# Safeguarding Advisory Client Assets > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2023-03681 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** March 9, 2023 - **Citation:** 88 FR 14672 ## Text 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 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 A. Background B. Overview of the Proposal II. Discussion A. Scope of Rule 1. Scope of Assets 2. Scope of Activity Subject to the Proposed Rule B. Qualified Custodian Protections 1. Definition of Qualified Custodian 2. Possession or Control 3. Minimum Custodial Protections C. Certain Assets That Are Unable To Be Maintained With a Qualified Custodian 1. Definition of Privately Offered Security and Physical Assets 2. Adviser's Reasonable Determination 3. Adviser Reasonably Safeguards Assets 4. Notification and Prompt Independent Public Accountant Verification 5. Surprise Examination or Audit D. Segregation of Client Assets E. Investment Adviser Delivery of Notice to Clients F. Amendments to the Surprise Examination Requirement G. Exceptions from the Surprise Examination 1. Entities Subject to Audit (“Audit Provision”) 2. Discretionary Authority 3. Standing Letters of Authorization H. Amendments to the Investment Adviser Recordkeeping Rule 1. Client Communications 2. Client Accounts 3. Account Activity 4. Independent Public Accountant Engagements 5. Standing Letters of Authorization I. Changes to Form ADV J. Existing Staff No-Action Letters and Other Staff Statements K. Transition Period and Compliance Date III. Economic Analysis A. Introduction B. Broad Economic Considerations C. Baseline 1. Current Regulation 2. Affected Parties and Industry Statistics 3. Market Practice D. Benefits and Costs of Proposed Rule and Form Amendments 1. Scope 2. Qualified Custodian Protections 3. Certain Assets That Are Unable To Be Maintained With a Qualified Custodian 4. Segregation of Investments 5. Investment Adviser Delivery of Notice to Clients 6. Exceptions From the Surprise Examination 7. Amendments to the Investment Adviser Recordkeeping Rule 8. Changes to Form ADV E. Efficiency, Competition, and Capital Formation F. Reasonable Alternatives 1. Scope of Assets 2. Elimination of Privately Offered Securities Exception 3. Distribution of Requirements Across Reasonable Assurances and Written Agreement 3. Additional Accounting and Client Notification Requirements for Privately Offered Securities and Physical Assets That Are Not Maintained With a Qualified Custodian 4. Additional Safeguards When Clients Assets Are Not Maintained With a Qualified Custodian 5. Designating Clearing Agencies and Transfer Agents as Qualified Custodians G. Request for Comment IV. Paperwork Reduction Act Analysis A. Introduction B. Rule 223-1 1. Qualified Custodian Provision 2. Notice to Clients 3. Annual Surprise Examination C. Exceptions 1. Certain Assets That Are Unable To Be Maintained With a Qualified Custodian 2. Audit Provision D. Total Hour Burden Associated With Proposed Rule 223-1 E. Rule 204-2 F. Form ADV G. Request for Comments V. Initial Regulatory Flexibility Analysis A. Reason for and Objectives of the Proposed Action 1. Proposed Rule 223-1 2. Proposed Rule 204-2 3. Proposed Amendments to Form ADV B. Legal Basis C. Small Entities Subject to the Rule and Rule Amendments 1. Small Entities Subject to Amendments to the Custody Rule D. Projected Reporting, Recordkeeping and Other Compliance Requirements 1. Proposed Rule 223-1 2. Proposed Amendments to Rule 204-2 3. Proposed Amendments to Form ADV E. Duplicative, Overlapping, or Conflicting Federal Rules F. Significant Alternatives 1. Proposed New Rule 223-1 and Amendments to Rule 204-2 and Form ADV G. Solicitation of Comments VI. Consideration of Impact on the Economy VII. Statutory Authority I. Introduction A. 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 2 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 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 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 examination 4 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. 3 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 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). 4 The terms “surprise examination” and “independent verification” are used throughout the release and are generally interchangeable. 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 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 5 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. 6 See id. 7 See 2003 Adopting Release, supra footnote 2, at note 10 and accompanying text. 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 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. 8 See 2003 Adopting Release supra footnote 2, at section I. 9 See 2002 Proposing Release, supra footnote 2, at section II.B. 10 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. 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 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 11 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., 09-CV-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). 12 See generally rule 206(4)-2; see also 2009 Adopting Release, supra footnote 11, at sections II.A and B. 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 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 13 See section 411 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 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. 14 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—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.”). 15 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)). 16 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). 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 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. 17 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. 2013-04 (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 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. 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 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. 18 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. 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 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 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. 19 Preqin Global Private Debt Report (2018), available at https://docs.preqin.com/samples/2018-Preqin-Global-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). 20 See discussion in section II.C infra and at text accompanying footnote 229. 21 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”). 22 See, e.g., DTCC, Project Whitney Case Study (May 2020), available at https://www.dtcc.com/~/media/Files/Downloads/settlement-asset-services/user-documentation/Project-Whitney-Paper.pdf . 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. 23 See, e.g., Tomito Geron, Companies Compete to Be Cryptocurrency Custodians, The Wall Street Journal (Sept. 17, 2019). 24 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). 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 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. 25 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 Broker-Dealers, Securities Exchange Act Release No. 90788 (Dec. 23, 2020), 86 FR 11627, 11627 n.1 (Feb. 26, 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.” 26 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-Ledger-Technology-and-Blockchain-Fintech-Notes.pdf?sequence=1&isAllowed=y. 27 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/news-releases/2023/nr-ia-2023-1a.pdf (generally discussing risks related to bank custody of crypto assets). 28 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 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. B. 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 30 We are also renumbering portions of the custody rule that we are not amending. 31 In a technical, conforming change from the current rule, the proposed rule would replace, in certain places, references to “you” with “investment adviser.” 32 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. 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 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. 33 See supra note 16 and accompanying text. 34 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). 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 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 35 Proposed rule 223-1(d)(3). 36 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. 37 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. 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 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 38 Proposed rule 223-1(d)(8). For further discussion of possession or control, please see discussion infra section II.B.2. 39 See infra discussion section II.B.3.b.ii. 40 Proposed rule 223-1(a)(1). 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 agreed-upon 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 person 41 that acts as a qualified custodian. 41 The term “related person” would have the same meaning as in the current rule. In addition to the written agreement requirement, advisers would have to obtain reasonable assurances that the qualified custodian satisfies five additional enumerated items. 42 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. 42 See proposed rule 223-1(a)(1)(ii). 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 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. 43 See proposed rule 223-1(b)(2). 44 See proposed rule 223-1(d)(9). 45 See proposed rule 223-1(b)(2). 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. 46 See proposed rule 223-1(a)(3). 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 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 47 See proposed rule 223-1(b)(7) and (8). 48 See proposed rule 223-1(b)(4). 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 Commission's examination initiatives and would allow the Commission and its staff to better assess risks specific advisers pose to investors. 50 49 See infra discussion at section II.I. 50 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). II. Discussion A. 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 51 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. 52 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). 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 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. 1. 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. 53 Proposed rule 223-1(d)(1). 54 See section 223, supra footnote 34. 55 See supra footnote 11. 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 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 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 56 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)). 57 See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Release No. IA-5248 (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). 58 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. 59 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. 60 See rule 6c-11, supra footnote 56. The release discussed that liabilities were contemplated to be part of “other positions.” 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 adviser-client 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 61 See rules 17f-1, 17f-2, 17f-5, and 17f-6 under the Investment Company Act. 62 See rule 2a51-1(b) under the Investment Company Act. 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? 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? 2. 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. 63 See proposed rule 223-1(d)(3). 64 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. 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, 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. 65 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. 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 66 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). 67 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). 68 Proposed rule 223-1(d)(4). 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 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 one-for-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 69 2003 Adopting Release, supra footnote 2, at n.10. 70 Id. 71 Our staff stated a similar view under the current rule. See Custody Rule FAQs, supra footnote 17, at Question VII.3. 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 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 72 Proposed rule 223-1(b)(8). See infra at section II.G.2. 73 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. 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? 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? 74 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. 75 Exchange Act Rule 17a-3(a)(17)(i)(B)(2). 76 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). 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 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? 77 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. 78 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. 79 See proposed rule section 223-1(d)(3). 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 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 co-trustee 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 80 We note that the staff has issued an FAQ on this topic. See Custody Rule FAQs, supra footnote 17, at Question XII.2. 81 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)). 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 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 204-2 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? 82 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. 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? 83 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-042516-206(4).htm . 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 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? B. 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. 84 2002 Proposing Release, supra footnote 2, at n. 30; 2009 Proposing Release, supra footnote 11, at n. 4. 85 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). 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 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. 86 See proposed rule 223-1(a)(1). 87 See proposed rule 223-1(d)(10)(i) and (iv); section II.B.1.b, infra. 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 afforded to advisory clients to improve the safeguarding of client assets over which advisers have custody. 1. 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 88 See 2003 Adopting Release, supra footnote 2; 2009 Adopting Release, supra footnote 11. 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 transactions 90 —all critical components of safeguarding client assets under the proposed rule. As a result, with the exception of proposed amendments to the 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 89 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 broker-dealers 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. 90 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). 91 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). a. 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 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 92 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). 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 93 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). 94 Id. 95 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). 96 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). 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 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. b. 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 97 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 reasonable 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 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 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. 98 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 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). 99 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). 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 authority 100 as a banking institution, trust company, or other financial institution that customarily holds financial assets for its customers; 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. 101 101 Proposed rule 223-1(d)(10)(iv). 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. 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 the Financial Crimes Enforcement Network of the U.S. Department of the Treasury (FinCEN”). 103 102 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 . 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). 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. 105 104 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. 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. 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 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. 107 107 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). 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. 108 17 CFR 270.17f-5(a)(7)(iii). 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 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? 109 See generally Membership of State Banking Institutions in the Federal Reserve System (Regulation H) 12 CFR 208.01 et. seq. 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 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? 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). 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 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 broker-dealer 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 customer-segregated funds secured in foreign futures and options accounts. 112 Are the 2013 CFTC regulatory enhancements sufficient grounds to eliminate that condition of the current rule? 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)]. 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 th [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2023-03681. Public record. Not legal advice.