Loyola University Chicago School of Law, JD 2024
On February 15, 2023, the Securities and Exchange Commission (SEC) proposed an enhanced safeguarding rule for registered investment advisers (RIAs) under the Investment Advisers Act of 1940. The proposal would require RIAs to implement certain additional measures to protect their clients’ assets from theft or misuse. Additionally, to combat the growing concerns around cryptocurrency and to modernize the Advisers Act, the SEC proposal would expand protection to all assets, not just funds or securities.
New requirements under proposed changes
This proposal would generally apply when an adviser has the ability or authority to effect a change in beneficial ownership of a client’s assets. Currently, an RIA has the ability to subject assets they are managing to the risk of loss, misuse, misappropriation, theft, or financial reverses. However, the proposed rule would require RIAs to establish written policies and procedures designed to safeguard client assets against theft, misappropriation, or other unauthorized activities. Some of the specific requirements the proposal would have RIAs meet are to use a qualified custodian, undergo annual surprise examinations, and to maintain a copy of all written notices required under the proposed rule and any responses thereto.
This part of the rule is important because it is supposed to enhance protection in safeguarding client assets. A qualified custodian is usually a bank or savings association, registered broker-dealers, registered futures commission merchants, and certain foreign financial institutions. However, an institution or individual would be a qualified custodian if they have possession or control of a client’s assets pursuant to a written agreement between the qualified custodian and the investment adviser. It adds enhanced protections to the client by, upon request, stating the qualified custodian shall provide records to the SEC or to an independent auditor conducting an annual audit, send an account statement to the client or its representative identifying each client asset held in the account and summarizing all transactions, at least annually provide the adviser with a written internal control report, and specify the adviser’s agreed-on authority to effect transactions in the custody account and any relevant limitations.
Additionally, the rule would require that an adviser obtain reasonable assurances from a qualified custodian relating to certain protections the qualified custodian will provide to the advisory client. These could include the qualified custodians’ standard of care, indemnification, limitation of liability for sub-custodial services, segregation of client assets, and attachment of liens to client assets. Also, the SEC notes that it’s aware certain physical assets and certain privately offered securities are unable to be maintained with a qualified custodian due to the inherent physical characteristics of the asset or the thin market for privately offered securities. The SEC has proposed a safeguarding rule that provides an exception to the requirement to maintain client assets with a qualified custodian where an adviser has custody of privately offered securities or physical assets, so long as it meets certain conditions.
Increased work for accountants
Furthermore, RIAs that have custody of client assets are required to undergo an annual surprise verification by an independent public accountant. The adviser should generally enter into a written agreement with the accountant based upon a reasonable belief that the accountant is capable of, and intends to, comply with the agreement and the obligations the accountant is responsible for. This part of the rule is meant to ensure that a new set of eyes reviews the client assets and addresses the effectiveness of the RIA’s controls over the custody of client assets. The SEC would receive notification of these independent audits, allowing the SEC to better identify advisers potentially engaged in harmful misconduct and bolster their efforts in preventing fraudulent, deceptive, and manipulative activity. The proposal would also allow for certain exceptions to the surprise examination.
The proposed rule is intended to help ensure that RIAs are taking appropriate measures to safeguard client assets, particularly in light of the increasing frequency and severity of cyber-attacks and other fraudulent activities. Investors should see more transparency and have greater access to information relating to their assets. This proposed rule would allow investors to stay better informed, make wiser investment decisions, and try to avoid being taken advantage of. Although there will be increased work for accountants and a possible increase in cost due to all the transactional work that must be done in order for RIAs to comply with the rule, the added cost shouldn’t outweigh the benefit of investor protection. The SEC has noted that the proposed rule is not intended to be prescriptive, and that RIAs may use a variety of approaches to comply with the requirements of the rule. The SEC has requested public comments on the proposed rule, which may result in revisions to the proposed rule before it is finalized.