New SEC Proposed Rule on Safeguarding Advisory Client Assets
The SEC reopened the comment period for its proposal, "Safeguarding Advisory Client Assets,” which was first introduced in February of 2023. The proposed rule is designed to redesignate and amend the current custody rule under the Investment Advisers Act of 1940. This move comes in the wake of the recently adopted private fund adviser audit rule, which was struck down by a federal court order. By reopening the comment period, the SEC seeks to allow industry participants more time to assess the proposed amendments, particularly concerning the current custody rule’s audit provision.
Background of the Custody Rule
The custody rule currently requires investment advisers with custody of client funds and securities to maintain these assets with a qualified custodian in the adviser's name and segregate client securities in a reasonably safe place. Advisers were also obligated to notify clients of these arrangements and engage an independent public accountant for an annual surprise examination to verify client funds and securities.
In 2003, the SEC expanded the definition of custody to include any scenario where an adviser had the ability to obtain possession of client funds or securities, either directly or indirectly. This expansion included possession of client funds or securities, authority to withdraw funds or securities from a client’s account, and any capacity that gives the adviser legal ownership of or access to client assets.
The rule was further amended in 2009 following several high-profile fraud cases, including those involving Bernard Madoff and Allen Stanford. These amendments extended the rule's scope to include an adviser's ability to access client funds or securities through related persons and required more frequent surprise examinations and internal control reports by independent accountants.
Need for the Proposed Amendments
The SEC's proposal to amend the current custody rule is driven by several factors, including technological advancements, changes in advisory services, and evolving custodial practices have introduced new risks to client assets. For example, discretionary trading practices now often bypass the involvement of qualified custodians, limiting clients' ability to monitor their investments for suspicious activities. This gap in oversight can result in undetected misappropriation of assets.
Additionally, some advisers inadvertently find themselves subject to the custody rule due to the broad authority granted by clients’ custodial agreements—authority they neither wanted nor used. This situation arises because advisers are usually not parties to these agreements, yet the rule applies nonetheless.
Finally, the current rule's exceptions, particularly for privately offered securities, have led to a significant number of assets not receiving adequate custodial protections. While these exceptions were initially intended for rare situations, the volume of privately offered securities has vastly increased, and custodians' practices have evolved accordingly. However, accommodation reporting, where custodians list assets without accepting liability, undermines the integrity of account statements, making it difficult for clients to verify the legitimacy of their holdings.
Conclusion
The SEC's proposal to amend the custody rule aims to address these gaps and enhance the protection of advisory client assets. By reopening the comment period, the SEC is encouraging stakeholders to provide input on the proposed changes and ensure the rule's efficacy in safeguarding client assets in today’s complex financial landscape.
For a more in-depth explanation of these proposed changes and their impact on compliance policies, procedures, and written information supervision plans, please see our additional resources.
