SEC Safeguarding Rule — Initial Impressions for Alternative Investment Managers

Summary:

• On 2/15/2023, the Securities and Exchange Commission (the “SEC” or “Commission”) proposed a renumbered and revised Custody Rule, now numbered 223-1 and renamed the “Safeguarding Rule.”  The Commission also added new requirements to the Books and Records Rule and Form ADV.
• The proposed rule significantly alters the current custody approach, (1) scoping in non-security assets; (2) introducing new paradigms and required contractual provisions for the adviser/client/custodian relationship; (3) substantially limiting the current privately offered securities exemption; (4) expanding the rule’s reach to accounts with discretionary trading authority, including DVP accounts; (5) clarifying that crypto assets are subject to the rule; and (6) contemplating entry by the adviser into an agreement with auditors or independent accountants that allows them to report any anomalies directly to the Commission.

Key Provisions:

• Scope:
  • This rule covers not just funds and securities but all client assets, including physical assets such as art, real estate, commodities, and other assets over which the SEC may not normally have jurisdiction.
  • The new rule requires custodians to have “possession or control” of a client asset rather than to just “maintain” a client asset, as is required by the current Custody Rule.  This is a raising of the custody standard.

• Qualified Custodians: The rule would require advisers to enter into a written agreement with, and provide certain oversight over, each custodian.   The agreement would:
  • Require the provision of records to the Commission and an independent public accountant for the purposes of Safeguarding Rule compliance;
  • Require the distribution of account statements to clients at least quarterly;
  • Require obtaining and providing an internal control report at least annually;
  • Document the level of transaction authority; and
  • Provide “reasonable assurances” that the custodian will: (1) exercise due care; (2) indemnify clients, including for simple negligence; (3) provide certain assurances about sub-custodial Page 1 agreements; (4) maintain account segregation; and (5) provide a bankruptcy/event-remote account structure.
    • Analysis: This provision fundamentally changes the traditional relationship among clients, advisers, and custodians. If it goes into effect, there will be substantial effort and expense put toward implementing these contractual requirements. Additionally, the simple negligence indemnity will increase costs for clients and advisers.

• Segregation of Assets: Client assets will be required to be segregated; however, the rule makes an exception for certain operational considerations such as interest collection and fee deduction, provided clients consent to this carveout in writing.
  • Analysis: This provision should be welcomed by credit managers, who would now be able to more easily comply with custody requirements.

• Surprise Exam / Independent Verification: Custodied assets will be subject to independent verification by a PCAOB registered accountant.  This provision of the new rule requires a written agreement with the accountant, a reasonable belief by the adviser that the asset verification will be implemented, and T+1 reporting by the accountant to the SEC of any material discrepancies.

• “Privately Offered Securities Exemption:” The Safeguarding Rule allows for certain privately offered securities and certain physical assets to be exempt from the qualified custodian requirement, provided that:
  • The adviser reasonably determines and documents that ownership cannot be maintained by a qualified custodian;
  • The adviser takes reasonable steps to prevent asset loss/theft or adviser insolvency;
  • An independent public accountant: (a) verifies purchases and sales and (b) notifies the SEC within one day of any discrepancies;
  • The adviser notifies its independent public accountant upon each purchase or sale within one day; and
  • The assets are subject to a surprise examination or an annual audit.
    • Analysis: While this provision may appear similar to the current Custody Rule’s privately offered securities exemption, it requires the adviser to establish, and at least annually re-establish, that no custodian can hold its assets.  As soon as a reasonable custodian is available, the adviser is no longer permitted to rely on the exemption.  The logical extension of this is that the market for privately offered security custodians will grow, as advisers migrate toward the use of such custodians and away from reliance on the exemption.  That will come at additional cost, which will most likely be passed to clients.

• Discretionary Trading Authority:  The new Safeguarding Rule removes the Custody Rule’s exemption for situations in which advisers have only trading authority.
  • Analysis: This provision will have significant impact on CLOs and advisers to other structured products who are now relying on the trading authority exemption to the Custody Rule.

• Crypto:  The new Safeguarding Rule makes no special accommodations for crypto assets.  Instead, it explicitly scopes them in, whether or not they are considered securities.  It also explicitly carves out crypto from the privately offered securities/hard-to-custody asset exemptions.
  • Analysis: If the provision is adopted, crypto advisers would need to custody their assets at qualified custodians and would not be permitted to trade on crypto exchanges that weren’t also qualified custodians.  While some custody services are available for crypto now, many blockchains are not served by custodians, and no glide path is provided for crypto assets to comply with the rule in the interim.

• Record Keeping and Form ADV: The new Safeguarding Rule expands record keeping requirements and adds questions to the Form ADV.
  • Analysis:  While the Form ADV requirements should increase transparency for investors and the SEC, who could use the data to select exam candidates, none of these provisions appear to be particularly burdensome to advisers.