[Federal Register Volume 88, Number 46 (Thursday, March 9, 2023)]
[Proposed Rules]
[Pages 14672-14792]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2023-03681]



[[Page 14671]]

Vol. 88

Thursday,

No. 46

March 9, 2023

Part II





 Securities and Exchange Commission





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





17 CFR Parts 275 and 279





Safeguarding Advisory Client Assets; Proposed Rule

  Federal Register / Vol. 88 , No. 46 / Thursday, March 9, 2023 / 
Proposed Rules  

[[Page 14672]]


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

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 275 and 279

[Release No. IA-6240; File No. S7-04-23]
RIN 3235-AM32


Safeguarding Advisory Client Assets

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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

SUMMARY: The Securities and Exchange Commission (``Commission'' or 
``SEC'') is proposing a new rule under the Investment Advisers Act of 
1940 (``Advisers Act'' or ``Act'') to address how investment advisers 
safeguard client assets. To effect our redesignation of the current 
custody rule for the proposed new safeguarding rule, we are proposing 
to renumber the current rule. In addition we are proposing to amend 
certain provisions of the current custody rule for enhanced investor 
protections. We also are proposing corresponding amendments to the 
recordkeeping rule under the Advisers Act and to Form ADV for 
investment adviser registration under the Advisers Act.

DATES: Comments should be received on or before May 8, 2023.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's internet comment form (https://www.sec.gov/rules/submitcomments.html); or
     Send an email to [email protected]. Please include 
File Number S7-04-23 on the subject line.

Paper Comments

     Send paper comments to Secretary, Securities and Exchange 
Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-04-23. This file number 
should be included on the subject line if email is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
website (https://www.sec.gov/rules/proposed.shtml). Comments are also 
available for website viewing and printing in the Commission's Public 
Reference Room, 100 F Street NE, Washington, DC 20549, on official 
business days between the hours of 10 a.m. and 3 p.m. Operating 
conditions may limit access to the Commission's Public Reference Room. 
All comments received will be posted without change. Persons submitting 
comments are cautioned that the Commission does not redact or edit 
personal identifying information from comment submissions. You should 
submit only information that you wish to make available publicly. 
Studies, memoranda, or other substantive items may be added by the 
Commission or staff to the comment file during this rulemaking. A 
notification of the inclusion in the comment file of any such materials 
will be made available on the Commission's website. To ensure direct 
electronic receipt of such notifications, sign up through the ``Stay 
Connected'' option at www.sec.gov to receive notifications by email.

FOR FURTHER INFORMATION CONTACT: Shane Cox, Laura Harper Powell, 
Michael Schrader, and Samuel Thomas, Senior Counsels; Holly H. Miller, 
Senior Financial Analyst; Alex Bradford and Michael Republicano, 
Assistant Chief Accountants; Christopher Staley, Branch Chief; and 
Melissa Roverts Harke, Assistant Director at (202) 551- 6787 or 
[email protected], Investment Adviser Regulation Office, Division of 
Investment Management, Securities and Exchange Commission, 100 F Street 
NE, Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The Commission is proposing for public 
comment to amend and renumber 17 CFR 275.206(4)-2 (rule 206(4)-2) under 
the Investment Advisers Act of 1940 [15 U.S.C. 80b-1 et seq.] to 
redesignate it as rule 17 CFR 275.223-1 (rule 223-1) under the Advisers 
Act, and make corresponding amendments to 17 CFR 275.204-2 (rule 204-2) 
and 17 CFR 279.1 (Form ADV) under the Advisers Act.\1\
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 80b. Unless otherwise noted, when we refer to the 
Advisers Act, or any section of the Advisers Act, we are referring 
to 15 U.S.C. 80b, at which the Advisers Act is codified, and when we 
refer to rules under the Advisers Act, or any section of these 
rules, we are referring to title 17, part 275 of the Code of Federal 
Regulations [17 CFR 275], in which these rules are published.
---------------------------------------------------------------------------

Table of Contents

I. Introduction
    A. Background
    B. Overview of the Proposal
II. Discussion
    A. Scope of Rule
    1. Scope of Assets
    2. Scope of Activity Subject to the Proposed Rule
    B. Qualified Custodian Protections
    1. Definition of Qualified Custodian
    2. Possession or Control
    3. Minimum Custodial Protections
    C. Certain Assets That Are Unable To Be Maintained With a 
Qualified Custodian
    1. Definition of Privately Offered Security and Physical Assets
    2. Adviser's Reasonable Determination
    3. Adviser Reasonably Safeguards Assets
    4. Notification and Prompt Independent Public Accountant 
Verification
    5. Surprise Examination or Audit
    D. Segregation of Client Assets
    E. Investment Adviser Delivery of Notice to Clients
    F. Amendments to the Surprise Examination Requirement
    G. Exceptions from the Surprise Examination
    1. Entities Subject to Audit (``Audit Provision'')
    2. Discretionary Authority
    3. Standing Letters of Authorization
    H. Amendments to the Investment Adviser Recordkeeping Rule
    1. Client Communications
    2. Client Accounts
    3. Account Activity
    4. Independent Public Accountant Engagements
    5. Standing Letters of Authorization
    I. Changes to Form ADV
    J. Existing Staff No-Action Letters and Other Staff Statements
    K. Transition Period and Compliance Date
III. Economic Analysis
    A. Introduction
    B. Broad Economic Considerations
    C. Baseline
    1. Current Regulation
    2. Affected Parties and Industry Statistics
    3. Market Practice
    D. Benefits and Costs of Proposed Rule and Form Amendments
    1. Scope
    2. Qualified Custodian Protections
    3. Certain Assets That Are Unable To Be Maintained With a 
Qualified Custodian
    4. Segregation of Investments
    5. Investment Adviser Delivery of Notice to Clients
    6. Exceptions From the Surprise Examination
    7. Amendments to the Investment Adviser Recordkeeping Rule
    8. Changes to Form ADV
    E. Efficiency, Competition, and Capital Formation
    F. Reasonable Alternatives
    1. Scope of Assets
    2. Elimination of Privately Offered Securities Exception
    3. Distribution of Requirements Across Reasonable Assurances and 
Written Agreement
    3. Additional Accounting and Client Notification Requirements 
for Privately Offered Securities and Physical Assets That Are Not 
Maintained With a Qualified Custodian
    4. Additional Safeguards When Clients Assets Are Not Maintained 
With a Qualified Custodian
    5. Designating Clearing Agencies and Transfer Agents as 
Qualified Custodians
    G. Request for Comment
IV. Paperwork Reduction Act Analysis
    A. Introduction
    B. Rule 223-1
    1. Qualified Custodian Provision
    2. Notice to Clients
    3. Annual Surprise Examination
    C. Exceptions

[[Page 14673]]

    1. Certain Assets That Are Unable To Be Maintained With a 
Qualified Custodian
    2. Audit Provision
    D. Total Hour Burden Associated With Proposed Rule 223-1
    E. Rule 204-2
    F. Form ADV
    G. Request for Comments
V. Initial Regulatory Flexibility Analysis
    A. Reason for and Objectives of the Proposed Action
    1. Proposed Rule 223-1
    2. Proposed Rule 204-2
    3. Proposed Amendments to Form ADV
    B. Legal Basis
    C. Small Entities Subject to the Rule and Rule Amendments
    1. Small Entities Subject to Amendments to the Custody Rule
    D. Projected Reporting, Recordkeeping and Other Compliance 
Requirements
    1. Proposed Rule 223-1
    2. Proposed Amendments to Rule 204-2
    3. Proposed Amendments to Form ADV
    E. Duplicative, Overlapping, or Conflicting Federal Rules
    F. Significant Alternatives
    1. Proposed New Rule 223-1 and Amendments to Rule 204-2 and Form 
ADV
    G. Solicitation of Comments
VI. Consideration of Impact on the Economy
VII. Statutory Authority

I. Introduction

A. Background

    Rule 206(4)-2 under the Act (the ``custody rule'' or ``current 
rule'') regulates the custodial practices of advisers. Although the 
Commission has amended the rule over time as custodial and advisory 
practices have changed, since its adoption it has been designed to 
safeguard client funds and securities from the financial reverses, 
including insolvency, of an investment adviser and to prevent client 
assets from being lost, misused, stolen, or misappropriated.\2\
---------------------------------------------------------------------------

    \2\ See Custody or Possession of Funds or Securities of Clients, 
Investment Advisers Act Release No. 123 (Feb. 27, 1962) [44 FR 2149 
(Mar. 6, 1962)] (``1962 Adopting Release''). See also Custody of 
Funds or Securities of Clients by Investment Advisers, Investment 
Advisers Act Release No. 2176 (Sept. 25, 2003) [68 FR 56692 (Oct. 1, 
2003)] (``2003 Adopting Release''); Custody of Funds or Securities 
of Clients by Investment Advisers, Investment Advisers Act Release 
No. 2044 (Jul. 18, 2002) [67 FR 48579 (Jul. 25, 2002)], at nn. 3, 15 
(``2002 Proposing Release'').
---------------------------------------------------------------------------

    As originally adopted in 1962, the rule required all investment 
advisers with ``custody'' (i.e., physical possession) of client funds 
and securities to deposit client funds in a bank account that was 
maintained in the adviser's name and contained only client funds.\3\ 
Advisers, in addition, were required to segregate client securities and 
hold them in a ``reasonably safe'' place. In each case, the rule 
required investment advisers to provide their clients notice of these 
protocols and to engage an independent public accountant to conduct an 
annual surprise examination \4\ to verify client funds and securities 
independently. These requirements were designed to protect client 
assets at a time when the system for owning and transacting in 
securities was paper-based.
---------------------------------------------------------------------------

    \3\ As with the current rule, the proposed amendments would 
apply to investment advisers registered, or required to be 
registered, with the Commission. However, the original rule was 
broader in scope, applying to ``all investment advisers,'' until it 
was amended in 1997. Rules Implementing Amendments to the Investment 
Advisers Act of 1940, Investment Advisers Act Release No. 1633 (May 
15, 1997) [62 FR 28112 (May 22, 1997)], at section II.I.5. Unless 
otherwise indicated, references throughout this release to 
``adviser'' or ``investment adviser'' refer to investment advisers 
registered, or required to be registered, with the Commission. 
Further, we have previously stated, and would continue to take the 
position (if these amendments were adopted), that most of the 
substantive provisions of the Advisers Act do not apply with respect 
to the non-U.S. clients (including funds) of a registered offshore 
adviser. This approach was designed to provide appropriate 
flexibility where an adviser has its principal office and place of 
business outside of the United States. We believe it would be 
appropriate to continue to apply this approach, including in the 
proposed safeguarding rule context (if adopted). For an adviser 
whose principal office and place of business is in the United States 
(onshore adviser), the Advisers Act and rules thereunder, including 
the proposed safeguarding rule, would apply with respect to the 
adviser's U.S. and non-U.S. clients. See Exemptions for Advisers to 
Venture Capital Funds, Private Fund Advisers With Less Than $150 
Million in Assets Under Management, and Foreign Private Advisers, 
Release No. IA-3222 (June 22, 2011) [76 FR 39645 (July 6, 2011)] 
(Most of the substantive provisions of the Advisers Act do not apply 
to the non-U.S. clients of a non-U.S. adviser registered with the 
Commission.); Registration Under the Advisers Act of Certain Hedge 
Fund Advisers, Release No. IA-2333 (Dec. 2, 2004) [69 FR 72054, 
72072 (Dec. 10, 2004)] (``Hedge Fund Adviser Release'') (stating (1) 
that the following rules under the Advisers Act would not apply to a 
registered offshore adviser, assuming it has no U.S. clients: 
compliance rule, custody rule, and proxy voting rule; (2) stating 
that the Commission would not subject an offshore adviser to the 
rules governing adviser advertising [17 CFR 275.206(4)-1] or cash 
solicitations [17 CFR 275.206(4)-3] with respect to offshore 
clients; and (3) noting that U.S. investors in an offshore fund 
generally would not expect the full protection of the U.S. 
securities laws and that U.S. investors may be precluded from an 
opportunity to invest in an offshore fund if their participation 
would result in full application of the Advisers Act and rules 
thereunder, but that a registered offshore adviser would be required 
to comply with the Advisers Act and rules thereunder with respect to 
any U.S. clients it may have).
    \4\ The terms ``surprise examination'' and ``independent 
verification'' are used throughout the release and are generally 
interchangeable.
---------------------------------------------------------------------------

    The Commission amended the rule in 2003 to expand the definition of 
custody beyond physical possession to include situations in which an 
adviser had any ability to obtain possession of client funds or 
securities. The 2003 amendments made clear that the rule applied to any 
investment adviser ``holding, directly or indirectly, client funds or 
securities, or having any authority to obtain possession of them.'' \5\ 
It included three illustrative examples in the rule's definition of 
``custody'': (1) possession of client funds or securities, even 
briefly; (2) authority to withdraw funds or securities from a client's 
account; and (3) any capacity that gives the adviser legal ownership 
of, or access to, client funds or securities.\6\ In the adopting 
release, the Commission stated this expansion of the concept of adviser 
custody would not include authorized trading, however, stating that 
clients' custodians are generally under instructions to transfer funds 
or securities out of a client's account only upon a corresponding 
transfer of securities or funds into the account.\7\
---------------------------------------------------------------------------

    \5\ See rule 206(4)-2(a). See also rule 206(4)-2(d)(v)(2) 
(defining ``custody''). The original rule did not define 
``custody,'' which was conceptualized at that time as limited to 
physically holding securities.
    \6\ See id.
    \7\ See 2003 Adopting Release, supra footnote 2, at note 10 and 
accompanying text.
---------------------------------------------------------------------------

    In recognition of then-modern custodial practices, the Commission 
in 2003 required advisers to keep securities (not just funds as under 
the 1962 rule) with a custodian, and it expanded the types of 
custodians that would qualify under the rule.\8\ The Commission 
expressed concern that some advisers were still keeping certificates in 
office files or safety deposit boxes, which put those securities at 
risk.\9\ The Commission identified as ``qualified custodians'' the 
types of regulated financial institutions that customarily provided 
custodial services subject to regulatory examination.\10\ The 
Commission also relied more on the protections of qualified custodians, 
eliminating the adviser's need to undergo the rule's annual surprise 
examination by an independent public accountant if the adviser had a 
``reasonable belief'' that the qualified custodian would provide 
account statements directly to the adviser's clients. The Commission 
provided an exception, however, from the requirement to maintain client 
securities with a qualified custodian after commenters had pointed out 
that, on occasion, a client may purchase privately offered securities 
where the only evidence of the client's ownership was recorded on the 
issuer's books and

[[Page 14674]]

the transfer of ownership requires the consent of the issuer or the 
holders of the issuer's outstanding securities. As a result, commenters 
argued that it was difficult to maintain certain of these assets in 
accounts with qualified custodians. The Commission noted that these 
impediments to transferability along with the conditions it imposed in 
the privately offered securities exception (``privately offered 
securities exception''), including in some cases obtaining and 
distributing audited financial statements (``the audit provision''), 
provided external safeguards against the kinds of abuse the rule seeks 
to prevent.
---------------------------------------------------------------------------

    \8\ See 2003 Adopting Release supra footnote 2, at section I.
    \9\ See 2002 Proposing Release, supra footnote 2, at section 
II.B.
    \10\ The financial institutions identified by the Commission 
were broker-dealers, banks and savings associations, futures 
commission merchants, and certain foreign financial institutions. 
See 2003 Adopting Release at II.B.
---------------------------------------------------------------------------

    The Commission most recently amended the rule in 2009 after several 
enforcement actions against investment advisers, including actions 
stemming from the frauds perpetrated by Bernard Madoff and Allen 
Stanford (which also resulted in criminal convictions), alleging 
fraudulent conduct that included, among other things, misappropriation 
or other misuse of client assets involving certain affiliates of the 
adviser.\11\ These cases underlined additional risks both when an 
adviser has access to client funds or securities not explicitly covered 
within the scope of the rule, as well as when the qualified custodian 
is a related person of the adviser. In direct response to certain of 
these cases, the 2009 amendments explicitly extended the scope of the 
rule to reach an adviser's ability to access client funds or securities 
through its related persons, expanded the circumstances in which a 
surprise examination is necessary, and required advisers to obtain an 
independent accountant's report evaluating internal controls related to 
custody where the adviser or its related person serves as qualified 
custodian.\12\
---------------------------------------------------------------------------

    \11\ See Custody of Funds or Securities of Clients by Investment 
Advisers, Investment Advisers Act Release No. 2968 (Dec. 30, 2009) 
[75 FR 1455 (Jan. 11, 2010)], at n.1 (``2009 Adopting Release'') 
(referring to the cases cited in Custody of Funds or Securities of 
Clients by Investment Advisers, Investment Advisers Act Release No. 
2876 (May 20, 2009) [74 FR 25353 (May 27, 2009)] (``2009 Proposing 
Release'')). See also Judgment, ECF Doc No. 100, 4, United States v. 
Madoff, No. 09 Cr. 213 (S.D.N.Y. June 29, 2009) (Bernard L. Madoff 
pled guilty to eleven felony charges including securities fraud, 
investment adviser fraud, mail fraud, wire fraud, three counts of 
money laundering, false statements, perjury, and making false 
filings with the SEC); Order Granting Motion for Summary Judgment, 
SEC v. Stanford International Bank, Ltd., et al., Civil Action No. 
3:09-CV0298 (N.D. Tex. Apr. 25, 2013) (the SEC obtained a $5.9 
billion judgment against R. Allen Stanford who was convicted in a 
parallel criminal case of conspiracy to commit mail and wire fraud, 
four counts of wire fraud, five counts of mail fraud, one count of 
conspiracy to obstruct an SEC investigation, one count of 
obstruction of an SEC proceeding, and one count of conspiracy to 
commit money laundering and sentenced to a total of 110 years in 
prison); SEC v. WG Trading Investors, L.P., 09-CV-1750 (S.D.N.Y. 
July 29, 2010) (involving a broker-dealer and affiliated registered 
adviser that orchestrated a fraudulent investment scheme 
misappropriating as much as $554 million and sending clients 
misleading account information); Isaac I. Ovid, SEC Admin. 
Proceeding No. 3-14313 (Mar. 30 2011) (registered investment adviser 
and manager of purported hedge funds, pled guilty in parallel 
criminal proceeding in connection with which he was required to pay 
restitution in excess of $12 million); Young and Acorn Capital 
Management, LLC, SEC Admin. Proceeding No. 3-14654 (Feb. 28 2012) 
(registered investment adviser and its principal convicted of 
misappropriating $95 million in a Ponzi scheme in a parallel 
criminal case whereupon the SEC issued an order revoking the 
adviser's registration and barred the principal from association 
with an investment adviser, broker, dealer, municipal securities 
dealer, or transfer agent); SEC v. The Nutmeg Group, LLC, et al., 
Litigation Release No. 24677 (Nov. 26, 2019) (commingled investor 
funds with his personal assets, implemented flawed internal systems 
and methods for valuing and reporting assets under management, and 
transferred millions of dollars out of the investment pools to 
himself and companies controlled by family members).
    \12\ See generally rule 206(4)-2; see also 2009 Adopting 
Release, supra footnote 11, at sections II.A and B.
---------------------------------------------------------------------------

    Following the Madoff and Stanford frauds, and on the heels of the 
Commission's recently adopted 2009 amendments to the custody rule, 
Congress expressly vested the Commission with authority to promulgate 
rules requiring registered advisers to take steps to safeguard client 
assets over which advisers have custody by adding section 223 to the 
Advisers Act in the Dodd-Frank Wall Street Reform and Consumer 
Protection Act (``Dodd-Frank Act'').\13\ Leading up to the enactment of 
the Dodd-Frank Act, Congress heard testimony that certain client 
investments were not covered by the custody rule because they were 
neither funds nor securities, putting them at greater risk of loss, 
theft, misappropriation, or being subject to the financial reverses of 
an adviser.\14\ Congress also heard testimony about the important role 
requiring advisers to maintain client funds and securities with 
qualified custodians has in preventing fraud--a requirement that 
applies only if an adviser is subject to the custody rule and the 
assets are not subject to an exception from the qualified custodian 
requirement.\15\ Subsequently, Congress authorized the Commission to 
prescribe rules requiring advisers to take steps to safeguard all 
client assets, not just funds and securities, over which an adviser has 
custody.\16\
---------------------------------------------------------------------------

    \13\ See section 411 of the Dodd-Frank Wall Street Reform and 
Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010) 
(adding section 223 to the Advisers Act which provides ``[a]n 
investment adviser registered under this subchapter shall take such 
steps to safeguard client assets over which such adviser has 
custody, including, without limitation, verification of such assets 
by an independent public accountant, as the Commission may, by rule, 
prescribe.'' 15 U.S.C. 80b-18b). Congress also required the U.S. 
Government Accountability Office to study the rule's compliance 
costs. See id. at section 412.
    \14\ See Regulating Hedge Funds and other Private Investment 
Pools, Hearing Before the House Subcommittee on Securities, 
Insurance, and Investment, 111 Cong. 50-51 (2009) (Statement of 
James S. Chanos, Chairman, Coalition of Private Investment 
Companies) (stating that the current rule's scope--which was ``funds 
and securities'' and with an exception from certain protections for 
privately offered securities--excluded assets such as privately 
issued uncertificated securities, bank deposits, real estate assets, 
swaps, and interests in other private investment funds leaving a 
``gaping hole'' in the rule) (``Dodd Frank Regulating Hedge Funds 
and other Private Investment Pools Testimony by James S. Chanos''). 
Congress also heard testimony about the benefits qualified 
custodians provide in preventing fraud. See id. (``Requiring 
independence between the function of managing a private investment 
fund and controlling its assets, by requiring that all assets be 
titled in the name of a custodian bank or broker-dealer for the 
benefit of the private fund and requiring all cash flows to move 
through the independent custodian, would be an important control. 
Similarly, requiring an independent check on the records of 
ownership of the interests in the private investment fund, as well 
as imposing standards for the qualification of private investment 
fund auditors--neither of which currently is required by the 
Advisers Act--would also greatly reduce opportunities for 
mischief.'').
    \15\ See S. Rep. No. 111-176, at 77 (2010) (``the custodian 
requirement largely removes the ability of an investment adviser to 
pay the proceeds invested by new investors to old investors. The 
custodian will take the instructions to buy or sell securities, but 
not to remit the proceeds of sales to the adviser or to others 
(except in return for share redemptions by investors). At a stroke, 
this requirement eliminates the ability of the manager to `recycle' 
funds from new to old investors.'' quoting Testimony of Professor 
John C. Coffee, Jr.; The Madoff Investment Securities Fraud: 
Regulatory and Oversight Concerns and the Need for Reform: Testimony 
before the U.S. Senate Committee on Banking, Housing and Urban 
Affairs, 111th Congress, 1st session, pp. 8, 10 (2009)).
    \16\ Earlier versions of this bill show that Congress considered 
retaining the current rule's funds and securities formulation. See 
Investor Protection Act of 2009, H.R. 3817, 111th Cong section 419 
(2009).
---------------------------------------------------------------------------

    In addition to this legislative context, industry developments 
prompt us again to reconsider the important prophylactic protections of 
the custody rule and to address certain gaps in protections--some of 
which Congress identified and gave us the tools to address 13 years 
ago.\17\ We have seen changes in

[[Page 14675]]

technology, advisory services, and custodial practices create new and 
different ways for client assets to be placed at risk of loss, theft, 
misuse, or misappropriation that may not be fully addressed under the 
current rule.
---------------------------------------------------------------------------

    \17\ The current rule has also been the subject of numerous 
inquiries and requests for staff views. See, e.g., Staff Responses 
to Questions about the Custody Rule (``Custody Rule FAQs''), 
available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm; Privately Offered Securities under the 
Investment Advisers Act Custody Rule, Division of Investment 
Management Guidance Update No. 2013-04 (Aug. 2013) (``2013 IM 
Guidance''); Private Funds and Application of the Custody Rule to 
Special Purpose Vehicles and Escrows, Division of Investment 
Management Guidance Update No. 2014-07 (June 2014) (``2014 IM 
Guidance''). Staff reports, statistics, and other staff documents 
(including those cited herein) represent the views of Commission 
staff and are not a rule, regulation, or statement of the 
Commission. Furthermore, the Commission has neither approved nor 
disapproved these documents and, like all staff statements, they 
have no legal force or effect, do not alter or amend applicable law, 
and create no new or additional obligations for any person. The 
Commission has expressed no view regarding the analysis, findings, 
or conclusions contained therein. As discussed in section II.J, 
staff in the Division of Investment Management is reviewing staff 
no-action letters and other staff letters to determine whether any 
such letters should be withdrawn in connection with any adoption of 
this proposal. If the rule is adopted, some of the letters and 
statements may be moot, superseded, or otherwise inconsistent with 
the rule and, therefore, would be withdrawn.
---------------------------------------------------------------------------

    For example, advisory services have expanded and developed in 
recent years, leading to questions about the scope of activities that 
trigger application of the current rule. More specifically, nearly 20 
years ago when the Commission interpreted authorized trading not to be 
within the definition of custody, it had stated that clients' 
custodians are generally under instructions to transfer funds or 
securities out of a client's account only upon corresponding transfer 
of securities or funds into the account. At the time, the Commission's 
view was that such an arrangement would minimize the risk that an 
adviser could withdraw or misappropriate the funds or securities in its 
client's custodial account.
    Discretionary trading practices today, however, do not necessarily 
involve a one-for-one exchange of assets under a custodian's oversight. 
For instance, an adviser may instruct an issuer or a transfer agent 
that recorded ownership of a client's privately offered security to 
redeem the client's interest and direct the proceeds to a particular 
account. Because there is no qualified custodian involved in such a 
transaction, a client's ability to monitor its investments for 
suspicious activity is limited (e.g., a qualified custodian would not 
attest to this transaction on the account statements it provides), and 
a surprise examination or an audit may not discover any 
misappropriation until the assets are gone. Moreover, if the security 
is not included in the sample over which an accountant performs its 
procedures during a surprise examination or if the client's holdings of 
the security do not meet the materiality threshold for a financial 
statement audit, misappropriation may go undetected for an 
indeterminate amount of time.
    Other times, advisers find themselves subject to the rule because 
of authority they do not wish to have. For instance, we understand that 
some advisory clients' custodial agreements empower investment advisers 
with a broad array of authority that they neither want nor use.\18\ 
Advisers have little to no ability to eliminate this authority because 
they are usually not parties to the custodial agreements between 
clients and qualified custodians, but nonetheless these arrangements 
result in an adviser having custody under the rule.
---------------------------------------------------------------------------

    \18\ We use the term ``custodial agreement'' throughout the 
release to refer to a contract between an advisory client and the 
qualified custodian. The adviser usually is not a party.
---------------------------------------------------------------------------

    While these developments suggest a need to protect clients better 
and modify the application of the current rule, other developments 
suggest a need to improve the rule's efficacy, including particularly 
the protections provided by the qualified custodian, who has long been 
the key gatekeeper under this rule. A growing number of assets are not 
receiving custodial protections as a result of certain of the current 
rule's exceptions from the requirement to maintain assets with a 
qualified custodian, particularly the exception for privately offered 
securities.\19\ That exception and the exception for mutual fund shares 
were adopted at a time when dematerialized ownership of securities was 
still developing, and the exceptions were envisioned as being necessary 
``at times'' or ``on occasion.'' This rarity is no longer the case. We 
understand that, today, the overwhelming majority of securities are 
uncertificated, the volume of privately offered securities has vastly 
expanded with the expansion of private capital, and custodians have 
developed safeguarding and reporting practices, particularly with 
respect to publicly traded securities.\20\ We acknowledge that the 
custodial market for privately issued securities is less developed,\21\ 
but we believe that some custodians presently custody these assets and 
we understand that new custodial services are being developed.\22\ What 
has also developed, however, is a practice by custodians in which the 
custodian lists assets for which it does not accept custodial liability 
on a client's account statement on an accommodation basis only; the 
custodian does not attest to the holdings of or transactions in those 
investments or take steps to ensure that the investments are 
safeguarded appropriately (``accommodation reporting''). The custodian 
merely reports the holdings or transactions as reported to it by the 
adviser. This practice undermines the account statement's integrity and 
utility in helping to verify that the client owns the assets and they 
have not been stolen or misappropriated. We view the integrity of 
custodial account statements to be critical to the safeguarding of 
client assets. Clients should be able to review their account 
statements to evaluate the legitimacy of any movement within their 
account, whether it is a trade, a payment, or a fee withdrawal. In 
contrast, the current exception for mutual fund shares requires a 
transfer agent of the mutual fund to fulfill all of the obligations 
assigned to a qualified custodian under the rule, including sending 
statements directly to the client. In our longstanding experience with 
the current rule, this exception has not raised similar types of 
investor protection concerns.
---------------------------------------------------------------------------

    \19\ Preqin Global Private Debt Report (2018), available at 
https://docs.preqin.com/samples/2018-Preqin-Global-Private-Debt-Report-Sample-Pages.pdf (showing the growth in private capital 
assets under management from 2007 to 2017 by the following asset 
classes: private equity, private debt, real estate, infrastructure, 
natural resources).
    \20\ See discussion in section II.C infra and at text 
accompanying footnote 229.
    \21\ We understand that many qualified custodians will not 
currently accept custodial liability for certain instruments 
including certain crypto assets, commodities, and privately issued 
securities. See Letter to Karen Barr re Engaging on Non-DVP 
Custodial Practices and Digital Assets: Investment Advisers Act of 
1940: Rule 206(4)-2 (Mar. 12, 2019) (``2019 RFI'').
    \22\ See, e.g., DTCC, Project Whitney Case Study (May 2020), 
available at https://www.dtcc.com/~/media/Files/Downloads/
settlement-asset-services/user-documentation/Project-Whitney-
Paper.pdf.
---------------------------------------------------------------------------

    At the same time, the evolution of financial products and services 
discussed above has led to new entrants and new services in the 
custodial marketplace, including newly launched state-chartered trust 
companies, as well as established bank and broker-dealer custodians 
seeking to develop new practices to safeguard assets.\23\ Our staff has 
also observed a general reduction in the level of protections offered 
by custodians, often resulting in advisory clients with the least 
amount of bargaining power (i.e., retail investors) receiving the most 
limited protections. We understand, for instance, that it is 
decreasingly common for banks acting as custodians to do so in a 
fiduciary capacity.\24\ These changes in the

[[Page 14676]]

industry have caused us to reconsider the role of a ``qualified 
custodian'' under our rule and what minimum protections clients should 
receive.
---------------------------------------------------------------------------

    \23\ See, e.g., Tomito Geron, Companies Compete to Be 
Cryptocurrency Custodians, The Wall Street Journal (Sept. 17, 2019).
    \24\ See OCC Bulletin 2019-21, April 29, 2019, ``Fiduciary 
Regulations; Non-Fiduciary Activities; Advance Notice of Proposed 
Rulemaking.'' According to this Bulletin, Bank non-fiduciary custody 
activities have increased in asset size since 1996. This Bulletin 
reports, as of December 2018, bank non-fiduciary custody assets were 
about $42 trillion, whereas bank fiduciary custody assets were about 
$9 trillion. See also Edward H. Klees, How Safe are Institutional 
Assets in a Custodial Bank's Insolvency, 68 Bus. LAW. 103, 110, 
footnote 46 (2012) (``Klees Article''). In addition to certain 
institutions identified under the Home Owners' Loan Act and members 
of the Federal Reserve System, the Advisers Act generally identifies 
``banks'' as banking institutions or savings associations a 
substantial portion of the business of which consists of receiving 
deposits or exercising fiduciary powers similar to those permitted 
to national banks. Advisers Act sec. 202(a)(2).
---------------------------------------------------------------------------

    Finally, since the Commission last amended the current rule, there 
have been significant developments with respect to crypto assets,\25\ 
which generally use distributed ledger or blockchain technology 
(broadly referred to as ``DLT'') \26\ as a method to record ownership 
and transfer assets. While potentially creating certain efficiencies in 
transactions, this technology also presents technological, legal, and 
regulatory risks to advisers and their clients.\27\ Unlike mechanisms 
used to transact in more traditional assets, this technology generally 
requires the use of public and private cryptographic key pairings, 
resulting in the inability to restore or recover many crypto assets in 
the event the keys are lost, forgotten, misappropriated, or 
destroyed.\28\ By design, DLT finality often makes it difficult or 
impossible to reverse erroneous or fraudulent crypto asset 
transactions, whereas processes and protocols exist to reverse 
erroneous or fraudulent transactions with respect to more traditional 
assets. These specific characteristics could leave advisory clients 
without meaningful recourse to reverse erroneous or fraudulent 
transactions, recover or replace lost crypto assets, or correct errors 
that result from their adviser having custody of these assets.
---------------------------------------------------------------------------

    \25\ There are also digital assets. The term ``digital asset'' 
refers to an asset that is issued and/or transferred using 
distributed ledger or blockchain technology, including, but not 
limited to, so-called ``virtual currencies,'' ``coins,'' and 
``tokens.'' See Custody of Digital Asset Securities by Special 
Purpose Broker-Dealers, Securities Exchange Act Release No. 90788 
(Dec. 23, 2020), 86 FR 11627, 11627 n.1 (Feb. 26, 2021) 
(``Commission Statement''). A digital asset may or may not meet the 
definition of a ``security'' under the Federal securities laws. See, 
e.g., Report of Investigation Pursuant to section 21(a) of the 
Securities Exchange Act of 1934: The DAO, Securities Exchange Act 
Release No. 81207 (July 25, 2017) (``DAO 21(a) Report''), available 
at https://www.sec.gov/litigation/investreport/34-81207.pdf; SEC v. 
W.J. Howey Co., 328 U.S. 293 (1946). To the extent digital assets 
rely on cryptographic protocols, these types of assets also are 
commonly referred to as ``crypto assets.'' For purposes of this 
release, the Commission does not distinguish between the terms 
``digital asset'' and ``crypto asset.''
    \26\ The terms DLT and blockchain, a type of DLT, generally 
refer to databases that maintain information across a network of 
computers in a decentralized or distributed manner. Blockchain 
networks commonly use cryptographic protocols to ensure data 
integrity. See, e.g., World Bank Group, ``Distributed Ledger 
Technology (DLT) and Blockchain,'' FinTech Note No. 1 (2017), 
available at: https://openknowledge.worldbank.org/bitstream/handle/10986/29053/WP-PUBLIC-Distributed-Ledger-Technology-and-Blockchain-Fintech-Notes.pdf?sequence=1&isAllowed=y.
    \27\ We note that our staff has expressed a similar view. See, 
e.g., SEC Staff Accounting Bulletin No. 121, [87 FR 21016 (Apr. 11, 
2022)] (generally describing risks related to the safeguarding of 
crypto assets); Custody of Digital Asset Securities by Special 
Purpose Broker-Dealers, supra footnote 25 (generally discussing 
risks related to broker-dealer custody of crypto asset securities). 
See also Joint Statement on Crypto-Asset Risks to Banking 
Organizations (Jan 3, 2023), available at https://occ.treas.gov/news-issuances/news-releases/2023/nr-ia-2023-1a.pdf (generally 
discussing risks related to bank custody of crypto assets).
    \28\ See, e.g., Not Your Keys, Not Your Coins: Unpriced Credit 
Risk in Cryptocurrency, at section I, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4107019.
---------------------------------------------------------------------------

    Additionally, we understand that many advisers may be reluctant to 
provide a full range of advisory services to their clients with respect 
to crypto assets because of concerns that a market for custodial 
services to safeguard these assets has not yet fully developed. We 
understand that other advisers provide advisory services that would 
generally result in an adviser having ``custody'' within the meaning of 
the rule (e.g., serving as the general partner for a private fund that 
holds crypto asset securities), and therefore are required to comply 
with the rule. Some of these advisers, however, may not maintain their 
client's crypto assets with a qualified custodian, instead attempting 
to safeguard their client's crypto assets themselves--a practice that 
is not compliant with the custody rule if those crypto assets are funds 
or securities and do not meet an exception from the qualified custodian 
requirement. Other advisers offering similar advisory services might 
take the position that crypto assets are not covered by the custody 
rule at all. This, however, is incorrect because most crypto assets are 
likely to be funds or crypto asset securities covered by the current 
rule.\29\
---------------------------------------------------------------------------

    \29\ The application of the current rule turns on whether a 
particular client investment is a fund or a security. To the extent 
there is a question as to whether a particular crypto asset is an 
investment contract that is a security, the analysis is governed by 
the test first articulated by the Supreme Court in SEC v. W.J. Howey 
Co., 328 U.S. 293, 301 (1946). See, e.g., SEC v. Kik Interactive 
Inc., 492 F. Supp. 3d 169, 177-180 (S.D.N.Y. 2020) (applying Howey 
in granting the Commission's motion for summary judgment finding 
Kik's sale of Kin tokens to the public was a sale of a security and 
required a registration statement); SEC v. LBRY, No. 21-CV-260-PB, 
2022 WL 16744741 (D.N.H. Nov. 7, 2022) (applying Howey in granting 
the Commission's motion of summary judgement finding ``no reasonable 
trier of fact could reject the SEC's contention that LBRY offered 
LBC [a crypto asset] as a security.'' Id. at 21); Report of 
Investigation Pursuant to section 21(a) of the Securities Exchange 
Act of 1934: The DAO, Rel. No. 81207 (July 25, 2017) (describing how 
DAO tokens were securities under Howey); see also Spotlight on 
Crypto Assets and Cyber Enforcement Actions, available at https://www.sec.gov/spotlight/cybersecurity-enforcement-actions. 
Importantly, even if a particular crypto asset is not a security, 
the current rule also covers funds.
---------------------------------------------------------------------------

B. Overview of the Proposal

    In the light of these developments and additional authority that 
Congress has given us under the Dodd-Frank Act to prescribe investment 
adviser custody rules, we are redesignating the custody rule as new 
rule 223-1 under the Advisers Act (the ``safeguarding rule'' or the 
``proposed rule'') and proposing a number of amendments to strengthen 
its protections.\30\ The proposal is designed to recognize the 
evolution in products and services investment advisers offer to their 
clients and to strengthen and clarify existing custody protections, 
while also proposing complementary refinements to how advisers report 
custody information on Form ADV and the books and records they are 
required to keep that are designed to improve our oversight and risk-
assessment abilities.\31\ Importantly, the proposal maintains the core 
purpose of protecting client assets from loss, misuse, theft, or 
misappropriation by, and the insolvency or financial reverses of, the 
adviser and maintains the Commission's ability to pursue advisers for 
failing to properly safeguard client assets under the Act's antifraud 
provisions.\32\
---------------------------------------------------------------------------

    \30\ We are also renumbering portions of the custody rule that 
we are not amending.
    \31\ In a technical, conforming change from the current rule, 
the proposed rule would replace, in certain places, references to 
``you'' with ``investment adviser.''
    \32\ While we are renumbering the current rule as rule 223-1, 
section 206(4) is still available to the Commission and is also a 
basis of statutory authority for this proposed rulemaking. To 
establish a violation of section 206(4) for an adviser's failure to 
safeguard client assets, the Commission does not need to demonstrate 
that an investment adviser acted with scienter. See SEC v. Steadman, 
967 F.2d 636, 646-7 (D.C. Cir. 1992). As we noted when we adopted 
rule 206(4)-8, the court in Steadman analogized section 206(4) of 
the Advisers Act to section 17(a)(3) of the Securities Act, which 
the Supreme Court had held did not require a finding of scienter 
(citing Aaron v. SEC, 446 U.S. 680 (1980)). See Prohibition of Fraud 
by Advisers to Certain Pooled Investment Vehicles, Investment 
Advisers Act Rel. 2628, (Aug. 3, 2007), 72 FR 44763 (Aug. 9, 2007). 
See also Steadman at 643, n.5.
---------------------------------------------------------------------------

    First, the proposed amendments are designed to modernize the scope 
of assets and activities that would trigger application of the rule. In 
today's increasingly complex and global financial markets, this update 
also would simplify the rule's application and better align the rule 
with the Commission's statutory authority.\33\ Because investment 
advisers provide

[[Page 14677]]

services related to an array of financial products beyond just funds or 
securities, the proposed rule would require certain minimum 
protections, particularly the safeguards of a qualified custodian, for 
substantially all types of client assets held in an advisory account. 
Specifically, the safeguarding rule would specify the types of assets 
subject to the safeguarding requirements of the rule by defining 
``assets'' as ``funds, securities, or other positions held in a 
client's account,'' as opposed to the custody rule's use of ``funds and 
securities.'' \34\ This change would expressly include certain assets 
that may not have previously been categorized as ``funds'' or 
``securities'' and would accommodate developments in the market for 
various investment types that develop in the future, irrespective of 
their status as funds or securities. By expanding the scope of the rule 
to include client assets instead of only client funds and securities, 
we believe we are properly balancing the desire of investment advisers 
to provide advisory services regarding novel or innovative asset types 
with the need to ensure that such assets are properly safeguarded.
---------------------------------------------------------------------------

    \33\ See supra note 16 and accompanying text.
    \34\ See 15 U.S.C. 80b-23 (``section 223'') ``An investment 
adviser registered under this subchapter shall take such steps to 
safeguard client assets over which such adviser has custody, 
including, without limitation, verification of such assets by an 
independent public accountant, as the Commission may, by rule, 
prescribe.'' See proposed rule 223-1(a).
---------------------------------------------------------------------------

    The proposed rule also would explicitly include discretionary 
authority to trade within the definition of custody.\35\ When an 
adviser has discretion to trade client assets, it has an arrangement in 
which it may instruct the adviser's custodian to dispose the client's 
assets. An adviser with discretion may also have broad authority to 
direct purchases or sales of client assets that may not currently 
involve a qualified custodian, such as loan participation interests. An 
adviser's ability or authority to effect a change in beneficial 
ownership of a client's assets, including for purposes of trading, 
could place client assets at risk of loss that the rule is designed to 
address.\36\ This change would rectify any unintended consequences of 
our prior interpretive position.\37\
---------------------------------------------------------------------------

    \35\ Proposed rule 223-1(d)(3).
    \36\ See section II.A.2. Recognizing that there are times when 
an investment adviser neither wants nor uses the ability or 
authority that would trigger the proposed rule and that there are 
times when an adviser inadvertently receives client investments, the 
proposed rule would provide limited and tailored exclusions in these 
circumstances. See infra, discussion of discretionary trading 
authority in section II.G.2.
    \37\ When adopting amendments to the custody rule in 2003, we 
stated in a footnote: ``An adviser's authority to issue instructions 
to a broker-dealer or [other] custodian to effect or settle trades 
does not constitute `custody.' Clients' custodians are generally 
under instructions to transfer funds (or securities) out of a 
client's account only upon corresponding transfer of securities (or 
funds) into the account. This `delivery versus payment' arrangement 
minimizes the risk that an adviser could withdraw or misappropriate 
the funds or securities in its client's custodial account.'' 2003 
Adopting Release, supra footnote 2, at n.10. Absent this narrowly 
drawn exception for ``delivery versus payment'' transactions, 
authorized trading comes within the definition of custody.
---------------------------------------------------------------------------

    Like the custody rule, the safeguarding rule would entrust 
safekeeping of client assets to a qualified custodian because we 
continue to believe it provides critical safeguards for those assets. 
Unlike the custody rule, however, the safeguarding rule would specify 
that a qualified custodian does not ``maintain'' a client asset for 
purposes of the rule if it does not have ``possession or control'' of 
that asset. The proposed rule would further define ``possession or 
control'' to mean holding assets such that the qualified custodian is 
required to participate in any change in beneficial ownership of those 
assets.\38\ This change is designed to improve account statement 
integrity and reliability by eliminating an adviser's ability to 
request accommodation reporting.\39\ Further, in a change from the 
current rule, the proposed rule would require an adviser to enter into 
a written agreement with and receive certain assurances from the 
qualified custodian to make sure the qualified custodian provides 
certain standard custodial protections when maintaining client 
assets.\40\
---------------------------------------------------------------------------

    \38\ Proposed rule 223-1(d)(8). For further discussion of 
possession or control, please see discussion infra section II.B.2.
    \39\ See infra discussion section II.B.3.b.ii.
    \40\ Proposed rule 223-1(a)(1).
---------------------------------------------------------------------------

    Under the proposal, the written agreement would require two 
provisions that are not explicitly addressed by the current rule. One 
provision would require the qualified custodian to provide promptly, 
upon request, records relating to clients' assets held in the account 
at the qualified custodian to the Commission or to an independent 
public accountant engaged for purposes of complying with the 
safeguarding rule. The other would specify the adviser's agreed-upon 
level of authority to effect transactions in the account. The proposed 
rule's written agreement requirement would also incorporate, and 
expand, two components of the current rule: account statements and 
internal control reports. Under the first, the written agreement must 
contain a provision requiring the qualified custodian to deliver 
account statements to clients and to the adviser, as currently advisers 
must have only a reasonable basis for believing this is done. The other 
provision would require the qualified custodian to obtain a written 
internal control report that includes an opinion of an independent 
public accountant regarding the adequacy of the qualified custodian's 
controls. This provision expands the internal control requirement to 
all qualified custodians from the current rule's application to an 
adviser or its related person \41\ that acts as a qualified custodian.
---------------------------------------------------------------------------

    \41\ The term ``related person'' would have the same meaning as 
in the current rule.
---------------------------------------------------------------------------

    In addition to the written agreement requirement, advisers would 
have to obtain reasonable assurances that the qualified custodian 
satisfies five additional enumerated items.\42\ These include 
assurances that the custodian will: (1) exercise due care in accordance 
with reasonable commercial standards in discharging its duty as 
custodian and implement appropriate measures to safeguard client assets 
from theft, misuse, misappropriation, or other similar type of loss; 
(2) indemnify the client against losses caused by the qualified 
custodian's negligence, recklessness, or willful misconduct; (3) not be 
excused from its obligations to the client as a result of any sub-
custodial or other similar arrangements; (4) clearly identify and 
segregate client assets from the custodian's assets and liabilities; 
and (5) 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.
---------------------------------------------------------------------------

    \42\ See proposed rule 223-1(a)(1)(ii).
---------------------------------------------------------------------------

    We are proposing to modify the current rule's privately offered 
securities exception from the obligation to maintain client assets with 
a qualified custodian by expanding the exception to include certain 
physical assets.\43\ We are also proposing refinements to the 
definition of privately offered securities that are designed to ensure 
appropriate application and interpretation of this exception.\44\ In 
addition, we are proposing to modify the conditions for relying on this 
exception to improve investor protections in the absence of one of the 
rule's key gatekeepers. Specifically, an adviser could rely on the 
exception only if it reasonably

[[Page 14678]]

determines that ownership cannot be recorded and maintained by a 
qualified custodian, the adviser reasonably safeguards the assets, the 
adviser notifies the independent public accountant performing the 
verification of such an asset transfer within one business day, an 
independent public accountant verifies asset transfers and notifies the 
Commission upon the findings of any material discrepancies, and the 
existence and ownership of the assets are verified during an annual 
independent verification or as part of a financial statement audit by 
an independent public accountant.\45\ The modifications are also 
designed to limit availability of the exception to circumstances that 
truly warrant it because we believe the bulk of advisory client assets 
are able to be maintained by qualified custodians and should be 
safeguarded in the manner contemplated under the safeguarding rule.
---------------------------------------------------------------------------

    \43\ See proposed rule 223-1(b)(2).
    \44\ See proposed rule 223-1(d)(9).
    \45\ See proposed rule 223-1(b)(2).
---------------------------------------------------------------------------

    Under the proposed rule, advisers with custody of client assets 
would be required to segregate those assets by (1) titling or 
registering the assets in the client's name or otherwise holding the 
assets for the client's benefit, (2) not commingling the assets with 
the adviser's or any of its related persons' assets, and (3) not 
subjecting the assets to any right, charge, security interest, lien, or 
claim of any kind in favor of the investment adviser or its related 
persons or creditors, except to the extent agreed to or authorized in 
writing by the client.\46\ This provision, which would apply regardless 
of whether the client's assets are maintained by a qualified custodian, 
is designed to prevent the adviser, or its related person, from using 
client assets for its own purposes or in a manner not authorized by the 
client or in a manner inconsistent with its fiduciary duty. We believe 
this will also help to protect client assets and enable them to be 
returned in the event that an adviser experiences financial hardship.
---------------------------------------------------------------------------

    \46\ See proposed rule 223-1(a)(3).
---------------------------------------------------------------------------

    The proposed rule would continue to depend on the protections 
provided by independent public accountants. We have long relied on 
these third-party gatekeepers to provide ``another set of eyes'' on 
client assets, and we believe they serve an important role in 
safeguarding client assets. In light of the proposed changes to the 
rule's scope, however, the proposal seeks to balance better the costs 
associated with obtaining a surprise examination with the investor 
protections it offers by providing exceptions to the surprise 
examination requirement when the adviser's sole reason for having 
custody is because it has discretionary authority or because the 
adviser is acting according to a standing letter of authorization, each 
subject to certain conditions.\47\ We believe that the risk to client 
assets is lower in these contexts and the protections offered by the 
surprise examination may not justify the cost of obtaining one. 
Finally, the proposed safeguarding rule amendments would expand the 
scope of who can satisfy the rule's surprise examination requirement 
through financial statement audits by specifying that an entity is not 
required to be a limited partnership, limited liability company, or 
another type of pooled investment vehicle to rely on this 
provision.\48\
---------------------------------------------------------------------------

    \47\ See proposed rule 223-1(b)(7) and (8).
    \48\ See proposed rule 223-1(b)(4).
---------------------------------------------------------------------------

    The proposal also seeks to update and enhance recordkeeping 
requirements for advisers that would work in concert with the proposed 
rule. We believe that these updates would enhance the Commission's 
oversight of the safeguarding practices of advisers and their 
compliance with the rule, which will, in turn, promote investor 
protections.
    Finally, we are proposing amendments to Form ADV to align reporting 
obligations with the proposal and improve the accuracy of custody-
related data available to the Commission, its staff, and the public. In 
addition, we are improving the structure of Form ADV Item 9.\49\ More 
accurate and comprehensive information that aligns with the proposed 
rule would inform the Commission's examination initiatives and would 
allow the Commission and its staff to better assess risks specific 
advisers pose to investors.\50\
---------------------------------------------------------------------------

    \49\ See infra discussion at section II.I.
    \50\ See infra discussion at section II.J. Because Form ADV Part 
1A is submitted in a structured, XML-based data language specific to 
that form, the information in the proposed amendments to Part 1A 
would continue to be structured (i.e., machine-readable).
---------------------------------------------------------------------------

II. Discussion

A. Scope of Rule

    Like the current rule, the proposed rule would apply to any 
investment adviser registered or required to be registered with the 
Commission under section 203 of the Act that has ``custody'' of a 
client's assets.\51\ Also consistent with the current rule, the 
proposed rule would also apply to any adviser whose ``related persons'' 
have custody in connection with advisory services the adviser provides 
to the client.\52\
---------------------------------------------------------------------------

    \51\ Proposed rule 223-1. As with the current rule, an adviser 
would be required to comply with the proposed rule in circumstances 
where the adviser provides advisory services to a person's assets, 
even if uncompensated. ``Although a person is not an `investment 
adviser' for purposes of the Advisers Act unless it receives 
compensation for providing advice to others, once a person meets 
that definition (by receiving compensation from any client to which 
it provides advice), the person is an adviser, and the Act applies 
to the relationship between the adviser and any of its clients 
(whether or not the adviser receives compensation from them).'' See 
Rules Implementing Amendments to the Investment Advisers Act of 
1940, Investment Advisers Act Release No. 3221 (June 22, 2011) [76 
FR 42,950 (July 19, 2011)], at text accompanying n.74.
    \52\ Consistent with the current rule, under the proposed rule, 
the term ``related person'' would mean ``any person, directly or 
indirectly, controlling or controlled by [the investment adviser], 
and any person that is under common control with [the investment 
adviser].'' Proposed rule 223-1(d)(11).
---------------------------------------------------------------------------

    The proposed rule would change the current rule's scope, however, 
in two important ways. First, it would expand the types of investments 
covered by the rule. Currently, the rule applies to client ``funds and 
securities'' of which an adviser has custody. The proposed rule would 
extend the rule's coverage beyond client ``funds and securities'' to 
client ``assets'' so as to include additional investments held in a 
client's account. Second, the proposed rule would make explicit that 
the current rule's defined term ``custody'' includes discretionary 
authority.
1. Scope of Assets
    The proposed rule would define ``assets'' as ``funds, securities, 
or other positions held in a client's account.'' \53\ The proposal, 
like the current rule, therefore would apply to a client's funds as 
well as a client's securities. However, the proposed rule also would 
apply to other positions held in a client's account that are not funds 
or securities. This proposed change uses the more expansive and 
explicit language employed by Congress in empowering the Commission to 
develop rules to protect client assets when advisers have custody.\54\ 
Congress made this change following several high profile enforcement 
actions relating to misappropriation of client assets.\55\ The proposed 
amendments also recognize the continued evolution of the types of 
investments held in advisory accounts since the custody rule was 
amended in 2009 and since the enactment of section 223. Looking 
forward, the proposed definition of assets is designed to remain 
evergreen, encompassing new investment types as they continue to evolve 
and multiply to recognize that the protections of the rule should not

[[Page 14679]]

depend on which type of assets the client entrusts to the adviser.
---------------------------------------------------------------------------

    \53\ Proposed rule 223-1(d)(1).
    \54\ See section 223, supra footnote 34.
    \55\ See supra footnote 11.
---------------------------------------------------------------------------

    The proposed rule's use of the term ``other positions'' in the 
definition of assets encompasses holdings that may not necessarily be 
recorded on a balance sheet as an asset for accounting purposes, 
including, for example, short positions and written options.\56\ We 
believe, in the advisory account context, that the entirety of a client 
account's positions, holdings, or investments should receive the 
protections of the proposed rule regardless of how they may be treated 
for accounting purposes. Moreover, the fiduciary duty extends to the 
entire relationship between the adviser and client regardless of 
whether a specific holding in a client account meets the definition of 
funds or a security.\57\ Consequently, the proposed rule's definition 
of assets would include investments such as all crypto assets, even in 
the instances where such assets are neither funds nor securities.\58\ 
Assets under the rule also would include financial contracts held for 
investment purposes, collateral posted in connection with a swap 
contract on behalf of the client, and other assets that may not be 
clearly funds or securities covered by the current rule.\59\ 
Additionally, physical assets, including artwork, real estate, precious 
metals, or physical commodities (e.g., wheat or lumber), would be 
within the scope of the proposed rule. ``Assets'' also would encompass 
investments that would be accounted for in the liabilities column of a 
balance sheet or represented as a financial obligation of the client 
including negative cash, which we believe would be consistent with the 
purposes of the Act and the longstanding policy goal of the rule to 
prevent potential fraud, misuse, or misappropriation.\60\
---------------------------------------------------------------------------

    \56\ Similarly, rule 6(c)-11 under the Investment Company Act of 
1940 [15 U.S.C. 80a-1 et seq.] (the ``Investment Company Act'') 
defines an exchange-traded fund's portfolio holdings as the 
securities, assets, or other positions held by the exchange-traded 
fund. See 17 CFR 270.6c-11. See Exchange Traded Funds, Investment 
Company Act Release No. 33646 (Sept. 25, 2019) [84 FR 57162 (Oct. 
24, 2019)], at n.249 (including within the term ``other positions'' 
short positions in equity, overdrawn or negative cash balances, 
written call or put options (where the other side has the option and 
can put or call the underlying instrument to the party who wrote the 
contract)).
    \57\ See Commission Interpretation Regarding Standard of Conduct 
for Investment Advisers, Release No. IA-5248 (Jun. 5, 2019) at 
footnote 17 (discussing the broad scope of the fiduciary duty in a 
variety of contexts, including situations where securities are not 
specifically involved).
    \58\ Crypto assets that are funds or securities are subject to 
the current custody rule, which applies to all ``funds and 
securities'' over which an adviser has custody. See discussion of 
whether crypto assets or digital assets meet the definition of 
security at supra footnote 29.
    \59\ Id. Our staff has taken a similar position regarding 
collateral for transactions, such as swaps. See Custody Rule FAQs, 
supra footnote 17, at Question II.10.
    \60\ See rule 6c-11, supra footnote 56. The release discussed 
that liabilities were contemplated to be part of ``other 
positions.''
---------------------------------------------------------------------------

    We also request comment on all aspects of the proposed definition 
of ``assets,'' including the following items:
    1. Should the rule apply to client ``assets'' beyond the scope of 
the current rule's formulation of ``funds or securities,'' as proposed? 
Should the proposed rule include the term ``other positions'' as a 
catch-all for a client's positions subject to the adviser-client 
relationship? Should another term, such as client investments, be used 
instead?
    2. Should we define client ``assets'' by referencing other terms, 
such as ``securities and similar investments'' or ``any investment,'' 
which are used but not defined in the Investment Company Act custody 
rules? \61\ Should we instead incorporate the term ``investment'' from 
the definition of ``qualified purchaser'' under the Investment Company 
Act? \62\
---------------------------------------------------------------------------

    \61\ See rules 17f-1, 17f-2, 17f-5, and 17f-6 under the 
Investment Company Act.
    \62\ See rule 2a51-1(b) under the Investment Company Act.
---------------------------------------------------------------------------

    3. Are there particular types of assets held in a client's advisory 
account that should or should not be subject to the proposed rule? If 
so, what are they and why should they be included or excluded? Are 
there other safeguards outside of the proposed rule that apply to these 
positions that would satisfy the policy goals of the rule? Does the 
answer depend on the type of asset?
    4. To the extent that the adviser has custody of certain physical 
assets, should we narrow the proposed definition to exclude such 
physical assets? For example, should the proposed definition exclude 
artwork, real estate, precious metals, or physical commodities (e.g., 
wheat or lumber), for example?
    5. It is our understanding that some advisers treat client assets 
that may not be ``funds or securities'' consistent with rule 206(4)-2. 
If so, what types of assets do they maintain with a qualified custodian 
under the current rule? If not, how do the advisers safeguard these 
client assets?
    6. Should we provide guidance about how the proposed rule would 
apply to certain asset types? If so, for what types of assets? Should 
we provide guidance for certain assets that would be subject to 
exceptions from the proposed rule, such as privately offered securities 
or physical assets?
    7. Should the proposed rule apply to assets that are treated as 
liabilities from an accounting perspective? Is it sufficiently clear 
that the proposed rule would apply to portfolio holdings that are 
liabilities on a balance sheet? Should we provide additional 
clarification as to what types of investments may appear as liabilities 
within the scope of the advisory relationship? What types of holdings 
typically appear as liabilities? Are there any exemptions or provisions 
required for such investments if they are included within the scope of 
the rule?
2. Scope of Activity Subject to the Proposed Rule
    The proposal generally would preserve the current rule's definition 
of ``custody,'' and apply when an adviser ``holds, directly or 
indirectly, client assets, or has any authority to obtain possession of 
them.'' \63\ The general principle of this definition is to apply the 
rule when an adviser has the ability or authority to effect a change in 
beneficial ownership of a client's assets.\64\ An adviser with this 
ability or authority can subject a client's assets to the risks of 
loss, misuse, misappropriation, theft, or financial reverses of the 
adviser. Moreover, the rule would continue to apply when an adviser's 
related person has the ability to obtain client assets in connection 
with advisory services. Like the current rule, the proposed rule would 
institute prophylactic safeguards where there is this potential for 
loss or harm to a client given the adviser's ability or authority to 
deprive the client of ownership and to obtain possession of the 
client's assets.
---------------------------------------------------------------------------

    \63\ See proposed rule 223-1(d)(3).
    \64\ For example, an adviser that physically holds a check drawn 
by the advisory client and made payable to a third party is not 
subject to the rule solely as a result of holding the check, since 
the adviser cannot use the check to change ownership of the client's 
underlying cash holdings. See rule 206(4)-2(d)(2)(i). Similarly, if 
a stock certificate is non-transferable (i.e., it cannot be used to 
effect a change in beneficial ownership of the client's investment), 
an adviser would not be subject to the rule as a result of holding 
it. Our staff previously took a similar view. See 2013 IM Guidance, 
supra footnote 17.
---------------------------------------------------------------------------

    In addition to this overarching principle, the current definition 
of custody includes three categories that serve as examples of custody: 
physical possession, certain arrangements when the adviser is 
authorized or permitted to instruct the client's custodian, and 
circumstances when the adviser acts in certain capacities.\65\ The 
proposed rule

[[Page 14680]]

would retain these categories because, going forward, we believe this 
approach will continue to provide flexibility as the asset management 
industry continues to evolve, introduces novel investment products, and 
provides new services to its advisory clients.
---------------------------------------------------------------------------

    \65\ Under the current rule, custody includes three prongs: (i) 
Possession of client funds or securities (but not of checks drawn by 
clients and made payable to third parties) unless the adviser 
receives them inadvertently and returns them to the sender promptly 
but in any case within three business days of receiving them; (ii) 
Any arrangement (including a general power of attorney) under which 
the adviser is authorized or permitted to withdraw client funds or 
securities maintained with a custodian upon the adviser's 
instruction to the custodian; and (iii) Any capacity (such as 
general partner of a limited partnership, managing member of a 
limited liability company or a comparable position for another type 
of pooled investment vehicle, or trustee of a trust) that gives the 
adviser or its supervised person legal ownership of or access to 
client funds or securities.
---------------------------------------------------------------------------

    We believe we need to provide specificity, however, regarding the 
arrangement category of the custody definition to state explicitly that 
discretionary trading authority is an arrangement that triggers the 
rule.\66\ Specifically, the amended custody definition would include 
any arrangement (including, but not limited to, a general power of 
attorney or discretionary authority) under which the adviser is 
authorized or permitted to withdraw or transfer beneficial ownership of 
client assets upon the adviser's instruction.\67\ In addition, the 
proposed discretionary authority definition is consistent with the 
definition in Form ADV and is the authority to decide which assets to 
purchase and sell for the client.\68\
---------------------------------------------------------------------------

    \66\ Proposed rule 223-1(d)(3) (proposed custody definition) and 
proposed rule 223-1(d)(4)(discretionary authority definition). The 
second prong of the current custody definition states: ``Any 
arrangement (including a general power of attorney) under which you 
are authorized or permitted to withdraw client funds or securities 
maintained with a custodian upon your instruction to the 
custodian.'' See current rule 206(4)-2(d)(3).
    \67\ The proposed amended definition also removes the reference 
``to the custodian'' from the arrangement category. This formulation 
ensures that custody is triggered if, for example, an adviser can 
instruct a transfer agent or administrator to withdraw or transfer 
beneficial ownership of client assets. See proposed rule 223-
1(d)(3).
    \68\ Proposed rule 223-1(d)(4).
---------------------------------------------------------------------------

    The Commission previously stated that an adviser's authority to 
issue instructions to a broker-dealer or a custodian to effect or to 
settle trades, or authorized trading, does not constitute custody.\69\ 
We had explained then that the risk of an adviser withdrawing or 
misappropriating funds and securities are minimized when a client's 
custodian is under instructions to transfer funds (or securities) out 
of a client's account only upon corresponding transfer of securities 
(or funds) into the account.\70\ However, while we continue to believe 
that there is a more limited risk of loss to a client from authorized 
trading when a qualified custodian participates in a one-for-one 
exchange of assets like this, we also believe that discretionary 
authority presents the types of risks the rule is designed to address. 
The adviser, for instance, could use its discretionary authority over a 
client's assets to instruct an issuer's transfer agent or administrator 
(e.g., the administrator for a loan syndicate) to sell its client's 
interest and to direct the cash proceeds of the sale to an account that 
the adviser owns and controls, thereby depriving the client of 
ownership, unbeknownst to the client or its qualified custodian. Unless 
a client or its custodian is required to participate in these 
transactions, such as when the client must sign the subscription 
agreement to purchase the security (i.e., the adviser does not have a 
power of attorney and cannot sign for the client in any other 
capacity), the client will be unable to monitor the assets in its 
account for potential misuse or misappropriation effectively.\71\
---------------------------------------------------------------------------

    \69\ 2003 Adopting Release, supra footnote 2, at n.10.
    \70\ Id.
    \71\ Our staff stated a similar view under the current rule. See 
Custody Rule FAQs, supra footnote 17, at Question VII.3.
---------------------------------------------------------------------------

    We believe it is important to extend the protections of the rule by 
explicitly including ``discretionary authority'' within the definition 
of custody. However, because we continue to believe more limited risk 
of loss exists when a qualified custodian participates in transactions, 
we are also proposing a limited exception to the surprise examination 
requirement of the rule. The exception would generally apply to client 
assets that are maintained with a qualified custodian when the sole 
basis for the application of the rule is an adviser's discretionary 
authority that is limited to instructing the client's qualified 
custodian to transact in assets that settle only on a delivery versus 
payment (``DVP'') basis.\72\ In DVP transactions, clients' custodians 
are under instructions to transfer assets out of a client's account 
only upon corresponding transfer of assets into the account. This 
``delivery versus payment'' arrangement minimizes the risk that an 
investment adviser could withdraw or misappropriate the assets in its 
client's custodial account. In our view, DVP transactions reduce the 
risk that the seller of an asset could deliver the asset but not 
receive payment or that the buyer of an asset could make payment but 
not receive delivery of the asset.\73\
---------------------------------------------------------------------------

    \72\ Proposed rule 223-1(b)(8). See infra at section II.G.2.
    \73\ For discussion of delivery versus payment settlement 
operations, see Bank for International Settlements, ``Delivery 
versus Payment in Securities Settlement Systems,'' Sept. 1992, p. 1 
at https://www.bis.org/cpmi/publ/d06.pdf.
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed application of 
the rule to advisers with discretionary authority, along with the 
continuing application of the rule more generally, including the 
following items.
    8. Should the proposal generally retain the current rule's 
definition of custody? The proposed rule would generally retain the 
three categories that serve as examples of custody in the current rule: 
physical possession, certain arrangements when the adviser is 
authorized or permitted to withdraw or transfer beneficial ownership of 
client assets upon the adviser's instructions, and circumstances when 
the adviser acts in certain capacities. Should the proposed rule change 
the current definition of custody from these three categories? What 
should the proposal provide alternatively?
    9. Should the rule apply to when an adviser has discretionary 
authority over client assets, as proposed? Are there provisions of the 
proposed rule that should or should not apply to advisers who have 
custody because they have discretionary authority?
    10. Do advisers with discretionary authority over a client's assets 
(regardless of settlement method) currently have safeguards in place 
that effectively limit the risks to clients of loss, misuse, theft, 
or--in particular--misappropriation? If so, what are they? Do these 
safeguards differ depending on whether the arrangement involves a 
qualified custodian?
    11. When a trade settles in a manner that is not DVP, are there 
controls that are or could be established in the event one leg of the 
trade does not complete? If so, how commonly are such controls 
utilized? Are there circumstances when such controls could not be 
established or implemented? Should we require controls or policies and 
procedures for advisers and/or the respective custodians in these 
circumstances?
    12. Should the definition of custody contain an exception (or 
should we interpret the definition of custody not to include) when the 
adviser has authority to instruct the client's custodian to remit 
assets from the custodial account to the client at his or her mailing 
address of record? If so, should such an exception or interpretation be 
subject to any conditions? For example, should the client be required 
to grant the adviser this authority in writing to the qualified 
custodian? Should an exception or interpretation also be conditioned on 
the adviser lacking authority to open an account on behalf

[[Page 14681]]

of the client? Should the adviser also lack authority to designate or 
change the client's mailing address of record with the qualified 
custodian, or if the adviser has this authority, would it be sufficient 
protection for the adviser to have a reasonable belief that the 
custodian would send a notice of any change of mailing address to the 
client at the client's old address of record upon receiving the request 
from the adviser to change the mailing address? \74\ For example, 
broker-dealers must send a customer who is a natural person a 
notification of a change of mailing address to the customer's old 
mailing address.\75\ Similarly, banks that follow guidance issued by 
banking regulators send confirmation of a customer request for a change 
of mailing address to both the old and new address on record.\76\ Is 
there adequate protection when the custodian is subject to these 
regulatory requirements because the adviser would be unable to remit 
its client's assets to the client at a mailing address other than the 
client's address of record at the custodian? Alternatively, should such 
an exception or interpretation hinge on whether advisers design 
policies and procedures under rule 206(4)-7 (the ``Compliance Rule'') 
that address the risk to clients of remitting client investments to 
non-clients?
---------------------------------------------------------------------------

    \74\ We note that the staff has issued an FAQ on this topic. See 
Custody Rule FAQs, supra footnote 17, at FAQ II.5.A. and B.
    \75\ Exchange Act Rule 17a-3(a)(17)(i)(B)(2).
    \76\ See, e.g., Federal Reserve System Supervisory Letter SR 0-
11 (Apr. 26, 2001), Office of Comptroller of the Currency (``OCC'') 
Advisory Letter 2001-4 (Apr. 30, 2001), Federal Deposit Insurance 
Corporation Financial Institution Letter 39-2001 (May 9, 2001), 
Office of Thrift Supervision CEO Letter No. 139 (May 4, 2001), and 
National Credit Union Administration Letter No. 01-CU-09 (Sept. 
2001).
---------------------------------------------------------------------------

    13. Should we make clear that an adviser is subject to the custody 
rule and would also be subject to the proposed rule with respect to its 
client's assets that are held, or accessible, by a related carrying 
broker or executed through a related introducing broker? \77\ 
Conversely, should we make clear that an adviser would not be subject 
to the rule solely due to its related person acting as the trustee of a 
participant-directed defined contribution plan established for the 
benefit of the adviser's employees, provided the adviser does not 
provide investment advisory services to the plan or any investment 
option available under the plan? \78\ Similarly, should we clarify the 
meaning of ``in connection with advisory services'' in the context of 
related person custody? \79\ For example, should we make clear that 
where an adviser's client has a bank account with a bank that is the 
adviser's related person, but does not use the bank account in 
connection with the adviser's advisory activity, we would not view the 
bank's authority to be ``in connection with advisory services'' that 
the adviser provides to its client and that the rule, therefore, would 
not apply?
---------------------------------------------------------------------------

    \77\ We note that the staff has issued an FAQ on this topic. See 
Custody Rule FAQs, supra footnote 17, at Question XIV.2-3. See also 
section II.J, infra.
    \78\ We note that the staff has issued an FAQ on this topic. Our 
staff has stated that it would not consider an adviser to have 
custody where the investment adviser and the related person trustee 
are, to the extent applicable, in compliance with the Employee 
Retirement Income Security Act of 1974 (ERISA) and rules and 
regulations issued thereunder with respect to the plan. See Custody 
Rule FAQs, supra footnote 17, Question XII.1.
    \79\ See proposed rule section 223-1(d)(3).
---------------------------------------------------------------------------

    14. Advisers that act as trustee of a trust would have custody of 
that trust's assets under the proposed rule. Should we adopt an 
exception from the definition of custody for (or should we interpret 
the definition of custody not to include) cases where an adviser acts 
as co-trustee of a trust and no single co-trustee is able to effect any 
change in control of the beneficial ownership of the trust's 
investments without the prior written consent of a co-trustee(s) that 
is not a related person? \80\ In what circumstances is a co-trustee 
required either by law or the trust instrument to protect the trust 
beneficiaries from the actions of a single trustee acting alone? 
Similarly, should we adopt an exception in (or should we interpret the 
definition of custody not to include) circumstances where an adviser 
has the ability or authority to effect a change in beneficial ownership 
of a trust's investments, where an adviser is co-trustee along with the 
grantor of a revocable grantor trust, and the adviser is prohibited by 
the trust instrument or by law from withdrawing any investments from 
the trust without the prior written consent of all of its co-trustees? 
\81\
---------------------------------------------------------------------------

    \80\ We note that the staff has issued an FAQ on this topic. See 
Custody Rule FAQs, supra footnote 17, at Question XII.2.
    \81\ We note that the staff has issued an FAQ on this topic. See 
Custody Rule FAQs, supra footnote 17, Question XII.3. See also, 2003 
Adopting Release, supra footnote 2 at note 15 (stating that the 
Commission would not view the adviser to have custody of the funds 
or securities of the estate, conservatorship, or trust solely 
because the supervised person has been appointed in these capacities 
as a result of family or personal relationship with the decedent, 
beneficiary or grantor (and not a result of employment with the 
adviser)).
---------------------------------------------------------------------------

    15. An adviser would have custody under the proposed rule when it 
comes into possession of client assets. The rule contains an exception 
from the definition of custody for possession of client assets when the 
adviser receives them inadvertently and returns them to the sender 
within three business days. Should we amend the exception to 
accommodate (or interpret the definition of custody not to include) 
other situations in which the adviser inadvertently receives client 
assets? \82\ For example, should such an exception or interpretation be 
conditioned such that the adviser return the client's assets to the 
sender or forward them to the client or the client's custodian within 
five days of receipt? Should such an exception or interpretation be 
available only when client assets are received from senders, such as 
those identified in staff statements? Rather than specify senders in 
such an exception, should the exception or interpretation be available 
when an adviser determines it would be unfeasible to return the assets, 
or when there is a risk that the client's assets could be lost if the 
adviser attempted to return them to the sender? Should such an 
exception or interpretation be available only if the investment 
adviser's receipt of its client's assets is inadvertent? Should we 
condition such an exception or interpretation on recordkeeping 
requirements under proposed rule 204-2 or on whether advisers design 
policies and procedures under rule 206(4)-7? We understand that for 
certain private fund advisers and trustees it is difficult to avoid 
temporarily possessing client checks and physical assets because there 
may not be an independent representative to arrange the movement of 
such assets into a qualified custodian. Are there any particularities 
to these contexts that would benefit from an exception or 
interpretation? In addition, are there other circumstances that involve 
checks written to third parties, checks written to clients, and checks 
written to advisers where the adviser has no authority to deposit 
client assets into any account other than directed by the client that 
would benefit from exceptions or interpretations? Are there certain 
policies and procedures maintained by advisers that mitigate the 
custody risks associated with receiving checks that may be beneficial 
to include in this rulemaking? For example, if the adviser has policies 
and procedures reasonably designed to maintain such

[[Page 14682]]

assets with a qualified custodian, should we provide an exception if an 
adviser to a private fund or serving as a trustee would not be subject 
to the rule for the brief handling of client checks or physical assets?
---------------------------------------------------------------------------

    \82\ We note that the staff has issued a no-action letter on 
this topic. The Commission's staff has stated that when advisers 
infrequently receive specific types of client funds or securities 
from a list of enumerated third parties that the staff identified, 
the staff would not recommend enforcement for violation of the 
current custody rule if the adviser meets specified conditions. See 
Investment Adviser Association, SEC Staff No-Action Letter (Sep. 20, 
2007) (``2007 IAA No-Action Letter''). See also Custody Rule FAQs, 
supra footnote 17, at Question II.1.
---------------------------------------------------------------------------

    16. Should we include an exception from the rule for assets for 
which the adviser provides advice in certain sub-adviser relationships, 
such as was described in our staff's statements? \83\ In what 
circumstances should such an exception apply? Would an exception 
designed to capture circumstances where the proposed rule would apply 
to the sub-adviser only because its related person triggers the rule 
with respect to the same advisory clients be beneficial? Such an 
exception could be conditioned on the related person being fully 
subject to (and in compliance with) the applicable requirements of the 
custody rule. Would such a condition to the exception work in practice? 
Should such exception be conditioned on the adviser's related person 
fully complying with the requirements of the proposed rule? If not, why 
not? If so, how would advisers determine whether their related person 
is fully complying with the rule? Are there alternative safeguards that 
commenters would suggest? Alternatively, should such sub-advisers be 
subject to all or certain requirements of the rule? If only certain 
requirements, which ones and why? Should we condition such an exception 
on recordkeeping requirements under proposed rule 204-2 or on whether 
advisers design policies and procedures under rule 206(4)-7?
---------------------------------------------------------------------------

    \83\ We note that the staff has issued a no-action letter on 
this topic. See Investment Adviser Association, SEC Staff No-Action 
Letter (Apr. 25, 2016), available at: https://www.sec.gov/divisions/investment/noaction/2016/investment-adviser-association-042516-206(4).htm.
---------------------------------------------------------------------------

    17. Are there are any other arrangements or circumstances where an 
adviser would have custody under the proposed rules but an exception 
would be beneficial and not inconsistent with the policy goals of the 
rule? For example, are there specific circumstances involving custody 
at electronic platforms, investment adviser aggregators, benefit plans, 
introducing broker-dealers, plan sponsors, record-keepers, or third 
party administrators that would benefit from an exception or 
interpretation that these arrangements constitute or do not constitute 
custody?

B. Qualified Custodian Protections

    Qualified custodians would continue to serve as key gatekeepers 
under the proposed rule. These institutions' custodial activities are 
subject to regulation and oversight.\84\ Accordingly, as under the 
current rule, investment advisers with custody of client assets would 
be required to maintain those assets with a qualified custodian.\85\ We 
are proposing several ways to strengthen the requirement, however, in 
light of the evolution of the market for custodial services, financial 
products, and advisory services over the last decade. These proposed 
changes aim to provide investors with certain standard custodial 
protections that will improve the safeguarding of their assets in the 
current market as well as in the future as the market for financial 
products and advisory services continues to evolve.
---------------------------------------------------------------------------

    \84\ 2002 Proposing Release, supra footnote 2, at n. 30; 2009 
Proposing Release, supra footnote 11, at n. 4.
    \85\ Proposed rule 223-1(a)(1)(i). The proposed rule would 
provide an exception, and another means of compliance with the rule, 
for certain assets that are unable to be maintained with a qualified 
custodian. See proposed rule 223-1(b)(2).
---------------------------------------------------------------------------

    The proposed rule would continue to allow banks or savings 
associations, registered broker-dealers, registered futures commission 
merchants, and certain foreign financial institutions to act as 
qualified custodians, but, in a change from the current rule, only if 
they have ``possession or control'' of client assets pursuant to a 
written agreement between the qualified custodian and the investment 
adviser.\86\ Also in a change from the current rule, the proposed rule 
would modify the definition of foreign financial institution and 
requirements for banks and savings associations in the definition of 
qualified custodian.\87\ In the case of a qualified custodian that is 
the adviser, the proposed rule would require that the written agreement 
be between the adviser and the client.
---------------------------------------------------------------------------

    \86\ See proposed rule 223-1(a)(1).
    \87\ See proposed rule 223-1(d)(10)(i) and (iv); section 
II.B.1.b, infra.
---------------------------------------------------------------------------

    The proposed rule would require that the written agreement contain 
contractual provisions that we believe are critical to providing 
important protections for advisory client assets. As discussed in 
further detail below, the contractual terms would address 
recordkeeping, client account statements, internal control reports, and 
the adviser's agreed-upon level of authority to effect transactions in 
the account. In addition, the proposed 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, including with respect to the qualified 
custodian's standard of care, indemnification, limitation of liability 
for sub-custodial services, segregation of client assets, and 
attachment of liens to client assets. Also as discussed below, we 
believe that many of these important protections are already provided--
through contract or practice--by certain custodians to certain 
custodial customers in the current market. However, the proposed rule 
is designed to expand and formalize the minimum 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. We believe that the proposed rule 
leverages the expertise and regulatory regimes of qualified custodians 
with respect to a wide range of assets, while, at the same time, 
tailoring and bolstering the protections afforded to advisory clients 
to improve the safeguarding of client assets over which advisers have 
custody.
1. Definition of Qualified Custodian
    Qualified custodians under the proposed rule would include the 
types of financial institutions that clients and advisers customarily 
turn to for custodial services and that have in place practices that 
are designed to protect custodial assets. We continue to believe that 
the use of a qualified custodian would enhance the protections afforded 
to client assets.\88\
---------------------------------------------------------------------------

    \88\ See 2003 Adopting Release, supra footnote 2; 2009 Adopting 
Release, supra footnote 11.
---------------------------------------------------------------------------

    The proposed rule, like the current rule, would define the term 
``qualified custodian'' to mean a bank or savings association, 
registered broker-dealer, registered futures commission merchant 
(``FCM''), or certain type of foreign financial institution (``FFI'') 
that meets the specified conditions and requirements.\89\ We continue 
to believe that these financial institutions should be permitted to act 
as qualified custodians because, as discussed in more detail below, 
they operate under regular government oversight, are subjected to 
periodic inspection and examination, have familiarity with providing 
custodial services, and are in a position to attest to custodial 
customer holdings and transactions \90\--all critical

[[Page 14683]]

components of safeguarding client assets under the proposed rule. As a 
result, with the exception of proposed amendments to the definition of 
qualified custodian relating to banks, savings associations, and FFIs, 
we are not changing the types of institutions that may serve as 
qualified custodians under the rule.\91\
---------------------------------------------------------------------------

    \89\ Proposed rule 223-1(d)(10). Not all registered broker-
dealers and registered FCMs meet the definition of qualified 
custodian under the custody rule or the proposed safeguarding rule. 
Notably, only those broker-dealers or FCMs holding client assets in 
customer accounts meet this definition. This would include the 
broker-dealers subject to the customer protection rule (Exchange Act 
Rule 15c3-3) and FCMs holding futures customers funds subject to 17 
CFR 1.20.
    \90\ See, e.g., 2009 Adopting Release, supra footnote 11, at 
section I (describing qualified custodians under the rule as the 
types of financial institutions to which clients and advisers 
customarily turn for custodial services and as subject to regulation 
and oversight).
    \91\ We remind advisers that as additional financial 
institutions become available to custody assets, advisers must 
continue to exercise their fiduciary duties to clients in connection 
with selection and monitoring of the qualified custodian. See, e.g., 
Standard of Conduct for Investment Advisers Release, supra note 57, 
at section II (``The investment adviser's fiduciary duty is broad 
and applies to the entire adviser-client relationship.'') (citations 
omitted).
---------------------------------------------------------------------------

a. Bank and Savings Association Qualified Custodian Proposed Amendments
    The current rule includes in the definition of qualified custodian 
a bank as defined in section 202(a)(2) of the Advisers Act (15 U.S.C. 
80b-2(a)(2)) or a savings association as defined in section 3(b)(1) of 
the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has 
deposits insured by the Federal Deposit Insurance Corporation under the 
Federal Deposit Insurance Act (12 U.S.C. 1811). The proposed rule would 
largely retain this definition of qualified custodian relating to banks 
and savings associations. However, in connection with the proposed 
rule's focus on setting certain minimum protections for client assets, 
the rule would require that a qualifying bank or savings association 
hold client assets in an account that is designed to protect such 
assets from creditors of the bank or savings association in the event 
of the insolvency or failure of the bank or savings association (i.e., 
an account in which client assets are easily identifiable and clearly 
segregated from the bank's assets) in order to qualify as a qualified 
custodian. We believe that requiring banks and savings associations to 
hold client assets in such an account brings the requirements for bank 
and savings association qualified custodians in line with the 
protections required for broker-dealers, FCMs, and FFIs acting as 
qualified custodians under the current custody rule and under the 
proposed safeguarding rule.\92\
---------------------------------------------------------------------------

    \92\ The current custody rule requires that in order to be 
included in the definition of qualified custodian, a broker-dealer 
registered under section 15(b)(1) of the Securities Exchange Act of 
1934 (15 U.S.C. 78o(b)(1)), must hold the client assets in customer 
accounts, a futures commission merchant registered under section 
4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)) must hold the 
client assets in customer accounts subject to certain additional 
requirements, and an FFI must customarily hold financial assets for 
its customers and must keep the advisory clients' assets in customer 
accounts segregated from its proprietary assets. See rule 206(4)-
2(d)(6)(ii), (iii), and (iv). See also proposed rule 223-1(d)(10).
---------------------------------------------------------------------------

    We believe that the proposed account requirement would improve the 
safeguarding of client assets. We understand that, generally, a bank 
deposit account creates a debtor-creditor relationship between the bank 
and depositor.\93\ This debtor-creditor relationship typically does not 
create a special or fiduciary relationship.\94\ While applicable 
insolvency law and procedures vary depending on any particular bank or 
savings association's regulatory regime,\95\ we understand that assets 
held in accounts of the type proposed by the rule are more likely to be 
returned to clients upon the insolvency of the qualified custodian 
because they may pass outside of a bank's insolvency, may be 
recoverable if wrongly transferred or converted, and are not treated as 
general assets of the bank.\96\
---------------------------------------------------------------------------

    \93\ See generally, Graham, Heitz, Lapine, et al., 6a Banking 
Law section 134.05 (2022) section 134.05 (collecting cases) 
(``Banking Law''). We understand that a deposit in a bank is either 
general or special and that a deposit is a general deposit unless 
there is an agreement or understanding that it should be special. 
See 5C Michie on Banks and Banking, Deposits section 339 (Sept. 
2022) (collecting cases) (``Michie on Banks & Banking''); Banking 
Law, section 134.05 (``Accounts are either special accounts or 
general accounts.'') (collecting cases).
    \94\ Id.
    \95\ See 3 Michie on Banks & Banking, Insolvency and 
Dissolution. section 17. Jurisdiction and Powers of Courts and 
Officials in General (discussing state-by state jurisdiction and 
certain regulatory powers).
    \96\ See Michie on Banks & Banking, Deposits section 339 
(collecting cases under a wide variety of state laws where a bank 
may be acting as a trustee, bailee, or agent in connection with a 
customer account that is treated as other than a general deposit 
account).
---------------------------------------------------------------------------

    We believe that the proposed rule would provide flexibility to 
banks and savings associations to use the appropriate accounts 
available to them under applicable law and offered by them to 
customers. Rather than consider the treatment of custodial customer 
assets upon a bank's failure in all 50 states, and risk the protections 
of our rule eroding if state banking law protections vary or evolve, we 
are proposing to establish a consistent and uniform standard to protect 
all advisory clients. The account terms should identify clearly that 
the account is distinguishable from a general deposit account and 
clarify the nature of the relationship between the account holder and 
the qualified custodian as a relationship account that protects the 
client assets from creditors of the bank or savings association in the 
event of the insolvency or failure of the bank or savings association.
b. Proposed Enhancements to Definition of Foreign Financial Institution
    Advisory clients often invest in assets traded on foreign exchanges 
and their advisers must, as a practical matter, maintain those assets 
with financial institutions in foreign countries where the assets are 
traded. In order to facilitate these types of holdings, the current 
rule includes FFIs that customarily hold financial assets for their 
customers, as qualified custodians, provided that the FFI keeps the 
advisory clients' assets in customer accounts segregated from the FFI's 
proprietary assets.\97\
---------------------------------------------------------------------------

    \97\ See rule 206(4)-2(d)(6)(iv). Under the current rule, when 
an adviser selects an FFI to hold clients' assets, we believe the 
adviser's fiduciary obligations require it either to have a 
reasonable basis for believing that the FFI satisfies the conditions 
and would provide a level of safety for client assets similar to 
that which would be provided by a ``qualified custodian'' in the 
United States or to disclose fully to clients any material risks 
attendant to maintaining the assets with the foreign custodian. See 
2003 Adopting Release, supra footnote 2, at note 22.
---------------------------------------------------------------------------

    We are proposing to require that an FFI satisfy seven new 
conditions in order to serve as a qualified custodian for client assets 
under the proposed rule.\98\ These proposed conditions are partly drawn 
from our experience with the factors relevant to the safekeeping of 
``Foreign Assets'' by the types of foreign financial entities that can 
act as an ``Eligible Foreign Custodian'' as defined in rule 17f-5 under 
the Investment Company Act.\99\ Such conditions are also designed to 
address our understanding of market developments since the adoption of 
rule 17f-5 by providing enhanced investor protections for advisory 
clients and their assets that

[[Page 14684]]

we believe would help promote an FFI having generally similar 
protections as a U.S.-based qualified custodian. Recent events in 
crypto assets markets also have highlighted the need for similarly 
enhanced custody safeguards of client assets held outside the United 
States.
---------------------------------------------------------------------------

    \98\ We also propose to eliminate the requirement under the 
current definition that the FFI keeps the advisory clients' assets 
in customer accounts segregated from its proprietary assets because 
the proposed rule, more broadly, would require advisers to obtain 
reasonable assurances from qualified custodians that all advisory 
client assets are segregated from the qualified custodian's 
proprietary assets and liabilities. See proposed rule 223-
1(a)(1)(ii)(D).
    \99\ Rule 17f-5 under the Investment Company Act defines an 
Eligible Foreign Custodian as an entity that is incorporated or 
organized under the laws of a country other than the United States 
and that is a Qualified Foreign Bank or a majority-owned direct or 
indirect subsidiary of a U.S. Bank or bank-holding company. For 
these purposes, a Qualified Foreign Bank is defined as a banking 
institution or trust company, incorporated or organized under the 
laws of a country other than the United States, that is regulated as 
such by the country's government or an agency of the country's 
government. See 17 CFR 270.17f-5(a)(1) and (a)(5). Rule 17f-5(c)(1) 
under the Investment Company Act lists the factors relevant to the 
safekeeping of Foreign Assets, as defined in rule 17f-5(a)(2). See 
17 CFR 270.17f-5(c)(1) and (a)(2).
---------------------------------------------------------------------------

    For an FFI to be a qualified custodian under the proposed rule, it 
would need to be:
     Incorporated or organized under the laws of a country or 
jurisdiction other than the United States, provided that the adviser 
and the Commission are able to enforce judgments, including civil 
monetary penalties, against the FFI;
     Regulated by a foreign country's government, an agency of 
a foreign country's government, or a foreign financial regulatory 
authority \100\ as a banking institution, trust company, or other 
financial institution that customarily holds financial assets for its 
customers;
---------------------------------------------------------------------------

    \100\ Defined in section 202(a)(24) of the Advisers Act [15 
U.S.C. 80b-2(a)(24)].
---------------------------------------------------------------------------

     Required by law to comply with anti-money laundering and 
related provisions similar to those of the Bank Secrecy Act [31 U.S.C. 
5311, et seq.] and regulations thereunder;
     Holding financial assets for its customers in an account 
designed to protect such assets from creditors of the foreign financial 
institution in the event of the insolvency or failure of the foreign 
financial institution;
     Having the requisite financial strength to provide due 
care for client assets;
     Required by law to implement practices, procedures, and 
internal controls designed to ensure the exercise of due care with 
respect to the safekeeping of client assets; and
     Not operated for the purpose of evading the provisions of 
the proposed rule.\101\
---------------------------------------------------------------------------

    \101\ Proposed rule 223-1(d)(10)(iv).
---------------------------------------------------------------------------

    We believe each of these proposed new conditions would enhance the 
ability and responsibility of advisers to protect client assets 
maintained outside the United States for the following reasons.
    Regarding the first condition, we are proposing to require the 
adviser to determine that the adviser and the Commission are able to 
enforce judgments, including civil monetary penalties, against the FFI. 
The FFI could satisfy this condition by such means as appointing an 
agent for service of process in the United States or having offices in 
the United States, and the adviser can request the relevant 
documentation for verification purposes. This condition would thus 
limit the types of foreign financial entities to those that are subject 
to or consent to U.S. jurisdiction.
    Regarding the second condition, we believe requiring an FFI be 
regulated by a foreign country's government, an agency of a foreign 
country's government, or a foreign financial regulatory authority, as 
defined in section 202(a)(24) of the Advisers Act, would help ensure 
that client assets maintained with an FFI are subject to regulatory 
oversight that would better serve our policy goal of protecting 
custodial assets by the use of qualified custodians that meet our 
proposed requirements. In addition to banking institutions and trust 
companies, we would permit foreign-regulated financial institutions who 
customarily hold financial assets for their customers (e.g., the 
foreign equivalent of broker-dealers or FCMs) to serve as ``qualified 
custodians.''
    We believe the requirement in the third condition for an FFI to 
comply with anti-money laundering (``AML'') and related provisions 
similar to those of the Bank Secrecy Act (``BSA'') and regulations 
thereunder would help increase the likelihood that the FFI would 
readily identify and investigate aberrant behavior in a client account, 
such as activity that might suggest misappropriation or some other type 
of loss to a client. We generally believe an FFI would be able to 
satisfy this condition if it is required to comply with the laws and 
regulations established by a member or observer jurisdiction of the 
Financial Action Task Force (``FATF'') and not otherwise listed on any 
sanctions list administered by the Office of Foreign Assets Control of 
the U.S. Department of the Treasury (``OFAC''),\102\ or on any special 
measures list administered by the Financial Crimes Enforcement Network 
of the U.S. Department of the Treasury (FinCEN'').\103\
---------------------------------------------------------------------------

    \102\ The FATF is an inter-governmental body whose purpose is 
the development and promotion of policies, both at the national and 
international levels, to combat money laundering and the financing 
of terrorism and proliferation. The FATF monitors members' progress 
in implementing AML measures, reviews money laundering techniques 
and counter-measures, and promotes the adoption and implementation 
of AML measures globally. See https://www.fatf-gafi.org/en/the-fatf/what-we-do.html/. To search sanctions lists administered by OFAC, 
such as the Specially Designated Nationals and Blocked Persons list, 
see https://sanctionssearch.ofac.treas.gov.
    \103\ See section 311 of the USA PATRIOT Act [Pub. L. 107-56] 
(granting the Secretary of the Treasury the authority to conclude, 
if reasonable grounds exist, that a foreign jurisdiction, foreign 
financial institution, or an international transaction or account is 
of ``primary money laundering concern,'' and to require domestic 
financial institutions and financial agencies to take certain 
``special measures,'' such as additional due diligence and special 
attention to particular account transactions, among other measures, 
against the designated entity).
---------------------------------------------------------------------------

    The fourth condition would replace and strengthen the segregation 
requirement for FFIs in the current definition of qualified custodian 
in the custody rule, and it is designed to complement the proposed 
segregation requirements of the safeguarding rule. In the current rule, 
an FFI that customarily holds financial assets for its customers is 
permitted to serve as a qualified custodian, provided that the FFI 
keeps the advisory clients' assets in customer accounts segregated from 
its proprietary assets. The proposed new condition would require the 
FFI to hold financial assets for its customers in accounts designed to 
protect such assets from creditors of the FFI in the event of the 
insolvency or failure of the FFI.\104\ This condition would thereby 
impose investor protections, particularly in the event of an FFI 
insolvency or bankruptcy, that are more comparable to those we are 
proposing for assets held with U.S.-regulated bank or savings 
association qualified custodians. We believe advisers would be able to 
assess whether an FFI is holding client assets in such accounts in the 
course of obtaining the reasonable assurances we are proposing to 
require advisers obtain from all qualified custodians, which are 
discussed more fully below.\105\
---------------------------------------------------------------------------

    \104\ Compare rule 204-2(d)(6)(iv) with proposed rule 223-
1(d)(10)(iv)(D).
    \105\ See infra section II.B.3.a.iv (discussing the adviser's 
requirement to obtain reasonable assurances from qualified 
custodians regarding the required account segregation requirements).
---------------------------------------------------------------------------

    The fifth condition is designed to limit the types of FFIs that can 
serve as qualified custodians to those that have the requisite 
financial strength to meet the proposed due care standard for client 
assets. We believe the determination of an FFI's financial strength 
could be based on objective measures and other indicators of financial 
health that are reasonably comparable to those that apply to U.S. banks 
and other regulated financial institutions.\106\ Given that advisers 
would be required to maintain an ongoing reasonable belief that the FFI 
qualified custodian is meeting its due

[[Page 14685]]

care standard, advisers also could require notifications from the FFI 
of any changes, including changes in the financial strength of the FFI, 
that would have an impact on the agreed terms of the written custodial 
contract. Such notifications may provide timely information to help 
advisers, as fiduciaries, to react and respond to emerging risks of 
loss of client assets.
---------------------------------------------------------------------------

    \106\ When the Commission adopted amendments to rule 17f-5 (17 
CFR 270.17f-5) in 1997, its adopting release offered guidance to 
evaluate financial strength by ``assess[ing] the adequacy of the 
custodian's capital with a view of protecting the fund against the 
risk of loss from a custodian's insolvency.'' See Custody of 
Investment Company Assets Outside the United States, Investment 
Company Act Release No. 22658 (May 12, 1997) [62 FR 26923 (May 16, 
1997)], at 26928. We understand that relevant governments and their 
banking regulators typically set regulatory capital requirements for 
foreign banking institutions.
---------------------------------------------------------------------------

    Under the sixth condition, FFI qualified custodians would be 
required by law to implement practices, procedures, and internal 
controls designed to ensure the exercise of due care with respect to 
the safekeeping of assets. Since FFIs are subject to a broad range of 
regulatory regimes, we believe this condition would help promote a 
minimum level of practices, procedures, and internal controls across 
qualified custodians for safekeeping client assets under the proposed 
rule, regardless of where and how they are held. Further, we believe 
this requirement will help to ensure that an FFI's practices, 
procedures, and internal controls, including, but not limited to, those 
with respect to the safekeeping of certificated and uncertificated 
assets, custodial recordkeeping, and security and data protection, 
should not differ in material ways from those of U.S.-regulated 
qualified custodians. Similar to the fourth condition, advisers should 
be able to assess and evaluate an FFI's internal controls while 
obtaining the reasonable assurances we are proposing advisers obtain 
from all qualified custodians.\107\
---------------------------------------------------------------------------

    \107\ See infra section II.B.3.a.i (discussing the adviser's 
requirement to obtain reasonable assurances from a qualified 
custodian regarding the qualified custodian's required exercise of 
due care and implementation of appropriate measures to safeguard 
client assets from theft, misuse, misappropriation, or other similar 
type of loss).
---------------------------------------------------------------------------

    Finally, we have included an anti-evasion requirement in the 
seventh condition for FFI qualified custodians that is similar to the 
anti-evasion provision currently in the definition of ``bank'' under 
section 202(a)(2) of the Advisers Act and in the definition of ``U.S. 
Bank'' under rule 17f-5 of the Investment Company Act.\108\ Given the 
broad scope of foreign financial entities that we would permit to serve 
as qualified custodians, we believe it is appropriate to apply the 
anti-evasion requirement to all types of FFIs, rather than limiting its 
application to only banking institutions or trust companies.
---------------------------------------------------------------------------

    \108\ 17 CFR 270.17f-5(a)(7)(iii).
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed rule's qualified 
custodian requirement, including the following items.
    18. Should we continue to require that client assets be maintained 
with qualified custodians? If not, what alternative protections for 
client assets should we require as part of the rule?
    19. Should the rule continue to include banks as defined in section 
202(a)(2) of the Advisers Act or savings associations as defined in 
section 3(b)(1) of the Federal Deposit Insurance Act as qualified 
custodians, as proposed? Should the rule narrow the definition to 
include only certain banks and savings associations as qualified 
custodians? If so, how? For example, should the rule permit only banks 
or savings associations that are subject to Federal regulation and 
supervision to act as qualified custodians? Alternatively, should the 
rule permit only state banks and savings association that are members 
of the Federal Reserve System to act as qualified custodians? \109\ 
Would narrowing of the types of banks and savings associations that 
meet the definition of qualified custodian provide additional 
protections to advisory clients in the event of the custodian's 
insolvency? Is there another way to achieve our policy goal?
---------------------------------------------------------------------------

    \109\ See generally Membership of State Banking Institutions in 
the Federal Reserve System (Regulation H) 12 CFR 208.01 et. seq.
---------------------------------------------------------------------------

    20. Should we require banks and savings associations to hold client 
assets in an account designed to protect such assets from creditors of 
the bank or savings association in the event of the insolvency or 
failure of the bank or savings association as proposed? Is our 
understanding correct that requiring banks and savings associations to 
hold client assets in an account of this type would provide client 
assets with enhanced protection from general creditors in the event of 
the qualified custodian's insolvency and increase the likelihood of 
return of client assets to advisory clients upon a qualified 
custodian's insolvency? Do commenters agree with our view that this 
enhanced protection is especially important in light of the broad range 
of regulatory regimes and insolvency processes to which a growing 
number of state-chartered trust companies and other state-chartered, 
limited purpose banking entities entering the custodial market may be 
subject?
    21. Should the rule require the account terms to identify clearly 
that the account is distinguishable from a general deposit account? 
Should the rule require the terms of the account clarify the nature of 
the relationship between the account holder and the qualified 
custodian, for example, whether the account is a special account,\110\ 
a fiduciary account,\111\ or whether the bank or savings association is 
acting as a trustee, a bailee, or agent of the account holder?
---------------------------------------------------------------------------

    \110\ See, e.g., Bank of America, N.A. v. Lehman Bros. Holdings, 
Inc. (In re Lehman Bros. Holdings, Inc.), 439 B.R. 811, 824-825 
(Bankr. S.D.N.Y. Nov. 16, 2010) (``Other factors that courts have 
examined to ascertain the parties' mutual intent [to create a 
special rather than general account] include: (1) whether the 
parties agreed to segregate the funds; (2) whether the bank paid 
interest on the funds; (3) whether the depositor lacked an 
unfettered right to withdraw the funds; and (4) whether a third 
party possessed an interest in the funds.'').
    \111\ See, e.g., 12 CFR 9.13 and 12 CFR 150.230 (addressing 
custody of fiduciary assets for banks and savings associations, 
respectively).
---------------------------------------------------------------------------

    22. Would requiring banks and savings associations to hold client 
assets in an account designed to protect such assets from creditors of 
the bank or savings association in the event of the insolvency or 
failure of the bank or savings association reduce the availability of 
banks or savings associations that could offer services as a qualified 
custodian? Would it increase costs to advisory clients?
    23. Rather than requiring accounts of this type for all banks and 
savings associations, should the rule require accounts that protect 
client assets from creditors of a bank or savings association in the 
event of the insolvency or failure of the bank or savings association 
for a subset of these institutions that are not federally insured or 
OCC member banks? For example, should the rule require accounts of this 
type for state banks that are not members of the Federal Reserve 
System?
    24. Are there alternative bank and savings association account 
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,

[[Page 14686]]

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?
---------------------------------------------------------------------------

    \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)].
---------------------------------------------------------------------------

    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?
---------------------------------------------------------------------------

    \113\ See 17 CFR 270.17f-5(c)(1)((iv).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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

[[Page 14687]]

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).
---------------------------------------------------------------------------

    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?
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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

[[Page 14688]]

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.'').

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

[[Page 14689]]

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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

[[Page 14690]]

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?
---------------------------------------------------------------------------

    \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.'').
---------------------------------------------------------------------------

    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?
---------------------------------------------------------------------------

    \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/.
---------------------------------------------------------------------------

    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

[[Page 14691]]

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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.'').
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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

[[Page 14692]]

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).
---------------------------------------------------------------------------

    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:
---------------------------------------------------------------------------

    \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

[[Page 14693]]

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\
---------------------------------------------------------------------------

    \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.'').
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

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

[[Page 14694]]

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \160\ Proposed rule 223-1(a)(1)(ii)(B).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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'').
---------------------------------------------------------------------------

    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,

[[Page 14695]]

can be attributed to a sub-custodian or other third party selected by 
the qualified custodian.
---------------------------------------------------------------------------

    \164\ Proposed rule 223-1(a)(1)(ii)(C).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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

[[Page 14696]]

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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'').
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    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.'').
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

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

[[Page 14697]]

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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).

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

[[Page 14698]]

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \193\ See Accounting Guidance, supra footnote 188, at section 
III.
    \194\ See rule 206(4)-2(a)(6)(ii).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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)].
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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

[[Page 14699]]

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.
---------------------------------------------------------------------------

    \200\ Proposed rule 223-1(a)(1)(i)(C)(1).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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?

[[Page 14700]]

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?
    60. Should the proposed rule include the reasonable assurances 
requirement requiring the qualified custodian to provide indemnity and 
have insurance arrangements in place to adequately protect its clients? 
Should the rule include additional safeguards regarding the 
indemnification requirement, such as stating that insurance proceeds 
will be solely for the benefit of the client, and will not be 
considered an asset of anyone other than the client? Should the rule 
include any safeguards around the type of insurance a qualified 
custodian could maintain for those indemnification purposes? If yes, 
what types of safeguards should be imposed? For example, should the 
insurance company be of a certain type or hold a certain qualification 
or rating? What alternatives should we require to achieve our policy 
goals? Are there any particular challenges for FFIs meeting this 
requirement? If so, what are they?
    61. Should the proposed rule include the reasonable assurances 
requirement 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? Would that requirement help ensure that a qualified 
custodian could not avoid responsibility for the other important 
safeguarding obligations it owes to the client by delegating custodial 
responsibility to a sub-custodian or other responsibilities to other 
third parties? Would the requirement provide additional protections for 
clients when an adviser has custody of client assets and further the 
policy goals of the rule?
    62. Should the rule include the proposed reasonable assurances of 
segregation of client assets requirements? Are these requirements 
sufficiently clear?
    63. Would the proposed reasonable assurances of segregation of 
client assets requirements impose appropriate limitations to safeguard 
client assets? Should we eliminate or modify any of them? 
Alternatively, are there other limitations that would be appropriate?
    64. Would the proposed reasonable assurance of segregation of 
client assets requirement increase the likelihood that client assets 
will be available to be returned to clients if a qualified custodian 
experiences financial events such as insolvency or bankruptcy? For 
example, do commenters believe the requirements would help ensure that 
client assets are more readily identifiable as client property?
    65. Should certain assets be excluded from these reasonable 
assurances of segregation of client assets requirements? If so, which 
assets and why? Would limiting these requirements to certain types of 
assets present compliance challenges? If so, which assets and why?
    66. In particular, would the proposed reasonable assurances of 
segregation of client assets requirement present challenges with 
respect to crypto assets? Should we address crypto asset segregation 
and/or custody with separate requirements? Do crypto assets raise 
specific segregation issues not presented by other assets? If so, what 
are they and why? Would the proposed requirements offer substantial 
protections in the event of a bankruptcy or financial losses involving 
a custodian with custody of crypto assets? Would the proposed 
reasonable assurances of segregation of client assets requirement 
present challenges with respect to other types of assets?
    67. Does the proposed reasonable assurance of segregation 
requirement guard against loss, misappropriation, misuse, theft, and 
the risk of client assets being subject to creditor claims in the 
insolvency or bankruptcy of the qualified custodian, while permitting 
the flexibility that would address some of the compliance challenges 
that the current rule presents (e.g., commingling of client and non-
client assets)?
    68. Should we instead retain the custody rule's requirement to 
maintain client funds and securities with a qualified custodian in a 
separate account for each client under the client's name or in accounts 
that contain client funds and securities under the adviser's name as 
agent or trustee? If so, should any of the custody rule's requirements 
be modified in any way? If we were to retain the custody rule's 
requirement, should we expand the scope of the separate account 
requirement to assets from funds and securities?
    69. Is our understanding correct 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? Do commenters agree that this 
practice may be even more common when a qualified custodian uses a sub-
custodian to hold client assets?
    70. Should the rule require that an adviser obtain reasonable 
assurances that the qualified custodian will not commingle client and 
non-client assets, similar to the custody rule? \206\ Alternatively, 
should the rule be modified to permit the commingling of client and 
non-client assets for administrative convenience and efficiency? If so, 
what should be considered ``administrative convenience and 
efficiency''? Does allowing client and non-client assets to be 
commingled (e.g., in the same omnibus account) increase the risk that 
client assets will be lost, misused, stolen, or misappropriated? Could 
an advisory client's assets be used to satisfy the debts of someone 
else in a bankruptcy event if client and non-client assets are 
commingled?
---------------------------------------------------------------------------

    \206\ See rule 206(4)-2(a)(1)(i).
---------------------------------------------------------------------------

    71. Do commenters agree that there are circumstances when qualified 
custodians' services require them to commingle advisory client assets 
and assets of non-advisory customers? For example, when a qualified 
custodian uses sweep accounts, escrow accounts, and loan servicing 
accounts? In these circumstances, should the rule require additional 
protections? Which protections and why and would they differ depending 
on the type of commingled account?
    72. Should the rule require that an adviser obtain reasonable 
assurances from the qualified custodian regarding the sub-accounting of 
commingled accounts? Would such a requirement provide additional 
protection to client assets?
    73. Are there instances where commingling or pooling of certain 
assets by qualified custodians may occur via certain omnibus and sub-
accounting arrangements that may present compliance challenges under 
the reasonable assurances of segregation of client assets requirement? 
What are those instances and what are the challenges?
    74. Do commenters think that qualified custodians will include 
contractual segregation provisions in their custodial agreements with 
advisory clients if they do not already do so? Should the rule require 
an

[[Page 14701]]

express contractual requirement between the adviser and custodian to 
identify and segregate client investments? Would a contractual 
requirement help ensure that advisory client assets are protected?
    75. Do commenters agree with our belief that not all financial 
institutions that serve as qualified custodians, particularly FFIs, are 
currently required to segregate and identify their client investments? 
Do commenters agree that requiring an adviser to obtain reasonable 
assurances that a qualified custodian will segregate client assets from 
the custodian's proprietary assets and liabilities would be critical to 
protecting client investments in the event of a qualified custodian's 
insolvency as well as in the event of a taking by a foreign government? 
Do commenters believe there may be reluctance by some financial 
institutions to segregate client assets? Are there circumstances in 
which segregation might not be important? If so, which circumstances?
    76. Would this segregation provision present practical challenges? 
For example, would it present practical challenges in the context of 
omnibus accounts or temporary sweep accounts? Would financial 
institutions be able to satisfy the segregation provision? For example, 
we know that national banks and Federal savings associations are 
required to segregate all assets held in any fiduciary capacity from 
their general assets. Is this also true of national banks and Federal 
savings associations that hold custodial assets in a non-fiduciary 
capacity? Are there other compliance challenges that this proposed 
segregation requirement would pose? Are there circumstances in which 
qualified custodians' services require them to commingle advisory 
client assets with other assets?
    77. In the context of requiring an FFI to segregate client 
investments, do commenters believe that the reasonable assurances 
segregation requirement would help to preserve the client's interests 
in the event of a government taking?
    78. In the event of the insolvency or bankruptcy of a qualified 
custodian, do commenters agree with our understanding that the sub-
accounting of commingled accounts allows a qualified custodian to 
readily identify the rightful owner of any investment at any point in 
time? Are there any particular assets or services for which such 
identification via sub-accounting is difficult or burdensome? If so, 
what are the reasons for these difficulties?
    79. Is our approach in requiring a qualified custodian to maintain 
client assets pursuant to a written agreement between the qualified 
custodian and the investment adviser appropriate? Would the proposed 
approach provide additional protections for clients when advisers have 
custody of client assets and further the policy goals of the rule? 
Would this requirement increase costs to maintain client assets with a 
qualified custodian? Would this approach limit the pool of financial 
institutions that are able to serve as qualified custodians? Would 
financial institutions currently acting as qualified custodians exit 
the business as a result of the written agreement requirement? Do 
commenters agree that custodial practices, types of instruments 
custodians hold, and the regulatory framework to which these financial 
institutions are subject have evolved, in part to accommodate new 
entrants to the market for custodial services? Do commenters agree that 
this evolution, including new custodians and new custodial practices, 
has resulted, in at least some cases, in a general reduction in the 
level of protections offered by custodians, often resulting in advisory 
clients with the least amount of bargaining power (i.e., retail 
investors) receiving the most limited protections? Are there other 
reasons that commenters believe custodial practices have evolved to 
result in a general reduction in the level of protections offered by 
custodians? Would the proposed approach mitigate some of our concerns 
with regard to these custodial market changes?
    80. Is our belief correct 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 
contractual requirements, either to satisfy regulatory requirements or 
pursuant to their existing contracts with their clients? Do these 
qualified custodians already provide the protections that would be 
required in the proposed written agreement to every customer? Are some 
protections provided to customers more often than others? If so, which 
protections and why?
    81. Should the rule permit an adviser or its related person to be a 
qualified custodian, as under the custody rule, or should we prohibit 
the adviser or its related person from being the qualified custodian? 
Do commenters agree that an adviser or related person acting as the 
qualified custodian presents risks to client assets that are not 
present when a qualified custodian is not the adviser or a related 
person of the adviser? Do commenters agree that the proposed 
requirements in the rule, including the proposed internal control 
report requirements applicable to qualified custodians that are the 
advisers or a related person, would help to reduce those risks? If the 
rule prohibits the adviser or its related person from being the 
qualified custodian, would it result in additional costs or operational 
burdens on advisory clients? For example, would the requirement cause 
advisory clients to lose access to services or other efficiencies they 
currently receive? Would the requirement result in higher costs for 
advisory clients?
    82. Given that the written agreement and reasonable assurances 
approach would be applicable equally to the different types of 
qualified custodians, should the rule identify other financial 
institutions such as securities depositories, transfer agents, credit 
unions, insurance companies, or other intermediaries as qualified 
custodians?
    83. Are the contractual requirements and reasonable assurances 
requirements sufficiently clear? Are there additional contractual 
requirements or reasonable assurances related to the safeguarding of 
client investments that should be included in the written agreement or 
obtained by the adviser? If so, what are they, and why? Should we 
eliminate any of the contractual requirements or reasonable assurances 
requirements? If so, which ones, and why? Should all of the 
requirements be contractual or reasonable assurances, rather than a mix 
of these two categories as we proposed? Should any be re-categorized?
    84. Are there alternatives to all or any of the contractual 
requirements or reasonable assurances requirements that would support 
the policy goals of the proposed requirements while obviating the need 
for one or more specific contractual provisions or reasonable 
assurances? If so, what are the alternatives? Specifically, would we be 
able to achieve the same policy goals by requiring that an adviser 
adopt and implement policies and procedures reasonably designed to 
ensure that a qualified custodian was providing certain protections to 
client assets, rather than requiring a contractual clause for the 
protection? For example, would requiring advisers to adopt and 
implement a policy and procedure reasonably designed to ensure that a 
qualified custodian would promptly, upon request, provide records 
relating to the adviser's clients' assets held in the account at the 
qualified custodian to the Commission or to an independent public 
accountant provide protection equivalent to the proposed contractual 
obligation to provide these records? What about the proposed internal 
control report contractual obligation?

[[Page 14702]]

Would a client be able to obtain equivalent protection provided by an 
adviser's adoption and implementation of a policy and procedure 
reasonably designed to ensure that the qualified custodian will provide 
the internal control report required in the proposed contractual 
requirement? Are there other alternatives to any of the contractual 
requirements, such as requiring that an adviser obtain reasonable 
assurances from the qualified custodian that the qualified custodian 
has contractually agreed to provide account statements, internal 
control reports, or any of the other requirements we are proposing to 
be included in the written agreement? Are there any other alternatives 
that we should require?
    85. Are there circumstances in which the written agreement and 
reasonable assurances requirements should not be required? For example, 
should the written agreement and reasonable assurances requirements not 
apply in instances where an advisory client has a custodial 
relationship with a qualified custodian that precedes the client's 
engagement of the adviser? If so, how long should the custodial 
relationship precede the advisory relationship in order for an 
exception of this type to apply?
    86. Should the proposed rule include the contractual provision that 
the qualified custodian will promptly, upon request, provide records 
relating to client investments to an independent public accountant for 
purposes of compliance with the rule? Are we correct in our belief that 
this proposed provision would facilitate the public accountant's 
ability to obtain custodial account records? Would this requirement 
provide additional protections when the adviser has custody of client 
assets and further the policy goals of the rule?
    87. Should we require a more specific time period in which a 
qualified custodian would be required to provide records? For example, 
should we require that a qualified custodian provide records within 
three days of a request?
    88. Is our understanding correct 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? If so, would the proposed contractual requirement 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 records?
    89. Should the proposed rule include the contractual requirement 
that the qualified custodian will send account statements, at least 
quarterly, to the client and the investment adviser? The current rule 
requires an investment adviser to have a reasonable basis, after due 
inquiry, for believing that the qualified custodian maintaining client 
investments sends an account statement, at least quarterly, to the 
client. Is the proposed requirement regarding sending account 
statements to the adviser necessary or helpful? Would that requirement 
have a significant cost impact on qualified custodians and would those 
costs be passed on to advisory clients? Are there alternatives to the 
proposed contractual provision that we should require? For example, 
would the client have sufficient protection when an adviser has custody 
of its assets if we were to require that an adviser must have 
reasonable assurance that the qualified custodian maintaining client 
assets sends an account statement, at least quarterly, to the client?
    90. To what extent would the proposed requirement to provide 
custodial account statements to advisers increase costs to advisory 
clients?
    91. To what extent do commenters believe that the requirement to 
provide custodial account statements to advisers would have an impact 
on an adviser's duty to monitor? Do commenters believe that it would 
increase the frequency at which some advisers would be required to 
monitor activity in client accounts? Would this enhance protection of 
client assets? Could it increase advisory costs?
    92. Do commenters agree that custodians regularly send account 
statements to their custodial customers attesting to the holdings and 
transactions in the account during a particular period? Do commenters 
agree that advisory clients use these account statements to identify 
erroneous or unauthorized transactions or withdrawals in their 
accounts?
    93. Many advisers or their related persons serve as advisers to 
pooled investment vehicles or to other similar entities (e.g., general 
partner of a limited partnership). The proposed rule would continue to 
except these advisers from the requirement to have a qualified 
custodian send account statements with respect to pooled investment 
vehicles that are audited annually and distribute their audited 
financial statements to the investors in the pool. Should we continue 
to except these advisers from the account statement requirement? Would 
the investors in those pools find the account statement useful to 
monitor the pool's account activity? Should we extend this exception to 
all entities that are audited annually and distribute audited financial 
statements to investors in the entities pursuant to the audit 
provision, as proposed, provided the entity complies with all of the 
requirements in the proposed audit provision? \207\ Are there other 
persons that we should except from this requirement?
---------------------------------------------------------------------------

    \207\ See proposed rule 223-1(b)(4) and section II.G.1, infra.
---------------------------------------------------------------------------

    94. 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''), should the 
contract with the qualified custodian require the quarterly account 
statement to be delivered by the qualified custodian to 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)? Do commenters 
agree with our understanding that 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? Do commenters agree with our view that 
requiring the qualified custodian to ``look through'' in these 
instances would lead to meaningful delivery of the quarterly statement 
to advisory clients?
    95. Is our understanding correct with respect to current practices 
of reporting certain custodial customer holdings for which the 
qualified custodian lacks possession or control on an accommodation 
basis?
    96. Should the proposed rule prohibit account statements from 
identifying clients' investments for which the qualified custodian 
lacks possession or control unless the client requests otherwise? Do 
commenters agree that the practice of a qualified custodian including 
on an account statement assets that it is not safeguarding may be 
misleading to clients? Are there challenging practical implications of 
this proposed prohibition? For instance, our staff has previously taken 
the view that, under some arrangements, an adviser that is a qualified 
custodian may send its advisory clients account statements that include 
assets maintained with a sub-custodian that is also a qualified 
custodian.\208\ Would the proposed contract provision preclude

[[Page 14703]]

this type of arrangement? Similarly, some qualified custodians 
(regardless of whether they are related persons of the adviser) send 
consolidated account statements that include the holdings of sub-
custodians. Would the proposed contract provision disrupt this 
practice? Are there ways of improving account statement integrity 
without eliminating qualified custodians' ability to send consolidated 
account statements in these circumstances? For example, should we 
permit an adviser to request that these assets be included on the 
account statement but require that such request instruct a qualified 
custodian to include disclosure on the statement explaining that the 
qualified custodian does not have custodial liability for those 
investments? Are there are other disclosures that would appropriately 
distinguish how the qualified custodian maintains investments?
---------------------------------------------------------------------------

    \208\ See Custody Rule FAQs, supra footnote 17, at Question 
IX.1.
---------------------------------------------------------------------------

    97. Should we include the contractual requirement that the 
qualified custodian, at least annually, obtain, and provide to the 
investment adviser a written internal control report? Would the 
proposed internal control requirement provide additional protections 
where the adviser has custody? Would the proposed internal control 
requirement raise costs for advisory clients? Should the contractual 
requirement require some additional notification of any material 
discrepancies identified in an examination supporting the internal 
control report? For example, should the contractual requirement require 
that the accountant performing the examination notify the Commission of 
any material discrepancies by submitting a form such as Form ADV-E to 
the Commission? Should the contractual requirement require the 
accountant to notify the clients of the material discrepancies? Should 
the contractual requirement include any other provisions with respect 
to the written internal control report?
    98. Should we prescribe particular steps an adviser should take to 
review internal control reports for control exceptions? For example, 
should we require an annual review of these reports by the adviser's 
Chief Compliance Officer or an adviser personnel with the skill set to 
review such reports?
    99. Should we specify the internal control report to be obtained at 
least annually, as proposed? Alternatively, should the internal control 
report be obtained more or less frequently?
    100. Should the proposed internal control report be based on an 
assessment of the same control objectives outlined in the 2009 
Accounting Guidance? \209\ Are these control objectives applicable to 
all qualified custodians? Should certain of the control objectives be 
required only when the adviser uses a related party qualified 
custodian? Have custodial practices changed since the 2009 Accounting 
Guidance was published which would necessitate the addition or removal 
of control objectives in order to meet the policy goals of the proposed 
rule? Would additional control objectives be necessary in order to 
appropriately safeguard all client assets as required under the 
proposed rule, compared to funds and securities as required under the 
current custody rule?
---------------------------------------------------------------------------

    \209\ See Accounting Guidance, supra footnote, 188 at section 
III.
---------------------------------------------------------------------------

    101. When preparing an internal control report for a related party 
qualified custodian, should an accountant continue to be required to 
verify that client assets are reconciled to a custodian other than the 
adviser or its related person? Should this required reconciliation be 
limited to only securities? Are there custodians (like a securities 
depository) unaffiliated with the adviser that can hold all client 
assets when a related party qualified custodian is utilized? Is further 
guidance needed on this reconciliation requirement?
    102. Should the contractual provision require that the independent 
public accountant that prepares or issues the report be registered with 
the PCAOB when the adviser serves as, or is a related person of, the 
qualified custodian, as proposed? If so, should the independent public 
accountant also be subject to regular inspection by the PCAOB, as 
proposed? Would using independent public accountants registered with, 
and subject to regular inspection by, the PCAOB increase the costs to 
obtain these reports or make it too difficult to obtain a qualified 
accounting firm to provide an internal control report? Should there be 
a different independence standard for accountants performing the 
engagement? Rather than the independence standard proposed, should the 
rule require an accountant to not be a related person of the qualified 
custodian as that term is defined under the safeguarding rule? \210\
---------------------------------------------------------------------------

    \210\ Proposed rule 223-1(d)(11).
---------------------------------------------------------------------------

    103. The current rule \211\ and proposed rule \212\ define an 
independent public accountant as a public accountant that meets the 
standards of independence described in rule 2-01 of Regulation S-X (17 
CFR 210.2-01). Do custodians that voluntarily obtain internal control 
reports or obtain them to satisfy other requirements often obtain them 
from independent public accountants that are independent according to 
this standard? If not, do they have another standard for determining 
independence? For example, do custodians require auditors to meet the 
independence standard set by the Association of International Certified 
Professional Accountants? Do custodians require an independent public 
accountant to be unaffiliated from the custodian?
---------------------------------------------------------------------------

    \211\ Current rule 206(4)-2(d)(3).
    \212\ Proposed rule 223-1(d)(5).
---------------------------------------------------------------------------

    104. Rather than the contractual provision requiring that the 
independent public accountant that prepares or issues the report be 
registered with the PCAOB when the adviser serves as, or is a related 
person of, the qualified custodian, as proposed, should this 
requirement apply to all qualified custodians, regardless of whether 
the qualified custodian is the adviser or a related person? If so, 
should the rule contain different requirements for a qualified 
custodian that is the adviser or a related person?
    105. Is it appropriate, as proposed, to require that an adviser 
that is also the qualified custodian include all of the proposed 
reasonable assurances protections in the written agreement with the 
client? Should we require similar protections for any related person 
qualified custodian? For example, should the rule require the written 
agreement of any related person that is the qualified custodian to 
include all of the proposed reasonable assurances requirements? Would 
doing so provide enhanced protections for client assets? Would it 
result in any additional burdens on advisers, related persons, or 
clients?
    106. Do commenters agree with our proposed requirement that the 
accountant who prepares the internal control report should be 
``independent'' from the qualified custodian? Should it, instead, 
require independence from adviser?
    107. Would obtaining or receiving an internal control report 
present additional issues if the qualified custodian for client assets 
is located outside of the United States? Would the requirement that the 
independent public accountant be registered with, and subject to 
regular inspection by, the PCAOB in affiliated or self-custody 
situations make it more difficult to obtain such an internal control 
report?
    108. Instead of making it a term of the required written agreement, 
should we permit an adviser to rely on the representations of a 
qualified custodian that it has obtained the required internal control 
report?

[[Page 14704]]

    109. Should the proposed rule include the contractual requirement 
that the qualified custodian will 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? Are there other 
ways in which we could accomplish our objective to help empower 
advisers to modify or eliminate their unwanted ability in a custodial 
agreement to better reflect their client intentions? Would the 
requirement provide additional protections where the adviser has 
custody of client assets and further the policy goals of the rule?
    110. Is it difficult for advisers that have custody, including 
inadvertent custody, pursuant to a client's custodial agreement with a 
qualified custodian, to reduce or eliminate their authority over the 
client's custodial account? Would the proposed qualified custodian 
contractual requirement make it easier for advisers to reduce or 
repudiate this authority? Do qualified custodians often reject an 
adviser's request to modify its agreement with its client to reduce or 
eliminate the adviser's authority?
    111. Do qualified custodians sometimes lend, invest, or otherwise 
use their custodial customers' investments? Do advisers with custody of 
client assets have knowledge of these transactions? Do these 
transactions present risk to custodial customers? Do advisers consider 
whether a custodian engages in these transactions, or has sufficient 
insurance coverage to cover the risk of loss arising from these 
transactions when involved in selecting a qualified custodian for an 
advisory client? Should we include in the final rule a contractual 
requirement requiring qualified custodians to record a liability and 
maintain sufficient capital and/or insurance when lending, investing, 
or otherwise using their custodial customers' investments? Would 
qualified custodians be able to satisfy the requirement? If not, what 
type of financial institutions would be unable to satisfy it? Are there 
other ways of protecting custodial customers when an adviser has 
custody from risk of loss when those financial institutions lend, 
invest, or otherwise use client investments?
    112. Should the proposed rule include other contractual provisions 
or reasonable assurances? For example, should we require the written 
agreement to contain a contractual provision requiring the qualified 
custodian to make and keep adequate records? Would that provision 
facilitate compliance with the contractual provision requiring that the 
qualified custodian provide records to the Commission or independent 
public accountant? Would this requirement provide additional 
protections for clients where the adviser has custody and further the 
policy goals of the rule?
    113. Are there other risks that the rule should require the written 
agreement to address? For example, should the rule require that the 
written agreement expressly address the transfer of custodial assets in 
the event of the custodian's bankruptcy or insolvency? Should the 
written agreement be required to state, or should the adviser be 
required to obtain reasonable assurances, that the intent of parties is 
to enter into a custodial relationship, and under no circumstances 
should the relationship be considered a debtor-creditor relationship?
    114. Investment companies registered under the Investment Company 
Act (``RICs'') are subject to a comprehensive regime for the custody of 
their assets under the Investment Company Act and Commission rules 
thereunder, with specific requirements that vary based on the type of 
custodian. Should we continue to except accounts of RICs under proposed 
rule 223-1 in light of this regime for RICs? Should we apply any of the 
provisions of proposed rule 223-1 to RIC custodial arrangements, 
particularly the proposed contractual provisions for the qualified 
custodian agreement? Should the required contractual provisions depend 
on the type of custodian involved? For example, should RICs be required 
to include some or all of the proposed contractual provisions in 
agreements with bank custodians because the Commission has not adopted 
a rule related to bank custodians specifically?
    115. Does the custody rule contain any safeguards that the 
safeguarding rule retains that are not necessary and which we should 
not require?

C. Certain Assets That Are Unable To Be Maintained With a Qualified 
Custodian

    We believe that the bulk of advisory client assets are able to be 
maintained by qualified custodians; however, we understand that is not 
universally the case, particularly for two types of assets: certain 
physical assets and certain privately offered securities.
    It is not uncommon for physical assets, such as precious metals, 
physical commodities, and real estate, to be held in client portfolios, 
and thus there are likely circumstances in which advisers would have 
custody of these physical assets as a result of the expanded scope of 
the safeguarding rule. We understand that these assets are sometimes 
unable to be maintained by qualified custodians, and that some 
qualified custodians may refuse to custody such assets, in part, 
because the inherent physical characteristics of the items increase the 
expenses associated with their maintenance and safekeeping. Some of 
these assets by their very nature or size may not easily be subject to 
theft or loss, and that may reduce the need for the safeguarding 
protections offered by a qualified custodian, but when an adviser has 
an ability or authority to change beneficial ownership of these assets, 
there is still a risk of misuse, misappropriation, or loss associated 
with the adviser's insolvency or bankruptcy.
    Similarly, it is increasingly common for advisory clients to have 
privately offered securities in their portfolio.\213\ We understand 
that advisers with trading authority of privately offered securities 
that do not settle DVP often have custody of these securities because 
of the broad, general power of attorney-like authority required to 
trade these securities.\214\ There are certain impediments to 
transferability typically associated with certain privately offered 
securities--specifically, the need to obtain the consent of the issuer 
or other securities holders prior to any transfer of ownership--that 
make certain of these assets less susceptible to some of the risks the 
rule is designed to address. In particular, they would be less likely 
to be stolen by a third party or simply lost. These characteristics 
reduce the need for the safeguarding protections offered by a qualified 
custodian. These characteristics, however, do little, if anything, to 
protect a client against misuse, misappropriation, or losses that

[[Page 14705]]

may result from the adviser's insolvency or bankruptcy.
---------------------------------------------------------------------------

    \213\ See, e.g., Form ADV data current as of [Nov. 30, 2021] 
(showing that there are currently 5,037 registered private fund 
advisers with over $18 trillion in private fund assets under 
management); See also, Vanguard, The role of private equity in 
strategic portfolios (Oct. 2020), available at https://corporate.vanguard.com/content/dam/corp/research/pdf/Role-of-private-equity-in-strategic-portfolios-US-ISGRPE_102020_US_F_online.pdf (``[T]he asset size of the private 
equity market has been gradually growing on an absolute basis and 
relative to the public equity market over the last 20 years. Private 
equity has risen from 2% to 7% of total investable global equity 
assets.''); see also Scott Bauguess et al., Capital Raising in the 
U.S.: An Analysis of the Market for Unregistered Securities 
Offerings, 2009- 2017 (2018), available at https://www.sec.gov/files/dera-white-paper_regulation-d_082018.pdf (noting that an 
analysis of issuer self-reported data through electronic Form D 
filings indicates that the number of unregistered offerings and 
corresponding amounts raised have been increasing over the years 
2009-2017); Concept Release on Harmonization of Securities Offering 
Exemptions, Release No. 33-10649 (June 18, 2019) [84 FR 30460 (June 
26, 2019)], at n.37 (stating that the amounts raised in exempt 
markets have increased both absolutely and relative to public 
markets).
    \214\ See supra footnote 71 and accompanying text.
---------------------------------------------------------------------------

    We understand that the current market for custodial services of 
privately offered securities is fairly thin. We also understand that, 
although some custodians will custody these securities by holding them 
in nominee form, many do not custody them. We similarly understand that 
demand for these services may also be thin. Moreover, we understand 
that many advisers with custody of these assets do not seek to maintain 
them with a qualified custodian--at least in part--because the custody 
rule contains the ``privately offered securities exception'' \215\ from 
the qualified custodian requirement.
---------------------------------------------------------------------------

    \215\ See rule 206(4)-2(b)(2).
---------------------------------------------------------------------------

    To qualify for the privately offered securities exception today, 
the security must meet the exception's description of ``privately 
offered securities.'' This definition includes securities acquired from 
the issuer in a transaction or chain of transactions not involving any 
public offering; uncertificated, and ownership thereof is recorded only 
on the books of the issuer or its transfer agent in the name of the 
client; and transferable only with prior consent of the issuer or 
holders of the outstanding securities of the issuer. This custody rule 
exception contains one additional condition: for an adviser to a 
limited partnership or similar pooled investment vehicle to rely on 
this exception, the adviser must also comply with the custody rule's 
audit provision. In adopting this exception, the Commission had 
expressed its concern that these safeguards may be ineffective in the 
case of limited partnerships (or other pooled investment vehicles), 
noting that because the private securities are held in the name of the 
limited partnership and the adviser acts for the partnership, the 
adviser has apparent authority to arrange transfers that would be 
recognized by the issuer of the securities.\216\
---------------------------------------------------------------------------

    \216\ See 2003 Adopting Release, supra footnote 2.
---------------------------------------------------------------------------

    However, the Commission adopted this exception in 2003, following 
concerns raised by commenters that a requirement to maintain certain 
privately offered securities with qualified custodians could pose 
difficulties; particularly given that ownership of such assets 
generally was recorded only on the books of the issuer (e.g., 
investments in limited partnerships where clients receive only a copy 
of the partnership agreement as evidence of their investment or 
assignment agreements for debt or equity interests in a private 
company).\217\ In support of its decision to adopt the exception, the 
Commission stated that some of the impediments to transferability 
typically associated with certain privately offered securities provide 
some external safeguards against the kinds of abuse the rule seeks to 
prevent.\218\
---------------------------------------------------------------------------

    \217\ See 2003 Adopting Release, supra footnote 2, at section 
II.B. (``Commenters [ ] pointed out that, on occasion, a client may 
purchase privately-offered securities and that maintaining certain 
of these assets in accounts with qualified custodians poses 
difficulties because the client's ownership of the security is 
recorded only on the books of the issuer.'') (emphasis added).
    \218\ Id. The 2003 Adopting Release identified a specific and 
limited range of securities to which commenters referred. See 2003 
Adopting Release, supra footnote 2, at n.26 (``Commenters 
specifically mentioned clients' investments in limited partnerships, 
where clients receive only a copy of the partnership agreement as 
evidence of their investment. Commenters also mentioned assignment 
agreements for debt or equity interests in a private company, or 
other types of customized agreements.'').
---------------------------------------------------------------------------

    When this exception was adopted, the size of the privately held 
securities market was much smaller than it is now on an absolute basis 
as well as in relation to the size of the publicly traded securities 
market.\219\ In addition, the type, nature, structure, and prevalence 
of private issues have also changed and expanded in recent years, all 
of which have led the Commission to reconsider the current rule's 
exception.\220\ We have become concerned over the years since its 
adoption that this exception may not adequately protect an advisory 
client from the broad types of risks the custody rule is intended to 
address: chiefly, misappropriation.\221\
---------------------------------------------------------------------------

    \219\ See Vanguard, The role of private equity in strategic 
portfolios (Oct. 2020), available at https://corporate.vanguard.com/content/dam/corp/research/pdf/Role-of-private-equity-in-strategic-portfolios-US-ISGRPE_102020_US_F_online.pdf (``[T]he asset size of 
the private equity market has been gradually growing on an absolute 
basis and relative to the public equity market over the last 20 
years. Private equity has risen from 2% to 7% of total investable 
global equity assets.''); see also Scott Bauguess et al., Capital 
Raising in the U.S.: An Analysis of the Market for Unregistered 
Securities Offerings, 2009- 2017 (2018), available at https://www.sec.gov/files/dera-white-paper_regulation-d_082018.pdf (noting 
that an analysis of issuer self-reported data through electronic 
Form D filings indicates that the number of unregistered offerings 
and corresponding amounts raised have been increasing over the years 
2009-2017); Concept Release on Harmonization of Securities Offering 
Exemptions, Release No. 33-10649 (June 18, 2019) [84 FR 30460 (June 
26, 2019)], at n.37 (stating that the amounts raised in exempt 
markets have increased both absolutely and relative to public 
markets).
    \220\ For example, our staff has received several questions over 
the years about whether certain securities would still qualify for 
the exception if the securities were not acquired from the issuer 
but were transferred, for instance, in a subsequent private 
offering, from one owner to the next. Our staff has also responded 
to other questions concerning the application of the exception. See, 
e.g., 2013 IM Guidance, supra footnote 17 (providing staff views 
regarding security evidenced by a private stock certificate).
    \221\ See 2009 Adopting Release, supra footnote 11, at section 
II.B.3 (noting the difficulty for advisory clients to verify that 
assets actually exist because ownership is recorded only on the 
issuers' books). In the 2009 Adopting Release, the Commission 
expanded the protections of the surprise examination to privately 
offered securities. See id. The growth of the privately offered 
securities market since our 2009 amendments to the custody rule has 
increased our concerns regarding the risks we identified in the 2009 
Adopting Release to these client assets. We have also taken into 
account concerns expressed by others. See, e.g., Dodd Frank 
Regulating Hedge Funds and other Private Investment Pools Testimony 
of James S. Chanos, supra footnote 14, at 50 (``These instruments 
are privately issued uncertificated securities, bank deposits, real 
estate assets, swaps, and interests in other private investment 
funds, as well as shares of mutual funds, which, under current law, 
can simply be titled in the name of the private investment fund care 
of the manager, and the evidence of ownership held in a file drawer 
at the manager of the private investment fund. The issuers of those 
assets are permitted to accept instructions from the manager to 
transfer cash or other value to the manager. This gaping hole in 
current Advisers Act custody requirements can allow SEC-registered 
advisers easily to abscond with money or other assets and falsify 
documentation of ownership of certain categories of assets, and 
makes it difficult for auditors, investors and counterparties to 
verify the financial condition of advisory accounts and private 
investment funds. Requiring independence between the function of 
managing a private investment fund and controlling its assets, by 
requiring that all assets be titled in the name of a custodian bank 
or broker-dealer for the benefit of the private fund and requiring 
all cash flows to move through the independent custodian, would be 
an important control. Similarly, requiring an independent check on 
the records of ownership of the interests in the private investment 
fund, as well as imposing standards for the qualification of private 
investment fund auditors--neither of which currently is required by 
the Advisers Act--would also greatly reduce opportunities for 
mischief.'').
---------------------------------------------------------------------------

    When an asset cannot be maintained with a qualified custodian, a 
client may not have a full understanding of its holdings or receive 
periodic account statements reflecting transactions in those assets. 
This reduces the likelihood that a client will be able to identify 
suspicious activity in its account or notice that its assets are gone. 
Moreover, these assets may not be included in the sample of assets 
subject to verification procedures during a surprise examination or 
meet the materiality threshold for verification during a financial 
statement audit. As a result, a loss could similarly go undetected by 
an independent public accountant for a substantial period.
    Ideally, a robust market for custodial services would develop for 
physical assets and privately offered securities. Absent such a 
development and the exception, however, advisers would be faced with 
the inability to comply with a Commission requirement or a need to 
transition to providing nondiscretionary advice or take certain other 
actions in

[[Page 14706]]

order to avoid a violation of Commission rules, which could be 
disruptive or result in client harm. We are therefore proposing to 
reform the privately offered securities exception to address our 
concerns about the lack of protections and transparency that could 
result when privately offered securities and physical assets cannot be 
maintained by a qualified custodian and to reduce the likelihood that a 
loss of these assets could be undetected for an indeterminate amount of 
time. The safeguarding rule would provide 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, provided it meets the following conditions: \222\
---------------------------------------------------------------------------

    \222\ See proposed rule 223-1(b)(2).
---------------------------------------------------------------------------

     The adviser reasonably determines and documents in writing 
ownership cannot be recorded and maintained (book-entry, digital, or 
otherwise) in a manner in which a qualified custodian can maintain 
possession, or control transfers of beneficial ownership, of such 
assets;
     The adviser reasonably safeguards the assets from loss, 
theft, misuse, misappropriation, or the adviser's financial reverses, 
including the adviser's insolvency;
     An independent public accountant, pursuant to a written 
agreement between the adviser and the accountant,
    [cir] Verifies any purchase, sale, or other transfer of beneficial 
ownership of such assets promptly upon receiving notice from the 
adviser of any purchase, sale, or other transfer of beneficial 
ownership of such assets; and
    [cir] Notifies the Commission within one business day upon finding 
any material discrepancies during the course of performing its 
procedures;
     The adviser notifies the independent public accountant 
engaged to perform the verification of any purchase, sale, or other 
transfer of beneficial ownership of such assets within one business 
day; and
     The existence and ownership of each of the client's 
privately offered securities or physical assets that is not maintained 
with a qualified custodian are verified during the annual surprise 
examination or as part of a financial statement audit.
1. Definition of Privately Offered Security and Physical Assets
    The proposed rule's definition of privately offered securities 
would retain the elements from the custody rule's description that 
require the securities to be acquired from the issuer in a transaction 
or chain of transactions not involving any public offering, and 
transferable only with prior consent of the issuer or holders of other 
outstanding securities of the issuer.\223\ Like the custody rule, the 
safeguarding rule would also require the securities to be 
uncertificated and would require ownership to be recorded only on the 
books of the issuer or its transfer agent in the name of the client. 
However, the safeguarding rule would also require that the securities 
be capable of only being recorded on the non-public books of the issuer 
or its transfer agent in the name of the client as it appears in the 
records the adviser is required to keep under Rule 204-2. This 
definitional requirement would enhance the assurance of the existence 
of the client asset provided by the verification required by proposed 
223-1(b)(2)(iii)(A) and will make the verification process more 
efficient. The term ``uncertificated'' would generally have the same 
meaning as set forth in article 8 of the Uniform Commercial Code.\224\ 
Additionally, we would not view a security to be certificated where the 
certificate cannot be used to redeem, transfer, purchase, or otherwise 
effect a change in beneficial ownership of the security for which the 
certificate is issued.\225\ We understand that transactions and 
ownership involving crypto asset securities on public, permissionless 
blockchains are generally evidenced through public keys or wallet 
addresses.\226\ As proposed, in order for a security to be a privately 
offered security under the proposed safeguarding rule, among other 
conditions, it must be uncertificated, and the ownership can only be 
recorded on the non-public books of the issuer or its transfer agent in 
the name of the client as it appears in the adviser's required records. 
As a result, we believe that such crypto asset securities issued on 
public, permissionless blockchains would not satisfy the conditions of 
privately offered securities under the proposed safeguarding rule.\227\
---------------------------------------------------------------------------

    \223\ Rule 206(4)-2(b)(2)(i). ``Privately offered securities'' 
are defined by rule 206(4)-2(b)(2) as securities that are (1) 
acquired from the issuer in a transaction or chain of transactions 
not involving any public offering, (2) uncertificated, and ownership 
thereof is recorded only on the books of the issuer or its transfer 
agent in the name of the client, and (3) transferable only with 
prior consent of the issuer or holders of the outstanding securities 
of the issuer. See also proposed rule 223-1(d)(9).
    \224\ See UCC Sec. 8-102(a)(18) (`` `Uncertificated security' 
means a security that is not represented by a certificate.'').
    \225\ Our staff took a similar view. See 2013 IM Guidance, supra 
footnote 17.
    \226\ See generally, PwC, Demystifying cryptocurrency and 
digital assets (accessed Dec. 5, 2022), available at https://www.pwc.com/us/en/tech-effect/emerging-tech/understanding-cryptocurrency-digital-assets.html (describing storage, ownership, 
and transactions, of crypto assets).
    \227\ Crypto assets that are not crypto asset securities would 
not qualify for the exception because they do not satisfy the 
definition of privately offered security under proposed 223-1(d)(9).
---------------------------------------------------------------------------

    We are not providing a definition of the term ``physical asset'' or 
including specific types of assets in the proposed rule. Rather, we 
believe that the plain language of the phrase, along with a principles-
based facts and circumstances approach that requires an adviser to look 
to the characteristics and nature of a particular physical asset is 
more appropriate. We believe that what constitutes a ``physical asset'' 
is often self-evident, particularly when compared to other assets that 
are certificated, maintained digitally, or in book-entry form. For 
example, real estate and physical commodities \228\ such as, corn, oil, 
and lumber are physical assets, while assets like cash, stocks, bonds, 
options, futures and funds are not, even if they provide exposure to 
physical assets. Physical evidence of ownership of non-physical assets 
that can be used to transfer beneficial ownership, like stock 
certificates, private keys, and bearer or registered instruments do 
not, themselves, qualify as physical assets and would not qualify for 
the exception from the qualified custodian requirement. Similarly, 
certain physical evidence of physical assets such as a warehouse 
receipt for certain commodities would not qualify for the exception if 
they can be used to transfer beneficial ownership even though the 
commodities documented by the warehouse receipt may qualify for the 
exception. Or in the real estate context, a deed or similar indicia of 
ownership that could be used to transfer beneficial ownership of a 
property would not qualify for the exception, but the physical 
buildings or land would qualify.
---------------------------------------------------------------------------

    \228\ See, e.g., International Organization of Securities 
Commissions, Principles for the Regulation and Supervision of 
Commodity Derivatives Markets--Consultation Report at 82 (Nov. 
2021), available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD689.pdf (defining physical commodity as ``[a] tangible 
product or raw material, as opposed to an instrument which 
references a physical commodity.'').
---------------------------------------------------------------------------

2. Adviser's Reasonable Determination
    In order to be eligible for the exception, the rule would require 
an adviser to determine, and document in writing, that ownership cannot 
be recorded and maintained (book-entry, digital, or otherwise) in a 
manner in which a qualified custodian can

[[Page 14707]]

maintain possession or control of such assets. Such a determination 
necessarily depends on the facts and circumstances in issue. Moreover, 
these determinations would necessarily evolve over time as assets and 
the custodial industry change, allowing the proposed rule to remain 
evergreen.
    An adviser's reasonable determination of whether a qualified 
custodian is able to maintain possession or control of a particular 
asset would generally involve an analysis of the asset and the 
available custodial market. An adviser's reasonable determination 
generally would not require the identification of every conceivable 
qualified custodian and an evaluation of its custodial services. 
Fundamentally, to determine whether an asset can or cannot be 
maintained by a qualified custodian under the proposed rule, an adviser 
generally should obtain a reasonable understanding of the marketplace 
of custody services available for each client asset for which it has 
custody. The adviser's written documentation of its determination would 
generally contain material facts concerning its understanding of the 
custodial marketplace and a description of the client asset in issue.
    The proposed rule does not specify the frequency with which an 
adviser must make this determination. What frequency would be 
reasonable for any determination would depend on the particular assets 
and the facts and circumstances. For example, an adviser might develop 
policies and procedures for conducting this analysis, and those 
policies and procedures might reasonably call for an annual assessment 
of one type of asset for which there have been no indicators of a 
developing custodial market. On the other hand, it would likely be 
unreasonable for an adviser to annually assess the custodial market for 
an asset for which developing custodial services are well publicized as 
imminent.
    As discussed above, we believe that many privately offered 
securities are not currently maintained by qualified custodians. 
However, we understand that a substantial portion of securities--
privately and publicly held--are uncertificated (i.e., paper stock 
certificates are largely a relic from a prior era, replaced by more 
modern methods of recording ownership).\229\ Particularly as a result 
of the growth of uncertificated publicly traded securities, we 
understand that custodians have refined safeguarding and reporting 
practices with respect to uncertificated securities. Therefore, we 
believe that this experience has made it increasingly possible for 
qualified custodians to provide custody services for privately offered 
securities. Accordingly, while today it may be reasonable under 
appropriate circumstances for an adviser to determine that a qualified 
custodian cannot maintain possession or control of a particular 
privately offered security, we believe that determination may be more 
difficult to support as the custodial industry continues to evolve.
---------------------------------------------------------------------------

    \229\ See Paech, Philipp, Securities, Intermediation and the 
Blockchain: An Inevitable Choice Between Liquidity and Legal 
Certainty? 21(4) Unif. L. Rev. 612 (Dec. 1, 2016) (``The practice of 
securities holding, transfer, and collateral has changed 
significantly over the past 200 years-moving from paper certificates 
and issuer registers, to an intermediated environment, and from 
there to computerization and globalization.''); Intermediated 
Securities, supra footnote 143, at 386 (``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.''); DTCC, From Physical 
to Digital: Advancing the Dematerialization of U.S. Securities 
(Sept. 2020), available at https://www.dtcc.com/~/media/Files/PDFs/
DTCC-Dematerialization-Whitepaper-092020.pdf (``the crushing 
mountain of paper of the paperwork crisis in the 1960s and 1970s was 
addressed by the two-pronged approach of immobilization and 
dematerialization''). While the terminology is sometimes used 
interchangeably, ``dematerialized securities'' generally refer to 
securities, sometimes certificated, that are represented by entries 
in securities accounts maintained by financial intermediaries for 
investors, while ``uncertificated securities'' refer to securities 
that are not represented by a certificate but are registered on an 
issuer's books. See generally, Thevenoz, Intermediated Securities, 
supra footnote 143 at 386 (``Certificated securities do not need to 
move if they are immobilized in the custody of reliable depositories 
and represented by entries in securities accounts maintained by 
financial intermediaries for investors. When needed, immobilized 
securities can be transferred by way of book-entries in investors' 
accounts, which substitute for their physical delivery. Where 
corporate law and investor preferences allow, physical individual 
securities can become wholly unnecessary. A whole issue can be 
replaced by one global certificate, or it can even be recorded in an 
`issue account' without the need for any certificate, against which 
the dematerialized securities can be credited to the securities 
accounts of market participants and, here again, be transferred by 
way of book-entries. 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.''); and see UCC section 8-102(18) (`` 
`Uncertificated security' means a security that is not represented 
by a certificate.'').
---------------------------------------------------------------------------

    Whether an adviser can make the reasonable determination regarding 
a particular physical asset necessarily depends on the asset type and 
the availability of custody services. For example, an adviser could 
likely conclude that qualified custodian services are unavailable for 
unharvested wheat or a shopping center. Similarly, custody of certain 
tangible agricultural commodities may be impossible to insure at a 
qualified custodian.\230\ In these circumstances, an adviser may 
reasonably determine that ownership cannot be recorded and maintained 
(book-entry, digital, or otherwise) in a manner in which a qualified 
custodian can maintain possession or control of such asset. Conversely, 
it is likely that a qualified custodian can hold gold bullion,\231\ and 
it would therefore be difficult for an adviser to make the 
determination required to invoke the proposed exception.
---------------------------------------------------------------------------

    \230\ Though such physical assets may be unable to be held with 
a qualified custodian as defined under the proposed rule, we 
understand that agricultural commodities and other physical 
commodities do have certain non-qualified custodians, exchange-
approved warehouses or clearing houses that provide substantial 
record keeping and safeguarding protections for such assets. These 
often include secure storage facilities, internal control 
procedures, and relevant insurance coverages.
    \231\ It is our understanding that banks are able to custody 
gold bullion and other precious metals, but that other non-bank 
custodians provide secure storage and transportation services for 
gold bullion and other precious metals, including vault custody and 
related transportation services. See, e.g., The Brinks Company, SEC 
Staff No-Action Letter (Feb. 3, 2014). We also understand that, from 
time to time, bank custodians or others may exit the precious metals 
custody business, but that other custodians may become available to 
perform those custody services. See, e.g., Depository Trust Company 
of Delaware, LLC, SEC Staff No-Action Letter (Sept. 12, 2016).
---------------------------------------------------------------------------

3. Adviser Reasonably Safeguards Assets
    To rely on the exception, the adviser would be required to 
reasonably safeguard any privately offered securities or physical 
assets that are not maintained with a qualified custodian from loss, 
theft, misuse, misappropriation, or the adviser's financial reverses, 
including the adviser's insolvency. While the specific procedures 
implemented to safeguard assets may vary depending on the asset, 
advisers must satisfy their fiduciary duty in safeguarding any 
particular asset.\232\
---------------------------------------------------------------------------

    \232\ The principles-based requirement to reasonably safeguard a 
client's physical assets is drawn from an adviser's fiduciary duty 
including its duty of care or duty of loyalty under the Advisers 
Act, which extends to the entirety of the adviser-client 
relationship. See supra footnote 57.
---------------------------------------------------------------------------

    With respect to privately offered securities, an adviser might 
``reasonably safeguard'' an asset by looking to reasonable commercial 
standards, which we understand presently may draw from a variety of 
protections such as enhanced recordkeeping, additional change of 
control terms in governance agreements, designation of an agent 
required to be involved in transfers of beneficial ownership, among 
others. For

[[Page 14708]]

example, one critical safeguard that advisers should consider is the 
types of internal controls that they can implement to reasonably 
safeguard clients' privately offered securities. If possible, an 
adviser may consider separating duties of the person responsible for 
recording investments in privately offered securities from the person 
responsible for authorizing the buying and selling of privately offered 
securities from the person responsible for holding certificates or 
other legal records evidencing ownership of privately offered 
securities.\233\ An adviser may also consider implementing procedures 
to regularly review and reconcile the following documents to the 
adviser's records: legal documents demonstrating evidence of ownership 
of privately offered securities, including any changes year over year; 
board meeting minutes, if available, for any activity that may evidence 
a change in a client's ownership of privately offered securities; and 
records of share ownership maintained by the issuer or its transfer 
agent in the name of the client. An adviser may also consider 
periodically reviewing and documenting that the privately offered 
securities are transferable only with the prior consent of the issuer 
or its shareholders. Importantly, the rule recognizes that the 
privately offered securities vary, as do the relationships between an 
adviser and its advisory clients, and the rule retains the flexibility 
necessary for advisers to make reasonable determinations concerning the 
safeguarding of those privately offered securities that are unable to 
be maintained with a qualified custodian.
---------------------------------------------------------------------------

    \233\ We recognize in some smaller organizations it may be more 
challenging to separate these functions.
---------------------------------------------------------------------------

    With respect to physical assets, an adviser might ``reasonably 
safeguard'' such assets by looking to reasonable commercial standards, 
which may include storage in a secure facility or vault that adheres to 
exchange, clearing house, or other licensing requirements for 
participation in certain commodities markets; dual control procedures 
for access to assets in safekeeping; maintenance of records to evidence 
movement or transfer of assets (including details on depositor, 
beneficiary and/or the legal owner); periodic reconciliation of records 
with assets held (e.g., vault counts); separation of duties for 
movement or transfer of assets, recordkeeping and reconciliation; 
periodic audits; smoke detection and fire suppression systems; and 
insurance coverage for any custody-related losses incurred by its 
clients. Advisers may need to tailor their standards for safeguarding 
to each particular physical asset depending on the relative common 
standards for its market.\234\ For example, reasonable commercial 
standards for safeguarding and taking delivery of an agricultural 
commodity like a bushel of wheat \235\ necessarily would be different 
from the appropriate maintenance gold bullion \236\ or of personal 
property like jewelry, antiques, or art.\237\ We believe this approach 
will give advisers the flexibility to develop and implement 
safeguarding practices with respect to assets not maintained with a 
qualified custodian that are appropriately tailored, while helping to 
ensure client assets receive appropriate protections.
---------------------------------------------------------------------------

    \234\ See, e.g., The Board of the International Organization of 
Securities Commissions, Commodity Storage and Delivery 
Infrastructures: Good or Sound Practices (Feb. 2019), available at 
https://www.iosco.org/library/pubdocs/pdf/IOSCOPD622.pdf 
(encouraging the adoption of ``Good or Sound Practices'' in member 
jurisdictions, but noting that ``[n]ot all of the Practices 
described may be relevant to all market participants. It is for 
market participants to determine the applicability of any particular 
Practice and to apply it as their circumstances require.'').
    \235\ For example, in the agricultural context, clearing members 
and delivery facilities are subject to the various rules of the 
exchange or clearing house as well as inspection by the exchange and 
the Department of Agriculture. See, Chapter 7, Delivery Facilities 
and Procedures, Chicago Board of Trade Rule Book (2022) available 
at: https://www.cmegroup.com/rulebook/CBOT/.
    \236\ See Global Previous Metals Code Global Precious Metals 
Code available at https://www.lbma.org.uk/market-standards/global-precious-metals-code.
    \237\ The OCC notes in its Handbook that miscellaneous assets 
(e.g., jewelry, art, coins) should be maintained in a vault 
consistent with applicable law and sound custodial management. Vault 
control procedures should ensure physical security, dual control 
procedures, maintenance of records evidencing access to the vault, 
proper asset transfer ticketing, and periodic vault counts. See, 
Custody Services, Comptrollers Handbook (Jan. 2002) available here: 
https://www.occ.treas.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/pub-ch-custody-services.pdf (``OCC Custody Handbook''). See also Inland Marine 
Underwriters Association, Evaluating the Risk in the Storage and 
Shipping of Fine Art: Insights into the Art Service Industry at 
https://www.imua.org/Files/reports/2019reports/EvaluatingRiskinStorageandShippingofFineArtsUpdateFinal1_4_2019.pdf.
---------------------------------------------------------------------------

    When an adviser has custody of client physical assets that are not 
maintained with a qualified custodian, the ultimate obligation to 
safeguard those assets falls to the adviser. In some circumstances, an 
adviser might conclude that it could safeguard the asset itself, 
provided it can do so in accordance with reasonable commercial 
standards. In other circumstances, the adviser could instead determine 
that it could permissibly maintain physical assets with a third party 
that the adviser concludes could safeguard the assets in accordance 
with reasonable commercial standards. The proposed rule does not 
require a particular approach.
    More broadly, an adviser might demonstrate that it is reasonably 
safeguarding a client asset itself or through a third party, by 
adopting, implementing, and regularly reassessing policies and 
procedures that include robust due diligence and ongoing oversight 
designed to ensure the adviser has assessed and evaluated the 
safeguarding measures put in place by itself or the third party 
maintaining physical assets. Such policies and procedures might include 
procedures to assess whether the person maintaining the client asset 
has exercised and is likely to continue to be able to exercise due care 
in accordance with reasonable commercial standards in safeguarding the 
asset.
4. Notification and Prompt Independent Public Accountant Verification
    The exception to the requirement to maintain assets with a 
qualified custodian would also require an adviser to enter into a 
written agreement with an independent public accountant.\238\ The 
proposed rule would require the adviser to notify the independent 
public accountant of any purchase, sale, or other transfer of 
beneficial ownership of such assets within one business day.\239\ The 
written agreement would require the independent public accountant to 
verify the purchase, sale, or other transfer promptly upon receiving 
the required transfer notice.\240\ The written agreement would also 
require the accountant to notify the Commission by electronic means 
directed to the Division of Examinations within one business day upon 
finding any material discrepancies during the course of performing its 
procedures.\241\ We believe that these requirements would provide 
advisory clients meaningful and much-needed protection when their 
advisers have custody of assets that are not maintained with a 
qualified custodian.
---------------------------------------------------------------------------

    \238\ See proposed rule 223-1(b)(2)(iii).
    \239\ See proposed rule 223-1(b)(2)(iv).
    \240\ See proposed rule 223-1(b)(2)(iii)(A).
    \241\ See proposed rule 223-1(b)(2)(iii)(B).
---------------------------------------------------------------------------

    It has been our longstanding view that the involvement of 
independent public accountants in the review and verification of client 
assets of which advisers have custody is an important safeguarding tool 
and reduces the risk of loss of client assets.\242\ Consistent with

[[Page 14709]]

that view, we believe that an independent public accountant's 
involvement in the verification and notification requirements in the 
proposed rule enhances the reliability and integrity of the 
verification and would help identify problems that clients may not, and 
thus would provide deterrence against fraudulent conduct by advisers.
---------------------------------------------------------------------------

    \242\ See, e.g., Adoption of Rule 206(4)-2 under the Investment 
Advisers Act of 1940, IA Release No. 123 (Feb. 27, 1962) [27 FR 2149 
(Mar. 6, 1962)] (requiring advisers with custody of client 
securities or funds to engage an independent public accountant to 
conduct an annual surprise examination); 2009 Adopting Release, 
supra footnote 11, at section II.B.1. (``Because advisers with 
custody often have authority to access, obtain and, potentially, 
misuse client funds or securities, we believed the additional review 
provided by an independent public accountant would help identify 
problems that clients may not, and thus would provide deterrence 
against fraudulent conduct by advisers.'').
---------------------------------------------------------------------------

    We believe that the timing requirement for the notice--that the 
adviser would be required to provide notice to an independent public 
accountant within one business day of a transfer of beneficial 
ownership--is important to inform an independent public accountant as 
soon as practicable of a transfer of beneficial ownership of client 
assets that are not held with a qualified custodian. This timing will 
build a record for the accountant to review in connection with an 
annual surprise examination or financial statement audit and, 
therefore, would reduce the likelihood of loss or misappropriation of 
client assets. Moreover, we anticipate the timing of these requirements 
in close proximity to the timing of a transaction, coupled with the 
annual confirmation during a surprise examination or financial 
statement audit, would also reduce the likelihood that any loss would 
go undetected for an extensive time. Further, we believe that this 
notice would not be challenging for any adviser to provide to the 
independent public accountant, especially considering the limited 
nature of the requirement relative to the more involved aspects of many 
of the closings related to privately offered securities or physical 
assets such as the preparation or review of closing memos, confirmation 
of receipt of funds, execution of signature pages, and many other more 
time-consuming tasks related to closings for these types of assets.
    Based on our experience with the audit provision in the current 
rule,\243\ we understand that independent public accountants are 
familiar with a wide variety of transaction verification and tracing 
transaction activity as this is a normal audit procedure. We recognize, 
however, that the verification and transaction tracing process of any 
purchase, sale, or other transfer of beneficial ownership of the assets 
would necessarily vary depending on the type of asset. For example, for 
a privately offered security purchased or sold by an advisory client, 
the independent public accountant could contact the issuer of the 
security or its agent to verify the existence of the asset and relevant 
information concerning the transfer of beneficial ownership of the 
client asset. The independent public accountant may also take a wide 
array of additional steps depending on the nature of the security--and 
the transaction--along with other relevant facts and circumstances. For 
example, the independent public accountant may review a private 
placement memorandum, the issuer's Regulation D filings,\244\ or take 
other steps to assist in verifying the existence and transfers of 
beneficial ownership of the asset.
---------------------------------------------------------------------------

    \243\ Rule 206(4)-2(a)(4) and 206(4)-2(b)(4).
    \244\ See Form D, Notice of Exempt Offering of Securities, 
available at https://www.sec.gov/files/formd.pdf.
---------------------------------------------------------------------------

    For a physical asset purchased or sold by an advisory client, such 
as a commercial shopping center, the independent public accountant may 
confirm the existence of the asset through a variety of reliable means. 
To confirm the transfer of beneficial ownership of the asset, the 
independent public accountant may review deeds or other land 
recordation materials, or seek to obtain other reliable information 
concerning the transfer of the asset. The independent public accountant 
may use similar methodologies in connection with the verification of 
the existence, and purchase or sale, of physical commodities. For 
example, an independent public accountant may seek to confirm existence 
and the relevant transfers of beneficial ownership of grain by 
reviewing a warehouse receipt for the assets held in a grain elevator.
    The written agreement required by the proposed rule would require 
the accountant to notify the Commission within one business day upon 
finding any material discrepancies during the course of its 
examination.\245\ This requirement is effectively identical to the 
notification requirement for material discrepancies found during a 
surprise examination under the custody rule \246\ and would require an 
effectively identical decision-making process by the independent public 
accountant: the independent public accountant may first take reasonable 
steps to establish the basis for believing a material discrepancy 
exists. The obligation to notify the Commission arises once the 
accountant has a basis for believing there is a material discrepancy. 
Ordinarily, an accountant should be able to determine promptly whether 
it has a basis for believing there is a material discrepancy.\247\ The 
reporting by the independent public accountant of a material 
discrepancy would provide the staff with timely notice of a potential 
issue with the adviser's custodial practices, providing the staff with 
an earlier opportunity to examine an adviser or take other action 
against an adviser, as appropriate, in an effort to help safeguard 
client assets. This proposed requirement also bears similarities to the 
proposed notification requirement for an audit under the proposed 
safeguarding rule.\248\
---------------------------------------------------------------------------

    \245\ See proposed rule 223-1(b)(2)(iii).
    \246\ See rule 206(4)-2(a)(4)(ii).
    \247\ See 2003 Adopting Release, supra footnote 2, at note 34; 
2009 Proposing Release, supra footnote 11, at note 10.
    \248\ See infra, section II.F.
---------------------------------------------------------------------------

5. Surprise Examination or Audit
    Like the custody rule, the safeguarding rule would require advisers 
relying on the exception to undergo an annual surprise examination or 
rely on the audit provision.\249\ In a change from the custody rule, 
however, the proposed rule would require each privately offered 
security or physical asset not maintained with a qualified custodian to 
be verified.\250\ This change from the custody rule is designed to 
address our concerns that a loss of these assets could go undetected 
for an extended period of time as a result of a not being included 
within the accountant's sample to be tested during a surprise 
examination or verified during an audit if they do not meet the 
threshold for materiality. Moreover, this proposed requirement would 
supplement the proposed requirement to verify transactions promptly 
after they occur, operating similarly to an annual ``bring down.'' This 
would help ensure the client has some comfort regarding the status and 
ultimate disposition of these assets over time despite the lack of 
ability to monitor quarterly custodial statements. We

[[Page 14710]]

recognize that this proposed requirement likely constitutes a departure 
from current practice for most surprise examinations and audits, but 
believe that the protective benefits of the surprise examination and 
annual audit are critical to the safeguarding of client assets, 
especially where these assets do not have the additional protections 
afforded by the oversight of a qualified custodian.
---------------------------------------------------------------------------

    \249\ See rule 206(4)-2(a)(4); 2009 Adopting Release, supra 
footnote 11, at section II.B.3. (``Because clients are more 
dependent on the adviser with respect to the safeguarding of these 
securities, advisory clients may be exposed to additional risks when 
their advisers acquire these securities on their behalf. To mitigate 
these risks and to provide assurance that privately offered 
securities are properly safeguarded, we believe that it is 
appropriate to require an independent third-party to verify client 
ownership with the issuers of the securities by requiring that these 
securities be subject to the surprise examination requirement under 
the amended rule.'').
    \250\ See proposed rule 223-1(b)(2)(v).
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed exception, 
including the following:
    116. Should the rule retain the privately offered securities 
exception of the custody rule without any modifications?
    117. Do commenters agree with our understanding that, today, the 
overwhelming majority of securities are uncertificated, that the volume 
of privately offered securities has vastly expanded since 2003, and 
that custodians have developed safeguarding and reporting practices, 
particularly with respect to publicly-traded securities? Are we correct 
that the custodial market for privately issued securities is less 
developed? Do commenters also agree that some custodians will presently 
custody privately issued securities and that new custodial services are 
being developed?
    118. Should the rule eliminate the current rule's privately offered 
securities exception to the requirement to maintain securities with a 
qualified custodian, as proposed? Rather than eliminating the custody 
rule exception and creating the new safeguarding rule exception for 
privately offered securities and physical assets, should the custody 
rule exception be retained, but modified in a different way? For 
example, should it be made available solely to advisers whose clients' 
financial statements are audited and distributed to investors in 
accordance with the requirements of this rule? If so, what standard of 
independence should an auditor be required to satisfy?
    119. Are we correct in our belief that the privately offered 
securities exception may not adequately protect an advisory client from 
the broad types of risks the rule is intended to address? If not, in 
what ways does the exception provide adequate protections? Are there 
alternatives to eliminating the exception and creating the new 
exception as proposed that would better serve the proposed rule's 
policy goals?
    120. Is our understanding correct that advisers with trading 
authority of privately offered securities that do not settle DVP often 
have custody of these securities because of the broad general power of 
attorney-like authority required to trade these securities?
    121. Are qualified custodians able to provide custody services for 
privately offered securities? If so, what services? Would maintaining 
these securities with qualified custodians be practically challenging 
and/or costly? If so, what are the challenges or cost constraints?
    122. Do commenters agree that the custody rule exception's 
restrictions on transferability of privately offered securities do not 
provide comparable protections to those provided under the proposed 
rule? If commenters disagree, how do these restrictions protect against 
misappropriation by the adviser or theft by a third party? Do issuers 
and other holders of outstanding securities evaluate whether a 
transaction in the securities would result in misappropriation by the 
adviser or theft by a third party? Do they have an incentive to 
evaluate a transaction for misappropriation or any of the other policy 
goals of the rule?
    123. We are proposing to retain the mutual fund shares exception 
because, in our experience, this exception has not raised similar types 
of investor protection concerns that we are seeking to address in this 
proposal.\251\ Do commenters believe that the mutual fund shares 
exception raises investor protection risks? Should we eliminate the 
exception for mutual fund shares? To what extent do advisory clients 
purchase mutual fund shares through qualified custodians such as 
broker-dealers such that the exception may not be necessary?
---------------------------------------------------------------------------

    \251\ See rule 206(4)-2(b)(1) and proposed rule 223-1(b)(1).
---------------------------------------------------------------------------

    124. Our understanding is that certain assets cannot be maintained 
with a qualified custodian, but that the bulk of client assets that 
advisers service are able to be held by a qualified custodian. Do 
commenters agree with this understanding? What are some examples of 
assets that cannot be held by a qualified custodian? If an asset cannot 
be maintained with a qualified custodian, should an adviser be 
permitted to have custody of the asset, as that term is defined in the 
proposed rule? Should advisers, instead, be required to relinquish the 
authority that triggers the application of the definition of custody in 
the context of the asset that is unable to be maintained with a 
qualified custodian? Alternatively, should they be required to provide 
alternative safeguards for the asset, such as those proposed?
    125. Are there currently assets that qualified custodians will 
maintain, but doing so would be cost-prohibitive for advisers or their 
clients? If so, what are some examples of these assets? At what point 
does it become cost-prohibitive? Is it measured based on a percentage 
of the value of the asset? Is it based on a percentage of the adviser's 
fee for providing advisory services with respect to that asset? Is it 
the point at which it becomes unprofitable for the adviser to provide 
advice to the client?
    126. Should the proposed rule permit an adviser to conclude that an 
asset is eligible for the exception if it would be prohibitively 
expensive to custody the asset with a qualified custodian? What would 
be considered prohibitively expensive?
    127. Is the proposed definition of privately offered securities 
clear? Should it include any additional factors? Should any of the 
proposed factors be removed? For example, is the description of the 
meaning of uncertificated clear? Should it be revised? Are there 
securities that qualify for the custody rule's description of this term 
that would be unable to rely on the proposed exception as a result of 
the differences of the proposed definition? Please explain.
    128. Do commenters agree with our belief that ownership of crypto 
asset securities that is evidenced through public keys or wallet 
addresses on public blockchains would not qualify for the proposed 
privately offered securities exception? If not, why? Could the 
rationale for the privately offered securities exception--namely, that 
impediments to transferability present with certain privately offered 
securities mitigate some of the risks and provide some external 
safeguards against the kinds of abuse the rule seeks to prevent (loss 
and third-party theft) when those assets cannot be maintained by a 
qualified custodian--also apply to the custody of crypto asset 
securities, the ownership of which is evidenced through public keys or 
wallet addresses on public, permissionless blockchains? \252\ If so, 
how do the protections work? How do they mitigate some or all of the 
risks the rule is designed to address--loss, theft, misappropriation, 
misuse, and adviser insolvency or bankruptcy?
---------------------------------------------------------------------------

    \252\ See 2003 Adopting Release, supra footnote 2 at nn. 26-28 
and accompanying text.
---------------------------------------------------------------------------

    129. Should we provide a more prescriptive definition of physical 
asset? Do commenters believe that there are certain physical assets 
that are unable to be maintained with a qualified custodian? If so, do 
commenters believe that those assets will remain static as the custody 
industry evolves?

[[Page 14711]]

    130. Is the term ``physical assets'' sufficiently clear such that 
advisers will be able to understand its application and appropriately 
utilize the exception? Should we define the term ``physical assets'' or 
use another term for this exception, such as ``tangible assets''? If 
so, should such a definition include or exclude specific asset types? 
What assets are commonly considered to be physical assets that are 
unable to be held at a qualified custodian?
    131. Should the proposed rule provide flexibility for advisers to 
make a reasonable determination that a privately offered security or 
physical asset is eligible for the exception? Are there concerns that 
providing advisers with the ability to make a reasonable determination 
as to whether a privately offered security or physical asset is 
eligible for the exception will allow some advisers to avoid using 
qualified custodians to protect client assets? Should the Commission 
take a different approach instead?
    132. Should we limit the exception to privately offered securities 
and physical assets as proposed? Should we expand the scope of the 
exception to other types of assets? If we expanded the scope, which 
types of assets should we include and why? Specifically, are there 
impediments to transferability present with other types of assets that 
mitigate some of the risks and provide some external safeguards against 
the kinds of abuse the rule seeks to prevent (loss, third-party theft, 
misuse, misappropriation, adviser insolvency/bankruptcy) when those 
assets cannot be maintained by a qualified custodian? Please explain 
your answer. Alternatively, should we not create an exception for 
privately offered securities and physical assets?
    133. Is our understanding correct that the current market for 
custodial services of privately offered securities is limited? Is our 
understanding correct that demand for these services is also limited? 
Do commenters agree with our understanding of the market for custodial 
services for physical assets? Please explain.
    134. To be ``reasonable,'' how frequently should advisers determine 
whether a qualified custodian can maintain possession or control of an 
asset? Should the rule provide flexibility as proposed? Should it 
instead specify intervals, such as monthly, quarterly, semi-annually, 
or annually?
    135. If we expanded the scope of the exception beyond privately 
offered securities and physical assets to other assets that an adviser 
reasonably determines cannot be held at a qualified custodian what 
requirements should we put in place to ensure the assets are properly 
safeguarded? Should such measures include some or all of the 
protections for qualified custodians that we discuss in section II.3.C 
above?
    136. Rule 206(4)-7 requires advisers to adopt and implement 
policies and procedures reasonably designed to prevent violations of 
the Advisers Act and its rules, which will include the safeguarding 
rule. Should we, nonetheless, prescribe specific written policies and 
procedures to be adopted and implemented for determining when privately 
offered securities or physical assets would be eligible for the 
exception? For example, should any such written policies and procedures 
be designed to help ensure that any party involved in maintaining 
client assets be required to exercise due care in accordance with 
reasonable commercial standards to safeguard client assets? Would this 
requirement improve safeguarding of client assets not maintained with a 
qualified custodian?
    137. How do advisers currently safeguard securities for which they 
rely on the privately offered securities exception under the custody 
rule? Do these practices differ from what would be required under the 
proposed rule? Please explain. Should these practices be prescribed 
under the final rule?
    138. Should we define the term ``reasonably safeguard'' in the rule 
text? Do commenters believe that reasonable safeguards are generally 
within reasonable commercial standards for particular physical assets 
or privately offered securities? Are advisers able to ascertain what 
safeguards are within such reasonable commercial standards for 
particular physical assets or privately offered securities they may 
hold on behalf of clients?
    139. How would an adviser document that it is satisfying its 
fiduciary duty to an advisory client when maintaining client assets not 
with a qualified custodian under the proposed exception? How frequently 
would it be required to provide this evidence?
    140. Should we require a particular standard of care? Should we 
require particular safeguards or practices?
    141. Should the rule require an independent public accountant, 
pursuant to a written agreement between the adviser and the accountant, 
to verify transfers of privately offered securities or physical assets 
promptly upon receiving notice from the adviser of any purchase, sale, 
or other transfer of beneficial ownership of such assets? Would the 
requirement enhance the safeguarding of client assets not maintained 
with a qualified custodian and reduce the risk of loss or 
misappropriation?
    142. Is the proposed rule's timing requirement that the written 
agreement require an independent public accountant to ``promptly'' 
verify any purchase, sale, or other transfer of beneficial ownership of 
such assets sufficiently clear? Is the meaning of the term ``promptly'' 
in this context sufficiently understood in practice? Is additional 
guidance needed? In lieu of the ``promptly'' requirement proposed, 
should we require an independent public account to verify any purchase, 
sale, or other transfer of beneficial ownership within a set number of 
days? If so, how many days? For example, within 24 hours of the 
transfer of beneficial ownership? Within 24 hours of receipt of notice 
from adviser? Within two days of the transfer of beneficial ownership 
or notice from the adviser? Within one week of the transfer of 
beneficial ownership or notice from the adviser?
    143. Are we correct in our understanding that independent public 
accountants are familiar with asset verification and transaction 
tracing procedures? Do commenters believe that there are alternative 
procedures that would achieve the policy goals of the rule? Should we 
require the independent public accountant to be the same as the 
independent public accountant hired to conduct the annual surprise 
examination or financial statement audit? Conversely, should we 
prohibit this? Would there be benefits to using the same accountant, 
such as an ability to leverage work papers from the verification when 
performing annual surprise examination or audit procedures? Would there 
be benefits to using a different accountant?
    144. Would the 2009 Accounting Guidance contain sufficient guidance 
for an accountant that is engaged to perform the proposed verification 
procedures around privately offered securities and physical assets that 
are not maintained with a qualified custodian? What changes, if any, do 
you believe would be necessary to provide adequate direction with 
respect to the proposed verification procedures?
    145. Should we require the independent public accountant employed 
by the adviser under this exception to verify the transfers to be 
registered with and subject to inspection by the PCAOB?
    146. Should the rule require the adviser to notify the accountant 
of a transaction within one business day as proposed? Should we require 
these notices to be in writing? Alternatively, should the rule require 
that the written

[[Page 14712]]

agreement between the adviser and the accountant require the adviser to 
notify the accountant of a transaction within one business day?
    147. Do commenters agree with our view that this notification 
should occur as soon as practicable after the closing of a transfer of 
beneficial ownership of assets not custodied with a qualified 
custodian? If not, what timeframe do commenters recommend that would 
achieve the policy goals of the proposed rule? For example, should we 
require the notice be no later than a certain number of hours after the 
transaction date? After the settlement date? After money or asset(s) 
are sent to a counterparty? After receipt of proceeds of a redemption?
    148. Do commenters agree with our belief that it would not be 
challenging for advisers to provide the required notification, as 
proposed?
    149. Is there a way to mitigate the risk that an adviser intending 
to misappropriate client assets does not comply with the notification 
requirement? Should we require other safeguards that limit the risk 
that an adviser intentionally or unintentionally fails to comply with 
the notification requirement?
    150. Rather than requiring verification by an accountant promptly 
after each purchase, sale, or other transfer, as proposed, should we 
require timely notification to the auditor and require the auditor to 
reconcile each reported purchase, sale, or other transfer reported to 
the books and records subject to the annual audit or surprise 
examination? Would this provide the same level of protection for client 
assets not maintained with a qualified custodian as the prompt 
verification requirement proposed? If not, are there nonetheless good 
reasons to require annual verification rather than prompt verification? 
If we were to require only annual verification, are there other 
safeguards that we should require to mitigate the risk of 
misappropriation?
    151. Rather than requiring verification by an accountant promptly 
after each transfer, as proposed, should the rule require, as part of 
the annual surprise examination or annual audit, an accountant to 
verify holdings of privately offered securities from one year to the 
next and evaluate discrepancies? For example, if a client's account 
held assets X, Y, and Z in one year, but only X the following year, the 
accountant would evaluate the disposition of assets Y and Z.
    152. Should the rule require the written agreement between the 
adviser and the accountant to require the accountant to notify the 
Commission within one business day upon finding any material 
discrepancies during the course of its examination? Is the material 
discrepancy requirement clear or should we provide further guidance 
regarding how accountants should make the materiality determination? In 
light of the fact that the requirement is effectively identical to the 
notification requirement for material discrepancies found during a 
surprise examination under the current custody rule, do commenters 
believe that the requirement for the accountant to notify the 
Commission within one business day upon finding any material 
discrepancies would result in ``false positives'' or unnecessary 
notifications to the Commission as a result of the one-business-day 
reporting timeframe? If so, do commenters recommend a different 
timeframe?
    153. Rather than the form of verification and asset tracing 
proposed, should the rule require verification procedures substantially 
in the form used by independent public accountants under custody rule 
206(4)-2(a)(4)?
    154. Should the rule require the independent public accountant to 
file a certificate on Form ADV-E stating that it has verified the 
transactions and describing the nature and extent of its verification? 
If so, when should the certificate be filed? Promptly upon completion 
of the verification? Within one business day? Within a certain period 
of time after being notified by the adviser? Would such a requirement 
enhance the safeguarding of client assets not maintained with a 
qualified custodian and reduce the risk of loss or misappropriation?
    155. Should the rule permit other persons or entities to perform 
the verification that the rule proposes be performed by the independent 
public accountant? For example, should an independent representative be 
permitted to perform this function? If so, should the rule retain the 
independent representative definition from the current rule? \253\ If 
not, what changes should be made? What, if any, procedures should we 
require to be performed to verify the transaction, especially for the 
broad array of physical assets that may be covered by the rule? Would 
an independent representative be equipped to perform verification? 
Would such an approach be more or less burdensome than the proposed 
approach?
---------------------------------------------------------------------------

    \253\ See rule 223-1(d)(4).
---------------------------------------------------------------------------

    156. If an independent representative should be permitted to 
perform the role we are proposing for an independent public accountant, 
should the rule require or prohibit certain parties from acting as an 
independent representative? What persons and entities do commenters 
believe might act as independent representatives? Do commenters believe 
that qualified custodians would be willing to act as independent 
representatives? Do commenters believe that a client could serve as its 
own independent representative? If so, would that further the policy 
goals of the rule? Should there be limits on which clients could serve 
as their own independent representative? For example, should those 
clients be required to be a qualified purchaser, accredited investor, 
or satisfy certain other tests (e.g., net worth, education, licensing)? 
Would there be difficulties in locating a sufficient number of 
independent representatives to perform this function?
    157. Should we require that the proposed verification procedures 
provide a certain level of assurance to investors? If so, what level of 
assurance should we require? Should we require the written agreement 
specify a required assurance framework that would be applied? Should we 
require a reporting mechanism requiring the auditor to communicate the 
results of the ongoing verification procedures to the adviser? If so, 
how frequently should we require reports and what information should we 
require to be included?
    158. As an alternative to the notification and verification 
elements of the proposed rule, should we instead require periodic 
examinations for privately offered securities and physical assets that 
are not maintained with a qualified custodian? If so, should the 
procedures be substantially similar as those required for surprise 
examinations under current rule 206(4)-2(a)(4)? How frequently should 
these examinations occur? Would quarterly be sufficient to reduce the 
risk of misappropriation and loss of client assets? Would quarterly 
surprise examinations be more or less expensive than the notification 
and verification proposed rules?
    159. Are there other challenges with these aspects of the rule, as 
proposed? Would this requirement be expensive for advisers, and would 
advisers pass those costs along to advisory clients?
    160. Should the rule require asset verification of all client 
assets not maintained with a qualified custodian? Would this help 
reduce the risk of theft, loss, or misappropriation of client assets? 
How common is asset verification for privately held securities? For 
physical assets? Should the verification requirement permit sampling of 
client accounts, as opposed to verification of assets for all client

[[Page 14713]]

accounts? Should advisers with custody of assets not maintained with a 
qualified custodian be required to obtain more surprise examinations? 
If so, how frequently? Would quarterly or bi-annual asset verification 
be more appropriate? Is 100% asset verification of assets in all client 
accounts common in other contexts or performed for other purposes 
unrelated to the requirements of the custody rule?
    161. Should the rule require that the audit verify all client 
assets not maintained with a qualified custodian, which would thus bar 
the accountant engaged by the adviser from performing asset sampling 
with respect to such assets? Would this help reduce the risk of theft, 
loss, or misappropriation of client assets? How common is 100% asset 
verification for audits of privately held securities? For physical 
assets? Should advisers with custody of assets not maintained with a 
qualified custodian be required to obtain more audits? If so, how 
frequently? Would quarterly or bi-annual asset audits be more 
appropriate? Is 100% asset verification of client assets common in 
other contexts or audits performed for other purposes unrelated to the 
requirements of the custody rule?
    162. Do audits provide an appropriate level of protection for 
clients where an adviser is unable to keep certain assets with a 
qualified custodian? If not, why not? In addition to the requirement 
that all assets be verified during the annual audit, should we 
recommend any specific audit procedures to test that client assets not 
kept at a qualified custodian are appropriately safeguarded from loss 
or misappropriation?
    163. If an adviser has any assets not maintained with a qualified 
custodian, should the rule require asset verification of all assets, 
including those assets that are maintained with a qualified custodian 
to ensure a complete accounting of all assets occurs as of the audit 
date? Are there other controls that could be put in place to ensure 
assets are not transferred to satisfy an audit and then returned to 
their original location?
    164. Are there risks not discussed above created when an adviser 
has custody of privately offered securities or physical assets that are 
not maintained with a qualified custodian? If so, what are those risks? 
Would the proposed rule sufficiently mitigate those risks? If not, what 
additional safeguards should be required?
    165. As an alternative or in addition to any of the safeguards in 
the proposed exception, should we require advisers to promptly deliver 
a written notice to each client whose assets are not maintained with a 
qualified custodian (or the client's independent representative) 
containing certain specified information regarding the assets, such as 
to inform the client that the assets are not kept by a qualified 
custodian and to explain how the client can verify the existence and 
ownership of those holdings? Should the notice be required to be 
delivered within a certain time to allow an adviser to enter into an 
agreement with an entity to maintain the assets? If so, what should 
that timing be? Should it be similar to the timing the proposed 
exception would require for the adviser to provide notice to the 
accountant? Is there additional information that should be required to 
be included in the notice?
    166. As an alternative or in addition to any of the safeguards in 
the proposed rule, should the rule require that an adviser provide a 
quarterly summary of a client's transactions involving assets that are 
not maintained with a qualified custodian? Should the summary be more 
or less frequent? Should the summary be in a prescribed format or 
should certain specific information be required? If the Commission 
adopts requirements to send quarterly statements to investors in 
private funds as recently proposed,\254\ should that satisfy the 
requirement to send these account statements? Should those quarterly 
statements be required to be audited as an additional or alternative 
condition of the proposed exception?
---------------------------------------------------------------------------

    \254\ See, Private Fund Advisers; Documentation of Registered 
Investment Adviser Compliance Reviews, Release No. IA-5955 (Feb. 9, 
2022) [87 FR 16886] (Mar. 24, 2022).
---------------------------------------------------------------------------

    167. As an alternative or in addition to any of the safeguards in 
the proposed rule, should we require the adviser to obtain an internal 
control report for assets not maintained with a qualified custodian? If 
so, what type(s) of internal control report(s) should we require and 
why? For example, should it have similar control objectives to the 
internal control report we would require of qualified custodians? Who 
should prepare such internal control report(s)? For example, should it 
be an independent public accountant registered with and subject to 
inspection as of the commencement of the engagement period by the 
PCAOB? Should we require an adviser to obtain an internal control 
report covering all of its internal controls, not just internal 
controls relating to the safeguarding of assets not maintained with a 
qualified custodian, or is the proposed exception sufficient to address 
our policy goals? Would requiring an adviser to obtain an internal 
control report be sufficient to mitigate the risks created when an 
adviser has custody of client assets that are not maintained with a 
qualified custodian?
    168. As an alternative or in addition to any of the elements of the 
proposed safeguarding rule, should we require advisers to maintain 
insurance to reimburse clients for losses as a result of the advisers' 
misconduct? For example, should we require fidelity bonds? Should the 
insurance policy limits correspond to the amount of assets not 
maintained with a qualified custodian? Should the insurance policy 
limits correspond to the amount of all of the assets of which the 
adviser has custody? Are policies of this nature common? What costs 
would be associated with this kind of insurance? Who would be the payee 
of any claims--the client who suffered the loss or the adviser? What 
would be the advantages or disadvantages of either approach to payee? 
Are these policies occurrence based (the policy that pays on a claim is 
the one that is in effect at the time the incident occurred) or based 
on when the claims are made (the policy that pays on a claim is the one 
that is in effect at the time the claim is made regardless of when the 
incident occurred)? What would be the advantages and disadvantages to 
occurrence-based or claims-made policies in this context? What are 
common exclusions under these policies? Do they cover simple/ordinary 
negligence? Does the underwriting process for these policies involve an 
evaluation of the adviser's internal controls? Does the underwriting 
process take place annually and if so, does it differ from the initial 
underwriting assessment? Should the insurance policy be obtained from 
an insurer with certain credentials or subject to certain regulatory or 
other standards? Please explain.
    169. As an alternative or in addition to any of the elements of the 
proposed rule, should we require advisers to have certain capital 
requirements? Should capital requirements be required to correspond to 
the amount of assets not maintained with a qualified custodian? Should 
capital requirements correspond to the amount of all of the assets of 
which the adviser has custody? Do advisers often maintain capital 
reserves in the event of a client loss as a result of their misconduct? 
If yes, is the capital maintained in escrow? If we were to require 
financial reserves, should the reserves be maintained in escrow? Who 
would be an appropriate escrow agent? And what would be appropriate 
terms of the escrow, particularly for release of funds? Should the 
capital be maintained

[[Page 14714]]

in a particular type of bank account? If yes, what kind of account is 
commonly used or would be appropriate for these purposes? Should such a 
requirement be conditioned upon using a particular type of bank? What 
type? For example, should it be chartered by the OCC? Subject to 
Federal Deposit Insurance Corporation oversight? What costs are 
associated with escrow accounts and financial reserve/net capital 
requirements?
    170. Are there compliance challenges to this proposed exception? If 
so, what are they?

D. Segregation of Client Assets

    Though advisers must attain reasonable assurance of segregation of 
client assets at a qualified custodian,\255\ the proposed rule also 
would require advisers to segregate client assets from the adviser's 
assets and its related persons' assets in circumstances where the 
adviser has custody. Specifically, the proposed rule would require that 
client assets over which an adviser has custody:
---------------------------------------------------------------------------

    \255\ See discussion of qualified custodian segregation 
requirements at supra section II.(C)(4).
---------------------------------------------------------------------------

    (1) Be titled or registered in the client's name or otherwise held 
for the benefit of that client;
    (2) Not be commingled with the adviser's assets or its related 
persons' assets; and
    (3) Not be subject to any right, charge, security interest, lien, 
or claim of any kind in favor of the adviser, its related persons, or 
its creditors, except to the extent agreed to or authorized in writing 
by the client.\256\
---------------------------------------------------------------------------

    \256\ Proposed rule 223-1(a)(1). See also supra footnote 171.
---------------------------------------------------------------------------

    Segregation of client assets from the assets of others continues to 
be a fundamental element of safeguarding client assets.\257\ This 
aspect of the proposed rule is designed to ensure the client's 
continued ownership and authorized use of its assets. This proposed 
requirement is intended to complement, but serves a slightly different 
purpose than the proposed requirement that the adviser obtain 
reasonable assurance from the qualified custodian that the client's 
assets are similarly segregated. This proposed adviser segregation 
provision is critical in light of the fact that some client assets are 
not maintained with a qualified custodian.\258\ Moreover, we view it as 
essential not only for the custodian, but also for the adviser, to keep 
its own proprietary assets and liabilities segregated from client 
assets to prevent misuse or misappropriation of client assets.
---------------------------------------------------------------------------

    \257\ See supra footnote 168.
    \258\ See proposed rule 223-1(a)(1)(ii)(D).
---------------------------------------------------------------------------

    The proposed requirement that a client's assets be titled or 
registered in the client's name is designed to ensure that the client's 
assets are clearly identified as belonging to the appropriate client, 
regardless of whether a qualified custodian is holding the assets. The 
proposed rule would also permit advisers to identify the assets ``for 
the benefit of'' a particular client where assets may not be ``titled 
or registered'' in the client's name. For example, an adviser acting as 
a trustee would generally maintain client assets in trust for the 
benefit of a particular client for estate planning or other 
purposes.\259\ ``For the benefit of'' is also meant to recognize 
various ways advisory clients can title or register their investments. 
For example, clients may hold securities in ``street name'' or 
``nominee name'' through a book-entry account with a broker-dealer, and 
the broker-dealer will keep records showing the client as the real or 
``beneficial'' owner.\260\ This requirement would protect client assets 
even if the assets are maintained with a broker-dealer in such a manner 
that gives the broker-dealer legal ownership of, or access to, the 
assets.
---------------------------------------------------------------------------

    \259\ The client would maintain the beneficial interest in the 
trust property and the trustee would hold only legal title without 
the benefits of ownership; the trust property is not subject to 
personal obligations of the trustee, even if the trustee becomes 
insolvent or bankrupt. See section 507 of the Uniform Trust Code 
(Jan. 2013).
    \260\ See, e.g., Concept Release on the U.S. Proxy System, 
Investment Advisers Act Release No. 3052 (July 14, 2010) [75 FR 
42981 (July 22, 2010)] (``Proxy Concept Release'').
---------------------------------------------------------------------------

    Similarly, if an adviser purchases privately offered securities 
that are held on the books of the issuer or the issuer's transfer 
agent, the adviser should ensure that the issuer or transfer agent 
properly records and registers the adviser's client as owner. For 
example, if the adviser invests in a private fund or purchases private 
debt for a client, the records at the private fund's transfer agent or 
the private debt issuer should reflect the client as the owner of the 
investment. We believe this requirement would safeguard the client's 
assets from intentionally or inadvertently becoming someone else's 
property as well as prevent circumstances that could result in the 
misuse or misappropriation of client assets.
    The proposed rule would also require that client assets not be 
commingled with the adviser's assets, or those of its related persons. 
The proposed requirement is designed to help ensure that client assets 
are isolated and more readily identifiable as client property.\261\ 
Consequently, we believe the proposed prohibition on commingling would 
help protect client assets from claims by a third party looking to 
secure or satisfy an obligation of the adviser, including in cases of 
insolvency or bankruptcy of the adviser, or its related persons.\262\ 
We do not intend the prohibition on commingling to preclude traditional 
operational practices in which client assets are held together with 
other clients' assets. We recognize that some advisers and custodians 
regularly service assets in a manner where such assets are reasonably 
identifiable from other clients' assets and not subject to increased 
risk of loss from adviser misuse or in the case of adviser insolvency. 
Accordingly, we request comment on some of these practices and the 
potential impact of this prohibition below.
---------------------------------------------------------------------------

    \261\ We have taken a similar approach in other contexts. See, 
e.g., Financial Responsibility Adopting Release, supra footnote 171 
(discussing similar requirements under Rule 15c3-3 that would cause 
a broker-dealer to keep customer securities and cash isolated and 
readily identifiable as ``customer property'' and, consequently, 
available to be distributed to customers in the event that the 
broker-dealer is liquidated in a formal proceeding under the 
Securities Investor Protection Act of 1970).
    \262\ See, e.g., supra footnote 172.
---------------------------------------------------------------------------

    Under the proposed rule, client assets would also be required to 
remain free from any right, charge, security interest, lien, or claim 
of any kind in favor of the adviser, its related persons, or their 
creditors. These requirements are designed to protect client assets by 
limiting the ability of an adviser, or its related persons, to use 
client assets for their own purposes or in a manner not authorized by 
the client. However, we do not intend this condition to limit or 
prohibit authorized actions by clients. We are therefore proposing an 
exception to these requirements to the extent a client agrees to or 
authorizes such arrangements in writing.\263\ In our understanding, 
some clients authorize these types of arrangements depending on the 
types of assets, products, or strategies in which they invest resulting 
in the subject assets being commingled and potentially subject to 
certain claims. For example, such an authorization might allow assets 
to be subject to a securities lending arrangement authorized by the 
client.\264\ In a typical securities lending transaction, the legal 
title to loaned securities passes to the borrower for the loan term. 
The lender regains title to the securities when the securities are 
returned, either upon demand or at the end of a specified

[[Page 14715]]

term. Similarly, in a margin account, which is a type of brokerage 
account, a broker lends cash to a client to allow the client to 
purchase securities. The loan is collateralized by the securities 
purchased, other assets in a client account, and cash, and the broker 
charges a periodic interest rate.\265\ This proposed exception would 
also allow arrangements in which an adviser deducts fees directly from 
client assets for the payment for services rendered by the investment 
adviser or its related persons, so long as the client authorizes such 
payments in writing.
---------------------------------------------------------------------------

    \263\ See proposed rule 223-1(b)(7).
    \264\ See proposed rule 223-1(a)(1)(iii).
    \265\ 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.'').
---------------------------------------------------------------------------

    To the extent a client agrees to or authorizes in writing one of 
these, or similar, arrangements, it would be excepted from the proposed 
prohibition against subjecting the client's assets to any right, 
charge, security interest, lien, or claim in favor of the investment 
adviser or a qualified custodian.\266\ Although these activities may 
implicate the types of risks the proposed rule is designed to address, 
we believe the client is aware of, and consents to, the arrangement for 
ease or by necessity to effect a desired activity with respect to its 
assets.\267\ Without the ability to authorize such arrangements, 
clients would be unable to engage in these potentially beneficial, 
authorized activities.
---------------------------------------------------------------------------

    \266\ Proposed rule 223-1(a)(3)(iii).
    \267\ See also, Standard of Conduct for Investment Advisers 
Release, supra footnote 57, page 8 (noting that although all 
investment advisers owe each of their clients a fiduciary duty under 
the Advisers Act, that the fiduciary duty must be viewed in the 
context of the agreed-upon scope of the relationship and necessarily 
depend upon what functions the adviser, as agent, has agreed to 
assume for the client, its principal).
---------------------------------------------------------------------------

    We believe that proper segregation of client assets, as required by 
the three-part requirements of the proposed rule, would mitigate 
concerns regarding the safety of a client's assets, particularly when 
coupled with the requirement described above that the adviser obtain 
reasonable assurance from the qualified custodian that the custodian is 
similarly segregating the client's assets.
    We request comment on all aspects of the proposed rule's 
requirements for the segregation of investments, including the 
following items.
    171. Should the rule include the proposed segregation requirements? 
Are these requirements sufficiently clear?
    172. Do the proposed segregation requirements properly align with 
the proposed qualified custodian contract provisions and the reasonable 
assurance requirements, especially those proposed in subsections 223-
1(a)(2)(ii)(D) and (E)?
    173. Is the scope of the proposed segregation requirement's 
application to the adviser and its related persons appropriate? Should 
this section also apply to the qualified custodian, or are the proposed 
reasonable assurance requirements in 223-1(a)(2)(ii) sufficient to 
ensure segregation and protection of assets in a custodial account?
    174. Would advisers be able to ensure that assets are held in the 
client's name or for the client's benefit in situations that involve 
recording of interests at a transfer agent or in circumstances 
involving the custody of privately offered securities or physical 
assets?
    175. Would the proposed segregation requirements impose appropriate 
limitations to safeguard client assets? Should we eliminate or modify 
any of them? Alternatively, are there other limitations that would be 
appropriate?
    176. Would the proposed requirements increase the likelihood that 
client assets will be available to be returned to clients if an adviser 
or its related persons experience any financial reverses, such as 
insolvency or bankruptcy? For example, do commenters believe the 
requirements would help ensure that client assets are more readily 
identifiable as client property?
    177. Should certain assets be excluded from these requirements? If 
so, which assets and why? Would limiting these requirements to certain 
types of assets present compliance challenges? If so, what assets and 
why?
    178. In particular, would the proposed segregation requirements 
present challenges with respect to crypto assets? Should we address 
crypto asset segregation and/or custody with separate requirements? Do 
crypto assets raise specific segregation issues not presented by other 
assets? If so, what are they and why? Would the proposed requirements 
offer substantial protections in the event of a bankruptcy or financial 
losses involving an adviser or custodian with custody of crypto assets? 
Would the proposed segregation requirements present challenges with 
respect to other types of assets?
    179. Would the proposed requirements ensure that a third party's 
lien against one client's assets would not be improperly attached to 
other clients' investments? Are there any other rights, charges or 
claims that should be expressly identified in the proposed segregation 
requirements?
    180. The proposed requirements would provide an exception to the 
provision that client assets not be subject to right, charge, security 
interest, lien, or claim of any kind to the extent it is authorized by 
the client in writing. Is this exception appropriate? Is it 
sufficiently clear? Would it properly account for assets that are 
subject to a securities lending arrangement or margin trading 
agreement? Is the proposed exception too broad? For example, should the 
proposed exception apply to only certain types of assets or 
arrangements? Should we prescribe specific conditions that must be 
included in any client authorization?
    181. Is it sufficiently clear from the rule text that client assets 
are not to be subject to any claim except claims for payment of 
services rendered by the investment adviser or related person that is 
agreed to or authorized by the client? Should we explicitly exempt such 
claims for certain types of fees?
    182. Do the proposed segregation requirements to be titled in the 
client's name, not to be commingled, and not to be subject to any 
right, charge, security interest, lien or claim guard against loss, 
misappropriation, misuse, theft, and the financial reverses of the 
adviser, permit the adviser with reasonable operational flexibility to 
use omnibus and other similar accounts?
    183. Should the rule prohibit commingling client and non-client 
assets, as does the current rule? Alternatively, should it permit the 
commingling of client and non-client assets for administrative 
convenience and efficiency? If so, what should be considered 
``administrative convenience and efficiency''? Does allowing client and 
non-client assets to be commingled (e.g., in the same escrow account) 
increase the risk that client assets will be lost, misused, stolen, or 
misappropriated? Could an advisory client's assets be used to satisfy 
the debts of someone else in a bankruptcy event if client and non-
client assets are commingled?
    184. Should the rule include express requirements regarding the 
sub-accounting of commingled accounts if the rule permits commingling 
of client and non-client assets?
    185. We recognize there are some instances where commingling or 
pooling of certain assets may occur via certain omnibus and sub 
accounting arrangements that may present compliance challenges under 
the segregation requirements. We also understand that though such 
commingling may occur, the client assets may still be considered to be 
identifiable via omnibus recordkeeping though they sit among non-client 
assets. In what circumstances may such a requirement restricting 
commingling

[[Page 14716]]

place burdens on advisers? Are there certain assets or transaction 
types for which such a requirement may be particularly burdensome? 
Should we include any exceptions to the prohibition on commingling?
    186. Do commenters agree that there are circumstances when 
advisers' services require them to commingle client assets and non-
client assets? For example, when an adviser uses sweep accounts, escrow 
accounts, or when an adviser serves as administrative agent to a loan 
syndicate where the lenders consist of advisory clients and non-
advisory clients? \268\ In these circumstances, should the rule require 
additional protections? Which protections and why and would they differ 
depending on the type of commingled account? For example, should the 
rule include specific requirements to allow an adviser to hold a 
percentage of the proceeds from the sale or merger of a portfolio 
company owned by one or more client pooled investment vehicles (e.g., 
private equity funds) and other non-clients for a limited period? If 
so, should we limit the types of proceeds that could be included in the 
escrow account or the period in which the escrow exists? Should we 
require the portion of the escrow attributable to the pooled investment 
vehicle client to be included on financial statements that are audited? 
Should we require any contract governing the escrow or other commingled 
account to include certain terms (such as requiring a seller's 
representative or administrative agent to distribute the funds in the 
escrow or commingled account promptly on a predetermined formula)? 
\269\
---------------------------------------------------------------------------

    \268\ See, e.g., Madison Capital No-Action Letter.
    \269\ See 2014 IM Guidance, supra footnote 17, in which our 
staff discussed its views on application of the current rule to 
various situations involving special purposes vehicles SPVs and 
escrows.
---------------------------------------------------------------------------

E. Investment Adviser Delivery of Notice to Clients

    The proposed rule, like the custody rule, would require an 
investment adviser to notify its client in writing promptly upon 
opening an account with a qualified custodian on its behalf.\270\ The 
notice is designed to alert a client to the existence of the qualified 
custodian that maintains possession or control of client assets and 
whom to contact regarding such assets. Based on our experience with the 
custody rule, we continue to believe it provides important client 
protections.
---------------------------------------------------------------------------

    \270\ See proposed rule 223-1(a)(2).
---------------------------------------------------------------------------

    The notice would continue to include the qualified custodian's 
name, address, and the manner in which the investments are maintained. 
The proposed rule would also explicitly require that the notice include 
the custodial account number to improve the utility of the notice. If 
the client is a pooled investment vehicle, the notice must be sent to 
all of the investors in the pool, provided that, if an investor is a 
pooled investment vehicle that is in a control relationship with the 
adviser or the adviser's related persons, the sender must look through 
that pool (and any pools in a control relationship with the adviser or 
its related persons) in order to send the notice to investors in those 
pools.\271\ As discussed above, this is intended to promote meaningful 
delivery of this important information. As is permitted under the 
current rule, the notice could also be delivered to the client's (or 
pooled investment vehicle investor's) independent representative and 
the adviser would continue to be required to provide the notice 
promptly when an account is opened and following any changes in the 
information contained in the notice. If adopted, this provision would 
require advisers to send account opening notices only to clients for 
which it has opened new client accounts with a qualified custodian 
after the effective date of the rule. Advisers would not have to 
provide new notices to existing clients for which it has already opened 
accounts as these clients are likely already aware of the location of 
their assets at the qualified custodian from prior notices.
---------------------------------------------------------------------------

    \271\ See proposed rule 223-1(c).
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed rule's investment 
adviser notice requirement, including the following items.
    187. Should the notice include the qualified custodian's account 
number? Should we require other types of information to be included in 
the notice? If so, what information, and why? Should we eliminate any 
of the proposed types of information from the notice? If so, why?
    188. If an adviser uses several qualified custodians for one of its 
clients, should the proposed rule permit the adviser to provide the 
client a one-time notice for these qualified custodians rather than 
providing a new notice each time the assets move among the qualified 
custodians? \272\ If yes, should the rule require the adviser also to 
provide the client a new notice promptly upon using a new qualified 
custodian to maintain the client's investments?
---------------------------------------------------------------------------

    \272\ Our staff has taken a similar view under the current 
custody rule. See Custody Rule FAQs, supra footnote 17, at Question 
V.1.
---------------------------------------------------------------------------

    189. Should we require advisers to provide notice to clients when 
assets are not held at a qualified custodian? If yes, what form should 
these notices take? Should they be provided on a one-off or periodic 
basis?

F. Amendments to the Surprise Examination Requirement

    We are proposing changes to the surprise examination 
requirement.\273\ Under the current custody rule advisers with custody, 
subject to certain exceptions, must undergo an annual surprise 
verification by an independent public accountant to put ``another set 
of eyes'' on client assets.\274\ In circumstances where the adviser or 
a related person maintain client assets as a qualified custodian, the 
independent public accountant must be 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 PCAOB in 
accordance with its rules. Currently, the surprise examination 
requirement does not require the adviser explicitly to have a 
reasonable belief about the implementation of the written agreement 
between the adviser and the accountant. The surprise examination 
requirement would be amended to state that the adviser must reasonably 
believe that a written agreement has been implemented (i.e., that the 
accountant will perform the surprise examination pursuant to the 
agreement and comply with the section's ADV-E filing and notification 
requirements when required). We are also proposing to amend the 
language concerning notice upon the finding of any material 
discrepancies during the course of an examination that the notice be 
sent by electronic means to the newly designated Division of 
Examinations as opposed to the current rule's requirement to send to 
the Director of the Office of Compliance Inspections and 
Examinations.\275\
---------------------------------------------------------------------------

    \273\ See proposed rule 223-1(a)(4).
    \274\ 2009 Adopting Release, supra footnote 11.
    \275\ See proposed rule 223-1(a)(4)(v).
---------------------------------------------------------------------------

    In a change from the current rule, we are proposing an amendment 
requiring that an adviser ``must reasonably believe'' that the written 
agreement has been implemented. We designed this to address 
circumstances where, in our experience, there is an adviser that has 
entered into the agreement with the accountant, but failed to ensure 
the surprise examination occurs and the requirements of the rule are 
met. Entering into the contract with the

[[Page 14717]]

accountant alone would not satisfy the rule. Accordingly, advisers 
generally should 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 under the surprise examination 
requirement. For example, after securing a written agreement for the 
engagement, the adviser generally should ensure that the accountant is 
able to access the Commission's filing system so that it can perform 
its Form ADV-E filing functions properly under the rule.
    It has been our longstanding view that the involvement of 
independent public accountants in the review and verification of client 
assets of which advisers have custody is an important safeguarding tool 
and reduces the risk of loss of client assets.\276\ Consistent with 
that view, we believe that the adviser must ensure that the independent 
public accountant's involvement in the verification and notification 
requirements in the proposed rule are implemented effectively so as to 
ensure the reliability and integrity of the surprise exam.
---------------------------------------------------------------------------

    \276\ See, 2009 Adopting Release, supra note 11.
---------------------------------------------------------------------------

    We request comment on the proposed rule's modifications to the 
surprise exam requirement, including the following:
    190. Should the rule require that an adviser must reasonably 
believe that the written agreement with the accountant has been 
implemented to satisfy the Form ADV-E and notice requirements of the 
provision? Are advisers able to ensure that an accountant fulfills the 
surprise examination requirements, or are there certain limitations 
that would make satisfaction of this requirement difficult?
    191. What difficulties do accountants have when fulfilling their 
obligations on behalf of advisers under this section of the proposed 
rule? Should we make other amendments to this paragraph of the rule to 
ensure that accountants are able to fulfill their duties under the 
rule? Does the expansion of the scope of the rule from funds and 
securities to assets raise any problems for advisers and auditors that 
would need to comply with the surprise examination requirement?

G. Exceptions From the Surprise Examination

    In light of the proposed changes to the rule's scope to cover all 
assets, the proposal seeks to balance better the costs associated with 
obtaining a surprise examination with the investor protections it 
offers by providing exceptions to the surprise examination requirement 
when the adviser's sole reason for having custody is because it has 
discretionary authority or because the adviser is acting according to a 
standing letter of authorization, each subject to certain conditions. 
We are also proposing modifications to the current rule's audit 
provision that we believe will expand the availability of its use, 
enhance investor protection, and facilitate compliance. These 
exceptions are discussed below.
1. Entities Subject to Audit (``Audit Provision'')
a. Scope of the Audit Provision
    Similar to the custody rule, an adviser that obtains an audit at 
least annually and upon an entity's liquidation under the proposed rule 
would be deemed to have complied with the surprise examination 
requirement and would eliminate the need for an adviser to comply with 
the client notice requirement.\277\ Although the requirement to deliver 
account statements to clients would be different under the proposed 
rule than under the custody rule, the audit provision would still 
eliminate the adviser's need to comply with the account statement 
aspect under the proposed rule as well. Specifically, for the adviser 
to qualify for the audit provision under the proposed rule, its client 
that is a limited partnership (or limited liability company, or another 
type of pooled investment vehicle or any other entity) would need to 
undergo a financial statement audit that meets the terms of the rule at 
least annually and upon liquidation.\278\ Under the proposed rule:
---------------------------------------------------------------------------

    \277\ See proposed rule 223-1(b)(4). As under the custody rule, 
an adviser that relies on an exception from the surprise examination 
requirement, such as the exception for fee deduction under proposed 
rule 223-1(b)(3) or the proposed exception for discretionary trading 
under proposed rule 223-1(b)(8) and see Discretionary Authority, 
infra, need not rely on the audit provision.
    \278\ See proposed rule 223-1(b)(4).
---------------------------------------------------------------------------

    (1) The audit must be performed by an independent public accountant 
that meets the standards of independence 17 CFR 210.2-01 (in rule 2-01 
of Regulation S-X) that 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 PCAOB in accordance 
with its rules;
    (2) The audit meets the definition in 17 CFR 210.1-02(d) (rule 1-
02(d) of Regulation S-X),\279\ the professional engagement period of 
which shall begin and end as indicated in Regulation S-X Rule 2-
01(f)(5); \280\
---------------------------------------------------------------------------

    \279\ Under the definition in rule 1-02(d) of Regulation S-X, an 
``audit'' of an entity (such as a private fund) that is not an 
issuer as defined in section 2(a)(7) of the Sarbanes-Oxley Act of 
2002 means an examination of the financial statements by an 
independent accountant performed in accordance with either the 
generally accepted auditing standards of the United States (``U.S. 
GAAS'') or the standards of the PCAOB. When conducting an audit of 
financial statements in accordance with the standards of the PCAOB, 
however, the auditor would also be required to conduct the audit in 
accordance with U.S. GAAS because the audit would not be within the 
jurisdiction of the PCAOB as defined by the Sarbanes-Oxley Act of 
2002, as amended, (i.e., not an issuer, broker, or dealer). See 
AICPA auditing standards, AU-C section 700.46. We believe most 
advisers would choose to perform the audit in accordance with U.S. 
GAAS only rather than both standards, though it would be permissible 
under the proposed audit rule to perform the audit in accordance 
with both standards.
    \280\ This provision reflects the existing process. Among other 
things, rule 2-01(f)(5) of Regulation S-X indicates that the 
professional engagement period begins at the earlier of when the 
accountant either signs an initial engagement letter (or other 
agreement to review or audit a client's financial statements) or 
begins audit, review, or attest procedures; and the period ends when 
the audit client or the accountant notifies the Commission that the 
client is no longer that accountant's audit client.
---------------------------------------------------------------------------

    (3) Audited financial statements must be prepared in accordance 
with U.S. Generally Accepted Accounting Principles (``U.S. GAAP'') or, 
in the case of financial statements of entities organized under non-
U.S. law or that have a general partner or other manager with a 
principal place of business outside the United States, must contain 
information substantially similar to statements prepared in accordance 
with U.S. GAAP and material differences with U.S. GAAP must be 
reconciled;
    (4) Within 120 days (or 180 days in the case of a fund of funds or 
260 days in the case of a fund of funds of funds) of an entity's fiscal 
year end, the entity's audited financial statements, including any 
reconciliations to U.S. GAAP or supplementary U.S. GAAP disclosures, as 
applicable, are distributed to investors in the entity (or their 
independent representatives); and
    (5) Pursuant to a written agreement between the auditor and the 
adviser or the entity, the auditor notifies the Commission upon certain 
events.\281\
---------------------------------------------------------------------------

    \281\ Proposed rule 223-1(b)(4).
---------------------------------------------------------------------------

    Elements of the proposed rule's audit provision are largely 
unchanged from the audit provision of the custody rule.\282\ 
Differences include: (1) expanded availability from ``pooled investment 
vehicle'' clients to ``entities''; (2) a requirement for the financial 
statements of non-U.S. clients to contain information substantially 
similar to statements prepared in

[[Page 14718]]

accordance with U.S. GAAP and material differences with U.S. GAAP to be 
reconciled; and (3) a requirement for there to be a written agreement 
between the adviser or the entity and the auditor requiring the auditor 
to notify the Commission upon the auditor's termination or issuance of 
a modified opinion.\283\
---------------------------------------------------------------------------

    \282\ Compare rule 206(4)-2(b)(4) with proposed rule 223-
1(b)(4).
    \283\ See proposed rule 223-1(b)(4)(v). See also AICPA auditing 
standard, AU-C section 705, which establishes three types of 
modified opinions: a qualified opinion, an adverse opinion, and a 
disclaimer of opinion.
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed rule's annual 
audit provision, including the following:
    192. Should the rule continue to permit an adviser to satisfy 
certain elements of the rule by relying on the audit provision as 
proposed? Should the rule require an audit upon an entity's liquidation 
as proposed? Should we modify either or both of these requirements? If 
so, how should we modify these requirements, and why?
    193. Should the rule require audits to cover a period of 12 months? 
Would investors derive value from audits that cover periods longer or 
shorter than 12 months? If so, what time periods, and why?
    194. Should the proposed rule allow newly formed and liquidating 
entities to perform an audit less frequently than annually, provided 
that the audit period does not exceed 15 consecutive months, with no 
more than three months of such period occurring immediately before or 
after the entity's fiscal year end? Is 15 months the appropriate audit 
period limit for newly formed and/or liquidating entities? Should we 
increase or decrease this limit? If so, what time period should we 
require, and why? Should we include additional restrictions or 
requirements for newly formed entities and/or liquidating entities 
under the audit provision? If so, what restrictions or requirements, 
and why? Would allowing for less frequent auditing during liquidation--
for example, requiring an audit every 18 months or two years in such 
circumstances--result in a meaningful cost reduction to advisers or 
investors?
    195. Should the proposed rule require investment advisers to 
provide investors with a form of interim financial reporting when an 
entity's audit period will be in excess of 12 months? If so, what 
information should be included in this reporting and who should receive 
this reporting? Should the reporting be audited?
    196. Should the rule permit advisers to satisfy the audit provision 
by relying on an audit on an interval other than annually when an 
entity is liquidating? For example, should we allow advisers to rely on 
an audit of an entity every two years during the liquidation process? 
If so, should we modify the proposed rule to require investment 
advisers to create and distribute alternative financial reporting for 
the entity to investors (e.g., cash-flow audit or asset verification)? 
Alternatively, or in addition to alternative financial reporting, 
should the rule require investment advisers to obtain a third-party 
examination of the liquidating entity? If so, what should the 
examination consist of, and why? For example, an independent auditor 
could examine a liquidating entity to confirm existence of the entity 
and that cash flows were appropriate.
    197. Would allowing investment advisers to satisfy the audit 
provision by relying on an audit less frequently than annually during a 
liquidation raise any investor protection concerns that additional 
requirements could address? If so, what additional requirements, and 
why? For example, should advisers be required to provide notice to 
investors of their intent to liquidate an entity in these 
circumstances? Should advisers be required to obtain investor consent 
prior to satisfying the audit requirement by relying on audits on less 
than annual basis?
    198. The custody rule does not define liquidation or liquidating 
entity for purposes of the liquidation audit requirement. Should it? If 
so, how? For example, should the definition be based on (1) a certain 
percentage of assets under management of the entity from or over 
previous fiscal period(s), (2) a stated threshold based on an absolute 
dollar amount of the entity's assets under management, (3) a 
calculation of the ratio of the management fees assessed on assets 
under management of the entity, (4) some combination of the foregoing, 
or (5) some other basis?
    199. Are there risks posed to investors when an entity is 
liquidating that the proposed rule does not address? If so, please 
describe those risks and how the rule should be modified to address 
such risks.
    200. Are there some types of investments that pose a greater risk 
of misappropriation or loss to investors during a liquidation that the 
rule should specifically address to provide greater investor 
protection? If so, please describe (1) the investment type; (2) the 
particular risk poses to investors by the investment type during 
liquidation; and (3) how to modify the proposed rule to address such 
investor risk.
    201. Should we define ``fund of funds''? \284\ If so, how should we 
define ``fund of funds''? For example, should we define a ``fund of 
funds'' as a pooled investment vehicle that invests 10 percent or more 
of its total assets in other pooled investment vehicles that are not, 
and are not advised by, a related person of the pool, its general 
partner, or its adviser? \285\ Are there other circumstances in which 
the proposed 180-day deadline might be appropriate?
---------------------------------------------------------------------------

    \284\ For example, we have described funds that invest in other 
funds as a ``fund of funds'' arrangement under rule 12d1-4 under the 
Investment Company Act. See Fund of Funds Arrangements, Release Nos. 
33-10871; IC-34045 (Oct. 7, 2020) (Adopting Release).
    \285\ We note that our staff has expressed its views of what 
constitutes a fund of funds for purposes of the custody rule. See 
Custody Rule FAQs, supra footnote 17, at Question VI.7.
---------------------------------------------------------------------------

    202. Should we define ``fund of funds of funds''? If so, how should 
we define ``fund of funds of funds''? For example, should we define 
fund of funds of funds as a fund of funds that invests 10 percent or 
more of its total assets in one or more fund of funds that are not, and 
are not advised by, a related person of the fund of funds, its general 
partner, or its adviser.\286\ Are there other circumstances in which 
the proposed 260-day deadline might be appropriate?
---------------------------------------------------------------------------

    \286\ We note that our staff has expressed its views of what 
constitutes a fund of funds of funds for purposes of the custody 
rule. See Custody Rule FAQs, supra footnote 17, at Question VI.8B.
---------------------------------------------------------------------------

b. The Expanded Availability of Audit Provision
    The current audit provision is available only to advisers to a 
limited partnership (or limited liability company or another type of 
pooled investment vehicle).\287\ Historically, we have relied on 
financial statement audits to verify the existence of pooled investment 
vehicle investments.\288\ Based on our experience since introducing the 
custody rule's audit provision, we have come to believe that audits 
provide substantial benefits to pooled investment vehicles and their 
investors because audits test assertions associated with the investment 
portfolio (e.g., completeness, existence, rights and obligations, 
valuation, presentation). Audits may also provide a check against 
adviser misrepresentations of performance, fees, and other information 
about the pool. We are thus proposing to expand the availability of the 
audit provision from limited partnerships, limited liability companies, 
and other types of pooled investment vehicle clients to any

[[Page 14719]]

advisory client entity whose financial statements are able to be 
audited in accordance with the rule.\289\
---------------------------------------------------------------------------

    \287\ See rule 206(4)-2(b)(4).
    \288\ See, e.g., rule 206(4)-2(b)(4) under the Advisers Act; see 
also 2009 Adopting Release, supra footnote 11.
    \289\ See rule 206(4)-2(b)(4). This provision does not depend 
upon a minimum number of investors in the entity. See also Custody 
Rule FAQs, supra footnote 17, at Question X.1, in which our staff 
expressed a similar view. Similar to the approach under the custody 
rule, under the proposed rule, if the investors or participants in 
the legal entity client that is being audited are also clients of 
the adviser, the adviser would have to evaluate separately whether 
it has the ability or authority to effect a change in beneficial 
ownership of that investor's or participant's investments and comply 
with the proposed rule as appropriate. The financial statement audit 
of the legal entity whose investors or participants have invested 
would not satisfy the adviser's obligations under the proposed rule 
with respect to the investors or participants. See infra footnote 
307.
---------------------------------------------------------------------------

    This aspect of the proposed rule would also eliminate uncertainty 
about the entity types for which the audit provision is currently 
available and extend the investor protection benefits of an audit to a 
larger number of investors, such as pension plans, retirement plans, 
college saving plans (529 plans), and Achieving a Better Life 
Experience savings accounts (ABLE plans or 529 A accounts).\290\ 
Because of uncertainty about the entity types eligible to use the audit 
provision, we believe that some investment advisers do not use the 
current rule's audit provision.
---------------------------------------------------------------------------

    \290\ The staff has previously provided its position to certain 
entities that requested clarity about their eligibility to comply 
with the current rule's exception for audited entities. See, e.g., 
Investment Company Institute, SEC Staff No-Action Letter (Sept. 5, 
2012).
---------------------------------------------------------------------------

    We believe that financial statement audits provide additional 
meaningful protections to investors as compared to a surprise 
examination by increasing the likelihood that fraudulent activity is 
uncovered, thereby providing deterrence against fraudulent conduct by 
advisers. In a financial statement audit, the accountant performs 
procedures beyond those procedures performed during a surprise 
examination. Similar to a surprise examination, a financial statement 
audit involves an accountant verifying the existence of an entity's 
assets. A financial statement audit, however, also typically involves 
an accountant addressing additional important matters that are not 
covered by a surprise examination, such as tests of valuations of 
entity investments, income, operating expenses, and, if applicable, 
incentive fees and allocations that accrue to the adviser. Thus, an 
audit includes the evaluation of amounts and disclosures within the 
financial statements that may be particularly significant to entity 
investors.
    Moreover, we believe many entities other than pooled investment 
vehicles already undergo financial statement audits. These financial 
statement audits of entities may be similar in scope and offer similar 
investor protection benefits as an audit of a pooled investment 
vehicle. The proposed expansion of the availability of the audit 
provision, therefore, may reduce costs for these entities if they no 
longer must additionally undergo a surprise examination.
    The account notice and custodial account statement delivery 
requirements are designed to help ensure the integrity of account 
statements and permit clients to identify any erroneous or unauthorized 
transactions or withdrawals by an adviser.\291\ A financial statement 
audit regularly involves an accountant confirming bank account balances 
and securities holdings as of a point in time and includes the testing 
of transactions that have occurred throughout the year. We believe that 
the common types of audit evidence procedures performed by accountants 
during a financial statement audit--physical examination or inspection, 
confirmation, documentation, inquiry, recalculation, re-performance, 
observation, and analytical procedures--act as an important check to 
identify erroneous or unauthorized transactions or withdrawals by the 
adviser, obviating the need for the account notice and delivery 
requirements for entities that are not pooled investment vehicles.
---------------------------------------------------------------------------

    \291\ See generally 2003 Adopting Release, supra footnote 2; see 
also discussion supra at section II.B and II.E.
---------------------------------------------------------------------------

    We request comment on all aspects of the expanded availability of 
the audit provision, including the following items:
    203. Should we expand the availability of the audit provision 
beyond limited partnerships, limited liability companies, or other 
types of pooled investment vehicle to entities as proposed? If not, 
explain why. If we expand the availability of the audit provision, in 
what circumstances would this likely be utilized? Should we impose any 
limits on the types of entities that can make use of the audit 
provision? If so, what limits, and why? It is our understanding that a 
separate account cannot be audited. Is our understanding correct? If 
not, are separate accounts currently being audited, and if so, for what 
purpose? To the extent separate accounts can be audited, should the 
audit provision be available for separate account clients in addition 
to entities?
    204. Do commenters agree that expanding the scope of entities 
eligible for the audit provision, as proposed, is likely to result in a 
greater percentage of client audits?
    205. Is the term ``entity'' the appropriate term to use to describe 
the audit provision client type, or is there another term we should 
use? For example, an adviser may manage a separate account for a 
corporate institutional client that undergoes a financial statement 
audit for reasons unrelated to the custody rule. Although the financial 
statements pertain to a much broader universe of transactions than just 
transactions in the account or the assets the adviser manages for that 
client, should the adviser be able to rely on this audit to comply with 
the proposed rule? Would the answer depend on whether the adviser 
manages a non-entity sleeve of the client corporation's assets or a 
subsidiary entity?
    206. Should the proposed rule define the term ``entity''? If so, 
how? Would using the term ``entity'' reduce or eliminate any existing 
confusion regarding which entities may make use of the audit provision?
    207. Do other entity client types currently undergo the type of 
audit, i.e., a full scope audit that is required under the audit 
provision? If so, how do the audit procedures for these entity clients 
differ, if at all, from the audit procedures currently performed during 
audits of pooled investment vehicles? If the audit procedures for these 
entity clients differ, do they still offer substantially similar 
protections to investors as the audits currently performed of pooled 
investment vehicles? Why or why not?
    208. We understand that certain entities may undergo audits that 
are limited in scope, e.g., an ERISA section 103(a)(3)(C) audit. We 
understand that these limited scope audits restrict the testing of 
certain investment information where a qualified institution has 
certified to both the completeness and accuracy of the required 
information. These limited scope audits may be more cost-effective, but 
they also do not involve all of the procedures of a full scope audit. 
What audit procedures are performed during these limited scope 
engagements? Do these procedures offer substantially similar protection 
to investors as full scope audits? Why or why not? Should these limited 
scope audits be sufficient to satisfy the requirements of the audit 
exception? If so, why?
    209. Given the independent public accountant's involvement to 
address the risks around the existence of investments and the risk of 
misappropriation, should the

[[Page 14720]]

safeguarding rule require full scope--rather than limited scope--audits 
as proposed? Or should the rule require full scope audits only in 
certain circumstances or with respect to certain entities? If so, what 
are those circumstances and why should the proposed rule require full 
scope audits in those circumstances? Would requiring full scope audits 
prohibit certain entities from being able to use the audit provision? 
If the rule allowed limited scope audits in some or all circumstances, 
should it impose any additional requirements on the investment adviser 
relying on that audit, the accountant performing that audit, or both?
c. PCAOB Inspection
    As is the case with the current custody rule, the proposed rule 
would continue to require accountants performing audits to be 
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 PCAOB in accordance with its rules. We 
believe that registration and periodic inspection of an independent 
public accountant's system of quality control by the PCAOB provides 
investors with some additional level of confidence in the quality of 
audit produced under the proposed rule. Under the PCAOB's current 
inspection program, we understand that the PCAOB selects audit 
engagements of audits performed involving U.S. public companies, other 
issuers, and broker-dealers, so private fund and certain other entity 
audit engagements would not be selected for review. Even if private 
fund and other entity audit engagements are not selected for review 
under the PCAOB's current inspection program, we believe that 
accounting firms registered with and subject to the PCAOB's inspection 
program would implement their quality control systems throughout the 
accounting firm related to their assurance engagements.
    In light of our proposal to expand the availability of the audit 
provision, we understand that this requirement may limit the pool of 
accountants that are eligible to perform these services because only 
those accountants that currently conduct public company issuer audits 
are subject to regular inspection by the PCAOB. Many of an adviser's 
clients are already undergoing a financial statement audit; therefore, 
the increase in demand for these services may be limited.\292\ 
Nonetheless, the resulting competition for these services as a result 
of our proposed expanded availability of the audit provision may result 
in a limited pool of accountants eligible to provide the auditing 
services, which may increase costs to investment advisers and 
investors.
---------------------------------------------------------------------------

    \292\ For example, more than 90 percent of the total number of 
hedge funds and private equity funds currently undergo a financial 
statement audit.
---------------------------------------------------------------------------

    We also understand that, as part of its interim inspection program, 
the PCAOB inspects accountants auditing brokers and dealers, and 
identifies and addresses with these firms any significant issues in 
those audits.\293\ Similar to the inspection program for issuer audits, 
we believe that the interim inspection program for broker-dealers 
provides valuable oversight of these accountants, which may result in 
better quality audits. Although the PCAOB may not disclose which 
accounting firms have been inspected under the interim inspection 
program for broker-dealers, we believe that the PCAOB uses a varied 
approach for selecting a particular audit engagement for review focused 
on both risk-based selections and random selections.\294\ Accordingly, 
we would also consider an accountant's compliance with the PCAOB's 
interim inspection program for auditors of brokers and dealers to 
satisfy the requirement for regular inspection by the PCAOB under the 
proposed audit provision until the effective date of a permanent 
program for the inspection of broker and dealer auditors that is 
approved by the Commission.\295\
---------------------------------------------------------------------------

    \293\ See PCAOB Adopts Interim Inspection Program for Broker-
Dealer Audits and Broker and Dealer Funding Rules (June 14, 2011) 
(``interim inspection program''), available at https://pcaobus.org/News/Releases/Pages/06142011_OpenBoardMeeting.aspx. See also Dodd-
Frank Act section 982.
    \294\ See, e.g., Annual Report on the Interim Inspection Program 
Related to Audits of Brokers and Dealers, PCAOB Release No. 2022-04 
(Aug. 19, 2022) at 7.
    \295\ We note that our staff took a similar position and has had 
several years to observe the impact on the availability of 
accountants to perform services and the quality of services produced 
by these accountants. See Robert Van Grover Esq., Seward & Kissel 
LLP, SEC Staff No-Action Letter (Dec. 11, 2019) (extending the no-
action position taken in prior letters until the date that a PCAOB-
adopted permanent program, having been approved by the Commission, 
takes effect).
---------------------------------------------------------------------------

    An independent public accounting firm would not be considered to be 
``subject to regular inspection,'' however, if it is included on the 
list of firms that is headquartered or has an office in a foreign 
jurisdiction that the PCAOB has determined it is unable to inspect or 
investigate completely because of a position taken by one or more 
authorities in that jurisdiction in accordance with PCAOB Rule 
6100.\296\ We recognize that there may be a limited number of PCAOB-
registered and inspected independent public accountants in certain 
foreign jurisdictions. However, we do not believe that advisers would 
have significant difficulty in finding an accountant that is eligible 
under the proposed rule in most jurisdictions because many PCAOB-
registered independent public accountants who are subject to regular 
inspection currently have practices in various jurisdictions, which may 
ease concerns regarding offshore availability.
---------------------------------------------------------------------------

    \296\ See, e.g., Reports of Board Determinations Pursuant to 
Rule 6100, available at https://pcaobus.org/oversight/international/board-determinations-holding-foreign-companies-accountable-act-hfcaa.
---------------------------------------------------------------------------

    We request comment on the all aspects of the proposed requirement 
that accountants be registered with, and subject to inspection by, the 
PCAOB, including the following items:
    210. Should the rule require accountants performing audits under 
the rule to be registered with the PCAOB as proposed? Should the rule 
require accountants to be subject to regular inspection by the PCAOB as 
proposed? Do accounting firms registered with and subject to regular 
inspection by the PCAOB implement their quality control systems 
throughout the accounting firm related to their assurance engagements? 
Why or why not?
    211. If the rule did not include these requirements, should the 
rule impose any additional licensing, examination, or inspection 
requirements on such accountants? If so, describe these additional 
requirements and explain why they are necessary? For example, should 
the rule require accountants to have a CPA license in good standing?
    212. The PCAOB has specific rules governing regular and special 
inspections under its inspection program.\297\ We understand, however, 
that sometimes advisers may be unsure whether a registered public 
accounting firm is ``subject to regular inspection'' by the PCAOB. 
Rather than require the accountant to be ``subject to regular 
inspection,'' should we instead require the accountant to be a 
registered public accounting firm with either an issuer or broker 
dealer audit client (or play a substantial role in the audit of an 
issuer or broker dealer) as of the start of the engagement period and 
as of each calendar year end? If we were to take this approach, would 
it significantly diminish the number of accountants available to 
perform audits? How would this approach affect the cost of audits?

[[Page 14721]]

Would this have any potential unintended consequences, including, for 
example, adversely affecting smaller public accounting firms compared 
to larger public accounting firms?
---------------------------------------------------------------------------

    \297\ See PCAOB Rule 4000-4003, available at https://pcaobus.org/about/rules-rulemaking/rules/section_4.
---------------------------------------------------------------------------

    213. The PCAOB has explained that it will inspect at least five 
percent of the number of registered public accounting firms reporting 
that they have ``played a substantial role in the preparation or 
furnishing of an audit report with respect to an issuer without having 
issued an audit report with respect to an issuer in that reporting 
period.'' \298\ Should we define ``subject to regular inspection'' for 
purposes of compliance with the safeguarding rule to exclude registered 
public accounting firms that ``played a substantial role in the 
preparation or furnishing of audit report with respect to an issuer 
without having issued an audit report with respect to an issuer in that 
reporting period''? If not, explain why not? If we defined ``subject to 
regular inspection'' in this way, would this significantly diminish the 
number of accountants available to perform audits? If so, how would 
this affect the cost of audits?
---------------------------------------------------------------------------

    \298\ See PCAOB Rule 4003(h), available at https://pcaobus.org/about/rules-rulemaking/rules/section_4.
---------------------------------------------------------------------------

    214. By extending the availability of the audit provision and 
continuing to require that the independent accountants performing 
audits be registered with and subject to regular inspection by the 
PCAOB, the proposed rule may narrow the pool of auditors who would be 
able to perform services under the proposed rule. Should the proposed 
rule instead require only PCAOB-registered public accounting firms to 
be used to perform certain services under the proposed rule? If so, 
which services and why?
    215. Do commenters agree that the availability of accountants to 
perform services for purposes of the proposed rule is sufficient? If 
not, please describe how the proposed rule could provide greater 
availability.
    216. Do commenters agree that advisers have reasonable access to 
public accountants that are registered with and subject to inspection 
by the PCAOB in the foreign jurisdictions in which they operate? If 
not, how should the proposed rule address this issue?
d. Accounting Standards for Financial Statements
    As is the case with the current custody rule, the proposed rule 
would require audited financial statements to be prepared in accordance 
with the generally accepted accounting principles.\299\ Entities that 
are organized outside of the United States, or that have a general 
partner or other manager with a principal place of business outside of 
the United States, may have their financial statements prepared in 
accordance with accounting standards other than U.S. GAAP.\300\ We 
would consider these financial statements to meet the requirements of 
the proposed rule so long as they contain information substantially 
similar to financial statements prepared in accordance with U.S. GAAP, 
material differences with U.S. GAAP are reconciled, and the 
reconciliation, including supplementary U.S. GAAP disclosures, is 
distributed to U.S. investors as part of the audited financial 
statements. Requiring that financial statements comply with U.S. GAAP 
or standards substantially similar to U.S. GAAP along with a 
reconciliation to U.S. GAAP in the case of foreign entities would help 
assure that clients receive consistent and quality financial reporting 
on their assets from their adviser.
---------------------------------------------------------------------------

    \299\ See proposed rule 223-1(b)(4)(iii).
    \300\ This proposed provision is intended to codify our current 
approach. For example, we have previously allowed an adviser to a 
foreign pooled investment vehicle to have its financial statements 
prepared in accordance with International Accounting Standards or 
some other comprehensive body of accounting standards provided that 
the financial statements contain information that is substantially 
similar to financial statements prepared in accordance with U.S. 
GAAP and contains a footnote reconciling any material variations 
between the comprehensive body of accounting standards and U.S. 
GAAP. See 2003 Adopting Release supra footnote 2 at n.41.
---------------------------------------------------------------------------

    We believe that this approach balances the needs of users of the 
financial statements with the cost to prepare financial statements 
under separate accounting standards by allowing advisers the 
flexibility to provide clients with financial statements that are 
prepared in accordance with applicable local accounting standards. We 
also believe a reconciliation to U.S. GAAP is necessary for entity 
audits because U.S. GAAP has industry specific accounting principles 
for certain pooled vehicles, including private funds. For example, U.S. 
GAAP may require measurement of trades on trade date as opposed to 
settlement date, presentation of a schedule of investments, and certain 
financial highlights that may not be required under other accounting 
standards. Because these differences may be material, a reconciliation 
to U.S. GAAP would enhance investor protection.
    We request comment on all aspects of the proposed requirements for 
preparing financial statements in accordance with generally accepted 
accounting principles, including the following items:
    217. Should the rule continue to require accountants to prepare 
audited financial statements in accordance with generally accepted 
accounting principles as proposed? Should the rule include any 
additional requirements regarding the preparation of financial 
statements? If so, what requirements, and why? For example, should we, 
as proposed, consider financial statements of non-U.S. advisers and 
non-U.S. entities to meet the requirements of the rule provided that 
they contain information substantially similar to statements prepared 
in accordance with U.S. GAAP, material differences with U.S. GAAP are 
reconciled, and the reconciliation is distributed to U.S. clients along 
with the financial statements? If so, should we specify what 
``substantially similar'' means? What standards should be viewed as 
``substantially similar'' to U.S. GAAP, and why? Is the requirement to 
reconcile financial statements of entities organized under non-U.S. law 
or that have a general partner or other manager with a principal place 
of business outside the U.S. with U.S. GAAP necessary? Would this 
reconciliation requirement present any difficulties?
    218. In light of our proposal to make the audit provision available 
to advisers to additional entities (e.g., pension plans, retirement 
plans, 529 plans, and ABLE plans), would these additional entities be 
able to meet the proposed accounting standards? Would they present any 
challenges for such entities? Should we modify this aspect of the 
proposal to address these additional entities? If so, how?
    219. It is our understanding that the financial statement 
presentation required under U.S. GAAP may be different for pooled 
investment vehicles, e.g., private funds, compared to other entities, 
e.g., 529 plans. Would these presentation differences have an impact on 
investor's ability to understand the financial statements?
e. Distribution of Audited Financial Statements
    Under the custody rule, an adviser must annually distribute its 
audited financial statements to all limited partners (or members or 
other beneficial owners) within 120 days of the end of its fiscal year 
and promptly upon completion of the audit in the final year of 
liquidation.\301\ The proposed audit provision would generally retain 
this approach, requiring an adviser to

[[Page 14722]]

distribute an entity's audited financial statements to current 
investors within 120 days, but would extend the delivery deadline to 
180 days in the case of a fund of funds or 260 days in the case of a 
fund of funds of funds of the entity's fiscal year end.\302\ The 
audited financial statements would consist of the applicable financial 
statements (including any required reconciliation to U.S. GAAP, 
including supplementary U.S. GAAP disclosures), related schedules, 
accompanying footnotes, and the audit report. Based on our experience 
administering the custody rule, we believe that a 120-day time period 
is appropriate to allow the financial statements of an entity to be 
audited and to provide investors with timely information. We 
understand, however, that preparing audited financial statements for 
some arrangements, such as sub-adviser or outsourced Chief Investment 
Officer (OCIO) arrangements, may require reliance on third parties, 
which could cause an adviser to fail to meet the current 120-day timing 
requirements for distributing audited financial statements regardless 
of actions it takes to meet the requirements. We also recognize there 
may be times when an adviser reasonably believes that an entity's 
audited financial statements would be distributed within the 120-day 
timeframe but fails to have them distributed within that timeframe 
because of unforeseeable circumstances. For example, during the COVID-
19 pandemic, some advisers were unable to distribute audited financial 
statements in the timeframes required under the custody rule due to 
logistical disruptions. Accordingly, the Commission would take the 
position that, if an adviser is unable to deliver audited financial 
statements in the timeframe required under the proposed safeguarding 
rule due to reasonably unforeseeable circumstances, this would not 
provide a basis for enforcement action so long as the adviser 
reasonably believed that the audited financial statements would be 
distributed by the applicable deadline.\303\ We similarly believe that 
a 180-day time period (subject to this position and its reasonable 
belief standard) is appropriate in the context of a fund of funds and 
that a 260-day time period (subject to this position and its reasonable 
belief standard) is appropriate in the context of a fund of funds of 
funds because advisers to these types of pooled investment vehicles may 
face practical difficulties completing their audits before the 
completion of audits for the underlying funds in which they 
invest.\304\
---------------------------------------------------------------------------

    \301\ See rule 206(4)-2(b)(4)(i) and rule 206(4)-2(b)(4)(iii).
    \302\ See proposed rule 223-1(b)(4)(iv).
    \303\ Compare proposed rule 223-1(b)(4)(iv) to rule 206(4)-
2(b)(4)(i). Under the proposed rule, we would still continue to 
require liquidation audited financial statements to be distributed 
``promptly.''
    \304\ See also Custody Rule FAQs, supra footnote 17, at Question 
VI.8A and VI.8B, in which we note that our staff expressed a similar 
view.
---------------------------------------------------------------------------

    Under the proposed audit provision, the audited financial 
statements (including any reconciliation to U.S. GAAP prepared for a 
foreign entity, as applicable) must be sent to all of the entity's 
investors.\305\ Further, if an investor is a pooled investment vehicle 
that is in a control relationship with the adviser or the adviser's 
related persons, the sender must look through that pool (and any pools 
in a control relationship with the adviser or its related persons) in 
order to send the audited financial statements to investors in those 
pools.\306\
---------------------------------------------------------------------------

    \305\ See proposed rule 223-1(b)(4)(iv).
    \306\ See proposed rule 223-1(c); see supra section II.B.3.b.ii.
---------------------------------------------------------------------------

    In addition, an adviser to a pooled investment vehicle client may 
utilize an SPV, organized as a limited liability company, trust, 
partnership, corporation or other similar vehicle, to facilitate 
investments for legal, tax, regulatory or other similar purposes. For 
example, the adviser's pooled investment vehicle client may invest a 
portion of its capital in an SPV, which in turn purchases a single 
investment for the pooled investment vehicle client (``single purpose 
vehicle''). Similarly, an adviser to multiple pooled investment vehicle 
clients may utilize an SPV to purchase a single investment for multiple 
pooled investment vehicle clients (``multi-fund single purpose 
vehicle''). In another variation, an adviser to one or more pooled 
investment vehicle clients may utilize an SPV to purchase multiple 
investments for one or more pooled investment vehicle clients (``multi-
purpose vehicle''). Similar to under the custody rule,\307\ an 
investment adviser could either treat an SPV as a separate client, in 
which case the adviser will have custody of the SPV's assets, or treat 
the SPV's assets as assets of the pooled investment vehicles of which 
it has custody indirectly under the safeguarding rule. If the adviser 
is relying on the audit provision and treats the SPV as a separate 
client, the safeguarding rule would require the adviser to comply 
separately with the safeguarding rule's audited financial statement 
distribution requirements like the custody rule.\308\ Accordingly, the 
adviser would distribute the SPV's audited financial statements to the 
pooled investment vehicle's beneficial owners. If, however, the adviser 
is relying on the audit provision and treats the SPV's assets as the 
pooled investment vehicle's assets of which it has custody indirectly, 
the SPV's assets would be required to be considered within the scope of 
the pooled investment vehicle's financial statement audit.\309\
---------------------------------------------------------------------------

    \307\ Advisers Act Rule 206(4)-2(c) states that sending an 
account statement under paragraph (a)(5) of the custody rule or 
distributing audited financial statements under paragraph (b)(4) of 
the custody rule shall not satisfy the requirements of the custody 
rule if such account statements or financial statements are sent 
solely to limited partners (or members or other beneficial owners) 
that themselves are limited partnerships (or limited liability 
companies, or another type of pooled investment vehicle) and are the 
adviser's related persons.
    \308\ See discussion supra at section II.B.3.b.ii.
    \309\ See also id.
---------------------------------------------------------------------------

    An adviser would have the choice of whether to treat the SPV as a 
separate client or treat the SPV's assets as the pooled investment 
vehicle's assets of which it has custody indirectly, regardless of 
whether the SPV is a single purpose vehicle, multi-fund single purpose 
vehicle, or a multi-purpose vehicle (as applicable), provided that the 
SPV's assets would be considered within the scope of the financial 
statement audit of the pooled investment vehicle client(s) and provided 
that the SPV has no owners other than the adviser, the adviser's 
related person(s) or the pooled investment vehicle clients that are 
controlled by the adviser or the adviser's related person(s). If, 
however, the adviser uses an SPV to purchase one or more investments 
for one or more pooled investment vehicle clients and third parties 
that are not pooled investment vehicles controlled by the adviser or 
the adviser's related person(s), the adviser may not treat the SPV's 
assets as assets of the pooled investment vehicle clients of which the 
adviser or the adviser's related person(s) has custody indirectly for 
purposes of the safeguarding rule. The adviser would, instead, be 
required to treat the SPV's assets as a separate client for purposes of 
the safeguarding rule because the SPV has owners other than the 
adviser, the adviser's related person(s) or pooled investment vehicles 
controlled by the adviser or the adviser's related person(s).\310\
---------------------------------------------------------------------------

    \310\ We note that our staff previously took a similar view. See 
2014 IM Guidance supra footnote 17.
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed rule's 
requirements for distributing audited financial statements, including 
the following items:

[[Page 14723]]

    220. Should the safeguarding rule require audited financial 
statements of an entity to be distributed to all the entity's investors 
within 120 days (or 180 days in the case of a fund of funds or 260 days 
in the case of a fund of funds of funds) as proposed? Would a longer or 
shorter period be appropriate (e.g., 180 days or 90 days)? Should the 
rule expressly allow the statements to be distributed beyond the 
prescribed period of 120 (or 180 or 260) days if a reasonably 
unforeseeable circumstance necessitates a longer period? If so, should 
such a longer period have an outer limit? If so, should other 
conditions apply such as requiring the adviser to retain documentation 
supporting the reasons for the delay? Should it require advisers to 
notify investors of the delay and, if so, what information should be 
included in the notice and by when should it be distributed?
    221. If the adviser is unable to deliver audited financial 
statements in the timeframe required under the proposed safeguarding 
rule because of reasonably unforeseeable circumstances but the adviser 
reasonably believed that the audited financial statements would be 
distributed by the applicable deadline, the Commission would take the 
position that this would not provide a basis for enforcement action. Do 
commenters believe that this position should be incorporated into rule 
text? If so, why?
    222. Instead of requiring distribution of the audited financial 
statement to investors, should we require the statement to be 
distributed or made available to investors upon request?
    223. For entities, we understand that audited financial statements 
are posted to the entity's website, e.g., a 529 plan's website, along 
with a written notification sent to accountholders of the availability 
of the financial statements. The entity also provides a hardcopy of the 
financial statements by mail within three business days upon an 
accountholder's request. Should we continue to allow this type of 
electronic delivery to meet the distribution requirement? Should we 
expand the availability of electronic delivery of audited financial 
statements? If so, how?
    224. Do commenters agree that funds of funds or certain funds in 
master-feeder structures (including those advised by related persons) 
may not be able to prepare and distribute financial statements within 
the current rule's 120-day requirement? Subject to the qualification 
above that the Commission would take the position that an inability to 
deliver audited financial statements in the required timeframe under 
certain circumstances would not provide a basis for enforcement action, 
do commenters agree that distribution within 180 or 260 days of the 
fund's fiscal year end would be appropriate? With the proposed 
expansion of the audit exception to entities, are there any types of 
entities other than fund of funds that should be permitted additional 
time for distribution? If so, why and what should that limit be?
    225. Where an investor is a pooled investment vehicle that is in a 
control relationship with the adviser or the adviser's related persons, 
should we require the sender to look through that pool (and any pools 
in a control relationship with the adviser or its related persons) to 
satisfy the distribution requirement? If not, why not?
    226. We understand that some registered fund families have 
organized unregistered money market funds for investment exclusively by 
their registered investment companies, in compliance with rule 12d1-1 
under the Investment Company Act. The financial statements of the 
unregistered money market funds are audited, but delivered to the 
registered investment companies, which may be related persons of the 
adviser. Should there be an exception to the distribution requirements 
of proposed rule 223-1(c) under these circumstances? \311\ Are there 
other similar circumstances where an exception would be appropriate? 
Please explain.
---------------------------------------------------------------------------

    \311\ We note that our staff has stated that it would not 
recommend enforcement action to the Commission under similar 
circumstances. See Custody Rule FAQs, supra footnote 17, at Question 
VI.10.
---------------------------------------------------------------------------

f. Commission Notification
    The proposed rule would require an adviser to enter into, or cause 
the entity to enter into, a written agreement with the independent 
public accountant performing the audit to notify the Commission (i) 
within one business day upon issuing an audit report to the entity that 
contains a modified opinion and (ii) within four business days of 
resignation or dismissal from, or other termination of, the engagement, 
or upon removing itself or being removed from consideration for being 
reappointed.\312\ These proposed requirements are drawn from the 
current rule's Form ADV-E filing requirement for independent public 
accountants performing surprise examinations.\313\ The accountant 
making such a notification would be required to provide its contact 
information and indicate its reason for sending the notification. The 
written agreement must require the independent public accountant to 
notify the Commission by electronic means directed to the Division of 
Examinations. Timely receipt of this information would enable our staff 
to evaluate the need for an examination of the adviser. We expect the 
Division of Examinations would establish a dedicated email address to 
receive these confidential transmissions and would make the address 
available on the Commission's website in an easily retrievable 
location.
---------------------------------------------------------------------------

    \312\ See proposed rule 223-1(b)(4)(v).
    \313\ See rule 206(4)-2(a)(4).
---------------------------------------------------------------------------

    Although there is a requirement on Form ADV for an adviser to a 
private fund to report to the Commission whether it received a 
qualified audit opinion and to provide, and update, its auditor's 
identifying information, there is not a similar obligation for an 
accountant to notify the Commission as there is for a surprise 
examination under the current rule.\314\ Based on our experience in 
receiving notifications from accountants who perform surprise 
examinations under the custody rule, we believe that the timely receipt 
of this information--from an independent third party--would more 
readily enable our staff to identify advisers potentially engaged in 
harmful misconduct and who have other compliance issues. This would 
bolster the Commission's efforts at preventing fraudulent, deceptive, 
and manipulative activity and would aid oversight of investment 
advisers.
---------------------------------------------------------------------------

    \314\ See rule 206(4)-2(a)(4) compare to rule 206(4)-2(b)(4); 
see also Form ADV Part 1A, Schedule D, section 7.B.1, Q.23.
---------------------------------------------------------------------------

    We request comment on all aspects these notification requirements, 
including the following items:
    227. Should independent public accountants completing financial 
statement audits under the proposed rule be required to provide these 
proposed notifications? Would the requirement for an accountant to 
comply with the notification requirement change the approach that an 
accountant would take regarding audits that normally are performed for 
purposes of satisfying the custody rule? If so, how?
    228. Are there any privacy concerns or contractual obligations that 
could prohibit or restrict an accountant from providing this 
information? If so, what?
    229. The regulations in 17 CFR 240.17a-5 (rule 17a-5) require a 
broker or dealer to self-report to the Commission within one business 
day and to provide a copy to the accountant. The accountant must report 
to the Commission about any aspects of the broker's or dealer's report 
with which the accountant does not agree. If the

[[Page 14724]]

broker or dealer fails to self-report, the accountant must report to 
the Commission to describe any material weaknesses or any instances of 
non-compliance that triggered the notification requirement. Should the 
audit provision under the proposed rule contain a notification 
requirement similar to rule 17a-5? Why or why not?
    230. The regulations in 17 CFR 240.17a-5 (rule 17a-5) also require 
a broker-dealer, pursuant to a statement filed with the Commission, to 
allow access to the audit documentation associated with the reports of 
the independent public accountant and to allow the independent public 
accountant to discuss the findings associated with the reports with 
representatives of the Commission. Should the rule include a similar 
provision? Specifically, should the rule require that an investment 
adviser, pursuant to a written agreement between the adviser and the 
accountant, allow access to the audit or examination documentation 
associated with the reports of the independent public accountant, by 
representatives of the Commission, if requested in writing for purposes 
of an examination of the adviser? Should the rule require the 
investment adviser, pursuant to a written agreement between the adviser 
and the accountant, to require the independent public accountant to 
discuss with representatives of the Commission, if requested in writing 
for purposes of an examination of the adviser, the findings associated 
with the reports of the independent public accountant?
    231. Should the accountant instead be required to file Form ADV-E 
in a similar manner as independent public accountants who complete 
surprise examinations? If so, what types of information should be 
included on Form ADV-E with respect to financial statement audits? 
Should a copy of the audit report or a copy of the audited financial 
statements be filed with the Commission? If so, would there be issues 
with making copies of these reports publicly available, particularly 
since the adviser typically is not a party to the audit engagement 
agreement between the audited entity and the independent public 
accountant?
    232. Is one business day the appropriate timeframe for notification 
upon an accountant issuing a modified opinion? Should we use a 
different timeframe, such as promptly? Why or why not?
    233. Is four business days the appropriate timeframe for 
notification after an accountant's resignation or dismissal from, or 
other termination of, the engagement, or upon removing itself or being 
removed from consideration for being reappointed? Should we use a 
different timeframe? Why or why not?
    234. Should the independent public accountants completing financial 
statement audits under the proposed rule be required to provide these 
proposed notifications of resignation or dismissal from, or other 
termination of, the engagement, or upon removing itself or being 
removed from consideration for being reappointed? Are there any 
instances of resignation or dismissal from, or other termination of, 
the engagement, or upon removing itself or being removed from 
consideration for being reappointed that should not be reported? If so, 
why? Should we also amend the instructions to Form ADV-E in a similar 
way?
2. Discretionary Authority
    The proposed rule would contain an exception from the surprise 
examination requirement for client assets if the adviser's sole basis 
for having custody is discretionary authority with respect to those 
assets, provided this exception applies only for client assets that are 
maintained with a qualified custodian in accordance with the proposed 
rule and for accounts where the adviser's discretionary authority is 
limited to instructing its client's qualified custodian to transact in 
assets that settle exclusively on a DVP basis.\315\ In DVP 
transactions, clients' custodians are generally under instructions to 
transfer assets out of a client's account only upon corresponding 
transfer of assets into the account.
---------------------------------------------------------------------------

    \315\ Proposed rule 223-1(b)(8).
---------------------------------------------------------------------------

    When a custodian is under instructions to transfer assets out of a 
client's account only upon corresponding transfer of assets into the 
account, there is a reduced risk that the adviser could misappropriate 
the assets, and when the transaction settles on a DVP basis there is a 
reduced risk of theft of the asset because, on a non-DVP basis, the 
seller of an asset could deliver the asset but not receive payment or 
the buyer of an asset could make payment but not receive delivery of 
the asset.\316\ We believe this exception will focus the requirement to 
obtain a surprise examination where the risk of misappropriation is 
greatest. As an example, if the custodian's instructions from the 
client authorize the adviser to wire cash from the client's account in 
exchange for an equivalent amount of XYZ stock that is to be received 
into the client's account, the adviser need not undergo a surprise 
examination. If, however, the custodian's instructions from the client 
authorize the adviser to wire cash from the client's account without 
receipt of a corresponding asset, the adviser would need to undergo a 
surprise examination.
---------------------------------------------------------------------------

    \316\ We note that the staff has acknowledged that limiting the 
adviser's authority to transactions that settle via DVP at a 
qualified custodian is one way for an adviser to avoid inadvertent 
custody. The staff's statement noted that an adviser could draft a 
letter (or other form of document) addressed to the custodian that 
limits the adviser's authority to ``delivery versus payment,'' 
notwithstanding the wording of the custodial agreement, and have the 
client and custodian provide written consent to acknowledge the new 
arrangement. See 2017 IM Guidance, supra footnote 135.
---------------------------------------------------------------------------

    We propose to limit this exception to instances where this is the 
adviser's sole basis for custody. Accordingly, if an adviser also has 
custody of the client's assets for additional reasons, such as via a 
power of attorney that confers one-way transfer authority, the adviser 
cannot rely on the exception. Conversely, if an adviser also has 
custody of the client's assets for reasons that are also subject to 
similar exceptions (e.g., sole basis is fee deduction, sole basis is 
related person custody),\317\ the adviser can rely on the exception. 
These exceptions from the surprise examination requirement are not 
mutually exclusive of one another notwithstanding our use of ``solely'' 
in each of them.\318\
---------------------------------------------------------------------------

    \317\ See Rule 206(4)-2(b)(3) and (6) and proposed rule 223-
1(b)(6).
    \318\ See proposed rule 223-1(b)(9).
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed exception for 
discretionary authority, including the following items.
    235. Should we provide an exception from the requirement to obtain 
an independent verification of client assets if an adviser's sole basis 
for custody is having discretionary authority with respect to client 
assets that are maintained with a qualified custodian in accordance 
with the rule? Does providing such an exception from asset verification 
in these limited circumstances produce additional risks for client 
assets?
    236. Are we correct in our assessment that this proposed exception 
would better balance the costs and protections of the proposed rule?
    237. Should we limit the exception to situations in which the 
qualified custodian implements certain policies and procedures? If so, 
what should they include? For example, would a qualified custodian need 
to demonstrate that it has certain systems, confirmations, or 
authorizations in place to ensure that an adviser is unable to initiate 
any one-way transactions and that the adviser's authority is limited to 
only trading?

[[Page 14725]]

    238. Should we limit the exception to situations in which the 
adviser implements certain policies and procedures with regard to 
discretionary authority? If so, what should those policies and 
procedures be? If we were to rely more heavily on the adviser's 
policies and procedures, should we require external testing or auditing 
of those policies and procedures or internal controls? For example, 
should we require an internal control report with similar control 
objectives to the internal control reports we require under the custody 
rule or what we would require under the safeguarding rule?
    239. Do commenters agree with our assessment of the risks to client 
assets as a result of discretionary authority in qualified custodian 
accounts? Do commenters agree with our assumption that a one-way 
transfer of assets from an account at a qualified custodian is a 
riskier form of discretionary authority than DVP transactions? Are 
there circumstances in a discretionary trading environment at a 
qualified custodian where risks of misappropriation or theft in an 
account are not mitigated by DVP settlement or requiring a one-for-one 
exchange of assets? If so, please provide such examples.
    240. If an adviser's authority over an account with a qualified 
custodian includes the ability to transfer assets free of payment to 
another account with the same account title, should such an account 
still be eligible for the limited exception to the surprise 
examination?
    241. Should this exception apply ``solely'' when the basis for 
custody is discretionary authority? Should we allow use of the 
exception when the adviser also qualifies for another exception that is 
similarly premised on an adviser ``solely'' having custody for a 
specifically identified reason, such as when an adviser has custody of 
client assets ``solely'' as a consequence of its authority to make 
withdrawals from client accounts to pay its advisory fee, or ``solely'' 
because a related person has custody of them in connection with the 
adviser's advisory services? Notwithstanding the use of ``solely'' in 
certain exceptions from the surprise examination requirement, these 
limited exceptions are not mutually exclusive; should they be? \319\
---------------------------------------------------------------------------

    \319\ See rule 206(4)-2(b)(3) and (6); proposed rule 223-1(b)(3) 
and (6).
---------------------------------------------------------------------------

3. Standing Letters of Authorization
    The proposed rule also contains an exception from the surprise 
examination requirement for client assets if the adviser has custody of 
those assets solely because of a standing letter of authorization 
(``SLOA'').\320\ The rule would define SLOA as an arrangement among the 
adviser, the client, and the client's qualified custodian in which the 
adviser is authorized, in writing, to direct the qualified custodian to 
transfer assets to a third-party recipient on a specified schedule or 
from time to time. In such an arrangement the client's qualified 
custodian could not be an adviser's related person.\321\ Such an 
authorization must include the client's signature, the third party 
recipient's name, and either the third party's address or the third 
party's account number at a custodian to which the transfer should be 
directed. The authorization must also provide that the investment 
adviser has no ability or authority to designate or change any 
information about the recipient, including name, address, and account 
number.\322\
---------------------------------------------------------------------------

    \320\ Proposed rule 223-1(b)(7).
    \321\ The term ``related person'' would have the same meaning as 
in the current rule.
    \322\ Proposed rule 223-1(d)(12).
---------------------------------------------------------------------------

    Clients increasingly grant their advisers limited powers to 
disburse assets from their accounts to one or more specifically 
designated third parties in a manner that limits the adviser's ability 
to redirect the assets. For example, a client may grant its adviser 
this authority pursuant to a one-time or standing letter of instruction 
or other similar asset transfer authorization arrangement that the 
client establishes with qualified custodians. In granting such 
authority the client may authorize the adviser to perform transfers or 
disbursements via automated clearing house (i.e., ACH) transfers, 
wires, checks, or other methods. Such authorizations can be for one-
time wires out of the account or standing authorization where an 
adviser is given ongoing authority by the client to execute certain 
asset movements into and out of a client's account.
    The written instruction and authorization could be provided to the 
adviser on the same form the client delivers to its qualified 
custodian, or it could be provided separately, but it must be delivered 
to both parties. The required signature would ensure that the 
instructions and authorizations are verifiably from the client. We 
believe the types of financial institutions identified as meeting the 
proposed definition of qualified custodian are required by their 
primary functional regulator or otherwise to perform procedures to 
verify the instruction and authorization, through a signature review 
and, if determined to be necessary, based on the facts and 
circumstances, another method of verification. The required information 
could help ensure that the instructions to the qualified custodian 
provide relevant information about the recipient. These instructions 
could include a specified schedule for transfers, or they could include 
a more general instruction for the adviser to direct transfers to the 
recipient from time to time.
    Where the arrangement is structured so that the adviser's role is 
limited to determining the timing and amounts when disbursing a 
client's assets, we believe that the adviser's role in effecting any 
change in beneficial ownership is circumscribed and ministerial, and 
there is little risk to clients of loss, misuse, misappropriation, or 
theft of its asset.\323\ We also believe under such circumstances that 
a qualified custodian would be best positioned to ensure that the 
required authorizations and instructions are properly and verifiably 
issued by the client (e.g., the client's signature is verifiable), 
provided the custodian is not a related person of the adviser to reduce 
the incentive and opportunity to collude in such an arrangement.\324\ 
Under these circumstances, we believe that the proposed rule's 
independent verification requirement would not be meaningfully additive 
to protect a client's assets.\325\
---------------------------------------------------------------------------

    \323\ We note that the staff has taken a similar position. See 
Investment Adviser Association, SEC Staff No-Action Letter (Feb. 21, 
2017) (indicating the staff would not recommend enforcement action 
to the Commission if advisers exercise limited authority pursuant to 
a SLOA without undergoing an annual surprise examination, if the 
SLOA arrangement meets certain specified conditions).
    \324\ Each of the types of financial institutions identified in 
the proposed rule as meeting the definition of qualified custodian 
is subject to anti-money laundering and know your customer 
requirements that require the financial institution to verify 
signatures. See, e.g., 12 CFR 21.21 (requiring every national bank 
and savings association to have a written, board approved program 
that is reasonably designed to assure and monitor compliance with 
the Bank Secrecy Act); FINRA Rule 3310 (setting forth the minimum 
standards for broker-dealer firm's written anti-money laundering 
compliance programs); FINRA Rule 2090 (requiring broker-dealers to 
use reasonable diligence, in regard to the opening and maintenance 
of customer accounts, to know (and retain) essential facts 
concerning its customers and concerning the authority of each person 
acting on behalf of such customers); see also Federal Financial 
Institutions Examination Council Bank Secrecy Act/Anti-Money 
Laundering Examination Manual, available at https://bsaaml.ffiec.gov/manual database of BSA/AML policies and procedures.
    \325\ An adviser would be required to report to the Commission 
on Form ADV if it is relying on this exception. See proposed Form 
ADV amendment to Item 9 (Safeguarding). In addition, we are 
proposing corresponding amendments to the books and records rule. 
Proposed rule 204-2(b)(2) would require advisers to retain true, 
accurate, and current copies of, and records relating to, any SLOA 
issued by a client to the adviser. Proposed rule 204-2(b)(2)(vi).

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

[[Page 14726]]

    Finally, as noted above, this exception is not mutually exclusive 
of similar limited exceptions within the proposed rule, notwithstanding 
our use of ``solely'' in each of them. It would not, however, be 
available if the adviser has custody for another reason outside of the 
ones that would qualify the adviser for an exception as a sole basis 
for custody. In our view, the approach outlined above clarifies that 
the initiation of SLOAs means that advisers have custody under the 
rule, but also recognizes the lower risks to client assets associated 
with these arrangements. We request comment on all aspects of the 
proposed rule's SLOA exception, including the following items.
    242. Do commenters agree that an adviser should be exempt from the 
independent verification requirements if it has custody solely because 
of an SLOA where the client grants its adviser the limited power for 
disbursements to third parties specifically designated by the client 
and the adviser can comply with the conditions of the proposed 
exception? Are there other protections we should require? If so, what 
protections?
    243. Should this exception be available when the client's assets 
are not maintained with a qualified custodian? Does a qualified 
custodian better protect client assets subject to limited powers of 
attorney (such as by performing signature verification procedures under 
anti-money laundering and know-your-customer requirements that require 
the financial institution to verify signatures)?
    244. Should this exception be unavailable when the client's assets 
are at a related qualified custodian, as proposed? If not, what 
specific conditions would safeguard client assets from the risks of 
loss, theft, misuse, or misappropriation in these circumstances?
    245. Would an adviser's authority be appropriately limited (and 
therefore circumscribed and ministerial) if the client's instructions 
include the name and either the address or the account number of the 
recipient to whom a transfer of investments should be directed? Should 
the instructions and authorization include different, or additional, 
information, and if so, what?
    246. Are qualified custodians required to verify SLOAs, or other 
limited power of attorney, instructions under their governing 
regulations, such as a signature review or other method? If not, should 
we require the adviser to confirm or contract with the qualified 
custodian so that it takes these steps?
    247. Would it be appropriate to permit another party, such as an 
introducing broker, to perform these steps for the qualified custodian? 
Is this sometimes necessary, such as in the context of signature 
verification, if the introducing broker has a relationship with the 
client while a clearing broker serves as qualified custodian? If yes, 
under what conditions? For instance, should the person performing the 
steps be regulated for this activity? Should the person be prohibited 
from performing these steps if it is a related person of the adviser?
    248. Are qualified custodians required under their governing 
regulations to provide a transfer of funds notice to the client 
promptly after each transfer under a power of attorney and/or send the 
client, in writing, an initial notice confirming the instruction and an 
annual notice reconfirming the instruction? If not, should we require 
the qualified custodian take these steps as part of this proposed 
exception? Alternatively, should we require the adviser to include a 
provision requiring such notice in its written agreement with the 
qualified custodian?
    249. Do commenters agree that, in order to rely on this proposed 
exception, the investment adviser must have no authority or ability to 
designate or change the identity of the third party, the address, or 
any other information about the third party contained in the client's 
instruction, as proposed? Are there other safeguards that an investment 
adviser should comply with in order to rely on this proposed exception?
    250. Are clients that issue limited powers of attorney able to 
terminate or change the instruction to their qualified custodians? If 
not, should we require that the client have this ability as part of 
this proposed exception?
    251. Are there some types of limited powers of attorney for which 
an adviser cannot satisfy the proposed conditions, where we should 
nevertheless permit an adviser to rely on this proposed exception? In 
those cases, is the adviser's role in effecting any change in 
beneficial ownership of a client's assets similarly circumscribed by 
the client and ministerial in nature? If so, what are they?
    252. Could online bill pay be integrated into the proposed 
framework for the standing letters of authorization exception or 
another exception? Would there be the difficulties in crafting an 
exception for bill pay that offered similar protections to those we 
describe above?
    253. Given the general irreversibility of crypto asset transactions 
in the event of erroneous or fraudulent transactions, should this 
proposed exception be unavailable for crypto assets?

H. Amendments to the Investment Adviser Recordkeeping Rule

    We are proposing to amend rule 204-2 to set forth requirements for 
making and keeping books and records related to the requirements of the 
proposed custody rule. The proposed amendments to rule 204-2 are 
designed to work in concert with the proposed rule to help ensure that 
a complete custodial record with respect to client assets is maintained 
and preserved.
    The proposed changes to the recordkeeping rule would help 
facilitate the Commission's inspection and enforcement capabilities, 
including assessing compliance with the requirements of the proposed 
rule. Reviewing client account activity and holdings is a routine part 
of most adviser examinations conducted by Commission staff. Currently, 
however, Commission staff experience challenges in requesting, 
receiving, and reconciling complete and accurate client-level 
information from some investment advisers due to a lack of 
recordkeeping and coordination between advisers and custodians. The 
proposed recordkeeping amendments are designed to help reduce these 
challenges by making it easier for examiners to obtain and review more 
complete and accurate advisory client account records. We believe 
having more complete records would facilitate client account 
reconciliation of all debits and credits to and from client accounts. 
This would benefit investors directly by virtue of enhanced detection 
and deterrence of possible misappropriation or fraud. More complete 
records also would better enable examiners to identify and detect 
potential investment adviser misappropriation or loss or misuse of 
client assets during their examinations, resulting in more effective 
investor protections.
    The proposed amendments to rule 204-2 would require an investment 
adviser that has custody of client assets to make and keep true, 
accurate, and current records of required client notifications and 
independent public accountant engagements under proposed rule 223-1, as 
well as books and records related to specific types of client account 
information, custodian information, transaction and position 
information, and standing letters of

[[Page 14727]]

authorization.\326\ The proposed amendments would require a more 
detailed and broader scope of records of trade and transaction activity 
and position information for each client account than the existing 
requirements for such records.\327\ The proposed amendments also would 
add new recordkeeping requirements that include: (i) retaining copies 
of required client notices; \328\ (ii) creating and retaining records 
documenting client account identifying information, including copies of 
all account opening records and whether the adviser has discretionary 
authority; \329\ (iii) creating and retaining records of custodian 
identifying information, including copies of required qualified 
custodian agreements, copies of all records received from the qualified 
custodian relating to client assets, a record of required reasonable 
assurances that the adviser obtains from the qualified custodian, and 
if applicable, a copy of the adviser's written reasonable determination 
that ownership of certain specified client assets cannot be recorded 
and maintained (book-entry, digital, or otherwise) in a manner in which 
a qualified custodian can maintain possession or control of such 
assets; \330\ (iv) creating and retaining a record that indicates the 
basis of the adviser's custody of client assets; \331\ (v) retaining 
copies of all account statements; \332\ and (vi) retaining copies of 
any standing letters of authorization.\333\ Lastly, the proposed 
amendments would add new recordkeeping requirements to address 
independent public accountant engagements.\334\ We believe that all of 
these requirements would enhance the Commission's oversight of the 
safeguarding practices of advisers and their compliance with the rule, 
which would, in turn, promote investor protection.
---------------------------------------------------------------------------

    \326\ Advisers would be required to maintain the proposed 
records for a period of not less than five years as required under 
the current books and recordkeeping rule. See rule 204-2(e)(1).
    \327\ Compare rules 204-2(b)(1) through (4) with proposed rule 
204-2(b)(2)(v). Advisers would continue to be required to make and 
keep a record describing the basis upon which the adviser has 
determined that the presumption that any related person is not 
operationally independent has been overcome, as required under 
current rule 204-2(b)(5). This requirement would be renumbered in 
the proposed rule with an updated cross-reference to the definition 
of ``operationally independent'' in proposed rule 223-1(d)(7).
    \328\ Proposed rule 204-2(b)(1).
    \329\ Proposed rule 204-2(b)(2)(i). Given this proposed client 
account recordkeeping requirement, we would eliminate the current 
requirement under rule 204-2(a)(8) to keep a list or other record of 
all client accounts for which the investment adviser has any 
discretionary power.
    \330\ Proposed rule 204-2(b)(2)(ii).
    \331\ Proposed rule 204-2(b)(2)(iii).
    \332\ Proposed rule 204-2(b)(2)(iv).
    \333\ Proposed rule 204-2(b)(2)(vi).
    \334\ Proposed rule 204-2(b)(3). Given that the proposed 
independent public accountant recordkeeping requirements would 
include a requirement to retain copies of internal control reports 
under proposed rule 223-1, we would eliminate the current 
requirement under rule 204-2(a)(17)(iii) to keep a copy of any 
internal control report obtained or received pursuant to rule 
206(4)-2(a)(6)(ii). See proposed rule 204-2(b)(3)(ii).
---------------------------------------------------------------------------

1. Client Communications
    The proposed amendments also would require an adviser to maintain a 
copy of all written notices to clients required under the proposed rule 
and any responses thereto.\335\ Specifically, this would include 
notifications provided by the adviser to each client upon opening 
accounts at qualified custodians on the client's behalf, along with 
notices in writing of any subsequent changes in the qualified 
custodian's name, address, and account number, and the manner in which 
the client's assets are maintained.\336\ Again, we believe these 
requirements will enable our staff to confirm that an adviser is 
complying with providing appropriate client communications requirements 
under proposed rule 223-1.
---------------------------------------------------------------------------

    \335\ See proposed rule 204-2(b)(1).
    \336\ See proposed rule 223-1(a)(2).
---------------------------------------------------------------------------

2. Client Accounts
    Additionally, the proposed amendments would require an adviser to 
maintain six categories of records \337\ with respect to each client 
account for which the adviser has custody of client assets: (1) client 
account identification; \338\ (2) custodian identification; \339\ (3) 
the basis for the adviser having custody of client assets in the 
account, and whether a related person holds the adviser's client 
assets; (4) any account statements received or sent by the adviser, 
including those delivered by the qualified custodian; (5) transaction 
and position information; and (6) standing letters of authorization.
---------------------------------------------------------------------------

    \337\ See generally proposed rule 204-2(b)(2) for these six 
categories of records.
    \338\ For each client account, the adviser would maintain: the 
advisory account name; client contact information (including name, 
mailing address, phone number, email address); advisory account 
number; client type (as identified in Item 5.D. of Form ADV); or any 
other identifying information used by the investment adviser to 
identify the account. Further, the provision would require that the 
record identify the inception date for the advisory account, whether 
the investment adviser has discretionary authority with respect to 
any client assets in the account, whether the investment adviser has 
authority to deduct advisory fees from the account, and, if 
applicable, the termination date of the account, asset disposition 
upon termination, and the reason for the termination.
    \339\ For each client account, the adviser would maintain a 
record that identifies and matches, for each client of which the 
adviser has custody of client assets, the account name and account 
number, or any other identifying information, from any person or 
entity, including any qualified custodian, that maintains client 
assets to the corresponding advisory account record for each client 
required by rule 204-2(b)(2)(i). To the extent applicable, the 
record must contain a copy of the required written agreement with 
each qualified custodian under proposed rule 223-1(a)(2)(i), 
including any amendments thereto. The record must also reflect the 
basis for the reasonable assurances that the investment adviser 
obtains from the qualified custodian under proposed rule 223-
1(a)(1)(ii).
---------------------------------------------------------------------------

    Included among the proposed advisory account identification records 
an adviser would be required to maintain is a record indicating whether 
the adviser has discretionary authority with respect to any client 
assets in the account.\340\ This requirement would inform whether the 
independent verification exception applies in the specific circumstance 
of the adviser having custody of client assets solely because the 
adviser has discretionary authority with respect to those assets.\341\ 
This requirement also would subsume and replace the requirement in the 
current recordkeeping rule to make and keep a list or other record of 
all client accounts for which the adviser has any discretionary 
power.\342\ The proposed advisory account identification records also 
would require the adviser to maintain a record indicating whether the 
adviser has authority to deduct advisory fees from the account.\343\ 
This requirement would inform whether the independent verification 
exception applies in the specific circumstance of the adviser having 
custody of client assets solely as a consequence of the adviser's 
authority to make withdrawals from the account to pay its advisory fee, 
and the qualified custodian being an operationally independent related 
person.\344\
---------------------------------------------------------------------------

    \340\ See proposed rule 204-2(b)(2)(i).
    \341\ See proposed rule 223-1(b)(8).
    \342\ See rule 204-(2)(a)(8).
    \343\ See proposed rule 204-2(b)(2)(i).
    \344\ See proposed rule 223-1(b)(3).
---------------------------------------------------------------------------

    Included among the custodian identification information an adviser 
would be required to maintain are copies of each contract with a 
qualified custodian and copies of all records received from the 
qualified custodian thereunder relating to client assets, if 
applicable, and a record that indicates the basis for the reasonable 
assurances the adviser obtains from the qualified custodian under 
proposed rule 223-1(a)(1).\345\ These aspects of the client account 
recordkeeping requirements generally are designed to specify that 
advisers must maintain such records

[[Page 14728]]

whenever client assets are maintained by a qualified custodian. These 
records also would be necessary for the adviser to help demonstrate its 
compliance with the requisite set of qualified custodian contractual 
provisions and reasonable assurances it must obtain from qualified 
custodians in proposed rule 223-1(a)(1). It would also help the adviser 
to identify and match the client custodial account to the corresponding 
advisory account record as discussed above. If applicable, the 
custodian identification information would require the adviser to 
maintain a copy of its written reasonable determination that ownership 
of certain specified client assets cannot be recorded and maintained in 
a manner in which a qualified custodian can maintain possession or 
control of such assets. This recordkeeping obligation would be required 
if the adviser wants to rely on the exception for privately offered 
securities and physical assets to be held at a qualified custodian. It 
also would help our examination staff to verify the reasonableness of 
the adviser's determination and enable both internal advisory personnel 
and our examination staff to readily identify the specified client 
assets that are at risk of loss or misappropriation.
---------------------------------------------------------------------------

    \345\ See proposed rule 204-2(b)(2)(ii).
---------------------------------------------------------------------------

    The proposed recordkeeping rule would also require the adviser to 
document the basis for the adviser's custody of client assets, 
including whether a related person holds the adviser's client assets or 
has any authority to obtain possession of them in connection with the 
adviser's advisory services.\346\ This information would be essential 
for internal advisory personnel and for our examination staff to be 
able to readily identify the client assets that are at risk of loss or 
misappropriation. It also would provide additional explanation in the 
client account record to complement the custodial information discussed 
above.
---------------------------------------------------------------------------

    \346\ See proposed rule 204-2(b)(2)(iii).
---------------------------------------------------------------------------

3. Account Activity
    In addition to client account identification requirements, the 
proposed amendments include corollary books and records requirements 
relating to client account activity that address account statements, 
transaction and position information, and standing letters of 
authorization. In order to demonstrate compliance with the account 
statement aspects of the rule, the proposed amendments would require an 
investment adviser to maintain copies of any account statement 
delivered by the qualified custodian to the client and to the adviser 
under proposed rule. The adviser also would be required to maintain 
copies of any account statement it delivers to the client, including 
copies of any account statement it delivers to the client containing 
the required notification under proposed rule 223-1(a)(2).\347\ If the 
client is a pooled investment vehicle, we would require that the record 
reflect the delivery of account statements, notices, or financial 
statements, as applicable, to all investors in such client pursuant to 
proposed rule 223-1(c).\348\
---------------------------------------------------------------------------

    \347\ See proposed rule 223-1(a)(2). If the adviser sends 
account statements to a client to which the adviser is required to 
provide the account opening notice under this section, the adviser 
must include in that notice and in any subsequent account statement 
it sends to such client, a statement urging the client to compare 
the account statements from the custodian with those from the 
adviser.
    \348\ See supra section II.B.3.b.ii, for discussion of proposed 
rule 223-1(c).
---------------------------------------------------------------------------

    Regarding transaction and position information in client accounts, 
we are proposing several modifications that would clarify certain 
obligations of the current recordkeeping rule's requirements.\349\ 
First, we are proposing modifications to the current recordkeeping 
rule's requirement that the adviser maintain records related to a 
client's position in each security.\350\ The proposed amendments would 
replace the current rule's references to ``security'' or ``securities'' 
with ``asset'' or ``assets'' to align this requirement with the broader 
scope of proposed rule 223-1.
---------------------------------------------------------------------------

    \349\ Compare rules 204-2(b)(1) through (4) with proposed rule 
204-2(b)(2)(v).
    \350\ See rule 204-2(b)(4).
---------------------------------------------------------------------------

    Second, we would modify the current recordkeeping requirement for 
advisers to make and keep records of debits and credits in client 
accounts, including all purchases, sales, receipts, and deliveries of 
securities for such accounts.\351\ Specifically, we propose to require 
that in addition to trade activity, as required by rule 204-2, the 
records should reflect other transaction activity in client accounts, 
which we would interpret more broadly to include all debits and credits 
to or from the account, including deposits, transfers, and withdrawals 
as well as cash flows, corporate action activity, maturities, 
expirations, expenses, and income posted. The adviser's records also 
would be required to include the date and price or amount of any 
purchases, sales, receipts, deliveries, including any one-way delivery 
of assets, and free receipt and delivery of securities and certificate 
numbers, deposits, transfers, withdrawals, cash flows, corporate action 
activity, maturities, expirations, expenses, income posted to the 
account, and all other debits and credits. Although we are not 
prescribing the particular form in which the records must be kept, we 
would view as acceptable keeping the records on a trade blotter, 
customer account ledger, or accounting records maintained by the 
adviser. We believe that these modifications would help ensure that an 
adviser maintains sufficient information regarding client account 
activity when an adviser has custody of client assets, and would 
enhance the ability of our examination staff to verify the proper 
handling of client assets by the adviser and compliance with the 
proposed rule and other applicable provisions of the Federal securities 
laws.
---------------------------------------------------------------------------

    \351\ Compare rules 204-2(b)(1) and (2) with proposed rule 204-
2(b)(2)(v)(A).
---------------------------------------------------------------------------

    We also would modify the current recordkeeping rule's requirement 
that advisers keep copies of confirmations of all transactions effected 
by or for the client in the client account.\352\ The proposed 
amendments would expressly provide for trade confirmations that show 
the date and price of each trade as well as any instruction received by 
the adviser concerning transacting in the assets.\353\ We believe these 
modifications are necessary because our staff has periodically received 
questions as to what is required under the current rule and, 
particularly, whether the current rule requires only that the adviser 
maintain a record of trade tickets rather than counterparty 
confirmations.
---------------------------------------------------------------------------

    \352\ Compare rule 204-2(b)(3) with proposed rule 204-
2(b)(2)(v)(B).
    \353\ As under the current rule, advisers would be required to 
retain information about all orders placed (whether executed or 
not). See rule 204-2(a)(3).
---------------------------------------------------------------------------

4. Independent Public Accountant Engagements
    The proposed amendments also would require advisers to retain 
copies of documents relating to independent account engagements.\354\ 
Specifically, these documents include: (1) all audited financial 
statements prepared under the safeguarding rule; \355\ (2) a copy of 
each internal control report received by the investment adviser; \356\ 
and (3) a copy of any written agreement between the independent public 
accountant and the adviser or the client, as applicable, required under 
proposed rule 223-1.
---------------------------------------------------------------------------

    \354\ Proposed rule 204-2(b)(3).
    \355\ Proposed rule 204-2(b)(4).
    \356\ This requirement would subsume and replace the current 
recordkeeping requirement to retain a copy of any internal control 
report obtained or received under the current custody rule. See rule 
204-2(a)(17)(iii).

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

[[Page 14729]]

    With respect to all three aspects of the proposed amendments for 
independent public accountant engagements, we believe that maintaining 
these records would give our staff critical access to the findings of 
the independent public accountant(s) that perform procedures to verify 
the existence of client assets not maintained with a qualified 
custodian and/or the accuracy of an adviser's transactions in client 
assets using enhanced authority.
5. Standing Letters of Authorization
    Finally, we propose to add a requirement for advisers to keep 
copies of, and records relating to, any standing letter of 
authorization issued by a client to the investment adviser.\357\ These 
records generally should include the name and either the address or the 
account number of each recipient to whom a transfer of client assets 
may be directed, along with any instructions the adviser has provided 
to the client's qualified custodian to transfer client's assets to that 
recipient. We believe that this requirement would enhance the ability 
of our examinations staff to verify client-authorized transfers of 
assets to designated recipients. This requirement also would be 
critical for our examination staff and internal compliance personnel to 
demonstrate that the adviser is appropriately safeguarding a client's 
assets while relying on the proposed SLOA exception from the 
independent verification requirements in the proposed rule.\358\
---------------------------------------------------------------------------

    \357\ See proposed rule 204-2(b)(vi).
    \358\ Proposed rule 223-1(b)(7).
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed books and 
recordkeeping amendments, including the following items.
    254. Should we amend rule 204-2 as proposed? Are there any other 
records that an adviser should be required to maintain? If so, what are 
they, and why?
    255. Are there alternatives to the proposed amendments to rule 204-
2 that would minimize recordkeeping burdens and the associated costs, 
while promoting the goals of facilitating the inspection and 
enforcement capabilities of the Commission and its staff? If so, what 
are they, and why?
    256. Should we require advisers to maintain the proposed records in 
electronic, text-searchable, machine-readable, and/or structured 
format?
    257. Should we eliminate the requirement to maintain responses to 
any written client communications required under proposed rule 223-1? 
If so, why?
    258. The proposed rule would require an adviser to make and keep 
records that identify client accounts for which the adviser has 
discretionary authority. As a result, we are proposing to eliminate the 
current rule's requirement to keep a list or other record of all client 
accounts for which the investment adviser has any discretionary power 
under 204-2(a)(8) as it is no longer necessary. Do commenters agree?
    259. Is the proposed requirement sufficiently clear regarding 
account activity in a client's account? Should we require advisers to 
include additional information about transactions effected in a client 
account in their records? If so, please explain what additional 
information the rule should require and why it should be required. If 
the proposed requirement should require less information about account 
activity in a client account, please identify the information that 
should not be required and why.
    260. Would advisers find the proposed modifications to the current 
recordkeeping rule's requirements regarding transaction and position 
information helpful for account reconciliation purposes?
    261. The proposed rule would require an adviser to maintain the 
proposed records for the same period as required under the current 
books and recordkeeping rule (i.e., 5 years). Should advisers be 
required to maintain these records for a shorter or longer period? If 
so, what time period, and why?
    262. As proposed in amended rule 204-2, advisers that rely on the 
audited financial statements exception in the safeguarding rule for a 
pooled investment vehicle or any other entity would be required to 
maintain copies of such audited financial statements. Should we also 
require such advisers to maintain records verifying the delivery and 
distribution of such audited financial statements to investors in the 
entity (or their independent representatives)?

I. Changes to Form ADV

    We are proposing to amend Part 1A, Schedule D, and the Instructions 
and Glossary of Form ADV.\359\ The amendments are designed to help 
advisers identify when they may have custody of client assets, to 
provide the Commission with information related to advisers' practices 
to safeguard client assets, and to provide the Commission with 
additional data to improve our ability to identify compliance risks. 
Because Form ADV is publicly available, these amendments may also 
provide clients or investors additional protection because they will be 
better able to discern the reasons why a particular adviser has 
custody. Further, these amendments may offer ancillary market benefits 
to the extent that market participants are better able to analyze the 
Form ADV data to assess fraud risk. The proposed amendments would 
continue to collect much of the information currently reported by 
advisers in Item 9 of Form ADV Part 1A and the corresponding sections 
of Schedule D, along with new information that corresponds with certain 
aspects of the proposed rule.\360\ These proposed revisions would also 
streamline the collection of this information by reorganizing Item 9 
and refining certain reporting requirements to eliminate confusion and 
prevent inaccurate or incomplete reporting.\361\
---------------------------------------------------------------------------

    \359\ This section discusses the Commission's proposed rule and 
form amendments that would affect advisers registered with the 
Commission. We understand that the state securities authorities 
intend to consider similar changes that affect advisers registered 
with the states, who are also required to complete Form ADV Part 1A 
as part of their state registrations. We will accept any comments 
and forward them to the North American Securities Administrators 
Association (``NASAA'') for consideration by the state securities 
authorities. We request that you clearly indicate in your comment 
letter which of your comments relate to these items.
    \360\ Because Form ADV, Part 1A--including the current Item 9--
is submitted in a structured, XML-based data language specific to 
that Form, the information in the amended Item 9 would continue to 
be structured (i.e., machine readable) as well. That is, the 
Commission is not proposing to change the structured data language 
used for Item 9.
    \361\ See proposed Form ADV, Part 1A, Item 9. The following 
definitions from the proposed rule would be added to Form ADV: 
Assets (for purposes of Item 9 and related sections of Schedule D), 
Operationally Independent (for purposes of Item 9 and related 
sections of Schedule D), Qualified Custodian, and Standing Letter of 
Authorization. Additionally, the definition of Discretionary 
Authority or Discretionary Basis would be expanded to include 
Discretionary Trading Authority. See proposed Form ADV, Part 1A, 
Glossary and Item 9.C, D, E, and F, which currently collect 
information about an adviser's methods of compliance with rule 
206(4)-2, whether a related-party acts as a qualified custodian, 
whether the adviser was subject to a surprise examination, and the 
number of qualified custodians, respectively, would be deleted or 
revised in the proposed Item 9 to reflect the proposed changes to 
the rule and to collect similar information more effectively.
---------------------------------------------------------------------------

    Item 9 currently requires an adviser to report whether it or a 
related person has custody of any advisory client's cash or bank 
accounts or securities, along with certain additional information if an 
adviser reports having custody. Nonetheless, an adviser is not required 
to report having custody if it has custody solely because it deducts 
advisory fees or because a related person has custody but an adviser 
has overcome the presumption that it is not operationally independent. 
The adviser may, however, still be required to

[[Page 14730]]

complete other sections of Item 9. In the Commission's experience, 
advisers often are confused by these requirements, because they may 
have custody under the rule but are instructed to report not having 
custody for purposes of completing Item 9.A.(1) of Form ADV. This can 
result in inaccurate or incomplete reporting, which in turn, could 
limit our staff's ability to effectively analyze this important Form 
ADV data. Further, not being required to report having custody on Form 
ADV when an adviser in fact has custody under the rule may result in 
adviser's erroneously believing that it is not subject to the custody 
rule. The proposed amendments to Form ADV are designed to eliminate 
this confusion, improve the information available to the Commission and 
the public about how advisers safeguard clients' assets, and promote 
greater compliance with the proposed safeguarding rule.
    First, consistent with the proposed rule, we are proposing to 
capture information in Item 9 about an adviser's custody of its 
``client assets'' including a client's funds, securities, and other 
positions held in a client's account. We are proposing to revise the 
introductory language, replace references to funds and securities in 
Item 9 with the term assets (as defined in the proposed rule), and add 
a new sub-item to allow advisers to indicate their reliance on certain 
exceptions in the proposed rule.\362\ These revisions are designed to 
align Form ADV with the proposed rule.
---------------------------------------------------------------------------

    \362\ We would retain the instruction to exclude reporting 
information in Item 9 about advisory clients that are investment 
companies registered under the Investment Company Act as this 
provision in rule 223-1 is not proposed to be amended.
---------------------------------------------------------------------------

    Next, we are also proposing to revise Item 9.A.(1) to require 
advisers to indicate, in a single place, if they directly, or 
indirectly through a related person, have custody of client assets, 
including if custody is solely due to an adviser's ability to deduct 
fees from client accounts or because the adviser has discretionary 
authority.\363\ Form ADV, Part 1A currently distinguishes reporting 
among advisers having direct custody, advisers subject to the current 
rule because a related person has custody, and advisers having custody 
of client funds or securities solely because of the ability to deduct 
advisory fees from client accounts. Further, as noted above, in certain 
circumstances advisers are currently instructed not to report having 
custody in Item 9.A.(1), despite having custody (i.e., when the basis 
for custody is an adviser's ability to deduct advisory fees or through 
an operationally independent related person). While these distinctions 
are important for evaluating compliance risks, the current structure of 
Item 9 makes it difficult to easily analyze this data. For example, 
under the current structure of Item 9, we cannot easily identify the 
total number of clients or the total amount of assets over which an 
adviser has custody. The proposed revisions to Item 9.A.(1) are 
designed to increase the quality of the information reported on Form 
ADV by reducing confusion about how and where to report certain 
information and make it easier for the public and the Commission to 
understand and analyze.
---------------------------------------------------------------------------

    \363\ We are also proposing to include new instructional 
language directing advisers to answer ``Yes'' to Item 9.A.(1) if 
they have the ability to deduct advisory fees directly from client 
accounts, reported discretionary RAUM in Item 5.F.(2).(a), or 
reported having discretionary trading authority in Item 8.C.(1).
---------------------------------------------------------------------------

    Third, we are proposing to modify Item 9.A.(2) to preserve 
information currently reported by advisers in Item 9 about the amount 
of client assets and number of clients falling into each category of 
custody (i.e., direct or indirect) and to require advisers to report 
similar information about client assets over which they have custody 
resulting from (1) having the ability to deduct advisory fees; (2) 
having discretionary trading authority; (3) serving as a general 
partner, managing member, trustee (or equivalent) for clients that are 
private funds; (4) serving as a general partner, managing member, 
trustee (or equivalent) for clients that are not private funds; (5) 
having a general power of attorney over client assets or check-writing 
authority; (6) having a standing letter of authorization; (7) having 
physical possession of client assets; (8) acting as a qualified 
custodian; (9) a related person with custody that is operationally 
independent; and (10) any other reason.\364\ We believe this 
information would enhance the quality and utility of the data reported 
on the form, enhancing the Commission's ability to exercise oversight 
of the safeguarding practices of advisers. We believe this information 
may also be beneficial to clients or investors attempting to discern 
the reasons why a particular adviser has custody. Further, this updated 
format may help market participants to analyze Form ADV data on an 
aggregated basis to assess fraud risk more accurately.
---------------------------------------------------------------------------

    \364\ Proposed Form ADV, Part 1A, Item 9.A.(2). Advisers are 
currently required to report information with respect to funds and 
securities over which their related persons have custody, including 
the dollar amount and number of clients whose funds or securities 
are in the adviser's custody and whether any related person has 
custody of any clients' cash or bank accounts or securities and the 
relevant dollar amount and number of clients. See Form ADV, Part 1A 
Item 9.A.(2) through, Item 9.B. Based on its responses, an adviser 
is also required to report additional custody-related information in 
Schedule D of Form ADV, Part 1A.
---------------------------------------------------------------------------

    Fourth, we are also proposing new Item 9.B. requiring an adviser to 
indicate whether it is relying on any of the exceptions from the 
proposed rule and, if so, to indicate on which exception(s) the adviser 
is relying. This information would be valuable for Commission staff to 
assess compliance with the proposed rule, and it may also be beneficial 
to clients or investors to assess which exception(s) the adviser is 
relying upon.
    Fifth, we are proposing to require advisers to report whether 
client assets over which they or a related person have custody are 
maintained at a qualified custodian and the number of clients and 
approximate amount of client assets maintained with a qualified 
custodian.\365\ Advisers also would be required to report certain 
identifying information about the qualified custodians maintaining 
client assets.\366\ Item 9 currently collects only limited information 
from advisers about advisers and their related persons that act as 
qualified custodians under the rule.\367\ Qualified custodians continue 
to serve a critical role in safeguarding client assets under the 
proposed rule. Given this important role, we are proposing to require 
advisers to report the following information for all qualified 
custodians maintaining client assets:
---------------------------------------------------------------------------

    \365\ See proposed Form ADV, Part 1A, Item 9.C.(1)and proposed 
Form ADV, Part 1A, Schedule D, section 9.C.(1).
    \366\ Proposed Form ADV, Part 1A, Schedule D, section 9.C.(1).
    \367\ See Form ADV, Part 1A, Item 9.D.(2) and Form ADV, Part 1A, 
Schedule D, section 7.A. Advisers are currently required to report 
more detailed custodial information about their separately managed 
accounts and about the private funds they advise. See Form ADV, Part 
1A, Schedule D, section 5.K.(3); Form ADV, Part 1A, Schedule D, 
section 7.B.(1)(25).
---------------------------------------------------------------------------

     Full legal name of the qualified custodian;
     Location of the qualified custodian's office responsible 
for the services provided;
     Contact information for an individual to receive 
regulatory inquiries;
     Type of entity;
     Legal Entity Identifier (if applicable);
     Number of clients and approximate amount of client assets 
(rounded to the nearest $1,000) maintained by the qualified custodian; 
and

[[Page 14731]]

     Whether the qualified custodian is a related person, and 
if so, the identifying information for the independent public 
accountant engaged to prepare the proposed internal control report and 
verification required under the proposed safeguarding rule.\368\
---------------------------------------------------------------------------

    \368\ See proposed Form ADV, Part 1A, Schedule D, section 
9.C.(1). This information is similar to the information advisers 
currently report regarding separately managed accounts and private 
fund custodians. See Form ADV, Part 1A, Schedule D, section 5.K.(3); 
Form ADV, Part 1A, Schedule D, section 7.B.(1)(25).
---------------------------------------------------------------------------

    Similarly, we are also proposing revisions to Item 9 that would 
require advisers to report information about accountants completing 
surprise examinations, financial statement audits, or verification of 
client assets under the proposed rule.\369\ We believe requiring 
advisers to disclose more detailed information about the qualified 
custodians maintaining client assets and the accountants completing 
these engagements under the proposed rule would provide useful 
information to the public and facilitate the Commission's examination 
efforts.
---------------------------------------------------------------------------

    \369\ See proposed Form ADV, Part 1A, Schedule D, section 
9.C.(3). Advisers report similar information about the independent 
public accountants completing surprise examinations under the 
current rule in section 9.C of Form ADV Part 1A Schedule D.
---------------------------------------------------------------------------

    Advisers currently are required to file an other-than-annual-
amendment to Form ADV promptly if certain information provided in 
response to Item 9 becomes inaccurate in any way.\370\ Information 
triggering this obligation includes whether the adviser or a related 
person has custody of client cash, bank accounts, or securities; \371\ 
the methods by which the adviser complies with the custody rule; \372\ 
and whether the adviser or a related person acts as a qualified 
custodian.\373\ Given the importance of this information, we continue 
to believe that advisers should update this information to the extent 
it becomes inaccurate. Thus, we are proposing to retain the current 
requirement that advisers file an other-than-annual-amendment to Form 
ADV promptly if similar information we are proposing to collect on Form 
ADV becomes inaccurate.\374\ More specifically, we are proposing to 
require an adviser to file promptly an other-than-annual amendment to 
Form ADV if any of an adviser's responses regarding the following 
becomes inaccurate in any way: (1) whether the adviser has custody of 
client assets either directly or because a related person has custody 
of client assets in connection with advisory services that the adviser 
provides to the client; (2) whether the adviser is relying on certain 
exceptions to the proposed rule; (3) whether client assets are 
maintained with a qualified custodian; (4) whether the adviser or a 
related person serves as a qualified custodian under the proposed rule; 
(5) whether client assets are not maintained by a qualified custodian; 
(6) whether the adviser is required to obtain a surprise examination by 
an independent public accountant under the proposed rule; or (7) 
whether the adviser is relying on the audit provision.\375\ An adviser 
would be required to update the other information reported in Item 9 
(e.g., information about the number of clients and approximate amount 
of assets or certain information about qualified custodians) only on 
its annual updating amendment, which is the same frequency with which 
advisers update similar information on the current form.\376\
---------------------------------------------------------------------------

    \370\ See Form ADV, General Instructions. Advisers, however, are 
not required to file an other-than-annual amendment to update 
information provided in response to Items 9.A.(2), 9.B.(2), 9.E, and 
9.F even if that information becomes inaccurate--though advisers are 
required to update this information when filing their next annual 
updating amendment. Id.
    \371\ See Form ADV, Item 9.A.(1) and Item 9.B.(1).
    \372\ See Form ADV, Item 9.C.
    \373\ See Form ADV, Item 9.D.
    \374\ See proposed amendments to Form ADV General Instructions.
    \375\ See generally proposed Form ADV, Items 9.A.(1), 9.B.(1), 
9.C., 9.D.(1), and 9.E.
    \376\ See proposed amendments to Form ADV, General Instructions.
---------------------------------------------------------------------------

    We request comment on all aspects of proposed revisions to Form ADV 
Part 1A, including the following items.
    263. Would the proposed reorganization of Item 9 make it easier for 
advisers to complete Item 9 more accurately and eliminate the confusion 
created by the current structure or wording of Item 9? Are there other 
changes to Item 9 that would make the information reported on that Item 
more accurate or less confusing? Is additional guidance needed to 
clarify any of the requirements of the proposed revisions?
    264. In proposed Item 9.A.(2), we ask advisers to identify various 
ways that they may have custody, directly or indirectly, broken out by 
the approximate amount of client assets and number of clients. Based on 
our experience, we understand that a client may have several different 
advisory accounts. Should we also ask for information at the advisory 
account level? Should we ask for information on an account level basis 
rather than a client level basis? Would this information be more 
meaningful? Why or why not?
    265. In proposed Item 9.B.(2), we ask advisers about which 
exception(s) in rule 223-1(b) they are relying upon. Should we also ask 
for the approximate amount of assets and number of clients under each 
exception? Should we also ask for information at the advisory account 
level for each exception? Should we ask for information on an account 
level basis rather than a client level basis for each exception? Would 
this information be more meaningful? Why or why not?
    266. Would advisers be able to provide the information we are 
proposing to collect about qualified custodians? Should we collect 
additional or different information from advisers about qualified 
custodians? If so, what types of information should advisers be 
required to report? Does the proposal seek to collect information about 
qualified custodians that would be unnecessary or overly burdensome for 
advisers to report? For example, do advisers keep records of the 
regulator for foreign financial institutions acting as qualified 
custodians? In particular, what information should not be collected and 
why? For instance, are there any privacy laws or other legal barriers 
that would prohibit or restrict an adviser from reporting this 
information about qualified custodians?
    267. Should advisers be required to file promptly an other-than-
annual-amendment to Form ADV when the information provided in response 
to certain parts of Item 9 becomes inaccurate? Should an adviser be 
required to update promptly only some of this information, as proposed, 
or, alternatively, all of this information when it becomes inaccurate? 
Are there different items on Form ADV that advisers should have to 
update promptly than those proposed?
    268. Is there any additional information an adviser should be 
required to report regarding its practices to safeguard client assets? 
If so, what types of additional information should advisers be required 
to report on Form ADV?
    269. Should advisers be required to report their holdings of 
physical assets on Form ADV?
    270. Should advisers be required to report their holdings of 
privately offered securities that cannot be recorded and maintained 
with a qualified custodian on Form ADV?
    271. Should advisers also be required to report information about 
the independent public accountant where the adviser cannot maintain 
assets with a qualified custodian?
    272. Should advisers be required to disclose information on Form 
ADV regarding sub-custodial, securities depository, or other similar

[[Page 14732]]

arrangements about client assets? Do advisers often have this 
information?
    273. Should advisers be required to disclose on Form ADV whether 
financial statements distributed to investors under the audit provision 
comply with U.S. GAAP or another comprehensive body of accounting 
standards?
    274. Some of the information we are proposing be reported in 
section 9.C.(1) and 9.C.(3) of Schedule D is similar to the information 
adviser are required to report in section 7.B.(1) of Schedule D, 
particularly as it relates to whether reports provided by independent 
public accountants contain unqualified, qualified, or modified 
opinions. Should we amend these portions of section 7.B.(1) of Schedule 
D to conform with the proposed amendments to section 9.C.(2) and 
9.C.(3)?
    275. Where a filing adviser files Form ADV along with a relying 
adviser, it is our understanding that some filing advisers may include 
the amount of client funds and securities and total number of clients 
for which the filing adviser has custody in response to Item 9.A.(2) 
and for which the relying adviser has custody in response to Item 
9.B.(2) of Form ADV.\377\ Should we provide additional guidance in Form 
ADV about how we expect filing and relying advisers to complete Item 9? 
If so, please explain.
---------------------------------------------------------------------------

    \377\ See Form ADV and Investment Advisers Act Rules, Advisers 
Act Rel. No. 4509 (Aug. 25, 2016) where the Commission amended Form 
ADV instructions, among other items, to allow umbrella registration 
for a filing adviser and relying advisers.
---------------------------------------------------------------------------

J. Existing Staff No-Action Letters and Other Staff Statements

    Staff in the Division of Investment Management is reviewing certain 
of its no-action letters and other staff statements addressing the 
application of the custody rule to determine whether any such letters, 
statements, or portions thereof, should be withdrawn in connection with 
any adoption of this proposal. We list below the letters and other 
staff statements that are being reviewed as of the date of any adoption 
of the proposed rules or following a transition period after such 
adoption. If interested parties believe that additional letters or 
other staff statements, or portions thereof, should be withdrawn, they 
should identify the letter or statement, state why it is relevant to 
the proposed rule, and how it or any specific portion thereof should be 
treated and the reason therefor. To the extent that a letter listed 
relates both to the custody rule and another topic, the portion 
unrelated to the custody rule is not being reviewed in connection with 
the adoption of this proposal.

                                             Letters To Be Reviewed
----------------------------------------------------------------------------------------------------------------
         Name of staff statement                                        Date issued
----------------------------------------------------------------------------------------------------------------
All staff statements issued prior to the  Various Dates.
 2003 Commission Adopting Release.
American Bar Association (Question 1,     December 8, 2005.
 Custody Rule Section, only).
American Bar Association (Question D      August 10, 2006.
 only).
Deloitte & Touche LLP...................  August 28, 2006.
Investment Adviser Association..........  September 20, 2007.
Investment Company Institute............  September 5, 2012.
Investment Adviser Association..........  April 25, 2016.
Investment Adviser Association..........  February 21, 2017.
Madison Capital Funding, Inc............  December 20, 2018.
Robert Van Grover, Esq., Seward and       December 11, 2019.
 Kissel LLP.
Privately Offered Securities Under the    August 2013.
 Investment Advisers Act Custody Rule,
 Investment Management Guidance Update
 (``IMGU'') 2013-04.
Private Funds and the Application of the  June 2014.
 Custody Rule to SPVs and Escrows, IMGU
 2014-07.
Inadvertent Custody, IMGU 2017-01.......  February 2017.
Staff Responses to Questions About the    Issued on various dates since 2003.
 Custody Rule (all).
----------------------------------------------------------------------------------------------------------------

K. Transition Period and Compliance Date

    We are proposing a one-year transition period to provide time for 
advisers to come into compliance with the following if they are 
adopted: redesignation of rule 206(4)-2 as new rule 223-1, and 
corresponding amendments to rule 204-2 and Form ADV, as applicable. 
Accordingly, we propose that the compliance date of any adoption of 
this proposal would be one year following the rules' effective dates 
which would be sixty days after the date of publication of the final 
rules in the Federal Register for advisers with more than $1 billion in 
regulatory assets under management (``RAUM''). For advisers with up to 
$1 billion in RAUM, we propose that the compliance date of any adoption 
of this proposal would be 18 months following the rules' effective 
dates which would be sixty days after the date of publication of the 
final rules in the Federal Register. If adopted as proposed, 
approximately 10,454 advisers, which represents approximately 69% of 
all registered advisers and 2.5% of the total RAUM of all advisers, 
would be subject to the longer, 18 month transition period.\378\ The 
chart below indicates the impact applying different RAUM threshold 
would have on the number of advisers subject to the proposed 18-month 
transition period.\379\
---------------------------------------------------------------------------

    \378\ As of June 2022, 15,062 investment advisers were 
registered with the Commission and reported a total of $128.96 
trillion in RAUM, while 10,454 advisers reported having less than $1 
billion in RAUM, while the aggregate RAUM reported by these advisers 
as of June 2022 was approximately $3.2 trillion.
    \379\ The data in the table is based upon data reported by 
advisers as of June 2022.

----------------------------------------------------------------------------------------------------------------
                                                                                                    Percent of
                                                     Number of      Percent of     Total RAUM of   total RAUM of
                    Threshold                     advisers under  advisers under  advisers under  advisers under
                                                     threshold       threshold       threshold       threshold
----------------------------------------------------------------------------------------------------------------
$500 million....................................           8,396            55.4            $1.7             1.3
1 billion.......................................          10,454            69.0             3.2             2.5
1.5 billion.....................................          11,448            75.5             4.4             3.4

[[Page 14733]]

 
2 billion.......................................          11,987            79.1             5.3             4.1
2.5 billion.....................................          12,378            81.6             6.2             4.8
3 billion.......................................          12,657            83.5             6.9             5.4
3.5 billion.....................................          12,859            84.8             7.6             5.9
4 billion.......................................          13,044            86.0             8.3             6.5
4.5 billion.....................................          13,215            87.2             9.0             7.0
5 billion.......................................          13,357            88.1             9.7             7.6
10 billion......................................          13,994            92.3            14.1            11.0
----------------------------------------------------------------------------------------------------------------

    Under this proposal, advisers could continue to rely on current 
rule 206(4)-2, rule 204-2, and Form ADV until the compliance date. We 
are proposing that once the rules become effective, advisers may 
voluntarily comply with them in advance of the compliance date. To 
promote regulatory consistency, however, we are proposing that any 
adviser that elects to rely, prior to the compliance date, on the 
effective rule 223-1 must also comply with, as applicable, the amended 
rule 204-2 and the amended Form ADV beginning at the same time.
    We request comments on the proposed transition period:
    276. Do commenters agree that a one-year transition period 
following each rule's effective date is appropriate for advisers with 
more than $1 billion in RAUM? Should the period be shorter or longer? 
For example, would six months be an appropriate amount of time? 
Alternatively would 18 months be necessary? Do commenters agree that an 
18-month transition period following each rule's effective date is 
appropriate for advisers with up to $1 billion in RAUM? Should the 
period be shorter or longer? For example, would one year be an 
appropriate amount of time? Alternatively would 24 months be necessary? 
Should there be different compliance dates for different types of 
advisers, such as advisers to pooled investment vehicles or advisers to 
separate account clients? Should the $1 billion threshold for the 
different compliance groups be higher or lower?
    277. Should the transition period be the same for proposed new rule 
223-1 and amendments to rule 204-2 and Form ADV? Should we permit that 
once the rules become effective, advisers may voluntarily comply with 
them in advance of the compliance date, and require that any adviser 
that elects to rely on new rule 223-1 prior to the compliance date must 
also comply beginning at the same time with the amended rule 204-2 and 
amended Form ADV? Does this promote regulatory consistency, and if not, 
why not?
    278. Should we also require that any adviser that elects to rely on 
rule 223-1 and amended rule 204-2 and amended Form ADV prior to the 
compliance date must also cease to rely on Commission and staff letters 
and other statements that would be withdrawn on the compliance date?
    279. Should the transition period vary for different rule 
requirements? For example, would advisers need 18 months to comply with 
the proposed amendments to the qualified custodian provisions and three 
months to comply with the exception from the surprise examination for 
SLOAs? Please explain your answer and suggest transition period 
durations.

III. Economic Analysis

A. Introduction

    We are mindful of the costs imposed by, and the benefits obtained 
from, our rules. Section 202(c) of the Advisers Act provides that when 
the Commission is engaging in rulemaking under the Act and is required 
to consider or determine whether an action is necessary or appropriate 
in the public interest, the Commission shall also consider whether the 
action will promote efficiency, competition, and capital formation, in 
addition to the protection of investors. The following analysis 
considers, in detail, the likely significant economic effects that may 
result from the proposed rule amendments, including the benefits and 
costs to investors and other market participants as well as the broader 
implications of the proposed rule amendments for efficiency, 
competition, and capital formation.
    Where possible, the Commission quantifies the likely economic 
effects of its proposed amendments and rules. However, the Commission 
is unable to quantify certain economic effects because it lacks the 
information necessary to provide estimates or ranges of costs. 
Additionally, in some cases, quantification would require numerous 
assumptions to forecast how investment advisers and other affected 
parties would respond to the proposed amendments, and how those 
responses would in turn affect the broader markets in which they 
operate. In addition, many factors determining the economic effects of 
the proposed amendments would vary significantly among investment 
advisers. Investment advisers vary in size and sophistication as well 
as the assets on which they provide advice. As a result, investment 
advisers' existing practices and the extent to which investment 
advisers qualify for exceptions from the rule varies, making it 
inherently difficult to quantify economic effects. Even if it were 
possible to calculate a range of potential quantitative estimates, that 
range would be so wide as to not be informative about the magnitude of 
the benefits or costs associated with the proposed rule. Many parts of 
the discussion below are, therefore, qualitative in nature. As 
described more fully below, the Commission is providing a qualitative 
assessment and, where practicable, a quantified estimate of the 
economic effects.

B. Broad Economic Considerations

    Investors rely on the asset management industry for a wide variety 
of wealth management and financial planning functions. These services 
are critical for investors to plan for the future and diversify their 
investment risks. Investment advisers are a key part of this industry, 
as they provide investment advice to investors and clients about the 
value of, or about investing in, securities and other investment 
products.\380\
---------------------------------------------------------------------------

    \380\ See, e.g., https://www.investor.gov/introduction-investing/investing-basics/glossary/investment-adviser.
---------------------------------------------------------------------------

    When performing services for investors and clients, an adviser may 
frequently have access to client assets, exposing them to the risk of 
loss, misuse, theft, or misappropriation. This gives rise to a 
principal-agent problem between investors and clients (the principals) 
on the one hand and their

[[Page 14734]]

investment advisers (the agents) on the other. This is because, while 
advisers face relevant competitive market forces and therefore have 
private reputational incentives to maintain some level of oversight and 
internal controls, as discussed below market failures can lead their 
chosen levels of oversight and control to be sub-optimally low. The 
current custody rule, which the Commission has amended over time, has 
been designed to deter such behavior and alleviate these market 
failures in part by relying on a third party, a qualified custodian, in 
safeguarding client assets. While requiring the use of a qualified 
custodians helps mitigate the principal-agent problem between 
investors, clients, and their advisers, the introduction of an 
additional agent--the custodian--introduces the potential for 
additional principal-agent conflicts.
    Such principal-agent problems provide the economic rationale for 
revised Commission rules aimed at further mitigating the underlying 
market failures.\381\ Specifically, in the absence of targeted 
regulation, principal-agent problems can result when investment 
advisers and custodians have different preferences and goals than 
clients. As a result, investment advisers and custodians might take 
actions that increase their well-being at the expense of imposing 
agency costs on investors and clients.\382\ For example, a custodian 
may not have sufficient incentive to provide custodial account records 
to an independent public accountant on a timely basis, to the extent 
providing a timely response is burdensome to a custodian. This would 
make adviser compliance with the audit provision, surprise examination, 
or Form ADV-E filing provisions of the rule more difficult, which would 
ultimately be to the disadvantage of clients.
---------------------------------------------------------------------------

    \381\ As discussed above in section I, there have been market 
developments that suggest a need to better protect client assets by 
broadening the scope of the application of the rule and by improving 
its efficacy.
    \382\ See, e.g., Michael C. Jensen & William H. Meckling, Theory 
of the Firm: Managerial Behavior, Agency Costs and Ownership 
Structure, 3 J.Fin. Econ. 305 (1976).
---------------------------------------------------------------------------

    Market forces generally provide some incentive for principals and 
agents to mitigate principal-agent conflicts. Advisers that effectively 
mitigate conflicts, for example, by offering targeted private contract 
terms, may, all else being equal, gain a reputational advantage that 
will help them in retaining and attracting investors and clients. The 
assurance provided by such terms, however, would depend on both 
investors' perception of the costs of enforcing the terms, as well as 
the likelihood that disputes would be resolved in investors' 
favor.\383\ A market failure may exist to the extent that more costly 
enforcement of the contract and more unpredictable favorable outcomes 
reduce the effectiveness of the contract in mitigating conflicts of 
interest between clients and investment advisers. Factors affecting the 
cost of enforcement in the context of investment advice may include: 
(1) the cost of verifying adviser conduct, (2) the extensiveness and 
complexity of services over which the terms apply, and (3) the ability 
of investors, who likely lack specialized knowledge, to understand how 
adviser conduct relates to the terms.\384\
---------------------------------------------------------------------------

    \383\ See, e.g., Andrei Shleifer, ``Efficient Regulation'', 
(2010), available at http://www.nber.org/papers/w15651 (``Shleifer 
paper''), for a general discussion of these points.
    \384\ See Shleifer paper for a general discussion of factors 
affecting the cost of enforcement of the terms and the 
predictability of favorable legal outcomes. Several factors may also 
affect an investor's assessment of a favorable legal outcome should 
the investor believe an adviser to have violated the contractual 
terms. First, while investors may believe an adviser has violated 
the terms, investors may be uncertain of their ability to verify 
such conduct. Second, given the potentially complex fact patterns of 
litigation related to the provision of investment advice, investors 
may believe that there is some chance that courts will simply ``get 
it wrong.'' Third, advisers may have access to substantially greater 
financial resources than investors. Investors may believe that the 
financial inequality between themselves and advisers makes a 
favorable legal outcome less likely. An investment adviser's 
fiduciary duty to their clients could mitigate the incentive for an 
adviser to provide fewer terms that protect investors. The ability 
of the adviser's fiduciary duty to mitigate the incentive for an 
adviser to provide fewer terms that protect investors will depend on 
factors affecting the cost of enforcing that duty. See, Frank H. 
Easterbrook & Daniel R. Fischel, ``The Economic Structure of 
Corporate Law,'' 1991, Harvard University Press.
---------------------------------------------------------------------------

    When the incentives of advisers or custodians do not sufficiently 
align with investors' or clients' interests, and market failures 
prevent market participants from effectively resolving these conflicts 
of interest via private contracting, targeted regulatory requirements 
can help increase the level of investor protection. The investor 
protection benefits of such regulatory requirements will depend, 
however, on an adviser's ability and incentive to comply with the 
requirements. Encouraging or requiring independent oversight and 
verification of adviser conduct is one way to incentivize 
compliance.\385\ For example, an adviser is less likely to engage in 
unauthorized trading in a client's account when the adviser knows that 
the client will be receiving an account statement detailing any trading 
activity. Similarly, an adviser is less likely to misappropriate client 
assets when it knows that an independent public accountant is required 
to verify client assets.\386\
---------------------------------------------------------------------------

    \385\ Even in the absence of such a regulatory requirement, an 
adviser could contractually offer independent oversight and 
verification of its conduct to its investors and clients. However, 
there may be practical impediments, such as the lack of specialized 
knowledge, which may lead investors to not seek out such terms. In 
addition, individual negotiation of contracts may be less cost 
effective than a market-wide regulatory solution.
    \386\ See, e.g., Stephen G. Dimmock & William W. Gerken, 
``Predicting fraud by investment managers,'' 105 J. Fin. Econ. 153 
(Aug. 2011). This article finds that monitoring is a significant 
predictor of investment fraud. For example, large investors who have 
stronger incentive and greater ability to monitor are associated 
with fewer frauds. Also see, e.g., Ben Charoenwong, Alan Kwan & 
Tarik Umar, ``Does Regulatory Jurisdiction Affect the Quality of 
Investment-Adviser Regulation?,'' 109 Am. Econ. Rev., Am. Econ. 
Ass'n. 3681 (Oct. 2019). This article finds that registered 
investment advisers that are costlier for state regulators to 
supervise, or primarily serve less sophisticated investors, receive 
more complaints.
---------------------------------------------------------------------------

    There are three ways in which regulation facilitating clients' and 
third parties' oversight of advisers' conduct through verification of 
client assets can reduce potential harm to investors and clients. 
First, such regulation can increase the likelihood that any non-
compliant behavior by advisers is detected. Second, it can increase the 
likelihood that any non-compliant behavior is detected sooner, 
potentially mitigating loss to clients. Third, and perhaps most 
importantly, facilitating verification of client assets would likely 
have a prophylactic effect, countering the incentive for non-compliant 
behavior by advisers. Indirectly, regulation that enhances verification 
of client assets also reduces potential harm to clients by facilitating 
detection of non-compliant behavior by the qualified custodians with 
whom the clients have custody agreements, potentially mitigating client 
losses and deterring non-compliant behavior by custodians. This 
ameliorates principal-agent problems between the client and the 
qualified custodian and facilitates advisers' exercise of fiduciary 
duty over client assets held by the qualified custodian.\387\
---------------------------------------------------------------------------

    \387\ For those custodians that are registered broker-dealers, 
it also facilitates compliance with their obligations under Exchange 
Act Rule 15c3-3.
---------------------------------------------------------------------------

    Finally, the ability to oversee investment advisers' (and 
custodians') conduct through verification of client assets depends on 
the quality of the third party's verification processes and the 
independence of the third party.\388\ Generally, a higher quality 
verification process is one that has an increased likelihood of 
detecting misconduct.\389\

[[Page 14735]]

Similarly, a more independent third party is one that is more likely to 
report misconduct or violations of regulatory requirements that it 
detects.\390\ Regulation designed to enhance the quality of third-party 
verification processes and/or enhance the independence of third 
parties, then, generally enhances the ability of third parties to 
oversee investment advisers' conduct.
---------------------------------------------------------------------------

    \388\ See, e.g., Ross L. Watts & Jerold L. Zimmerman, ``Positive 
Accounting Theory: A Ten Year Perspective,'' 65 Acc. Rev. 131 (Jan. 
1990).
    \389\ The use of PCAOB-registered independent public accountants 
is required for certain engagements under the current rule. In 
particular, a PCAOB-registered independent public accountant is 
required to perform surprise examinations and periodically inspect 
internal controls under the current rule when an adviser or its 
related person serves as a qualified custodian for client assets, 
and a PCAOB-registered independent public accountant must audit the 
financial statements of a pooled investment vehicle to be deemed to 
be in compliance with the surprise examination requirement. See 
current rule 206(4)-2(a)(6) and (b)(4). As the Commission noted in 
adopting these requirements in 2009, the Commission has greater 
confidence in the quality of audits conducted by an independent 
public accountant registered with, and subject to regular inspection 
by, the PCAOB. See 2009 Adopting Release, supra footnote 11, at 17.
    \390\ See, e.g., Ross L. Watts & Jerold L. Zimmerman, ``Agency 
Problems, Auditing and the Theory of the Firm: Some Evidence,'' 26 
J.L. Econ. 613 (1983).
---------------------------------------------------------------------------

C. Baseline

    The Commission assesses the economic effects of the proposed 
amendments relative to the baseline of existing requirements and 
practices of advisers.
1. Current Regulation
a. Custody
    As discussed in greater detail in section II above, the regulatory 
framework regarding safeguarding of investment adviser client assets is 
set forth in rule 206(4)-2, which applies to any investment adviser 
registered or required to be registered with the Commission under 
section 203 of the Act that has custody of client funds or 
securities.\391\ As defined by the current rule, ``custody'' means that 
the investment adviser, or its related persons, holds, directly or 
indirectly, client funds or securities, or has any authority to obtain 
possession of them.\392\
---------------------------------------------------------------------------

    \391\ See rule 206(4)-2(a). Our exam program commits significant 
resources ensuring advisers are in compliance with the custody rule 
and verifying the existence of investor assets at custodians--a 
process called asset verification. In FY 2022, EXAMS verified over 
2.1 million investor accounts, totaling over $2 trillion.
    \392\ Rule 206(4)-2(d)(2). The Commission stated in 2003, 
however, that because a one-for-one exchange of assets represents a 
limited risk of client loss, an adviser's authority to issue 
instructions to a broker-dealer or another custodian to effect or to 
settle trades does not constitute ``custody'' under the current 
rule. See 2003 Adopting Release at footnote 10. See also rule 
206(4)-2(d)(7), defining ``related person'' as ``any person, 
directly or indirectly, controlling or controlled by [the investment 
adviser], and any person that is under common control with [the 
investment adviser].''
---------------------------------------------------------------------------

    The current rule requires such advisers to maintain all funds and 
securities of which the adviser has custody with a ``qualified 
custodian'' in separate accounts under that client's name or in 
accounts containing only the funds and securities of such adviser's 
clients, under the adviser's name as agent or trustee, subject to 
certain exceptions.\393\ Qualified custodians generally include banks 
and savings associations, broker-dealers, futures commission merchants, 
and certain FFIs \394\--all of which are financial institutions that 
are currently subject to regular government oversight and are subjected 
to periodic inspection and examination.\395\
---------------------------------------------------------------------------

    \393\ See rule 206(4)-2(a)(1).
    \394\ See rule 206(4)-2(d)(6).
    \395\ See supra footnote 89.
---------------------------------------------------------------------------

    The current rule generally requires an adviser with custody of 
client assets to obtain an annual surprise examination from an 
independent public accountant to verify client funds and securities 
independently.\396\ With certain exceptions, the adviser must report on 
Form ADV whether it or its related person has custody of an advisory 
client's cash, bank accounts, and securities, and disclose the details 
of the custodial relationship (including, inter alia, dollar amounts, 
total number of clients, distribution of quarterly account statements, 
audits, annual surprise examinations, and internal control 
reports).\397\
---------------------------------------------------------------------------

    \396\ See rule 206(4)-2(a)(4). A 2013 Government Accountability 
Office (GAO) study, which examined 12 average-sized registered 
advisers, found that the cost of surprise examinations ranged from 
$3,500 to $31,000. The GAO noted that the costs of surprise 
examinations vary widely across advisers and are typically based on 
the amount of hours required to conduct the examinations, which is a 
function of a number of factors including the number of client 
accounts under custody. See Gov't Accountability Office, GAO-13-569, 
Investment Advisers: Requirements and Costs Associated with the 
Custody Rule (2013), https://www.gao.gov/assets/gao-13-569.pdf.
    \397\ 17 CFR 279.1; Form ADV, Part 1A, Item 9; see also supra 
notes 268-69, 271, 274-77.297, 303-309. An adviser must also include 
a notice in its brochure concerning its qualified custodian's 
account statement obligations, and a disclosure in its balance sheet 
of any financial conditions that are reasonably likely to impair the 
adviser's ability to meet contractual commitments to clients, when 
the adviser has discretionary authority or custody over client funds 
or securities. See Form ADV, Part 2A, Items 15, 18.
---------------------------------------------------------------------------

    In situations where the adviser or a related person acts as 
qualified custodian, the current rule requires advisers to obtain, or 
receive from its related person, an annual internal control report with 
respect to the adviser's or related person's custody controls, which 
includes an opinion from an independent public accountant that is 
registered with, and subject to regular inspection by, the PCAOB.\398\ 
The required internal control report addresses the greater custodial 
risks associated with situations where an adviser, or its related 
person, acts as a qualified custodian.\399\
---------------------------------------------------------------------------

    \398\ See rule 206(4)-2(a)(6). The surprise examination must 
also be conducted by a PCAOB-registered and inspected independent 
public accountant. See Custody Rule Amendments Adopting Release, 
supra footnote 11 (stating that the internal control report should 
address control objectives and associated controls related to the 
areas of client account setup and maintenance, authorization and 
processing of client transactions, security maintenance and setup, 
processing of income and corporate action transactions, 
reconciliation of funds and security positions to depositories and 
other unaffiliated custodians, and client reporting).
    \399\ As noted in the Custody Rule Amendments Adopting Release, 
supra footnote 11, the surprise examination alone does not 
adequately address custodial risks associated with self-custody or 
related-person custody because the independent public accountant 
seeking to verify client assets would rely, at least in part, on 
custodial reports issued by the adviser or its related person. The 
internal control report can significantly strengthen the utility of 
the surprise examination when the adviser or its related person acts 
as qualified custodian for client assets because it provides a basis 
for the independent accountant performing the surprise examination 
to obtain additional comfort that the confirmations received from 
the custodian are reliable.
---------------------------------------------------------------------------

    The current rule's requirements are, however, subject to certain 
exceptions. Specifically, the current rule provides an exception to the 
requirement to maintain securities with a qualified custodian for 
certain ``privately offered securities''.\400\ The current rule also 
provides that advisers need not comply with the requirements of rule 
206(4)-2 with respect to the accounts of registered investment 
companies,\401\ and allows shares of mutual funds to be maintained with 
the fund's transfer agent in lieu of a qualified custodian.\402\ In 
addition, an adviser that has custody solely because of its authority 
to deduct advisory fees, or because a related person has custody and 
such related person is operationally independent of the adviser, is not 
required to obtain an annual surprise examination.\403\
---------------------------------------------------------------------------

    \400\ See rule 206(4)-2(b)(2). As discussed in section II.C, we 
understand that demand for custodial services of privately offered 
may be thin.
    \401\ See rule 206(4)-2(b)(5).
    \402\ Rule 206(4)-2(b)(1).
    \403\ See rule 206(4)-2(b)(3), (6).
---------------------------------------------------------------------------

    The current rule also requires that certain communications be made 
to clients. An investment adviser is required to provide its clients 
notice if the adviser establishes an account with a qualified custodian 
on a client's behalf.\404\ Advisers must also have a

[[Page 14736]]

reasonable basis, after due inquiry, for believing that the qualified 
custodian sends an account statement, at least quarterly, to each of 
the adviser's applicable clients.\405\ When an adviser has custody of 
funds and securities belonging to a client that is a pooled investment 
vehicle, these account statements must be sent to each limited partner, 
member, or other beneficial owner if the adviser or its related person 
is a general partner of a limited partnership, managing member of a 
limited liability company, or holds a comparable position for another 
type of pooled investment vehicle.\406\
---------------------------------------------------------------------------

    \404\ See rule 206(4)-2(a)(2).
    \405\ See rule 206(4)-2(a)(3).
    \406\ See rule 206(4)-2(a)(5).
---------------------------------------------------------------------------

    An adviser is not required to comply with the notice and account 
statement delivery requirements of the rule and shall be deemed to 
comply with the surprise examination requirement with respect to the 
account of a limited partnership or other pooled investment vehicle 
that is subject to annual audit, provided certain conditions are 
satisfied (the ``current audit provision'').\407\ To rely on the 
current audit provision, the pool's financial statements must, among 
other things, be prepared in accordance with U.S. GAAP and distributed 
to all limited partners (or other beneficial owners) within 120 days of 
the end of the pool's fiscal year. The current audit provision also 
requires the auditor to be registered with and subject to inspection by 
the PCAOB.
---------------------------------------------------------------------------

    \407\ See rule 206(4)-2(b)(4).
---------------------------------------------------------------------------

b. Recordkeeping
    Rule 204-2 applies to any investment adviser registered or required 
to be registered with the Commission under section 203 of the Act. This 
rule requires, among other things, that an adviser make and keep a list 
or other record of all client accounts for which the adviser has any 
discretionary power,\408\ and copies of internal control reports 
obtained or received pursuant to current rule 206(4)-2.\409\ Rule 204-2 
also currently requires investment advisers subject to rule 206(4)-2 to 
make and keep records regarding all purchases, sales, receipts and 
deliveries of securities for such accounts and all other debits and 
credits to such accounts, separate ledgers for such accounts, copies of 
confirmations of all effected transactions, a record for each security 
in which any such client has a position, and a memorandum describing 
the basis upon which the adviser has determined that the presumption 
that any related person is not operationally independent has been 
overcome.\410\
---------------------------------------------------------------------------

    \408\ See rule 204-2(a)(8).
    \409\ See rule 204-2(a)(17)(iii).
    \410\ See rule 204-2(b).
---------------------------------------------------------------------------

c. Regulation of Qualified Custodians
    Finally, other regulations affect entities' responsibilities as 
qualified custodians, namely, banks and savings associations, broker-
dealers registered with the Commission, futures commission merchants 
registered with the CFTC, and FFIs. A broker-dealer acting in the 
capacity of a custodian is subject to Exchange Act Rule 15c3-3, under 
which customers' assets must be segregated from proprietary assets to 
permit prompt return in the event of the firm's liquidation in a 
proceeding under the Securities Investor Protection Act of 1970; \411\ 
and, where applicable, to FINRA rule 2231, requiring broker-dealers' 
statements of assets to be sent to customers not less than quarterly. 
Futures commission merchants are subject to Commodities Exchange Act 
sections 4d(a)(2) and 4d(b) and regulations issued thereunder, which 
require segregation of client funds from the entities' funds, and 
impose related accounting and recordkeeping requirements.\412\ Banks 
and savings associations are also subject to regulation with respect to 
their custodial services. For example, under applicable Treasury 
regulations, generally, a depository institution holding government 
securities for its customers must segregate the customer's securities 
from its own assets, free of any lien, charge, or claim of any third 
party granted or created by such custodian; and it may lend the 
securities to a third party only by written agreement with the customer 
and in full compliance with the appropriate regulatory agency.\413\ 
Additionally, national banks and Federal savings associations are 
subject to OCC regulations when providing fiduciary custody 
services,\414\ and the OCC has provided substantial guidance with 
respect to these firms' non-fiduciary custody services.\415\ As a 
result, banks and savings associations have developed and deployed 
comprehensive custodial service agreements governing their 
relationships with their custodial customers. In addition, depository 
institutions are subject to the long-standing, efficient orderly 
resolution process deployed by the FDIC and non-depository member banks 
are subject to the efficient orderly resolution process by the OCC. 
Finally, as noted in part II.C.1, some FFIs are regulated in their 
local jurisdictions and subject to laws and regulations established by 
their national jurisdictions to combat money laundering and terrorism 
financing, consistent with standards and measures recommended by the 
FATF.
---------------------------------------------------------------------------

    \411\ 17 CFR 240.15c3-3. Specifically, see Rule 15c3-3(b)(1) 
(requirement for a broker-dealer to promptly obtain and maintain the 
physical possession or control of all fully-paid securities and 
excess margin securities carried for the account of customers); 
(e)(1) (requiring every broker-dealer to maintain with a bank a 
``Special Reserve Bank Account for the Exclusive Benefit of 
Customers'' and a ``Special Reserve Bank Account for Brokers and 
Dealers,'' separate from each other and from the broker-dealer's 
other bank accounts); and (f) (requiring written notification that 
the bank was informed that cash or securities are being held for the 
exclusive benefit of the broker-dealer's customers and account 
holders, separate from the broker-dealer's other accounts; and that 
the broker-dealer must have a written contract with the bank 
providing that the cash or securities will not be used as security 
for a loan to the broker-dealer by the bank, and will not be subject 
to any right, charge, security interest, lien, or claim in favor of 
the bank or any person claiming through the bank).
    \412\ 7 U.S.C. 6d(a)(2), 6d(6); 17 CFR 1.20-1.30, 1.32, 1.36.
    \413\ 17 CFR 450.4(a)(1), (a)(6).
    \414\ See 12 CFR 9.1 et seq. (rules governing fiduciary powers 
of national banks); 12 CFR 150.10 et seq. (rules governing fiduciary 
powers of Federal savings associations).
    \415\ See generally OCC Custody Handbook, supra note 237.
---------------------------------------------------------------------------

d. Accredited Investors
    Aspects of the proposed rule address investments in privately 
offered securities such as investments in private companies, and 
offerings made by certain hedge funds, private equity funds, and 
venture capital funds.\416\ Congress and the Commission have provided 
exemptions for these offerings based on various factors, including that 
the offerings are generally limited to individuals and entities (e.g., 
accredited investors) that do not require the protection of 
registration.\417\ Under Commission rules, qualifying as an accredited 
investor allows an investor to participate in investment opportunities 
that are generally not available to non-accredited investors, including 
certain investments in private companies and

[[Page 14737]]

offerings by certain hedge funds, private equity funds, and venture 
capital funds.
---------------------------------------------------------------------------

    \416\ The Securities Act of 1933 contains a number of exemptions 
from its registration requirements and authorizes the Commission to 
adopt additional exemptions.
    \417\ Historically, the Commission has stated that the 
accredited investor definition is ``intended to encompass those 
persons whose financial sophistication and ability to sustain the 
risk of loss of investment or fend for themselves render the 
protections of the Securities Act's registration process 
unnecessary.'' See Regulation D Revisions; Exemption for Certain 
Employee Benefit Plans, Release No. 33-6683 (Jan. 16, 1987) [52 FR 
3015 (Jan. 30, 1987)]. See also SEC v. Ralston Purina Co., 346 U.S. 
119, 125 (1953) (taking the position that the availability of the 
section 4(a)(2) exemption ``should turn on whether the particular 
class of persons affected needs the protection of the Act. An 
offering to those who are shown to be able to fend for themselves is 
a transaction `not involving any public offering' '').
---------------------------------------------------------------------------

e. Effect of State Law
    The relationship between clients and qualified custodians is also 
governed by the common law of agency and contracts, and--to the extent 
adopted under state law--corresponding articles of the Uniform 
Commercial Code (UCC).\418\ Thus under sections 8-504 and 8-509 of the 
UCC, unless otherwise agreed to, and unless duties are specified 
otherwise by statute, regulation, or rule, a custodian ``may not grant 
security interests in a financial asset it is obligated to maintain'' 
for the client and must exercise ``due care in accordance with 
reasonable commercial standards to obtain and maintain the financial 
asset.'' \419\
---------------------------------------------------------------------------

    \418\ See supra footnotes 157, 159.
    \419\ U.C.C. 8-504(b), (c), 8-509(a) (Am. L. Inst. & Unif. L. 
Comm'n 2021).
---------------------------------------------------------------------------

2. Affected Parties and Industry Statistics
    The proposed amendments would affect registered investment 
advisers, and those required to be registered, as well as current and 
prospective clients of investment advisers, qualified custodians, and 
independent public accountants.
a. Investment Advisers
    As of June 2022 there were 15,062 investment advisers registered 
with the SEC. Registered investment advisers reported $128.96 trillion 
in RAUM with $117.57 trillion in 47.51 million accounts over which 
advisers have discretionary authority and $11.38 trillion in 14.55 
million accounts over which advisers do not have discretionary 
authority.\420\ The average RAUM among registered investment advisers 
was $8.56 billion and the median was $427.53 million.
---------------------------------------------------------------------------

    \420\ The term ``regulatory assets under management'' or 
``RAUM'' refers to an adviser's assets under management as reported 
in response to Item 5.F. of Part 1A of Form ADV. See Form ADV: 
Instructions for Part 1A, instr. 5.b. (setting forth instructions 
for calculation of assets under management for regulatory purposes).
---------------------------------------------------------------------------

b. Clients
    Form ADV requires investment advisers to indicate the approximate 
number of advisory clients and the amount of total RAUM attributable to 
various client types.\421\ Table 1 provides information on the number 
of client accounts, total RAUM, and the number of advisers by client 
type.
---------------------------------------------------------------------------

    \421\ If a client fits into more than one category, Form ADV 
requires an adviser to select one category that most accurately 
represents the client (to avoid double counting clients and assets).

                                       Table 1--Investment Adviser Clients
----------------------------------------------------------------------------------------------------------------
                                                                     Number of                      Registered
                           Client type                                clients       Total RAUM      investment
                                                                    (thousands)     (billions)       advisers
----------------------------------------------------------------------------------------------------------------
Investment Companies............................................              25         $43,838           1,603
Pooled investment vehicles--Other...............................              95          34,584           5,763
High net worth individuals......................................           6,917          11,832           8,989
Pension Plans...................................................             431           8,106           5,271
Insurance Companies.............................................              13           7,630           1,028
Non-high net worth individuals..................................          43,824           7,093           8,286
State/Municipal Entities........................................              27           4,285           1,299
Corporations....................................................             340           3,267           4,934
Foreign Institutions............................................               2           2,209             363
Charities.......................................................             121           1,613           5,134
Other Advisers..................................................             908           1,427             814
Banking Institutions............................................              11             966             432
Business Development Companies..................................              <1             211              98
----------------------------------------------------------------------------------------------------------------
Source: Form ADV, Items 5D.

c. Qualified Custodians
    Qualified custodians include state and federally-chartered trusts, 
banks and savings associations, broker-dealers, FCMs, and certain 
FFIs.\422\ The custody service industry has been characterized as 
dominated by a small number of large market share participants.\423\ 
Several factors contribute to this: (i) economies of scale, because 
custodial services require a costly infrastructure capable of 
processing a large volume of transactions reliably; (ii) low margins, 
which makes it difficult for new entrants to compete against 
incumbents; and (iii) the importance of reputation/trust.\424\ Large 
financial institutions headquartered in the U.S. dominate the global 
custody service industry.\425\ In 2020, four large U.S. banks serviced 
around $114 trillion of global assets under in their custody.\426\
---------------------------------------------------------------------------

    \422\ The FDIC reports that as of March 31, 2022, there were 
4,194 FDIC-insured commercial banks and 602 FDIC-insured savings 
institutions. See https://www.fdic.gov/analysis/quarterly-banking-profile/statistics-at-a-glance/2022mar/industry.pdf. We do not have 
data on the number of FDIC-insured commercial banks and FDIC-insured 
savings institutions providing custodial services. As of November 
2022, there were 3,530 broker-dealers registered with the 
Commission. See https://www.sec.gov/files/data/broker-dealers/company-information-about-active-broker-dealers/bd110122.txt. The 
CFTC reports that as of September 30, 2022, there were 60 FCMs. See 
https://www.cftc.gov/sites/default/files/2022-11/01%20-%20FCM%20webpage%20Update%20-%20September%202022.pdf. Out of 3,498 
broker-dealers registered with the Commission, 153 were classified 
as carrying broker-dealers based on FOCUS filings as of June 2022. 
Per EDGAR Form Custody: A ``Carrying broker-dealer'' is a broker-
dealer that carries customer or broker or dealer accounts and 
receives or holds funds or securities for those customers. We do not 
have data on the number of qualifying FFIs.
    \423\ Deloitte, ``The evolution of core financial service. 
Custodian & Depository Banks.'' (2019), available at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf. See also 
Congressional Research Service, ``Digital Assets and SEC 
Regulation,'' January 30, 2020. According to this report, in 2020, 
four large banks service around $114 trillion of global assets under 
custody.
    \424\ Charles-Enguerrand Coste et al., One size fits some: 
analyzing profitability, capital and liquidity constraints of 
custodian banks through the lens of the SREP methodology (Eur. Cent. 
Bank Occasional Paper No. 256, 2021).
    \425\ Id; see also Congressional Research Service, ``Digital 
Assets and SEC Regulations,'' (Jan. 30, 2020.).
    \426\ Congressional Research Service, ``Digital Assets and SEC 
Regulations,'' (Jan. 30, 2020.).
---------------------------------------------------------------------------

d. Independent Public Accountants
    As discussed above, the current rule generally requires an adviser 
with custody of client assets to obtain an annual surprise examination 
from an independent public accountant.\427\ As of June 2022, 13% of 
investment advisers obtain a surprise examination by an

[[Page 14738]]

independent public accountant.\428\ Not all advisers with custody, 
however, are subject to an annual surprise examination. For example, as 
of June 2022, 4,933 investment advisers satisfied their custody rule 
obligations by complying with the current rule's audit provision.\429\ 
Advisers reported that 86% of the accountants performing surprise 
examinations or conducting pooled investment vehicle financial 
statement audits are subject to regular inspection by the PCAOB.\430\
---------------------------------------------------------------------------

    \427\ See rule 206(4)-2(a)(4).
    \428\ Based on advisers' responses to Item 9.C.(2) of Part 1A of 
Form ADV. Comparable numbers for 2019, 2020, and 2021 were 13%, 13%, 
and 13%, respectively.
    \429\ Based on advisers' responses to Item 9.C.(3) of Part 1A of 
Form ADV. Comparable numbers for 2019, 2020, and 2021 were 4,460, 
4,565, and 4,768, respectively.
    \430\ These percentages are based on advisers' responses to Item 
9.C.(3) of Part 1A of Form ADV. Comparable percentages for 2019, 
2020, and 2021 were 86%, 86%, and 86%, respectively.
---------------------------------------------------------------------------

    Advisers that are subject to an annual surprise examination also 
are required to obtain (or receive from the relevant related person) an 
internal control report if the adviser or a related person of the 
adviser serves as a qualified custodian for client assets. However, in 
the circumstance where an adviser is deemed to have custody solely 
because of a related person custodian and the related person custodian 
is operationally independent of the adviser, the adviser is not 
required to have an annual surprise examination but is subject to the 
internal control requirement.\431\ As of June 2022, 98 investment 
advisers have a control report prepared by an independent public 
accountant without being subject to a surprise examination.\432\
---------------------------------------------------------------------------

    \431\ See rule 206(4)-2(a)(6) and (b)(6). In these 
circumstances, the adviser typically receives the internal control 
report from the related person custodian.
    \432\ Based on advisers' responses to Item 9.C.(3) and 9.C.(4) 
of Part 1A of Form ADV. Comparable numbers for 2019, 2020, and 2021 
were 117, 112, and 105, respectively.
---------------------------------------------------------------------------

3. Market Practice
a. Investment Advice
    Academic studies have documented a number of benefits to retail 
investors from receiving investment advice, including, but not limited 
to: higher household savings rates, setting long-term goals and 
calculating retirement needs, more efficient portfolio diversification 
and asset allocation, increased confidence and peace of mind, 
facilitation of small investor participation, and improved tax 
efficiency.\433\ Investment advisers can also help correct potential 
systematic errors that retail investors might make, including limited 
allocation of savings to equities, under-diversification, or investing 
too little in foreign assets.\434\
---------------------------------------------------------------------------

    \433\ See, e.g., Mitchell Marsden, Catherine D. Zick, & Robert 
N. Mayer, The Value of Seeking Financial Advice, 32 J. Fam. & Econ. 
Issues 625 (2011); Jinhee Kim, Jasook Kwon & Elaine A. Anderson, 
Factors Related to Retirement Confidence: Retirement Preparation and 
Workplace Financial Education, 16 J. Fin. Counseling & Plan. 77 
(2005); Michael S. Finke, Sandra J. Huston, & Danielle D. 
Winchester, Financial Advice: Who Pays, 22 J. Fin. Counseling & 
Plan. 18 (2011); Daniel Bergstresser, John M.R. Chalmers, & Peter 
Tufano, Assessing the Costs and Benefits of Brokers in the Mutual 
Fund Industry, 22 Rev. Fin. Stud. 4129 (2009); Ralph Bluethgen, 
Steffen Meyer & Andreas Hackethal, High-Quality Financial Advice 
Wanted! (Working Paper, Feb. 2008), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1102445; Neal M. 
Stoughton, Youchang Wu & Josef Zechner, Intermediated Investment 
Management, 66 J. Fin. 947 (2011). Marsden et al. (2011) documents 
benefits attributable to hiring a financial professional, such as 
better retirement account diversification and savings goals, but 
does not find that hiring a financial professional measurably 
increases the amount of overall wealth accumulation for those 
investors. See, also, Jeremy Burke & Angela A. Hung, Do Financial 
Advisors Influence Savings Behavior?, RAND Labor and Population 
Report Prepared for the Department of Labor (2015), available at 
https://www.rand.org/pubs/research_reports/RR1289; Terrance Martin & 
Michael Finke. ``A Comparison of Retirement Strategies and Financial 
Planner Value.'' 27 J. Fin. Plan. 46 (2014); Crystal R. Hudson L & 
Lance Palmer. ``Low-Income Employees: The Relationship between 
Information from Formal Advisors and Financial Behaviors.'' 23 Fin. 
Serv. Rev. (2014): 25; Marc M. Kramer, Financial Literacy, 
Overconfidence and Financial Advice Seeking (Working Paper, Dec. 19, 
2014), available at https://efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2015-Amsterdam/papers/EFMA2015_0067_fullpaper.pdf; John R. Salter, Nathan Harness & Swarn 
Chatterjee. ``Utilization of Financial Advisors by Affluent 
Retirees.'' 19 Fin. Serv. Rev. 245 (2010), for additional studies on 
the causal relation between the use of a financial professional and 
wealth accumulation. Francis M. Kinniry et al., Putting a Value on 
Your Value: Quantifying Vanguard Advisor's Alpha, Vanguard Research 
(Sept. 2016), available at https://advisors.vanguard.com/iwe/pdf/IARCQAA.pdf, estimates the value to investors associated with 
obtaining financial advice of approximately 3% in net returns to 
investors, associated with suitable asset allocation, managing 
expense ratios, behavioral coaching, alleviating home bias, among 
others.
    \434\ See, e.g., Luigi Guiso, Paolo Sapienza & Luigi Zingales, 
People's Opium? Religion and Economic Attitudes, 50 J. Monetary 
Econ. 225 (2003); Laurent E. Calvet, John Y. Campbell & Paolo 
Sodini, Down or Out: Assessing the Welfare Costs of Household 
Investment Mistakes, 115 J. Pol. Econ. 707 (2007); Brad M. Barber & 
Terrance Odean, ``Trading is Hazardous to Your Wealth: The Common 
Stock Performance of Individual Investors'', 55 J. Fin. 773 (2000); 
Karen K. Lewis, Trying to Explain Home Bias in Equities and 
Consumption, 37 J. Econ. Literature 571 (1999). Guiso et al., 2003; 
Calvet et al., 2007; Barber and Odean, 2000; Lewis, 1999. Possible 
explanations for these investor mistakes may arise from behavioral 
biases, such as cognitive errors, the cost of information 
acquisition, or the selection of the financial professional. For 
example, investors have been observed to hold too little of their 
wealth in foreign assets, which is often called ``home bias.''
---------------------------------------------------------------------------

    Investor demand for investment advice, however, may be affected by 
investor's assessment of the conflicts between themselves and 
investment advisers. For example, while investors may benefit from 
receiving investment advice, reports have indicated that the ability to 
trust the advice of a financial professional is an important factor in 
determining investors' demand for investment advice. In particular, one 
academic study has shown that trust in financial institutions is 
associated with the propensity to use financial advice.\435\ Based on 
survey data analysis, this study found that financial trust is 
correlated with the likelihood of seeking financial advice. Using data 
from experiments, this study found that trust is an important predictor 
of who takes up advice, even after controlling for demographic 
characteristics and financial literacy.
---------------------------------------------------------------------------

    \435\ See, e.g., Jeremy Burke & Angela A. Hung, Trust and 
Financial Advice (RAND Working Paper WR-1075, 2015).
---------------------------------------------------------------------------

b. Adviser Custody
    As of June 2022, 8,536 advisers (56.67% of the total number of 
advisers) reported on Form ADV that they or their related persons, in 
aggregate, had custody of $45.56 trillion (35.33% of aggregate RAUM) of 
client assets.436 437 Advisers reported directly having 
custody of approximately $21.28 trillion, and $24.28 trillion resulted 
indirectly from custody through a related person. As of June 2022, 
1,904 (12.64% of the total) advisers reported that an independent 
public accountant conducted an annual surprise examination of client 
assets.\438\ 4,933 advisers reported that an independent

[[Page 14739]]

public accountant annually audits the pooled investment vehicle(s) the 
adviser manages and the audited financial statements are distributed to 
investors in the pools.\439\ 1,405 (9.33% of the total) advisers 
reported having a qualified custodian send quarterly statements to 
investors in pooled investment vehicles.\440\ As of June 2022, 98 
(0.65%) registered advisers reported that they had an internal control 
report prepared by an independent public accountant but did not report 
that they were subject to a surprise examination.\441\
---------------------------------------------------------------------------

    \436\ This analysis is based on advisers' responses to Items 
9.A. and 9.B. of Part 1A of Form ADV. The instructions to Item 9.A. 
of Part 1A of Form ADV provide that an adviser that has custody 
solely because (i) it deducts advisory fees directly from client 
accounts, or (ii) an operationally independent related person has 
custody of client assets in connection with advisory services 
provided to clients, should answer ``No'' in response to Item 
9.A.(1), which asks whether the adviser has custody of client 
assets, meaning the number of advisers with custody is likely 
larger.
    \437\ The total number of advisers reporting custody of client 
assets or custody by a related person, in response to Items 9.A. and 
9.B. of Part 1A of Form ADV was 7,424 in 2019, 7,774 in 2020, and 
8,180 in 2021. As a percent of the total number of registered 
advisers, the percent of advisers reporting custody of client assets 
or custody by a related person in response to Items 9.A. and 9.B. of 
Part 1A of Form ADV was 55.20% in 2019, 55.88% in 2020, and 55.95% 
in 2021. As a percent of aggregate RAUM, advisers reporting custody 
of client assets or custody by a related person in response to these 
Items of Form ADV, managed 33.92% in 2019, 33.80% in 2020, and 
34.44% in 2021.
    \438\ Based on advisers' responses to Item 9.C.(3) of Part 1A of 
Form ADV, the total number of advisers reporting that an independent 
public accountant conducts an annual surprise examination of client 
assets was 800 (13.38%) in 2019, 1,834 (13.18%) in 2020, and 1,887 
(12.91%) in 2021.
    \439\ Based on advisers responses to Item 9.C.(2) of Form ADV. 
Comparable numbers for 2019, 2020, and 2021 were 4,460, 4,565, and 
4,768, respectively.
     In addition, based on advisers' responses to Items 9.A., 9.B., 
and 9.F., 8,165 registered advisers had custody solely because of 
their authority to deduct fees in 2020 as of June 2022.
    \440\ Based on advisers' responses to Item 9.C.(2) of Form ADV. 
Comparable numbers for 2019, 2020, and 2021 were 1,313 (9.76%), 
1,328 (9.55%), and 1,348 (9.22%), respectively.
    \441\ These statistics are based on advisers' responses to Items 
9.C.(3) and (4) of Part 1A of Form ADV. The comparable numbers for 
2019, 2020, and 2021 were 117 (0.87%), 112 (0.81%), and 105 (0.72%), 
respectively.
---------------------------------------------------------------------------

    As of June 2022, approximately 0.5% of all registered investment 
advisers (6.51% of aggregate RAUM) acted as a qualified custodian for 
their clients. Approximately 0.6% of all registered investment advisers 
(23.67% of aggregate RAUM) had a related person acting as a qualified 
custodian.
c. Market Practice Baseline
    In addition to rule 206(4)-2, the 2009 Accounting Guidance, no-
action letters, interpretive letters, and other staff statements (some 
of which are enumerated in section II.K) shape investment advisers' 
custody rule compliance. For example, staff has issued 70 FAQs on a 
wide range of topics, including the contours of custody and how custody 
applies in the setting of pooled investment vehicles.\442\
---------------------------------------------------------------------------

    \442\ See supra note 17.
---------------------------------------------------------------------------

    Banks' practices as qualified custodians are also shaped by 
guidance, such as the Office of the Comptroller of the Currency's 
handbook on custody, which furnishes guidance to national banks and 
savings associations acting as custodians.\443\ The OCC guidance 
provides that the custodian's management has the responsibility to 
assess its control environment and ensure an appropriate system of 
internal controls, including separation of duties, and accounting 
controls to monitor and measure transactional workflows and their 
accuracy.\444\ The custodian's management should further ensure that 
custody account assets are kept separate from the custodian's own 
assets and maintained under joint control, and that securities under 
custody are not subject to lending transactions without a written 
agreement between the custodian and the client.\445\
---------------------------------------------------------------------------

    \443\ Off. Of the Comptroller of the Currency, Comptroller's 
Handbook, Custody (2002), available at https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/index-custody-services.html.
    \444\ Comptroller's Handbook, Custody at 6-7.
    \445\ Id. at 14, 30.
---------------------------------------------------------------------------

d. Custody Market Trends
    Competition among bank qualified custodians has been characterized 
as fierce, with shrinking profit margins, and the dominance of a 
handful of large entities.\446\ One report noted that custodians need 
to adapt and expand their service offerings to accommodate new types of 
assets, such as crypto assets, and assets that are now held and 
transferred using new technological methods, such as central bank 
digital currencies (also known as CBDCs).\447\
---------------------------------------------------------------------------

    \446\ Id. at 1. See also Deloitte, ``The evolution of a core 
financial service. Custodian & Depository Banks.'' (2019) available 
at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf. 
See also Congressional Research Service, ``Digital Assets and SEC 
Regulations,'' January (Jan. 30, 2020). According to this report, in 
2020, four large banks service around $114 trillion of global assets 
under custody.
    \447\ See, e.g., Deloitte, ``The evolution of a core financial 
service. Custodian & Depository Banks.'' (2019) available at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf.
---------------------------------------------------------------------------

    The industry-reported market capitalization for crypto assets 
experienced a rapid growth from $1 billion in 2018 to $1 trillion in 
2021.\448\ One survey found that 16 percent of U.S. adults say they 
personally have invested in, traded, or otherwise used 
``cryptocurrencies.'' \449\ Institutional investors also invested in 
``cryptocurrencies.'' \450\ The Commission analyzed the extent to which 
investment advisers offer various kinds of services related to digital 
assets.\451\ This analysis relied on Commission filings, advisers' 
websites, and mentions of an adviser's services from third-party online 
news sources.\452\ The analysis was conducted as of June 2022 \453\ and 
focuses on the 50 largest investment advisers \454\ by RAUM. The 
Commission estimates that, of these 50 largest investment advisers, (i) 
21 are offering or planning on offering some services related to 
digital assets,\455\ (ii) 9 are giving or planning on giving investment 
advice related to digital assets,\456\ (iii) 13 provide or are planning 
on providing custody of digital assets or custodial services of digital 
assets,\457\ and (iv) 7 advise or are planning on advising a pooled 
investment vehicle (like a fund or commodity pool) that holds some 
digital assets.\458\
---------------------------------------------------------------------------

    \448\ See, e.g., Deloitte, ``Market Manipulation in Digital 
Assets'' (Mar. 2021), available at https://www2.deloitte.com/content/dam/Deloitte/global/Documents/Financial-Services/gx-design-market-manipulation-in-digital-assets-whitepaper-v2-1.pdf.
    \449\ See ``46% of Americans who have invested in cryptocurrency 
say it's done worse than expected,''.'' Pew Research Center, 
Washington, DC (Aug. 23, 2022), available at https://www.pewresearch.org/fact-tank/2022/08/23/46-of-americans-who-have-invested-in-cryptocurrency-say-its-done-worse-than-expected/. Also, 
another study in 2019 estimated about 40 million Americans owned 
assets identified as cryptocurrencies. See Office of the Comptroller 
of the Currency, Interpretative Letter #1170, July 2020.
    \450\ See Office of the Comptroller of the Currency, 
Interpretative Letter #1170, July 2020.
    \451\ A search of Commission filings, advisers' websites, and 
mentions of an adviser's services from third-party only news 
services used the term ``digital assets'' because several of the 
sources did not explicitly state that they were strictly referring 
to crypto assets.
    \452\ Filings on Form ADV did not, in all cases, provide 
sufficient information to determine exactly the extent to which an 
adviser offers services related to digital assets. Therefore, this 
analysis relied on supplementary information obtained from advisers' 
websites, online news sources, and in two cases, other forms filed 
with the SEC. Both of these two cases involved funds that held 
digital assets. In the case of one adviser, the staff used 
information from Form D, in the case of the other the staff used 
information from Form S-1. Web pages whose terms and conditions 
required citation are: https://investor.vanguard.com/, 
www.franklintempleton.com, www.mufg.jp, https://www.pimco.com/, and 
https://citywire.com/.
    \453\ Commission analysis used advisers' most recent filings 
that were submitted during the period from July 2021 to June 2022. 
Supplemental data from websites was evaluated in October 2022.
    \454\ The Commission considered filers that represent the same 
firm to be a single adviser. In aggregate, these 50 investment 
advisers (i) reflect 49% of total RAUM (as reported in response to 
question 5F(2)(c)), (ii) manage 37% of all accounts (as reported in 
response to question 5F(2)(f)), (iii) hold 35% of client funds and 
securities in investment adviser firm's custody or in a related 
person's custody (as reported in response to questions 9A(2)(a) and 
9B(2)(a)), and hold 32% of client funds and securities in investment 
adviser firm's custody (as reported in response to question 9A(2)(a) 
only).
    \455\ These investment advisers comprise 67% of RAUM and manage 
66% of accounts of the largest 50 investment advisers.
    \456\ These investment advisers comprise 26% of RAUM and manage 
41% of accounts of the largest 50 investment advisers.
    \457\ These investment advisers comprise 51% of RAUM and manage 
43% of accounts of the largest 50 investment advisers. They further 
comprise 49% of client funds and securities in the largest fifty 
investment adviser firms' custody or in related persons' custody (as 
reported in response to questions 9A(2)(a) and 9B(2)(a)) and 48% of 
client funds and securities in the largest fifty investment adviser 
firms' custody (as reported in response to question 9A(2)(a) only).
    \458\ These investment advisers comprise 67% of RAUM and manage 
66% of accounts of the largest 50 investment advisers.
---------------------------------------------------------------------------

    The market for crypto asset custodial services continues to 
develop. Our understanding is that one OCC-regulated national bank, 
four OCC-

[[Page 14740]]

regulated trusts, approximately 20 state-chartered trust companies and 
other state-chartered, limited purpose banking entities, and at least 
one FCM currently offer custodial services for crypto assets. We also 
understand that the provision of custodial services for crypto assets 
can arise in the context of the trading of crypto assets. As discussed 
above, many platforms that provide users with the ability to transact 
in crypto assets are not qualified custodians and require investors to 
pre-fund trades, a process in which investors transfer their crypto 
assets or fiat currency to such a platform prior to the execution of 
any trade.\459\ Our understanding is that the majority of crypto asset 
trading occurs on platforms requiring pre-funding of trades, though 
crypto asset trading also occurs on so-called decentralized platforms 
that may not rely on pre-funding. We are aware that a limited number of 
SEC-registered crypto asset securities trade on Alternative Trading 
Systems (``ATSs'') that do not require pre-funding of trades.\460\ ATSs 
that trade crypto asset securities follow a three-step process or four-
step process \461\ that does not involve the broker-dealer operator of 
the ATS providing custodial services for the crypto asset 
securities.\462\ We understand, however, that ATSs do not offer trading 
of crypto asset non-securities.
---------------------------------------------------------------------------

    \459\ See supra, footnote 128 and accompanying text.
    \460\ ATSs that do not trade NMS stocks file with the Commission 
a Form ATS notice, which the Commission does not approve. In 
addition, all ATSs must file quarterly reports on Form ATS-R with 
the Commission. Form ATS-R requires, among other things, volume 
information for specified categories of securities, a list of all 
securities traded in the ATS during the quarter, and a list of all 
subscribers that were participants. To the extent that an ATS trades 
crypto asset securities, the ATS must disclose information regarding 
its crypto asset securities activities as required by Form ATS and 
Form ATS-R. Form ATS and Form ATS-R are deemed confidential when 
filed with the Commission. Based on information provided on these 
forms, a limited number of ATSs have noticed on Form ATS their 
intention to trade certain crypto asset securities and a subset of 
those ATSs have reported transactions in crypto asset securities on 
their Form ATS-R.
    \461\ For background on the models, the staff has noted as 
follows: A non-custodial ATS four-step model involves the following 
steps: Step 1--the buyer and seller send their respective orders to 
the ATS; Step 2--the ATS matches the orders; Step 3--the ATS 
notifies the buyer and seller of the matched trade; and Step 4--the 
buyer and seller settle the transaction bilaterally, either directly 
with each other or by instructing their respective custodians to 
settle the transaction on their behalf. In a non-custodial ATS 
three-step model involves the following steps: Step 1--the buyer and 
seller send their respective orders to the ATS, notify their 
respective custodians of their respective orders submitted to the 
ATS, and instruct their respective custodians to settle transactions 
in accordance with the terms of their orders when the ATS notifies 
the custodians of a match on the ATS; Step 2--the ATS matches the 
orders; and Step 3--the ATS notifies the buyer and seller and their 
respective custodians of the matched trade and the custodians carry 
out the conditional instructions. The custodians would then settle 
the trade on behalf of the buyer and seller based on the 
instructions received in Step 1. As with the four-step process, the 
broker-dealer operator does not guarantee or otherwise have 
responsibility for settling the trades and does not at any time 
exercise any level of control over the digital asset securities 
being sold or the cash being used to make the purchase (e.g., the 
ATS does not place a temporary hold on the seller's wallet or on the 
buyer's cash to ensure the transaction is completed) other than by 
notifying the custodians for the buyer and seller, and the buyer and 
seller, of the match. See finra-ats-role-in-settlement-of-digital-
asset-security-trades-09252020.pdf.
    \462\ Our understanding is that for existing ATSs, custodial 
services are typically provided by state-chartered trust companies 
and other state-chartered, limited purpose banking entities.
---------------------------------------------------------------------------

    We understand that certain advisers provide advisory services with 
respect to client funds and securities that would generally result in 
an adviser having ``custody'' within the meaning of the rule (e.g., 
serving as the general partner for a private fund that holds crypto 
asset securities), and therefore are required to comply with the rule. 
Some of these advisers, however, may not maintain their client's crypto 
assets with a qualified custodian, instead attempting to safeguard 
their client's crypto assets themselves--a practice that is not 
compliant with the custody rule if those crypto assets are funds or 
securities and do not meet an exception from the qualified custodian 
requirement. Other advisers offering similar advisory services may take 
the position that crypto assets are not covered by the custody rule at 
all because they believe that crypto assets are neither funds nor 
securities.\463\
---------------------------------------------------------------------------

    \463\ This, however, is incorrect because most such assets are 
likely to be funds or crypto asset securities covered by the current 
rule. See infra footnote 29 and accompanying text.
---------------------------------------------------------------------------

    Assets other than publicly traded stocks and bonds have 
increased.\464\ One investment services industry data provider 
forecasted that global assets under management across alternative asset 
classes would grow by 60 percent between the end of 2020 and the end of 
2025.\465\ For example, capital raised in the private equity market was 
less than $60 billion in 2010. About a decade later, in 2019, capital 
raised in the private equity market was more than $316 billion.\466\ 
Also, investor interest in physical assets may have increased.\467\ As 
discussed in section II.D, safeguarding alternative assets may involve 
unique procedures that differ across each specific asset type and that 
substantially differ from safeguarding practices with respect to more 
traditional asset classes (like equities and fixed income products). 
Additionally, physical assets potentially create more complex 
challenges with regard to transaction processing, monitoring, and 
reporting services.\468\ The breadth and variety of alternative assets 
diminish an entity's ability to scale and automate its safekeeping 
services for efficiency and profitability and, therefore, entities 
providing safekeeping services may be reluctant to expend the resources 
necessary to accommodate such assets. As a result, custodians may 
outsource the safekeeping of alternative assets to entities that 
specialize in safekeeping certain asset classes.\469\
---------------------------------------------------------------------------

    \464\ Financial Times, ``Global shift into alternative assets 
gathers pace,'' (July 16, 2017,), available at https://www.ft.com/content/1167a4b8-6653-11e7-8526-7b38dcaef614.
    \465\ See, e.g., David Lowery & Preqin Blog, ``Future of 
Alternative 2025: Preqin Forecasts Alternative AUM Growth of 9.8% 
though to 2025,'' (Nov. 4, 2020), available athttps://
www.preqin.com/insights/research/blogs/preqin-forecasts-alternative-aum-growth-of-9-8-percent-through-to-2025.
    \466\ See, e.g., PitchBook, ``Data, Inc., A PE fundraising 
record could await in 2021,'', (Dec. 15, 2020), available at https://pitchbook.com/newsletter/a-pe-fundraising-record-could-await-in-2021.
    \467\ For example, the creation of art-market indices suggests 
that interest in physical assets, such as fine art, may have 
increased. Sotheby's, ``The Sotheby's Mei Moses Indices,'' available 
at https://www.sothebys.com/en/the-sothebys-mei-moses-indices.
    \468\ Deloitte, ``The evolution of core financial service. 
Custodian & Depository Banks.'' (2019) available at https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf.
    \469\ See, e.g., Colonnade, ``Alternative Asset Custody 
Services, Positive Dynamics Power Growth,'' Market Commentary--(Jan. 
2015), available at https://www.coladv.com/wp-content/uploads/Alt-Asset-Admin-Jan-2015-FINAL.pdf.
---------------------------------------------------------------------------

    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.\470\ Staff has also observed that the contractual 
limitations on custodial liability vary between a gross negligence 
standard and a simple negligence standard. Also, we understand that 
some custodial agreements contain contractual language addressing when 
a lien or similar claim will attach to client assets. Finally, staff 
has observed a practice by custodians in which the custodian lists 
assets for which it does not accept custodial

[[Page 14741]]

liability on a client's account statement on an accommodation basis 
only; the custodian does not attest to the holdings of, or transactions 
in, those investments or take steps to ensure that the investments are 
safeguarded appropriately. The custodian reports the holdings or 
transactions as reported to it by the adviser.
---------------------------------------------------------------------------

    \470\ Custodial agreements are generally between an advisory 
client and a qualified custodian. We do not have data on custodial 
agreements that would allow us to characterize the relative 
frequency of various agreement provisions.
---------------------------------------------------------------------------

e. Compliance Trends
    In 2013, the Commission staff issued a National Exam Program 
(``NEP'') Risk Alert stating that the NEP had observed widespread and 
varied non-compliance with elements of the custody rule.\471\ In 
reviewing examinations that contained significant deficiencies, the NEP 
found that approximately one-third (over 140) included custody-related 
issues. The findings from the examinations resulted in remedial 
measures taken by advisers, including among other things, drafting, 
amending or enhancing their written compliance procedures, policies, or 
processes; changing their business practices; or devoting more 
resources or attention to the area of custody.
---------------------------------------------------------------------------

    \471\ See, e.g., SEC, ``National Exam Program Risk Alert'' (Mar. 
4, 2013), available at https://www.sec.gov/about/offices/ocie/custody-risk-alert.pdf.
---------------------------------------------------------------------------

    In 2017, the Commission staff issued a NEP Risk Alert reporting 
that deficiencies or weaknesses related to the custody rule were among 
the five most frequent compliance topics identified during examinations 
of investment advisers.\472\ Typical examples of deficiencies or 
weaknesses with respect to the custody rule identified by the staff 
were: (1) advisers did not recognize that they may have custody due to 
online access to client accounts, (2) advisers with custody obtained 
surprise examinations that did not meet the requirements of the custody 
rule, and (3) advisers did not recognize that they may have custody as 
a result of certain authority over client accounts.
---------------------------------------------------------------------------

    \472\ See, e.g., SEC, ``National Exam Program Risk Alert'' (Feb. 
7, 2017), available at https://www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdfhttps://www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdf.. 
https://www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdf.
---------------------------------------------------------------------------

    In 2021, the Division of Examinations issued a Risk Alert stating 
that in its experience, a number of activities related to digital asset 
securities presented specific risks to investors.\473\ Included among 
the risks identified by the Division of Examinations were risks related 
to advisers' crypto asset custodial practices and their compliance with 
the custody rule. As discussed above, the custody rule was designed to 
help ensure advisers adequately safeguard client investments in their 
custody by requiring advisers to take steps to mitigate the risk that 
client investments will be lost, misused, stolen, misappropriated, or 
subject to the financial reverses, including insolvency, of an 
investment adviser.\474\ Crypto assets are not exempt from these risks. 
Based on that experience, the Division of Examinations indicated that 
it would continue to review the risks and practices related to crypto 
asset custody and examine for compliance with the custody rule.\475\
---------------------------------------------------------------------------

    \473\ See Division of Examinations, ``Risk Alert: The Division 
of Examinations' Continued Focus on Digital Asset Securities'' (Feb. 
26, 2021), available at https://www.sec.gov/files/digital-assets-risk-alert.pdf.
    \474\ See section I infra.
    \475\ Specifically the Division of Examinations stated that 
staff would review: (i) occurrences of unauthorized transactions, 
including theft of digital assets, (ii) controls around safekeeping 
of digital assets (e.g., employee access to private keys and trading 
platform accounts), (iii) business continuity plans where key 
personnel have exclusive access to private keys, (iv) how the 
adviser evaluates harm due to the loss of private keys, (v) 
reliability of software used to interact with relevant digital asset 
networks, (vi) storage of digital assets on trading platform 
accounts and with third party custodians, and (vii) security 
procedures related to software and hardware wallets.
---------------------------------------------------------------------------

D. Benefits and Costs of Proposed Rule and Form Amendments

1. Scope
    The proposed rule would change the current rule's scope in two 
ways. First, it would expand the types of investments covered by the 
rule beyond a client's funds or securities to include other positions 
held in a client's account that are not funds or securities. Second, 
the proposed rule would make explicit that the current rule's defined 
term ``custody'' includes discretionary trading authority. The scope of 
the rule determines, in part, the costs and benefits of the regulatory 
program set forth by the other components of the proposed rule (the 
``programmatic effects'').
a. Scope of Assets
    The proposed rule's expanded scope would include all client assets 
for which an adviser has custody. The proposed rule would define 
``assets'' as ``funds, securities, or other positions held in a 
client's account.'' \476\ Assets under the rule also would include 
financial contracts held for investment purposes, collateral posted in 
connection with a swap contract on behalf of the client, and other 
assets that may not clearly be funds or securities covered by the 
current rule. ``Other positions held in the client's account'' covers 
current asset types and asset types that develop in the future 
regardless of their status as funds or securities. The addition of 
``other positions held in the client's account'' would also include 
crypto assets when not otherwise covered by the rule's references to 
funds and securities.\477\ Further, the proposed rule's use of the term 
``assets'' would not exclude client investments that may appear in the 
liabilities column of a balance sheet or that may be represented as a 
financial obligation of the client including short positions, written 
options, or negative cash.
---------------------------------------------------------------------------

    \476\ Proposed rule 223-1(d)(1).
    \477\ See Part II.A, supra.
---------------------------------------------------------------------------

    We believe that the proposed rule reduces the risk of loss of 
client assets by expanding the types of assets covered by the rule 
beyond ``funds and securities.'' Bringing more categories of assets 
into the scope of the rule's requirements will protect investors 
because the assets will be subject to custodial safeguards. Expanding 
the scope of the rule will also reduce uncertainty over the status of 
assets under advisement that must be held in the custody of a qualified 
custodian, thereby reducing the legal risk associated with advisory 
services and custodial arrangements for the assets. This may increase 
investment opportunities and the availability of advisory services for 
those assets. Looking forward, the proposed definition of assets is 
designed to remain evergreen, encompassing new investment types as they 
continue to evolve and to recognize that the protections of the rule 
should not depend on which type of assets the client entrusts to the 
adviser.
    Expanding the scope of the custody rule to include client assets 
instead of only client funds and securities would also involve costs. 
We expect that this expansion in scope would cause advisers to incur 
compliance costs in connection with these newly covered investment 
positions. Accordingly, advisers with custody of such assets would 
incur additional costs to ensure their safeguarding practices with 
respect to such assets comply with the custody rule; for example, the 
costs associated with finding a qualified custodian that is able to 
take possession or control of these assets. Rather than incur such 
costs, advisers may continue providing advice with respect to clients' 
funds and securities, but stop providing advice with respect to 
clients' other assets within the scope of the expanded

[[Page 14742]]

rule.\478\ Investment advisers may accordingly eliminate the aspect of 
their services that gives them custody (they may decline the authority 
to hold or take possession of the other assets, including any 
discretionary authority to withdraw or transfer beneficial ownership of 
such assets). To the extent clients benefit from advice on such other 
assets--which may be merely ancillary to advice on funds and 
securities--investors would no longer receive these benefits.\479\ 
Also, advisers would forego any fees associated with providing such 
services.
---------------------------------------------------------------------------

    \478\ Analysis described in section III.C.3.d indicates that 
seven advisers either currently advise, or are planning to advise, a 
pooled investment vehicle (such as a private fund or commodity pool) 
that holds some crypto assets. To the extent these pooled investment 
vehicles hold crypto assets that may be outside of the current 
rule's scope (i.e., they are neither funds nor securities), those 
assets would be within the scope of the proposed rule. To the extent 
that it becomes cost-prohibitive for advisers to find a qualified 
custodian, or otherwise comply with the proposed rule with respect 
to these newly covered crypto assets, we believe that advisers may 
choose to cease providing advisory services to pooled investment 
vehicles holding such assets, implying these pooled investment 
vehicles may no longer be offered to investors.
    \479\ To the extent competition in the market for those aspects 
of services that gives advisers custody is linked to the number of 
advisers offering such services, advisers choosing to eliminate the 
aspect of their services that gives them custody could result in a 
reduction in competition. A reduction in competition could result in 
higher fees for investors, lower quality services, or some 
combination of the two.
---------------------------------------------------------------------------

    The expanded scope of assets subject to the proposed rule could 
create other costs. For example, as discussed above, the staff has 
observed a growing number of state-chartered trust companies and other 
state-chartered, limited purpose banking entities now offering 
custodial services for crypto assets. Also, the staff has observed an 
increase in the number of entities that provide platform users with the 
ability to transact in crypto assets. In connection with these 
services, these entities and/or their agents might safeguard the 
platform user's crypto asset(s) and also maintain the cryptographic key 
information necessary to access the crypto asset.
    The expanded scope of assets subject to the proposed rule could 
create costs for those advisers (and their clients) with custody of 
crypto assets that are not funds or securities subject to the current 
custody rule. For example, to the extent advisers have custody of 
client crypto assets that are not funds or securities and those assets 
are maintained with state-chartered trust companies, other state-
chartered, limited purpose banking entities, and entities providing 
platform users with the ability to transact in crypto assets who may 
choose not to make the changes necessary to satisfy all of the 
requirements to act as a qualified custodian under the proposed rule, 
the proposed rule would require such crypto assets to be removed from 
those entities. Removing assets from those entities could create costs 
for investors. For example, there would be costs associated with 
switching from one entity to another. As we noted in section II.C.3, 
the technical requirements for transacting and safeguarding crypto 
assets are likely to differ from those of traditional assets that 
include stocks, bonds, and options. The proposed rule could cause 
investors to remove their assets from an entity that has developed 
innovative safeguarding procedures for those assets, possibly putting 
those assets at a greater risk of loss. These costs would be mitigated, 
however, to the extent existing qualified custodians develop, or 
otherwise acquire, innovative safeguarding procedures for crypto 
assets, or are able to contract with specialized sub-custodians, as a 
result of the proposed rule.
    If investors remove newly scoped-in assets from entities currently 
providing safeguarding services, those entities providing safeguarding 
services will experience a decline in fees because they would be 
providing custody for fewer assets. For example, if investors remove 
their crypto assets that are not funds or securities subject to the 
current rule from entities such as state-chartered trust companies, 
other state-chartered, limited-purpose banking entities, and entities 
providing platform users with the ability to transact in crypto assets, 
those entities could experience a decline in fees. The extent of the 
decline in fees would depend on investors' holdings of crypto assets 
that are not funds or securities subject to the current rule, the rates 
charged by those entities for safeguarding crypto assets, as well as 
the extent to which investors remove their crypto assets from those 
entities. We do not have data that would allow us to predict accurately 
investor holdings of crypto assets or the extent to which investors 
would remove crypto assets from those entities, or the resulting effect 
on profitability. A sufficiently large decline in profitability could 
lead such entities to reconsider their business models or exit the 
business altogether.
    This aspect of the proposed rule could create additional costs as 
well. Independent public accountants would have to perform verification 
procedures over a larger universe of investments which could increase 
the cost of performing verification procedures. Absent an increase in 
the capacity of independent public accountants, the increased demand on 
the services of independent public accountants resulting from having to 
perform verification procedures over a larger universe of assets could 
result in increased costs for accountant services generally. To the 
extent independent public accountants reallocate resources away from 
other services to meet the increased demand for asset verification, 
other services provided by independent public accountants could become 
more costly. That said, as a result of requiring that all assets be 
held in the possession or control of a qualified custodian, performing 
verification procedures may be less labor-intensive and less costly 
than under the current rule.
b. Scope of Activity Subject to the Proposed Rule
    The proposal would generally preserve the current rule's definition 
of ``custody''. The current definition of custody includes three 
categories that serve as examples of custody including certain 
arrangements when the adviser is authorized or permitted to instruct 
the client's custodian. The proposed rule would explicitly identify 
discretionary trading authority as an arrangement that triggers the 
rule. An adviser with this ability or authority can subject a client's 
assets to the risks of loss, misuse, misappropriation, theft, or 
financial reverses of the adviser. The proposed rule would also expand 
the scope of subject activity by explicitly identifying discretionary 
trading authority as an arrangement that triggers the rule.
    The authority for discretionary trading presents the kinds of risks 
to client assets that the rule is designed to address. When advisers 
have this authority, they have the ability to sell or purchase assets 
for the client's account without first obtaining client consent. This 
creates an opportunity for an adviser to put those assets at risk of 
loss, misuse, misappropriation, theft, or financial reverses of the 
adviser. If an adviser has custody solely because the adviser has 
discretionary authority that is limited to instructing the custodian to 
transact in assets that settle on a DVP basis, the risk of loss is less 
pronounced, though not completely eliminated, when a client's custodian 
must participate in the transaction. In those cases, the custodian will 
observe, and record on a client's account statement, that assets are 
transferred out of a client's account only upon corresponding transfer 
of other assets of equal value into the account. Although the risk of 
loss is not reduced to zero in these situations, the client is at least 
on

[[Page 14743]]

notice via the account statement from the custodian that a transaction 
has occurred. The proposed rule would thus benefit clients by extending 
the protections of the rule, namely the protections of the qualified 
custodian and the account statement reporting, to instances where an 
adviser has discretionary trading authority. The benefits will be 
mitigated to the extent that advisers comply with the rule today for 
reasons other than discretionary trading authority.
    Advisers who currently do not need to comply with the rule for this 
type of authority will bear the costs of compliance with the rule. 
Those costs will be mitigated to the extent that advisers comply with 
the rule today for reasons other than discretionary trading authority. 
For example, if advisers also have a general power of attorney with 
respect to the same assets, such advisers already have custody of these 
assets under the current rule. For advisers that will be newly subject 
to the rule as a result of this change, the costs of compliance will be 
reduced if discretionary trading authority is their sole reason for 
having custody because they will not have to comply with the surprise 
examination requirement.\480\
---------------------------------------------------------------------------

    \480\ Proposed rule 223-1(b)(9).
---------------------------------------------------------------------------

    Investment advisers with custody of client assets because of 
discretionary trading authority may continue to provide discretionary 
trading services to their clients, or, as discussed above, they may 
choose to no longer provide advice on assets which are not funds or 
securities and, accordingly, no longer exercise custody (including 
discretionary trading) for such other assets as a result of the 
compliance costs. If advisers choose to no longer offer discretionary 
trading services for assets other than funds or securities, to the 
extent clients benefit from those discretionary trading services, 
investors would bear a cost associated with the loss of those services 
or with finding an investment adviser that provides them.
2. Qualified Custodian Protections
    As discussed in section II.B above, the proposed rule would require 
investment advisers to maintain client assets with a qualified 
custodian having ``possession or control'' of client assets pursuant to 
a written agreement between the qualified custodian and the investment 
adviser. The term ``possession or control'' would 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. In the case of a qualified custodian that is the adviser, 
the proposed rule would require that the written agreement be between 
the adviser and the client.\481\
---------------------------------------------------------------------------

    \481\ Proposed rule 223-1(a)(1)(i).
---------------------------------------------------------------------------

    The proposed rule also would require the adviser to obtain 
reasonable assurances in writing from the custodian regarding certain 
vital protections for the safeguarding of client assets. If the 
qualified custodian is the adviser, the proposed rule would require 
that the reasonable assurances be part of the written agreement between 
the adviser and the client, described above.\482\
---------------------------------------------------------------------------

    \482\ Proposed rule 223-1(a)(1)(ii).
---------------------------------------------------------------------------

a. Definition of Qualified Custodian
    Banks. The current rule includes in the definition of qualified 
custodian a bank as defined in section 202(a)(2) of the Advisers Act 
(15 U.S.C. 80b-2(a)(2)) or a savings association as defined in section 
3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) 
that has deposits insured by the Federal Deposit Insurance Corporation 
under the Federal Deposit Insurance Act (12 U.S.C. 1811). The proposed 
rule would largely retain this definition of qualified custodian 
relating to banks and savings associations. However, in connection with 
the proposed rule's focus on setting certain minimum protections for 
client assets, the rule would require that a qualifying bank or savings 
association hold client assets in an account designed to protect such 
assets from creditors of the bank or savings association in the event 
of the insolvency or failure of the bank or savings association in 
order to qualify as a qualified custodian. While applicable insolvency 
law and procedures vary depending on any particular bank's regulatory 
regime, we understand that assets held in these accounts are more 
likely to be returned to clients upon the insolvency of the qualified 
custodian because they may pass outside of a bank's insolvency, may be 
recoverable if wrongly transferred or converted, and are not treated as 
general assets of the bank.\483\
---------------------------------------------------------------------------

    \483\ See supra footnote 96.
---------------------------------------------------------------------------

    We believe that requiring banks and savings associations to hold 
client assets in an account designed to protect such assets from 
creditors of the bank or savings association in the event of the 
insolvency or failure of the bank or savings association would benefit 
clients by providing client assets with enhanced protection from 
general creditors in the event of the qualified custodian's insolvency 
or failure and increasing the likelihood of return of client assets to 
advisory clients upon a qualified custodian's insolvency or failure. We 
acknowledge, however, that the benefit would be limited to the clients 
of those qualified custodians that would not be subject to the 
resolution processes deployed by the FDIC or by the OCC or have not 
developed and deployed comprehensive custodial service agreements 
governing their relationships with their custodial customers. For those 
custodians that would not be subject to the resolution processes 
deployed by the FDIC or by the OCC or have not developed and deployed 
comprehensive custodial service agreements governing their 
relationships with their custodial customers, we estimate that changing 
the terms of account agreements to comply with the proposed account 
requirement would require 1 hour from an assistant general counsel 
($510/hour) and 5 hours from a paralegal ($199/hour), for a total 
estimated cost of $1,505 per agreement.
    Foreign Financial Institutions. The proposed definition of 
qualified custodian would continue to include FFIs, but would require 
an FFI to satisfy certain additional conditions in order to serve as a 
qualified custodian for client investments. For an FFI to be a 
qualified custodian under the proposed rule, it would need to be:
     Incorporated or organized under the laws of a country or 
jurisdiction other than the United States, provided that the adviser 
and the Commission are able to enforce judgments, including civil 
monetary penalties, against the FFI;
     Regulated by a foreign country's government, an agency of 
a foreign country's government, or a foreign financial regulatory 
authority \484\ as a banking institution, trust company, or other 
financial institution that customarily holds financial assets for its 
customers;
---------------------------------------------------------------------------

    \484\ Defined in section 202(a)(24) of the Advisers Act [15 
U.S.C. 80b-2(a)(24)].
---------------------------------------------------------------------------

     Required by law to comply with anti-money laundering and 
related provisions similar to those of the Bank Secrecy Act [31 U.S.C. 
5311, et seq.] and regulations thereunder;
     Holding financial assets for its customers in an account 
designed to protect such assets from creditors of the foreign financial 
institution in the event of the insolvency or failure of the foreign 
financial institution;

[[Page 14744]]

     Having the requisite financial strength to provide due 
care for client assets;
     Required by law to implement practices, procedures, and 
internal controls designed to ensure the exercise of due care with 
respect to the safekeeping of client assets; and
     Not operated for the purpose of evading the provisions of 
the proposed rule.\485\
---------------------------------------------------------------------------

    \485\ Proposed rule 223-1(d)(10)(iv).
---------------------------------------------------------------------------

    As discussed in section II.B.1.b above, these proposed conditions 
are partly drawn from our experience with the conditions on the types 
of foreign financial entities that can act as ``eligible foreign 
custodians'' as defined in rule 17f-5 under the Investment Company 
Act.\486\ Such conditions are designed to provide enhanced investor 
protections for advisory clients and their assets that we believe would 
help promote an FFI having generally similar protections as a U.S.-
based qualified custodian.
---------------------------------------------------------------------------

    \486\ Furthermore, the proposed rule would replace and 
strengthen the segregation requirement applicable to FFIs in the 
current custody rule, and it is designed to complement the proposed 
segregation requirements of the safeguarding rule.
---------------------------------------------------------------------------

    Advisory clients often invest in securities traded on foreign 
exchanges and their advisers must, as a practical matter, maintain 
securities with financial institutions in foreign countries where the 
securities are traded. In order to facilitate these types of holdings, 
the current rule includes any FFI that customarily holds financial 
assets for its customers, as qualified custodian, provided that the FFI 
keeps the advisory clients' assets in customer accounts segregated from 
its proprietary assets. The proposed new conditions would require that 
an FFI have similar protections as a U.S.-based qualified custodian, 
thereby enhancing investor protections for advisory clients by reducing 
the risk of loss of their securities and other financial assets held 
outside the United States. For example, for an FFI to be a qualified 
custodian under the proposed rule it would need to be regulated by a 
foreign country's government, an agency of a foreign country's 
government, or a foreign financial regulatory authority as a banking 
institution, trust company, or other financial institution that 
customarily holds financial assets for its customers. An FFI also would 
have to be required by law to comply with AML requirements and related 
requirements comparable to those of the Bank Secrecy Act.\487\ We 
believe the requirement to comply with AML and related provisions 
similar to those of the BSA and regulations thereunder would help 
increase the likelihood that the FFI would readily identify and 
investigate aberrant behavior in a client account, such as activity 
that might suggest misappropriation or some other type of loss to a 
client. An FFI also would have to hold financial assets for its 
customers in an account designed to protect such assets from creditors 
of the foreign financial institution in the event of the insolvency or 
failure of the foreign financial institution. We believe this 
requirement would help to promote investor protections that are more 
comparable, particularly in the event of an FFI insolvency or 
bankruptcy, to those we are proposing for assets held with U.S.-
regulated bank or savings association qualified custodians.
---------------------------------------------------------------------------

    \487\ Proposed rule 223-1(d)(10)(iv)(C); see also pt. II.B.1.
---------------------------------------------------------------------------

    FFIs that no longer meet the conditions to be a qualified custodian 
would either incur costs to become compliant, or incur costs in the 
form of lost custodial business, and potential loss of other banking 
business from the same clients. Clients of FFIs that incur costs to 
become compliant may experience higher fees. Clients whose assets were 
maintained with banks and savings associations that do not comply with 
the proposed requirements would incur one-time costs related to 
switching custodians or, if no financial institutions qualify as 
custodians in a country where securities are traded on a foreign 
exchange,\488\ costs associated with divestiture, potentially at a 
loss. Advisers would incur costs associated with loss of client assets 
under management. The magnitude of these costs would depend on the 
number of client accounts and the quantity of assets affected.\489\
---------------------------------------------------------------------------

    \488\ This could occur if, for example, if the country does not 
have a regulatory framework equivalent to the Bank Secrecy Act 
requirements for reporting transactions to financial intelligence 
authorities.
    \489\ We do not have data on the number of client accounts and 
the quantity of assets affected.
---------------------------------------------------------------------------

b. Possession or Control
    Under the custody rule, advisers with custody of client funds and 
securities must maintain them with a qualified custodian, subject to 
certain exceptions.\490\ The proposed rule would require that an 
investment adviser with custody of client assets maintain those assets 
with a qualified custodian that must maintain possession or control of 
those assets.\491\ The term ``possession or control'' would 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.\492\
---------------------------------------------------------------------------

    \490\ See rule 206(4)-2(a)(1).
    \491\ See proposed rule 223-1(a)(1)(i).
    \492\ See proposed rule 223-1(d)(8).
---------------------------------------------------------------------------

    The proposed requirement would benefit clients in several ways. 
First, a critical custodial function is to prevent loss or unauthorized 
transfers of ownership of client assets. It is our understanding that a 
custodian will only provide this safeguarding function and assume 
custodial liability for a custodial customer's loss if the custodian 
has 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 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, the proposed 
possession or control definition would provide assurance to the client 
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 assets. Further, clients would be able to 
review their account statements to evaluate the legitimacy of any 
movement within their account, whether it is a trade, a payment, or a 
fee withdrawal. Finally, clients could take greater comfort that what 
is reported on their account statements is an accurate attestation of 
holdings and transactions because anything held by a qualified 
custodian would be required to be in its possession or control.
    The proposed definition is designed to be consistent with the laws, 
rules, or regulations administered by the qualified custodian's 
functional regulator for purposes of its custodial activities. As 
detailed in section II.C.2 above, this would include Exchange Act 
requirements for broker-dealers, regulatory requirements for national 
banks, Commodity Exchange Act requirements for FCMs, as well as the 
broad range of regulatory requirements for FFIs. Given the proposed 
definition's consistency with the laws, rules, or regulations 
administered by a qualified custodian's functional regulator, we 
believe the additional cost of the proposed definition of ``possession 
or control'' on qualified custodians would be minimal.

[[Page 14745]]

    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. We acknowledge, however, that to the extent account 
statements provided by a qualified custodian on an accommodation basis 
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, the proposed rule's 
elimination of the custodian's ability to provide account statements on 
an accommodation basis could impose a cost on investors. Clients would 
bear costs to collect information from multiple sources rather than 
relying on a single consolidated account statement.\493\ 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.\494\
---------------------------------------------------------------------------

    \493\ It is possible that the requirement could lead to reduced 
costs for custodians. Our understanding, however, is that the 
custodian merely reports the holdings or transactions as reported to 
it by the adviser--the custodian does not attest to the holdings of 
or transactions in those investments or take steps to ensure that 
the investments are safeguarded appropriately. As a result, we would 
expect cost savings for custodians to be minimal.
    \494\ See supra note 185.
---------------------------------------------------------------------------

c. Reasonable Assurances
    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. The proposed rule would 
require an adviser to obtain reasonable assurances in writing from 
qualified custodians regarding certain vital protections for the 
safeguarding of client assets and that the adviser maintain an ongoing 
reasonable belief that the custodian is complying with the client 
protections for which the adviser obtains reasonable assurances.
i. Benefits
    Due Care. The proposed rule would require that the adviser obtain 
reasonable assurances 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.\495\ We 
recognize that the appropriateness of the measures required to 
safeguard assets varies depending on the asset.\496\ We believe such 
appropriate measures would, in turn, mitigate the risk to client assets 
from theft, misuse, misappropriation, or other similar types of loss.
---------------------------------------------------------------------------

    \495\ Proposed rule 223-1(a)(1)(ii)(A).
    \496\ See discussion in section II.B.3.a.i and supra footnote 
154.
---------------------------------------------------------------------------

    Indemnification. The proposed rule would require the 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.\497\ Our staff has 
observed that custodians often include indemnification clauses in their 
custodial agreements with customers. Staff has also observed that the 
contractual limitations on custodial liability vary widely in the 
marketplace, in some instances reducing a qualified custodian's 
liability to such an extent as to not provide an appropriate level of 
investor protection. By requiring advisers to obtain reasonable 
assurances from the qualified custodian that the qualified custodian 
will indemnify the client against the risk of loss in the event of the 
qualified custodian's own negligence, recklessness, or willful 
misconduct, the proposed rule seeks to create a minimum floor of 
custodial protection for investors in the event of custodial misconduct 
(i.e., simple negligence). For those investors whose qualified 
custodians indemnify the client against the risk of loss in the event 
of the qualified custodian's gross negligence, the proposed requirement 
that an adviser obtain reasonable assurances from the qualified 
custodian that the qualified custodian will indemnify the client 
against the risk of loss in the event of the qualified custodian's own 
negligence, recklessness, or willful misconduct would likely operate as 
a substantial expansion in the protections provided by qualified 
custodians to advisory clients by preventing these custodians from 
disclaiming liability for misconduct that does not rise to the level of 
gross negligence.
---------------------------------------------------------------------------

    \497\ Proposed rule 223-1(a)(1)(ii)(B).
---------------------------------------------------------------------------

    Sub-custodian or Other Similar Arrangements. The proposed rule 
would require the adviser to obtain reasonable assurances 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 its obligations to the client.\498\
---------------------------------------------------------------------------

    \498\ Proposed rule 223-1(a)(1)(ii)(C).
---------------------------------------------------------------------------

    As discussed in section II.B.3.a.3 outsourcing has become 
increasingly common in the custodial space, whether outsourcing of 
back-office functions or the core function of safeguarding a custodial 
customer's assets. 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. 
This proposed requirement would enhance investor protections by 
reducing 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. To the extent 
advisory clients are aware of risks resulting from a qualified 
custodian delegating its safeguarding obligations to a sub-custodian, 
we believe that this requirement would give advisory clients greater 
confidence that their assets maintained with a qualified custodian 
would not lose protections as a result of such a delegation.
    Segregation of Client Assets. The proposed rule would require the 
adviser to obtain reasonable assurances 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.\499\ The proposed requirement 
would benefit investors by helping to 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. We believe this proposed requirement would also benefit 
clients by helping to protect client assets from claims by a qualified 
custodian's third-party creditors looking to secure or satisfy an 
obligation of the qualified custodian. We believe that the proposed 
requirement would also benefit clients by helping to identify clearly 
client assets as belonging to the appropriate client and, in the 
context of an FFI in a region facing political risk, we believe these 
actions would help to preserve the client's interests in the event of a 
government taking.
---------------------------------------------------------------------------

    \499\ Proposed rule 223-1(a)(1)(ii)(D).
---------------------------------------------------------------------------

    No Liens Unless Authorized in Writing. The proposed rule would

[[Page 14746]]

require the adviser to obtain reasonable assurances 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.\500\ This 
requirement would benefit clients by discouraging qualified custodians 
from using client assets in a manner not authorized by the client, 
reducing the risk of loss of client assets. The requirement would also 
help reduce the risk of the loss of client assets to 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. The magnitude of the 
benefits will depend on the extent to which such arrangements may 
already be common. As discussed in section II.B.3.a.v, 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.
---------------------------------------------------------------------------

    \500\ See proposed rule 223-1(a)(1)(ii)(E).
---------------------------------------------------------------------------

ii. Costs
    Obtaining Reasonable Assurances. The proposed rule would require an 
adviser to obtain reasonable assurances in writing from a qualified 
custodian regarding certain client protections. As discussed above, one 
way that advisers are likely to satisfy this requirement is by seeking 
confirmation from a qualified custodian that the custodial agreement 
with the advisory client contains contractual language reflecting the 
reasonable assurances required by the rule. The reasonable assurances 
requirement could also require conforming changes in custody agreements 
between clients and qualified custodians. The cost of obtaining 
reasonable assurances and conforming changes in custody agreements 
include costs attributable to attorneys and compliance professionals, 
both prior to and at the inception of the relationship between a client 
and a qualified custodian as well as over the life of the relationship. 
We describe the nature of these costs in detail below. For purposes of 
the Paperwork Reduction Act, we estimate that qualified custodians and 
advisers will incur aggregate initial costs of $27,469,680 associated 
with advisers obtaining reasonable assurances from qualified 
custodians.\501\ The requirements that an adviser obtain reasonable 
assurances from qualified custodians also will require due diligence 
and periodic monitoring by the adviser. For purposes of the Paperwork 
Reduction Act, we estimate that qualified custodians and advisers will 
incur aggregate ongoing annual costs of $5,493,936 associated with 
advisers obtaining reasonable assurances from qualified 
custodians.\502\
---------------------------------------------------------------------------

    \501\ See infra footnote 620.
    \502\ See infra footnote 622.
---------------------------------------------------------------------------

    Due Care. The proposed due care requirement is the same as the 
standard that generally applies to custodians under Article 8 of the 
Uniform Commercial Code.\503\ As a result, we believe the proposed 
standard of care is not uncommon in the custodial market, and that 
financial institutions acting as qualified custodians are familiar with 
it. We believe, however, that the standard of care is not universal in 
the custodial market. As discussed above, this requirement may result 
in certain qualified custodians incurring costs to change the terms of 
their custodial agreements with advisory clients to incorporate this 
standard.\504\
---------------------------------------------------------------------------

    \504\ See infra footnote 619.
---------------------------------------------------------------------------

    Indemnification. As discussed above, staff has observed that the 
contractual limitations on custodial liability vary widely in the 
marketplace. The proposed rule seeks to create a minimum floor of 
custodial protection for investors in the event of custodial 
misconduct. First, the proposed simple negligence requirement could 
impose operational costs on those custodians holding advisory client 
assets subject to a gross negligence standard. The operational costs 
would include the costs of adapting existing systems and processes to 
meet the more stringent simple negligence standard. Second, the 
insurance requirement of the proposed indemnification requirement would 
likely create a substantial increase in the cost of liability insurance 
for custodians that currently do not insure against loss resulting from 
simple negligence. We note, however, that operational costs and costs 
of liability insurance would be mitigated to the extent custodians who 
currently hold client assets subject to a gross negligence standard 
already have systems, processes and liability insurance that are 
consistent with a simple negligence standard.
    Sub-custodian or Other Similar Arrangements. As discussed above, 
staff has observed custodial agreements addressing the use of sub-
custodians that seek to contractually limit 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. The proposed reasonable assurances requirement could impose 
operational costs on those custodians who make use of sub-custodial, 
securities depository, or other similar arrangements and who would seek 
to disclaim responsibility in circumstances where a loss or other 
failure to satisfy its obligations to the client can be attributed to a 
sub-custodian or other third party selected by the qualified custodian. 
The operational costs would include the costs of adapting existing 
systems and processes to meet the proposed requirement. We note, 
however, that the costs would be mitigated to the extent custodians who 
make use of sub-custodial, securities depository, or other similar 
arrangements already have systems and processes in place that are 
consistent with the proposed requirement.
    Segregation of Client Assets. We understand that custodial 
agreements between advisory clients and qualified custodians may 
currently contain a contractual provision requiring segregation of 
client assets from the custodian's assets. In addition, we understand 
that many qualified custodians are currently required by their 
functional regulator to segregate assets. The proposed segregation 
requirements are drawn from rule 15c3-3 of the Exchange Act. To the 
extent existing regulatory requirements for qualified custodians are 
the same or similar to the requirements of 15c3-3, the costs of 
adapting existing systems may be mitigated for broker-dealers who act 
as qualified custodians. For example, rule 15c3-3 of the Exchange Act 
requires broker-dealers to safeguard their customer assets and keep 
customer assets separate from the firm's assets. Given their existing 
regulatory requirements, we believe custodian broker-dealers already 
have systems to segregate customer assets from their own and, as a 
result, the cost of the proposed requirement for broker-dealer 
qualified custodians largely would be mitigated. Other regulatory 
regimes have adopted similar requirements. For example, under the 
Commodity Exchange Act, futures commission merchants are required to 
segregate customer assets from their own

[[Page 14747]]

assets.\505\ Because futures commission merchants already have systems 
to segregate customer assets from their own, we believe their cost of 
meeting the segregation requirement of the proposed rule would also 
largely be mitigated for futures commission merchants.
---------------------------------------------------------------------------

    \505\ See discussion in section III.C.1.
---------------------------------------------------------------------------

    We believe, however, that not all financial institutions that serve 
as qualified custodians are required to segregate and identify their 
client assets, particularly FFIs. In addition, for those qualified 
custodians that are required to segregate and identify their client 
assets, the extent of those activities varies.\506\ To the extent 
certain custodians currently do not segregate client assets, the 
reasonable assurances requirement in the proposed rule would result in 
qualified custodians adapting existing systems and processes to meet 
the proposed requirement.
---------------------------------------------------------------------------

    \506\ 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).
---------------------------------------------------------------------------

    No Liens Unless Authorized in Writing. The rule would not prohibit 
liens and the other claims addressed in the proposed rule, but 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. The proposed 
reasonable assurances requirement could impose operational costs on 
those custodians who make use of liens and the other claims addressed 
in the proposed rule. The operational costs would include the costs of 
adapting existing systems and processes to ensure that qualified 
custodians get written client authorization. The proposed requirement 
may also result in qualified custodians adding a conforming provision 
to custodial agreements for those clients that authorize such claims. 
Doing so would result in an additional burden for those qualified 
custodians. 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. 
Operational costs and the cost of adding conforming provisions for 
those clients that authorize such claims would be mitigated to the 
extent qualified custodians already have such systems and provisions in 
place.
d. Written Agreement
    The proposed rule would require advisers to enter into a written 
agreement with a qualified custodian based upon a reasonable belief 
that certain contractual provisions have been implemented. Further, 
during the term of the written agreement and related advisory 
relationship, advisers generally 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.
    We discuss the benefits and costs of the proposed written agreement 
requirement below. The magnitude of both the benefits and costs of the 
proposed written agreement requirement would depend on the extent to 
which advisers currently are party to custodial agreements, and 
advisers' actions to ensure that the elements of the written agreements 
are effective and being met.\507\
---------------------------------------------------------------------------

    \507\ While we understand that advisers are rarely parties to 
the custodial agreement, which is generally between an advisory 
client and its qualified custodian, we lack quantitative data to 
confirm this understanding.
---------------------------------------------------------------------------

i. Benefits
    Under the proposed rule, one provision would require the qualified 
custodian to provide promptly, upon request, records relating to 
clients' assets held in the account at the qualified custodian to the 
Commission or to an independent public accountant engaged for purposes 
of complying with the rule. Another provision would specify the 
adviser's agreed-upon level of authority to effect transactions in the 
account. A third provision would require the qualified custodian to 
deliver account statements to clients and to the adviser, whereas 
currently, advisers must only have a reasonable basis for believing 
that clients are receiving these account statements upon due inquiry. 
The fourth provision would require the qualified custodian to obtain a 
written internal control report that includes an opinion of an 
independent public accountant regarding the adequacy of the qualified 
custodian's controls.
    Record Sharing. The proposed rule would require that the written 
agreement with the qualified custodian include a provision requiring 
the qualified custodian to provide, promptly, upon request, records 
relating to client assets to the Commission or an independent public 
accountant engaged for purposes of compliance with the rule.\508\ We 
understand, currently, 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 believe 
that accountants likely struggle to obtain information from qualified 
custodians because the qualified custodian has no contractual agreement 
with the adviser or the accountant that has been hired by the adviser. 
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--
potentially reducing the costs attributable to completing a surprise 
examination under the rule.
---------------------------------------------------------------------------

    \508\ Proposed rule 223-1(a)(1)(i)(A).
---------------------------------------------------------------------------

    Account Statements. The proposed rule would require that the 
written agreement 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 proposed rule), 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.\509\ We believe 
that the delivery of quarterly account statements to the adviser, which 
is a new requirement, would allow the adviser to more easily perform 
account statement reconciliations. We believe that qualified 
custodians' delivery of account statements directly to advisory clients 
enhances investor protections by facilitating clients' ability to 
verify adviser conduct as well as client assets. We also continue to 
believe that qualified custodians' delivery of account statements 
directly to advisory clients--without the 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,

[[Page 14748]]

would deter advisers from fraudulent activities.\510\
---------------------------------------------------------------------------

    \509\ Proposed rules 223-1(a)(1)(i)(B), 223-1(b)(4).
    \510\ Rule 206(4)-2(a)(3) requires the adviser to have 
reasonable belief upon due inquiry that the qualified custodian 
delivers quarterly account statements to the client.
---------------------------------------------------------------------------

    The proposed rule would also require a provision prohibiting the 
account statement from identifying assets for which the qualified 
custodian lacks possession or control, unless requested by the client 
and the qualified custodian clearly indicates that the custodian does 
not have possession or control over such assets. We believe the 
proposed requirement would enhance investor protections by enhancing 
the integrity and utility of the account statements, thereby reducing 
the risk investors are misled or become confused about those assets for 
which the custodian is responsible in the event of a loss.
    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). The objectives and 
scope of the proposed internal control report are substantially the 
same as those of the internal control report required under the current 
rule, but would expand the requirement to all qualified custodians as 
opposed to the current rule, which only requires the internal control 
report when the adviser or its related person acts as a qualified 
custodian.
    In circumstances where the qualified custodian is not the adviser 
or its related person, we believe the proposed requirement would help 
enhance investor protections by ensuring that the qualified custodian's 
controls with respect to its safeguarding practices are routinely 
evaluated in a timely manner by an independent third party. Also, in 
those circumstances where qualified custodians currently obtain 
internal control reports, the scope of those reports likely covers the 
financial institutions' safeguarding activities for ``funds and 
securities'' rather than all ``assets,'' as defined in the proposed 
amendments. We believe the proposed requirement would help enhance 
investor protection by expanding the scope of internal control reports 
to cover safeguarding actives for ``assets'' rather than ``funds and 
securities.'' We believe the requirement that auditors must be 
independent in fact and in appearance contributes to investor 
protection and investor confidence in connection with the relationship 
between an auditor and the qualified custodian. Unlike the current rule 
that only requires an internal control report when the adviser or its 
related person acts as a qualified custodian, the proposed rule would 
mitigate risks to client assets regardless of the affiliation of the 
qualified custodian.
    Under circumstances where the proposed rule requires the engagement 
of a PCAOB-registered and inspected public accountant, we anticipate 
that the proposed rule will have client protection benefits. As the 
Commission noted in adopting the current custody rule, the Commission 
has greater confidence in the quality of the processes followed by an 
independent public accountant registered with, and subject to regular 
inspection by, the PCAOB.511 512 We believe that 
registration and the periodic inspection of an independent public 
accountant's system of quality control by the PCAOB would provide 
clients with confidence in the quality of the reports produced under 
the proposed rule.
---------------------------------------------------------------------------

    \511\ See Custody Rule Amendments Adopting Release, supra 
footnote 11, at 17.
    \512\ For example, in response to our 2009 proposed Custody Rule 
amendments requiring the use of PCAOB-registered independent public 
accountants for annual surprise examinations in certain 
circumstances, many commenters agreed with our belief that PCAOB 
registration and inspection provided an important quality check on 
the independent accountants providing those examinations. See 
comment letter of Investment Adviser Association (July 24, 2009); 
comment letter of The National Association of Active Investment 
Managers (July 27, 2009); comment letter of Timothy P. Turner (July 
27, 2009); comment letter of American Bar Association (Committee on 
Federal Regulation of Securities) (July 28, 2009); comment letter of 
Curian Capital LLC, Financial Wealth Management, Inc., LPL Financial 
Corporation, and SEI Investments Company (July 28, 2009); comment 
letter of Ernst & Young (July 28, 2009); comment letter of Financial 
Planning Association (July 28, 2009); comment letter of Coalition of 
Private Investment Companies (July 31, 2009); comment letter of 
North American Securities Administrators Association, Inc. (Aug. 5, 
2009). Academic research suggests that PCAOB registration and 
inspection is associated with higher quality engagements. See, e.g., 
Mark L. DeFond & Clive S. Lennox, Do PCAOB Inspections Improve the 
Quality of Internal Control Audits? (Sept. 2015), available at 
https://pcaobus.org//News/Events/Documents/10222015_CEA/PCAOB-Inspections-Internal-Control-Audits-DeFond_Lennox.pdf. DeFond and 
Lennox (2015) posit that auditors are motivated to receive clean 
inspection reports from the PCAOB because adverse inspection 
outcomes are detrimental to the auditors' compensation (Johnson, 
Lindsay, Marsha Keune & Jennifer Winchel, Auditors' Perceptions of 
the PCAOB Process (2015) working paper, University of Virginia). 
They also note that the PCAOB has broad powers within its 
jurisdiction to sanction individual auditors and firms that provide 
substandard audits, which provides further incentive for auditors to 
perform high quality audits.
---------------------------------------------------------------------------

    Adviser's Level of Authority. The proposed rule would require that 
the adviser's 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.\513\ As discussed in section II.B.3.b.iv above, our 
understanding is that custodial agreements between advisory clients and 
qualified custodians often contain provisions that give investment 
advisers authority over their clients' custodial accounts that may be 
broader than what the adviser and client have agreed to in their 
advisory agreements. 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, or the advisory agreement may not 
be entirely clear on the level of authority granted to the adviser. If, 
however, the client's agreement with its qualified custodian grants the 
adviser broad authority over the client's account, the qualified 
custodian will accept and act upon instructions from the adviser to 
disburse or transfer assets, for example, without verifying or 
confirming those instructions with the advisory client), even though 
the adviser's agreement with its client does not give the adviser the 
authority to do so.\514\ This puts client assets at risk by giving the 
adviser access to client assets that the adviser may not otherwise be 
authorized to access. The proposed requirement that the contract 
between the adviser and the qualified custodian specify the adviser's 
agreed upon level of authority would mitigate these concerns and 
empower advisers to tailor custodial arrangements to better reflect 
client intentions and to be consistent with the adviser's contractual 
obligations to its clients.
---------------------------------------------------------------------------

    \513\ Proposed rule 223-1(a)(1)(i)(D).
    \514\ See supra note 202.
---------------------------------------------------------------------------

ii. Costs
    The proposed written agreement requirements would impose costs on 
advisers and qualified custodians related to negotiating, drafting, and 
implementing the written agreements.
(a) Negotiating, Drafting, and Forming a Reasonable Belief the 
Agreement Provisions Have Been Implemented
    We understand that advisers are rarely parties to the custodial 
agreements. Those advisers who are not a party to a custodial agreement 
and those qualified custodians with whom

[[Page 14749]]

they would be contracting would have to bear costs to negotiate and 
draft the written agreement required by the proposed rule, and the 
adviser would be required to form a reasonable belief that the 
agreement provisions have been implemented by the qualified custodian. 
This would include costs attributable to attorneys and compliance 
professionals, both prior to and at the inception of the written 
agreement, and over the life of the written agreement. For purposes of 
the Paperwork Reduction Act, we estimate that investment advisers and 
qualified custodians would incur aggregate initial costs of $41,218,464 
to prepare these written agreements,\515\ and that aggregate annual 
costs associated with modifying these agreements would be 
$3,503,599.\516\ Advisers may also incur costs associated with 
developing and maintaining a reasonable belief that the contractual 
provisions have been implemented. These costs would largely depend upon 
how each adviser satisfies and evidences compliance with this 
requirement, making them difficult to quantify. However, the proposed 
revisions to the recordkeeping rule would require an adviser to 
maintain records that would likely be useful in demonstrating an 
adviser's reasonable belief that a qualified custodian has implemented 
the proposed contractual provisions. As a result, we estimate any 
additional costs incurred by an adviser to develop and maintain a 
reasonable belief that the proposed contractual provisions have been 
implemented would be marginal.\517\
---------------------------------------------------------------------------

    \515\ See infra footnote 593.
    \516\ See infra footnote 595.
    \517\ For example, under the revised recordkeeping rule, and 
adviser would be required to maintain copies of the client account 
statements it receives from a qualified custodian. These records 
could form the basis of an adviser's reasonable belief that a 
qualified custodian has implemented the proposed contractual 
requirement to deliver account statements. See Proposed rule 204-
2(b)(iv). The costs associated with proposed amendments to the 
recordkeeping rule are discussed in more detail below. See section 
3.D.7, infra.
---------------------------------------------------------------------------

(b) Required Provisions
    The proposed rule would require a written agreement between 
advisers and qualified custodians that incorporates certain elements. 
We believe the cost of including elements likely varies, depending on 
the nature of each required element. Including certain elements may 
involve minimal cost, while including other elements may involve more 
substantial costs.
    We understand that qualified custodians often do not provide 
independent public accountants access to custodial account records in 
light of privacy concerns for their customers. The requirement that the 
written agreement with the qualified custodian include a provision 
requiring the qualified custodian to promptly, upon request, provide 
records relating to client assets to the Commission or an independent 
public accountant for purposes of compliance with the rule could impose 
additional costs on custodians. We believe these costs would largely be 
mitigated because we believe that providing custodial account records 
is consistent with the longstanding custodial practice of providing 
account statements to clients.\518\ For purposes of the Paperwork 
Reduction Act, we estimate that qualified custodians would incur 
aggregate annual costs of $19,462,024 associated with this record 
provision requirement.\519\
---------------------------------------------------------------------------

    \518\ Current rule 206(4)-2(a)(3). Qualified custodians use 
custodial account records to produce client account statements.
    \519\ See infra footnote 601, which estimates the annual burden 
associated with records provision to independent public accountants 
as being 18,422 hours. Using a blended rate of $394 per hour (see 
infra footnote 605) produces an estimated annual burden of (18,422 * 
$394) = $7,258,268 associated with records provision to independent 
public accountants. See infra footnote 605, which estimates the 
annual burden associated with records provision to the Commission as 
being $12,203,756, producing a total annual burden associated with 
records provision of ($7,258,268 + $12,203,756) = $19,462,024.
---------------------------------------------------------------------------

    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), 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. Because qualified custodians generally already send quarterly 
account statements to clients, we expect the additional costs 
associated with also sending such statements to advisers to be small. 
For purposes of the Paperwork Reduction Act, we estimate that qualified 
custodians would incur aggregate costs of $4,869,322.50 associated with 
this requirement.\520\
---------------------------------------------------------------------------

    \520\ See infra note 609.
---------------------------------------------------------------------------

    The proposed rule would also require a provision prohibiting the 
account statements from identifying assets for which the qualified 
custodian lacks possession or control, unless requested by the client 
and the qualified custodian clearly indicates that the custodian does 
not have possession or control over such assets. As discussed in 
section III.D.2.b, that provision could impose a cost on clients to the 
extent account statements provided by a qualified custodian on an 
accommodation basis 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. This 
provision would also impose costs on qualified custodians associated 
with accommodating customization requests from clients. For purposes of 
the Paperwork Reduction Act, we estimate that qualified custodians will 
incur aggregate annual costs of $324,621.50 associated with these 
customized requests.\521\
---------------------------------------------------------------------------

    \521\ See infra note 613.
---------------------------------------------------------------------------

    Internal Control Report. The objectives of the proposed internal 
control report are substantially the same as those of the internal 
control report required under the current rule.\522\ The internal 
control report 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. For those qualified 
custodians that currently obtain internal control reports, the scope of 
those reports likely do not cover the financial institutions' 
safeguarding activities that this proposed requirement, which would 
expand the scope of the rule to include all ``assets'' instead of 
``funds and securities,'' is designed to cover, thus potentially 
creating new costs for those firms whose report scope would need to be 
modified. Any such new cost would be mitigated, however, to the extent 
newly included assets would share existing controls or implicate 
controls similar to those for funds and securities. We understand, 
however, that not all qualified custodians may currently obtain 
internal control reports--or may not be obtaining internal control 
reports that meet the requirements of the proposed rule. While we 
believe those financial institutions will be able to obtain a report 
that satisfies the requirements of the proposed rule, doing so could 
pose a substantial financial burden and time commitment. As discussed 
above, we are not requiring that a specific type of internal control 
report be provided under the proposed rule as long as the required 
objectives are addressed. For example, a report on the description of 
controls placed in operation and tests of operation effectiveness, 
commonly

[[Page 14750]]

referred to as a ``SOC 1 Type 2 Report,'' generally should be 
sufficient to satisfy the requirements of the proposed internal control 
report requirement. For purposes of the Paperwork Reduction Act, we 
estimate that an average internal control report would cost 
approximately $750,000 per year and that qualified custodians will 
incur aggregate annual costs of $35,962,500 associated with obtaining 
internal control reports.\523\
---------------------------------------------------------------------------

    \522\ Rule 206(4)-2(a)(4)(ii).
    \523\ See infra footnote 617.
---------------------------------------------------------------------------

    Adviser's Level of Authority. As discussed above, our understanding 
is that custodial agreements between advisory clients and qualified 
custodians often give advisers authority over custodial accounts that 
is broader than what the adviser and client agreed to in the advisory 
agreement. Our staff has observed that qualified custodians have been 
reluctant to modify or customize the level of authority of investment 
advisers with respect to customer accounts. We believe that qualified 
custodians have been reluctant to modify or customize advisers' level 
of authority because doing so would increase qualified custodians' need 
to monitor customer accounts, and to accept liability, for unauthorized 
transactions by an adviser and its personnel. The proposed requirement 
could create operational costs for qualified custodians including the 
costs of adapting existing systems and processes to modify or customize 
the level of authority of investment advisers with respect to customer 
accounts. Also, qualified custodians might incur costs to incorporate 
new provisions into their contracts with advisers as well as amend any 
inconsistent provisions in their existing contracts. As a result, we 
believe the proposed requirement that the written agreement contain a 
provision addressing the adviser's authority, including authority of 
the client and adviser to reduce that authority, may be costly for 
qualified custodians.
3. Certain Assets That Are Unable To Be Maintained With a Qualified 
Custodian
    As discussed in section II.C above, we believe the bulk of advisory 
client assets can be maintained by qualified custodians. Some assets by 
their very nature or size may not easily be subject to misuse or 
misappropriation, and that may reduce the need for the safeguarding 
protections offered by a qualified custodian, but it is also our 
understanding that qualified custodians often refuse to custody such 
assets for both advisers and their clients. In addition, as discussed 
above, certain privately offered securities may not be able to be 
maintained by a qualified custodian because, in our understanding, 
demand for these services is low and thus there may not be a ready 
market.
    In circumstances where the protections of a qualified custodian are 
unavailable for certain physical assets and privately offered 
securities, the proposed rule would provide an exception to the 
requirement to maintain client assets with a qualified custodian, but 
would also require additional protections to help ensure that these 
assets are properly safeguarded. In this section, we discuss the costs 
and benefits of each of the proposed rule's safeguarding requirements 
for assets that are unable to be maintained by a qualified custodian.
a. Definition of Privately Offered Security
    The proposed rule's definition of privately offered securities 
would retain the elements from the custody rule's description that 
require the securities to be acquired from the issuer in a transaction 
or chain of transactions not involving any public offering and 
transferable only with prior consent of the issuer or holders of other 
outstanding securities of the issuer.\524\ Like the custody rule, the 
safeguarding rule would also require the securities to be 
uncertificated and would require ownership to be recorded only on the 
books of the issuer or its transfer agent in the name of the client. 
However, the safeguarding rule would also require that the securities 
be capable of only being recorded on the non-public books of the issuer 
or its transfer agent in the name of the client as it appears in the 
records the adviser is required to keep under rule 204-2.
---------------------------------------------------------------------------

    \524\ See supra note 223.
---------------------------------------------------------------------------

    To the extent crypto asset securities may qualify as privately 
offered securities under the current rule's privately offered 
securities exception, advisers with custody of such assets may not be 
maintaining them with a qualified custodian in reliance upon the 
exception. However, as discussed above, we believe crypto asset 
securities issued on public, permissionless blockchains would not 
satisfy the definition of privately offered securities.\525\ As a 
result, advisers with custody of such crypto asset securities generally 
would be required to maintain those assets with a qualified custodian 
and their clients would benefit from the enhanced protections qualified 
custodians provide.\526\ To the extent that crypto asset securities 
exist or develop that are able to meet the conditions of the privately 
offered securities exception, the costs and benefits discussed below 
with respect to the safeguarding of privately offered securities would 
apply to such assets.
---------------------------------------------------------------------------

    \525\ See supra note 227 and surrounding discussion.
    \526\ See section III.D.2 for a discussion of the benefits and 
costs for assets that do not qualify for the privately offered 
security exception and are not physical assets.
---------------------------------------------------------------------------

a. Adviser's Reasonable Determination
    In order to be eligible for the exception, the rule would require 
an adviser to reasonably determine, and document in writing, that 
ownership cannot be recorded and maintained (book-entry, digital, or 
otherwise) in a manner in which a qualified custodian can maintain 
possession or control of such assets. Such a determination necessarily 
depends on the facts and circumstances at issue. Moreover, these 
determinations would necessarily evolve over time as assets and the 
custodial industry change.
    An adviser's reasonable determination of whether a qualified 
custodian is able to maintain possession or control of a particular 
asset would generally involve an analysis of the asset and the 
available custodial market. An adviser's reasonable determination 
generally would not require the identification of every conceivable 
qualified custodian and an evaluation of its custodial services. 
Fundamentally, to determine whether an asset can or cannot be 
maintained by a qualified custodian under the proposed rule, an adviser 
generally should obtain a reasonable understanding of the marketplace 
of custody services available for each client asset for which it has 
custody.
    The proposed rule's reasonable determination requirement would 
benefit investors by limiting the scope of assets eligible for the 
exception and helping to ensure that any privately offered security or 
physical asset for which a qualified custodian is available is held by 
such custodian, maximizing the set of assets for which investors 
receive the enhanced protections associated with maintaining possession 
or control by a qualified custodian. The magnitude of this benefit 
would depend on the extent to which advisers currently would not 
otherwise maintain assets they have control of with a qualified 
custodian despite the availability of custodial services for such 
assets. For example, if the costs associated with maintaining an asset 
with a qualified custodian exceeded the costs of safeguarding the asset

[[Page 14751]]

internally, an adviser with custody of the asset might choose to 
safeguard the asset internally absent this requirement. Alternatively, 
in cases where custodial services are available at prices that are 
competitive with the costs of internally safeguarding an asset, 
advisers may have chosen to maintain assets in their custody with a 
qualified custodian regardless of this requirement.
    Advisers would incur costs associated with the proposed rule's 
reasonable determination requirement. For example, while the rule does 
not prescribe exactly how advisers should comply with the requirement, 
many advisers may choose to develop policies and procedures that 
establish the frequency with which the market for custodial services is 
reviewed, the manner in which the availability of custodial services 
for an asset should be assessed, and the manner in which an ultimate 
determination is made. The development and implementation of such 
policies and procedures, including the documentation of each reasonable 
determination, would cause advisers to incur costs that may be passed 
on to their clients in the form of higher fees. The proposed rule does 
provide advisers with flexibility in determining the frequency with 
which they make the required reasonable determinations, which should 
allow advisers to tailor these policies and procedures to the types of 
asset they hold on behalf of clients and control the associated costs.
    In addition, in cases where custodial services become available for 
an asset but are highly costly, the reasonable determination 
requirement would force advisers to incur such high custodial costs, 
which may be passed on to their clients, whereas they otherwise may 
have chosen to forgo custodial services in such cases. The costs an 
adviser incurs as a result of the requirement would vary depending on 
factors such as the types of assets the adviser has custody of and the 
heterogeneity in these asset types. For example, an adviser that has 
custody of client assets that are relatively homogenous may only have 
to monitor a single market for custodial services, whereas an adviser 
with custody of many different types of assets would likely incur 
higher costs in monitoring and determining whether custodial services 
are available in multiple markets. We lack precise information on the 
degree of homogeneity versus heterogeneity in the assets held by 
advisers, as well as the eventual costs advisers would pay to custody 
assets under the proposed rule, so we cannot quantify the costs 
associated with this requirement.
b. Adviser Reasonably Safeguards Client Assets That Are Unable To Be 
Maintained With a Qualified Custodian
    To rely on the exception, the adviser would be required to 
reasonably safeguard physical assets and privately offered securities 
that cannot be maintained with a qualified custodian. The proposed rule 
would not require that advisers implement any particular measures to 
safeguard physical assets or privately offered securities not 
maintained with a qualified custodian. Instead, the proposed rule would 
take a more principles-based approach. If an adviser has custody of a 
physical asset or privately offered security that it has determined 
cannot be maintained with a qualified custodian, the adviser may decide 
to safeguard that asset itself, designing and implementing safeguarding 
policies and procedures accordingly. An adviser must act consistently 
with its fiduciary role in safeguarding any particular asset. For 
example, the adviser might ``reasonably safeguard'' an asset by looking 
to reasonable commercial standards for safeguarding that asset from 
theft, misuse, misappropriation, or other similar type of loss. Under 
the rule, however, an adviser would have the flexibility to determine 
the specific safeguarding measures it puts in place, which may differ 
from asset to asset. If an adviser does not ``self-custody'' physical 
assets or privately offered securities that it has determined cannot be 
maintained with a qualified custodian, and instead maintains those 
assets with a third party that is in the business of safeguarding those 
assets, the adviser might implement policies and procedures reasonably 
designed to ensure that the entity directly maintaining the client's 
assets has implemented appropriate measures to safeguard them.
    Advisers are already obligated to safeguard client assets as part 
of their fiduciary duty. However, to the extent that the proposed rule 
would lead advisers to develop practices that more effectively 
safeguard assets that are not maintained by a qualified custodian, the 
proposed rule would benefit investors by reducing the risk that their 
assets are subject to loss, theft, misuse, or misappropriation by an 
adviser. Even to the extent advisers already effectively safeguard 
client assets that are not maintained by a qualified custodian, the 
proposed rule may still benefit investors by establishing a minimum 
safeguarding standard which they can expect will be applied to those 
assets, increasing investors' confidence in the market for advisory 
services.
    The proposed rule would not require advisers to implement any 
particular measures to safeguard physical assets or privately offered 
securities not maintained with a qualified custodian. This principles-
based approach would give advisers the flexibility to safeguard client 
assets in a way consistent with the nature of the assets and each 
adviser's individual facts and circumstances. If advisers choose to 
safeguard client assets themselves, then, to the extent they do not 
already safeguard client assets in accordance with the proposed 
requirement, advisers would bear any costs associated with developing 
and implementing effective safeguarding practices. For example, some 
advisers may incur costs designing and implementing safeguarding 
policies and procedures.
    If physical assets or privately offered securities are maintained 
with a third party, advisers might comply with the proposed rule's 
safeguarding requirement by implementing policies and procedures 
reasonably designed to ensure that the third party maintaining the 
client's physical assets has implemented appropriate measures to 
safeguard them. Such policies and procedures might include robust due 
diligence and ongoing oversight procedures designed to ensure the 
adviser has assessed and evaluated the measures put in place by the 
third party. To the extent advisers do not already employ practices 
that can ensure that client assets maintained with a third party are 
safeguarded consistently with the proposed rule, advisers will incur 
costs in developing and implementing such practices in order to comply 
with the rule.
c. Notification and Prompt Independent Public Accountant Verification
    The exception to the requirement to maintain assets with a 
qualified custodian would also require an adviser to enter into a 
written agreement with an independent public accountant. The proposed 
rule would require the adviser to notify the independent public 
accountant of any purchase, sale, or other transfer of beneficial 
ownership of such assets within one business day. The proposed rule 
would require the written agreement to require the independent public 
accountant to verify the purchase, sale, or other transfer promptly 
upon receiving the required transfer notice. We believe the involvement 
of independent public accountants in the review and verification of 
client assets of which advisers have custody is an important 
safeguarding tool. The timing of the requirement would build a record 
for

[[Page 14752]]

the accountant to review in connection with an annual surprise 
examination or financial statement audit. The written agreement would 
also require the independent public accountant to notify the Commission 
by electronic means directed to the Division of Examinations within one 
business day upon finding any material discrepancies during the course 
of performing its procedures.
    The notification and verification requirement would benefit 
investors by reducing the risk that a loss, theft, misuse, or 
misappropriation of their assets goes undetected for a significant 
amount of time, which might allow investors or the Commission to 
mitigate losses associated with such events in a timely manner. Even in 
cases where an adviser fails to notify the independent public 
accountant of a transaction because it involves loss, theft, misuse, or 
misappropriation, the absence of such notifications relative to what 
has been observed in the past may serve as a warning sign that is 
useful in identifying potential losses during annual audits or surprise 
examinations by the independent public accountant.
    Advisers would incur costs associated with the proposed rule's 
notification and verification requirement. While an adviser would 
likely incur some initial costs associated with designing and 
implementing any policies and procedures necessary to notify the 
independent public accountant that a transaction of client assets has 
occurred, the ongoing costs of notifying the independent public 
accountant are likely to be small relative to the more involved 
transaction costs associated with a change of ownership for privately 
offered securities or physical assets. For purposes of the Paperwork 
Reduction Act, we estimate that advisers would incur aggregate ongoing 
annual costs of $48,013 associated with notifying independent public 
accountants of transactions.\527\ Advisers will also incur one-time 
costs associated with negotiating, drafting, and implementing the 
written agreement with their designated independent public accountant. 
Advisers may be able to mitigate these one-time costs if they already 
have written agreements associated with an annual surprise exam or 
audit by the same independent public accountant. In addition, advisers 
may incur minimal costs associated with the occasional modification of 
these agreements. For purposes of the Paperwork Reduction Act, we 
estimate that investment advisers would incur aggregate initial costs 
of $2,443,194 to prepare these written agreements,\528\ and that 
aggregate annual costs associated with modifying these agreements would 
be $977,514.\529\
---------------------------------------------------------------------------

    \527\ See infra note 648.
    \528\ See infra note 642.
    \529\ See infra note 644.
---------------------------------------------------------------------------

    Finally, the adviser will have to pay the independent public 
accountant for its services, the costs of which may be passed onto 
investors. Verification costs would likely vary across advisers 
depending on factors such as the type of client assets they have 
custody of as well as the volume of transactions in which they engage. 
For example, a transaction involving a real estate asset that requires 
the independent public accountant to verify titles or deeds in person 
is likely to be costlier to verify than a transaction that can be 
verified electronically or via telephone. Similarly, an adviser that 
engages in a high volume of annual transactions would incur higher 
costs associated with transaction verification, which may ultimately be 
borne by the advisers' clients. For purposes of the Paperwork Reduction 
Act, we estimate that advisers would incur aggregate ongoing annual 
costs of $21,000,000 associated with the verification of transactions 
by independent public accountants.\530\
---------------------------------------------------------------------------

    \530\ See infra note 649.
---------------------------------------------------------------------------

d. Surprise Examination or Audit
    Like the existing custody rule, the proposed safeguarding rule 
would require advisers relying on the exception to undergo an annual 
surprise examination or rely on the audit provision. In a change from 
the custody rule, however, the proposed rule would require each 
privately offered security or physical asset not maintained with a 
qualified custodian to be verified, rather than only requiring that a 
sampling of assets be verified during a surprise exam or that only 
assets meeting the materiality threshold be verified during an audit.
    The proposed requirement that each asset be verified in annual 
surprise examinations or audits would benefit investors by reducing the 
risk that the loss or theft of client assets is not detected when those 
assets are either not included in a surprise examination's sample or do 
not meet the materiality threshold when advisers rely on the audit 
provision. For clients of advisers that do not rely on the audit 
provision, the magnitude of this benefit depends on the extent to which 
the sampling techniques used in conducting a surprise examination are 
likely to omit assets that have been subject to loss or theft. To the 
extent that the sampling techniques currently used in surprise 
examinations are effective at capturing instances of asset loss or 
theft, or that the sampling techniques are already a sufficient 
deterrent to adviser misconduct that might result in loss or theft, the 
benefit of this requirement will be more limited with respect to 
surprise examinations.
    For clients of advisers that rely on the audit provision, the 
magnitude of this benefit depends on the extent to which loss or theft 
tend to occur in client assets that do not meet the materiality 
threshold. While the existing custody rule might not deter adviser 
misconduct in assets below the materiality threshold, the proposed 
safeguarding rule would act as more of a deterrent against such 
misconduct because those assets would be subject to regular 
verification for advisers that rely on the audit provision.
    Advisers would incur additional costs as a result of the 
requirement that, to rely on the exception, each client asset be 
verified in a surprise examination or annual audit, and these costs may 
be passed on to their clients. These costs will vary with the type of 
asset subject to verification and the number of assets held by an 
adviser. For example, verifying a privately offered security held by an 
adviser on behalf of its client might require an independent public 
accountant to contact the issuer of the security or its agent to verify 
the existence of the asset, or to review documents such as private 
placement memoranda and the issuer's Regulation D filings. For physical 
assets, an independent public accountant may be required to review 
deeds or other land recordation materials (e.g., for real estate 
assets) or to review other documents, such as warehouse receipts, that 
confirm the existence of a physical commodity. For both physical assets 
and privately offered securities, incremental verification costs could 
be high in cases where the number of assets held by an adviser is large 
relative to the number of assets typically verified in surprise 
examinations or audits under the current custody rule. If the supply of 
qualified independent public accountants is scarce relative to any 
increased demand for their services as a result of this requirement, 
the overall cost of their services would also increase, at least 
temporarily until those higher prices attract new entrants into the 
public accounting market. For purposes of the Paperwork Reduction Act, 
we estimate that advisers would incur aggregate ongoing annual costs of 
$322,956,000 associated with the

[[Page 14753]]

verification of transactions by independent public accountants.\531\
---------------------------------------------------------------------------

    \531\ See infra note 655.
---------------------------------------------------------------------------

4. Segregation of Investments
    In addition to requiring advisers to attain reasonable assurance of 
segregation of client assets from a qualified custodian's assets, the 
proposed rule also would require advisers to segregate client assets 
from the adviser's assets and its related person's assets in 
circumstances where the adviser has custody. Specifically, the proposed 
rule would require that client assets of which an adviser has custody:
    (1) Be titled or registered in the client's name or otherwise held 
for the benefit of that client;
    (2) Not be commingled with the adviser's assets or the adviser's 
related persons' assets; and
    (3) Not be subject to any right, charge, security interest, lien, 
or claim of any kind in favor of the adviser, its related persons, or 
its creditors, except to the extent agreed to or authorized in writing 
by the client.\532\
---------------------------------------------------------------------------

    \532\ Proposed rule 223-1(a)(3).
---------------------------------------------------------------------------

    The proposed requirement that a client's assets be titled or 
registered in the client's name would help ensure that the client's 
assets are clearly identified as belonging to the appropriate client. 
The proposed rule would also permit advisers to identify the assets 
``for the benefit of'' a particular client where assets may not be 
``titled or registered'' in the client's name. Permitting advisers to 
identify assets ``for the benefit of'' a particular client benefits 
investors by recognizing that advisory clients can title or register 
their investments in various ways.
    The proposed rule would also require that client assets not be 
commingled with the adviser's assets or those of its related persons. 
The proposed requirement would help ensure that client assets are 
isolated and more readily identifiable as client property. We believe 
isolating client assets and making them more readily identifiable as 
client property would help protect client assets from claims by a third 
party looking to secure or satisfy an obligation of the adviser, 
including in cases of insolvency or bankruptcy of the adviser, or its 
related persons.
    The proposed rule would also require client assets to remain free 
from any right, charge, security interest, lien, or claim of any kind 
in favor of the adviser, its related persons, or its creditors. These 
requirements would protect client assets by limiting the ability of an 
adviser, or its related persons, to use client assets for their own 
purposes or in a manner not authorized by the client. We recognize that 
some advisers regularly service assets in a manner where such assets 
are reasonably identifiable from other clients' assets and not subject 
to increased risk of loss from adviser misuse or in the case of adviser 
insolvency, thereby mitigating the potential benefits of the proposed 
requirement. Also, we recognize that, depending on the types of assets, 
products, or strategies in which they invest, some clients may 
authorize these types of arrangements. We do not intend this condition 
to limit or prohibit clients' ability to authorize such arrangements.
    We recognize that not all advisers service assets in a manner where 
such asserts are reasonably identifiable from the other clients' assets 
and not subject to increased risk of loss from adviser misuse or in the 
case of adviser insolvency. In addition, for those advisers that 
segregate and identify their client assets, the extent of those 
activities varies. To the extent certain advisers currently do not 
segregate client assets, the segregation requirement in the proposed 
rule would result in advisers adapting existing systems and processes 
to meet the proposed requirement.
5. Investment Adviser Delivery of Notice to Clients
    The proposed rule, like the custody rule, would require an 
investment adviser to notify its client in writing promptly upon 
opening an account with a qualified custodian on the client's behalf. 
The proposed rule, however, would require that the notice must include 
the custodial account number in addition to the currently required 
qualified custodian's name and address.\533\ The proposed rule would 
also continue to allow the notice to be delivered to the client's 
independent representative. If the client is a pooled investment 
vehicle, the notice must be sent to all of the investors in the pool, 
provided that, if an investor is a pooled investment vehicle that is in 
a control relationship with the adviser or the adviser's related 
persons, the sender must look through that pool (and any pools in a 
control relationship with the adviser or its related persons) in order 
to send the notice to investors in those pools.\534\
---------------------------------------------------------------------------

    \533\ Proposed rule 223-1(a)(2).
    \534\ See proposed rule 223-1(c).
---------------------------------------------------------------------------

    The addition of the custodial account number would benefit clients 
by allowing them to more easily identify the custodial account. The 
client would be able to compare the custodial account number on 
subsequent account statements received from the qualified custodian to 
the custodial account number on the notice received from their 
investment adviser. Also, if the client is a pooled investment vehicle, 
the look-through requirement on senders promotes meaningful delivery of 
this important information.
    We understand that custodial account numbers are readily available 
to qualified custodians and that the cost of including the custodial 
account number in the notice to clients would be minimal. For purposes 
of the Paperwork Reduction Act, we estimate that advisers would incur 
aggregate initial costs of $4,720,044 associated with ensuring that 
custodial account numbers are included in notices to clients.\535\
---------------------------------------------------------------------------

    \535\ See infra note 624.
---------------------------------------------------------------------------

6. Exceptions From the Surprise Examination
    The proposed rule would create new exceptions to the surprise 
examination requirement in certain limited circumstances where advisers 
may have custody. We believe that in these circumstances, the subject 
activities or arrangements have built-in adequate preventative 
safeguards or simply pose less risk to client assets.
a. Entities Subject to an Audit
    We believe that audits provide substantial protections to private 
funds and their investors both because audits test assertions 
associated with the investment portfolio (e.g., completeness, 
existence, rights and obligations, valuation, presentation) and because 
they provide a check against adviser misrepresentations of performance, 
fees, and other information about the fund. Because of that belief, the 
proposed rule's audit provision would allow audits to serve as a 
substitute mechanism of compliance with certain aspects of the proposed 
rule. Elements of the proposed rule's audit provision are largely 
unchanged from the audit provision of the current rule.\536\ 
Differences include: expanded availability from ``pooled investment 
vehicle'' clients to ``entities,'' extending the current rule's 
specific deadlines for distribution of audited financial statements to 
180 days in the case of fund of funds or 260 days of a fund of funds of 
funds of the entity's fiscal year end, and a requirement for there to 
be a written agreement between the adviser or the client and the 
auditor requiring the auditor to notify the Commission

[[Page 14754]]

upon the auditor's termination or issuance of a modified opinion.\537\
---------------------------------------------------------------------------

    \536\ See supra note 282.
    \537\ See supra note 283.
---------------------------------------------------------------------------

i. The Expanded Availability of Audit Provision
    While the current rule's audit provision is only available to an 
adviser to clients that are limited partnerships, limited liability 
companies, and other types of pooled investment vehicles, the proposed 
audit provision would also be available to an adviser for any other 
client ``entity'' whose financial statements can be audited in 
accordance with the rule.\538\
---------------------------------------------------------------------------

    \538\ Compare rule 206(4)-2(b)(4); proposed rule 223-1(b)(4).
---------------------------------------------------------------------------

    As discussed in section II.G.1.b, this aspect of the proposed rule 
would extend the investor protection benefits of an audit to a larger 
number of investors, such as pension plans, retirement plans, college 
saving plans (529 plans), and Achieving a Better Life Experience 
savings accounts (ABLE plans or 529 A accounts). Investment advisers do 
not use the current rule's audit provision for clients that are not 
pooled investment vehicles, a consequence that may increase compliance 
burdens for advisers and result in additional costs.
    Also, we believe that financial statement audits provide additional 
meaningful protections to investors by increasing the likelihood that 
fraudulent activity is uncovered, thereby providing deterrence against 
fraudulent conduct by advisers. In a financial statement audit, the 
accountant performs procedures beyond those procedures performed during 
a surprise examination. For example, a financial statement audit 
typically involves tests of valuations of entity investments, income, 
operating expenses, and, if applicable, incentive fees and allocations 
that accrue to the adviser. Additionally, a financial statement audit 
regularly involves an accountant confirming bank account balances and 
securities holdings as of a point in time, and a financial statement 
audit frequently includes the testing of transactions that have 
occurred throughout the year. These common types of audit evidence 
procedures performed by accountants during a financial statement 
audit--physical examination or inspection, confirmation, documentation, 
inquiry, recalculation, re-performance, observation, and analytical 
procedures--act as an important check on the adviser obviating the need 
for the account notice and delivery requirements for pooled investment 
vehicles and other entities.
    Based on our experience, we estimate that the party (or parties) 
that bears the audit expense would pay an average audit fee of $60,000 
per fund. We estimate that individual fund audit fees would tend to 
vary over an estimated range from $15,000 to $300,000, and that some 
fund audit fees would be higher or lower than this range. We noted that 
the price of a private fund audit depends on many factors, such as 
whether it is a liquid fund or an illiquid fund, the number of its 
holdings, availability of a PCAOB-registered and -inspected auditor, 
economies of scale, and the location and size of the auditor. We 
believe that the cost of audit for client entities whose financial 
statements can be audited would be of a similar 
magnitude.539 540
---------------------------------------------------------------------------

    \539\ Although we believe that the procedures performed by the 
accountant during the course of an audit provide meaningful 
protections to clients beyond those of a surprise examination, 
certain protections provided by surprise examinations would no 
longer be provided. The loss of those protections could create a 
cost for investors, but we believe the requirements under the 
proposed rule mitigate those potential costs. For example, although 
the annual audit is not required to be performed at a time of the 
accountant's choosing (as is a surprise examination), we believe 
other elements of the audit incorporate an element of uncertainty 
similar to the surprise element of the surprise examination, with 
corresponding benefits to investors. Specifically, in the course of 
an annual audit, the auditor will select transactions to test during 
the period that the adviser will not be able to anticipate.
    \540\ Under the proposed rule, only those accountants that are 
subject to regular inspection by the PCAOB are eligible to perform 
these services which limits eligible accountants to those that 
currently conduct public company issuer and broker-dealer audits. 
The expansion of the availability of audit provision could result in 
an increase in demand for audit services provided by PCAOB-inspected 
accountants. Absent an offsetting increase in the supply of such 
services, the cost of audit services for client entities could 
increase. If PCAOB-inspected accountants reallocate resources from 
other market segments, thereby decreasing the supply of PCAOB-
inspected accountant capacity in those other market segments, the 
cost of audit services, more generally, could increase.
---------------------------------------------------------------------------

ii. Distribution of Audited Financial Statements
    The proposed audit provision would require an adviser to distribute 
an entity's audited financial statements to current investors within 
120 days (or 180 days in the case of a fund of funds or 260 days in the 
case of a fund of funds of funds) of the entity's fiscal year end, 
instead of the 120-day period required currently.\541\ As discussed in 
section II.G.1.e above, we understand that reliance on third parties 
could cause an adviser to fail to meet the 120-day timing requirements 
regardless of an adviser's actions. We also recognize there may be 
times when an adviser reasonably believes that an entity's audited 
financial statements would be distributed within the required timeframe 
but fails to have them distributed in time under certain unforeseeable 
circumstances.
---------------------------------------------------------------------------

    \541\ See proposed rule 223-1(b)(4)(iv).
---------------------------------------------------------------------------

    By extending the timeframe in which advisers of certain types of 
pooled investment vehicles (i.e., funds of funds and funds of funds of 
funds) must distribute an entity's audited financial statements,\542\ 
the proposed rule may reduce any uncertainty advisers to such pooled 
investment vehicles face under the current rule. Because we understand 
existing market practices with respect to these pooled investment 
vehicles already follow similar timeframes, we believe the costs of the 
proposed changes to the audit provision with respect to the 
distribution of audited financial statements would be minimal.
---------------------------------------------------------------------------

    \542\ See supra note 304.
---------------------------------------------------------------------------

    For purposes of the Paperwork Reduction Act, we estimate that 
investment advisers would incur an aggregate annual burden of 
$1,242,150 associated with delivering audited financial statements to 
their clients.\543\
---------------------------------------------------------------------------

    \543\ See infra note 660.
---------------------------------------------------------------------------

iii. Commission Notification
    The proposed rule would require an adviser to enter into, or cause 
the entity to enter into, a written agreement with the independent 
public accountant performing the audit to notify the Commission (i) 
within one business day upon issuing an audit report to the entity that 
contains a modified opinion and (ii) within four business days of 
resignation or dismissal from, or other termination of, the engagement, 
or upon removing itself or being removed from consideration for being 
reappointed.\544\ The written agreement must require the independent 
public accountant to notify the Commission by electronic means directed 
to the Division of Examinations. Although there is a requirement on 
Form ADV for an adviser to a private fund to report to the Commission 
whether it received a qualified audit opinion and to provide and update 
its auditor's identifying information, there is not a similar current 
obligation for an accountant to notify the Commission under the current 
rule.
---------------------------------------------------------------------------

    \544\ See proposed rule 223-1(b)(4)(v).
---------------------------------------------------------------------------

    The proposed requirement to notify the Commission (i) within one 
business day upon issuing an audit report to the entity that contains a 
modified opinion and (ii) within four business days of resignation or 
dismissal from, or other termination of, the engagement, or upon

[[Page 14755]]

removing itself or being removed from consideration for being 
reappointed would enable the Commission to receive more timely, 
complete, and independent information in these circumstances and to 
evaluate the need for an examination of the adviser. Based on our 
experience in receiving notifications from accountants who perform 
surprise examinations under the custody rule, we believe that the 
timely receipt of this information--from an independent third party--
would more readily enable our staff to identify advisers potentially 
engaged in harmful misconduct and who have other compliance issues. 
This would bolster the Commission's efforts at preventing fraudulent, 
deceptive, and manipulative activity and would aid oversight of 
investment advisers. This could lead to a higher rate of detection of 
activities that lead to the loss of client assets and a greater 
potential for mitigation of such losses. Anticipating this, advisers 
would have stronger incentives to avoid such harmful activities.
    The proposed written agreement requirement could impose costs on 
advisers and accountants related to negotiating, drafting, and 
implementing the written agreements. Based on staff experience, 
however, we understand that written agreements are commonplace and 
reflect industry practice when a person retains the services of a 
professional, such as an accountant, and they are typically prepared by 
the independent public accountant in advance. Also, the proposed 
requirements are drawn from the current rule's Form ADV-E filing 
requirement for independent public accountants performing surprise 
examinations and, as a result, should not be burdensome for accountants 
to include in their written agreements.\545\ As a result, we do not 
believe that the proposed requirement would significantly increase the 
costs attributable to the proposed requirement. For purposes of the 
Paperwork Reduction Act, we estimate that investment advisers would 
incur an initial aggregate burden of 48,735 hours and an ongoing annual 
burden of 35,869 hours associated with the written agreement.\546\
---------------------------------------------------------------------------

    \545\ Form ADV-E Instructions, pt. 3.ii, https://www.sec.gov/files/formadv-e.pdf.
    \546\ See infra notes 662 and 664.
---------------------------------------------------------------------------

b. Discretionary Trading Authority
    The proposed rule would contain an exception from the surprise 
examination requirement of client assets if the adviser's sole basis 
for having custody is discretionary authority with respect to those 
assets, provided this exception applies only for client assets that are 
maintained with a qualified custodian and for accounts where the 
adviser's discretionary authority is limited to instructing its 
client's qualified custodian to transact in assets that settle 
exclusively on a delivery versus payment basis.\547\ The proposed rule 
would limit this exception to instances where this is the adviser's 
sole basis for custody. Also, if an adviser also has custody of the 
client's assets for reasons that are also subject to similar exceptions 
(e.g., sole basis is fee deduction, sole basis is related person 
custody),\548\ the adviser can rely on the exception.
---------------------------------------------------------------------------

    \547\ Proposed rule 223-1(b)(8).
    \548\ See Rule 206(4)-2(b)(3) and (6) and proposed rule 223-
1(b)(3) and (6).
---------------------------------------------------------------------------

    We understand that certain investors may prefer to give their 
adviser discretionary trading authority. In delivery versus payment 
transactions, clients' custodians are generally under instructions to 
transfer assets out of a client's account only upon corresponding 
transfer of assets into the account. When a custodian is under 
instructions to transfer assets out of a client's account only upon 
corresponding transfer of assets into the account, there is a reduced 
risk that the adviser could misappropriate the assets, and when the 
transaction settles on a DVP basis there is a reduced risk of theft of 
the asset because, on a non-DVP basis, the seller of an asset could 
deliver but not receive payment or that the buyer of an asset could 
make payment but not receive delivery of the asset. The proposed 
exception would reduce the cost of discretionary trading authority in 
these instances by not requiring the adviser to comply with the 
surprise examination requirement of the proposed rule in those 
circumstances where the discretionary trading authority arrangement 
minimizes the risk that an investment adviser could withdraw or 
misappropriate assets in its clients' accounts. We believe this 
exception will mitigate the creation of new burdens for many advisers, 
particularly smaller advisers, as a result of the expanded scope of the 
definition of custody in the proposed rule and will focus the 
requirement to obtain a surprise examination where the risk of 
misappropriation is greatest. To the extent advisers pass along cost 
savings to clients, clients could realize a benefit in the form of 
reduced fees.
c. Standing Letters of Authorization
    The proposed rule would provide an exception from the surprise 
examination requirement for an investment adviser that has custody of 
client assets solely because of a standing letter of 
authorization.\549\
---------------------------------------------------------------------------

    \549\ Proposed rule 223-1(b)(7).
---------------------------------------------------------------------------

    We understand that certain investors may prefer to grant their 
adviser authority to disburse assets from the client's account to one 
or more specifically designated third parties in a manner that limits 
the adviser's ability to redirect the assets, via standing letter of 
instruction or other similar asset transfer authorization arrangement. 
The proposed exception would reduce the cost of granting an adviser 
such authority by not requiring the adviser to comply with the surprise 
examination requirement of the proposed rule. To the extent advisers 
pass along cost savings to clients, clients could realize a benefit in 
the form of reduced fees.
    As discussed in section II.G.3 above, where an arrangement is 
structured so that the adviser's role is limited to determining when to 
disburse a client's assets, we believe that the adviser's role in 
effecting any change in beneficial ownership is circumscribed and 
ministerial, and there is little risk to clients of loss, misuse, 
misappropriation, or theft of its asset. We also believe under such 
circumstances that a qualified custodian would be best positioned to 
ensure that the required authorizations and instructions are properly 
and verifiably issued by the client (e.g., the client's signature is 
verifiable). As a result, we believe the cost of the exception to 
clients would be minimal.
    The proposed required information could benefit qualified 
custodians by helping ensure that the instructions to the qualified 
custodian provide relevant information about the recipient. The 
proposed rule's requirement could also impose operational costs on 
qualified custodians. As described in section II.G.3, we believe the 
types of financial institutions identified as meeting the proposed 
definition of qualified custodian are required by their primary 
functional regulator or otherwise to perform procedures to verify the 
instruction and authorization, through a signature review and, if 
determined to be necessary, based on the facts and circumstances, 
another method of verification. To the extent existing regulatory 
requirements for qualified custodians are the same or similar to the 
proposed rule's requirements, the costs of adapting existing systems 
may be mitigated.

[[Page 14756]]

7. Amendments to the Investment Adviser Recordkeeping Rule
    The proposed amendments to rule 204-2 would require an investment 
adviser that has custody of client assets to make and keep true, 
accurate, and current records of required client notifications and 
independent public accountant engagements under proposed rule 223-1, as 
well as books and records related to specific types of client account 
information, custodian information, transaction and position 
information, and standing letters of authorization.\550\ The proposed 
amendments would require a more detailed and broader scope of records 
of trade and transaction activity and position information for each 
client account than the existing requirements for such records.\551\ 
The proposed amendments also would add new recordkeeping requirements 
that include: (i) retaining copies of required client notices; \552\ 
(ii) creating and retaining records documenting client account 
identifying information, including whether the adviser has 
discretionary authority; \553\ (iii) creating and retaining records of 
custodian identifying information, including copies of required 
qualified custodian agreements, and a record of required reasonable 
assurances that the adviser obtains from the qualified custodian; \554\ 
(iv) creating and retaining a record that indicates the basis of the 
adviser's custody of client assets; \555\ (v) retaining copies of all 
account statements; \556\ and (vi) retaining copies of any standing 
letters of authorization.\557\ Lastly, the proposed amendments would 
add new recordkeeping requirements to address independent public 
accountant engagements.\558\
---------------------------------------------------------------------------

    \550\ Advisers would be required to maintain the proposed 
records for a period of not less than five years as required under 
the current books and recordkeeping rule. See rule 204-2(e)(1).
    \551\ Compare rule 204-2(b)(1)-(4) with proposed rule 204-
2(b)(2)(v).
    \552\ Proposed rule 204-2(b)(1).
    \553\ Proposed rule 204-2(b)(2)(i).
    \554\ Proposed rule 204-2(b)(2)(ii).
    \555\ Proposed rule 204-2(b)(2)(iii).
    \556\ Proposed rule 204-2(b)(2)(iv).
    \557\ Proposed rule 204-2(b)(2)(vi).
    \558\ Proposed rule 204-2(b)(3).
---------------------------------------------------------------------------

    The proposed recordkeeping requirements are designed to work in 
concert with the proposed rule to help ensure that a complete custodial 
record with respect to client assets is maintained and preserved. The 
proposed changes to the recordkeeping rule would benefit clients by 
helping to facilitate the Commission's inspection and enforcement 
capabilities, including assessing compliance with the requirements of 
the proposed rule. In particular, the proposed recordkeeping 
requirement would benefit investors by providing more complete records 
that would facilitate client account reconciliation of all debits and 
credits to and from client accounts. More complete records also would 
better enable examiners to identify and detect potential investment 
adviser misappropriation or loss or misuse of client assets during 
their examinations, resulting in more effective investor protections. 
More generally, the recordkeeping requirements would enhance the 
transparency of custody of client assets and enhance the Commission's 
oversight capabilities. Enhancing the Commission's oversight 
capabilities could benefit clients and investors through reduced risks 
of loss and greater regulatory transparency and resulting effectiveness 
of the Commission's client and investor protection efforts.
    The proposed recordkeeping requirements would impose costs on 
advisers related to creating and maintaining the required records. 
These costs include those that can be attributed to compliance 
professionals who would review and familiarize themselves with 
requirements as specified in the proposed rule. In particular, advisers 
would be required to make and retain a list of covered functions and 
contributing factors, document their due diligence efforts, retain any 
written agreements with service providers, and document periodic 
monitoring of retained service providers. For purposes of the Paperwork 
Reduction Act, we estimate that advisers would incur aggregate annual 
costs of $41,352,853 as a result of the proposed amendments to rule 
204-2.\559\
---------------------------------------------------------------------------

    \559\ See infra footnote 674.
---------------------------------------------------------------------------

8. Changes to Form ADV
    We are proposing to amend Part 1A, Schedule D, and the Instructions 
and Glossary of Form ADV.\560\ The amendments are designed to 
categorize information about advisers' practices to safeguard client 
assets, to provide the Commission with information related to these 
practices, and to provide the Commission with additional data to 
improve our ability to identify compliance risks. The Commission is 
not, however, proposing to change the structured data language used for 
Part 1A. Specifically, given that Form ADV Part 1A currently is 
submitted in a structured (i.e., machine-readable), XML-based data 
language specific to that Form, the information in amended new Item 9 
would continue to be structured in the same manner.
---------------------------------------------------------------------------

    \560\ See supra note 359.
---------------------------------------------------------------------------

    The amendments will provide the Commission with information related 
to these practices, and also provide the Commission with additional 
data to improve our ability to identify compliance risks. Also, public 
reporting of these custodial practices could allow clients or third 
parties to assess potential risks (e.g., concentration of investments 
with a small number of custodians) associated with the market for 
custodial services, generally. For example, these amendments may also 
provide clients or investors additional protection because they will be 
better able to discern the reasons why a particular adviser has 
custody. Further, these amendments may offer ancillary market benefits 
to the extent that market participants are better able to analyze the 
Form ADV data to assess fraud risk. These proposed revisions would also 
streamline the collection of this information by reorganizing Item 9 
and refining certain reporting requirements to eliminate confusion and 
prevent inaccurate or incomplete reporting.\561\
---------------------------------------------------------------------------

    \561\ See proposed Form ADV, Part 1A, Item 9.
---------------------------------------------------------------------------

    Reporting this additional information would impose additional costs 
on investment advisers, but we believe that such costs would not be 
significant since we understand that much of the information we propose 
requesting on Form ADV would be readily available to or easily 
accessible by advisers.\562\
---------------------------------------------------------------------------

    \562\ See infra Table 10 for the revised From ADV PRA burden 
that includes incremental changes due to the proposed amendments as 
well as adjustments due to wage inflation and changes in the number 
of advisers.
---------------------------------------------------------------------------

E. Efficiency, Competition, and Capital Formation

    Efficiency. As discussed above, the proposed rule should benefit 
clients and investors by mitigating risks associated with the custody 
of client assets, thereby enhancing client and investor protections. 
The enhancement to client and investor protections could, in turn, lead 
to current clients being willing to invest a greater portion of their 
resources with registered advisers or for more clients and investors to 
seek the advice of registered advisers. Investment advisers provide 
investment advice to investors and clients about the value of, or about 
investing in, securities and other investment products. To the extent 
investors benefit from such advice, we could expect an improvement in 
the efficiency of client investment.
    It is possible, however, that the proposed rule could have the 
opposite

[[Page 14757]]

effect on efficiency. The costs of the proposed rule would be borne by 
advisers, their clients, and qualified custodians. It is possible that 
the costs borne by advisers may be large enough to cause some advisers 
to stop providing investment advice for certain assets.\563\ If 
advisers were to stop providing investment advice for certain assets, 
clients could experience a decrease in the quality of advisers' 
services. Alternatively, if advisers do try to push the costs, or some 
component thereof, to clients, it is possible that costs will be large 
enough to cause some clients to seek alternatives to registered 
advisers. To the extent clients would benefit from the advice provided 
by registered investment advisers, the decreased use of advisory 
services could result in a decline in the efficiency of client 
investment including lower realized returns.
---------------------------------------------------------------------------

    \563\ If there are fixed costs associated with the proposed 
regulations, then smaller advisers will generally tend to bear a 
greater cost, relative to adviser size, than larger advisers. If 
there are material fixed costs associated with the proposed rule, 
then we would expect the possible negative effect on competition to 
be greater for smaller advisers because the proposed regulations 
will tend to increase their costs more (relative to adviser size) 
than for larger advisers.
---------------------------------------------------------------------------

    The proposed amendments would result in a substantive increase in 
the information about custodial practices available to the Commission. 
That increased information could, for example, aid Commission staff in 
examinations, increase the likelihood that non-compliant behavior by 
custodians or advisers is detected, and increase the likelihood that 
non-compliant behavior is detected sooner. That increased information 
should also allow the Commission to develop a better understanding 
custodial practices, generally. As a result, we would expect an 
enhancement in regulatory efficiency.
    Competition. The proposed rule would enhance protections associated 
with the custody of client assets. These enhancements to client and 
investor protection, as well as the additional information available to 
current and potential clients, could lead to an increased demand for 
advisory services. That increase in demand for advisory services could, 
in turn, lead to increased competition among advisers to meet the 
increased demand. Alternatively, the increased demand for advisory 
services could lead to an increase in the number of advisers in the 
marketplace, also leading to an increase in competition among advisers. 
An increase in competition could, presumably, manifest itself in terms 
of better service, better pricing, or some combination of the two, for 
clients.
    As discussed above, however, it is possible that the proposed rule 
could have the opposite effect on competition. As noted above, the 
costs of the proposed rule would be borne by advisers, clients, and 
qualified custodians. It is possible that the costs borne by advisers 
may be large enough to cause some advisers to stop providing advice 
with respect to certain assets. To the extent the proposed rule would 
create new fixed costs of providing advisory services, those fixed 
costs would disproportionately impact small or newly emerging advisers. 
As a result, those fixed costs could discourage entry of new advisers 
or cause certain advisers to exit the market. Rather than exiting the 
market, there could be consolidation among advisers that could result 
in fewer options, and potentially higher costs, for investors. If 
advisers were to stop providing advice with respect to certain assets, 
competition among advisers with respect to providing advice for those 
assets could decline. Further, if advisers do try to push the costs, or 
some component thereof, to clients, it is possible that costs will be 
large enough to cause some clients to seek alternatives to the advice 
of registered advisers. The decreased demand for advisory services 
could result in a decline in the number of registered advisers and a 
decrease in competition among registered advisers.
    Also, we understand that the requirements of the proposed rule may 
result in additional costs for qualified custodians, particularly the 
requirements of a written agreement and reasonable assurances between 
the qualified custodian and the investment adviser incorporating 
certain minimum investor protection elements for advisory clients. To 
the extent qualified custodians are unable to pass these costs along to 
advisers and their clients, an increase in compliance costs could cause 
some qualified custodians to exit the market. A decrease in the number 
of qualified custodians could, in turn, lead to reduced competition, 
increased custodial fees, or both.
    Capital Formation. As noted above, the proposed amendments enhance 
investor protections by mitigating risks associated with custody of 
client assets. Additionally, the proposed rule would result in more 
information about custodial practices being available to the public. 
Those enhancements to client and investor protection as well as the 
additional information available to potential current clients and 
potential investors could lead to greater investor confidence which 
could result in current investors being willing to invest more and 
potential investors being more willing to invest for the first time. To 
the extent that the proposed rule leads to greater investment, we could 
expect greater demand for securities, which could, in turn, promote 
capital formation.

F. Reasonable Alternatives

    In this section, reasonable alternatives to the proposed elements 
of rule 223-1 are discussed.
1. Scope of Assets
    The proposed rule would define ``assets'' as ``funds, securities, 
or other positions held in a client's account.'' While, like the 
current rule, the proposed rule would apply to a client's cash and cash 
equivalents as well as a client's securities, it also would generally 
apply to other positions held in a client's account that are not funds 
or securities. The Commission alternatively could define the scope of 
other positions more narrowly, perhaps by identifying specific types of 
other positions subject to the proposed rule's safeguarding 
requirements.
    As discussed above, however, we observe a continuing evolution of 
the types of investments held in advisory accounts. If the proposed 
rule were to identify specific types of assets as subject to the 
safeguarding requirements of the rule, clients may not benefit from the 
safeguarding requirements of the rule if they invest in new asset types 
introduced in the future that fall outside the rule's scope. We 
therefore believe a broad definition of other positions strikes the 
correct balance in terms of investor protections and the cost of 
complying with the proposed rule.
2. Elimination of Privately Offered Securities Exception
    The proposed rule would modify the current rule's exception to the 
requirement to maintain client funds and securities with a qualified 
custodian with respect to certain privately offered securities.\564\ As 
discussed above, we believe qualified custodians serve as key 
gatekeepers to mitigate loss of client assets. The Commission 
alternatively could seek to enhance investor protections by eliminating 
the exception--thus requiring advisers with custody of privately 
offered securities to either maintain these assets with a qualified 
custodian or eliminate having custody--or retain the current exception 
without the proposed modifications.
---------------------------------------------------------------------------

    \564\ Proposed rule 223-1(b)(2).

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

[[Page 14758]]

    The choice between retaining the current exception, the exception 
modified as proposed, or eliminating the exception entirely necessarily 
involves tradeoffs. Eliminating the exception and requiring privately 
offered securities be maintained with a qualified custodian would 
increase the likelihood that a loss would be prevented or that non-
compliant behavior is detected earlier, potentially mitigating loss to 
clients. Also, to the extent the likelihood of timely detection deters 
non-compliant behavior, requiring privately offered securities to be 
maintained with a qualified custodian could have an important 
prophylactic effect.
    While we believe that requiring a qualified custodian to be 
involved in any transfer of ownership of privately offered securities 
would best mitigate the risk of loss of client assets, the current 
costs associated with this approach would be substantial while a 
custodial market is still relatively undeveloped. Although we believe 
that this market would be more robust if the custody rule's exception 
for uncertificated privately offered securities were eliminated and 
demand for custodian services would increase, it is possible that this 
market would not develop as we may expect or would develop in a way 
that the costs of maintaining privately offered securities with 
qualified custodians would not be justified by the benefits of doing 
so. At the same time, we believe retaining the current exception 
without modification leaves client assets at risk. In our view, the 
proposed modifications strike the correct balance in terms of investor 
protections and the cost of complying with the proposed rule.
3. Distribution of Requirements Across Reasonable Assurances and 
Written Agreement
    The proposed rule would require an adviser to obtain certain 
reasonable assurances regarding the protections clients receive from 
the qualified custodians maintaining their assets. The proposed rule 
would also require a written agreement between advisers and qualified 
custodians specifying different provisions related to the relationship 
among an adviser, its client, and a qualified custodian. Both the 
proposed reasonable assurances and written agreement requirements 
expand and formalize the minimum standard protections to advisory 
clients' assets. The Commission alternatively could specify a different 
composition of client protections realized via reasonable assurances 
and written agreements. For example, the Commission could require fewer 
protections be realized via written agreements and more be realized via 
a reasonable assurances requirement. Or, the Commission could require 
more protections be realized via written agreements and fewer 
protections be realized via a reasonable assurances requirement.
    Under the proposal, the written agreement covers matters that 
directly affect the adviser's own legal compliance (i.e., requiring the 
custodian to promptly provide records to the Commission or to an 
independent public accountant when required for compliance; requiring 
the qualified custodian to deliver account statements to the adviser as 
well as to the client; requiring the qualified custodian to assure the 
adequacy of its internal controls) and that concern the adviser's 
authority to effect transactions with funds in the client's account 
held by the custodian. In contrast, the reasonable assurances 
requirements cover matters which--while within the scope of the 
adviser's fiduciary duty--principally concern the qualified custodian's 
direct obligations to the client (i.e., the qualified custodian's 
standard of due care to the client, the custodian's measures to 
safeguard the client's assets, the custodian's indemnification of the 
client against loss, the custodian's obligations to the client when 
making sub-custodial arrangements, and the custodian's responsibility 
to identify and segregate the client's assets and to protect the client 
from liens or third-party claims).
    Committing more of these requirements to a written agreement would 
have the benefit of establishing a uniform, predictable set of 
requirements for all custodial arrangements and giving the adviser--as 
well as the client--a contractual enforcement mechanism. The existence 
of a written agreement might be a greater deterrent to misconduct than 
a reasonable assurances requirement, and the agreement might provide 
useful terms of reference for examinations. But committing more of the 
requirements to a written agreement could result in significant 
contracting costs, potential loss of flexibility in qualified 
custodians' business practices, a significant disruption in current 
practices, and increased litigation costs. In contrast, committing more 
of these requirements to reasonable assurances would have the benefit 
of reducing contracting costs, but with the added cost associated with 
advisers exercising due diligence and periodic monitoring of qualified 
custodians to obtain reasonable assurances, without the benefit of an 
agreement to establish basic expectations on matters directly affecting 
client advisory services. Moreover, qualified custodians may have 
concerns about implementing certain protections in the absence of 
contractual privity between themselves and investment advisers. For 
example, qualified custodians may have privacy concerns for their 
clients in the absence of an agreement with the adviser governing 
provision of records to an independent public accountant. Weighing 
these factors, we believe that the composition of client protections 
realized via reasonable assurances and written agreements in the 
proposal strikes the correct balance in terms of investor protections 
and the cost of complying with the proposed rule.
3. Additional Accounting and Client Notification Requirements for 
Privately Offered Securities and Physical Assets That Are Not 
Maintained With a Qualified Custodian
    The proposed rule would require an investment adviser to implement 
certain safeguards for clients' privately offered securities and 
physical assets that cannot be maintained with a qualified custodian. 
The safeguards are designed to improve protection of these assets and 
to create transparency for an investor as to holdings of and 
transactions in these assets, thereby increasing the likelihood that a 
loss will be detected sooner, and misconduct will be deterred. These 
include requirements for the adviser to reasonably determine that 
ownership cannot be recorded and maintained in a manner in which a 
qualified custodian can maintain possession or control of such assets; 
\565\ for the adviser to reasonably safeguard the assets from loss, 
theft, misuse, misappropriation, or the adviser's financial reverses, 
including insolvency; \566\ for the adviser to enter into a written 
agreement for an independent public accountant (``IPA'') to verify any 
purchase, sale, or other transfer of beneficial ownership of such 
assets promptly upon receiving notice from the adviser, and for the IPA 
to notify the Commission within one business day upon finding any 
material discrepancies during the course of performing its procedures; 
\567\ for the adviser to notify the IPA of any purchase, sale, or other 
transfer of beneficial ownership of such assets within one business 
day; \568\ and for verification of the existence and ownership of such 
assets during an

[[Page 14759]]

annual surprise examination or a financial statement audit.\569\
---------------------------------------------------------------------------

    \565\ Proposed rule 223-1(b)(2)(i).
    \566\ Proposed rule 223-1(b)(2)(ii).
    \567\ Proposed rule 223-1(b)(2)(iii).
    \568\ Proposed rule 223-1(b)(2)(iv).
    \569\ Proposed rule 223-1(b)(2)(v).
---------------------------------------------------------------------------

    We considered whether these safeguards should be supplemented or 
replaced with additional accounting and client notification 
requirements, including periodic examinations of the assets; prompt 
delivery to the client of a written notice that the assets are not kept 
by a qualified custodian, with an explanation of how the client can 
verify the existence and ownership of those holdings; a summary of a 
client's transactions involving assets that are not maintained with a 
qualified custodian, to be issued on a quarterly or other periodic 
basis; or for the adviser to obtain an internal control report for 
assets not maintained with a qualified custodian.\570\ We also 
considered requiring the independent public accountant engaged to 
perform the proposed transaction verifications to be PCAOB-registered. 
We believe the proposed safeguards are sufficient, and the costs of 
additional safeguards to advisers and clients alike may not be 
justified.
---------------------------------------------------------------------------

    \570\ See part II.D.5, Requests for Comment.
---------------------------------------------------------------------------

    As previously noted, we lack precise information on the degree of 
homogeneity versus heterogeneity of assets held by advisers that cannot 
be maintained by a qualified custodian, and more prescriptive 
accounting and notification requirements could be more costly when the 
assets are more varied and unique,\571\ when the custodian must rely on 
a third-party service provider to safeguard and inventory physical 
assets, or when the client engages in high-volume transactions.\572\ 
Moreover, the benefits of these additional safeguards would be limited 
where the assets are of such a nature that loss or misappropriation is 
readily detectable.\573\
---------------------------------------------------------------------------

    \571\ See part III.D.3.b.
    \572\ See generally parts III.D.3.c, III.D.3.d.
    \573\ For example, unique, high-value, non-fungible assets, such 
as developed real estate.
---------------------------------------------------------------------------

4. Additional Safeguards When Clients Assets Are Not Maintained With a 
Qualified Custodian
    As discussed above, we recognize that not all client assets for 
which an adviser may have custody can currently be maintained with 
qualified custodians.\574\ We considered proposing several alternative 
additional protections designed to help protect client investments when 
they are not maintained at a qualified custodian. One such alternative 
we considered would have required advisers to implement at least one 
financial responsibility safeguard. Specifically, we considered 
requiring advisers having custody of client assets that they determined 
could not be maintained with a qualified custodian to either (i) 
maintain an insurance policy covering losses to the investment adviser 
or its clients resulting from the loss, misuse, theft, or 
misappropriation of investments not maintained at a qualified 
custodian; or (ii) maintain a reserve bank account containing a 
specified amount of cash or certain qualified securities that could be 
used only to compensate clients for violations of the proposed 
rule.\575\
---------------------------------------------------------------------------

    \574\ See section II.D, supra.
    \575\ In the past--though in different contexts--the Commission 
and Congress have considered various financial responsibility 
requirements for advisers, including requiring advisers to maintain 
insurance (in the form of fidelity bonds) or satisfy minimum capital 
requirements. The Commission most recently sought comment on these 
concepts in 2018 in conjunction with its proposed interpretation 
regarding the standard of conduct for investment advisers. See 
Proposed Commission Interpretation Regarding Standard of Conduct for 
Investment Advisers; Request for Comment on Enhancing Investment 
Adviser Regulation, Release No. IA-4889, at 4 n.8 (Apr. 18, 2018) 
[83 FR 21203 (May 9, 2018)]. Comments received in response to this 
request were still under evaluation at the time the Commission 
adopted its final interpretation regarding the standard of conduct 
for investment advisers. See Commission Interpretation Regarding 
Standard of Conduct for Investment Advisers, supra footnote 57. 
Previously, in 2003, the Commission requested comment on whether to 
require a fidelity bonding requirement for advisers as a way to 
increase private sector oversight of the compliance by funds and 
advisers with the Federal securities laws. See Compliance Programs 
of Investment Companies and Investment Advisers, Release Nos. IC-
25925 and IA-2107 (Feb. 5, 2003) [68 FR 7037 (Feb. 11, 2003)]. The 
Commission decided not to adopt a fidelity bonding requirement at 
that time, but noted that it regarded such a requirement as a viable 
option should the Commission wish to further strengthen compliance 
programs of funds and advisers. See Compliance Programs of 
Investment Companies and Investment Advisers, Release Nos. IC-26299 
and IA-2204 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)]. Also, in 
1973, a Commission advisory committee recommended that Congress 
authorize the Commission to adopt minimum financial responsibility 
requirements for investment advisers, including minimum capital 
requirements. See Report of the Advisory Committee on Investment 
Management Services for Individual Investors, Small Account 
Investment Management Services, Fed. Sec. L. Rep. (CCH) No. 465, Pt. 
III, 64-66 (Jan. 1973). Three years later, in 1976, the Senate 
Committee on Banking, Housing and Urban Affairs considered a bill 
that, among other things, would have authorized the Commission to 
adopt rules requiring investment advisers with discretionary 
authority over client assets, or that advise registered investment 
companies, to meet financial responsibility standards. S. Rep. No. 
94-910, 94th Cong. 2d Sess. (May 20, 1976) (reporting favorably S. 
2849). S.2849 was never enacted, however. The issue of adviser 
financial responsibility was also considered by Congress in 1992, 
with both the Senate and House of Representatives passing bills that 
would have given the Commission the explicit authority to require 
investment advisers with custody of client assets to obtain fidelity 
bonds. S.226, 102d Cong., 2d Sess. (Aug. 12, 1992) and H.R. 5726, 
102d Cong. Ed (Sept. 23, 1992). Differences in these two bills were 
never reconciled and thus neither became law.
---------------------------------------------------------------------------

    While this approach is similar to the types of fidelity bonds that 
broker-dealers, investment companies, ERISA fiduciaries, and some 
state-registered investment advisers are required to maintain,\576\ we 
considered requiring advisers to maintain insurance coverage that would 
have been more comprehensive than a typical fidelity bond in order to 
address the risks the proposed rule is designed to mitigate. For 
example, we considered requiring an adviser to maintain an insurance 
policy covering losses to the investment adviser or its clients 
resulting from the loss, misuse, theft, or misappropriation of 
investments not maintained at a qualified custodian due to the 
adviser's negligence, recklessness, or intentional misconduct.
---------------------------------------------------------------------------

    \576\ See, e.g., FINRA Rule 4360 (broker-dealers); 17 CFR 
270.17g-1 (investment companies); 29 CFR 2580.412-1 (ERISA 
fiduciaries). Many state-registered investment advisers are required 
to maintain fidelity bonds. See, e.g., Ala. Code 1975 section 8-6-3; 
Ark. Admin. Code 214.00.1-303.2; Ga. Code Ann., section 10-5-40; see 
also NASAA Bonding Requirements for Investment Advisers Model Rule, 
available at https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Bonding.pdf.
---------------------------------------------------------------------------

    However, we recognize there could be legal and logistical 
challenges in implementing such a requirement. For example, fidelity 
bond policies generally only protect policyholders from direct losses 
suffered from a covered event (e.g., theft of the insured's property by 
an employee), not third parties such as an adviser's clients, and even 
to the extent fidelity policies are written to specifically cover 
third-party property, there is disagreement as to whether the money a 
policyholder uses to compensate a third party qualifies as a loss 
covered under these policies.\577\ Also, it could be difficult for an 
adviser to maintain appropriate coverage efficiently and effectively as 
they buy and sell various investments on behalf of their clients or as 
those investments increase and decrease in value. Finally, while this 
approach may provide some means for recovery if an adviser's clients 
are harmed, requiring this type of insurance coverage would likely 
require advisers to pay significant premiums, which they would likely 
pass along to clients through increased fees.
---------------------------------------------------------------------------

    \577\ See Adam D. Cornett & Andrew S. Kent, Who Can Recover 
Under a Fidelity Policy?, XX Fid. L.J. 139, 139-41, 177-180 (2014) 
(citing Retail Ventures, Inc. v. Nat'l Union Fire Ins. Co. of 
Pittsburgh, Pa., 691 F3d 821, 828-32 (6th Cir. 2012)).
---------------------------------------------------------------------------

    We similarly considered requiring an adviser to maintain a 
specified level of reserves based on the value of client investments 
not maintained by a qualified custodian or for which an adviser has an 
enhanced ability or

[[Page 14760]]

authority to effect a change in beneficial ownership. Requiring an 
adviser to have sufficient liquid assets to cover these types of client 
investments would have provided a source of recovery when those client 
investments are lost, misused, stolen, or misappropriated due to the 
adviser's failure to adequately safeguard them. This approach would 
have resembled the capitalization requirements of other financial 
firms.\578\ However, because the value of these client investments 
would vary based on market fluctuations as well as client transactions, 
designing a reserve requirement that would ensure that an adviser 
maintained adequate reserves to allow for full recovery at all times 
could be operationally challenging and costly. Further requiring 
advisers to maintain reserves sufficient to provide for full--or even 
meaningful--client recovery, may be prohibitively costly because 
advisers would need to set aside significant amounts of capital, 
potentially acting as a barrier to entry for new advisory firms or 
causing existing advisers to leave the market.
---------------------------------------------------------------------------

    \578\ Broker-dealers are subject to minimum capitalization 
requirements under the net capital and customer protection rules. 
See, e.g., 17 CFR 240.15c3-1 (net capital rule); 17 CFR 240.15c3-3 
(customer protection rule). Some state-registered investment 
advisers are also subjected to minimum capitalization requirements. 
See, e.g., Ark. Admin. Code 214.00.1-303.2; Ga. Code Ann., section 
10-5-40; see also NASAA Minimum Financial Requirements for 
Investment Advisers Model Rule (2011), available at https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Minimum-Financial-Requirements.pdf.
---------------------------------------------------------------------------

    Another alternative we considered would have required an adviser to 
undergo an enhanced independent verification of assets not kept with a 
qualified custodian or when an adviser has one-way transfer authority 
over a client's account, irrespective of whether those assets are 
maintained with a qualified custodian. For assets not kept with a 
qualified custodian, the surprise examination would have been required 
to verify 100% of a client's assets, and it would have required the 
independent public accountant to verify the disposition of assets from 
one examination to the next. We have opted, instead, to propose 
limiting the assets an adviser is not required to maintain assets with 
a qualified custodian to shares of mutual funds, and certain physical 
assets and privately issued securities that the adviser has determined 
cannot be maintained in the possession or control of a qualified 
custodian. With respect to the latter category of assets, we are also 
proposing to require advisers to implement other protections to ensure 
they are adequately safeguarded, including, for example, more frequent 
asset verifications. We believe this approach is likely to result in 
more client assets being maintained by qualified custodians and better 
tailoring the protections for client assets that cannot be maintained 
with a qualified custodian. For one-way transfer authority, under this 
alternative, the surprise examination would have required the 
independent public accountant to evaluate whether each one-way transfer 
of client assets was authorized (e.g., client authorized a cash 
withdrawal from the client's account to be transferred to a particular 
recipient). We were uncertain whether an independent public accountant 
would make such an evaluation, however, and if so, whether it would be 
cost-prohibitive for them to do so. We determined, instead, to promote 
transparency around all transactions for a client's evaluation in the 
proposal's approach. The proposed rule would promote this by 
eliminating accommodation reporting on a qualified custodian account 
statement, by limiting the circumstances in which advisers are not 
required to maintain client assets with a qualified custodian, by 
requiring an independent public accountant to verify transactions with 
respect to certain assets not maintained with a qualified custodian 
more frequently, and by eliminating the possibility that assets not 
kept with a qualified custodian might not be included in the sampling 
of assets verified under the current rule.
5. Designating Clearing Agencies and Transfer Agents as Qualified 
Custodians
    The Commission considered expanding the definition of a qualified 
custodian to include clearing agencies that perform the function, under 
the Exchange Act,\579\ of acting as central securities depositories 
(``CSDs''), as well as transfer agents.\580\ Both CSDs and transfer 
agents are functionally similar to qualified custodians in several 
respects and are already subject to regulatory safeguards. These 
entities safeguard a significant volume of assets and are subject to 
Commission oversight through regulatory standards, registration 
requirements, supervision, and examination.\581\ For example, among 
other requirements, CSDs must establish, implement, maintain, and 
enforce written policies and procedures reasonably designed to ensure 
the integrity of securities issues, and minimize and manage the risks 
associated with the safekeeping and transfer of securities; implement 
internal auditing and other controls to safeguard the rights of 
securities issuers and holders and prevent the unauthorized creation or 
deletion of securities, and conduct periodic and at least daily 
reconciliation of securities issues they maintain; and protect assets 
against custody risk.\582\ Similarly, transfer agents are responsible 
for countersigning securities upon issuance, monitoring to prevent 
unauthorized issuance of securities, registering the transfer of 
securities, and effecting the exchange, conversion, and transfer of 
securities.\583\ Expanding the definition of a qualified custodian to 
include CSDs and transfer agents could benefit investors by increasing 
the number of potential entities that provide custodial services in 
compliance with the rule, which could increase competition in the 
market for such services and reduce costs. In addition, different types 
of entities may be more or less suited to providing custodial services 
for certain types of assets, such as privately offered securities, so 
expanding the definition of a qualified custodian may reduce the costs 
associated with maintaining these assets with a qualified custodian by 
providing additional custodial options.
---------------------------------------------------------------------------

    \579\ See Exchange Act section 3(a)(23)(A)(i), 15 U.S.C. 
78c(a)(23)(A)(i); Rule 17Ad-22(a)(3), 17 CFR 240.17Ad-22(a)(3).
    \580\ See part II.C.1, Requests for Comment.
    \581\ See, e.g., Release No. 34-78963 (Sept. 28, 2016), 81 FR 
70744, 70745-47 (Oct. 13, 2016) (summarizing authorities applicable 
to clearing agencies); Release No. 34-76743 (Dec. 22, 2015), 80 FR 
81948, 81959-69 (Dec. 31, 2015) (summarizing authorities applicable 
to transfer agents).
    \582\ See Rule 17Ad-22(e)(11).
    \583\ Exchange Act section 3(a)(25), 15 U.S.C. 78c(a)(25).
---------------------------------------------------------------------------

    However, CSDs currently perform many functions at an aggregate or 
omnibus level for institutional participants, so they might need to 
build systems to account for and interact with individual clients (to, 
for example, directly furnish quarterly statements). The potential 
costs CSDs would incur were they to provide services as qualified 
custodians under this alternative might pose a significant barrier to 
entry, which could limit the degree to which expanding the definition 
of a qualified custodian would increase competition in the market for 
custodial services. Moreover, providing custodial services could 
significantly alter the risk management features of CSDs, which have 
been tailored for other purposes and are supported by an architecture 
that involves a more limited number of institutional participants.
    While some transfer agents are currently used by mutual funds in 
lieu of a qualified custodian with respect to

[[Page 14761]]

fund shares,\584\ they might also have to develop systems and processes 
to enable them to custody assets other than fund shares. Transfer 
agents that are used by mutual funds may also have some systems and 
processes in place to interact with clients, such as those used to 
furnish quarterly statements, but other transfer agents might incur 
significant costs building such systems and processes. Like CSDs, the 
costs associated with providing custodial services might pose a 
significant barrier to entry for transfer agents, which could limit the 
degree to which expanding the definition of a qualified custodian would 
increase competition in the market for custodial services. In addition, 
while transfer agents are currently subject to regulatory safeguards, 
they are not currently subject to individual client protections that 
are as extensive as the entities we are including in the definition of 
a qualified custodian under the proposed rule. For example, they are 
not subject to the specific safeguarding requirements of Rule 206(4)-
2(a), and their capitalization and risk management practices are 
oriented to the markets where they operate, not necessarily to the 
range and variety of clients and assets contemplated by the proposed 
rule.
---------------------------------------------------------------------------

    \584\ See Rule 206(4)-2(b)(1).
---------------------------------------------------------------------------

G. Request for Comment

    The Commission requests comment on all aspects of this initial 
economic analysis, including whether the analysis has: (i) identified 
all benefits and costs, including all effects on efficiency, 
competition, and capital formation; (ii) given due consideration to 
each benefit and cost, including each effect on efficiency, 
competition, and capital formation; and (iii) identified and considered 
reasonable alternatives to the proposed rule. We request and encourage 
any interested person to submit comments regarding the proposed rule, 
our analysis of the potential effects of the proposed rule, and other 
matters that may have an effect on the proposed rule. We request that 
commenters identify sources of data and information as well as provide 
data and information to assist us in analyzing the economic 
consequences of the proposed rule. We also are interested in comments 
on the qualitative benefits and costs we have identified and any 
benefits and costs we may not have discussed.
    280. The proposed rule affects banks and savings associations, 
broker-dealers registered with the Commission, futures commission 
merchants registered with the CFTC, and FFIs. How do rules and 
regulations of other financial regulators and of self-regulatory 
organizations affect these entities in their capacity as qualified 
custodians? How do these existing rules and regulations affect the 
benefits of the proposed rule and its costs?
    281. The proposed rule would expand the scope of assets currently 
subject to the custody rule. To what extent do investors benefit from 
advisers having custody of assets newly scoped in under the proposed 
rule? What is the nature of those benefits? To what extent would those 
benefits be lost given the requirements of the proposed rule?
    282. The proposed rule would explicitly identify discretionary 
trading authority as an arrangement that triggers the rule. To what 
extent do investors benefit from discretionary trading services offered 
by investment advisers? What is the nature of those benefits? To what 
extent would investment advisers no longer offer discretionary trading 
services given the requirements of the proposed rule?
    283. The proposed rule would generally 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). To what extent are investment advisers currently 
party to custodial agreements? To what extent are the required 
provisions similar to, or different from, provisions in custodial 
agreements between investors and qualified custodians? Have we 
appropriately estimated the costs of the reasonable assurances and 
written agreement requirements? Do commenters agree that qualified 
custodians will have in incentive to provide written agreements that 
are consistent with the requirements of the proposed rule? Have we 
appropriately identified the costs of the proposed required provisions?
    284. To what extent do entities maintaining client physical assets 
currently enter into written agreements obligating the entity to comply 
with provisions the same as, or similar to, the provisions required 
under the proposed rule?
    285. We state that existing regulatory requirements for qualified 
custodians with respect to asset segregation are similar to the 
requirements of the proposed rule and that, as a result, the costs of 
the proposed asset segregation requirements would be mitigated. Is this 
an accurate characterization of existing regulatory requirements? If 
not, how do existing regulatory requirements differ from those of the 
proposed rule?
    286. We state that for those qualified custodians indemnifying the 
client against the risk of loss in the event of the qualified 
custodian's gross negligence, the insurance requirement of the proposed 
indemnification requirement would likely create a substantial increase 
in the cost of liability insurance. Is this an accurate 
characterization? How costly is insurance covering loss in the event of 
a qualified custodian's gross negligence? How costly is insurance 
covering loss in the event of a qualified custodian's simple 
negligence? For example, how much does it cost to insure, per $1,000 of 
covered assets, losses in the event of a qualified custodian's gross 
negligence? How much does it cost to insure, per $1,000 of covered 
assets, losses in the event of a qualified custodian's simple 
negligence? Do the per-dollar costs change as the amount of covered 
assets increases? If so, how? What other factor might affect the cost 
of liability insurance for qualified custodians? What kinds of 
operational burdens might be associated with purchasing and maintaining 
liability insurance? To what extent do custodians currently have 
systems, processes, and liability insurance that are consistent with a 
simple negligence standard?

IV. Paperwork Reduction Act Analysis

A. Introduction

    Certain provisions of our proposal would result in new ``collection 
of information'' requirements within the meaning of the Paperwork 
Reduction Act of 1995 (``PRA'').\585\ The proposed new rule 223-1 and 
related amendments to rules 206(4)-2 and 204-2 under the Act and Form 
ADV would have an impact on current collection of information burdens. 
Specifically, we are proposing new collection of information 
requirements under proposed rule 223-1 and corresponding amendments to 
currently approved collection of information burdens under: (i) ``Rule 
206(4)-2 under the Investment Advisers Act of 1940--Custody of Funds or 
Securities of Clients by Investment Advisers'' (OMB number 3235-0241); 
(ii) ``Rule 204-2 under the Investment Advisers Act of 1940'' (OMB 
control number 3235-0278); and (iii) ``Form ADV'' (OMB control number 
3235-0049). The Commission is submitting these collections of 
information to the OMB for review and approval in accordance with 44 
U.S.C. 3507(d) and 5 CFR

[[Page 14762]]

1320.11. An agency may not conduct or sponsor, and a person is not 
required to respond to, a collection of information unless it displays 
a currently valid OMB control number.
---------------------------------------------------------------------------

    \585\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    We discuss below these proposed amendments and new collection of 
information burdens. Responses provided to the Commission in the 
context of its examination and oversight program concerning the 
proposed redesignation of rule 206(4)-2 as new rule 223-1, and 
corresponding amendments to rule 204-2 would be kept confidential 
subject to the provisions of applicable law. Responses to the 
disclosure requirements of the proposed amendments to Form ADV are not 
kept confidential.

B. Rule 223-1

    Proposed rule 223-1, which will effectively replace current rule 
206(4)-2 by a redesignation, states that an adviser registered or 
required to be registered under section 203 of the Act, shall take 
certain steps to safeguard the client assets of which the adviser has 
custody, and lays out five requirements with which advisers must 
comply.\586\ Paragraph (a)(1) would require advisers to maintain 
client's assets at a qualified custodian in a specified manner pursuant 
to a written contract that contains enumerated elements. Paragraph 
(a)(1)(ii) would require an adviser to obtain reasonable assurances in 
writing from a qualified custodian that such custodian will exercise 
due care over client assets; will indemnify the client against risk of 
loss; not excuse any obligations to the client based upon the existence 
of any sub-custodial, securities depository, or other similar 
arrangements with regard to the client's assets; clearly identify and 
segregate client assets from the custodian's proprietary assets and 
liabilities; and 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. Paragraph (a)(2) would require an 
investment adviser that opens an account with a qualified custodian on 
a client's behalf to notify the client of the account details. 
Paragraph (a)(3) would require an investment adviser to title or 
register a client's assets in the client's name or otherwise hold such 
assets for the benefit of that client; prohibit the commingling of 
client assets with the adviser's (or its related persons') assets; and 
require client assets generally to be held free of any right, charge, 
security interest, lien, or claim in favor of the adviser and its 
related persons or creditors. Paragraph (a)(4) would require an adviser 
that maintains custody of client assets to obtain independent 
verification from an independent public accountant at least once during 
a calendar year pursuant to a written agreement that provides for the 
filing of Form ADV-E.
---------------------------------------------------------------------------

    \586\ Proposed rule 223-1.
---------------------------------------------------------------------------

    Paragraph (b) lays out limited exceptions from certain requirements 
of the proposed rule, some which would change the current collections 
of information burdens of rule 206(4)-2. These include paragraphs 
(b)(2) excepting the requirement to maintain certain privately offered 
securities or physical assets with a qualified custodian in certain 
circumstances; (b)(3) excepting advisers from the independent 
verification of client assets maintained by a qualified custodian if an 
adviser has custody solely as a consequence of the authority to deduct 
advisory fees; (b)(4) exempting an adviser from the account statement 
and certain notification requirements, along with the independent 
verification requirement, when the advisory client undergoes a 
financial statement audit annually and upon liquidation in accordance 
with the rule; (b)(7) creating an exemption from the independent 
verification requirement if an adviser has custody of client assets 
solely because of a standing letter of authorization with the client; 
and (b)(8) excepting advisers from the independent verification of 
assets requirement under certain circumstances if custody exists solely 
because the adviser has discretionary authority with respect to those 
client assets that are maintained in accounts with a qualified 
custodian where the discretionary authority is limited to transacting 
in assets that settle exclusively on a delivery versus payment basis.
    Each requirement to disclose or obtain information, deliver 
communications, or cause reporting by an independent public accountant 
constitutes a ``collection of information'' requirement under the PRA 
and is mandatory. Advisory clients would use this information to 
confirm proper handling of their accounts. The Commission's staff uses 
the information obtained through these collections in its enforcement, 
regulatory, and examination programs. The respondents to these 
collections of information requirements would be investment advisers 
that are registered or required to be registered with the Commission 
that have custody of client assets. As of September 2022, there were 
15,160 investment advisers registered with the Commission and 8,724 
advisers reported to have custody of client assets in Item 9 of Form 
ADV. Although not all investment advisers would be subject to this 
rule, we expect that most would be for two reasons: first, the proposed 
rule would be triggered by most services advisers commonly provide to 
their clients, such as trading on a discretionary basis; and second, 
the proposed rule's application to ``assets'' would apply to a broad 
array of client investments, not just to funds or securities as under 
the current rule. We, therefore, estimate that 13,944 which is the 
number of all registered advisers that currently report having 
discretionary authority, would be subject to the proposed rule.\587\ 
The application of the provisions of the proposed rule--and thus the 
extent to which there are collections of information and their related 
burdens--would be contingent on a number of factors, such as the types 
of services the adviser provides, the number of clients to whom it 
provides those services, and the nature of the relevant assets. Because 
of the wide diversity of services and relationships offered by 
investment advisers, we expect that the obligations imposed by the 
proposed rule would, accordingly, vary substantially among advisers. 
However, we have made certain estimates of this data solely for the 
purpose of this PRA analysis.
---------------------------------------------------------------------------

    \587\ This estimate is based on the 14,204 advisers who answer 
yes to Form ADV Item 8(C)(1) and have discretionary authority to 
determine the ``securities to be bought or sold for a client's 
account.'' For purposes of this estimate, we have excluded 260 
advisers answering yes to Form ADV Item 8(C)(1) but reporting that 
they solely advise investment company clients in response to Form 
ADV Item 5.D.(1)(d).
---------------------------------------------------------------------------

1. Qualified Custodian Provision
a. Written Agreement
    Under the proposed rule investment advisers would be required to 
enter into a written agreement with a qualified custodian to maintain 
possession or control of their clients' assets and to satisfy certain 
other requirements enumerated in the rule, subject to certain 
exceptions.\588\ We estimate that nearly all of the 13,944 registered 
advisers that we estimate would be subject to the rule will be required 
to comply with this requirement.\589\ We believe that an investment 
adviser

[[Page 14763]]

would enter into a single agreement with each qualified custodian that 
provides custodial services for the adviser's clients, regardless of 
how many of the adviser's clients the qualified custodian provides 
custodial services for. Based on the information currently reported by 
advisers about qualified custodians on in Item 9.F of Form ADV, we 
estimate that each adviser would enter into approximately 4 written 
agreements.\590\ We therefore estimate that, initially, advisers would 
enter into a total of 55,776 written agreements.\591\ We estimate that 
each investment adviser and each qualified custodian that enters into 
an agreement would incur an internal burden of 1 hour each to prepare 
the written agreement, for a total initial burden hour estimate of 
111,552 \592\ which we expect would mostly be attributable to the 
requirement to 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. Based on our estimates, there 
would be an initial cost to each respondent of this internal hour 
burden of $43,951,488 to draft and finalize these written 
agreements.\593\
---------------------------------------------------------------------------

    \588\ Proposed rule 223-1(a)(1) (the proposed rule would require 
a written agreement between the adviser and client if the adviser is 
also the qualified custodian).
    \589\ While some of these advisers may have custody of certain 
client assets that the proposed rule would except from the 
requirement to use a qualified custodian, we assume that these 
advisers likely also have at least some client assets that must be 
maintained with a qualified custodian under the proposed rule.
    \590\ This estimate is based on responses to Form ADV, Part 1A, 
Item 9.F, which requires advisers to report the number of persons 
acting as qualified custodian. For all advisers responding to this 
question, the average number of persons acting as qualified 
custodians amounted to 4. We believe that it is possible that the 
proposed rule could result in advisers entering into agreements with 
a greater number of qualified custodians for custody services 
related to assets that advisers may not currently maintain with a 
custodian. At the same time, we believe that it is possible that 
current custodians will expand their services in order to provide 
custody services for asset types that they do not currently maintain 
for advisers. As a result, for the purposes of this analysis, we 
will rely on the average obtained from Form ADV Part 1A, Item 9.F. 
data.
    \591\ This estimate is based on the following calculation: 
13,944 advisers x 4 written agreements.
    \592\ This estimate is based on the following calculation: 
55,776 written agreements x 2 hours.
    \593\ This estimate is based on the following calculation: 
111,552 hours (for preparation and review of draft agreement) x $394 
(blended rate for a compliance manager ($361) and a compliance 
attorney ($426)). Unless otherwise indicated in this section IV, all 
hourly wages used are from the Securities Industry and Financial 
Markets Association's Report on Management & Professional Earnings 
in the Securities Industry 2013 (``SIFMA Wage Report''), updated for 
2023, modified to account for an 1800-hour work-year and inflation.
---------------------------------------------------------------------------

    Once these agreements are created they will require little, if any, 
modification, except in circumstances where the adviser's level of 
authority changes (which we estimate would occur approximately once per 
year). We estimate that these changes would take, on average, 10 
minutes per written agreement. Therefore, we estimate that the yearly 
total internal burden of preparing the written agreement would be 9,482 
hours,\594\ and there would be an annual cost of this internal hour 
burden of $3,735,908.\595\
---------------------------------------------------------------------------

    \594\ This estimate is based on the following calculation: 
55,776 written agreements x .17 hours.
    \595\ This estimate is based on the following calculation: 9,482 
hours x $394 (blended rate for a compliance manager ($361) and a 
compliance attorney ($426)).
---------------------------------------------------------------------------

    The written agreement proposed by the rule would require a 
qualified custodian to promptly, upon request, provide records relating 
to an adviser's clients' assets held in the account at the qualified 
custodian to the Commission or to an independent public accountant 
engaged for purposes of complying with the rule.\596\ As noted above, 
we believe that advisers would enter into approximately 4 written 
agreements on average. We anticipate that 1,842 \597\ of the advisers 
party to these written agreements would be subject to the surprise 
examination requirement. For these advisers, we estimate that qualified 
custodians would be required to provide information to an independent 
public accountant once annually in connection with each adviser for 
which they have a written agreement under the rule. We estimate that it 
would take qualified custodians approximately 0.5 hours to provide the 
required information. Therefore, we estimate the internal annual hour 
burden for qualified custodians to provide this information to total 
3,684 hours.\598\ Further, we anticipate that 7,018 advisers to these 
written agreements would comply with the proposed rule's audit 
exception.\599\ Because we estimate that 5 percent of pooled investment 
vehicles are liquidated annually at a time other than their fiscal 
year-end, for these advisers, we estimate that qualified custodians 
would be required to provide information to an independent public 
accountant 1.05 times annually. Therefore, we estimate that the total 
annual burden for respondents to provide information to independent 
public accountants for the audit related to these advisers would be 
14,738 hours.\600\ In the aggregate, we estimate the total annual 
burden for respondents to provide information to independent public 
accountants for the surprise examination and audit to amount to 18,422 
hours.\601\
---------------------------------------------------------------------------

    \596\ See proposed rule 223-1(a)(1)(i)(A).
    \597\ See infra footnote 619and accompanying text.
    \598\ This estimate is based on the following calculation: 1,842 
(advisers that we estimate will obtain a surprise examination) x 4 
(average number of written agreements per adviser) x .5 hours.
    \599\ Advisers to pooled investment vehicles: 4,961. 20% of 
advisers with custody that have pension and profit sharing plan 
clients (3,068 x .20): 614. 20% of advisers with custody that have 
charitable organization clients(3,205 x .20): 641. 20% of advisers 
with custody that have state or municipal government entity clients 
(986 x .20): 197. 20% of advisers with custody that have 
corporations and other business entity clients (3,025 x .20): 605. 
Total advisers expected to use the audit provision (4,961 + 614 + 
641 + 197 + 605): 7,018 advisers; See also infra footnote 654.
    \600\ This estimate is based on the following calculation: 7,018 
(number of advisers using the audit exception) x 4 (average number 
of qualified custodians per adviser) x 1.05 (average number of 
audits annually) x .5 hours = burden for respondents to provide 
information to independent public accountants for the audit related 
to these advisers.
    \601\ 3,684 + 14,738 hours.
---------------------------------------------------------------------------

    We estimate that the Commission would examine approximately 2,092 
of the advisers required to enter into a written agreement under the 
rule, which is consistent with the number of advisers generally 
examined by Commission staff over the last three fiscal years.\602\ As 
noted above, because we estimate that an adviser will on average 
maintain client assets with approximately four qualified custodians, we 
estimate that Commission will issue approximately 8,368 requests to 
qualified custodians under the rule. We believe that these information 
requests may be more customized and would take custodians approximately 
1.5 hours to respond to, slightly longer than it would take a custodian 
to provide more standardized information requested by an independent 
public accountant. Accordingly, the internal burden hours for 
respondents to this collection of information would equal approximately 
12,552 hours.\603\ In total, for the requirement to provide information 
to accountants and the Commission, we estimate the collection of 
information burden on respondents amounts to 30,974 hours 
annually.\604\ Accordingly, we estimate that the annual internal 
monetized cost burden amounts to approximately $12,203,756.\605\
---------------------------------------------------------------------------

    \602\ This estimate is based on the following calculation: 
13,944 advisers subject to the rule and required to enter into a 
written agreement with a qualified custodian x 15% (the approximate 
number of registered advisers the Commission examined in each of 
fiscal years 2019, 2020, and 2021). See U.S. Securities and Exchange 
Commission, Division of Examinations, 2022 Examination Priorities at 
4 (Mar. 2022), available at https://www.sec.gov/files/2022-exam-priorities.pdf.
    \603\ This estimate is based on the following calculation: 8,368 
written agreements x 1.5 hours.
    \604\ This estimate is based on the following calculation: 
18,422 (hour burden to provide information to accountants) + 12,552 
(hour burden to provide information to Commission).
    \605\ This estimate is based on the following calculation: 
30,974 (internal annual burden hours) x $394 (blended rate for a 
compliance manager ($361) and a compliance attorney ($426)).
---------------------------------------------------------------------------

    The proposed rule would require that the written agreement with the 
qualified

[[Page 14764]]

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), 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.\606\ We estimate that the average burden for custodians to 
provide quarterly financial statements to advisers is limited. Because 
qualified custodians are already sending quarterly account statements 
to clients,\607\ we estimate that one additional burden incurred would 
be in connection with qualified custodians adding advisers to their 
distribution lists. We estimate this would aggregate approximately 
14,385 hours in initial burden hours.\608\ We estimate that this 
initial internal burden equates to an initial internal monetized cost 
burden of approximately $4,869,322.50.\609\
---------------------------------------------------------------------------

    \606\ Proposed rule 223-1(a)(1)(i)(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 custody rule 206(4)-2(a)(3).
    \607\ See custody rule 206(4)-2(a)(3).
    \608\ 15 hours (development of distribution list) x 959 
(estimated number of qualified custodians). We believe that any 
ongoing annual burden in connection with this requirement would be 
de minimis.
    \609\ This estimate is based on the following calculation: 
14,385 hours (estimated internal hour burden of preparing and 
distributing quarterly account statements) x $338.50 (blended rate 
for a programmer $316 and a compliance manager $361)).
---------------------------------------------------------------------------

    We also believe that this proposed rule would result in a small 
additional burden in terms of modifications to quarterly statements 
related to including, at the client's request, information related to 
assets not maintained by the qualified custodian,\610\ customizing the 
statements for any client that requests such assets to be included, and 
adding language that identifies those assets.\611\ We estimate this 
would aggregate approximately 959 hours annually.\612\ We estimate that 
this annual internal burden equates to an annual internal monetized 
cost burden of approximately $324,621.50.\613\
---------------------------------------------------------------------------

    \610\ See proposed rule 223-1(a)(1)(i)(B) (``Such account 
statements shall not identify assets for which the qualified 
custodian lacks possession or control, unless requested by the 
client and the qualified custodian clearly identifies any such 
assets that appear on the account statement'').
    \611\ See id. Since custodians are aware of the assets for which 
they are providing accommodation reporting, we believe that the 
custodian's removal of current accommodation reporting will be de 
minimis.
    \612\ 1 hour (modifications to account statements) x 959 
(estimated number of qualified custodians).
    \613\ This estimate is based on the following calculation: 959 
hours (estimated internal hour burden of preparing and distributing 
quarterly account statements) x $338.50 (blended rate for a 
programmer $316 and a compliance manager $361)).
---------------------------------------------------------------------------

    As discussed above, the proposed rule would require the written 
agreement to contain a provision requiring the qualified custodian, at 
least annually, to obtain and provide to the adviser a written internal 
control report that includes an opinion of an independent public 
accountant.\614\ We estimate that approximately 959 qualified 
custodians \615\ would have to obtain an internal control report 
relating to custodial services, and would have to provide the report to 
the adviser. We understand that the cost to prepare an internal control 
report relating to custody would vary based on the size and services 
offered by the qualified custodian, but that on average an internal 
control report would cost approximately $750,000 per year.\616\ We 
believe that 95% of custodians currently obtain internal control 
reports, and, therefore, estimate total aggregate monetized costs 
attributable to this section of the proposed rule to be $35,962,500 
annually.\617\
---------------------------------------------------------------------------

    \614\ Proposed rule 223-1(a)(1)(i)(C).
    \615\ This estimate was obtained by the following calculation: 
8,724 (advisers reporting that they have custody)/600 (total number 
of custodians reported in Form ADV Part 1A, Question 9.F. = 14.54 
(mathematical average number of advisers served by each custodian 
obtained solely for the purpose of performing the calculation); 
13,944 (advisers that we estimate would have to comply with the 
proposed rule)/14.54 (average number of advisers served by each 
custodian) = 959.
    \616\ We recognize, however, that as a result of the proposed 
rule's expansion to cover all assets, rather than funds and 
securities, the internal control reports currently obtained by 
qualified custodians may not fully reflect the type of report that 
would be obtained under the proposed rule.
    \617\ This estimate is based on the following calculation: 959 
(estimated number of qualified custodians operating under written 
agreements) x $750,000 (average cost of obtaining internal control 
report) x 5% (percent of custodians that we estimate are not 
currently obtaining internal control reports).
---------------------------------------------------------------------------

b. Reasonable Assurances
    The proposed rule would require an adviser to obtain reasonable 
assurances in writing from a qualified custodian regarding certain 
client protections.\618\ As discussed above, one way that advisers are 
likely to satisfy this requirement is by seeking confirmation from a 
qualified custodian that the custodial agreement with the advisory 
client contains contractual language reflecting the reasonable 
assurances required by the rule. We estimate the amount of time it 
would take an adviser to request, and a qualified custodian to provide, 
information necessary to satisfy this requirement to be approximately 
15 minutes, and we expect that any related changes a qualified 
custodian makes to a custodial agreement to reflect the reasonable 
assurances provided to the adviser would take approximately 1 hour. We 
believe this exchange is most likely to occur in the context of the 
negotiation and execution of the written agreement. Therefore, we 
estimate that the initial aggregate time burden for this collection of 
information would amount to 69,720 hours.\619\ We believe that the 
initial monetized costs imposed by the proposed rule approximate 
$27,469,680.\620\ We believe that most custodial agreements change very 
little from year to year, and therefore, we estimate the total annual 
internal hour burden to be 13,944.\621\ We believe that the monetized 
costs imposed by the proposed rule would approximate $5,493,936 
annually.\622\
---------------------------------------------------------------------------

    \618\ Proposed rule 223-1(a)(1)(ii).
    \619\ 1.25 hours x 55,776 written agreements.
    \620\ 69,720 hours (estimated initial internal hour burden) x 
$394 (blended rate for a compliance manager ($361) and a compliance 
attorney ($426)).
    \621\ 55,776 written agreements x .25 hours.
    \622\ 13,944 (estimated annual internal hour burden) x $394 
(blended rate for a compliance manager ($361) and a compliance 
attorney ($426)).
---------------------------------------------------------------------------

2. Notice to Clients
    The proposed rule, like the current rule, would require an 
investment adviser to notify its client in writing promptly upon 
opening an account with a qualified custodian on its behalf.\623\ The 
notice is designed to alert a client to the existence of the qualified 
custodian that maintains possession or control of client assets and 
whom to contact regarding such assets. One change from the current rule 
is that the proposed rule would explicitly require that the notice 
include the custodial account number, an important detail that is not 
required under the current rule. However, we do not believe including a 
custodial account number to the notice would significantly impact the 
costs incurred by advisers as they are already required to provide a 
nearly identical notice under the current rule. Therefore, we estimate 
that the initial burden of updating their processes and systems to 
ensure account numbers are included in the relevant notices is 1 hour 
with a total estimated monetized cost of $4,720,044.\624\
---------------------------------------------------------------------------

    \623\ See proposed rule 223-1(a)(2).
    \624\ The initial burden hours are calculated as follows (14,204 
advisers with discretionary authority--260 advisers to investment 
company clients in response to Form ADV Item 5.D.(1)(d) = 13,944 
advisers) x 1 hour x blended rate for a compliance manager ($361) 
and a programmer ($316) = $338.50) = $4,720,044.

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

[[Page 14765]]

3. Annual Surprise Examination
    The proposed safeguarding rule does not change the current rule's 
annual surprise exam requirement, but changes to other portions of the 
rule that expand the application of the rule to certain advisers or 
that provide exceptions to the surprise exam requirement would impact 
the number of advisers subject to this requirement if adopted. The 
current rule requires each registered investment adviser that has 
custody of client funds or securities to undergo an annual surprise 
examination by an independent public accountant to verify client assets 
pursuant to a written agreement with the accountant that specifies 
certain duties. We estimate that 1,842 advisers would be subject to the 
surprise examination requirement upon its redesignation under the 
proposal.\625\
---------------------------------------------------------------------------

    \625\ Based on data from the Investment Adviser Registration 
Depository (``IARD'') of the advisers that report having discretion, 
of the 1,842 advisers indicated in response to Item 9.C.(3) that an 
independent public accountant conducts an annual surprise 
examination of client funds and securities. The calculations in this 
section regarding the annual surprise exam represent information as 
of June 2022 and incorporate Form ADV filings received through the 
(IARD) through August 31, 2022.
---------------------------------------------------------------------------

    For purposes of estimating the collection of information burden, we 
have divided the estimated 1,842 advisers into three subgroups. First, 
we estimate that 381 advisers have custody because they serve as 
qualified custodians for their clients, or they have a related person 
that serves as qualified custodian for clients, in connection with 
advisory services the adviser provides to the clients.\626\ We estimate 
that these advisers are subject to an annual surprise examination with 
respect to 100 percent of their clients (or 9,006 clients per adviser) 
based on the assumption that all of their clients maintain custodial 
accounts with the adviser or its related person.\627\ We estimate that 
each adviser will spend an average of 0.02 hours for each client to 
create a client contact list for the independent public accountant. The 
estimated total annual aggregate burden with respect to the surprise 
examination requirement for this group of advisers is 68,626 
hours.\628\
---------------------------------------------------------------------------

    \626\ Based on IARD data, 381 advisers indicated that an 
independent public accountant prepares an internal control report 
because the adviser or its affiliate acts as a qualified custodian 
(in response to Item 9.C.(4)). Similarly, 76 advisers indicated that 
they act as a qualified custodian (in response to Item 9.D.(1), and 
321 advisers indicated that their related person(s) act as qualified 
custodian(s) (in response to Item 9.D.(2)). 76 + 321 = 397.
    \627\ We base our estimate on IARD data of the average number of 
clients of all the advisers that will be subject to the surprise 
examination requirement under the rule. To derive our estimate, we 
utilized the winsorization method, by setting all values for 
advisers (above the 99th percentile of number of clients) at the 
number of clients at the 99th percentile. The method lessens the 
effect of outliers on client estimates.
    \628\ 381 advisers x 9,006 (average number of clients subject to 
the surprise examination requirement) x 0.02 hour = 68,626 hours.
---------------------------------------------------------------------------

    The second group of advisers, estimated at 835, are those that have 
custody because they have broad authority to access client assets held 
at an independent qualified custodian, such as through a power of 
attorney or acting as a trustee for a client's trust.\629\ Based on our 
staff's experience, advisers that have access to client assets through 
a power of attorney, acting as trustee, or similar legal authority 
typically do not have access to all of their client accounts, but 
rather only to a small percentage of their client accounts pursuant to 
these special arrangements. We estimate that these advisers will be 
subject to an annual surprise examination with respect to 5 percent of 
their clients (or 450 clients per adviser) who have these types of 
arrangements with the adviser.\630\ We estimate that each adviser will 
spend an average of 0.02 hours for each client to create a client 
contact list for the independent public accountant. The estimated total 
annual aggregate burden with respect to the surprise examination 
requirement for this group of advisers is 7,515 hours.\631\
---------------------------------------------------------------------------

    \629\ This estimate is based on the total number of advisers 
subject to surprise examinations less those described above in the 
first group (custody as a result of serving as, or having a related 
person serving as, qualified custodian) less those described below 
in the third group (custody as a result of solely managing private 
funds). (1,842-381)-626 = 835 advisers.
    \630\ Based on the IARD data, we estimate that the average 
number of clients of advisers subject to the surprise examination 
requirement is 9,006. 9,006 x 0.05 = 450 clients per adviser.
    \631\ 835 advisers x 450 clients x 0.02 hours = 7, 515 hours.
---------------------------------------------------------------------------

    A third group of advisers provides advice to pooled investment 
vehicles that are not undergoing an annual audit and therefore would 
undergo the surprise examination with respect to those pooled 
investment vehicle clients. Based on current IARD data, we estimate 
that 626 advisers manage private funds and undergo surprise 
examinations.\632\ We estimate that each adviser managing private funds 
has an average of 6 pooled investment vehicle clients with an average 
of 14 investors. We estimate that advisers to these pooled investment 
vehicles will spend 1 hour for the pool and 0.02 hours for each 
investor in the pool to create a contact list for the independent 
public accountant, for an estimated total annual burden with respect to 
the surprise examination requirement for these advisers of 4,808 
hours.\633\
---------------------------------------------------------------------------

    \632\ Based on IARD data, we estimate that 626 advisers manage 
private funds and undergo a surprise examination (responses to Items 
7.B. and 9.C.(3)).
    \633\ ((626 advisers x 6 pools) x 1 hour = 3,756 hours) + ((626 
x 6 pools x 14 investors) x .02 hours = 1,052 hours) = 4,808 hours.
---------------------------------------------------------------------------

    These estimates bring the total annual aggregate burden with 
respect to the surprise examination requirement for all three groups of 
advisers to 80,949 hours.\634\ This estimate does not include the 
collection of information discussed below relating to the written 
agreement required by paragraph (a)(4) of the rule.
---------------------------------------------------------------------------

    \634\ 68,626 hours + 7,515 hours + 4,808 hours = 80,949 hours.
---------------------------------------------------------------------------

    Related to the surprise exam, the current custody rule and the 
redesignated safeguarding rule require that an adviser subject to the 
surprise examination requirement must enter into a written agreement 
with the independent public accountant engaged to conduct the surprise 
examination and specify certain duties to be performed by the 
independent public accountant.\635\ We estimate that each adviser will 
spend 0.25 hour to add the required provisions to the written 
agreement, with an aggregate of approximately 461 hours for all 
advisers that undergo surprise examinations.\636\ Therefore the total 
annual burden in connection with the surprise examination is estimated 
at 81,410 hours under the rule.\637\ We estimate the monetized burden 
related to the surprise exam is $27,623,345.\638\
---------------------------------------------------------------------------

    \635\ Compare 17 CFR 275.206(4)-2(a)(4) with proposed rule 223-
1(a)(4).
    \636\ 1,842 advisers would be required to obtain a surprise 
examination x 0.25 = 461.
    \637\ 80,949 exam hours + 461 written agreement hours = 81,410 
hours.
    \638\ 80,949 exam hours x $338.50 (blended rate for a compliance 
manager ($361) and a programmer ($316) = $339) + 461 written 
agreement hours x $394 (blended rate for a compliance manager ($361) 
and a compliance attorney ($426) = $393.50) to amend the written 
agreement = $27,623,345.
---------------------------------------------------------------------------

C. Exceptions

    The proposal contains several exceptions that will result in a new 
``collection of information'' requirement within the meaning of the PRA 
and would have an impact on the current collection of information 
burdens of rule 206(4)-2. These exceptions are discussed below.
1. Certain Assets That Are Unable To Be Maintained With a Qualified 
Custodian
    We are proposing 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 if the

[[Page 14766]]

ownership of such assets cannot be recorded and maintained (book-entry, 
digital, or otherwise) in a manner in which a qualified custodian can 
maintain possession or control of such assets. This exception will 
allow advisers who service client accounts containing such assets to 
either safeguard the assets themselves or engage another entity to 
safeguard the assets subject to certain safeguarding requirements 
discussed below. For the purpose of approximating the average burden 
for advisers to comply with the collections of information that would 
be created by this exception, we estimate that 4,961 advisers currently 
have custody of privately offered securities and physical assets that 
cannot be maintained with a qualified custodian.\639\
---------------------------------------------------------------------------

    \639\ Based on IARD data, 4,961 advisers with custody of client 
assets provided advice to pooled investment vehicles as of June 30, 
2022. We believe that this number is overinclusive of some number of 
advisers solely to funds that do not hold privately offered 
securities or physical assets. But we also believe that there may be 
a small number of advisers who are not advisers to pooled investment 
vehicles who have client assets that would be subject to the 
exception. We believe that the estimate is reasonable based on the 
data available.
---------------------------------------------------------------------------

(a) Written Agreement With Independent Public Accountant
    An adviser relaying on the proposed exception would be required to 
enter into a written agreement with an independent public accountant 
that specifies certain obligations of the accountant.\640\ We assume 
that many advisers will amend agreements that they have with 
accountants to perform other accounting services for the adviser, such 
as a surprise examination, while some number of advisers will enter 
into new agreements with accountants to perform the services required 
by the proposed rule. On average, we estimate that each adviser will 
spend 1.25 hours, initially, to prepare the written agreement with an 
accountant. In the aggregate, we estimate that advisers will spend 
6,201 hours, initially, to enter into these agreements.\641\ We 
estimate the aggregate initial monetized cost burden to equal 
$2,443,194.\642\
---------------------------------------------------------------------------

    \640\ See proposed rule 223-1(b)(2)(iii).
    \641\ 4,961 (estimated number of advisers with custody of 
privately offered securities and physical assets that cannot be 
maintained with a qualified custodian under the proposed rule) x 
1.25 hours.
    \642\ 6,201 (estimated internal hour burden) x $394 (blended 
rate for a compliance manager ($361) and a compliance attorney 
($426)).
---------------------------------------------------------------------------

    We believe that these agreements will change minimally from year to 
year and, therefore, estimate that advisers will spend approximately 
2,481 aggregate hours annually amending these agreements or entering 
into new agreements.\643\ The related total monetized cost burden for 
these amendments would equal $977,514.\644\
---------------------------------------------------------------------------

    \643\ This estimate is based on the following calculation: 4,961 
(estimated number of advisers with custody of privately offered 
securities and physical assets that cannot be maintained with a 
qualified custodian under the proposed rule) x .5 hours (estimate of 
average amount of time to amend agreement).
    \644\ 2,481 (estimated internal hour burden) x $394 (blended 
rate for a compliance manager ($361) and a compliance attorney 
($426)).
---------------------------------------------------------------------------

(b) Notice to Accountant
    The proposed rule would require the adviser to notify the 
accountant of any purchase, sale, or other transfer of beneficial 
ownership of such assets within one business day.\645\ As discussed in 
section II.C.4, above, we believe that this notice would likely be 
provided by the adviser in connection with the closing of a 
transaction, and could be provided to the accountant without much 
additional effort beyond that required in connection with the closing 
of the transaction. We estimate that this notice would take advisers 
approximately one minute to deliver to the accountant. We also estimate 
that advisers will send 8,000 of these notices annually.\646\ 
Accordingly, we estimate that these notices will take advisers 
approximately 133 hours \647\ in the aggregate to send annually with an 
annual monetized cost of $48,013.\648\
---------------------------------------------------------------------------

    \645\ See proposed rule 223-1(b)(2)(iv).
    \646\ This estimate is based on a review of a number of sources 
of private equity transaction data in and prior to 2021. See 
generally, S&P Global Market Intelligence, 2022 Global Private 
Equity Outlook (Apr. 20, 2022), available at https://www.spglobal.com/marketintelligence/en/news-insights/research/2022-global-private-equity-outlook (``2021 was a record year for the PE 
industry as investment activity surpassed the trillion-dollar mark 
for the first time. In total, 24,520 deals globally were closed, 
with an aggregate deal value worth $1.04 trillion, nearly double the 
amount from the year before. At the same time, deal volume grew by 
41.6% over 2020, proving that investors' predictions of improved 
deal-making in 2021 came to fruition.''); Pitchbook, Data, Inc., 
2021 Annual US PE Breakdown, (Jan. 11, 2022), available at https://pitchbook.com/news/reports/2021-annual-us-pe-breakdown (``At over 
8,600, [U.S.] deal count topped 2019's record by 50%.''); Statista, 
Global private equity (PE) activity from 2002 to 2021 (Mar. 30, 
2022) available at https://www.statista.com/statistics/1292230/private-equity-deal-activity-worldwide/ (``2021 was a record-
breaking year for private equity (PE) activity worldwide. Investment 
activity grew nearly twofold compared to 2020, and reached a value 
of nearly 1.2 trillion U.S. dollars from 2,616 private equity 
deals.''); Bain & Co., The Private Equity Market in 2021: The Allure 
of Growth (Mar. 7, 2022), available at https://www.bain.com/insights/private-equity-market-in-2021-global-private-equity-report-2022/ (``While the number of individual [buyout] deals jumped to 
nearly 4,300 in 2021, up 16% from 2020 levels, that doesn't explain 
the extraordinary growth in capital deployed.''). The estimate takes 
into account the increasing trend in transaction volume over the 
past few years, but also takes into account that registered advisers 
are responsible for only a portion of these total global and total 
U.S. transactions.
    \647\ 8,000 (estimated annual transactions)/60 minutes (based on 
estimate of one minute per notice).
    \648\ 133 (estimated number of hours) x $361 compliance manager.
---------------------------------------------------------------------------

(c) Accountant Verification
    The written agreement would require the independent public 
accountant to verify the purchase, sale, or other transfer promptly 
upon receiving the required transfer notice. As discussed in section 
II.C.4, above, we believe the verification process would vary 
considerably depending on the asset involved. Based on our estimate of 
8,000 transactions under the proposed exception annually, we believe 
that these verifications will result in an aggregate monetized cost 
burden to advisers of $21,000,000 annually.\649\
---------------------------------------------------------------------------

    \649\ 8,000 (estimated number of annual transactions) x 15 hours 
(estimated average time to verify a transaction) x $175 (blended 
rate for intermediate accountant ($200), a general accounting 
supervisor ($252), and general clerk ($73)). The proposed rule 
requires that an accountant report to the Commission any material 
discrepancies and our estimate for those notices is included in the 
estimated average time to verify a transaction.
---------------------------------------------------------------------------

(d) All Assets Verified During Surprise Examination or Annual Audit
    The proposed rule would require that the existence and ownership of 
each privately offered security or physical asset of a client that is 
not maintained with a qualified custodian to be verified during an 
adviser's annual surprise examination or financial statement audit 
under the audit provision.\650\ We estimate that 95 percent of advisers 
relying on this exception, or 4,713 advisers,\651\ will obtain a 
financial statement audit and 5 percent of advisers, or 248 advisers, 
will obtain surprise examinations.\652\ For advisers obtaining an audit 
under the audit provision, we estimate the aggregate annual cost of 
asset verification to be $282,780,000.\653\ We estimate the

[[Page 14767]]

aggregate annual cost of asset verification for all assets during a 
surprise examination to be $40,176,000.\654\ In sum, the total annual 
monetized collection of information burden related to the exception for 
privately offered securities and physical assets is $322,956,000.\655\
---------------------------------------------------------------------------

    \650\ See proposed rule 223-1(b)(2)(v).
    \651\ 4,961 (advisers relying on exception)/95% (estimated 
number of advisers relying on the exception obtaining audits) = 
4,713.
    \652\ 4,961 (advisers relying on exception)/5% (estimated number 
of advisers relying on the exception obtaining surprise exams) = 
248.
    \653\ 4,713 (estimated number of advisers subject to the 
exception relying on the audit provision) x $60,000 (additive 
estimated cost of audit). The additive costs to the audit (and 
surprise examination) of full asset verification are mitigated by 
proposed rule 223-1(b)(2)(iii), which requires an accountant to 
verify any purchase, sale, or other transfer of beneficial ownership 
of assets subject to the exception promptly after receipt of notice 
from the adviser. The extent of this mitigation is hard to estimate 
with certainty. We estimate that all asset verification will 
approximately double the cost of an audit, estimated at $60,000 per 
audit. See infra section IV.C.2.
    \654\ 248 (estimated number of advisers subject to the 
exception) x $162,000. We previously estimated that advisers subject 
to the surprise examination with respect to 100 percent of their 
clients will each spend an average of approximately $162,000 
annually. As with the cost of an audit, we estimate that full asset 
verification will approximately double the cost of the surprise 
examination.
    \655\ $282,780,000 + $40,176,000.
---------------------------------------------------------------------------

2. Audit Provision
    The proposed rule would expand the availability of the audit 
provision from limited partnerships, limited liability companies, and 
other types of pooled investment vehicle clients to any advisory client 
entity whose financial statements are able to be audited. Advisers that 
seek to comply with the audit provision would be required to deliver, 
promptly after the completion of the audit, the financial statements of 
the entity to all investors.
    The collection of information burden imposed on an adviser relating 
to the distribution of audited financial statements to each investor in 
a client entity that the adviser manages should be minimal, as the 
financial statements could be included with account statements or other 
mailings or delivered electronically. Based on our experience with the 
audit provision in the current custody rule, we have estimated 
previously that the average burden for advisers to deliver audited 
financial statements to investors in the client entity is 1 minute per 
investor.\656\ Based on our estimate of the number of advisers to 
audited pooled investment vehicles,\657\ with an adjustment for our 
expectation that an increasing number of advisers will obtain audits of 
client entities,\658\ we estimate that the aggregate annual hour burden 
in connection with the distribution of audited financial statements is 
7,098 hours,\659\ and there would be an annual cost of this internal 
hour burden of $1,242,150.\660\
---------------------------------------------------------------------------

    \656\ 2009 Adopting Release, supra note 11.
    \657\ Based on IARD data as of June 30, 2022, 4,961 advisers 
with custody of client assets provided advice to pooled investment 
vehicles. We estimate that each adviser has an average of 6 pooled 
investment vehicle clients with an average of 14 investors.
    \658\ Because the proposed rule expands the types of entities 
that can obtain an audit (i.e., is not limited to pooled investment 
vehicles as in the current rule), we expect that an increasing 
number of advisers will seek to comply with the proposed rule by 
obtaining an audit. To estimate the number of entities that may 
utilize the expanded availability of the audit provision, we 
selected the following categories of clients with custody based on 
IARD data as of June 30, 2022: Investment advisers with custody that 
have pension and profit sharing plan clients: 3,068 (Average number 
of pension and profit sharing clients: (6); Investment advisers with 
custody that have charitable organization clients: 3,205 (Average 
number of charitable organization clients: (3); Investment advisers 
with custody that have state or municipal government entity clients: 
986 (Average number of state or municipal government entity clients: 
(3); Investment advisers with custody that have corporations and 
other business entity clients: 3,025 (Average number of corporations 
and other business entity clients: (5). We estimate that 20% of 
advisers to these categories of clients will utilize the expanded 
availability of the audit provision.
    \659\ (4,961 advisers to pooled investment vehicles x 6 pooled 
investment vehicle clients x 14 investors x 1 minute)/60 minutes = 
6,945 hours; (3,068 advisers to pension and profit sharing clients x 
20% x 6 clients x 1 minute)/60 minutes = 61 hours; (3,205 advisers 
to charitable organization clients x 20% x 3 clients x 1 minute)/60 
minutes = 32 hours; (986 advisers to state or municipal government 
entity clients x 20% x 3 clients x 1 minute)/60 minutes = 10 hours; 
(3,025 advisers to corporations and other business entity clients x 
20% x 5 clients x 1 minute)/60 minutes = 50 hours; 6,945 hours + 61 
hours +32 hours +10 hours +50 hours = 7,098 hours.
    \660\ This estimate is based on the following calculation: 7,098 
hours x $175 (blended rate for an intermediate accountant ($200), a 
general accounting supervisor ($252), and a general clerk ($73).
---------------------------------------------------------------------------

    The proposed rule would require an adviser or the client entity to 
enter into a written agreement with the independent public accountant 
to ensure that the independent public accountant that audits the client 
entity notifies the Commission (i) within one business day of issuing 
an audit report to the entity that contains a modified opinion and (ii) 
within four business days of resignation or dismissal from, or other 
termination of, the engagement, or upon removing itself or being 
removed from consideration for being reappointed.\661\ We assume that, 
regardless of whether the adviser or the client entity enters into the 
written agreement, the accountant would incur the hour burden of 
preparing the agreement. We also assume that, if the client entity was 
party to the agreement, the client entity would delegate the task of 
reviewing the agreement to the adviser. This estimate also assumes that 
the adviser would enter into a separate agreement for each client 
entity, even if multiple client entities use the same auditor. We 
believe that written agreements are commonplace and reflect industry 
practice when a person retains the services of a professional such as 
an accountant, and they are typically prepared by the independent 
public accountant in advance. We therefore estimate that each adviser 
will initially spend 1.25 hours to add the required provisions to, or 
confirm that the required provisions are in, the written agreement, 
with an initial aggregate of 48,735 hours \662\ for all advisers that 
satisfy the requirements of the audit engagement. We further estimate 
that each adviser will spend 0.92 hours \663\ on an annual basis to 
reassess current written agreements and execute new agreements as an 
adviser adds entity clients for an annual aggregate of 35,869 hours 
\664\ and an annual cost of this internal hour burden of $19,476,867 
\665\ for all advisers that satisfy the requirements of the audit 
provision.
---------------------------------------------------------------------------

    \661\ Proposed rule 223-1(b)(4)(v).
    \662\ 4,961 advisers to pooled investment vehicles x 6 pooled 
investment vehicle clients = 29,766 client written agreements; 3,068 
advisers to pension and profit sharing clients x 20% x 6 clients = 
3,682 client written agreements; 3,205 advisers to charitable 
organization clients x 20% x 3 clients = 1,923 client written 
agreements; 986 advisers to state or municipal government entity 
clients x 20% x 3 clients = 592 client written agreements; 3,025 
advisers to corporations and other business entity clients x 20% x 5 
clients = 3,025 client written agreements; (29,766 + 3,682 + 1,923 + 
592 + 3,025) x 1.25 hours per agreement = 48,735 hours.
    \663\ This includes the internal initial burden estimate 
amortized over a three-year period (1.25 hours/3 years) and another 
0.5 hours of additional ongoing burden hours = 0.92 hours.
    \664\ (29,766 + 3,682 + 1,923 + 592 + 3,025) x 0.92 hours per 
ongoing annual burden = 35,869 hours.
    \665\ This estimate is based on the following calculation: 
35,869 hours x $543 (rate for assistant general counsel).
---------------------------------------------------------------------------

D. Total Hour Burden Associated With Proposed Rule 223-1

    Accordingly, we estimate investment advisers that would be subject 
to the proposed rule would incur a total annual hour burden resulting 
from the collections of information discussed above of approximately 
398,152 hours,\666\ at a time cost of $154,579,839.\667\ The total 
external burden costs would be $378,598,500.\668\
---------------------------------------------------------------------------

    \666\ This estimate is based upon the following calculations: 
111,552 + 9,482 + 12,552 + 18,422 + 14,385 + 959 + 69,720 + 13,944 + 
6,201 + 2,481 + 133 + 13,944 + 80,949 + 461 + 7,098 + 35,869 hours = 
398,152 hours.
    \667\ This estimate is based upon the following calculations: 
$43,951,488 + $3,735,908 + $12,203,756 + $4,869,322.50 + $324,621.50 
+ $27,469,680 + $5,493,936 + $4,720,044 + $27,623,345 + $2,443,194 + 
$977,514 + $48,013 + $1,242,150 + $19,476,867 = $154,579,839.
    \668\ This estimate is based upon the following calculations: 
$35,962,500 + $19,680,000 + $322,956,000 = $378,598,500.
---------------------------------------------------------------------------

    A chart summarizing the various proposed components of the total 
annual burden for investment advisers with custody of client assets is 
below.

[[Page 14768]]



----------------------------------------------------------------------------------------------------------------
   Rule 223-1 description of new                                                                External burden
            requirements                    Number of responses         Internal burden hours        costs
----------------------------------------------------------------------------------------------------------------
                      Final Estimates for Qualified Custodian Protections Under 223-1(a)(1)
----------------------------------------------------------------------------------------------------------------
Initial burden for drafting,         55,776 (4 per adviser with        111,552 (2 per
 negotiating, and executing new       custody).                         response).
 written custodial agreements with
 required provisions between the
 adviser and qualified custodian
 (``QC'') (IA-QC custodial
 contract).
Annual burden for drafting,          55,776 (4 per adviser with        9,482 (.17 hour per
 negotiating, and executing new       custody).                         response).
 written custodial agreements with
 required provisions between the
 adviser and qualified custodian
 (IA-QC custodial contract).
Annual burden for QC to provide      8,368 (4 per adviser examined)..  12,552 (1.5 hour per
 records relating to clients'                                           response).
 assets to the Commission *.
* This is not broken up into
 initial and ongoing burden because
 the annual burden is estimated to
 be the same each year.
Annual burden for QC to provide      36,844 (4 per adviser obtaining   18,422 (.5 hour per
 records relating to clients'         a surprise examination or         response).
 assets to an independent public      audit).
 accountant *.
* This is not broken up into
 initial and ongoing burden because
 the annual burden is estimated to
 be the same each year.
Initial burden for QC to send        959 (estimated qualified          14,385 hours (15 hours
 account statements, at least         custodians).                      per qualified
 quarterly, to the client, or its                                       custodian).
 independent representative, and to
 adviser.
Annual burden for QC to modify and   959 (estimated qualified          959 (1 hour per
 send account statements.             custodians).                      qualified custodian).
Annual burden for QC to obtain       ................................  ......................        $35,962,500
 internal control report.
Initial burden for adviser           55,776 (1 per adviser)..........  69,720 (1.25 hours per
 obtaining reasonable assurances                                        response).
 from the QC.
Annual burden for adviser obtaining  55,776 (1 per adviser)..........  13,944 (.25 hours per
 reasonable assurances from the QC.                                     response).
----------------------------------------------------------------------------------------------------------------
  Final Estimates for Exceptions for Certain Assets that are Unable to be Maintained with a Qualified Custodian
                                                Under 223-1(b)(2)
----------------------------------------------------------------------------------------------------------------
Initial burden for written           4,961 (estimated number of        6,201 (1.25 hours per
 agreement with independent public    advisers with custody of          adviser).
 accountant (IPA).                    privately offered securities
                                      and physical assets that cannot
                                      be maintained with a qualified
                                      custodian under the proposed
                                      rule).
Annual burden for written agreement  4,961...........................  2,481 (.5 hour per
 with IPA.                                                              adviser).
Annual burden to notify the IPA of   8,000 (estimated number of        133 hours (1 minute
 any purchase, sale, or other         annual transactions).             per transaction).
 transfer of beneficial ownership
 of such assets within one business
 day.
Annual burden to verify the          ................................  ......................        $19,680,000
 purchase, sale, or other transfer
 promptly upon receiving the
 required transfer notice *.
* This does not contain an internal
 burden estimate because the burden
 under this requirement is solely
 an external monetary burden.
Annual burden to verify all assets   ................................  ......................       $322,956,000
 during a surprise exam or an
 annual audit *.
* This does not contain an internal
 burden estimate because the burden
 under this requirement is solely
 an external monetary burden.
----------------------------------------------------------------------------------------------------------------
                   Final Estimates for Complying with the Notice Requirement Under 223-1(a)(2)
----------------------------------------------------------------------------------------------------------------
Initial burden for complying with    13,944 advisers (1 per adviser).  13,944 hours (1 hour
 the notice requirement*.                                               per adviser ).
* This would be a one-time burden
 to include account numbers in the
 notices.
----------------------------------------------------------------------------------------------------------------
             Final Estimates for Independent Verification or Surprise Examination Under 223-1(a)(4)
----------------------------------------------------------------------------------------------------------------
Annual burden for complying with     1,842 advisers are subject to     80,949 hours \1\......
 the independent verification/        the surprise exam.
 surprise examination of client
 assets by an IPA under a written
 agreement between the IPA and the
 adviser *.
* This is not broken up into
 initial and ongoing burden because
 the annual burden is estimated to
 be the same each year.

[[Page 14769]]

 
Annual burden to enter into a        1,842 advisers..................  461 hours (.25 per
 written agreement with an IPA                                          adviser).
 engaged to conduct the surprise
 examination and specify certain
 duties to be performed by the
 independent public accountant *.
* This is not broken up into
 initial and ongoing burden because
 the annual burden is estimated to
 be the same each year.
----------------------------------------------------------------------------------------------------------------
                         Exception for Entities Subject to the Annual Audit 223-1(b)(4)
----------------------------------------------------------------------------------------------------------------
Annual burden for distributing       7,018 advisers..................  7,098 hours...........
 audited financial statements.
Annual burden for drafting,          7,018 advisers..................  35,869 hours..........
 negotiating, and executing the
 required written agreement between
 the IPA and adviser regarding
 notifications from the IPA to the
 Commission of specified events.
----------------------------------------------------------------------------------------------------------------
                                   TOTAL ESTIMATED FINAL BURDEN FOR RULE 223-1
----------------------------------------------------------------------------------------------------------------
Total estimated burden for rule 223- 319,856.........................  398,152 hours.........       $378,598,500
 1.
Currently approved burden for rule   24,133,429......................  288,202 hours.........       $174,367,000
 206(4)-2.
Comparison of proposed rule 223-1    (23,813,573)....................  109,950 hours.........       $204,231,500
 burdens to current rule 206(4)-2
 burdens.
----------------------------------------------------------------------------------------------------------------
Notes:
1. Advisers can be subject to the surprise exam for several reasons. For a more detailed breakout of the types
  of advisers and their respective burdens see section IV.B.3.

E. Rule 204-2

    Under section 204 of the Advisers Act, investment advisers 
registered or required to register with the Commission under section 
203 of the Advisers Act must make and keep for prescribed periods such 
records (as defined in section 3(a)(37) of the Exchange Act), furnish 
copies thereof, and make and disseminate such reports as the 
Commission, by rule, may prescribe as necessary or appropriate in the 
public interest or for the protection of investors. Rule 204-2 sets 
forth the requirements for maintaining and preserving specified books 
and records. This collection of information is found at 17 CFR 275.204-
2 and is mandatory. The Commission staff uses the collection of 
information in its examination and oversight program. As noted above, 
responses provided to the Commission in the context of its examination 
and oversight program concerning the proposed amendments to rule 204-2 
would be kept confidential subject to the provisions of applicable law.
    We are proposing amendments to rule 204-2 to correspond to proposed 
new rule 223-1. Specifically, we are proposing to require investment 
advisers to maintain the following records for client accounts: (1) 
client account identification, (2) custodian information, including 
copies of qualified custodian agreements with the adviser, a record of 
required reasonable assurances from the qualified custodian, and if 
applicable, a copy of the adviser's written reasonable determination 
that ownership of certain specified client assets cannot be recorded 
and maintained under a qualified custodian's possession or control, (3) 
the basis for the adviser having custody of client assets in the 
account, (4) any account statements received or sent by the adviser, 
(5) transaction and position information, and (6) any SLOAs and related 
records to verify that an adviser can avail itself of the proposed 
exception to the surprise examination requirement.\669\ The proposed 
amendments also would require an adviser to maintain copies of all 
written notices to clients required under proposed rule 223-1 and any 
responses thereto, and copies of documents relating to independent 
public accountant engagements.
---------------------------------------------------------------------------

    \669\ Proposed rule 204-2(b)(2)(vi).
---------------------------------------------------------------------------

    Each of these records would be required to be maintained in the 
same manner, and for the same period of time, as other books and 
records required to be maintained under rule 204-2(a). Specifically, 
investment advisers would be required to maintain and preserve these 
records in an easily accessible place for not less than five years from 
the end of the fiscal year during which the last entry was made on such 
record, the first two years in an appropriate office of the investment 
adviser. Requiring maintenance of these records would facilitate the 
Commission's ability to inspect and enforce compliance with proposed 
rule 223-1. The information generally is kept confidential.\670\
---------------------------------------------------------------------------

    \670\ See section 210(b) of the Advisers Act (15 U.S.C. 80b-
10(b)).
---------------------------------------------------------------------------

    The respondents to this collection of information are investment 
advisers registered or required to be registered with the Commission 
that have custody of client assets. As noted above, based on Form ADV 
filings, as of June 30, 2022, we estimate that 13,944 registered 
investment advisers would have custody of client assets under proposed 
rule 223-1 and would be subject to the proposed amendments to rule 204-
2.
    For the proposed retention of SLOAs and related records, however, 
we believe that not every adviser with custody of client assets will 
have clients that issue SLOAs. Thus, such advisers would not seek to 
rely on the proposed SLOA exception. Of the 13,944 advisers with 
custody of client assets, we estimate that approximately 20%, or 
approximately 2,789 advisers, will have clients that issue SLOAs. 
Because we believe that many such advisers already retain copies of 
client SLOAs in their books and records, in our view this particular 
collection of information requirement would have a negligible impact on 
them. As a result, we estimate that this collection of information will 
result in an increased burden of .25 hours for each adviser seeking to 
rely on the proposed SLOA exception. Therefore, we estimate that the 
annual total internal burden of retaining copies of, and records 
relating to, client SLOAs would be approximately 697.25 hours,\671\ 
represented by a monetized cost of $57,174.50.
---------------------------------------------------------------------------

    \671\ This estimate is based on the following calculation: .25 
hours per adviser x 2,789 advisers.
---------------------------------------------------------------------------

    The approved annual aggregate burden for rule 204-2 is currently

[[Page 14770]]

2,764,563 hours, based on an estimate of 13,724 registered advisers, or 
201.44 hours per registered adviser.\672\ For the proposed 
recordkeeping amendments that correspond to proposed changes to the 
custody rule as discussed in this release, we estimate that the 
proposed amendments would result in an increase in the collection of 
information burden estimate by 21 hours for each of the estimated 
13,944 registered advisers with custody of client assets. We, 
therefore, estimate that the revised annual aggregate hourly burden for 
rule 204-2 would be 3,347,352 hours, represented by a monetized cost of 
$217,333,279 based on an estimate of 15,160 registered advisers, of 
which we estimate 13,944 would have custody of client assets under the 
proposed rule. This represents an increase of 582,789 \673\ annual 
aggregate hours in the hour burden and an annual monetized cost 
increase of $41,352,853 from the currently approved total aggregate 
monetized cost for rule 204-2.\674\ These increases are attributable to 
a larger registered investment adviser population since the most recent 
approval and adjustments for inflation, as well as the proposed rule 
204-2 amendments as discussed in this proposing release.
---------------------------------------------------------------------------

    \672\ 2,764,563 hours/13,724 registered advisers = 201.44 hours 
per adviser.
    \673\ 3,347,352 hours-2,764,563 hours = 582,789 hours.
    \674\ $217,333,279-$175,980,426 = $41,352,853.
---------------------------------------------------------------------------

    A chart summarizing the various components of the total annual 
burden for investment advisers with custody of client assets is below.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                                Annual
                                               Internal hour                              Wage rate \1\                     Internal time      external
                                                   burden                                                                       costs        cost burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                Final Estimates for Rule 204-2 for Client Communications
--------------------------------------------------------------------------------------------------------------------------------------------------------
Retention of written client notifications                    3      x   $82 (compliance clerk)..........................               $246  ...........
 and responses.
                                            ------------------------------------------------------------------------------------------------------------
    Total burden per adviser...............                  3  ......  ................................................               $246  ...........
    Total number of affected advisers......           x 13,944  ......  ................................................           x 13,944  ...........
                                            ------------------------------------------------------------------------------------------------------------
        Sub-total burden...................             41,832  ......  ................................................         $3,430,224  ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                   Final Estimates for Rule 204-2 for Client Accounts
--------------------------------------------------------------------------------------------------------------------------------------------------------
Creation and retention of records                            2      x   $73 (general clerk).............................               $146
 documenting client account identifying
 information, including adviser
 discretionary authority.
                                                             1      x   $82 (compliance clerk)..........................                $82  ...........
                                            ------------------------------------------------------------------------------------------------------------
    Total burden per adviser...............                  3  ......  ................................................               $228  ...........
    Total number of affected advisers......           x 13,944  ......  ................................................           x 13,944  ...........
                                            ------------------------------------------------------------------------------------------------------------
        Sub-total burden...................             41,832  ......  ................................................         $3,179,232  ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Creation and retention of records                            2      x   $73 (general clerk).............................               $146  ...........
 documenting custodian identifying
 information corresponding to each client
 account, including copies of qualified
 custodian agreements with adviser, a
 record of required reasonable assurances
 from the qualified custodian, and if
 applicable, a copy of the adviser's
 written reasonable determination that
 ownership of certain specified client
 assets cannot be recorded and maintained
 under a qualified custodian's possession
 or control.
                                                             1      x   $82 (compliance clerk)..........................                $82  ...........
                                            ------------------------------------------------------------------------------------------------------------
    Total burden per adviser...............                  3  ......  ................................................               $228  ...........
    Total number of affected advisers......           x 13,944  ......  ................................................           x 13,944  ...........
                                            ------------------------------------------------------------------------------------------------------------
        Sub-total burden...................             41,832  ......  ................................................         $3,179,232  ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Creation and retention of records                            2      x   $73 (general clerk).............................               $146  ...........
 documenting adviser's basis of custody of
 client assets.
                                                             1      x   $82 (compliance clerk)..........................                $82  ...........
                                            ------------------------------------------------------------------------------------------------------------
    Total burden per adviser...............                  3  ......  ................................................               $228  ...........
    Total number of affected advisers......           x 13,944  ......  ................................................           x 13,944  ...........
                                            ------------------------------------------------------------------------------------------------------------
        Sub-total burden...................             41,832  ......  ................................................         $3,179,232  ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Retention of copies of account statements..                  2      x   $82 (compliance clerk)..........................               $164  ...........
                                            ------------------------------------------------------------------------------------------------------------
    Total burden per adviser...............                  2  ......  ................................................               $164  ...........
    Total number of affected advisers......           x 13,944  ......  ................................................           x 13,944  ...........
                                            ------------------------------------------------------------------------------------------------------------
        Sub-total burden...................             27,888  ......  ................................................         $2,286,816  ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Creation and retention of records of                         3      x   $82 (compliance clerk)..........................               $246  ...........
 detailed transaction and position
 information for each client account.
                                            ------------------------------------------------------------------------------------------------------------
    Total burden per adviser...............                  3  ......  ................................................               $246  ...........
    Total number of advisers...............           x 13,944  ......  ................................................           x 13,944  ...........
                                            ------------------------------------------------------------------------------------------------------------
        Sub-total burden...................             41,832  ......  ................................................         $3,430,224  ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Retention of copies of, and records                        .25      x   $82 (compliance clerk)..........................             $20.50  ...........
 relating to, standing letters of
 authorization.
                                            ------------------------------------------------------------------------------------------------------------
    Total burden per adviser...............                .25  ......  ................................................             $20.50  ...........

[[Page 14771]]

 
    Total number of advisers...............            x 2,789  ......  ................................................            x 2,789  ...........
                                            ------------------------------------------------------------------------------------------------------------
        Sub-total burden...................             697.25  ......  ................................................         $57,174.50  ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                            Final Estimates for Rule 204-2 for Independent Public Accountant
--------------------------------------------------------------------------------------------------------------------------------------------------------
Retention of copies of all audited                           3      x   $73 (general clerk).............................               $219  ...........
 financial statements, internal control
 reports, and required written agreements
 between independent public accountant and
 adviser or its client.
                                                             1      x   $82 (compliance clerk)..........................                $82  ...........
                                            ------------------------------------------------------------------------------------------------------------
    Total burden per adviser...............                  4  ......  ................................................               $301  ...........
    Total number of affected advisers......           x 13,944  ......  ................................................           x 13,944  ...........
                                            ------------------------------------------------------------------------------------------------------------
        Sub-total burden...................             55,776  ......  ................................................         $4,197,144  ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                       Total Estimated Final Burden for Rule 204-2
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total burden for this rulemaking...........         293,521.25  ......  ................................................     $22,939,278.50  ...........
Previously approved burden plus the                  3,053,831  ......  ................................................       $194,394,000  ...........
 additional burden due to the increase in
 the number of advisers.
                                            ------------------------------------------------------------------------------------------------------------
    Total burden...........................          3,347,352  ......  ................................................       $217,333,279  ...........
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ The Commission's estimates of the relevant wage rates are based on salary information for the securities industry compiled by the Securities
  Industry and Financial Markets Association's Office Salaries in the Securities Industry 2013. The estimated figures are modified by firm size,
  employee benefits, overhead, and adjusted to account for the effects of inflation. See the SIFMA Wage Report.

F. Form ADV

    The proposed amendments to Form ADV would increase the information 
requested in Form ADV Part 1A. More specifically, we are proposing 
amendments to Form ADV Part 1A, Schedule D, and the Instructions and 
Glossary of Form ADV that are designed to help advisers identify when 
they may have custody of client assets, to provide the Commission with 
information related to advisers' practices to safeguard client assets 
information about advisers' practices to safeguard client assets, to 
provide the Commission with information related to these practices, and 
to provide the Commission with additional data to improve our ability 
to identify compliance risks.
    The estimated new burdens below also take into account changes in 
the numbers of advisers since the last approved PRA for Form ADV and 
increased costs due to inflation. Based on the prior amendments to Form 
ADV, we estimated the annual compliance burden to comply with the 
collection of information requirement of Form ADV is 433,004 burden 
hours per year and an external cost burden estimate of 
$14,125,083.\675\ Compliance with the disclosure requirements of Form 
ADV is mandatory, and the responses to the disclosure requirements will 
not be kept confidential.
---------------------------------------------------------------------------

    \675\ See Investment Adviser Marketing, Final Rule, Investment 
Advisers Act Release No. 5653 (Dec. 22, 2020) [81 FR 60418 (Mar. 5, 
2021)] and corresponding submission to the Office of Information and 
Regulatory Affairs at Reginfo.gov (``2021 Form ADV PRA'').
---------------------------------------------------------------------------

    We propose the following changes to our PRA methodology for Form 
ADV:
     Form ADV Parts 1 and 2. Form ADV PRA has historically 
calculated a per adviser per year hourly burden for Form ADV Parts 1 
and 2 for each of (i) the initial burden and (ii) the ongoing burden, 
which reflects advisers' filings of annual and other-than-annual 
updating amendments. We noted in previous PRA amendments that most of 
the paperwork burden for Form ADV Parts 1 and 2 would be incurred in 
the initial submissions of Form ADV. However, recent PRA amendments 
have continued to apply the total initial hourly burden for Parts 1 and 
2 to all currently registered or reporting SEC-registered investment 
advisers (``RIAs'') and exempt reporting advisers (``ERAs''), 
respectively, in addition to the estimated number of new advisers 
expected to be registering or reporting with the Commission annually. 
We believe that the total initial hourly burden for Form ADV Parts 1 
and 2 going forward should be applied only to the estimated number of 
expected new advisers annually. This is because currently registered or 
reporting advisers have generally already incurred the total initial 
burden for filing Form ADV for the first time. On the other hand, the 
estimated expected new advisers will incur the full total burden of 
initial filing of Form ADV, and we believe it is appropriate to apply 
this total initial burden to these advisers. We propose to continue to 
apply any new initial burdens resulting from proposed amendments to 
Form ADV Parts 1 and 2, as applicable, to all currently registered or 
reporting investment advisers plus all estimated expected new RIAs and 
ERAs annually.
     Private fund reporting. We have previously calculated 
advisers' private fund reporting as a separate initial burden. The 
currently approved burden for all registered and exempt reporting 
advisers, including expected new registered advisers and new exempt 
reporting advisers, with respect to reported private funds, is 1 hour 
per private fund reported, which we have previously amortized over 
three years for all private fund advisers. We propose to continue to 
calculate advisers' private fund reporting as a separate reporting 
burden, but we propose to apply the initial burden only with respect to 
the expected new private funds.

[[Page 14772]]



                                                            Table 10--Form ADV PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                              Internal annual
                                  Initial hours per year     amendment  burden       Wage rate \2\          Internal time costs        Annual external
                                                                 hours \1\                                                             cost burden \3\
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                             PROPOSED AMENDMENTS TO FORM ADV
                                        RIAs (burden for Parts 1 and 2, not including private fund reporting) \4\
--------------------------------------------------------------------------------------------------------------------------------------------------------
Proposed additions (per adviser)  1 hour for Part 1A....  0.4 hours \5\.........  $318 per hour        1.4 hours x $318 per hour =
 to Part 1A Item 9 and                                                             (blended rate for    $445.20.
 corresponding schedules.                                                          senior compliance
                                                                                   examiner and
                                                                                   compliance
                                                                                   manager) \6\.
Current burden per adviser \7\..  29.72 hours \8\.......  11.8 hours \9\........  $273.00 per hour     (29.72 + 11.8) x $273.00 =    $2,069,250
                                                                                   (blended rate for    $11,334.96.                   aggregated
                                                                                   senior compliance                                  (previously
                                                                                   examiner and                                       presented only in
                                                                                   compliance                                         the aggregate)
                                                                                   manager).                                          \10\.
Revised burden per adviser......  29.72 hours + 1 hour =  0.4 hours + 11.8 hours  $318 (blended rate   (30.72 + 12.2) x $318 =       $4,780.50 \11\.
                                   30.72 hours.            = 12.2 hours.           for senior           $13,648.56.
                                                                                   compliance
                                                                                   examiner and
                                                                                   compliance
                                                                                   manager).
--------------------------------------------------------------------------------------------------------------------------------------------------------
    Total revised aggregate       32,117.44 \12\........  191,686.4 hours \13\..  Same as above......  (32,177,44 + 191,686.4) x     $11,162,546 \14\.
     burden estimate.                                                                                   $318 = $71,169,621.12.
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                              RIAs (burden for Part 3) \15\
--------------------------------------------------------------------------------------------------------------------------------------------------------
No proposed changes
Current burden per RIA..........  20 hours, amortized     1.58 hours \17\.......  $273 (blended rate   $273 x (6.67 + 1.58) =        $2,433.74 per
                                   over three years =                              for senior           $2,249.52.                    adviser \18\.
                                   6.67 hours \16\.                                compliance
                                                                                   examiner and
                                                                                   compliance
                                                                                   manager).
--------------------------------------------------------------------------------------------------------------------------------------------------------
    Total updated aggregate       70,646.67 hours \19\..  15,646.74 hours \20\..  $318 (blended rate   $27,441,303.32 ($318 x        $9,930,272.08 \21\.
     burden estimate.                                                              for senior           (70,646.67 hours +
                                                                                   compliance           15,646.74 hours).
                                                                                   examiner and
                                                                                   compliance manager.
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                          ERAs (burden for Part 1A, not including private fund reporting) \22\
--------------------------------------------------------------------------------------------------------------------------------------------------------
No proposed changes.............
Current burden per ERA..........  3.60 hours \23\.......  1.5 hours + final       $273 (blended rate   ............................  $0
                                                           filings \24\.           for senior
                                                                                   compliance
                                                                                   examiner and
                                                                                   compliance
                                                                                   manager).
--------------------------------------------------------------------------------------------------------------------------------------------------------
    Total revised aggregate       1,245.60 \25\.........  8,777.60 hours \26\...  $318 (blended rate   $3,187,377.60 ($318 x         $0
     burden estimate.                                                              for senior           (1,245.6 + 8,777.60 hours)).
                                                                                   compliance
                                                                                   examiner and
                                                                                   compliance manager.
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                               Private Fund Reporting \27\
--------------------------------------------------------------------------------------------------------------------------------------------------------
No proposed changes.............
Current burden per adviser to     1 hour per private      N/A--included in the    $273 (blended rate   ............................  Cost of $46,865.74
 private fund.                     fund \28\.              existing annual         for senior                                         per fund, applied
                                                           amendment burden.       compliance                                         to 6% of RIAs that
                                                                                   examiner and                                       report private
                                                                                   compliance                                         funds \29\.
                                                                                   manager).
Total updated aggregate burden    1,150 hours \30\......  N/A...................  $318 (blended rate   $5,173,478.40 ($318 x 16,269  $14,856,439.58
 estimate.                                                                         for senior           \30\ hours)).                 \31\.
                                                                                   compliance
                                                                                   examiner and
                                                                                   compliance
                                                                                   manager).
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                      TOTAL ESTIMATED BURDENS, INCLUDING AMENDMENTS
--------------------------------------------------------------------------------------------------------------------------------------------------------
Current per adviser burden/       23.82 hours \32\.                                                    23.82 hours x $273 =          $777 \33\.
 external cost per adviser.                                                                             $6,502.86 per adviser cost
                                                                                                        of the burden hour.
Revised per adviser burden/       15.62 hours \34\.                                                    15.62 hours x $318 =          $1,669.03 \35\.
 external cost per adviser.                                                                             $4,966.43 per adviser cost
                                                                                                        of the burden hour.
Current aggregate burden          433,004 initial and amendment hours annually \36\.                   433,004 x $273 =              $14,125,083 \37\.
 estimates.                                                                                             $118,210,092 aggregate cost
                                                                                                        of the burden hour.
Revised aggregate burden          336,389.45 \38\ Initial and amendment hours annually.                336,389.45 x $318 =           $35,949,257.66
 estimates.                                                                                             $106,971,844.04 aggregate     \39\.
                                                                                                        cost of the burden hour.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ This column estimates the hourly burden attributable to annual and other-than-annual updating amendments to Form ADV, plus RIAs' ongoing obligations
  to deliver codes of ethics to clients.
\2\ As with Form ADV generally, and pursuant to the currently approved PRA (see 2021 Form ADV PRA), we expect that for most RIAs and ERAs, the
  performance of these functions will most likely be equally allocated between a senior compliance examiner and a compliance manager, or persons
  performing similar functions. The Commission's estimates of the relevant wage rates are based on the SIFMA Wage Report, modified by firm size,
  employee benefits, overhead, and adjusted to account for the effects of inflation.
\3\ External fees are in addition to the projected hour per adviser burden. Form ADV has a one-time initial cost for outside legal and compliance
  consulting fees in connection with the initial preparation of Parts 2 and 3 of the form. In addition to the estimated legal and compliance consulting
  fees, investment advisers of private funds incur one-time costs with respect to the requirement for investment advisers to report the fair value of
  private fund assets.

[[Page 14773]]

 
\4\ Based on Form ADV data as of June 2022, we estimate that there are 15,160 RIAs (``current RIAs'') and 552 advisers that are expected to become RIAs
  annually (``newly expected RIAs'').
\5\ We estimate that 12,570 RIAs (80% of the total of 15,712 combined current and expected RIAs that are required to complete Parts 1 and 2) would incur
  a burden of 0.5 hour, and 3,142 RIAs (20% of 15,712 current and expected RIAs that are required to complete Parts 1 and 2) would incur a burden of 0
  hours. (12,570 RIAs x 0.5) + (3,142 RIAs x 0)/15,712 = 0.4 blended average hours per RIA.
\6\ The $318 wage rate reflects current estimates from the SIFMA Wage Report of the blended hourly rate for a senior compliance examiner ($276) and a
  compliance manager ($360). ($276 + $360)/2 = $318.
\7\ Per above, we are proposing to revise the PRA calculation methodology to apply the full initial burden only to expected RIAs, as we believe that
  current RIAs have generally already incurred the burden of initially preparing Form ADV.
\8\ See 2020 Form ADV PRA Renewal (stating that the estimate average collection of information burden per adviser for Parts 1 and 2 is 29.22 hours,
  prior to the most recent amendment to Form ADV). See also 2021 Form ADV PRA (adding 0.5 hours to the estimated initial burden for Part 1A in
  connection with the most recent amendment to Form ADV). Therefore, the current estimated average initial collection of information hourly burden per
  adviser for Parts 1 and 2 is 29.72 hours (29.22 + 0.5 = 29.72).
\9\ The currently approved average total annual burden for RIAs attributable to annual and other-than-annual updating amendments to Form ADV Parts 1 and
  2 is 10.5 hours per RIA, plus 1.3 hours per year for each RIA to meet its obligation to deliver codes of ethics to clients (10.5 + 1.3 = 11.8 hours
  per adviser). See 2020 Form ADV PRA Renewal (these 2020 hourly estimates were not affected by the 2021 amendments to Form ADV). As we explained in
  previous PRAs, we estimate that each RIA filing Form ADV Part 1 will amend its form 2 times per year, which consists of one interim updating amendment
  (at an estimated 0.5 hours per amendment), and one annual updating amendment (at an estimated 8 hours per amendment), each year. We also explained
  that we estimate in that each RIA will, on average, spend 1 hour per year making interim amendments to brochure supplements, and an additional 1 hour
  per year to prepare brochure supplements as required by Form ADV Part 2. See id.
\10\ See 2020 Form ADV PRA Renewal (the subsequent amendment to Form ADV described in the 2021 Form ADV PRA did not affect that estimate).
\11\ External cost per RIA includes the external cost for initially preparing Part 2, which we have previously estimated to be approximately 10 hours of
  outside legal counsel for a quarter of RIAs, and 8 hours of outside management consulting services for half of RIAs. See 2020 Form ADV Renewal (these
  estimates were not affected by subsequent amendments to Form ADV). The proposal does not add to this burden. This burden remains 10 hours and 8 hours,
  respectively, for \1/4\ and \1/2\ of RIAs, respectively). (((.25 x 15,160 RIAs) x ($565 x 10 hours)) + ((0.50 x 15,160 RIAs) x ($842 x 8 hours)))/
  15,160 RIAs = $4,780.50 per adviser.
\12\ Per above, we are proposing to revise the PRA calculation methodology for current RIAs to not apply the full initial burden to current RIAs, as we
  believe that current RIAs have generally already incurred the initial burden of preparing Form ADV. Therefore, we calculate the initial burden
  associated with complying with the proposed amendment of 1 initial hours x 15,160 current RIAs = 15,160, initial hours in the first year aggregated
  for current RIAs. We are not amortizing this burden because we believe current advisers will incur it in the first year. For expected RIAs, we
  estimate that they will incur the full revised initial burden, which is 30.72 hours per RIA. Therefore, 30.72 hours x 552 expected RIAs = 16,957.44
  aggregate hours for expected RIAs. We do not amortize this burden for expected new RIAs because we expect a similar number of new RIAs to incur this
  initial burden each year. Therefore, the total revised aggregate initial burden for current and expected RIAs is 15,160 hours + 16,957.44 hours =
  32,117.44 aggregate initial hours.
\13\ 12.2 amendment hours x (15,160 current RIAs + 552 expected new RIAs) = 191,686 aggregate amendment hours.
\14\ Per above, for current RIAs, we are proposing to not apply the currently approved external cost for initially preparing Part 2, because we believe
  that current RIAs have already incurred that initial external cost. For current RIAs, therefore, we are applying only the external cost we estimate
  they will incur in complying with the proposed amendment. Therefore, the revised total burden for current RIAs is (((.25 x 15,160 RIAs) x ($565 x 1
  hour)) + ((0.50 x 15,160 RIAs) x ($842 x 1 hour))) = $8,523,710 aggregated for current RIAs, We do not amortize this cost for current RIAs because we
  expect current RIAs will incur this initial cost in the first year. For expected RIAs, we apply the currently approved external cost for initially
  preparing Part 2 plus the estimated external cost for complying with the proposed amendment. Therefore, $4,780.50 per expected RIA x 552 = $2,638,836
  aggregated for expected RIAs. We do not amortize this cost for expected new RIAs because we expect a similar number of new RIAs to incur this external
  cost each year. $8,523,710 aggregated for current RIAs + $2,638,836 aggregated for expected RIAs = $11,162,546 aggregated external cost for RIAs.
\15\ Even though we are not proposing amendments to Form ADV Part 3 (``Form CRS''), the burdens associated with completing Part 3 are included in the
  PRA for purposes of updating the overall Form ADV information collection. Based on Form ADV data as of October 31, 2021, we estimate that 8,877
  current RIAs provide advice to retail investors and are therefore required to complete Form CRS, and we estimate an average of 347 expected new RIAs
  to be advising retail advisers and completing Form CRS for the first time annually.
\16\ See Form CRS Relationship Summary; Amendments to Form ADV, Investment Advisers Act Release No. 5247 (June 5, 2019) [84 FR 33492 (Sep. 10, 2019)]
  (``2019 Form ADV PRA''). Subsequent PRA amendments for Form ADV have not adjusted the burdens or costs associated with Form CRS. Because Form CRS is
  still a new requirement for all applicable RIAs, we have, and are continuing to, apply the total initial burden to all current and expected new RIAs
  that are required to file Form CRS, and amortize that initial burden over three years for current RIAs.
\17\ As reflected in the currently approved PRA burden estimate, we stated that we expect advisers required to prepare and file the relationship summary
  on Form ADV Part 3 will spend an average 1 hour per year making amendments to those relationship summaries and will likely amend the disclosure an
  average of 1.71 times per year, for approximately 1.58 hours per adviser. See 2019 Form ADV PRA (these estimates were not amended by the 2021
  amendments to Form ADV).
\18\ See 2020 Form ADV PRA Amendment (this cost was not affected by the subsequent amendment to Form ADV and was not updated in connection with that
  amendment; while this amendment did not break out a per adviser cost, we calculated this cost from the aggregate total and the number of advisers we
  estimated prepared Form CRS). Note, however, that in our 2020 Form ADV PRA Renewal, we applied the external cost only to expected new retail RIAs,
  whereas we had previously applied the external cost to current and expected retail RIAs. We believe that since Form CRS is still a newly adopted
  requirement, we should continue to apply the cost to both current and expected new retail RIAs. See 2019 Form ADV PRA.
\19\ 9,556 current RIAs x 6.67 hours each for initially preparing Form CRS = 63,706.67 aggregate hours for current RIAs initially filing Form CRS. For
  expected new RIAs initially filing Form CRS each year, we are not proposing to use the amortized initial burden estimate, because we expect a similar
  number of new RIAs to incur the burden of initially preparing Form CRS each year. Therefore, 347 expected new RIAs x 20 initial hours for preparing
  Form CRS = 6,940 aggregate initial hours for expected RIAs. 63,706.67 hours + 6,940 hours = 70,646.67 aggregate hours for current and expected RIAs to
  initially prepare Form CRS.
\20\ 1.58 hours x (9,556 current RIAs updating Form CRS + 347 expected new RIAs updating Form CRS) = 15,646.74 aggregate amendment hours per year for
  RIAs updating Form CRS.
\21\ We have previously estimated the initial preparation of Form CRS would require 5 hours of external legal services for an estimated quarter of
  advisers that prepare Part 3, and 5 hours of external compliance consulting services for an estimated half of advisers that prepare Part 3. See 2020
  PRA Renewal (these estimates were not amended by the most recent amendment to Form ADV). The hourly cost estimate of $565 and $842 for outside legal
  services and management consulting services, respectively, are based on an inflation-adjusted figure in the SIFMA Wage Report. Therefore, (((.25 x
  9,556 current RIAs preparing Form CRS) x ($565 x 5 hours)) + ((0.50 x 9,556 current RIAs preparing Form CRS) x ($842 x 5 hours))) = $26,864,305. For
  current RIAs, since this is still a new requirement, we amortize this cost over three years for a per year initial external aggregated cost of
  $8,954,768.33. For expected RIAs that we expect would prepare Form CRS each year, we use the following formula: (((.25 x 347 expected RIAs preparing
  Form CRS) x ($565 x 5 hours)) + ((0.50 x 347 expected RIAs preparing Form CRS) x ($842 x 5 hours))) = $975,503.75 aggregated cost for expected RIAs.
  We are not amortizing this initial cost because we estimate a similar number of new RIAs would incur this initial cost in preparing Form CRS each
  year, $8,954,768.33 + $975,503.75 = $9,930,272.08 aggregate external cost for current and expected RIAs to initially prepare Form CRS.
\22\ Based on Form ADV data as of June 30, 2022, we estimate that there are 5,481 currently reporting ERAs (``current ERAs''), and an average of 346
  expected new ERAs annually (``expected ERAs'').
\23\ See 2021 Form ADV PRA.
\24\ The previously approved average per adviser annual burden for ERAs attributable to annual and updating amendments to Form ADV is 1.5 hours. See
  2021 Form ADV PRA. As we have done in the past, we add to this burden the burden for ERAs making final filings, which we have previously estimated to
  be 0.1 hour per applicable adviser, and we estimate that an expected 371 current ERAs will prepare final filings annually, based on Form ADV data as
  of December 2020.
\25\ For current ERAs, we are proposing to not apply the currently approved burden for initially preparing Form ADV, because we believe that current
  ERAs have already incurred this burden. For expected ERAs, we are applying the initial burden of preparing Form ADV of 3.6 hours. Therefore, 3.6 hours
  x 346 expected new ERAs per year = 1,245.60 aggregate initial hours for expected ERAs. For these expected ERAs, we are not proposing to amortize this
  burden because we expect a similar number of new ERAs to incur this burden each year. Therefore, we estimate 1,245.60 aggregate initial annual hours
  for expected ERAs.
\26\ The previously approved average total annual burden of ERAs attributable to annual and updating amendments to Form ADV is 1.5 hours. See 2020 Form
  ADV Renewal (this estimate was not affected by the subsequent amendment to Form ADV). As we have done in the past, we added to this burden the
  currently approved burden for ERAs making final filings of 0.1 hour, and multiplied that by the number of final filings we are estimating ERAs would
  file per year (371 final filings based on Form ADV data as of December 2020). (1.5 hours x 5,481 currently reporting ERAs) + (0.1 hour x 371 final
  filings) = 8,258.60 updated aggregated hours for currently reporting ERAs. For expected ERAs, the aggregate burden is 1.5 hours for each ERA
  attributable to annual and other-than-annual updating amendments to Form ADV x 346 expected new ERAs = 519 annual aggregated hours for expected new
  ERAs updating Form ADV (other than for private fund reporting). The total aggregate amendment burden for ERAs (other than for private fund reporting)
  is 8,258.60 + 519 = 8,777.60 hours.
\27\ Based on Form ADV data as of June 30, 2022, we estimate that 5,142 current RIAs advise 50,968 private funds. Previously, based on Form ADV data as
  of October 31, 2021, we have estimated 136 new RIAs will advise 407 reported private funds per year. We have also estimated that 4,959 current ERAs
  advise 23,476 private funds, and estimate an expected 372 new ERAs will advise 743 reported private funds per year. Therefore, we estimate that there
  are 74,444 currently reported private funds reported by current private fund advisers (50,968 + 23,476), and there will be annually 1,150 new private
  funds reported by expected private fund advisers (407 + 743). The total number of current and expected new RIAs that report or are expected to report
  private funds is 5,278 (5,142 current RIAs that report private funds + 136 expected RIAs that would report private funds).
\28\ See 2020 Form ADV PRA Renewal (this per adviser burden was not affected by subsequent amendments to Form ADV).

[[Page 14774]]

 
\29\ We previously estimated that an adviser without the internal capacity to value specific illiquid assets would obtain pricing or valuation services
  at an estimated cost of $37,625 each on an annual basis. See Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers
  Act Release No. IA-3221 (June 22, 2011) [76 FR 42950 (July 19, 2011)]. However, because we estimated that external cost in 2011, we are proposing to
  use an inflation-adjusted cost of $46,865.74, based on the CPI calculator published by the Bureau of Labor Statistics at https://www.bls.gov/data/inflation_calculator.htm. As with previously approved PRA methodologies, we continue to estimate that 6% of RIAs have at least one private fund client
  that may not be audited. See 2020 Form ADV PRA Renewal.
\30\ Per above, for currently reported private funds, we are proposing to not apply the currently approved burden for initially reporting private funds
  on Form ADV, because we believe that current private fund advisers have already incurred this burden. Therefore, we calculated the burden on current
  private fund advisers for only the proposed incremental new additional burden attributable to private fund reporting of 0.2 hours per private fund x
  74,444 currently reported private funds = 14,889 aggregate hours for current private fund advisers. We expect advisers to incur the initial burden in
  the first year and are therefore not amortizing this burden. For the estimated 1,150 new private funds annually of expected private fund advisers, we
  calculate the initial burden of both the proposed incremental new additional burden attributable to private fund reporting of 0.2 hours per private
  fund and the 1 hour initial burden per private fund. Therefore, 1.2 hours per expected new private fund x 1,150 expected new private funds = 1,380
  aggregate hours for expected new private funds. For these expected new private funds, we are not proposing to amortize this burden, because we expect
  new private fund advisers to incur this burden with respect to new private funds each year. 14,889 hours + 1,380 hours = 16,269 aggregate hours for
  private fund advisers.
\31\ As with previously approved PRA methodologies, we continue to estimate that 6% of registered advisers have at least one private fund client that
  may not be audited, therefore we estimate that the total number of audits for current and expected RIAs is 6% x 5,278 current and expected RIAs
  reporting private funds or expected to report private funds = 316.68 audits. We therefore estimate that approximately 317 registered advisers incur
  costs of $46,865.74 each on an annual basis (see note 29 describing the cost per audit), for an aggregate annual total cost of $14,856,439.58.
\32\ 433,004 currently approved burden hours/18,179 advisers (current and expected annually) = 23.82 hours per adviser. See 2021 Form ADV PRA.
\33\ $14,125,083 currently approved aggregate external cost/18,179 advisers (current and expected annually) = $777 blended average external cost per
  adviser.
\34\ 336,389.45 aggregate annual hours for current and expected new advisers (see infra note 38)/(15,160 current RIAs + 552 expected RIAs + 5,481
  current ERAs +346 expected ERAs*) = 15.62 blended average hours per adviser. * The parenthetical totals 21,539 current and expected advisers.
\35\ $35,949,257.66 aggregate external cost for current and expected new advisers (see infra note 39)/(21,539 advisers current and expected annually) =
  $1,669.03 blended average hours per adviser.
\36\ See 2021 Form ADV PRA.
\37\ See 2021 Form ADV PRA.
\38\ 32,117.44 hours (internal initial burden for Parts 1 and 2) + 191,686.40 hours (internal annual amendment burden for Parts 1 and 2) + 70,646.67
  hours (internal initial burden for Part 3) + 15,646.74 hours (internal annual amendment burden for Part 3) + 1,245.60 hours (internal initial burden
  for ERAs) + 8,777.60 hours (internal annual amendment burden for ERAs)+ 16,269 hours (internal initial burden for private funds) = 336,389.45
  aggregate annual hours for current and expected new advisers.
\39\ $11,162,546.00 (annual external cost burden for Parts 1 and 2) + $9,930,272.08 (annual external cost burden for Part 3) + $14,856,439.58 (annual
  external cost burden for private funds) = $35,949,257.66.

G. Request for Comments

    We request comment on whether our estimates for burden hours and 
any external costs as described above are reasonable. Pursuant to 44 
U.S.C. 3506(c)(2)(B), the Commission solicits comments in order to: (i) 
evaluate whether the proposed collections of information are necessary 
for the proper performance of the functions of the Commission, 
including whether the information will have practical utility; (ii) 
evaluate the accuracy of the Commission's estimate of the burden of the 
proposed collections of information; (iii) determine whether there are 
ways to enhance the quality, utility, and clarity of the information to 
be collected; and (iv) determine whether there are ways to minimize the 
burden of the collections of information on those who are to respond, 
including through the use of automated collection techniques or other 
forms of information technology.
    In addition to these general requests for comment, we also request 
comment specifically on the following issues:
     Our analysis relies upon certain assumptions, such as 
13,944 advisers will enter into written agreements as required by the 
rule, 959 qualified custodians will be counterparties to those written 
agreements, and 55,776 written agreements will initially be executed. 
Do commenters agree with these assumptions? If not, why not, and what 
data would commenters propose?
     Our analysis also relies on the assumption that a new 
written agreement will require approximately one hour per adviser and 
per qualified custodian. Our analysis also assumes that subsequent 
annual changes to the written agreement require an aggregate of 10 
minutes of adviser and qualified custodian time per agreement. Do 
commenters agree with these assumptions? If not, why not, and what data 
would commenters propose?
     Our analysis also relies on the assumption that 1,842 of 
the advisers to the written agreements would be subject to the surprise 
examination requirement and we estimate that qualified custodians would 
be required to provide information to an independent public accountant 
once annually for each adviser. Further, our analysis relies on the 
assumption that it would take qualified custodians approximately 5 
hours to provide the required information. Do commenters agree with 
these assumptions? If not, why not, and what data would commenters 
propose?
     Our analysis also relies on the assumption that 7,018 
advisers to the written agreements would comply with the proposed 
rule's audit exception and that qualified custodians would be required 
to provide information to an independent public accountant 1.05 times 
annually for these advisers. Also, our analysis relies on the 
assumption that a qualified custodian will take .5 hours to provide 
information to the independent public accountant. Do commenters agree 
with these assumptions? If not, why not, and what data would commenters 
propose?
     Our analysis also relies on the assumption that the 
Commission would examine approximately 2,092 of the advisers required 
to enter into a written agreement under the rule and assume that the 
Commission will issue approximately 8,368 requests to qualified 
custodians under the rule. Additionally, we assume qualified custodians 
would take 1.5 hours to respond to the information requested by an 
independent public accountant. Do commenters agree with these 
assumptions? If not, why not, and what data would commenters propose?
     Our analysis also relies on the assumption that it would 
take qualified custodians 15 hours each to update distribution lists to 
add advisers to the distribution of quarterly statements and one hour 
per each qualified custodian to make modifications and send quarterly 
account statements annually. Do commenters agree with this assumption? 
If not, why not, and what data would commenters propose?
     Our analysis also relies on the assumption that, on 
average, an internal control report for a qualified custodian costs 
approximately $750,000. Further, our analysis relies on the assumption 
that 95% of custodians currently obtain internal control reports. As a 
result, our analysis assumes an annual external cost burden of 
obtaining internal control reports to be $35,962,500. Do commenters 
agree with this assumption? If not, why not, and what data would 
commenters propose?
     Our analysis also relies on the assumptions that it would 
take 15 minutes for an adviser to obtain the proposed reasonable 
assurances requirements from a qualified custodian and one hour to 
update any written agreement, if necessary, to reflect the reasonable 
assurances. Further, we estimate that the exchange is most likely to 
occur in the context of the negotiation and execution of the written 
agreement. Additionally, our analysis relies on the assumption that it 
will take

[[Page 14775]]

approximately .25 hours to update the reasonable assurances annually. 
Do commenters agree with these assumptions? If not, why not, and what 
data would commenters propose?
     Our analysis relies on the assumption that each of the 
1,842 advisers expected to undergo a surprise examination under the 
proposed rule will spend 0.25 hour to enter into a written agreement 
with the independent public accountant engaged to conduct the surprise 
examination. Our analysis also relies on the assumption that these 
advisers can be categorized into three groups for purposes of the 
calculation of the burden. Do commenters agree with these assumptions? 
If not, why not, and what data would commenters propose?
     Our analysis relies on the assumption that 381 advisers 
subject to the surprise examination requirement have custody because 
they serve as qualified custodians for their clients, or they have a 
related person that serves as qualified custodian for clients. 
Additionally, our analysis relies on the assumption that these advisers 
are subject to an annual surprise examination with respect to 100 
percent of their clients (or 9,006 clients per adviser) based on the 
assumption that all of their clients maintain custodial accounts with 
the adviser or its related person. Our analysis assumes that each 
adviser will spend an average of 0.02 hours for each client to create a 
client contact list for the independent public accountant to conduct 
the asset verification. Do commenters agree with these assumptions? If 
not, why not, and what data would commenters propose?
     Our analysis relies on the assumption that 834 advisers 
subject to the surprise examination requirement have custody because 
they have broad authority to access client assets held at an 
independent qualified custodian, such as through a power of attorney or 
acting as a trustee for a client's trust. Also, our analysis assumes 
that these advisers will be subject to an annual surprise examination 
with respect to 5 percent of their clients (or 450 clients per adviser) 
who maintain these types of arrangements with the adviser. In addition, 
our analysis assumes that each adviser will spend an average of 0.02 
hours for each client that is subject to these arrangements to create a 
client contact list for the independent public accountant. Do 
commenters agree with these assumptions? If not, why not, and what data 
would commenters propose?
     Our analysis relies on the assumption that 626 advisers 
manage private funds and undergo surprise examinations. For these 
advisers, our analysis relies on the assumption that each adviser 
managing private funds has an average of 6 pooled investment vehicle 
clients with an average of 14 investors. Our analysis relies on the 
assumption that these advisers will spend 1 hour for the pool and 0.02 
hours for each investor in the pool to create a contact list for the 
independent public accountant. Do commenters agree with these 
assumptions? If not, why not, and what data would commenters propose?
     Our analysis relies on the assumption that 4,961 advisers 
currently have custody of privately offered securities and physical 
assets that cannot be maintained with a qualified custodian. Our 
analysis further relies on the assumption that there will be 
approximately 8,000 purchases, sales, or other transfers of beneficial 
ownership of assets subject to the exception in proposed rule 223-
1(b)(2). Do commenters agree with these assumptions? If not, why not, 
and what data would commenters propose?
     Our analysis relies on the assumption that it would take 
each adviser 1.25 hours, initially, to prepare the written agreement 
with an accountant for verification of assets under proposed rule 223-
1(b)(2)(iii). Additionally, our analysis relies on the assumption that 
these agreements will change minimally from year to year and that 
advisers will spend approximately .5 hours annually amending these 
agreements or entering into new agreements. Do commenters agree with 
these assumptions? If not, why not, and what data would commenters 
propose?
     Our analysis also relies on the assumption that the 
adviser's required notice to an accountant under proposed rule 223-
1(b)(2)(iv) would likely be provided by the adviser in connection with 
the closing of a transaction, and would take advisers approximately one 
minute to deliver to the accountant. Do commenters agree with this 
assumption? If not, why not, and what data would commenters propose?
     Our analysis relies on the assumption that accountant 
verifications of transfers of beneficial ownership will have an annual 
cost burden of $19,680,000 to advisers. Do commenters agree with this 
assumption? If not, why not, and what data would commenters propose?
     Our analysis also relies on the assumption that the 
additional cost of asset verification for all assets during a surprise 
examination or audit under the audit provision aggregates to 
$322,956,000 annually. Do commenters agree with this assumption? If 
not, why not, and what data would commenters propose?
     Our analysis relies on the assumption that distributions 
of audited financial statements to investors in the client entity will 
take advisers approximately 1 minute per investor. Our analysis relies 
on the assumption that there are 4,961 advisers to audited pooled 
investment vehicles, with an upward adjustment to 7,018 to account for 
our expectation that an increasing number of advisers will obtain 
audits of client entities. Do commenters agree with these assumptions? 
If not, why not, and what data would commenters propose?
     Our analysis relies on the assumption that each of the 
7,018 advisers that rely on the audit provision will spend 1.25 hours 
to add the provisions required under proposed rule 223-1(b)(4)(v) to 
the written agreement with the independent public accountant. Our 
analysis also relies on the assumption that each adviser will spend 
0.92 hours on an annual basis to reassess these written agreements and 
execute new agreements as an adviser adds entity clients. Do commenters 
agree with these assumptions? If not, why not, and what data would 
commenters propose?
     Our analysis also relies on the assumption that of the 
13,944 advisers with custody of client assets, we estimate that 
approximately 20%, or approximately 2,789 advisers, will have clients 
that issue SLOAs. Further, our analysis assumes that many such advisers 
already retain copies of client SLOAs in their books and records and we 
assume, therefore, that this collection of information will result in 
an increased burden of only .25 hours for each adviser seeking to rely 
on the proposed SLOA exception. Do commenters agree with these 
assumptions? If not, why not, and what data would commenters propose?
     Our analysis relies on the assumption that 12,570 advisers 
(80% of the total of 15,712 combined current and expected advisers that 
are required to complete Parts 1 and 2 of the Form ADV) would incur an 
additional burden of 5 hour under the proposed amendments to Form ADV 
Part 1A, and 3,142 advisers (20% of 15,712 current and expected 
advisers that are required to complete Parts 1 and 2 of Form ADV) would 
incur a burden of 0 hours. Do commenters agree with these assumptions? 
If not, why not, and what data would commenters propose?
    The agency is submitting the proposed collections of information to 
OMB for approval. Persons wishing to submit comments on the collection 
of information requirements of the proposed amendments should direct

[[Page 14776]]

them to the Office of Management and Budget, Attention Desk Officer for 
the Securities and Exchange Commission, Office of Information and 
Regulatory Affairs, Washington, DC 20503, and should send a copy to 
Vanessa A. Countryman, Secretary, Securities and Exchange Commission, 
100 F Street NE, Washington, DC 20549 1090, with reference to File S7-
04-23. OMB is required to make a decision concerning the collections of 
information between 30 and 60 days after publication of this release; 
therefore, a comment to OMB is best assured of having its full effect 
if OMB receives it within 30 days after publication of this release. 
Requests for materials submitted to OMB by the Commission with regard 
to these collections of information should be in writing, refer to File 
S7-04-23, and be submitted to the Securities and Exchange Commission, 
Office of FOIA Services, 100 F Street NE, Washington, DC 20549-2736.

V. Initial Regulatory Flexibility Analysis

    The Commission has prepared the following Initial Regulatory 
Flexibility Analysis (``IRFA'') in accordance with section 3(a) of the 
Regulatory Flexibility Act (``RFA'').\676\ It relates to: (i) new rule 
223-1 under the Advisers Act; (ii) proposed rule 204(d)-1; (iii) 
proposed amendments to rule 204-2; and (iv) proposed amendments to Form 
ADV Part 1A.
---------------------------------------------------------------------------

    \676\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

A. Reason for and Objectives of the Proposed Action

1. Proposed Rule 223-1
    We are proposing amendments to the custody rule, which we adopted 
in 1962 and amended in 2003 and 2009. The current custody rule 
generally requires an adviser to:
     Maintain client funds and securities with a qualified 
custodian (broker-dealers, banks or savings associations, futures 
commission merchants, and certain foreign financial institutions);
     Have a reasonable basis upon due inquiry for believing 
qualified custodians send account statements directly to advisory 
clients;
     Undergo an annual surprise examination by an independent 
public accountant to verify that a sampling of client funds and 
securities exists or have the audited financial statements of a pooled 
investment vehicle prepared in accordance with generally accepted 
accounting principles and distributed to investors in the pool; and
     Obtain a report of the internal controls of related person 
qualified custodians relating to custody from an independent public 
accountant.
    The proposed changes to the custody rule are designed to recognize 
the expansion in products and services investment advisers offer to 
their clients, evolution in the types of investments and ways of 
evidencing their ownership, and developments in the market for 
custodial services. We have accounted for these advancements by 
clarifying the rule's scope and implementing more impactful and 
tailored protections. Specifically, the rule would subject investment 
advisers to requirements pertaining to the use of a qualified 
custodian, delivery of notices to clients, segregation of client 
assets, and independent public accountant assessments. The rule would 
also subject investment advisers to requirements relating to the 
safeguarding of client assets that are not able to be maintained by a 
qualified custodian. Importantly, the proposal maintains the core 
purpose of protecting client assets from loss, misuse, theft, 
misappropriation, and the insolvency or financial reverses of the 
adviser. We believe that modernized rules would help advisers better 
recognize and protect against vulnerabilities to advisory client assets 
and would improve our oversight and risk-assessment abilities. The 
reasons for, and objectives of, the proposed amendments are discussed 
in more detail in sections I and II, above. The burdens of these 
requirements on small advisers are discussed below as well as above in 
sections III and IV, which discuss the burdens on all advisers. The 
professional skills required to meet these specific burdens are also 
discussed in section IV.
2. Proposed Rule 204-2
    We also are proposing amendments to rule 204-2 to correspond to 
proposed rule 223-1. Specifically, we are proposing to require 
investment advisers to maintain the following records for client 
accounts: (1) client account identification, (2) custodian 
identification, (3) the basis for the adviser having custody of client 
assets in the account, (4) any account statements received or sent by 
the adviser, (5) transaction and position information, and (6) any 
standing letters of authorization and records relating thereto. The 
proposed amendments also would require an adviser to maintain copies of 
all written notices to clients required under proposed rule 223-1 and 
any responses thereto, and copies of documents relating to independent 
account engagements.
    Although the current rule requires certain recordkeeping relating 
to investment advisers' custody rule compliance, the proposal would 
align the recordkeeping requirements with proposed rule 223-1. We are 
proposing to amend the current rule to require advisers to retain 
documentation that would allow the Commission examination staff to 
verify advisers' compliance with proposed rule 223-1, particularly in 
the categories of client communications, client accounts, and 
independent public account engagements, and reliance on the proposed 
rule's exceptions. The proposed recordkeeping rules are designed to 
work in concert with proposed rule 223-1 so that a complete custodial 
record with respect to client assets is maintained and preserved. This 
would help facilitate the Commission's inspection and enforcement 
capabilities, including assessing compliance with rules, and therefore, 
it would provide important investor protections.
3. Proposed Amendments to Form ADV
    We are also proposing to amend Item 9 of Part 1A, Schedule D, and 
the Instructions and Glossary of Form ADV to improve information 
available to us and to the general public about advisers' practices in 
safeguarding client assets. We are proposing amendments to Form ADV to 
align reporting obligations with the proposed changes to the custody 
rule and to help advisers identify when they may have custody of client 
assets, to provide the Commission with information related to advisers' 
practices to safeguard client assets, and to provide the Commission 
with additional data to improve our ability to identify compliance 
risks. More accurate and comprehensive information would inform the 
Commission's examination initiatives and would allow the Commission and 
its staff to better assess risks specific advisers pose to investors.
    The proposed revisions would require an adviser to report the 
amount and number of clients falling into each category of custody 
(i.e., direct or indirect) and to require advisers to report similar 
information about client assets over which they have custody resulting 
from (1) having the ability to deduct advisory fees; (2) having 
discretionary trading authority; (3) serving as a general partner, 
managing member, trustee (or equivalent) for clients that are private 
funds; (4) serving as a general partner, managing member, trustee (or 
equivalent) for clients that are not private funds; (5) having a 
general power of attorney over client assets or check-writing 
authority; (6)

[[Page 14777]]

having a standing letter of authorization; (7) having physical 
possession of client assets; (8) acting as a qualified custodian; (9) a 
related person with custody that is operationally independent; and (10) 
any other reason.\677\ Amendments to the form would require an adviser 
to indicate whether it is relying on any of the exceptions from the 
safeguarding rule and, if so, to indicate on which exception(s) the 
adviser is relying. We are also proposing to require advisers to report 
whether client assets for which the adviser triggers the rule are 
maintained at a qualified custodian and the number of clients and 
approximate amount of assets not maintained with a qualified custodian. 
Advisers would also be required to report certain identifying 
information about the qualified custodians and independent public 
accountants. The reasons for and objectives of, the proposed amendments 
to Form ADV are discussed in more detail in section II.I above. The 
burdens of these requirements on small advisers are discussed below as 
well as above in our Economic Analysis and Paperwork Reduction Act 
Analysis, which discuss the burdens on all advisers. The professional 
skills required to meet these specific burdens are also discussed in 
section IV.
---------------------------------------------------------------------------

    \677\ Proposed Form ADV, Part 1A, Item 9.A.(2). Advisers are 
currently required to report information with respect to funds and 
securities over which their related persons have custody, including 
the dollar amount and number of clients whose funds or securities 
are in the adviser's custody and whether any related person has 
custody of any clients' cash or bank accounts or securities and the 
relevant dollar amount and number of clients. See Form ADV, Part 1A 
Item 9.A.(2) through, Item 9.B. Based on its responses, an adviser 
is also required to report additional custody-related information in 
Schedule D of Form ADV, Part 1A.
---------------------------------------------------------------------------

B. Legal Basis

    The Commission is proposing new rule 223-1 and to redesignate rule 
206(4)-2 pursuant to the authority set forth in sections 206(4), 
211(a), and 223 of the Advisers Act [15 U.S.C. 80b-6(4), 80b-11(a), and 
80b-23]; to proposed rule 204(d)-1 pursuant to authority set forth in 
sections 204, 211(a), and 223 of the Advisers Act [15 U.S.C. 80b-4 and 
80b-11(a)]; to amend rule 204-2 pursuant to the authority set forth in 
sections 204, 211, and 223 of the Advisers Act [15 U.S.C. 80b-4, 80b-
11, 80b-23]; and to amend Form ADV pursuant to the authority set forth 
in sections 203(c)(1), 204, 211(a), and 223 of the Advisers Act [15 
U.S.C. 80b-3(c)(1), 80b-4, 80b-11(a), and 80b-23].

C. Small Entities Subject to the Rule and Rule Amendments

    In developing these proposals, we have considered their potential 
impact on small entities that would be subject to the proposed 
amendments. The proposed amendments would affect many, but not all, 
investment advisers registered with the Commission, including some 
small entities.
    Under Commission rules, for the purposes of the Advisers Act and 
the RFA, an investment adviser generally is a small entity if it: (1) 
has assets under management having a total value of less than $25 
million; (2) did not have total assets of $5 million or more on the 
last day of the most recent fiscal year; and (3) does not control, is 
not controlled by, and is not under common control with another 
investment adviser that has assets under management of $25 million or 
more, or any person (other than a natural person) that had total assets 
of $5 million or more on the last day of its most recent fiscal 
year.\678\ Our proposed new rules and amendments would not affect most 
investment advisers that are small entities (``small advisers'') 
because they are generally registered with one or more state securities 
authorities and not with the Commission. Under section 203A of the 
Advisers Act, most small advisers are prohibited from registering with 
the Commission and are regulated by state regulators. Based on IARD 
data, we estimate that as of June 30, 2022, approximately 522 SEC-
registered advisers are small entities under the RFA.\679\
---------------------------------------------------------------------------

    \678\ Advisers Act rule 0-7(a).
    \679\ Based on SEC-registered investment adviser responses to 
Items 5.F. and 12 of Form ADV.
---------------------------------------------------------------------------

1. Small Entities Subject to Amendments to the Custody Rule
    As discussed above in section III (the Economic Analysis), the 
Commission estimates that based on IARD data as of June 30, 2022, 
approximately 13,944 investment advisers would be subject to the new 
rule 223-1 under the Advisers Act, the related proposed amendments to 
rule 204-2 under the Advisers Act, and the related proposed amendments 
to Form ADV.\680\
---------------------------------------------------------------------------

    \680\ See supra note 553.
---------------------------------------------------------------------------

    Of the approximately 522 SEC-registered advisers that are small 
entities under the RFA, 321 would be subject to the new rule 223-1, the 
corresponding amendments to rule 204-2, and the amendments to Form ADV. 
This is because, as discussed above in the PRA, we estimate that all 
small entities that have custody would be subject to the requirements 
of the proposed rule.\681\
---------------------------------------------------------------------------

    \681\ See PRA discussion supra section IV.
---------------------------------------------------------------------------

D. Projected Reporting, Recordkeeping and Other Compliance Requirements

1. Proposed Rule 223-1
    Proposed rule 223-1 would impose certain reporting and compliance 
requirements on certain investment advisers, including those that are 
small entities. All registered investment advisers that have custody of 
client assets, which we estimate to be 13,944 advisers, would be 
required to comply with the proposed safeguarding rule's segregation, 
qualified custodian protection, notice to client, and independent 
verification requirements. Although all of these advisers would also be 
subject to the qualified custodian requirements, some would satisfy 
these requirements by entering into contracts with qualified 
custodians, while others would satisfy them by satisfying conditions of 
a limited exception for investments in privately offered securities and 
physical assets. The proposed requirements and rule amendments, 
including compliance, reporting, and recordkeeping requirements, are 
summarized in this IRFA (section V.A., above). All of these proposed 
requirements are also discussed in detail, above, in sections I and II, 
and these requirements and the burdens on respondents, including those 
that are small entities, are discussed above in sections III and IV 
(the Economic Analysis and Paperwork Reduction Act Analysis, 
respectively) and below. The professional skills required to meet these 
specific burdens are also discussed in section IV.
    As discussed above, there are approximately 522 small advisers 
currently registered with us, and we estimate that 480 of those small 
advisers registered with us would be subject to amendments to the 
safeguarding rule (92% of all registered small advisers).\682\ As 
discussed above in our Paperwork Reduction Act Analysis in section IV 
above, the proposed amendments to rule 223-1 under the Advisers Act 
would create a new annual burden of approximately 28.4 hours per 
adviser, or 9,116 hours in aggregate for small advisers.\683\ We 
therefore expect the annual monetized aggregate cost to
---------------------------------------------------------------------------

    \682\ See supra note 587and accompanying text.
    \683\ 396,041 hours/13,944 advisers subject to the proposed rule 
= 28.4 hours per adviser. 28.4 hours x 480 small advisers = 13,632 
hours.

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

[[Page 14778]]

small advisers associated with our proposed amendments to the 
safeguarding rule would be $5,371,008.\684\
---------------------------------------------------------------------------

    \684\ 13,632 aggregate small adviser hours x $394 (blended rate 
for a compliance manager ($361) and a compliance attorney ($426)) = 
$5,371,008.
---------------------------------------------------------------------------

2. Proposed Amendments to Rule 204-2
    Proposed amendments to rule 204-2 would require investment advisers 
to maintain the following records for client accounts: (1) client 
account identification, (2) custodian identification, (3) the basis for 
the adviser having custody of client assets in the account, (4) any 
account statements received or sent by the adviser, (5) transaction and 
position information, and (6) any standing letters of authorization and 
records relating thereto. The proposed amendments also would require an 
adviser to maintain copies of all written notices to clients required 
under proposed rule 223-1 and any responses thereto, and copies of 
documents relating to independent account engagements. Each of these 
records would correspond to proposed rule 223-1, and also would be 
required to be maintained in the same manner, and for the same period 
of time, as other books and records required to be maintained under 
rule 204-2(a).
    As discussed above, there are approximately 522 small advisers 
currently registered with us. We estimate that 92% percent of all 
advisers registered with us that have investment discretion over client 
assets (and thus deemed custody of such assets) \685\ would be subject 
to proposed rule 223-1 and corresponding amendments to the books and 
records rule. As discussed above in our Paperwork Reduction Act 
Analysis in section IV.E above, the proposed amendments to rule 204-2 
under the Advisers Act would increase the annual burden by 
approximately 21 hours per affected adviser, or 10,080 hours in 
aggregate for small advisers with custody of client assets.\686\ We 
therefore believe the annual monetized aggregate cost to small advisers 
associated with our proposed amendments would be $3,971,520.\687\
---------------------------------------------------------------------------

    \685\ 522 small advisers x 92% = 480 small advisers with 
custody.
    \686\ 21 hours x 480 small advisers with custody = 10,080 hours.
    \687\ 10,080 aggregate small adviser hours x $394 (blended rate 
for a compliance manager ($361) and a compliance attorney ($426)) = 
$3,971,520.
---------------------------------------------------------------------------

3. Proposed Amendments to Form ADV
    Proposed amendments to Form ADV would impose certain reporting and 
compliance requirements on certain investment advisers, including those 
that are small entities, requiring them to provide information about 
their practices in safeguarding client assets. The proposed 
requirements and rule amendments, including recordkeeping requirements, 
are summarized above in this IRFA (section V.A). All of these proposed 
requirements are also discussed in detail, above, in section II, and 
these requirements and the burdens on respondents, including those that 
are small entities, are discussed above in sections III and IV (the 
Economic Analysis and Paperwork Reduction Act Analysis) and below. The 
professional skills required to meet these specific burdens are also 
discussed in section IV.
    Our Economic Analysis (section III above) discusses these costs and 
burdens for respondents, which include small advisers. As discussed 
above in our Paperwork Reduction Act Analysis in section IV.F above, 
the proposed amendments to Form ADV would increase the annual burden 
for advisers (other than exempt reporting advisers, who would not be 
required to respond to the new Form ADV questions we are proposing) by 
approximately 1.4 hours per adviser, or 730.8 hours in aggregate for 
small advisers (other than exempt reporting advisers).\688\ We 
therefore expect the annual monetized aggregate cost to small advisers 
(other than exempt reporting advisers, for whom there would be no 
additional cost) associated with our proposed amendments would be 
$232,394.40.\689\
---------------------------------------------------------------------------

    \688\ 1.4 hours x 522 small advisers = 730.8 hours.
    \689\ 730.8 hours x $318 = $232,394.40. See supra Table 10 for a 
discussion of who we believe would perform this function, and the 
applicable blended rate.
---------------------------------------------------------------------------

E. Duplicative, Overlapping, or Conflicting Federal Rules

    The Commission believes that there are no rules that duplicate, 
overlap, or conflict with the proposed rule amendments.

F. Significant Alternatives

1. Proposed New Rule 223-1 and Amendments to Rule 204-2 and Form ADV
    The RFA directs the Commission to consider significant alternatives 
that would accomplish our stated objectives, while minimizing any 
significant adverse impact on small entities. We considered the 
following alternatives for small entities in relation to proposed new 
rule 223-1 and the corresponding proposed amendments to rule 204-2 
under the Advisers Act and to Form ADV: (i) differing compliance or 
reporting requirements that take into account the resources available 
to small entities; (ii) the clarification, consolidation, or 
simplification of compliance and reporting requirements under the 
proposed rule for such small entities; (iii) the use of performance 
rather than design standards; and (iv) an exemption from coverage of 
the proposals, or any part thereof, for such small entities.
    Regarding the first and fourth alternatives, the Commission 
believes that establishing different compliance or reporting 
requirements for small advisers, or exempting small advisers from the 
proposed rule, or any part thereof, would be inappropriate under these 
circumstances. Because the protections of the Advisers Act are intended 
to apply equally to clients of both large and small firms, it would be 
inconsistent with the purposes of the Advisers Act to specify 
differences for small entities under proposed rule 223-1 and 
corresponding changes to rule 204-2 and Form ADV. As discussed above, 
we believe that the proposed safeguarding rule would result in multiple 
benefits to clients. For example, segregation requirements and the 
imposition of certain minimum standard requirements for assets 
maintained at a qualified custodian would provide investors with 
additional safeguards to protect their assets from the financial 
reverses, including insolvency, of an investment adviser and to prevent 
client assets from being lost, misused, stolen, or misappropriated. We 
believe that these benefits should apply to clients of smaller firms as 
well as larger firms. In addition, as discussed above, our staff would 
use the corresponding information that advisers would report on the 
proposed amended Form ADV for risk-assessment and to help prepare for 
examinations of investment advisers. Establishing different conditions 
for large and small advisers that have custody of client assets would 
negate these benefits. Though we are not exempting small advisers from 
portions of the proposals, we believe that the exception from the 
surprise examination requirement for discretionary authority for client 
assets that settle exclusively on a DVP basis will mitigate the 
creation of new burdens for many advisers, particularly smaller 
advisers. We also have requested comment on whether we should provide 
different compliance dates for differing types of advisers including 
smaller advisers.
    Regarding the second alternative, we believe the current proposal 
is clear and that further clarification, consolidation, or 
simplification of the compliance requirements is not necessary. As

[[Page 14779]]

discussed above: the proposed rule would provide a requirement to 
segregate client assets to prevent them from potential misuse or 
misappropriation; would require that advisers maintain a written 
agreement with or obtain reasonable assurances from qualified 
custodians concerning certain minimal safeguarding requirements that we 
believe are critical to providing important protections for advisory 
client assets; and would provide certain limited exceptions from 
requirements to maintain assets with a qualified custodian or obtain an 
independent verification of assets. These provisions would address a 
number of safeguarding risks for assets maintained at a qualified 
custodian that the current rule does not address while extending the 
protections of the rule from ``funds and securities'' to ``assets'' to 
account for new and evolving financial products that may be maintained 
in client accounts. The proposed provisions would strengthen investment 
advisers' safeguarding practices, which we believe currently has gaps.
    Further, we believe our proposal would allow the Commission 
examination staff to verify all advisers' compliance with the proposed 
amendments to rule 204-2, particularly in the categories of client 
communications, client accounts, and independent public account 
engagements, and reliance on the exceptions to proposed new rule 223-1. 
The proposed recordkeeping rules are designed to work in concert with 
proposed new rule 223-1 so that a complete custodial record with 
respect to client assets is maintained and preserved. This would help 
facilitate the Commission's inspection and enforcement capabilities, 
including assessing compliance with rules, and therefore, it would 
provide important investor protections.
    Regarding the third alternative, we determined to use a combination 
of performance and design standards in the current proposal. The 
general requirement to maintain assets with a qualified custodian would 
apply to all advisers to establish certain minimum standard 
requirements under the proposed safeguarding rule, subject to narrowly 
tailored exemptions and exceptions from certain requirements (e.g., the 
surprise exam) if certain conditions are met. By design, these 
exemptions and exceptions address specific circumstances to ensure 
safekeeping of client assets, but also to provide relief from certain 
requirements in circumstances where an adviser's ability to misuse or 
misappropriate client assets are limited. The corresponding changes to 
rule 204-2 and Form ADV also are narrowly tailored to address proposed 
new rule 223-1.

G. Solicitation of Comments

    We encourage written comments on the matters discussed in this 
IRFA. We solicit comment on the number of small entities subject to 
proposed new rule 223-1 and related amendments to rules 206(4)-2 and 
204-2, and Form ADV, as well as the potential impacts discussed in this 
analysis; and whether the proposal could have an effect on small 
entities that has not been considered. We request that commenters 
describe the nature of any impact on small entities and provide 
empirical data to support the extent of such impact.

VI. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \690\ we must advise OMB whether a proposed 
regulation constitutes a ``major'' rule. Under SBREFA, a rule is 
considered ``major'' where, if adopted, it results in or is likely to 
result in (1) an annual effect on the economy of $100 million or more; 
(2) a major increase in costs or prices for consumers or individual 
industries; or (3) significant adverse effects on competition, 
investment or innovation. We request comment on the potential effect of 
the proposed amendments on the U.S. economy on an annual basis; any 
potential increase in costs or prices for consumers or individual 
industries; and any potential effect on competition, investment or 
innovation. Commenters are requested to provide empirical data and 
other factual support for their views to the extent possible.
---------------------------------------------------------------------------

    \690\ Public Law 104-121, Title II, 110 Stat. 857 (1996) 
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note 
to 5 U.S.C. 601).
---------------------------------------------------------------------------

VII. Statutory Authority

    The Commission is proposing new rule 223-1 by a redesignation of 
rule 206(4)-2 of the Advisers Act under the authority set forth in 
sections 206(4), 211(a), and 223 of the Advisers Act [15 U.S.C. 80b-
6(4), 80b-11(a), and 80b-23]. The Commission is proposing corresponding 
amendments to rule 204-2 under the Advisers Act under the authority set 
forth in 206(4), 211(a), and 223 of the Advisers Act [15 U.S.C. 80b-
6(4), 80b-11(a), and 80b-23]. The Commission is proposing to amend Form 
ADV pursuant to the authority set forth in sections 203(c)(1), 204, 
211(a), and 223 of the Advisers Act [15 U.S.C. 80b-3(c)(1), 80b-4, 80b-
11(a), and 80b-23].

List of Subjects in 17 CFR Parts 275 and 279

    Reporting and recordkeeping requirements; Securities.

Text of Proposed Rules and Rule and Form Amendments

    For the reasons set out in the preamble, title 17, chapter II of 
the Code of Federal Regulations is proposed to be amended as follows:

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

0
1. The authority citation for part 275 is revised to read, in part, as 
follows:

    Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless 
otherwise noted.
* * * * *
    Section 275.204-2 is also issued under 15 U.S.C. 80b-6.
* * * * *
    Section 275.223-1 is also issued under 15 U.S.C. 80b-18b.

0
2. Amend Sec.  275.204-2 by:
0
a. Removing and reserving paragraphs (a)(8) and (a)(17)(iii).
0
b. Revising paragraph (b).
    The revisions read as follows:


Sec.  275.204-2  Books and records to be maintained by investment 
advisers.

* * * * *
    (b) If an investment adviser subject to paragraph (a) of this 
section is subject to Sec.  275.223-1 (Rule 223-1) of this chapter, the 
investment adviser shall make and keep true, accurate, and current the 
following books and records:
    (1) Client communications. A copy of all written client 
notifications required under Sec.  275.223-1(a)(2) (Rule 223-1(a)(2)), 
and any responses thereto.
    (2) Client accounts. For each client account:
    (i) Account identification. A record of the advisory account name, 
client contact information (including name, mailing address, phone 
number, email address), and advisory account number, client type (as 
identified in Item 5.D of Form ADV), or other identifying information 
used by the investment adviser to identify the account, and copies of 
all account opening records. The record must show the advisory account 
inception date, whether the investment adviser has discretionary 
authority (as defined by Sec.  275.223-1(d)(4) (Rule 223-1(d)(4)) with 
respect to any client assets in the account, whether the investment 
adviser has

[[Page 14780]]

authority to deduct advisory fees from the account, and, if applicable, 
the termination date of the account, asset disposition upon 
termination, and the reason for the termination.
    (ii) Custodian identification. A record that identifies and 
matches, for each client of which the adviser has custody of client 
assets, the account name and account number, or any other identifying 
information, from any person or entity, including any qualified 
custodian, that maintains client assets to the corresponding advisory 
account record for each client required by paragraph (b)(2)(i) of this 
section. To the extent applicable, the record must contain a copy of 
the required written agreement with each qualified custodian under 
Sec.  275.223-1(a)(1)(i) (Rule 223-1(a)(1)(i)), including any 
amendments thereto, and copies of all records received from the 
qualified custodian thereunder relating to client assets. The record 
must also reflect the basis for the reasonable assurances that the 
investment adviser obtains from the qualified custodian under Sec.  
275.223-1(a)(1)(ii) (Rule 223-1(a)(1)(ii)). To the extent applicable, 
the record must contain a copy of the investment adviser's required 
written reasonable determination that ownership of certain specified 
client assets cannot be recorded and maintained (book-entry, digital, 
or otherwise) in a manner in which a qualified custodian can maintain 
possession or control (as defined by Sec.  275.223-1(d)(8) (Rule 223-
1(d)(8)) of such assets, as required under Sec.  275.223-1(b)(2) (Rule 
223-1(b)(2)).
    (iii) Basis for being subject to Rule 223-1. A memorandum or other 
record that indicates the basis of the investment adviser's custody (as 
defined in Sec.  275.223-1(d)(3) (Rule 223-1(d)(3)) of the client's 
assets (as defined by Sec.  275.223-1(d)(1) (Rule 223-1(d)(1)), 
including whether a related person (as defined by Sec.  275.223-
1(d)(11) (Rule 223-1(d)(11)) holds the investment adviser's client 
assets (or has any authority to obtain possession of them) in 
connection with the investment adviser's advisory services.
    (iv) Account statements. Copies of each account statement delivered 
by the qualified custodian to the client and to the investment adviser 
pursuant to Sec.  275.223-1(a)(1)(i)(B) (Rule 223-1(a)(1)(i)(B)), 
copies of any account statement delivered by the investment adviser to 
the client, including copies of any account statement delivered by the 
investment adviser to the client containing the required notification 
under Sec.  275.223-1(a)(2) (Rule 223-1(a)(2)). If the client is a 
pooled investment vehicle, the record must also reflect the delivery of 
account statements, notices, or financial statements (as applicable) to 
all investors in such client pursuant to Sec.  275.223-1(c) (Rule 223-
1(c)).
    (v) Transaction and position information.
    (A) A detailed record of all trade and transaction activity for 
each such client account that includes the date and price or amount of 
all purchases, sales, receipts, deliveries (including one-way delivery 
of assets, and free receipt and delivery of securities and certificate 
numbers, as applicable), deposits, transfers, withdrawals, cash flows, 
corporate action activity, maturities, expirations, expenses, income 
posted to the account, and all other debits and credits to or from the 
account.
    (B) Copies of confirmations of all trades effected by or for the 
account of each client that show the date and price of each trade, and 
any instruction received by the investment adviser concerning 
transacting in the client's assets (as defined by Rule 223-1(d)(1)).
    (C) A record for each asset (as defined by Rule 223-1(d)(1)) in 
which each client has a position, which record shall show the name of 
such client having any interest in such asset, the amount or interest 
of such client, and the location of such asset.
    (D) A memorandum describing the basis upon which the adviser has 
determined that the presumption that any related person is not 
operationally independent under Sec.  275.223-1(d)(7) has been 
overcome.
    (vi) Standing letters of authorization. Copies of, and records 
relating to, any standing letter of authorization (as defined in Sec.  
275.223-1(d)(12) (Rule 223-1(d)(12)) issued by a client to the 
investment adviser.
    (2) Independent public accountant.
    (i) Copies of all audited financial statements prepared pursuant to 
Sec.  275.223-1(b)(4) (Rule 223-1(b)(4)).
    (ii) A copy of any internal control report:
    (A) Obtained by a qualified custodian and received by an investment 
adviser pursuant to Sec.  275.223-1(a)(1)(i)(C) (Rule 223-
1(a)(1)(i)(C)); and
    (B) Obtained by the investment adviser if the investment adviser is 
also the client's qualified custodian.
    (iii) A copy of any written agreement between the independent 
public accountant and the investment adviser or its client, as 
applicable, required under Rule 223-1.
* * * * *


Sec.  275.206(4)-2  [Removed]

0
3. Section 275.206(4)-2 is removed.
0
4. Section 275.223-1 is added to read as follows:


Sec.  275.223-1  Safeguarding client assets.

    (a) Safekeeping required. If you are an investment adviser 
registered or required to be registered under section 203 of the Act 
(15 U.S.C. 80b-3), you shall take the following steps to safeguard 
client assets of which you have custody:
    (1) Qualified custodian.
    (i) Written agreement. A qualified custodian must maintain 
possession or control of your client's assets pursuant to a written 
agreement between you and the qualified custodian (or between you and 
the client if you are also the qualified custodian) that must provide 
the following provisions, which you must reasonably believe have been 
implemented:
    (A) The qualified custodian will promptly, upon request, provide 
records relating to your clients' assets held in the account at the 
qualified custodian to the Commission or to an independent public 
accountant engaged for purposes of complying with paragraph (a)(4), 
(b)(1), or (b)(4) of this section;
    (B) The qualified custodian will send account statements, at least 
quarterly, to the client, or its independent representative, and to 
you, identifying the amount of each client asset in the account at the 
end of the period and setting forth all transactions in the account 
during that period, including investment advisory fees. Such account 
statements shall not identify assets for which the qualified custodian 
lacks possession or control, unless requested by the client and the 
qualified custodian clearly identifies any such assets that appear on 
the account statement;
    (C) At least annually, the qualified custodian will obtain, and 
provide to you 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), and
    (1) If you are the qualified custodian, or if the qualified 
custodian is a related person, 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 and be 
registered with, and subject to regular inspection as of the 
commencement of the professional engagement period, and as of each

[[Page 14781]]

calendar year-end, by, the Public Company Accounting Oversight Board in 
accordance with its rules;
    (D) Specifies your agreed-upon level of authority to effect 
transactions in the account as well as any applicable terms or 
limitations, and permits you and the client to reduce that authority; 
and
    (ii) Reasonable assurances obtained by adviser. You must obtain 
reasonable assurances in writing from the qualified custodian (or, if 
you are also the qualified custodian, the written agreement required by 
paragraph (a)(1)(i) of this section must provide) that the custodian 
will comply with the following requirements, and you must maintain an 
ongoing reasonable belief that the custodian is complying with these 
requirements:
    (A) 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 type of 
loss;
    (B) 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 of the client's assets maintained with 
the qualified custodian in the event of the qualified custodian's own 
negligence, recklessness, or willful misconduct;
    (C) 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;
    (D) The qualified custodian will clearly identify the client's 
assets as such, hold them in a custodial account, and will segregate 
all client assets from the qualified custodian's proprietary assets and 
liabilities; and
    (E) 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.
    (2) Notice to clients. If you open an account with a qualified 
custodian on your client's behalf, you must promptly notify the client, 
or its independent representative, in writing of the qualified 
custodian's name, address, and account number, and the manner in which 
the client's assets are maintained, when the account is opened and 
following any changes to this information. If you send account 
statements to a client to which you are required to provide this 
notice, include in the notification provided to that client and in any 
subsequent account statement you send that client a statement urging 
the client to compare the account statements from the custodian with 
those from the adviser.
    (3) Segregation of client assets. The client's assets must:
    (i) Be titled or registered in the client's name or otherwise held 
for the benefit of that client;
    (ii) Not be commingled with your assets or your related persons' 
assets; and
    (iii) Not be subject to any right, charge, security interest, lien, 
or claim of any kind in favor of you, your related persons, or your 
creditors, except to the extent agreed to or authorized in writing by 
the client.
    (4) Independent verification. The client assets of which you have 
custody are verified by actual examination at least once during each 
calendar year by an independent public accountant, provided that, if 
you, or a related person in connection with advisory services you 
provide to clients, maintain client assets pursuant to this section as 
a qualified custodian, the independent public accountant must be 
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 in 
accordance with its rules. The independent verification must be 
performed pursuant to a written agreement between you and the 
accountant, at a time that is chosen by the accountant without prior 
notice or announcement to you and that is irregular from year to year. 
The written agreement must provide for the first examination to occur 
within six months of becoming subject to this paragraph, except that, 
if you maintain client assets pursuant to this section as a qualified 
custodian, the agreement must provide for the first examination to 
occur no later than six months after obtaining your internal control 
report. The written agreement, which you must reasonably believe has 
been implemented, must require the accountant to:
    (i) File a certificate on Form ADV-E (17 CFR 279.8) with the 
Commission within 120 days of the time chosen by the accountant in 
paragraph (a)(4) of this section, stating that it has examined the 
assets and describing the nature and extent of the examination;
    (ii) Upon finding any material discrepancies during the course of 
the examination, notify the Commission within one business day of the 
finding, by electronic means directed to the Division of Examinations; 
and
    (iii) Upon resignation or dismissal from, or other termination of, 
the engagement, or upon removing itself or being removed from 
consideration for being reappointed, file within four business days 
Form ADV-E accompanied by a statement that includes:
    (A) The date of such resignation, dismissal, removal, or other 
termination, and the name, address, and contact information of the 
accountant; and
    (B) An explanation of any problems relating to examination scope or 
procedure that contributed to such resignation, dismissal, removal, or 
other termination.
    (b) Exceptions.
    (1) Shares of mutual funds. With respect to shares of an open-end 
company as defined in section 5(a)(1) of the Investment Company Act of 
1940 (15 U.S.C. 80a-5(a)(1)) (``mutual fund''), you may use the mutual 
fund's transfer agent in lieu of a qualified custodian for purposes of 
complying with paragraph (a) of this section.
    (2) Certain assets unable to be maintained with a qualified 
custodian. You are not required to comply with paragraph (a)(1) of this 
section with respect to client assets that are privately offered 
securities or physical assets, provided:
    (i) You reasonably determine, and document in writing, that 
ownership cannot be recorded and maintained (book-entry, digital, or 
otherwise) in a manner in which a qualified custodian can maintain 
possession or control of such assets;
    (ii) You reasonably safeguard the assets from loss, theft, misuse, 
misappropriation, or your financial reverses, including your 
insolvency;
    (iii) An independent public accountant, pursuant to a written 
agreement between you and the accountant,
    (A) verifies any purchase, sale, or other transfer of beneficial 
ownership of such assets, promptly, upon receiving the notice required 
by paragraph (b)(2)(iv) of this section; and
    (B) notifies the Commission by electronic means directed to the 
Division of Examinations within one business day upon finding any 
material discrepancies during the course of performing its procedures;
    (iv) You notify the independent public accountant engaged to 
perform the verification required by paragraph (b)(2)(iii) of this 
section of any purchase, sale, or other transfer of beneficial 
ownership of such assets within one business day; and

[[Page 14782]]

    (v) The existence and ownership of each of the client's privately 
offered securities or physical assets that are not maintained with a 
qualified custodian are verified during the annual independent 
verification conducted pursuant to paragraph (a)(4) of this section or 
as part of a financial statement audit performed pursuant to paragraph 
(b)(4) of this section.
    (3) Fee deduction. Notwithstanding paragraph (a)(4) of this 
section, you are not required to obtain an independent verification of 
client assets maintained by a qualified custodian if:
    (i) You have custody of the client assets solely as a consequence 
of your authority to make withdrawals from client accounts to pay your 
advisory fee;
    (ii) If the qualified custodian is a related person, you can rely 
on paragraph (b)(6) of this section.
    (4) Entities subject to annual audit. You are not required to 
comply with paragraphs (a)(1)(i)(B) and (a)(2) of this section and you 
shall be deemed to have complied with paragraphs (a)(4) of this section 
with respect to the account of a limited partnership (or limited 
liability company, or another type of pooled investment vehicle or any 
other entity) if it undergoes a financial statement audit as follows at 
least annually and upon liquidation:
    (i) The audit is performed by an independent public accountant that 
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 in 
accordance with its rules;
    (ii) The audit meets the definition in 17 CFR 210.1-02(d) (Rule 1-
02(d) of Regulation S-X), the professional engagement period of which 
shall begin and end as indicated in Regulation S-X Rule 2-01(f)(5); and
    (iii) Audited financial statements are prepared in accordance with 
U.S. Generally Accepted Accounting Principles (``U.S. GAAP'') or, in 
the case of financial statements of entities organized under non-U.S. 
law or that have a general partner or other manager with a principal 
place of business outside the United States, contain information 
substantially similar to statements prepared in accordance with U.S. 
GAAP and material differences with U.S. GAAP are reconciled;
    (iv) Within 120 days (or 180 days in the case of a fund of funds or 
260 days in the case of a fund of funds of funds) of an entity's fiscal 
year end, the entity's audited financial statements, including any 
reconciliations to U.S. GAAP or supplementary U.S. GAAP disclosures, as 
applicable, are distributed to investors in the entity (or their 
independent representatives); and
    (v) Pursuant to a written agreement between the independent public 
accountant and the adviser or the entity, the independent public 
accountant that completes the audit notifies the Commission by 
electronic means directed to the Division of Examinations:
    (A) Within one business day of issuing an audit report to the 
entity that contains a modified opinion, and
    (B) Within four business days of resignation or dismissal from, or 
other termination of, the engagement, or upon removing itself or being 
removed from consideration for being reappointed.
    (5) Registered investment companies. You are not required to comply 
with this section [(17 CFR 275.223-1)] with respect to the account of 
an investment company registered under the Investment Company Act of 
1940 (15 U.S.C. 80a-1 to 80a-64).
    (6) Certain related persons. Notwithstanding paragraph (a)(4) of 
this section, you are not required to obtain an independent 
verification of client assets if:
    (i) You have custody under this rule solely because a related 
person holds, directly or indirectly, client assets, or has any 
authority to obtain possession of them, in connection with advisory 
services you provide to clients; and
    (ii) Your related person is operationally independent of you.
    (7) Standing letters of authorization. Notwithstanding paragraph 
(a)(4) of this section, you are not required to obtain an independent 
verification of client assets if you have custody of client assets 
solely because of a standing letter of authorization.
    (8) Discretionary authority. Notwithstanding paragraph (a)(4) of 
this section, you are not required to obtain an independent 
verification of client assets if you have custody of client assets 
solely because you have discretionary authority with respect to those 
assets, provided this exception applies only for client assets that are 
maintained with a qualified custodian in accordance with paragraph 
(a)(1) of this rule and for accounts where your discretionary authority 
is limited to instructing your client's qualified custodian to transact 
in assets that settle exclusively on a delivery versus payment basis.
    (9) Reliance on multiple exceptions. Notwithstanding the use of 
``solely'' in paragraphs (b)(3), (b)(6), (b)(7), and (b)(8) of this 
section, the exceptions in paragraphs (b)(3), (b)(6), (b)(7), and 
(b)(8) of this section are not mutually exclusive.
    (c) Delivery to pooled investment vehicle clients. To satisfy the 
requirements of paragraph (a)(1), (a)(2), (b)(1), or (b)(4), the 
account statements, notices, or financial statements (as applicable) 
must be sent to all of the investors in each pooled investment vehicle 
client, provided that, if an investor is a pooled investment vehicle 
that is controlling, controlled by, or under common control with (``a 
control relationship'') you or your related persons, the sender must 
look through that pool (and any pools in a control relationship with 
you or your related persons) in order to send to investors in those 
pools.
    (d) Definitions. For the purposes of this section:
    (1) Assets means funds, securities, or other positions held in the 
client's account.
    (2) Control means the power, directly or indirectly, to direct the 
management or policies of a person, whether through ownership of 
securities, by contract, or otherwise. Control includes:
    (i) Each of your firm's officers, partners, or directors exercising 
executive responsibility (or persons having similar status or 
functions) is presumed to control your firm;
    (ii) A person is presumed to control a corporation if the person:
    (A) Directly or indirectly has the right to vote 25 percent or more 
of a class of the corporation's voting securities; or
    (B) Has the power to sell or direct the sale of 25 percent or more 
of a class of the corporation's voting securities;
    (C) A person is presumed to control a partnership if the person has 
the right to receive upon dissolution, or has contributed, 25 percent 
or more of the capital of the partnership;
    (D) A person is presumed to control a limited liability company if 
the person:
    (1) Directly or indirectly has the right to vote 25 percent or more 
of a class of the interests of the limited liability company;
    (2) Has the right to receive upon dissolution, or has contributed, 
25 percent or more of the capital of the limited liability company; or
    (3) Is an elected manager of the limited liability company; or
    (E) A person is presumed to control a trust if the person is a 
trustee or managing agent of the trust.
    (3) Custody means holding, directly or indirectly, client assets, 
or having any authority to obtain possession of them. You have custody 
if a related person holds, directly or indirectly, client assets, or 
has any authority to obtain possession of them, in connection with

[[Page 14783]]

advisory services you provide to clients. Custody includes:
    (i) Possession of client assets (but not of checks drawn by clients 
and made payable to third parties) unless you receive them 
inadvertently and you return them to the sender promptly but in any 
case within three business days of receiving them;
    (ii) Any arrangement (including, but not limited to a general power 
of attorney or discretionary authority) under which you are authorized 
or permitted to withdraw or transfer beneficial ownership of client 
assets upon your instruction; and
    (iii) Any capacity (such as general partner of a limited 
partnership, managing member of a limited liability company or a 
comparable position for another type of pooled investment vehicle, or 
trustee of a trust) that gives you or your supervised person legal 
ownership of or access to client assets.
    (4) Discretionary authority means the authority to decide which 
assets to purchase and sell for the client.
    (5) Independent public accountant means a public accountant that 
meets the standards of independence described in 17 CFR 210.2-01 (rule 
2-01 of Regulation S-X).
    (6) Independent representative means a person that:
    (i) Acts as agent for an advisory client, including in the case of 
a pooled investment vehicle, for limited partners of a limited 
partnership (or members of a limited liability company, or other 
beneficial owners of another type of pooled investment vehicle) and by 
law or contract is obliged to act in the best interest of the advisory 
client or the limited partners (or members, or other beneficial 
owners);
    (ii) Does not control, is not controlled by, and is not under 
common control with you; and
    (iii) Does not have, and has not had within the past two years, a 
material business relationship with you.
    (7) Operationally independent: for purposes of paragraph (b)(6) of 
this section, a related person is presumed not to be operationally 
independent unless each of the following conditions is met and no other 
circumstances can reasonably be expected to compromise the operational 
independence of the related person:
    (i) Client assets in the custody of the related person are not 
subject to claims of the adviser's creditors;
    (ii) Advisory personnel do not have custody or possession of, or 
direct or indirect access to client assets of which the related person 
has custody, or the power to control the disposition of such client 
assets to third parties for the benefit of the adviser or its related 
persons, or otherwise have the opportunity to misappropriate such 
client assets;
    (iii) Advisory personnel and personnel of the related person who 
have access to advisory client assets are not under common supervision; 
and
    (iv) Advisory personnel do not hold any position with the related 
person or share premises with the related person.
    (8) Possession or control means 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.
    (9) Privately offered securities means securities:
    (i) Acquired from the issuer in a transaction or chain of 
transactions not involving any public offering;
    (ii) That are uncertificated; and the ownership of which can only 
be recorded on the non-public books of the issuer or its transfer agent 
in the name of the client as it appears in the records you are required 
to keep under Rule 204-2; and
    (iii) That are transferable only with prior consent of the issuer 
or holders of the outstanding securities of the issuer.
    (10) Qualified custodian means:
    (i) A bank as defined in section 202(a)(2) of the Advisers Act (15 
U.S.C. 80b-2(a)(2)) or a savings association as defined in section 
3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) 
that has deposits insured by the Federal Deposit Insurance Corporation 
under the Federal Deposit Insurance Act (12 U.S.C. 1811), provided that 
the bank or savings association holds the client assets in an account 
designed to protect such assets from creditors of the bank or savings 
association in the event of the insolvency or failure of the bank or 
savings association;
    (ii) A broker-dealer registered under section 15(b)(1) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78o(b)(1)), holding the 
client assets in customer accounts;
    (iii) A futures commission merchant registered under section 4f(a) 
of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client 
assets in customer accounts, but only with respect to clients' funds 
and security futures, or other securities incidental to transactions in 
contracts for the purchase or sale of a commodity for future delivery 
and options thereon; and
    (iv) A foreign financial institution that:
    (A) Is incorporated or organized under the laws of a country or 
jurisdiction other than the United States, provided that you and the 
Commission are able to enforce judgments, including civil monetary 
penalties, against the foreign financial institution;
    (B) Is regulated by a foreign country's government, an agency of a 
foreign country's government, or a foreign financial regulatory 
authority as defined in section 202(a)(24) of the Investment Advisers 
Act of 1940 [15 U.S.C. 80b-2(a)(24)] as a banking institution, trust 
company, or other financial institution that customarily holds 
financial assets for its customers;
    (C) Is required by law to comply with anti-money laundering and 
related provisions similar to those of the Bank Secrecy Act [31 U.S.C. 
5311, et seq.] and regulations thereunder;
    (D) Holds financial assets for its customers in an account designed 
to protect such assets from creditors of the foreign financial 
institution in the event of the insolvency or failure of the foreign 
financial institution;
    (E) Has the requisite financial strength to provide due care for 
client assets;
    (F) Is required by law to implement practices, procedures, and 
internal controls designed to ensure the exercise of due care with 
respect to the safekeeping of client assets; and
    (G) Is not operated for the purpose of evading the provisions of 
this rule 223-1.
    (11) Related person means any person, directly or indirectly, 
controlling or controlled by you, and any person that is under common 
control with you.
    (12) Standing letter of authorization means an arrangement among 
you, the client, and the client's qualified custodian in which you are 
authorized, in writing, to direct the qualified custodian to transfer 
assets to a third-party recipient on a specified schedule or from time 
to time, provided:
    (i) The client's qualified custodian is not your related person;
    (ii) The client's authorization includes the client's signature, 
the third-party recipient's name, and either its address or account 
number at a custodian to which the transfer should be directed; and
    (iii) You have no ability or authority to designate or change any 
information about the third-party recipient, including name, address, 
and account number.
    (13) U.S. generally accepted accounting principles (U.S. GAAP) 
means accounting principles recognized

[[Page 14784]]

by the Commission as generally accepted in accordance with section 
19(b) of the Securities Act of 1933 (15 U.S.C. 77s).

PART 279--FORMS PRESCRIBED UNDER THE INVESTMENT ADVISERS ACT OF 
1940

0
5. The authority citation for part 279 continues to read as follows:

    Authority: The Investment Advisers Act of 1940, 15 U.S.C. 80b-1, 
et seq., Pub. L. 111-203, 124 Stat. 1376.

0
6. Amend Form ADV (referenced in Sec.  279.1) by:
0
a. In General Instructions, revising the second sub-bullet point 
paragraph to the first bullet point paragraph under Instruction 4 
related to Other-than-annual amendments;
0
b. In Glossary of Terms, revising the definitions of items 12 (Custody) 
and 13 (Discretionary Authority or Discretionary Basis);
0
c. In Glossary of Terms, add new items defining the terms Assets, 
Operationally Independent, Qualified Custodian, and Standing Letter of 
Authorization and redesignating the items accordingly;
0
d. In Part 1A, revising Item 9;
0
e. In Schedule D, adding section 9.C.1; and revising section 9.C.3.
    The additions and revisions read as follows:

    Note:  The text of Form ADV does not, and this amendment will 
not, appear in the Code of Federal Regulations.


[[Page 14785]]


[GRAPHIC] [TIFF OMITTED] TP09MR23.000


[[Page 14786]]


[GRAPHIC] [TIFF OMITTED] TP09MR23.001


[[Page 14787]]


[GRAPHIC] [TIFF OMITTED] TP09MR23.002


[[Page 14788]]


[GRAPHIC] [TIFF OMITTED] TP09MR23.003


[[Page 14789]]


[GRAPHIC] [TIFF OMITTED] TP09MR23.004


[[Page 14790]]


[GRAPHIC] [TIFF OMITTED] TP09MR23.005


[[Page 14791]]


[GRAPHIC] [TIFF OMITTED] TP09MR23.006


[[Page 14792]]


[GRAPHIC] [TIFF OMITTED] TP09MR23.007

* * * * *

    By the Commission.

    Dated: February 15, 2023.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2023-03681 Filed 3-8-23; 8:45 am]
BILLING CODE 8011-01-P


