September 11, 2024

The U.S. Securities and Exchange Commission (SEC) has announced two settled charges¹ involving alleged violations of Rule 206(4)-2 under the Investment Advisers Act of 1940 (Advisers Act), known as the “Custody Rule.” These two actions likely result from increased scrutiny by the SEC of the custody-related practices of investment advisers. That scrutiny in turn appears to be part of an effort by the SEC to inform its anticipated revamping of the Custody Rule into a proposed new rule, the “Safekeeping Rule.” The original proposal was widely criticized by the investment adviser industry, and the SEC’s rulemaking agenda has indicated a re-proposal may be issued at the end of October 2024.

The Custody Rule. At a high level, the Custody Rule imposes requirements as to how investment advisers hold client assets. Among other things, the rule requires an adviser arrange for either a surprise examination of client assets or, in the case of private funds, an annual audit, the results of which must be distributed to investors in the fund within 120 days. Client funds and securities must also typically be held with a “qualified custodian” such as a bank or broker-dealer.

One issue of particular attention in recent years is how advisers that hold digital assets for their clients can comply with the Custody Rule, because there is uncertainty as to which, if any, existing institutions meet the definition of a “qualified custodian.” Advisers have approached this issue in several ways, including by treating certain state trust companies as “banks” for these purposes; taking the position that digital assets are not “funds” or “securities” subject to the requirement; or providing disclosures about their inability to comply.

The Proposed Safekeeping Rule. The Safekeeping Rule as proposed would (among other things) expand the qualified custodian requirement to cover all client assets, including not only digital assets but commodities like gold, collateral used to secure swaps contracts, and others. In addition, it would specify that only entities with deposits insured by the Federal Deposit Insurance Corporation can be “banks” for purposes of the requirement—most trust companies are not. The Safekeeping Rule would generally maintain the surprise examination or audit requirement of the Custody Rule, including the requirement that results of an audit be sent to private fund investors within 120 days.

Recent Settlements. The two recent settlements underscore SEC scrutiny of compliance with the Custody Rule. In one, the SEC charged Galois Capital with noncompliance with the qualified custodian requirement as a result of keeping client assets on crypto asset trading platforms, including FTX. The other settlement involved, among other things, a failure of ClearPath Capital Partners to deliver results of fund audits within the 120-day period in certain years and to send the results to investors at all in others; in the year a fund was liquidated, no audit was performed at all.

These two settlements suggest that any re-proposal of the Safekeeping Rule will continue to emphasize compliance with investor protection requirements by investment advisers managing digital assets, as well as compliance generally with the rule’s more basic requirements (such as delivery of audit results within 120 days).

The SEC May Proceed with Caution. An interesting piece of context for the anticipated re-proposal is the U.S. Court of Appeals for the Fifth Circuit’s decision to vacate the SEC’s 2023 private fund adviser amendments as outside the SEC’s jurisdiction, based on Congressional intent to exempt private fund advisers from full Advisers Act regulation. The SEC did not appeal that decision, which means that the amendments will not take effect. The SEC will likely approach its re-proposal of the Safeguarding Rule with a goal of avoiding a similar outcome.

For more information, please contact any member of Wilson Sonsini's fintech and financial services practice.