[Federal Register Volume 88, Number 46 (Thursday, March 9, 2023)]
[Proposed Rules]
[Pages 14672-14792]
[FR Doc No: 2023-03681]

Vol. 88

Thursday,

No. 46

March 9, 2023

Part II

 Securities and Exchange Commission

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17 CFR Parts 275 and 279

Safeguarding Advisory Client Assets; Proposed Rule

Federal Register / Vol. 88 , No. 46 / Thursday, March 9, 2023 /
Proposed Rules

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 275 and 279

[Release No. IA-6240; File No. S7-04-23]
RIN 3235-AM32

Safeguarding Advisory Client Assets

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'' or
``SEC'') is proposing a new rule under the Investment Advisers Act of
1940 (``Advisers Act'' or ``Act'') to address how investment advisers
safeguard client assets. To effect our redesignation of the current
custody rule for the proposed new safeguarding rule, we are proposing
to renumber the current rule. In addition we are proposing to amend
certain provisions of the current custody rule for enhanced investor
protections. We also are proposing corresponding amendments to the
recordkeeping rule under the Advisers Act and to Form ADV for
investment adviser registration under the Advisers Act.

DATES: Comments should be received on or before May 8, 2023.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's internet comment form (https://www.sec.gov/rules/submitcomments.html); or
     Send an email to [email protected]. Please include
File Number S7-04-23 on the subject line.

Paper Comments

     Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-04-23. This file number
should be included on the subject line if email is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
website (https://www.sec.gov/rules/proposed.shtml). Comments are also
available for website viewing and printing in the Commission's Public
Reference Room, 100 F Street NE, Washington, DC 20549, on official
business days between the hours of 10 a.m. and 3 p.m. Operating
conditions may limit access to the Commission's Public Reference Room.
All comments received will be posted without change. Persons submitting
comments are cautioned that the Commission does not redact or edit
personal identifying information from comment submissions. You should
submit only information that you wish to make available publicly.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.

FOR FURTHER INFORMATION CONTACT: Shane Cox, Laura Harper Powell,
Michael Schrader, and Samuel Thomas, Senior Counsels; Holly H. Miller,
Senior Financial Analyst; Alex Bradford and Michael Republicano,
Assistant Chief Accountants; Christopher Staley, Branch Chief; and
Melissa Roverts Harke, Assistant Director at (202) 551- 6787 or
[email protected], Investment Adviser Regulation Office, Division of
Investment Management, Securities and Exchange Commission, 100 F Street
NE, Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The Commission is proposing for public
comment to amend and renumber 17 CFR 275.206(4)-2 (rule 206(4)-2) under
the Investment Advisers Act of 1940 [15 U.S.C. 80b-1 et seq.] to
redesignate it as rule 17 CFR 275.223-1 (rule 223-1) under the Advisers
Act, and make corresponding amendments to 17 CFR 275.204-2 (rule 204-2)
and 17 CFR 279.1 (Form ADV) under the Advisers Act.\1\
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    \1\ 15 U.S.C. 80b. Unless otherwise noted, when we refer to the
Advisers Act, or any section of the Advisers Act, we are referring
to 15 U.S.C. 80b, at which the Advisers Act is codified, and when we
refer to rules under the Advisers Act, or any section of these
rules, we are referring to title 17, part 275 of the Code of Federal
Regulations [17 CFR 275], in which these rules are published.
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Table of Contents

I. Introduction
    A. Background
    B. Overview of the Proposal
II. Discussion
    A. Scope of Rule
    1. Scope of Assets
    2. Scope of Activity Subject to the Proposed Rule
    B. Qualified Custodian Protections
    1. Definition of Qualified Custodian
    2. Possession or Control
    3. Minimum Custodial Protections
    C. Certain Assets That Are Unable To Be Maintained With a
Qualified Custodian
    1. Definition of Privately Offered Security and Physical Assets
    2. Adviser's Reasonable Determination
    3. Adviser Reasonably Safeguards Assets
    4. Notification and Prompt Independent Public Accountant
Verification
    5. Surprise Examination or Audit
    D. Segregation of Client Assets
    E. Investment Adviser Delivery of Notice to Clients
    F. Amendments to the Surprise Examination Requirement
    G. Exceptions from the Surprise Examination
    1. Entities Subject to Audit (``Audit Provision'')
    2. Discretionary Authority
    3. Standing Letters of Authorization
    H. Amendments to the Investment Adviser Recordkeeping Rule
    1. Client Communications
    2. Client Accounts
    3. Account Activity
    4. Independent Public Accountant Engagements
    5. Standing Letters of Authorization
    I. Changes to Form ADV
    J. Existing Staff No-Action Letters and Other Staff Statements
    K. Transition Period and Compliance Date
III. Economic Analysis
    A. Introduction
    B. Broad Economic Considerations
    C. Baseline
    1. Current Regulation
    2. Affected Parties and Industry Statistics
    3. Market Practice
    D. Benefits and Costs of Proposed Rule and Form Amendments
    1. Scope
    2. Qualified Custodian Protections
    3. Certain Assets That Are Unable To Be Maintained With a
Qualified Custodian
    4. Segregation of Investments
    5. Investment Adviser Delivery of Notice to Clients
    6. Exceptions From the Surprise Examination
    7. Amendments to the Investment Adviser Recordkeeping Rule
    8. Changes to Form ADV
    E. Efficiency, Competition, and Capital Formation
    F. Reasonable Alternatives
    1. Scope of Assets
    2. Elimination of Privately Offered Securities Exception
    3. Distribution of Requirements Across Reasonable Assurances and
Written Agreement
    3. Additional Accounting and Client Notification Requirements
for Privately Offered Securities and Physical Assets That Are Not
Maintained With a Qualified Custodian
    4. Additional Safeguards When Clients Assets Are Not Maintained
With a Qualified Custodian
    5. Designating Clearing Agencies and Transfer Agents as
Qualified Custodians
    G. Request for Comment
IV. Paperwork Reduction Act Analysis
    A. Introduction
    B. Rule 223-1
    1. Qualified Custodian Provision
    2. Notice to Clients
    3. Annual Surprise Examination
    C. Exceptions

    1. Certain Assets That Are Unable To Be Maintained With a
Qualified Custodian
    2. Audit Provision
    D. Total Hour Burden Associated With Proposed Rule 223-1
    E. Rule 204-2
    F. Form ADV
    G. Request for Comments
V. Initial Regulatory Flexibility Analysis
    A. Reason for and Objectives of the Proposed Action
    1. Proposed Rule 223-1
    2. Proposed Rule 204-2
    3. Proposed Amendments to Form ADV
    B. Legal Basis
    C. Small Entities Subject to the Rule and Rule Amendments
    1. Small Entities Subject to Amendments to the Custody Rule
    D. Projected Reporting, Recordkeeping and Other Compliance
Requirements
    1. Proposed Rule 223-1
    2. Proposed Amendments to Rule 204-2
    3. Proposed Amendments to Form ADV
    E. Duplicative, Overlapping, or Conflicting Federal Rules
    F. Significant Alternatives
    1. Proposed New Rule 223-1 and Amendments to Rule 204-2 and Form
ADV
    G. Solicitation of Comments
VI. Consideration of Impact on the Economy
VII. Statutory Authority

I. Introduction

A. Background

    Rule 206(4)-2 under the Act (the ``custody rule'' or ``current
rule'') regulates the custodial practices of advisers. Although the
Commission has amended the rule over time as custodial and advisory
practices have changed, since its adoption it has been designed to
safeguard client funds and securities from the financial reverses,
including insolvency, of an investment adviser and to prevent client
assets from being lost, misused, stolen, or misappropriated.\2\
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    \2\ See Custody or Possession of Funds or Securities of Clients,
Investment Advisers Act Release No. 123 (Feb. 27, 1962) [44 FR 2149
(Mar. 6, 1962)] (``1962 Adopting Release''). See also Custody of
Funds or Securities of Clients by Investment Advisers, Investment
Advisers Act Release No. 2176 (Sept. 25, 2003) [68 FR 56692 (Oct. 1,
2003)] (``2003 Adopting Release''); Custody of Funds or Securities
of Clients by Investment Advisers, Investment Advisers Act Release
No. 2044 (Jul. 18, 2002) [67 FR 48579 (Jul. 25, 2002)], at nn. 3, 15
(``2002 Proposing Release'').
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    As originally adopted in 1962, the rule required all investment
advisers with ``custody'' (i.e., physical possession) of client funds
and securities to deposit client funds in a bank account that was
maintained in the adviser's name and contained only client funds.\3\
Advisers, in addition, were required to segregate client securities and
hold them in a ``reasonably safe'' place. In each case, the rule
required investment advisers to provide their clients notice of these
protocols and to engage an independent public accountant to conduct an
annual surprise examination \4\ to verify client funds and securities
independently. These requirements were designed to protect client
assets at a time when the system for owning and transacting in
securities was paper-based.
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    \3\ As with the current rule, the proposed amendments would
apply to investment advisers registered, or required to be
registered, with the Commission. However, the original rule was
broader in scope, applying to ``all investment advisers,'' until it
was amended in 1997. Rules Implementing Amendments to the Investment
Advisers Act of 1940, Investment Advisers Act Release No. 1633 (May
15, 1997) [62 FR 28112 (May 22, 1997)], at section II.I.5. Unless
otherwise indicated, references throughout this release to
``adviser'' or ``investment adviser'' refer to investment advisers
registered, or required to be registered, with the Commission.
Further, we have previously stated, and would continue to take the
position (if these amendments were adopted), that most of the
substantive provisions of the Advisers Act do not apply with respect
to the non-U.S. clients (including funds) of a registered offshore
adviser. This approach was designed to provide appropriate
flexibility where an adviser has its principal office and place of
business outside of the United States. We believe it would be
appropriate to continue to apply this approach, including in the
proposed safeguarding rule context (if adopted). For an adviser
whose principal office and place of business is in the United States
(onshore adviser), the Advisers Act and rules thereunder, including
the proposed safeguarding rule, would apply with respect to the
adviser's U.S. and non-U.S. clients. See Exemptions for Advisers to
Venture Capital Funds, Private Fund Advisers With Less Than $150
Million in Assets Under Management, and Foreign Private Advisers,
Release No. IA-3222 (June 22, 2011) [76 FR 39645 (July 6, 2011)]
(Most of the substantive provisions of the Advisers Act do not apply
to the non-U.S. clients of a non-U.S. adviser registered with the
Commission.); Registration Under the Advisers Act of Certain Hedge
Fund Advisers, Release No. IA-2333 (Dec. 2, 2004) [69 FR 72054,
72072 (Dec. 10, 2004)] (``Hedge Fund Adviser Release'') (stating (1)
that the following rules under the Advisers Act would not apply to a
registered offshore adviser, assuming it has no U.S. clients:
compliance rule, custody rule, and proxy voting rule; (2) stating
that the Commission would not subject an offshore adviser to the
rules governing adviser advertising [17 CFR 275.206(4)-1] or cash
solicitations [17 CFR 275.206(4)-3] with respect to offshore
clients; and (3) noting that U.S. investors in an offshore fund
generally would not expect the full protection of the U.S.
securities laws and that U.S. investors may be precluded from an
opportunity to invest in an offshore fund if their participation
would result in full application of the Advisers Act and rules
thereunder, but that a registered offshore adviser would be required
to comply with the Advisers Act and rules thereunder with respect to
any U.S. clients it may have).
    \4\ The terms ``surprise examination'' and ``independent
verification'' are used throughout the release and are generally
interchangeable.
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    The Commission amended the rule in 2003 to expand the definition of
custody beyond physical possession to include situations in which an
adviser had any ability to obtain possession of client funds or
securities. The 2003 amendments made clear that the rule applied to any
investment adviser ``holding, directly or indirectly, client funds or
securities, or having any authority to obtain possession of them.'' \5\
It included three illustrative examples in the rule's definition of
``custody'': (1) possession of client funds or securities, even
briefly; (2) authority to withdraw funds or securities from a client's
account; and (3) any capacity that gives the adviser legal ownership
of, or access to, client funds or securities.\6\ In the adopting
release, the Commission stated this expansion of the concept of adviser
custody would not include authorized trading, however, stating that
clients' custodians are generally under instructions to transfer funds
or securities out of a client's account only upon a corresponding
transfer of securities or funds into the account.\7\
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    \5\ See rule 206(4)-2(a). See also rule 206(4)-2(d)(v)(2)
(defining ``custody''). The original rule did not define
``custody,'' which was conceptualized at that time as limited to
physically holding securities.
    \6\ See id.
    \7\ See 2003 Adopting Release, supra footnote 2, at note 10 and
accompanying text.
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    In recognition of then-modern custodial practices, the Commission
in 2003 required advisers to keep securities (not just funds as under
the 1962 rule) with a custodian, and it expanded the types of
custodians that would qualify under the rule.\8\ The Commission
expressed concern that some advisers were still keeping certificates in
office files or safety deposit boxes, which put those securities at
risk.\9\ The Commission identified as ``qualified custodians'' the
types of regulated financial institutions that customarily provided
custodial services subject to regulatory examination.\10\ The
Commission also relied more on the protections of qualified custodians,
eliminating the adviser's need to undergo the rule's annual surprise
examination by an independent public accountant if the adviser had a
``reasonable belief'' that the qualified custodian would provide
account statements directly to the adviser's clients. The Commission
provided an exception, however, from the requirement to maintain client
securities with a qualified custodian after commenters had pointed out
that, on occasion, a client may purchase privately offered securities
where the only evidence of the client's ownership was recorded on the
issuer's books and

the transfer of ownership requires the consent of the issuer or the
holders of the issuer's outstanding securities. As a result, commenters
argued that it was difficult to maintain certain of these assets in
accounts with qualified custodians. The Commission noted that these
impediments to transferability along with the conditions it imposed in
the privately offered securities exception (``privately offered
securities exception''), including in some cases obtaining and
distributing audited financial statements (``the audit provision''),
provided external safeguards against the kinds of abuse the rule seeks
to prevent.
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    \8\ See 2003 Adopting Release supra footnote 2, at section I.
    \9\ See 2002 Proposing Release, supra footnote 2, at section
II.B.
    \10\ The financial institutions identified by the Commission
were broker-dealers, banks and savings associations, futures
commission merchants, and certain foreign financial institutions.
See 2003 Adopting Release at II.B.
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    The Commission most recently amended the rule in 2009 after several
enforcement actions against investment advisers, including actions
stemming from the frauds perpetrated by Bernard Madoff and Allen
Stanford (which also resulted in criminal convictions), alleging
fraudulent conduct that included, among other things, misappropriation
or other misuse of client assets involving certain affiliates of the
adviser.\11\ These cases underlined additional risks both when an
adviser has access to client funds or securities not explicitly covered
within the scope of the rule, as well as when the qualified custodian
is a related person of the adviser. In direct response to certain of
these cases, the 2009 amendments explicitly extended the scope of the
rule to reach an adviser's ability to access client funds or securities
through its related persons, expanded the circumstances in which a
surprise examination is necessary, and required advisers to obtain an
independent accountant's report evaluating internal controls related to
custody where the adviser or its related person serves as qualified
custodian.\12\
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    \11\ See Custody of Funds or Securities of Clients by Investment
Advisers, Investment Advisers Act Release No. 2968 (Dec. 30, 2009)
[75 FR 1455 (Jan. 11, 2010)], at n.1 (``2009 Adopting Release'')
(referring to the cases cited in Custody of Funds or Securities of
Clients by Investment Advisers, Investment Advisers Act Release No.
2876 (May 20, 2009) [74 FR 25353 (May 27, 2009)] (``2009 Proposing
Release'')). See also Judgment, ECF Doc No. 100, 4, United States v.
Madoff, No. 09 Cr. 213 (S.D.N.Y. June 29, 2009) (Bernard L. Madoff
pled guilty to eleven felony charges including securities fraud,
investment adviser fraud, mail fraud, wire fraud, three counts of
money laundering, false statements, perjury, and making false
filings with the SEC); Order Granting Motion for Summary Judgment,
SEC v. Stanford International Bank, Ltd., et al., Civil Action No.
3:09-CV0298 (N.D. Tex. Apr. 25, 2013) (the SEC obtained a $5.9
billion judgment against R. Allen Stanford who was convicted in a
parallel criminal case of conspiracy to commit mail and wire fraud,
four counts of wire fraud, five counts of mail fraud, one count of
conspiracy to obstruct an SEC investigation, one count of
obstruction of an SEC proceeding, and one count of conspiracy to
commit money laundering and sentenced to a total of 110 years in
prison); SEC v. WG Trading Investors, L.P., 09-CV-1750 (S.D.N.Y.
July 29, 2010) (involving a broker-dealer and affiliated registered
adviser that orchestrated a fraudulent investment scheme
misappropriating as much as $554 million and sending clients
misleading account information); Isaac I. Ovid, SEC Admin.
Proceeding No. 3-14313 (Mar. 30 2011) (registered investment adviser
and manager of purported hedge funds, pled guilty in parallel
criminal proceeding in connection with which he was required to pay
restitution in excess of $12 million); Young and Acorn Capital
Management, LLC, SEC Admin. Proceeding No. 3-14654 (Feb. 28 2012)
(registered investment adviser and its principal convicted of
misappropriating $95 million in a Ponzi scheme in a parallel
criminal case whereupon the SEC issued an order revoking the
adviser's registration and barred the principal from association
with an investment adviser, broker, dealer, municipal securities
dealer, or transfer agent); SEC v. The Nutmeg Group, LLC, et al.,
Litigation Release No. 24677 (Nov. 26, 2019) (commingled investor
funds with his personal assets, implemented flawed internal systems
and methods for valuing and reporting assets under management, and
transferred millions of dollars out of the investment pools to
himself and companies controlled by family members).
    \12\ See generally rule 206(4)-2; see also 2009 Adopting
Release, supra footnote 11, at sections II.A and B.
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    Following the Madoff and Stanford frauds, and on the heels of the
Commission's recently adopted 2009 amendments to the custody rule,
Congress expressly vested the Commission with authority to promulgate
rules requiring registered advisers to take steps to safeguard client
assets over which advisers have custody by adding section 223 to the
Advisers Act in the Dodd-Frank Wall Street Reform and Consumer
Protection Act (``Dodd-Frank Act'').\13\ Leading up to the enactment of
the Dodd-Frank Act, Congress heard testimony that certain client
investments were not covered by the custody rule because they were
neither funds nor securities, putting them at greater risk of loss,
theft, misappropriation, or being subject to the financial reverses of
an adviser.\14\ Congress also heard testimony about the important role
requiring advisers to maintain client funds and securities with
qualified custodians has in preventing fraud--a requirement that
applies only if an adviser is subject to the custody rule and the
assets are not subject to an exception from the qualified custodian
requirement.\15\ Subsequently, Congress authorized the Commission to
prescribe rules requiring advisers to take steps to safeguard all
client assets, not just funds and securities, over which an adviser has
custody.\16\
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    \13\ See section 411 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010)
(adding section 223 to the Advisers Act which provides ``[a]n
investment adviser registered under this subchapter shall take such
steps to safeguard client assets over which such adviser has
custody, including, without limitation, verification of such assets
by an independent public accountant, as the Commission may, by rule,
prescribe.'' 15 U.S.C. 80b-18b). Congress also required the U.S.
Government Accountability Office to study the rule's compliance
costs. See id. at section 412.
    \14\ See Regulating Hedge Funds and other Private Investment
Pools, Hearing Before the House Subcommittee on Securities,
Insurance, and Investment, 111 Cong. 50-51 (2009) (Statement of
James S. Chanos, Chairman, Coalition of Private Investment
Companies) (stating that the current rule's scope--which was ``funds
and securities'' and with an exception from certain protections for
privately offered securities--excluded assets such as privately
issued uncertificated securities, bank deposits, real estate assets,
swaps, and interests in other private investment funds leaving a
``gaping hole'' in the rule) (``Dodd Frank Regulating Hedge Funds
and other Private Investment Pools Testimony by James S. Chanos'').
Congress also heard testimony about the benefits qualified
custodians provide in preventing fraud. See id. (``Requiring
independence between the function of managing a private investment
fund and controlling its assets, by requiring that all assets be
titled in the name of a custodian bank or broker-dealer for the
benefit of the private fund and requiring all cash flows to move
through the independent custodian, would be an important control.
Similarly, requiring an independent check on the records of
ownership of the interests in the private investment fund, as well
as imposing standards for the qualification of private investment
fund auditors--neither of which currently is required by the
Advisers Act--would also greatly reduce opportunities for
mischief.'').
    \15\ See S. Rep. No. 111-176, at 77 (2010) (``the custodian
requirement largely removes the ability of an investment adviser to
pay the proceeds invested by new investors to old investors. The
custodian will take the instructions to buy or sell securities, but
not to remit the proceeds of sales to the adviser or to others
(except in return for share redemptions by investors). At a stroke,
this requirement eliminates the ability of the manager to `recycle'
funds from new to old investors.'' quoting Testimony of Professor
John C. Coffee, Jr.; The Madoff Investment Securities Fraud:
Regulatory and Oversight Concerns and the Need for Reform: Testimony
before the U.S. Senate Committee on Banking, Housing and Urban
Affairs, 111th Congress, 1st session, pp. 8, 10 (2009)).
    \16\ Earlier versions of this bill show that Congress considered
retaining the current rule's funds and securities formulation. See
Investor Protection Act of 2009, H.R. 3817, 111th Cong section 419
(2009).
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    In addition to this legislative context, industry developments
prompt us again to reconsider the important prophylactic protections of
the custody rule and to address certain gaps in protections--some of
which Congress identified and gave us the tools to address 13 years
ago.\17\ We have seen changes in

technology, advisory services, and custodial practices create new and
different ways for client assets to be placed at risk of loss, theft,
misuse, or misappropriation that may not be fully addressed under the
current rule.
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    \17\ The current rule has also been the subject of numerous
inquiries and requests for staff views. See, e.g., Staff Responses
to Questions about the Custody Rule (``Custody Rule FAQs''),
available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm; Privately Offered Securities under the
Investment Advisers Act Custody Rule, Division of Investment
Management Guidance Update No. 2013-04 (Aug. 2013) (``2013 IM
Guidance''); Private Funds and Application of the Custody Rule to
Special Purpose Vehicles and Escrows, Division of Investment
Management Guidance Update No. 2014-07 (June 2014) (``2014 IM
Guidance''). Staff reports, statistics, and other staff documents
(including those cited herein) represent the views of Commission
staff and are not a rule, regulation, or statement of the
Commission. Furthermore, the Commission has neither approved nor
disapproved these documents and, like all staff statements, they
have no legal force or effect, do not alter or amend applicable law,
and create no new or additional obligations for any person. The
Commission has expressed no view regarding the analysis, findings,
or conclusions contained therein. As discussed in section II.J,
staff in the Division of Investment Management is reviewing staff
no-action letters and other staff letters to determine whether any
such letters should be withdrawn in connection with any adoption of
this proposal. If the rule is adopted, some of the letters and
statements may be moot, superseded, or otherwise inconsistent with
the rule and, therefore, would be withdrawn.
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    For example, advisory services have expanded and developed in
recent years, leading to questions about the scope of activities that
trigger application of the current rule. More specifically, nearly 20
years ago when the Commission interpreted authorized trading not to be
within the definition of custody, it had stated that clients'
custodians are generally under instructions to transfer funds or
securities out of a client's account only upon corresponding transfer
of securities or funds into the account. At the time, the Commission's
view was that such an arrangement would minimize the risk that an
adviser could withdraw or misappropriate the funds or securities in its
client's custodial account.
    Discretionary trading practices today, however, do not necessarily
involve a one-for-one exchange of assets under a custodian's oversight.
For instance, an adviser may instruct an issuer or a transfer agent
that recorded ownership of a client's privately offered security to
redeem the client's interest and direct the proceeds to a particular
account. Because there is no qualified custodian involved in such a
transaction, a client's ability to monitor its investments for
suspicious activity is limited (e.g., a qualified custodian would not
attest to this transaction on the account statements it provides), and
a surprise examination or an audit may not discover any
misappropriation until the assets are gone. Moreover, if the security
is not included in the sample over which an accountant performs its
procedures during a surprise examination or if the client's holdings of
the security do not meet the materiality threshold for a financial
statement audit, misappropriation may go undetected for an
indeterminate amount of time.
    Other times, advisers find themselves subject to the rule because
of authority they do not wish to have. For instance, we understand that
some advisory clients' custodial agreements empower investment advisers
with a broad array of authority that they neither want nor use.\18\
Advisers have little to no ability to eliminate this authority because
they are usually not parties to the custodial agreements between
clients and qualified custodians, but nonetheless these arrangements
result in an adviser having custody under the rule.
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    \18\ We use the term ``custodial agreement'' throughout the
release to refer to a contract between an advisory client and the
qualified custodian. The adviser usually is not a party.
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    While these developments suggest a need to protect clients better
and modify the application of the current rule, other developments
suggest a need to improve the rule's efficacy, including particularly
the protections provided by the qualified custodian, who has long been
the key gatekeeper under this rule. A growing number of assets are not
receiving custodial protections as a result of certain of the current
rule's exceptions from the requirement to maintain assets with a
qualified custodian, particularly the exception for privately offered
securities.\19\ That exception and the exception for mutual fund shares
were adopted at a time when dematerialized ownership of securities was
still developing, and the exceptions were envisioned as being necessary
``at times'' or ``on occasion.'' This rarity is no longer the case. We
understand that, today, the overwhelming majority of securities are
uncertificated, the volume of privately offered securities has vastly
expanded with the expansion of private capital, and custodians have
developed safeguarding and reporting practices, particularly with
respect to publicly traded securities.\20\ We acknowledge that the
custodial market for privately issued securities is less developed,\21\
but we believe that some custodians presently custody these assets and
we understand that new custodial services are being developed.\22\ What
has also developed, however, is 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 (``accommodation reporting''). The custodian
merely reports the holdings or transactions as reported to it by the
adviser. This practice undermines the account statement's integrity and
utility in helping to verify that the client owns the assets and they
have not been stolen or misappropriated. We view the integrity of
custodial account statements to be critical to the safeguarding of
client assets. Clients should 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. In
contrast, the current exception for mutual fund shares requires a
transfer agent of the mutual fund to fulfill all of the obligations
assigned to a qualified custodian under the rule, including sending
statements directly to the client. In our longstanding experience with
the current rule, this exception has not raised similar types of
investor protection concerns.
---------------------------------------------------------------------------

    \19\ Preqin Global Private Debt Report (2018), available at
https://docs.preqin.com/samples/2018-Preqin-Global-Private-Debt-Report-Sample-Pages.pdf (showing the growth in private capital
assets under management from 2007 to 2017 by the following asset
classes: private equity, private debt, real estate, infrastructure,
natural resources).
    \20\ See discussion in section II.C infra and at text
accompanying footnote 229.
    \21\ We understand that many qualified custodians will not
currently accept custodial liability for certain instruments
including certain crypto assets, commodities, and privately issued
securities. See Letter to Karen Barr re Engaging on Non-DVP
Custodial Practices and Digital Assets: Investment Advisers Act of
1940: Rule 206(4)-2 (Mar. 12, 2019) (``2019 RFI'').
    \22\ See, e.g., DTCC, Project Whitney Case Study (May 2020),
available at https://www.dtcc.com/~/media/Files/Downloads/
settlement-asset-services/user-documentation/Project-Whitney-
Paper.pdf.
---------------------------------------------------------------------------

    At the same time, the evolution of financial products and services
discussed above has led to new entrants and new services in the
custodial marketplace, including newly launched state-chartered trust
companies, as well as established bank and broker-dealer custodians
seeking to develop new practices to safeguard assets.\23\ Our staff has
also observed a general reduction in the level of protections offered
by custodians, often resulting in advisory clients with the least
amount of bargaining power (i.e., retail investors) receiving the most
limited protections. We understand, for instance, that it is
decreasingly common for banks acting as custodians to do so in a
fiduciary capacity.\24\ These changes in the

industry have caused us to reconsider the role of a ``qualified
custodian'' under our rule and what minimum protections clients should
receive.
---------------------------------------------------------------------------

    \23\ See, e.g., Tomito Geron, Companies Compete to Be
Cryptocurrency Custodians, The Wall Street Journal (Sept. 17, 2019).
    \24\ See OCC Bulletin 2019-21, April 29, 2019, ``Fiduciary
Regulations; Non-Fiduciary Activities; Advance Notice of Proposed
Rulemaking.'' According to this Bulletin, Bank non-fiduciary custody
activities have increased in asset size since 1996. This Bulletin
reports, as of December 2018, bank non-fiduciary custody assets were
about $42 trillion, whereas bank fiduciary custody assets were about
$9 trillion. See also Edward H. Klees, How Safe are Institutional
Assets in a Custodial Bank's Insolvency, 68 Bus. LAW. 103, 110,
footnote 46 (2012) (``Klees Article''). In addition to certain
institutions identified under the Home Owners' Loan Act and members
of the Federal Reserve System, the Advisers Act generally identifies
``banks'' as banking institutions or savings associations a
substantial portion of the business of which consists of receiving
deposits or exercising fiduciary powers similar to those permitted
to national banks. Advisers Act sec. 202(a)(2).
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    Finally, since the Commission last amended the current rule, there
have been significant developments with respect to crypto assets,\25\
which generally use distributed ledger or blockchain technology
(broadly referred to as ``DLT'') \26\ as a method to record ownership
and transfer assets. While potentially creating certain efficiencies in
transactions, this technology also presents technological, legal, and
regulatory risks to advisers and their clients.\27\ Unlike mechanisms
used to transact in more traditional assets, this technology generally
requires the use of public and private cryptographic key pairings,
resulting in the inability to restore or recover many crypto assets in
the event the keys are lost, forgotten, misappropriated, or
destroyed.\28\ By design, DLT finality often makes it difficult or
impossible to reverse erroneous or fraudulent crypto asset
transactions, whereas processes and protocols exist to reverse
erroneous or fraudulent transactions with respect to more traditional
assets. These specific characteristics could leave advisory clients
without meaningful recourse to reverse erroneous or fraudulent
transactions, recover or replace lost crypto assets, or correct errors
that result from their adviser having custody of these assets.
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    \25\ There are also digital assets. The term ``digital asset''
refers to an asset that is issued and/or transferred using
distributed ledger or blockchain technology, including, but not
limited to, so-called ``virtual currencies,'' ``coins,'' and
``tokens.'' See Custody of Digital Asset Securities by Special
Purpose Broker-Dealers, Securities Exchange Act Release No. 90788
(Dec. 23, 2020), 86 FR 11627, 11627 n.1 (Feb. 26, 2021)
(``Commission Statement''). A digital asset may or may not meet the
definition of a ``security'' under the Federal securities laws. See,
e.g., Report of Investigation Pursuant to section 21(a) of the
Securities Exchange Act of 1934: The DAO, Securities Exchange Act
Release No. 81207 (July 25, 2017) (``DAO 21(a) Report''), available
at https://www.sec.gov/litigation/investreport/34-81207.pdf; SEC v.
W.J. Howey Co., 328 U.S. 293 (1946). To the extent digital assets
rely on cryptographic protocols, these types of assets also are
commonly referred to as ``crypto assets.'' For purposes of this
release, the Commission does not distinguish between the terms
``digital asset'' and ``crypto asset.''
    \26\ The terms DLT and blockchain, a type of DLT, generally
refer to databases that maintain information across a network of
computers in a decentralized or distributed manner. Blockchain
networks commonly use cryptographic protocols to ensure data
integrity. See, e.g., World Bank Group, ``Distributed Ledger
Technology (DLT) and Blockchain,'' FinTech Note No. 1 (2017),
available at: https://openknowledge.worldbank.org/bitstream/handle/10986/29053/WP-PUBLIC-Distributed-Ledger-Technology-and-Blockchain-Fintech-Notes.pdf?sequence=1&isAllowed=y.
    \27\ We note that our staff has expressed a similar view. See,
e.g., SEC Staff Accounting Bulletin No. 121, [87 FR 21016 (Apr. 11,
2022)] (generally describing risks related to the safeguarding of
crypto assets); Custody of Digital Asset Securities by Special
Purpose Broker-Dealers, supra footnote 25 (generally discussing
risks related to broker-dealer custody of crypto asset securities).
See also Joint Statement on Crypto-Asset Risks to Banking
Organizations (Jan 3, 2023), available at https://occ.treas.gov/news-issuances/news-releases/2023/nr-ia-2023-1a.pdf (generally
discussing risks related to bank custody of crypto assets).
    \28\ See, e.g., Not Your Keys, Not Your Coins: Unpriced Credit
Risk in Cryptocurrency, at section I, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4107019.
---------------------------------------------------------------------------

    Additionally, we understand that many advisers may be reluctant to
provide a full range of advisory services to their clients with respect
to crypto assets because of concerns that a market for custodial
services to safeguard these assets has not yet fully developed. We
understand that other advisers provide advisory services 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 might
take the position that crypto assets are not covered by the custody
rule at all. This, however, is incorrect because most crypto assets are
likely to be funds or crypto asset securities covered by the current
rule.\29\
---------------------------------------------------------------------------

    \29\ The application of the current rule turns on whether a
particular client investment is a fund or a security. To the extent
there is a question as to whether a particular crypto asset is an
investment contract that is a security, the analysis is governed by
the test first articulated by the Supreme Court in SEC v. W.J. Howey
Co., 328 U.S. 293, 301 (1946). See, e.g., SEC v. Kik Interactive
Inc., 492 F. Supp. 3d 169, 177-180 (S.D.N.Y. 2020) (applying Howey
in granting the Commission's motion for summary judgment finding
Kik's sale of Kin tokens to the public was a sale of a security and
required a registration statement); SEC v. LBRY, No. 21-CV-260-PB,
2022 WL 16744741 (D.N.H. Nov. 7, 2022) (applying Howey in granting
the Commission's motion of summary judgement finding ``no reasonable
trier of fact could reject the SEC's contention that LBRY offered
LBC [a crypto asset] as a security.'' Id. at 21); Report of
Investigation Pursuant to section 21(a) of the Securities Exchange
Act of 1934: The DAO, Rel. No. 81207 (July 25, 2017) (describing how
DAO tokens were securities under Howey); see also Spotlight on
Crypto Assets and Cyber Enforcement Actions, available at https://www.sec.gov/spotlight/cybersecurity-enforcement-actions.
Importantly, even if a particular crypto asset is not a security,
the current rule also covers funds.
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B. Overview of the Proposal

    In the light of these developments and additional authority that
Congress has given us under the Dodd-Frank Act to prescribe investment
adviser custody rules, we are redesignating the custody rule as new
rule 223-1 under the Advisers Act (the ``safeguarding rule'' or the
``proposed rule'') and proposing a number of amendments to strengthen
its protections.\30\ The proposal is designed to recognize the
evolution in products and services investment advisers offer to their
clients and to strengthen and clarify existing custody protections,
while also proposing complementary refinements to how advisers report
custody information on Form ADV and the books and records they are
required to keep that are designed to improve our oversight and risk-
assessment abilities.\31\ Importantly, the proposal maintains the core
purpose of protecting client assets from loss, misuse, theft, or
misappropriation by, and the insolvency or financial reverses of, the
adviser and maintains the Commission's ability to pursue advisers for
failing to properly safeguard client assets under the Act's antifraud
provisions.\32\
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    \30\ We are also renumbering portions of the custody rule that
we are not amending.
    \31\ In a technical, conforming change from the current rule,
the proposed rule would replace, in certain places, references to
``you'' with ``investment adviser.''
    \32\ While we are renumbering the current rule as rule 223-1,
section 206(4) is still available to the Commission and is also a
basis of statutory authority for this proposed rulemaking. To
establish a violation of section 206(4) for an adviser's failure to
safeguard client assets, the Commission does not need to demonstrate
that an investment adviser acted with scienter. See SEC v. Steadman,
967 F.2d 636, 646-7 (D.C. Cir. 1992). As we noted when we adopted
rule 206(4)-8, the court in Steadman analogized section 206(4) of
the Advisers Act to section 17(a)(3) of the Securities Act, which
the Supreme Court had held did not require a finding of scienter
(citing Aaron v. SEC, 446 U.S. 680 (1980)). See Prohibition of Fraud
by Advisers to Certain Pooled Investment Vehicles, Investment
Advisers Act Rel. 2628, (Aug. 3, 2007), 72 FR 44763 (Aug. 9, 2007).
See also Steadman at 643, n.5.
---------------------------------------------------------------------------

    First, the proposed amendments are designed to modernize the scope
of assets and activities that would trigger application of the rule. In
today's increasingly complex and global financial markets, this update
also would simplify the rule's application and better align the rule
with the Commission's statutory authority.\33\ Because investment
advisers provide

services related to an array of financial products beyond just funds or
securities, the proposed rule would require certain minimum
protections, particularly the safeguards of a qualified custodian, for
substantially all types of client assets held in an advisory account.
Specifically, the safeguarding rule would specify the types of assets
subject to the safeguarding requirements of the rule by defining
``assets'' as ``funds, securities, or other positions held in a
client's account,'' as opposed to the custody rule's use of ``funds and
securities.'' \34\ This change would expressly include certain assets
that may not have previously been categorized as ``funds'' or
``securities'' and would accommodate developments in the market for
various investment types that develop in the future, irrespective of
their status as funds or securities. By expanding the scope of the rule
to include client assets instead of only client funds and securities,
we believe we are properly balancing the desire of investment advisers
to provide advisory services regarding novel or innovative asset types
with the need to ensure that such assets are properly safeguarded.
---------------------------------------------------------------------------

    \33\ See supra note 16 and accompanying text.
    \34\ See 15 U.S.C. 80b-23 (``section 223'') ``An investment
adviser registered under this subchapter shall take such steps to
safeguard client assets over which such adviser has custody,
including, without limitation, verification of such assets by an
independent public accountant, as the Commission may, by rule,
prescribe.'' See proposed rule 223-1(a).
---------------------------------------------------------------------------

    The proposed rule also would explicitly include discretionary
authority to trade within the definition of custody.\35\ When an
adviser has discretion to trade client assets, it has an arrangement in
which it may instruct the adviser's custodian to dispose the client's
assets. An adviser with discretion may also have broad authority to
direct purchases or sales of client assets that may not currently
involve a qualified custodian, such as loan participation interests. An
adviser's ability or authority to effect a change in beneficial
ownership of a client's assets, including for purposes of trading,
could place client assets at risk of loss that the rule is designed to
address.\36\ This change would rectify any unintended consequences of
our prior interpretive position.\37\
---------------------------------------------------------------------------

    \35\ Proposed rule 223-1(d)(3).
    \36\ See section II.A.2. Recognizing that there are times when
an investment adviser neither wants nor uses the ability or
authority that would trigger the proposed rule and that there are
times when an adviser inadvertently receives client investments, the
proposed rule would provide limited and tailored exclusions in these
circumstances. See infra, discussion of discretionary trading
authority in section II.G.2.
    \37\ When adopting amendments to the custody rule in 2003, we
stated in a footnote: ``An adviser's authority to issue instructions
to a broker-dealer or [other] custodian to effect or settle trades
does not constitute `custody.' Clients' custodians are generally
under instructions to transfer funds (or securities) out of a
client's account only upon corresponding transfer of securities (or
funds) into the account. This `delivery versus payment' arrangement
minimizes the risk that an adviser could withdraw or misappropriate
the funds or securities in its client's custodial account.'' 2003
Adopting Release, supra footnote 2, at n.10. Absent this narrowly
drawn exception for ``delivery versus payment'' transactions,
authorized trading comes within the definition of custody.
---------------------------------------------------------------------------

    Like the custody rule, the safeguarding rule would entrust
safekeeping of client assets to a qualified custodian because we
continue to believe it provides critical safeguards for those assets.
Unlike the custody rule, however, the safeguarding rule would specify
that a qualified custodian does not ``maintain'' a client asset for
purposes of the rule if it does not have ``possession or control'' of
that asset. The proposed rule would further define ``possession or
control'' to mean holding assets such that the qualified custodian is
required to participate in any change in beneficial ownership of those
assets.\38\ This change is designed to improve account statement
integrity and reliability by eliminating an adviser's ability to
request accommodation reporting.\39\ Further, in a change from the
current rule, the proposed rule would require an adviser to enter into
a written agreement with and receive certain assurances from the
qualified custodian to make sure the qualified custodian provides
certain standard custodial protections when maintaining client
assets.\40\
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    \38\ Proposed rule 223-1(d)(8). For further discussion of
possession or control, please see discussion infra section II.B.2.
    \39\ See infra discussion section II.B.3.b.ii.
    \40\ Proposed rule 223-1(a)(1).
---------------------------------------------------------------------------

    Under the proposal, the written agreement would require two
provisions that are not explicitly addressed by the current rule. One
provision would require the qualified custodian to provide promptly,
upon request, records relating to clients' assets held in the account
at the qualified custodian to the Commission or to an independent
public accountant engaged for purposes of complying with the
safeguarding rule. The other would specify the adviser's agreed-upon
level of authority to effect transactions in the account. The proposed
rule's written agreement requirement would also incorporate, and
expand, two components of the current rule: account statements and
internal control reports. Under the first, the written agreement must
contain a provision requiring the qualified custodian to deliver
account statements to clients and to the adviser, as currently advisers
must have only a reasonable basis for believing this is done. The other
provision would require the qualified custodian to obtain a written
internal control report that includes an opinion of an independent
public accountant regarding the adequacy of the qualified custodian's
controls. This provision expands the internal control requirement to
all qualified custodians from the current rule's application to an
adviser or its related person \41\ that acts as a qualified custodian.
---------------------------------------------------------------------------

    \41\ The term ``related person'' would have the same meaning as
in the current rule.
---------------------------------------------------------------------------

    In addition to the written agreement requirement, advisers would
have to obtain reasonable assurances that the qualified custodian
satisfies five additional enumerated items.\42\ These include
assurances that the custodian will: (1) exercise due care in accordance
with reasonable commercial standards in discharging its duty as
custodian and implement appropriate measures to safeguard client assets
from theft, misuse, misappropriation, or other similar type of loss;
(2) indemnify the client against losses caused by the qualified
custodian's negligence, recklessness, or willful misconduct; (3) not be
excused from its obligations to the client as a result of any sub-
custodial or other similar arrangements; (4) clearly identify and
segregate client assets from the custodian's assets and liabilities;
and (5) not subject client assets to any right, charge, security
interest, lien, or claim in favor of the qualified custodian or its
related persons or creditors, except to the extent agreed to or
authorized in writing by the client.
---------------------------------------------------------------------------

    \42\ See proposed rule 223-1(a)(1)(ii).
---------------------------------------------------------------------------

    We are proposing to modify the current rule's privately offered
securities exception from the obligation to maintain client assets with
a qualified custodian by expanding the exception to include certain
physical assets.\43\ We are also proposing refinements to the
definition of privately offered securities that are designed to ensure
appropriate application and interpretation of this exception.\44\ In
addition, we are proposing to modify the conditions for relying on this
exception to improve investor protections in the absence of one of the
rule's key gatekeepers. Specifically, an adviser could rely on the
exception only if it reasonably

determines that ownership cannot be recorded and maintained by a
qualified custodian, the adviser reasonably safeguards the assets, the
adviser notifies the independent public accountant performing the
verification of such an asset transfer within one business day, an
independent public accountant verifies asset transfers and notifies the
Commission upon the findings of any material discrepancies, and the
existence and ownership of the assets are verified during an annual
independent verification or as part of a financial statement audit by
an independent public accountant.\45\ The modifications are also
designed to limit availability of the exception to circumstances that
truly warrant it because we believe the bulk of advisory client assets
are able to be maintained by qualified custodians and should be
safeguarded in the manner contemplated under the safeguarding rule.
---------------------------------------------------------------------------

    \43\ See proposed rule 223-1(b)(2).
    \44\ See proposed rule 223-1(d)(9).
    \45\ See proposed rule 223-1(b)(2).
---------------------------------------------------------------------------

    Under the proposed rule, advisers with custody of client assets
would be required to segregate those assets by (1) titling or
registering the assets in the client's name or otherwise holding the
assets for the client's benefit, (2) not commingling the assets with
the adviser's or any of its related persons' assets, and (3) not
subjecting the assets to any right, charge, security interest, lien, or
claim of any kind in favor of the investment adviser or its related
persons or creditors, except to the extent agreed to or authorized in
writing by the client.\46\ This provision, which would apply regardless
of whether the client's assets are maintained by a qualified custodian,
is designed to prevent the adviser, or its related person, from using
client assets for its own purposes or in a manner not authorized by the
client or in a manner inconsistent with its fiduciary duty. We believe
this will also help to protect client assets and enable them to be
returned in the event that an adviser experiences financial hardship.
---------------------------------------------------------------------------

    \46\ See proposed rule 223-1(a)(3).
---------------------------------------------------------------------------

    The proposed rule would continue to depend on the protections
provided by independent public accountants. We have long relied on
these third-party gatekeepers to provide ``another set of eyes'' on
client assets, and we believe they serve an important role in
safeguarding client assets. In light of the proposed changes to the
rule's scope, however, the proposal seeks to balance better the costs
associated with obtaining a surprise examination with the investor
protections it offers by providing exceptions to the surprise
examination requirement when the adviser's sole reason for having
custody is because it has discretionary authority or because the
adviser is acting according to a standing letter of authorization, each
subject to certain conditions.\47\ We believe that the risk to client
assets is lower in these contexts and the protections offered by the
surprise examination may not justify the cost of obtaining one.
Finally, the proposed safeguarding rule amendments would expand the
scope of who can satisfy the rule's surprise examination requirement
through financial statement audits by specifying that an entity is not
required to be a limited partnership, limited liability company, or
another type of pooled investment vehicle to rely on this
provision.\48\
---------------------------------------------------------------------------

    \47\ See proposed rule 223-1(b)(7) and (8).
    \48\ See proposed rule 223-1(b)(4).
---------------------------------------------------------------------------

    The proposal also seeks to update and enhance recordkeeping
requirements for advisers that would work in concert with the proposed
rule. We believe that these updates would enhance the Commission's
oversight of the safeguarding practices of advisers and their
compliance with the rule, which will, in turn, promote investor
protections.
    Finally, we are proposing amendments to Form ADV to align reporting
obligations with the proposal and improve the accuracy of custody-
related data available to the Commission, its staff, and the public. In
addition, we are improving the structure of Form ADV Item 9.\49\ More
accurate and comprehensive information that aligns with the proposed
rule would inform the Commission's examination initiatives and would
allow the Commission and its staff to better assess risks specific
advisers pose to investors.\50\
---------------------------------------------------------------------------

    \49\ See infra discussion at section II.I.
    \50\ See infra discussion at section II.J. Because Form ADV Part
1A is submitted in a structured, XML-based data language specific to
that form, the information in the proposed amendments to Part 1A
would continue to be structured (i.e., machine-readable).
---------------------------------------------------------------------------

II. Discussion

A. Scope of Rule

    Like the current rule, the proposed rule would apply to any
investment adviser registered or required to be registered with the
Commission under section 203 of the Act that has ``custody'' of a
client's assets.\51\ Also consistent with the current rule, the
proposed rule would also apply to any adviser whose ``related persons''
have custody in connection with advisory services the adviser provides
to the client.\52\
---------------------------------------------------------------------------

    \51\ Proposed rule 223-1. As with the current rule, an adviser
would be required to comply with the proposed rule in circumstances
where the adviser provides advisory services to a person's assets,
even if uncompensated. ``Although a person is not an `investment
adviser' for purposes of the Advisers Act unless it receives
compensation for providing advice to others, once a person meets
that definition (by receiving compensation from any client to which
it provides advice), the person is an adviser, and the Act applies
to the relationship between the adviser and any of its clients
(whether or not the adviser receives compensation from them).'' See
Rules Implementing Amendments to the Investment Advisers Act of
1940, Investment Advisers Act Release No. 3221 (June 22, 2011) [76
FR 42,950 (July 19, 2011)], at text accompanying n.74.
    \52\ Consistent with the current rule, under the proposed rule,
the term ``related person'' would mean ``any person, directly or
indirectly, controlling or controlled by [the investment adviser],
and any person that is under common control with [the investment
adviser].'' Proposed rule 223-1(d)(11).
---------------------------------------------------------------------------

    The proposed rule would change the current rule's scope, however,
in two important ways. First, it would expand the types of investments
covered by the rule. Currently, the rule applies to client ``funds and
securities'' of which an adviser has custody. The proposed rule would
extend the rule's coverage beyond client ``funds and securities'' to
client ``assets'' so as to include additional investments held in a
client's account. Second, the proposed rule would make explicit that
the current rule's defined term ``custody'' includes discretionary
authority.
1. Scope of Assets
    The proposed rule would define ``assets'' as ``funds, securities,
or other positions held in a client's account.'' \53\ The proposal,
like the current rule, therefore would apply to a client's funds as
well as a client's securities. However, the proposed rule also would
apply to other positions held in a client's account that are not funds
or securities. This proposed change uses the more expansive and
explicit language employed by Congress in empowering the Commission to
develop rules to protect client assets when advisers have custody.\54\
Congress made this change following several high profile enforcement
actions relating to misappropriation of client assets.\55\ The proposed
amendments also recognize the continued evolution of the types of
investments held in advisory accounts since the custody rule was
amended in 2009 and since the enactment of section 223. Looking
forward, the proposed definition of assets is designed to remain
evergreen, encompassing new investment types as they continue to evolve
and multiply to recognize that the protections of the rule should not

depend on which type of assets the client entrusts to the adviser.
---------------------------------------------------------------------------

    \53\ Proposed rule 223-1(d)(1).
    \54\ See section 223, supra footnote 34.
    \55\ See supra footnote 11.
---------------------------------------------------------------------------

    The proposed rule's use of the term ``other positions'' in the
definition of assets encompasses holdings that may not necessarily be
recorded on a balance sheet as an asset for accounting purposes,
including, for example, short positions and written options.\56\ We
believe, in the advisory account context, that the entirety of a client
account's positions, holdings, or investments should receive the
protections of the proposed rule regardless of how they may be treated
for accounting purposes. Moreover, the fiduciary duty extends to the
entire relationship between the adviser and client regardless of
whether a specific holding in a client account meets the definition of
funds or a security.\57\ Consequently, the proposed rule's definition
of assets would include investments such as all crypto assets, even in
the instances where such assets are neither funds nor securities.\58\
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 be
clearly funds or securities covered by the current rule.\59\
Additionally, physical assets, including artwork, real estate, precious
metals, or physical commodities (e.g., wheat or lumber), would be
within the scope of the proposed rule. ``Assets'' also would encompass
investments that would be accounted for in the liabilities column of a
balance sheet or represented as a financial obligation of the client
including negative cash, which we believe would be consistent with the
purposes of the Act and the longstanding policy goal of the rule to
prevent potential fraud, misuse, or misappropriation.\60\
---------------------------------------------------------------------------

    \56\ Similarly, rule 6(c)-11 under the Investment Company Act of
1940 [15 U.S.C. 80a-1 et seq.] (the ``Investment Company Act'')
defines an exchange-traded fund's portfolio holdings as the
securities, assets, or other positions held by the exchange-traded
fund. See 17 CFR 270.6c-11. See Exchange Traded Funds, Investment
Company Act Release No. 33646 (Sept. 25, 2019) [84 FR 57162 (Oct.
24, 2019)], at n.249 (including within the term ``other positions''
short positions in equity, overdrawn or negative cash balances,
written call or put options (where the other side has the option and
can put or call the underlying instrument to the party who wrote the
contract)).
    \57\ See Commission Interpretation Regarding Standard of Conduct
for Investment Advisers, Release No. IA-5248 (Jun. 5, 2019) at
footnote 17 (discussing the broad scope of the fiduciary duty in a
variety of contexts, including situations where securities are not
specifically involved).
    \58\ Crypto assets that are funds or securities are subject to
the current custody rule, which applies to all ``funds and
securities'' over which an adviser has custody. See discussion of
whether crypto assets or digital assets meet the definition of
security at supra footnote 29.
    \59\ Id. Our staff has taken a similar position regarding
collateral for transactions, such as swaps. See Custody Rule FAQs,
supra footnote 17, at Question II.10.
    \60\ See rule 6c-11, supra footnote 56. The release discussed
that liabilities were contemplated to be part of ``other
positions.''
---------------------------------------------------------------------------

    We also request comment on all aspects of the proposed definition
of ``assets,'' including the following items:
    1. Should the rule apply to client ``assets'' beyond the scope of
the current rule's formulation of ``funds or securities,'' as proposed?
Should the proposed rule include the term ``other positions'' as a
catch-all for a client's positions subject to the adviser-client
relationship? Should another term, such as client investments, be used
instead?
    2. Should we define client ``assets'' by referencing other terms,
such as ``securities and similar investments'' or ``any investment,''
which are used but not defined in the Investment Company Act custody
rules? \61\ Should we instead incorporate the term ``investment'' from
the definition of ``qualified purchaser'' under the Investment Company
Act? \62\
---------------------------------------------------------------------------

    \61\ See rules 17f-1, 17f-2, 17f-5, and 17f-6 under the
Investment Company Act.
    \62\ See rule 2a51-1(b) under the Investment Company Act.
---------------------------------------------------------------------------

    3. Are there particular types of assets held in a client's advisory
account that should or should not be subject to the proposed rule? If
so, what are they and why should they be included or excluded? Are
there other safeguards outside of the proposed rule that apply to these
positions that would satisfy the policy goals of the rule? Does the
answer depend on the type of asset?
    4. To the extent that the adviser has custody of certain physical
assets, should we narrow the proposed definition to exclude such
physical assets? For example, should the proposed definition exclude
artwork, real estate, precious metals, or physical commodities (e.g.,
wheat or lumber), for example?
    5. It is our understanding that some advisers treat client assets
that may not be ``funds or securities'' consistent with rule 206(4)-2.
If so, what types of assets do they maintain with a qualified custodian
under the current rule? If not, how do the advisers safeguard these
client assets?
    6. Should we provide guidance about how the proposed rule would
apply to certain asset types? If so, for what types of assets? Should
we provide guidance for certain assets that would be subject to
exceptions from the proposed rule, such as privately offered securities
or physical assets?
    7. Should the proposed rule apply to assets that are treated as
liabilities from an accounting perspective? Is it sufficiently clear
that the proposed rule would apply to portfolio holdings that are
liabilities on a balance sheet? Should we provide additional
clarification as to what types of investments may appear as liabilities
within the scope of the advisory relationship? What types of holdings
typically appear as liabilities? Are there any exemptions or provisions
required for such investments if they are included within the scope of
the rule?
2. Scope of Activity Subject to the Proposed Rule
    The proposal generally would preserve the current rule's definition
of ``custody,'' and apply when an adviser ``holds, directly or
indirectly, client assets, or has any authority to obtain possession of
them.'' \63\ The general principle of this definition is to apply the
rule when an adviser has the ability or authority to effect a change in
beneficial ownership of a client's assets.\64\ 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. Moreover, the rule would continue to apply when an adviser's
related person has the ability to obtain client assets in connection
with advisory services. Like the current rule, the proposed rule would
institute prophylactic safeguards where there is this potential for
loss or harm to a client given the adviser's ability or authority to
deprive the client of ownership and to obtain possession of the
client's assets.
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    \63\ See proposed rule 223-1(d)(3).
    \64\ For example, an adviser that physically holds a check drawn
by the advisory client and made payable to a third party is not
subject to the rule solely as a result of holding the check, since
the adviser cannot use the check to change ownership of the client's
underlying cash holdings. See rule 206(4)-2(d)(2)(i). Similarly, if
a stock certificate is non-transferable (i.e., it cannot be used to
effect a change in beneficial ownership of the client's investment),
an adviser would not be subject to the rule as a result of holding
it. Our staff previously took a similar view. See 2013 IM Guidance,
supra footnote 17.
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    In addition to this overarching principle, the current definition
of custody includes three categories that serve as examples of custody:
physical possession, certain arrangements when the adviser is
authorized or permitted to instruct the client's custodian, and
circumstances when the adviser acts in certain capacities.\65\ The
proposed rule

would retain these categories because, going forward, we believe this
approach will continue to provide flexibility as the asset management
industry continues to evolve, introduces novel investment products, and
provides new services to its advisory clients.
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    \65\ Under the current rule, custody includes three prongs: (i)
Possession of client funds or securities (but not of checks drawn by
clients and made payable to third parties) unless the adviser
receives them inadvertently and returns them to the sender promptly
but in any case within three business days of receiving them; (ii)
Any arrangement (including a general power of attorney) under which
the adviser is authorized or permitted to withdraw client funds or
securities maintained with a custodian upon the adviser's
instruction to the custodian; and (iii) Any capacity (such as
general partner of a limited partnership, managing member of a
limited liability company or a comparable position for another type
of pooled investment vehicle, or trustee of a trust) that gives the
adviser or its supervised person legal ownership of or access to
client funds or securities.
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    We believe we need to provide specificity, however, regarding the
arrangement category of the custody definition to state explicitly that
discretionary trading authority is an arrangement that triggers the
rule.\66\ Specifically, the amended custody definition would include
any arrangement (including, but not limited to, a general power of
attorney or discretionary authority) under which the adviser is
authorized or permitted to withdraw or transfer beneficial ownership of
client assets upon the adviser's instruction.\67\ In addition, the
proposed discretionary authority definition is consistent with the
definition in Form ADV and is the authority to decide which assets to
purchase and sell for the client.\68\
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    \66\ Proposed rule 223-1(d)(3) (proposed custody definition) and
proposed rule 223-1(d)(4)(discretionary authority definition). The
second prong of the current custody definition states: ``Any
arrangement (including a general power of attorney) under which you
are authorized or permitted to withdraw client funds or securities
maintained with a custodian upon your instruction to the
custodian.'' See current rule 206(4)-2(d)(3).
    \67\ The proposed amended definition also removes the reference
``to the custodian'' from the arrangement category. This formulation
ensures that custody is triggered if, for example, an adviser can
instruct a transfer agent or administrator to withdraw or transfer
beneficial ownership of client assets. See proposed rule 223-
1(d)(3).
    \68\ Proposed rule 223-1(d)(4).
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    The Commission previously stated that an adviser's authority to
issue instructions to a broker-dealer or a custodian to effect or to
settle trades, or authorized trading, does not constitute custody.\69\
We had explained then that the risk of an adviser withdrawing or
misappropriating funds and securities are minimized when a client's
custodian is under instructions to transfer funds (or securities) out
of a client's account only upon corresponding transfer of securities
(or funds) into the account.\70\ However, while we continue to believe
that there is a more limited risk of loss to a client from authorized
trading when a qualified custodian participates in a one-for-one
exchange of assets like this, we also believe that discretionary
authority presents the types of risks the rule is designed to address.
The adviser, for instance, could use its discretionary authority over a
client's assets to instruct an issuer's transfer agent or administrator
(e.g., the administrator for a loan syndicate) to sell its client's
interest and to direct the cash proceeds of the sale to an account that
the adviser owns and controls, thereby depriving the client of
ownership, unbeknownst to the client or its qualified custodian. Unless
a client or its custodian is required to participate in these
transactions, such as when the client must sign the subscription
agreement to purchase the security (i.e., the adviser does not have a
power of attorney and cannot sign for the client in any other
capacity), the client will be unable to monitor the assets in its
account for potential misuse or misappropriation effectively.\71\
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    \69\ 2003 Adopting Release, supra footnote 2, at n.10.
    \70\ Id.
    \71\ Our staff stated a similar view under the current rule. See
Custody Rule FAQs, supra footnote 17, at Question VII.3.
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    We believe it is important to extend the protections of the rule by
explicitly including ``discretionary authority'' within the definition
of custody. However, because we continue to believe more limited risk
of loss exists when a qualified custodian participates in transactions,
we are also proposing a limited exception to the surprise examination
requirement of the rule. The exception would generally apply to client
assets that are maintained with a qualified custodian when the sole
basis for the application of the rule is an adviser's discretionary
authority that is limited to instructing the client's qualified
custodian to transact in assets that settle only on a delivery versus
payment (``DVP'') basis.\72\ In DVP transactions, clients' custodians
are under instructions to transfer assets out of a client's account
only upon corresponding transfer of assets into the account. This
``delivery versus payment'' arrangement minimizes the risk that an
investment adviser could withdraw or misappropriate the assets in its
client's custodial account. In our view, DVP transactions reduce the
risk that the seller of an asset could deliver the asset but not
receive payment or that the buyer of an asset could make payment but
not receive delivery of the asset.\73\
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    \72\ Proposed rule 223-1(b)(8). See infra at section II.G.2.
    \73\ For discussion of delivery versus payment settlement
operations, see Bank for International Settlements, ``Delivery
versus Payment in Securities Settlement Systems,'' Sept. 1992, p. 1
at https://www.bis.org/cpmi/publ/d06.pdf.
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    We request comment on all aspects of the proposed application of
the rule to advisers with discretionary authority, along with the
continuing application of the rule more generally, including the
following items.
    8. Should the proposal generally retain the current rule's
definition of custody? The proposed rule would generally retain the
three categories that serve as examples of custody in the current rule:
physical possession, certain arrangements when the adviser is
authorized or permitted to withdraw or transfer beneficial ownership of
client assets upon the adviser's instructions, and circumstances when
the adviser acts in certain capacities. Should the proposed rule change
the current definition of custody from these three categories? What
should the proposal provide alternatively?
    9. Should the rule apply to when an adviser has discretionary
authority over client assets, as proposed? Are there provisions of the
proposed rule that should or should not apply to advisers who have
custody because they have discretionary authority?
    10. Do advisers with discretionary authority over a client's assets
(regardless of settlement method) currently have safeguards in place
that effectively limit the risks to clients of loss, misuse, theft,
or--in particular--misappropriation? If so, what are they? Do these
safeguards differ depending on whether the arrangement involves a
qualified custodian?
    11. When a trade settles in a manner that is not DVP, are there
controls that are or could be established in the event one leg of the
trade does not complete? If so, how commonly are such controls
utilized? Are there circumstances when such controls could not be
established or implemented? Should we require controls or policies and
procedures for advisers and/or the respective custodians in these
circumstances?
    12. Should the definition of custody contain an exception (or
should we interpret the definition of custody not to include) when the
adviser has authority to instruct the client's custodian to remit
assets from the custodial account to the client at his or her mailing
address of record? If so, should such an exception or interpretation be
subject to any conditions? For example, should the client be required
to grant the adviser this authority in writing to the qualified
custodian? Should an exception or interpretation also be conditioned on
the adviser lacking authority to open an account on behalf

of the client? Should the adviser also lack authority to designate or
change the client's mailing address of record with the qualified
custodian, or if the adviser has this authority, would it be sufficient
protection for the adviser to have a reasonable belief that the
custodian would send a notice of any change of mailing address to the
client at the client's old address of record upon receiving the request
from the adviser to change the mailing address? \74\ For example,
broker-dealers must send a customer who is a natural person a
notification of a change of mailing address to the customer's old
mailing address.\75\ Similarly, banks that follow guidance issued by
banking regulators send confirmation of a customer request for a change
of mailing address to both the old and new address on record.\76\ Is
there adequate protection when the custodian is subject to these
regulatory requirements because the adviser would be unable to remit
its client's assets to the client at a mailing address other than the
client's address of record at the custodian? Alternatively, should such
an exception or interpretation hinge on whether advisers design
policies and procedures under rule 206(4)-7 (the ``Compliance Rule'')
that address the risk to clients of remitting client investments to
non-clients?
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    \74\ We note that the staff has issued an FAQ on this topic. See
Custody Rule FAQs, supra footnote 17, at FAQ II.5.A. and B.
    \75\ Exchange Act Rule 17a-3(a)(17)(i)(B)(2).
    \76\ See, e.g., Federal Reserve System Supervisory Letter SR 0-
11 (Apr. 26, 2001), Office of Comptroller of the Currency (``OCC'')
Advisory Letter 2001-4 (Apr. 30, 2001), Federal Deposit Insurance
Corporation Financial Institution Letter 39-2001 (May 9, 2001),
Office of Thrift Supervision CEO Letter No. 139 (May 4, 2001), and
National Credit Union Administration Letter No. 01-CU-09 (Sept.
2001).
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    13. Should we make clear that an adviser is subject to the custody
rule and would also be subject to the proposed rule with respect to its
client's assets that are held, or accessible, by a related carrying
broker or executed through a related introducing broker? \77\
Conversely, should we make clear that an adviser would not be subject
to the rule solely due to its related person acting as the trustee of a
participant-directed defined contribution plan established for the
benefit of the adviser's employees, provided the adviser does not
provide investment advisory services to the plan or any investment
option available under the plan? \78\ Similarly, should we clarify the
meaning of ``in connection with advisory services'' in the context of
related person custody? \79\ For example, should we make clear that
where an adviser's client has a bank account with a bank that is the
adviser's related person, but does not use the bank account in
connection with the adviser's advisory activity, we would not view the
bank's authority to be ``in connection with advisory services'' that
the adviser provides to its client and that the rule, therefore, would
not apply?
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    \77\ We note that the staff has issued an FAQ on this topic. See
Custody Rule FAQs, supra footnote 17, at Question XIV.2-3. See also
section II.J, infra.
    \78\ We note that the staff has issued an FAQ on this topic. Our
staff has stated that it would not consider an adviser to have
custody where the investment adviser and the related person trustee
are, to the extent applicable, in compliance with the Employee
Retirement Income Security Act of 1974 (ERISA) and rules and
regulations issued thereunder with respect to the plan. See Custody
Rule FAQs, supra footnote 17, Question XII.1.
    \79\ See proposed rule section 223-1(d)(3).
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    14. Advisers that act as trustee of a trust would have custody of
that trust's assets under the proposed rule. Should we adopt an
exception from the definition of custody for (or should we interpret
the definition of custody not to include) cases where an adviser acts
as co-trustee of a trust and no single co-trustee is able to effect any
change in control of the beneficial ownership of the trust's
investments without the prior written consent of a co-trustee(s) that
is not a related person? \80\ In what circumstances is a co-trustee
required either by law or the trust instrument to protect the trust
beneficiaries from the actions of a single trustee acting alone?
Similarly, should we adopt an exception in (or should we interpret the
definition of custody not to include) circumstances where an adviser
has the ability or authority to effect a change in beneficial ownership
of a trust's investments, where an adviser is co-trustee along with the
grantor of a revocable grantor trust, and the adviser is prohibited by
the trust instrument or by law from withdrawing any investments from
the trust without the prior written consent of all of its co-trustees?
\81\
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    \80\ We note that the staff has issued an FAQ on this topic. See
Custody Rule FAQs, supra footnote 17, at Question XII.2.
    \81\ We note that the staff has issued an FAQ on this topic. See
Custody Rule FAQs, supra footnote 17, Question XII.3. See also, 2003
Adopting Release, supra footnote 2 at note 15 (stating that the
Commission would not view the adviser to have custody of the funds
or securities of the estate, conservatorship, or trust solely
because the supervised person has been appointed in these capacities
as a result of family or personal relationship with the decedent,
beneficiary or grantor (and not a result of employment with the
adviser)).
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    15. An adviser would have custody under the proposed rule when it
comes into possession of client assets. The rule contains an exception
from the definition of custody for possession of client assets when the
adviser receives them inadvertently and returns them to the sender
within three business days. Should we amend the exception to
accommodate (or interpret the definition of custody not to include)
other situations in which the adviser inadvertently receives client
assets? \82\ For example, should such an exception or interpretation be
conditioned such that the adviser return the client's assets to the
sender or forward them to the client or the client's custodian within
five days of receipt? Should such an exception or interpretation be
available only when client assets are received from senders, such as
those identified in staff statements? Rather than specify senders in
such an exception, should the exception or interpretation be available
when an adviser determines it would be unfeasible to return the assets,
or when there is a risk that the client's assets could be lost if the
adviser attempted to return them to the sender? Should such an
exception or interpretation be available only if the investment
adviser's receipt of its client's assets is inadvertent? Should we
condition such an exception or interpretation on recordkeeping
requirements under proposed rule 204-2 or on whether advisers design
policies and procedures under rule 206(4)-7? We understand that for
certain private fund advisers and trustees it is difficult to avoid
temporarily possessing client checks and physical assets because there
may not be an independent representative to arrange the movement of
such assets into a qualified custodian. Are there any particularities
to these contexts that would benefit from an exception or
interpretation? In addition, are there other circumstances that involve
checks written to third parties, checks written to clients, and checks
written to advisers where the adviser has no authority to deposit
client assets into any account other than directed by the client that
would benefit from exceptions or interpretations? Are there certain
policies and procedures maintained by advisers that mitigate the
custody risks associated with receiving checks that may be beneficial
to include in this rulemaking? For example, if the adviser has policies
and procedures reasonably designed to maintain such

assets with a qualified custodian, should we provide an exception if an
adviser to a private fund or serving as a trustee would not be subject
to the rule for the brief handling of client checks or physical assets?
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    \82\ We note that the staff has issued a no-action letter on
this topic. The Commission's staff has stated that when advisers
infrequently receive specific types of client funds or securities
from a list of enumerated third parties that the staff identified,
the staff would not recommend enforcement for violation of the
current custody rule if the adviser meets specified conditions. See
Investment Adviser Association, SEC Staff No-Action Letter (Sep. 20,
2007) (``2007 IAA No-Action Letter''). See also Custody Rule FAQs,
supra footnote 17, at Question II.1.
---------------------------------------------------------------------------

    16. Should we include an exception from the rule for assets for
which the adviser provides advice in certain sub-adviser relationships,
such as was described in our staff's statements? \83\ In what
circumstances should such an exception apply? Would an exception
designed to capture circumstances where the proposed rule would apply
to the sub-adviser only because its related person triggers the rule
with respect to the same advisory clients be beneficial? Such an
exception could be conditioned on the related person being fully
subject to (and in compliance with) the applicable requirements of the
custody rule. Would such a condition to the exception work in practice?
Should such exception be conditioned on the adviser's related person
fully complying with the requirements of the proposed rule? If not, why
not? If so, how would advisers determine whether their related person
is fully complying with the rule? Are there alternative safeguards that
commenters would suggest? Alternatively, should such sub-advisers be
subject to all or certain requirements of the rule? If only certain
requirements, which ones and why? Should we condition such an exception
on recordkeeping requirements under proposed rule 204-2 or on whether
advisers design policies and procedures under rule 206(4)-7?
---------------------------------------------------------------------------

    \83\ We note that the staff has issued a no-action letter on
this topic. See Investment Adviser Association, SEC Staff No-Action
Letter (Apr. 25, 2016), available at: https://www.sec.gov/divisions/investment/noaction/2016/investment-adviser-association-042516-206(4).htm.
---------------------------------------------------------------------------

    17. Are there are any other arrangements or circumstances where an
adviser would have custody under the proposed rules but an exception
would be beneficial and not inconsistent with the policy goals of the
rule? For example, are there specific circumstances involving custody
at electronic platforms, investment adviser aggregators, benefit plans,
introducing broker-dealers, plan sponsors, record-keepers, or third
party administrators that would benefit from an exception or
interpretation that these arrangements constitute or do not constitute
custody?

B. Qualified Custodian Protections

    Qualified custodians would continue to serve as key gatekeepers
under the proposed rule. These institutions' custodial activities are
subject to regulation and oversight.\84\ Accordingly, as under the
current rule, investment advisers with custody of client assets would
be required to maintain those assets with a qualified custodian.\85\ We
are proposing several ways to strengthen the requirement, however, in
light of the evolution of the market for custodial services, financial
products, and advisory services over the last decade. These proposed
changes aim to provide investors with certain standard custodial
protections that will improve the safeguarding of their assets in the
current market as well as in the future as the market for financial
products and advisory services continues to evolve.
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    \84\ 2002 Proposing Release, supra footnote 2, at n. 30; 2009
Proposing Release, supra footnote 11, at n. 4.
    \85\ Proposed rule 223-1(a)(1)(i). The proposed rule would
provide an exception, and another means of compliance with the rule,
for certain assets that are unable to be maintained with a qualified
custodian. See proposed rule 223-1(b)(2).
---------------------------------------------------------------------------

    The proposed rule would continue to allow banks or savings
associations, registered broker-dealers, registered futures commission
merchants, and certain foreign financial institutions to act as
qualified custodians, but, in a change from the current rule, only if
they have ``possession or control'' of client assets pursuant to a
written agreement between the qualified custodian and the investment
adviser.\86\ Also in a change from the current rule, the proposed rule
would modify the definition of foreign financial institution and
requirements for banks and savings associations in the definition of
qualified custodian.\87\ 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.
---------------------------------------------------------------------------

    \86\ See proposed rule 223-1(a)(1).
    \87\ See proposed rule 223-1(d)(10)(i) and (iv); section
II.B.1.b, infra.
---------------------------------------------------------------------------

    The proposed rule would require that the written agreement contain
contractual provisions that we believe are critical to providing
important protections for advisory client assets. As discussed in
further detail below, the contractual terms would address
recordkeeping, client account statements, internal control reports, and
the adviser's agreed-upon level of authority to effect transactions in
the account. In addition, the proposed rule would require that an
adviser obtain reasonable assurances from a qualified custodian
relating to certain protections the qualified custodian will provide to
the advisory client, including with respect to the qualified
custodian's standard of care, indemnification, limitation of liability
for sub-custodial services, segregation of client assets, and
attachment of liens to client assets. Also as discussed below, we
believe that many of these important protections are already provided--
through contract or practice--by certain custodians to certain
custodial customers in the current market. However, the proposed rule
is designed to expand and formalize the minimum standard of protections
to advisory clients' assets held by qualified custodians in a manner
that would provide consistent investor protections across all qualified
custodians under our proposed rule. We believe that the proposed rule
leverages the expertise and regulatory regimes of qualified custodians
with respect to a wide range of assets, while, at the same time,
tailoring and bolstering the protections afforded to advisory clients
to improve the safeguarding of client assets over which advisers have
custody.
1. Definition of Qualified Custodian
    Qualified custodians under the proposed rule would include the
types of financial institutions that clients and advisers customarily
turn to for custodial services and that have in place practices that
are designed to protect custodial assets. We continue to believe that
the use of a qualified custodian would enhance the protections afforded
to client assets.\88\
---------------------------------------------------------------------------

    \88\ See 2003 Adopting Release, supra footnote 2; 2009 Adopting
Release, supra footnote 11.
---------------------------------------------------------------------------

    The proposed rule, like the current rule, would define the term
``qualified custodian'' to mean a bank or savings association,
registered broker-dealer, registered futures commission merchant
(``FCM''), or certain type of foreign financial institution (``FFI'')
that meets the specified conditions and requirements.\89\ We continue
to believe that these financial institutions should be permitted to act
as qualified custodians because, as discussed in more detail below,
they operate under regular government oversight, are subjected to
periodic inspection and examination, have familiarity with providing
custodial services, and are in a position to attest to custodial
customer holdings and transactions \90\--all critical

components of safeguarding client assets under the proposed rule. As a
result, with the exception of proposed amendments to the definition of
qualified custodian relating to banks, savings associations, and FFIs,
we are not changing the types of institutions that may serve as
qualified custodians under the rule.\91\
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    \89\ Proposed rule 223-1(d)(10). Not all registered broker-
dealers and registered FCMs meet the definition of qualified
custodian under the custody rule or the proposed safeguarding rule.
Notably, only those broker-dealers or FCMs holding client assets in
customer accounts meet this definition. This would include the
broker-dealers subject to the customer protection rule (Exchange Act
Rule 15c3-3) and FCMs holding futures customers funds subject to 17
CFR 1.20.
    \90\ See, e.g., 2009 Adopting Release, supra footnote 11, at
section I (describing qualified custodians under the rule as the
types of financial institutions to which clients and advisers
customarily turn for custodial services and as subject to regulation
and oversight).
    \91\ We remind advisers that as additional financial
institutions become available to custody assets, advisers must
continue to exercise their fiduciary duties to clients in connection
with selection and monitoring of the qualified custodian. See, e.g.,
Standard of Conduct for Investment Advisers Release, supra note 57,
at section II (``The investment adviser's fiduciary duty is broad
and applies to the entire adviser-client relationship.'') (citations
omitted).
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a. Bank and Savings Association Qualified Custodian Proposed Amendments
    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 that is 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 (i.e.,
an account in which client assets are easily identifiable and clearly
segregated from the bank's assets) in order to qualify as a qualified
custodian. We believe that requiring banks and savings associations to
hold client assets in such an account brings the requirements for bank
and savings association qualified custodians in line with the
protections required for broker-dealers, FCMs, and FFIs acting as
qualified custodians under the current custody rule and under the
proposed safeguarding rule.\92\
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    \92\ The current custody rule requires that in order to be
included in the definition of qualified custodian, a broker-dealer
registered under section 15(b)(1) of the Securities Exchange Act of
1934 (15 U.S.C. 78o(b)(1)), must hold the client assets in customer
accounts, a futures commission merchant registered under section
4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)) must hold the
client assets in customer accounts subject to certain additional
requirements, and an FFI must customarily hold financial assets for
its customers and must keep the advisory clients' assets in customer
accounts segregated from its proprietary assets. See rule 206(4)-
2(d)(6)(ii), (iii), and (iv). See also proposed rule 223-1(d)(10).
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    We believe that the proposed account requirement would improve the
safeguarding of client assets. We understand that, generally, a bank
deposit account creates a debtor-creditor relationship between the bank
and depositor.\93\ This debtor-creditor relationship typically does not
create a special or fiduciary relationship.\94\ While applicable
insolvency law and procedures vary depending on any particular bank or
savings association's regulatory regime,\95\ we understand that assets
held in accounts of the type proposed by the rule 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.\96\
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    \93\ See generally, Graham, Heitz, Lapine, et al., 6a Banking
Law section 134.05 (2022) section 134.05 (collecting cases)
(``Banking Law''). We understand that a deposit in a bank is either
general or special and that a deposit is a general deposit unless
there is an agreement or understanding that it should be special.
See 5C Michie on Banks and Banking, Deposits section 339 (Sept.
2022) (collecting cases) (``Michie on Banks & Banking''); Banking
Law, section 134.05 (``Accounts are either special accounts or
general accounts.'') (collecting cases).
    \94\ Id.
    \95\ See 3 Michie on Banks & Banking, Insolvency and
Dissolution. section 17. Jurisdiction and Powers of Courts and
Officials in General (discussing state-by state jurisdiction and
certain regulatory powers).
    \96\ See Michie on Banks & Banking, Deposits section 339
(collecting cases under a wide variety of state laws where a bank
may be acting as a trustee, bailee, or agent in connection with a
customer account that is treated as other than a general deposit
account).
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    We believe that the proposed rule would provide flexibility to
banks and savings associations to use the appropriate accounts
available to them under applicable law and offered by them to
customers. Rather than consider the treatment of custodial customer
assets upon a bank's failure in all 50 states, and risk the protections
of our rule eroding if state banking law protections vary or evolve, we
are proposing to establish a consistent and uniform standard to protect
all advisory clients. The account terms should identify clearly that
the account is distinguishable from a general deposit account and
clarify the nature of the relationship between the account holder and
the qualified custodian as a relationship account that protects the
client assets from creditors of the bank or savings association in the
event of the insolvency or failure of the bank or savings association.
b. Proposed Enhancements to Definition of Foreign Financial Institution
    Advisory clients often invest in assets traded on foreign exchanges
and their advisers must, as a practical matter, maintain those assets
with financial institutions in foreign countries where the assets are
traded. In order to facilitate these types of holdings, the current
rule includes FFIs that customarily hold financial assets for their
customers, as qualified custodians, provided that the FFI keeps the
advisory clients' assets in customer accounts segregated from the FFI's
proprietary assets.\97\
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    \97\ See rule 206(4)-2(d)(6)(iv). Under the current rule, when
an adviser selects an FFI to hold clients' assets, we believe the
adviser's fiduciary obligations require it either to have a
reasonable basis for believing that the FFI satisfies the conditions
and would provide a level of safety for client assets similar to
that which would be provided by a ``qualified custodian'' in the
United States or to disclose fully to clients any material risks
attendant to maintaining the assets with the foreign custodian. See
2003 Adopting Release, supra footnote 2, at note 22.
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    We are proposing to require that an FFI satisfy seven new
conditions in order to serve as a qualified custodian for client assets
under the proposed rule.\98\ These proposed conditions are partly drawn
from our experience with the factors relevant to the safekeeping of
``Foreign Assets'' by the types of foreign financial entities that can
act as an ``Eligible Foreign Custodian'' as defined in rule 17f-5 under
the Investment Company Act.\99\ Such conditions are also designed to
address our understanding of market developments since the adoption of
rule 17f-5 by providing 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. Recent events in
crypto assets markets also have highlighted the need for similarly
enhanced custody safeguards of client assets held outside the United
States.
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    \98\ We also propose to eliminate the requirement under the
current definition that the FFI keeps the advisory clients' assets
in customer accounts segregated from its proprietary assets because
the proposed rule, more broadly, would require advisers to obtain
reasonable assurances from qualified custodians that all advisory
client assets are segregated from the qualified custodian's
proprietary assets and liabilities. See proposed rule 223-
1(a)(1)(ii)(D).
    \99\ Rule 17f-5 under the Investment Company Act defines an
Eligible Foreign Custodian as an entity that is incorporated or
organized under the laws of a country other than the United States
and that is a Qualified Foreign Bank or a majority-owned direct or
indirect subsidiary of a U.S. Bank or bank-holding company. For
these purposes, a Qualified Foreign Bank is defined as a banking
institution or trust company, incorporated or organized under the
laws of a country other than the United States, that is regulated as
such by the country's government or an agency of the country's
government. See 17 CFR 270.17f-5(a)(1) and (a)(5). Rule 17f-5(c)(1)
under the Investment Company Act lists the factors relevant to the
safekeeping of Foreign Assets, as defined in rule 17f-5(a)(2). See
17 CFR 270.17f-5(c)(1) and (a)(2).
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    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 \100\ as a banking institution, trust company, or other
financial institution that customarily holds financial assets for its
customers;
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    \100\ 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.\101\
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    \101\ Proposed rule 223-1(d)(10)(iv).
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    We believe each of these proposed new conditions would enhance the
ability and responsibility of advisers to protect client assets
maintained outside the United States for the following reasons.
    Regarding the first condition, we are proposing to require the
adviser to determine that the adviser and the Commission are able to
enforce judgments, including civil monetary penalties, against the FFI.
The FFI could satisfy this condition by such means as appointing an
agent for service of process in the United States or having offices in
the United States, and the adviser can request the relevant
documentation for verification purposes. This condition would thus
limit the types of foreign financial entities to those that are subject
to or consent to U.S. jurisdiction.
    Regarding the second condition, we believe requiring an FFI be
regulated by a foreign country's government, an agency of a foreign
country's government, or a foreign financial regulatory authority, as
defined in section 202(a)(24) of the Advisers Act, would help ensure
that client assets maintained with an FFI are subject to regulatory
oversight that would better serve our policy goal of protecting
custodial assets by the use of qualified custodians that meet our
proposed requirements. In addition to banking institutions and trust
companies, we would permit foreign-regulated financial institutions who
customarily hold financial assets for their customers (e.g., the
foreign equivalent of broker-dealers or FCMs) to serve as ``qualified
custodians.''
    We believe the requirement in the third condition for an FFI to
comply with anti-money laundering (``AML'') and related provisions
similar to those of the Bank Secrecy Act (``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. We generally believe an FFI would be able to
satisfy this condition if it is required to comply with the laws and
regulations established by a member or observer jurisdiction of the
Financial Action Task Force (``FATF'') and not otherwise listed on any
sanctions list administered by the Office of Foreign Assets Control of
the U.S. Department of the Treasury (``OFAC''),\102\ or on any special
measures list administered by the Financial Crimes Enforcement Network
of the U.S. Department of the Treasury (FinCEN'').\103\
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    \102\ The FATF is an inter-governmental body whose purpose is
the development and promotion of policies, both at the national and
international levels, to combat money laundering and the financing
of terrorism and proliferation. The FATF monitors members' progress
in implementing AML measures, reviews money laundering techniques
and counter-measures, and promotes the adoption and implementation
of AML measures globally. See https://www.fatf-gafi.org/en/the-fatf/what-we-do.html/. To search sanctions lists administered by OFAC,
such as the Specially Designated Nationals and Blocked Persons list,
see https://sanctionssearch.ofac.treas.gov.
    \103\ See section 311 of the USA PATRIOT Act [Pub. L. 107-56]
(granting the Secretary of the Treasury the authority to conclude,
if reasonable grounds exist, that a foreign jurisdiction, foreign
financial institution, or an international transaction or account is
of ``primary money laundering concern,'' and to require domestic
financial institutions and financial agencies to take certain
``special measures,'' such as additional due diligence and special
attention to particular account transactions, among other measures,
against the designated entity).
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    The fourth condition would replace and strengthen the segregation
requirement for FFIs in the current definition of qualified custodian
in the custody rule, and it is designed to complement the proposed
segregation requirements of the safeguarding rule. In the current rule,
an FFI that customarily holds financial assets for its customers is
permitted to serve as a qualified custodian, provided that the FFI
keeps the advisory clients' assets in customer accounts segregated from
its proprietary assets. The proposed new condition would require the
FFI to hold financial assets for its customers in accounts designed to
protect such assets from creditors of the FFI in the event of the
insolvency or failure of the FFI.\104\ This condition would thereby
impose investor protections, particularly in the event of an FFI
insolvency or bankruptcy, that are more comparable to those we are
proposing for assets held with U.S.-regulated bank or savings
association qualified custodians. We believe advisers would be able to
assess whether an FFI is holding client assets in such accounts in the
course of obtaining the reasonable assurances we are proposing to
require advisers obtain from all qualified custodians, which are
discussed more fully below.\105\
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    \104\ Compare rule 204-2(d)(6)(iv) with proposed rule 223-
1(d)(10)(iv)(D).
    \105\ See infra section II.B.3.a.iv (discussing the adviser's
requirement to obtain reasonable assurances from qualified
custodians regarding the required account segregation requirements).
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    The fifth condition is designed to limit the types of FFIs that can
serve as qualified custodians to those that have the requisite
financial strength to meet the proposed due care standard for client
assets. We believe the determination of an FFI's financial strength
could be based on objective measures and other indicators of financial
health that are reasonably comparable to those that apply to U.S. banks
and other regulated financial institutions.\106\ Given that advisers
would be required to maintain an ongoing reasonable belief that the FFI
qualified custodian is meeting its due

care standard, advisers also could require notifications from the FFI
of any changes, including changes in the financial strength of the FFI,
that would have an impact on the agreed terms of the written custodial
contract. Such notifications may provide timely information to help
advisers, as fiduciaries, to react and respond to emerging risks of
loss of client assets.
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    \106\ When the Commission adopted amendments to rule 17f-5 (17
CFR 270.17f-5) in 1997, its adopting release offered guidance to
evaluate financial strength by ``assess[ing] the adequacy of the
custodian's capital with a view of protecting the fund against the
risk of loss from a custodian's insolvency.'' See Custody of
Investment Company Assets Outside the United States, Investment
Company Act Release No. 22658 (May 12, 1997) [62 FR 26923 (May 16,
1997)], at 26928. We understand that relevant governments and their
banking regulators typically set regulatory capital requirements for
foreign banking institutions.
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    Under the sixth condition, FFI qualified custodians would be
required by law to implement practices, procedures, and internal
controls designed to ensure the exercise of due care with respect to
the safekeeping of assets. Since FFIs are subject to a broad range of
regulatory regimes, we believe this condition would help promote a
minimum level of practices, procedures, and internal controls across
qualified custodians for safekeeping client assets under the proposed
rule, regardless of where and how they are held. Further, we believe
this requirement will help to ensure that an FFI's practices,
procedures, and internal controls, including, but not limited to, those
with respect to the safekeeping of certificated and uncertificated
assets, custodial recordkeeping, and security and data protection,
should not differ in material ways from those of U.S.-regulated
qualified custodians. Similar to the fourth condition, advisers should
be able to assess and evaluate an FFI's internal controls while
obtaining the reasonable assurances we are proposing advisers obtain
from all qualified custodians.\107\
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    \107\ See infra section II.B.3.a.i (discussing the adviser's
requirement to obtain reasonable assurances from a qualified
custodian regarding the qualified custodian's required exercise of
due care and implementation of appropriate measures to safeguard
client assets from theft, misuse, misappropriation, or other similar
type of loss).
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    Finally, we have included an anti-evasion requirement in the
seventh condition for FFI qualified custodians that is similar to the
anti-evasion provision currently in the definition of ``bank'' under
section 202(a)(2) of the Advisers Act and in the definition of ``U.S.
Bank'' under rule 17f-5 of the Investment Company Act.\108\ Given the
broad scope of foreign financial entities that we would permit to serve
as qualified custodians, we believe it is appropriate to apply the
anti-evasion requirement to all types of FFIs, rather than limiting its
application to only banking institutions or trust companies.
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    \108\ 17 CFR 270.17f-5(a)(7)(iii).
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    We request comment on all aspects of the proposed rule's qualified
custodian requirement, including the following items.
    18. Should we continue to require that client assets be maintained
with qualified custodians? If not, what alternative protections for
client assets should we require as part of the rule?
    19. Should the rule continue to include banks as defined in section
202(a)(2) of the Advisers Act or savings associations as defined in
section 3(b)(1) of the Federal Deposit Insurance Act as qualified
custodians, as proposed? Should the rule narrow the definition to
include only certain banks and savings associations as qualified
custodians? If so, how? For example, should the rule permit only banks
or savings associations that are subject to Federal regulation and
supervision to act as qualified custodians? Alternatively, should the
rule permit only state banks and savings association that are members
of the Federal Reserve System to act as qualified custodians? \109\
Would narrowing of the types of banks and savings associations that
meet the definition of qualified custodian provide additional
protections to advisory clients in the event of the custodian's
insolvency? Is there another way to achieve our policy goal?
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    \109\ See generally Membership of State Banking Institutions in
the Federal Reserve System (Regulation H) 12 CFR 208.01 et. seq.
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    20. Should we require 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 as proposed? Is our
understanding correct that requiring banks and savings associations to
hold client assets in an account of this type would provide client
assets with enhanced protection from general creditors in the event of
the qualified custodian's insolvency and increase the likelihood of
return of client assets to advisory clients upon a qualified
custodian's insolvency? Do commenters agree with our view that this
enhanced protection is especially important in light of the broad range
of regulatory regimes and insolvency processes to which a growing
number of state-chartered trust companies and other state-chartered,
limited purpose banking entities entering the custodial market may be
subject?
    21. Should the rule require the account terms to identify clearly
that the account is distinguishable from a general deposit account?
Should the rule require the terms of the account clarify the nature of
the relationship between the account holder and the qualified
custodian, for example, whether the account is a special account,\110\
a fiduciary account,\111\ or whether the bank or savings association is
acting as a trustee, a bailee, or agent of the account holder?
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    \110\ See, e.g., Bank of America, N.A. v. Lehman Bros. Holdings,
Inc. (In re Lehman Bros. Holdings, Inc.), 439 B.R. 811, 824-825
(Bankr. S.D.N.Y. Nov. 16, 2010) (``Other factors that courts have
examined to ascertain the parties' mutual intent [to create a
special rather than general account] include: (1) whether the
parties agreed to segregate the funds; (2) whether the bank paid
interest on the funds; (3) whether the depositor lacked an
unfettered right to withdraw the funds; and (4) whether a third
party possessed an interest in the funds.'').
    \111\ See, e.g., 12 CFR 9.13 and 12 CFR 150.230 (addressing
custody of fiduciary assets for banks and savings associations,
respectively).
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    22. Would 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 reduce the availability of
banks or savings associations that could offer services as a qualified
custodian? Would it increase costs to advisory clients?
    23. Rather than requiring accounts of this type for all banks and
savings associations, should the rule require accounts that protect
client assets from creditors of a bank or savings association in the
event of the insolvency or failure of the bank or savings association
for a subset of these institutions that are not federally insured or
OCC member banks? For example, should the rule require accounts of this
type for state banks that are not members of the Federal Reserve
System?
    24. Are there alternative bank and savings association account