Executive Summary
In February 2023, the U.S. Securities and Exchange Commission published a proposal which, if adopted as proposed, would, among other things:
- Recast the current custody rule (Rule 206(4)-2) as a rule adopted under Section 223 of the Investment Advisers Act of 1940, which was added in 2010 as part of the Dodd Frank Wall Street Reform and Consumer Protection Act;
- Expand the requirements for safeguarding “funds and securities” in the current rule to safeguarding “funds, securities, or other positions held in a client’s account”, which draws in physical property, many non-securities such as CFTC-regulated swaps, loans and certain digital assets, as well as certain assets treated as liabilities, such as short sales;
- Add a new presumption that having discretionary authority to trade client assets means an investment adviser has custody for purposes of the new safeguarding rule;
- Require that, subject to two very limited exceptions for (i) mutual fund shares and (ii) privately offered securities and physical assets, a qualified custodian must maintain any client asset over with the adviser is deemed to have custody in the qualified custodian's “possession or control” (i.e., holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets, the qualified custodian’s participation would effectuate the transaction involved in the change in beneficial ownership, and the qualified custodian’s involvement is a condition precedent to the change in beneficial ownership);
- Impose additional limitations on who would be considered a qualified custodian, especially for foreign financial institutions;
- Require the investment adviser to enter into a written agreement with each qualified custodian (and reasonably believe it has been implemented), inlcuding specific provisions related to access to records, quarterly statements to clients/investors, internal control reports and the agreed upon level of investment adviser authority;
- Require the investment adviser to obtain reasonable assurances from the custodian that the custodian will comply certain requirements, and the investment adviser must maintain an ongoing reasonable belief that the custodian is complying with these requirements, with respect to exercising due care in accordance with reasonable commercial standards in discharging its duty as custodian, indenmification and liability standards, liability for sub-advisers, segregation of client assets from the custodian's assets and prohibition of liens, charges and the like by the custodian or its related persons or creditors except as agreed by the client in writing;
- Amend the related recordkeeping; and
- Require revised reporting on Form ADV regarding custody relationships.
If adopted as proposed, large advisers would have 12 months and smaller advisers would have 18 months to comply.
If you would like to read more about the requirements under this proposal, you can access our full summary here.
Please contact Jennifer Wood with any questions regarding this proposal.
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Jennifer Wood
Managing Director, Global Head of Asset Management Regulation & Sound Practices
Practical Implications
If these changes are adopted as proposed, they will present the following practical implications:
- RIAs will no longer be able to advise on the purchase of certain assets - including, bilateral OTC derivatives, futures and cleared swaps and commodities - because they would not be held in compliance with the new safeguarding requirements.
- Broker-dealers and banks acting as qualified custodians will be prohibited from rehypothecating client assets, which is currently permitted under SEC and banking regulations.
- The qualified custodian will be required to enter into a written agreement with the RIA that includes several provisions, most of which direct the qualified custodian to comply with certain requirements and to provide and obtain certain reports and/or records.
- Foreign financial institutions that serve as qualified custodians will face new costs and requirements that could limit the number of foreign financial institutions eligible to serve as qualified custodians.
- Qualified custodians will send each client/investor in a fund a quarterly statement identifying each client asset in the account at the end of the period and setting forth all transactions in the account during that period.
- Large advisers will have 12 months to come into compliance with the new rule, and smaller advisers would have 18 months.
- Digital assets must remain with the qualified custodian throughout the lifecycle of the trade.
- RIAs will effectively be prohibited from employing direct staking strategies involving self-custody of non-securities/non-funds digital assets.
- Because this rule applies a rigid, one-size-fits-all set of custody requirements that do not correspond to the wide variety of current business models and client relationships among advisers, clients and custodians in the wide range of affected asset classes, many contracts will have to be reviewed and renegotiated, which will be very difficult in many cases, particularly where the adviser currently has no or minimal interaction with the custodian.
Timeline
AIMA has categorized this proposal as High Priority/High Impact and it is therefore represented in bright orange in the AIMA Regulatory Horizon Scan gantt chart.
Estimated Compliance Date for smaller advisers | November 26, 2026 | **New** |
Estimated Compliance Date for larger advisers3 | May 26, 2026 | **New** |
Estimated Effective Date2 | May 26, 2025 | **New** |
Estimated Publication Date1 | March 26, 2025 | **New** |
Deadline for responses in re-opened comment period | October 30, 2023 | |
Comment period re-opened | August 23, 2023 | |
Comment deadline for proposal | May 8, 2023 | |
AIMA response to proposal filed | May 8, 2023 | |
Proposal published by SEC | February 15, 2023 |
1 Subject to change. We understand this proposal may be in the process of being amended and may be re-proposed. For this reason, we have pushed back the estimated date. Of course, this is only an estimate and may move forward or backward as actual matters develop depending on the priorities of the SEC. This estimate has been provided solely to allow people to visualize the potential overlaps in compliance burdens for multiple pending rules at the same time.
2 Subject to change. The effective date has been estimated as 60 days following publication. Note that for this purpose we have assumed the SEC's publication date and the Federal Register publication date are identical for ease of calculation. This will not be the case, but the actual time between (i) the SEC approval and publication on the SEC website and (ii) the official Federal Register publication is an unknowable period ranging from a few days to several weeks depending on multiple non-transparent variables. This means that in the end the actual effective date and therefore the actual compliance date will always be later than the estimate even if the SEC approval date estimate is correct.
3 Subject to change. Estimated based on 12 month compliance period for large managers and 18 month compliance period for smaller managers as proposed.