partner, managing member, trustee (or equivalent) for clients that are
private funds; (4) serving as a general partner, managing member,
trustee (or equivalent) for clients that are not private funds; (5)
having a general power of attorney over client assets or check-writing
authority; (6) having a standing letter of authorization; (7) having
physical possession of client assets; (8) acting as a qualified
custodian; (9) a related person with custody that is operationally
independent; and (10) any other reason.\364\ We believe this
information would enhance the quality and utility of the data reported
on the form, enhancing the Commission's ability to exercise oversight
of the safeguarding practices of advisers. We believe this information
may also be beneficial to clients or investors attempting to discern
the reasons why a particular adviser has custody. Further, this updated
format may help market participants to analyze Form ADV data on an
aggregated basis to assess fraud risk more accurately.
---------------------------------------------------------------------------

    \364\ Proposed Form ADV, Part 1A, Item 9.A.(2). Advisers are
currently required to report information with respect to funds and
securities over which their related persons have custody, including
the dollar amount and number of clients whose funds or securities
are in the adviser's custody and whether any related person has
custody of any clients' cash or bank accounts or securities and the
relevant dollar amount and number of clients. See Form ADV, Part 1A
Item 9.A.(2) through, Item 9.B. Based on its responses, an adviser
is also required to report additional custody-related information in
Schedule D of Form ADV, Part 1A.
---------------------------------------------------------------------------

    Fourth, we are also proposing new Item 9.B. requiring an adviser to
indicate whether it is relying on any of the exceptions from the
proposed rule and, if so, to indicate on which exception(s) the adviser
is relying. This information would be valuable for Commission staff to
assess compliance with the proposed rule, and it may also be beneficial
to clients or investors to assess which exception(s) the adviser is
relying upon.
    Fifth, we are proposing to require advisers to report whether
client assets over which they or a related person have custody are
maintained at a qualified custodian and the number of clients and
approximate amount of client assets maintained with a qualified
custodian.\365\ Advisers also would be required to report certain
identifying information about the qualified custodians maintaining
client assets.\366\ Item 9 currently collects only limited information
from advisers about advisers and their related persons that act as
qualified custodians under the rule.\367\ Qualified custodians continue
to serve a critical role in safeguarding client assets under the
proposed rule. Given this important role, we are proposing to require
advisers to report the following information for all qualified
custodians maintaining client assets:
---------------------------------------------------------------------------

    \365\ See proposed Form ADV, Part 1A, Item 9.C.(1)and proposed
Form ADV, Part 1A, Schedule D, section 9.C.(1).
    \366\ Proposed Form ADV, Part 1A, Schedule D, section 9.C.(1).
    \367\ See Form ADV, Part 1A, Item 9.D.(2) and Form ADV, Part 1A,
Schedule D, section 7.A. Advisers are currently required to report
more detailed custodial information about their separately managed
accounts and about the private funds they advise. See Form ADV, Part
1A, Schedule D, section 5.K.(3); Form ADV, Part 1A, Schedule D,
section 7.B.(1)(25).
---------------------------------------------------------------------------

     Full legal name of the qualified custodian;
     Location of the qualified custodian's office responsible
for the services provided;
     Contact information for an individual to receive
regulatory inquiries;
     Type of entity;
     Legal Entity Identifier (if applicable);
     Number of clients and approximate amount of client assets
(rounded to the nearest $1,000) maintained by the qualified custodian;
and

     Whether the qualified custodian is a related person, and
if so, the identifying information for the independent public
accountant engaged to prepare the proposed internal control report and
verification required under the proposed safeguarding rule.\368\
---------------------------------------------------------------------------

    \368\ See proposed Form ADV, Part 1A, Schedule D, section
9.C.(1). This information is similar to the information advisers
currently report regarding separately managed accounts and private
fund custodians. See Form ADV, Part 1A, Schedule D, section 5.K.(3);
Form ADV, Part 1A, Schedule D, section 7.B.(1)(25).
---------------------------------------------------------------------------

    Similarly, we are also proposing revisions to Item 9 that would
require advisers to report information about accountants completing
surprise examinations, financial statement audits, or verification of
client assets under the proposed rule.\369\ We believe requiring
advisers to disclose more detailed information about the qualified
custodians maintaining client assets and the accountants completing
these engagements under the proposed rule would provide useful
information to the public and facilitate the Commission's examination
efforts.
---------------------------------------------------------------------------

    \369\ See proposed Form ADV, Part 1A, Schedule D, section
9.C.(3). Advisers report similar information about the independent
public accountants completing surprise examinations under the
current rule in section 9.C of Form ADV Part 1A Schedule D.
---------------------------------------------------------------------------

    Advisers currently are required to file an other-than-annual-
amendment to Form ADV promptly if certain information provided in
response to Item 9 becomes inaccurate in any way.\370\ Information
triggering this obligation includes whether the adviser or a related
person has custody of client cash, bank accounts, or securities; \371\
the methods by which the adviser complies with the custody rule; \372\
and whether the adviser or a related person acts as a qualified
custodian.\373\ Given the importance of this information, we continue
to believe that advisers should update this information to the extent
it becomes inaccurate. Thus, we are proposing to retain the current
requirement that advisers file an other-than-annual-amendment to Form
ADV promptly if similar information we are proposing to collect on Form
ADV becomes inaccurate.\374\ More specifically, we are proposing to
require an adviser to file promptly an other-than-annual amendment to
Form ADV if any of an adviser's responses regarding the following
becomes inaccurate in any way: (1) whether the adviser has custody of
client assets either directly or because a related person has custody
of client assets in connection with advisory services that the adviser
provides to the client; (2) whether the adviser is relying on certain
exceptions to the proposed rule; (3) whether client assets are
maintained with a qualified custodian; (4) whether the adviser or a
related person serves as a qualified custodian under the proposed rule;
(5) whether client assets are not maintained by a qualified custodian;
(6) whether the adviser is required to obtain a surprise examination by
an independent public accountant under the proposed rule; or (7)
whether the adviser is relying on the audit provision.\375\ An adviser
would be required to update the other information reported in Item 9
(e.g., information about the number of clients and approximate amount
of assets or certain information about qualified custodians) only on
its annual updating amendment, which is the same frequency with which
advisers update similar information on the current form.\376\
---------------------------------------------------------------------------

    \370\ See Form ADV, General Instructions. Advisers, however, are
not required to file an other-than-annual amendment to update
information provided in response to Items 9.A.(2), 9.B.(2), 9.E, and
9.F even if that information becomes inaccurate--though advisers are
required to update this information when filing their next annual
updating amendment. Id.
    \371\ See Form ADV, Item 9.A.(1) and Item 9.B.(1).
    \372\ See Form ADV, Item 9.C.
    \373\ See Form ADV, Item 9.D.
    \374\ See proposed amendments to Form ADV General Instructions.
    \375\ See generally proposed Form ADV, Items 9.A.(1), 9.B.(1),
9.C., 9.D.(1), and 9.E.
    \376\ See proposed amendments to Form ADV, General Instructions.
---------------------------------------------------------------------------

    We request comment on all aspects of proposed revisions to Form ADV
Part 1A, including the following items.
    263. Would the proposed reorganization of Item 9 make it easier for
advisers to complete Item 9 more accurately and eliminate the confusion
created by the current structure or wording of Item 9? Are there other
changes to Item 9 that would make the information reported on that Item
more accurate or less confusing? Is additional guidance needed to
clarify any of the requirements of the proposed revisions?
    264. In proposed Item 9.A.(2), we ask advisers to identify various
ways that they may have custody, directly or indirectly, broken out by
the approximate amount of client assets and number of clients. Based on
our experience, we understand that a client may have several different
advisory accounts. Should we also ask for information at the advisory
account level? Should we ask for information on an account level basis
rather than a client level basis? Would this information be more
meaningful? Why or why not?
    265. In proposed Item 9.B.(2), we ask advisers about which
exception(s) in rule 223-1(b) they are relying upon. Should we also ask
for the approximate amount of assets and number of clients under each
exception? Should we also ask for information at the advisory account
level for each exception? Should we ask for information on an account
level basis rather than a client level basis for each exception? Would
this information be more meaningful? Why or why not?
    266. Would advisers be able to provide the information we are
proposing to collect about qualified custodians? Should we collect
additional or different information from advisers about qualified
custodians? If so, what types of information should advisers be
required to report? Does the proposal seek to collect information about
qualified custodians that would be unnecessary or overly burdensome for
advisers to report? For example, do advisers keep records of the
regulator for foreign financial institutions acting as qualified
custodians? In particular, what information should not be collected and
why? For instance, are there any privacy laws or other legal barriers
that would prohibit or restrict an adviser from reporting this
information about qualified custodians?
    267. Should advisers be required to file promptly an other-than-
annual-amendment to Form ADV when the information provided in response
to certain parts of Item 9 becomes inaccurate? Should an adviser be
required to update promptly only some of this information, as proposed,
or, alternatively, all of this information when it becomes inaccurate?
Are there different items on Form ADV that advisers should have to
update promptly than those proposed?
    268. Is there any additional information an adviser should be
required to report regarding its practices to safeguard client assets?
If so, what types of additional information should advisers be required
to report on Form ADV?
    269. Should advisers be required to report their holdings of
physical assets on Form ADV?
    270. Should advisers be required to report their holdings of
privately offered securities that cannot be recorded and maintained
with a qualified custodian on Form ADV?
    271. Should advisers also be required to report information about
the independent public accountant where the adviser cannot maintain
assets with a qualified custodian?
    272. Should advisers be required to disclose information on Form
ADV regarding sub-custodial, securities depository, or other similar

arrangements about client assets? Do advisers often have this
information?
    273. Should advisers be required to disclose on Form ADV whether
financial statements distributed to investors under the audit provision
comply with U.S. GAAP or another comprehensive body of accounting
standards?
    274. Some of the information we are proposing be reported in
section 9.C.(1) and 9.C.(3) of Schedule D is similar to the information
adviser are required to report in section 7.B.(1) of Schedule D,
particularly as it relates to whether reports provided by independent
public accountants contain unqualified, qualified, or modified
opinions. Should we amend these portions of section 7.B.(1) of Schedule
D to conform with the proposed amendments to section 9.C.(2) and
9.C.(3)?
    275. Where a filing adviser files Form ADV along with a relying
adviser, it is our understanding that some filing advisers may include
the amount of client funds and securities and total number of clients
for which the filing adviser has custody in response to Item 9.A.(2)
and for which the relying adviser has custody in response to Item
9.B.(2) of Form ADV.\377\ Should we provide additional guidance in Form
ADV about how we expect filing and relying advisers to complete Item 9?
If so, please explain.
---------------------------------------------------------------------------

    \377\ See Form ADV and Investment Advisers Act Rules, Advisers
Act Rel. No. 4509 (Aug. 25, 2016) where the Commission amended Form
ADV instructions, among other items, to allow umbrella registration
for a filing adviser and relying advisers.
---------------------------------------------------------------------------

J. Existing Staff No-Action Letters and Other Staff Statements

    Staff in the Division of Investment Management is reviewing certain
of its no-action letters and other staff statements addressing the
application of the custody rule to determine whether any such letters,
statements, or portions thereof, should be withdrawn in connection with
any adoption of this proposal. We list below the letters and other
staff statements that are being reviewed as of the date of any adoption
of the proposed rules or following a transition period after such
adoption. If interested parties believe that additional letters or
other staff statements, or portions thereof, should be withdrawn, they
should identify the letter or statement, state why it is relevant to
the proposed rule, and how it or any specific portion thereof should be
treated and the reason therefor. To the extent that a letter listed
relates both to the custody rule and another topic, the portion
unrelated to the custody rule is not being reviewed in connection with
the adoption of this proposal.

                                             Letters To Be Reviewed
----------------------------------------------------------------------------------------------------------------
         Name of staff statement                                        Date issued
----------------------------------------------------------------------------------------------------------------
All staff statements issued prior to the  Various Dates.
 2003 Commission Adopting Release.
American Bar Association (Question 1,     December 8, 2005.
 Custody Rule Section, only).
American Bar Association (Question D      August 10, 2006.
 only).
Deloitte & Touche LLP...................  August 28, 2006.
Investment Adviser Association..........  September 20, 2007.
Investment Company Institute............  September 5, 2012.
Investment Adviser Association..........  April 25, 2016.
Investment Adviser Association..........  February 21, 2017.
Madison Capital Funding, Inc............  December 20, 2018.
Robert Van Grover, Esq., Seward and       December 11, 2019.
 Kissel LLP.
Privately Offered Securities Under the    August 2013.
 Investment Advisers Act Custody Rule,
 Investment Management Guidance Update
 (``IMGU'') 2013-04.
Private Funds and the Application of the  June 2014.
 Custody Rule to SPVs and Escrows, IMGU
 2014-07.
Inadvertent Custody, IMGU 2017-01.......  February 2017.
Staff Responses to Questions About the    Issued on various dates since 2003.
 Custody Rule (all).
----------------------------------------------------------------------------------------------------------------

K. Transition Period and Compliance Date

    We are proposing a one-year transition period to provide time for
advisers to come into compliance with the following if they are
adopted: redesignation of rule 206(4)-2 as new rule 223-1, and
corresponding amendments to rule 204-2 and Form ADV, as applicable.
Accordingly, we propose that the compliance date of any adoption of
this proposal would be one year following the rules' effective dates
which would be sixty days after the date of publication of the final
rules in the Federal Register for advisers with more than $1 billion in
regulatory assets under management (``RAUM''). For advisers with up to
$1 billion in RAUM, we propose that the compliance date of any adoption
of this proposal would be 18 months following the rules' effective
dates which would be sixty days after the date of publication of the
final rules in the Federal Register. If adopted as proposed,
approximately 10,454 advisers, which represents approximately 69% of
all registered advisers and 2.5% of the total RAUM of all advisers,
would be subject to the longer, 18 month transition period.\378\ The
chart below indicates the impact applying different RAUM threshold
would have on the number of advisers subject to the proposed 18-month
transition period.\379\
---------------------------------------------------------------------------

    \378\ As of June 2022, 15,062 investment advisers were
registered with the Commission and reported a total of $128.96
trillion in RAUM, while 10,454 advisers reported having less than $1
billion in RAUM, while the aggregate RAUM reported by these advisers
as of June 2022 was approximately $3.2 trillion.
    \379\ The data in the table is based upon data reported by
advisers as of June 2022.

----------------------------------------------------------------------------------------------------------------
                                                                                Percent of
                                                     Number of      Percent of     Total RAUM of   total RAUM of
                    Threshold                     advisers under  advisers under  advisers under  advisers under
                                                     threshold       threshold       threshold       threshold
----------------------------------------------------------------------------------------------------------------
$500 million....................................           8,396            55.4            $1.7             1.3
1 billion.......................................          10,454            69.0             3.2             2.5
1.5 billion.....................................          11,448            75.5             4.4             3.4

2 billion.......................................          11,987            79.1             5.3             4.1
2.5 billion.....................................          12,378            81.6             6.2             4.8
3 billion.......................................          12,657            83.5             6.9             5.4
3.5 billion.....................................          12,859            84.8             7.6             5.9
4 billion.......................................          13,044            86.0             8.3             6.5
4.5 billion.....................................          13,215            87.2             9.0             7.0
5 billion.......................................          13,357            88.1             9.7             7.6
10 billion......................................          13,994            92.3            14.1            11.0
----------------------------------------------------------------------------------------------------------------

    Under this proposal, advisers could continue to rely on current
rule 206(4)-2, rule 204-2, and Form ADV until the compliance date. We
are proposing that once the rules become effective, advisers may
voluntarily comply with them in advance of the compliance date. To
promote regulatory consistency, however, we are proposing that any
adviser that elects to rely, prior to the compliance date, on the
effective rule 223-1 must also comply with, as applicable, the amended
rule 204-2 and the amended Form ADV beginning at the same time.
    We request comments on the proposed transition period:
    276. Do commenters agree that a one-year transition period
following each rule's effective date is appropriate for advisers with
more than $1 billion in RAUM? Should the period be shorter or longer?
For example, would six months be an appropriate amount of time?
Alternatively would 18 months be necessary? Do commenters agree that an
18-month transition period following each rule's effective date is
appropriate for advisers with up to $1 billion in RAUM? Should the
period be shorter or longer? For example, would one year be an
appropriate amount of time? Alternatively would 24 months be necessary?
Should there be different compliance dates for different types of
advisers, such as advisers to pooled investment vehicles or advisers to
separate account clients? Should the $1 billion threshold for the
different compliance groups be higher or lower?
    277. Should the transition period be the same for proposed new rule
223-1 and amendments to rule 204-2 and Form ADV? Should we permit that
once the rules become effective, advisers may voluntarily comply with
them in advance of the compliance date, and require that any adviser
that elects to rely on new rule 223-1 prior to the compliance date must
also comply beginning at the same time with the amended rule 204-2 and
amended Form ADV? Does this promote regulatory consistency, and if not,
why not?
    278. Should we also require that any adviser that elects to rely on
rule 223-1 and amended rule 204-2 and amended Form ADV prior to the
compliance date must also cease to rely on Commission and staff letters
and other statements that would be withdrawn on the compliance date?
    279. Should the transition period vary for different rule
requirements? For example, would advisers need 18 months to comply with
the proposed amendments to the qualified custodian provisions and three
months to comply with the exception from the surprise examination for
SLOAs? Please explain your answer and suggest transition period
durations.

III. Economic Analysis

A. Introduction

    We are mindful of the costs imposed by, and the benefits obtained
from, our rules. Section 202(c) of the Advisers Act provides that when
the Commission is engaging in rulemaking under the Act and is required
to consider or determine whether an action is necessary or appropriate
in the public interest, the Commission shall also consider whether the
action will promote efficiency, competition, and capital formation, in
addition to the protection of investors. The following analysis
considers, in detail, the likely significant economic effects that may
result from the proposed rule amendments, including the benefits and
costs to investors and other market participants as well as the broader
implications of the proposed rule amendments for efficiency,
competition, and capital formation.
    Where possible, the Commission quantifies the likely economic
effects of its proposed amendments and rules. However, the Commission
is unable to quantify certain economic effects because it lacks the
information necessary to provide estimates or ranges of costs.
Additionally, in some cases, quantification would require numerous
assumptions to forecast how investment advisers and other affected
parties would respond to the proposed amendments, and how those
responses would in turn affect the broader markets in which they
operate. In addition, many factors determining the economic effects of
the proposed amendments would vary significantly among investment
advisers. Investment advisers vary in size and sophistication as well
as the assets on which they provide advice. As a result, investment
advisers' existing practices and the extent to which investment
advisers qualify for exceptions from the rule varies, making it
inherently difficult to quantify economic effects. Even if it were
possible to calculate a range of potential quantitative estimates, that
range would be so wide as to not be informative about the magnitude of
the benefits or costs associated with the proposed rule. Many parts of
the discussion below are, therefore, qualitative in nature. As
described more fully below, the Commission is providing a qualitative
assessment and, where practicable, a quantified estimate of the
economic effects.

B. Broad Economic Considerations

    Investors rely on the asset management industry for a wide variety
of wealth management and financial planning functions. These services
are critical for investors to plan for the future and diversify their
investment risks. Investment advisers are a key part of this industry,
as they provide investment advice to investors and clients about the
value of, or about investing in, securities and other investment
products.\380\
---------------------------------------------------------------------------

    \380\ See, e.g., https://www.investor.gov/introduction-investing/investing-basics/glossary/investment-adviser.
---------------------------------------------------------------------------

    When performing services for investors and clients, an adviser may
frequently have access to client assets, exposing them to the risk of
loss, misuse, theft, or misappropriation. This gives rise to a
principal-agent problem between investors and clients (the principals)
on the one hand and their

investment advisers (the agents) on the other. This is because, while
advisers face relevant competitive market forces and therefore have
private reputational incentives to maintain some level of oversight and
internal controls, as discussed below market failures can lead their
chosen levels of oversight and control to be sub-optimally low. The
current custody rule, which the Commission has amended over time, has
been designed to deter such behavior and alleviate these market
failures in part by relying on a third party, a qualified custodian, in
safeguarding client assets. While requiring the use of a qualified
custodians helps mitigate the principal-agent problem between
investors, clients, and their advisers, the introduction of an
additional agent--the custodian--introduces the potential for
additional principal-agent conflicts.
    Such principal-agent problems provide the economic rationale for
revised Commission rules aimed at further mitigating the underlying
market failures.\381\ Specifically, in the absence of targeted
regulation, principal-agent problems can result when investment
advisers and custodians have different preferences and goals than
clients. As a result, investment advisers and custodians might take
actions that increase their well-being at the expense of imposing
agency costs on investors and clients.\382\ For example, a custodian
may not have sufficient incentive to provide custodial account records
to an independent public accountant on a timely basis, to the extent
providing a timely response is burdensome to a custodian. This would
make adviser compliance with the audit provision, surprise examination,
or Form ADV-E filing provisions of the rule more difficult, which would
ultimately be to the disadvantage of clients.
---------------------------------------------------------------------------

    \381\ As discussed above in section I, there have been market
developments that suggest a need to better protect client assets by
broadening the scope of the application of the rule and by improving
its efficacy.
    \382\ See, e.g., Michael C. Jensen & William H. Meckling, Theory
of the Firm: Managerial Behavior, Agency Costs and Ownership
Structure, 3 J.Fin. Econ. 305 (1976).
---------------------------------------------------------------------------

    Market forces generally provide some incentive for principals and
agents to mitigate principal-agent conflicts. Advisers that effectively
mitigate conflicts, for example, by offering targeted private contract
terms, may, all else being equal, gain a reputational advantage that
will help them in retaining and attracting investors and clients. The
assurance provided by such terms, however, would depend on both
investors' perception of the costs of enforcing the terms, as well as
the likelihood that disputes would be resolved in investors'
favor.\383\ A market failure may exist to the extent that more costly
enforcement of the contract and more unpredictable favorable outcomes
reduce the effectiveness of the contract in mitigating conflicts of
interest between clients and investment advisers. Factors affecting the
cost of enforcement in the context of investment advice may include:
(1) the cost of verifying adviser conduct, (2) the extensiveness and
complexity of services over which the terms apply, and (3) the ability
of investors, who likely lack specialized knowledge, to understand how
adviser conduct relates to the terms.\384\
---------------------------------------------------------------------------

    \383\ See, e.g., Andrei Shleifer, ``Efficient Regulation'',
(2010), available at http://www.nber.org/papers/w15651 (``Shleifer
paper''), for a general discussion of these points.
    \384\ See Shleifer paper for a general discussion of factors
affecting the cost of enforcement of the terms and the
predictability of favorable legal outcomes. Several factors may also
affect an investor's assessment of a favorable legal outcome should
the investor believe an adviser to have violated the contractual
terms. First, while investors may believe an adviser has violated
the terms, investors may be uncertain of their ability to verify
such conduct. Second, given the potentially complex fact patterns of
litigation related to the provision of investment advice, investors
may believe that there is some chance that courts will simply ``get
it wrong.'' Third, advisers may have access to substantially greater
financial resources than investors. Investors may believe that the
financial inequality between themselves and advisers makes a
favorable legal outcome less likely. An investment adviser's
fiduciary duty to their clients could mitigate the incentive for an
adviser to provide fewer terms that protect investors. The ability
of the adviser's fiduciary duty to mitigate the incentive for an
adviser to provide fewer terms that protect investors will depend on
factors affecting the cost of enforcing that duty. See, Frank H.
Easterbrook & Daniel R. Fischel, ``The Economic Structure of
Corporate Law,'' 1991, Harvard University Press.
---------------------------------------------------------------------------

    When the incentives of advisers or custodians do not sufficiently
align with investors' or clients' interests, and market failures
prevent market participants from effectively resolving these conflicts
of interest via private contracting, targeted regulatory requirements
can help increase the level of investor protection. The investor
protection benefits of such regulatory requirements will depend,
however, on an adviser's ability and incentive to comply with the
requirements. Encouraging or requiring independent oversight and
verification of adviser conduct is one way to incentivize
compliance.\385\ For example, an adviser is less likely to engage in
unauthorized trading in a client's account when the adviser knows that
the client will be receiving an account statement detailing any trading
activity. Similarly, an adviser is less likely to misappropriate client
assets when it knows that an independent public accountant is required
to verify client assets.\386\
---------------------------------------------------------------------------

    \385\ Even in the absence of such a regulatory requirement, an
adviser could contractually offer independent oversight and
verification of its conduct to its investors and clients. However,
there may be practical impediments, such as the lack of specialized
knowledge, which may lead investors to not seek out such terms. In
addition, individual negotiation of contracts may be less cost
effective than a market-wide regulatory solution.
    \386\ See, e.g., Stephen G. Dimmock & William W. Gerken,
``Predicting fraud by investment managers,'' 105 J. Fin. Econ. 153
(Aug. 2011). This article finds that monitoring is a significant
predictor of investment fraud. For example, large investors who have
stronger incentive and greater ability to monitor are associated
with fewer frauds. Also see, e.g., Ben Charoenwong, Alan Kwan &
Tarik Umar, ``Does Regulatory Jurisdiction Affect the Quality of
Investment-Adviser Regulation?,'' 109 Am. Econ. Rev., Am. Econ.
Ass'n. 3681 (Oct. 2019). This article finds that registered
investment advisers that are costlier for state regulators to
supervise, or primarily serve less sophisticated investors, receive
more complaints.
---------------------------------------------------------------------------

    There are three ways in which regulation facilitating clients' and
third parties' oversight of advisers' conduct through verification of
client assets can reduce potential harm to investors and clients.
First, such regulation can increase the likelihood that any non-
compliant behavior by advisers is detected. Second, it can increase the
likelihood that any non-compliant behavior is detected sooner,
potentially mitigating loss to clients. Third, and perhaps most
importantly, facilitating verification of client assets would likely
have a prophylactic effect, countering the incentive for non-compliant
behavior by advisers. Indirectly, regulation that enhances verification
of client assets also reduces potential harm to clients by facilitating
detection of non-compliant behavior by the qualified custodians with
whom the clients have custody agreements, potentially mitigating client
losses and deterring non-compliant behavior by custodians. This
ameliorates principal-agent problems between the client and the
qualified custodian and facilitates advisers' exercise of fiduciary
duty over client assets held by the qualified custodian.\387\
---------------------------------------------------------------------------

    \387\ For those custodians that are registered broker-dealers,
it also facilitates compliance with their obligations under Exchange
Act Rule 15c3-3.
---------------------------------------------------------------------------

    Finally, the ability to oversee investment advisers' (and
custodians') conduct through verification of client assets depends on
the quality of the third party's verification processes and the
independence of the third party.\388\ Generally, a higher quality
verification process is one that has an increased likelihood of
detecting misconduct.\389\

Similarly, a more independent third party is one that is more likely to
report misconduct or violations of regulatory requirements that it
detects.\390\ Regulation designed to enhance the quality of third-party
verification processes and/or enhance the independence of third
parties, then, generally enhances the ability of third parties to
oversee investment advisers' conduct.
---------------------------------------------------------------------------

    \388\ See, e.g., Ross L. Watts & Jerold L. Zimmerman, ``Positive
Accounting Theory: A Ten Year Perspective,'' 65 Acc. Rev. 131 (Jan.
1990).
    \389\ The use of PCAOB-registered independent public accountants
is required for certain engagements under the current rule. In
particular, a PCAOB-registered independent public accountant is
required to perform surprise examinations and periodically inspect
internal controls under the current rule when an adviser or its
related person serves as a qualified custodian for client assets,
and a PCAOB-registered independent public accountant must audit the
financial statements of a pooled investment vehicle to be deemed to
be in compliance with the surprise examination requirement. See
current rule 206(4)-2(a)(6) and (b)(4). As the Commission noted in
adopting these requirements in 2009, the Commission has greater
confidence in the quality of audits conducted by an independent
public accountant registered with, and subject to regular inspection
by, the PCAOB. See 2009 Adopting Release, supra footnote 11, at 17.
    \390\ See, e.g., Ross L. Watts & Jerold L. Zimmerman, ``Agency
Problems, Auditing and the Theory of the Firm: Some Evidence,'' 26
J.L. Econ. 613 (1983).
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C. Baseline

    The Commission assesses the economic effects of the proposed
amendments relative to the baseline of existing requirements and
practices of advisers.
1. Current Regulation
a. Custody
    As discussed in greater detail in section II above, the regulatory
framework regarding safeguarding of investment adviser client assets is
set forth in rule 206(4)-2, which applies to any investment adviser
registered or required to be registered with the Commission under
section 203 of the Act that has custody of client funds or
securities.\391\ As defined by the current rule, ``custody'' means that
the investment adviser, or its related persons, holds, directly or
indirectly, client funds or securities, or has any authority to obtain
possession of them.\392\
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    \391\ See rule 206(4)-2(a). Our exam program commits significant
resources ensuring advisers are in compliance with the custody rule
and verifying the existence of investor assets at custodians--a
process called asset verification. In FY 2022, EXAMS verified over
2.1 million investor accounts, totaling over $2 trillion.
    \392\ Rule 206(4)-2(d)(2). The Commission stated in 2003,
however, that because a one-for-one exchange of assets represents a
limited risk of client loss, an adviser's authority to issue
instructions to a broker-dealer or another custodian to effect or to
settle trades does not constitute ``custody'' under the current
rule. See 2003 Adopting Release at footnote 10. See also rule
206(4)-2(d)(7), defining ``related person'' as ``any person,
directly or indirectly, controlling or controlled by [the investment
adviser], and any person that is under common control with [the
investment adviser].''
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    The current rule requires such advisers to maintain all funds and
securities of which the adviser has custody with a ``qualified
custodian'' in separate accounts under that client's name or in
accounts containing only the funds and securities of such adviser's
clients, under the adviser's name as agent or trustee, subject to
certain exceptions.\393\ Qualified custodians generally include banks
and savings associations, broker-dealers, futures commission merchants,
and certain FFIs \394\--all of which are financial institutions that
are currently subject to regular government oversight and are subjected
to periodic inspection and examination.\395\
---------------------------------------------------------------------------

    \393\ See rule 206(4)-2(a)(1).
    \394\ See rule 206(4)-2(d)(6).
    \395\ See supra footnote 89.
---------------------------------------------------------------------------

    The current rule generally requires an adviser with custody of
client assets to obtain an annual surprise examination from an
independent public accountant to verify client funds and securities
independently.\396\ With certain exceptions, the adviser must report on
Form ADV whether it or its related person has custody of an advisory
client's cash, bank accounts, and securities, and disclose the details
of the custodial relationship (including, inter alia, dollar amounts,
total number of clients, distribution of quarterly account statements,
audits, annual surprise examinations, and internal control
reports).\397\
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    \396\ See rule 206(4)-2(a)(4). A 2013 Government Accountability
Office (GAO) study, which examined 12 average-sized registered
advisers, found that the cost of surprise examinations ranged from
$3,500 to $31,000. The GAO noted that the costs of surprise
examinations vary widely across advisers and are typically based on
the amount of hours required to conduct the examinations, which is a
function of a number of factors including the number of client
accounts under custody. See Gov't Accountability Office, GAO-13-569,
Investment Advisers: Requirements and Costs Associated with the
Custody Rule (2013), https://www.gao.gov/assets/gao-13-569.pdf.
    \397\ 17 CFR 279.1; Form ADV, Part 1A, Item 9; see also supra
notes 268-69, 271, 274-77.297, 303-309. An adviser must also include
a notice in its brochure concerning its qualified custodian's
account statement obligations, and a disclosure in its balance sheet
of any financial conditions that are reasonably likely to impair the
adviser's ability to meet contractual commitments to clients, when
the adviser has discretionary authority or custody over client funds
or securities. See Form ADV, Part 2A, Items 15, 18.
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    In situations where the adviser or a related person acts as
qualified custodian, the current rule requires advisers to obtain, or
receive from its related person, an annual internal control report with
respect to the adviser's or related person's custody controls, which
includes an opinion from an independent public accountant that is
registered with, and subject to regular inspection by, the PCAOB.\398\
The required internal control report addresses the greater custodial
risks associated with situations where an adviser, or its related
person, acts as a qualified custodian.\399\
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    \398\ See rule 206(4)-2(a)(6). The surprise examination must
also be conducted by a PCAOB-registered and inspected independent
public accountant. See Custody Rule Amendments Adopting Release,
supra footnote 11 (stating that the internal control report should
address control objectives and associated controls related to the
areas of client account setup and maintenance, authorization and
processing of client transactions, security maintenance and setup,
processing of income and corporate action transactions,
reconciliation of funds and security positions to depositories and
other unaffiliated custodians, and client reporting).
    \399\ As noted in the Custody Rule Amendments Adopting Release,
supra footnote 11, the surprise examination alone does not
adequately address custodial risks associated with self-custody or
related-person custody because the independent public accountant
seeking to verify client assets would rely, at least in part, on
custodial reports issued by the adviser or its related person. The
internal control report can significantly strengthen the utility of
the surprise examination when the adviser or its related person acts
as qualified custodian for client assets because it provides a basis
for the independent accountant performing the surprise examination
to obtain additional comfort that the confirmations received from
the custodian are reliable.
---------------------------------------------------------------------------

    The current rule's requirements are, however, subject to certain
exceptions. Specifically, the current rule provides an exception to the
requirement to maintain securities with a qualified custodian for
certain ``privately offered securities''.\400\ The current rule also
provides that advisers need not comply with the requirements of rule
206(4)-2 with respect to the accounts of registered investment
companies,\401\ and allows shares of mutual funds to be maintained with
the fund's transfer agent in lieu of a qualified custodian.\402\ In
addition, an adviser that has custody solely because of its authority
to deduct advisory fees, or because a related person has custody and
such related person is operationally independent of the adviser, is not
required to obtain an annual surprise examination.\403\
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    \400\ See rule 206(4)-2(b)(2). As discussed in section II.C, we
understand that demand for custodial services of privately offered
may be thin.
    \401\ See rule 206(4)-2(b)(5).
    \402\ Rule 206(4)-2(b)(1).
    \403\ See rule 206(4)-2(b)(3), (6).
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    The current rule also requires that certain communications be made
to clients. An investment adviser is required to provide its clients
notice if the adviser establishes an account with a qualified custodian
on a client's behalf.\404\ Advisers must also have a

reasonable basis, after due inquiry, for believing that the qualified
custodian sends an account statement, at least quarterly, to each of
the adviser's applicable clients.\405\ When an adviser has custody of
funds and securities belonging to a client that is a pooled investment
vehicle, these account statements must be sent to each limited partner,
member, or other beneficial owner if the adviser or its related person
is a general partner of a limited partnership, managing member of a
limited liability company, or holds a comparable position for another
type of pooled investment vehicle.\406\
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    \404\ See rule 206(4)-2(a)(2).
    \405\ See rule 206(4)-2(a)(3).
    \406\ See rule 206(4)-2(a)(5).
---------------------------------------------------------------------------

    An adviser is not required to comply with the notice and account
statement delivery requirements of the rule and shall be deemed to
comply with the surprise examination requirement with respect to the
account of a limited partnership or other pooled investment vehicle
that is subject to annual audit, provided certain conditions are
satisfied (the ``current audit provision'').\407\ To rely on the
current audit provision, the pool's financial statements must, among
other things, be prepared in accordance with U.S. GAAP and distributed
to all limited partners (or other beneficial owners) within 120 days of
the end of the pool's fiscal year. The current audit provision also
requires the auditor to be registered with and subject to inspection by
the PCAOB.
---------------------------------------------------------------------------

    \407\ See rule 206(4)-2(b)(4).
---------------------------------------------------------------------------

b. Recordkeeping
    Rule 204-2 applies to any investment adviser registered or required
to be registered with the Commission under section 203 of the Act. This
rule requires, among other things, that an adviser make and keep a list
or other record of all client accounts for which the adviser has any
discretionary power,\408\ and copies of internal control reports
obtained or received pursuant to current rule 206(4)-2.\409\ Rule 204-2
also currently requires investment advisers subject to rule 206(4)-2 to
make and keep records regarding all purchases, sales, receipts and
deliveries of securities for such accounts and all other debits and
credits to such accounts, separate ledgers for such accounts, copies of
confirmations of all effected transactions, a record for each security
in which any such client has a position, and a memorandum describing
the basis upon which the adviser has determined that the presumption
that any related person is not operationally independent has been
overcome.\410\
---------------------------------------------------------------------------

    \408\ See rule 204-2(a)(8).
    \409\ See rule 204-2(a)(17)(iii).
    \410\ See rule 204-2(b).
---------------------------------------------------------------------------

c. Regulation of Qualified Custodians
    Finally, other regulations affect entities' responsibilities as
qualified custodians, namely, banks and savings associations, broker-
dealers registered with the Commission, futures commission merchants
registered with the CFTC, and FFIs. A broker-dealer acting in the
capacity of a custodian is subject to Exchange Act Rule 15c3-3, under
which customers' assets must be segregated from proprietary assets to
permit prompt return in the event of the firm's liquidation in a
proceeding under the Securities Investor Protection Act of 1970; \411\
and, where applicable, to FINRA rule 2231, requiring broker-dealers'
statements of assets to be sent to customers not less than quarterly.
Futures commission merchants are subject to Commodities Exchange Act
sections 4d(a)(2) and 4d(b) and regulations issued thereunder, which
require segregation of client funds from the entities' funds, and
impose related accounting and recordkeeping requirements.\412\ Banks
and savings associations are also subject to regulation with respect to
their custodial services. For example, under applicable Treasury
regulations, generally, a depository institution holding government
securities for its customers must segregate the customer's securities
from its own assets, free of any lien, charge, or claim of any third
party granted or created by such custodian; and it may lend the
securities to a third party only by written agreement with the customer
and in full compliance with the appropriate regulatory agency.\413\
Additionally, national banks and Federal savings associations are
subject to OCC regulations when providing fiduciary custody
services,\414\ and the OCC has provided substantial guidance with
respect to these firms' non-fiduciary custody services.\415\ As a
result, banks and savings associations have developed and deployed
comprehensive custodial service agreements governing their
relationships with their custodial customers. In addition, depository
institutions are subject to the long-standing, efficient orderly
resolution process deployed by the FDIC and non-depository member banks
are subject to the efficient orderly resolution process by the OCC.
Finally, as noted in part II.C.1, some FFIs are regulated in their
local jurisdictions and subject to laws and regulations established by
their national jurisdictions to combat money laundering and terrorism
financing, consistent with standards and measures recommended by the
FATF.
---------------------------------------------------------------------------

    \411\ 17 CFR 240.15c3-3. Specifically, see Rule 15c3-3(b)(1)
(requirement for a broker-dealer to promptly obtain and maintain the
physical possession or control of all fully-paid securities and
excess margin securities carried for the account of customers);
(e)(1) (requiring every broker-dealer to maintain with a bank a
``Special Reserve Bank Account for the Exclusive Benefit of
Customers'' and a ``Special Reserve Bank Account for Brokers and
Dealers,'' separate from each other and from the broker-dealer's
other bank accounts); and (f) (requiring written notification that
the bank was informed that cash or securities are being held for the
exclusive benefit of the broker-dealer's customers and account
holders, separate from the broker-dealer's other accounts; and that
the broker-dealer must have a written contract with the bank
providing that the cash or securities will not be used as security
for a loan to the broker-dealer by the bank, and will not be subject
to any right, charge, security interest, lien, or claim in favor of
the bank or any person claiming through the bank).
    \412\ 7 U.S.C. 6d(a)(2), 6d(6); 17 CFR 1.20-1.30, 1.32, 1.36.
    \413\ 17 CFR 450.4(a)(1), (a)(6).
    \414\ See 12 CFR 9.1 et seq. (rules governing fiduciary powers
of national banks); 12 CFR 150.10 et seq. (rules governing fiduciary
powers of Federal savings associations).
    \415\ See generally OCC Custody Handbook, supra note 237.
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d. Accredited Investors
    Aspects of the proposed rule address investments in privately
offered securities such as investments in private companies, and
offerings made by certain hedge funds, private equity funds, and
venture capital funds.\416\ Congress and the Commission have provided
exemptions for these offerings based on various factors, including that
the offerings are generally limited to individuals and entities (e.g.,
accredited investors) that do not require the protection of
registration.\417\ Under Commission rules, qualifying as an accredited
investor allows an investor to participate in investment opportunities
that are generally not available to non-accredited investors, including
certain investments in private companies and

offerings by certain hedge funds, private equity funds, and venture
capital funds.
---------------------------------------------------------------------------

    \416\ The Securities Act of 1933 contains a number of exemptions
from its registration requirements and authorizes the Commission to
adopt additional exemptions.
    \417\ Historically, the Commission has stated that the
accredited investor definition is ``intended to encompass those
persons whose financial sophistication and ability to sustain the
risk of loss of investment or fend for themselves render the
protections of the Securities Act's registration process
unnecessary.'' See Regulation D Revisions; Exemption for Certain
Employee Benefit Plans, Release No. 33-6683 (Jan. 16, 1987) [52 FR
3015 (Jan. 30, 1987)]. See also SEC v. Ralston Purina Co., 346 U.S.
119, 125 (1953) (taking the position that the availability of the
section 4(a)(2) exemption ``should turn on whether the particular
class of persons affected needs the protection of the Act. An
offering to those who are shown to be able to fend for themselves is
a transaction `not involving any public offering' '').
---------------------------------------------------------------------------

e. Effect of State Law
    The relationship between clients and qualified custodians is also
governed by the common law of agency and contracts, and--to the extent
adopted under state law--corresponding articles of the Uniform
Commercial Code (UCC).\418\ Thus under sections 8-504 and 8-509 of the
UCC, unless otherwise agreed to, and unless duties are specified
otherwise by statute, regulation, or rule, a custodian ``may not grant
security interests in a financial asset it is obligated to maintain''
for the client and must exercise ``due care in accordance with
reasonable commercial standards to obtain and maintain the financial
asset.'' \419\
---------------------------------------------------------------------------

    \418\ See supra footnotes 157, 159.
    \419\ U.C.C. 8-504(b), (c), 8-509(a) (Am. L. Inst. & Unif. L.
Comm'n 2021).
---------------------------------------------------------------------------

2. Affected Parties and Industry Statistics
    The proposed amendments would affect registered investment
advisers, and those required to be registered, as well as current and
prospective clients of investment advisers, qualified custodians, and
independent public accountants.
a. Investment Advisers
    As of June 2022 there were 15,062 investment advisers registered
with the SEC. Registered investment advisers reported $128.96 trillion
in RAUM with $117.57 trillion in 47.51 million accounts over which
advisers have discretionary authority and $11.38 trillion in 14.55
million accounts over which advisers do not have discretionary
authority.\420\ The average RAUM among registered investment advisers
was $8.56 billion and the median was $427.53 million.
---------------------------------------------------------------------------

    \420\ The term ``regulatory assets under management'' or
``RAUM'' refers to an adviser's assets under management as reported
in response to Item 5.F. of Part 1A of Form ADV. See Form ADV:
Instructions for Part 1A, instr. 5.b. (setting forth instructions
for calculation of assets under management for regulatory purposes).
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b. Clients
    Form ADV requires investment advisers to indicate the approximate
number of advisory clients and the amount of total RAUM attributable to
various client types.\421\ Table 1 provides information on the number
of client accounts, total RAUM, and the number of advisers by client
type.
---------------------------------------------------------------------------

    \421\ If a client fits into more than one category, Form ADV
requires an adviser to select one category that most accurately
represents the client (to avoid double counting clients and assets).

                                       Table 1--Investment Adviser Clients
----------------------------------------------------------------------------------------------------------------
                                                                     Number of                      Registered
                           Client type                                clients       Total RAUM      investment
                                                                    (thousands)     (billions)       advisers
----------------------------------------------------------------------------------------------------------------
Investment Companies............................................              25         $43,838           1,603
Pooled investment vehicles--Other...............................              95          34,584           5,763
High net worth individuals......................................           6,917          11,832           8,989
Pension Plans...................................................             431           8,106           5,271
Insurance Companies.............................................              13           7,630           1,028
Non-high net worth individuals..................................          43,824           7,093           8,286
State/Municipal Entities........................................              27           4,285           1,299
Corporations....................................................             340           3,267           4,934
Foreign Institutions............................................               2           2,209             363
Charities.......................................................             121           1,613           5,134
Other Advisers..................................................             908           1,427             814
Banking Institutions............................................              11             966             432
Business Development Companies..................................              <1             211              98
----------------------------------------------------------------------------------------------------------------
Source: Form ADV, Items 5D.

c. Qualified Custodians
    Qualified custodians include state and federally-chartered trusts,
banks and savings associations, broker-dealers, FCMs, and certain
FFIs.\422\ The custody service industry has been characterized as
dominated by a small number of large market share participants.\423\
Several factors contribute to this: (i) economies of scale, because
custodial services require a costly infrastructure capable of
processing a large volume of transactions reliably; (ii) low margins,
which makes it difficult for new entrants to compete against
incumbents; and (iii) the importance of reputation/trust.\424\ Large
financial institutions headquartered in the U.S. dominate the global
custody service industry.\425\ In 2020, four large U.S. banks serviced
around $114 trillion of global assets under in their custody.\426\
---------------------------------------------------------------------------

    \422\ The FDIC reports that as of March 31, 2022, there were
4,194 FDIC-insured commercial banks and 602 FDIC-insured savings
institutions. See https://www.fdic.gov/analysis/quarterly-banking-profile/statistics-at-a-glance/2022mar/industry.pdf. We do not have
data on the number of FDIC-insured commercial banks and FDIC-insured
savings institutions providing custodial services. As of November
2022, there were 3,530 broker-dealers registered with the
Commission. See https://www.sec.gov/files/data/broker-dealers/company-information-about-active-broker-dealers/bd110122.txt. The
CFTC reports that as of September 30, 2022, there were 60 FCMs. See
https://www.cftc.gov/sites/default/files/2022-11/01%20-%20FCM%20webpage%20Update%20-%20September%202022.pdf. Out of 3,498
broker-dealers registered with the Commission, 153 were classified
as carrying broker-dealers based on FOCUS filings as of June 2022.
Per EDGAR Form Custody: A ``Carrying broker-dealer'' is a broker-
dealer that carries customer or broker or dealer accounts and
receives or holds funds or securities for those customers. We do not
have data on the number of qualifying FFIs.
    \423\ Deloitte, ``The evolution of core financial service.
Custodian & Depository Banks.'' (2019), available at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf. See also
Congressional Research Service, ``Digital Assets and SEC
Regulation,'' January 30, 2020. According to this report, in 2020,
four large banks service around $114 trillion of global assets under
custody.
    \424\ Charles-Enguerrand Coste et al., One size fits some:
analyzing profitability, capital and liquidity constraints of
custodian banks through the lens of the SREP methodology (Eur. Cent.
Bank Occasional Paper No. 256, 2021).
    \425\ Id; see also Congressional Research Service, ``Digital
Assets and SEC Regulations,'' (Jan. 30, 2020.).
    \426\ Congressional Research Service, ``Digital Assets and SEC
Regulations,'' (Jan. 30, 2020.).
---------------------------------------------------------------------------

d. Independent Public Accountants
    As discussed above, the current rule generally requires an adviser
with custody of client assets to obtain an annual surprise examination
from an independent public accountant.\427\ As of June 2022, 13% of
investment advisers obtain a surprise examination by an

independent public accountant.\428\ Not all advisers with custody,
however, are subject to an annual surprise examination. For example, as
of June 2022, 4,933 investment advisers satisfied their custody rule
obligations by complying with the current rule's audit provision.\429\
Advisers reported that 86% of the accountants performing surprise
examinations or conducting pooled investment vehicle financial
statement audits are subject to regular inspection by the PCAOB.\430\
---------------------------------------------------------------------------

    \427\ See rule 206(4)-2(a)(4).
    \428\ Based on advisers' responses to Item 9.C.(2) of Part 1A of
Form ADV. Comparable numbers for 2019, 2020, and 2021 were 13%, 13%,
and 13%, respectively.
    \429\ Based on advisers' responses to Item 9.C.(3) of Part 1A of
Form ADV. Comparable numbers for 2019, 2020, and 2021 were 4,460,
4,565, and 4,768, respectively.
    \430\ These percentages are based on advisers' responses to Item
9.C.(3) of Part 1A of Form ADV. Comparable percentages for 2019,
2020, and 2021 were 86%, 86%, and 86%, respectively.
---------------------------------------------------------------------------

    Advisers that are subject to an annual surprise examination also
are required to obtain (or receive from the relevant related person) an
internal control report if the adviser or a related person of the
adviser serves as a qualified custodian for client assets. However, in
the circumstance where an adviser is deemed to have custody solely
because of a related person custodian and the related person custodian
is operationally independent of the adviser, the adviser is not
required to have an annual surprise examination but is subject to the
internal control requirement.\431\ As of June 2022, 98 investment
advisers have a control report prepared by an independent public
accountant without being subject to a surprise examination.\432\
---------------------------------------------------------------------------

    \431\ See rule 206(4)-2(a)(6) and (b)(6). In these
circumstances, the adviser typically receives the internal control
report from the related person custodian.
    \432\ Based on advisers' responses to Item 9.C.(3) and 9.C.(4)
of Part 1A of Form ADV. Comparable numbers for 2019, 2020, and 2021
were 117, 112, and 105, respectively.
---------------------------------------------------------------------------

3. Market Practice
a. Investment Advice
    Academic studies have documented a number of benefits to retail
investors from receiving investment advice, including, but not limited
to: higher household savings rates, setting long-term goals and
calculating retirement needs, more efficient portfolio diversification
and asset allocation, increased confidence and peace of mind,
facilitation of small investor participation, and improved tax
efficiency.\433\ Investment advisers can also help correct potential
systematic errors that retail investors might make, including limited
allocation of savings to equities, under-diversification, or investing
too little in foreign assets.\434\
---------------------------------------------------------------------------

    \433\ See, e.g., Mitchell Marsden, Catherine D. Zick, & Robert
N. Mayer, The Value of Seeking Financial Advice, 32 J. Fam. & Econ.
Issues 625 (2011); Jinhee Kim, Jasook Kwon & Elaine A. Anderson,
Factors Related to Retirement Confidence: Retirement Preparation and
Workplace Financial Education, 16 J. Fin. Counseling & Plan. 77
(2005); Michael S. Finke, Sandra J. Huston, & Danielle D.
Winchester, Financial Advice: Who Pays, 22 J. Fin. Counseling &
Plan. 18 (2011); Daniel Bergstresser, John M.R. Chalmers, & Peter
Tufano, Assessing the Costs and Benefits of Brokers in the Mutual
Fund Industry, 22 Rev. Fin. Stud. 4129 (2009); Ralph Bluethgen,
Steffen Meyer & Andreas Hackethal, High-Quality Financial Advice
Wanted! (Working Paper, Feb. 2008), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1102445; Neal M.
Stoughton, Youchang Wu & Josef Zechner, Intermediated Investment
Management, 66 J. Fin. 947 (2011). Marsden et al. (2011) documents
benefits attributable to hiring a financial professional, such as
better retirement account diversification and savings goals, but
does not find that hiring a financial professional measurably
increases the amount of overall wealth accumulation for those
investors. See, also, Jeremy Burke & Angela A. Hung, Do Financial
Advisors Influence Savings Behavior?, RAND Labor and Population
Report Prepared for the Department of Labor (2015), available at
https://www.rand.org/pubs/research_reports/RR1289; Terrance Martin &
Michael Finke. ``A Comparison of Retirement Strategies and Financial
Planner Value.'' 27 J. Fin. Plan. 46 (2014); Crystal R. Hudson L &
Lance Palmer. ``Low-Income Employees: The Relationship between
Information from Formal Advisors and Financial Behaviors.'' 23 Fin.
Serv. Rev. (2014): 25; Marc M. Kramer, Financial Literacy,
Overconfidence and Financial Advice Seeking (Working Paper, Dec. 19,
2014), available at https://efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2015-Amsterdam/papers/EFMA2015_0067_fullpaper.pdf; John R. Salter, Nathan Harness & Swarn
Chatterjee. ``Utilization of Financial Advisors by Affluent
Retirees.'' 19 Fin. Serv. Rev. 245 (2010), for additional studies on
the causal relation between the use of a financial professional and
wealth accumulation. Francis M. Kinniry et al., Putting a Value on
Your Value: Quantifying Vanguard Advisor's Alpha, Vanguard Research
(Sept. 2016), available at https://advisors.vanguard.com/iwe/pdf/IARCQAA.pdf, estimates the value to investors associated with
obtaining financial advice of approximately 3% in net returns to
investors, associated with suitable asset allocation, managing
expense ratios, behavioral coaching, alleviating home bias, among
others.
    \434\ See, e.g., Luigi Guiso, Paolo Sapienza & Luigi Zingales,
People's Opium? Religion and Economic Attitudes, 50 J. Monetary
Econ. 225 (2003); Laurent E. Calvet, John Y. Campbell & Paolo
Sodini, Down or Out: Assessing the Welfare Costs of Household
Investment Mistakes, 115 J. Pol. Econ. 707 (2007); Brad M. Barber &
Terrance Odean, ``Trading is Hazardous to Your Wealth: The Common
Stock Performance of Individual Investors'', 55 J. Fin. 773 (2000);
Karen K. Lewis, Trying to Explain Home Bias in Equities and
Consumption, 37 J. Econ. Literature 571 (1999). Guiso et al., 2003;
Calvet et al., 2007; Barber and Odean, 2000; Lewis, 1999. Possible
explanations for these investor mistakes may arise from behavioral
biases, such as cognitive errors, the cost of information
acquisition, or the selection of the financial professional. For
example, investors have been observed to hold too little of their
wealth in foreign assets, which is often called ``home bias.''
---------------------------------------------------------------------------

    Investor demand for investment advice, however, may be affected by
investor's assessment of the conflicts between themselves and
investment advisers. For example, while investors may benefit from
receiving investment advice, reports have indicated that the ability to
trust the advice of a financial professional is an important factor in
determining investors' demand for investment advice. In particular, one
academic study has shown that trust in financial institutions is
associated with the propensity to use financial advice.\435\ Based on
survey data analysis, this study found that financial trust is
correlated with the likelihood of seeking financial advice. Using data
from experiments, this study found that trust is an important predictor
of who takes up advice, even after controlling for demographic
characteristics and financial literacy.
---------------------------------------------------------------------------

    \435\ See, e.g., Jeremy Burke & Angela A. Hung, Trust and
Financial Advice (RAND Working Paper WR-1075, 2015).
---------------------------------------------------------------------------

b. Adviser Custody
    As of June 2022, 8,536 advisers (56.67% of the total number of
advisers) reported on Form ADV that they or their related persons, in
aggregate, had custody of $45.56 trillion (35.33% of aggregate RAUM) of
client assets.436 437 Advisers reported directly having
custody of approximately $21.28 trillion, and $24.28 trillion resulted
indirectly from custody through a related person. As of June 2022,
1,904 (12.64% of the total) advisers reported that an independent
public accountant conducted an annual surprise examination of client
assets.\438\ 4,933 advisers reported that an independent

public accountant annually audits the pooled investment vehicle(s) the
adviser manages and the audited financial statements are distributed to
investors in the pools.\439\ 1,405 (9.33% of the total) advisers
reported having a qualified custodian send quarterly statements to
investors in pooled investment vehicles.\440\ As of June 2022, 98
(0.65%) registered advisers reported that they had an internal control
report prepared by an independent public accountant but did not report
that they were subject to a surprise examination.\441\
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    \436\ This analysis is based on advisers' responses to Items
9.A. and 9.B. of Part 1A of Form ADV. The instructions to Item 9.A.
of Part 1A of Form ADV provide that an adviser that has custody
solely because (i) it deducts advisory fees directly from client
accounts, or (ii) an operationally independent related person has
custody of client assets in connection with advisory services
provided to clients, should answer ``No'' in response to Item
9.A.(1), which asks whether the adviser has custody of client
assets, meaning the number of advisers with custody is likely
larger.
    \437\ The total number of advisers reporting custody of client
assets or custody by a related person, in response to Items 9.A. and
9.B. of Part 1A of Form ADV was 7,424 in 2019, 7,774 in 2020, and
8,180 in 2021. As a percent of the total number of registered
advisers, the percent of advisers reporting custody of client assets
or custody by a related person in response to Items 9.A. and 9.B. of
Part 1A of Form ADV was 55.20% in 2019, 55.88% in 2020, and 55.95%
in 2021. As a percent of aggregate RAUM, advisers reporting custody
of client assets or custody by a related person in response to these
Items of Form ADV, managed 33.92% in 2019, 33.80% in 2020, and
34.44% in 2021.
    \438\ Based on advisers' responses to Item 9.C.(3) of Part 1A of
Form ADV, the total number of advisers reporting that an independent
public accountant conducts an annual surprise examination of client
assets was 800 (13.38%) in 2019, 1,834 (13.18%) in 2020, and 1,887
(12.91%) in 2021.
    \439\ Based on advisers responses to Item 9.C.(2) of Form ADV.
Comparable numbers for 2019, 2020, and 2021 were 4,460, 4,565, and
4,768, respectively.
     In addition, based on advisers' responses to Items 9.A., 9.B.,
and 9.F., 8,165 registered advisers had custody solely because of
their authority to deduct fees in 2020 as of June 2022.
    \440\ Based on advisers' responses to Item 9.C.(2) of Form ADV.
Comparable numbers for 2019, 2020, and 2021 were 1,313 (9.76%),
1,328 (9.55%), and 1,348 (9.22%), respectively.
    \441\ These statistics are based on advisers' responses to Items
9.C.(3) and (4) of Part 1A of Form ADV. The comparable numbers for
2019, 2020, and 2021 were 117 (0.87%), 112 (0.81%), and 105 (0.72%),
respectively.
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    As of June 2022, approximately 0.5% of all registered investment
advisers (6.51% of aggregate RAUM) acted as a qualified custodian for
their clients. Approximately 0.6% of all registered investment advisers
(23.67% of aggregate RAUM) had a related person acting as a qualified
custodian.
c. Market Practice Baseline
    In addition to rule 206(4)-2, the 2009 Accounting Guidance, no-
action letters, interpretive letters, and other staff statements (some
of which are enumerated in section II.K) shape investment advisers'
custody rule compliance. For example, staff has issued 70 FAQs on a
wide range of topics, including the contours of custody and how custody
applies in the setting of pooled investment vehicles.\442\
---------------------------------------------------------------------------

    \442\ See supra note 17.
---------------------------------------------------------------------------

    Banks' practices as qualified custodians are also shaped by
guidance, such as the Office of the Comptroller of the Currency's
handbook on custody, which furnishes guidance to national banks and
savings associations acting as custodians.\443\ The OCC guidance
provides that the custodian's management has the responsibility to
assess its control environment and ensure an appropriate system of
internal controls, including separation of duties, and accounting
controls to monitor and measure transactional workflows and their
accuracy.\444\ The custodian's management should further ensure that
custody account assets are kept separate from the custodian's own
assets and maintained under joint control, and that securities under
custody are not subject to lending transactions without a written
agreement between the custodian and the client.\445\
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    \443\ Off. Of the Comptroller of the Currency, Comptroller's
Handbook, Custody (2002), available at https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/index-custody-services.html.
    \444\ Comptroller's Handbook, Custody at 6-7.
    \445\ Id. at 14, 30.
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d. Custody Market Trends
    Competition among bank qualified custodians has been characterized
as fierce, with shrinking profit margins, and the dominance of a
handful of large entities.\446\ One report noted that custodians need
to adapt and expand their service offerings to accommodate new types of
assets, such as crypto assets, and assets that are now held and
transferred using new technological methods, such as central bank
digital currencies (also known as CBDCs).\447\
---------------------------------------------------------------------------

    \446\ Id. at 1. See also Deloitte, ``The evolution of a core
financial service. Custodian & Depository Banks.'' (2019) available
at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf.
See also Congressional Research Service, ``Digital Assets and SEC
Regulations,'' January (Jan. 30, 2020). According to this report, in
2020, four large banks service around $114 trillion of global assets
under custody.
    \447\ See, e.g., Deloitte, ``The evolution of a core financial
service. Custodian & Depository Banks.'' (2019) available at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf.
---------------------------------------------------------------------------

    The industry-reported market capitalization for crypto assets
experienced a rapid growth from $1 billion in 2018 to $1 trillion in
2021.\448\ One survey found that 16 percent of U.S. adults say they
personally have invested in, traded, or otherwise used
``cryptocurrencies.'' \449\ Institutional investors also invested in
``cryptocurrencies.'' \450\ The Commission analyzed the extent to which
investment advisers offer various kinds of services related to digital
assets.\451\ This analysis relied on Commission filings, advisers'
websites, and mentions of an adviser's services from third-party online
news sources.\452\ The analysis was conducted as of June 2022 \453\ and
focuses on the 50 largest investment advisers \454\ by RAUM. The
Commission estimates that, of these 50 largest investment advisers, (i)
21 are offering or planning on offering some services related to
digital assets,\455\ (ii) 9 are giving or planning on giving investment
advice related to digital assets,\456\ (iii) 13 provide or are planning
on providing custody of digital assets or custodial services of digital
assets,\457\ and (iv) 7 advise or are planning on advising a pooled
investment vehicle (like a fund or commodity pool) that holds some
digital assets.\458\
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    \448\ See, e.g., Deloitte, ``Market Manipulation in Digital
Assets'' (Mar. 2021), available at https://www2.deloitte.com/content/dam/Deloitte/global/Documents/Financial-Services/gx-design-market-manipulation-in-digital-assets-whitepaper-v2-1.pdf.
    \449\ See ``46% of Americans who have invested in cryptocurrency
say it's done worse than expected,''.'' Pew Research Center,
Washington, DC (Aug. 23, 2022), available at https://www.pewresearch.org/fact-tank/2022/08/23/46-of-americans-who-have-invested-in-cryptocurrency-say-its-done-worse-than-expected/. Also,
another study in 2019 estimated about 40 million Americans owned
assets identified as cryptocurrencies. See Office of the Comptroller
of the Currency, Interpretative Letter #1170, July 2020.
    \450\ See Office of the Comptroller of the Currency,
Interpretative Letter #1170, July 2020.
    \451\ A search of Commission filings, advisers' websites, and
mentions of an adviser's services from third-party only news
services used the term ``digital assets'' because several of the
sources did not explicitly state that they were strictly referring
to crypto assets.
    \452\ Filings on Form ADV did not, in all cases, provide
sufficient information to determine exactly the extent to which an
adviser offers services related to digital assets. Therefore, this
analysis relied on supplementary information obtained from advisers'
websites, online news sources, and in two cases, other forms filed
with the SEC. Both of these two cases involved funds that held
digital assets. In the case of one adviser, the staff used
information from Form D, in the case of the other the staff used
information from Form S-1. Web pages whose terms and conditions
required citation are: https://investor.vanguard.com/,
www.franklintempleton.com, www.mufg.jp, https://www.pimco.com/, and
https://citywire.com/.
    \453\ Commission analysis used advisers' most recent filings
that were submitted during the period from July 2021 to June 2022.
Supplemental data from websites was evaluated in October 2022.
    \454\ The Commission considered filers that represent the same
firm to be a single adviser. In aggregate, these 50 investment
advisers (i) reflect 49% of total RAUM (as reported in response to
question 5F(2)(c)), (ii) manage 37% of all accounts (as reported in
response to question 5F(2)(f)), (iii) hold 35% of client funds and
securities in investment adviser firm's custody or in a related
person's custody (as reported in response to questions 9A(2)(a) and
9B(2)(a)), and hold 32% of client funds and securities in investment
adviser firm's custody (as reported in response to question 9A(2)(a)
only).
    \455\ These investment advisers comprise 67% of RAUM and manage
66% of accounts of the largest 50 investment advisers.
    \456\ These investment advisers comprise 26% of RAUM and manage
41% of accounts of the largest 50 investment advisers.
    \457\ These investment advisers comprise 51% of RAUM and manage
43% of accounts of the largest 50 investment advisers. They further
comprise 49% of client funds and securities in the largest fifty
investment adviser firms' custody or in related persons' custody (as
reported in response to questions 9A(2)(a) and 9B(2)(a)) and 48% of
client funds and securities in the largest fifty investment adviser
firms' custody (as reported in response to question 9A(2)(a) only).
    \458\ These investment advisers comprise 67% of RAUM and manage
66% of accounts of the largest 50 investment advisers.
---------------------------------------------------------------------------

    The market for crypto asset custodial services continues to
develop. Our understanding is that one OCC-regulated national bank,
four OCC-

regulated trusts, approximately 20 state-chartered trust companies and
other state-chartered, limited purpose banking entities, and at least
one FCM currently offer custodial services for crypto assets. We also
understand that the provision of custodial services for crypto assets
can arise in the context of the trading of crypto assets. As discussed
above, many platforms that provide users with the ability to transact
in crypto assets are not qualified custodians and require investors to
pre-fund trades, a process in which investors transfer their crypto
assets or fiat currency to such a platform prior to the execution of
any trade.\459\ Our understanding is that the majority of crypto asset
trading occurs on platforms requiring pre-funding of trades, though
crypto asset trading also occurs on so-called decentralized platforms
that may not rely on pre-funding. We are aware that a limited number of
SEC-registered crypto asset securities trade on Alternative Trading
Systems (``ATSs'') that do not require pre-funding of trades.\460\ ATSs
that trade crypto asset securities follow a three-step process or four-
step process \461\ that does not involve the broker-dealer operator of
the ATS providing custodial services for the crypto asset
securities.\462\ We understand, however, that ATSs do not offer trading
of crypto asset non-securities.
---------------------------------------------------------------------------

    \459\ See supra, footnote 128 and accompanying text.
    \460\ ATSs that do not trade NMS stocks file with the Commission
a Form ATS notice, which the Commission does not approve. In
addition, all ATSs must file quarterly reports on Form ATS-R with
the Commission. Form ATS-R requires, among other things, volume
information for specified categories of securities, a list of all
securities traded in the ATS during the quarter, and a list of all
subscribers that were participants. To the extent that an ATS trades
crypto asset securities, the ATS must disclose information regarding
its crypto asset securities activities as required by Form ATS and
Form ATS-R. Form ATS and Form ATS-R are deemed confidential when
filed with the Commission. Based on information provided on these
forms, a limited number of ATSs have noticed on Form ATS their
intention to trade certain crypto asset securities and a subset of
those ATSs have reported transactions in crypto asset securities on
their Form ATS-R.
    \461\ For background on the models, the staff has noted as
follows: A non-custodial ATS four-step model involves the following
steps: Step 1--the buyer and seller send their respective orders to
the ATS; Step 2--the ATS matches the orders; Step 3--the ATS
notifies the buyer and seller of the matched trade; and Step 4--the
buyer and seller settle the transaction bilaterally, either directly
with each other or by instructing their respective custodians to
settle the transaction on their behalf. In a non-custodial ATS
three-step model involves the following steps: Step 1--the buyer and
seller send their respective orders to the ATS, notify their
respective custodians of their respective orders submitted to the
ATS, and instruct their respective custodians to settle transactions
in accordance with the terms of their orders when the ATS notifies
the custodians of a match on the ATS; Step 2--the ATS matches the
orders; and Step 3--the ATS notifies the buyer and seller and their
respective custodians of the matched trade and the custodians carry
out the conditional instructions. The custodians would then settle
the trade on behalf of the buyer and seller based on the
instructions received in Step 1. As with the four-step process, the
broker-dealer operator does not guarantee or otherwise have
responsibility for settling the trades and does not at any time
exercise any level of control over the digital asset securities
being sold or the cash being used to make the purchase (e.g., the
ATS does not place a temporary hold on the seller's wallet or on the
buyer's cash to ensure the transaction is completed) other than by
notifying the custodians for the buyer and seller, and the buyer and
seller, of the match. See finra-ats-role-in-settlement-of-digital-
asset-security-trades-09252020.pdf.
    \462\ Our understanding is that for existing ATSs, custodial
services are typically provided by state-chartered trust companies
and other state-chartered, limited purpose banking entities.
---------------------------------------------------------------------------

    We understand that certain advisers provide advisory services with
respect to client funds and securities that would generally result in
an adviser having ``custody'' within the meaning of the rule (e.g.,
serving as the general partner for a private fund that holds crypto
asset securities), and therefore are required to comply with the rule.
Some of these advisers, however, may not maintain their client's crypto
assets with a qualified custodian, instead attempting to safeguard
their client's crypto assets themselves--a practice that is not
compliant with the custody rule if those crypto assets are funds or
securities and do not meet an exception from the qualified custodian
requirement. Other advisers offering similar advisory services may take
the position that crypto assets are not covered by the custody rule at
all because they believe that crypto assets are neither funds nor
securities.\463\
---------------------------------------------------------------------------

    \463\ This, however, is incorrect because most such assets are
likely to be funds or crypto asset securities covered by the current
rule. See infra footnote 29 and accompanying text.
---------------------------------------------------------------------------

    Assets other than publicly traded stocks and bonds have
increased.\464\ One investment services industry data provider
forecasted that global assets under management across alternative asset
classes would grow by 60 percent between the end of 2020 and the end of
2025.\465\ For example, capital raised in the private equity market was
less than $60 billion in 2010. About a decade later, in 2019, capital
raised in the private equity market was more than $316 billion.\466\
Also, investor interest in physical assets may have increased.\467\ As
discussed in section II.D, safeguarding alternative assets may involve
unique procedures that differ across each specific asset type and that
substantially differ from safeguarding practices with respect to more
traditional asset classes (like equities and fixed income products).
Additionally, physical assets potentially create more complex
challenges with regard to transaction processing, monitoring, and
reporting services.\468\ The breadth and variety of alternative assets
diminish an entity's ability to scale and automate its safekeeping
services for efficiency and profitability and, therefore, entities
providing safekeeping services may be reluctant to expend the resources
necessary to accommodate such assets. As a result, custodians may
outsource the safekeeping of alternative assets to entities that
specialize in safekeeping certain asset classes.\469\
---------------------------------------------------------------------------

    \464\ Financial Times, ``Global shift into alternative assets
gathers pace,'' (July 16, 2017,), available at https://www.ft.com/content/1167a4b8-6653-11e7-8526-7b38dcaef614.
    \465\ See, e.g., David Lowery & Preqin Blog, ``Future of
Alternative 2025: Preqin Forecasts Alternative AUM Growth of 9.8%
though to 2025,'' (Nov. 4, 2020), available athttps://
www.preqin.com/insights/research/blogs/preqin-forecasts-alternative-aum-growth-of-9-8-percent-through-to-2025.
    \466\ See, e.g., PitchBook, ``Data, Inc., A PE fundraising
record could await in 2021,'', (Dec. 15, 2020), available at https://pitchbook.com/newsletter/a-pe-fundraising-record-could-await-in-2021.
    \467\ For example, the creation of art-market indices suggests
that interest in physical assets, such as fine art, may have
increased. Sotheby's, ``The Sotheby's Mei Moses Indices,'' available
at https://www.sothebys.com/en/the-sothebys-mei-moses-indices.
    \468\ Deloitte, ``The evolution of core financial service.
Custodian & Depository Banks.'' (2019) available at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf.
    \469\ See, e.g., Colonnade, ``Alternative Asset Custody
Services, Positive Dynamics Power Growth,'' Market Commentary--(Jan.
2015), available at https://www.coladv.com/wp-content/uploads/Alt-Asset-Admin-Jan-2015-FINAL.pdf.
---------------------------------------------------------------------------

    Staff has observed that custodians often include indemnification
clauses in their custodial agreements with customers. Generally, the
provisions indemnify custodial customers from losses arising out of or
in connection with the custodian's execution or performance under the
agreement to the extent the loss is caused by, among other things, the
custodian's negligence, gross negligence, bad-faith, recklessness, or
willful misconduct.\470\ Staff has also observed that the contractual
limitations on custodial liability vary between a gross negligence
standard and a simple negligence standard. Also, we understand that
some custodial agreements contain contractual language addressing when
a lien or similar claim will attach to client assets. Finally, staff
has observed a practice by custodians in which the custodian lists
assets for which it does not accept custodial

liability on a client's account statement on an accommodation basis
only; the custodian does not attest to the holdings of, or transactions
in, those investments or take steps to ensure that the investments are
safeguarded appropriately. The custodian reports the holdings or
transactions as reported to it by the adviser.
---------------------------------------------------------------------------

    \470\ Custodial agreements are generally between an advisory
client and a qualified custodian. We do not have data on custodial
agreements that would allow us to characterize the relative
frequency of various agreement provisions.
---------------------------------------------------------------------------

e. Compliance Trends
    In 2013, the Commission staff issued a National Exam Program
(``NEP'') Risk Alert stating that the NEP had observed widespread and
varied non-compliance with elements of the custody rule.\471\ In
reviewing examinations that contained significant deficiencies, the NEP
found that approximately one-third (over 140) included custody-related
issues. The findings from the examinations resulted in remedial
measures taken by advisers, including among other things, drafting,
amending or enhancing their written compliance procedures, policies, or
processes; changing their business practices; or devoting more
resources or attention to the area of custody.
---------------------------------------------------------------------------

    \471\ See, e.g., SEC, ``National Exam Program Risk Alert'' (Mar.
4, 2013), available at https://www.sec.gov/about/offices/ocie/custody-risk-alert.pdf.
---------------------------------------------------------------------------

    In 2017, the Commission staff issued a NEP Risk Alert reporting
that deficiencies or weaknesses related to the custody rule were among
the five most frequent compliance topics identified during examinations
of investment advisers.\472\ Typical examples of deficiencies or
weaknesses with respect to the custody rule identified by the staff
were: (1) advisers did not recognize that they may have custody due to
online access to client accounts, (2) advisers with custody obtained
surprise examinations that did not meet the requirements of the custody
rule, and (3) advisers did not recognize that they may have custody as
a result of certain authority over client accounts.
---------------------------------------------------------------------------

    \472\ See, e.g., SEC, ``National Exam Program Risk Alert'' (Feb.
7, 2017), available at https://www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdfhttps://www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdf..
https://www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdf.
---------------------------------------------------------------------------

    In 2021, the Division of Examinations issued a Risk Alert stating
that in its experience, a number of activities related to digital asset
securities presented specific risks to investors.\473\ Included among
the risks identified by the Division of Examinations were risks related
to advisers' crypto asset custodial practices and their compliance with
the custody rule. As discussed above, the custody rule was designed to
help ensure advisers adequately safeguard client investments in their
custody by requiring advisers to take steps to mitigate the risk that
client investments will be lost, misused, stolen, misappropriated, or
subject to the financial reverses, including insolvency, of an
investment adviser.\474\ Crypto assets are not exempt from these risks.
Based on that experience, the Division of Examinations indicated that
it would continue to review the risks and practices related to crypto
asset custody and examine for compliance with the custody rule.\475\
---------------------------------------------------------------------------

    \473\ See Division of Examinations, ``Risk Alert: The Division
of Examinations' Continued Focus on Digital Asset Securities'' (Feb.
26, 2021), available at https://www.sec.gov/files/digital-assets-risk-alert.pdf.
    \474\ See section I infra.
    \475\ Specifically the Division of Examinations stated that
staff would review: (i) occurrences of unauthorized transactions,
including theft of digital assets, (ii) controls around safekeeping
of digital assets (e.g., employee access to private keys and trading
platform accounts), (iii) business continuity plans where key
personnel have exclusive access to private keys, (iv) how the
adviser evaluates harm due to the loss of private keys, (v)
reliability of software used to interact with relevant digital asset
networks, (vi) storage of digital assets on trading platform
accounts and with third party custodians, and (vii) security
procedures related to software and hardware wallets.
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D. Benefits and Costs of Proposed Rule and Form Amendments

1. Scope
    The proposed rule would change the current rule's scope in two
ways. First, it would expand the types of investments covered by the
rule beyond a client's funds or securities to include other positions
held in a client's account that are not funds or securities. Second,
the proposed rule would make explicit that the current rule's defined
term ``custody'' includes discretionary trading authority. The scope of
the rule determines, in part, the costs and benefits of the regulatory
program set forth by the other components of the proposed rule (the
``programmatic effects'').
a. Scope of Assets
    The proposed rule's expanded scope would include all client assets
for which an adviser has custody. The proposed rule would define
``assets'' as ``funds, securities, or other positions held in a
client's account.'' \476\ Assets under the rule also would include
financial contracts held for investment purposes, collateral posted in
connection with a swap contract on behalf of the client, and other
assets that may not clearly be funds or securities covered by the
current rule. ``Other positions held in the client's account'' covers
current asset types and asset types that develop in the future
regardless of their status as funds or securities. The addition of
``other positions held in the client's account'' would also include
crypto assets when not otherwise covered by the rule's references to
funds and securities.\477\ Further, the proposed rule's use of the term
``assets'' would not exclude client investments that may appear in the
liabilities column of a balance sheet or that may be represented as a
financial obligation of the client including short positions, written
options, or negative cash.
---------------------------------------------------------------------------

    \476\ Proposed rule 223-1(d)(1).
    \477\ See Part II.A, supra.
---------------------------------------------------------------------------

    We believe that the proposed rule reduces the risk of loss of
client assets by expanding the types of assets covered by the rule
beyond ``funds and securities.'' Bringing more categories of assets
into the scope of the rule's requirements will protect investors
because the assets will be subject to custodial safeguards. Expanding
the scope of the rule will also reduce uncertainty over the status of
assets under advisement that must be held in the custody of a qualified
custodian, thereby reducing the legal risk associated with advisory
services and custodial arrangements for the assets. This may increase
investment opportunities and the availability of advisory services for
those assets. Looking forward, the proposed definition of assets is
designed to remain evergreen, encompassing new investment types as they
continue to evolve and to recognize that the protections of the rule
should not depend on which type of assets the client entrusts to the
adviser.
    Expanding the scope of the custody rule to include client assets
instead of only client funds and securities would also involve costs.
We expect that this expansion in scope would cause advisers to incur
compliance costs in connection with these newly covered investment
positions. Accordingly, advisers with custody of such assets would
incur additional costs to ensure their safeguarding practices with
respect to such assets comply with the custody rule; for example, the
costs associated with finding a qualified custodian that is able to
take possession or control of these assets. Rather than incur such
costs, advisers may continue providing advice with respect to clients'
funds and securities, but stop providing advice with respect to
clients' other assets within the scope of the expanded

rule.\478\ Investment advisers may accordingly eliminate the aspect of
their services that gives them custody (they may decline the authority
to hold or take possession of the other assets, including any
discretionary authority to withdraw or transfer beneficial ownership of
such assets). To the extent clients benefit from advice on such other
assets--which may be merely ancillary to advice on funds and
securities--investors would no longer receive these benefits.\479\
Also, advisers would forego any fees associated with providing such
services.
---------------------------------------------------------------------------

    \478\ Analysis described in section III.C.3.d indicates that
seven advisers either currently advise, or are planning to advise, a
pooled investment vehicle (such as a private fund or commodity pool)
that holds some crypto assets. To the extent these pooled investment
vehicles hold crypto assets that may be outside of the current
rule's scope (i.e., they are neither funds nor securities), those
assets would be within the scope of the proposed rule. To the extent
that it becomes cost-prohibitive for advisers to find a qualified
custodian, or otherwise comply with the proposed rule with respect
to these newly covered crypto assets, we believe that advisers may
choose to cease providing advisory services to pooled investment
vehicles holding such assets, implying these pooled investment
vehicles may no longer be offered to investors.
    \479\ To the extent competition in the market for those aspects
of services that gives advisers custody is linked to the number of
advisers offering such services, advisers choosing to eliminate the
aspect of their services that gives them custody could result in a
reduction in competition. A reduction in competition could result in
higher fees for investors, lower quality services, or some
combination of the two.
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    The expanded scope of assets subject to the proposed rule could
create other costs. For example, as discussed above, the staff has
observed a growing number of state-chartered trust companies and other
state-chartered, limited purpose banking entities now offering
custodial services for crypto assets. Also, the staff has observed an
increase in the number of entities that provide platform users with the
ability to transact in crypto assets. In connection with these
services, these entities and/or their agents might safeguard the
platform user's crypto asset(s) and also maintain the cryptographic key
information necessary to access the crypto asset.
    The expanded scope of assets subject to the proposed rule could
create costs for those advisers (and their clients) with custody of
crypto assets that are not funds or securities subject to the current
custody rule. For example, to the extent advisers have custody of
client crypto assets that are not funds or securities and those assets
are maintained with state-chartered trust companies, other state-
chartered, limited purpose banking entities, and entities providing
platform users with the ability to transact in crypto assets who may
choose not to make the changes necessary to satisfy all of the
requirements to act as a qualified custodian under the proposed rule,
the proposed rule would require such crypto assets to be removed from
those entities. Removing assets from those entities could create costs
for investors. For example, there would be costs associated with
switching from one entity to another. As we noted in section II.C.3,
the technical requirements for transacting and safeguarding crypto
assets are likely to differ from those of traditional assets that
include stocks, bonds, and options. The proposed rule could cause
investors to remove their assets from an entity that has developed
innovative safeguarding procedures for those assets, possibly putting
those assets at a greater risk of loss. These costs would be mitigated,
however, to the extent existing qualified custodians develop, or
otherwise acquire, innovative safeguarding procedures for crypto
assets, or are able to contract with specialized sub-custodians, as a
result of the proposed rule.
    If investors remove newly scoped-in assets from entities currently
providing safeguarding services, those entities providing safeguarding
services will experience a decline in fees because they would be
providing custody for fewer assets. For example, if investors remove
their crypto assets that are not funds or securities subject to the
current rule from entities such as state-chartered trust companies,
other state-chartered, limited-purpose banking entities, and entities
providing platform users with the ability to transact in crypto assets,
those entities could experience a decline in fees. The extent of the
decline in fees would depend on investors' holdings of crypto assets
that are not funds or securities subject to the current rule, the rates
charged by those entities for safeguarding crypto assets, as well as
the extent to which investors remove their crypto assets from those
entities. We do not have data that would allow us to predict accurately
investor holdings of crypto assets or the extent to which investors
would remove crypto assets from those entities, or the resulting effect
on profitability. A sufficiently large decline in profitability could
lead such entities to reconsider their business models or exit the
business altogether.
    This aspect of the proposed rule could create additional costs as
well. Independent public accountants would have to perform verification
procedures over a larger universe of investments which could increase
the cost of performing verification procedures. Absent an increase in
the capacity of independent public accountants, the increased demand on
the services of independent public accountants resulting from having to
perform verification procedures over a larger universe of assets could
result in increased costs for accountant services generally. To the
extent independent public accountants reallocate resources away from
other services to meet the increased demand for asset verification,
other services provided by independent public accountants could become
more costly. That said, as a result of requiring that all assets be
held in the possession or control of a qualified custodian, performing
verification procedures may be less labor-intensive and less costly
than under the current rule.
b. Scope of Activity Subject to the Proposed Rule
    The proposal would generally preserve the current rule's definition
of ``custody''. The current definition of custody includes three
categories that serve as examples of custody including certain
arrangements when the adviser is authorized or permitted to instruct
the client's custodian. The proposed rule would explicitly identify
discretionary trading authority as an arrangement that triggers the
rule. An adviser with this ability or authority can subject a client's
assets to the risks of loss, misuse, misappropriation, theft, or
financial reverses of the adviser. The proposed rule would also expand
the scope of subject activity by explicitly identifying discretionary
trading authority as an arrangement that triggers the rule.
    The authority for discretionary trading presents the kinds of risks
to client assets that the rule is designed to address. When advisers
have this authority, they have the ability to sell or purchase assets
for the client's account without first obtaining client consent. This
creates an opportunity for an adviser to put those assets at risk of
loss, misuse, misappropriation, theft, or financial reverses of the
adviser. If an adviser has custody solely because the adviser has
discretionary authority that is limited to instructing the custodian to
transact in assets that settle on a DVP basis, the risk of loss is less
pronounced, though not completely eliminated, when a client's custodian
must participate in the transaction. In those cases, the custodian will
observe, and record on a client's account statement, that assets are
transferred out of a client's account only upon corresponding transfer
of other assets of equal value into the account. Although the risk of
loss is not reduced to zero in these situations, the client is at least
on

notice via the account statement from the custodian that a transaction
has occurred. The proposed rule would thus benefit clients by extending
the protections of the rule, namely the protections of the qualified
custodian and the account statement reporting, to instances where an
adviser has discretionary trading authority. The benefits will be
mitigated to the extent that advisers comply with the rule today for
reasons other than discretionary trading authority.
    Advisers who currently do not need to comply with the rule for this
type of authority will bear the costs of compliance with the rule.
Those costs will be mitigated to the extent that advisers comply with
the rule today for reasons other than discretionary trading authority.
For example, if advisers also have a general power of attorney with
respect to the same assets, such advisers already have custody of these
assets under the current rule. For advisers that will be newly subject
to the rule as a result of this change, the costs of compliance will be
reduced if discretionary trading authority is their sole reason for
having custody because they will not have to comply with the surprise
examination requirement.\480\
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    \480\ Proposed rule 223-1(b)(9).
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    Investment advisers with custody of client assets because of
discretionary trading authority may continue to provide discretionary
trading services to their clients, or, as discussed above, they may
choose to no longer provide advice on assets which are not funds or
securities and, accordingly, no longer exercise custody (including
discretionary trading) for such other assets as a result of the
compliance costs. If advisers choose to no longer offer discretionary
trading services for assets other than funds or securities, to the
extent clients benefit from those discretionary trading services,
investors would bear a cost associated with the loss of those services
or with finding an investment adviser that provides them.
2. Qualified Custodian Protections
    As discussed in section II.B above, the proposed rule would require
investment advisers to maintain client assets with a qualified
custodian having ``possession or control'' of client assets pursuant to
a written agreement between the qualified custodian and the investment
adviser. The term ``possession or control'' would mean holding assets
such that the qualified custodian is required to participate in any
change in beneficial ownership of those assets, the qualified
custodian's participation would effectuate the transaction involved in
the change in beneficial ownership, and the qualified custodian's
involvement is a condition precedent to the change in beneficial
ownership. In the case of a qualified custodian that is the adviser,
the proposed rule would require that the written agreement be between
the adviser and the client.\481\
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    \481\ Proposed rule 223-1(a)(1)(i).
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    The proposed rule also would require the adviser to obtain
reasonable assurances in writing from the custodian regarding certain
vital protections for the safeguarding of client assets. If the
qualified custodian is the adviser, the proposed rule would require
that the reasonable assurances be part of the written agreement between
the adviser and the client, described above.\482\
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    \482\ Proposed rule 223-1(a)(1)(ii).
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a. Definition of Qualified Custodian
    Banks. The current rule includes in the definition of qualified
custodian a bank as defined in section 202(a)(2) of the Advisers Act
(15 U.S.C. 80b-2(a)(2)) or a savings association as defined in section
3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1))
that has deposits insured by the Federal Deposit Insurance Corporation
under the Federal Deposit Insurance Act (12 U.S.C. 1811). The proposed
rule would largely retain this definition of qualified custodian
relating to banks and savings associations. However, in connection with
the proposed rule's focus on setting certain minimum protections for
client assets, the rule would require that a qualifying bank or savings
association hold client assets in an account designed to protect such
assets from creditors of the bank or savings association in the event
of the insolvency or failure of the bank or savings association in
order to qualify as a qualified custodian. While applicable insolvency
law and procedures vary depending on any particular bank's regulatory
regime, we understand that assets held in these accounts are more
likely to be returned to clients upon the insolvency of the qualified
custodian because they may pass outside of a bank's insolvency, may be
recoverable if wrongly transferred or converted, and are not treated as
general assets of the bank.\483\
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    \483\ See supra footnote 96.
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    We believe that requiring banks and savings associations to hold
client assets in an account designed to protect such assets from
creditors of the bank or savings association in the event of the
insolvency or failure of the bank or savings association would benefit
clients by providing client assets with enhanced protection from
general creditors in the event of the qualified custodian's insolvency
or failure and increasing the likelihood of return of client assets to
advisory clients upon a qualified custodian's insolvency or failure. We
acknowledge, however, that the benefit would be limited to the clients
of those qualified custodians that would not be subject to the
resolution processes deployed by the FDIC or by the OCC or have not
developed and deployed comprehensive custodial service agreements
governing their relationships with their custodial customers. For those
custodians that would not be subject to the resolution processes
deployed by the FDIC or by the OCC or have not developed and deployed
comprehensive custodial service agreements governing their
relationships with their custodial customers, we estimate that changing
the terms of account agreements to comply with the proposed account
requirement would require 1 hour from an assistant general counsel
($510/hour) and 5 hours from a paralegal ($199/hour), for a total
estimated cost of $1,505 per agreement.
    Foreign Financial Institutions. The proposed definition of
qualified custodian would continue to include FFIs, but would require
an FFI to satisfy certain additional conditions in order to serve as a
qualified custodian for client investments. For an FFI to be a
qualified custodian under the proposed rule, it would need to be:
     Incorporated or organized under the laws of a country or
jurisdiction other than the United States, provided that the adviser
and the Commission are able to enforce judgments, including civil
monetary penalties, against the FFI;
     Regulated by a foreign country's government, an agency of
a foreign country's government, or a foreign financial regulatory
authority \484\ as a banking institution, trust company, or other
financial institution that customarily holds financial assets for its
customers;
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    \484\ Defined in section 202(a)(24) of the Advisers Act [15
U.S.C. 80b-2(a)(24)].
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     Required by law to comply with anti-money laundering and
related provisions similar to those of the Bank Secrecy Act [31 U.S.C.
5311, et seq.] and regulations thereunder;
     Holding financial assets for its customers in an account
designed to protect such assets from creditors of the foreign financial
institution in the event of the insolvency or failure of the foreign
financial institution;

     Having the requisite financial strength to provide due
care for client assets;
     Required by law to implement practices, procedures, and
internal controls designed to ensure the exercise of due care with
respect to the safekeeping of client assets; and
     Not operated for the purpose of evading the provisions of
the proposed rule.\485\
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    \485\ Proposed rule 223-1(d)(10)(iv).
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    As discussed in section II.B.1.b above, these proposed conditions
are partly drawn from our experience with the conditions on the types
of foreign financial entities that can act as ``eligible foreign
custodians'' as defined in rule 17f-5 under the Investment Company
Act.\486\ Such conditions are designed to provide enhanced investor
protections for advisory clients and their assets that we believe would
help promote an FFI having generally similar protections as a U.S.-
based qualified custodian.
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    \486\ Furthermore, the proposed rule would replace and
strengthen the segregation requirement applicable to FFIs in the
current custody rule, and it is designed to complement the proposed
segregation requirements of the safeguarding rule.
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    Advisory clients often invest in securities traded on foreign
exchanges and their advisers must, as a practical matter, maintain
securities with financial institutions in foreign countries where the
securities are traded. In order to facilitate these types of holdings,
the current rule includes any FFI that customarily holds financial
assets for its customers, as qualified custodian, provided that the FFI
keeps the advisory clients' assets in customer accounts segregated from
its proprietary assets. The proposed new conditions would require that
an FFI have similar protections as a U.S.-based qualified custodian,
thereby enhancing investor protections for advisory clients by reducing
the risk of loss of their securities and other financial assets held
outside the United States. For example, for an FFI to be a qualified
custodian under the proposed rule it would need to be regulated by a
foreign country's government, an agency of a foreign country's
government, or a foreign financial regulatory authority as a banking
institution, trust company, or other financial institution that
customarily holds financial assets for its customers. An FFI also would
have to be required by law to comply with AML requirements and related
requirements comparable to those of the Bank Secrecy Act.\487\ We
believe the requirement to comply with AML and related provisions
similar to those of the BSA and regulations thereunder would help
increase the likelihood that the FFI would readily identify and
investigate aberrant behavior in a client account, such as activity
that might suggest misappropriation or some other type of loss to a
client. An FFI also would have to hold financial assets for its
customers in an account designed to protect such assets from creditors
of the foreign financial institution in the event of the insolvency or
failure of the foreign financial institution. We believe this
requirement would help to promote investor protections that are more
comparable, particularly in the event of an FFI insolvency or
bankruptcy, to those we are proposing for assets held with U.S.-
regulated bank or savings association qualified custodians.
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    \487\ Proposed rule 223-1(d)(10)(iv)(C); see also pt. II.B.1.
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    FFIs that no longer meet the conditions to be a qualified custodian
would either incur costs to become compliant, or incur costs in the
form of lost custodial business, and potential loss of other banking
business from the same clients. Clients of FFIs that incur costs to
become compliant may experience higher fees. Clients whose assets were
maintained with banks and savings associations that do not comply with
the proposed requirements would incur one-time costs related to
switching custodians or, if no financial institutions qualify as
custodians in a country where securities are traded on a foreign
exchange,\488\ costs associated with divestiture, potentially at a
loss. Advisers would incur costs associated with loss of client assets
under management. The magnitude of these costs would depend on the
number of client accounts and the quantity of assets affected.\489\
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    \488\ This could occur if, for example, if the country does not
have a regulatory framework equivalent to the Bank Secrecy Act
requirements for reporting transactions to financial intelligence
authorities.
    \489\ We do not have data on the number of client accounts and
the quantity of assets affected.
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b. Possession or Control
    Under the custody rule, advisers with custody of client funds and
securities must maintain them with a qualified custodian, subject to
certain exceptions.\490\ The proposed rule would require that an
investment adviser with custody of client assets maintain those assets
with a qualified custodian that must maintain possession or control of
those assets.\491\ The term ``possession or control'' would mean
holding assets such that the qualified custodian is required to
participate in any change in beneficial ownership of those assets, the
qualified custodian's participation would effectuate the transaction
involved in the change in beneficial ownership, and the qualified
custodian's involvement is a condition precedent to the change in
beneficial ownership.\492\
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    \490\ See rule 206(4)-2(a)(1).
    \491\ See proposed rule 223-1(a)(1)(i).
    \492\ See proposed rule 223-1(d)(8).
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    The proposed requirement would benefit clients in several ways.
First, a critical custodial function is to prevent loss or unauthorized
transfers of ownership of client assets. It is our understanding that a
custodian will only provide this safeguarding function and assume
custodial liability for a custodial customer's loss if the custodian
has possession or control of the asset that is lost. Second, because
the qualified custodian would be required to participate in any change
in beneficial ownership of a client asset, the qualified custodian's
participation would effectuate the transaction involved in the change
in beneficial ownership, and the qualified custodian's involvement is a
condition precedent to the change in beneficial ownership, the proposed
possession or control definition would provide assurance to the client
that a regulated party who is hired for safekeeping services by the
client to act for the client is involved in any change in beneficial
ownership of the client's assets. Further, clients would be able to
review their account statements to evaluate the legitimacy of any
movement within their account, whether it is a trade, a payment, or a
fee withdrawal. Finally, clients could take greater comfort that what
is reported on their account statements is an accurate attestation of
holdings and transactions because anything held by a qualified
custodian would be required to be in its possession or control.
    The proposed definition is designed to be consistent with the laws,
rules, or regulations administered by the qualified custodian's