Custody Battle
On February 15, 2023, the U.S. Securities and Exchange Commission (SEC) proposed new amendments to the Custody Rule under the Advisers Act, which was last amended in 2009 following the Bernard Madoff and Allen Stanford frauds. The proposed rule, known as Rule 223-1 under the Advisers Act, aims to replace the current Custody Rule with a new Safeguarding Rule and make corresponding amendments to the recordkeeping rule and Form ADV. The new rule would expand the types of client assets covered under the rule to include any client assets of which an advisor has custody, which means that crypto assets that might not be considered funds or securities under the current rule, as well as other assets such as real estate, loans, and derivatives, will be explicitly covered (the SEC believes that most crypto assets are likely already covered under the Custody Rule as either funds or securities).
The proposed rule also explicitly states that discretionary trading authority would trigger the application of the rule. The rule would provide a limited exception to the surprise examination requirement for an advisor whose custody of client assets arises solely from discretionary authority. The exception applies so long as the client assets are maintained with a qualified custodian and the advisor’s trading under discretionary authority is limited to client assets that settle exclusively on a “delivery-versus-payment” (DVP) basis. However, the exception would not be available to collateralized loan obligations (CLOs) as syndicated bank loans typically trade on a non-DVP basis.
The new rule would require advisors to enter into written agreements with and obtain reasonable assurances from qualified custodians to ensure that clients receive standard custodial protections. It would also impose additional requirements on entities that serve as qualified custodians for purposes of the rule. Additionally, the proposed rule would expand the current Custody Rule’s audit provision as a means of satisfying the surprise examination requirement. The rule would also modify the current rule’s privately offered securities exception from the obligation to maintain assets with a qualified custodian by refining the definition of “privately offered securities,” expanding the exception to include certain physical assets, and requiring advisors to take additional steps to safeguard these assets.
In a related development, the SEC has also proposed a rule that would make it harder for hedge funds, private equity firms, and pension funds to work with crypto firms. The proposed rule would make it harder for crypto firms to become “qualified custodians” or companies that hold client assets for money managers, (appropriate custodians under the SEC’s regulations would generally mean a chartered bank or trust company, a broker-dealer registered with the SEC, or a futures commission merchant registered with the Commodity Futures Trading Commission (CFTC)).
Crypto trading and lending platforms routinely offer custody for crypto customers, but they are not “qualified custodians,” creating issues for RIAs whose clients would like to diversify into digital assets, but who cannot rely on crypto platforms as qualified custodians per SEC rules.
The current SEC proposal demands that investment advisors trust only regulated financial institutions, which would leave most crypto businesses on the outside looking in (with rare exception). The proposed rule also notes that, in the case that crypto businesses do complete the process to become qualified custodians (assuming that their applications would be given a fair chance and impartial review), they would be subject to independent audits, regular disclosures, and would need to segregate customer assets into accounts under the customers’ identity (as is the case with all traditional qualified custodians).
Of course, the proposed rule has sparked concerns in the crypto industry.
The proposed raises questions about the role of companies like Anchorage Digital, a crypto-oriented trust regulated by the Office of the Comptroller of the Currency (OCC), or state-chartered institutions such as those in Wyoming. SEC officials have said that as long as a company can meet necessary requirements, they can seek to act as a qualified custodian, but it remains to be seen how the proposed rule, if adopted, would affect existing custodians.
Clearly, the proposed rule is part of the SEC's effort to increase its oversight of the crypto sector, and it follows recent actions against Paxos (which may be the subject of another post).
So, what is the takeaway? As a cynic, one might say that the Staff is doing everything in its power to harm the crypto sector by shrinking the number of crypto custodians. Alternatively, this may be a necessary step towards protecting investors from the risks associated with the custody of digital assets.
One way or the other, comment letters on the proposed rule are due 60 days following publication in the Federal Register. So, stay tuned.
What kind of lawyer would I be without a disclaimer?
Everything I post here constitutes my own thoughts, should only be used for informational purposes, and does not constitute legal advice or establish a client-attorney relationship (though I am happy to discuss if there is something I can help you with). I can be reached via email (dlopezkurtz@crokefairchild.com or david@bsl.group), telegram (@davidlopezkurtz), twitter (@lopezkurtz), and on LinkedIn here.
