60. Should the proposed rule include the reasonable assurances
requirement requiring the qualified custodian to provide indemnity and
have insurance arrangements in place to adequately protect its clients?
Should the rule include additional safeguards regarding the
indemnification requirement, such as stating that insurance proceeds
will be solely for the benefit of the client, and will not be
considered an asset of anyone other than the client? Should the rule
include any safeguards around the type of insurance a qualified
custodian could maintain for those indemnification purposes? If yes,
what types of safeguards should be imposed? For example, should the
insurance company be of a certain type or hold a certain qualification
or rating? What alternatives should we require to achieve our policy
goals? Are there any particular challenges for FFIs meeting this
requirement? If so, what are they?
    61. Should the proposed rule include the reasonable assurances
requirement that the existence of any sub-custodial, securities
depository, or other similar arrangements with regard to the client's
assets will not excuse any of the qualified custodian's obligations to
the client? Would that requirement help ensure that a qualified
custodian could not avoid responsibility for the other important
safeguarding obligations it owes to the client by delegating custodial
responsibility to a sub-custodian or other responsibilities to other
third parties? Would the requirement provide additional protections for
clients when an adviser has custody of client assets and further the
policy goals of the rule?
    62. Should the rule include the proposed reasonable assurances of
segregation of client assets requirements? Are these requirements
sufficiently clear?
    63. Would the proposed reasonable assurances of segregation of
client assets requirements impose appropriate limitations to safeguard
client assets? Should we eliminate or modify any of them?
Alternatively, are there other limitations that would be appropriate?
    64. Would the proposed reasonable assurance of segregation of
client assets requirement increase the likelihood that client assets
will be available to be returned to clients if a qualified custodian
experiences financial events such as insolvency or bankruptcy? For
example, do commenters believe the requirements would help ensure that
client assets are more readily identifiable as client property?
    65. Should certain assets be excluded from these reasonable
assurances of segregation of client assets requirements? If so, which
assets and why? Would limiting these requirements to certain types of
assets present compliance challenges? If so, which assets and why?
    66. In particular, would the proposed reasonable assurances of
segregation of client assets requirement present challenges with
respect to crypto assets? Should we address crypto asset segregation
and/or custody with separate requirements? Do crypto assets raise
specific segregation issues not presented by other assets? If so, what
are they and why? Would the proposed requirements offer substantial
protections in the event of a bankruptcy or financial losses involving
a custodian with custody of crypto assets? Would the proposed
reasonable assurances of segregation of client assets requirement
present challenges with respect to other types of assets?
    67. Does the proposed reasonable assurance of segregation
requirement guard against loss, misappropriation, misuse, theft, and
the risk of client assets being subject to creditor claims in the
insolvency or bankruptcy of the qualified custodian, while permitting
the flexibility that would address some of the compliance challenges
that the current rule presents (e.g., commingling of client and non-
client assets)?
    68. Should we instead retain the custody rule's requirement to
maintain client funds and securities with a qualified custodian in a
separate account for each client under the client's name or in accounts
that contain client funds and securities under the adviser's name as
agent or trustee? If so, should any of the custody rule's requirements
be modified in any way? If we were to retain the custody rule's
requirement, should we expand the scope of the separate account
requirement to assets from funds and securities?
    69. Is our understanding correct that, for administrative
convenience and other reasons, qualified custodians often hold client
assets in omnibus accounts containing assets of more than one client or
similar commingled-style accounts? Do commenters agree that this
practice may be even more common when a qualified custodian uses a sub-
custodian to hold client assets?
    70. Should the rule require that an adviser obtain reasonable
assurances that the qualified custodian will not commingle client and
non-client assets, similar to the custody rule? \206\ Alternatively,
should the rule be modified to permit the commingling of client and
non-client assets for administrative convenience and efficiency? If so,
what should be considered ``administrative convenience and
efficiency''? Does allowing client and non-client assets to be
commingled (e.g., in the same omnibus account) increase the risk that
client assets will be lost, misused, stolen, or misappropriated? Could
an advisory client's assets be used to satisfy the debts of someone
else in a bankruptcy event if client and non-client assets are
commingled?
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    \206\ See rule 206(4)-2(a)(1)(i).
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    71. Do commenters agree that there are circumstances when qualified
custodians' services require them to commingle advisory client assets
and assets of non-advisory customers? For example, when a qualified
custodian uses sweep accounts, escrow accounts, and loan servicing
accounts? In these circumstances, should the rule require additional
protections? Which protections and why and would they differ depending
on the type of commingled account?
    72. Should the rule require that an adviser obtain reasonable
assurances from the qualified custodian regarding the sub-accounting of
commingled accounts? Would such a requirement provide additional
protection to client assets?
    73. Are there instances where commingling or pooling of certain
assets by qualified custodians may occur via certain omnibus and sub-
accounting arrangements that may present compliance challenges under
the reasonable assurances of segregation of client assets requirement?
What are those instances and what are the challenges?
    74. Do commenters think that qualified custodians will include
contractual segregation provisions in their custodial agreements with
advisory clients if they do not already do so? Should the rule require
an

express contractual requirement between the adviser and custodian to
identify and segregate client investments? Would a contractual
requirement help ensure that advisory client assets are protected?
    75. Do commenters agree with our belief that not all financial
institutions that serve as qualified custodians, particularly FFIs, are
currently required to segregate and identify their client investments?
Do commenters agree that requiring an adviser to obtain reasonable
assurances that a qualified custodian will segregate client assets from
the custodian's proprietary assets and liabilities would be critical to
protecting client investments in the event of a qualified custodian's
insolvency as well as in the event of a taking by a foreign government?
Do commenters believe there may be reluctance by some financial
institutions to segregate client assets? Are there circumstances in
which segregation might not be important? If so, which circumstances?
    76. Would this segregation provision present practical challenges?
For example, would it present practical challenges in the context of
omnibus accounts or temporary sweep accounts? Would financial
institutions be able to satisfy the segregation provision? For example,
we know that national banks and Federal savings associations are
required to segregate all assets held in any fiduciary capacity from
their general assets. Is this also true of national banks and Federal
savings associations that hold custodial assets in a non-fiduciary
capacity? Are there other compliance challenges that this proposed
segregation requirement would pose? Are there circumstances in which
qualified custodians' services require them to commingle advisory
client assets with other assets?
    77. In the context of requiring an FFI to segregate client
investments, do commenters believe that the reasonable assurances
segregation requirement would help to preserve the client's interests
in the event of a government taking?
    78. In the event of the insolvency or bankruptcy of a qualified
custodian, do commenters agree with our understanding that the sub-
accounting of commingled accounts allows a qualified custodian to
readily identify the rightful owner of any investment at any point in
time? Are there any particular assets or services for which such
identification via sub-accounting is difficult or burdensome? If so,
what are the reasons for these difficulties?
    79. Is our approach in requiring a qualified custodian to maintain
client assets pursuant to a written agreement between the qualified
custodian and the investment adviser appropriate? Would the proposed
approach provide additional protections for clients when advisers have
custody of client assets and further the policy goals of the rule?
Would this requirement increase costs to maintain client assets with a
qualified custodian? Would this approach limit the pool of financial
institutions that are able to serve as qualified custodians? Would
financial institutions currently acting as qualified custodians exit
the business as a result of the written agreement requirement? Do
commenters agree that custodial practices, types of instruments
custodians hold, and the regulatory framework to which these financial
institutions are subject have evolved, in part to accommodate new
entrants to the market for custodial services? Do commenters agree that
this evolution, including new custodians and new custodial practices,
has resulted, in at least some cases, in a general reduction in the
level of protections offered by custodians, often resulting in advisory
clients with the least amount of bargaining power (i.e., retail
investors) receiving the most limited protections? Are there other
reasons that commenters believe custodial practices have evolved to
result in a general reduction in the level of protections offered by
custodians? Would the proposed approach mitigate some of our concerns
with regard to these custodial market changes?
    80. Is our belief correct that financial institutions that act as
qualified custodians under the current rule already provide some of the
protections that would be required under the proposed rule's
contractual requirements, either to satisfy regulatory requirements or
pursuant to their existing contracts with their clients? Do these
qualified custodians already provide the protections that would be
required in the proposed written agreement to every customer? Are some
protections provided to customers more often than others? If so, which
protections and why?
    81. Should the rule permit an adviser or its related person to be a
qualified custodian, as under the custody rule, or should we prohibit
the adviser or its related person from being the qualified custodian?
Do commenters agree that an adviser or related person acting as the
qualified custodian presents risks to client assets that are not
present when a qualified custodian is not the adviser or a related
person of the adviser? Do commenters agree that the proposed
requirements in the rule, including the proposed internal control
report requirements applicable to qualified custodians that are the
advisers or a related person, would help to reduce those risks? If the
rule prohibits the adviser or its related person from being the
qualified custodian, would it result in additional costs or operational
burdens on advisory clients? For example, would the requirement cause
advisory clients to lose access to services or other efficiencies they
currently receive? Would the requirement result in higher costs for
advisory clients?
    82. Given that the written agreement and reasonable assurances
approach would be applicable equally to the different types of
qualified custodians, should the rule identify other financial
institutions such as securities depositories, transfer agents, credit
unions, insurance companies, or other intermediaries as qualified
custodians?
    83. Are the contractual requirements and reasonable assurances
requirements sufficiently clear? Are there additional contractual
requirements or reasonable assurances related to the safeguarding of
client investments that should be included in the written agreement or
obtained by the adviser? If so, what are they, and why? Should we
eliminate any of the contractual requirements or reasonable assurances
requirements? If so, which ones, and why? Should all of the
requirements be contractual or reasonable assurances, rather than a mix
of these two categories as we proposed? Should any be re-categorized?
    84. Are there alternatives to all or any of the contractual
requirements or reasonable assurances requirements that would support
the policy goals of the proposed requirements while obviating the need
for one or more specific contractual provisions or reasonable
assurances? If so, what are the alternatives? Specifically, would we be
able to achieve the same policy goals by requiring that an adviser
adopt and implement policies and procedures reasonably designed to
ensure that a qualified custodian was providing certain protections to
client assets, rather than requiring a contractual clause for the
protection? For example, would requiring advisers to adopt and
implement a policy and procedure reasonably designed to ensure that a
qualified custodian would promptly, upon request, provide records
relating to the adviser's clients' assets held in the account at the
qualified custodian to the Commission or to an independent public
accountant provide protection equivalent to the proposed contractual
obligation to provide these records? What about the proposed internal
control report contractual obligation?

Would a client be able to obtain equivalent protection provided by an
adviser's adoption and implementation of a policy and procedure
reasonably designed to ensure that the qualified custodian will provide
the internal control report required in the proposed contractual
requirement? Are there other alternatives to any of the contractual
requirements, such as requiring that an adviser obtain reasonable
assurances from the qualified custodian that the qualified custodian
has contractually agreed to provide account statements, internal
control reports, or any of the other requirements we are proposing to
be included in the written agreement? Are there any other alternatives
that we should require?
    85. Are there circumstances in which the written agreement and
reasonable assurances requirements should not be required? For example,
should the written agreement and reasonable assurances requirements not
apply in instances where an advisory client has a custodial
relationship with a qualified custodian that precedes the client's
engagement of the adviser? If so, how long should the custodial
relationship precede the advisory relationship in order for an
exception of this type to apply?
    86. Should the proposed rule include the contractual provision that
the qualified custodian will promptly, upon request, provide records
relating to client investments to an independent public accountant for
purposes of compliance with the rule? Are we correct in our belief that
this proposed provision would facilitate the public accountant's
ability to obtain custodial account records? Would this requirement
provide additional protections when the adviser has custody of client
assets and further the policy goals of the rule?
    87. Should we require a more specific time period in which a
qualified custodian would be required to provide records? For example,
should we require that a qualified custodian provide records within
three days of a request?
    88. Is our understanding correct that qualified custodians do not
often provide third parties access to custodial account records in
light of privacy concerns for their customers, unless there is
contractual privity with those third parties or their customers request
they do so? If so, would the proposed contractual requirement mitigate
these record access challenges because the qualified custodian would be
in direct contractual privity with the adviser and would have a
contractual obligation to provide records?
    89. Should the proposed rule include the contractual requirement
that the qualified custodian will send account statements, at least
quarterly, to the client and the investment adviser? The current rule
requires an investment adviser to have a reasonable basis, after due
inquiry, for believing that the qualified custodian maintaining client
investments sends an account statement, at least quarterly, to the
client. Is the proposed requirement regarding sending account
statements to the adviser necessary or helpful? Would that requirement
have a significant cost impact on qualified custodians and would those
costs be passed on to advisory clients? Are there alternatives to the
proposed contractual provision that we should require? For example,
would the client have sufficient protection when an adviser has custody
of its assets if we were to require that an adviser must have
reasonable assurance that the qualified custodian maintaining client
assets sends an account statement, at least quarterly, to the client?
    90. To what extent would the proposed requirement to provide
custodial account statements to advisers increase costs to advisory
clients?
    91. To what extent do commenters believe that the requirement to
provide custodial account statements to advisers would have an impact
on an adviser's duty to monitor? Do commenters believe that it would
increase the frequency at which some advisers would be required to
monitor activity in client accounts? Would this enhance protection of
client assets? Could it increase advisory costs?
    92. Do commenters agree that custodians regularly send account
statements to their custodial customers attesting to the holdings and
transactions in the account during a particular period? Do commenters
agree that advisory clients use these account statements to identify
erroneous or unauthorized transactions or withdrawals in their
accounts?
    93. Many advisers or their related persons serve as advisers to
pooled investment vehicles or to other similar entities (e.g., general
partner of a limited partnership). The proposed rule would continue to
except these advisers from the requirement to have a qualified
custodian send account statements with respect to pooled investment
vehicles that are audited annually and distribute their audited
financial statements to the investors in the pool. Should we continue
to except these advisers from the account statement requirement? Would
the investors in those pools find the account statement useful to
monitor the pool's account activity? Should we extend this exception to
all entities that are audited annually and distribute audited financial
statements to investors in the entities pursuant to the audit
provision, as proposed, provided the entity complies with all of the
requirements in the proposed audit provision? \207\ Are there other
persons that we should except from this requirement?
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    \207\ See proposed rule 223-1(b)(4) and section II.G.1, infra.
---------------------------------------------------------------------------

    94. In circumstances where an investor is itself a pooled vehicle
that is controlling, controlled by, or under common control with the
adviser or its related persons (a ``control relationship''), should the
contract with the qualified custodian require the quarterly account
statement to be delivered by the qualified custodian to investors in
the underlying pools by looking through that pooled vehicle (and any
pools in a control relationship with the adviser or its related
persons, such as in a master-feeder fund structure)? Do commenters
agree with our understanding that if a qualified custodian did not look
through each pool in a control relationship with the adviser, the
qualified custodian would be essentially delivering the quarterly
statement to the adviser rather than to the parties the quarterly
statement is designed to inform? Do commenters agree with our view that
requiring the qualified custodian to ``look through'' in these
instances would lead to meaningful delivery of the quarterly statement
to advisory clients?
    95. Is our understanding correct with respect to current practices
of reporting certain custodial customer holdings for which the
qualified custodian lacks possession or control on an accommodation
basis?
    96. Should the proposed rule prohibit account statements from
identifying clients' investments for which the qualified custodian
lacks possession or control unless the client requests otherwise? Do
commenters agree that the practice of a qualified custodian including
on an account statement assets that it is not safeguarding may be
misleading to clients? Are there challenging practical implications of
this proposed prohibition? For instance, our staff has previously taken
the view that, under some arrangements, an adviser that is a qualified
custodian may send its advisory clients account statements that include
assets maintained with a sub-custodian that is also a qualified
custodian.\208\ Would the proposed contract provision preclude

this type of arrangement? Similarly, some qualified custodians
(regardless of whether they are related persons of the adviser) send
consolidated account statements that include the holdings of sub-
custodians. Would the proposed contract provision disrupt this
practice? Are there ways of improving account statement integrity
without eliminating qualified custodians' ability to send consolidated
account statements in these circumstances? For example, should we
permit an adviser to request that these assets be included on the
account statement but require that such request instruct a qualified
custodian to include disclosure on the statement explaining that the
qualified custodian does not have custodial liability for those
investments? Are there are other disclosures that would appropriately
distinguish how the qualified custodian maintains investments?
---------------------------------------------------------------------------

    \208\ See Custody Rule FAQs, supra footnote 17, at Question
IX.1.
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    97. Should we include the contractual requirement that the
qualified custodian, at least annually, obtain, and provide to the
investment adviser a written internal control report? Would the
proposed internal control requirement provide additional protections
where the adviser has custody? Would the proposed internal control
requirement raise costs for advisory clients? Should the contractual
requirement require some additional notification of any material
discrepancies identified in an examination supporting the internal
control report? For example, should the contractual requirement require
that the accountant performing the examination notify the Commission of
any material discrepancies by submitting a form such as Form ADV-E to
the Commission? Should the contractual requirement require the
accountant to notify the clients of the material discrepancies? Should
the contractual requirement include any other provisions with respect
to the written internal control report?
    98. Should we prescribe particular steps an adviser should take to
review internal control reports for control exceptions? For example,
should we require an annual review of these reports by the adviser's
Chief Compliance Officer or an adviser personnel with the skill set to
review such reports?
    99. Should we specify the internal control report to be obtained at
least annually, as proposed? Alternatively, should the internal control
report be obtained more or less frequently?
    100. Should the proposed internal control report be based on an
assessment of the same control objectives outlined in the 2009
Accounting Guidance? \209\ Are these control objectives applicable to
all qualified custodians? Should certain of the control objectives be
required only when the adviser uses a related party qualified
custodian? Have custodial practices changed since the 2009 Accounting
Guidance was published which would necessitate the addition or removal
of control objectives in order to meet the policy goals of the proposed
rule? Would additional control objectives be necessary in order to
appropriately safeguard all client assets as required under the
proposed rule, compared to funds and securities as required under the
current custody rule?
---------------------------------------------------------------------------

    \209\ See Accounting Guidance, supra footnote, 188 at section
III.
---------------------------------------------------------------------------

    101. When preparing an internal control report for a related party
qualified custodian, should an accountant continue to be required to
verify that client assets are reconciled to a custodian other than the
adviser or its related person? Should this required reconciliation be
limited to only securities? Are there custodians (like a securities
depository) unaffiliated with the adviser that can hold all client
assets when a related party qualified custodian is utilized? Is further
guidance needed on this reconciliation requirement?
    102. Should the contractual provision require that the independent
public accountant that prepares or issues the report be registered with
the PCAOB when the adviser serves as, or is a related person of, the
qualified custodian, as proposed? If so, should the independent public
accountant also be subject to regular inspection by the PCAOB, as
proposed? Would using independent public accountants registered with,
and subject to regular inspection by, the PCAOB increase the costs to
obtain these reports or make it too difficult to obtain a qualified
accounting firm to provide an internal control report? Should there be
a different independence standard for accountants performing the
engagement? Rather than the independence standard proposed, should the
rule require an accountant to not be a related person of the qualified
custodian as that term is defined under the safeguarding rule? \210\
---------------------------------------------------------------------------

    \210\ Proposed rule 223-1(d)(11).
---------------------------------------------------------------------------

    103. The current rule \211\ and proposed rule \212\ define an
independent public accountant as a public accountant that meets the
standards of independence described in rule 2-01 of Regulation S-X (17
CFR 210.2-01). Do custodians that voluntarily obtain internal control
reports or obtain them to satisfy other requirements often obtain them
from independent public accountants that are independent according to
this standard? If not, do they have another standard for determining
independence? For example, do custodians require auditors to meet the
independence standard set by the Association of International Certified
Professional Accountants? Do custodians require an independent public
accountant to be unaffiliated from the custodian?
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    \211\ Current rule 206(4)-2(d)(3).
    \212\ Proposed rule 223-1(d)(5).
---------------------------------------------------------------------------

    104. Rather than the contractual provision requiring that the
independent public accountant that prepares or issues the report be
registered with the PCAOB when the adviser serves as, or is a related
person of, the qualified custodian, as proposed, should this
requirement apply to all qualified custodians, regardless of whether
the qualified custodian is the adviser or a related person? If so,
should the rule contain different requirements for a qualified
custodian that is the adviser or a related person?
    105. Is it appropriate, as proposed, to require that an adviser
that is also the qualified custodian include all of the proposed
reasonable assurances protections in the written agreement with the
client? Should we require similar protections for any related person
qualified custodian? For example, should the rule require the written
agreement of any related person that is the qualified custodian to
include all of the proposed reasonable assurances requirements? Would
doing so provide enhanced protections for client assets? Would it
result in any additional burdens on advisers, related persons, or
clients?
    106. Do commenters agree with our proposed requirement that the
accountant who prepares the internal control report should be
``independent'' from the qualified custodian? Should it, instead,
require independence from adviser?
    107. Would obtaining or receiving an internal control report
present additional issues if the qualified custodian for client assets
is located outside of the United States? Would the requirement that the
independent public accountant be registered with, and subject to
regular inspection by, the PCAOB in affiliated or self-custody
situations make it more difficult to obtain such an internal control
report?
    108. Instead of making it a term of the required written agreement,
should we permit an adviser to rely on the representations of a
qualified custodian that it has obtained the required internal control
report?

    109. Should the proposed rule include the contractual requirement
that the qualified custodian will specify the investment adviser's
agreed-upon level of authority to effect transactions in the custodial
account as well as any applicable terms or limitations? Are there other
ways in which we could accomplish our objective to help empower
advisers to modify or eliminate their unwanted ability in a custodial
agreement to better reflect their client intentions? Would the
requirement provide additional protections where the adviser has
custody of client assets and further the policy goals of the rule?
    110. Is it difficult for advisers that have custody, including
inadvertent custody, pursuant to a client's custodial agreement with a
qualified custodian, to reduce or eliminate their authority over the
client's custodial account? Would the proposed qualified custodian
contractual requirement make it easier for advisers to reduce or
repudiate this authority? Do qualified custodians often reject an
adviser's request to modify its agreement with its client to reduce or
eliminate the adviser's authority?
    111. Do qualified custodians sometimes lend, invest, or otherwise
use their custodial customers' investments? Do advisers with custody of
client assets have knowledge of these transactions? Do these
transactions present risk to custodial customers? Do advisers consider
whether a custodian engages in these transactions, or has sufficient
insurance coverage to cover the risk of loss arising from these
transactions when involved in selecting a qualified custodian for an
advisory client? Should we include in the final rule a contractual
requirement requiring qualified custodians to record a liability and
maintain sufficient capital and/or insurance when lending, investing,
or otherwise using their custodial customers' investments? Would
qualified custodians be able to satisfy the requirement? If not, what
type of financial institutions would be unable to satisfy it? Are there
other ways of protecting custodial customers when an adviser has
custody from risk of loss when those financial institutions lend,
invest, or otherwise use client investments?
    112. Should the proposed rule include other contractual provisions
or reasonable assurances? For example, should we require the written
agreement to contain a contractual provision requiring the qualified
custodian to make and keep adequate records? Would that provision
facilitate compliance with the contractual provision requiring that the
qualified custodian provide records to the Commission or independent
public accountant? Would this requirement provide additional
protections for clients where the adviser has custody and further the
policy goals of the rule?
    113. Are there other risks that the rule should require the written
agreement to address? For example, should the rule require that the
written agreement expressly address the transfer of custodial assets in
the event of the custodian's bankruptcy or insolvency? Should the
written agreement be required to state, or should the adviser be
required to obtain reasonable assurances, that the intent of parties is
to enter into a custodial relationship, and under no circumstances
should the relationship be considered a debtor-creditor relationship?
    114. Investment companies registered under the Investment Company
Act (``RICs'') are subject to a comprehensive regime for the custody of
their assets under the Investment Company Act and Commission rules
thereunder, with specific requirements that vary based on the type of
custodian. Should we continue to except accounts of RICs under proposed
rule 223-1 in light of this regime for RICs? Should we apply any of the
provisions of proposed rule 223-1 to RIC custodial arrangements,
particularly the proposed contractual provisions for the qualified
custodian agreement? Should the required contractual provisions depend
on the type of custodian involved? For example, should RICs be required
to include some or all of the proposed contractual provisions in
agreements with bank custodians because the Commission has not adopted
a rule related to bank custodians specifically?
    115. Does the custody rule contain any safeguards that the
safeguarding rule retains that are not necessary and which we should
not require?

C. Certain Assets That Are Unable To Be Maintained With a Qualified
Custodian

    We believe that the bulk of advisory client assets are able to be
maintained by qualified custodians; however, we understand that is not
universally the case, particularly for two types of assets: certain
physical assets and certain privately offered securities.
    It is not uncommon for physical assets, such as precious metals,
physical commodities, and real estate, to be held in client portfolios,
and thus there are likely circumstances in which advisers would have
custody of these physical assets as a result of the expanded scope of
the safeguarding rule. We understand that these assets are sometimes
unable to be maintained by qualified custodians, and that some
qualified custodians may refuse to custody such assets, in part,
because the inherent physical characteristics of the items increase the
expenses associated with their maintenance and safekeeping. Some of
these assets by their very nature or size may not easily be subject to
theft or loss, and that may reduce the need for the safeguarding
protections offered by a qualified custodian, but when an adviser has
an ability or authority to change beneficial ownership of these assets,
there is still a risk of misuse, misappropriation, or loss associated
with the adviser's insolvency or bankruptcy.
    Similarly, it is increasingly common for advisory clients to have
privately offered securities in their portfolio.\213\ We understand
that advisers with trading authority of privately offered securities
that do not settle DVP often have custody of these securities because
of the broad, general power of attorney-like authority required to
trade these securities.\214\ There are certain impediments to
transferability typically associated with certain privately offered
securities--specifically, the need to obtain the consent of the issuer
or other securities holders prior to any transfer of ownership--that
make certain of these assets less susceptible to some of the risks the
rule is designed to address. In particular, they would be less likely
to be stolen by a third party or simply lost. These characteristics
reduce the need for the safeguarding protections offered by a qualified
custodian. These characteristics, however, do little, if anything, to
protect a client against misuse, misappropriation, or losses that

may result from the adviser's insolvency or bankruptcy.
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    \213\ See, e.g., Form ADV data current as of [Nov. 30, 2021]
(showing that there are currently 5,037 registered private fund
advisers with over $18 trillion in private fund assets under
management); See also, Vanguard, The role of private equity in
strategic portfolios (Oct. 2020), available at https://corporate.vanguard.com/content/dam/corp/research/pdf/Role-of-private-equity-in-strategic-portfolios-US-ISGRPE_102020_US_F_online.pdf (``[T]he asset size of the private
equity market has been gradually growing on an absolute basis and
relative to the public equity market over the last 20 years. Private
equity has risen from 2% to 7% of total investable global equity
assets.''); see also Scott Bauguess et al., Capital Raising in the
U.S.: An Analysis of the Market for Unregistered Securities
Offerings, 2009- 2017 (2018), available at https://www.sec.gov/files/dera-white-paper_regulation-d_082018.pdf (noting that an
analysis of issuer self-reported data through electronic Form D
filings indicates that the number of unregistered offerings and
corresponding amounts raised have been increasing over the years
2009-2017); Concept Release on Harmonization of Securities Offering
Exemptions, Release No. 33-10649 (June 18, 2019) [84 FR 30460 (June
26, 2019)], at n.37 (stating that the amounts raised in exempt
markets have increased both absolutely and relative to public
markets).
    \214\ See supra footnote 71 and accompanying text.
---------------------------------------------------------------------------

    We understand that the current market for custodial services of
privately offered securities is fairly thin. We also understand that,
although some custodians will custody these securities by holding them
in nominee form, many do not custody them. We similarly understand that
demand for these services may also be thin. Moreover, we understand
that many advisers with custody of these assets do not seek to maintain
them with a qualified custodian--at least in part--because the custody
rule contains the ``privately offered securities exception'' \215\ from
the qualified custodian requirement.
---------------------------------------------------------------------------

    \215\ See rule 206(4)-2(b)(2).
---------------------------------------------------------------------------

    To qualify for the privately offered securities exception today,
the security must meet the exception's description of ``privately
offered securities.'' This definition includes securities acquired from
the issuer in a transaction or chain of transactions not involving any
public offering; uncertificated, and ownership thereof is recorded only
on the books of the issuer or its transfer agent in the name of the
client; and transferable only with prior consent of the issuer or
holders of the outstanding securities of the issuer. This custody rule
exception contains one additional condition: for an adviser to a
limited partnership or similar pooled investment vehicle to rely on
this exception, the adviser must also comply with the custody rule's
audit provision. In adopting this exception, the Commission had
expressed its concern that these safeguards may be ineffective in the
case of limited partnerships (or other pooled investment vehicles),
noting that because the private securities are held in the name of the
limited partnership and the adviser acts for the partnership, the
adviser has apparent authority to arrange transfers that would be
recognized by the issuer of the securities.\216\
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    \216\ See 2003 Adopting Release, supra footnote 2.
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    However, the Commission adopted this exception in 2003, following
concerns raised by commenters that a requirement to maintain certain
privately offered securities with qualified custodians could pose
difficulties; particularly given that ownership of such assets
generally was recorded only on the books of the issuer (e.g.,
investments in limited partnerships where clients receive only a copy
of the partnership agreement as evidence of their investment or
assignment agreements for debt or equity interests in a private
company).\217\ In support of its decision to adopt the exception, the
Commission stated that some of the impediments to transferability
typically associated with certain privately offered securities provide
some external safeguards against the kinds of abuse the rule seeks to
prevent.\218\
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    \217\ See 2003 Adopting Release, supra footnote 2, at section
II.B. (``Commenters [ ] pointed out that, on occasion, a client may
purchase privately-offered securities and that maintaining certain
of these assets in accounts with qualified custodians poses
difficulties because the client's ownership of the security is
recorded only on the books of the issuer.'') (emphasis added).
    \218\ Id. The 2003 Adopting Release identified a specific and
limited range of securities to which commenters referred. See 2003
Adopting Release, supra footnote 2, at n.26 (``Commenters
specifically mentioned clients' investments in limited partnerships,
where clients receive only a copy of the partnership agreement as
evidence of their investment. Commenters also mentioned assignment
agreements for debt or equity interests in a private company, or
other types of customized agreements.'').
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    When this exception was adopted, the size of the privately held
securities market was much smaller than it is now on an absolute basis
as well as in relation to the size of the publicly traded securities
market.\219\ In addition, the type, nature, structure, and prevalence
of private issues have also changed and expanded in recent years, all
of which have led the Commission to reconsider the current rule's
exception.\220\ We have become concerned over the years since its
adoption that this exception may not adequately protect an advisory
client from the broad types of risks the custody rule is intended to
address: chiefly, misappropriation.\221\
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    \219\ See Vanguard, The role of private equity in strategic
portfolios (Oct. 2020), available at https://corporate.vanguard.com/content/dam/corp/research/pdf/Role-of-private-equity-in-strategic-portfolios-US-ISGRPE_102020_US_F_online.pdf (``[T]he asset size of
the private equity market has been gradually growing on an absolute
basis and relative to the public equity market over the last 20
years. Private equity has risen from 2% to 7% of total investable
global equity assets.''); see also Scott Bauguess et al., Capital
Raising in the U.S.: An Analysis of the Market for Unregistered
Securities Offerings, 2009- 2017 (2018), available at https://www.sec.gov/files/dera-white-paper_regulation-d_082018.pdf (noting
that an analysis of issuer self-reported data through electronic
Form D filings indicates that the number of unregistered offerings
and corresponding amounts raised have been increasing over the years
2009-2017); Concept Release on Harmonization of Securities Offering
Exemptions, Release No. 33-10649 (June 18, 2019) [84 FR 30460 (June
26, 2019)], at n.37 (stating that the amounts raised in exempt
markets have increased both absolutely and relative to public
markets).
    \220\ For example, our staff has received several questions over
the years about whether certain securities would still qualify for
the exception if the securities were not acquired from the issuer
but were transferred, for instance, in a subsequent private
offering, from one owner to the next. Our staff has also responded
to other questions concerning the application of the exception. See,
e.g., 2013 IM Guidance, supra footnote 17 (providing staff views
regarding security evidenced by a private stock certificate).
    \221\ See 2009 Adopting Release, supra footnote 11, at section
II.B.3 (noting the difficulty for advisory clients to verify that
assets actually exist because ownership is recorded only on the
issuers' books). In the 2009 Adopting Release, the Commission
expanded the protections of the surprise examination to privately
offered securities. See id. The growth of the privately offered
securities market since our 2009 amendments to the custody rule has
increased our concerns regarding the risks we identified in the 2009
Adopting Release to these client assets. We have also taken into
account concerns expressed by others. See, e.g., Dodd Frank
Regulating Hedge Funds and other Private Investment Pools Testimony
of James S. Chanos, supra footnote 14, at 50 (``These instruments
are privately issued uncertificated securities, bank deposits, real
estate assets, swaps, and interests in other private investment
funds, as well as shares of mutual funds, which, under current law,
can simply be titled in the name of the private investment fund care
of the manager, and the evidence of ownership held in a file drawer
at the manager of the private investment fund. The issuers of those
assets are permitted to accept instructions from the manager to
transfer cash or other value to the manager. This gaping hole in
current Advisers Act custody requirements can allow SEC-registered
advisers easily to abscond with money or other assets and falsify
documentation of ownership of certain categories of assets, and
makes it difficult for auditors, investors and counterparties to
verify the financial condition of advisory accounts and private
investment funds. Requiring independence between the function of
managing a private investment fund and controlling its assets, by
requiring that all assets be titled in the name of a custodian bank
or broker-dealer for the benefit of the private fund and requiring
all cash flows to move through the independent custodian, would be
an important control. Similarly, requiring an independent check on
the records of ownership of the interests in the private investment
fund, as well as imposing standards for the qualification of private
investment fund auditors--neither of which currently is required by
the Advisers Act--would also greatly reduce opportunities for
mischief.'').
---------------------------------------------------------------------------

    When an asset cannot be maintained with a qualified custodian, a
client may not have a full understanding of its holdings or receive
periodic account statements reflecting transactions in those assets.
This reduces the likelihood that a client will be able to identify
suspicious activity in its account or notice that its assets are gone.
Moreover, these assets may not be included in the sample of assets
subject to verification procedures during a surprise examination or
meet the materiality threshold for verification during a financial
statement audit. As a result, a loss could similarly go undetected by
an independent public accountant for a substantial period.
    Ideally, a robust market for custodial services would develop for
physical assets and privately offered securities. Absent such a
development and the exception, however, advisers would be faced with
the inability to comply with a Commission requirement or a need to
transition to providing nondiscretionary advice or take certain other
actions in

order to avoid a violation of Commission rules, which could be
disruptive or result in client harm. We are therefore proposing to
reform the privately offered securities exception to address our
concerns about the lack of protections and transparency that could
result when privately offered securities and physical assets cannot be
maintained by a qualified custodian and to reduce the likelihood that a
loss of these assets could be undetected for an indeterminate amount of
time. The safeguarding rule would provide an exception to the
requirement to maintain client assets with a qualified custodian where
an adviser has custody of privately offered securities or physical
assets, provided it meets the following conditions: \222\
---------------------------------------------------------------------------

    \222\ See proposed rule 223-1(b)(2).
---------------------------------------------------------------------------

     The adviser reasonably determines and documents in writing
ownership cannot be recorded and maintained (book-entry, digital, or
otherwise) in a manner in which a qualified custodian can maintain
possession, or control transfers of beneficial ownership, of such
assets;
     The adviser reasonably safeguards the assets from loss,
theft, misuse, misappropriation, or the adviser's financial reverses,
including the adviser's insolvency;
     An independent public accountant, pursuant to a written
agreement between the adviser and the accountant,
    [cir] Verifies any purchase, sale, or other transfer of beneficial
ownership of such assets promptly upon receiving notice from the
adviser of any purchase, sale, or other transfer of beneficial
ownership of such assets; and
    [cir] Notifies the Commission within one business day upon finding
any material discrepancies during the course of performing its
procedures;
     The adviser notifies the independent public accountant
engaged to perform the verification of any purchase, sale, or other
transfer of beneficial ownership of such assets within one business
day; and
     The existence and ownership of each of the client's
privately offered securities or physical assets that is not maintained
with a qualified custodian are verified during the annual surprise
examination or as part of a financial statement audit.
1. Definition of Privately Offered Security and Physical Assets
    The proposed rule's definition of privately offered securities
would retain the elements from the custody rule's description that
require the securities to be acquired from the issuer in a transaction
or chain of transactions not involving any public offering, and
transferable only with prior consent of the issuer or holders of other
outstanding securities of the issuer.\223\ Like the custody rule, the
safeguarding rule would also require the securities to be
uncertificated and would require ownership to be recorded only on the
books of the issuer or its transfer agent in the name of the client.
However, the safeguarding rule would also require that the securities
be capable of only being recorded on the non-public books of the issuer
or its transfer agent in the name of the client as it appears in the
records the adviser is required to keep under Rule 204-2. This
definitional requirement would enhance the assurance of the existence
of the client asset provided by the verification required by proposed
223-1(b)(2)(iii)(A) and will make the verification process more
efficient. The term ``uncertificated'' would generally have the same
meaning as set forth in article 8 of the Uniform Commercial Code.\224\
Additionally, we would not view a security to be certificated where the
certificate cannot be used to redeem, transfer, purchase, or otherwise
effect a change in beneficial ownership of the security for which the
certificate is issued.\225\ We understand that transactions and
ownership involving crypto asset securities on public, permissionless
blockchains are generally evidenced through public keys or wallet
addresses.\226\ As proposed, in order for a security to be a privately
offered security under the proposed safeguarding rule, among other
conditions, it must be uncertificated, and the ownership can only be
recorded on the non-public books of the issuer or its transfer agent in
the name of the client as it appears in the adviser's required records.
As a result, we believe that such crypto asset securities issued on
public, permissionless blockchains would not satisfy the conditions of
privately offered securities under the proposed safeguarding rule.\227\
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    \223\ Rule 206(4)-2(b)(2)(i). ``Privately offered securities''
are defined by rule 206(4)-2(b)(2) as securities that are (1)
acquired from the issuer in a transaction or chain of transactions
not involving any public offering, (2) uncertificated, and ownership
thereof is recorded only on the books of the issuer or its transfer
agent in the name of the client, and (3) transferable only with
prior consent of the issuer or holders of the outstanding securities
of the issuer. See also proposed rule 223-1(d)(9).
    \224\ See UCC Sec. 8-102(a)(18) (`` `Uncertificated security'
means a security that is not represented by a certificate.'').
    \225\ Our staff took a similar view. See 2013 IM Guidance, supra
footnote 17.
    \226\ See generally, PwC, Demystifying cryptocurrency and
digital assets (accessed Dec. 5, 2022), available at https://www.pwc.com/us/en/tech-effect/emerging-tech/understanding-cryptocurrency-digital-assets.html (describing storage, ownership,
and transactions, of crypto assets).
    \227\ Crypto assets that are not crypto asset securities would
not qualify for the exception because they do not satisfy the
definition of privately offered security under proposed 223-1(d)(9).
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    We are not providing a definition of the term ``physical asset'' or
including specific types of assets in the proposed rule. Rather, we
believe that the plain language of the phrase, along with a principles-
based facts and circumstances approach that requires an adviser to look
to the characteristics and nature of a particular physical asset is
more appropriate. We believe that what constitutes a ``physical asset''
is often self-evident, particularly when compared to other assets that
are certificated, maintained digitally, or in book-entry form. For
example, real estate and physical commodities \228\ such as, corn, oil,
and lumber are physical assets, while assets like cash, stocks, bonds,
options, futures and funds are not, even if they provide exposure to
physical assets. Physical evidence of ownership of non-physical assets
that can be used to transfer beneficial ownership, like stock
certificates, private keys, and bearer or registered instruments do
not, themselves, qualify as physical assets and would not qualify for
the exception from the qualified custodian requirement. Similarly,
certain physical evidence of physical assets such as a warehouse
receipt for certain commodities would not qualify for the exception if
they can be used to transfer beneficial ownership even though the
commodities documented by the warehouse receipt may qualify for the
exception. Or in the real estate context, a deed or similar indicia of
ownership that could be used to transfer beneficial ownership of a
property would not qualify for the exception, but the physical
buildings or land would qualify.
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    \228\ See, e.g., International Organization of Securities
Commissions, Principles for the Regulation and Supervision of
Commodity Derivatives Markets--Consultation Report at 82 (Nov.
2021), available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD689.pdf (defining physical commodity as ``[a] tangible
product or raw material, as opposed to an instrument which
references a physical commodity.'').
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2. Adviser's Reasonable Determination
    In order to be eligible for the exception, the rule would require
an adviser to determine, and document in writing, that ownership cannot
be recorded and maintained (book-entry, digital, or otherwise) in a
manner in which a qualified custodian can

maintain possession or control of such assets. Such a determination
necessarily depends on the facts and circumstances in issue. Moreover,
these determinations would necessarily evolve over time as assets and
the custodial industry change, allowing the proposed rule to remain
evergreen.
    An adviser's reasonable determination of whether a qualified
custodian is able to maintain possession or control of a particular
asset would generally involve an analysis of the asset and the
available custodial market. An adviser's reasonable determination
generally would not require the identification of every conceivable
qualified custodian and an evaluation of its custodial services.
Fundamentally, to determine whether an asset can or cannot be
maintained by a qualified custodian under the proposed rule, an adviser
generally should obtain a reasonable understanding of the marketplace
of custody services available for each client asset for which it has
custody. The adviser's written documentation of its determination would
generally contain material facts concerning its understanding of the
custodial marketplace and a description of the client asset in issue.
    The proposed rule does not specify the frequency with which an
adviser must make this determination. What frequency would be
reasonable for any determination would depend on the particular assets
and the facts and circumstances. For example, an adviser might develop
policies and procedures for conducting this analysis, and those
policies and procedures might reasonably call for an annual assessment
of one type of asset for which there have been no indicators of a
developing custodial market. On the other hand, it would likely be
unreasonable for an adviser to annually assess the custodial market for
an asset for which developing custodial services are well publicized as
imminent.
    As discussed above, we believe that many privately offered
securities are not currently maintained by qualified custodians.
However, we understand that a substantial portion of securities--
privately and publicly held--are uncertificated (i.e., paper stock
certificates are largely a relic from a prior era, replaced by more
modern methods of recording ownership).\229\ Particularly as a result
of the growth of uncertificated publicly traded securities, we
understand that custodians have refined safeguarding and reporting
practices with respect to uncertificated securities. Therefore, we
believe that this experience has made it increasingly possible for
qualified custodians to provide custody services for privately offered
securities. Accordingly, while today it may be reasonable under
appropriate circumstances for an adviser to determine that a qualified
custodian cannot maintain possession or control of a particular
privately offered security, we believe that determination may be more
difficult to support as the custodial industry continues to evolve.
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    \229\ See Paech, Philipp, Securities, Intermediation and the
Blockchain: An Inevitable Choice Between Liquidity and Legal
Certainty? 21(4) Unif. L. Rev. 612 (Dec. 1, 2016) (``The practice of
securities holding, transfer, and collateral has changed
significantly over the past 200 years-moving from paper certificates
and issuer registers, to an intermediated environment, and from
there to computerization and globalization.''); Intermediated
Securities, supra footnote 143, at 386 (``Immobilization and
dematerialization of securities have made the physical delivery of
certificates nearly irrelevant. In just a few decades, the issuance
of securities has shifted from the physical to a virtual world, to
which financial intermediaries hold the key.''); DTCC, From Physical
to Digital: Advancing the Dematerialization of U.S. Securities
(Sept. 2020), available at https://www.dtcc.com/~/media/Files/PDFs/
DTCC-Dematerialization-Whitepaper-092020.pdf (``the crushing
mountain of paper of the paperwork crisis in the 1960s and 1970s was
addressed by the two-pronged approach of immobilization and
dematerialization''). While the terminology is sometimes used
interchangeably, ``dematerialized securities'' generally refer to
securities, sometimes certificated, that are represented by entries
in securities accounts maintained by financial intermediaries for
investors, while ``uncertificated securities'' refer to securities
that are not represented by a certificate but are registered on an
issuer's books. See generally, Thevenoz, Intermediated Securities,
supra footnote 143 at 386 (``Certificated securities do not need to
move if they are immobilized in the custody of reliable depositories
and represented by entries in securities accounts maintained by
financial intermediaries for investors. When needed, immobilized
securities can be transferred by way of book-entries in investors'
accounts, which substitute for their physical delivery. Where
corporate law and investor preferences allow, physical individual
securities can become wholly unnecessary. A whole issue can be
replaced by one global certificate, or it can even be recorded in an
`issue account' without the need for any certificate, against which
the dematerialized securities can be credited to the securities
accounts of market participants and, here again, be transferred by
way of book-entries. Immobilization and dematerialization of
securities have made the physical delivery of certificates nearly
irrelevant. In just a few decades, the issuance of securities has
shifted from the physical to a virtual world, to which financial
intermediaries hold the key.''); and see UCC section 8-102(18) (``
`Uncertificated security' means a security that is not represented
by a certificate.'').
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    Whether an adviser can make the reasonable determination regarding
a particular physical asset necessarily depends on the asset type and
the availability of custody services. For example, an adviser could
likely conclude that qualified custodian services are unavailable for
unharvested wheat or a shopping center. Similarly, custody of certain
tangible agricultural commodities may be impossible to insure at a
qualified custodian.\230\ In these circumstances, an adviser may
reasonably determine that ownership cannot be recorded and maintained
(book-entry, digital, or otherwise) in a manner in which a qualified
custodian can maintain possession or control of such asset. Conversely,
it is likely that a qualified custodian can hold gold bullion,\231\ and
it would therefore be difficult for an adviser to make the
determination required to invoke the proposed exception.
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    \230\ Though such physical assets may be unable to be held with
a qualified custodian as defined under the proposed rule, we
understand that agricultural commodities and other physical
commodities do have certain non-qualified custodians, exchange-
approved warehouses or clearing houses that provide substantial
record keeping and safeguarding protections for such assets. These
often include secure storage facilities, internal control
procedures, and relevant insurance coverages.
    \231\ It is our understanding that banks are able to custody
gold bullion and other precious metals, but that other non-bank
custodians provide secure storage and transportation services for
gold bullion and other precious metals, including vault custody and
related transportation services. See, e.g., The Brinks Company, SEC
Staff No-Action Letter (Feb. 3, 2014). We also understand that, from
time to time, bank custodians or others may exit the precious metals
custody business, but that other custodians may become available to
perform those custody services. See, e.g., Depository Trust Company
of Delaware, LLC, SEC Staff No-Action Letter (Sept. 12, 2016).
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3. Adviser Reasonably Safeguards Assets
    To rely on the exception, the adviser would be required to
reasonably safeguard any privately offered securities or physical
assets that are not maintained with a qualified custodian from loss,
theft, misuse, misappropriation, or the adviser's financial reverses,
including the adviser's insolvency. While the specific procedures
implemented to safeguard assets may vary depending on the asset,
advisers must satisfy their fiduciary duty in safeguarding any
particular asset.\232\
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    \232\ The principles-based requirement to reasonably safeguard a
client's physical assets is drawn from an adviser's fiduciary duty
including its duty of care or duty of loyalty under the Advisers
Act, which extends to the entirety of the adviser-client
relationship. See supra footnote 57.
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    With respect to privately offered securities, an adviser might
``reasonably safeguard'' an asset by looking to reasonable commercial
standards, which we understand presently may draw from a variety of
protections such as enhanced recordkeeping, additional change of
control terms in governance agreements, designation of an agent
required to be involved in transfers of beneficial ownership, among
others. For

example, one critical safeguard that advisers should consider is the
types of internal controls that they can implement to reasonably
safeguard clients' privately offered securities. If possible, an
adviser may consider separating duties of the person responsible for
recording investments in privately offered securities from the person
responsible for authorizing the buying and selling of privately offered
securities from the person responsible for holding certificates or
other legal records evidencing ownership of privately offered
securities.\233\ An adviser may also consider implementing procedures
to regularly review and reconcile the following documents to the
adviser's records: legal documents demonstrating evidence of ownership
of privately offered securities, including any changes year over year;
board meeting minutes, if available, for any activity that may evidence
a change in a client's ownership of privately offered securities; and
records of share ownership maintained by the issuer or its transfer
agent in the name of the client. An adviser may also consider
periodically reviewing and documenting that the privately offered
securities are transferable only with the prior consent of the issuer
or its shareholders. Importantly, the rule recognizes that the
privately offered securities vary, as do the relationships between an
adviser and its advisory clients, and the rule retains the flexibility
necessary for advisers to make reasonable determinations concerning the
safeguarding of those privately offered securities that are unable to
be maintained with a qualified custodian.
---------------------------------------------------------------------------

    \233\ We recognize in some smaller organizations it may be more
challenging to separate these functions.
---------------------------------------------------------------------------

    With respect to physical assets, an adviser might ``reasonably
safeguard'' such assets by looking to reasonable commercial standards,
which may include storage in a secure facility or vault that adheres to
exchange, clearing house, or other licensing requirements for
participation in certain commodities markets; dual control procedures
for access to assets in safekeeping; maintenance of records to evidence
movement or transfer of assets (including details on depositor,
beneficiary and/or the legal owner); periodic reconciliation of records
with assets held (e.g., vault counts); separation of duties for
movement or transfer of assets, recordkeeping and reconciliation;
periodic audits; smoke detection and fire suppression systems; and
insurance coverage for any custody-related losses incurred by its
clients. Advisers may need to tailor their standards for safeguarding
to each particular physical asset depending on the relative common
standards for its market.\234\ For example, reasonable commercial
standards for safeguarding and taking delivery of an agricultural
commodity like a bushel of wheat \235\ necessarily would be different
from the appropriate maintenance gold bullion \236\ or of personal
property like jewelry, antiques, or art.\237\ We believe this approach
will give advisers the flexibility to develop and implement
safeguarding practices with respect to assets not maintained with a
qualified custodian that are appropriately tailored, while helping to
ensure client assets receive appropriate protections.
---------------------------------------------------------------------------

    \234\ See, e.g., The Board of the International Organization of
Securities Commissions, Commodity Storage and Delivery
Infrastructures: Good or Sound Practices (Feb. 2019), available at
https://www.iosco.org/library/pubdocs/pdf/IOSCOPD622.pdf
(encouraging the adoption of ``Good or Sound Practices'' in member
jurisdictions, but noting that ``[n]ot all of the Practices
described may be relevant to all market participants. It is for
market participants to determine the applicability of any particular
Practice and to apply it as their circumstances require.'').
    \235\ For example, in the agricultural context, clearing members
and delivery facilities are subject to the various rules of the
exchange or clearing house as well as inspection by the exchange and
the Department of Agriculture. See, Chapter 7, Delivery Facilities
and Procedures, Chicago Board of Trade Rule Book (2022) available
at: https://www.cmegroup.com/rulebook/CBOT/.
    \236\ See Global Previous Metals Code Global Precious Metals
Code available at https://www.lbma.org.uk/market-standards/global-precious-metals-code.
    \237\ The OCC notes in its Handbook that miscellaneous assets
(e.g., jewelry, art, coins) should be maintained in a vault
consistent with applicable law and sound custodial management. Vault
control procedures should ensure physical security, dual control
procedures, maintenance of records evidencing access to the vault,
proper asset transfer ticketing, and periodic vault counts. See,
Custody Services, Comptrollers Handbook (Jan. 2002) available here:
https://www.occ.treas.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/pub-ch-custody-services.pdf (``OCC Custody Handbook''). See also Inland Marine
Underwriters Association, Evaluating the Risk in the Storage and
Shipping of Fine Art: Insights into the Art Service Industry at
https://www.imua.org/Files/reports/2019reports/EvaluatingRiskinStorageandShippingofFineArtsUpdateFinal1_4_2019.pdf.
---------------------------------------------------------------------------

    When an adviser has custody of client physical assets that are not
maintained with a qualified custodian, the ultimate obligation to
safeguard those assets falls to the adviser. In some circumstances, an
adviser might conclude that it could safeguard the asset itself,
provided it can do so in accordance with reasonable commercial
standards. In other circumstances, the adviser could instead determine
that it could permissibly maintain physical assets with a third party
that the adviser concludes could safeguard the assets in accordance
with reasonable commercial standards. The proposed rule does not
require a particular approach.
    More broadly, an adviser might demonstrate that it is reasonably
safeguarding a client asset itself or through a third party, by
adopting, implementing, and regularly reassessing policies and
procedures that include robust due diligence and ongoing oversight
designed to ensure the adviser has assessed and evaluated the
safeguarding measures put in place by itself or the third party
maintaining physical assets. Such policies and procedures might include
procedures to assess whether the person maintaining the client asset
has exercised and is likely to continue to be able to exercise due care
in accordance with reasonable commercial standards in safeguarding the
asset.
4. Notification and Prompt Independent Public Accountant Verification
    The exception to the requirement to maintain assets with a
qualified custodian would also require an adviser to enter into a
written agreement with an independent public accountant.\238\ The
proposed rule would require the adviser to notify the independent
public accountant of any purchase, sale, or other transfer of
beneficial ownership of such assets within one business day.\239\ The
written agreement would require the independent public accountant to
verify the purchase, sale, or other transfer promptly upon receiving
the required transfer notice.\240\ The written agreement would also
require the accountant to notify the Commission by electronic means
directed to the Division of Examinations within one business day upon
finding any material discrepancies during the course of performing its
procedures.\241\ We believe that these requirements would provide
advisory clients meaningful and much-needed protection when their
advisers have custody of assets that are not maintained with a
qualified custodian.
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    \238\ See proposed rule 223-1(b)(2)(iii).
    \239\ See proposed rule 223-1(b)(2)(iv).
    \240\ See proposed rule 223-1(b)(2)(iii)(A).
    \241\ See proposed rule 223-1(b)(2)(iii)(B).
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    It has been our longstanding view that the involvement of
independent public accountants in the review and verification of client
assets of which advisers have custody is an important safeguarding tool
and reduces the risk of loss of client assets.\242\ Consistent with

that view, we believe that an independent public accountant's
involvement in the verification and notification requirements in the
proposed rule enhances the reliability and integrity of the
verification and would help identify problems that clients may not, and
thus would provide deterrence against fraudulent conduct by advisers.
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    \242\ See, e.g., Adoption of Rule 206(4)-2 under the Investment
Advisers Act of 1940, IA Release No. 123 (Feb. 27, 1962) [27 FR 2149
(Mar. 6, 1962)] (requiring advisers with custody of client
securities or funds to engage an independent public accountant to
conduct an annual surprise examination); 2009 Adopting Release,
supra footnote 11, at section II.B.1. (``Because advisers with
custody often have authority to access, obtain and, potentially,
misuse client funds or securities, we believed the additional review
provided by an independent public accountant would help identify
problems that clients may not, and thus would provide deterrence
against fraudulent conduct by advisers.'').
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    We believe that the timing requirement for the notice--that the
adviser would be required to provide notice to an independent public
accountant within one business day of a transfer of beneficial
ownership--is important to inform an independent public accountant as
soon as practicable of a transfer of beneficial ownership of client
assets that are not held with a qualified custodian. This timing will
build a record for the accountant to review in connection with an
annual surprise examination or financial statement audit and,
therefore, would reduce the likelihood of loss or misappropriation of
client assets. Moreover, we anticipate the timing of these requirements
in close proximity to the timing of a transaction, coupled with the
annual confirmation during a surprise examination or financial
statement audit, would also reduce the likelihood that any loss would
go undetected for an extensive time. Further, we believe that this
notice would not be challenging for any adviser to provide to the
independent public accountant, especially considering the limited
nature of the requirement relative to the more involved aspects of many
of the closings related to privately offered securities or physical
assets such as the preparation or review of closing memos, confirmation
of receipt of funds, execution of signature pages, and many other more
time-consuming tasks related to closings for these types of assets.
    Based on our experience with the audit provision in the current
rule,\243\ we understand that independent public accountants are
familiar with a wide variety of transaction verification and tracing
transaction activity as this is a normal audit procedure. We recognize,
however, that the verification and transaction tracing process of any
purchase, sale, or other transfer of beneficial ownership of the assets
would necessarily vary depending on the type of asset. For example, for
a privately offered security purchased or sold by an advisory client,
the independent public accountant could contact the issuer of the
security or its agent to verify the existence of the asset and relevant
information concerning the transfer of beneficial ownership of the
client asset. The independent public accountant may also take a wide
array of additional steps depending on the nature of the security--and
the transaction--along with other relevant facts and circumstances. For
example, the independent public accountant may review a private
placement memorandum, the issuer's Regulation D filings,\244\ or take
other steps to assist in verifying the existence and transfers of
beneficial ownership of the asset.
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    \243\ Rule 206(4)-2(a)(4) and 206(4)-2(b)(4).
    \244\ See Form D, Notice of Exempt Offering of Securities,
available at https://www.sec.gov/files/formd.pdf.
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    For a physical asset purchased or sold by an advisory client, such
as a commercial shopping center, the independent public accountant may
confirm the existence of the asset through a variety of reliable means.
To confirm the transfer of beneficial ownership of the asset, the
independent public accountant may review deeds or other land
recordation materials, or seek to obtain other reliable information
concerning the transfer of the asset. The independent public accountant
may use similar methodologies in connection with the verification of
the existence, and purchase or sale, of physical commodities. For
example, an independent public accountant may seek to confirm existence
and the relevant transfers of beneficial ownership of grain by
reviewing a warehouse receipt for the assets held in a grain elevator.
    The written agreement required by the proposed rule would require
the accountant to notify the Commission within one business day upon
finding any material discrepancies during the course of its
examination.\245\ This requirement is effectively identical to the
notification requirement for material discrepancies found during a
surprise examination under the custody rule \246\ and would require an
effectively identical decision-making process by the independent public
accountant: the independent public accountant may first take reasonable
steps to establish the basis for believing a material discrepancy
exists. The obligation to notify the Commission arises once the
accountant has a basis for believing there is a material discrepancy.
Ordinarily, an accountant should be able to determine promptly whether
it has a basis for believing there is a material discrepancy.\247\ The
reporting by the independent public accountant of a material
discrepancy would provide the staff with timely notice of a potential
issue with the adviser's custodial practices, providing the staff with
an earlier opportunity to examine an adviser or take other action
against an adviser, as appropriate, in an effort to help safeguard
client assets. This proposed requirement also bears similarities to the
proposed notification requirement for an audit under the proposed
safeguarding rule.\248\
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    \245\ See proposed rule 223-1(b)(2)(iii).
    \246\ See rule 206(4)-2(a)(4)(ii).
    \247\ See 2003 Adopting Release, supra footnote 2, at note 34;
2009 Proposing Release, supra footnote 11, at note 10.
    \248\ See infra, section II.F.
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5. Surprise Examination or Audit
    Like the custody rule, the safeguarding rule would require advisers
relying on the exception to undergo an annual surprise examination or
rely on the audit provision.\249\ In a change from the custody rule,
however, the proposed rule would require each privately offered
security or physical asset not maintained with a qualified custodian to
be verified.\250\ This change from the custody rule is designed to
address our concerns that a loss of these assets could go undetected
for an extended period of time as a result of a not being included
within the accountant's sample to be tested during a surprise
examination or verified during an audit if they do not meet the
threshold for materiality. Moreover, this proposed requirement would
supplement the proposed requirement to verify transactions promptly
after they occur, operating similarly to an annual ``bring down.'' This
would help ensure the client has some comfort regarding the status and
ultimate disposition of these assets over time despite the lack of
ability to monitor quarterly custodial statements. We

recognize that this proposed requirement likely constitutes a departure
from current practice for most surprise examinations and audits, but
believe that the protective benefits of the surprise examination and
annual audit are critical to the safeguarding of client assets,
especially where these assets do not have the additional protections
afforded by the oversight of a qualified custodian.
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    \249\ See rule 206(4)-2(a)(4); 2009 Adopting Release, supra
footnote 11, at section II.B.3. (``Because clients are more
dependent on the adviser with respect to the safeguarding of these
securities, advisory clients may be exposed to additional risks when
their advisers acquire these securities on their behalf. To mitigate
these risks and to provide assurance that privately offered
securities are properly safeguarded, we believe that it is
appropriate to require an independent third-party to verify client
ownership with the issuers of the securities by requiring that these
securities be subject to the surprise examination requirement under
the amended rule.'').
    \250\ See proposed rule 223-1(b)(2)(v).
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    We request comment on all aspects of the proposed exception,
including the following:
    116. Should the rule retain the privately offered securities
exception of the custody rule without any modifications?
    117. Do commenters agree with our understanding that, today, the
overwhelming majority of securities are uncertificated, that the volume
of privately offered securities has vastly expanded since 2003, and
that custodians have developed safeguarding and reporting practices,
particularly with respect to publicly-traded securities? Are we correct
that the custodial market for privately issued securities is less
developed? Do commenters also agree that some custodians will presently
custody privately issued securities and that new custodial services are
being developed?
    118. Should the rule eliminate the current rule's privately offered
securities exception to the requirement to maintain securities with a
qualified custodian, as proposed? Rather than eliminating the custody
rule exception and creating the new safeguarding rule exception for
privately offered securities and physical assets, should the custody
rule exception be retained, but modified in a different way? For
example, should it be made available solely to advisers whose clients'
financial statements are audited and distributed to investors in
accordance with the requirements of this rule? If so, what standard of
independence should an auditor be required to satisfy?
    119. Are we correct in our belief that the privately offered
securities exception may not adequately protect an advisory client from
the broad types of risks the rule is intended to address? If not, in
what ways does the exception provide adequate protections? Are there
alternatives to eliminating the exception and creating the new
exception as proposed that would better serve the proposed rule's
policy goals?
    120. Is our understanding correct that advisers with trading
authority of privately offered securities that do not settle DVP often
have custody of these securities because of the broad general power of
attorney-like authority required to trade these securities?
    121. Are qualified custodians able to provide custody services for
privately offered securities? If so, what services? Would maintaining
these securities with qualified custodians be practically challenging
and/or costly? If so, what are the challenges or cost constraints?
    122. Do commenters agree that the custody rule exception's
restrictions on transferability of privately offered securities do not
provide comparable protections to those provided under the proposed
rule? If commenters disagree, how do these restrictions protect against
misappropriation by the adviser or theft by a third party? Do issuers
and other holders of outstanding securities evaluate whether a
transaction in the securities would result in misappropriation by the
adviser or theft by a third party? Do they have an incentive to
evaluate a transaction for misappropriation or any of the other policy
goals of the rule?
    123. We are proposing to retain the mutual fund shares exception
because, in our experience, this exception has not raised similar types
of investor protection concerns that we are seeking to address in this
proposal.\251\ Do commenters believe that the mutual fund shares
exception raises investor protection risks? Should we eliminate the
exception for mutual fund shares? To what extent do advisory clients
purchase mutual fund shares through qualified custodians such as
broker-dealers such that the exception may not be necessary?
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    \251\ See rule 206(4)-2(b)(1) and proposed rule 223-1(b)(1).
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    124. Our understanding is that certain assets cannot be maintained
with a qualified custodian, but that the bulk of client assets that
advisers service are able to be held by a qualified custodian. Do
commenters agree with this understanding? What are some examples of
assets that cannot be held by a qualified custodian? If an asset cannot
be maintained with a qualified custodian, should an adviser be
permitted to have custody of the asset, as that term is defined in the
proposed rule? Should advisers, instead, be required to relinquish the
authority that triggers the application of the definition of custody in
the context of the asset that is unable to be maintained with a
qualified custodian? Alternatively, should they be required to provide
alternative safeguards for the asset, such as those proposed?
    125. Are there currently assets that qualified custodians will
maintain, but doing so would be cost-prohibitive for advisers or their
clients? If so, what are some examples of these assets? At what point
does it become cost-prohibitive? Is it measured based on a percentage
of the value of the asset? Is it based on a percentage of the adviser's
fee for providing advisory services with respect to that asset? Is it
the point at which it becomes unprofitable for the adviser to provide
advice to the client?
    126. Should the proposed rule permit an adviser to conclude that an
asset is eligible for the exception if it would be prohibitively
expensive to custody the asset with a qualified custodian? What would
be considered prohibitively expensive?
    127. Is the proposed definition of privately offered securities
clear? Should it include any additional factors? Should any of the
proposed factors be removed? For example, is the description of the
meaning of uncertificated clear? Should it be revised? Are there
securities that qualify for the custody rule's description of this term
that would be unable to rely on the proposed exception as a result of
the differences of the proposed definition? Please explain.
    128. Do commenters agree with our belief that ownership of crypto
asset securities that is evidenced through public keys or wallet
addresses on public blockchains would not qualify for the proposed
privately offered securities exception? If not, why? Could the
rationale for the privately offered securities exception--namely, that
impediments to transferability present with certain privately offered
securities mitigate some of the risks and provide some external
safeguards against the kinds of abuse the rule seeks to prevent (loss
and third-party theft) when those assets cannot be maintained by a
qualified custodian--also apply to the custody of crypto asset
securities, the ownership of which is evidenced through public keys or
wallet addresses on public, permissionless blockchains? \252\ If so,
how do the protections work? How do they mitigate some or all of the
risks the rule is designed to address--loss, theft, misappropriation,
misuse, and adviser insolvency or bankruptcy?
---------------------------------------------------------------------------

    \252\ See 2003 Adopting Release, supra footnote 2 at nn. 26-28
and accompanying text.
---------------------------------------------------------------------------

    129. Should we provide a more prescriptive definition of physical
asset? Do commenters believe that there are certain physical assets
that are unable to be maintained with a qualified custodian? If so, do
commenters believe that those assets will remain static as the custody
industry evolves?

    130. Is the term ``physical assets'' sufficiently clear such that
advisers will be able to understand its application and appropriately
utilize the exception? Should we define the term ``physical assets'' or
use another term for this exception, such as ``tangible assets''? If
so, should such a definition include or exclude specific asset types?
What assets are commonly considered to be physical assets that are
unable to be held at a qualified custodian?
    131. Should the proposed rule provide flexibility for advisers to
make a reasonable determination that a privately offered security or
physical asset is eligible for the exception? Are there concerns that
providing advisers with the ability to make a reasonable determination
as to whether a privately offered security or physical asset is
eligible for the exception will allow some advisers to avoid using
qualified custodians to protect client assets? Should the Commission
take a different approach instead?
    132. Should we limit the exception to privately offered securities
and physical assets as proposed? Should we expand the scope of the
exception to other types of assets? If we expanded the scope, which
types of assets should we include and why? Specifically, are there
impediments to transferability present with other types of assets that
mitigate some of the risks and provide some external safeguards against
the kinds of abuse the rule seeks to prevent (loss, third-party theft,
misuse, misappropriation, adviser insolvency/bankruptcy) when those
assets cannot be maintained by a qualified custodian? Please explain
your answer. Alternatively, should we not create an exception for
privately offered securities and physical assets?
    133. Is our understanding correct that the current market for
custodial services of privately offered securities is limited? Is our
understanding correct that demand for these services is also limited?
Do commenters agree with our understanding of the market for custodial
services for physical assets? Please explain.
    134. To be ``reasonable,'' how frequently should advisers determine
whether a qualified custodian can maintain possession or control of an
asset? Should the rule provide flexibility as proposed? Should it
instead specify intervals, such as monthly, quarterly, semi-annually,
or annually?
    135. If we expanded the scope of the exception beyond privately
offered securities and physical assets to other assets that an adviser
reasonably determines cannot be held at a qualified custodian what
requirements should we put in place to ensure the assets are properly
safeguarded? Should such measures include some or all of the
protections for qualified custodians that we discuss in section II.3.C
above?
    136. Rule 206(4)-7 requires advisers to adopt and implement
policies and procedures reasonably designed to prevent violations of
the Advisers Act and its rules, which will include the safeguarding
rule. Should we, nonetheless, prescribe specific written policies and
procedures to be adopted and implemented for determining when privately
offered securities or physical assets would be eligible for the
exception? For example, should any such written policies and procedures
be designed to help ensure that any party involved in maintaining
client assets be required to exercise due care in accordance with
reasonable commercial standards to safeguard client assets? Would this
requirement improve safeguarding of client assets not maintained with a
qualified custodian?
    137. How do advisers currently safeguard securities for which they
rely on the privately offered securities exception under the custody
rule? Do these practices differ from what would be required under the
proposed rule? Please explain. Should these practices be prescribed
under the final rule?
    138. Should we define the term ``reasonably safeguard'' in the rule
text? Do commenters believe that reasonable safeguards are generally
within reasonable commercial standards for particular physical assets
or privately offered securities? Are advisers able to ascertain what
safeguards are within such reasonable commercial standards for
particular physical assets or privately offered securities they may
hold on behalf of clients?
    139. How would an adviser document that it is satisfying its
fiduciary duty to an advisory client when maintaining client assets not
with a qualified custodian under the proposed exception? How frequently
would it be required to provide this evidence?
    140. Should we require a particular standard of care? Should we
require particular safeguards or practices?
    141. Should the rule require an independent public accountant,
pursuant to a written agreement between the adviser and the accountant,
to verify transfers of privately offered securities or physical assets
promptly upon receiving notice from the adviser of any purchase, sale,
or other transfer of beneficial ownership of such assets? Would the
requirement enhance the safeguarding of client assets not maintained
with a qualified custodian and reduce the risk of loss or
misappropriation?
    142. Is the proposed rule's timing requirement that the written
agreement require an independent public accountant to ``promptly''
verify any purchase, sale, or other transfer of beneficial ownership of
such assets sufficiently clear? Is the meaning of the term ``promptly''
in this context sufficiently understood in practice? Is additional
guidance needed? In lieu of the ``promptly'' requirement proposed,
should we require an independent public account to verify any purchase,
sale, or other transfer of beneficial ownership within a set number of
days? If so, how many days? For example, within 24 hours of the
transfer of beneficial ownership? Within 24 hours of receipt of notice
from adviser? Within two days of the transfer of beneficial ownership
or notice from the adviser? Within one week of the transfer of
beneficial ownership or notice from the adviser?
    143. Are we correct in our understanding that independent public
accountants are familiar with asset verification and transaction
tracing procedures? Do commenters believe that there are alternative
procedures that would achieve the policy goals of the rule? Should we
require the independent public accountant to be the same as the
independent public accountant hired to conduct the annual surprise
examination or financial statement audit? Conversely, should we
prohibit this? Would there be benefits to using the same accountant,
such as an ability to leverage work papers from the verification when
performing annual surprise examination or audit procedures? Would there
be benefits to using a different accountant?
    144. Would the 2009 Accounting Guidance contain sufficient guidance
for an accountant that is engaged to perform the proposed verification
procedures around privately offered securities and physical assets that
are not maintained with a qualified custodian? What changes, if any, do
you believe would be necessary to provide adequate direction with
respect to the proposed verification procedures?
    145. Should we require the independent public accountant employed
by the adviser under this exception to verify the transfers to be
registered with and subject to inspection by the PCAOB?
    146. Should the rule require the adviser to notify the accountant
of a transaction within one business day as proposed? Should we require
these notices to be in writing? Alternatively, should the rule require
that the written

agreement between the adviser and the accountant require the adviser to
notify the accountant of a transaction within one business day?
    147. Do commenters agree with our view that this notification
should occur as soon as practicable after the closing of a transfer of
beneficial ownership of assets not custodied with a qualified
custodian? If not, what timeframe do commenters recommend that would
achieve the policy goals of the proposed rule? For example, should we
require the notice be no later than a certain number of hours after the
transaction date? After the settlement date? After money or asset(s)
are sent to a counterparty? After receipt of proceeds of a redemption?
    148. Do commenters agree with our belief that it would not be
challenging for advisers to provide the required notification, as
proposed?
    149. Is there a way to mitigate the risk that an adviser intending
to misappropriate client assets does not comply with the notification
requirement? Should we require other safeguards that limit the risk
that an adviser intentionally or unintentionally fails to comply with
the notification requirement?
    150. Rather than requiring verification by an accountant promptly
after each purchase, sale, or other transfer, as proposed, should we
require timely notification to the auditor and require the auditor to
reconcile each reported purchase, sale, or other transfer reported to
the books and records subject to the annual audit or surprise
examination? Would this provide the same level of protection for client
assets not maintained with a qualified custodian as the prompt
verification requirement proposed? If not, are there nonetheless good
reasons to require annual verification rather than prompt verification?
If we were to require only annual verification, are there other
safeguards that we should require to mitigate the risk of
misappropriation?
    151. Rather than requiring verification by an accountant promptly
after each transfer, as proposed, should the rule require, as part of
the annual surprise examination or annual audit, an accountant to
verify holdings of privately offered securities from one year to the
next and evaluate discrepancies? For example, if a client's account
held assets X, Y, and Z in one year, but only X the following year, the
accountant would evaluate the disposition of assets Y and Z.
    152. Should the rule require the written agreement between the
adviser and the accountant to require the accountant to notify the
Commission within one business day upon finding any material
discrepancies during the course of its examination? Is the material
discrepancy requirement clear or should we provide further guidance
regarding how accountants should make the materiality determination? In
light of the fact that the requirement is effectively identical to the
notification requirement for material discrepancies found during a
surprise examination under the current custody rule, do commenters
believe that the requirement for the accountant to notify the
Commission within one business day upon finding any material
discrepancies would result in ``false positives'' or unnecessary
notifications to the Commission as a result of the one-business-day
reporting timeframe? If so, do commenters recommend a different
timeframe?
    153. Rather than the form of verification and asset tracing
proposed, should the rule require verification procedures substantially
in the form used by independent public accountants under custody rule
206(4)-2(a)(4)?
    154. Should the rule require the independent public accountant to
file a certificate on Form ADV-E stating that it has verified the
transactions and describing the nature and extent of its verification?
If so, when should the certificate be filed? Promptly upon completion
of the verification? Within one business day? Within a certain period
of time after being notified by the adviser? Would such a requirement
enhance the safeguarding of client assets not maintained with a
qualified custodian and reduce the risk of loss or misappropriation?
    155. Should the rule permit other persons or entities to perform
the verification that the rule proposes be performed by the independent
public accountant? For example, should an independent representative be
permitted to perform this function? If so, should the rule retain the
independent representative definition from the current rule? \253\ If
not, what changes should be made? What, if any, procedures should we
require to be performed to verify the transaction, especially for the
broad array of physical assets that may be covered by the rule? Would
an independent representative be equipped to perform verification?
Would such an approach be more or less burdensome than the proposed
approach?
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    \253\ See rule 223-1(d)(4).
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    156. If an independent representative should be permitted to
perform the role we are proposing for an independent public accountant,
should the rule require or prohibit certain parties from acting as an
independent representative? What persons and entities do commenters
believe might act as independent representatives? Do commenters believe
that qualified custodians would be willing to act as independent
representatives? Do commenters believe that a client could serve as its
own independent representative? If so, would that further the policy
goals of the rule? Should there be limits on which clients could serve
as their own independent representative? For example, should those
clients be required to be a qualified purchaser, accredited investor,
or satisfy certain other tests (e.g., net worth, education, licensing)?
Would there be difficulties in locating a sufficient number of
independent representatives to perform this function?
    157. Should we require that the proposed verification procedures
provide a certain level of assurance to investors? If so, what level of
assurance should we require? Should we require the written agreement
specify a required assurance framework that would be applied? Should we
require a reporting mechanism requiring the auditor to communicate the
results of the ongoing verification procedures to the adviser? If so,
how frequently should we require reports and what information should we
require to be included?
    158. As an alternative to the notification and verification
elements of the proposed rule, should we instead require periodic
examinations for privately offered securities and physical assets that
are not maintained with a qualified custodian? If so, should the
procedures be substantially similar as those required for surprise
examinations under current rule 206(4)-2(a)(4)? How frequently should
these examinations occur? Would quarterly be sufficient to reduce the
risk of misappropriation and loss of client assets? Would quarterly
surprise examinations be more or less expensive than the notification
and verification proposed rules?
    159. Are there other challenges with these aspects of the rule, as
proposed? Would this requirement be expensive for advisers, and would
advisers pass those costs along to advisory clients?
    160. Should the rule require asset verification of all client
assets not maintained with a qualified custodian? Would this help
reduce the risk of theft, loss, or misappropriation of client assets?
How common is asset verification for privately held securities? For
physical assets? Should the verification requirement permit sampling of
client accounts, as opposed to verification of assets for all client

accounts? Should advisers with custody of assets not maintained with a
qualified custodian be required to obtain more surprise examinations?
If so, how frequently? Would quarterly or bi-annual asset verification
be more appropriate? Is 100% asset verification of assets in all client
accounts common in other contexts or performed for other purposes
unrelated to the requirements of the custody rule?
    161. Should the rule require that the audit verify all client
assets not maintained with a qualified custodian, which would thus bar
the accountant engaged by the adviser from performing asset sampling
with respect to such assets? Would this help reduce the risk of theft,
loss, or misappropriation of client assets? How common is 100% asset
verification for audits of privately held securities? For physical
assets? Should advisers with custody of assets not maintained with a
qualified custodian be required to obtain more audits? If so, how
frequently? Would quarterly or bi-annual asset audits be more
appropriate? Is 100% asset verification of client assets common in
other contexts or audits performed for other purposes unrelated to the
requirements of the custody rule?
    162. Do audits provide an appropriate level of protection for
clients where an adviser is unable to keep certain assets with a
qualified custodian? If not, why not? In addition to the requirement
that all assets be verified during the annual audit, should we
recommend any specific audit procedures to test that client assets not
kept at a qualified custodian are appropriately safeguarded from loss
or misappropriation?
    163. If an adviser has any assets not maintained with a qualified
custodian, should the rule require asset verification of all assets,
including those assets that are maintained with a qualified custodian
to ensure a complete accounting of all assets occurs as of the audit
date? Are there other controls that could be put in place to ensure
assets are not transferred to satisfy an audit and then returned to
their original location?
    164. Are there risks not discussed above created when an adviser
has custody of privately offered securities or physical assets that are
not maintained with a qualified custodian? If so, what are those risks?
Would the proposed rule sufficiently mitigate those risks? If not, what
additional safeguards should be required?
    165. As an alternative or in addition to any of the safeguards in
the proposed exception, should we require advisers to promptly deliver
a written notice to each client whose assets are not maintained with a
qualified custodian (or the client's independent representative)
containing certain specified information regarding the assets, such as
to inform the client that the assets are not kept by a qualified
custodian and to explain how the client can verify the existence and
ownership of those holdings? Should the notice be required to be
delivered within a certain time to allow an adviser to enter into an
agreement with an entity to maintain the assets? If so, what should
that timing be? Should it be similar to the timing the proposed
exception would require for the adviser to provide notice to the
accountant? Is there additional information that should be required to
be included in the notice?
    166. As an alternative or in addition to any of the safeguards in
the proposed rule, should the rule require that an adviser provide a
quarterly summary of a client's transactions involving assets that are
not maintained with a qualified custodian? Should the summary be more
or less frequent? Should the summary be in a prescribed format or
should certain specific information be required? If the Commission
adopts requirements to send quarterly statements to investors in
private funds as recently proposed,\254\ should that satisfy the
requirement to send these account statements? Should those quarterly
statements be required to be audited as an additional or alternative
condition of the proposed exception?
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    \254\ See, Private Fund Advisers; Documentation of Registered
Investment Adviser Compliance Reviews, Release No. IA-5955 (Feb. 9,
2022) [87 FR 16886] (Mar. 24, 2022).
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    167. As an alternative or in addition to any of the safeguards in
the proposed rule, should we require the adviser to obtain an internal
control report for assets not maintained with a qualified custodian? If
so, what type(s) of internal control report(s) should we require and
why? For example, should it have similar control objectives to the
internal control report we would require of qualified custodians? Who
should prepare such internal control report(s)? For example, should it
be an independent public accountant registered with and subject to
inspection as of the commencement of the engagement period by the
PCAOB? Should we require an adviser to obtain an internal control
report covering all of its internal controls, not just internal
controls relating to the safeguarding of assets not maintained with a
qualified custodian, or is the proposed exception sufficient to address
our policy goals? Would requiring an adviser to obtain an internal
control report be sufficient to mitigate the risks created when an
adviser has custody of client assets that are not maintained with a
qualified custodian?
    168. As an alternative or in addition to any of the elements of the
proposed safeguarding rule, should we require advisers to maintain
insurance to reimburse clients for losses as a result of the advisers'
misconduct? For example, should we require fidelity bonds? Should the
insurance policy limits correspond to the amount of assets not
maintained with a qualified custodian? Should the insurance policy
limits correspond to the amount of all of the assets of which the
adviser has custody? Are policies of this nature common? What costs
would be associated with this kind of insurance? Who would be the payee
of any claims--the client who suffered the loss or the adviser? What
would be the advantages or disadvantages of either approach to payee?
Are these policies occurrence based (the policy that pays on a claim is
the one that is in effect at the time the incident occurred) or based
on when the claims are made (the policy that pays on a claim is the one
that is in effect at the time the claim is made regardless of when the
incident occurred)? What would be the advantages and disadvantages to
occurrence-based or claims-made policies in this context? What are
common exclusions under these policies? Do they cover simple/ordinary
negligence? Does the underwriting process for these policies involve an
evaluation of the adviser's internal controls? Does the underwriting
process take place annually and if so, does it differ from the initial
underwriting assessment? Should the insurance policy be obtained from
an insurer with certain credentials or subject to certain regulatory or
other standards? Please explain.
    169. As an alternative or in addition to any of the elements of the
proposed rule, should we require advisers to have certain capital
requirements? Should capital requirements be required to correspond to
the amount of assets not maintained with a qualified custodian? Should
capital requirements correspond to the amount of all of the assets of
which the adviser has custody? Do advisers often maintain capital
reserves in the event of a client loss as a result of their misconduct?
If yes, is the capital maintained in escrow? If we were to require
financial reserves, should the reserves be maintained in escrow? Who
would be an appropriate escrow agent? And what would be appropriate
terms of the escrow, particularly for release of funds? Should the
capital be maintained

in a particular type of bank account? If yes, what kind of account is
commonly used or would be appropriate for these purposes? Should such a
requirement be conditioned upon using a particular type of bank? What
type? For example, should it be chartered by the OCC? Subject to
Federal Deposit Insurance Corporation oversight? What costs are
associated with escrow accounts and financial reserve/net capital
requirements?
    170. Are there compliance challenges to this proposed exception? If
so, what are they?

D. Segregation of Client Assets

    Though advisers must attain reasonable assurance of segregation of
client assets at a qualified custodian,\255\ the proposed rule also
would require advisers to segregate client assets from the adviser's
assets and its related persons' assets in circumstances where the
adviser has custody. Specifically, the proposed rule would require that
client assets over which an adviser has custody:
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    \255\ See discussion of qualified custodian segregation
requirements at supra section II.(C)(4).
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    (1) Be titled or registered in the client's name or otherwise held
for the benefit of that client;
    (2) Not be commingled with the adviser's assets or its related
persons' assets; and
    (3) Not be subject to any right, charge, security interest, lien,
or claim of any kind in favor of the adviser, its related persons, or
its creditors, except to the extent agreed to or authorized in writing
by the client.\256\
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    \256\ Proposed rule 223-1(a)(1). See also supra footnote 171.
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    Segregation of client assets from the assets of others continues to
be a fundamental element of safeguarding client assets.\257\ This
aspect of the proposed rule is designed to ensure the client's
continued ownership and authorized use of its assets. This proposed
requirement is intended to complement, but serves a slightly different
purpose than the proposed requirement that the adviser obtain
reasonable assurance from the qualified custodian that the client's
assets are similarly segregated. This proposed adviser segregation
provision is critical in light of the fact that some client assets are
not maintained with a qualified custodian.\258\ Moreover, we view it as
essential not only for the custodian, but also for the adviser, to keep
its own proprietary assets and liabilities segregated from client
assets to prevent misuse or misappropriation of client assets.
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    \257\ See supra footnote 168.
    \258\ See proposed rule 223-1(a)(1)(ii)(D).
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    The proposed requirement that a client's assets be titled or
registered in the client's name is designed to ensure that the client's
assets are clearly identified as belonging to the appropriate client,
regardless of whether a qualified custodian is holding the assets. The
proposed rule would also permit advisers to identify the assets ``for
the benefit of'' a particular client where assets may not be ``titled
or registered'' in the client's name. For example, an adviser acting as
a trustee would generally maintain client assets in trust for the
benefit of a particular client for estate planning or other
purposes.\259\ ``For the benefit of'' is also meant to recognize
various ways advisory clients can title or register their investments.
For example, clients may hold securities in ``street name'' or
``nominee name'' through a book-entry account with a broker-dealer, and
the broker-dealer will keep records showing the client as the real or
``beneficial'' owner.\260\ This requirement would protect client assets
even if the assets are maintained with a broker-dealer in such a manner
that gives the broker-dealer legal ownership of, or access to, the
assets.
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    \259\ The client would maintain the beneficial interest in the
trust property and the trustee would hold only legal title without
the benefits of ownership; the trust property is not subject to
personal obligations of the trustee, even if the trustee becomes
insolvent or bankrupt. See section 507 of the Uniform Trust Code
(Jan. 2013).
    \260\ See, e.g., Concept Release on the U.S. Proxy System,
Investment Advisers Act Release No. 3052 (July 14, 2010) [75 FR
42981 (July 22, 2010)] (``Proxy Concept Release'').
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    Similarly, if an adviser purchases privately offered securities
that are held on the books of the issuer or the issuer's transfer
agent, the adviser should ensure that the issuer or transfer agent
properly records and registers the adviser's client as owner. For
example, if the adviser invests in a private fund or purchases private
debt for a client, the records at the private fund's transfer agent or
the private debt issuer should reflect the client as the owner of the
investment. We believe this requirement would safeguard the client's
assets from intentionally or inadvertently becoming someone else's
property as well as prevent circumstances that could result in the
misuse or misappropriation of client assets.
    The proposed rule would also require that client assets not be
commingled with the adviser's assets, or those of its related persons.
The proposed requirement is designed to help ensure that client assets
are isolated and more readily identifiable as client property.\261\
Consequently, we believe the proposed prohibition on commingling would
help protect client assets from claims by a third party looking to
secure or satisfy an obligation of the adviser, including in cases of
insolvency or bankruptcy of the adviser, or its related persons.\262\
We do not intend the prohibition on commingling to preclude traditional
operational practices in which client assets are held together with
other clients' assets. We recognize that some advisers and custodians
regularly service assets in a manner where such assets are reasonably
identifiable from other clients' assets and not subject to increased
risk of loss from adviser misuse or in the case of adviser insolvency.
Accordingly, we request comment on some of these practices and the
potential impact of this prohibition below.
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    \261\ We have taken a similar approach in other contexts. See,
e.g., Financial Responsibility Adopting Release, supra footnote 171
(discussing similar requirements under Rule 15c3-3 that would cause
a broker-dealer to keep customer securities and cash isolated and
readily identifiable as ``customer property'' and, consequently,
available to be distributed to customers in the event that the
broker-dealer is liquidated in a formal proceeding under the
Securities Investor Protection Act of 1970).
    \262\ See, e.g., supra footnote 172.
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    Under the proposed rule, client assets would also be required to
remain free from any right, charge, security interest, lien, or claim
of any kind in favor of the adviser, its related persons, or their
creditors. These requirements are designed to protect client assets by
limiting the ability of an adviser, or its related persons, to use
client assets for their own purposes or in a manner not authorized by
the client. However, we do not intend this condition to limit or
prohibit authorized actions by clients. We are therefore proposing an
exception to these requirements to the extent a client agrees to or
authorizes such arrangements in writing.\263\ In our understanding,
some clients authorize these types of arrangements depending on the
types of assets, products, or strategies in which they invest resulting
in the subject assets being commingled and potentially subject to
certain claims. For example, such an authorization might allow assets
to be subject to a securities lending arrangement authorized by the
client.\264\ In a typical securities lending transaction, the legal
title to loaned securities passes to the borrower for the loan term.
The lender regains title to the securities when the securities are
returned, either upon demand or at the end of a specified

term. Similarly, in a margin account, which is a type of brokerage
account, a broker lends cash to a client to allow the client to
purchase securities. The loan is collateralized by the securities
purchased, other assets in a client account, and cash, and the broker
charges a periodic interest rate.\265\ This proposed exception would
also allow arrangements in which an adviser deducts fees directly from
client assets for the payment for services rendered by the investment
adviser or its related persons, so long as the client authorizes such
payments in writing.
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    \263\ See proposed rule 223-1(b)(7).
    \264\ See proposed rule 223-1(a)(1)(iii).
    \265\ See Uniform Commercial Code, section 8-504 and cmt. 2
(``Margin accounts are common examples of arrangements in which an
entitlement holder authorizes the securities intermediary to grant
security interests in the positions held for the entitlement
holder.'').
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    To the extent a client agrees to or authorizes in writing one of
these, or similar, arrangements, it would be excepted from the proposed
prohibition against subjecting the client's assets to any right,
charge, security interest, lien, or claim in favor of the investment
adviser or a qualified custodian.\266\ Although these activities may
implicate the types of risks the proposed rule is designed to address,
we believe the client is aware of, and consents to, the arrangement for
ease or by necessity to effect a desired activity with respect to its
assets.\267\ Without the ability to authorize such arrangements,
clients would be unable to engage in these potentially beneficial,
authorized activities.
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    \266\ Proposed rule 223-1(a)(3)(iii).
    \267\ See also, Standard of Conduct for Investment Advisers
Release, supra footnote 57, page 8 (noting that although all
investment advisers owe each of their clients a fiduciary duty under
the Advisers Act, that the fiduciary duty must be viewed in the
context of the agreed-upon scope of the relationship and necessarily
depend upon what functions the adviser, as agent, has agreed to
assume for the client, its principal).
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    We believe that proper segregation of client assets, as required by
the three-part requirements of the proposed rule, would mitigate
concerns regarding the safety of a client's assets, particularly when
coupled with the requirement described above that the adviser obtain
reasonable assurance from the qualified custodian that the custodian is
similarly segregating the client's assets.
    We request comment on all aspects of the proposed rule's
requirements for the segregation of investments, including the
following items.