission merchants; and certain types of foreign financial institutions may serve as qualified custodians. Foreign financial institutions would need to meet additional qualification requirements not currently part of Rule 206(4)-2. In addition, the Safeguarding Rule would require that a qualifying bank or savings association hold client assets in an account that is designed to protect the assets from creditors or in the event of insolvency. Specifically, the qualifying bank or savings institution must maintain the client’s assets in an account in which assets are easily identifiable and clearly segregated from the bank’s assets. The Safeguarding Rule also expands the criteria specifically required of foreign financial institutions that seek to qualify as custodians.

      III. Digital Asset Implications

The Safeguarding Rule extensively addresses digital assets. Some significant implications for advisers that deal with digital assets:

  • Digital assets are in scope. In the Safeguarding Rule, the SEC asserts that the present Custody Rule covers digital assets. The SEC does not elaborate or analyze why digital assets are considered “funds,” as opposed to other types of property.
  • Possession or control. The requirement for qualified custodians to have “possession or control” of client assets may pose challenges for custodians of digital assets. It’s difficult to prove exclusive possession or control of digital assets due to their unique characteristics. However, the Safeguarding Rule allows for flexibility in demonstrating “possession or control” by permitting situations where the custodian is necessary to change the ownership of the asset. For instance, a “qualified custodian would have possession or control of a digital asset if it generates and maintains private keys for the wallets holding advisory client digital assets in a manner such that the adviser is unable to change beneficial ownership of the digital asset without the custodian’s involvement.”
  • Digital asset trading platforms. The SEC acknowledges that the requirement for qualified custodians to have “possession or control” of client assets while the investment adviser has custody presents a challenge for advisers trading on digital asset platforms that require prefunding. If the trading platform is not a qualified custodian, it would violate both the current Custody Rule and the Safeguarding Rule. However, the SEC points out that not all digital asset trading involves prefunding, and some trades occur on noncustodial decentralized platforms and Alternative Trading Systems (“ATSs”).

      IV. Form ADV amendments.

The Safeguarding Rule includes updates to recordkeeping requirements for advisers and changes to Form ADV regarding custody-related data that the Commission, its staff and the public can access. The proposed changes to Item 9 reporting requirements include more information on the basis of custody of client assets, qualified custodians responsible for maintaining client assets and independent public accountants engaged for surprise examinations or financial statement audits of private funds.

      V. Compliance transition.

Under the Safeguarding Rule, advisers with over $1 billion in regulatory assets under management (“RAUM”) would be required to comply with the rule within one year of the rule’s effective date, while advisers with less than $1 billion in RAUM would have 18 months to comply the rule.

The comment period will be open for 60 days following publication of the proposing release in the Federal Register.

Key Takeaways:

  • The SEC proposed the Safeguarding Rule, which expands the Custody Rule under the Advisers Act to include all client assets, including digital assets.
  • Advisers with custody of client assets would be required to maintain them with a qualified custodian who indemnifies clients in case of loss, clearly identifies and segregates client assets from proprietary assets, and maintains them in a separate account designed to protect them from creditors or insolvency.
  • Banks, broker-dealers, futures commission merchants, and certain foreign financial institutions may serve as qualified custodians, but they must comply with additional qualification requirements and criteria. Custodians may have to segregate digital assets into dedicated accounts to ensure their safekeeping, preventing the mixing of assets with the adviser’s or related parties’ assets.
  • The Safeguarding Rule extensively addresses digital assets and acknowledges that they are in scope. The requirement for custodians to have “possession or control” of digital assets may pose challenges for custodians, but the rule allows flexibility in demonstrating “possession or control” and includes provisions for digital asset trading platforms.
  • The Safeguarding Rule includes updates to recordkeeping requirements for advisers and changes to Form ADV regarding custody-related data that the Commission, its staff and the public can access.
  • Advisers with over $1 billion in AUM would have to comply with the new rule within one year of its adoption, while smaller advisers would have 18 months to comply.