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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 275 and 279

Release No. IA-6240; File No. S7-04-23

RIN 3235-AM32

Safeguarding Advisory Client Assets

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

SUMMARY: The Securities and Exchange Commission (“Commission” or “SEC”) is proposing

a new rule under the Investment Advisers Act of 1940 (“Advisers Act” or “Act”) to address how

investment advisers safeguard client assets. To effect our redesignation of the current custody

rule for the proposed new safeguarding rule, we are proposing to renumber the current rule. In

addition we are proposing to amend certain provisions of the current custody rule for enhanced

investor protections. We also are proposing corresponding amendments to the recordkeeping

rule under the Advisers Act and to Form ADV for investment adviser registration under the

Advisers Act.

DATES: Comments should be received on or before May 8, 2023.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments:



Use the Commission’s internet comment form

(https://www.sec.gov/rules/submitcomments.html); or



Send an email to rule-comments@sec.gov. Please include File Number S7-04-23 on the

subject line.

Paper Comments:



Send paper comments to Secretary, Securities and Exchange Commission, 100 F Street

NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-04-23. This file number should be included

on the subject line if email is used. To help us process and review your comments more

efficiently, please use only one method. The Commission will post all comments on the

Commission’s website (https://www.sec.gov/rules/proposed.shtml). Comments are also

available for website viewing and printing in the Commission’s Public Reference Room, 100 F

Street NE, Washington, DC 20549, on official business days between the hours of 10 a.m. and 3

p.m. Operating conditions may limit access to the Commission’s Public Reference Room. All

comments received will be posted without change. Persons submitting comments are cautioned

that the Commission does not redact or edit personal identifying information from comment

submissions. You should submit only information that you wish to make available publicly.

Studies, memoranda, or other substantive items may be added by the Commission or staff

to the comment file during this rulemaking. A notification of the inclusion in the comment file

of any such materials will be made available on the Commission’s website. To ensure direct

electronic receipt of such notifications, sign up through the “Stay Connected” option at

www.sec.gov to receive notifications by email.

FOR FURTHER INFORMATION CONTACT: Shane Cox, Laura Harper Powell, Michael

Schrader, and Samuel Thomas, Senior Counsels; Holly H. Miller, Senior Financial Analyst; Alex

Bradford and Michael Republicano, Assistant Chief Accountants; Christopher Staley, Branch

Chief; and Melissa Roverts Harke, Assistant Director at (202) 551- 6787 or IArules@sec.gov,

Investment Adviser Regulation Office, Division of Investment Management, Securities and

Exchange Commission, 100 F Street NE, Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The Commission is proposing for public comment to

amend and renumber 17 CFR 275.206(4)-2 (rule 206(4)-2) under the Investment Advisers Act of

1940 [15 U.S.C. 80b-1 et seq.] to redesignate it as rule 17 CFR 275.223-1 (rule 223-1) under the

Advisers Act, and make corresponding amendments to 17 CFR 275.204-2 (rule 204-2) and 17

CFR 279.1 (Form ADV) under the Advisers Act.1

15 U.S.C. 80b. Unless otherwise noted, when we refer to the Advisers Act, or any section of the Advisers

Act, we are referring to 15 U.S.C. 80b, at which the Advisers Act is codified, and when we refer to rules

under the Advisers Act, or any section of these rules, we are referring to title 17, part 275 of the Code of

Federal Regulations [17 CFR 275], in which these rules are published.

Table of Contents

I. Introduction .................................................................................................................. 7

A. Background ............................................................................................................. 7

B. Overview of the Proposal...................................................................................... 19

II. Discussion ................................................................................................................... 26

A. Scope of Rule ........................................................................................................ 26

1. Scope of Assets ............................................................................................... 27

2. Scope of Activity Subject to the Proposed Rule ............................................. 30

B. Qualified Custodian Protections ........................................................................... 41

1. Definition of Qualified Custodian .................................................................. 43

2. Possession or Control...................................................................................... 62

3. Minimum Custodial Protections ..................................................................... 74

C. Certain Assets that are Unable to be Maintained with a Qualified Custodian.... 127

1. Definition of Privately Offered Security and Physical Assets ...................... 133

2. Adviser’s Reasonable Determination ........................................................... 135

3. Adviser Reasonably Safeguards Assets ........................................................ 138

4. Notification and Prompt Independent Public Accountant Verification ........ 142

5. Surprise Examination or Audit ..................................................................... 146

D. Segregation of Client Assets ............................................................................... 164

E. Investment Adviser Delivery of Notice to Clients .............................................. 173

F. Amendments to the Surprise Examination Requirement .................................... 175

G. Exceptions from the Surprise Examination ........................................................ 178

1. Entities Subject to Audit (“Audit Provision”) .............................................. 178

2. Discretionary Authority ................................................................................ 206

3. Standing Letters of Authorization................................................................. 210

H. Amendments to the Investment Adviser Recordkeeping Rule ........................... 215

1. Client Communications ................................................................................ 218

2. Client Accounts ............................................................................................. 218

3. Account Activity ........................................................................................... 221

4. Independent Public Accountant Engagements.............................................. 224

5. Standing Letters of Authorization................................................................. 224

I. Changes to Form ADV ....................................................................................... 227

J. Existing Staff No-Action Letters and Other Staff Statements ............................ 237

K. Transition Period and Compliance Date ............................................................. 239

III. Economic Analysis ................................................................................................... 241

A. Introduction ......................................................................................................... 241

B. Broad Economic Considerations......................................................................... 242

C. Baseline ............................................................................................................... 247

1. Current Regulation ........................................................................................ 247

2. Affected Parties and Industry Statistics ........................................................ 254

3. Market Practice ............................................................................................. 258

D. Benefits and Costs of Proposed Rule and Form Amendments ........................... 269

1. Scope ............................................................................................................. 269

2. Qualified Custodian Protections ................................................................... 276

3. Certain Assets that are Unable to be Maintained with a Qualified Custodian

303

4. Segregation of Investments ........................................................................... 313

5. Investment Adviser Delivery of Notice to Clients ........................................ 315

6. Exceptions from the Surprise Examination .................................................. 317

7. Amendments to the Investment Adviser Recordkeeping Rule ..................... 325

8. Changes to Form ADV ................................................................................. 327

E. Efficiency, Competition, and Capital Formation ................................................ 329

F. Reasonable Alternatives...................................................................................... 332

1. Scope of Assets ............................................................................................. 332

2. Elimination of Privately Offered Securities Exception ................................ 332

3. Distribution of Requirements across Reasonable Assurances and Written

Agreement ..................................................................................................... 334

3. Additional Accounting and Client Notification Requirements for Privately

Offered Securities and Physical Assets that are Not Maintained with a

Qualified Custodian ...................................................................................... 336

4. Additional Safeguards when Clients Assets are Not Maintained with a

Qualified Custodian ...................................................................................... 338

5. Designating Clearing Agencies and Transfer Agents as Qualified Custodians

342

G. Request for Comment ......................................................................................... 344

IV. Paperwork Reduction Act Analysis .......................................................................... 347

A. Introduction ......................................................................................................... 347

B. Rule 223-1 ........................................................................................................... 348

1. Qualified Custodian Provision ...................................................................... 351

2. Notice to Clients ........................................................................................... 359

3. Annual Surprise Examination ....................................................................... 359

C. Exceptions ........................................................................................................... 363

1. Certain Assets that are Unable to be Maintained with a Qualified Custodian

363

2. Audit Provision ............................................................................................. 367

D. Total hour burden associated with proposed rule 223-1 ..................................... 370

E. Rule 204-2 ........................................................................................................... 373

F. Form ADV .......................................................................................................... 378

G. Request for Comments ........................................................................................ 384

V. Initial Regulatory Flexibility Analysis ..................................................................... 391

A. Reason for and Objectives of the Proposed Action ............................................ 392

1. Proposed rule 223-1 ...................................................................................... 392

2. Proposed rule 204-2 ...................................................................................... 393

3. Proposed amendments to Form ADV ........................................................... 394

B. Legal Basis .......................................................................................................... 395

C. Small Entities Subject to the Rule and Rule Amendments ................................. 396

1. Small entities subject to amendments to the custody rule ............................ 397

D. Projected Reporting, Recordkeeping and Other Compliance Requirements ...... 397

1. Proposed rule 223-1 ...................................................................................... 397

2. Proposed amendments to rule 204-2 ............................................................. 398

3. Proposed amendments to Form ADV ........................................................... 400

E. Duplicative, Overlapping, or Conflicting Federal Rules .................................... 401

F. Significant Alternatives ...................................................................................... 401

1. Proposed new rule 223-1 and amendments to rule 204-2 and Form ADV ... 401

G. Solicitation of Comments ................................................................................... 403

VI. CONSIDERATION OF IMPACT ON THE ECONOMYError! Bookmark not defined.

VII. Statutory Authority ............................................................................................. 404

Introduction

Background

Rule 206(4)-2 under the Act (the “custody rule” or “current rule”) regulates the custodial

practices of advisers. Although the Commission has amended the rule over time as custodial and

advisory practices have changed, since its adoption it has been designed to safeguard client funds

and securities from the financial reverses, including insolvency, of an investment adviser and to

prevent client assets from being lost, misused, stolen, or misappropriated.2

As originally adopted in 1962, the rule required all investment advisers with “custody”

(i.e., physical possession) of client funds and securities to deposit client funds in a bank account

that was maintained in the adviser’s name and contained only client funds.3 Advisers, in

See Custody or Possession of Funds or Securities of Clients, Investment Advisers Act Release No. 123

(Feb. 27, 1962) [44 FR 2149 (Mar. 6, 1962)] (“1962 Adopting Release”). See also Custody of Funds or

Securities of Clients by Investment Advisers, Investment Advisers Act Release No. 2176 (Sept. 25, 2003)

[68 FR 56692 (Oct. 1, 2003)] (“2003 Adopting Release”); Custody of Funds or Securities of Clients by

Investment Advisers, Investment Advisers Act Release No. 2044 (Jul. 18, 2002) [67 FR 48579 (Jul. 25,

2002)], at nn. 3, 15 (“2002 Proposing Release”).

As with the current rule, the proposed amendments would apply to investment advisers registered, or

required to be registered, with the Commission. However, the original rule was broader in scope, applying

to “all investment advisers,” until it was amended in 1997. Rules Implementing Amendments to the

Investment Advisers Act of 1940, Investment Advisers Act Release No. 1633 (May 15, 1997) [62 FR

28112 (May 22, 1997)], at section II.I.5. Unless otherwise indicated, references throughout this release to

“adviser” or “investment adviser” refer to investment advisers registered, or required to be registered, with

the Commission. Further, we have previously stated, and would continue to take the position (if these

amendments were adopted), that most of the substantive provisions of the Advisers Act do not apply with

respect to the non-U.S. clients (including funds) of a registered offshore adviser. This approach was

designed to provide appropriate flexibility where an adviser has its principal office and place of business

outside of the United States. We believe it would be appropriate to continue to apply this approach,

including in the proposed safeguarding rule context (if adopted). For an adviser whose principal office and

place of business is in the United States (onshore adviser), the Advisers Act and rules thereunder, including

the proposed safeguarding rule, would apply with respect to the adviser’s U.S. and non-U.S. clients. See

Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in

Assets Under Management, and Foreign Private Advisers, Release No. IA-3222 (June 22, 2011) [76 FR

39645 (July 6, 2011)] (Most of the substantive provisions of the Advisers Act do not apply to the non-U.S.

clients of a non-U.S. adviser registered with the Commission.); Registration Under the Advisers Act of

Certain Hedge Fund Advisers, Release No. IA-2333 (Dec. 2, 2004) [69 FR 72054, 72072 (Dec. 10, 2004)]

(“Hedge Fund Adviser Release”) (stating (1) that the following rules under the Advisers Act would not

addition, were required to segregate client securities and hold them in a “reasonably safe” place.

In each case, the rule required investment advisers to provide their clients notice of these

protocols and to engage an independent public accountant to conduct an annual surprise

examination4 to verify client funds and securities independently. These requirements were

designed to protect client assets at a time when the system for owning and transacting in

securities was paper-based.

The Commission amended the rule in 2003 to expand the definition of custody beyond

physical possession to include situations in which an adviser had any ability to obtain possession

of client funds or securities. The 2003 amendments made clear that the rule applied to any

investment adviser “holding, directly or indirectly, client funds or securities, or having any

authority to obtain possession of them.”5 It included three illustrative examples in the rule’s

definition of “custody”: (1) possession of client funds or securities, even briefly; (2) authority to

withdraw funds or securities from a client’s account; and (3) any capacity that gives the adviser

legal ownership of, or access to, client funds or securities.6 In the adopting release, the

Commission stated this expansion of the concept of adviser custody would not include

apply to a registered offshore adviser, assuming it has no U.S. clients: compliance rule, custody rule, and

proxy voting rule; (2) stating that the Commission would not subject an offshore adviser to the rules

governing adviser advertising [17 CFR 275.206(4)-1] or cash solicitations [17 CFR 275.206(4)-3] with

respect to offshore clients; and (3) noting that U.S. investors in an offshore fund generally would not expect

the full protection of the U.S. securities laws and that U.S. investors may be precluded from an opportunity

to invest in an offshore fund if their participation would result in full application of the Advisers Act and

rules thereunder, but that a registered offshore adviser would be required to comply with the Advisers Act

and rules thereunder with respect to any U.S. clients it may have).

The terms “surprise examination” and “independent verification” are used throughout the release and are

generally interchangeable.

See rule 206(4)-2(a). See also rule 206(4)-2(d)(v)(2) (defining “custody”). The original rule did not define

“custody,” which was conceptualized at that time as limited to physically holding securities.

See id.

authorized trading, however, stating that clients’ custodians are generally under instructions to

transfer funds or securities out of a client’s account only upon a corresponding transfer of

securities or funds into the account.7

In recognition of then-modern custodial practices, the Commission in 2003 required

advisers to keep securities (not just funds as under the 1962 rule) with a custodian, and it

expanded the types of custodians that would qualify under the rule.8 The Commission expressed

concern that some advisers were still keeping certificates in office files or safety deposit boxes,

which put those securities at risk.9 The Commission identified as “qualified custodians” the

types of regulated financial institutions that customarily provided custodial services subject to

regulatory examination.10 The Commission also relied more on the protections of qualified

custodians, eliminating the adviser’s need to undergo the rule’s annual surprise examination by

an independent public accountant if the adviser had a “reasonable belief” that the qualified

custodian would provide account statements directly to the adviser’s clients. The Commission

provided an exception, however, from the requirement to maintain client securities with a

qualified custodian after commenters had pointed out that, on occasion, a client may purchase

privately offered securities where the only evidence of the client’s ownership was recorded on

the issuer’s books and the transfer of ownership requires the consent of the issuer or the holders

of the issuer’s outstanding securities. As a result, commenters argued that it was difficult to

See 2003 Adopting Release, supra footnote 2,at note 10 and accompanying text.

See 2003 Adopting Release supra footnote 2, at section I.

See 2002 Proposing Release, supra footnote 2,at section II.B.

The financial institutions identified by the Commission were broker-dealers, banks and savings

associations, futures commission merchants, and certain foreign financial institutions. See 2003 Adopting

Release at II.B.

maintain certain of these assets in accounts with qualified custodians. The Commission noted

that these impediments to transferability along with the conditions it imposed in the privately

offered securities exception (“privately offered securities exception”), including in some cases

obtaining and distributing audited financial statements (“the audit provision”), provided external

safeguards against the kinds of abuse the rule seeks to prevent.

The Commission most recently amended the rule in 2009 after several enforcement

actions against investment advisers, including actions stemming from the frauds perpetrated by

Bernard Madoff and Allen Stanford (which also resulted in criminal convictions), alleging

fraudulent conduct that included, among other things, misappropriation or other misuse of client

assets involving certain affiliates of the adviser.11 These cases underlined additional risks both

See Custody of Funds or Securities of Clients by Investment Advisers, Investment Advisers Act Release

No. 2968 (Dec. 30, 2009) [75 FR 1455 (Jan. 11, 2010)], at n.1 (“2009 Adopting Release”) (referring to the

cases cited in Custody of Funds or Securities of Clients by Investment Advisers, Investment Advisers Act

Release No. 2876 (May 20, 2009) [74 FR 25353 (May 27, 2009)] (“2009 Proposing Release”)). See also

Judgment, ECF Doc No. 100, 4, United States v. Madoff, No. 09 Cr. 213 (S.D.N.Y. June 29, 2009) (Bernard

L. Madoff pled guilty to eleven felony charges including securities fraud, investment adviser fraud, mail

fraud, wire fraud, three counts of money laundering, false statements, perjury, and making false filings with

the SEC); Order Granting Motion for Summary Judgment, SEC v. Stanford International Bank, Ltd., et al.,

Civil Action No. 3:09-CV0298 (N.D. Tex. Apr. 25, 2013) (the SEC obtained a $5.9 billion judgment

against R. Allen Stanford who was convicted in a parallel criminal case of conspiracy to commit mail and

wire fraud, four counts of wire fraud, five counts of mail fraud, one count of conspiracy to obstruct an SEC

investigation, one count of obstruction of an SEC proceeding, and one count of conspiracy to commit

money laundering and sentenced to a total of 110 years in prison); SEC v. WG Trading Investors, L.P., 09CV-1750 (S.D.N.Y. July 29, 2010) (involving a broker-dealer and affiliated registered adviser that

orchestrated a fraudulent investment scheme misappropriating as much as $554 million and sending clients

misleading account information); Isaac I. Ovid, SEC Admin. Proceeding No. 3-14313 (Mar. 30 2011)

(registered investment adviser and manager of purported hedge funds, pled guilty in parallel criminal

proceeding in connection with which he was required to pay restitution in excess of $12 million); Young

and Acorn Capital Management, LLC, SEC Admin. Proceeding No. 3-14654 (Feb. 28 2012) (registered

investment adviser and its principal convicted of misappropriating $95 million in a Ponzi scheme in a

parallel criminal case whereupon the SEC issued an order revoking the adviser’s registration and barred the

principal from association with an investment adviser, broker, dealer, municipal securities dealer, or

transfer agent); SEC v. The Nutmeg Group, LLC, et al., Litigation Release No. 24677 (Nov. 26, 2019)

(commingled investor funds with his personal assets, implemented flawed internal systems and methods for

valuing and reporting assets under management, and transferred millions of dollars out of the investment

pools to himself and companies controlled by family members).

when an adviser has access to client funds or securities not explicitly covered within the scope of

the rule, as well as when the qualified custodian is a related person of the adviser. In direct

response to certain of these cases, the 2009 amendments explicitly extended the scope of the rule

to reach an adviser’s ability to access client funds or securities through its related persons,

expanded the circumstances in which a surprise examination is necessary, and required advisers

to obtain an independent accountant’s report evaluating internal controls related to custody

where the adviser or its related person serves as qualified custodian.12

Following the Madoff and Stanford frauds, and on the heels of the Commission’s recently

adopted 2009 amendments to the custody rule, Congress expressly vested the Commission with

authority to promulgate rules requiring registered advisers to take steps to safeguard client assets

over which advisers have custody by adding section 223 to the Advisers Act in the Dodd-Frank

Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”).13 Leading up to the

enactment of the Dodd-Frank Act, Congress heard testimony that certain client investments were

not covered by the custody rule because they were neither funds nor securities, putting them at

greater risk of loss, theft, misappropriation, or being subject to the financial reverses of an

adviser.14 Congress also heard testimony about the important role requiring advisers to maintain

See generally rule 206(4)-2; see also 2009 Adopting Release, supra footnote 11, at sections II.A and B.

See section 411 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203,

124 Stat. 1376 (2010) (adding section 223 to the Advisers Act which provides “[a]n investment adviser

registered under this subchapter shall take such steps to safeguard client assets over which such adviser

has custody, including, without limitation, verification of such assets by an independent public accountant,

as the Commission may, by rule, prescribe.” 15 U.S.C. 80b-18b). Congress also required the U.S.

Government Accountability Office to study the rule’s compliance costs. See id. at section 412.

See Regulating Hedge Funds and other Private Investment Pools, Hearing Before the House Subcommittee

on Securities, Insurance, and Investment, 111 Cong. 50-51 (2009) (Statement of James S. Chanos,

Chairman, Coalition of Private Investment Companies) (stating that the current rule’s scope—which was

“funds and securities” and with an exception from certain protections for privately offered securities—

client funds and securities with qualified custodians has in preventing fraud—a requirement that

applies only if an adviser is subject to the custody rule and the assets are not subject to an

exception from the qualified custodian requirement.15 Subsequently, Congress authorized the

Commission to prescribe rules requiring advisers to take steps to safeguard all client assets, not

just funds and securities, over which an adviser has custody.16

In addition to this legislative context, industry developments prompt us again to

reconsider the important prophylactic protections of the custody rule and to address certain gaps

in protections—some of which Congress identified and gave us the tools to address 13 years

ago.17 We have seen changes in technology, advisory services, and custodial practices create

excluded assets such as privately issued uncertificated securities, bank deposits, real estate assets, swaps,

and interests in other private investment funds leaving a “gaping hole” in the rule) (“Dodd Frank

Regulating Hedge Funds and other Private Investment Pools Testimony by James S. Chanos”). Congress

also heard testimony about the benefits qualified custodians provide in preventing fraud. See id.

(“Requiring independence between the function of managing a private investment fund and controlling its

assets, by requiring that all assets be titled in the name of a custodian bank or broker-dealer for the benefit

of the private fund and requiring all cash flows to move through the independent custodian, would be an

important control. Similarly, requiring an independent check on the records of ownership of the interests in

the private investment fund, as well as imposing standards for the qualification of private investment fund

auditors ─ neither of which currently is required by the Advisers Act ─ would also greatly reduce

opportunities for mischief.”).

See S. Rep. No. 111-176, at 77 (2010) (“the custodian requirement largely removes the ability of an

investment adviser to pay the proceeds invested by new investors to old investors. The custodian will take

the instructions to buy or sell securities, but not to remit the proceeds of sales to the adviser or to others

(except in return for share redemptions by investors). At a stroke, this requirement eliminates the ability of

the manager to ‘recycle’ funds from new to old investors.” quoting Testimony of Professor John C. Coffee,

Jr.; The Madoff Investment Securities Fraud: Regulatory and Oversight Concerns and the Need for Reform:

Testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs, 111th Congress, 1st

session, pp. 8,10 (2009)).

Earlier versions of this bill show that Congress considered retaining the current rule’s funds and securities

formulation. See Investor Protection Act of 2009, H.R. 3817, 111th Cong section 419 (2009).

The current rule has also been the subject of numerous inquiries and requests for staff views. See, e.g.,

Staff Responses to Questions about the Custody Rule (“Custody Rule FAQs”), available at

https://www.sec.gov/divisions/investment/custody_faq_030510.htm; Privately Offered Securities under the

Investment Advisers Act Custody Rule, Division of Investment Management Guidance Update No. 201304 (Aug. 2013) (“2013 IM Guidance”); Private Funds and Application of the Custody Rule to Special

Purpose Vehicles and Escrows, Division of Investment Management Guidance Update No. 2014-07 (June

new and different ways for client assets to be placed at risk of loss, theft, misuse, or

misappropriation that may not be fully addressed under the current rule.

For example, advisory services have expanded and developed in recent years, leading to

questions about the scope of activities that trigger application of the current rule. More

specifically, nearly 20 years ago when the Commission interpreted authorized trading not to be

within the definition of custody, it had stated that clients’ custodians are generally under

instructions to transfer funds or securities out of a client’s account only upon corresponding

transfer of securities or funds into the account. At the time, the Commission’s view was that

such an arrangement would minimize the risk that an adviser could withdraw or misappropriate

the funds or securities in its client’s custodial account.

Discretionary trading practices today, however, do not necessarily involve a one-for-one

exchange of assets under a custodian’s oversight. For instance, an adviser may instruct an issuer

or a transfer agent that recorded ownership of a client’s privately offered security to redeem the

client’s interest and direct the proceeds to a particular account. Because there is no qualified

custodian involved in such a transaction, a client’s ability to monitor its investments for

suspicious activity is limited (e.g., a qualified custodian would not attest to this transaction on the

account statements it provides), and a surprise examination or an audit may not discover any

2014) (“2014 IM Guidance”). Staff reports, statistics, and other staff documents (including those cited

herein) represent the views of Commission staff and are not a rule, regulation, or statement of the

Commission. Furthermore, the Commission has neither approved nor disapproved these documents and,

like all staff statements, they have no legal force or effect, do not alter or amend applicable law, and create

no new or additional obligations for any person. The Commission has expressed no view regarding the

analysis, findings, or conclusions contained therein. As discussed in section II.J, staff in the Division of

Investment Management is reviewing staff no-action letters and other staff letters to determine whether any

such letters should be withdrawn in connection with any adoption of this proposal. If the rule is adopted,

some of the letters and statements may be moot, superseded, or otherwise inconsistent with the rule and,

therefore, would be withdrawn.

misappropriation until the assets are gone. Moreover, if the security is not included in the

sample over which an accountant performs its procedures during a surprise examination or if the

client’s holdings of the security do not meet the materiality threshold for a financial statement

audit, misappropriation may go undetected for an indeterminate amount of time.

Other times, advisers find themselves subject to the rule because of authority they do not

wish to have. For instance, we understand that some advisory clients’ custodial agreements

empower investment advisers with a broad array of authority that they neither want nor use.18

Advisers have little to no ability to eliminate this authority because they are usually not parties to

the custodial agreements between clients and qualified custodians, but nonetheless these

arrangements result in an adviser having custody under the rule.

While these developments suggest a need to protect clients better and modify the

application of the current rule, other developments suggest a need to improve the rule’s efficacy,

including particularly the protections provided by the qualified custodian, who has long been the

key gatekeeper under this rule. A growing number of assets are not receiving custodial

protections as a result of certain of the current rule’s exceptions from the requirement to maintain

assets with a qualified custodian, particularly the exception for privately offered securities.19

That exception and the exception for mutual fund shares were adopted at a time when

dematerialized ownership of securities was still developing, and the exceptions were envisioned

We use the term “custodial agreement” throughout the release to refer to a contract between an advisory

client and the qualified custodian. The adviser usually is not a party.

Preqin Global Private Debt Report (2018), available at https://docs.preqin.com/samples/2018-PreqinGlobal-Private-Debt-Report-Sample-Pages.pdf (showing the growth in private capital assets under

management from 2007 to 2017 by the following asset classes: private equity, private debt, real estate,

infrastructure, natural resources).

as being necessary “at times” or “on occasion.” This rarity is no longer the case. We understand

that, today, the overwhelming majority of securities are uncertificated, the volume of privately

offered securities has vastly expanded with the expansion of private capital, and custodians have

developed safeguarding and reporting practices, particularly with respect to publicly traded

securities.20 We acknowledge that the custodial market for privately issued securities is less

developed,21 but we believe that some custodians presently custody these assets and we

understand that new custodial services are being developed.22 What has also developed,

however, is a practice by custodians in which the custodian lists assets for which it does not

accept custodial liability on a client’s account statement on an accommodation basis only; the

custodian does not attest to the holdings of or transactions in those investments or take steps to

ensure that the investments are safeguarded appropriately (“accommodation reporting”). The

custodian merely reports the holdings or transactions as reported to it by the adviser. This

practice undermines the account statement’s integrity and utility in helping to verify that the

client owns the assets and they have not been stolen or misappropriated. We view the integrity

of custodial account statements to be critical to the safeguarding of client assets. Clients should

be able to review their account statements to evaluate the legitimacy of any movement within

their account, whether it is a trade, a payment, or a fee withdrawal. In contrast, the current

exception for mutual fund shares requires a transfer agent of the mutual fund to fulfill all of the

See discussion in section II.C infra and at text accompanying footnote 229.

We understand that many qualified custodians will not currently accept custodial liability for certain

instruments including certain crypto assets, commodities, and privately issued securities. See Letter to

Karen Barr re Engaging on Non-DVP Custodial Practices and Digital Assets: Investment Advisers Act of

1940: Rule 206(4)-2 (Mar. 12, 2019) (“2019 RFI”).

See, e.g., DTCC, Project Whitney Case Study (May 2020), available at

https://www.dtcc.com/~/media/Files/Downloads/settlement-asset-services/user-documentation/ProjectWhitney-Paper.pdf.

obligations assigned to a qualified custodian under the rule, including sending statements directly

to the client. In our longstanding experience with the current rule, this exception has not raised

similar types of investor protection concerns.

At the same time, the evolution of financial products and services discussed above has

led to new entrants and new services in the custodial marketplace, including newly launched

state-chartered trust companies, as well as established bank and broker-dealer custodians seeking

to develop new practices to safeguard assets.23 Our staff has also observed a general reduction in

the level of protections offered by custodians, often resulting in advisory clients with the least

amount of bargaining power (i.e., retail investors) receiving the most limited protections. We

understand, for instance, that it is decreasingly common for banks acting as custodians to do so

in a fiduciary capacity.24 These changes in the industry have caused us to reconsider the role of a

“qualified custodian” under our rule and what minimum protections clients should receive.

Finally, since the Commission last amended the current rule, there have been significant

developments with respect to crypto assets,25 which generally use distributed ledger or

See, e.g., Tomito Geron, Companies Compete to Be Cryptocurrency Custodians, The Wall Street Journal

(Sept. 17, 2019).

See OCC Bulletin 2019-21, April 29, 2019, “Fiduciary Regulations; Non-Fiduciary Activities; Advance

Notice of Proposed Rulemaking.” According to this Bulletin, Bank non-fiduciary custody activities have

increased in asset size since 1996. This Bulletin reports, as of December 2018, bank non-fiduciary custody

assets were about $42 trillion, whereas bank fiduciary custody assets were about $9 trillion. See also

Edward H. Klees, How Safe are Institutional Assets in a Custodial Bank’s Insolvency, 68 Bus. LAW. 103,

110, footnote 46 (2012) (“Klees Article”). In addition to certain institutions identified under the Home

Owners’ Loan Act and members of the Federal Reserve System, the Advisers Act generally identifies

“banks” as banking institutions or savings associations a substantial portion of the business of which

consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks.

Advisers Act sec. 202(a)(2).

There are also digital assets. The term “digital asset” refers to an asset that is issued and/or transferred

using distributed ledger or blockchain technology, including, but not limited to, so-called “virtual

currencies,” “coins,” and “tokens.” See Custody of Digital Asset Securities by Special Purpose BrokerDealers, Securities Exchange Act Release No. 90788 (Dec. 23, 2020), 86 FR 11627, 11627 n.1 (Feb. 26,

blockchain technology (broadly referred to as “DLT”)26 as a method to record ownership and

transfer assets. While potentially creating certain efficiencies in transactions, this technology

also presents technological, legal, and regulatory risks to advisers and their clients.27 Unlike

mechanisms used to transact in more traditional assets, this technology generally requires the use

of public and private cryptographic key pairings, resulting in the inability to restore or recover

many crypto assets in the event the keys are lost, forgotten, misappropriated, or destroyed.28 By

design, DLT finality often makes it difficult or impossible to reverse erroneous or fraudulent

crypto asset transactions, whereas processes and protocols exist to reverse erroneous or

fraudulent transactions with respect to more traditional assets. These specific characteristics

could leave advisory clients without meaningful recourse to reverse erroneous or fraudulent

transactions, recover or replace lost crypto assets, or correct errors that result from their adviser

having custody of these assets.

2021) (“Commission Statement”). A digital asset may or may not meet the definition of a “security” under

the Federal securities laws. See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities

Exchange Act of 1934: The DAO, Securities Exchange Act Release No. 81207 (July 25, 2017) (“DAO

21(a) Report”), available at https://www.sec.gov/litigation/investreport/34-81207.pdf; SEC v. W.J. Howey

Co., 328 U.S. 293 (1946). To the extent digital assets rely on cryptographic protocols, these types of assets

also are commonly referred to as “crypto assets.” For purposes of this release, the Commission does not

distinguish between the terms “digital asset” and “crypto asset.”

The terms DLT and blockchain, a type of DLT, generally refer to databases that maintain information

across a network of computers in a decentralized or distributed manner. Blockchain networks commonly

use cryptographic protocols to ensure data integrity. See e.g., World Bank Group, “Distributed Ledger

Technology (DLT) and Blockchain,” FinTech Note No. 1 (2017), available at:

https://openknowledge.worldbank.org/bitstream/handle/10986/29053/WP-PUBLIC-Distributed-LedgerTechnology-and-Blockchain-Fintech-Notes.pdf?sequence=1&isAllowed=y.

We note that our staff has expressed a similar view. See, e.g., SEC Staff Accounting Bulletin No. 121, [87

FR 21016 (Apr. 11, 2022)] (generally describing risks related to the safeguarding of crypto assets); Custody

of Digital Asset Securities by Special Purpose Broker-Dealers, supra footnote 25 (generally discussing

risks related to broker-dealer custody of crypto asset securities). See also Joint Statement on Crypto-Asset

Risks to Banking Organizations (Jan 3, 2023), available at https://occ.treas.gov/news-issuances/newsreleases/2023/nr-ia-2023-1a.pdf (generally discussing risks related to bank custody of crypto assets).

See, e.g., Not Your Keys, Not Your Coins: Unpriced Credit Risk in Cryptocurrency, at section I, available

at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4107019.

Additionally, we understand that many advisers may be reluctant to provide a full range

of advisory services to their clients with respect to crypto assets because of concerns that a

market for custodial services to safeguard these assets has not yet fully developed. We

understand that other advisers provide advisory services that would generally result in an adviser

having “custody” within the meaning of the rule (e.g., serving as the general partner for a private

fund that holds crypto asset securities), and therefore are required to comply with the rule. Some

of these advisers, however, may not maintain their client’s crypto assets with a qualified

custodian, instead attempting to safeguard their client’s crypto assets themselves—a practice that

is not compliant with the custody rule if those crypto assets are funds or securities and do not

meet an exception from the qualified custodian requirement. Other advisers offering similar

advisory services might take the position that crypto assets are not covered by the custody rule at

all. This, however, is incorrect because most crypto assets are likely to be funds or crypto asset

securities covered by the current rule.29

The application of the current rule turns on whether a particular client investment is a fund or a security.

To the extent there is a question as to whether a particular crypto asset is an investment contract that is a

security, the analysis is governed by the test first articulated by the Supreme Court in SEC v. W.J. Howey

Co., 328 U.S. 293, 301 (1946). See, e.g., SEC v. Kik Interactive Inc., 492 F. Supp. 3d 169, 177-180

(S.D.N.Y. 2020) (applying Howey in granting the Commission’s motion for summary judgment finding

Kik’s sale of Kin tokens to the public was a sale of a security and required a registration statement); SEC v.

LBRY, No. 21-CV-260-PB, 2022 WL 16744741 (D.N.H. Nov. 7, 2022) (applying Howey in granting the

Commission’s motion of summary judgement finding “no reasonable trier of fact could reject the SEC’s

contention that LBRY offered LBC [a crypto asset] as a security.” Id. at 21); Report of Investigation

Pursuant to section 21(a) of the Securities Exchange Act of 1934: The DAO, Rel. No. 81207 (July 25,

2017) (describing how DAO tokens were securities under Howey); see also Spotlight on Crypto Assets and

Cyber Enforcement Actions, available at https://www.sec.gov/spotlight/cybersecurity-enforcement-actions.

Importantly, even if a particular crypto asset is not a security, the current rule also covers funds.

Overview of the Proposal

In the light of these developments and additional authority that Congress has given us

under the Dodd-Frank Act to prescribe investment adviser custody rules, we are redesignating

the custody rule as new rule 223-1 under the Advisers Act (the “safeguarding rule” or the

“proposed rule”) and proposing a number of amendments to strengthen its protections.30 The

proposal is designed to recognize the evolution in products and services investment advisers

offer to their clients and to strengthen and clarify existing custody protections, while also

proposing complementary refinements to how advisers report custody information on Form

ADV and the books and records they are required to keep that are designed to improve our

oversight and risk-assessment abilities.31 Importantly, the proposal maintains the core purpose of

protecting client assets from loss, misuse, theft, or misappropriation by, and the insolvency or

financial reverses of, the adviser and maintains the Commission’s ability to pursue advisers for

failing to properly safeguard client assets under the Act’s antifraud provisions.32

First, the proposed amendments are designed to modernize the scope of assets and

activities that would trigger application of the rule. In today’s increasingly complex and global

We are also renumbering portions of the custody rule that we are not amending.

In a technical, conforming change from the current rule, the proposed rule would replace, in certain places,

references to “you” with “investment adviser.”

While we are renumbering the current rule as rule 223-1, section 206(4) is still available to the Commission

and is also a basis of statutory authority for this proposed rulemaking. To establish a violation of section

206(4) for an adviser’s failure to safeguard client assets, the Commission does not need to demonstrate that

an investment adviser acted with scienter. See SEC v. Steadman, 967 F.2d 636, 646-7 (D.C. Cir. 1992). As

we noted when we adopted rule 206(4)-8, the court in Steadman analogized section 206(4) of the Advisers

Act to section 17(a)(3) of the Securities Act, which the Supreme Court had held did not require a finding of

scienter (citing Aaron v. SEC, 446 U.S. 680 (1980)). See Prohibition of Fraud by Advisers to Certain

Pooled Investment Vehicles, Investment Advisers Act Rel. 2628, (Aug. 3, 2007), 72 FR 44763 (Aug. 9,

2007). See also Steadman at 643, n.5.

financial markets, this update also would simplify the rule’s application and better align the rule

with the Commission’s statutory authority.33 Because investment advisers provide services

related to an array of financial products beyond just funds or securities, the proposed rule would

require certain minimum protections, particularly the safeguards of a qualified custodian, for

substantially all types of client assets held in an advisory account. Specifically, the safeguarding

rule would specify the types of assets subject to the safeguarding requirements of the rule by

defining “assets” as “funds, securities, or other positions held in a client’s account,” as opposed

to the custody rule’s use of “funds and securities.”34 This change would expressly include

certain assets that may not have previously been categorized as “funds” or “securities” and

would accommodate developments in the market for various investment types that develop in the

future, irrespective of their status as funds or securities. By expanding the scope of the rule to

include client assets instead of only client funds and securities, we believe we are properly

balancing the desire of investment advisers to provide advisory services regarding novel or

innovative asset types with the need to ensure that such assets are properly safeguarded.

The proposed rule also would explicitly include discretionary authority to trade within the

definition of custody.35 When an adviser has discretion to trade client assets, it has an

arrangement in which it may instruct the adviser’s custodian to dispose the client’s assets. An

adviser with discretion may also have broad authority to direct purchases or sales of client assets

See supra note 16 and accompanying text.

See 15 U.S.C. 80b-23 (“section 223”) “An investment adviser registered under this subchapter shall take

such steps to safeguard client assets over which such adviser has custody, including, without limitation,

verification of such assets by an independent public accountant, as the Commission may, by rule,

prescribe.” See proposed rule 223-1(a).

Proposed rule 223-1(d)(3).

that may not currently involve a qualified custodian, such as loan participation interests. An

adviser’s ability or authority to effect a change in beneficial ownership of a client’s assets,

including for purposes of trading, could place client assets at risk of loss that the rule is designed

to address.36 This change would rectify any unintended consequences of our prior interpretive

position.37

Like the custody rule, the safeguarding rule would entrust safekeeping of client assets to

a qualified custodian because we continue to believe it provides critical safeguards for those

assets. Unlike the custody rule, however, the safeguarding rule would specify that a qualified

custodian does not “maintain” a client asset for purposes of the rule if it does not have

“possession or control” of that asset. The proposed rule would further define “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.38 This change is designed to improve account

statement integrity and reliability by eliminating an adviser’s ability to request accommodation

reporting.39 Further, in a change from the current rule, the proposed rule would require an

See section II.A.2. Recognizing that there are times when an investment adviser neither wants nor uses the

ability or authority that would trigger the proposed rule and that there are times when an adviser

inadvertently receives client investments, the proposed rule would provide limited and tailored exclusions

in these circumstances. See infra, discussion of discretionary trading authority in section II.G.2.

When adopting amendments to the custody rule in 2003, we stated in a footnote: “An adviser’s authority to

issue instructions to a broker-dealer or [other] custodian to effect or settle trades does not constitute

‘custody.’ Clients’ custodians are generally under instructions to transfer funds (or securities) out of a

client’s account only upon corresponding transfer of securities (or funds) into the account. This ‘delivery

versus payment’ arrangement minimizes the risk that an adviser could withdraw or misappropriate the

funds or securities in its client’s custodial account.” 2003 Adopting Release, supra footnote 2, at n.10.

Absent this narrowly drawn exception for “delivery versus payment” transactions, authorized trading

comes within the definition of custody.

Proposed rule 223-1(d)(8). For further discussion of possession or control, please see discussion infra

section II.B.2.

See infra discussion section II.B.3.b.ii.

adviser to enter into a written agreement with and receive certain assurances from the qualified

custodian to make sure the qualified custodian provides certain standard custodial protections

when maintaining client assets.40

Under the proposal, the written agreement would require two provisions that are not

explicitly addressed by the current rule. One provision would require the qualified custodian to

provide promptly, upon request, records relating to clients’ assets held in the account at the

qualified custodian to the Commission or to an independent public accountant engaged for

purposes of complying with the safeguarding rule. The other would specify the adviser’s agreedupon level of authority to effect transactions in the account. The proposed rule’s written

agreement requirement would also incorporate, and expand, two components of the current rule:

account statements and internal control reports. Under the first, the written agreement must

contain a provision requiring the qualified custodian to deliver account statements to clients and

to the adviser, as currently advisers must have only a reasonable basis for believing this is done.

The other provision would require the qualified custodian to obtain a written internal control

report that includes an opinion of an independent public accountant regarding the adequacy of

the qualified custodian’s controls. This provision expands the internal control requirement to all

qualified custodians from the current rule’s application to an adviser or its related person41 that

acts as a qualified custodian.

In addition to the written agreement requirement, advisers would have to obtain

reasonable assurances that the qualified custodian satisfies five additional enumerated items.42

Proposed rule 223-1(a)(1).

The term “related person” would have the same meaning as in the current rule.

See proposed rule 223-1(a)(1)(ii).

These include assurances that the custodian will: (1) exercise due care in accordance with

reasonable commercial standards in discharging its duty as custodian and implement appropriate

measures to safeguard client assets from theft, misuse, misappropriation, or other similar type of

loss; (2) indemnify the client against losses caused by the qualified custodian’s negligence,

recklessness, or willful misconduct; (3) not be excused from its obligations to the client as a

result of any sub-custodial or other similar arrangements; (4) clearly identify and segregate client

assets from the custodian’s assets and liabilities; and (5) not subject client assets to any right,

charge, security interest, lien, or claim in favor of the qualified custodian or its related persons or

creditors, except to the extent agreed to or authorized in writing by the client.

We are proposing to modify the current rule’s privately offered securities exception from

the obligation to maintain client assets with a qualified custodian by expanding the exception to

include certain physical assets.43 We are also proposing refinements to the definition of privately

offered securities that are designed to ensure appropriate application and interpretation of this

exception.44 In addition, we are proposing to modify the conditions for relying on this exception

to improve investor protections in the absence of one of the rule’s key gatekeepers. Specifically,

an adviser could rely on the exception only if it reasonably determines that ownership cannot be

recorded and maintained by a qualified custodian, the adviser reasonably safeguards the assets,

the adviser notifies the independent public accountant performing the verification of such an

asset transfer within one business day, an independent public accountant verifies asset transfers

and notifies the Commission upon the findings of any material discrepancies, and the existence

See proposed rule 223-1(b)(2).

See proposed rule 223-1(d)(9).

and ownership of the assets are verified during an annual independent verification or as part of a

financial statement audit by an independent public accountant.45 The modifications are also

designed to limit availability of the exception to circumstances that truly warrant it because we

believe the bulk of advisory client assets are able to be maintained by qualified custodians and

should be safeguarded in the manner contemplated under the safeguarding rule.

Under the proposed rule, advisers with custody of client assets would be required to

segregate those assets by (1) titling or registering the assets in the client’s name or otherwise

holding the assets for the client’s benefit, (2) not commingling the assets with the adviser’s or

any of its related persons’ assets, and (3) not subjecting the assets to any right, charge, security

interest, lien, or claim of any kind in favor of the investment adviser or its related persons or

creditors, except to the extent agreed to or authorized in writing by the client.46 This provision,

which would apply regardless of whether the client’s assets are maintained by a qualified

custodian, is designed to prevent the adviser, or its related person, from using client assets for its

own purposes or in a manner not authorized by the client or in a manner inconsistent with its

fiduciary duty. We believe this will also help to protect client assets and enable them to be

returned in the event that an adviser experiences financial hardship.

The proposed rule would continue to depend on the protections provided by independent

public accountants. We have long relied on these third-party gatekeepers to provide “another set

of eyes” on client assets, and we believe they serve an important role in safeguarding client

assets. In light of the proposed changes to the rule’s scope, however, the proposal seeks to

balance better the costs associated with obtaining a surprise examination with the investor

See proposed rule 223-1(b)(2).

See proposed rule 223-1(a)(3).

protections it offers by providing exceptions to the surprise examination requirement when the

adviser’s sole reason for having custody is because it has discretionary authority or because the

adviser is acting according to a standing letter of authorization, each subject to certain

conditions.47 We believe that the risk to client assets is lower in these contexts and the

protections offered by the surprise examination may not justify the cost of obtaining one.

Finally, the proposed safeguarding rule amendments would expand the scope of who can satisfy

the rule’s surprise examination requirement through financial statement audits by specifying that

an entity is not required to be a limited partnership, limited liability company, or another type of

pooled investment vehicle to rely on this provision.48

The proposal also seeks to update and enhance recordkeeping requirements for advisers

that would work in concert with the proposed rule. We believe that these updates would enhance

the Commission’s oversight of the safeguarding practices of advisers and their compliance with

the rule, which will, in turn, promote investor protections.

Finally, we are proposing amendments to Form ADV to align reporting obligations with

the proposal and improve the accuracy of custody-related data available to the Commission, its

staff, and the public. In addition, we are improving the structure of Form ADV Item 9.49 More

accurate and comprehensive information that aligns with the proposed rule would inform the

See proposed rule 223-1(b)(7) and (8).

See proposed rule 223-1(b)(4).

See infra discussion at section II.I.

Commission’s examination initiatives and would allow the Commission and its staff to better

assess risks specific advisers pose to investors.50

II.

Discussion

Scope of Rule

Like the current rule, the proposed rule would apply to any investment adviser registered

or required to be registered with the Commission under section 203 of the Act that has “custody”

of a client’s assets.51 Also consistent with the current rule, the proposed rule would also apply to

any adviser whose “related persons” have custody in connection with advisory services the

adviser provides to the client.52

The proposed rule would change the current rule’s scope, however, in two important

ways. First, it would expand the types of investments covered by the rule. Currently, the rule

applies to client “funds and securities” of which an adviser has custody. The proposed rule

would extend the rule’s coverage beyond client “funds and securities” to client “assets” so as to

See infra discussion at section II.J. Because Form ADV Part 1A is submitted in a structured, XML-based

data language specific to that form, the information in the proposed amendments to Part 1A would continue

to be structured (i.e., machine-readable).

Proposed rule 223-1. As with the current rule, an adviser would be required to comply with the proposed

rule in circumstances where the adviser provides advisory services to a person’s assets, even if

uncompensated. “Although a person is not an ‘investment adviser’ for purposes of the Advisers Act unless

it receives compensation for providing advice to others, once a person meets that definition (by receiving

compensation from any client to which it provides advice), the person is an adviser, and the Act applies to

the relationship between the adviser and any of its clients (whether or not the adviser receives

compensation from them).” See Rules Implementing Amendments to the Investment Advisers Act of 1940,

Investment Advisers Act Release No. 3221 (June 22, 2011) [76 FR 42,950 (July 19, 2011)], at text

accompanying n.74.

Consistent with the current rule, under the proposed rule, the term “related person” would mean “any

person, directly or indirectly, controlling or controlled by [the investment adviser], and any person that is

under common control with [the investment adviser].” Proposed rule 223-1(d)(11).

include additional investments held in a client’s account. Second, the proposed rule would make

explicit that the current rule’s defined term “custody” includes discretionary authority.

Scope of Assets

The proposed rule would define “assets” as “funds, securities, or other positions held in a

client’s account.”53 The proposal, like the current rule, therefore would apply to a client’s funds

as well as a client’s securities. However, the proposed rule also would apply to other positions

held in a client’s account that are not funds or securities. This proposed change uses the more

expansive and explicit language employed by Congress in empowering the Commission to

develop rules to protect client assets when advisers have custody.54 Congress made this change

following several high profile enforcement actions relating to misappropriation of client assets.55

The proposed amendments also recognize the continued evolution of the types of investments

held in advisory accounts since the custody rule was amended in 2009 and since the enactment of

section 223. Looking forward, the proposed definition of assets is designed to remain evergreen,

encompassing new investment types as they continue to evolve and multiply to recognize that the

protections of the rule should not depend on which type of assets the client entrusts to the

adviser.

The proposed rule’s use of the term “other positions” in the definition of assets

encompasses holdings that may not necessarily be recorded on a balance sheet as an asset for

Proposed rule 223-1(d)(1).

See section 223, supra footnote 34.

See supra footnote 11.

accounting purposes, including, for example, short positions and written options.56 We believe,

in the advisory account context, that the entirety of a client account’s positions, holdings, or

investments should receive the protections of the proposed rule regardless of how they may be

treated for accounting purposes. Moreover, the fiduciary duty extends to the entire relationship

between the adviser and client regardless of whether a specific holding in a client account meets

the definition of funds or a security.57 Consequently, the proposed rule’s definition of assets

would include investments such as all crypto assets, even in the instances where such assets are

neither funds nor securities.58 Assets under the rule also would include financial contracts held

for investment purposes, collateral posted in connection with a swap contract on behalf of the

client, and other assets that may not be clearly funds or securities covered by the current rule.59

Additionally, physical assets, including artwork, real estate, precious metals, or physical

commodities (e.g., wheat or lumber), would be within the scope of the proposed rule. “Assets”

also would encompass investments that would be accounted for in the liabilities column of a

balance sheet or represented as a financial obligation of the client including negative cash, which

Similarly, rule 6(c)-11 under the Investment Company Act of 1940 [15 U.S.C. 80a-1 et seq.] (the

“Investment Company Act”) defines an exchange-traded fund’s portfolio holdings as the securities, assets,

or other positions held by the exchange-traded fund. See 17 CFR § 270.6c-11. See Exchange Traded

Funds, Investment Company Act Release No. 33646 (Sept. 25, 2019) [84 FR 57162 (Oct. 24, 2019)], at

n.249 (including within the term “other positions” short positions in equity, overdrawn or negative cash

balances, written call or put options (where the other side has the option and can put or call the underlying

instrument to the party who wrote the contract)).

See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Release No. IA5248 (Jun. 5, 2019) at footnote 17 (discussing the broad scope of the fiduciary duty in a variety of contexts,

including situations where securities are not specifically involved).

Crypto assets that are funds or securities are subject to the current custody rule, which applies to all “funds

and securities” over which an adviser has custody. See discussion of whether crypto assets or digital assets

meet the definition of security at supra footnote 29.

Id. Our staff has taken a similar position regarding collateral for transactions, such as swaps. See Custody

Rule FAQs, supra footnote 17, at Question II.10.

we believe would be consistent with the purposes of the Act and the longstanding policy goal of

the rule to prevent potential fraud, misuse, or misappropriation.60

We also request comment on all aspects of the proposed definition of “assets,” including

the following items:

1. Should the rule apply to client “assets” beyond the scope of the current rule’s

formulation of “funds or securities,” as proposed? Should the proposed rule include

the term “other positions” as a catch-all for a client’s positions subject to the adviserclient relationship? Should another term, such as client investments, be used

instead?

2. Should we define client “assets” by referencing other terms, such as “securities and

similar investments” or “any investment,” which are used but not defined in the

Investment Company Act custody rules?61 Should we instead incorporate the term

“investment” from the definition of “qualified purchaser” under the Investment

Company Act?62

3. Are there particular types of assets held in a client’s advisory account that should or

should not be subject to the proposed rule? If so, what are they and why should they

be included or excluded? Are there other safeguards outside of the proposed rule

that apply to these positions that would satisfy the policy goals of the rule? Does the

answer depend on the type of asset?

See rule 6c-11, supra footnote 56. The release discussed that liabilities were contemplated to be part of

“other positions.”

See rules 17f-1, 17f-2, 17f-5, and 17f-6 under the Investment Company Act.

See rule 2a51-1(b) under the Investment Company Act.

4. To the extent that the adviser has custody of certain physical assets, should we

narrow the proposed definition to exclude such physical assets? For example,

should the proposed definition exclude artwork, real estate, precious metals, or

physical commodities (e.g., wheat or lumber), for example?

5. It is our understanding that some advisers treat client assets that may not be “funds

or securities” consistent with rule 206(4)-2. If so, what types of assets do they

maintain with a qualified custodian under the current rule? If not, how do the

advisers safeguard these client assets?

6. Should we provide guidance about how the proposed rule would apply to certain

asset types? If so, for what types of assets? Should we provide guidance for certain

assets that would be subject to exceptions from the proposed rule, such as privately

offered securities or physical assets?

7. Should the proposed rule apply to assets that are treated as liabilities from an

accounting perspective? Is it sufficiently clear that the proposed rule would apply to

portfolio holdings that are liabilities on a balance sheet? Should we provide

additional clarification as to what types of investments may appear as liabilities

within the scope of the advisory relationship? What types of holdings typically

appear as liabilities? Are there any exemptions or provisions required for such

investments if they are included within the scope of the rule?

Scope of Activity Subject to the Proposed Rule

The proposal generally would preserve the current rule’s definition of “custody,” and

apply when an adviser “holds, directly or indirectly, client assets, or has any authority to obtain

possession of them.”63 The general principle of this definition is to apply the rule when an

adviser has the ability or authority to effect a change in beneficial ownership of a client’s

assets.64 An adviser with this ability or authority can subject a client’s assets to the risks of loss,

misuse, misappropriation, theft, or financial reverses of the adviser. Moreover, the rule would

continue to apply when an adviser’s related person has the ability to obtain client assets in

connection with advisory services. Like the current rule, the proposed rule would institute

prophylactic safeguards where there is this potential for loss or harm to a client given the

adviser’s ability or authority to deprive the client of ownership and to obtain possession of the

client’s assets.

In addition to this overarching principle, the current definition of custody includes three

categories that serve as examples of custody: physical possession, certain arrangements when the

adviser is authorized or permitted to instruct the client’s custodian, and circumstances when the

adviser acts in certain capacities.65 The proposed rule would retain these categories because,

See proposed rule 223-1(d)(3).

For example, an adviser that physically holds a check drawn by the advisory client and made payable to a

third party is not subject to the rule solely as a result of holding the check, since the adviser cannot use the

check to change ownership of the client’s underlying cash holdings. See rule 206(4)-2(d)(2)(i). Similarly,

if a stock certificate is non-transferable (i.e., it cannot be used to effect a change in beneficial ownership of

the client’s investment), an adviser would not be subject to the rule as a result of holding it. Our staff

previously took a similar view. See 2013 IM Guidance, supra footnote 17.

Under the current rule, custody includes three prongs: (i) Possession of client funds or securities (but not of

checks drawn by clients and made payable to third parties) unless the adviser receives them inadvertently

and returns them to the sender promptly but in any case within three business days of receiving them; (ii)

Any arrangement (including a general power of attorney) under which the adviser is authorized or

permitted to withdraw client funds or securities maintained with a custodian upon the adviser’s instruction

to the custodian; and (iii) Any capacity (such as general partner of a limited partnership, managing member

of a limited liability company or a comparable position for another type of pooled investment vehicle, or

trustee of a trust) that gives the adviser or its supervised person legal ownership of or access to client funds

or securities.

going forward, we believe this approach will continue to provide flexibility as the asset

management industry continues to evolve, introduces novel investment products, and provides

new services to its advisory clients.

We believe we need to provide specificity, however, regarding the arrangement category

of the custody definition to state explicitly that discretionary trading authority is an arrangement

that triggers the rule.66 Specifically, the amended custody definition would include any

arrangement (including, but not limited to, a general power of attorney or discretionary

authority) under which the adviser is authorized or permitted to withdraw or transfer beneficial

ownership of client assets upon the adviser’s instruction.67 In addition, the proposed

discretionary authority definition is consistent with the definition in Form ADV and is the

authority to decide which assets to purchase and sell for the client.68

The Commission previously stated that an adviser’s authority to issue instructions to a

broker-dealer or a custodian to effect or to settle trades, or authorized trading, does not constitute

custody.69 We had explained then that the risk of an adviser withdrawing or misappropriating

funds and securities are minimized when a client’s custodian is under instructions to transfer

Proposed rule 223-1(d)(3) (proposed custody definition) and proposed rule 223-1(d)(4)(discretionary

authority definition). The second prong of the current custody definition states: “Any arrangement

(including a general power of attorney) under which you are authorized or permitted to withdraw client

funds or securities maintained with a custodian upon your instruction to the custodian.” See current rule

206(4)-2(d)(3).

The proposed amended definition also removes the reference “to the custodian” from the arrangement

category. This formulation ensures that custody is triggered if, for example, an adviser can instruct a

transfer agent or administrator to withdraw or transfer beneficial ownership of client assets. See proposed

rule 223-1(d)(3).

Proposed rule 223-1(d)(4).

2003 Adopting Release, supra footnote 2, at n.10.

funds (or securities) out of a client’s account only upon corresponding transfer of securities (or

funds) into the account.70 However, while we continue to believe that there is a more limited

risk of loss to a client from authorized trading when a qualified custodian participates in a onefor-one exchange of assets like this, we also believe that discretionary authority presents the

types of risks the rule is designed to address. The adviser, for instance, could use its

discretionary authority over a client’s assets to instruct an issuer’s transfer agent or administrator

(e.g., the administrator for a loan syndicate) to sell its client’s interest and to direct the cash

proceeds of the sale to an account that the adviser owns and controls, thereby depriving the client

of ownership, unbeknownst to the client or its qualified custodian. Unless a client or its

custodian is required to participate in these transactions, such as when the client must sign the

subscription agreement to purchase the security (i.e., the adviser does not have a power of

attorney and cannot sign for the client in any other capacity), the client will be unable to monitor

the assets in its account for potential misuse or misappropriation effectively.71

We believe it is important to extend the protections of the rule by explicitly including

“discretionary authority” within the definition of custody. However, because we continue to

believe more limited risk of loss exists when a qualified custodian participates in transactions,

we are also proposing a limited exception to the surprise examination requirement of the rule.

The exception would generally apply to client assets that are maintained with a qualified

custodian when the sole basis for the application of the rule is an adviser’s discretionary

Id.

Our staff stated a similar view under the current rule. See Custody Rule FAQs, supra footnote 17, at

Question VII.3.

authority that is limited to instructing the client’s qualified custodian to transact in assets that

settle only on a delivery versus payment (“DVP”) basis.72 In DVP transactions, clients’

custodians are under instructions to transfer assets out of a client’s account only upon

corresponding transfer of assets into the account. This “delivery versus payment” arrangement

minimizes the risk that an investment adviser could withdraw or misappropriate the assets in its

client’s custodial account. In our view, DVP transactions reduce the risk that the seller of an

asset could deliver the asset but not receive payment or that the buyer of an asset could make

payment but not receive delivery of the asset.73

We request comment on all aspects of the proposed application of the rule to advisers

with discretionary authority, along with the continuing application of the rule more generally,

including the following items.

8. Should the proposal generally retain the current rule’s definition of custody? The

proposed rule would generally retain the three categories that serve as examples of

custody in the current rule: physical possession, certain arrangements when the

adviser is authorized or permitted to withdraw or transfer beneficial ownership of

client assets upon the adviser’s instructions, and circumstances when the adviser acts

in certain capacities. Should the proposed rule change the current definition of

custody from these three categories? What should the proposal provide

alternatively?

Proposed rule 223-1(b)(8). See infra at section II.G.2.

For discussion of delivery versus payment settlement operations, see Bank for International Settlements,

“Delivery versus Payment in Securities Settlement Systems,” Sept. 1992, p. 1 at

https://www.bis.org/cpmi/publ/d06.pdf.

9. Should the rule apply to when an adviser has discretionary authority over client

assets, as proposed? Are there provisions of the proposed rule that should or should

not apply to advisers who have custody because they have discretionary authority?

10. Do advisers with discretionary authority over a client’s assets (regardless of

settlement method) currently have safeguards in place that effectively limit the risks

to clients of loss, misuse, theft, or – in particular – misappropriation? If so, what are

they? Do these safeguards differ depending on whether the arrangement involves a

qualified custodian?

11. When a trade settles in a manner that is not DVP, are there controls that are or could

be established in the event one leg of the trade does not complete? If so, how

commonly are such controls utilized? Are there circumstances when such controls

could not be established or implemented? Should we require controls or policies and

procedures for advisers and/or the respective custodians in these circumstances?

12. Should the definition of custody contain an exception (or should we interpret the

definition of custody not to include) when the adviser has authority to instruct the

client’s custodian to remit assets from the custodial account to the client at his or her

mailing address of record? If so, should such an exception or interpretation be

subject to any conditions? For example, should the client be required to grant the

adviser this authority in writing to the qualified custodian? Should an exception or

interpretation also be conditioned on the adviser lacking authority to open an account

on behalf of the client? Should the adviser also lack authority to designate or change

the client’s mailing address of record with the qualified custodian, or if the adviser

has this authority, would it be sufficient protection for the adviser to have a

reasonable belief that the custodian would send a notice of any change of mailing

address to the client at the client’s old address of record upon receiving the request

from the adviser to change the mailing address?74 For example, broker-dealers must

send a customer who is a natural person a notification of a change of mailing address

to the customer’s old mailing address.75 Similarly, banks that follow guidance

issued by banking regulators send confirmation of a customer request for a change of

mailing address to both the old and new address on record.76 Is there adequate

protection when the custodian is subject to these regulatory requirements because the

adviser would be unable to remit its client’s assets to the client at a mailing address

other than the client’s address of record at the custodian? Alternatively, should such

an exception or interpretation hinge on whether advisers design policies and

procedures under rule 206(4)-7 (the “Compliance Rule”) that address the risk to

clients of remitting client investments to non-clients?

13. Should we make clear that an adviser is subject to the custody rule and would also be

subject to the proposed rule with respect to its client’s assets that are held, or

accessible, by a related carrying broker or executed through a related introducing

We note that the staff has issued an FAQ on this topic. See Custody Rule FAQs, supra footnote 17, at FAQ

II.5.A. and B.

Exchange Act Rule 17a-3(a)(17)(i)(B)(2).

See, e.g., Federal Reserve System Supervisory Letter SR 0-11 (Apr. 26, 2001), Office of Comptroller of the

Currency (“OCC”) Advisory Letter 2001-4 (Apr. 30, 2001), Federal Deposit Insurance Corporation

Financial Institution Letter 39-2001 (May 9, 2001), Office of Thrift Supervision CEO Letter No. 139 (May

4, 2001), and National Credit Union Administration Letter No. 01-CU-09 (Sept. 2001).

broker?77 Conversely, should we make clear that an adviser would not be subject to

the rule solely due to its related person acting as the trustee of a participant-directed

defined contribution plan established for the benefit of the adviser’s employees,

provided the adviser does not provide investment advisory services to the plan or

any investment option available under the plan?78 Similarly, should we clarify the

meaning of “in connection with advisory services” in the context of related person

custody?79 For example, should we make clear that where an adviser’s client has a

bank account with a bank that is the adviser’s related person, but does not use the

bank account in connection with the adviser’s advisory activity, we would not view

the bank’s authority to be “in connection with advisory services” that the adviser

provides to its client and that the rule, therefore, would not apply?

14. Advisers that act as trustee of a trust would have custody of that trust’s assets under

the proposed rule. Should we adopt an exception from the definition of custody for

(or should we interpret the definition of custody not to include) cases where an

adviser acts as co-trustee of a trust and no single co-trustee is able to effect any

change in control of the beneficial ownership of the trust’s investments without the

prior written consent of a co-trustee(s) that is not a related person?80 In what

We note that the staff has issued an FAQ on this topic. See Custody Rule FAQs, supra footnote 17, at

Question XIV.2-3. See also section II.J, infra.

We note that the staff has issued an FAQ on this topic. Our staff has stated that it would not consider an

adviser to have custody where the investment adviser and the related person trustee are, to the extent

applicable, in compliance with the Employee Retirement Income Security Act of 1974 (ERISA) and rules

and regulations issued thereunder with respect to the plan. See Custody Rule FAQs, supra footnote 17,

Question XII.1.

See proposed rule section 223-1(d)(3).

We note that the staff has issued an FAQ on this topic. See Custody Rule FAQs, supra footnote 17, at

Question XII.2.

circumstances is a co-trustee required either by law or the trust instrument to protect

the trust beneficiaries from the actions of a single trustee acting alone? Similarly,

should we adopt an exception in (or should we interpret the definition of custody not

to include) circumstances where an adviser has the ability or authority to effect a

change in beneficial ownership of a trust’s investments, where an adviser is cotrustee along with the grantor of a revocable grantor trust, and the adviser is

prohibited by the trust instrument or by law from withdrawing any investments from

the trust without the prior written consent of all of its co-trustees?81

15. An adviser would have custody under the proposed rule when it comes into

possession of client assets. The rule contains an exception from the definition of

custody for possession of client assets when the adviser receives them inadvertently

and returns them to the sender within three business days. Should we amend the

exception to accommodate (or interpret the definition of custody not to include)

other situations in which the adviser inadvertently receives client assets?82 For

example, should such an exception or interpretation be conditioned such that the

adviser return the client’s assets to the sender or forward them to the client or the

client’s custodian within five days of receipt? Should such an exception or

We note that the staff has issued an FAQ on this topic. See Custody Rule FAQs, supra footnote 17,

Question XII.3. See also, 2003 Adopting Release, supra footnote 2 at note 15 (stating that the Commission

would not view the adviser to have custody of the funds or securities of the estate, conservatorship, or trust

solely because the supervised person has been appointed in these capacities as a result of family or personal

relationship with the decedent, beneficiary or grantor (and not a result of employment with the adviser)).

We note that the staff has issued a no-action letter on this topic. The Commission’s staff has stated that

when advisers infrequently receive specific types of client funds or securities from a list of enumerated

third parties that the staff identified, the staff would not recommend enforcement for violation of the

current custody rule if the adviser meets specified conditions. See Investment Adviser Association, SEC

Staff No-Action Letter (Sep. 20, 2007) (“2007 IAA No-Action Letter”). See also Custody Rule FAQs,

supra footnote 17, at Question II.1.

interpretation be available only when client assets are received from senders, such as

those identified in staff statements? Rather than specify senders in such an

exception, should the exception or interpretation be available when an adviser

determines it would be unfeasible to return the assets, or when there is a risk that the

client’s assets could be lost if the adviser attempted to return them to the sender?

Should such an exception or interpretation be available only if the investment

adviser’s receipt of its client’s assets is inadvertent? Should we condition such an

exception or interpretation on recordkeeping requirements under proposed rule 2042 or on whether advisers design policies and procedures under rule 206(4)-7? We

understand that for certain private fund advisers and trustees it is difficult to avoid

temporarily possessing client checks and physical assets because there may not be an

independent representative to arrange the movement of such assets into a qualified

custodian. Are there any particularities to these contexts that would benefit from an

exception or interpretation? In addition, are there other circumstances that involve

checks written to third parties, checks written to clients, and checks written to

advisers where the adviser has no authority to deposit client assets into any account

other than directed by the client that would benefit from exceptions or

interpretations? Are there certain policies and procedures maintained by advisers

that mitigate the custody risks associated with receiving checks that may be

beneficial to include in this rulemaking? For example, if the adviser has policies and

procedures reasonably designed to maintain such assets with a qualified custodian,

should we provide an exception if an adviser to a private fund or serving as a trustee

would not be subject to the rule for the brief handling of client checks or physical

assets?

16. Should we include an exception from the rule for assets for which the adviser

provides advice in certain sub-adviser relationships, such as was described in our

staff’s statements?83 In what circumstances should such an exception apply? Would

an exception designed to capture circumstances where the proposed rule would

apply to the sub-adviser only because its related person triggers the rule with respect

to the same advisory clients be beneficial? Such an exception could be conditioned

on the related person being fully subject to (and in compliance with) the applicable

requirements of the custody rule. Would such a condition to the exception work in

practice? Should such exception be conditioned on the adviser’s related person fully

complying with the requirements of the proposed rule? If not, why not? If so, how

would advisers determine whether their related person is fully complying with the

rule? Are there alternative safeguards that commenters would suggest?

Alternatively, should such sub-advisers be subject to all or certain requirements of

the rule? If only certain requirements, which ones and why? Should we condition

such an exception on recordkeeping requirements under proposed rule 204-2 or on

whether advisers design policies and procedures under rule 206(4)-7?

17. Are there are any other arrangements or circumstances where an adviser would have

custody under the proposed rules but an exception would be beneficial and not

We note that the staff has issued a no-action letter on this topic. See Investment Adviser Association, SEC

Staff No-Action Letter (Apr. 25, 2016), available at:

https://www.sec.gov/divisions/investment/noaction/2016/investment-adviser-association-042516206(4).htm.

inconsistent with the policy goals of the rule? For example, are there specific

circumstances involving custody at electronic platforms, investment adviser

aggregators, benefit plans, introducing broker-dealers, plan sponsors, record-keepers,

or third party administrators that would benefit from an exception or interpretation

that these arrangements constitute or do not constitute custody?

Qualified Custodian Protections

Qualified custodians would continue to serve as key gatekeepers under the proposed rule.

These institutions’ custodial activities are subject to regulation and oversight.84 Accordingly, as

under the current rule, investment advisers with custody of client assets would be required to

maintain those assets with a qualified custodian.85 We are proposing several ways to strengthen

the requirement, however, in light of the evolution of the market for custodial services, financial

products, and advisory services over the last decade. These proposed changes aim to provide

investors with certain standard custodial protections that will improve the safeguarding of their

assets in the current market as well as in the future as the market for financial products and

advisory services continues to evolve.

The proposed rule would continue to allow banks or savings associations, registered

broker-dealers, registered futures commission merchants, and certain foreign financial

institutions to act as qualified custodians, but, in a change from the current rule, only if they have

“possession or control” of client assets pursuant to a written agreement between the qualified

2002 Proposing Release, supra footnote 2, at n. 30; 2009 Proposing Release, supra footnote 11, at n. 4.

Proposed rule 223-1(a)(1)(i). The proposed rule would provide an exception, and another means of

compliance with the rule, for certain assets that are unable to be maintained with a qualified custodian. See

proposed rule 223-1(b)(2).

custodian and the investment adviser.86 Also in a change from the current rule, the proposed rule

would modify the definition of foreign financial institution and requirements for banks and

savings associations in the definition of qualified custodian.87 In the case of a qualified

custodian that is the adviser, the proposed rule would require that the written agreement be

between the adviser and the client.

The proposed rule would require that the written agreement contain contractual

provisions that we believe are critical to providing important protections for advisory client

assets. As discussed in further detail below, the contractual terms would address recordkeeping,

client account statements, internal control reports, and the adviser’s agreed-upon level of

authority to effect transactions in the account. In addition, the proposed rule would require that

an adviser obtain reasonable assurances from a qualified custodian relating to certain protections

the qualified custodian will provide to the advisory client, including with respect to the qualified

custodian’s standard of care, indemnification, limitation of liability for sub-custodial services,

segregation of client assets, and attachment of liens to client assets. Also as discussed below, we

believe that many of these important protections are already provided—through contract or

practice—by certain custodians to certain custodial customers in the current market. However,

the proposed rule is designed to expand and formalize the minimum standard of protections to

advisory clients’ assets held by qualified custodians in a manner that would provide consistent

investor protections across all qualified custodians under our proposed rule. We believe that the

proposed rule leverages the expertise and regulatory regimes of qualified custodians with respect

to a wide range of assets, while, at the same time, tailoring and bolstering the protections

See proposed rule 223-1(a)(1).

See proposed rule 223-1(d)(10)(i) and (iv); section II.B.1.b, infra.

afforded to advisory clients to improve the safeguarding of client assets over which advisers have

custody.

Definition of Qualified Custodian

Qualified custodians under the proposed rule would include the types of financial

institutions that clients and advisers customarily turn to for custodial services and that have in

place practices that are designed to protect custodial assets. We continue to believe that the use

of a qualified custodian would enhance the protections afforded to client assets.88

The proposed rule, like the current rule, would define the term “qualified custodian” to

mean a bank or savings association, registered broker-dealer, registered futures commission

merchant (“FCM”), or certain type of foreign financial institution (“FFI”) that meets the

specified conditions and requirements.89 We continue to believe that these financial institutions

should be permitted to act as qualified custodians because, as discussed in more detail below,

they operate under regular government oversight, are subjected to periodic inspection and

examination, have familiarity with providing custodial services, and are in a position to attest to

custodial customer holdings and transactions90—all critical components of safeguarding client

assets under the proposed rule. As a result, with the exception of proposed amendments to the

See 2003 Adopting Release, supra footnote 2; 2009 Adopting Release, supra footnote 11.

Proposed rule 223-1(d)(10). Not all registered broker-dealers and registered FCMs meet the definition of

qualified custodian under the custody rule or the proposed safeguarding rule. Notably, only those brokerdealers or FCMs holding client assets in customer accounts meet this definition. This would include the

broker-dealers subject to the customer protection rule (Exchange Act Rule 15c3-3) and FCMs holding

futures customers funds subject to 17 CFR 1.20.

See, e.g., 2009 Adopting Release, supra footnote 11, at section I (describing qualified custodians under the

rule as the types of financial institutions to which clients and advisers customarily turn for custodial

services and as subject to regulation and oversight).

definition of qualified custodian relating to banks, savings associations, and FFIs, we are not

changing the types of institutions that may serve as qualified custodians under the rule.91

Bank and Savings Association Qualified Custodian Proposed

Amendments

The current rule includes in the definition of qualified custodian a bank as defined in

section 202(a)(2) of the Advisers Act (15 U.S.C. 80b-2(a)(2)) or a savings association as defined

in section 3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has deposits

insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act

(12 U.S.C. 1811). The proposed rule would largely retain this definition of qualified custodian

relating to banks and savings associations. However, in connection with the proposed rule’s

focus on setting certain minimum protections for client assets, the rule would require that a

qualifying bank or savings association hold client assets in an account that is designed to protect

such assets from creditors of the bank or savings association in the event of the insolvency or

failure of the bank or savings association (i.e., an account in which client assets are easily

identifiable and clearly segregated from the bank’s assets) in order to qualify as a qualified

custodian. We believe that requiring banks and savings associations to hold client assets in such

an account brings the requirements for bank and savings association qualified custodians in line

We remind advisers that as additional financial institutions become available to custody assets,

advisers must continue to exercise their fiduciary duties to clients in connection with selection and

monitoring of the qualified custodian. See, e.g., Standard of Conduct for Investment Advisers Release,

supra note 57, at section II (“The investment adviser's fiduciary duty is broad and applies to the entire

adviser-client relationship.”) (citations omitted).

with the protections required for broker-dealers, FCMs, and FFIs acting as qualified custodians

under the current custody rule and under the proposed safeguarding rule.92

We believe that the proposed account requirement would improve the safeguarding of

client assets. We understand that, generally, a bank deposit account creates a debtor-creditor

relationship between the bank and depositor.93 This debtor-creditor relationship typically does

not create a special or fiduciary relationship.94 While applicable insolvency law and procedures

vary depending on any particular bank or savings association’s regulatory regime,95 we

understand that assets held in accounts of the type proposed by the rule are more likely to be

returned to clients upon the insolvency of the qualified custodian because they may pass outside

of a bank’s insolvency, may be recoverable if wrongly transferred or converted, and are not

treated as general assets of the bank.96

We believe that the proposed rule would provide flexibility to banks and savings

associations to use the appropriate accounts available to them under applicable law and offered

The current custody rule requires that in order to be included in the definition of qualified custodian, a

broker-dealer registered under section 15(b)(1) of the Securities Exchange Act of 1934 (15 U.S.C.

78o(b)(1)), must hold the client assets in customer accounts, a futures commission merchant registered

under section 4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)) must hold the client assets in

customer accounts subject to certain additional requirements, and an FFI must customarily hold financial

assets for its customers and must keep the advisory clients’ assets in customer accounts segregated from its

proprietary assets. See rule 206(4)-2(d)(6)(ii), (iii), and (iv). See also proposed rule 223-1(d)(10).

See generally, Graham, Heitz, Lapine, et al., 6a Banking Law section 134.05 (2022) section 134.05

(collecting cases) (“Banking Law”). We understand that a deposit in a bank is either general or special and

that a deposit is a general deposit unless there is an agreement or understanding that it should be special.

See 5C Michie on Banks and Banking, Deposits section 339 (Sept. 2022) (collecting cases) (“Michie on

Banks & Banking”); Banking Law, section 134.05 (“Accounts are either special accounts or general

accounts.”) (collecting cases).

Id.

See 3 Michie on Banks & Banking, Insolvency and Dissolution. section 17. Jurisdiction and Powers of

Courts and Officials in General (discussing state-by state jurisdiction and certain regulatory powers).

See Michie on Banks & Banking, Deposits section 339 (collecting cases under a wide variety of state laws

where a bank may be acting as a trustee, bailee, or agent in connection with a customer account that is

treated as other than a general deposit account).

by them to customers. Rather than consider the treatment of custodial customer assets upon a

bank’s failure in all 50 states, and risk the protections of our rule eroding if state banking law

protections vary or evolve, we are proposing to establish a consistent and uniform standard to

protect all advisory clients. The account terms should identify clearly that the account is

distinguishable from a general deposit account and clarify the nature of the relationship between

the account holder and the qualified custodian as a relationship account that protects the client

assets from creditors of the bank or savings association in the event of the insolvency or failure

of the bank or savings association.

Proposed Enhancements to Definition of Foreign Financial

Institution

Advisory clients often invest in assets traded on foreign exchanges and their advisers

must, as a practical matter, maintain those assets with financial institutions in foreign countries

where the assets are traded. In order to facilitate these types of holdings, the current rule

includes FFIs that customarily hold financial assets for their customers, as qualified custodians,

provided that the FFI keeps the advisory clients’ assets in customer accounts segregated from the

FFI’s proprietary assets.97

We are proposing to require that an FFI satisfy seven new conditions in order to serve as

a qualified custodian for client assets under the proposed rule.98 These proposed conditions are

See rule 206(4)-2(d)(6)(iv). Under the current rule, when an adviser selects an FFI to hold clients’

assets, we believe the adviser’s fiduciary obligations require it either to have a reasonabl e basis for

believing that the FFI satisfies the conditions and would provide a level of safety for client assets

similar to that which would be provided by a “qualified custodian” in the United States or to disclose

fully to clients any material risks attendant to maintaining the assets with the foreign custodian. See

2003 Adopting Release, supra footnote 2, at note 22.

We also propose to eliminate the requirement under the current definition that the FFI keeps the advisory

clients’ assets in customer accounts segregated from its proprietary assets because the proposed rule, more

partly drawn from our experience with the factors relevant to the safekeeping of “Foreign

Assets” by the types of foreign financial entities that can act as an “Eligible Foreign Custodian”

as defined in rule 17f-5 under the Investment Company Act.99 Such conditions are also designed

to address our understanding of market developments since the adoption of rule 17f-5 by

providing enhanced investor protections for advisory clients and their assets that we believe

would help promote an FFI having generally similar protections as a U.S.-based qualified

custodian. Recent events in crypto assets markets also have highlighted the need for similarly

enhanced custody safeguards of client assets held outside the United States.

For an FFI to be a qualified custodian under the proposed rule, it would need to be:



Incorporated or organized under the laws of a country or jurisdiction other than

the United States, provided that the adviser and the Commission are able to

enforce judgments, including civil monetary penalties, against the FFI;



Regulated by a foreign country’s government, an agency of a foreign country’s

government, or a foreign financial regulatory authority100 as a banking institution,

trust company, or other financial institution that customarily holds financial assets

for its customers;

broadly, would require advisers to obtain reasonable assurances from qualified custodians that all advisory

client assets are segregated from the qualified custodian’s proprietary assets and liabilities. See proposed

rule 223-1(a)(1)(ii)(D).

Rule 17f-5 under the Investment Company Act defines an Eligible Foreign Custodian as an entity that is

incorporated or organized under the laws of a country other than the United States and that is a Qualified

Foreign Bank or a majority-owned direct or indirect subsidiary of a U.S. Bank or bank-holding company.

For these purposes, a Qualified Foreign Bank is defined as a banking institution or trust company,

incorporated or organized under the laws of a country other than the United States, that is regulated as such

by the country’s government or an agency of the country’s government. See 17 CFR 270.17f-5(a)(1) and

(a)(5). Rule 17f-5(c)(1) under the Investment Company Act lists the factors relevant to the safekeeping of

Foreign Assets, as defined in rule 17f-5(a)(2). See 17 CFR 270.17f-5(c)(1) and (a)(2).

100

Defined in section 202(a)(24) of the Advisers Act [15 U.S.C. 80b -2(a)(24)].



Required by law to comply with anti-money laundering and related provisions

similar to those of the Bank Secrecy Act [31 U.S.C. 5311, et seq.] and regulations

thereunder;



Holding financial assets for its customers in an account designed to protect such

assets from creditors of the foreign financial institution in the event of the

insolvency or failure of the foreign financial institution;



Having the requisite financial strength to provide due care for client assets;



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; and



Not operated for the purpose of evading the provisions of the proposed rule.101

We believe each of these proposed new conditions would enhance the ability and responsibility

of advisers to protect client assets maintained outside the United States for the following reasons.

Regarding the first condition, we are proposing to require the adviser to determine that

the adviser and the Commission are able to enforce judgments, including civil monetary

penalties, against the FFI. The FFI could satisfy this condition by such means as appointing an

agent for service of process in the United States or having offices in the United States, and the

adviser can request the relevant documentation for verification purposes. This condition would

thus limit the types of foreign financial entities to those that are subject to or consent to U.S.

jurisdiction.

101

Proposed rule 223-1(d)(10)(iv).

Regarding the second condition, we believe requiring an FFI be regulated by a foreign

country’s government, an agency of a foreign country’s government, or a foreign financial

regulatory authority, as defined in section 202(a)(24) of the Advisers Act, would help ensure that

client assets maintained with an FFI are subject to regulatory oversight that would better serve

our policy goal of protecting custodial assets by the use of qualified custodians that meet our

proposed requirements. In addition to banking institutions and trust companies, we would permit

foreign-regulated financial institutions who customarily hold financial assets for their customers

(e.g., the foreign equivalent of broker-dealers or FCMs) to serve as “qualified custodians.”

We believe the requirement in the third condition for an FFI to comply with anti-money

laundering (“AML”) and related provisions similar to those of the Bank Secrecy Act (“BSA”)

and regulations thereunder would help increase the likelihood that the FFI would readily identify

and investigate aberrant behavior in a client account, such as activity that might suggest

misappropriation or some other type of loss to a client. We generally believe an FFI would be

able to satisfy this condition if it is required to comply with the laws and regulations established

by a member or observer jurisdiction of the Financial Action Task Force (“FATF”) and not

otherwise listed on any sanctions list administered by the Office of Foreign Assets Control of the

U.S. Department of the Treasury (“OFAC”),102 or on any special measures list administered by

102

The FATF is an inter-governmental body whose purpose is the development and promotion of policies,

both at the national and international levels, to combat money laundering and the financing of terrorism and

proliferation. The FATF monitors members’ progress in implementing AML measures, reviews money

laundering techniques and counter-measures, and promotes the adoption and implementation of AML

measures globally. See https://www.fatf-gafi.org/en/the-fatf/what-we-do.html/. To search sanctions lists

administered by OFAC, such as the Specially Designated Nationals and Blocked Persons list, see

https://sanctionssearch.ofac.treas.gov.

the Financial Crimes Enforcement Network of the U.S. Department of the Treasury

(FinCEN”).103

The fourth condition would replace and strengthen the segregation requirement for FFIs

in the current definition of qualified custodian in the custody rule, and it is designed to

complement the proposed segregation requirements of the safeguarding rule. In the current rule,

an FFI that customarily holds financial assets for its customers is permitted to serve as a qualified

custodian, provided that the FFI keeps the advisory clients’ assets in customer accounts

segregated from its proprietary assets. The proposed new condition would require the FFI to

hold financial assets for its customers in accounts designed to protect such assets from creditors

of the FFI in the event of the insolvency or failure of the FFI.104 This condition would thereby

impose investor protections, particularly in the event of an FFI insolvency or bankruptcy, that are

more comparable to those we are proposing for assets held with U.S.-regulated bank or savings

association qualified custodians. We believe advisers would be able to assess whether an FFI is

holding client assets in such accounts in the course of obtaining the reasonable assurances we are

proposing to require advisers obtain from all qualified custodians, which are discussed more

fully below.105

103

See section 311 of the USA PATRIOT Act [Pub. L. 107-56] (granting the Secretary of the Treasury the

authority to conclude, if reasonable grounds exist, that a foreign jurisdiction, foreign financial institution, or

an international transaction or account is of “primary money laundering concern,” and to require domestic

financial institutions and financial agencies to take certain “special measures,” such as additional due

diligence and special attention to particular account transactions, among other measures, against the

designated entity).

104

Compare rule 204-2(d)(6)(iv) with proposed rule 223-1(d)(10)(iv)(D).

105

See infra section II.B.3.a.iv (discussing the adviser’s requirement to obtain reasonable assurances from

qualified custodians regarding the required account segregation requirements).

The fifth condition is designed to limit the types of FFIs that can serve as qualified

custodians to those that have the requisite financial strength to meet the proposed due care

standard for client assets. We believe the determination of an FFI’s financial strength could be

based on objective measures and other indicators of financial health that are reasonably

comparable to those that apply to U.S. banks and other regulated financial institutions.106 Given

that advisers would be required to maintain an ongoing reasonable belief that the FFI qualified

custodian is meeting its due care standard, advisers also could require notifications from the FFI

of any changes, including changes in the financial strength of the FFI, that would have an impact

on the agreed terms of the written custodial contract. Such notifications may provide timely

information to help advisers, as fiduciaries, to react and respond to emerging risks of loss of

client assets.

Under the sixth condition, FFI qualified custodians would be required by law to

implement practices, procedures, and internal controls designed to ensure the exercise of due

care with respect to the safekeeping of assets. Since FFIs are subject to a broad range of

regulatory regimes, we believe this condition would help promote a minimum level of practices,

procedures, and internal controls across qualified custodians for safekeeping client assets under

the proposed rule, regardless of where and how they are held. Further, we believe this

requirement will help to ensure that an FFI’s practices, procedures, and internal controls,

including, but not limited to, those with respect to the safekeeping of certificated and

106

When the Commission adopted amendments to rule 17f-5 (17 CFR 270.17f-5) in 1997, its adopting release

offered guidance to evaluate financial strength by “assess[ing] the adequacy of the custodian’s capital with

a view of protecting the fund against the risk of loss from a custodian’s insolvency.” See Custody of

Investment Company Assets Outside the United States, Investment Company Act Release No. 22658 (May

12, 1997) [62 FR 26923 (May 16, 1997)], at 26928. We understand that relevant governments and their

banking regulators typically set regulatory capital requirements for foreign banking institutions.

uncertificated assets, custodial recordkeeping, and security and data protection, should not differ

in material ways from those of U.S.-regulated qualified custodians. Similar to the fourth

condition, advisers should be able to assess and evaluate an FFI’s internal controls while

obtaining the reasonable assurances we are proposing advisers obtain from all qualified

custodians.107

Finally, we have included an anti-evasion requirement in the seventh condition for FFI

qualified custodians that is similar to the anti-evasion provision currently in the definition of

“bank” under section 202(a)(2) of the Advisers Act and in the definition of “U.S. Bank” under

rule 17f-5 of the Investment Company Act.108 Given the broad scope of foreign financial entities

that we would permit to serve as qualified custodians, we believe it is appropriate to apply the

anti-evasion requirement to all types of FFIs, rather than limiting its application to only banking

institutions or trust companies.

We request comment on all aspects of the proposed rule’s qualified custodian

requirement, including the following items.

18. Should we continue to require that client assets be maintained with qualified

custodians? If not, what alternative protections for client assets should we require as

part of the rule?

19. Should the rule continue to include banks as defined in section 202(a)(2) of the

Advisers Act or savings associations as defined in section 3(b)(1) of the Federal

107

See infra section II.B.3.a.i (discussing the adviser’s requirement to obtain reasonable assurances from a

qualified custodian regarding the qualified custodian’s required exercise of due care and implementation of

appropriate measures to safeguard client assets from theft, misuse, misappropriation, or other similar type

of loss).

108

17 CFR 270.17f-5(a)(7)(iii).

Deposit Insurance Act as qualified custodians, as proposed? Should the rule narrow

the definition to include only certain banks and savings associations as qualified

custodians? If so, how? For example, should the rule permit only banks or savings

associations that are subject to Federal regulation and supervision to act as qualified

custodians? Alternatively, should the rule permit only state banks and savings

association that are members of the Federal Reserve System to act as qualified

custodians?109 Would narrowing of the types of banks and savings associations that

meet the definition of qualified custodian provide additional protections to advisory

clients in the event of the custodian’s insolvency? Is there another way to achieve

our policy goal?

20. Should we require banks and savings associations to hold client assets in an account

designed to protect such assets from creditors of the bank or savings association in

the event of the insolvency or failure of the bank or savings association as proposed?

Is our understanding correct that requiring banks and savings associations to hold

client assets in an account of this type would provide client assets with enhanced

protection from general creditors in the event of the qualified custodian’s insolvency

and increase the likelihood of return of client assets to advisory clients upon a

qualified custodian’s insolvency? Do commenters agree with our view that this

enhanced protection is especially important in light of the broad range of regulatory

regimes and insolvency processes to which a growing number of state-chartered trust

109

See generally Membership of State Banking Institutions in the Federal Reserve System (Regulation H) 12

CFR 208.01 et. seq.

companies and other state-chartered, limited purpose banking entities entering the

custodial market may be subject?

21. Should the rule require the account terms to identify clearly that the account is

distinguishable from a general deposit account? Should the rule require the terms of

the account clarify the nature of the relationship between the account holder and the

qualified custodian, for example, whether the account is a special account,110 a

fiduciary account,111 or whether the bank or savings association is acting as a trustee,

a bailee, or agent of the account holder?

22. Would requiring banks and savings associations to hold client assets in an account

designed to protect such assets from creditors of the bank or savings association in

the event of the insolvency or failure of the bank or savings association reduce the

availability of banks or savings associations that could offer services as a qualified

custodian? Would it increase costs to advisory clients?

23. Rather than requiring accounts of this type for all banks and savings associations,

should the rule require accounts that protect client assets from creditors of a bank or

savings association in the event of the insolvency or failure of the bank or savings

association for a subset of these institutions that are not federally insured or OCC

110

See, e.g., Bank of America, N.A. v. Lehman Bros. Holdings, Inc. (In re Lehman Bros. Holdings, Inc.), 439

B.R. 811, 824-825 (Bankr. S.D.N.Y. Nov. 16, 2010) (“Other factors that courts have examined to ascertain

the parties’ mutual intent [to create a special rather than general account] include: (1) whether the parties

agreed to segregate the funds; (2) whether the bank paid interest on the funds; (3) whether the depositor

lacked an unfettered right to withdraw the funds; and (4) whether a third party possessed an interest in the

funds.”).

111

See, e.g., 12 CFR 9.13 and 12 CFR 150.230 (addressing custody of fiduciary assets for banks and savings

associations, respectively).

member banks? For example, should the rule require accounts of this type for state

banks that are not members of the Federal Reserve System?

24. Are there alternative bank and savings association account safeguards we should

require?

25. Should the rule continue to include broker-dealers registered under section 15(b)(1)

of the Securities Exchange Act of 1934 (“Exchange Act”) as qualified custodians, as

proposed? Are there additional requirements we should require when a brokerdealer is acting as a qualified custodian under the rule? For example, should we

explicitly clarify that this would include only registered broker-dealers that carry

customer accounts, or is that already understood from the current rule?

26. Should the rule continue to include FCMs as qualified custodians, as proposed?

Should we remove the condition in the current rule that prohibits maintaining client

securities with an FCM unless the securities are “incidental” to client futures

transactions? In 2013, the CFTC enhanced protections afforded to customers and

customer assets held by FCMs including protections covering, among other things,

risk management, recordkeeping and disclosure, and the treatment of customersegregated funds secured in foreign futures and options accounts.112 Are the 2013

112

The CFTC in 2013 enhanced FCM requirements surrounding the holding and investment of customer

funds, including the ability of FCMs to withdraw funds from futures customer segregated accounts. Under

the enhanced protections, FCMs are required to deposit proprietary funds (i.e. residual interest) into futures,

cleared swap, and foreign futures customer accounts for purposes of creating a buffer to ensure compliance

with segregation requirements. In addition, FCMs are required to file electronically their segregation

calculations with the CFTC and their self-regulatory organization each business day. Further, FCMs are

required to establish risk management programs designed to monitor and manage risks associated with

customer funds. See Enhancing Protections Afforded Customers and Customer Funds Held by Future

Commission Merchants and Derivatives Clearing Organizations, (“CFTC Enhanced Protections Release”)

[78 FR 68506 (Nov. 14, 2013)].

CFTC regulatory enhancements sufficient grounds to eliminate that condition of the

current rule?

27. Should the rule limit the FFIs that can act as qualified custodians under this rule, as

proposed? Are the proposed conditions on an FFI sufficiently clear, and if not, how

should they be made clearer? Should we eliminate any condition, add any condition,

or require only certain conditions and not others when an FFI is acting as a qualified

custodian under the rule? For example, as part of the rule, should we require an

adviser to find that the FFI provides a level of safety for client assets equivalent to

that which would be provided by a qualified custodian in the United States or to

fully disclose to clients any material risks attendant to maintaining the assets with

the foreign custodian? Should this requirement apply only when the adviser is

involved in selecting (or assisting a client in selecting) a qualified custodian? Are

there types of FFIs that currently serve as qualified custodians that would no longer

be eligible to serve as qualified custodians under the proposed rule? Would the

proposed changes to the definition of FFI enhance or inhibit investor protections?

Would the proposed changes to the definition of FFI cause any investments that an

investment adviser currently is able to select on behalf of its clients to become

unavailable for selection by the adviser due to the lack of the existence of an FFI that

satisfies the conditions of the proposed rule? Should we only permit institutions

regulated by a specific foreign financial regulatory authority? If so, which foreign

financial authority and why? Should we require the adviser to obtain documentation

that identifies the FFI’s specific financial regulatory authority or authorities? Should

the rule permit only certain types of FFIs to qualify as qualified custodians and if so,

which ones? Are there any types of regulated foreign entities that should not hold

certain types of client assets outside the United States? Should the proposed rule

account for the country or jurisdiction where an FFI is primarily operating, rather

than the country or jurisdiction of incorporation or organization, as proposed? If so,

how would the adviser determine where the FFI is primarily operating?

28. Should the proposed rule limit the types of FFIs that can be qualified custodians? If

so, which institutions should be included? Only banking institutions or trust

companies? Should we also specifically include foreign securities depositories and

clearing agencies or broker-dealer and FCM equivalents?

29. Is the proposed definition to include regulated FFIs that customarily hold financial

assets for customers too broad; would it allow unsound institutions to act as qualified

custodians under the proposed rule?

30. What, if any, impacts would our proposed conditions have on the availability of FFIs

that can serve as qualified custodians? What would be the positive and negative

effects of requiring FFIs to provide custodial protections similar to the protections

provided by U.S. qualified custodians?

31. Should the proposed rule require an FFI to be subject to or consent to U.S.

jurisdiction for judgment enforceability, as proposed? Alternatively, should

judgment enforceability be a factor relevant to the adviser’s consideration of whether

client assets will be subject to the requisite due care standard by an FFI, similar to

the approach in rule 17f-5(c)(1) under the Investment Company Act?113 Should we

113

See 17 CFR 270.17f-5(c)(1)((iv).

require the adviser to obtain the FFI’s consent to service of process in the United

States to verify that it meets this condition? Should such consent to service of

process be effected by the FFI’s submission of a specified form to the Commission,

similar in effect to Form ADV-NR for the appointment of an agent for service of

process by a non-resident general partner or a non-resident managing agent of any

investment adviser?

32. Should an FFI be required to comply with laws and regulations similar to the BSA to

act as a qualified custodian, as proposed? Do the AML requirements for FFIs help

ensure that a qualified custodian would more readily identify and investigate

aberrant behavior in a client’s account? Alternatively, should we specify the types

of AML programs that must be in place for FFIs?

33. Should we treat an FFI as being required to comply with laws and regulations similar

to the BSA if the FFI is required to comply with the laws and regulations established

by a member or observer jurisdiction of the FATF and not otherwise listed on any

sanctions list administered by the OFAC or on any special measures list under

section 311 of the USA PATRIOT Act administered by FinCEN? Alternatively (or

in addition), should we automatically consider an FFI to not be required to comply

with similar laws and regulations if it is required to comply with the laws and

regulations of a country identified by the FATF as a high-risk or other monitored

jurisdiction?114

114

The FATF identifies jurisdictions with weak measures to combat money laundering and terrorist financing

in two FATF public documents that are issued three times a year. See https://www.fatfgafi.org/en/topics/high-risk-and-other-monitored-jurisdictions.html.

34. Should we require that an FFI hold financial assets in accounts designed to protect

such assets from creditors of the FFI in the event of the FFI’s insolvency or failure,

as proposed? Alternatively, should we require advisers to obtain reasonable

assurances from an FFI qualified custodian that the FFI is holding client assets in

such accounts? Should we require an FFI to have account protections that are

generally similar to those of a U.S. bank or savings association in the event of its

insolvency or failure? If so, should we provide guidance around how an adviser

would make such determinations of general similarity and to maintain records of

these determinations?

35. Should we provide additional guidance around how an adviser would determine that

an FFI’s practices, procedures, and internal controls are designed to ensure the

exercise of due care with respect to safekeeping of client assets? Should we require

an FFI’s practices, procedures, and internal controls to be generally similar to those

of a U.S.-regulated bank or savings association? If an FFI is not a bank or savings

association, but rather a foreign-equivalent to a U.S. broker-dealer or U.S. FCM,

should we require the adviser to determine that such FFI’s practices, procedures, and

internal controls are generally similar to those required by U.S. broker-dealers or

FCMs? If so, should we provide guidance around how advisers would make such

determinations of general similarity and to maintain records of these determinations?

36. Should we provide additional guidance around how an adviser would determine the

requisite financial strength of an FFI qualified custodian? Should we require

advisers to maintain records of these determinations? Should we require advisers to

have policies and procedures to determine and monitor the financial strength of all

qualified custodians, not just FFI custodians? Should this requirement apply only

when the adviser is involved in selecting (or assisting a client in selecting) a

qualified custodian?

37. To what extent do advisers or qualified custodians utilize sub-custodians, such as

foreign subsidiaries of a domestic qualified custodian? What types of subcustodians 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?

38. Should the rule permit securities depositories, administrators, or other intermediaries

to be qualified custodians? Do they offer similar services to the other types of

financial institutions that meet this definition, for example, by safeguarding and

providing account statements to advisory clients? Would they be able to agree to the

contractual terms contained in the proposed written agreement requirement? Would

advisers be able to satisfy the reasonable assurances requirement under the proposed

rule if one of these types of entities were holding client assets? Do these types of

entities maintain “possession or control” of client assets, as discussed below? Do

they have similar capital adequacy requirements under their respective regulatory

regimes to the other types of financial institutions that are included in the definition

of qualified custodian? Are there certain categories of these entities that would more

easily function as qualified custodians than others?

39. The rule currently excepts advisers from complying with the requirement to maintain

mutual fund shares with a qualified custodian, provided they are maintained with a

transfer agent.115 Should transfer agents be included in the definition of qualified

custodian in the final rule? Do they offer similar services to the other types of

financial institutions that meet this definition, for example, by providing account

statements to advisory clients? Would they be able to agree to the contractual terms

contained in the proposed written agreement requirement? Would advisers be able

to satisfy the reasonable assurances requirement under the proposed rule if a transfer

agent were holding client assets?

40. Should insurance companies be included in the definition of qualified custodian

under certain circumstances, such as in the variable annuity context?116 Do they

offer services similar to the other types of financial institutions that meet this

definition, for example, by safeguarding and providing account statements to

advisory clients? Would they be able to agree to the contractual terms contained in

the proposed written agreement requirement? Would advisers be able to satisfy the

reasonable assurances requirement under the proposed rule if an insurance company

were holding client assets? Do insurance companies maintain “possession or

control” of client assets, as discussed below? Do insurance companies have similar

capital adequacy requirements to the other types of financial institutions that are

included in the definition of qualified custodian? Are there certain categories or

115

Rule 206(4)-2(b)(1).

116

Our staff indicated it would not recommend enforcement action when an insurance company served a

particular role with respect to variable annuity contracts similar to the role of a transfer agent with respect

to mutual fund shares. See American Skandia Life Assurance Corporation, May 16, 2005.

types of insurance companies that would more easily function as qualified

custodians than others?

Possession or Control

In a change from the current rule, the proposed rule would require that an investment

adviser maintain client assets with a qualified custodian that has possession or control of those

assets. For the purposes of proposed rule, “possession or control” would be defined 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.117 We understand

that a qualified custodian’s participation in a change in beneficial ownership may take different

forms depending on the type of asset involved.118 Similarly, we view participation by a qualified

custodian to require the qualified custodian to participate in a way that it is willing to attest to the

transaction on an account statement and for which it customarily takes custodial liability. By

contrast, we would not view “accommodation reporting,” as described above, to constitute

“participation.” The proposed requirement and related definition are designed to achieve several

objectives. First, a critical custodial function is to prevent loss or unauthorized transfers of

ownership of the client’s assets. It is our understanding that a custodian will only provide this

117

See proposed rule 223-1(a)(1)(i) and (d)(2)(8). Exchange Act Rule 15c3-3(c) prescribes when securities

shall be deemed to be under the control of a broker-dealer. See 17 CFR 240.15c3-3(c).

118

For example, for certain privately offered securities, we understand banks will put the securities in their

name as nominee. We also understand that a change in beneficial ownership may occur at different points

in the transaction lifecycle based on the type of asset involved. For example, when purchasing an equity

security, the change in beneficial ownership occurs on trade date (see, e.g., rule 240.13d-3 - Determination

of beneficial owner), but we understand that when purchasing real property, the change in beneficial

ownership typically occurs on the settlement date.

safeguarding function, however, and assume custodial liability for a custodial customer’s loss, if

the custodian had possession or control of the asset that is lost. Second, because the qualified

custodian would be required to participate in any change in beneficial ownership of a client asset,

the proposed possession or control definition would provide assurance that a regulated party who

is hired for safekeeping services by the client to act for the client is involved in any change in

beneficial ownership of the client’s asset. Finally, we believe it would help ensure the integrity

of account statements provided by qualified custodians because the custodian would report only

on the holdings in its possession or control (unless the client requests that the qualified custodian

report on holdings that are not in its possession or control). As a result, a client could take

comfort that what is reported on its account statement is an accurate attestation of holdings and

transactions by that custodian.

The proposed definition of “possession or control” in proposed rule 223-1 is designed to

be consistent with the laws, rules, or regulations administered by the qualified custodian’s

functional or primary financial regulator for purposes of its custodial activities. Under the

existing regulatory regimes under which qualified custodians currently operate, a qualified

custodian must generally maintain assets in its physical possession or control. We believe our

proposed definition of possession or control (i.e., being required to participate in any change of

beneficial ownership) is consistent with how the concept of possession or control is understood

currently by most qualified custodians and does not conflict with the requirements of qualified

custodians’ respective regulatory regimes. The proposed rule would formalize that

understanding.

For example, under the Exchange Act, broker-dealers are required promptly to obtain and

maintain in their physical possession or control all of their customers’ fully paid and excess

margin securities.119 As a result, a broker-dealer would necessarily be involved in the transfer of

beneficial ownership of those securities. In addition, national banks that offer safeguarding of

customer assets are responsible for maintaining adequate custody or control of their customer

assets.120 Again, as a result, national banks would have to relinquish their custody or control of

an asset to transfer ownership. Similarly, the protections under section 4d(a)(2) of the

Commodity Exchange Act and regulations promulgated thereunder, including, among others,

CFTC regulation 1.20 (Futures customer funds to be segregated and separately accounted for),

CFTC regulation 1.22 (Use of futures customer funds restricted), and CFTC regulation 1.25

119

See 17 CFR 240.15c3-3(b) and (c).

120

National banks that fail to exercise proper control over customer securities may be subject to enforcement

proceedings by the Comptroller of the Currency. See 12 U.S.C. 92a(k) (proceeding to revoke trust powers

on account of unlawful or unsound exercise of powers). See also OCC, Comptroller’s Handbook on Asset

Management Operations and Control (Jan. 2011), available at https://www.occ.gov/publications-andresources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-opscontrols.html; OCC regulation 12 CFR 9.13 (requiring, in connection with the custody of fiduciary assets,

among other things, that “assets of fiduciary accounts [be placed] in the joint custody or control” of certain

fiduciary officers or specially designated persons). The OCC has issued guidance relating specifically to

custody of crypto assets by banks and Federal savings associations. See Interpretive Letter 1170, Authority

of a National Bank to Provide Cryptocurrency Custody Services for Customers (July 22, 2020), available

at https://www.occ.gov/topics/charters-and-licensing/interpretations-and-actions/2020/int1170.pdf (“As

with all other activities performed by national banks and FSAs, a national bank or FSA that provides

cryptocurrency custody services must conduct these activities in a safe and sound manner, including having

adequate systems in place to identify, measure, monitor, and control the risks of its custody services. Such

systems should include policies, procedures, internal controls, and management information systems

governing custody services. Effective internal controls include safeguarding assets under custody,

producing reliable financial reports, and complying with laws and regulations. The OCC has previously

described that custody activities should include dual controls, segregation of duties and accounting

controls. A custodian’s accounting records and internal controls should ensure that assets of each custody

account are kept separate from the assets of the custodian and maintained under joint control to ensure that

that an asset is not lost, destroyed or misappropriated by internal or external parties. Other considerations

include settlement of transactions, physical access controls, and security servicing. Such controls may need

to be tailored in the context of digital custody. Specialized audit procedures may be necessary to ensure the

bank’s controls are effective for digital custody activities. For example, procedures for verifying that a bank

maintains access controls for a cryptographic key will differ from the procedures used for physical assets.

Banks seeking to engage in these activities should also conduct legal analysis to ensure the activities are

conducted consistent with all applicable laws.”).

(Investment of customer funds),121 are predicated on the acceptance of, and receipt by, a futures

commission merchant of futures customers money, securities, or property.122 It is our

understanding that together, these, and other regulations applicable to FCMs, holistically serve

the same purpose. In each of the foregoing cases, the respective custodian is required by its

functional regulator to possess or control customer assets. While functional regulators have not

defined possession or control in the custody context in a manner identical to our proposed rule

(i.e., holding assets such that the qualified custodian is required to participate in any change in

beneficial ownership of those assets), we view the proposed definition to be crucial to

safeguarding client assets and reflective of the fundamental underlying principle of the custody

industry—a custodian holds client assets for safekeeping until directed by the client or the

client’s duly authorized agent to enter into a transaction with a counterparty resulting in a change

of the client’s beneficial ownership.123

For purposes of an FFI, we believe that the proposed requirement would promote the

institution’s accountability for client assets and would thereby help to promote more comparable

121

See also section 4d(a)(2) of the Commodity Exchange Act and CFTC Regulations 1.20 – 1.30 (Customers’

Money, Securities, and Property); and see CFTC Regulation 1.32 (Reporting of segregated account

computation and details regarding the holding of futures customer funds; CFTC Regulation 1.36 (Record of

securities and property received from customers). These regulations address, among other things,

segregation of customer funds, limitations on institutions in which the FCM may deposit customer funds,

limitations on holding customer funds outside of the United States, limitations on the use of customer

funds, and recordkeeping requirements relating to customer funds.

122

CFTC Regulation 1.3 defines a futures commission merchant to be “[a]ny individual, association,

partnership, corporation, or trust [ . . . ] Who, in connection with any of the[] activities [identified in the

regulation] accepts any money, securities, or property [ . . . .] That regulation also defines futures customer

funds to mean “all money, securities, and property received by a futures commission merchant or by a

derivatives clearing organization from, for, or on behalf of, futures customers [for the purposes identified in

the regulation]. 17 CFR 1.3 (emphasis added).

123

Alternatively, a custodian may return the asset to the customer.

investor protections to those assets held with U.S. financial institutions.124 Since FFIs are subject

to a broad range of regulatory regimes, we believe that this requirement, together with the

account statement contract requirement discussed below, would formalize and make more

uniform the assets reported on account statements produced by an FFI, thereby better informing

clients regarding their holdings and transactions.

Application with respect to crypto assets

As discussed above, we believe that under their existing regulatory regimes, qualified

custodians are generally considered to have “possession or control” of assets that are in their

exclusive or physical possession or control. We understand, however, that proving exclusive

control of a crypto asset may be more challenging than for assets such as stocks and bonds. For

example, while we understand that it is possible for a custodian to implement processes that seek

to create exclusive possession or control of crypto assets (e.g., private key creation, maintenance,

etc.), it may be difficult actually to demonstrate exclusive possession or control of crypto assets

due to their specific characteristics (e.g., being transferable by anyone in possession of a private

key). Moreover, we are mindful of crypto asset custody models in which an advisory client and

a qualified custodian might simultaneously hold copies of the advisory client’s private key

material to access the associated wallet with the client’s crypto assets, and thus both have

authority to change beneficial ownership of those assets.125

124

See, e.g., the Undertaking for Collective Investment in Transferable Securities Regulations 2016 (UCITS

V) (enhancing the rules on the responsibilities of UCITS custodians including making the UCITS custodian

liable for the avoidable loss of a financial instrument held in its custody).

125

Letter from Anchorage Digital Bank NA re Custody Rule and Digital Assets (Apr. 13, 2021) (“Proof of

exclusive control can be securely achieved through a combination of software, hardware, and operational

processes. However, custody models that rely on private key redundancy (maintaining multiple physical or

electronic copies) and physical security as a proxy for digital asset security can’t ever truly prove this.”).

As discussed above, the proposed rule’s definition of possession or control turns on

whether the qualified custodian is required to participate in a change in beneficial ownership of a

particular asset. While demonstrating that a qualified custodian has exclusive possession or

control of an asset would be one way to demonstrate that the qualified custodian is required to

participate a change of beneficial ownership, it is not the only way. For example, under the

proposed rule, a qualified custodian would have possession or control of a crypto asset if it

generates and maintains private keys for the wallets holding advisory client crypto assets in a

manner such that an adviser is unable to change beneficial ownership of the crypto asset without

the custodian’s involvement.126

Importantly, however, to comply with the proposed rule, an adviser with custody of client

crypto assets would generally need to ensure those assets are maintained with a qualified

custodian that has possession or control of the assets at all times in which the adviser has

custody.127 While this is true for most client assets over which an adviser has custody, it is

particularly relevant with respect to crypto assets because, as we understand, much of the crypto

asset trading volume occurs on crypto asset trading platforms that often directly settle the trades

placed on their platforms. As a result, many crypto trading platforms require investors to pre-

126

We note that, in the context of crypto asset securities, the Commission has stated that, “a broker-dealer that

maintains custody of a fully paid or excess margin digital asset security for a customer must hold it in a

manner that complies with Rule 15c3-3, including that the digital asset security must be in the exclusive

possession or control of the broker-dealer. A digital asset security that is not in the exclusive possession or

control of the broker-dealer because, for example, an unauthorized person knows or has access to the

associated private key (and therefore has the ability to transfer it without the authorization of the brokerdealer) would not be held in a manner that complies with the possession or control requirement of Rule

15c3-3 . . . .]” Commission Statement, supra footnote 25 at 11629 (emphasis added).

127

This is not only true for crypto assets, but any client asset for which an adviser has custody, subject to the

exceptions in the proposed rule. See proposed rule 223-1(b)(1) (Shares of Mutual Funds), (2) (Certain

Assets Unable to be Maintained with a Qualified Custodian), and (5) (Registered Investment Companies).

fund trades, a process in which investors transfer their crypto assets, including crypto asset

securities, or fiat currency to such an exchange prior to the execution of any trade. Because we

understand that most crypto assets, including crypto asset securities, trade on platforms that are

not qualified custodians, this practice would generally result in an adviser with custody of a

crypto asset security being in violation of the current custody rule because custody of the crypto

asset security would not be maintained by a qualified custodian from the time the crypto asset

security was moved to the trading platform through the settlement of the trade.128 In light of our

proposal to expand the rule’s application from “funds or securities”129 to “assets,”130 this practice

would also constitute a violation of the proposed rule for an adviser with custody of client crypto

assets if the adviser trades those assets on a crypto asset trading platform that does not satisfy the

definition of “qualified custodian.” Alternative Trading Systems that do not require pre-funding

of trades and that trade crypto asset securities following a process that does not involve the

broker-dealer operator of the Alternative Trading System providing custodial services for the

crypto asset securities are discussed further below.131

We request comment on all aspects of the proposed possession or control requirement,

including the following items.

128

This differs from the approach with a U.S. national securities exchange, which does not routinely exercise

possession or control of the securities listed on a national securities exchange. In this scenario, trades are

executed on a national securities exchange, establishing the contract between buyer and seller. The

national securities exchange then passes transaction details on to a clearing agency or depository, which

steps in to facilitate and complete settlement between each party’s custodian, specifically the exchange of

cash and securities per the trade’s contracted terms agreed on the national securities exchange on a delivery

versus payment basis.

129

See rule 206(4)-2(a).

130

See proposed rule 223-1(a).

131

See infra footnotes 460-461 and accompanying text.

41. Should the rule include the possession or control requirement, as proposed? Would

the proposed requirement provide additional protections for clients? Possession or

control would be defined to mean holding assets such that the qualified custodian is

required to participate in any change in beneficial ownership of those assets. Do

commenters agree with our view that the term “participation” would mean that the

qualified custodian would effectuate the transaction and its involvement would be a

condition precedent to the change in beneficial ownership? How else would

commenters describe a qualified custodian’s participation? Should we instead define

possession or control to mean holding assets such that the qualified custodian is

required to effectuate any change in beneficial ownership of those assets? Do

commenters agree with our understanding that a qualified custodian’s participation

in a change in beneficial ownership may take different forms depending on the type

of asset involved? Do commenters agree with our view that participation by a

qualified custodian would require the qualified custodian be willing to attest to the

transaction on an account statement? Do commenters agree with our understanding

that a qualified custodian will customarily take custodial liability for client assets for

which it participates in beneficial changes of ownership?

42. Do the types of financial institutions serving as qualified custodians under the

current rule maintain client assets in a manner that would satisfy the proposed

definition of “possession or control”? Do commenters agree with our view that the

proposed definition of possession or control (i.e., being required to participate in any

change of beneficial ownership) is consistent with how the concept of possession or

control is understood currently by most qualified custodians and does not conflict

with the requirements of qualified custodians’ respective regulatory regimes?

43. Is our understanding correct that qualified custodians hold client assets for

safekeeping until directed by the client or the client’s duly authorized agent to enter

into a transaction with a counterparty resulting in a change of the client’s beneficial

ownership or until directed to return the assets to the client, subject to duly

authorized custodial charges? Is our understanding correct that this is crucial to

safeguarding client assets and reflective of a fundamental underlying principle of the

custody industry?

44. Should we have different possession or control requirements for different qualified

custodians? If so, what should they be, and why?

45. Are we correct in our understanding that a custodian will assume custodial liability

for a custodial customer’s avoidable loss only if the custodian has possession or

control (i.e., is required to participate in any change in beneficial ownership) of the

asset that is lost?

46. Unlike as proposed, should the rule explicitly state that the qualified custodian

maintain “physical” or “exclusive” possession or control of the client’s assets? Do

commenters agree with our understanding qualified custodians may face greater

challenges in their ability to demonstrate exclusivity with respect to crypto assets as

compared their ability to demonstrate exclusive possession or control with respect to

stocks and bonds? Do custodians for crypto assets routinely consider the crypto

assets they service to be in their exclusive possession or control? If so, how would

exclusivity be demonstrated? Are there particular safeguarding practices with

respect to crypto assets that are better suited to demonstrating exclusivity than

others? What kind of evidence would be necessary to demonstrate proof of

exclusive possession or control of crypto assets? What type of procedures would a

crypto asset custodian need to have to demonstrate exclusive possession or control of

crypto assets?132 Would requiring exclusive possession or control improve

safeguarding of crypto assets? Given the nature of crypto assets, is it possible to

demonstrate the exclusive possession or control of a particular crypto asset? How

important do custodians view “exclusive” possession or control of a client asset,

including a crypto asset, to be for liability reasons? How do existing custodians of

crypto assets address the risk of liability for theft, fraud, or misappropriation of

crypto assets when a client (and potentially others with whom the client has shared

the private key material) retains the ability to effect a change in beneficial ownership

of the asset without the involvement of the custodian?

47. Would a custodian for crypto assets be able to satisfy the proposed possession or

control requirement? Would such a custodian be able to participate in a change of

beneficial ownership for a client’s crypto asset? What does it mean for a custodian

to “participate” in a change of beneficial ownership for a client’s crypto asset

transaction? Does this involve only the deployment of the private key or keys

associated with the public address where the client’s crypto assets are recorded to

transfer, as instructed, the client’s crypto assets to another person with a public key?

132

See Commission Statement, supra footnote 25, at 11629 (“A digital asset security that is not in the

exclusive physical possession or control of the broker-dealer because, for example, an unauthorized person

knows or has access to the associated private key (and therefore has the ability to transfer it without the

authorization of the broker-dealer) would not be held in a manner that complies with the possession or

control requirement of Rule 15c3-3 and thus would be vulnerable to the risks the rule seeks to mitigate.”).

Does this also include recording or communicating a change in beneficial

ownership?

48. To what extent does a custodian for crypto assets take custodial liability for a

beneficial change in ownership of a client’s crypto assets?

49. Is our understanding of how many crypto asset trading platforms require investors to

pre-fund trades correct? How many of these trading platforms require pre-funding

trades? How many rely on other custodial arrangements and how do those crypto

asset trading platforms operate with such custodial arrangements? How would the

proposed rule impact advisers who trade on such trading platforms currently? What,

if any, impacts would the proposed rule have on the availability of crypto asset

trading platforms that may be able to serve as qualified custodians? Would the

proposed definition of “possession or control” enhance or inhibit investor protections

with respect to client assets traded on crypto asset trading platforms?

50. Do custodians for crypto assets permit the customer (and potentially others with

whom the customer has shared a private key) to retain the ability to effect a change

in beneficial ownership of the asset without

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