Worried That Your Next SEC Audit Will End in Fines? TAKE THE ASSESSMENT

SEC Custody Rule Explained: What Investment Advisers Should Know

Dive deep into the SEC's custody rule, understanding its implications, requirements, and relevance for your financial operations.

As an investment adviser, you are familiar with the intricate nature of regulatory laws and guidelines. One crucial regulation that directly affects your role is the Securities and Exchange Commission (SEC) Custody Rule. It is of utmost importance that you comprehend this rule in its entirety as you serve as a custodian of your clients’ assets.

Recent developments indicate that there are proposed changes on the horizon for this rule. These changes have the potential to significantly impact how you manage and protect your clients’ assets. The SEC has drafted revisions that introduce new requirements for qualified custodians, broaden the definitions of custody, and specifically address digital assets—a rapidly growing area in asset management. It is important to note that these proposed amendments come with challenges, including potential costs, especially for smaller firms.

Today, we will delve into these proposed changes under the SEC Custody Rule and explore their implications for you as an investment adviser.

What is the SEC Custody Rule?

The SEC Custody Rule, officially known as Rule 206(4)-2, is designed to safeguard client assets held by RIAs. It aims to protect investors from potential misappropriation or misuse of their funds. By following the guidelines outlined in this rule, investment advisers can maintain transparency and build trust with their clients.

So, what exactly does the SEC Custody Rule require? Here are the key compliance measures you need to be aware of:

  1. Written Agreement: RIAs must establish a written agreement with an independent, qualified custodian who will hold client assets. This agreement should outline the custodian’s responsibilities and the adviser’s access to client assets.
  2. Account Statements: Advisers should ensure that their clients receive regular account statements directly from the custodian. These statements should provide detailed information about the assets held and any transactions that occurred.
  3. Surprise Examinations: If an RIA has custody of client assets, they must undergo a surprise examination by an independent public accountant at least once a year.
  4. Qualified Custodians: RIAs must utilize qualified custodians to hold client funds and securities. These custodians should be independent entities, separate from the adviser, to minimize the risk of fraudulent activities.
  5. Notice to Clients: Investment advisers must provide clients with a detailed written statement informing them of the custodial arrangements. This statement should include the custodian’s contact information and emphasize the importance of reviewing account statements regularly.

Failure to comply with the SEC Custody Rule can have serious consequences, including reputational damage, regulatory penalties, and legal liabilities. As an investment adviser, you must implement robust compliance measures to protect your clients and your business.

What Are the Proposed Changes to the Safeguarding Rule?

A proposed revision to the Advisers Act custody rule could significantly change how registered investment advisers manage and safeguard their clients’ assets – everything from digital currencies to real estate.

The SEC proposes that all client assets held in advisory accounts are covered under this rule, including those as diverse as loans and physical goods. This might lead you to ask: ‘What exactly is the definition of custody?’

In this case, it refers to an adviser’s authority to trade or physically possess client assets.

The aim of the proposed rule is not just to update regulations for current market conditions but also to uphold the principles of safeguarding client assets amidst the advances in technology and finance. It requires qualified custodians (like banks and brokers) who hold these assets on behalf of advisers, providing assurances for protecting these items through written agreements with advisors.

Implications on Client Assets

This new regulation could significantly change how assets held in advisory accounts, including digital and physical ones, are managed and protected. If you’re an investment adviser with custody of client assets solely for fee withdrawal or Delivery Versus Payment (DVP) settled transactions, be aware that the safeguarding rule would require written agreements with qualified custodians as a protective measure.

These agreements must provide assurances for safeguarding client assets, effectively requiring them to be maintained in bankruptcy-remote accounts segregated from the custodian’s assets.

New Custodian Requirements

Under the proposed safeguarding rule by SEC, qualified custodians must adjust how they manage client assets across all types of advisory accounts. The safeguarding rule would apply to traditional and digital assets like cryptocurrencies and physical properties like real estate and loans.

This shift aims at preserving existing safeguarding principles while incorporating technological advancements. The proposed rule also expands on what’s considered ‘custody,’ which now includes an adviser’s discretionary authority over trading client assets.

Along with this expansion come several obligations for you as an adviser and your chosen custodian:

  • You both need a written agreement outlining specific asset management responsibilities.
  • Client assets must be maintained separate from your or the custodian’s property – held in bankruptcy-remote accounts.
  • Any change of ownership has to involve qualified custodians.
  • There are additional recordkeeping demands involving retaining client notices, account details, custodian information, and the engagement of independent accountants.

These changes under the Advisers Act proposed rule aim to bolster protection for your client’s assets. However, these new custodian requirements might present a few challenges, especially if you’re dealing with certain kinds of privately offered securities or physical assets that can’t readily be kept with a qualified custodian.

Rule Exceptions

While the new guidelines may seem all-encompassing, it’s important to note there are certain exceptions carved out for specific situations. For instance, under the SEC custody rule proposed expansion, certain privately offered securities or physical assets that cannot be maintained with a qualified custodian can be exempted. However, as an investment adviser with custody of these types of assets, you’ll need to reasonably determine and document that ownership cannot be recorded and maintained in a manner that a qualified custodian can handle.

In addition to this exemption, the current custody rule excludes assets when your advisory role is limited solely to fee deduction or involves DVP settled transactions. If you have discretionary trading authority over a client’s funds or securities that might trigger custody requirements under normal circumstances, these exemptions could prove beneficial in mitigating audit-related complications.

Custody Definition and Scope

Under the SEC custody rule, the definition and scope have been expanded to ensure investment advisers adequately safeguard their clients’ assets.

The definition of ‘custody,’ as proposed by the SEC, includes three key principles:

  1. Physical possession or control of an asset.
  2. Authority to instruct a custodian on behalf of a client.
  3. Legal ownership or access to securities.

This means that if you, as an investment adviser, hold or have authority over your clients’ assets in any way; be it physical possession or discretionary trading authority, then you fall under the custody requirements of the Advisers Act.

The proposed expansion intends to capture all client assets held in advisory accounts, including digital assets like cryptocurrencies, real estate, loans, and physical assets like artwork or precious metals.

Impact on Digital Assets

Navigating the choppy waters of managing digital assets like cryptocurrencies could get trickier with these new regulatory revisions. The proposed rule would require that all client assets, including digital ones, be held in advisory accounts by qualified custodians and safeguarded under the same principles as traditional assets.

This means that your responsibility extends to trading and managing these digital assets and their proper custody. The marketplace of custody services available for digital assets might not be as vast or standardized as it is for more traditional asset classes, potentially making finding a suitable custodian more challenging.

You and other advisers must ensure you’re working with qualified custodians who can effectively meet these updated standards and navigate any objections or concerns they may have about them. Failure to comply with this safeguarding rule would put you and your clients at risk, so you must fully understand what’s expected under these potential changes.

Compliance Measures for Registered Investment Advisers

To ensure proper compliance with the SEC Custody Rule and other regulatory obligations, seek professional assistance from a reliable compliance firm like My RIA Lawyer. With our experience, we can help you navigate complex regulations, establish foolproof compliance systems, and provide ongoing support to safeguard your client’s assets.

Don’t let compliance become a burden; take proactive steps to protect your clients and your RIA firm. Consult My RIA Lawyer today and let their experienced team guide you towards regulatory success.

Contact us now to schedule a consultation.

Author Bio

Leila Shaver is the Founder of My RIA Lawyer, a law firm that provides compliance and legal consulting for financial institutions. With extensive experience as a securities attorney and compliance expert, she has served as Chief Compliance Officer and General Counsel to RIAs, BDs, and TAMPs with billions in assets under management.

Leila understands the challenges RIAs face and is committed to helping RIAs streamline their processes, mitigate risks, and ensure compliance with regulatory requirements. She received her Juris Doctor from Atlanta’s John Marshall Law School and is a West Georgia Young Lawyers’ Association member. Leila has received numerous accolades for her work, including the Carroll County Bar Association’s Outstanding Young Lawyer Award in 2017.

LinkedIn | State Bar Association | Avvo | Google