Update: On March 9, 2023, the SEC's proposing release was published in the Federal Register. Comments on the proposal should be received by May 8, 2023.

On February 15, 2023, the SEC issued a proposed rule that would amend certain provisions of the current custody rule under the Advisers Act and redesignate it as a new safeguarding rule.

Rule 206(4)-2 under the Advisers Act (the custody rule) currently establishes an investment adviser's obligations regarding the custody of client funds and securities. However, the SEC believes the custody rule needs to be modernized to address new technologies and changes to advisory services and custodial practices since its last update in 2009. Thus, the SEC is now proposing to:

With the expanded scope and additional custodial protections provided by the proposed amendments, the SEC is also proposing to redesignate the custody rule as new Rule 223-1 under the Advisers Act (the safeguarding rule).

Details of the proposed rule and redesignation are discussed further below. Comments on the proposal are due 60 days after publication in the Federal Register.

In connection with the proposed amendments to expand the scope and enhance the custodial protections under the current custody rule, the SEC is proposing to replace Rule 206(4)-2 with new Rule 223-1 (the safeguarding rule) through redesignation. The provisions of current Rule 206(4)-2 that would not be amended would still be renumbered into the proposed safeguarding rule.

The proposed new safeguarding rule would require investment advisers to take certain minimum steps to safeguard client assets, as opposed to funds and securities, of which the adviser has custody. Rule 223-1(d)(1) would define assets as "funds, securities, or other positions held in the client's account." This definition would include certain assets and holdings not covered by the current rule, including physical assets such as artwork, real estate, precious metals, or physical commodities. The definition would also include investments in crypto assets (see Application to Crypto Assets) and be flexible enough to accommodate potential future investment types that develop in the market.

In addition, while the proposed safeguarding rule would generally preserve the current rule's definition of custody, the SEC is proposing to explicitly include discretionary authority to trade within the definition of custody.

The proposed safeguarding rule will continue to require investment advisers with custody of client assets to maintain those assets with qualified custodians, which are typically banks or savings associations, broker-dealers, registered futures commission merchants, and foreign financial institutions (FFIs). However, the SEC is proposing amendments to improve the custodial protections under the rule.

The new safeguarding rule would require qualified custodians to maintain "possession or control" of the client's assets under a written agreement between the adviser and qualified custodian (or between the adviser and client if the adviser is also the qualified custodian). Rule 223-1(d)(8) would define possession or control as holding assets such that the qualified custodian is required to participate in any change in beneficial ownership.

The written agreement would have to meet certain minimum requirements under the rule, including providing provisions for:

Investment advisers would also be required to obtain reasonable assurances in writing from qualified custodians regarding certain protections for the safeguarding of client assets, and the adviser must maintain an ongoing reasonable belief that the custodian is complying with such protections.

Additional proposed amendments include new requirements in order for certain institutions to serve as qualified custodians, such as:

The SEC is also proposing a number of other amendments and conforming changes, including, among others:

The proposed definition of assets and use of the term "other positions" in the safeguarding rule would include investments in crypto assets, even where such assets are not funds or securities.

The proposed new rule would therefore require investment advisers with custody of client crypto assets to ensure the assets are maintained with a qualified custodian that has possession or control of the assets at all times during which the adviser has custody. As most crypto assets are currently traded on trading platforms that are not qualified custodians, the process of moving crypto assets to the platform in order to execute any trade would generally constitute a violation of the safeguarding rule.

The SEC is requesting comment on all aspects of its proposal, with many of its specific questions related to the proposal's application to crypto assets.

For more information on the regulation of investment advisers, see Practice Note, Investment Adviser Regulation: Overview.