IAA Files Comments on SEC’s Safeguarding Client Assets Proposal
May 9, 2023
On May 8, the IAA submitted a comment letter urging the SEC to make substantial changes to its proposed new rule relating to the safeguarding of advisory client assets. We strongly support the SEC’s efforts to protect client assets from misuse, misappropriation, or losses resulting from an adviser’s insolvency or bankruptcy. However, we have serious concerns with several of the central features of the proposed rule that we believe will be ineffective in achieving – and are likely to undermine – the SEC’s goal, prove impractical, if not infeasible in many respects, and impose significant costs on investment advisers that far exceed any perceived benefits.
The proposal goes well beyond its core purpose of protecting client assets from misappropriation by, or losses of, the adviser. In particular, we are deeply concerned by the proposed expansion of the concept of custody to include all discretionary authority, the potentially boundless scope of assets and markets that would be covered, unrealistic requirements to enter into written agreements with custodians, and the attempt to use the Investment Advisers Act to indirectly regulate qualified custodians, which are already subject to their own regulatory regimes, and most of which the SEC has no authority to regulate directly.
The proposed rule is also the latest in a series of rulemaking proposals that are unprecedented in their scope and speed, and we are concerned that the SEC has not considered their cumulative effect on investment advisers, especially smaller investment advisers, despite repeated urging from the IAA.
We have long called on the SEC to make the current Custody Rule framework more workable and effective and, while we disagree with its proposed approach, we are committed to working constructively with the SEC to achieve our shared goal of enhanced investor protection.
The IAA makes the following points in our letter:
The SEC incorrectly presumes the acquiescence of, and underestimates the challenges for, qualified custodians to the proposed requirements that advisers enter into agreements with and obtain certain assurances from these custodians. The proposal would require advisers to enter into potentially multiple separate contracts with each and every custodian their clients use. These requirements are unrealistic for both advisers and custodians. Not only do advisers – especially smaller advisers – lack the leverage to negotiate contracts with specific terms with custodians, but custodians are unlikely to agree to take on expanded liability and enormous increased costs. We believe that focusing the adviser’s role in safeguarding client assets on an internal controls approach, i.e., the implementation of reasonably designed principles- and risk-based policies, procedures, and internal controls, would more effectively achieve the SEC’s goal of protecting advisory client assets.
The SEC is attempting to indirectly regulate through investment advisers a group of service providers over which the Commission does not have regulatory jurisdiction. The proposal would compel the investment adviser to police commercial terms between custodians and their customers on matters unrelated to the investment advice provided by the adviser to its clients, including custodians not regulated by the SEC. We believe that this type of “backdoor” regulation is inappropriate, turns on its head the regulatory purpose of the Custody Rule, and imposes regulatory burdens unfairly, as we have noted in the similar context of the SEC’s proposed rule on outsourcing by investment advisers.
The recharacterization of discretionary authority as having custody would create enormous challenges for investment advisers and ultimately harm investors. We are very concerned that the proposed expansion of the breadth of the definition of custody to include discretionary authority, which would greatly expand the investment adviser activities within the scope of the rule, would make trading on behalf of clients impracticable. It would be especially difficult for investment advisers to trade in asset classes that do not settle on a delivery versus payment (DVP) basis. Ultimately, this recharacterization of custody would harm investors by limiting their investment universe and the number of advisers that can bear the burden of compliance with the rule. The SEC has not demonstrated with any meaningful evidence or cost-benefit analysis that discretionary trading authority presents risks that are in any way proportionate to the vast new burdens and expenses that the proposed rule would impose on investment advisers considered to have custody of client assets. In fact, more than 20 years of experience with the scope of the current Custody Rule have demonstrated the opposite: discretionary authority in itself does not create meaningful custody risks.
The SEC has not provided a sufficient rationale to justify abandoning the existing Custody Rule framework for privately offered securities and upending the market practices and (in some cases) the regulatory regimes of certain other asset classes, given their low risk of misappropriation or loss. The provisions of the proposed rule that would apply to privately offered securities fail to reflect their low risk of misappropriation or loss. The SEC cannot and does not cite a record or history of actual misappropriation or loss of privately offered securities that is remotely proportionate to the burdens and costs that the proposed rule would impose on investment advisers, and by extension, their clients and funds. Similar points can be made about the provisions of the proposed rule that would apply to a range of other asset classes as well.
We strongly recommend an internal controls approach in lieu of the proposed framework. We recognize that not all asset classes present only minimal risks of misappropriation or loss, and that these risks can change, depending on the circumstances. However, we believe an internal controls approach reasonably designed to mitigate the risk of loss, misuse, and misappropriation by the adviser would more effectively address the spectrum of risks across different assets and markets and achieve the Commission’s goal of protecting advisory client assets more broadly. This alternative approach to safeguarding client assets would avoid the impracticalities, weaknesses, and flaws in the proposed rule and would be proportionate to the actual risks presented by different asset classes, advisory practices, and business models.
We make several additional recommendations to improve and streamline the proposal. We recommend several additional revisions that we believe would improve the proposal and alleviate unnecessary burdens on investment advisers, including (i) replacing the adviser asset segregation requirement with an internal controls approach; (ii) making the exceptions from surprise examinations more practical and effective; (iii) excepting certain types of accounts and transfers from the proposed rule; (iv) making the proposed changes to the recordkeeping rule less burdensome; and (v) simplifying custody-related reporting on Form ADV.
The SEC severely underestimates the negative impacts of the proposal. We feel compelled to highlight on behalf of our members that the proposed rule is the latest in a series of rulemaking proposals that are unprecedented in their scope and speed, including the Outsourcing Proposal, the Private Fund Advisers Proposal, the Regulation S-P Proposal, and the Cybersecurity Risk Proposal, among others. We are concerned that the SEC has not considered their cumulative effect on investment advisers, and particularly smaller advisers.
We will continue to work constructively with the SEC on this and the many other open rule proposals affecting investment advisers. If you are interested in joining our member workstreams on any of these rulemakings, or have any questions or comments, please contact the IAA legal team at firstname.lastname@example.org.
The proposal is available here, the fact sheet is available here, and the press release is available here.