SEC Proposes Amendments to the Custody Rule

On February 15, the Securities and Exchange Commission (SEC) voted 4-1 to propose amendments to the Custody Rule under the Advisers Act (last amended in 2009 following the Bernard Madoff and Allen Stanford frauds). Over time, the current Custody Rule has presented challenges regarding, for example, when an adviser has "custody" under the rule, as well as the treatment of digital assets. While a number of current Custody Rule concepts remain familiar, proposed rule 223-1 (redesignated from rule 206(4)-2) would, among other things:

• Expand the scope of the rule to cover any client assets over which an investment adviser has custody beyond "funds and securities" covered under the current rule. Importantly, this would bring into scope cryptoassets that might be argued not to be funds or securities (as well as other assets such as real estate, loans, and derivatives). The SEC implies, however, in its proposing release, that most cryptoassets are today likely covered by the Custody Rule as either funds or securities.
• Make explicit that discretionary trading authority would trigger application of the rule. Notably, the proposed rule would provide a limited exception to the surprise examination requirement with regard to client assets maintained with a qualified custodian when the sole basis for application of the rule is an adviser's discretionary authority that is limited to instructing the client's custodian to transact in assets that settle only on a delivery versus payment basis. 
• Require that advisers enter into written agreements with and obtain reasonable assurances from qualified custodians to ensure that clients receive standard custodial protections and impose additional requirements on entities who serve as qualified custodians for purposes of the rule.
• Expand the current Custody Rule's audit provision as a means of satisfying the surprise examination requirement.
• Modify the current rule's privately offered securities exception from the obligation to maintain assets with a qualified custodian by refining the definition of "privately offered securities," expanding the exception to include certain physical assets, and requiring advisers to take additional steps to safeguard these assets.
• Amend reporting obligations on Form ADV and require corresponding amendments to the books and records provisions.

Commissioner Uyeda, while voting in favor of publishing the proposal, noted that the proposing release (i) acknowledges that banking regulators have safety and soundness concerns with respect to a bank's ability to custody crypto assets and (ii) suggests that an adviser that trades crypto assets on a platform would, in many cases, violate the proposed rule because such platforms likely do not meet the qualified custodian standard. Commissioner Uyeda further cautioned that the proposing release "takes great pains to paint a 'no-win' scenario for crypto assets" and "appears to mask a policy decision to block access to crypto as an asset class."

In voting against the rule proposal, Commissioner Peirce raised concerns regarding the feasibility of new requirements related to the written agreement requirement between the adviser and qualified custodian and new obligations imposed on qualified custodians. Commissioner Peirce also noted that expanding the rule to capture crypto assets runs the risk of "causing investors to remove their assets from an entity that has developed safeguarding procedures for those assets, possibly putting those assets at greater risk of loss."

We will continue to monitor developments in this area. Comment letters are due 60 days following publication in the Federal Register. For more information, the SEC’s fact sheet can be found here and the full proposing release here.