safeguards we should require?
    25. Should the rule continue to include broker-dealers registered
under section 15(b)(1) of the Securities Exchange Act of 1934
(``Exchange Act'') as qualified custodians, as proposed? Are there
additional requirements we should require when a broker-dealer is
acting as a qualified custodian under the rule? For example, should we
explicitly clarify that this would include only registered broker-
dealers that carry customer accounts, or is that already understood
from the current rule?
    26. Should the rule continue to include FCMs as qualified
custodians, as proposed? Should we remove the condition in the current
rule that prohibits maintaining client securities with an FCM unless
the securities are ``incidental'' to client futures transactions? In
2013, the CFTC enhanced protections afforded to customers and customer
assets held by FCMs including protections covering,

among other things, risk management, recordkeeping and disclosure, and
the treatment of customer-segregated funds secured in foreign futures
and options accounts.\112\ Are the 2013 CFTC regulatory enhancements
sufficient grounds to eliminate that condition of the current rule?
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    \112\ The CFTC in 2013 enhanced FCM requirements surrounding the
holding and investment of customer funds, including the ability of
FCMs to withdraw funds from futures customer segregated accounts.
Under the enhanced protections, FCMs are required to deposit
proprietary funds (i.e. residual interest) into futures, cleared
swap, and foreign futures customer accounts for purposes of creating
a buffer to ensure compliance with segregation requirements. In
addition, FCMs are required to file electronically their segregation
calculations with the CFTC and their self-regulatory organization
each business day. Further, FCMs are required to establish risk
management programs designed to monitor and manage risks associated
with customer funds. See Enhancing Protections Afforded Customers
and Customer Funds Held by Future Commission Merchants and
Derivatives Clearing Organizations, (``CFTC Enhanced Protections
Release'') [78 FR 68506 (Nov. 14, 2013)].
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    27. Should the rule limit the FFIs that can act as qualified
custodians under this rule, as proposed? Are the proposed conditions on
an FFI sufficiently clear, and if not, how should they be made clearer?
Should we eliminate any condition, add any condition, or require only
certain conditions and not others when an FFI is acting as a qualified
custodian under the rule? For example, as part of the rule, should we
require an adviser to find that the FFI provides a level of safety for
client assets equivalent to that which would be provided by a qualified
custodian in the United States or to fully disclose to clients any
material risks attendant to maintaining the assets with the foreign
custodian? Should this requirement apply only when the adviser is
involved in selecting (or assisting a client in selecting) a qualified
custodian? Are there types of FFIs that currently serve as qualified
custodians that would no longer be eligible to serve as qualified
custodians under the proposed rule? Would the proposed changes to the
definition of FFI enhance or inhibit investor protections? Would the
proposed changes to the definition of FFI cause any investments that an
investment adviser currently is able to select on behalf of its clients
to become unavailable for selection by the adviser due to the lack of
the existence of an FFI that satisfies the conditions of the proposed
rule? Should we only permit institutions regulated by a specific
foreign financial regulatory authority? If so, which foreign financial
authority and why? Should we require the adviser to obtain
documentation that identifies the FFI's specific financial regulatory
authority or authorities? Should the rule permit only certain types of
FFIs to qualify as qualified custodians and if so, which ones? Are
there any types of regulated foreign entities that should not hold
certain types of client assets outside the United States? Should the
proposed rule account for the country or jurisdiction where an FFI is
primarily operating, rather than the country or jurisdiction of
incorporation or organization, as proposed? If so, how would the
adviser determine where the FFI is primarily operating?
    28. Should the proposed rule limit the types of FFIs that can be
qualified custodians? If so, which institutions should be included?
Only banking institutions or trust companies? Should we also
specifically include foreign securities depositories and clearing
agencies or broker-dealer and FCM equivalents?
    29. Is the proposed definition to include regulated FFIs that
customarily hold financial assets for customers too broad; would it
allow unsound institutions to act as qualified custodians under the
proposed rule?
    30. What, if any, impacts would our proposed conditions have on the
availability of FFIs that can serve as qualified custodians? What would
be the positive and negative effects of requiring FFIs to provide
custodial protections similar to the protections provided by U.S.
qualified custodians?
    31. Should the proposed rule require an FFI to be subject to or
consent to U.S. jurisdiction for judgment enforceability, as proposed?
Alternatively, should judgment enforceability be a factor relevant to
the adviser's consideration of whether client assets will be subject to
the requisite due care standard by an FFI, similar to the approach in
rule 17f-5(c)(1) under the Investment Company Act? \113\ Should we
require the adviser to obtain the FFI's consent to service of process
in the United States to verify that it meets this condition? Should
such consent to service of process be effected by the FFI's submission
of a specified form to the Commission, similar in effect to Form ADV-NR
for the appointment of an agent for service of process by a non-
resident general partner or a non-resident managing agent of any
investment adviser?
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    \113\ See 17 CFR 270.17f-5(c)(1)((iv).
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    32. Should an FFI be required to comply with laws and regulations
similar to the BSA to act as a qualified custodian, as proposed? Do the
AML requirements for FFIs help ensure that a qualified custodian would
more readily identify and investigate aberrant behavior in a client's
account? Alternatively, should we specify the types of AML programs
that must be in place for FFIs?
    33. Should we treat an FFI as being required to comply with laws
and regulations similar to the BSA if the FFI is required to comply
with the laws and regulations established by a member or observer
jurisdiction of the FATF and not otherwise listed on any sanctions list
administered by the OFAC or on any special measures list under section
311 of the USA PATRIOT Act administered by FinCEN? Alternatively (or in
addition), should we automatically consider an FFI to not be required
to comply with similar laws and regulations if it is required to comply
with the laws and regulations of a country identified by the FATF as a
high-risk or other monitored jurisdiction? \114\
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    \114\ The FATF identifies jurisdictions with weak measures to
combat money laundering and terrorist financing in two FATF public
documents that are issued three times a year. See https://www.fatf-gafi.org/en/topics/high-risk-and-other-monitored-jurisdictions.html.
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    34. Should we require that an FFI hold financial assets in accounts
designed to protect such assets from creditors of the FFI in the event
of the FFI's insolvency or failure, as proposed? Alternatively, should
we require advisers to obtain reasonable assurances from an FFI
qualified custodian that the FFI is holding client assets in such
accounts? Should we require an FFI to have account protections that are
generally similar to those of a U.S. bank or savings association in the
event of its insolvency or failure? If so, should we provide guidance
around how an adviser would make such determinations of general
similarity and to maintain records of these determinations?
    35. Should we provide additional guidance around how an adviser
would determine that an FFI's practices, procedures, and internal
controls are designed to ensure the exercise of due care with respect
to safekeeping of client assets? Should we require an FFI's practices,
procedures, and internal controls to be generally similar to those of a
U.S.-regulated bank or savings association? If an FFI is not a bank or
savings association, but rather a foreign-equivalent to a U.S. broker-
dealer or U.S. FCM, should we require the adviser to determine that
such FFI's practices, procedures, and internal controls are generally
similar to those required by U.S. broker-dealers or FCMs? If so, should
we provide guidance around how advisers would make such determinations
of general similarity and

to maintain records of these determinations?
    36. Should we provide additional guidance around how an adviser
would determine the requisite financial strength of an FFI qualified
custodian? Should we require advisers to maintain records of these
determinations? Should we require advisers to have policies and
procedures to determine and monitor the financial strength of all
qualified custodians, not just FFI custodians? Should this requirement
apply only when the adviser is involved in selecting (or assisting a
client in selecting) a qualified custodian?
    37. To what extent do advisers or qualified custodians utilize sub-
custodians, such as foreign subsidiaries of a domestic qualified
custodian? What types of sub-custodians are utilized? Do these sub-
custodians have direct relationships with the adviser or client or do
they only interact directly with the qualified custodian? How are sub-
custodians overseen? Is this oversight performed by the adviser or the
qualified custodian? If it is by the qualified custodian, how do
advisers ensure that the client assets are safeguarded properly?
    38. Should the rule permit securities depositories, administrators,
or other intermediaries to be qualified custodians? Do they offer
similar services to the other types of financial institutions that meet
this definition, for example, by safeguarding and providing account
statements to advisory clients? Would they be able to agree to the
contractual terms contained in the proposed written agreement
requirement? Would advisers be able to satisfy the reasonable
assurances requirement under the proposed rule if one of these types of
entities were holding client assets? Do these types of entities
maintain ``possession or control'' of client assets, as discussed
below? Do they have similar capital adequacy requirements under their
respective regulatory regimes to the other types of financial
institutions that are included in the definition of qualified
custodian? Are there certain categories of these entities that would
more easily function as qualified custodians than others?
    39. The rule currently excepts advisers from complying with the
requirement to maintain mutual fund shares with a qualified custodian,
provided they are maintained with a transfer agent.\115\ Should
transfer agents be included in the definition of qualified custodian in
the final rule? Do they offer similar services to the other types of
financial institutions that meet this definition, for example, by
providing account statements to advisory clients? Would they be able to
agree to the contractual terms contained in the proposed written
agreement requirement? Would advisers be able to satisfy the reasonable
assurances requirement under the proposed rule if a transfer agent were
holding client assets?
---------------------------------------------------------------------------

    \115\ Rule 206(4)-2(b)(1).
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    40. Should insurance companies be included in the definition of
qualified custodian under certain circumstances, such as in the
variable annuity context? \116\ Do they offer services similar to the
other types of financial institutions that meet this definition, for
example, by safeguarding and providing account statements to advisory
clients? Would they be able to agree to the contractual terms contained
in the proposed written agreement requirement? Would advisers be able
to satisfy the reasonable assurances requirement under the proposed
rule if an insurance company were holding client assets? Do insurance
companies maintain ``possession or control'' of client assets, as
discussed below? Do insurance companies have similar capital adequacy
requirements to the other types of financial institutions that are
included in the definition of qualified custodian? Are there certain
categories or types of insurance companies that would more easily
function as qualified custodians than others?
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    \116\ Our staff indicated it would not recommend enforcement
action when an insurance company served a particular role with
respect to variable annuity contracts similar to the role of a
transfer agent with respect to mutual fund shares. See American
Skandia Life Assurance Corporation, May 16, 2005.
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2. Possession or Control
    In a change from the current rule, the proposed rule would require
that an investment adviser maintain client assets with a qualified
custodian that has possession or control of those assets. For the
purposes of proposed rule, ``possession or control'' would be defined
to mean holding assets such that the qualified custodian is required to
participate in any change in beneficial ownership of those assets, the
qualified custodian's participation would effectuate the transaction
involved in the change in beneficial ownership, and the qualified
custodian's involvement is a condition precedent to the change in
beneficial ownership.\117\ We understand that a qualified custodian's
participation in a change in beneficial ownership may take different
forms depending on the type of asset involved.\118\ Similarly, we view
participation by a qualified custodian to require the qualified
custodian to participate in a way that it is willing to attest to the
transaction on an account statement and for which it customarily takes
custodial liability. By contrast, we would not view ``accommodation
reporting,'' as described above, to constitute ``participation.'' The
proposed requirement and related definition are designed to achieve
several objectives. First, a critical custodial function is to prevent
loss or unauthorized transfers of ownership of the client's assets. It
is our understanding that a custodian will only provide this
safeguarding function, however, and assume custodial liability for a
custodial customer's loss, if the custodian had possession or control
of the asset that is lost. Second, because the qualified custodian
would be required to participate in any change in beneficial ownership
of a client asset, the proposed possession or control definition would
provide assurance that a regulated party who is hired for safekeeping
services by the client to act for the client is involved in any change
in beneficial ownership of the client's asset. Finally, we believe it
would help ensure the integrity of account statements provided by
qualified custodians because the custodian would report only on the
holdings in its possession or control (unless the client requests that
the qualified custodian report on holdings that are not in its
possession or control). As a result, a client could take comfort that
what is reported on its account statement is an accurate attestation of
holdings and transactions by that custodian.
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    \117\ See proposed rule 223-1(a)(1)(i) and (d)(2)(8). Exchange
Act Rule 15c3-3(c) prescribes when securities shall be deemed to be
under the control of a broker-dealer. See 17 CFR 240.15c3-3(c).
    \118\ For example, for certain privately offered securities, we
understand banks will put the securities in their name as nominee.
We also understand that a change in beneficial ownership may occur
at different points in the transaction lifecycle based on the type
of asset involved. For example, when purchasing an equity security,
the change in beneficial ownership occurs on trade date (see, e.g.,
rule 240.13d-3--Determination of beneficial owner), but we
understand that when purchasing real property, the change in
beneficial ownership typically occurs on the settlement date.
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    The proposed definition of ``possession or control'' in proposed
rule 223-1 is designed to be consistent with the laws, rules, or
regulations administered by the qualified custodian's functional or
primary financial regulator for purposes of its custodial activities.
Under the existing regulatory regimes under which qualified custodians
currently operate, a qualified custodian must generally

maintain assets in its physical possession or control. We believe our
proposed definition of possession or control (i.e., being required to
participate in any change of beneficial ownership) is consistent with
how the concept of possession or control is understood currently by
most qualified custodians and does not conflict with the requirements
of qualified custodians' respective regulatory regimes. The proposed
rule would formalize that understanding.
    For example, under the Exchange Act, broker-dealers are required
promptly to obtain and maintain in their physical possession or control
all of their customers' fully paid and excess margin securities.\119\
As a result, a broker-dealer would necessarily be involved in the
transfer of beneficial ownership of those securities. In addition,
national banks that offer safeguarding of customer assets are
responsible for maintaining adequate custody or control of their
customer assets.\120\ Again, as a result, national banks would have to
relinquish their custody or control of an asset to transfer ownership.
Similarly, the protections under section 4d(a)(2) of the Commodity
Exchange Act and regulations promulgated thereunder, including, among
others, CFTC regulation 1.20 (Futures customer funds to be segregated
and separately accounted for), CFTC regulation 1.22 (Use of futures
customer funds restricted), and CFTC regulation 1.25 (Investment of
customer funds),\121\ are predicated on the acceptance of, and receipt
by, a futures commission merchant of futures customers money,
securities, or property.\122\ It is our understanding that together,
these, and other regulations applicable to FCMs, holistically serve the
same purpose. In each of the foregoing cases, the respective custodian
is required by its functional regulator to possess or control customer
assets. While functional regulators have not defined possession or
control in the custody context in a manner identical to our proposed
rule (i.e., holding assets such that the qualified custodian is
required to participate in any change in beneficial ownership of those
assets), we view the proposed definition to be crucial to safeguarding
client assets and reflective of the fundamental underlying principle of
the custody industry--a custodian holds client assets for safekeeping
until directed by the client or the client's duly authorized agent to
enter into a transaction with a counterparty resulting in a change of
the client's beneficial ownership.\123\
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    \119\ See 17 CFR 240.15c3-3(b) and (c).
    \120\ National banks that fail to exercise proper control over
customer securities may be subject to enforcement proceedings by the
Comptroller of the Currency. See 12 U.S.C. 92a(k) (proceeding to
revoke trust powers on account of unlawful or unsound exercise of
powers). See also OCC, Comptroller's Handbook on Asset Management
Operations and Control (Jan. 2011), available at https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html; OCC regulation 12 CFR 9.13 (requiring, in connection
with the custody of fiduciary assets, among other things, that
``assets of fiduciary accounts [be placed] in the joint custody or
control'' of certain fiduciary officers or specially designated
persons). The OCC has issued guidance relating specifically to
custody of crypto assets by banks and Federal savings associations.
See Interpretive Letter 1170, Authority of a National Bank to
Provide Cryptocurrency Custody Services for Customers (July 22,
2020), available at https://www.occ.gov/topics/charters-and-licensing/interpretations-and-actions/2020/int1170.pdf (``As with
all other activities performed by national banks and FSAs, a
national bank or FSA that provides cryptocurrency custody services
must conduct these activities in a safe and sound manner, including
having adequate systems in place to identify, measure, monitor, and
control the risks of its custody services. Such systems should
include policies, procedures, internal controls, and management
information systems governing custody services. Effective internal
controls include safeguarding assets under custody, producing
reliable financial reports, and complying with laws and regulations.
The OCC has previously described that custody activities should
include dual controls, segregation of duties and accounting
controls. A custodian's accounting records and internal controls
should ensure that assets of each custody account are kept separate
from the assets of the custodian and maintained under joint control
to ensure that that an asset is not lost, destroyed or
misappropriated by internal or external parties. Other
considerations include settlement of transactions, physical access
controls, and security servicing. Such controls may need to be
tailored in the context of digital custody. Specialized audit
procedures may be necessary to ensure the bank's controls are
effective for digital custody activities. For example, procedures
for verifying that a bank maintains access controls for a
cryptographic key will differ from the procedures used for physical
assets. Banks seeking to engage in these activities should also
conduct legal analysis to ensure the activities are conducted
consistent with all applicable laws.'').
    \121\ See also section 4d(a)(2) of the Commodity Exchange Act
and CFTC Regulations 1.20-1.30 (Customers' Money, Securities, and
Property); and see CFTC Regulation 1.32 (Reporting of segregated
account computation and details regarding the holding of futures
customer funds; CFTC Regulation 1.36 (Record of securities and
property received from customers). These regulations address, among
other things, segregation of customer funds, limitations on
institutions in which the FCM may deposit customer funds,
limitations on holding customer funds outside of the United States,
limitations on the use of customer funds, and recordkeeping
requirements relating to customer funds.
    \122\ CFTC Regulation 1.3 defines a futures commission merchant
to be ``[a]ny individual, association, partnership, corporation, or
trust [ . . . ] Who, in connection with any of the[ ] activities
[identified in the regulation] accepts any money, securities, or
property [ . . . .] That regulation also defines futures customer
funds to mean ``all money, securities, and property received by a
futures commission merchant or by a derivatives clearing
organization from, for, or on behalf of, futures customers [for the
purposes identified in the regulation]. 17 CFR 1.3 (emphasis added).
    \123\ Alternatively, a custodian may return the asset to the
customer.
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    For purposes of an FFI, we believe that the proposed requirement
would promote the institution's accountability for client assets and
would thereby help to promote more comparable investor protections to
those assets held with U.S. financial institutions.\124\ Since FFIs are
subject to a broad range of regulatory regimes, we believe that this
requirement, together with the account statement contract requirement
discussed below, would formalize and make more uniform the assets
reported on account statements produced by an FFI, thereby better
informing clients regarding their holdings and transactions.
---------------------------------------------------------------------------

    \124\ See, e.g., the Undertaking for Collective Investment in
Transferable Securities Regulations 2016 (UCITS V) (enhancing the
rules on the responsibilities of UCITS custodians including making
the UCITS custodian liable for the avoidable loss of a financial
instrument held in its custody).
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a. Application With Respect to Crypto Assets
    As discussed above, we believe that under their existing regulatory
regimes, qualified custodians are generally considered to have
``possession or control'' of assets that are in their exclusive or
physical possession or control. We understand, however, that proving
exclusive control of a crypto asset may be more challenging than for
assets such as stocks and bonds. For example, while we understand that
it is possible for a custodian to implement processes that seek to
create exclusive possession or control of crypto assets (e.g., private
key creation, maintenance, etc.), it may be difficult actually to
demonstrate exclusive possession or control of crypto assets due to
their specific characteristics (e.g., being transferable by anyone in
possession of a private key). Moreover, we are mindful of crypto asset
custody models in which an advisory client and a qualified custodian
might simultaneously hold copies of the advisory client's private key
material to access the associated wallet with the client's crypto
assets, and thus both have authority to change beneficial ownership of
those assets.\125\
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    \125\ Letter from Anchorage Digital Bank NA re Custody Rule and
Digital Assets (Apr. 13, 2021) (``Proof of exclusive control can be
securely achieved through a combination of software, hardware, and
operational processes. However, custody models that rely on private
key redundancy (maintaining multiple physical or electronic copies)
and physical security as a proxy for digital asset security can't
ever truly prove this.'').

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

    As discussed above, the proposed rule's definition of possession or
control turns on whether the qualified custodian is required to
participate in a change in beneficial ownership of a particular asset.
While demonstrating that a qualified custodian has exclusive possession
or control of an asset would be one way to demonstrate that the
qualified custodian is required to participate a change of beneficial
ownership, it is not the only way. For example, under the proposed
rule, a qualified custodian would have possession or control of a
crypto asset if it generates and maintains private keys for the wallets
holding advisory client crypto assets in a manner such that an adviser
is unable to change beneficial ownership of the crypto asset without
the custodian's involvement.\126\
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    \126\ We note that, in the context of crypto asset securities,
the Commission has stated that, ``a broker-dealer that maintains
custody of a fully paid or excess margin digital asset security for
a customer must hold it in a manner that complies with Rule 15c3-3,
including that the digital asset security must be in the exclusive
possession or control of the broker-dealer. A digital asset security
that is not in the exclusive possession or control of the broker-
dealer because, for example, an unauthorized person knows or has
access to the associated private key (and therefore has the ability
to transfer it without the authorization of the broker-dealer) would
not be held in a manner that complies with the possession or control
requirement of Rule 15c3-3 . . . .]'' Commission Statement, supra
footnote 25 at 11629 (emphasis added).
---------------------------------------------------------------------------

    Importantly, however, to comply with the proposed rule, an adviser
with custody of client crypto assets would generally need to ensure
those assets are maintained with a qualified custodian that has
possession or control of the assets at all times in which the adviser
has custody.\127\ While this is true for most client assets over which
an adviser has custody, it is particularly relevant with respect to
crypto assets because, as we understand, much of the crypto asset
trading volume occurs on crypto asset trading platforms that often
directly settle the trades placed on their platforms. As a result, many
crypto trading platforms require investors to pre-fund trades, a
process in which investors transfer their crypto assets, including
crypto asset securities, or fiat currency to such an exchange prior to
the execution of any trade. Because we understand that most crypto
assets, including crypto asset securities, trade on platforms that are
not qualified custodians, this practice would generally result in an
adviser with custody of a crypto asset security being in violation of
the current custody rule because custody of the crypto asset security
would not be maintained by a qualified custodian from the time the
crypto asset security was moved to the trading platform through the
settlement of the trade.\128\ In light of our proposal to expand the
rule's application from ``funds or securities'' \129\ to ``assets,''
\130\ this practice would also constitute a violation of the proposed
rule for an adviser with custody of client crypto assets if the adviser
trades those assets on a crypto asset trading platform that does not
satisfy the definition of ``qualified custodian.'' Alternative Trading
Systems that do not require pre-funding of trades and that trade crypto
asset securities following a process that does not involve the broker-
dealer operator of the Alternative Trading System providing custodial
services for the crypto asset securities are discussed further
below.\131\
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    \127\ This is not only true for crypto assets, but any client
asset for which an adviser has custody, subject to the exceptions in
the proposed rule. See proposed rule 223-1(b)(1) (Shares of Mutual
Funds), (2) (Certain Assets Unable to be Maintained with a Qualified
Custodian), and (5) (Registered Investment Companies).
    \128\ This differs from the approach with a U.S. national
securities exchange, which does not routinely exercise possession or
control of the securities listed on a national securities exchange.
In this scenario, trades are executed on a national securities
exchange, establishing the contract between buyer and seller. The
national securities exchange then passes transaction details on to a
clearing agency or depository, which steps in to facilitate and
complete settlement between each party's custodian, specifically the
exchange of cash and securities per the trade's contracted terms
agreed on the national securities exchange on a delivery versus
payment basis.
    \129\ See rule 206(4)-2(a).
    \130\ See proposed rule 223-1(a).
    \131\ See infra footnotes 460-461 and accompanying text.
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    We request comment on all aspects of the proposed possession or
control requirement, including the following items.
    41. Should the rule include the possession or control requirement,
as proposed? Would the proposed requirement provide additional
protections for clients? Possession or control would be defined to mean
holding assets such that the qualified custodian is required to
participate in any change in beneficial ownership of those assets. Do
commenters agree with our view that the term ``participation'' would
mean that the qualified custodian would effectuate the transaction and
its involvement would be a condition precedent to the change in
beneficial ownership? How else would commenters describe a qualified
custodian's participation? Should we instead define possession or
control to mean holding assets such that the qualified custodian is
required to effectuate any change in beneficial ownership of those
assets? Do commenters agree with our understanding that a qualified
custodian's participation in a change in beneficial ownership may take
different forms depending on the type of asset involved? Do commenters
agree with our view that participation by a qualified custodian would
require the qualified custodian be willing to attest to the transaction
on an account statement? Do commenters agree with our understanding
that a qualified custodian will customarily take custodial liability
for client assets for which it participates in beneficial changes of
ownership?
    42. Do the types of financial institutions serving as qualified
custodians under the current rule maintain client assets in a manner
that would satisfy the proposed definition of ``possession or
control''? Do commenters agree with our view that the proposed
definition of possession or control (i.e., being required to
participate in any change of beneficial ownership) is consistent with
how the concept of possession or control is understood currently by
most qualified custodians and does not conflict with the requirements
of qualified custodians' respective regulatory regimes?
    43. Is our understanding correct that qualified custodians hold
client assets for safekeeping until directed by the client or the
client's duly authorized agent to enter into a transaction with a
counterparty resulting in a change of the client's beneficial ownership
or until directed to return the assets to the client, subject to duly
authorized custodial charges? Is our understanding correct that this is
crucial to safeguarding client assets and reflective of a fundamental
underlying principle of the custody industry?
    44. Should we have different possession or control requirements for
different qualified custodians? If so, what should they be, and why?
    45. Are we correct in our understanding that a custodian will
assume custodial liability for a custodial customer's avoidable loss
only if the custodian has possession or control (i.e., is required to
participate in any change in beneficial ownership) of the asset that is
lost?
    46. Unlike as proposed, should the rule explicitly state that the
qualified custodian maintain ``physical'' or ``exclusive'' possession
or control of the client's assets? Do commenters agree with our
understanding qualified custodians may face greater challenges in their
ability to demonstrate exclusivity with respect to crypto assets as
compared their ability to demonstrate

exclusive possession or control with respect to stocks and bonds? Do
custodians for crypto assets routinely consider the crypto assets they
service to be in their exclusive possession or control? If so, how
would exclusivity be demonstrated? Are there particular safeguarding
practices with respect to crypto assets that are better suited to
demonstrating exclusivity than others? What kind of evidence would be
necessary to demonstrate proof of exclusive possession or control of
crypto assets? What type of procedures would a crypto asset custodian
need to have to demonstrate exclusive possession or control of crypto
assets? \132\ Would requiring exclusive possession or control improve
safeguarding of crypto assets? Given the nature of crypto assets, is it
possible to demonstrate the exclusive possession or control of a
particular crypto asset? How important do custodians view ``exclusive''
possession or control of a client asset, including a crypto asset, to
be for liability reasons? How do existing custodians of crypto assets
address the risk of liability for theft, fraud, or misappropriation of
crypto assets when a client (and potentially others with whom the
client has shared the private key material) retains the ability to
effect a change in beneficial ownership of the asset without the
involvement of the custodian?
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    \132\ See Commission Statement, supra footnote 25, at 11629 (``A
digital asset security that is not in the exclusive physical
possession or control of the broker-dealer because, for example, an
unauthorized person knows or has access to the associated private
key (and therefore has the ability to transfer it without the
authorization of the broker-dealer) would not be held in a manner
that complies with the possession or control requirement of Rule
15c3-3 and thus would be vulnerable to the risks the rule seeks to
mitigate.'').
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    47. Would a custodian for crypto assets be able to satisfy the
proposed possession or control requirement? Would such a custodian be
able to participate in a change of beneficial ownership for a client's
crypto asset? What does it mean for a custodian to ``participate'' in a
change of beneficial ownership for a client's crypto asset transaction?
Does this involve only the deployment of the private key or keys
associated with the public address where the client's crypto assets are
recorded to transfer, as instructed, the client's crypto assets to
another person with a public key? Does this also include recording or
communicating a change in beneficial ownership?
    48. To what extent does a custodian for crypto assets take
custodial liability for a beneficial change in ownership of a client's
crypto assets?
    49. Is our understanding of how many crypto asset trading platforms
require investors to pre-fund trades correct? How many of these trading
platforms require pre-funding trades? How many rely on other custodial
arrangements and how do those crypto asset trading platforms operate
with such custodial arrangements? How would the proposed rule impact
advisers who trade on such trading platforms currently? What, if any,
impacts would the proposed rule have on the availability of crypto
asset trading platforms that may be able to serve as qualified
custodians? Would the proposed definition of ``possession or control''
enhance or inhibit investor protections with respect to client assets
traded on crypto asset trading platforms?
    50. Do custodians for crypto assets permit the customer (and
potentially others with whom the customer has shared a private key) to
retain the ability to effect a change in beneficial ownership of the
asset without the involvement of the custodian? In these cases, do
commenters believe that advisory clients would receive the benefits of
the protections of the proposed rule if they contractually required a
qualified custodian to be involved in any beneficial change of
ownership of the crypto asset? Would crypto asset advisory clients and
custodians be willing to enter into contractual agreements of that
type? Would requiring that a qualified custodian have exclusive
possession or control over the crypto asset have an impact on the
crypto asset custody industry? How big of an impact?
    51. Are there asset types other than crypto assets over which a
qualified custodian may not be able to obtain ``exclusive'' possession
or control? Please indicate which asset types and explain why
exclusivity may not be possible.
    52. Is our understanding correct that beneficial ownership change
may occur at different points in the transaction lifecycle based on
asset type? Is there a customary reference to when a change in
beneficial ownership occurs for each asset type? For crypto assets,
does the change in beneficial ownership occur when the transaction is
recorded on the blockchain or when the transaction is settled off-chain
on the internal ledger system of a crypto asset trading platform? Are
there differences if the transaction is recorded on a private or
permissioned ledger than on a public or un-permissioned ledger? Are
there differences if the transaction is settled on a centralized crypto
asset trading platform versus a so-called decentralized crypto asset
trading platform?
    53. Many market participants refer today to ``atomic settlement''
of crypto asset trades.\133\ Is this is commonly understood and used
term? Does it mean that both legs of the trade settle simultaneously
(similar to a delivery vs. payment transaction), or that the trade
settles instantly, or both? Which aspect of crypto asset settlement
(simultaneous settlement or instantaneous settlement) is preferable
from an investor protection standpoint? Are there drawbacks to either?
Should the Commission require particular protections related to crypto
asset trades or custody? What about other crypto asset transactions?
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    \133\ See Michael Lee, Antoine Martin, and Benjamin M[uuml]ller,
What Is Atomic Settlement? (Nov. 7, 2022), available at https://libertystreeteconomics.newyorkfed.org/2022/11/what-is-atomic-settlement/.
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    54. Is it possible for an adviser to execute any trade that settles
instantly and while maintaining the assets at a qualified custodian
throughout the lifecycle of that trade? If so, how? Could the adviser
do so and still have the ability to trade with counterparties other
than the qualified custodian? How would that work?
3. Minimum Custodial Protections
    The proposed rule would promote minimum standard custodial
protections for advisory clients whose advisers have custody of client
assets. It generally would require that the investment adviser maintain
client assets with a qualified custodian pursuant to a written
agreement between the qualified custodian and the investment adviser
(or between the adviser and client if the adviser is also the qualified
custodian).\134\ It would further require the adviser to obtain
reasonable assurances in writing from the custodian regarding certain
vital protections for the safeguarding of client assets. 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, resulting in an adviser having limited
visibility into the custodial arrangements of its clients. This
presents several issues under the current rule and can result in an
adviser being subject to the rule due to what has become known as
inadvertent custody, which can occur, for example, when the custodial
agreement between a client and custodian grants an adviser broader
access to client funds or securities than contemplated by the adviser's
own agreement with the client and the

adviser did not intend to have such access to client assets.\135\ We
understand that inadvertent custody often arises because a custodial
agreement grants an adviser expansive authority to transact in or
transfer assets held in its client custodial accounts (e.g., the
ability to initiate wire transfers) that are often superfluous to the
advisory services being provided. However, because advisers are rarely
a party to these agreements, their ability to repudiate unwanted
authority is limited.
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    \134\ Proposed rule 223-1(a)(1)(i).
    \135\ See Inadvertent Custody: Advisory Contract Versus
Custodial Contract Authority, Division of Investment Management
Guidance Update No. 2017-01 (Feb. 2017) (in which our staff
discussed its views on the application of the current custody rule
to various types of custodial agreements between a client and a
custodian that grant an adviser broader access to client funds or
securities than the adviser's own agreement with the client
contemplates).
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    In addition, custodial market practices have evolved and expanded
since the rule was last amended, as have the types of assets qualified
custodians hold.\136\ Some bank qualified custodians have developed
custodial practices for crypto assets. However, Federal banking
regulators have stated more broadly regarding crypto asset-related
activities that ``[b]ased on the agencies' current understanding and
experience to date [ . . . ] the agencies have significant safety and
soundness concerns with business models that are concentrated in
crypto-asset-related activities or have concentrated exposures to the
crypto-asset sector.'' \137\ The regulatory framework to which these
institutions are subject is evolving, in part, to accommodate new
entrants to the market for custodial services, including newly launched
state-chartered trust companies that focus on providing crypto asset
custody services.\138\ In light of this evolution, we must be mindful
of the extent to which many of these new entrants to the custodial
marketplace offer, and are regulated to provide, the types of
protections we believe a qualified custodian should provide under the
rule.\139\
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    \136\ See, e.g., Fiduciary Capacity; Non-Fiduciary Custody
Activities, 84 FR 17967 (Apr. 29, 2019) (the Office of the
Comptroller of Currency estimating that the size of non-fiduciary
custody assets held at national banks and Federal savings
associations has increased, since it last updated its fiduciary
regulation in 1996, to approximately $41.7 trillion as of December
21, 2018); Olga Kharif, Fidelity Says a Third of Big Institutions
Own Crypto Assets BNN Bloomberg (June 9, 2020), available at https://www.bnnbloomberg.ca/fidelity-says-a-third-of-big-institutions-own-crypto-assets-1.1447708 (reporting that, according to a survey by
Fidelity Investments, 36 percent of institutional investors in the
U.S. and Europe report holding crypto assets).
    \137\ See Joint Statement on Crypto-Asset Risks to Banking
Organizations, supra footnote 27.
    \138\ See, e.g., Application by Anchorage Trust Company, Sioux
Falls, South Dakota to Convert to a National Trust Bank; Application
for Residency Waiver (Jan. 13, 2021), available at https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-6a.pdf; Application by Protego Trust Company, Seattle, Washington,
to Convert to a National Trust Bank; Application for Director
Residency Waiver (Feb. 4, 2021), available at https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-19a.pdf; Application to charter Paxos National Trust, New York, New
York, OCC Control Number: 2020-NE-Charter-318305, OCC Charter
Number: 25252 (Apr. 23, 2021), available at https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-49a.pdf; New York Department of Financial Services, Financial
Services Superintendent Linda A. Lacewell Announces Grant of DFS
Trust Charter to Bitgo to Engage in New York's Growing Virtual
Currency Market (Mar. 4, 2021), available at https://www.dfs.ny.gov/reports_and_publications/press_releases/pr202103041. See also, New
York Department of Financial Services, Guidance on Custodial
Structures for Customer Protection in the Event of Insolvency (Jan
23, 2023), https://www.dfs.ny.gov/industry_guidance/industry_letters/il20230123_guidance_custodial_structures (issuing
guidance focusing on customer protection relating to segregation of
and separate accounting for customer virtual currency, custodian's
use of customer virtual currency, sub-custody arrangements, and
customer disclosure).
    \139\ See, e.g., Financial Stability Oversight Council, Report
on Digital Asset Financial Stability Risks and Regulation (2022),
available at https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf (``[S]ome platforms emphasize that
they are regulated through MSB laws. These laws generally are
intended to address consumer protection related to money
transmission and to combat illicit finance. They are not intended to
address funding mismatches outside of money transmission or risks
posed by platforms custodying crypto-assets internally within
omnibus accounts, particularly when commingled with platform
assets.'').
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    At the same time, we understand that some existing qualified
custodians have modified their practices to remain profitable amid
these changes, such as by contractually limiting their liability to
their customers in a variety of ways. Others have turned to outsourcing
less profitable parts of their custodial services.\140\ Our staff has
observed that the clients who are least likely to have bargaining power
are often afforded the fewest protections. These changes in the
custodial industry have caused us to reconsider the minimum protections
we believe an adviser who uses a qualified custodian to maintain
possession or control of client assets should provide.
---------------------------------------------------------------------------

    \140\ See Deloitte (2019), The Evolution of a Core Financial
Service: Custodian & Depository Banks, available at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf, at 42-43
(noting the trend with custodians and depositories outsourcing
operational departments to low cost labor regions in order to lower
costs and increase margins on core services that have experienced
the largest margin pressures).
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    Consequently, the proposed rule would require a written agreement
between a qualified custodian and the investment adviser that
incorporates certain minimum investor protection elements for advisory
clients. Additionally, for certain protections in which the qualified
custodian's duty runs primarily or exclusively to the advisory client,
it would require the adviser to obtain reasonable assurances of certain
minimum investor protection elements for advisory clients. We believe
that this approach would have direct benefits for advisory clients and
investment advisers. We acknowledge that an agreement between the
custodian and the adviser would be a substantial departure from current
industry practice. We also understand that certain of the protections
that the rule text would promote are not universally provided to all
custodial customers today. Nonetheless, we believe it is necessary to
help protect client assets from the harms the custody rule is designed
to address and would help ensure that they receive certain standard
custodial protections under the rule.
    The proposed requirements do not prescribe specific safeguarding
procedures or require that client assets be maintained in a particular
manner. Rather, they are designed to serve as guardrails that would
apply irrespective of the type of asset or the type of financial
institution acting as a qualified custodian. The requirements are also
designed to remain evergreen as methods for safekeeping continue to
evolve to reflect changes in technology, investment products, and
custodial service best practices. For example, technical requirements
for transacting and safeguarding crypto assets are likely to be
different from those for traditional assets, such as stocks, bonds, and
options. Furthermore, the design of blockchains and other distributed
ledgers that require irreversibility of crypto asset transactions
(without the consent of all parties to reverse), and the bearer nature
of private keys make it challenging to recover assets that have been
lost or stolen or to reverse benign trading errors even if an owner of
a crypto asset wallet may be identified. This is unlike the traditional
securities infrastructure, which has well-developed protocols allowing
for the reversal and cancellation of mistaken or unauthorized
transactions.
    These additional risks and nuanced challenges of safeguarding
emerging assets, such as crypto assets, have caused us to consider
alternatives to the current rule's more asset-neutral approach. In
2020, our staff issued a statement requesting input on, among other
things, the types of qualities an adviser seeks when entrusting a
client's assets to a particular custodian and whether there are
qualities that would

be important for safeguarding crypto assets that might not be important
for safeguarding other types of assets.\141\ Several commenters shared
with the staff their views, advocating for such things as specifically
tailoring the rule based on how changes in ownership of the asset are
effectuated, including setting particular standards for qualified
custodians of crypto assets.\142\ While we agree that custodial
activities may differ between traditional assets and crypto assets, we
believe that the asset neutral approach of the current rule has been
and will continue to be more effective because it relies on the
expertise of the various types of qualified custodians and allows the
rule to remain evergreen as the types of assets held by custodians
evolve.
---------------------------------------------------------------------------

    \141\ See Staff Statement on WY Division of Banking's ``NAL on
Custody of Digital Assets and Qualified Custodian Status'' (Nov. 9,
2020), available at https://www.sec.gov/news/public-statement/statement-im-finhub-wyoming-nal-custody-digital-assets (the Staff
Statement used the term ``digital'' assets rather than the term
``crypto'' assets as used in this release).
    \142\ See, e.g., Letter from Coinbase re Custody Rule and
Digital Assets (May 25, 2021) (stating that qualified custodians for
digital assets should, at a minimum have: institutional technical
expertise; personnel with technical expertise; minimum size;
authority to custody digital assets; robust staffing; audited
control environment; and annual certified audits); Letter from
Anchorage re Custody Rule and Digital Assets (Apr. 13, 2021)
(advocating for standard requirements for a qualified custodian that
maintains digital assets including proof of exclusive control, proof
of existence of digital assets in custody, hardware security, and
blockchain monitoring).
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    Although crypto assets are a relatively recent and emerging type of
asset, this is not the first time custodians have had to adapt their
practices to safeguard different types of assets.\143\ The proposed
rule relies on the expertise of custodians with a long history of
developing different procedures for safeguarding a variety of assets.
It is also not the first time custodians have grappled with a new
method of transacting in or holding assets.\144\ These custodians also
have a long history of innovating and modernizing their practices as
methods of transacting in or holding client assets have evolved.
Rather, the proposed rule recognizes that there are certain fundamental
protections that should be provided to a custodial customer when the
adviser has custody:
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    \143\ For example, bank custodians have traditionally provided
safekeeping to a variety of physical objects, such as valuable
papers, rare coins, and jewelry. See, OCC, Comptroller's Handbook on
Asset Management Operations and Control (Jan. 2011), available at
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html, at 15. See also Thevenoz, Luc, Intermediated
Securities, Legal Risk, and the International Harmonization of
Commercial Law, 13 Stan. J.L. Bus. & Fin. 384, 386 (Spring 2008)
(``Intermediated Securities'') (``Immobilization and
dematerialization of securities have made the physical delivery of
certificates nearly irrelevant. In just a few decades, the issuance
of securities has shifted from the physical to a virtual world, to
which financial intermediaries hold the key.'').
    \144\ See, James Rogers, Policy Perspectives on Revised UCC
Article 8, 43 UCLA L. Rev. 1431 (1996) (discussing the role large
broker-dealers or banks acting as dealers or custodians played
during the evolution from a manual securities settlement process
focused on the processing of physical securities certificates to
highly automated electronic settlement centered on processing and
transfer of electronic book-entry securities); Adam Back, Lien on
Me, Uniformity Is Coming to Crypto-Backed Transactions, 41-12 Am.
Bankr. Inst. J. 16 (Dec. 1, 2022) (discussing proposed UCC Article
12 governing property rights in a ``controllable electronic
record'').
---------------------------------------------------------------------------

     A qualified custodian should exercise due care and
implement appropriate measures to safeguard the advisory client's
assets;
     A qualified custodian should indemnify an advisory client
when its negligence, recklessness, or willful misconduct results in
that client's loss;
     A qualified custodian should not be relieved of its
responsibilities to an advisory client as a result of sub-custodial
arrangements;
     A qualified custodian should clearly identify an advisory
client's assets and segregate an advisory client's assets from its
proprietary assets;
     The client's assets should remain free of liens in favor
of a qualified custodian unless authorized in writing by the client;
     A qualified custodian should keep certain records relating
to those assets;
     A qualified custodian should cooperate with an independent
public accountant's efforts to assess its safeguarding efforts;
     Advisory clients should receive periodic custodial account
statements directly from the qualified custodian;
     A qualified custodian's internal controls relating to its
custodial practices should be evaluated periodically for effectiveness;
and
     A custodial agreement should reflect an investment
adviser's agreed-upon level of authority to effect transactions in the
advisory client's account.
    We believe that financial institutions that act as qualified
custodians under the current rule already provide some of the
protections that would be required under the proposed rule's
requirements, either to satisfy regulatory requirements, or pursuant to
their existing contracts with their clients. For example, we understand
that some qualified custodians usually provide quarterly account
statements to their custodial customers. We also understand that
qualified custodians often obtain periodic reports of their internal
controls. Further, we understand that qualified custodians may
currently indemnify their custodial customers against the risk of loss,
but we understand that the indemnification standard--for example,
ordinary negligence or gross negligence--often varies by institution
and by customer. To the extent an element is not typical for a
particular custodian, it may create practical difficulties (e.g.,
higher costs of compliance, or market contraction for custodial
services). On balance, however, we believe the proposed rule promotes
key protections to which every custodial customer should be entitled
when the adviser has custody.
    Some of these protections are best promoted via written agreement
between the adviser and custodian; others are best promoted via the
adviser obtaining reasonable assurances in writing from the qualified
custodian that the protections will be provided to the advisory client.
We view the safekeeping protections that would be required in the
proposed written agreement to be duties owed to both the client and
adviser, while we view the safekeeping protections in the proposed
reasonable assurances requirements to be duties owed primarily to the
client and, therefore, are proposing these protections in a manner that
we believe appropriately reflects the respective obligations. We are
also proposing to require that the adviser reasonably believe that the
contractual provisions and reasonable assurances obtained by the
adviser have been implemented by the qualified custodian.\145\ We
understand that many of the obligations under the contractual
provisions and reasonable assurances obtained by the adviser rest on
the qualified custodian, and that implementation for each requirement
may vary widely depending on the facts and circumstances of the parties
in interest and assets in interest. Nonetheless, advisers should enter
into a written agreement with a qualified custodian based upon a
reasonable belief that the qualified custodian is capable of, and
intends to, comply with the contractual provisions. The adviser should
have the same reasonable belief regarding the reasonable assurances
obtained from the qualified custodian. Further, during the term of the
written agreement and related advisory relationship, advisers 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. For example, if the
qualified custodian fails to properly provide the adviser with the
required quarterly account statement or the required annual internal
control report discussed below, the adviser could not reasonably
believe that the qualified custodian is complying with the contractual
obligations of the written agreement.
---------------------------------------------------------------------------

    \145\ See proposed rule 223-1(a)(1)(i), (ii).
---------------------------------------------------------------------------

    Finally, as under the custody rule, the safeguarding rule would
continue to permit an adviser or its related person to serve as a
qualified custodian for client assets. We continue to believe that
self-custody and related person safeguarding arrangements provide
practical benefits for advisory clients; however, we remain wary of the
potential risks of such arrangements that do not have an independent
party involved in safeguarding client assets.\146\ Accordingly,
heightened protections similar to those required under the custody rule
would continue to be required in such an arrangement.\147\ Moreover,
the following elements would all be required to be part of a written
agreement with the client.\148\
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    \146\ See 2009 Adopting Release, supra footnote 11, at section
II.C.1 (discussing the benefits and associated risks of maintaining
client investments with advisers or their related persons and
suggesting that the use of an independent custodian would be an
impractical requirement for many types of advisory accounts).
    \147\ The proposed rule would require a qualified custodian that
is a related person to the adviser to enter into a written agreement
with the adviser.
    \148\ A rulemaking petition submitted to the Commission
requested that we adopt a rule prohibiting related person custody.
We have considered the petition and share certain of the petition's
concerns regarding custody arrangements not involving independent
parties. However, we believe that the protections proposed in the
rule appropriately limit those risks. Kaswell, Stuart J Re: Petition
for Rulemaking; Custody Rule 206(4)(2), Oct. 30, 2020 [File No. 4-
767, Nov. 9, 2020], available at https://www.sec.gov/rules/petitions/2020/petn4-767.pdf (``[I]t is my view that the SEC should
take the next step and require the adviser to use a custodian that
is unaffiliated in any way with the adviser.''); and see Kaswell,
Stuart J. Supplement to Petition for Rulemaking; Custody Rule
206(4)(2); File No. 4-767 (Apr. 19, 2021), available at https://www.sec.gov/comments/4-767/4767-8685524-235622.pdf (``As indicated
in my rule petition, I respectfully suggest that the Commission
should amend the Custody Rule to require that each investment
adviser use a custodian that is independent of that adviser.'').
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a. Reasonable Assurances
    We believe that requiring an adviser to obtain the reasonable
assurances in writing \149\ that the custodian will comply with the
client protections required in the proposed rule and discussed below
would improve safekeeping of client assets. Similarly, we believe that
requiring the adviser to maintain an ongoing reasonable belief that the
custodian is complying with such client protection requirements will
improve safekeeping of client assets.\150\ It is our understanding that
many current custodial agreements address these issues and, therefore,
custodians are already familiar with these concepts. For example, we
understand that many custodial agreements address the attachment of a
lien on, or security interest in, client assets, in some cases for the
protection of the qualified custodian for nonpayment of fees by a
custodial client. Similarly, many custodial agreements address
indemnification between the advisory client and the custodian, but we
understand that the indemnification standard--for example, ordinary
negligence or gross negligence--often varies by institution and by
customer. The proposed reasonable assurances requirements--and the
requirement for the adviser to maintain the ongoing reasonable belief
that the reasonable assurances provided by the qualified custodian are
being implemented--in the rule are important protections for client
assets that, together with the client protections contained in the
written agreement, are designed to expand and formalize the standard of
protections to advisory clients' assets held by qualified custodians in
a manner that would provide consistent investor protections across all
qualified custodians under our proposed rule.
---------------------------------------------------------------------------

    \149\ Exchange Act section 13(b)(7) defines ``reasonable
assurance'' and ``reasonable detail'' as ``such level of detail and
degree of assurance as would satisfy prudent officials in the
conduct of their own affairs.'' 15 U.S.C. 78m(b)(7). See Commission
Guidance Regarding Management's Report on Internal Control Over
Financial Reporting Under section 13(a) or 15(d) of the Securities
Exchange Act of 1934 (Jun. 27, 2007) [72 FR 35323] (discussing
meaning of ``reasonable assurance'').
    \150\ See proposed rule 223-1(a)(1)(ii).
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i. Due Care
    The proposed rule would require that the adviser obtain reasonable
assurances in writing 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.\151\ The
requirement that the adviser obtain reasonable assurances that a
qualified custodian will exercise due care in accordance with
reasonable commercial standards is similar to the standard required of
certain custodians under Investment Company Act rules.\152\ The
Commission has had experience with the standard of care under rule 17f-
4 under the Investment Company Act and believes that advisory clients
should receive protections similar to those afforded under that rule.
In addition, we believe that this investor protection element would
provide an important standard for evaluating the qualified custodian's
custodial practices.
---------------------------------------------------------------------------

    \151\ Proposed rule 223-1(a)(1)(ii)(A).
    \152\ See, e.g., rule 17f-4 of the Investment Company Act.
---------------------------------------------------------------------------

    We also believe that it is crucial for a qualified custodian to
implement appropriate measures to safeguard assets from theft, misuse,
misappropriation, or other similar types of loss based on the asset
type and manner in which ownership is evidenced.\153\ We recognize that
the appropriateness of the measures required to safeguard assets varies
depending on the asset.\154\ For instance, the exercise of due care may
require that a bearer instrument, such as a physical coupon bond, a
physical security certificate, or a commodity such as gold, be kept in
a vault. Likewise, an investment that is evidenced in electronic book-
entry form, such as an exchange-traded note, could be maintained in
line with robust cybersecurity standards. And the exercise of due care
may require, in many cases, that crypto assets be stored in a cold
wallet, but depending on the facts and circumstances, such as when a
client seeks to buy and sell crypto assets very frequently, due care
may mean the use of hot wallets in combination with robust policies and
procedures.\155\ Other facts and

circumstances may require a hybrid of the two.\156\ Further, because
crypto assets and distributed ledger technology are still evolving, we
expect the methods used to safeguard crypto assets will likewise
evolve, which may lead to reevaluation of best practices in the future.
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    \153\ See, e.g., Customer Protection Rules 17 CFR 240.15c3-3
(requiring appropriate measures to protect and preserve customer
property held at broker-dealers).
    \154\ We also recognize that while the understanding of
appropriate safeguarding measures is generally expected to be within
the expertise of the qualified custodian, advisers also generally
should seek to become sufficiently familiar with safeguarding
practices to identify concerns or red flags in order to, among other
things, form an opinion as to whether the assurance that they
receive from the qualified custodian that the qualified custodian is
acting with due care is reasonable. More broadly, identifying
concerns and red flags is an important factor in the adviser forming
a reasonable belief that the protections in the proposed written
agreement have been implemented.
    \155\ See, e.g., R. Travis Leppky and Guy Sadeh, Matthew Bender
and Co., Blockchain and Smart Contract Law: U.S. and International
Perspectives; Ch. 7, Sec. 7 (Security and Custody: Security Issues
for Cryptographic Asset Wallets) (2022) (``[T]he difference between
a hot and cold wallet is whether or not they are connected to the
internet. Generally speaking, hot wallets are less secure because of
threats that come with being connected to the internet and
additional indirect threats if the cryptocurrency wallets are held
by an external provider (i.e., hacks, phishing, external provider
stability issues, etc.). Hot wallets are generally better for day-
to-day transactions and trading, since near instant access is
provided. Cold wallets, meanwhile, are stored offline, which
provides additional security. They are generally better for holding
crypto assets for the long term.''); Deborah A. Sabalot & Madeleine
Yates, Cryptoassets and custody: an elephant in the room?, 9 Journal
of International Banking and Financial Law 580 (Sept. 24, 2019)
(``Hot storage means devices connected with the internet and
generally means that the asset can be transferred quickly but will
also be at greater risk of loss through hacking. Cold storage
devices are physically offline and disconnected from the internet
but are generally considered less accessible although are arguably
more secure in that they cannot be attacked in the way that online
systems can. Other arrangements include hybrid systems which allow
the temporary storage of cryptoassets in a hot facility before being
moved to cold storage.''); see generally Cryptopedia Staff, Hot
Wallets vs. Cold Wallets, GEMINI (July 4, 2021), available at
https://www.gemini.com/cryptopedia/crypto-wallets-hot-cold (``A hot
wallet is connected to the internet and could be vulnerable to
online attacks--which could lead to stolen funds--but it's faster
and makes it easier to trade or spend crypto. A cold wallet is
typically not connected to the internet, so while it may be more
secure, it's less convenient.'').
    \156\ See id.
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    The proposed standard of care is not uncommon in the custodial
market and we believe that financial institutions acting as qualified
custodians are familiar with it.\157\ We believe, however, that the
standard of care is not universal in the custodial market, and that
this requirement may result in some qualified custodians changing the
terms of their custodial agreements with advisory clients to
incorporate this standard. We believe that this provision would promote
this important protection in a consistent manner across all advisory
client assets \158\ and would discourage the qualified custodian from
establishing contractual performance standards that are less
stringent.\159\
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    \157\ The proposed contractual requirement is the same as the
standard that automatically applies to custodians under Article 8 of
the Uniform Commercial Code. See UCC sections 8-504(c)(2) and 8-509
(a) and (b).
    \158\ The requirement of due care, of course, may impose on a
qualified custodian a number of practices not expressly addressed in
this release.
    \159\ See, e.g., UCC section 8-504(c)(2) (allowing alteration of
the standard of care by agreement).
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ii. Indemnification
    The proposed rule would require that the adviser obtain reasonable
assurances in writing 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.\160\ The goal of this
proposed requirement would be for the client to be compensated in the
event of a loss for which the qualified custodian is responsible.
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    \160\ Proposed rule 223-1(a)(1)(ii)(B).
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    Our staff has observed that custodians often include
indemnification clauses in their custodial agreements with customers.
Generally, the provisions indemnify custodial customers from losses
arising out of or in connection with the custodian's execution or
performance under the agreement to the extent the loss is caused by,
among other things, the custodian's negligence, gross negligence, bad-
faith, recklessness, or willful misconduct. Our staff has observed that
the contractual limitations on custodial liability vary widely in the
marketplace. Our staff has also observed that the negotiating power of
the investor appears to play an outsized role in the type of misconduct
for which a custodian will provide indemnity and that retail investors
appear to have limited ability to negotiate these terms effectively.
    Custodial misconduct is one of the primary risks that can undercut
or eliminate the protections of a custody account.\161\ The proposed
rule seeks to create a minimum floor of custodial protection for
investors--including those investors that have little or no power to
negotiate for those protections--in the event of custodial misconduct.
We question the extent to which investors, and particularly retail
investors, understand that they may have limited recourse against the
financial institution that was hired to safeguard their assets in the
event they suffer a loss because of that institution's misconduct.\162\
As such, we believe that it is reasonable to require an adviser to
obtain reasonable assurances from a qualified custodian that it will
provide the required indemnification for advisory clients.
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    \161\ Klees Article, supra footnote 24, at 106.
    \162\ See, e.g., Klees Article, supra footnote 24, at 103
(``clients bear several significant legal and operational risks that
could limit recovery of their custodied assets'').
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    The current practice in the custodial marketplace reflects a broad
range of contractual limitations on the qualified custodian's liability
to its customers to reduce exposure and may result in sub-optimal
safeguarding protections for client assets. While we understand that
custodians, as a gesture of goodwill or to avoid headline exposure, may
cover losses caused by their own misconduct even if the customer is
ineligible for indemnification under the custodial agreement, such
gestures are at the sole discretion and ability of the custodian and we
believe that this does not provide sufficient, consistent, reliable
investor protection.\163\ Custodians may not always be willing to
extend such goodwill, such as in the event of an extremely large loss
caused by, for example, custodial negligence under a custodial contract
providing for indemnification of the custodial client only in the event
that the custodian's misconduct constitutes gross negligence, during a
general downturn in the economy, or at a time that the custodian is
otherwise not sufficiently capitalized to easily absorb the loss.
Requiring an 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, as
proposed, will help protect clients from custodial misconduct and
reduce the need to rely on the goodwill of a custodian to make a client
whole in the event of the custodian's misconduct.
---------------------------------------------------------------------------

    \163\ We also do not know whether the willingness of custodians
to cover losses for which they may not be contractually liable
depends on whether the advisory client is retail or institutional.
---------------------------------------------------------------------------

    In our view, the proposed indemnification requirement would likely
operate as a substantial expansion in the protections provided by
qualified custodians to advisory clients, in particular because it
would result in some custodians holding advisory client assets subject
to a simple negligence standard rather than a gross negligence
standard. We believe that this requirement is justified because of the
important investor protection benefits it will provide.
iii. Sub-Custodian or Other Similar Arrangements
    The proposed rule would require that the adviser obtain reasonable
assurances in writing 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 any of
the qualified custodian's obligations to the client.\164\ This
requirement is designed to help ensure that the qualified custodian
would remain responsible in circumstances where a loss or other failure
to satisfy its obligations to the client, whether contractual or
otherwise,

can be attributed to a sub-custodian or other third party selected by
the qualified custodian.
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    \164\ Proposed rule 223-1(a)(1)(ii)(C).
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    As discussed above, outsourcing has become increasingly common in
the custodial space, whether outsourcing of back-office functions or
the core function of holding a custodial client's assets.\165\
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.\166\ Further, our
staff has observed that custodial agreements addressing the use of sub-
custodians seek to limit contractually 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. We view the increase in use of sub-custodians to similarly
increase the risk to client assets because, among other things, an
adviser and a client are not likely to have a direct contractual
relationship with the sub-custodian and are not likely to be able to
have decision-making authority with respect to which sub-custodian a
qualified custodian uses. The client and adviser, therefore, are more
likely to experience challenges in recovering losses caused by the sub-
custodian in the event of a loss of client assets. We similarly believe
that this is true for a securities depository or other third-party
arrangement implemented by the custodian with respect to client assets
over which the advisory client has no control.
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    \165\ See, e.g., Deloitte Outsourcing Article, supra footnote
140; U.S. Bank, 5 questions you should ask your custodian about
outsourcing (May 19, 2022), available at https://www.usbank.com/financialiq/plan-your-growth/find-partners/outsourcing-questions-ask-custodian.html (``It's fairly common for custody banks to
outsource day-to-day securities processing work to external
vendors--both domestically and overseas.''); Avantage Reply,
Outsourcing in the Asset Servicing Industry: Custodian and
Depositary Banks, Evolving regulatory requirements and industry
practices in the Eurozone and the UK (Nov. 2015), available at
https://www.reply.com/en/topics/risk-regulation-and-reporting/Shared%20Documents/Outsourcing%20Working%20Paper.pdf (``Custodian
banks have traditionally outsourced high-volume operational tasks.
While these still form the bulk of outsourcing, activities that
contribute to the running of banks themselves are now also being
routinely outsourced, including significant chunks of Customer
Services, Human Resources, Risk and Finance.''); Geis, George S.,
Traceable Shares and Corporate Law, 113 Nw. U.L. Rev. 227 (2018), at
233-234 (discussing the largest custodial banks performing
recordkeeping and information dissemination functions for smaller
custodian banks).
    \166\ See Thomas Droll, Natalia Podlich, and, Michael Wedow
(2015) Out of Sight, Out of Mind? On the Risk of Sub-Custodian
Structures. Bundesbank Discussion Paper No. 31/2015, available at
SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2797055.
---------------------------------------------------------------------------

    We believe that requiring the proposed reasonable assurances
requirement would help reduce 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.
We believe these requirements are justified because a qualified
custodian should not be able to disclaim liability for a third-party it
hires.
iv. Segregation of Client Assets
    The proposed rule would require the adviser to obtain reasonable
assurances in writing 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 and liabilities.\167\ We are proposing
this requirement because we continue to believe that segregation is a
fundamental element of safeguarding client assets.\168\ We believe that
some financial institutions that serve as qualified custodians,
particularly FFIs, are not required to segregate and identify their
client assets.\169\ In addition, for those qualified custodians that
are required to segregate and identify their client assets, the extent
of those activities varies.\170\ The proposed requirement is designed
to help 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 or if the financial
institution's creditors assert a lien against the qualified custodian's
proprietary assets (or liabilities).\171\ We believe this proposed
requirement would help protect client assets from claims by a third
party looking to secure or satisfy an obligation of the qualified
custodian, including in cases of insolvency or bankruptcy.\172\ We
believe that the proposed requirement would help to identify clearly
client assets as belonging to the appropriate client and, in the
context of an FFI, we believe these actions would help to preserve the
client's interests in the event of a government taking.
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    \167\ Proposed rule 223-1(a)(1)(ii)(D). In contrast to the
requirements we are proposing to include in the written agreement,
and as with the other reasonable assurances requirements, we believe
this safekeeping obligation runs primarily to the client.
    \168\ Segregation of client investments has been a fundamental
element of the custody rule since its inception. See, e.g., 1962
Adopting Release, supra footnote 2 (requiring advisers to segregate
and identify securities beneficially owned by each client, and to
hold them in a ``reasonably safe'' place). See also, Klees Article,
supra footnote 24 (describing segregation as a pillar of custody
that has generally been recognized in the United States).
    \169\ The custody rule requires a foreign financial institution
to segregate client assets in order to meet the definition of
qualified custodian. As discussed above and below, we propose to
replace and strengthen the segregation requirement for FFIs in the
custody rule that would complement the proposed segregation
requirements of the safeguarding rule.
    \170\ 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).
    \171\ The proposed segregation requirements are drawn from rule
15c3-3 of the Exchange Act, which requires broker-dealers to
safeguard their customer assets and keep customer assets separate
from the firm's assets, to prevent investor loss or harm in the
event of the broker-dealer's failure. See Financial Responsibility
Rules of Broker-Dealers, Exchange Act Release No. 70072 (Jul. 30,
2013) [78 FR 51824 (Aug. 21, 2013)] (``Financial Responsibility
Adopting Release''). In addition, other regulatory regimes have
adopted similar requirements. See, e.g., rule 1.20 [17 CFR 1.20]
under the Commodity Exchange Act, which requires a futures
commission merchant to segregate customer assets from its own
assets.
    \172\ See, e.g., Report of the Trustee's Investigation and
Recommendations, In re MF Global Inc., No. 11-2790 (MG) SIPA (Bankr.
S.D.N.Y. June 4, 2012) (noting that about $1.6 billion in customer
funds were found to be missing after the financial institution's
bankruptcy). Crypto asset trading platforms have also experienced
failures resulting in bankruptcy, raising questions as to whether
investors' funds will be returned. See, e.g., In re Celsius Network
LLC, 2023 Bankr. LEXIS 2, at *60 (Bankr. S.D.N.Y., Jan 4, 2023)
(holding that customer crypto assets in ``Earn Accounts'' were
property of the bankruptcy estate).
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    We also understand that for administrative convenience and other
reasons qualified custodians often hold client assets in omnibus
accounts containing assets of more than one client or similar
commingled-style accounts. We understand that practice may be even more
common when a qualified custodian uses a sub-custodian to hold client
assets. We do not intend the segregation requirement to preclude
traditional operational practices in which client assets are held in
omnibus accounts or otherwise commingled with assets of other clients
because we recognize that custodians regularly maintain assets in a
manner that allows such assets to be identified as held for a
particular client, distinct from assets of other clients, and not
subject to

increased risk of loss arising from a custodian's insolvency.
    We understand that the current rule's account requirements in
206(4)-2(a)(1) pose certain compliance challenges when client assets
are commingled, including in the context of sweep accounts, escrow
accounts, and loan servicing accounts. We believe the proposed
segregation requirements \173\ along with the proposed written
agreement and other reasonable assurances requirements more directly
and comprehensively achieve our policy goal than the custody rule's
account requirements in rule 206(4)-2(a)(1). In light of the proposed
segregation requirements, the safeguarding rule would not include the
custody rule's requirement to maintain client funds and securities with
a qualified custodian (1) in a separate account for each client under
the client's name; or (2) in accounts that contain only client funds
and securities under an adviser's name as agent or trustee for the
clients.\174\
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    \173\ The safeguarding rule would also require certain
additional segregation requirements related to, among other things,
segregating client assets from the adviser's assets, discussed in
more detail in section D, below. See proposed rule 223-1(a)(3).
    \174\ Custody rule 206(4)-2(a)(1).
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    We believe that proper identification of client assets, as required
by the segregation requirement of the proposed rule, would mitigate
concerns regarding the safety of a client's assets. Sub-accounting of
commingled accounts allows qualified custodians to identify readily an
owner's commingled assets at any point in time. Eliminating the custody
rule's requirement to maintain accounts that contain only clients'
funds and securities also should alleviate certain compliance
challenges when client and non-client assets are commingled for
administrative convenience and efficiency purposes, such as in the
context of sweep accounts, escrow accounts, and loan servicing
accounts.\175\ We understand that some custodial agreements between
advisory clients and qualified custodians contain a contractual
provision requiring segregation of client assets from the custodian's
proprietary assets and liabilities. We believe that the reasonable
assurances requirement in the proposed rule may result in qualified
custodians adding such a contractual provision to custodial agreements
that do not contain this language. However, we believe that some
custodial agreements already contain language addressing the
requirement. Moreover, because we understand that many qualified
custodians are required by their functional regulator to segregate
assets, we believe that an adviser obtaining reasonable assurances
regarding segregation as required under the proposed rule would not
result in a substantial change in the operational practices of many
custodians. More importantly, we believe that the proposed rule's
requirement that an adviser obtain reasonable assurances from the
qualified custodian regarding the segregation requirement provides
vital protections.
---------------------------------------------------------------------------

    \175\ See 2014 IM Guidance, supra footnote 17; Madison Capital
Funding, Inc., SEC Staff No-Action Letter (Dec. 20, 2018) (``Madison
Capital No-Action Letter'').
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v. No Liens Unless Authorized in Writing
    The proposed rule would require the adviser to obtain reasonable
assurances in writing 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.\176\ This requirement is designed
to protect client assets by discouraging qualified custodians from
using those assets in a manner not authorized by the client. This
provision would help ensure that client assets maintained with the
qualified custodian are protected and are free of any 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.
---------------------------------------------------------------------------

    \176\ See proposed rule 223-1(a)(1)(ii)(E).
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    Liens and the other claims addressed in the proposed rule can arise
in favor of a qualified custodian in a variety of circumstances. For
example, in a margin account, a type of brokerage account, a qualified
custodian may lend cash to a client to allow the client to purchase
securities. The qualified custodian's loan is typically collateralized
by the securities purchased by the client, other assets in a client
account, and cash, all of which are typically subject to a security
interest in favor of the qualified custodian.\177\ Similarly, qualified
custodians often have contractual or other rights to liens or similar
claims arising from unpaid client fees. The rule would not prohibit
arrangements like these. Rather, the rule 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 that would arise in connection with these
arrangements or others. While we recognize that these and similar
arrangements involve some level of risk to client assets, we recognize
that they can also be beneficial, and should be permitted when
authorized.
---------------------------------------------------------------------------

    \177\ See Uniform Commercial Code, section 8-504 and cmt. 2
(``Margin accounts are common examples of arrangements in which an
entitlement holder authorizes the securities intermediary to grant
security interests in the positions held for the entitlement
holder.'').
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    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.
Therefore, we believe requiring an adviser to obtain this reasonable
assurance from the qualified custodian would provide important client
protections.
b. Written Agreement
    As discussed above, the proposed rule would require an adviser to
enter into a written agreement with a qualified custodian containing
certain terms that we view as critical to safeguarding client
assets.\178\ The rule would require that the written agreement contain
the terms described in more detail below.
---------------------------------------------------------------------------

    \178\ Proposed rule 223-1(a)(1)(i).
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i. Provision of Records
    The proposed rule would require that the written agreement with the
qualified custodian include a provision requiring the qualified
custodian promptly, upon request, to provide records relating to client
assets to the Commission \179\ or an independent public accountant for
purposes of compliance with the rule.\180\ Custodial account records
provide information that is critical to an independent public
accountant's ability to perform its role under the current rule, and
would be similarly critical under the proposed rule. We understand,
however, 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 realize this is
likely because the qualified custodian has no contractual agreement
with the adviser or the accountant that has been hired by the adviser.
We believe the proposed contractual requirement would substantially
mitigate these complications.
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    \179\ All custodians, including foreign custodians, must provide
records of custody and use of the securities, deposits, and credits
related to an investment adviser's client to representatives of the
Commission upon request. Advisers Act section 204(d)(1). The
Commission believes that formalizing this requirement in the written
agreement between a qualified custodian and an investment adviser
will ensure qualified custodians are aware of the requirements of
the Advisers Act.
    \180\ Proposed rule 223-1(a)(1)(i)(A).
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    We understand that qualified custodians do not often provide third
parties access to custodial account records in light of privacy
concerns for their customers, unless there is contractual privity with
those third parties or their customers request they do so. 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.
ii. Account Statements
    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),\181\ 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, including advisory fees.\182\
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    \181\ See proposed rule 223-1(b)(4).
    \182\ Proposed rule 223-1(a)(1)(ii)(B). The proposed requirement
is similar to the approach in the current rule with regard to the
investment adviser forming a reasonable belief after due inquiry
that the qualified custodian sends account statements, at least
quarterly, to the client. See rule 206(4)-2(a)(3).
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    The custody rule requires an adviser to have a reasonable basis,
after due inquiry, for believing that the qualified custodian sends an
account statement, at least quarterly, to each of the adviser's clients
for which it maintains funds or securities, identifying the amount of
funds and of each security in the account at the end of the period and
setting forth all transactions in the account during that period.\183\
We continue to believe that qualified custodians' delivery of account
statements directly to advisory clients--without 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. In a change from the current custody rule, the
qualified custodian would also now be required to send account
statements, at least quarterly, to the investment adviser, which would
allow the adviser to more easily perform account reconciliations. We
also believe that, because of custody rule 206(4)-2(a)(3), the account
statement contract provision is consistent with longstanding custodial
practices and would easily be incorporated by qualified custodians into
the written agreement. The account statements could also be delivered
to the client's (or pooled investment vehicle investor's) independent
representative.
---------------------------------------------------------------------------

    \183\ Custody rule 206(4)-2(a)(3).
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    In circumstances where an investor is itself a pooled vehicle that
is controlling, controlled by, or under common control with the adviser
or its related persons (a ``control relationship''), the contract with
the qualified custodian must require the quarterly account statement to
be delivered by the qualified custodian to all of the investors in each
pooled investment vehicle client, which includes investors in the
underlying pools by looking through that pooled vehicle (and any pools
in a control relationship with the adviser or its related persons, such
as in a master-feeder fund structure).\184\ Advisers to pooled
investment vehicles may from time to time establish special purpose
vehicles (``SPVs'') or other pooled vehicles for a variety of reasons,
including facilitating investments by one or more private funds that
the advisers manage. If a qualified custodian did not look through each
pool in a control relationship with the adviser, the qualified
custodian would be essentially delivering the quarterly statement to
the adviser rather than to the parties the quarterly statement is
designed to inform. Outside of a control relationship, such as if a
private fund investor is an unaffiliated fund of funds, this same
concern is not present, and the qualified custodian would not need to
look through the structure to make meaningful delivery. The qualified
custodian would just distribute the quarterly statement to the
unaffiliated fund of funds' adviser or other designated party. We
believe that this approach would lead to meaningful delivery of the
quarterly statement to advisory clients. Also in a change from the
current custody rule, the proposed rule would require the written
agreement to contain a provision prohibiting the qualified custodian
from identifying assets on account statements for which the qualified
custodian lacks possession or control, unless requested by the client.
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.\185\ Advisers have, at times, requested a
qualified custodian to include particular holdings and transactions on
the custodial account statements for a variety of reasons, including in
an attempt to demonstrate compliance with the custody rule. For
example, 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.
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    \184\ See proposed rule 223-1(c).
    \185\ To the extent that a client requests that a qualified
custodian report in account statements holdings and transactions to
which the custodian is not attesting as a custodian and for which
the custodian is disclaiming liability, the proposed rule would not
disrupt this practice, though it would require them to be clearly
identified as such.
---------------------------------------------------------------------------

    We recognize that account statements provided by a qualified
custodian on a so-called ``accommodation basis'' may 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.\186\ We are concerned, however, that the
practice of a qualified custodian including investments that it is not
safeguarding on an account statement may be misleading and confusing to
clients. To evaluate the holdings and transactions reported on an
account statement, a client must have confidence in the statement's
integrity and accuracy. Accordingly, we would prohibit an adviser from
participating in a practice that we believe undermines that integrity
and utility.\187\
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    \186\ The rule proposes a process and protections for certain
assets unable to be maintained with a qualified custodian, thereby
making accommodation reporting unnecessary. See section II.C, infra.
    \187\ Other regulatory regimes have raised concerns about this
practice including the potential for communicating inaccurate,
confusing or misleading information to customers, lapses in
supervisory controls, and the use of these reports for fraudulent or
unethical purposes. See, e.g., FINRA's Regulatory Notice 10-19
(reminding broker-dealer firms of their responsibilities to ensure
that they comply with all applicable rules when engaging in
providing customers with consolidated financial account reporting).

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iii. 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).\188\ Consistent with an adviser's fiduciary
duty, an adviser should review the report for control exceptions and
take appropriate action where necessary.\189\
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    \188\ This requirement would apply as a control objective of the
internal control report rather than a requirement in the rule,
thereby expanding the requirement to all qualified custodians, not
just a qualified custodian that is the adviser or its related
person. See generally, Commission Guidance Regarding Independent
Public Accountant Engagements Performed Pursuant to Rule 206(4)-2
Under the Investment Advisers Act of 1940, Advisers Act Release No.
2969 (Dec. 30, 2009) [75 FR 1492 (Jan. 11, 2010)] (``Accounting
Guidance'').
    \189\ See supra footnote 57.
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    Although the custody rule requires an internal control report only
when the adviser or its related person acts as a qualified
custodian,\190\ we believe expanding this requirement to all qualified
custodians under the proposed rule would mitigate risks to client
assets regardless of the affiliation of the qualified custodian.\191\
We believe the proposed requirement would help protect client assets by
ensuring that the qualified custodian's controls with respect to its
safeguarding practices are routinely evaluated by a third party that is
independent of the custodian. We drew the proposed requirement from our
experience with the internal control report requirement under the
custody rule, understanding of requirements currently applicable to
some types of qualified custodians, as well as best practices.\192\
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    \190\ Current rule 206(4)-2(a)(6).
    \191\ An introducing broker that is also an adviser or the
adviser's related person would not be considered as acting as a
qualified custodian under the proposed rule if all client
investments are maintained with a carrying broker (which is not a
related person of the adviser) and thus the introducing broker would
not be subject to the internal control report requirement.
    \192\ Rule 206(4)-2(a)(6)(ii). See 2009 Proposing Release, supra
footnote 11, at n.88 (noting that custodians often provide internal
control reports to clients who demand a rigorous evaluation of
internal controls as a condition of obtaining their business and
that obtaining such report is an ``industry best practice.''). See
also United States Government Accountability Office, Investment
Advisers; Requirements and Costs Associated with the Custody Rule
(July 2013), available at https://www.gao.gov/assets/gao-13-569.pdf
(stating that representatives from two industry associations
discussed that institutional investors commonly require custodians
to obtain internal control reports).
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    The objective of the examination supporting the internal control
report is to obtain reasonable assurance that the qualified custodian's
controls have been placed in operation as of a specific date, and are
suitably designed and operating effectively to meet control objectives
related to safeguarding of client assets during the period
specified.\193\ Based on our experience with the custody rule, we
believe that the benefits and protections that we initially believed
were warranted for a more limited group of qualified custodians should
be expanded to include all qualified custodians.\194\
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    \193\ See Accounting Guidance, supra footnote 188, at section
III.
    \194\ See rule 206(4)-2(a)(6)(ii).
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    We understand that not all qualified custodians obtain internal
control reports, although we believe many do. We also understand that
for those qualified custodians that currently obtain internal control
reports, the scope of those reports may not cover the financial
institutions' safeguarding activities that this proposed requirement is
designed to cover. Nonetheless, we believe this requirement is
justified because the proposed internal control report requirement
would provide meaningful investor protection benefits by, among other
things, providing advisers with information regarding the control
practices of the qualified custodian that would enable advisers to
assist advisory clients in making more informed decisions concerning
holding assets with particular qualified custodians.
    We are not requiring the provision of a specific type of internal
control report as long as the required objectives are addressed.\195\
This flexibility would permit qualified custodians to leverage existing
audit work to satisfy regulatory requirements, or work currently
performed as part of internal control reports prepared to meet client
demand.
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    \195\ For example, we believe that 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,''
would be sufficient to satisfy the requirements of the internal
control report, provided that the report covers whether the controls
have been placed in operation as of a specific date, are suitably
designed, and are operating effectively in order to meet control
objectives as required by the rule. A report that simply provides a
report of procedures or controls a qualified custodian has put in
place as of a point in time, commonly referred to as a ``SOC 1 Type
1 Report,'' would not satisfy the requirements of the internal
control report because it does not test operation effectiveness of
the controls. In addition, a report issued in connection with an
examination of internal control conducted in accordance with AT-C
section 315: Compliance Attestation (``AT-C section 315'') or AT-C
section 320: Reporting on an Examination of Controls at a Service
Organization Relevant to User Entities' Internal Control over
Financial Reporting (``AT-C section 320'') under the standards of
the American Institute of Certified Public Accountants would also be
sufficient provided that the report covers whether the controls have
been placed in operation as of a specific date, are suitably
designed, and are operating effectively in order to meet control
objectives as required by the rule. See 2009 Adopting Release, supra
footnote 11, at section II.C.1. Similarly, a report based on an
examination in accordance with PCAOB AT-1 of a broker-dealer's
compliance report prepared pursuant to rule 17a-5 of the Exchange
Act would be sufficient to satisfy the internal control requirement.
See 17 CFR 240.17a-5; Broker-Dealer Reports, Exchange Act Release
No. 34-70073 (July 30, 2013) [78 FR 51910 (Aug. 21, 2013)].
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    The proposed rule would define ``independent public accountant'' to
mean a public accountant that meets the standards of independence
described in rule 2-01 of Regulation S-X (17 CFR 210.2-01).\196\ The
Commission has long recognized that an audit by an objective,
impartial, and skilled professional contributes to both investor
protection and investor confidence.\197\ We understand that qualified
custodians currently obtaining internal control reports voluntarily or
pursuant to requirements of the qualified custodian's functional
regulator may need to engage a new accountant if the qualified
custodian's current accountant is not independent as defined by the
proposed rule.\198\ We believe that adherence to the bedrock principle
that auditors must be independent in fact and in appearance \199\
contributes to investor protection and investor confidence in
connection with the relationship between an auditor and the qualified
custodian. We therefore believe that this requirement is appropriate.
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    \196\ See proposed rule 223-1(d)(5). The definition in the
proposed rule would be amended to reference Rule 2-01 in its
entirety rather than the more limited reference in the current
custody rule (see rule 206(4)-2(d)(3), referencing 2-01(b) and (c)),
which amendment is designed to clarify that the entirety of the
auditor qualification and independence requirements in Rule 2-01
apply.
    \197\ See Revision of the Commission's Auditor Independence
Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec.
5, 2000)].
    \198\ See proposed rule 223-1(a)(1)(i)(C); 223-1(d)(5).
    \199\ See Qualifications of Accountants, Release No. 33-10876
(Oct. 16, 2020) [85 FR 80508 (Dec. 11, 2020) (discussing bedrock
principles).
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    In connection with our concerns noted above regarding circumstances
in which an adviser or related person is the qualified custodian, we
are proposing to retain the current rule's approach that if the
qualified custodian is a related person or the adviser, the independent
public accountant that prepares the internal control report

must verify that client assets are reconciled to a custodian other than
you or your related person. In addition, we would continue to require
that if the qualified custodian is a related person or the adviser, the
independent public accountant is registered with and subject to regular
inspection as of the commencement of the professional engagement
period, and as of each calendar year-end, by, the Public Company
Accounting Oversight Board (``PCAOB''), in accordance with the rules of
the PCAOB.\200\ We believe that qualified custodians routinely retain
accountants that satisfy this requirement because of this requirement
under the custody rule. In light of our experience with this
requirement of the current rule, we believe that registration and the
periodic PCAOB inspection of an independent public accountant's overall
quality control system will provide us greater confidence in the
quality of the internal control report in the context of an affiliated
adviser and custodian.
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    \200\ Proposed rule 223-1(a)(1)(i)(C)(1).
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iv. Adviser's Level of Authority
    The proposed rule would require that the 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.\201\ We are also proposing that
this contract provision permit the adviser and the client to reduce the
specified level of authority. Our understanding is that investment
advisers often are given authority over the custodial account in the
custodial agreement between the custodian and the client that is
broader than what the adviser and client agreed to in the advisory
agreement. 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. If, however, the client's agreement with its
qualified custodian grants the adviser broad authority over the
client's account, including to disburse or transfer assets, the adviser
would be able to effect a change in beneficial ownership of the
client's assets.\202\ In these circumstances, from the qualified
custodian's perspective, the client has authorized the adviser to
withdraw the client's assets and, while there may be constraints
contained in the advisory agreement between the adviser and a client,
the custodian may not be aware of these constraints or may be unwilling
or unable to treat the terms of the advisory agreement as
controlling.\203\ In this scenario, believing the adviser to have
authority over the client's assets, the custodian could accept the
adviser's instructions to direct the disposition of the client's
assets.\204\ We are concerned this puts clients at risk, such as in the
event a rogue advisory employee misuses the authority to direct the
disposition of a client's assets held by the custodian. We understand
that advisers have had little success in modifying or eliminating their
unwanted authority either because a custodian is reluctant to accept
the adviser's request to modify its agreement with its client, or the
client may lack the bargaining power to negotiate more limited terms on
the adviser's authority over the client's assets because the custodian
may refuse to modify its standard forms.\205\ This contractual
requirement of the proposed rule is designed to mitigate these concerns
and empower advisers to modify this aspect of the custodial agreement
to better reflect client intentions and to be consistent with the
adviser's contractual obligations to its clients.
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    \201\ Proposed rule 223-1(a)(1)(i)(D).
    \202\ See, e.g., Inadvertent Custody: Advisory Contract Versus
Custodial Contract Authority, Division of Investment Management
Guidance Update No. 2017-01 (Feb. 2017) (``2017 IM Guidance'') in
which our staff discussed its views on the application of the
current custody rule to various types of custodial agreements
between a client and a custodian that grant an adviser broader
access to client funds or securities than the adviser's own
agreement with the client contemplates.
    \203\ Our staff took a similar view. See id.
    \204\ While the advisory agreement between the adviser and its
client may constrain the adviser's authority, the custodian may not
be aware of such constraints. A separate bilateral restriction
between the adviser and the client is insufficient to prevent the
adviser from having custody where the custodial agreement enables
the adviser to withdraw or transfer client funds, securities or
similar investments upon instruction to the custodian. Our staff
took a similar view. See 2017 IM Guidance, supra footnote 202.
    \205\ See supra footnote 202 and accompanying text.
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    Our staff has observed that qualified custodians have been
reluctant to modify or customize the level of authority investment
advisers have with respect to customer accounts. It increases their
need to monitor customer accounts, and to accept liability, for
unauthorized transactions by an adviser and its personnel. We believe
that the risks of inadvertent custody, the related risk that a
custodian may follow an instruction with respect to client assets
presuming authority that the adviser does not have under its advisory
contract with the client, and our staff's observation of the reluctance
of qualified custodians to modify adviser authority, warrant the
proposed requirement. Ultimately, we believe this requirement would
better protect advisory clients than the current default broad
authority provisions in current contracts.
    We request comment on all aspects of the proposed reasonable
assurances and written agreement requirement, including the following:
    55. Is our understanding correct that custodians are familiar with
the concepts addressed by the reasonable assurances and written
agreement requirements?
    56. Should the rule include the due care reasonable assurances
requirement? Is this standard of care common practice in the custodial
marketplace and, if so, would custodians be willing to provide
information to an adviser sufficient to satisfy the proposed rule?
Instead of the proposed approach, should the rule require generally
that an adviser obtain reasonable assurances that a qualified custodian
meets certain minimum commercial standards and then specify some but
not all applicable standards? Would the proposed requirement provide
additional protections for clients when an adviser has custody of
client assets and further the policy goals of the rule?
    57. Should the rule include the reasonable assurances requirement
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? Would
this requirement provide additional protections for clients when an
adviser has custody of client assets and further the policy goals of
the rule? Alternatively, should we require reasonable assurances of a
different indemnification standard? If so, what standard and how would
that standard protect investors consistent with the policy goals of the
rule?
    58. Would the proposed indemnification standard be a substantial
departure from current industry practice? Would it be expensive for
qualified custodians and would those costs be passed on to custodial
clients? If so, are there less expensive ways of achieving the policy
goals of the rule? Would this requirement result in custodians ceasing
operations in the custody business? If so, what proportion of
custodians would commenters expect to stop providing custody services
as a result of this proposed rule? Should the safeguarding rule,
instead, require disclosure to clients that they could lose their
assets in the event of custodian misconduct?

We understand that retail clients were often afforded the fewest
protections. If we were to require disclosure, instead of
indemnification, would such retail clients be able to negotiate with
custodians for better protection?
    59. Do commenters agree with our understanding that custodians may
cover losses caused by their own misconduct even if the customer is
ineligible for indemnification under the custodial agreement to avoid
headline exposure or as a gesture of goodwill to their custodial
customers? Do insurers contribute compensation as part of these
payouts? If so, how frequently? Do advisers step in to compensate
customers in these circumstances? If so, how frequently?