Skip to Main Content

SEC Proposed Rule on Safeguarding Advisory Client Assets

The Securities and Exchange Commission (“SEC”) recently issues its proposed rules on “Safeguarding Advisory Client Assets” (the “proposed rule”) which are supposed improvements to Rule 206(4)-2 under the Investment Advisers Act of 1940 (the “custody rule”). In this post we will discuss the custody rule as it currently stands and discuss how the proposed rule aims to make improvements.

The Custody Rule

We will start by briefly running through the requirements of the current custody rule.

  • When does custody arise under the custody rule?
    • Under the custody rule, an investment adviser has custody of client assets, and therefore must comply with the requirements of the custody rule, when it holds, “directly or indirectly, client funds or securities or [has] any authority to obtain possession of them.”
  • When is a qualified custodian required under the custody rule?
    • The custody rule imposes a requirement that investment advisers with custody of client funds and securities maintain them with qualified custodians. The qualified custodian must hold the funds or securities in an account either under the client’s name or under the adviser’s name as agent or trustee for its clients.
  • What is a “qualified custodian”?
    • A “qualified custodian” under the custody rule includes the types of financial institutions that clients and advisers customarily turn to for custodial services. These include banks and savings associations and registered broker-dealers.
  • Requirement of Delivery of Account Statement to Clients.
    •  The custody rule requires that investment advisers with custody of clients’ funds or securities have a reasonable belief that the qualified custodian holding the assets provides periodic account statements to those clients.
  • What are the exemptions from the custody rule?
    • Registered Investment Companies. Investment advisers need not comply with the rule with respect to clients that are registered investment companies.
    • Pooled Investment Vehicles. Investment advisers need not comply with the reporting requirements of the custody rule with respect to pooled investment vehicles, such as limited partnerships or limited liability companies, if the pooled investment vehicle (i) is audited at least annually; and (ii) distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year.
    • Registered Broker-Dealers. Investment advisers that are also registered broker-dealers acting as qualified custodians are also exempt from the requirements of the custody rule.

Custody Rule Enforcement Action

In a recent administrative proceeding against Spruce Investment Advisors, LLC (“Spruce”), the SEC found that the firm had failed to distribute the required audited financial statements, for “numerous years”. Briefly, Spruce was an investment adviser to approximately 100 private equity funds formed as limited liability companies that each have “AEI” in the fund name (the “AEI Funds”).  Spruce became the investment adviser to the AEI Funds in 2014, when it formed Spruce Direct Investment Fund I (“SDIF”) and raised funds from SDIF investors for SDIF to acquire the managing membership interests in the AEI Funds.

The SEC reminded us that, the custody rule provides an alternative to complying with the requirements of Rule 206(4)-2(a)(2), (3) and (4) for investment advisers to limited partnerships or other types of pooled investment vehicles, such as the Funds.  The custody rule provides that an investment adviser “shall be deemed to have complied with” the independent verification requirement and is not required to satisfy the notification and accounts statements delivery requirements with respect to a fund if the fund is subject to audit at least annually and “distributes [the fund’s] audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) . . . within 120 days of the end of [the fund’s] fiscal year” (“Audited Financials Alternative”).

Unfortunately for Spruce, the following was taken directly form the SEC’s report:

With respect to the Funds, Spruce purported to rely on the Audited Financials Alternative to attempt to comply with the custody rule but failed to have the required audits performed or deliver the audited financials to the Funds’ investors.  Although Spruce engaged PCAOB-registered auditing firms to conduct annual audits of the Funds’ financial statements, the auditing firms were not able to complete timely audits.  This occurred in part because Spruce was not able to provide pertinent records.  Spruce failed to distribute the requisite audited financial statements to investors within 120 days of fiscal year end 2014 forward for certain AEI Funds, or for fiscal year end 2015 forward for the other AEI Funds.  It failed to distribute the required audited financial statements to SDIF and SPIF II investors within 180 days of fiscal year end 2018 forward.  Accordingly, Spruce did not satisfy the requirements of the Audited Financials Alternative in Rule 206(4)-2(b)(4) for the Funds and was therefore obligated to comply with Rule 206(4)-2(a)(2), (3) and (4), which it also failed to do.    

Ultimately, Spruce consented to a cease-and-desist order and a censure and agreed to pay a civil money penalty of $75,000. Spruce also agreed to undertakings to provide notice of the SEC’s order to past and current investors in the private funds at issue.

The Proposed Rule

The SEC’s press release states that:

The proposed rules would exercise Commission authority under section 411 of the Dodd-Frank Act by broadening the application of the current investment adviser custody rule beyond client funds and securities to include any client assets in an investment adviser’s possession or when an investment adviser has authority to obtain possession of client assets. Like the current rule, the proposed rule would entrust safekeeping of client assets to qualified custodians, including, for example, certain banks or broker-dealers.

The SEC also noted the following considerations:

  • The proposed changes are intended to help ensure that qualified custodians provide certain standard custodial protections when maintaining an advisory client’s assets. These protections are designed, among other things, to ensure client assets are properly segregated and held in accounts to protect the assets in the event of a qualified custodian bankruptcy or other insolvency.
  • The proposed rule would also enhance protections for certain securities and physical assets that cannot be maintained by a qualified custodian.
  • Additionally, the proposal retains the current requirement for an adviser with custody of client assets to obtain a surprise examination from an independent public accountant to verify client assets, but it would modify the audit provision to expand the availability of its use, enhance investor protection, and facilitate compliance.
  • Finally, the proposal would update and enhance related recordkeeping requirements for advisers and amend Form ADV to align reporting obligations with the proposed rule and to improve the accuracy of custody-related data available to the [SEC], its staff, and the public.

In a following post we will take a deeper dive into what exactly is covered in the proposed rule and how it will impact investment advisers.

Closing Thoughts

Whether the proposed rule comes to pass or not, now is a great time for investment advisers to consider looking at their compliance with the custody rule. With the announcement of this proposed rule, it is clear that custody is an issue on the minds of the regulations. In addition to required audits, we recommend that our clients test custody controls internally; typically six months before/after the formal examination to make sure everything is on track and that the firm does not end up with any surprises during the required audit.

Michael Rasmussen

About the Author

Michael Rasmussen is the founder of United Atlantic Legal Services. He is a licensed attorney in Florida and registered solicitor in the United Kingdom. Michael has acted as General Counsel and Chief Compliance Officer to several investment advisers, including private fund managers, responsible for the management of billions of dollars in client assets.  

Michael is also the founder of FinProLaw, an online learning platform where Michael has created courses designed for investment adviser compliance professionals. These courses include: 

  • Investment Adviser Compliance Essential for Chief Compliance Officers 
  • Foundations of Investment Adviser Compliance 
  • What is a “Security”? 
  • Investment Adviser Marketing Rule 
  • Regulation A – Exemption from Registration 
  • Regulation Crowdfunding – Exemption from Registration 
  • Regulation D – Exemption from Registration 

Investment adviser firms who are also clients of United Atlantic Legal Services can receive many of these courses at a significantly reduced fee or, in some cases, at no expense. Contact us today or visit the FinProLaw to learn more. 

Please visit Michael’s website to learn more about Michael and his insights into the investment adviser industry. He can also be found on LinkedIn.