functional regulator for purposes of its custodial activities. As
detailed in section II.C.2 above, this would include Exchange Act
requirements for broker-dealers, regulatory requirements for national
banks, Commodity Exchange Act requirements for FCMs, as well as the
broad range of regulatory requirements for FFIs. Given the proposed
definition's consistency with the laws, rules, or regulations
administered by a qualified custodian's functional regulator, we
believe the additional cost of the proposed definition of ``possession
or control'' on qualified custodians would be minimal.

    It is our understanding that custodians have been unwilling or
unable to take possession or control of certain investments, such as a
variety of privately issued securities. Advisers sometimes request that
custodians report these securities as an ``accommodation'' on a
custodial account statement so that the client is aware of their
existence. We acknowledge, however, that to the extent account
statements provided by a qualified custodian on an accommodation basis
offer a client the ability to review all of its investments in a single
consolidated account statement, and potentially alert a client or an
auditor to the existence of an investment, the proposed rule's
elimination of the custodian's ability to provide account statements on
an accommodation basis could impose a cost on investors. Clients would
bear costs to collect information from multiple sources rather than
relying on a single consolidated account statement.\493\ If a client
requests such assets be included on its account statement, the account
statement may identify the assets, but only if the account statement
clearly indicates that the custodian does not have possession or
control of the assets.\494\
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    \493\ It is possible that the requirement could lead to reduced
costs for custodians. Our understanding, however, is that the
custodian merely reports the holdings or transactions as reported to
it by the adviser--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. As a result, we would
expect cost savings for custodians to be minimal.
    \494\ See supra note 185.
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c. Reasonable Assurances
    We understand that under existing market practices, advisers are
rarely parties to the custodial agreement, which is generally between
an advisory client and a qualified custodian. The proposed rule would
require an adviser to obtain reasonable assurances in writing from
qualified custodians regarding certain vital protections for the
safeguarding of client assets and that the adviser maintain an ongoing
reasonable belief that the custodian is complying with the client
protections for which the adviser obtains reasonable assurances.
i. Benefits
    Due Care. The proposed rule would require that the adviser obtain
reasonable assurances from the qualified custodian that the qualified
custodian will exercise due care in accordance with reasonable
commercial standards in discharging its duty as custodian and will
implement appropriate measures to safeguard client assets from theft,
misuse, misappropriation, or other similar types of loss.\495\ We
recognize that the appropriateness of the measures required to
safeguard assets varies depending on the asset.\496\ We believe such
appropriate measures would, in turn, mitigate the risk to client assets
from theft, misuse, misappropriation, or other similar types of loss.
---------------------------------------------------------------------------

    \495\ Proposed rule 223-1(a)(1)(ii)(A).
    \496\ See discussion in section II.B.3.a.i and supra footnote
154.
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    Indemnification. The proposed rule would require the adviser to
obtain reasonable assurances from the qualified custodian that the
qualified custodian will indemnify the client (and will have insurance
arrangements in place that will adequately protect the client) against
the risk of loss in the event of the qualified custodian's own
negligence, recklessness, or willful misconduct.\497\ Our staff has
observed that custodians often include indemnification clauses in their
custodial agreements with customers. Staff has also observed that the
contractual limitations on custodial liability vary widely in the
marketplace, in some instances reducing a qualified custodian's
liability to such an extent as to not provide an appropriate level of
investor protection. By requiring advisers to obtain reasonable
assurances from the qualified custodian that the qualified custodian
will indemnify the client against the risk of loss in the event of the
qualified custodian's own negligence, recklessness, or willful
misconduct, the proposed rule seeks to create a minimum floor of
custodial protection for investors in the event of custodial misconduct
(i.e., simple negligence). For those investors whose qualified
custodians indemnify the client against the risk of loss in the event
of the qualified custodian's gross negligence, the proposed requirement
that an adviser obtain reasonable assurances from the qualified
custodian that the qualified custodian will indemnify the client
against the risk of loss in the event of the qualified custodian's own
negligence, recklessness, or willful misconduct would likely operate as
a substantial expansion in the protections provided by qualified
custodians to advisory clients by preventing these custodians from
disclaiming liability for misconduct that does not rise to the level of
gross negligence.
---------------------------------------------------------------------------

    \497\ Proposed rule 223-1(a)(1)(ii)(B).
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    Sub-custodian or Other Similar Arrangements. The proposed rule
would require the adviser to obtain reasonable assurances from the
qualified custodian that the existence of any sub-custodial, securities
depository, or other similar arrangements with regard to the client's
assets will not excuse its obligations to the client.\498\
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    \498\ Proposed rule 223-1(a)(1)(ii)(C).
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    As discussed in section II.B.3.a.3 outsourcing has become
increasingly common in the custodial space, whether outsourcing of
back-office functions or the core function of safeguarding a custodial
customer's assets. Additionally, we understand that the delegation of
safeguarding to sub-custodians can result in opaque structures; for
example, involving several FFI sub-custodians in different countries.
This proposed requirement would enhance investor protections by
reducing the ability of a qualified custodian to avoid responsibility
for the other important safeguarding obligations it has to the advisory
client by delegating custodial responsibility to a sub-custodian,
securities depository, or other similar arrangements. To the extent
advisory clients are aware of risks resulting from a qualified
custodian delegating its safeguarding obligations to a sub-custodian,
we believe that this requirement would give advisory clients greater
confidence that their assets maintained with a qualified custodian
would not lose protections as a result of such a delegation.
    Segregation of Client Assets. The proposed rule would require the
adviser to obtain reasonable assurances from the qualified custodian
that the qualified custodian will clearly identify the client's assets
as such, hold them in a custodial account, and segregate them from the
qualified custodian's proprietary assets.\499\ The proposed requirement
would benefit investors by helping to ensure that client assets are at
all times readily identifiable as client property and remain available
to the client even if the qualified custodian becomes financially
insolvent. We believe this proposed requirement would also benefit
clients by helping to protect client assets from claims by a qualified
custodian's third-party creditors looking to secure or satisfy an
obligation of the qualified custodian. We believe that the proposed
requirement would also benefit clients by helping to identify clearly
client assets as belonging to the appropriate client and, in the
context of an FFI in a region facing political risk, we believe these
actions would help to preserve the client's interests in the event of a
government taking.
---------------------------------------------------------------------------

    \499\ Proposed rule 223-1(a)(1)(ii)(D).
---------------------------------------------------------------------------

    No Liens Unless Authorized in Writing. The proposed rule would

require the adviser to obtain reasonable assurances from the qualified
custodian that the qualified custodian will 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.\500\ This
requirement would benefit clients by discouraging qualified custodians
from using client assets in a manner not authorized by the client,
reducing the risk of loss of client assets. The requirement would also
help reduce the risk of the loss of client assets to claims by the
qualified custodian, or a third party looking to secure or satisfy an
obligation of the qualified custodian, including in cases of the
qualified custodian's insolvency or bankruptcy. The magnitude of the
benefits will depend on the extent to which such arrangements may
already be common. As discussed in section II.B.3.a.v, we believe that
many qualified custodians maintain their custodial customer assets free
of liens and similar claims, other than those agreed to or authorized
in writing by the client. Further, we understand that some custodial
agreements contain contractual language addressing when a lien or
similar claim will attach to client assets.
---------------------------------------------------------------------------

    \500\ See proposed rule 223-1(a)(1)(ii)(E).
---------------------------------------------------------------------------

ii. Costs
    Obtaining Reasonable Assurances. The proposed rule would require an
adviser to obtain reasonable assurances in writing from a qualified
custodian regarding certain client protections. As discussed above, one
way that advisers are likely to satisfy this requirement is by seeking
confirmation from a qualified custodian that the custodial agreement
with the advisory client contains contractual language reflecting the
reasonable assurances required by the rule. The reasonable assurances
requirement could also require conforming changes in custody agreements
between clients and qualified custodians. The cost of obtaining
reasonable assurances and conforming changes in custody agreements
include costs attributable to attorneys and compliance professionals,
both prior to and at the inception of the relationship between a client
and a qualified custodian as well as over the life of the relationship.
We describe the nature of these costs in detail below. For purposes of
the Paperwork Reduction Act, we estimate that qualified custodians and
advisers will incur aggregate initial costs of $27,469,680 associated
with advisers obtaining reasonable assurances from qualified
custodians.\501\ The requirements that an adviser obtain reasonable
assurances from qualified custodians also will require due diligence
and periodic monitoring by the adviser. For purposes of the Paperwork
Reduction Act, we estimate that qualified custodians and advisers will
incur aggregate ongoing annual costs of $5,493,936 associated with
advisers obtaining reasonable assurances from qualified
custodians.\502\
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    \501\ See infra footnote 620.
    \502\ See infra footnote 622.
---------------------------------------------------------------------------

    Due Care. The proposed due care requirement is the same as the
standard that generally applies to custodians under Article 8 of the
Uniform Commercial Code.\503\ As a result, we believe the proposed
standard of care is not uncommon in the custodial market, and that
financial institutions acting as qualified custodians are familiar with
it. We believe, however, that the standard of care is not universal in
the custodial market. As discussed above, this requirement may result
in certain qualified custodians incurring costs to change the terms of
their custodial agreements with advisory clients to incorporate this
standard.\504\
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    \504\ See infra footnote 619.
---------------------------------------------------------------------------

    Indemnification. As discussed above, staff has observed that the
contractual limitations on custodial liability vary widely in the
marketplace. The proposed rule seeks to create a minimum floor of
custodial protection for investors in the event of custodial
misconduct. First, the proposed simple negligence requirement could
impose operational costs on those custodians holding advisory client
assets subject to a gross negligence standard. The operational costs
would include the costs of adapting existing systems and processes to
meet the more stringent simple negligence standard. Second, the
insurance requirement of the proposed indemnification requirement would
likely create a substantial increase in the cost of liability insurance
for custodians that currently do not insure against loss resulting from
simple negligence. We note, however, that operational costs and costs
of liability insurance would be mitigated to the extent custodians who
currently hold client assets subject to a gross negligence standard
already have systems, processes and liability insurance that are
consistent with a simple negligence standard.
    Sub-custodian or Other Similar Arrangements. As discussed above,
staff has observed custodial agreements addressing the use of sub-
custodians that seek to contractually limit the custodian's liability
for acts or omissions of the sub-custodian in a variety of ways,
including expressly limiting the contractual liability of the custodian
for acts of the sub-custodian, as well as limiting the affirmative
steps the custodian may be required to take in connection with any loss
of client assets as a result of the sub-custodian's willful default or
insolvency. The proposed reasonable assurances requirement could impose
operational costs on those custodians who make use of sub-custodial,
securities depository, or other similar arrangements and who would seek
to disclaim responsibility in circumstances where a loss or other
failure to satisfy its obligations to the client can be attributed to a
sub-custodian or other third party selected by the qualified custodian.
The operational costs would include the costs of adapting existing
systems and processes to meet the proposed requirement. We note,
however, that the costs would be mitigated to the extent custodians who
make use of sub-custodial, securities depository, or other similar
arrangements already have systems and processes in place that are
consistent with the proposed requirement.
    Segregation of Client Assets. We understand that custodial
agreements between advisory clients and qualified custodians may
currently contain a contractual provision requiring segregation of
client assets from the custodian's assets. In addition, we understand
that many qualified custodians are currently required by their
functional regulator to segregate assets. The proposed segregation
requirements are drawn from rule 15c3-3 of the Exchange Act. To the
extent existing regulatory requirements for qualified custodians are
the same or similar to the requirements of 15c3-3, the costs of
adapting existing systems may be mitigated for broker-dealers who act
as qualified custodians. For example, rule 15c3-3 of the Exchange Act
requires broker-dealers to safeguard their customer assets and keep
customer assets separate from the firm's assets. Given their existing
regulatory requirements, we believe custodian broker-dealers already
have systems to segregate customer assets from their own and, as a
result, the cost of the proposed requirement for broker-dealer
qualified custodians largely would be mitigated. Other regulatory
regimes have adopted similar requirements. For example, under the
Commodity Exchange Act, futures commission merchants are required to
segregate customer assets from their own

assets.\505\ Because futures commission merchants already have systems
to segregate customer assets from their own, we believe their cost of
meeting the segregation requirement of the proposed rule would also
largely be mitigated for futures commission merchants.
---------------------------------------------------------------------------

    \505\ See discussion in section III.C.1.
---------------------------------------------------------------------------

    We believe, however, that not all financial institutions that serve
as qualified custodians are required to segregate and identify their
client assets, particularly FFIs. In addition, for those qualified
custodians that are required to segregate and identify their client
assets, the extent of those activities varies.\506\ To the extent
certain custodians currently do not segregate client assets, the
reasonable assurances requirement in the proposed rule would result in
qualified custodians adapting existing systems and processes to meet
the proposed requirement.
---------------------------------------------------------------------------

    \506\ See, e.g., 12 U.S.C. 92(c) and 12 U.S.C. 1464(n)(2)
(requiring national banks and Federal savings associations to
segregate all assets held in any fiduciary capacity from their
general assets and to keep a separate set of books and records
showing all transactions in these accounts); section 4d(a)(2) of the
Commodity Exchange Act (requiring FCMs to segregate from their own
assets all money, securities and other property deposited by futures
customers to margin, secure, or guarantee futures contracts and
options on futures contracts traded on designated contract markets).
---------------------------------------------------------------------------

    No Liens Unless Authorized in Writing. The rule would not prohibit
liens and the other claims addressed in the proposed rule, but would
require that the adviser obtain reasonable assurances from the
qualified custodian that the client has authorized in writing any
right, charge, security interest, lien, or claim in favor of the
qualified custodian or its related persons or creditors. The proposed
reasonable assurances requirement could impose operational costs on
those custodians who make use of liens and the other claims addressed
in the proposed rule. The operational costs would include the costs of
adapting existing systems and processes to ensure that qualified
custodians get written client authorization. The proposed requirement
may also result in qualified custodians adding a conforming provision
to custodial agreements for those clients that authorize such claims.
Doing so would result in an additional burden for those qualified
custodians. We believe that many qualified custodians maintain their
custodial customer assets free of liens and similar claims, other than
those agreed to or authorized in writing by the client. Further, we
understand that some custodial agreements contain contractual language
addressing when a lien or similar claim will attach to client assets.
Operational costs and the cost of adding conforming provisions for
those clients that authorize such claims would be mitigated to the
extent qualified custodians already have such systems and provisions in
place.
d. Written Agreement
    The proposed rule would require advisers to enter into a written
agreement with a qualified custodian based upon a reasonable belief
that certain contractual provisions have been implemented. Further,
during the term of the written agreement and related advisory
relationship, advisers generally should have a reasonable belief that
the qualified custodian is complying with the contractual obligations
of the agreement and continuing to provide the protections to client
assets for which the adviser obtained reasonable assurances from the
qualified custodian.
    We discuss the benefits and costs of the proposed written agreement
requirement below. The magnitude of both the benefits and costs of the
proposed written agreement requirement would depend on the extent to
which advisers currently are party to custodial agreements, and
advisers' actions to ensure that the elements of the written agreements
are effective and being met.\507\
---------------------------------------------------------------------------

    \507\ While we understand that advisers are rarely parties to
the custodial agreement, which is generally between an advisory
client and its qualified custodian, we lack quantitative data to
confirm this understanding.
---------------------------------------------------------------------------

i. Benefits
    Under the proposed 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 rule. Another provision would specify the
adviser's agreed-upon level of authority to effect transactions in the
account. A third provision would require the qualified custodian to
deliver account statements to clients and to the adviser, whereas
currently, advisers must only have a reasonable basis for believing
that clients are receiving these account statements upon due inquiry.
The fourth 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.
    Record Sharing. The proposed rule would require that the written
agreement with the qualified custodian include a provision requiring
the qualified custodian to provide, promptly, upon request, records
relating to client assets to the Commission or an independent public
accountant engaged for purposes of compliance with the rule.\508\ We
understand, currently, that accountants often struggle to obtain--or to
obtain timely--information from qualified custodians when performing
surprise examinations under the current rule unless the advisory client
requests that the qualified custodian share the information. We believe
that accountants likely struggle to obtain information from qualified
custodians because the qualified custodian has no contractual agreement
with the adviser or the accountant that has been hired by the adviser.
We believe that the proposed contractual requirement would mitigate
these record access challenges because the qualified custodian would be
in direct contractual privity with the adviser and would have a
contractual obligation to provide the records required by the rule--
potentially reducing the costs attributable to completing a surprise
examination under the rule.
---------------------------------------------------------------------------

    \508\ Proposed rule 223-1(a)(1)(i)(A).
---------------------------------------------------------------------------

    Account Statements. The proposed rule would require that the
written agreement provide that the qualified custodian will send
account statements (unless the client is an entity whose investors will
receive audited financial statements as part of the financial statement
audit process pursuant to the proposed rule), at least quarterly, to
the client and the investment adviser, identifying the amount of each
client asset in the custodial account at the end of the period as well
as all transactions in the account during that period.\509\ We believe
that the delivery of quarterly account statements to the adviser, which
is a new requirement, would allow the adviser to more easily perform
account statement reconciliations. We believe that qualified
custodians' delivery of account statements directly to advisory clients
enhances investor protections by facilitating clients' ability to
verify adviser conduct as well as client assets. We also continue to
believe that qualified custodians' delivery of account statements
directly to advisory clients--without the involvement of the adviser--
helps provide clients with confidence that any erroneous or
unauthorized transactions by an adviser would be reflected in the
account statement and, as a result,

would deter advisers from fraudulent activities.\510\
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    \509\ Proposed rules 223-1(a)(1)(i)(B), 223-1(b)(4).
    \510\ Rule 206(4)-2(a)(3) requires the adviser to have
reasonable belief upon due inquiry that the qualified custodian
delivers quarterly account statements to the client.
---------------------------------------------------------------------------

    The proposed rule would also require a provision prohibiting the
account statement from identifying assets for which the qualified
custodian lacks possession or control, unless requested by the client
and the qualified custodian clearly indicates that the custodian does
not have possession or control over such assets. We believe the
proposed requirement would enhance investor protections by enhancing
the integrity and utility of the account statements, thereby reducing
the risk investors are misled or become confused about those assets for
which the custodian is responsible in the event of a loss.
    Internal Control Report. The proposed rule would require that the
written agreement with the qualified custodian provide that the
qualified custodian, at least annually, will obtain, and provide to the
investment adviser a written internal control report that includes an
opinion of an independent public accountant as to whether controls have
been placed in operation as of a specific date, are suitably designed,
and are operating effectively to meet control objectives relating to
custodial services (including the safeguarding of the client assets
held by that qualified custodian during the year). The objectives and
scope of the proposed internal control report are substantially the
same as those of the internal control report required under the current
rule, but would expand the requirement to all qualified custodians as
opposed to the current rule, which only requires the internal control
report when the adviser or its related person acts as a qualified
custodian.
    In circumstances where the qualified custodian is not the adviser
or its related person, we believe the proposed requirement would help
enhance investor protections by ensuring that the qualified custodian's
controls with respect to its safeguarding practices are routinely
evaluated in a timely manner by an independent third party. Also, in
those circumstances where qualified custodians currently obtain
internal control reports, the scope of those reports likely covers the
financial institutions' safeguarding activities for ``funds and
securities'' rather than all ``assets,'' as defined in the proposed
amendments. We believe the proposed requirement would help enhance
investor protection by expanding the scope of internal control reports
to cover safeguarding actives for ``assets'' rather than ``funds and
securities.'' We believe the requirement that auditors must be
independent in fact and in appearance contributes to investor
protection and investor confidence in connection with the relationship
between an auditor and the qualified custodian. Unlike the current rule
that only requires an internal control report when the adviser or its
related person acts as a qualified custodian, the proposed rule would
mitigate risks to client assets regardless of the affiliation of the
qualified custodian.
    Under circumstances where the proposed rule requires the engagement
of a PCAOB-registered and inspected public accountant, we anticipate
that the proposed rule will have client protection benefits. As the
Commission noted in adopting the current custody rule, the Commission
has greater confidence in the quality of the processes followed by an
independent public accountant registered with, and subject to regular
inspection by, the PCAOB.511 512 We believe that
registration and the periodic inspection of an independent public
accountant's system of quality control by the PCAOB would provide
clients with confidence in the quality of the reports produced under
the proposed rule.
---------------------------------------------------------------------------

    \511\ See Custody Rule Amendments Adopting Release, supra
footnote 11, at 17.
    \512\ For example, in response to our 2009 proposed Custody Rule
amendments requiring the use of PCAOB-registered independent public
accountants for annual surprise examinations in certain
circumstances, many commenters agreed with our belief that PCAOB
registration and inspection provided an important quality check on
the independent accountants providing those examinations. See
comment letter of Investment Adviser Association (July 24, 2009);
comment letter of The National Association of Active Investment
Managers (July 27, 2009); comment letter of Timothy P. Turner (July
27, 2009); comment letter of American Bar Association (Committee on
Federal Regulation of Securities) (July 28, 2009); comment letter of
Curian Capital LLC, Financial Wealth Management, Inc., LPL Financial
Corporation, and SEI Investments Company (July 28, 2009); comment
letter of Ernst & Young (July 28, 2009); comment letter of Financial
Planning Association (July 28, 2009); comment letter of Coalition of
Private Investment Companies (July 31, 2009); comment letter of
North American Securities Administrators Association, Inc. (Aug. 5,
2009). Academic research suggests that PCAOB registration and
inspection is associated with higher quality engagements. See, e.g.,
Mark L. DeFond & Clive S. Lennox, Do PCAOB Inspections Improve the
Quality of Internal Control Audits? (Sept. 2015), available at
https://pcaobus.org//News/Events/Documents/10222015_CEA/PCAOB-Inspections-Internal-Control-Audits-DeFond_Lennox.pdf. DeFond and
Lennox (2015) posit that auditors are motivated to receive clean
inspection reports from the PCAOB because adverse inspection
outcomes are detrimental to the auditors' compensation (Johnson,
Lindsay, Marsha Keune & Jennifer Winchel, Auditors' Perceptions of
the PCAOB Process (2015) working paper, University of Virginia).
They also note that the PCAOB has broad powers within its
jurisdiction to sanction individual auditors and firms that provide
substandard audits, which provides further incentive for auditors to
perform high quality audits.
---------------------------------------------------------------------------

    Adviser's Level of Authority. The proposed rule would require that
the adviser's written agreement with the qualified custodian specify
the investment adviser's agreed-upon level of authority to effect
transactions in the custodial account as well as any applicable terms
or limitations.\513\ As discussed in section II.B.3.b.iv above, our
understanding is that custodial agreements between advisory clients and
qualified custodians often contain provisions that give investment
advisers authority over their clients' custodial accounts that may be
broader than what the adviser and client have agreed to in their
advisory agreements. For example, an adviser may not have authority
under its advisory agreement with a client to instruct the client's
custodian to disburse client assets, or the advisory agreement may not
be entirely clear on the level of authority granted to the adviser. If,
however, the client's agreement with its qualified custodian grants the
adviser broad authority over the client's account, the qualified
custodian will accept and act upon instructions from the adviser to
disburse or transfer assets, for example, without verifying or
confirming those instructions with the advisory client), even though
the adviser's agreement with its client does not give the adviser the
authority to do so.\514\ This puts client assets at risk by giving the
adviser access to client assets that the adviser may not otherwise be
authorized to access. The proposed requirement that the contract
between the adviser and the qualified custodian specify the adviser's
agreed upon level of authority would mitigate these concerns and
empower advisers to tailor custodial arrangements to better reflect
client intentions and to be consistent with the adviser's contractual
obligations to its clients.
---------------------------------------------------------------------------

    \513\ Proposed rule 223-1(a)(1)(i)(D).
    \514\ See supra note 202.
---------------------------------------------------------------------------

ii. Costs
    The proposed written agreement requirements would impose costs on
advisers and qualified custodians related to negotiating, drafting, and
implementing the written agreements.
(a) Negotiating, Drafting, and Forming a Reasonable Belief the
Agreement Provisions Have Been Implemented
    We understand that advisers are rarely parties to the custodial
agreements. Those advisers who are not a party to a custodial agreement
and those qualified custodians with whom

they would be contracting would have to bear costs to negotiate and
draft the written agreement required by the proposed rule, and the
adviser would be required to form a reasonable belief that the
agreement provisions have been implemented by the qualified custodian.
This would include costs attributable to attorneys and compliance
professionals, both prior to and at the inception of the written
agreement, and over the life of the written agreement. For purposes of
the Paperwork Reduction Act, we estimate that investment advisers and
qualified custodians would incur aggregate initial costs of $41,218,464
to prepare these written agreements,\515\ and that aggregate annual
costs associated with modifying these agreements would be
$3,503,599.\516\ Advisers may also incur costs associated with
developing and maintaining a reasonable belief that the contractual
provisions have been implemented. These costs would largely depend upon
how each adviser satisfies and evidences compliance with this
requirement, making them difficult to quantify. However, the proposed
revisions to the recordkeeping rule would require an adviser to
maintain records that would likely be useful in demonstrating an
adviser's reasonable belief that a qualified custodian has implemented
the proposed contractual provisions. As a result, we estimate any
additional costs incurred by an adviser to develop and maintain a
reasonable belief that the proposed contractual provisions have been
implemented would be marginal.\517\
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    \515\ See infra footnote 593.
    \516\ See infra footnote 595.
    \517\ For example, under the revised recordkeeping rule, and
adviser would be required to maintain copies of the client account
statements it receives from a qualified custodian. These records
could form the basis of an adviser's reasonable belief that a
qualified custodian has implemented the proposed contractual
requirement to deliver account statements. See Proposed rule 204-
2(b)(iv). The costs associated with proposed amendments to the
recordkeeping rule are discussed in more detail below. See section
3.D.7, infra.
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(b) Required Provisions
    The proposed rule would require a written agreement between
advisers and qualified custodians that incorporates certain elements.
We believe the cost of including elements likely varies, depending on
the nature of each required element. Including certain elements may
involve minimal cost, while including other elements may involve more
substantial costs.
    We understand that qualified custodians often do not provide
independent public accountants access to custodial account records in
light of privacy concerns for their customers. The requirement that the
written agreement with the qualified custodian include a provision
requiring the qualified custodian to promptly, upon request, provide
records relating to client assets to the Commission or an independent
public accountant for purposes of compliance with the rule could impose
additional costs on custodians. We believe these costs would largely be
mitigated because we believe that providing custodial account records
is consistent with the longstanding custodial practice of providing
account statements to clients.\518\ For purposes of the Paperwork
Reduction Act, we estimate that qualified custodians would incur
aggregate annual costs of $19,462,024 associated with this record
provision requirement.\519\
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    \518\ Current rule 206(4)-2(a)(3). Qualified custodians use
custodial account records to produce client account statements.
    \519\ See infra footnote 601, which estimates the annual burden
associated with records provision to independent public accountants
as being 18,422 hours. Using a blended rate of $394 per hour (see
infra footnote 605) produces an estimated annual burden of (18,422 *
$394) = $7,258,268 associated with records provision to independent
public accountants. See infra footnote 605, which estimates the
annual burden associated with records provision to the Commission as
being $12,203,756, producing a total annual burden associated with
records provision of ($7,258,268 + $12,203,756) = $19,462,024.
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    The proposed rule would require that the written agreement with the
qualified custodian provide that the qualified custodian will send
account statements (unless the client is an entity whose investors will
receive audited financial statements as part of the financial statement
audit process pursuant to the audit provision of the proposed rule), at
least quarterly, to the client and the investment adviser, identifying
the amount of each client asset in the custodial account at the end of
the period as well as all transactions in the account during that
period. Because qualified custodians generally already send quarterly
account statements to clients, we expect the additional costs
associated with also sending such statements to advisers to be small.
For purposes of the Paperwork Reduction Act, we estimate that qualified
custodians would incur aggregate costs of $4,869,322.50 associated with
this requirement.\520\
---------------------------------------------------------------------------

    \520\ See infra note 609.
---------------------------------------------------------------------------

    The proposed rule would also require a provision prohibiting the
account statements from identifying assets for which the qualified
custodian lacks possession or control, unless requested by the client
and the qualified custodian clearly indicates that the custodian does
not have possession or control over such assets. As discussed in
section III.D.2.b, that provision could impose a cost on clients to the
extent account statements provided by a qualified custodian on an
accommodation basis offer a client the ability to review all of its
investments in a single consolidated account statement and potentially
alert a client or an auditor to the existence of an investment. This
provision would also impose costs on qualified custodians associated
with accommodating customization requests from clients. For purposes of
the Paperwork Reduction Act, we estimate that qualified custodians will
incur aggregate annual costs of $324,621.50 associated with these
customized requests.\521\
---------------------------------------------------------------------------

    \521\ See infra note 613.
---------------------------------------------------------------------------

    Internal Control Report. The objectives of the proposed internal
control report are substantially the same as those of the internal
control report required under the current rule.\522\ The internal
control report includes an opinion of an independent public accountant
as to whether controls have been placed in operation as of a specific
date, are suitably designed, and are operating effectively to meet
control objectives relating to custodial services. For those qualified
custodians that currently obtain internal control reports, the scope of
those reports likely do not cover the financial institutions'
safeguarding activities that this proposed requirement, which would
expand the scope of the rule to include all ``assets'' instead of
``funds and securities,'' is designed to cover, thus potentially
creating new costs for those firms whose report scope would need to be
modified. Any such new cost would be mitigated, however, to the extent
newly included assets would share existing controls or implicate
controls similar to those for funds and securities. We understand,
however, that not all qualified custodians may currently obtain
internal control reports--or may not be obtaining internal control
reports that meet the requirements of the proposed rule. While we
believe those financial institutions will be able to obtain a report
that satisfies the requirements of the proposed rule, doing so could
pose a substantial financial burden and time commitment. As discussed
above, we are not requiring that a specific type of internal control
report be provided under the proposed rule as long as the required
objectives are addressed. For example, a report on the description of
controls placed in operation and tests of operation effectiveness,
commonly

referred to as a ``SOC 1 Type 2 Report,'' generally should be
sufficient to satisfy the requirements of the proposed internal control
report requirement. For purposes of the Paperwork Reduction Act, we
estimate that an average internal control report would cost
approximately $750,000 per year and that qualified custodians will
incur aggregate annual costs of $35,962,500 associated with obtaining
internal control reports.\523\
---------------------------------------------------------------------------

    \522\ Rule 206(4)-2(a)(4)(ii).
    \523\ See infra footnote 617.
---------------------------------------------------------------------------

    Adviser's Level of Authority. As discussed above, our understanding
is that custodial agreements between advisory clients and qualified
custodians often give advisers authority over custodial accounts that
is broader than what the adviser and client agreed to in the advisory
agreement. Our staff has observed that qualified custodians have been
reluctant to modify or customize the level of authority of investment
advisers with respect to customer accounts. We believe that qualified
custodians have been reluctant to modify or customize advisers' level
of authority because doing so would increase qualified custodians' need
to monitor customer accounts, and to accept liability, for unauthorized
transactions by an adviser and its personnel. The proposed requirement
could create operational costs for qualified custodians including the
costs of adapting existing systems and processes to modify or customize
the level of authority of investment advisers with respect to customer
accounts. Also, qualified custodians might incur costs to incorporate
new provisions into their contracts with advisers as well as amend any
inconsistent provisions in their existing contracts. As a result, we
believe the proposed requirement that the written agreement contain a
provision addressing the adviser's authority, including authority of
the client and adviser to reduce that authority, may be costly for
qualified custodians.
3. Certain Assets That Are Unable To Be Maintained With a Qualified
Custodian
    As discussed in section II.C above, we believe the bulk of advisory
client assets can be maintained by qualified custodians. Some assets by
their very nature or size may not easily be subject to misuse or
misappropriation, and that may reduce the need for the safeguarding
protections offered by a qualified custodian, but it is also our
understanding that qualified custodians often refuse to custody such
assets for both advisers and their clients. In addition, as discussed
above, certain privately offered securities may not be able to be
maintained by a qualified custodian because, in our understanding,
demand for these services is low and thus there may not be a ready
market.
    In circumstances where the protections of a qualified custodian are
unavailable for certain physical assets and privately offered
securities, the proposed rule would provide an exception to the
requirement to maintain client assets with a qualified custodian, but
would also require additional protections to help ensure that these
assets are properly safeguarded. In this section, we discuss the costs
and benefits of each of the proposed rule's safeguarding requirements
for assets that are unable to be maintained by a qualified custodian.
a. Definition of Privately Offered Security
    The proposed rule's definition of privately offered securities
would retain the elements from the custody rule's description that
require the securities to be acquired from the issuer in a transaction
or chain of transactions not involving any public offering and
transferable only with prior consent of the issuer or holders of other
outstanding securities of the issuer.\524\ Like the custody rule, the
safeguarding rule would also require the securities to be
uncertificated and would require ownership to be recorded only on the
books of the issuer or its transfer agent in the name of the client.
However, the safeguarding rule would also require that the securities
be capable of only being recorded on the non-public books of the issuer
or its transfer agent in the name of the client as it appears in the
records the adviser is required to keep under rule 204-2.
---------------------------------------------------------------------------

    \524\ See supra note 223.
---------------------------------------------------------------------------

    To the extent crypto asset securities may qualify as privately
offered securities under the current rule's privately offered
securities exception, advisers with custody of such assets may not be
maintaining them with a qualified custodian in reliance upon the
exception. However, as discussed above, we believe crypto asset
securities issued on public, permissionless blockchains would not
satisfy the definition of privately offered securities.\525\ As a
result, advisers with custody of such crypto asset securities generally
would be required to maintain those assets with a qualified custodian
and their clients would benefit from the enhanced protections qualified
custodians provide.\526\ To the extent that crypto asset securities
exist or develop that are able to meet the conditions of the privately
offered securities exception, the costs and benefits discussed below
with respect to the safeguarding of privately offered securities would
apply to such assets.
---------------------------------------------------------------------------

    \525\ See supra note 227 and surrounding discussion.
    \526\ See section III.D.2 for a discussion of the benefits and
costs for assets that do not qualify for the privately offered
security exception and are not physical assets.
---------------------------------------------------------------------------

a. Adviser's Reasonable Determination
    In order to be eligible for the exception, the rule would require
an adviser to reasonably determine, and document in writing, that
ownership cannot be recorded and maintained (book-entry, digital, or
otherwise) in a manner in which a qualified custodian can maintain
possession or control of such assets. Such a determination necessarily
depends on the facts and circumstances at issue. Moreover, these
determinations would necessarily evolve over time as assets and the
custodial industry change.
    An adviser's reasonable determination of whether a qualified
custodian is able to maintain possession or control of a particular
asset would generally involve an analysis of the asset and the
available custodial market. An adviser's reasonable determination
generally would not require the identification of every conceivable
qualified custodian and an evaluation of its custodial services.
Fundamentally, to determine whether an asset can or cannot be
maintained by a qualified custodian under the proposed rule, an adviser
generally should obtain a reasonable understanding of the marketplace
of custody services available for each client asset for which it has
custody.
    The proposed rule's reasonable determination requirement would
benefit investors by limiting the scope of assets eligible for the
exception and helping to ensure that any privately offered security or
physical asset for which a qualified custodian is available is held by
such custodian, maximizing the set of assets for which investors
receive the enhanced protections associated with maintaining possession
or control by a qualified custodian. The magnitude of this benefit
would depend on the extent to which advisers currently would not
otherwise maintain assets they have control of with a qualified
custodian despite the availability of custodial services for such
assets. For example, if the costs associated with maintaining an asset
with a qualified custodian exceeded the costs of safeguarding the asset

internally, an adviser with custody of the asset might choose to
safeguard the asset internally absent this requirement. Alternatively,
in cases where custodial services are available at prices that are
competitive with the costs of internally safeguarding an asset,
advisers may have chosen to maintain assets in their custody with a
qualified custodian regardless of this requirement.
    Advisers would incur costs associated with the proposed rule's
reasonable determination requirement. For example, while the rule does
not prescribe exactly how advisers should comply with the requirement,
many advisers may choose to develop policies and procedures that
establish the frequency with which the market for custodial services is
reviewed, the manner in which the availability of custodial services
for an asset should be assessed, and the manner in which an ultimate
determination is made. The development and implementation of such
policies and procedures, including the documentation of each reasonable
determination, would cause advisers to incur costs that may be passed
on to their clients in the form of higher fees. The proposed rule does
provide advisers with flexibility in determining the frequency with
which they make the required reasonable determinations, which should
allow advisers to tailor these policies and procedures to the types of
asset they hold on behalf of clients and control the associated costs.
    In addition, in cases where custodial services become available for
an asset but are highly costly, the reasonable determination
requirement would force advisers to incur such high custodial costs,
which may be passed on to their clients, whereas they otherwise may
have chosen to forgo custodial services in such cases. The costs an
adviser incurs as a result of the requirement would vary depending on
factors such as the types of assets the adviser has custody of and the
heterogeneity in these asset types. For example, an adviser that has
custody of client assets that are relatively homogenous may only have
to monitor a single market for custodial services, whereas an adviser
with custody of many different types of assets would likely incur
higher costs in monitoring and determining whether custodial services
are available in multiple markets. We lack precise information on the
degree of homogeneity versus heterogeneity in the assets held by
advisers, as well as the eventual costs advisers would pay to custody
assets under the proposed rule, so we cannot quantify the costs
associated with this requirement.
b. Adviser Reasonably Safeguards Client Assets That Are Unable To Be
Maintained With a Qualified Custodian
    To rely on the exception, the adviser would be required to
reasonably safeguard physical assets and privately offered securities
that cannot be maintained with a qualified custodian. The proposed rule
would not require that advisers implement any particular measures to
safeguard physical assets or privately offered securities not
maintained with a qualified custodian. Instead, the proposed rule would
take a more principles-based approach. If an adviser has custody of a
physical asset or privately offered security that it has determined
cannot be maintained with a qualified custodian, the adviser may decide
to safeguard that asset itself, designing and implementing safeguarding
policies and procedures accordingly. An adviser must act consistently
with its fiduciary role in safeguarding any particular asset. For
example, the adviser might ``reasonably safeguard'' an asset by looking
to reasonable commercial standards for safeguarding that asset from
theft, misuse, misappropriation, or other similar type of loss. Under
the rule, however, an adviser would have the flexibility to determine
the specific safeguarding measures it puts in place, which may differ
from asset to asset. If an adviser does not ``self-custody'' physical
assets or privately offered securities that it has determined cannot be
maintained with a qualified custodian, and instead maintains those
assets with a third party that is in the business of safeguarding those
assets, the adviser might implement policies and procedures reasonably
designed to ensure that the entity directly maintaining the client's
assets has implemented appropriate measures to safeguard them.
    Advisers are already obligated to safeguard client assets as part
of their fiduciary duty. However, to the extent that the proposed rule
would lead advisers to develop practices that more effectively
safeguard assets that are not maintained by a qualified custodian, the
proposed rule would benefit investors by reducing the risk that their
assets are subject to loss, theft, misuse, or misappropriation by an
adviser. Even to the extent advisers already effectively safeguard
client assets that are not maintained by a qualified custodian, the
proposed rule may still benefit investors by establishing a minimum
safeguarding standard which they can expect will be applied to those
assets, increasing investors' confidence in the market for advisory
services.
    The proposed rule would not require advisers to implement any
particular measures to safeguard physical assets or privately offered
securities not maintained with a qualified custodian. This principles-
based approach would give advisers the flexibility to safeguard client
assets in a way consistent with the nature of the assets and each
adviser's individual facts and circumstances. If advisers choose to
safeguard client assets themselves, then, to the extent they do not
already safeguard client assets in accordance with the proposed
requirement, advisers would bear any costs associated with developing
and implementing effective safeguarding practices. For example, some
advisers may incur costs designing and implementing safeguarding
policies and procedures.
    If physical assets or privately offered securities are maintained
with a third party, advisers might comply with the proposed rule's
safeguarding requirement by implementing policies and procedures
reasonably designed to ensure that the third party maintaining the
client's physical assets has implemented appropriate measures to
safeguard them. Such policies and procedures might include robust due
diligence and ongoing oversight procedures designed to ensure the
adviser has assessed and evaluated the measures put in place by the
third party. To the extent advisers do not already employ practices
that can ensure that client assets maintained with a third party are
safeguarded consistently with the proposed rule, advisers will incur
costs in developing and implementing such practices in order to comply
with the rule.
c. Notification and Prompt Independent Public Accountant Verification
    The exception to the requirement to maintain assets with a
qualified custodian would also require an adviser to enter into a
written agreement with an independent public accountant. The proposed
rule would require the adviser to notify the independent public
accountant of any purchase, sale, or other transfer of beneficial
ownership of such assets within one business day. The proposed rule
would require the written agreement to require the independent public
accountant to verify the purchase, sale, or other transfer promptly
upon receiving the required transfer notice. We believe the involvement
of independent public accountants in the review and verification of
client assets of which advisers have custody is an important
safeguarding tool. The timing of the requirement would build a record
for

the accountant to review in connection with an annual surprise
examination or financial statement audit. The written agreement would
also require the independent public accountant to notify the Commission
by electronic means directed to the Division of Examinations within one
business day upon finding any material discrepancies during the course
of performing its procedures.
    The notification and verification requirement would benefit
investors by reducing the risk that a loss, theft, misuse, or
misappropriation of their assets goes undetected for a significant
amount of time, which might allow investors or the Commission to
mitigate losses associated with such events in a timely manner. Even in
cases where an adviser fails to notify the independent public
accountant of a transaction because it involves loss, theft, misuse, or
misappropriation, the absence of such notifications relative to what
has been observed in the past may serve as a warning sign that is
useful in identifying potential losses during annual audits or surprise
examinations by the independent public accountant.
    Advisers would incur costs associated with the proposed rule's
notification and verification requirement. While an adviser would
likely incur some initial costs associated with designing and
implementing any policies and procedures necessary to notify the
independent public accountant that a transaction of client assets has
occurred, the ongoing costs of notifying the independent public
accountant are likely to be small relative to the more involved
transaction costs associated with a change of ownership for privately
offered securities or physical assets. For purposes of the Paperwork
Reduction Act, we estimate that advisers would incur aggregate ongoing
annual costs of $48,013 associated with notifying independent public
accountants of transactions.\527\ Advisers will also incur one-time
costs associated with negotiating, drafting, and implementing the
written agreement with their designated independent public accountant.
Advisers may be able to mitigate these one-time costs if they already
have written agreements associated with an annual surprise exam or
audit by the same independent public accountant. In addition, advisers
may incur minimal costs associated with the occasional modification of
these agreements. For purposes of the Paperwork Reduction Act, we
estimate that investment advisers would incur aggregate initial costs
of $2,443,194 to prepare these written agreements,\528\ and that
aggregate annual costs associated with modifying these agreements would
be $977,514.\529\
---------------------------------------------------------------------------

    \527\ See infra note 648.
    \528\ See infra note 642.
    \529\ See infra note 644.
---------------------------------------------------------------------------

    Finally, the adviser will have to pay the independent public
accountant for its services, the costs of which may be passed onto
investors. Verification costs would likely vary across advisers
depending on factors such as the type of client assets they have
custody of as well as the volume of transactions in which they engage.
For example, a transaction involving a real estate asset that requires
the independent public accountant to verify titles or deeds in person
is likely to be costlier to verify than a transaction that can be
verified electronically or via telephone. Similarly, an adviser that
engages in a high volume of annual transactions would incur higher
costs associated with transaction verification, which may ultimately be
borne by the advisers' clients. For purposes of the Paperwork Reduction
Act, we estimate that advisers would incur aggregate ongoing annual
costs of $21,000,000 associated with the verification of transactions
by independent public accountants.\530\
---------------------------------------------------------------------------

    \530\ See infra note 649.
---------------------------------------------------------------------------

d. Surprise Examination or Audit
    Like the existing custody rule, the proposed safeguarding rule
would require advisers relying on the exception to undergo an annual
surprise examination or rely on the audit provision. In a change from
the custody rule, however, the proposed rule would require each
privately offered security or physical asset not maintained with a
qualified custodian to be verified, rather than only requiring that a
sampling of assets be verified during a surprise exam or that only
assets meeting the materiality threshold be verified during an audit.
    The proposed requirement that each asset be verified in annual
surprise examinations or audits would benefit investors by reducing the
risk that the loss or theft of client assets is not detected when those
assets are either not included in a surprise examination's sample or do
not meet the materiality threshold when advisers rely on the audit
provision. For clients of advisers that do not rely on the audit
provision, the magnitude of this benefit depends on the extent to which
the sampling techniques used in conducting a surprise examination are
likely to omit assets that have been subject to loss or theft. To the
extent that the sampling techniques currently used in surprise
examinations are effective at capturing instances of asset loss or
theft, or that the sampling techniques are already a sufficient
deterrent to adviser misconduct that might result in loss or theft, the
benefit of this requirement will be more limited with respect to
surprise examinations.
    For clients of advisers that rely on the audit provision, the
magnitude of this benefit depends on the extent to which loss or theft
tend to occur in client assets that do not meet the materiality
threshold. While the existing custody rule might not deter adviser
misconduct in assets below the materiality threshold, the proposed
safeguarding rule would act as more of a deterrent against such
misconduct because those assets would be subject to regular
verification for advisers that rely on the audit provision.
    Advisers would incur additional costs as a result of the
requirement that, to rely on the exception, each client asset be
verified in a surprise examination or annual audit, and these costs may
be passed on to their clients. These costs will vary with the type of
asset subject to verification and the number of assets held by an
adviser. For example, verifying a privately offered security held by an
adviser on behalf of its client might require an independent public
accountant to contact the issuer of the security or its agent to verify
the existence of the asset, or to review documents such as private
placement memoranda and the issuer's Regulation D filings. For physical
assets, an independent public accountant may be required to review
deeds or other land recordation materials (e.g., for real estate
assets) or to review other documents, such as warehouse receipts, that
confirm the existence of a physical commodity. For both physical assets
and privately offered securities, incremental verification costs could
be high in cases where the number of assets held by an adviser is large
relative to the number of assets typically verified in surprise
examinations or audits under the current custody rule. If the supply of
qualified independent public accountants is scarce relative to any
increased demand for their services as a result of this requirement,
the overall cost of their services would also increase, at least
temporarily until those higher prices attract new entrants into the
public accounting market. For purposes of the Paperwork Reduction Act,
we estimate that advisers would incur aggregate ongoing annual costs of
$322,956,000 associated with the

verification of transactions by independent public accountants.\531\
---------------------------------------------------------------------------

    \531\ See infra note 655.
---------------------------------------------------------------------------

4. Segregation of Investments
    In addition to requiring advisers to attain reasonable assurance of
segregation of client assets from a qualified custodian's assets, the
proposed rule also would require advisers to segregate client assets
from the adviser's assets and its related person's assets in
circumstances where the adviser has custody. Specifically, the proposed
rule would require that client assets of which an adviser has custody:
    (1) Be titled or registered in the client's name or otherwise held
for the benefit of that client;
    (2) Not be commingled with the adviser's assets or the adviser's
related persons' assets; and
    (3) Not be subject to any right, charge, security interest, lien,
or claim of any kind in favor of the adviser, its related persons, or
its creditors, except to the extent agreed to or authorized in writing
by the client.\532\
---------------------------------------------------------------------------

    \532\ Proposed rule 223-1(a)(3).
---------------------------------------------------------------------------

    The proposed requirement that a client's assets be titled or
registered in the client's name would help ensure that the client's
assets are clearly identified as belonging to the appropriate client.
The proposed rule would also permit advisers to identify the assets
``for the benefit of'' a particular client where assets may not be
``titled or registered'' in the client's name. Permitting advisers to
identify assets ``for the benefit of'' a particular client benefits
investors by recognizing that advisory clients can title or register
their investments in various ways.
    The proposed rule would also require that client assets not be
commingled with the adviser's assets or those of its related persons.
The proposed requirement would help ensure that client assets are
isolated and more readily identifiable as client property. We believe
isolating client assets and making them more readily identifiable as
client property would help protect client assets from claims by a third
party looking to secure or satisfy an obligation of the adviser,
including in cases of insolvency or bankruptcy of the adviser, or its
related persons.
    The proposed rule would also require client assets to remain free
from any right, charge, security interest, lien, or claim of any kind
in favor of the adviser, its related persons, or its creditors. These
requirements would protect client assets by limiting the ability of an
adviser, or its related persons, to use client assets for their own
purposes or in a manner not authorized by the client. We recognize that
some advisers regularly service assets in a manner where such assets
are reasonably identifiable from other clients' assets and not subject
to increased risk of loss from adviser misuse or in the case of adviser
insolvency, thereby mitigating the potential benefits of the proposed
requirement. Also, we recognize that, depending on the types of assets,
products, or strategies in which they invest, some clients may
authorize these types of arrangements. We do not intend this condition
to limit or prohibit clients' ability to authorize such arrangements.
    We recognize that not all advisers service assets in a manner where
such asserts are reasonably identifiable from the other clients' assets
and not subject to increased risk of loss from adviser misuse or in the
case of adviser insolvency. In addition, for those advisers that
segregate and identify their client assets, the extent of those
activities varies. To the extent certain advisers currently do not
segregate client assets, the segregation requirement in the proposed
rule would result in advisers adapting existing systems and processes
to meet the proposed requirement.
5. Investment Adviser Delivery of Notice to Clients
    The proposed rule, like the custody rule, would require an
investment adviser to notify its client in writing promptly upon
opening an account with a qualified custodian on the client's behalf.
The proposed rule, however, would require that the notice must include
the custodial account number in addition to the currently required
qualified custodian's name and address.\533\ The proposed rule would
also continue to allow the notice to be delivered to the client's
independent representative. If the client is a pooled investment
vehicle, the notice must be sent to all of the investors in the pool,
provided that, if an investor is a pooled investment vehicle that is in
a control relationship with the adviser or the adviser's related
persons, the sender must look through that pool (and any pools in a
control relationship with the adviser or its related persons) in order
to send the notice to investors in those pools.\534\
---------------------------------------------------------------------------

    \533\ Proposed rule 223-1(a)(2).
    \534\ See proposed rule 223-1(c).
---------------------------------------------------------------------------

    The addition of the custodial account number would benefit clients
by allowing them to more easily identify the custodial account. The
client would be able to compare the custodial account number on
subsequent account statements received from the qualified custodian to
the custodial account number on the notice received from their
investment adviser. Also, if the client is a pooled investment vehicle,
the look-through requirement on senders promotes meaningful delivery of
this important information.
    We understand that custodial account numbers are readily available
to qualified custodians and that the cost of including the custodial
account number in the notice to clients would be minimal. For purposes
of the Paperwork Reduction Act, we estimate that advisers would incur
aggregate initial costs of $4,720,044 associated with ensuring that
custodial account numbers are included in notices to clients.\535\
---------------------------------------------------------------------------

    \535\ See infra note 624.
---------------------------------------------------------------------------

6. Exceptions From the Surprise Examination
    The proposed rule would create new exceptions to the surprise
examination requirement in certain limited circumstances where advisers
may have custody. We believe that in these circumstances, the subject
activities or arrangements have built-in adequate preventative
safeguards or simply pose less risk to client assets.
a. Entities Subject to an Audit
    We believe that audits provide substantial protections to private
funds and their investors both because audits test assertions
associated with the investment portfolio (e.g., completeness,
existence, rights and obligations, valuation, presentation) and because
they provide a check against adviser misrepresentations of performance,
fees, and other information about the fund. Because of that belief, the
proposed rule's audit provision would allow audits to serve as a
substitute mechanism of compliance with certain aspects of the proposed
rule. Elements of the proposed rule's audit provision are largely
unchanged from the audit provision of the current rule.\536\
Differences include: expanded availability from ``pooled investment
vehicle'' clients to ``entities,'' extending the current rule's
specific deadlines for distribution of audited financial statements to
180 days in the case of fund of funds or 260 days of a fund of funds of
funds of the entity's fiscal year end, and a requirement for there to
be a written agreement between the adviser or the client and the
auditor requiring the auditor to notify the Commission

upon the auditor's termination or issuance of a modified opinion.\537\
---------------------------------------------------------------------------

    \536\ See supra note 282.
    \537\ See supra note 283.
---------------------------------------------------------------------------

i. The Expanded Availability of Audit Provision
    While the current rule's audit provision is only available to an
adviser to clients that are limited partnerships, limited liability
companies, and other types of pooled investment vehicles, the proposed
audit provision would also be available to an adviser for any other
client ``entity'' whose financial statements can be audited in
accordance with the rule.\538\
---------------------------------------------------------------------------

    \538\ Compare rule 206(4)-2(b)(4); proposed rule 223-1(b)(4).
---------------------------------------------------------------------------

    As discussed in section II.G.1.b, this aspect of the proposed rule
would extend the investor protection benefits of an audit to a larger
number of investors, such as pension plans, retirement plans, college
saving plans (529 plans), and Achieving a Better Life Experience
savings accounts (ABLE plans or 529 A accounts). Investment advisers do
not use the current rule's audit provision for clients that are not
pooled investment vehicles, a consequence that may increase compliance
burdens for advisers and result in additional costs.
    Also, we believe that financial statement audits provide additional
meaningful protections to investors by increasing the likelihood that
fraudulent activity is uncovered, thereby providing deterrence against
fraudulent conduct by advisers. In a financial statement audit, the
accountant performs procedures beyond those procedures performed during
a surprise examination. For example, a financial statement audit
typically involves tests of valuations of entity investments, income,
operating expenses, and, if applicable, incentive fees and allocations
that accrue to the adviser. Additionally, a financial statement audit
regularly involves an accountant confirming bank account balances and
securities holdings as of a point in time, and a financial statement
audit frequently includes the testing of transactions that have
occurred throughout the year. These common types of audit evidence
procedures performed by accountants during a financial statement
audit--physical examination or inspection, confirmation, documentation,
inquiry, recalculation, re-performance, observation, and analytical
procedures--act as an important check on the adviser obviating the need
for the account notice and delivery requirements for pooled investment
vehicles and other entities.
    Based on our experience, we estimate that the party (or parties)
that bears the audit expense would pay an average audit fee of $60,000
per fund. We estimate that individual fund audit fees would tend to
vary over an estimated range from $15,000 to $300,000, and that some
fund audit fees would be higher or lower than this range. We noted that
the price of a private fund audit depends on many factors, such as
whether it is a liquid fund or an illiquid fund, the number of its
holdings, availability of a PCAOB-registered and -inspected auditor,
economies of scale, and the location and size of the auditor. We
believe that the cost of audit for client entities whose financial
statements can be audited would be of a similar
magnitude.539 540
---------------------------------------------------------------------------

    \539\ Although we believe that the procedures performed by the
accountant during the course of an audit provide meaningful
protections to clients beyond those of a surprise examination,
certain protections provided by surprise examinations would no
longer be provided. The loss of those protections could create a
cost for investors, but we believe the requirements under the
proposed rule mitigate those potential costs. For example, although
the annual audit is not required to be performed at a time of the
accountant's choosing (as is a surprise examination), we believe
other elements of the audit incorporate an element of uncertainty
similar to the surprise element of the surprise examination, with
corresponding benefits to investors. Specifically, in the course of
an annual audit, the auditor will select transactions to test during
the period that the adviser will not be able to anticipate.
    \540\ Under the proposed rule, only those accountants that are
subject to regular inspection by the PCAOB are eligible to perform
these services which limits eligible accountants to those that
currently conduct public company issuer and broker-dealer audits.
The expansion of the availability of audit provision could result in
an increase in demand for audit services provided by PCAOB-inspected
accountants. Absent an offsetting increase in the supply of such
services, the cost of audit services for client entities could
increase. If PCAOB-inspected accountants reallocate resources from
other market segments, thereby decreasing the supply of PCAOB-
inspected accountant capacity in those other market segments, the
cost of audit services, more generally, could increase.
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ii. Distribution of Audited Financial Statements
    The proposed audit provision would require an adviser to distribute
an entity's audited financial statements to current investors within
120 days (or 180 days in the case of a fund of funds or 260 days in the
case of a fund of funds of funds) of the entity's fiscal year end,
instead of the 120-day period required currently.\541\ As discussed in
section II.G.1.e above, we understand that reliance on third parties
could cause an adviser to fail to meet the 120-day timing requirements
regardless of an adviser's actions. We also recognize there may be
times when an adviser reasonably believes that an entity's audited
financial statements would be distributed within the required timeframe
but fails to have them distributed in time under certain unforeseeable
circumstances.
---------------------------------------------------------------------------

    \541\ See proposed rule 223-1(b)(4)(iv).
---------------------------------------------------------------------------

    By extending the timeframe in which advisers of certain types of
pooled investment vehicles (i.e., funds of funds and funds of funds of
funds) must distribute an entity's audited financial statements,\542\
the proposed rule may reduce any uncertainty advisers to such pooled
investment vehicles face under the current rule. Because we understand
existing market practices with respect to these pooled investment
vehicles already follow similar timeframes, we believe the costs of the
proposed changes to the audit provision with respect to the
distribution of audited financial statements would be minimal.
---------------------------------------------------------------------------

    \542\ See supra note 304.
---------------------------------------------------------------------------

    For purposes of the Paperwork Reduction Act, we estimate that
investment advisers would incur an aggregate annual burden of
$1,242,150 associated with delivering audited financial statements to
their clients.\543\
---------------------------------------------------------------------------

    \543\ See infra note 660.
---------------------------------------------------------------------------

iii. Commission Notification
    The proposed rule would require an adviser to enter into, or cause
the entity to enter into, a written agreement with the independent
public accountant performing the audit to notify the Commission (i)
within one business day upon issuing an audit report to the entity that
contains a modified opinion and (ii) within four business days of
resignation or dismissal from, or other termination of, the engagement,
or upon removing itself or being removed from consideration for being
reappointed.\544\ The written agreement must require the independent
public accountant to notify the Commission by electronic means directed
to the Division of Examinations. Although there is a requirement on
Form ADV for an adviser to a private fund to report to the Commission
whether it received a qualified audit opinion and to provide and update
its auditor's identifying information, there is not a similar current
obligation for an accountant to notify the Commission under the current
rule.
---------------------------------------------------------------------------

    \544\ See proposed rule 223-1(b)(4)(v).
---------------------------------------------------------------------------

    The proposed requirement to notify the Commission (i) within one
business day upon issuing an audit report to the entity that contains a
modified opinion and (ii) within four business days of resignation or
dismissal from, or other termination of, the engagement, or upon

removing itself or being removed from consideration for being
reappointed would enable the Commission to receive more timely,
complete, and independent information in these circumstances and to
evaluate the need for an examination of the adviser. Based on our
experience in receiving notifications from accountants who perform
surprise examinations under the custody rule, we believe that the
timely receipt of this information--from an independent third party--
would more readily enable our staff to identify advisers potentially
engaged in harmful misconduct and who have other compliance issues.
This would bolster the Commission's efforts at preventing fraudulent,
deceptive, and manipulative activity and would aid oversight of
investment advisers. This could lead to a higher rate of detection of
activities that lead to the loss of client assets and a greater
potential for mitigation of such losses. Anticipating this, advisers
would have stronger incentives to avoid such harmful activities.
    The proposed written agreement requirement could impose costs on
advisers and accountants related to negotiating, drafting, and
implementing the written agreements. Based on staff experience,
however, we understand that written agreements are commonplace and
reflect industry practice when a person retains the services of a
professional, such as an accountant, and they are typically prepared by
the independent public accountant in advance. Also, the proposed
requirements are drawn from the current rule's Form ADV-E filing
requirement for independent public accountants performing surprise
examinations and, as a result, should not be burdensome for accountants
to include in their written agreements.\545\ As a result, we do not
believe that the proposed requirement would significantly increase the
costs attributable to the proposed requirement. For purposes of the
Paperwork Reduction Act, we estimate that investment advisers would
incur an initial aggregate burden of 48,735 hours and an ongoing annual
burden of 35,869 hours associated with the written agreement.\546\
---------------------------------------------------------------------------

    \545\ Form ADV-E Instructions, pt. 3.ii, https://www.sec.gov/files/formadv-e.pdf.
    \546\ See infra notes 662 and 664.
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b. Discretionary Trading Authority
    The proposed rule would contain an exception from the surprise
examination requirement of client assets if the adviser's sole basis
for having custody is discretionary authority with respect to those
assets, provided this exception applies only for client assets that are
maintained with a qualified custodian and for accounts where the
adviser's discretionary authority is limited to instructing its
client's qualified custodian to transact in assets that settle
exclusively on a delivery versus payment basis.\547\ The proposed rule
would limit this exception to instances where this is the adviser's
sole basis for custody. Also, if an adviser also has custody of the
client's assets for reasons that are also subject to similar exceptions
(e.g., sole basis is fee deduction, sole basis is related person
custody),\548\ the adviser can rely on the exception.
---------------------------------------------------------------------------

    \547\ Proposed rule 223-1(b)(8).
    \548\ See Rule 206(4)-2(b)(3) and (6) and proposed rule 223-
1(b)(3) and (6).
---------------------------------------------------------------------------

    We understand that certain investors may prefer to give their
adviser discretionary trading authority. In delivery versus payment
transactions, clients' custodians are generally under instructions to
transfer assets out of a client's account only upon corresponding
transfer of assets into the account. When a custodian is under
instructions to transfer assets out of a client's account only upon
corresponding transfer of assets into the account, there is a reduced
risk that the adviser could misappropriate the assets, and when the
transaction settles on a DVP basis there is a reduced risk of theft of
the asset because, on a non-DVP basis, the seller of an asset could
deliver but not receive payment or that the buyer of an asset could
make payment but not receive delivery of the asset. The proposed
exception would reduce the cost of discretionary trading authority in
these instances by not requiring the adviser to comply with the
surprise examination requirement of the proposed rule in those
circumstances where the discretionary trading authority arrangement
minimizes the risk that an investment adviser could withdraw or
misappropriate assets in its clients' accounts. We believe this
exception will mitigate the creation of new burdens for many advisers,
particularly smaller advisers, as a result of the expanded scope of the
definition of custody in the proposed rule and will focus the
requirement to obtain a surprise examination where the risk of
misappropriation is greatest. To the extent advisers pass along cost
savings to clients, clients could realize a benefit in the form of
reduced fees.
c. Standing Letters of Authorization
    The proposed rule would provide an exception from the surprise
examination requirement for an investment adviser that has custody of
client assets solely because of a standing letter of
authorization.\549\
---------------------------------------------------------------------------

    \549\ Proposed rule 223-1(b)(7).
---------------------------------------------------------------------------

    We understand that certain investors may prefer to grant their
adviser authority to disburse assets from the client's account to one
or more specifically designated third parties in a manner that limits
the adviser's ability to redirect the assets, via standing letter of
instruction or other similar asset transfer authorization arrangement.
The proposed exception would reduce the cost of granting an adviser
such authority by not requiring the adviser to comply with the surprise
examination requirement of the proposed rule. To the extent advisers
pass along cost savings to clients, clients could realize a benefit in
the form of reduced fees.
    As discussed in section II.G.3 above, where an arrangement is
structured so that the adviser's role is limited to determining when to
disburse a client's assets, we believe that the adviser's role in
effecting any change in beneficial ownership is circumscribed and
ministerial, and there is little risk to clients of loss, misuse,
misappropriation, or theft of its asset. We also believe under such
circumstances that a qualified custodian would be best positioned to
ensure that the required authorizations and instructions are properly
and verifiably issued by the client (e.g., the client's signature is
verifiable). As a result, we believe the cost of the exception to
clients would be minimal.
    The proposed required information could benefit qualified
custodians by helping ensure that the instructions to the qualified
custodian provide relevant information about the recipient. The
proposed rule's requirement could also impose operational costs on
qualified custodians. As described in section II.G.3, we believe the
types of financial institutions identified as meeting the proposed
definition of qualified custodian are required by their primary
functional regulator or otherwise to perform procedures to verify the
instruction and authorization, through a signature review and, if
determined to be necessary, based on the facts and circumstances,
another method of verification. To the extent existing regulatory
requirements for qualified custodians are the same or similar to the
proposed rule's requirements, the costs of adapting existing systems
may be mitigated.

7. Amendments to the Investment Adviser Recordkeeping Rule
    The proposed amendments to rule 204-2 would require an investment
adviser that has custody of client assets to make and keep true,
accurate, and current records of required client notifications and
independent public accountant engagements under proposed rule 223-1, as
well as books and records related to specific types of client account
information, custodian information, transaction and position
information, and standing letters of authorization.\550\ The proposed
amendments would require a more detailed and broader scope of records
of trade and transaction activity and position information for each
client account than the existing requirements for such records.\551\
The proposed amendments also would add new recordkeeping requirements
that include: (i) retaining copies of required client notices; \552\
(ii) creating and retaining records documenting client account
identifying information, including whether the adviser has
discretionary authority; \553\ (iii) creating and retaining records of
custodian identifying information, including copies of required
qualified custodian agreements, and a record of required reasonable
assurances that the adviser obtains from the qualified custodian; \554\
(iv) creating and retaining a record that indicates the basis of the
adviser's custody of client assets; \555\ (v) retaining copies of all
account statements; \556\ and (vi) retaining copies of any standing
letters of authorization.\557\ Lastly, the proposed amendments would
add new recordkeeping requirements to address independent public
accountant engagements.\558\
---------------------------------------------------------------------------

    \550\ Advisers would be required to maintain the proposed
records for a period of not less than five years as required under
the current books and recordkeeping rule. See rule 204-2(e)(1).
    \551\ Compare rule 204-2(b)(1)-(4) with proposed rule 204-
2(b)(2)(v).
    \552\ Proposed rule 204-2(b)(1).
    \553\ Proposed rule 204-2(b)(2)(i).
    \554\ Proposed rule 204-2(b)(2)(ii).
    \555\ Proposed rule 204-2(b)(2)(iii).
    \556\ Proposed rule 204-2(b)(2)(iv).
    \557\ Proposed rule 204-2(b)(2)(vi).
    \558\ Proposed rule 204-2(b)(3).
---------------------------------------------------------------------------

    The proposed recordkeeping requirements are designed to work in
concert with the proposed rule to help ensure that a complete custodial
record with respect to client assets is maintained and preserved. The
proposed changes to the recordkeeping rule would benefit clients by
helping to facilitate the Commission's inspection and enforcement
capabilities, including assessing compliance with the requirements of
the proposed rule. In particular, the proposed recordkeeping
requirement would benefit investors by providing more complete records
that would facilitate client account reconciliation of all debits and
credits to and from client accounts. More complete records also would
better enable examiners to identify and detect potential investment
adviser misappropriation or loss or misuse of client assets during
their examinations, resulting in more effective investor protections.
More generally, the recordkeeping requirements would enhance the
transparency of custody of client assets and enhance the Commission's
oversight capabilities. Enhancing the Commission's oversight
capabilities could benefit clients and investors through reduced risks
of loss and greater regulatory transparency and resulting effectiveness
of the Commission's client and investor protection efforts.
    The proposed recordkeeping requirements would impose costs on
advisers related to creating and maintaining the required records.
These costs include those that can be attributed to compliance
professionals who would review and familiarize themselves with
requirements as specified in the proposed rule. In particular, advisers
would be required to make and retain a list of covered functions and
contributing factors, document their due diligence efforts, retain any
written agreements with service providers, and document periodic
monitoring of retained service providers. For purposes of the Paperwork
Reduction Act, we estimate that advisers would incur aggregate annual
costs of $41,352,853 as a result of the proposed amendments to rule
204-2.\559\
---------------------------------------------------------------------------

    \559\ See infra footnote 674.
---------------------------------------------------------------------------

8. Changes to Form ADV
    We are proposing to amend Part 1A, Schedule D, and the Instructions
and Glossary of Form ADV.\560\ The amendments are designed to
categorize information about advisers' practices to safeguard client
assets, to provide the Commission with information related to these
practices, and to provide the Commission with additional data to
improve our ability to identify compliance risks. The Commission is
not, however, proposing to change the structured data language used for
Part 1A. Specifically, given that Form ADV Part 1A currently is
submitted in a structured (i.e., machine-readable), XML-based data
language specific to that Form, the information in amended new Item 9
would continue to be structured in the same manner.
---------------------------------------------------------------------------

    \560\ See supra note 359.
---------------------------------------------------------------------------

    The amendments will provide the Commission with information related
to these practices, and also provide the Commission with additional
data to improve our ability to identify compliance risks. Also, public
reporting of these custodial practices could allow clients or third
parties to assess potential risks (e.g., concentration of investments
with a small number of custodians) associated with the market for
custodial services, generally. For example, these amendments may also
provide clients or investors additional protection because they will be
better able to discern the reasons why a particular adviser has
custody. Further, these amendments may offer ancillary market benefits
to the extent that market participants are better able to analyze the
Form ADV data to assess fraud risk. These proposed revisions would also
streamline the collection of this information by reorganizing Item 9
and refining certain reporting requirements to eliminate confusion and
prevent inaccurate or incomplete reporting.\561\
---------------------------------------------------------------------------

    \561\ See proposed Form ADV, Part 1A, Item 9.
---------------------------------------------------------------------------

    Reporting this additional information would impose additional costs
on investment advisers, but we believe that such costs would not be
significant since we understand that much of the information we propose
requesting on Form ADV would be readily available to or easily
accessible by advisers.\562\
---------------------------------------------------------------------------

    \562\ See infra Table 10 for the revised From ADV PRA burden
that includes incremental changes due to the proposed amendments as
well as adjustments due to wage inflation and changes in the number
of advisers.
---------------------------------------------------------------------------

E. Efficiency, Competition, and Capital Formation

    Efficiency. As discussed above, the proposed rule should benefit
clients and investors by mitigating risks associated with the custody
of client assets, thereby enhancing client and investor protections.
The enhancement to client and investor protections could, in turn, lead
to current clients being willing to invest a greater portion of their
resources with registered advisers or for more clients and investors to
seek the advice of registered advisers. Investment advisers provide
investment advice to investors and clients about the value of, or about
investing in, securities and other investment products. To the extent
investors benefit from such advice, we could expect an improvement in
the efficiency of client investment.
    It is possible, however, that the proposed rule could have the
opposite

effect on efficiency. The costs of the proposed rule would be borne by
advisers, their clients, and qualified custodians. It is possible that
the costs borne by advisers may be large enough to cause some advisers
to stop providing investment advice for certain assets.\563\ If
advisers were to stop providing investment advice for certain assets,
clients could experience a decrease in the quality of advisers'
services. Alternatively, if advisers do try to push the costs, or some
component thereof, to clients, it is possible that costs will be large
enough to cause some clients to seek alternatives to registered
advisers. To the extent clients would benefit from the advice provided
by registered investment advisers, the decreased use of advisory
services could result in a decline in the efficiency of client
investment including lower realized returns.
---------------------------------------------------------------------------

    \563\ If there are fixed costs associated with the proposed
regulations, then smaller advisers will generally tend to bear a
greater cost, relative to adviser size, than larger advisers. If
there are material fixed costs associated with the proposed rule,
then we would expect the possible negative effect on competition to
be greater for smaller advisers because the proposed regulations
will tend to increase their costs more (relative to adviser size)
than for larger advisers.
---------------------------------------------------------------------------

    The proposed amendments would result in a substantive increase in
the information about custodial practices available to the Commission.
That increased information could, for example, aid Commission staff in
examinations, increase the likelihood that non-compliant behavior by
custodians or advisers is detected, and increase the likelihood that
non-compliant behavior is detected sooner. That increased information
should also allow the Commission to develop a better understanding
custodial practices, generally. As a result, we would expect an
enhancement in regulatory efficiency.
    Competition. The proposed rule would enhance protections associated
with the custody of client assets. These enhancements to client and
investor protection, as well as the additional information available to
current and potential clients, could lead to an increased demand for
advisory services. That increase in demand for advisory services could,
in turn, lead to increased competition among advisers to meet the
increased demand. Alternatively, the increased demand for advisory
services could lead to an increase in the number of advisers in the
marketplace, also leading to an increase in competition among advisers.
An increase in competition could, presumably, manifest itself in terms
of better service, better pricing, or some combination of the two, for
clients.
    As discussed above, however, it is possible that the proposed rule
could have the opposite effect on competition. As noted above, the
costs of the proposed rule would be borne by advisers, clients, and
qualified custodians. It is possible that the costs borne by advisers
may be large enough to cause some advisers to stop providing advice
with respect to certain assets. To the extent the proposed rule would
create new fixed costs of providing advisory services, those fixed
costs would disproportionately impact small or newly emerging advisers.
As a result, those fixed costs could discourage entry of new advisers
or cause certain advisers to exit the market. Rather than exiting the
market, there could be consolidation among advisers that could result
in fewer options, and potentially higher costs, for investors. If
advisers were to stop providing advice with respect to certain assets,
competition among advisers with respect to providing advice for those
assets could decline. Further, if advisers do try to push the costs, or
some component thereof, to clients, it is possible that costs will be
large enough to cause some clients to seek alternatives to the advice
of registered advisers. The decreased demand for advisory services
could result in a decline in the number of registered advisers and a
decrease in competition among registered advisers.
    Also, we understand that the requirements of the proposed rule may
result in additional costs for qualified custodians, particularly the
requirements of a written agreement and reasonable assurances between
the qualified custodian and the investment adviser incorporating
certain minimum investor protection elements for advisory clients. To
the extent qualified custodians are unable to pass these costs along to
advisers and their clients, an increase in compliance costs could cause
some qualified custodians to exit the market. A decrease in the number
of qualified custodians could, in turn, lead to reduced competition,
increased custodial fees, or both.
    Capital Formation. As noted above, the proposed amendments enhance
investor protections by mitigating risks associated with custody of
client assets. Additionally, the proposed rule would result in more
information about custodial practices being available to the public.
Those enhancements to client and investor protection as well as the
additional information available to potential current clients and
potential investors could lead to greater investor confidence which
could result in current investors being willing to invest more and
potential investors being more willing to invest for the first time. To
the extent that the proposed rule leads to greater investment, we could
expect greater demand for securities, which could, in turn, promote
capital formation.

F. Reasonable Alternatives

    In this section, reasonable alternatives to the proposed elements
of rule 223-1 are discussed.
1. Scope of Assets
    The proposed rule would define ``assets'' as ``funds, securities,
or other positions held in a client's account.'' While, like the
current rule, the proposed rule would apply to a client's cash and cash
equivalents as well as a client's securities, it also would generally
apply to other positions held in a client's account that are not funds
or securities. The Commission alternatively could define the scope of
other positions more narrowly, perhaps by identifying specific types of
other positions subject to the proposed rule's safeguarding
requirements.
    As discussed above, however, we observe a continuing evolution of
the types of investments held in advisory accounts. If the proposed
rule were to identify specific types of assets as subject to the
safeguarding requirements of the rule, clients may not benefit from the
safeguarding requirements of the rule if they invest in new asset types
introduced in the future that fall outside the rule's scope. We
therefore believe a broad definition of other positions strikes the
correct balance in terms of investor protections and the cost of
complying with the proposed rule.
2. Elimination of Privately Offered Securities Exception
    The proposed rule would modify the current rule's exception to the
requirement to maintain client funds and securities with a qualified
custodian with respect to certain privately offered securities.\564\ As
discussed above, we believe qualified custodians serve as key
gatekeepers to mitigate loss of client assets. The Commission
alternatively could seek to enhance investor protections by eliminating
the exception--thus requiring advisers with custody of privately
offered securities to either maintain these assets with a qualified
custodian or eliminate having custody--or retain the current exception
without the proposed modifications.
---------------------------------------------------------------------------

    \564\ Proposed rule 223-1(b)(2).

---------------------------------------------------------------------------

    The choice between retaining the current exception, the exception
modified as proposed, or eliminating the exception entirely necessarily
involves tradeoffs. Eliminating the exception and requiring privately
offered securities be maintained with a qualified custodian would
increase the likelihood that a loss would be prevented or that non-
compliant behavior is detected earlier, potentially mitigating loss to
clients. Also, to the extent the likelihood of timely detection deters
non-compliant behavior, requiring privately offered securities to be
maintained with a qualified custodian could have an important
prophylactic effect.
    While we believe that requiring a qualified custodian to be
involved in any transfer of ownership of privately offered securities
would best mitigate the risk of loss of client assets, the current
costs associated with this approach would be substantial while a
custodial market is still relatively undeveloped. Although we believe
that this market would be more robust if the custody rule's exception
for uncertificated privately offered securities were eliminated and
demand for custodian services would increase, it is possible that this
market would not develop as we may expect or would develop in a way
that the costs of maintaining privately offered securities with
qualified custodians would not be justified by the benefits of doing
so. At the same time, we believe retaining the current exception
without modification leaves client assets at risk. In our view, the
proposed modifications strike the correct balance in terms of investor
protections and the cost of complying with the proposed rule.
3. Distribution of Requirements Across Reasonable Assurances and
Written Agreement
    The proposed rule would require an adviser to obtain certain
reasonable assurances regarding the protections clients receive from
the qualified custodians maintaining their assets. The proposed rule
would also require a written agreement between advisers and qualified
custodians specifying different provisions related to the relationship
among an adviser, its client, and a qualified custodian. Both the
proposed reasonable assurances and written agreement requirements
expand and formalize the minimum standard protections to advisory
clients' assets. The Commission alternatively could specify a different
composition of client protections realized via reasonable assurances
and written agreements. For example, the Commission could require fewer
protections be realized via written agreements and more be realized via
a reasonable assurances requirement. Or, the Commission could require
more protections be realized via written agreements and fewer
protections be realized via a reasonable assurances requirement.
    Under the proposal, the written agreement covers matters that
directly affect the adviser's own legal compliance (i.e., requiring the
custodian to promptly provide records to the Commission or to an
independent public accountant when required for compliance; requiring
the qualified custodian to deliver account statements to the adviser as
well as to the client; requiring the qualified custodian to assure the
adequacy of its internal controls) and that concern the adviser's
authority to effect transactions with funds in the client's account
held by the custodian. In contrast, the reasonable assurances
requirements cover matters which--while within the scope of the
adviser's fiduciary duty--principally concern the qualified custodian's
direct obligations to the client (i.e., the qualified custodian's
standard of due care to the client, the custodian's measures to
safeguard the client's assets, the custodian's indemnification of the
client against loss, the custodian's obligations to the client when
making sub-custodial arrangements, and the custodian's responsibility
to identify and segregate the client's assets and to protect the client
from liens or third-party claims).
    Committing more of these requirements to a written agreement would
have the benefit of establishing a uniform, predictable set of
requirements for all custodial arrangements and giving the adviser--as
well as the client--a contractual enforcement mechanism. The existence
of a written agreement might be a greater deterrent to misconduct than
a reasonable assurances requirement, and the agreement might provide
useful terms of reference for examinations. But committing more of the
requirements to a written agreement could result in significant
contracting costs, potential loss of flexibility in qualified
custodians' business practices, a significant disruption in current
practices, and increased litigation costs. In contrast, committing more
of these requirements to reasonable assurances would have the benefit
of reducing contracting costs, but with the added cost associated with
advisers exercising due diligence and periodic monitoring of qualified
custodians to obtain reasonable assurances, without the benefit of an
agreement to establish basic expectations on matters directly affecting
client advisory services. Moreover, qualified custodians may have
concerns about implementing certain protections in the absence of
contractual privity between themselves and investment advisers. For
example, qualified custodians may have privacy concerns for their
clients in the absence of an agreement with the adviser governing
provision of records to an independent public accountant. Weighing
these factors, we believe that the composition of client protections
realized via reasonable assurances and written agreements in the
proposal strikes the correct balance in terms of investor protections
and the cost of complying with the proposed rule.
3. Additional Accounting and Client Notification Requirements for
Privately Offered Securities and Physical Assets That Are Not
Maintained With a Qualified Custodian
    The proposed rule would require an investment adviser to implement
certain safeguards for clients' privately offered securities and
physical assets that cannot be maintained with a qualified custodian.
The safeguards are designed to improve protection of these assets and
to create transparency for an investor as to holdings of and
transactions in these assets, thereby increasing the likelihood that a
loss will be detected sooner, and misconduct will be deterred. These
include requirements for the adviser to reasonably determine that
ownership cannot be recorded and maintained in a manner in which a
qualified custodian can maintain possession or control of such assets;
\565\ for the adviser to reasonably safeguard the assets from loss,
theft, misuse, misappropriation, or the adviser's financial reverses,
including insolvency; \566\ for the adviser to enter into a written
agreement for an independent public accountant (``IPA'') to verify any
purchase, sale, or other transfer of beneficial ownership of such
assets promptly upon receiving notice from the adviser, and for the IPA
to notify the Commission within one business day upon finding any
material discrepancies during the course of performing its procedures;
\567\ for the adviser to notify the IPA of any purchase, sale, or other
transfer of beneficial ownership of such assets within one business
day; \568\ and for verification of the existence and ownership of such
assets during an

annual surprise examination or a financial statement audit.\569\
---------------------------------------------------------------------------

    \565\ Proposed rule 223-1(b)(2)(i).
    \566\ Proposed rule 223-1(b)(2)(ii).
    \567\ Proposed rule 223-1(b)(2)(iii).
    \568\ Proposed rule 223-1(b)(2)(iv).
    \569\ Proposed rule 223-1(b)(2)(v).
---------------------------------------------------------------------------

    We considered whether these safeguards should be supplemented or
replaced with additional accounting and client notification
requirements, including periodic examinations of the assets; prompt
delivery to the client of a written notice that the assets are not kept
by a qualified custodian, with an explanation of how the client can
verify the existence and ownership of those holdings; a summary of a
client's transactions involving assets that are not maintained with a
qualified custodian, to be issued on a quarterly or other periodic
basis; or for the adviser to obtain an internal control report for
assets not maintained with a qualified custodian.\570\ We also
considered requiring the independent public accountant engaged to
perform the proposed transaction verifications to be PCAOB-registered.
We believe the proposed safeguards are sufficient, and the costs of
additional safeguards to advisers and clients alike may not be
justified.
---------------------------------------------------------------------------

    \570\ See part II.D.5, Requests for Comment.
---------------------------------------------------------------------------

    As previously noted, we lack precise information on the degree of
homogeneity versus heterogeneity of assets held by advisers that cannot
be maintained by a qualified custodian, and more prescriptive
accounting and notification requirements could be more costly when the
assets are more varied and unique,\571\ when the custodian must rely on
a third-party service provider to safeguard and inventory physical
assets, or when the client engages in high-volume transactions.\572\
Moreover, the benefits of these additional safeguards would be limited
where the assets are of such a nature that loss or misappropriation is
readily detectable.\573\
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    \571\ See part III.D.3.b.
    \572\ See generally parts III.D.3.c, III.D.3.d.
    \573\ For example, unique, high-value, non-fungible assets, such
as developed real estate.
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4. Additional Safeguards When Clients Assets Are Not Maintained With a
Qualified Custodian
    As discussed above, we recognize that not all client assets for
which an adviser may have custody can currently be maintained with
qualified custodians.\574\ We considered proposing several alternative
additional protections designed to help protect client investments when
they are not maintained at a qualified custodian. One such alternative
we considered would have required advisers to implement at least one
financial responsibility safeguard. Specifically, we considered
requiring advisers having custody of client assets that they determined
could not be maintained with a qualified custodian to either (i)
maintain an insurance policy covering losses to the investment adviser
or its clients resulting from the loss, misuse, theft, or
misappropriation of investments not maintained at a qualified
custodian; or (ii) maintain a reserve bank account containing a
specified amount of cash or certain qualified securities that could be
used only to compensate clients for violations of the proposed
rule.\575\
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    \574\ See section II.D, supra.
    \575\ In the past--though in different contexts--the Commission
and Congress have considered various financial responsibility
requirements for advisers, including requiring advisers to maintain
insurance (in the form of fidelity bonds) or satisfy minimum capital
requirements. The Commission most recently sought comment on these
concepts in 2018 in conjunction with its proposed interpretation
regarding the standard of conduct for investment advisers. See
Proposed Commission Interpretation Regarding Standard of Conduct for
Investment Advisers; Request for Comment on Enhancing Investment
Adviser Regulation, Release No. IA-4889, at 4 n.8 (Apr. 18, 2018)
[83 FR 21203 (May 9, 2018)]. Comments received in response to this
request were still under evaluation at the time the Commission
adopted its final interpretation regarding the standard of conduct
for investment advisers. See Commission Interpretation Regarding
Standard of Conduct for Investment Advisers, supra footnote 57.
Previously, in 2003, the Commission requested comment on whether to
require a fidelity bonding requirement for advisers as a way to
increase private sector oversight of the compliance by funds and
advisers with the Federal securities laws. See Compliance Programs
of Investment Companies and Investment Advisers, Release Nos. IC-
25925 and IA-2107 (Feb. 5, 2003) [68 FR 7037 (Feb. 11, 2003)]. The
Commission decided not to adopt a fidelity bonding requirement at
that time, but noted that it regarded such a requirement as a viable
option should the Commission wish to further strengthen compliance
programs of funds and advisers. See Compliance Programs of
Investment Companies and Investment Advisers, Release Nos. IC-26299
and IA-2204 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)]. Also, in
1973, a Commission advisory committee recommended that Congress
authorize the Commission to adopt minimum financial responsibility
requirements for investment advisers, including minimum capital
requirements. See Report of the Advisory Committee on Investment
Management Services for Individual Investors, Small Account
Investment Management Services, Fed. Sec. L. Rep. (CCH) No. 465, Pt.
III, 64-66 (Jan. 1973). Three years later, in 1976, the Senate
Committee on Banking, Housing and Urban Affairs considered a bill
that, among other things, would have authorized the Commission to
adopt rules requiring investment advisers with discretionary
authority over client assets, or that advise registered investment
companies, to meet financial responsibility standards. S. Rep. No.
94-910, 94th Cong. 2d Sess. (May 20, 1976) (reporting favorably S.
2849). S.2849 was never enacted, however. The issue of adviser
financial responsibility was also considered by Congress in 1992,
with both the Senate and House of Representatives passing bills that
would have given the Commission the explicit authority to require
investment advisers with custody of client assets to obtain fidelity
bonds. S.226, 102d Cong., 2d Sess. (Aug. 12, 1992) and H.R. 5726,
102d Cong. Ed (Sept. 23, 1992). Differences in these two bills were
never reconciled and thus neither became law.
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    While this approach is similar to the types of fidelity bonds that
broker-dealers, investment companies, ERISA fiduciaries, and some
state-registered investment advisers are required to maintain,\576\ we
considered requiring advisers to maintain insurance coverage that would
have been more comprehensive than a typical fidelity bond in order to
address the risks the proposed rule is designed to mitigate. For
example, we considered requiring an adviser to maintain an insurance
policy covering losses to the investment adviser or its clients
resulting from the loss, misuse, theft, or misappropriation of
investments not maintained at a qualified custodian due to the
adviser's negligence, recklessness, or intentional misconduct.
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    \576\ See, e.g., FINRA Rule 4360 (broker-dealers); 17 CFR
270.17g-1 (investment companies); 29 CFR 2580.412-1 (ERISA
fiduciaries). Many state-registered investment advisers are required
to maintain fidelity bonds. See, e.g., Ala. Code 1975 section 8-6-3;
Ark. Admin. Code 214.00.1-303.2; Ga. Code Ann., section 10-5-40; see
also NASAA Bonding Requirements for Investment Advisers Model Rule,
available at https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Bonding.pdf.
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    However, we recognize there could be legal and logistical
challenges in implementing such a requirement. For example, fidelity
bond policies generally only protect policyholders from direct losses
suffered from a covered event (e.g., theft of the insured's property by
an employee), not third parties such as an adviser's clients, and even
to the extent fidelity policies are written to specifically cover
third-party property, there is disagreement as to whether the money a
policyholder uses to compensate a third party qualifies as a loss
covered under these policies.\577\ Also, it could be difficult for an
adviser to maintain appropriate coverage efficiently and effectively as
they buy and sell various investments on behalf of their clients or as
those investments increase and decrease in value. Finally, while this
approach may provide some means for recovery if an adviser's clients
are harmed, requiring this type of insurance coverage would likely
require advisers to pay significant premiums, which they would likely
pass along to clients through increased fees.
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    \577\ See Adam D. Cornett & Andrew S. Kent, Who Can Recover
Under a Fidelity Policy?, XX Fid. L.J. 139, 139-41, 177-180 (2014)
(citing Retail Ventures, Inc. v. Nat'l Union Fire Ins. Co. of
Pittsburgh, Pa., 691 F3d 821, 828-32 (6th Cir. 2012)).
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    We similarly considered requiring an adviser to maintain a
specified level of reserves based on the value of client investments
not maintained by a qualified custodian or for which an adviser has an
enhanced ability or

authority to effect a change in beneficial ownership. Requiring an
adviser to have sufficient liquid assets to cover these types of client
investments would have provided a source of recovery when those client
investments are lost, misused, stolen, or misappropriated due to the
adviser's failure to adequately safeguard them. This approach would
have resembled the capitalization requirements of other financial
firms.\578\ However, because the value of these client investments
would vary based on market fluctuations as well as client transactions,
designing a reserve requirement that would ensure that an adviser
maintained adequate reserves to allow for full recovery at all times
could be operationally challenging and costly. Further requiring
advisers to maintain reserves sufficient to provide for full--or even
meaningful--client recovery, may be prohibitively costly because
advisers would need to set aside significant amounts of capital,
potentially acting as a barrier to entry for new advisory firms or
causing existing advisers to leave the market.
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    \578\ Broker-dealers are subject to minimum capitalization
requirements under the net capital and customer protection rules.
See, e.g., 17 CFR 240.15c3-1 (net capital rule); 17 CFR 240.15c3-3
(customer protection rule). Some state-registered investment
advisers are also subjected to minimum capitalization requirements.
See, e.g., Ark. Admin. Code 214.00.1-303.2; Ga. Code Ann., section
10-5-40; see also NASAA Minimum Financial Requirements for
Investment Advisers Model Rule (2011), available at https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Minimum-Financial-Requirements.pdf.
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    Another alternative we considered would have required an adviser to
undergo an enhanced independent verification of assets not kept with a
qualified custodian or when an adviser has one-way transfer authority
over a client's account, irrespective of whether those assets are
maintained with a qualified custodian. For assets not kept with a