FCMs are Custodians: The SEC's Proposed Safekeeping Rule Will Present Challenges for Them

Much has been, and remains to be, written on the SEC’s recent proposal to replace the custody rule for registered investment advisers with a new “safekeeping” rule.  The implications are indeed far-reaching for registered advisers and their clients, alike. 

Less apparent on the face of coverage of the SEC release are the no less far-reaching implications for qualified custodians – banks, broker-dealers, futures commission merchants and foreign financial institutions.  If adopted as proposed the new safekeeping rule will require these entities to implement new processes and procedures around the onboarding of registered advisers and their clients, and, more broadly, to rethink the risks involved in providing custody services to them.  

Among the new requirements worthy of note from the custodian’s perspective:

Written Agreement.   The proposed revision requires registered advisers to adhere to a written agreement with their custodians under which the custodian provides “reasonable assurances” to the adviser that it will (i) “exercise due care in accordance with reasonable commercial standards in discharging its duty as custodian and will implement appropriate measures to safeguard client assets from theft, misappropriation, or other similar type of loss”; and (ii) “indemnify the client (and will have insurance arrangements in place that will adequately protect the client against the risk of loss of the client’s assets maintained with the qualified custodian in the event of the qualified custodian’s own negligence, recklessness, or willful misconduct.”  Notably, “the existence of any sub-custodial, securities depository, or other similar arrangements with regard to the client will not excuse any of the qualified custodian’s obligations to the client.”  

Broker-dealers, FCMs and banks are accustomed to assuming a duty to exercise due care in accordance with reasonable commercial standards.  But they will want to think through carefully assuming the additional duty to indemnify clients for loss of client assets “in the event of” their own negligence, and what it means to say that sub-custodial, depository and other similar arrangements “will not excuse” the duties of due care and indemnification.  (Insurers, meanwhile, will want to think about how to price policies insuring the risk of loss to the hundreds of billions in registered adviser client assets currently held in custody.)  Broker-dealers and FCMs have long operated under a standard of limited liability for loss of customer funds resulting from the failure of downstream custodians and depositories, under which they assume no liability for such losses, provided that they used due care in selecting the custodian or depository and fully complied with regulatory requirements relating to the establishment of such custodial relationships and the handling of customer funds.  The proposed revision appears to alter the allocation of downstream custodial risk as between custodians and the clients of registered advisers.  Custodians will want to draft carefully around these new documentation requirements in order to preserve settled expectations around such risk.  And custodians subject to Basel capital requirements will need to consider the capital consequences of issuing such indemnifications: for example, is client cash held under an indemnity required to be held on balance sheet (thereby becoming an input in the denominator of the supplementary leverage ratio)? 

Possession or Control.  The proposal defines “possession or control” to mean: “holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets, the qualified custodian’s participation would effectuate the transaction involved in the change in beneficial ownership, and the qualified custodian’s involvement is a condition precedent to the change in beneficial ownership.”  This definition reveals a peculiar blind spot around how FCMs typically handle customer funds.  FCMs operate under a safekeeping regime that, in fact, effectively prohibits them from being “involved in” changing the beneficial ownership of customer property.  Rather, FCMs use customer funds to “margin, guarantee or secure” customer trades or contracts.  In practice, this means that customer funds are deposited with FCMs under a pledge, which gives the FCM the right in turn to pledge those funds to downstream intermediaries and clearinghouses.  The “beneficial ownership” of the funds does not change when FCMs pledge customer funds to clearinghouses or intermediaries to secure customer trades; those funds remain customer property (subject to liens, in favor of the FCM and the relevant clearinghouse or intermediary – priority determined by control – securing the trading- and clearing-related obligations of the customer).  The SEC may wish to consider revising the proposed definition of possession or control to recognize the distinctive role of FCM custodians. 

Exceptions for certain assets.  The proposed rule carves out from the new safekeeping requirements assets that are “unable to be maintained with a qualified custodian,” including “physical assets” that a registered adviser determines cannot be maintained in a qualified custodian’s possession or control.  FCMs custody “physical assets” for their customers – namely, commodities that are deliverable upon expiry of their customers’ physically settled futures contracts (think gold, crude oil, coffee, soybean meal, and pork bellies, but also, Treasuries and emissions allowances).  Registered advisers and their FCMs will need to classify the various commodities they may handle in connection with their futures transactions under the possession or control standard.  It’s likely that diligence and interpretive analysis will, in time, confirm that Treasuries, gold and other commodities that an FCM can custody through depositories that maintain electronic warehouse receipts for commodities deliverable on registered US futures exchanges will satisfy the standard.  But that analysis may not be so straight-forward for commodities deliverable on non-US exchanges, and commodities like emissions allowances, where legal certainty around how security may be taken is still developing. 

Foreign Financial Institutions.  Today, when a registered adviser establishes a trading or clearing account with a “foreign financial institution” for the purpose of transacting on non-US financial markets, the adviser is required to confirm that the FFI will keep client assets “in customer accounts segregated from its proprietary assets.”  The SEC is looking for that minimal diligence burden to expand significantly; FFIs will need to satisfy seven new conditions in order to serve as a qualified custodian for client assets under the proposed rule.  Two of these conditions may require nuanced analysis and consultation: namely, determinations that the FFI holds financial assets for its customers in an account designed to protect such assets from creditors of the FFI in the event of its insolvency or failure; and that the FFI is required by law to implement practices, procedures, and internal controls designed to ensure the exercise of due care with respect to the safekeeping of client assets. 

The proposing release poses several questions about the use of FFIs as sub-custodians of broker-dealers, FCMs and banks.  Question 37 asks: “To what extent do advisers or qualified custodians utilize sub-custodians, such as foreign subsidiaries of a domestic qualified custodian? What types of sub-custodians are utilized? Do these sub-custodians have direct relationships with the adviser or client or do they only interact directly with the qualified custodian? How are sub-custodians overseen? Is this oversight performed by the adviser or the qualified custodian? If it is by the qualified custodian, how do advisers ensure that the client assets are safeguarded properly?”  These questions suggest that additional diligence requirements around the use, establishment and monitoring of such sub-custodial chains may be forthcoming. 

The SEC’s proposed safekeeping rule is available here.