February 24, 2023

Protective Custody: SEC Proposes Safeguarding Rule

Move Suggests Significant Changes Coming to Adviser Custody Obligations
Holland & Knight SECond Opinions Blog
Jennifer A. Connors | Elliot Magruder | Andrew W. Balthazor
Gavel and scale resting on desk

The SEC on Feb. 15, 2023, announced new proposed obligations for registered investment advisers concerning custody of investor assets. Although the rule is only in proposed form, given the current composition of the SEC, the proposal suggests significant changes are coming for SEC-registered investment advisers on the custody front.1

The current custody obligations, which exist under Rule 206(4)-2 of the Investment Advisers Act of 1940 (Advisers Act), are colloquially known as the SEC's "custody rule" (Custody Rule). The SEC has proposed replacing the Custody Rule, initially adopted in 1962 and last amended in 2009 (largely in response to the Bernard Madoff and Allen Stanford scandals), with a new rule concerning the "safeguarding" of client assets in the custody of an investment adviser (Safeguarding Rule or the Rule). As with the 2009 amendment, the SEC is reacting, at least in part, to significant turmoil in the financial markets – here, the "crypto winter" and recent high-profile investment-related disruptions tied to cryptocurrencies and other digital assets.

The proposed Safeguarding Rule, which would continue to impose custody requirements on all registered investment advisers,2 would remove the custody obligations from the Investment Advisers Act's Section 206 suite of rules and be re-codified as new Rule 223-1 of the Advisers Act. The SEC has largely preserved the longstanding parameters for custody that exist under current Rule 206(4)-2(d) (holding or having authority to possess assets), but the proposed Rule lays the groundwork for a significant reshaping of custody obligations applicable to registered investment advisers. If adopted, the proposed Rule will precipitate material and significant compliance requirements for advisers and impose potentially material changes on service providers to investment advisers, most notably qualified custodians.

Among other changes, the proposed Safeguarding Rule would:

  • expand the type of assets managed by an investment adviser from "funds and securities" to any assets over which an adviser has custody and exercises discretionary authority, including cryptocurrency and other digital assets, as well as physical assets such as art, precious metals and real estate;
  • revamp the requirements applicable to an adviser's use of qualified custodians, including mandating that an investment adviser execute a comprehensive written agreement with a custodian that requires confirmation that the custodian has "possession or control" of client assets and provides "reasonable assurances" concerning several custodial provisions to safeguard client assets, such as ensuring that client assets are segregated from the adviser's proprietary assets;
  • implement changes to the books and records rule and Form ADV to enhance reporting requirements and heighten the accuracy of investment advisers' custody-related data available to the SEC and the public; and
  • limit the current exception from the custodian requirement for not only privately offered securities, but also physical assets to certain situations

Details of the Proposed Safeguarding Rule

The proposed Safeguarding Rule would constitute a significant overhaul of the Custody Rule. Below are some key details from the proposed Rule:

First, the proposed Safeguarding Rule would broaden the current custody obligations from "funds and securities" to include any client "assets" within the "custody" of the adviser. The revised definition would encompass, inter alia, digital assets, non-balance sheet assets, real estate, precious metals and certain commodities.3 The SEC isn't shy about its position with regard to crypto assets under the current Custody Rule, suggesting that "most crypto assets are likely to be funds or crypto asset securities covered by the current rule,"4 a statement that drew the ire of Commissioner Hester Peirce in her dissenting statement. Under the proposed Safeguarding Rule, the SEC is attempting to remove any ambiguity by specifically noting that "crypto assets" are covered by the proposed obligations.5

Second, the proposed Safeguarding Rule would be re-characterized as Rule 223-1 under the Advisers Act, bringing it under the broader language provided in Section 223 of the Advisers Act (Custody of Client Accounts) that notes advisers must take steps to safeguard client assets over which they have custody. Indeed, as Commissioner Caroline Crenshaw acknowledged in her statement on the Safeguarding Rule, and as further explained in the proposed Rule, Section 411 of Dodd-Frank Wall Street Reform and Consumer Protection Act is the statutory basis to apply protections to all client assets in the custody of the investment adviser. By re-designating the Custody Rule, the SEC is taking the position that statutory authority includes not only Section 223, but also Sections 206(4) and 211(a), such that it continues to derive its statutory basis from the anti-fraud provisions of the Advisers Act.

Third, while the definition of "qualified custodian" remains largely static with respect to domestic entities (e.g., a registered broker-dealer and a federally chartered bank or savings association), the proposed Safeguarding Rule imposes additional "robust" requirements on foreign financial institutions (FFI). These additional requirements include the segregation of assets and the legal implications of certain anti-money laundering regulations akin to those of the Bank Secrecy Act (which notably is not yet applicable to investment advisers).6 Moreover, the adviser would need to determine whether the adviser and the SEC are able to enforce judgments against an FFI, which would limit the types of entities who could qualify as an FFI to those subject to (or those that have consented to) jurisdiction in the U.S.7 The SEC is clear that "[s]uch conditions are designed to provide 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."8

Fourth, similar to the Custody Rule, the proposed Safeguarding Rule would provide an exception to maintaining assets at a qualified custodian for certain privately offered securities.9 However, the proposed Rule modifies the exception in several ways, including requirements that advisers can utilize such exception only if: 1) the adviser reasonably determines that ownership cannot be recorded and maintained by a qualified custodian; 2) the adviser reasonably safeguards the assets; 3) the adviser notifies an independent public accountant performing the verification of such an asset transfer within one business day; 4) an independent public accountant verifies asset transfers and notifies the SEC upon the findings of any material discrepancies; and 5) the existence and ownership of the assets are verified during a surprise examination or as part of a financial statement audit by an independent public accountant.10

Finally, the proposed Safeguarding Rule would require an investment adviser to execute a written agreement with a qualified custodian containing certain required provisions.11 Such provisions include the custodian's agreement to promptly provide records relating to client assets upon request to the SEC or to an independent public accountant, along with a requirement that the custodians deliver account statements to clients.12 Additionally, the adviser must obtain "reasonable assurances" from the custodian with respect to several additional enumerated items, including that the custodian: 1) exercise due care in accordance with reasonable commercial standards; 2) indemnify the client against losses caused by its own negligence, recklessness or willful misconduct; and 3) clearly identify and segregate client assets from the custodian's assets and liabilities.13 Although the proposed Rule states that these current practices – whether through contract or otherwise – are already provided by certain custodians, the proposed Rule is designed to expand and formalize the minimum standard of protections currently in place.

Key Takeaways

If ultimately implemented, these provisions will have a significant impact on how registered investment advisers safeguard and protect client assets as well as influence the operations and services provided by qualified custodians. Some notable impacts:

  • The SEC's emphasis on cryptocurrency assets will undoubtedly increase the pressure on qualified custodians to either enhance their own capabilities related to the custody of digital assets or to partner with expert sub-custodians that are able to implement cold storage and other secure solutions. Such obligations will naturally have spillover impact on other areas of the entity's operations, such as cybersecurity.
  • These proposed obligations would undoubtedly result in costly compliance-related changes for both advisers and custodians. This is the result of not only increased obligations related to cryptocurrency assets, but also for other aspects of the proposed Rule tied to privately offered securities and physical assets.14 For example, it is the SEC's position that "to determine whether an asset can or cannot be maintained by a qualified custodian under the proposed [R]ule, an adviser generally should obtain a reasonable understanding of the marketplace of custody services available for each client asset for which it has custody" and would be expected to maintain written documentation containing "material facts concerning its understanding of the custodial marketplace …."15 This aspect of the proposed Rule would require not only time and investment, but also the development of policies and procedures to conduct such analysis.
  • The proposed implementation of only one year from approval for large advisers would not leave much time for these entities to establish compliance frameworks the Rule’s significant obligations. This is a particularly thorny issue here given that certain aspects of the proposed Rule, such as the written agreement obligations between the adviser and qualified custodian, cut against the grain of current industry practice.16
  • If the SEC ultimately adopts such provisions, it remains to be seen how violations of such provisions will be enforced by the agency. Notably, although the SEC and the courts will further weigh in on the mental state necessary for violations of the safeguarding obligations, the SEC is seemingly staking out a position that scienter would not be required.17

The SECond Opinions Blog will continue to analyze the proposed Safeguarding Rule and provide further observations. If you need additional information on this topic or are interested in providing comments to the SEC on the proposed Rule, please contact the authors, another member of Holland & Knight's Securities Enforcement Defense Team or a member of Holland & Knight's Investment Management Team.


1 Comments on the proposed Safeguarding Rule are due within 60 days after the Rule's publication in the Federal Register.

2 Exempt Reporting Advisers are not subject to the custody requirements under the current rules. Additionally, registered investment companies are subject to separate custody requirements under the Investment Company Act of 1940.

3 See Safeguarding Advisory Client Assets, Release No. 1A-6240, File No. S7-04-23 (Feb. 15, 2023) (Proposed Release), at 28.

4 Id. at 18 n. 29.

5 Id. at 28.

6 Id. at 280.

7 Proposed Release at 48

8 Id. at 281.

9 The proposed Rule also expands the applicability of the exception to include certain physical assets. Id. at 23.

10 The SEC specifically notes that the proposed revisions were intended to limit applicability of the exception: "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." Id. at 23-24.

11 Id. at 23

12 Id. at 22.

13 Id. at 23.

14 See, e.g., Proposed Release at 272-275. Notably, the SEC acknowledges that the "current market for custodial services of privately offered securities is fairly thin." Id. at 129.

15 Id. at 137.

16 See, e.g., Id. at 74 ("We understand that under existing market practices, advisers are rarely parties to the custodial agreement, which is generally between an advisory client and a qualified custodian, resulting in an adviser having limited visibility into the custodial arrangements of its clients.").

17 Id. at 19 n. 32.


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