The SEC is proposing to amend the rule that regulates the custodial practices of advisers in order to better protect client funds and securities. The new safeguard aims to prevent the theft or misuse of client assets. Although addressing wider changes in advisory and custodial services, the changes can be viewed as part of a concerted regulatory response to the collapse of FTX and other problems in the crypto sector that involved the commingling and misappropriation of client assets.
The proposed rule extends the scope of coverage from the more specific funds and securities to the more generic term assets. Assets are defined as “funds, securities, or other positions held in a client’s account”. The protection afforded by the rule is in effect extended to client assets even in a scenario where they are not deemed to be funds and securities.
The SEC is attempting to ensure that the rule remains fit for purpose, or “evergreen”, even against the backdrop of continuing innovation in both products and services. Although the SEC asserts that the current rule already covers crypto assets because they have been held to be securities by the courts, the proposed language attempts to ensure that adequate protection is afforded to innovative crypto products even in a case where they might not be deemed to be securities.
The amendment to the definition also means that financial contracts, collateral and physical assets held on behalf of a client would fall within its scope.
The new rule also explicitly defines the term custody to include discretionary authority over client assets. The amendment here is intended to protect client assets in scenarios where the adviser is able to exercise its authority over these without the explicit agreement of the client or a qualified custodian.
A small exception to the surprise examination requirement of the rule is carved out for the adviser’s discretionary authority over delivery versus payment (DVP) transactions handled by the client’s custodians. The SEC believes that this arrangement, which involves the transfer of assets out of an account only upon a corresponding transfer into the account, minimizes the risk of withdrawal or misappropriation.
Improving custodial protections
The SEC continues to view qualified custodians as “key gatekeepers under the proposed rules.” And investment advisers are required to maintain client assets with a qualified custodian. The SEC is proposing to strengthen custodial protection by requiring written agreements, containing specific contractual provisions, in order for parties, whether they are financial institutions or advisers themselves, to act as qualified custodians.
The contractual provisions of such agreements would address:
- client account statements;
- internal control reports; and
- level of authority to effect transactions.
An adviser would also be required to obtain reasonable assurances related to client protection from the qualified custodian including:
- standard of care;
- limitation of liability for sub-custodial services;
- segregation of client assets; and
- attachment of liens to client assets.
The qualified custodian would also be required to segregate client assets from those of the adviser or any related party.
The new rule introduces more stringent requirements that a foreign financial institution (FFI) must meet in order to serve as a qualified custodian. These include legal and regulatory requirements as well as due care and anti-evasion provisions. The additional requirements are intended to offer a higher level of protection for client assets that are held outside the United States.
The requirements for the verification of client assets by an accountant are enhanced beyond demonstrating compliance by simply entering into an agreement. The adviser is not required to have a reasonable belief that the accountant has the capability and will actually carry out the requisite surprise inspection.
More rigorous recordkeeping measures are also being introduced that require the adviser to keep records of client communications, letters or authorization, accounts and account activity, as well as accountant engagements.