How the SEC’s Proposed New Safeguarding Rule May Impact Private Fund Advisers
On February 15, 2023, the U.S. Securities and Exchange Commission (“SEC”) issued a proposed rule (the “Proposal”) under the Investment Advisers Act of 1940 (the “Advisers Act”), which would (i) amend certain provisions of the current custody rule (Rule 206(4)-2), (ii) re-designate the custody rule as a new “safeguarding rule” (to be renumbered as Rule 223-1, the “Safeguarding Rule”), (iii) align certain provisions under the recordkeeping rule (Rule 204-2) with the new Safeguarding Rule, and (iv) amend Form ADV Part 1A as well as related Form ADV Instructions and Glossary in line with the new Safeguarding Rule.
The Proposal is open for public comment until 60 days after publication in the Federal Register. Once adopted, the SEC proposed a one-year transition period for investment advisers registered or required to be registered with the SEC (“RIAs”) with more than $1 billion in regulatory assets under management, and an 18 month compliance period for other RIAs.
While the Proposal covers all RIAs, this article specifically discusses how the Proposal may impact RIAs that manage private funds.
1. Proposed Changes Impacting RIAs of Private Funds in General
(1) Expanded Coverage of “Assets” under Safeguarding Rule
In response to the evolution of products and services that RIAs manage for clients, the Proposal defines “assets” as “funds, securities, or other positions held in a client’s account.” By contrast, the current custody rule covers only “funds and securities.” The proposed term “assets” may additionally cover, for example, crypto assets, physical commodities, or even investments that would be accounted for in the liabilities column of a balance sheet.
(2) Expanded Definition of “Custody” under Safeguarding Rule
The Proposal expands the definition of “custody” to additionally include discretionary authority as an arrangement that triggers the Safeguarding Rule, and defines “discretionary authority” as the authority to decide which assets to purchase and sell for the client.
(3) Minimum Custodian Protection
The Proposal would continue to regard qualified custodians as key gatekeepers for client assets, other than certain assets that are unable to be maintained with a qualified custodian (as detailed in paragraph 1(5) below), while imposing the following changes to the qualified custodian requirements.
A. Definition of “Qualified Custodian”
The Proposal continues to define “qualified custodians” as including the same types of financial institutions as the current custody rule, but requires a foreign financial institution to satisfy seven (7) new conditions in order to be eligible to serve as a “qualified custodian.”
B. Written Agreement
The Proposal would impose the following new requirements:
- ·A qualified custodian must have possession or control of the RIA’s client assets pursuant to a written agreement. The proposed definition of “possession or control” requires that a qualified custodian “participate in any change of beneficial ownership” of client assets, not necessarily maintain exclusive or physical possession or control of such assets (which is especially difficult to demonstrate for crypto assets).
- The written agreement must be entered into between the RIA and the qualified custodian, as opposed to between the client (e.g., the private fund) and the qualified custodian. If adopted, current custody agreements of most private funds would need to be amended or novated in order to remain in compliance.
- The written agreement must include certain provisions, which the RIA reasonably believes have been implemented by the qualified custodian.
C. Reasonable Assurances
In order to enhance client protection, the Proposal requires RIAs to obtain reasonable assurance in writing from qualified custodians regarding certain safeguards (such as segregation client assets from the custodian’s proprietary assets and liabilities).
(4) Segregation of Client Assets
In addition to the above requirement for qualified custodians to segregate client assets from their proprietary assets and liabilities, the Proposal requires that the client assets for which an RIA has custody be segregated from the assets of the RIA and its related persons, and free from any lien or claim in favor of the RIA or its related persons or creditors, unless agreed to or authorized in writing by the client.
Under the current custody rule, however, a qualified custodian may maintain clients’ funds and securities either under each client’s name or under the RIA’s name as agent or trustee for its various clients, which poses certain compliance challenges when client assets are commingled, or when client and non-client assets are commingled.
(5) Exception to Minimum Custodian Protection
The Proposal expands exception for assets that are unable to be maintained with a qualified custodian such that, in addition to privately offered securities, the exception would also apply to certain physical assets, in each case, when certain conditions are met, including:
- the RIA reasonable determines and documents in writing that such assets cannot be maintained with a qualified custodian;
- the RIA reasonably safeguards the assets;
- the RIA notifies an independent public accountant of any transaction concerning the assets within one (1) business day;
- an independent public accountant verifies any transaction concerning the assets and notifies the SEC within one (1) business day upon finding any material discrepancies; and
- an independent public accountant verifies the existence and ownership of each such assets during the surprise examination or the annual audit of the private fund, as applicable.
2. Proposed Changes to Audit Exception
In practice, most RIAs of private funds rely on the annual audit provision under the custody rule to be deemed to be in compliance with the surprise examination requirement and to avoid the burden of the client notice and quarterly account statement delivery requirements under the custody rule (the “Audit Exception”). The Proposal would retain most elements of the Audit Exception but expand its availability and impose additional requirements including:
(A) RIAs advising any entities (not merely pooled investment vehicles) can rely on the Audit Exception.
(B) Annual audited financial statements may be distributed either to investors or to their independent representatives.
(C) Under its written agreement with the RIA or the fund, the auditor must be required to notify the SEC upon the auditor’s termination or issuance of a modified opinion.
(D) RIAs of a top tier pool may distribute audited financials within 180 days (in the case of a fund of funds) or 260 days (in the case of a fund of funds of funds) of such top tier pool’s fiscal year end (a codification of an SEC staff FAQ response).
(E) Financial statements of a non-U.S. fund (or a fund with a general partner or manager with a principal place of business outside the U.S.) should contain information substantially similar to statements prepared in accordance with U.S. GAAP, with material differences from U.S. GAAP being reconciled (a codification of an SEC staff FAQ response). In addition, the SEC reiterated in the Proposal that non-U.S. RIAs are not subject to the Safeguarding Rule with respect to their offshore clients; while for U.S. RIAs, the Safeguarding Rule would apply with respect to both their U.S. clients and their non-U.S. clients.
The Proposal includes certain corresponding changes to Item 9 and related Schedule D of Form ADV Part 1A to reflect the above changes. However, language similar to the requirement that “[i]f you check “Report Not Yet Received,” you must promptly file an amendment to your Form ADV to update your response when the accountant’s report is available” still remains under Section 7.B and Section 9.C of Schedule D. RIAs relying on the Audit Exception would need to continue to closely follow such requirement, as compliance with the Audit Exception has been one of the SEC’s enforcement priorities. On September 9, 2022, the SEC announced charges against nine (9) RIAs for failure to promptly file such amended Form ADV with the SEC, or failure to distribute audited financials to fund investors in a timely manner, or both.
3. Proposed Changes Impacting RIAs Not Relying on Audit Exception
RIAs subject to the new Safeguarding Rule that do not rely on the Audit Exception, would need to comply with the surprise examination requirement, the client notice requirement and the quarterly account statement delivery requirement. The Proposal largely retained those three (3) requirements, with certain limited proposed changes.
Since its adoption in 1962, the custody rule has been designed to safeguard funds and securities of RIAs’ clients from being lost, misused, stolen, or misappropriated. The SEC amended the custody rule in 2003 and 2009, with the 2009 amendment resulting from several enforcement actions against investment advisers including in respect of the Ponzi schemes perpetrated by Bernard Madoff and Allen Stanford.
The Proposed Safeguarding Rule aims to continue the SEC’s mission more effectively and comprehensively, in response to new developments in the industry. RIAs to private funds should note in particular those changes concerning the Audit Exception, qualified custodians, pooled investment vehicles, privately offered securities, and physical assets, as discussed in more detail in this article.
For more information on the topic discussed, contact:
BulletPoint® is a newsletter of Tannenbaum Helpern Syracuse & Hirschtritt LLP’s Investment Management practice. It is an alert covering recent regulatory and tax developments impacting the financial services industry. To subscribe for the newsletter, send email to firstname.lastname@example.org.
03.15.2023 | PUBLICATION: BulletPoint | TOPICS: Investment Management, Securities | INDUSTRIES: Professional Service Firms