The Securities and Exchange Commission (SEC) continually considers new rulings to meet evolving regulatory challenges. With that in mind, it’s not surprising that the governing body’s latest proposal was created to account for things like cryptocurrency and other alternative assets which are growing in popularity among investors.
Proposed Rule 223-1, also known as the Safeguarding Rule, was announced on Feb. 15, 2023, with the intention of updating the Investment Advisers Act’s Rule 206(4)-2 or “Custody Rule.” In short, Rule 223-1 is set to impose greater custody requirements regarding the types of assets a registered investment adviser (RIA) may oversee aside from funds and securities – cryptocurrency, precious metals, real estate, art collections, etc.
What’s included in SEC Rule 223-1?
The Custody Rule was last updated in 2009, which means there is currently little oversight regarding the custody of cryptocurrency or other types of digital and tangible assets. However, recent investment turmoil in the world of cryptocurrency has prompted the SEC to update its custody requirements.
The proposed Safeguarding Rule includes many compliance updates for RIAs and service providers, but here are a few of the most significant changes.
Asset types
Rule 223-1 would redefine the type of assets an adviser has custody of within a client’s account. Beyond funds and securities, this definition would expand to include cryptocurrency assets, financial contracts and physical assets.
The adviser would have discretionary authority to trade assets that fall into this expanded definition of assets in custody.
Qualified custodian
The SEC’s requirements regarding the definition of a qualified custodian would be changed with this proposed ruling. The adviser would need written confirmation that the custodian has possession or control of the adviser’s client assets. In other words, the custodian would not be permitted to report on assets they do not control.
In addition, the custodian would need to give reasonable assurances that they are providing advisers with certain protections when maintaining an advisor’s client assets. The adviser would also be required to receive copies of any statements sent by the qualified custodian to their clients.
Exceptions to the qualified custodian rule
An adviser may be able to bypass the qualified custodian requirement in the event the ownership of privately offered securities is unable to be recorded and maintained by a qualified custodian. The adviser is then required to reasonably safeguard the assets and notify the independent public accountant who is verifying that such is the case for the specific assets in question.
Surprise examination exceptions
Under normal circumstances, advisers are subject to a surprise examination by an independent public accountant specifically regarding custody use, recordkeeping and asset verification for assets not held at a qualified custodian. After which, the accountant/examiner files a report via ADV-E. An RIA may be exempt from this requirement if their sole reason for having custody of client assets is because:
- The adviser has discretionary authority.
- The adviser is acting in accordance with a standing letter of authorization.
- The adviser directly debits advisory fees.
Each of these exemption requirements does come with its own set of criteria and conditions, which advisers should review carefully. In addition, assets need to be held by a qualified custodian and are subject to delivery versus payment (DVP) transactions in order to qualify for the surprise examination exception.
Related: Download our checklist, “10 Tips for Conducting Your Firm’s Annual Review”
SLOA
Should this proposed rule pass, standing letters of authorization (SLOA) and written instruction need to be given to the financial adviser and qualified custodian by the client.
Separating client assets
Advisers will be required under Rule 223-1 to keep client assets segregated from their own proprietary assets. Advisers must title or register the client’s assets in their client’s name and ensure the assets are not mixed with the adviser’s or a related entity to the adviser’s assets. The assets can’t be subject to certain charges, liens or security interest that favors the adviser, unless it’s been agreed upon and put in writing by the client.
Changes to Form ADV Compliance
SEC Rule 223-1 would amend Form ADVs to require advisory firms to disclose some additional information and records.
Within the Form ADV, advisors will need to include information on:
- The basis for custody.
- Amount of client assets in custody.
- Number of clients in nine separate categories.
When do RIAs need to comply with the SEC’s Custody Rule?
At this point, the proposed rule is just that: a proposal.
If the proposed rule goes into effect, there will be a staggered compliance date for advisory firms. Large firms with more than $1 billion in regulatory assets under management (RAUM) will need to comply within 12 months. Smaller firms with less than $1 billion in RAUM will have an additional six months, or 18 months total, to comply.
Be the first to know when regulatory changes occur
Ensuring your RIA firm remains compliant with evolving regulations is an ongoing journey. RIA tech tools like MyRIACompliance® help firms stay on top of their compliance obligations while providing critical support to compliance teams, large and small.
By partnering with a compliance-focused platform, your team can best serve your clients while knowing you’re following the most up-to-date regulatory practices.