SEC's custody rule proposal draws criticism from industry

Several industry leaders and GOP lawmakers are opposed to a new SEC rule proposal that would amend the agency's existing custody rule and expand the scope of assets that are subject to custodial oversight.

The custody rule, as originally adopted in 1962, requires investment advisers "to safeguard client funds and securities in their possession or where they have authority to obtain possession of them," according to an SEC fact sheet.

The new proposal would expand the rule beyond client funds and securities to include all assets — including art, cash, commodities, cryptocurrency and non-traditional assets — and require advisers to maintain those assets with a qualified custodian.

Lance Dial, a Boston-based partner at K&L Gates LLP, said in an email that the proposal would "also apply to any arrangement where an investment adviser has 'discretionary authority' (i.e., the ability to trade client assets without specific client approval)."

In a March 29 publication, K&L Gates noted that the new rule proposal "would explicitly add discretionary trading authority of client's assets to the existing definition of 'custody.' This requirement will confer investment advisers with custody over substantially all of their client accounts other than pure advisory relationships."

In addition, the proposal would obligate advisers and qualified custodians to enter into written agreements with each other to ensure custodial protections, which would "impose new requirements on the relationship between investment advisers and client custodians," Mr. Dial said.

At an SEC meeting Feb. 15 when the proposal was issued, Chairman Gary Gensler said that though some cryptocurrency trading and lending institutions claim to custody investors' cryptocurrency assets, they are not qualified custodians.

"Rather than properly segregating investors' crypto, these platforms have commingled those assets with their own crypto or other investors' crypto," Mr. Gensler said. "When these platforms go bankrupt — something we've seen time and again recently — investors' assets often have become property of the failed company, leaving investors in line at the bankruptcy court."

Mr. Gensler added that the rule proposal would allow "investors working with advisers (to) receive the time-tested protections that they deserve for all of their assets, including crypto assets, consistent with what Congress envisioned."

However, many industry trade associations and a group of Republican lawmakers spoke out against the proposal, contending that it exceeds the SEC's authority and significantly burdens the investment community without clear justification. Several industry leaders have also made calls for extending the proposal's comment period, which ended May 8.

That's in addition to industry leaders sounding the alarm about too many comment periods and compliance deadlines at once, as the SEC continues to push out new proposals at what they say is an alarming pace. The custody proposal is just one of many in recent months that has received significant pushback.

On March 3, a group of 13 industry groups, including the Alternative Investment Management Association, Investment Adviser Association, Investment Company Institute and the Securities Industry and Financial Markets Association, sent a letter to the SEC requesting they extend the proposal's comment period by another 60 days.

"In light of the significance of the topic and the proposed number and magnitude of far-reaching changes, we are concerned that the existing comment deadline will not provide us with sufficient time to perform the level of analysis that this proposal warrants," the groups wrote in the letter.

At the Feb. 15 SEC meeting, Commissioner Hester M. Peirce was the only commissioner to oppose the proposal, with one of her concerns being that the proposal's comment period and proposed implementation period were too short.

In its own comment letter submitted May 8, SIFMA recommended an extended 120-day comment period, rather than the existing 60-day comment period. SIFMA also asked for "at least a three-year implementation period for all advisers and (qualified custodians), and a 3.5-year implementation period for smaller advisers."

Currently, the proposal allows one year to comply for investment advisers with at least $1 billion in regulatory assets under management, and 18 months for other investment advisers.

SIFMA's comment letter is one of many that argues the SEC overreaches its authority in the new custody rule proposal.

"The proposal exceeds the SEC's regulatory authority by imposing private contractual terms and other obligations on third-party (qualified custodians) over whom the SEC does not have jurisdiction, expanding the scope of custody to include discretionary trading authority, expanding the definition of assets to include all assets (not just funds and securities), intruding on non-U.S. laws governing foreign custodians, and failing to perform a proper cost-benefit analysis of the proposal's cumulative or interactive effects," the comment letter states.

The Investment Company Institute, a Washington-based global association representing regulated investment funds, said in its comment letter that "the Commission appears to be seeking to extend indirectly its regulatory jurisdiction over persons that Congress has not authorized it to regulate. As Commissioner Peirce correctly observed, '(t)he Commission does not have authority to regulate custodians directly, but we propose to regulate them indirectly.'"

On Capitol Hill, GOP leaders of the House Financial Services Committee voiced their concerns over several aspects of the proposal, including what they characterized as "a backdoor to regulate entities outside of (the SEC's) jurisdiction," according to a comment letter.

While the Dodd-Frank Wall Street Reform and Consumer Protection Act broadened the SEC's authority to require that registered investment advisers safeguard client assets, "this expansion was only intended to apply to assets within the SEC's jurisdiction," the lawmakers wrote. "The proposed rule, in contrast, extends to all assets, including art, cash, commodities, and non-traditional assets. By disregarding jurisdictional lines, the SEC is attempting to establish standards in areas that it has no authority to regulate."

Many commenters also expressed concern that the proposal creates unnecessary burdens for those in the investment community.

In a statement released May 8, Eric Pan, ICI president and CEO, said "the proposal would likely do more harm than good. It places onerous new responsibilities on both advisers and custodians without much evidence that these changes will improve the protection of client assets."

The proposal "(equates) an adviser's discretionary trading authority over client accounts with having custody of those assets," Mr. Pan said, which could result in advisers suddenly having custody over thousands of additional client accounts without any changes in their relationship with the client.

The Managed Funds Association, a Washington-based industry group representing the alternative asset management industry, said in its comment letter: "The burdens of the proposal could cause registered investment advisers and qualified custodians (including banks and broker-dealers) to exit markets where advisory client assets are implicated, leaving investors with limited choices and potentially greater exposure to unregistered advisers and unregulated entities."

Some of the potential costs of the proposal MFA lists include disrupting trading in markets where it's unclear how qualified custodians could provide required services, such as syndicated loan markets and natural gas markets; increasing transaction costs "and potentially shutting down certain markets (such as prime brokerage) due to the inability to rehypothecate collateral"; creating overlapping and unclear regulatory regimes among asset classes that are overseen by other regulators; and "significantly disrupting markets for private securities and physical assets that trade regularly."

Like many other industry groups, MFA ultimately argues that the SEC did not fully analyze all the potential effects of the proposal.

Separately, the Insured Retirement Institute, a Washington-based association representing those in the insured retirement strategies industry, raised concerns about the proposal's impact on access to protected lifetime income products. They requested that the SEC make a series of changes to the proposal "to ensure that advisory clients maintain equal access to all products and services that an advisory client may access through an investment adviser, including protected lifetime income products," according to their comment letter.