Ia 6240

Conformed to Federal Register 

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:  

https://www.sec.gov/rules/submitcomments.htm


2 

 

 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. 

https://www.sec.gov/rules/proposed.shtml
mailto:[email protected]


3 

 

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. 



4 

 

Table of Contents 

I. Introduction .................................................................................................................. 7 

A. Background ............................................................................................................. 7 

B. Overview of the Proposal...................................................................................... 19 

II. Discussion ................................................................................................................... 26 

A. Scope of Rule ........................................................................................................ 26 

1. Scope of Assets ............................................................................................... 27 

2. Scope of Activity Subject to the Proposed Rule ............................................. 30 

B. Qualified Custodian Protections ........................................................................... 41 

1. Definition of Qualified Custodian .................................................................. 43 

2. Possession or Control ...................................................................................... 62 

3. Minimum Custodial Protections ..................................................................... 74 

C. Certain Assets that are Unable to be Maintained with a Qualified Custodian .... 127 

1. Definition of Privately Offered Security and Physical Assets ...................... 133 

2. Adviser’s Reasonable Determination ........................................................... 135 

3. Adviser Reasonably Safeguards Assets ........................................................ 138 

4. Notification and Prompt Independent Public Accountant Verification ........ 142 

5. Surprise Examination or Audit ..................................................................... 146 

D. Segregation of Client Assets ............................................................................... 164 

E. Investment Adviser Delivery of Notice to Clients .............................................. 173 

F. Amendments to the Surprise Examination Requirement .................................... 175 

G. Exceptions from the Surprise Examination ........................................................ 178 

1. Entities Subject to Audit (“Audit Provision”) .............................................. 178 

2. Discretionary Authority ................................................................................ 206 

3. Standing Letters of Authorization ................................................................. 210 

H. Amendments to the Investment Adviser Recordkeeping Rule ........................... 215 

1. Client Communications ................................................................................ 218 

2. Client Accounts ............................................................................................. 218 

3. Account Activity ........................................................................................... 221 

4. Independent Public Accountant Engagements.............................................. 224 

5. Standing Letters of Authorization ................................................................. 224 

I. Changes to Form ADV ....................................................................................... 227 

J. Existing Staff No-Action Letters and Other Staff Statements ............................ 237 

K. Transition Period and Compliance Date ............................................................. 239 

III. Economic Analysis ................................................................................................... 241 

A. Introduction ......................................................................................................... 241 

B. Broad Economic Considerations......................................................................... 242 

C. Baseline ............................................................................................................... 247 

1. Current Regulation ........................................................................................ 247 

2. Affected Parties and Industry Statistics ........................................................ 254 

3. Market Practice ............................................................................................. 258 



5 

 

D. Benefits and Costs of Proposed Rule and Form Amendments ........................... 269 

1. Scope ............................................................................................................. 269 

2. Qualified Custodian Protections ................................................................... 276 

3. Certain Assets that are Unable to be Maintained with a Qualified Custodian

 303 

4. Segregation of Investments ........................................................................... 313 

5. Investment Adviser Delivery of Notice to Clients ........................................ 315 

6. Exceptions from the Surprise Examination .................................................. 317 

7. Amendments to the Investment Adviser Recordkeeping Rule ..................... 325 

8. Changes to Form ADV ................................................................................. 327 

E. Efficiency, Competition, and Capital Formation ................................................ 329 

F. Reasonable Alternatives...................................................................................... 332 

1. Scope of Assets ............................................................................................. 332 

2. Elimination of Privately Offered Securities Exception ................................ 332 

3. Distribution of Requirements across Reasonable Assurances and Written 

Agreement ..................................................................................................... 334 

3. Additional Accounting and Client Notification Requirements for Privately 

Offered Securities and Physical Assets that are Not Maintained with a 

Qualified Custodian ...................................................................................... 336 

4. Additional Safeguards when Clients Assets are Not Maintained with a 

Qualified Custodian ...................................................................................... 338 

5. Designating Clearing Agencies and Transfer Agents as Qualified Custodians

 342 

G. Request for Comment ......................................................................................... 344 

IV. Paperwork Reduction Act Analysis .......................................................................... 347 

A. Introduction ......................................................................................................... 347 

B. Rule 223-1 ........................................................................................................... 348 

1. Qualified Custodian Provision ...................................................................... 351 

2. Notice to Clients ........................................................................................... 359 

3. Annual Surprise Examination ....................................................................... 359 

C. Exceptions ........................................................................................................... 363 

1. Certain Assets that are Unable to be Maintained with a Qualified Custodian

 363 

2. Audit Provision ............................................................................................. 367 

D. Total hour burden associated with proposed rule 223-1 ..................................... 370 

E. Rule 204-2 ........................................................................................................... 373 

F. Form ADV .......................................................................................................... 378 

G. Request for Comments ........................................................................................ 384 

V. Initial Regulatory Flexibility Analysis ..................................................................... 391 

A. Reason for and Objectives of the Proposed Action ............................................ 392 

1. Proposed rule 223-1 ...................................................................................... 392 



6 

 

2. Proposed rule 204-2 ...................................................................................... 393 

3. Proposed amendments to Form ADV ........................................................... 394 

B. Legal Basis .......................................................................................................... 395 

C. Small Entities Subject to the Rule and Rule Amendments ................................. 396 

1. Small entities subject to amendments to the custody rule ............................ 397 

D. Projected Reporting, Recordkeeping and Other Compliance Requirements ...... 397 

1. Proposed rule 223-1 ...................................................................................... 397 

2. Proposed amendments to rule 204-2 ............................................................. 398 

3. Proposed amendments to Form ADV ........................................................... 400 

E. Duplicative, Overlapping, or Conflicting Federal Rules .................................... 401 

F. Significant Alternatives ...................................................................................... 401 

1. Proposed new rule 223-1 and amendments to rule 204-2 and Form ADV ... 401 

G. Solicitation of Comments ................................................................................... 403 

VI. CONSIDERATION OF IMPACT ON THE ECONOMYError! Bookmark not defined. 

VII. Statutory Authority ............................................................................................. 404 

 

  



7 

 

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    

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 

                                                                                                                                                                           

 
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”).   

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 



8 

 

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 

examination4 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.  

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 

                                                                                                                                                                           

 
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. 

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. 



9 

 

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  

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 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 

                                                                                                                                                                           

 
7  See 2003 Adopting Release, supra footnote 2,at note 10 and accompanying text. 

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. 



10 

 

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.      

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 

                                                                                                                                                                           

 
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). 



11 

 

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   

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 

                                                                                                                                                                           

 
12  See generally rule 206(4)-2; see also 2009 Adopting Release, supra footnote 11, at sections II.A and B.  

13  See section 411 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 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—

http://40act.com/investment-advisers/subjects/custody


12 

 

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 

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 technology, advisory services, and custodial practices create 

                                                                                                                                                                           

 
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). 

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 

https://www.sec.gov/divisions/investment/custody_faq_030510.htm


13 

 

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.   

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 

                                                                                                                                                                           

 
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. 



14 

 

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.       

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 

                                                                                                                                                                           

 
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. 

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). 



15 

 

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 

                                                                                                                                                                           

 
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.   



16 

 

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. 

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 industry have caused us to reconsider the role of a 

“qualified custodian” under our rule and what minimum protections clients should receive. 

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 

                                                                                                                                                                           

 
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). 

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, 

https://www.wsj.com/articles/companies-compete-to-be-cryptocurrency-custodians-11568772060


17 

 

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.   

                                                                                                                                                                           

 
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. 

https://openknowledge.worldbank.org/bitstream/handle/10986/29053/WP-PUBLIC-Distributed-Ledger-Technology-and-Blockchain-Fintech-Notes.pdf?sequence=1&isAllowed=y
https://openknowledge.worldbank.org/bitstream/handle/10986/29053/WP-PUBLIC-Distributed-Ledger-Technology-and-Blockchain-Fintech-Notes.pdf?sequence=1&isAllowed=y
https://occ.treas.gov/news-issuances/news-releases/2023/nr-ia-2023-1a.pdf
https://occ.treas.gov/news-issuances/news-releases/2023/nr-ia-2023-1a.pdf
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4107019


18 

 

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. 

https://www.sec.gov/spotlight/cybersecurity-enforcement-actions


19 

 

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 

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 

                                                                                                                                                                           

 
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.   



20 

 

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 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.   

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 

                                                                                                                                                                           

 
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).  

35  Proposed rule 223-1(d)(3).21 

 

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   

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 

                                                                                                                                                                           

 
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.      

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. 



22 

 

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   

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 person41 that 

acts as a qualified custodian.   

In addition to the written agreement requirement, advisers would have to obtain 

reasonable assurances that the qualified custodian satisfies five additional enumerated items.42  

                                                                                                                                                                           

 
40  Proposed rule 223-1(a)(1). 

41  The term “related person” would have the same meaning as in the current rule. 

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



23 

 

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. 

 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 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 

                                                                                                                                                                           

 
43  See proposed rule 223-1(b)(2). 

44  See proposed rule 223-1(d)(9).  



24 

 

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. 

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.   

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 

                                                                                                                                                                           

 
45  See proposed rule 223-1(b)(2). 

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



25 

 

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   

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 

                                                                                                                                                                           

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

48  See proposed rule 223-1(b)(4). 

49  See infra discussion at section II.I. 



26 

 

Commission’s examination initiatives and would allow the Commission and its staff to better 

assess risks specific advisers pose to investors.50    

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 

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 

                                                                                                                                                                           

 
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). 

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). 



27 

 

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 depend on which type of assets the client entrusts to the 

adviser.   

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 

                                                                                                                                                                           

 
53  Proposed rule 223-1(d)(1). 

54  See section 223, supra footnote 34. 

55  See supra footnote 11. 



28 

 

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 

                                                                                                                                                                           

 
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. 



29 

 

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 

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  

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? 

                                                                                                                                                                           

 
60  See rule 6c-11, supra footnote 56.  The release discussed that liabilities were contemplated to be part of 

“other positions.” 

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.   



30 

 

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 



31 

 

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.   

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 would retain these categories because, 

                                                                                                                                                                           

 
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.      

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. 



32 

 

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. 

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   

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 

                                                                                                                                                                           

 
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). 

69  2003 Adopting Release, supra footnote 2, at n.10. 



33 

 

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   

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 

                                                                                                                                                                           

 
70  Id. 

71  Our staff stated a similar view under the current rule.  See Custody Rule FAQs, supra footnote 17, at 

Question VII.3. 



34 

 

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 

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? 

                                                                                                                                                                           

 
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.  

https://www.bis.org/cpmi/publ/d06.pdf


35 

 

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 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 



36 

 

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? 

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 

                                                                                                                                                                           

 
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).   



37 

 

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? 

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 

                                                                                                                                                                           

 
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). 

80  We note that the staff has issued an FAQ on this topic.  See Custody Rule FAQs, supra footnote 17, at 

Question XII.2. 



38 

 

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 

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 

                                                                                                                                                                           

 
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)). 

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.       



39 

 

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 assets with a qualified custodian, 

should we provide an exception if an adviser to a private fund or serving as a trustee 



40 

 

would not be subject to the rule for the brief handling of client checks or physical 

assets? 

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? 

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 

                                                                                                                                                                           

 
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.41 

 

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.       

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 

                                                                                                                                                                           

 
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).  



42 

 

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.   

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 

                                                                                                                                                                           

 
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.     



43 

 

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 

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 transactions90—all critical components of safeguarding client 

assets under the proposed rule.  As a result, with the exception of proposed amendments to the 

                                                                                                                                                                           

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

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).    



44 

 

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   

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 

                                                                                                                                                                           

 
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). 



45 

 

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   

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   

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 

                                                                                                                                                                           

 
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). 

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).   



46 

 

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 

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 

                                                                                                                                                                           

 
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 reasonabl e 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. 

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 



47 

 

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 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.    

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 authority100 as a banking institution, 

trust company, or other financial institution that customarily holds financial assets 

for its customers; 

                                                                                                                                                                           

 
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). 

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



48 

 

 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 

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.   

                                                                                                                                                                           

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



49 

 

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 

                                                                                                                                                                           

 
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. 

https://www.fatf-gafi.org/en/the-fatf/what-we-do.html/
https://sanctionssearch.ofac.treas.gov/


50 

 

the Financial Crimes Enforcement Network of the U.S. Department of the Treasury 

(FinCEN”).103 

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   

                                                                                                                                                                           

 
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). 

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). 



51 

 

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 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. 

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 

                                                                                                                                                                           

 
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.  



52 

 

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   

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. 

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 

                                                                                                                                                                           

 
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). 

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



53 

 

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?  

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 

                                                                                                                                                                           

 
109  See generally Membership of State Banking Institutions in the Federal Reserve System (Regulation H) 12 

CFR 208.01 et. seq. 



54 

 

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?   

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 

                                                                                                                                                                           

 
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).     



55 

 

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, 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 

                                                                                                                                                                           

 
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)]. 



56 

 

CFTC regulatory enhancements sufficient grounds to eliminate that condition of the 

current rule?   

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, 



57 

 

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 

                                                                                                                                                                           

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



58 

 

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? 

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. 



59 

 

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 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 



60 

 

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?61 

 

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?   

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 

                                                                                                                                                                           

 
115  Rule 206(4)-2(b)(1).   

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.   



62 

 

types of insurance companies that would more easily function as qualified 

custodians than others? 

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 

                                                                                                                                                                           

 
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.   



63 

 

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.   

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 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 



64 

 

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 

                                                                                                                                                                           

 
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.”).   

https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html


65 

 

(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    

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 

                                                                                                                                                                           

 
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.   



66 

 

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.   

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   

                                                                                                                                                                           

 
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).  

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.”).   



67 

 

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   

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-

                                                                                                                                                                           

 
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). 

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).  



68 

 

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  

We request comment on all aspects of the proposed possession or control requirement, 

including the following items.  

                                                                                                                                                                           

 
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.   



69 

 

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 



70 

 

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 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 



71 

 

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? 

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?  

                                                                                                                                                                           

 
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.”).   



72 

 

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?   



73 

 

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 Müller, What Is Atomic Settlement? (Nov. 7, 2022), 

available at https://libertystreeteconomics.newyorkfed.org/2022/11/what-is-atomic-settlement/.   



74 

 

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 adviser did not intend to have such access to client assets.135  

                                                                                                                                                                           

 
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).   



75 

 

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.   

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 

                                                                                                                                                                           

 
136  See, e.g., Fiduciary Capacity; Non-Fiduciary Custody Activities, 84 Fed. Reg. 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 



76 

 

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   

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.  

                                                                                                                                                                           

 
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.”). 

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).  

https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-19a.pdf
https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-19a.pdf
https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-49a.pdf
https://www.dfs.ny.gov/reports_and_publications/press_releases/pr202103041
https://www.dfs.ny.gov/industry_guidance/industry_letters/il20230123_guidance_custodial_structures
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf


77 

 

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 



78 

 

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 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).  

https://www.sec.gov/news/public-statement/statement-im-finhub-wyoming-nal-custody-digital-assets
https://www.sec.gov/news/public-statement/statement-im-finhub-wyoming-nal-custody-digital-assets


79 

 

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:  

 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; 

                                                                                                                                                                           

 
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”).   

https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html


80 

 

 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81 

 

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 

                                                                                                                                                                           

 
145  See proposed rule 223-1(a)(1)(i), (ii).   



82 

 

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.  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.     

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 



83 

 

a. Reasonable Assurances 

We believe that requiring an adviser to obtain the reasonable assurances in writing149 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 

                                                                                                                                                                           

 
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.”). 

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).   



84 

 

would provide consistent investor protections across all qualified custodians under our proposed 

rule.   

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.   

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  

                                                                                                                                                                           

 
151  Proposed rule 223-1(a)(1)(ii)(A).  

152  See, e.g., rule 17f-4 of the Investment Company Act.  

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 



85 

 

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 circumstances may require a hybrid of the two.156  Further, 

because crypto assets and distributed ledger technology are still evolving, we expect the methods 

                                                                                                                                                                           

 
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.  

https://www.gemini.com/cryptopedia/crypto-wallets-hot-cold


86 

 

used to safeguard crypto assets will likewise evolve, which may lead to reevaluation of best 

practices in the future.   

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 

assets158 and would discourage the qualified custodian from establishing contractual performance 

standards that are less stringent.159  

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.   

                                                                                                                                                                           

 
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).   

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



87 

 

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. 

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 

                                                                                                                                                                           

 
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”).   



88 

 

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.   

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.   

                                                                                                                                                                           

 
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.   



89 

 

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, can be attributed to a sub-

custodian or other third party selected by the qualified custodian. 

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-

                                                                                                                                                                           

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

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.  

https://www.reply.com/en/topics/risk-regulation-and-reporting/Shared%20Documents/Outsourcing%20Working%20Paper.pdf
https://www.reply.com/en/topics/risk-regulation-and-reporting/Shared%20Documents/Outsourcing%20Working%20Paper.pdf
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2797055


90 

 

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. 

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 



91 

 

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 

                                                                                                                                                                           

 
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.   



92 

 

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.     

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 

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 

requirements173 along with the proposed written agreement and other reasonable assurances 

                                                                                                                                                                           

 
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).  

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).   



93 

 

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   

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 

                                                                                                                                                                           

 
174  Custody rule 206(4)-2(a)(1).   

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”).   



94 

 

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.   

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.   

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 

                                                                                                                                                                           

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



95 

 

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.     

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.   

                                                                                                                                                                           

 
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.”). 

178  Proposed rule 223-1(a)(1)(i).   



96 

 

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 Commission179 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 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.  

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.   

                                                                                                                                                                           

 
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). 



97 

 

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     

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 

                                                                                                                                                                           

 
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).  

183  Custody rule 206(4)-2(a)(3). 



98 

 

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.   

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 

                                                                                                                                                                           

 
184  See proposed rule 223-1(c).   



99 

 

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.   

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 

                                                                                                                                                                           

 
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.  

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.   



100 

 

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     

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 

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 

                                                                                                                                                                           

 
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).   

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.   

190  Current rule 206(4)-2(a)(6).101 

 

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   

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 

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’ 

                                                                                                                                                                           

 
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).   

193  See Accounting Guidance, supra footnote 188, at section III.  

194  See rule 206(4)-2(a)(6)(ii).   



102 

 

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.   

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 

                                                                                                                                                                           

 
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)]. 



103 

 

(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 appearance199 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.    

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 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 

                                                                                                                                                                           

 
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).   



104 

 

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.   

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 

                                                                                                                                                                           

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

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 



105 

 

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.   

                                                                                                                                                                           

 
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. 



106 

 

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?   



107 

 

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?  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 



108 

 

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?   



109 

 

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 



110 

 

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 



111 

 

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? 

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?    

                                                                                                                                                                           

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



112 

 

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 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 



113 

 

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 



114 

 

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 



115 

 

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 



116 

 

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?  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? 



117 

 

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 



118 

 

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 



119 

 

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?   

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? 

                                                                                                                                                                           

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



120 

 

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 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 

                                                                                                                                                                           

 
208  See Custody Rule FAQs, supra footnote 17, at Question IX.1.121 

 

are other disclosures that would appropriately distinguish how the qualified 

custodian maintains investments? 

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?   



122 

 

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? 

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 

                                                                                                                                                                           

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



123 

 

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   

103.  The current rule211 and proposed rule212 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?  

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 

                                                                                                                                                                           

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

211  Current rule 206(4)-2(d)(3). 

212  Proposed rule 223-1(d)(5).   



124 

 

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?   



125 

 

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 



126 

 

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 



127 

 

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.   



128 

 

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 may result from the adviser’s insolvency 

or bankruptcy.   

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 

                                                                                                                                                                           

 
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.  



129 

 

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.   

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   

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 

                                                                                                                                                                           

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

216  See 2003 Adopting Release, supra footnote 2.  



130 

 

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   

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 

                                                                                                                                                                           

 
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.”).  

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 



131 

 

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   

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.   

                                                                                                                                                                           

 
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.”).  



132 

 

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 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   

 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,  

                                                                                                                                                                           

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



133 

 

o 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  

o 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 

                                                                                                                                                                           

 
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).   



134 

 

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 

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 

                                                                                                                                                                           

 
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).   

https://www.pwc.com/us/en/tech-effect/emerging-tech/understanding-cryptocurrency-digital-assets.html


135 

 

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 commodities228 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. 

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 maintain possession or control of 

such assets.  Such a determination necessarily depends on the facts and circumstances in issue.  

                                                                                                                                                                           

 
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.”). 



136 

 

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 



137 

 

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.”). 



138 

 

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.      

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 

                                                                                                                                                                           

 
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). 



139 

 

depending on the asset, advisers must satisfy their fiduciary duty in safeguarding any particular 

asset.232   

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 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 

                                                                                                                                                                           

 
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. 

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



140 

 

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. 

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 wheat235 necessarily would be 

                                                                                                                                                                           

 
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/.141 

 

different from the appropriate maintenance gold bullion236 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.   

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 

                                                                                                                                                                           

 
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/EvaluatingRiskinStorageandShippingofFineArtsUpdateFin

al1_4_2019.pdf. 

https://www.occ.treas.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/pub-ch-custody-services.pdf
https://www.occ.treas.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/pub-ch-custody-services.pdf


142 

 

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). 



143 

 

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 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.    

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 

                                                                                                                                                                           

 
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.”).    



144 

 

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.   

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 

                                                                                                                                                                           

 
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.   

https://www.sec.gov/files/formd.pdf


145 

 

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 

rule246 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 

                                                                                                                                                                           

 
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.  



146 

 

proposed requirement also bears similarities to the proposed notification requirement for an audit 

under the proposed safeguarding rule.248    

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 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 

                                                                                                                                                                           

 
248  See infra, section II.F. 

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).  



147 

 

safeguarding of client assets, especially where these assets do not have the additional protections 

afforded by the oversight of a qualified custodian.  

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? 



148 

 

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 



149 

 

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? 

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 

                                                                                                                                                                           

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



150 

 

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 

                                                                                                                                                                           

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



151 

 

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?  

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?   

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 



152 

 

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 



153 

 

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? 



154 

 

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 



155 

 

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 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?   



156 

 

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.     



157 

 

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?   



158 

 

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?   

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? 

                                                                                                                                                                           

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



159 

 

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 



160 

 

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161 

 

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 



162 

 

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?  

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 

                                                                                                                                                                           

 
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). 



163 

 

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 



164 

 

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 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:  

(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  

                                                                                                                                                                           

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



165 

 

(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 

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.   

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 

                                                                                                                                                                           

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

257  See supra footnote 168. 

258  See proposed rule 223-1(a)(1)(ii)(D).   



166 

 

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.   

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  

                                                                                                                                                                           

 
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”).    

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, 



167 

 

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. 

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 

                                                                                                                                                                           

 
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.   

263  See proposed rule 223-1(b)(7) 



168 

 

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 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.   

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 

                                                                                                                                                                           

 
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.”). 

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). 



169 

 

authorize such arrangements, clients would be unable to engage in these potentially beneficial, 

authorized activities.     

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? 



170 

 

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? 



171 

 

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 



172 

 

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 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 

                                                                                                                                                                           

 
268  See, e.g., Madison Capital No-Action Letter. 



173 

 

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     

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.   

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 

                                                                                                                                                                           

 
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. 

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



174 

 

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. 

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?  

                                                                                                                                                                           

 
271  See proposed rule 223-1(c).   



175 

 

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?  

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 

                                                                                                                                                                           

 
272  Our staff has taken a similar view under the current custody rule.  See Custody Rule FAQs, supra footnote 

17, at Question V.1.   

273  See proposed rule 223-1(a)(4).  

274  2009 Adopting Release, supra footnote 11. 



176 

 

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  

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 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. 

                                                                                                                                                                           

 
275  See proposed rule 223-1(a)(4)(v) 



177 

 

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. 

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? 

                                                                                                                                                                           

 
276  See, 2009 Adopting Release, supra note 11. 



178 

 

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 

                                                                                                                                                                           

 
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.   



179 

 

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: 

(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 

(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 

                                                                                                                                                                           

 
278 See proposed rule 223-1(b)(4). 

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.   



180 

 

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 

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 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   

                                                                                                                                                                           

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

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.181 

 

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 



182 

 

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 



183 

 

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.   



184 

 

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?   

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 

                                                                                                                                                                           

 
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.   

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.    



185 

 

clients to any advisory client entity whose financial statements are able to be audited in 

accordance with the rule.289    

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.   

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 

                                                                                                                                                                           

 
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. 

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). 



186 

 

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.   

We request comment on all aspects of the expanded availability of the audit provision, 

including the following items:  

                                                                                                                                                                           

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



187 

 

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? 



188 

 

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 

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 



189 

 

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 



190 

 

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.   

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 

                                                                                                                                                                           

 
292  For example, more than 90 percent of the total number of hedge funds and private equity funds currently 

undergo a financial statement audit. 

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. 

https://pcaobus.org/News/Releases/Pages/06142011_OpenBoardMeeting.aspx


191 

 

permanent program for the inspection of broker and dealer auditors that is approved by the 

Commission.295   

 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.  

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 

                                                                                                                                                                           

 
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).   

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.  



192 

 

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?  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. 



193 

 

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?  

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.  

                                                                                                                                                                           

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



194 

 

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. 



195 

 

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 



196 

 

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 

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 

                                                                                                                                                                           

 
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). 



197 

 

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 

                                                                                                                                                                           

 
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.” 



198 

 

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     

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 

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 

                                                                                                                                                                           

 
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.   

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

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



199 

 

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   

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 

                                                                                                                                                                           

 
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.  



200 

 

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  

We request comment on all aspects of the proposed rule’s requirements for distributing 

audited financial statements, including the following items:  

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 

                                                                                                                                                                           

 
310  We note that our staff previously took a similar view.  See 2014 IM Guidance supra footnote 17.201 

 

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 



202 

 

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. 

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 

                                                                                                                                                                           

 
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.   



203 

 

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.   

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 

                                                                                                                                                                           

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

313  See rule 206(4)-2(a)(4). 

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.   



204 

 

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. 

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 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 



205 

 

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?  



206 

 

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 



207 

 

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.   

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. 

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, 

                                                                                                                                                                           

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

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. 



208 

 

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   

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? 

                                                                                                                                                                           

 
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). 



209 

 

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 



210 

 

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 

 

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   

                                                                                                                                                                           

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

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).   



211 

 

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 



212 

 

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   

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 

                                                                                                                                                                           

 
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 C.F.R. 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).   



213 

 

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? 



214 

 

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? 



215 

 

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 



216 

 

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 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 

                                                                                                                                                                           

 
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 



217 

 

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 

                                                                                                                                                                           

 
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 



218 

 

oversight of the safeguarding practices of advisers and their compliance with the rule, which 

would, in turn, promote investor protection.   

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. 

2. Client Accounts 

Additionally, the proposed amendments would require an adviser to maintain six 

categories of records337 with respect to each client account for which the adviser has custody of 

                                                                                                                                                                           

 
internal control report obtained or received pursuant to rule 206(4)-2(a)(6)(ii).  See proposed rule 204-

2(b)(3)(ii). 

335  See proposed rule 204-2(b)(1). 

336  See proposed rule 223-1(a)(2).  

337  See generally proposed rule 204-2(b)(2) for these six categories of records. 



219 

 

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.  

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 

                                                                                                                                                                           

 
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).    

340  See proposed rule 204-2(b)(2)(i). 

341  See proposed rule 223-1(b)(8). 



220 

 

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 

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 

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 

                                                                                                                                                                           

 
342  See rule 204-(2)(a)(8).   

343  See proposed rule 204-2(b)(2)(i). 

344  See proposed rule 223-1(b)(3). 

345  See proposed rule 204-2(b)(2)(ii).221 

 

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. 

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. 

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 

                                                                                                                                                                           

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



222 

 

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 

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.   

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 

                                                                                                                                                                           

 
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). 

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

350  See rule 204-2(b)(4).   

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



223 

 

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.  

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 

                                                                                                                                                                           

 
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). 



224 

 

current rule requires only that the adviser maintain a record of trade tickets rather than 

counterparty confirmations.   

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.  

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 

                                                                                                                                                                           

 
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). 

357  See proposed rule 204-2(b)(vi). 



225 

 

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   

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 

                                                                                                                                                                           

 
358  Proposed rule 223-1(b)(7). 



226 

 

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)? 



227 

 

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 



228 

 

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 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 

                                                                                                                                                                           

 
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.  



229 

 

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.  

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 

                                                                                                                                                                           

 
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.   

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).   



230 

 

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.   

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. 



231 

 

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: 

 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; 

                                                                                                                                                                           

 
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).  



232 

 

 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 

 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 

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. 

 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  

                                                                                                                                                                           

 
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). 

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. 

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. 



233 

 

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 

                                                                                                                                                                           

 
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. 



234 

 

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 

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 

                                                                                                                                                                           

 
376  See proposed amendments to Form ADV, General Instructions. 



235 

 

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? 



236 

 

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 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 



237 

 

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.    

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 2003 

Commission Adopting Release 

Various Dates 

                                                                                                                                                                           

 
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.   



238 

 

American Bar Association (Question 1, 

Custody Rule Section, only) 

December 8, 2005 

American Bar Association (Question D only) August 10, 2006 

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 Kissel 

LLP 

December 11, 2019 

Privately Offered Securities Under the 

Investment Advisers Act Custody Rule, 

Investment Management Guidance Update 

(“IMGU”) 2013-04 

August 2013 

Private Funds and the Application of the 

Custody Rule to SPVs and Escrows, IMGU 

2014-07 

June 2014 

Inadvertent Custody, IMGU 2017-01 February 2017 

Staff Responses to Questions About the 

Custody Rule (all) 

Issued on various dates since 2003 

 



239 

 

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 

Threshold Number of 

Advisers Under 

Threshold 

Percent of 

Advisers Under 

Threshold 

Total RAUM of 

Advisers Under 

Threshold  

Percent of Total 

RAUM of 

Advisers Under 

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% 

$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% 

                                                                                                                                                                           

 
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. 



240 

 

$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?241 

 

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 



242 

 

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, 



243 

 

securities and other investment products.380   

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 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 

                                                                                                                                                                           

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

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).   



244 

 

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.  

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 

http://www.nber.org/papers/w15651


245 

 

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   

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 

                                                                                                                                                                           

 
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.      

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.  

https://ideas.repec.org/a/aea/aecrev/v109y2019i10p3681-3712.html
https://ideas.repec.org/a/aea/aecrev/v109y2019i10p3681-3712.html
https://ideas.repec.org/s/aea/aecrev.html


246 

 

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  

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  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 

                                                                                                                                                                           

 
337 For those custodians that are registered broker-dealers, it also facilitates compliance with their obligations 

under Exchange Act Rule 15c3-3.   

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). 



247 

 

and/or enhance the independence of third parties, then, generally enhances the ability of third 

parties to oversee investment advisers’ conduct.   

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    

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 

                                                                                                                                                                           

 
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].”   



248 

 

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 

FFIs394—all of which are financial institutions that are currently subject to regular government 

oversight and are subjected to periodic inspection and examination.395  

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  

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 

                                                                                                                                                                           

 
393  See rule 206(4)-2(a)(1). 

394  See rule 206(4)-2(d)(6).   

395  See supra footnote 89. 

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. 



249 

 

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 

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 

                                                                                                                                                                           

 
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. 

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). 



250 

 

and such related person is operationally independent of the adviser, is not required to obtain an 

annual surprise examination.403  

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 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   

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 

                                                                                                                                                                           

 
403  See rule 206(4)-2(b)(3), (6). 

404  See rule 206(4)-2(a)(2). 

405  See rule 206(4)-2(a)(3). 

406  See rule 206(4)-2(a)(5). 

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



251 

 

current audit provision also requires the auditor to be registered with and subject to inspection by 

the PCAOB.   

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  

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 

                                                                                                                                                                           

 
408  See rule 204-2(a)(8). 

409  See rule 204-2(a)(17)(iii). 

410  See rule 204-2(b). 



252 

 

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 

                                                                                                                                                                           

 
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). 



253 

 

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. 

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 

                                                                                                                                                                           

 
415  See generally OCC Custody Handbook, supra note 237. 

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’”). 



254 

 

investors, including certain investments in private companies and offerings by certain hedge 

funds, private equity funds, and venture capital funds.  

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     

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 

                                                                                                                                                                           

 
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). 

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 



255 

 

RAUM among registered investment advisers was $8.56 billion and the median was $427.53 

million. 

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. 

Table 1 

Investment Adviser Clients 

 

Client Type  

Number of 

Clients 

(thousands) 

Total 

RAUM 

(billions) 

Registered 

Investment 

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 

                                                                                                                                                                           

 
for Part 1A, instr. 5.b. (setting forth instructions for calculation of assets under management for regulatory 

purposes). 

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). 



256 

 

 

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.). 

https://www.fdic.gov/analysis/quarterly-banking-profile/statistics-at-a-glance/2022mar/industry.pdf
https://www.fdic.gov/analysis/quarterly-banking-profile/statistics-at-a-glance/2022mar/industry.pdf
https://www.sec.gov/files/data/broker-dealers/company-information-about-active-broker-dealers/bd110122.txt
https://www.sec.gov/files/data/broker-dealers/company-information-about-active-broker-dealers/bd110122.txt
https://www.cftc.gov/sites/default/files/2022-11/01%20-%20FCM%20Webpage%20Update%20-%20September%202022.pdf
https://www.cftc.gov/sites/default/files/2022-11/01%20-%20FCM%20Webpage%20Update%20-%20September%202022.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf


257 

 

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 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   

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 

                                                                                                                                                                           

 
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. 



258 

 

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 

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 

                                                                                                                                                                           

 
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. 

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 http:// 

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: 

https://www.rand.org/pubs/research_reports/RR1289


259 

 

systematic errors that retail investors might make, including limited allocation of savings to 

equities, under-diversification, or investing too little in foreign assets.434  

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.  

b. Adviser Custody   

As of June 2022, 8,536 advisers (56.67% of the total number of advisers) reported on 

                                                                                                                                                                           

 
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.”    

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

2015). 



260 

 

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 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 

                                                                                                                                                                           

 
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.261 

 

an independent public accountant but did not report that they were subject to a surprise 

examination.441 

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  

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 

                                                                                                                                                                           

 
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.   

442  See supra note 17.   

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. 

https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/index-custody-services.html
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/index-custody-services.html


262 

 

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  

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  

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  

                                                                                                                                                                           

 
444  COMPTROLLER’S HANDBOOK, CUSTODY at 6-7. 

445  Id. at 14, 30. 

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. 

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, D.C. (Aug. 23, 2022), available at https://www.pewresearch.org/fact-

https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://sharepoint/sites/IM/Rulemaking/CustodyRulemaking/Proposing%20Release/Deloitte


263 

 

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 2022453 

and focuses on the 50 largest investment advisers454 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 

                                                                                                                                                                           

 
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. 

Webpages 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.  

https://citywire.com/


264 

 

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      

The market for crypto asset custodial services continues to develop.  Our understanding is 

that one OCC-regulated national bank, four OCC-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 

                                                                                                                                                                           

 
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.  

459  See supra, footnote 128and 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 



265 

 

process or four-step process461 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. 

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 

                                                                                                                                                                           

 
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. 



266 

 

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   

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, 

                                                                                                                                                                           

 
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.  

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 at 

https://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 



267 

 

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  

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 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 

                                                                                                                                                                           

 
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 

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.   



268 

 

ensure that the investments are safeguarded appropriately.  The custodian reports the holdings or 

transactions as reported to it by the adviser.   

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. 

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, 

                                                                                                                                                                           

 
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. 

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. 

https://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


269 

 

and 3) advisers did not recognize that they may have custody as a result of certain authority over 

client accounts. 

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   

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 

                                                                                                                                                                           

 
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. 



270 

 

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. 

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 

                                                                                                                                                                           

 
476  Proposed rule 223-1(d)(1). 

477  See Part II.A, supra. 



271 

 

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 rule.478  Investment advisers may accordingly 

                                                                                                                                                                           

 
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. 



272 

 

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. 

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 

                                                                                                                                                                           

 
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. 



273 

 

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 



274 

 

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. 



275 

 

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 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 



276 

 

discretionary trading authority is their sole reason for having custody because they will not have 

to comply with the surprise examination requirement.480     

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   

                                                                                                                                                                           

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

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



277 

 

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     

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     

                                                                                                                                                                           

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

483  See supra footnote 96. 



278 

 

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; 



279 

 

 Regulated by a foreign country’s government, an agency of a foreign country’s 

government, or a foreign financial regulatory authority484 as a banking institution, 

trust company, or other financial institution that customarily holds financial assets 

for its customers; 

 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.485 

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 

                                                                                                                                                                           

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

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

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.  



280 

 

their assets that we believe would help promote an FFI having generally similar protections as a 

U.S.-based qualified custodian.   

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 

                                                                                                                                                                           

 
487  Proposed rule 223-1(d)(10)(iv)(C); see also pt. II.B.1.281 

 

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. 

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 

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 

                                                                                                                                                                           

 
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.   

490  See rule 206(4)-2(a)(1). 



282 

 

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   

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 

                                                                                                                                                                           

 
491  See proposed rule 223-1(a)(1)(i). 

492  See proposed rule 223-1(d)(8).   



283 

 

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.   

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 



284 

 

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   

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, 

                                                                                                                                                                           

 
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. 

495  Proposed rule 223-1(a)(1)(ii)(A).   

496  See discussion in section II.B.3.a.i and supra footnote 154. 



285 

 

in turn, mitigate the risk to client assets from theft, misuse, misappropriation, or other similar 

types of loss.   

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 

                                                                                                                                                                           

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



286 

 

by preventing these custodians from disclaiming liability for misconduct that does not rise to the 

level of gross negligence.     

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   

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 

                                                                                                                                                                           

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



287 

 

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.   

No Liens Unless Authorized in Writing.  The proposed rule would 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 

                                                                                                                                                                           

 
499  Proposed rule 223-1(a)(1)(ii)(D).   
500  See proposed rule 223-1(a)(1)(ii)(E).   

 



288 

 

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. 

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 

                                                                                                                                                                           

 
501  See infra footnote 620. 



289 

 

$5,493,936 associated with advisers obtaining reasonable assurances from qualified 

custodians.502       

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   

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 

                                                                                                                                                                           

 
502  See infra footnote 622. 

 

504  See infra footnote 619 



290 

 

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 



291 

 

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 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. 

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.   

No Liens Unless Authorized in Writing.  The rule would not prohibit liens and the other 

                                                                                                                                                                           

 
505  See discussion in section III.C.1. 

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). 



292 

 

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.   



293 

 

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   

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 

                                                                                                                                                                           

 
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. 

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



294 

 

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.     

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 – 

                                                                                                                                                                           

 
509  Proposed rules 223-1(a)(1)(i)(B), 223-1(b)(4).   



295 

 

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, would deter advisers from fraudulent activities.510     

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.   

                                                                                                                                                                           

 
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. 



296 

 

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 

                                                                                                                                                                           

 
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 



297 

 

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.    

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 

                                                                                                                                                                           

 
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. 

513  Proposed rule 223-1(a)(1)(i)(D).  



298 

 

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. 

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 

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 

                                                                                                                                                                           

 
514  See supra note 202. 



299 

 

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       

(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. 

                                                                                                                                                                           

 
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.  



300 

 

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 

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 

                                                                                                                                                                           

 
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.301 

 

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 

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 

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 

                                                                                                                                                                           

 
520  See infra note 609. 

521  See infra note 613. 

522  Rule 206(4)-2(a)(4)(ii).   



302 

 

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 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 

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 

                                                                                                                                                                           

 
523  See infra footnote 617. 



303 

 

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 



304 

 

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. 

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 

                                                                                                                                                                           

 
524  See supra note 223. 

525  See supra note 227 and surrounding discussion. 



305 

 

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.   

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 

                                                                                                                                                                           

 
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. 



306 

 

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 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. 



307 

 

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 



308 

 

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 



309 

 

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 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 



310 

 

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 

                                                                                                                                                                           

 
527  See infra note 648. 



311 

 

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 

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 

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 

                                                                                                                                                                           

 
528  See infra note 642. 

529  See infra note 644. 

530  See infra note 649. 



312 

 

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 



313 

 

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 verification of transactions by 

independent public accountants.531 

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 

                                                                                                                                                                           

 
531  See infra note 655. 



314 

 

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 

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. 

                                                                                                                                                                           

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



315 

 

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 



316 

 

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   

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 

                                                                                                                                                                           

 
533  Proposed rule 223-1(a)(2). 

534  See proposed rule 223-1(c).   

535  See infra note 624. 



317 

 

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 upon the 

auditor’s termination or issuance of a modified opinion.537   

                                                                                                                                                                           

 
536  See supra note 282.  

537  See supra note 283.  



318 

 

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   

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 

                                                                                                                                                                           

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



319 

 

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.  



320 

 

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.   

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.   

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 

                                                                                                                                                                           

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

542  See supra note 304 

543  See infra note 660.321 

 

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.   

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 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 

                                                                                                                                                                           

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



322 

 

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 

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 

                                                                                                                                                                           

 
545  Form ADV-E Instructions, pt. 3.ii, https://www.sec.gov/files/formadv-e.pdf. 

546  See infra notes 662 and 664. 



323 

 

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.  

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 

                                                                                                                                                                           

 
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).   



324 

 

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  

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 

                                                                                                                                                                           

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



325 

 

(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.   

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 

                                                                                                                                                                           

 
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).  



326 

 

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   

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.  

                                                                                                                                                                           

 
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).   



327 

 

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 

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 

                                                                                                                                                                           

 
559  See infra footnote 674. 

560  See supra note 359.  



328 

 

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. 

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   

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  

                                                                                                                                                                           

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

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. 



329 

 

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 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.   



330 

 

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. 



331 

 

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 



332 

 

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 



333 

 

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.   

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 

                                                                                                                                                                           

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



334 

 

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 



335 

 

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. 



336 

 

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 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). 



337 

 

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. 

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 

                                                                                                                                                                           

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

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. 



338 

 

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 



339 

 

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. 

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 

                                                                                                                                                                           

 
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. 

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.   

https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Bonding.pdf


340 

 

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. 

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 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 

                                                                                                                                                                           

 
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)).   

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. 

https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Minimum-Financial-Requirements.pdf
https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Minimum-Financial-Requirements.pdf341 

 

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. 

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 



342 

 

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 

                                                                                                                                                                           

 
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). 



343 

 

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. 

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 

                                                                                                                                                                           

 
582  See Rule 17Ad– 22(e)(11).   

583  Exchange Act section 3(a)(25), 15 U.S.C. 78c(a)(25).  



344 

 

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 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. 

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 

                                                                                                                                                                           

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



345 

 

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 



346 

 

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? 



347 

 

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 

                                                                                                                                                                           

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



348 

 

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 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. 

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 

                                                                                                                                                                           

 
586  Proposed rule 223-1. 



349 

 

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.   

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 



350 

 

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 



351 

 

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. 

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 

                                                                                                                                                                           

 
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).   

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).   



352 

 

rule will be required to comply with this requirement.589  We believe that an investment adviser 

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 111,552592 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 

                                                                                                                                                                           

 
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)).  



353 

 

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      

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 1,842597 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 

                                                                                                                                                                           

 
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. 

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)). 

596  See proposed rule 223-1(a)(1)(i)(A).    

597  See infra footnote 619and accompanying text. 



354 

 

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 

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 

                                                                                                                                                                           

 
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.  

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 



355 

 

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   

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 

                                                                                                                                                                           

 
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)).   

https://www.sec.gov/files/2022-exam-priorities.pdf


356 

 

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   

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 

                                                                                                                                                                           

 
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)).   

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). 



357 

 

annual internal burden equates to an annual internal monetized cost burden of approximately 

$324,621.50.613    

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 custodians615 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   

                                                                                                                                                                           

 
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)).   

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).  



358 

 

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)).   



359 

 

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   

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 

                                                                                                                                                                           

 
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. 



360 

 

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 

 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 

                                                                                                                                                                           

 
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. 

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.361 

 

aggregate burden with respect to the surprise examination requirement for this group of advisers 

is 68,626 hours.628 

 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 

 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 

                                                                                                                                                                           

 
628  381 advisers x 9,006 (average number of clients subject to the surprise examination requirement) x 0.02 

hour = 68,626 hours.   

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. 



362 

 

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 

 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.  

 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 

                                                                                                                                                                           

 
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  

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

635  Compare 17 CFR 275.206(4)-2(a)(4) with proposed rule 223-1(a)(4).   



363 

 

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 

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 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 

                                                                                                                                                                           

 
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. 



364 

 

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 

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   

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 

                                                                                                                                                                           

 
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.   

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)).   



365 

 

agreements or entering into new agreements.643  The related total monetized cost burden for 

these amendments would equal $977,514.644   

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 

                                                                                                                                                                           

 
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)).   

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 



366 

 

hours647 in the aggregate to send annually with an annual monetized cost of $48,013.648   

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   

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 

                                                                                                                                                                           

 
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.   

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.   

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.  



367 

 

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 

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 

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 

                                                                                                                                                                           

 
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.   



368 

 

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). 



369 

 

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 hours662 for all advisers that satisfy the 

requirements of the audit engagement.  We further estimate that each adviser will spend 0.92 

                                                                                                                                                                           

 
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. 

 



370 

 

hours663 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 hours664 and an annual cost of 

this internal hour burden of $19,476,867665 for all advisers that satisfy the requirements of the 

audit provision. 

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 

A chart summarizing the various proposed components of the total annual burden for 

investment advisers with custody of client assets is below. 

                                                                                                                                                                           

 
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). 

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. 

Rule 223-1 Description of New Requirements No. of Responses Internal Burden Hours External Burden Costs 

 Final Estimates for Qualified Custodian Protections Under 223-1(a)(1) 

Initial burden for drafting, negotiating, and executing 

new written custodial agreements with required 

provisions between the adviser and qualified 

custodian (“QC”) (IA-QC custodial contract) 

55,776 (4 per 

adviser with 

custody) 

111,552 (2 per 

response)  

 



371 

 

  

Annual burden for drafting, negotiating, and 

executing new written custodial agreements with 

required provisions between the adviser and 

qualified custodian (IA-QC custodial contract) 

55,776 (4 per 

adviser with 

custody) 

9,482 (.17 hour per 

response) 

 

Annual burden for QC to provide records relating to 

clients’ 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.   

8,368 (4 per 

adviser examined) 

12,552 (1.5 hour per 

response) 

 

Annual burden for QC to provide records relating to 

clients’ assets to an 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.   

36,844 (4 per 

adviser obtaining  

a surprise 

examination or 

audit) 

18,422 (.5 hour per 

response) 

 

Initial burden for QC to send account statements, at 

least quarterly, to the client, or its independent 

representative, and to adviser 

 

959 (estimated 

qualified 

custodians) 

14,385 hours (15 

hours per qualified 

custodian) 

 

Annual burden for QC to modify and send account 

statements 

959 (estimated 

qualified 

custodians) 

959 (1 hour per 

qualified custodian)  

Annual burden for QC to obtain internal control report   $35,962,500 

Initial burden for adviser obtaining reasonable 

assurances from the QC  

55,776 (1 per  

adviser)  

69,720 (1.25 hours 

per response) 

 

Annual burden for adviser obtaining reasonable 

assurances from the QC 

55,776 (1 per  

adviser) 

13,944 (.25 hours per 

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 agreement with 

independent public accountant (IPA) 

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) 

6,201 (1.25 

hours per 

adviser) 

 

Annual burden for written agreement with IPA 4,961 2,481 (.5 

hour per 

adviser) 

 

Annual burden to notify the IPA of any purchase, 

sale, or other transfer of beneficial ownership of such 

assets within one business day 

8,000 (estimated 

number of annual 

transactions) 

133 hours (1 

minute per 

transaction)  

 

Annual burden to verify the purchase, sale, or other 

transfer promptly upon receiving the required 

transfer notice* 

                          $19,680,000 



372 

 

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. 

*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 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. 

                              $322,956,000 

 Final Estimates for Complying with the Notice Requirement Under 223-1(a)(2) 

Initial burden for complying with the notice 

requirement* 

*This would be a one-time burden to include account 

numbers in the notices. 

13,944 advisers (1 

per adviser)  

 

13,944 hours (1 hour 

per adviser ) 

 

 

Final Estimates for Independent Verification or Surprise Examination Under 223-1(a)(4) 

Annual burden for complying with the independent 

verification/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. 

1,842 advisers are 

subject to the 

surprise exam  

 

80,949 hours1 

 

 

 

 Annual burden to enter into a written agreement 

with an IPA 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. 

1,842 advisers 461 hours (.25 per 

adviser) 

 

Exception for Entities Subject to the Annual Audit 223-1(b)(4) 

Annual burden for distributing audited financial 

statements 

7,018 advisers 7,098 hours   

Annual burden for drafting, negotiating, and 

executing the required written agreement between 

the IPA and adviser regarding notifications from the 

IPA to the Commission of specified events 

7,018 advisers  35,869 hours  

 TOTAL ESTIMATED FINAL BURDEN FOR RULE 223-1 

Total estimated burden for rule 223-1 319,856  398,152 hours $378,598,500 

Currently approved burden for rule 206(4)-2 24,133,429 288,202 hours $174,367,000 

Comparison of proposed rule 223-1 burdens to 

current rule 206(4)-2 burdens 

(23,813,573) 109,950 hours $204,231,500 



373 

 

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 



374 

 

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.   

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 

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, 

                                                                                                                                                                           

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

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



375 

 

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. 

The approved annual aggregate burden for rule 204-2 is currently 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 582,789673 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 

                                                                                                                                                                           

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

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. 



376 

 

most recent approval and adjustments for inflation, as well as the proposed rule 204-2 

amendments as discussed in this proposing release.  

A chart summarizing the various components of the total annual burden for investment 

advisers with custody of client assets is below.  

 
 

 

Internal Hour 

Burden  Wage Rate1 

  

Internal Time Costs 

Annual External 

Cost Burden 

FINAL ESTIMATES FOR RULE 204-2 FOR CLIENT COMMUNICATIONS 

Retention of written 

client notifications and 

responses  

     

3 

 

 

× 

 

 

$82 

(compliance clerk) 

 

$246 

 

 

 

Total burden per adviser 3   $246  

Total number of affected 

advisers 
× 13,944   × 13,944  

Sub-total burden   41,832 hours   $3,430,224  

FINAL ESTIMATES FOR RULE 204-2 FOR CLIENT ACCOUNTS 

Creation and retention 

of records documenting 

client account identifying 

information, including 

adviser discretionary 

authority 

2 × 
$73 

(general clerk) 
$146  

1 × 
$82 

(compliance clerk) 
$82  

Total burden per adviser 3   $228  

Total number of affected 

advisers 
× 13,944   × 13,944  

Sub-total burden 41,832 hours   $3,179,232  

Creation and retention 

of records 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 

 2 

 

 

 

1 

 

× 

 

 

 

x          

 

$73 

(general clerk) 

 

 

$82 

(compliance clerk)              

$146 

 

 

$82 

 

 



377 

 

qualified custodian’s 

possession or control 

Total burden per adviser 

 

Total number of affected 

advisers 

3 

 

× 13,944 

 

  

$228 

 

× 13,944 

 

 

Sub-total burden 41,832 hours   $3,179,232  

Creation and retention 

of records documenting 

adviser’s basis of 

custody of client assets 

2 

 

1 

× 

 

x 

$73 

(general clerk) 

 

$82 

(compliance clerk) 

$146 

 

$82 

 

Total burden per adviser 

 

Total number of affected 

advisers 

3 

 

× 13,944 

 

  

$228 

 

×13,944 

 

 

Sub-total burden 41,832 hours   $3,179,232  

Retention of copies of 

account statements 
              2  x  

$82 

(compliance clerk) 
$164  

Total burden per adviser 

 

Total number of affected 

advisers 

              2 

 

       x 13,944 

  

$164 

 

x 13,944 

 

Sub-total burden 27,888 hours   $2,286,816  

Creation and retention 

of records of detailed 

transaction and position 

information for each 

client account 

3 

 

 

x 

 

 

$82 

(compliance clerk) 

 

$246 

 

 

 

Total burden per adviser 

 

Total number of advisers 

3 

 

x 13,944 

  

$246 

 

x 13,944 

 

Sub-total burden 41,832 hours   $3,430,224   

Retention of copies of, 

and records relating to, 

standing letters of 

authorization 

.25                        x              
$82 

(compliance clerk) 
$20.50  

Total burden per adviser 

 

Total number of advisers 

.25 

 

x 2,789 

 

 
 

$20.50 

 

x 2,789 

 

Sub-total burden 697.25 hours   $57,174.50  

FINAL ESTIMATES FOR RULE 204-2 FOR INDEPENDENT PUBLIC ACCOUNTANT 

Retention of copies of all 

audited financial 

statements, internal 

control reports, and 

required written 

agreements between 

independent public 

accountant and adviser  

or its client 

3 × 
$73 

(general clerk) 
$219  

1 × 
$82 

(compliance clerk) 
$82  

Total burden per adviser 4   $301  



378 

 

Total number of affected 

advisers 
× 13,944   × 13,944  

Sub-total burden 55,776 hours   $4,197,144  

TOTAL ESTIMATED FINAL BURDEN FOR RULE 204-2 

Total burden for this 

rulemaking 

293,521.25 

hours 
  $22,939,278.50     

Previously approved 

burden plus the 

additional burden due to 

the increase in the 

number of advisers 

3,053,831 hours   $194,394,000  

Total burden 3,347,352 hours   $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 



379 

 

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. 

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 

                                                                                                                                                                           

 
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”). 



380 

 

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.  

TABLE 10: FORM ADV PRA ESTIMATES 

  

Initial hours 

per year 

Internal annual 

amendment 

burden hours1  Wage rate2 Internal time costs 

Annual external 

cost burden3 

PROPOSED AMENDMENTS TO FORM ADV 

RIAs (burden for Parts 1 and 2, not including private fund reporting)4 

Proposed additions (per 

adviser) to Part 1A Item 9 

and corresponding 

schedules;  

 

 1 hour for 

Part 1A,  
0.4 hours5  

$318 per hour 

(blended rate for 

senior compliance 

examiner and 

compliance manager)6 

1.4 hours x $318 

per hour = 

$445.20 

 

Current burden per 

adviser7 

 

29.72 

hours8  
11.8 hours9  

$273.00 per hour 

(blended rate for 

senior compliance 

examiner and 

compliance manager) 

(29.72 + 11.8) x 

$273.00 = 

$11,334.96 

$2,069,250 

aggregated 

(previously 

presented only in 

the aggregate)10 

Revised burden per 

adviser 

 
29.72 hours 

+ 1 hour = 

30.72 hours  

 0.4 hours + 11.8 

hours = 12.2 hours  
 

$318 (blended rate for 

senior compliance 

examiner and 

compliance manager) 

(30.72 + 12.2) x 

$318 = 

$13,648.56 

$4,780.5011  

Total revised aggregate 

burden estimate 

 

32,117.44 
12 

191,686.4 hours13  Same as above 

 

 (32,177,44 + 

191,686.4) x $318 

= $71,169,621.12 

$11,162,54614 

RIAs (burden for Part 3)15 

No proposed changes  -- --  -- -- --381 

 

Current burden per RIA  

20 hours, 

amortized 

over three 

years = 

6.67 

hours16 

1.58 hours17  

$273 (blended rate for 

senior compliance 

examiner and 

compliance manager) 

$273 x (6.67 + 

1.58) = $2,249.52 

$2,433.74 per 

adviser18 

Total updated aggregate 

burden estimate 
 

70,646.67  

hours19 
15,646.74  hours20  

$318 (blended rate for 

senior compliance 

examiner and 

compliance manager  

$27,441,303.32 

($318 x 

(70,646.67 hours 

+ 15,646.74 

hours) 

$9,930,272.0821 

ERAs (burden for Part 1A, not including private fund reporting)22 

No proposed changes        

Current burden per ERA 

 

3.60 

hours23  

1.5 hours + final 

filings24 
 

$273 (blended rate for 

senior compliance 

examiner and 

compliance manager) 

 $0 

Total revised aggregate 

burden estimate 

 

1,245.6025 8,777.60 hours26  

$318 (blended rate for 

senior compliance 

examiner and 

compliance manager  

$3,187,377.60 

($318 x (1,245.6 + 

8,777.60 hours)) 

$0 

Private Fund Reporting27 

No proposed changes         

Current burden per 

adviser to private fund 

 

1 hour per 

private 

fund28  

N/A – included in 

the existing annual 

amendment 

burden 

 

$273 (blended rate for 

senior compliance 

examiner and 

compliance manager) 

 

Cost of 

$46,865.74 per 

fund, applied to 

6% of RIAs that 

report private 

funds29 

Total updated aggregate 

burden estimate 

 

1,150 

hours30 
N/A  

$318 (blended rate for 

senior compliance 

examiner and 

compliance manager)  

$5,173,478.40 

($318 x 16,26930 

hours)) 

$14,856,439.5831 

TOTAL ESTIMATED BURDENS, INCLUDING AMENDMENTS 

Current per adviser 

burden/external cost per 

adviser 

 

23.82 hours32 

23.82 hours x 

$273 = $6,502.86 

per adviser cost of 

the burden hour 

$77733 

Revised per adviser 

burden/external cost per 

adviser 

 

15.62 hours34 

15.62 hours x 

$318 = $4,966.43 

per adviser cost of 

the burden hour 

$1,669.0335 

Current aggregate burden 

estimates 

 

433,004 initial and amendment hours annually36 

433,004 x $273 = 

$118,210,092 

aggregate cost of 

the burden hour 

$14,125,08337 

Revised aggregate burden 

estimates 

 

336,389.4538 Initial and amendment hours annually 

336,389.45 x 

$318 = 

$106,971,844.04 

aggregate cost of 

the burden hour 

$35,949,257.6639 

Notes: 



382 

 

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. 

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 ¼ and ½ 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). 



383 

 

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).  

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 



384 

 

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 



385 

 

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? 



386 

 

 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.  



387 

 

Additionally, our analysis relies on the assumption that it will take 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 



388 

 

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? 



389 

 

 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 



390 

 

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 



391 

 

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 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). 



392 

 

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.  



393 

 

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, 



394 

 

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 



395 

 

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.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. 

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 

                                                                                                                                                                           

 
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. 



396 

 

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 

                                                                                                                                                                           

 
678  Advisers Act rule 0-7(a).  



397 

 

estimate that as of June 30, 2022, approximately 522 SEC-registered advisers are small entities 

under the RFA.679   

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   

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   

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 

                                                                                                                                                                           

 
679  Based on SEC-registered investment adviser responses to Items 5.F. and 12 of Form ADV.  

680  See supra note 553.   

681  See PRA discussion supra section IV. 



398 

 

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 small advisers associated with our proposed amendments to 

the safeguarding rule would be $5,371,008.684 

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 

                                                                                                                                                                           

 
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. 

684  13,632 aggregate small adviser hours x $394 (blended rate for a compliance manager ($361) and a 

compliance attorney ($426)) =$5,371,008. 



399 

 

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.  



400 

 

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.401 

 

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 



402 

 

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 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 



403 

 

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 



404 

 

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. 

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 

                                                                                                                                                                           

 
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).   



405 

 

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 

 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. 

 2.  Amend § 275.204-2 by: 

 a.  Removing and reserving paragraphs (a)(8) and (a)(17)(iii). 

 b.  Revising paragraph (b). 

 The revisions read as follows: 

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

* * * * * 



406 

 

(b) If an investment adviser subject to paragraph (a) of this section is subject to § 

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 § 

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, e-mail 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 § 275.223-1(d)(4) (Rule 223-

1(d)(4)) 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.  

(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 § 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 



407 

 

the reasonable assurances that the investment adviser obtains from the qualified custodian under 

§ 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 § 275.223-1(d)(8) (Rule 223-1(d)(8)) of such assets, as required under § 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 § 275.223-1(d)(3) (Rule 223-1(d)(3)) 

of the client’s assets (as defined by § 275.223-1(d)(1) (Rule 223-1(d)(1)), including whether a 

related person (as defined by § 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 § 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 § 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 § 

275.223-1(c) (Rule 223-1(c)). 

(v) Transaction and position information.   



408 

 

(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 § 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 § 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 § 275.223-1(b)(4) 

(Rule 223-1(b)(4)).  

(ii) A copy of any internal control report: 



409 

 

(A) Obtained by a qualified custodian and received by an investment adviser pursuant to 

§ 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. 

* * * * *  

§ 275.206(4)-2 [Removed] 

3.  Section 275.206(4)-2 is removed. 

4.  Section 275.223-1 is added to read as follows: 

§ 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;   



410 

 

(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 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 



411 

 

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. 



412 

 

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 



413 

 

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. 



414 

 

(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   

(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. 



415 

 

(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 



416 

 

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. 



417 

 

(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.  



418 

 

(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 advisory 

services you provide to clients. Custody includes: 



419 

 

(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. 



420 

 

(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;421 

 

(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; 



422 

 

(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 



423 

 

(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 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 

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. 

6.  Amend Form ADV (referenced in § 279.1) by: 

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; 

b.  In Glossary of Terms, revising the definitions of items 12 (Custody) and 13 

(Discretionary Authority or Discretionary Basis); 

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; 

d.  In Part 1A, revising Item 9; 

e.  In Schedule D, adding section 9.C.1; and revising section 9.C.3. 

The additions and revisions read as follows:    



424 

 

NOTE: The text of Form ADV does not, and this amendment will not, appear in the Code 

of Federal Regulations. 

FORM ADV (Paper Version) 

UNIFORM APPLICATION FOR INVESTMENT ADVISER REGISTRATION AND 

REPORT BY EXEMPT REPORTING ADVISERS 

Form ADV General Instructions 

* * * * * 

4. When am I required to update my Form ADV? 

* * * * * 

 Other-than-annual amendments: In addition to your annual updating amendment, 

o  If you are registered with the SEC or a state securities authority, you must amend 

Part 1A, 1B, 2A and 2B (as applicable) of your Form ADV, including 

corresponding sections of Schedules A, B, C, D, and R, by filing additional 

amendments (other-than-annual amendments) promptly, if: 

 you are adding or removing a relying adviser as part of your umbrella 

registration;  

 information you provided in response to Items 1 (except 1.O. and section 

1.F. of Schedule D), 3, 9 (except 9.A.(2) and 9.D.(2), unless your response 

to Item 9.D.(1) changed)), or 11 of Part 1A or Items 1, 2.A. through 2.F., 

or 2.I. of Part 1B or sections 1 or 3 of Schedule R becomes inaccurate in 

any way; 

* * * * * 

GLOSSARY OF TERMS 

* * * * * 



425 

 

Assets:  For purposes of Item 9 and related sections of Schedule D, has the same 

meaning as defined in Rule 223-1. 

* * * * * 

Custody:  Has the same meaning as in Rule 223-1. 

* * * * * 

Discretionary Authority, Discretionary Basis, or Discretionary Trading Authority: 

Your firm has discretionary authority or manages assets on a discretionary basis or has 

discretionary trading authority if it has the authority to decide which assets to purchase 

and sell for the client without consulting the client. Your firm also has discretionary 

authority if it has the authority to decide which investment advisers to retain on behalf of 

the client without consulting the client. 

* * * * * 

Operationally Independent:  For the purposes of Item 9 and related sections of 

Schedule D, has the same meaning as in Rule 223-1. 

* * * * * 

Qualified Custodian:  Has the same meaning as in Rule 223-1.   

* * * * * 

Standing Letter of Authorization:  Has the same meaning as in Rule 223-1. 

PART 1A  

* * * * * 

a. Item 9 Custody 

In this Item, we ask whether you or a related person has custody of client assets and about 

your custodial practices. 

 

A. (1) Do you have custody of client assets (excluding clients that are investment 

companies registered pursuant to the Investment Company Act of 1940 or 



426 

 

business development companies that elect to be regulated as such) either 

directly or because a related person has custody of client assets in connection 

with advisory services that you provide to the client: 

 

Yes 

No 

You must answer “yes” to Item 9.A.(1) if you reported discretionary RAUM in Item 

5.F.(2)(a); answered “yes” to Item 8.C.(1) indicating you have discretionary authority 

over client assets; or if you have the ability to deduct your advisory fee directly from 

client accounts.  If you answered “no” to Item 9.A.(1), do not complete the remainder of 

Item 9.   

 

(2) As of your most recent fiscal year end, what is the approximate amount of 

client assets (rounded to the nearest $1,000) of which you directly or a related 

person in connection with advisory services that you provide to the client have 

custody and for how many clients attributable to each of the following?  

 

Basis for Custody Direct Custody by Adviser Indirect Custody through a Related 

Person 

 (i) Approximate 

Amount of 

Client Assets 

(ii) Number of 

Clients 

(iii) Approximate 

Amount of Client 

Assets 

(iv) Number of 

Clients 

(a) Ability to 

deduct 

your advisory 

fees 

from client 

accounts 

    

(b) Discretionary 

Authority 

    

(c) Serving as a 

general partner, 

managing 

member, trustee 

(or equivalent) 

for clients that are 

private funds 

    

(d) Serving as 

a general partner, 

managing 

member, trustee 

(or equivalent) 

for clients that  

    



427 

 

are not private 

funds 

(e) Having 

general power  

of attorney  

or check-writing 

authority 

    

(f) Having a 

standing letter of 

authorization 

    

(g) Having 

physical 

possession of 

client assets 

    

(h) Acting as a 

qualified 

custodian 

    

(i) Through a 

related person 
that is 

operationally 
independent 

XXXXXX XXXXXX   

(j) Other     

(k) Total     

 

Because an adviser may have custody for more than one reason in the table above, the 

sum of (a) – (j) may not equal the amount in (k) Total. 

 

B.  (1) Are you relying on any of the exceptions in rule 223-1(b) to comply with rule 

223-1?  

 
Yes 

No 

(2) If you answered “yes” to Item 9.B.(1), on which exceptions in rule 223-1(b) 

are you relying (check all that apply).   

 

Shares of Mutual Funds (Rule 223-1(b)(1))

Certain Assets Unable to be Maintained with a Qualified Custodian (Rule 

223-1(b)(2)) 

If you checked the box above, list in section 9.C.(3) of Schedule D the accountants 

performing the verification required by Rule 223-1(b)(2)(iii)(A).



428 

 



Fee Deduction (Rule 223-1(b)(3)) 

Entities Subject to Annual Audit (Rule 223-1(b)(4)) 

If you checked the box above, list in section 9.C.(3) of Schedule D the accountants that 

performed the audit required by rule 223-1(b)(4).  You do not have to list independent 

public accountant information in section 9.C of Schedule D if you already provided this 

information with respect to the private funds you advise in section 7.B.(1) and that 

accountant only performs audits required by rule 223-1(b)(4) for those private funds. 


Certain Related Persons (Rule 223-1(b)(6)) 

Standing Letters of Authorization (Rule 223-1(b)(7)) 

Discretionary Authority (Rule 223-1(b)(8)) 

C. (1) Are any client assets of which you or a related person have custody 

maintained by a qualified custodian in accordance with rule 223-1 under the 

Advisers Act? 


Yes 

No 

If you answered “yes” to Item 9.C.(1) you must complete Section 9.C.(1) of Schedule D 

for each Qualified Custodian, including yourself or a related person, that maintains your 

client assets. 

 

D. (1) Are any client assets of which you or a related person have custody not 

maintained by a qualified custodian in accordance with rule 223-1 under the 

Advisers Act? 

 

Yes 

No 

(2) If you answered “yes” to item 9.D.(1), what are the number clients and 

approximate amount of client assets (rounded to the nearest $1,000) not 

maintained by a qualified custodian? 

 

(i) $   (ii) No. of clients:     

E. (1) Are you required to obtain a surprise examination in accordance with rule 

223-1(a)(4) under the Advisers Act? 

 



429 

 

Yes 

No 

If you are an adviser to pooled investment vehicle(s) or other entities relying on the audit 

provision under rule 223-1(b)(4) and do not otherwise need to obtain a surprise 

examination for other clients, indicate “No” in response to Item 9.E.(1).  If you 

responded “Yes” to Item 9.E.(1), list in Section 9.C.(3) of Schedule D the accountant 

engaged to perform the surprise examination required by rule 223-1(a)(4). 

 

* * * * * 

Schedule D 

* * * * * 

SECTION 9.C.(1) Qualified Custodian 

 

You must complete the following information for each qualified custodian that maintains 

your clients’ assets.  You must complete a separate Schedule D Section 9.C.(1) for each 

qualified custodian.  

 

Check only one box:  

 

 Add  Delete  Amend  

 

(1) Full legal name of the qualified custodian: ____________________________  

 

(2) The location of the qualified custodian’s office responsible for the services provided: 

________________________________________________________________________

______ (number and street) 

________________________________________________________________________

______ (city) (state/country) (zip+4/postal code) 

 

(3) Qualified custodian’s regulatory contact information: 

            

  

Name 

            

  

Telephone Number, including country code 

            

  

E-mail Address 

            

  



430 

 

Number and street (if different from above) 

            

  

City, state/country and zip+4/postal code (if different from above) 

 

(4) Type of entity: 

 

Broker/Dealer 

 SEC Registration Number:       

U.S. Bank or Savings Association

Futures Commission Merchant

Foreign Financial Institution 

  Primary Regulator/Country:       

 

(5) Legal Entity Identifier (if applicable):       

 

(6)  Number of clients and approximate amount of client assets (rounded to the nearest 

$1,000) held at the qualified custodian listed above: 

(i) Number of clients:       

(ii) Approximate amount of client assets: $      

 

(7) Is the qualified custodian listed above a related person?  Yes  No 

 

(i) If so, provide the following information about the independent public accountant 

that prepared the internal control report required by Rule 223-1(a)(1)(i)(C).  

 

(1) Name of the independent public accountant: ____________________________  

 

(2) The location of the independent public accountant’s office responsible for the services 

provided: 

________________________________________________________________________

______ (number and street) 

________________________________________________________________________

______ (city) (state/country) (zip+4/postal code) 

 

(3) Is the independent public accountant registered with the Public Company Accounting 

Oversight Board? 

 

Yes  No 

 

If “yes,” Public Company Accounting Oversight Board-Assigned Number:____________ 

 

(4) If “yes” to (3) above, is the independent public accountant subject to regular 

inspection by the Public Company Accounting Oversight Board in accordance with its 

rules? 

 



431 

 

Yes No 

 

(5) Did the internal control report prepared by the independent public accountant 

identified above contain an unqualified opinion?  

 

Yes No   Report Not Yet Received for Most Recent Fiscal Year End 

 

* * * * * 

SECTION 9.C.(3) Independent Public Accountants 

 

You must complete the following information for each independent public accountant 

engaged to perform a surprise examination, a financial statement audit of an entity whose 

assets you manage, or the verification of client assets required under rule 223-

1(b)(2)(iii)(A).  You must complete a separate Schedule D Section 9.C.(3) for each 

independent public accountant.  

 

Check only one box:  

 

 Add  Delete  Amend  

 

(1) Name of the independent public accountant: ____________________________  

 

(2) The location of the independent public accountant’s office responsible for the services 

provided: 

________________________________________________________________________

______ (number and street) 

________________________________________________________________________

______ (city) (state/country) (zip+4/postal code) 

 

(3) Is the independent public accountant registered with the Public Company Accounting 

Oversight Board? 

Yes  No 

If “yes,” Public Company Accounting Oversight Board-Assigned 

Number:____________ 

 

(4) If “yes” to (3) above, is the independent public accountant subject to regular 

inspection by the Public Company Accounting Oversight Board in accordance with its 

rules? 

Yes No 

 

(5) The independent public accountant is engaged to:  

A. perform a surprise examination  

B. perform an audit 

C. perform the verification required by Rule 223-1(b)(2)(iii)(A).  

 



432 

 

(6) Since the end of your most recent fiscal year, did all of the reports prepared by the 

independent public accountant identified above contain unqualified opinions?  

 

Yes  No Report Not Yet Received for Most Recent 

Fiscal Year End 

 

If you check “Report Not Yet Received for Most Recent Fiscal Year End,” you must 

promptly file an amendment to your Form ADV to update your response when the 

accountant’s report is available. 

 

* * * * *   

By the Commission. 

Dated:  February 15, 2023 

 

 

Vanessa A. Countryman, 

Secretary.

Conformed to Federal Register 

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:  

https://www.sec.gov/rules/submitcomments.htm


2 

 

 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. 

https://www.sec.gov/rules/proposed.shtml
mailto:[email protected]


3 

 

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. 



4 

 

Table of Contents 

I. Introduction .................................................................................................................. 7 

A. Background ............................................................................................................. 7 

B. Overview of the Proposal...................................................................................... 19 

II. Discussion ................................................................................................................... 26 

A. Scope of Rule ........................................................................................................ 26 

1. Scope of Assets ............................................................................................... 27 

2. Scope of Activity Subject to the Proposed Rule ............................................. 30 

B. Qualified Custodian Protections ........................................................................... 41 

1. Definition of Qualified Custodian .................................................................. 43 

2. Possession or Control ...................................................................................... 62 

3. Minimum Custodial Protections ..................................................................... 74 

C. Certain Assets that are Unable to be Maintained with a Qualified Custodian .... 127 

1. Definition of Privately Offered Security and Physical Assets ...................... 133 

2. Adviser’s Reasonable Determination ........................................................... 135 

3. Adviser Reasonably Safeguards Assets ........................................................ 138 

4. Notification and Prompt Independent Public Accountant Verification ........ 142 

5. Surprise Examination or Audit ..................................................................... 146 

D. Segregation of Client Assets ............................................................................... 164 

E. Investment Adviser Delivery of Notice to Clients .............................................. 173 

F. Amendments to the Surprise Examination Requirement .................................... 175 

G. Exceptions from the Surprise Examination ........................................................ 178 

1. Entities Subject to Audit (“Audit Provision”) .............................................. 178 

2. Discretionary Authority ................................................................................ 206 

3. Standing Letters of Authorization ................................................................. 210 

H. Amendments to the Investment Adviser Recordkeeping Rule ........................... 215 

1. Client Communications ................................................................................ 218 

2. Client Accounts ............................................................................................. 218 

3. Account Activity ........................................................................................... 221 

4. Independent Public Accountant Engagements.............................................. 224 

5. Standing Letters of Authorization ................................................................. 224 

I. Changes to Form ADV ....................................................................................... 227 

J. Existing Staff No-Action Letters and Other Staff Statements ............................ 237 

K. Transition Period and Compliance Date ............................................................. 239 

III. Economic Analysis ................................................................................................... 241 

A. Introduction ......................................................................................................... 241 

B. Broad Economic Considerations......................................................................... 242 

C. Baseline ............................................................................................................... 247 

1. Current Regulation ........................................................................................ 247 

2. Affected Parties and Industry Statistics ........................................................ 254 

3. Market Practice ............................................................................................. 258 



5 

 

D. Benefits and Costs of Proposed Rule and Form Amendments ........................... 269 

1. Scope ............................................................................................................. 269 

2. Qualified Custodian Protections ................................................................... 276 

3. Certain Assets that are Unable to be Maintained with a Qualified Custodian

 303 

4. Segregation of Investments ........................................................................... 313 

5. Investment Adviser Delivery of Notice to Clients ........................................ 315 

6. Exceptions from the Surprise Examination .................................................. 317 

7. Amendments to the Investment Adviser Recordkeeping Rule ..................... 325 

8. Changes to Form ADV ................................................................................. 327 

E. Efficiency, Competition, and Capital Formation ................................................ 329 

F. Reasonable Alternatives...................................................................................... 332 

1. Scope of Assets ............................................................................................. 332 

2. Elimination of Privately Offered Securities Exception ................................ 332 

3. Distribution of Requirements across Reasonable Assurances and Written 

Agreement ..................................................................................................... 334 

3. Additional Accounting and Client Notification Requirements for Privately 

Offered Securities and Physical Assets that are Not Maintained with a 

Qualified Custodian ...................................................................................... 336 

4. Additional Safeguards when Clients Assets are Not Maintained with a 

Qualified Custodian ...................................................................................... 338 

5. Designating Clearing Agencies and Transfer Agents as Qualified Custodians

 342 

G. Request for Comment ......................................................................................... 344 

IV. Paperwork Reduction Act Analysis .......................................................................... 347 

A. Introduction ......................................................................................................... 347 

B. Rule 223-1 ........................................................................................................... 348 

1. Qualified Custodian Provision ...................................................................... 351 

2. Notice to Clients ........................................................................................... 359 

3. Annual Surprise Examination ....................................................................... 359 

C. Exceptions ........................................................................................................... 363 

1. Certain Assets that are Unable to be Maintained with a Qualified Custodian

 363 

2. Audit Provision ............................................................................................. 367 

D. Total hour burden associated with proposed rule 223-1 ..................................... 370 

E. Rule 204-2 ........................................................................................................... 373 

F. Form ADV .......................................................................................................... 378 

G. Request for Comments ........................................................................................ 384 

V. Initial Regulatory Flexibility Analysis ..................................................................... 391 

A. Reason for and Objectives of the Proposed Action ............................................ 392 

1. Proposed rule 223-1 ...................................................................................... 392 



6 

 

2. Proposed rule 204-2 ...................................................................................... 393 

3. Proposed amendments to Form ADV ........................................................... 394 

B. Legal Basis .......................................................................................................... 395 

C. Small Entities Subject to the Rule and Rule Amendments ................................. 396 

1. Small entities subject to amendments to the custody rule ............................ 397 

D. Projected Reporting, Recordkeeping and Other Compliance Requirements ...... 397 

1. Proposed rule 223-1 ...................................................................................... 397 

2. Proposed amendments to rule 204-2 ............................................................. 398 

3. Proposed amendments to Form ADV ........................................................... 400 

E. Duplicative, Overlapping, or Conflicting Federal Rules .................................... 401 

F. Significant Alternatives ...................................................................................... 401 

1. Proposed new rule 223-1 and amendments to rule 204-2 and Form ADV ... 401 

G. Solicitation of Comments ................................................................................... 403 

VI. CONSIDERATION OF IMPACT ON THE ECONOMYError! Bookmark not defined. 

VII. Statutory Authority ............................................................................................. 404 

 

  



7 

 

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    

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 

                                                                                                                                                                           

 
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”).   

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 



8 

 

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 

examination4 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.  

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 

                                                                                                                                                                           

 
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. 

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. 



9 

 

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  

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 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 

                                                                                                                                                                           

 
7  See 2003 Adopting Release, supra footnote 2,at note 10 and accompanying text. 

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. 



10 

 

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.      

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 

                                                                                                                                                                           

 
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). 



11 

 

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   

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 

                                                                                                                                                                           

 
12  See generally rule 206(4)-2; see also 2009 Adopting Release, supra footnote 11, at sections II.A and B.  

13  See section 411 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 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—

http://40act.com/investment-advisers/subjects/custody


12 

 

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 

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 technology, advisory services, and custodial practices create 

                                                                                                                                                                           

 
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). 

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 

https://www.sec.gov/divisions/investment/custody_faq_030510.htm


13 

 

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.   

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 

                                                                                                                                                                           

 
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. 



14 

 

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.       

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 

                                                                                                                                                                           

 
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. 

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). 



15 

 

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 

                                                                                                                                                                           

 
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.   



16 

 

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. 

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 industry have caused us to reconsider the role of a 

“qualified custodian” under our rule and what minimum protections clients should receive. 

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 

                                                                                                                                                                           

 
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). 

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, 

https://www.wsj.com/articles/companies-compete-to-be-cryptocurrency-custodians-11568772060


17 

 

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.   

                                                                                                                                                                           

 
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. 

https://openknowledge.worldbank.org/bitstream/handle/10986/29053/WP-PUBLIC-Distributed-Ledger-Technology-and-Blockchain-Fintech-Notes.pdf?sequence=1&isAllowed=y
https://openknowledge.worldbank.org/bitstream/handle/10986/29053/WP-PUBLIC-Distributed-Ledger-Technology-and-Blockchain-Fintech-Notes.pdf?sequence=1&isAllowed=y
https://occ.treas.gov/news-issuances/news-releases/2023/nr-ia-2023-1a.pdf
https://occ.treas.gov/news-issuances/news-releases/2023/nr-ia-2023-1a.pdf
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4107019


18 

 

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. 

https://www.sec.gov/spotlight/cybersecurity-enforcement-actions


19 

 

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 

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 

                                                                                                                                                                           

 
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.   



20 

 

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 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.   

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 

                                                                                                                                                                           

 
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).  

35  Proposed rule 223-1(d)(3).21 

 

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   

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 

                                                                                                                                                                           

 
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.      

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. 



22 

 

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   

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 person41 that 

acts as a qualified custodian.   

In addition to the written agreement requirement, advisers would have to obtain 

reasonable assurances that the qualified custodian satisfies five additional enumerated items.42  

                                                                                                                                                                           

 
40  Proposed rule 223-1(a)(1). 

41  The term “related person” would have the same meaning as in the current rule. 

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



23 

 

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. 

 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 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 

                                                                                                                                                                           

 
43  See proposed rule 223-1(b)(2). 

44  See proposed rule 223-1(d)(9).  



24 

 

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. 

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.   

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 

                                                                                                                                                                           

 
45  See proposed rule 223-1(b)(2). 

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



25 

 

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   

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 

                                                                                                                                                                           

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

48  See proposed rule 223-1(b)(4). 

49  See infra discussion at section II.I. 



26 

 

Commission’s examination initiatives and would allow the Commission and its staff to better 

assess risks specific advisers pose to investors.50    

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 

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 

                                                                                                                                                                           

 
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). 

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). 



27 

 

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 depend on which type of assets the client entrusts to the 

adviser.   

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 

                                                                                                                                                                           

 
53  Proposed rule 223-1(d)(1). 

54  See section 223, supra footnote 34. 

55  See supra footnote 11. 



28 

 

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 

                                                                                                                                                                           

 
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. 



29 

 

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 

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  

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? 

                                                                                                                                                                           

 
60  See rule 6c-11, supra footnote 56.  The release discussed that liabilities were contemplated to be part of 

“other positions.” 

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.   



30 

 

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 



31 

 

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.   

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 would retain these categories because, 

                                                                                                                                                                           

 
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.      

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. 



32 

 

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. 

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   

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 

                                                                                                                                                                           

 
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). 

69  2003 Adopting Release, supra footnote 2, at n.10. 



33 

 

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   

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 

                                                                                                                                                                           

 
70  Id. 

71  Our staff stated a similar view under the current rule.  See Custody Rule FAQs, supra footnote 17, at 

Question VII.3. 



34 

 

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 

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? 

                                                                                                                                                                           

 
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.  

https://www.bis.org/cpmi/publ/d06.pdf


35 

 

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 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 



36 

 

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? 

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 

                                                                                                                                                                           

 
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).   



37 

 

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? 

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 

                                                                                                                                                                           

 
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). 

80  We note that the staff has issued an FAQ on this topic.  See Custody Rule FAQs, supra footnote 17, at 

Question XII.2. 



38 

 

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 

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 

                                                                                                                                                                           

 
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)). 

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.       



39 

 

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 assets with a qualified custodian, 

should we provide an exception if an adviser to a private fund or serving as a trustee 



40 

 

would not be subject to the rule for the brief handling of client checks or physical 

assets? 

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? 

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 

                                                                                                                                                                           

 
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.41 

 

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.       

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 

                                                                                                                                                                           

 
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).  



42 

 

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.   

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 

                                                                                                                                                                           

 
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.     



43 

 

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 

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 transactions90—all critical components of safeguarding client 

assets under the proposed rule.  As a result, with the exception of proposed amendments to the 

                                                                                                                                                                           

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

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).    



44 

 

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   

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 

                                                                                                                                                                           

 
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). 



45 

 

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   

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   

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 

                                                                                                                                                                           

 
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). 

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).   



46 

 

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 

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 

                                                                                                                                                                           

 
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 reasonabl e 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. 

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 



47 

 

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 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.    

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 authority100 as a banking institution, 

trust company, or other financial institution that customarily holds financial assets 

for its customers; 

                                                                                                                                                                           

 
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). 

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



48 

 

 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 

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.   

                                                                                                                                                                           

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



49 

 

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 

                                                                                                                                                                           

 
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. 

https://www.fatf-gafi.org/en/the-fatf/what-we-do.html/
https://sanctionssearch.ofac.treas.gov/


50 

 

the Financial Crimes Enforcement Network of the U.S. Department of the Treasury 

(FinCEN”).103 

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   

                                                                                                                                                                           

 
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). 

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). 



51 

 

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 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. 

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 

                                                                                                                                                                           

 
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.  



52 

 

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   

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. 

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 

                                                                                                                                                                           

 
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). 

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



53 

 

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?  

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 

                                                                                                                                                                           

 
109  See generally Membership of State Banking Institutions in the Federal Reserve System (Regulation H) 12 

CFR 208.01 et. seq. 



54 

 

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?   

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 

                                                                                                                                                                           

 
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).     



55 

 

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, 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 

                                                                                                                                                                           

 
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)]. 



56 

 

CFTC regulatory enhancements sufficient grounds to eliminate that condition of the 

current rule?   

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, 



57 

 

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 

                                                                                                                                                                           

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



58 

 

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? 

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. 



59 

 

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 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 



60 

 

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?61 

 

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?   

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 

                                                                                                                                                                           

 
115  Rule 206(4)-2(b)(1).   

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.   



62 

 

types of insurance companies that would more easily function as qualified 

custodians than others? 

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 

                                                                                                                                                                           

 
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.   



63 

 

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.   

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 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 



64 

 

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 

                                                                                                                                                                           

 
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.”).   

https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html


65 

 

(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    

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 

                                                                                                                                                                           

 
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.   



66 

 

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.   

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   

                                                                                                                                                                           

 
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).  

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.”).   



67 

 

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   

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-

                                                                                                                                                                           

 
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). 

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).  



68 

 

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  

We request comment on all aspects of the proposed possession or control requirement, 

including the following items.  

                                                                                                                                                                           

 
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.   



69 

 

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 



70 

 

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 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 



71 

 

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? 

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?  

                                                                                                                                                                           

 
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.”).   



72 

 

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?   



73 

 

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 Müller, What Is Atomic Settlement? (Nov. 7, 2022), 

available at https://libertystreeteconomics.newyorkfed.org/2022/11/what-is-atomic-settlement/.   



74 

 

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 adviser did not intend to have such access to client assets.135  

                                                                                                                                                                           

 
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).   



75 

 

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.   

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 

                                                                                                                                                                           

 
136  See, e.g., Fiduciary Capacity; Non-Fiduciary Custody Activities, 84 Fed. Reg. 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 



76 

 

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   

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.  

                                                                                                                                                                           

 
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.”). 

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).  

https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-19a.pdf
https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-19a.pdf
https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-49a.pdf
https://www.dfs.ny.gov/reports_and_publications/press_releases/pr202103041
https://www.dfs.ny.gov/industry_guidance/industry_letters/il20230123_guidance_custodial_structures
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf


77 

 

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 



78 

 

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 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).  

https://www.sec.gov/news/public-statement/statement-im-finhub-wyoming-nal-custody-digital-assets
https://www.sec.gov/news/public-statement/statement-im-finhub-wyoming-nal-custody-digital-assets


79 

 

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:  

 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; 

                                                                                                                                                                           

 
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”).   

https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-mgmt-ops-controls/index-asset-mgmt-ops-controls.html


80 

 

 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81 

 

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 

                                                                                                                                                                           

 
145  See proposed rule 223-1(a)(1)(i), (ii).   



82 

 

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.  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.     

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 



83 

 

a. Reasonable Assurances 

We believe that requiring an adviser to obtain the reasonable assurances in writing149 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 

                                                                                                                                                                           

 
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.”). 

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).   



84 

 

would provide consistent investor protections across all qualified custodians under our proposed 

rule.   

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.   

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  

                                                                                                                                                                           

 
151  Proposed rule 223-1(a)(1)(ii)(A).  

152  See, e.g., rule 17f-4 of the Investment Company Act.  

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 



85 

 

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 circumstances may require a hybrid of the two.156  Further, 

because crypto assets and distributed ledger technology are still evolving, we expect the methods 

                                                                                                                                                                           

 
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.  

https://www.gemini.com/cryptopedia/crypto-wallets-hot-cold


86 

 

used to safeguard crypto assets will likewise evolve, which may lead to reevaluation of best 

practices in the future.   

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 

assets158 and would discourage the qualified custodian from establishing contractual performance 

standards that are less stringent.159  

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.   

                                                                                                                                                                           

 
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).   

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



87 

 

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. 

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 

                                                                                                                                                                           

 
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”).   



88 

 

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.   

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.   

                                                                                                                                                                           

 
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.   



89 

 

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, can be attributed to a sub-

custodian or other third party selected by the qualified custodian. 

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-

                                                                                                                                                                           

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

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.  

https://www.reply.com/en/topics/risk-regulation-and-reporting/Shared%20Documents/Outsourcing%20Working%20Paper.pdf
https://www.reply.com/en/topics/risk-regulation-and-reporting/Shared%20Documents/Outsourcing%20Working%20Paper.pdf
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2797055


90 

 

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. 

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 



91 

 

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 

                                                                                                                                                                           

 
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.   



92 

 

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.     

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 

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 

requirements173 along with the proposed written agreement and other reasonable assurances 

                                                                                                                                                                           

 
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).  

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).   



93 

 

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   

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 

                                                                                                                                                                           

 
174  Custody rule 206(4)-2(a)(1).   

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”).   



94 

 

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.   

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.   

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 

                                                                                                                                                                           

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



95 

 

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.     

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.   

                                                                                                                                                                           

 
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.”). 

178  Proposed rule 223-1(a)(1)(i).   



96 

 

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 Commission179 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 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.  

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.   

                                                                                                                                                                           

 
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). 



97 

 

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     

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 

                                                                                                                                                                           

 
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).  

183  Custody rule 206(4)-2(a)(3). 



98 

 

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.   

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 

                                                                                                                                                                           

 
184  See proposed rule 223-1(c).   



99 

 

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.   

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 

                                                                                                                                                                           

 
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.  

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.   



100 

 

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     

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 

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 

                                                                                                                                                                           

 
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).   

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.   

190  Current rule 206(4)-2(a)(6).101 

 

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   

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 

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’ 

                                                                                                                                                                           

 
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).   

193  See Accounting Guidance, supra footnote 188, at section III.  

194  See rule 206(4)-2(a)(6)(ii).   



102 

 

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.   

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 

                                                                                                                                                                           

 
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)]. 



103 

 

(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 appearance199 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.    

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 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 

                                                                                                                                                                           

 
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).   



104 

 

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.   

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 

                                                                                                                                                                           

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

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 



105 

 

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.   

                                                                                                                                                                           

 
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. 



106 

 

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?   



107 

 

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?  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 



108 

 

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?   



109 

 

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 



110 

 

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 



111 

 

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? 

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?    

                                                                                                                                                                           

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



112 

 

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 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 



113 

 

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 



114 

 

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 



115 

 

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 



116 

 

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?  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? 



117 

 

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 



118 

 

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 



119 

 

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?   

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? 

                                                                                                                                                                           

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



120 

 

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 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 

                                                                                                                                                                           

 
208  See Custody Rule FAQs, supra footnote 17, at Question IX.1.121 

 

are other disclosures that would appropriately distinguish how the qualified 

custodian maintains investments? 

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?   



122 

 

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? 

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 

                                                                                                                                                                           

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



123 

 

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   

103.  The current rule211 and proposed rule212 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?  

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 

                                                                                                                                                                           

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

211  Current rule 206(4)-2(d)(3). 

212  Proposed rule 223-1(d)(5).   



124 

 

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?   



125 

 

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 



126 

 

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 



127 

 

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.   



128 

 

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 may result from the adviser’s insolvency 

or bankruptcy.   

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 

                                                                                                                                                                           

 
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.  



129 

 

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.   

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   

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 

                                                                                                                                                                           

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

216  See 2003 Adopting Release, supra footnote 2.  



130 

 

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   

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 

                                                                                                                                                                           

 
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.”).  

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 



131 

 

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   

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.   

                                                                                                                                                                           

 
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.”).  



132 

 

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 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   

 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,  

                                                                                                                                                                           

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



133 

 

o 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  

o 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 

                                                                                                                                                                           

 
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).   



134 

 

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 

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 

                                                                                                                                                                           

 
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).   

https://www.pwc.com/us/en/tech-effect/emerging-tech/understanding-cryptocurrency-digital-assets.html


135 

 

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 commodities228 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. 

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 maintain possession or control of 

such assets.  Such a determination necessarily depends on the facts and circumstances in issue.  

                                                                                                                                                                           

 
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.”). 



136 

 

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 



137 

 

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.”). 



138 

 

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.      

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 

                                                                                                                                                                           

 
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). 



139 

 

depending on the asset, advisers must satisfy their fiduciary duty in safeguarding any particular 

asset.232   

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 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 

                                                                                                                                                                           

 
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. 

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



140 

 

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. 

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 wheat235 necessarily would be 

                                                                                                                                                                           

 
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/.141 

 

different from the appropriate maintenance gold bullion236 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.   

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 

                                                                                                                                                                           

 
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/EvaluatingRiskinStorageandShippingofFineArtsUpdateFin

al1_4_2019.pdf. 

https://www.occ.treas.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/pub-ch-custody-services.pdf
https://www.occ.treas.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/pub-ch-custody-services.pdf


142 

 

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). 



143 

 

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 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.    

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 

                                                                                                                                                                           

 
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.”).    



144 

 

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.   

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 

                                                                                                                                                                           

 
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.   

https://www.sec.gov/files/formd.pdf


145 

 

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 

rule246 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 

                                                                                                                                                                           

 
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.  



146 

 

proposed requirement also bears similarities to the proposed notification requirement for an audit 

under the proposed safeguarding rule.248    

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 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 

                                                                                                                                                                           

 
248  See infra, section II.F. 

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).  



147 

 

safeguarding of client assets, especially where these assets do not have the additional protections 

afforded by the oversight of a qualified custodian.  

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? 



148 

 

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 



149 

 

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? 

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 

                                                                                                                                                                           

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



150 

 

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 

                                                                                                                                                                           

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



151 

 

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?  

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?   

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 



152 

 

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 



153 

 

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? 



154 

 

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 



155 

 

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 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?   



156 

 

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.     



157 

 

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?   



158 

 

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?   

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? 

                                                                                                                                                                           

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



159 

 

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 



160 

 

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161 

 

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 



162 

 

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?  

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 

                                                                                                                                                                           

 
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). 



163 

 

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 



164 

 

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 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:  

(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  

                                                                                                                                                                           

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



165 

 

(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 

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.   

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 

                                                                                                                                                                           

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

257  See supra footnote 168. 

258  See proposed rule 223-1(a)(1)(ii)(D).   



166 

 

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.   

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  

                                                                                                                                                                           

 
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”).    

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, 



167 

 

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. 

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 

                                                                                                                                                                           

 
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.   

263  See proposed rule 223-1(b)(7) 



168 

 

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 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.   

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 

                                                                                                                                                                           

 
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.”). 

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). 



169 

 

authorize such arrangements, clients would be unable to engage in these potentially beneficial, 

authorized activities.     

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? 



170 

 

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? 



171 

 

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 



172 

 

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 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 

                                                                                                                                                                           

 
268  See, e.g., Madison Capital No-Action Letter. 



173 

 

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     

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.   

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 

                                                                                                                                                                           

 
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. 

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



174 

 

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. 

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?  

                                                                                                                                                                           

 
271  See proposed rule 223-1(c).   



175 

 

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?  

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 

                                                                                                                                                                           

 
272  Our staff has taken a similar view under the current custody rule.  See Custody Rule FAQs, supra footnote 

17, at Question V.1.   

273  See proposed rule 223-1(a)(4).  

274  2009 Adopting Release, supra footnote 11. 



176 

 

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  

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 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. 

                                                                                                                                                                           

 
275  See proposed rule 223-1(a)(4)(v) 



177 

 

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. 

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? 

                                                                                                                                                                           

 
276  See, 2009 Adopting Release, supra note 11. 



178 

 

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 

                                                                                                                                                                           

 
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.   



179 

 

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: 

(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 

(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 

                                                                                                                                                                           

 
278 See proposed rule 223-1(b)(4). 

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.   



180 

 

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 

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 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   

                                                                                                                                                                           

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

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.181 

 

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 



182 

 

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 



183 

 

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.   



184 

 

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?   

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 

                                                                                                                                                                           

 
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.   

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.    



185 

 

clients to any advisory client entity whose financial statements are able to be audited in 

accordance with the rule.289    

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.   

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 

                                                                                                                                                                           

 
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. 

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). 



186 

 

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.   

We request comment on all aspects of the expanded availability of the audit provision, 

including the following items:  

                                                                                                                                                                           

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



187 

 

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? 



188 

 

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 

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 



189 

 

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 



190 

 

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.   

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 

                                                                                                                                                                           

 
292  For example, more than 90 percent of the total number of hedge funds and private equity funds currently 

undergo a financial statement audit. 

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. 

https://pcaobus.org/News/Releases/Pages/06142011_OpenBoardMeeting.aspx


191 

 

permanent program for the inspection of broker and dealer auditors that is approved by the 

Commission.295   

 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.  

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 

                                                                                                                                                                           

 
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).   

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.  



192 

 

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?  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. 



193 

 

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?  

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.  

                                                                                                                                                                           

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



194 

 

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. 



195 

 

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 



196 

 

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 

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 

                                                                                                                                                                           

 
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). 



197 

 

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 

                                                                                                                                                                           

 
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.” 



198 

 

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     

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 

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 

                                                                                                                                                                           

 
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.   

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

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



199 

 

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   

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 

                                                                                                                                                                           

 
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.  



200 

 

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  

We request comment on all aspects of the proposed rule’s requirements for distributing 

audited financial statements, including the following items:  

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 

                                                                                                                                                                           

 
310  We note that our staff previously took a similar view.  See 2014 IM Guidance supra footnote 17.201 

 

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 



202 

 

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. 

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 

                                                                                                                                                                           

 
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.   



203 

 

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.   

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 

                                                                                                                                                                           

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

313  See rule 206(4)-2(a)(4). 

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.   



204 

 

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. 

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 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 



205 

 

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?  



206 

 

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 



207 

 

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.   

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. 

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, 

                                                                                                                                                                           

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

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. 



208 

 

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   

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? 

                                                                                                                                                                           

 
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). 



209 

 

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 



210 

 

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 

 

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   

                                                                                                                                                                           

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

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).   



211 

 

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 



212 

 

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   

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 

                                                                                                                                                                           

 
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 C.F.R. 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).   



213 

 

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? 



214 

 

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? 



215 

 

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 



216 

 

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 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 

                                                                                                                                                                           

 
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 



217 

 

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 

                                                                                                                                                                           

 
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 



218 

 

oversight of the safeguarding practices of advisers and their compliance with the rule, which 

would, in turn, promote investor protection.   

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. 

2. Client Accounts 

Additionally, the proposed amendments would require an adviser to maintain six 

categories of records337 with respect to each client account for which the adviser has custody of 

                                                                                                                                                                           

 
internal control report obtained or received pursuant to rule 206(4)-2(a)(6)(ii).  See proposed rule 204-

2(b)(3)(ii). 

335  See proposed rule 204-2(b)(1). 

336  See proposed rule 223-1(a)(2).  

337  See generally proposed rule 204-2(b)(2) for these six categories of records. 



219 

 

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.  

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 

                                                                                                                                                                           

 
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).    

340  See proposed rule 204-2(b)(2)(i). 

341  See proposed rule 223-1(b)(8). 



220 

 

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 

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 

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 

                                                                                                                                                                           

 
342  See rule 204-(2)(a)(8).   

343  See proposed rule 204-2(b)(2)(i). 

344  See proposed rule 223-1(b)(3). 

345  See proposed rule 204-2(b)(2)(ii).221 

 

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. 

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. 

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 

                                                                                                                                                                           

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



222 

 

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 

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.   

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 

                                                                                                                                                                           

 
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). 

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

350  See rule 204-2(b)(4).   

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



223 

 

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.  

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 

                                                                                                                                                                           

 
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). 



224 

 

current rule requires only that the adviser maintain a record of trade tickets rather than 

counterparty confirmations.   

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.  

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 

                                                                                                                                                                           

 
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). 

357  See proposed rule 204-2(b)(vi). 



225 

 

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   

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 

                                                                                                                                                                           

 
358  Proposed rule 223-1(b)(7). 



226 

 

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)? 



227 

 

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 



228 

 

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 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 

                                                                                                                                                                           

 
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.  



229 

 

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.  

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 

                                                                                                                                                                           

 
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.   

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).   



230 

 

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.   

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. 



231 

 

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: 

 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; 

                                                                                                                                                                           

 
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).  



232 

 

 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 

 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 

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. 

 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  

                                                                                                                                                                           

 
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). 

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. 

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. 



233 

 

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 

                                                                                                                                                                           

 
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. 



234 

 

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 

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 

                                                                                                                                                                           

 
376  See proposed amendments to Form ADV, General Instructions. 



235 

 

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? 



236 

 

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 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 



237 

 

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.    

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 2003 

Commission Adopting Release 

Various Dates 

                                                                                                                                                                           

 
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.   



238 

 

American Bar Association (Question 1, 

Custody Rule Section, only) 

December 8, 2005 

American Bar Association (Question D only) August 10, 2006 

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 Kissel 

LLP 

December 11, 2019 

Privately Offered Securities Under the 

Investment Advisers Act Custody Rule, 

Investment Management Guidance Update 

(“IMGU”) 2013-04 

August 2013 

Private Funds and the Application of the 

Custody Rule to SPVs and Escrows, IMGU 

2014-07 

June 2014 

Inadvertent Custody, IMGU 2017-01 February 2017 

Staff Responses to Questions About the 

Custody Rule (all) 

Issued on various dates since 2003 

 



239 

 

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 

Threshold Number of 

Advisers Under 

Threshold 

Percent of 

Advisers Under 

Threshold 

Total RAUM of 

Advisers Under 

Threshold  

Percent of Total 

RAUM of 

Advisers Under 

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% 

$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% 

                                                                                                                                                                           

 
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. 



240 

 

$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?241 

 

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 



242 

 

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, 



243 

 

securities and other investment products.380   

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 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 

                                                                                                                                                                           

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

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).   



244 

 

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.  

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 

http://www.nber.org/papers/w15651


245 

 

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   

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 

                                                                                                                                                                           

 
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.      

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.  

https://ideas.repec.org/a/aea/aecrev/v109y2019i10p3681-3712.html
https://ideas.repec.org/a/aea/aecrev/v109y2019i10p3681-3712.html
https://ideas.repec.org/s/aea/aecrev.html


246 

 

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  

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  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 

                                                                                                                                                                           

 
337 For those custodians that are registered broker-dealers, it also facilitates compliance with their obligations 

under Exchange Act Rule 15c3-3.   

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). 



247 

 

and/or enhance the independence of third parties, then, generally enhances the ability of third 

parties to oversee investment advisers’ conduct.   

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    

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 

                                                                                                                                                                           

 
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].”   



248 

 

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 

FFIs394—all of which are financial institutions that are currently subject to regular government 

oversight and are subjected to periodic inspection and examination.395  

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  

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 

                                                                                                                                                                           

 
393  See rule 206(4)-2(a)(1). 

394  See rule 206(4)-2(d)(6).   

395  See supra footnote 89. 

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. 



249 

 

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 

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 

                                                                                                                                                                           

 
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. 

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). 



250 

 

and such related person is operationally independent of the adviser, is not required to obtain an 

annual surprise examination.403  

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 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   

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 

                                                                                                                                                                           

 
403  See rule 206(4)-2(b)(3), (6). 

404  See rule 206(4)-2(a)(2). 

405  See rule 206(4)-2(a)(3). 

406  See rule 206(4)-2(a)(5). 

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



251 

 

current audit provision also requires the auditor to be registered with and subject to inspection by 

the PCAOB.   

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  

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 

                                                                                                                                                                           

 
408  See rule 204-2(a)(8). 

409  See rule 204-2(a)(17)(iii). 

410  See rule 204-2(b). 



252 

 

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 

                                                                                                                                                                           

 
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). 



253 

 

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. 

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 

                                                                                                                                                                           

 
415  See generally OCC Custody Handbook, supra note 237. 

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’”). 



254 

 

investors, including certain investments in private companies and offerings by certain hedge 

funds, private equity funds, and venture capital funds.  

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     

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 

                                                                                                                                                                           

 
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). 

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 



255 

 

RAUM among registered investment advisers was $8.56 billion and the median was $427.53 

million. 

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. 

Table 1 

Investment Adviser Clients 

 

Client Type  

Number of 

Clients 

(thousands) 

Total 

RAUM 

(billions) 

Registered 

Investment 

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 

                                                                                                                                                                           

 
for Part 1A, instr. 5.b. (setting forth instructions for calculation of assets under management for regulatory 

purposes). 

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). 



256 

 

 

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.). 

https://www.fdic.gov/analysis/quarterly-banking-profile/statistics-at-a-glance/2022mar/industry.pdf
https://www.fdic.gov/analysis/quarterly-banking-profile/statistics-at-a-glance/2022mar/industry.pdf
https://www.sec.gov/files/data/broker-dealers/company-information-about-active-broker-dealers/bd110122.txt
https://www.sec.gov/files/data/broker-dealers/company-information-about-active-broker-dealers/bd110122.txt
https://www.cftc.gov/sites/default/files/2022-11/01%20-%20FCM%20Webpage%20Update%20-%20September%202022.pdf
https://www.cftc.gov/sites/default/files/2022-11/01%20-%20FCM%20Webpage%20Update%20-%20September%202022.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf


257 

 

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 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   

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 

                                                                                                                                                                           

 
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. 



258 

 

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 

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 

                                                                                                                                                                           

 
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. 

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 http:// 

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: 

https://www.rand.org/pubs/research_reports/RR1289


259 

 

systematic errors that retail investors might make, including limited allocation of savings to 

equities, under-diversification, or investing too little in foreign assets.434  

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.  

b. Adviser Custody   

As of June 2022, 8,536 advisers (56.67% of the total number of advisers) reported on 

                                                                                                                                                                           

 
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.”    

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

2015). 



260 

 

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 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 

                                                                                                                                                                           

 
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.261 

 

an independent public accountant but did not report that they were subject to a surprise 

examination.441 

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  

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 

                                                                                                                                                                           

 
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.   

442  See supra note 17.   

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. 

https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/index-custody-services.html
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/custody-services/index-custody-services.html


262 

 

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  

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  

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  

                                                                                                                                                                           

 
444  COMPTROLLER’S HANDBOOK, CUSTODY at 6-7. 

445  Id. at 14, 30. 

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. 

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, D.C. (Aug. 23, 2022), available at https://www.pewresearch.org/fact-

https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-the-evolution-of-a-core-financial-service.pdf
https://sharepoint/sites/IM/Rulemaking/CustodyRulemaking/Proposing%20Release/Deloitte


263 

 

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 2022453 

and focuses on the 50 largest investment advisers454 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 

                                                                                                                                                                           

 
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. 

Webpages 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.  

https://citywire.com/


264 

 

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      

The market for crypto asset custodial services continues to develop.  Our understanding is 

that one OCC-regulated national bank, four OCC-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 

                                                                                                                                                                           

 
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.  

459  See supra, footnote 128and 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 



265 

 

process or four-step process461 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. 

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 

                                                                                                                                                                           

 
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. 



266 

 

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   

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, 

                                                                                                                                                                           

 
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.  

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 at 

https://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 



267 

 

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  

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 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 

                                                                                                                                                                           

 
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 

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.   



268 

 

ensure that the investments are safeguarded appropriately.  The custodian reports the holdings or 

transactions as reported to it by the adviser.   

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. 

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, 

                                                                                                                                                                           

 
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. 

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. 

https://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


269 

 

and 3) advisers did not recognize that they may have custody as a result of certain authority over 

client accounts. 

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   

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 

                                                                                                                                                                           

 
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. 



270 

 

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. 

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 

                                                                                                                                                                           

 
476  Proposed rule 223-1(d)(1). 

477  See Part II.A, supra. 



271 

 

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 rule.478  Investment advisers may accordingly 

                                                                                                                                                                           

 
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. 



272 

 

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. 

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 

                                                                                                                                                                           

 
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. 



273 

 

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 



274 

 

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. 



275 

 

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 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 



276 

 

discretionary trading authority is their sole reason for having custody because they will not have 

to comply with the surprise examination requirement.480     

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   

                                                                                                                                                                           

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

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



277 

 

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     

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     

                                                                                                                                                                           

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

483  See supra footnote 96. 



278 

 

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; 



279 

 

 Regulated by a foreign country’s government, an agency of a foreign country’s 

government, or a foreign financial regulatory authority484 as a banking institution, 

trust company, or other financial institution that customarily holds financial assets 

for its customers; 

 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.485 

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 

                                                                                                                                                                           

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

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

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.  



280 

 

their assets that we believe would help promote an FFI having generally similar protections as a 

U.S.-based qualified custodian.   

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 

                                                                                                                                                                           

 
487  Proposed rule 223-1(d)(10)(iv)(C); see also pt. II.B.1.281 

 

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. 

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 

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 

                                                                                                                                                                           

 
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.   

490  See rule 206(4)-2(a)(1). 



282 

 

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   

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 

                                                                                                                                                                           

 
491  See proposed rule 223-1(a)(1)(i). 

492  See proposed rule 223-1(d)(8).   



283 

 

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.   

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 



284 

 

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   

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, 

                                                                                                                                                                           

 
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. 

495  Proposed rule 223-1(a)(1)(ii)(A).   

496  See discussion in section II.B.3.a.i and supra footnote 154. 



285 

 

in turn, mitigate the risk to client assets from theft, misuse, misappropriation, or other similar 

types of loss.   

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 

                                                                                                                                                                           

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



286 

 

by preventing these custodians from disclaiming liability for misconduct that does not rise to the 

level of gross negligence.     

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   

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 

                                                                                                                                                                           

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



287 

 

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.   

No Liens Unless Authorized in Writing.  The proposed rule would 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 

                                                                                                                                                                           

 
499  Proposed rule 223-1(a)(1)(ii)(D).   
500  See proposed rule 223-1(a)(1)(ii)(E).   

 



288 

 

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. 

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 

                                                                                                                                                                           

 
501  See infra footnote 620. 



289 

 

$5,493,936 associated with advisers obtaining reasonable assurances from qualified 

custodians.502       

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   

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 

                                                                                                                                                                           

 
502  See infra footnote 622. 

 

504  See infra footnote 619 



290 

 

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 



291 

 

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 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. 

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.   

No Liens Unless Authorized in Writing.  The rule would not prohibit liens and the other 

                                                                                                                                                                           

 
505  See discussion in section III.C.1. 

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). 



292 

 

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.   



293 

 

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   

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 

                                                                                                                                                                           

 
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. 

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



294 

 

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.     

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 – 

                                                                                                                                                                           

 
509  Proposed rules 223-1(a)(1)(i)(B), 223-1(b)(4).   



295 

 

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, would deter advisers from fraudulent activities.510     

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.   

                                                                                                                                                                           

 
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. 



296 

 

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 

                                                                                                                                                                           

 
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 



297 

 

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.    

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 

                                                                                                                                                                           

 
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. 

513  Proposed rule 223-1(a)(1)(i)(D).  



298 

 

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. 

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 

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 

                                                                                                                                                                           

 
514  See supra note 202. 



299 

 

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       

(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. 

                                                                                                                                                                           

 
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.  



300 

 

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 

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 

                                                                                                                                                                           

 
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.301 

 

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 

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 

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 

                                                                                                                                                                           

 
520  See infra note 609. 

521  See infra note 613. 

522  Rule 206(4)-2(a)(4)(ii).   



302 

 

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 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 

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 

                                                                                                                                                                           

 
523  See infra footnote 617. 



303 

 

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 



304 

 

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. 

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 

                                                                                                                                                                           

 
524  See supra note 223. 

525  See supra note 227 and surrounding discussion. 



305 

 

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.   

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 

                                                                                                                                                                           

 
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. 



306 

 

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 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. 



307 

 

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 



308 

 

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 



309 

 

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 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 



310 

 

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 

                                                                                                                                                                           

 
527  See infra note 648. 



311 

 

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 

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 

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 

                                                                                                                                                                           

 
528  See infra note 642. 

529  See infra note 644. 

530  See infra note 649. 



312 

 

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 



313 

 

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 verification of transactions by 

independent public accountants.531 

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 

                                                                                                                                                                           

 
531  See infra note 655. 



314 

 

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 

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. 

                                                                                                                                                                           

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



315 

 

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 



316 

 

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   

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 

                                                                                                                                                                           

 
533  Proposed rule 223-1(a)(2). 

534  See proposed rule 223-1(c).   

535  See infra note 624. 



317 

 

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 upon the 

auditor’s termination or issuance of a modified opinion.537   

                                                                                                                                                                           

 
536  See supra note 282.  

537  See supra note 283.  



318 

 

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   

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 

                                                                                                                                                                           

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



319 

 

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.  



320 

 

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.   

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.   

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 

                                                                                                                                                                           

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

542  See supra note 304 

543  See infra note 660.321 

 

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.   

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 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 

                                                                                                                                                                           

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



322 

 

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 

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 

                                                                                                                                                                           

 
545  Form ADV-E Instructions, pt. 3.ii, https://www.sec.gov/files/formadv-e.pdf. 

546  See infra notes 662 and 664. 



323 

 

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.  

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 

                                                                                                                                                                           

 
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).   



324 

 

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  

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 

                                                                                                                                                                           

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



325 

 

(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.   

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 

                                                                                                                                                                           

 
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).  



326 

 

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   

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.  

                                                                                                                                                                           

 
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).   



327 

 

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 

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 

                                                                                                                                                                           

 
559  See infra footnote 674. 

560  See supra note 359.  



328 

 

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. 

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   

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  

                                                                                                                                                                           

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

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. 



329 

 

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 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.   



330 

 

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. 



331 

 

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 



332 

 

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 



333 

 

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.   

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 

                                                                                                                                                                           

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



334 

 

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 



335 

 

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. 



336 

 

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 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). 



337 

 

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. 

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 

                                                                                                                                                                           

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

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. 



338 

 

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 



339 

 

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. 

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 

                                                                                                                                                                           

 
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. 

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.   

https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Bonding.pdf


340 

 

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. 

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 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 

                                                                                                                                                                           

 
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)).   

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. 

https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Minimum-Financial-Requirements.pdf
https://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-Minimum-Financial-Requirements.pdf341 

 

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. 

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 



342 

 

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 

                                                                                                                                                                           

 
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). 



343 

 

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. 

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 

                                                                                                                                                                           

 
582  See Rule 17Ad– 22(e)(11).   

583  Exchange Act section 3(a)(25), 15 U.S.C. 78c(a)(25).  



344 

 

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 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. 

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 

                                                                                                                                                                           

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



345 

 

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 



346 

 

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? 



347 

 

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 

                                                                                                                                                                           

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



348 

 

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 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. 

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 

                                                                                                                                                                           

 
586  Proposed rule 223-1. 



349 

 

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.   

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 



350 

 

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 



351 

 

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. 

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 

                                                                                                                                                                           

 
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).   

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).   



352 

 

rule will be required to comply with this requirement.589  We believe that an investment adviser 

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 111,552592 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 

                                                                                                                                                                           

 
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)).  



353 

 

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      

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 1,842597 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 

                                                                                                                                                                           

 
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. 

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)). 

596  See proposed rule 223-1(a)(1)(i)(A).    

597  See infra footnote 619and accompanying text. 



354 

 

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 

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 

                                                                                                                                                                           

 
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.  

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 



355 

 

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   

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 

                                                                                                                                                                           

 
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)).   

https://www.sec.gov/files/2022-exam-priorities.pdf


356 

 

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   

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 

                                                                                                                                                                           

 
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)).   

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). 



357 

 

annual internal burden equates to an annual internal monetized cost burden of approximately 

$324,621.50.613    

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 custodians615 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   

                                                                                                                                                                           

 
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)).   

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).  



358 

 

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)).   



359 

 

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   

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 

                                                                                                                                                                           

 
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. 



360 

 

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 

 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 

                                                                                                                                                                           

 
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. 

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.361 

 

aggregate burden with respect to the surprise examination requirement for this group of advisers 

is 68,626 hours.628 

 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 

 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 

                                                                                                                                                                           

 
628  381 advisers x 9,006 (average number of clients subject to the surprise examination requirement) x 0.02 

hour = 68,626 hours.   

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. 



362 

 

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 

 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.  

 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 

                                                                                                                                                                           

 
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  

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

635  Compare 17 CFR 275.206(4)-2(a)(4) with proposed rule 223-1(a)(4).   



363 

 

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 

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 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 

                                                                                                                                                                           

 
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. 



364 

 

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 

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   

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 

                                                                                                                                                                           

 
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.   

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)).   



365 

 

agreements or entering into new agreements.643  The related total monetized cost burden for 

these amendments would equal $977,514.644   

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 

                                                                                                                                                                           

 
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)).   

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 



366 

 

hours647 in the aggregate to send annually with an annual monetized cost of $48,013.648   

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   

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 

                                                                                                                                                                           

 
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.   

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.   

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.  



367 

 

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 

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 

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 

                                                                                                                                                                           

 
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.   



368 

 

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). 



369 

 

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 hours662 for all advisers that satisfy the 

requirements of the audit engagement.  We further estimate that each adviser will spend 0.92 

                                                                                                                                                                           

 
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. 

 



370 

 

hours663 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 hours664 and an annual cost of 

this internal hour burden of $19,476,867665 for all advisers that satisfy the requirements of the 

audit provision. 

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 

A chart summarizing the various proposed components of the total annual burden for 

investment advisers with custody of client assets is below. 

                                                                                                                                                                           

 
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). 

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. 

Rule 223-1 Description of New Requirements No. of Responses Internal Burden Hours External Burden Costs 

 Final Estimates for Qualified Custodian Protections Under 223-1(a)(1) 

Initial burden for drafting, negotiating, and executing 

new written custodial agreements with required 

provisions between the adviser and qualified 

custodian (“QC”) (IA-QC custodial contract) 

55,776 (4 per 

adviser with 

custody) 

111,552 (2 per 

response)  

 



371 

 

  

Annual burden for drafting, negotiating, and 

executing new written custodial agreements with 

required provisions between the adviser and 

qualified custodian (IA-QC custodial contract) 

55,776 (4 per 

adviser with 

custody) 

9,482 (.17 hour per 

response) 

 

Annual burden for QC to provide records relating to 

clients’ 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.   

8,368 (4 per 

adviser examined) 

12,552 (1.5 hour per 

response) 

 

Annual burden for QC to provide records relating to 

clients’ assets to an 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.   

36,844 (4 per 

adviser obtaining  

a surprise 

examination or 

audit) 

18,422 (.5 hour per 

response) 

 

Initial burden for QC to send account statements, at 

least quarterly, to the client, or its independent 

representative, and to adviser 

 

959 (estimated 

qualified 

custodians) 

14,385 hours (15 

hours per qualified 

custodian) 

 

Annual burden for QC to modify and send account 

statements 

959 (estimated 

qualified 

custodians) 

959 (1 hour per 

qualified custodian)  

Annual burden for QC to obtain internal control report   $35,962,500 

Initial burden for adviser obtaining reasonable 

assurances from the QC  

55,776 (1 per  

adviser)  

69,720 (1.25 hours 

per response) 

 

Annual burden for adviser obtaining reasonable 

assurances from the QC 

55,776 (1 per  

adviser) 

13,944 (.25 hours per 

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 agreement with 

independent public accountant (IPA) 

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) 

6,201 (1.25 

hours per 

adviser) 

 

Annual burden for written agreement with IPA 4,961 2,481 (.5 

hour per 

adviser) 

 

Annual burden to notify the IPA of any purchase, 

sale, or other transfer of beneficial ownership of such 

assets within one business day 

8,000 (estimated 

number of annual 

transactions) 

133 hours (1 

minute per 

transaction)  

 

Annual burden to verify the purchase, sale, or other 

transfer promptly upon receiving the required 

transfer notice* 

                          $19,680,000 



372 

 

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. 

*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 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. 

                              $322,956,000 

 Final Estimates for Complying with the Notice Requirement Under 223-1(a)(2) 

Initial burden for complying with the notice 

requirement* 

*This would be a one-time burden to include account 

numbers in the notices. 

13,944 advisers (1 

per adviser)  

 

13,944 hours (1 hour 

per adviser ) 

 

 

Final Estimates for Independent Verification or Surprise Examination Under 223-1(a)(4) 

Annual burden for complying with the independent 

verification/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. 

1,842 advisers are 

subject to the 

surprise exam  

 

80,949 hours1 

 

 

 

 Annual burden to enter into a written agreement 

with an IPA 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. 

1,842 advisers 461 hours (.25 per 

adviser) 

 

Exception for Entities Subject to the Annual Audit 223-1(b)(4) 

Annual burden for distributing audited financial 

statements 

7,018 advisers 7,098 hours   

Annual burden for drafting, negotiating, and 

executing the required written agreement between 

the IPA and adviser regarding notifications from the 

IPA to the Commission of specified events 

7,018 advisers  35,869 hours  

 TOTAL ESTIMATED FINAL BURDEN FOR RULE 223-1 

Total estimated burden for rule 223-1 319,856  398,152 hours $378,598,500 

Currently approved burden for rule 206(4)-2 24,133,429 288,202 hours $174,367,000 

Comparison of proposed rule 223-1 burdens to 

current rule 206(4)-2 burdens 

(23,813,573) 109,950 hours $204,231,500 



373 

 

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 



374 

 

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.   

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 

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, 

                                                                                                                                                                           

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

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



375 

 

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. 

The approved annual aggregate burden for rule 204-2 is currently 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 582,789673 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 

                                                                                                                                                                           

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

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. 



376 

 

most recent approval and adjustments for inflation, as well as the proposed rule 204-2 

amendments as discussed in this proposing release.  

A chart summarizing the various components of the total annual burden for investment 

advisers with custody of client assets is below.  

 
 

 

Internal Hour 

Burden  Wage Rate1 

  

Internal Time Costs 

Annual External 

Cost Burden 

FINAL ESTIMATES FOR RULE 204-2 FOR CLIENT COMMUNICATIONS 

Retention of written 

client notifications and 

responses  

     

3 

 

 

× 

 

 

$82 

(compliance clerk) 

 

$246 

 

 

 

Total burden per adviser 3   $246  

Total number of affected 

advisers 
× 13,944   × 13,944  

Sub-total burden   41,832 hours   $3,430,224  

FINAL ESTIMATES FOR RULE 204-2 FOR CLIENT ACCOUNTS 

Creation and retention 

of records documenting 

client account identifying 

information, including 

adviser discretionary 

authority 

2 × 
$73 

(general clerk) 
$146  

1 × 
$82 

(compliance clerk) 
$82  

Total burden per adviser 3   $228  

Total number of affected 

advisers 
× 13,944   × 13,944  

Sub-total burden 41,832 hours   $3,179,232  

Creation and retention 

of records 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 

 2 

 

 

 

1 

 

× 

 

 

 

x          

 

$73 

(general clerk) 

 

 

$82 

(compliance clerk)              

$146 

 

 

$82 

 

 



377 

 

qualified custodian’s 

possession or control 

Total burden per adviser 

 

Total number of affected 

advisers 

3 

 

× 13,944 

 

  

$228 

 

× 13,944 

 

 

Sub-total burden 41,832 hours   $3,179,232  

Creation and retention 

of records documenting 

adviser’s basis of 

custody of client assets 

2 

 

1 

× 

 

x 

$73 

(general clerk) 

 

$82 

(compliance clerk) 

$146 

 

$82 

 

Total burden per adviser 

 

Total number of affected 

advisers 

3 

 

× 13,944 

 

  

$228 

 

×13,944 

 

 

Sub-total burden 41,832 hours   $3,179,232  

Retention of copies of 

account statements 
              2  x  

$82 

(compliance clerk) 
$164  

Total burden per adviser 

 

Total number of affected 

advisers 

              2 

 

       x 13,944 

  

$164 

 

x 13,944 

 

Sub-total burden 27,888 hours   $2,286,816  

Creation and retention 

of records of detailed 

transaction and position 

information for each 

client account 

3 

 

 

x 

 

 

$82 

(compliance clerk) 

 

$246 

 

 

 

Total burden per adviser 

 

Total number of advisers 

3 

 

x 13,944 

  

$246 

 

x 13,944 

 

Sub-total burden 41,832 hours   $3,430,224   

Retention of copies of, 

and records relating to, 

standing letters of 

authorization 

.25                        x              
$82 

(compliance clerk) 
$20.50  

Total burden per adviser 

 

Total number of advisers 

.25 

 

x 2,789 

 

 
 

$20.50 

 

x 2,789 

 

Sub-total burden 697.25 hours   $57,174.50  

FINAL ESTIMATES FOR RULE 204-2 FOR INDEPENDENT PUBLIC ACCOUNTANT 

Retention of copies of all 

audited financial 

statements, internal 

control reports, and 

required written 

agreements between 

independent public 

accountant and adviser  

or its client 

3 × 
$73 

(general clerk) 
$219  

1 × 
$82 

(compliance clerk) 
$82  

Total burden per adviser 4   $301  



378 

 

Total number of affected 

advisers 
× 13,944   × 13,944  

Sub-total burden 55,776 hours   $4,197,144  

TOTAL ESTIMATED FINAL BURDEN FOR RULE 204-2 

Total burden for this 

rulemaking 

293,521.25 

hours 
  $22,939,278.50     

Previously approved 

burden plus the 

additional burden due to 

the increase in the 

number of advisers 

3,053,831 hours   $194,394,000  

Total burden 3,347,352 hours   $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 



379 

 

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. 

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 

                                                                                                                                                                           

 
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”). 



380 

 

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.  

TABLE 10: FORM ADV PRA ESTIMATES 

  

Initial hours 

per year 

Internal annual 

amendment 

burden hours1  Wage rate2 Internal time costs 

Annual external 

cost burden3 

PROPOSED AMENDMENTS TO FORM ADV 

RIAs (burden for Parts 1 and 2, not including private fund reporting)4 

Proposed additions (per 

adviser) to Part 1A Item 9 

and corresponding 

schedules;  

 

 1 hour for 

Part 1A,  
0.4 hours5  

$318 per hour 

(blended rate for 

senior compliance 

examiner and 

compliance manager)6 

1.4 hours x $318 

per hour = 

$445.20 

 

Current burden per 

adviser7 

 

29.72 

hours8  
11.8 hours9  

$273.00 per hour 

(blended rate for 

senior compliance 

examiner and 

compliance manager) 

(29.72 + 11.8) x 

$273.00 = 

$11,334.96 

$2,069,250 

aggregated 

(previously 

presented only in 

the aggregate)10 

Revised burden per 

adviser 

 
29.72 hours 

+ 1 hour = 

30.72 hours  

 0.4 hours + 11.8 

hours = 12.2 hours  
 

$318 (blended rate for 

senior compliance 

examiner and 

compliance manager) 

(30.72 + 12.2) x 

$318 = 

$13,648.56 

$4,780.5011  

Total revised aggregate 

burden estimate 

 

32,117.44 
12 

191,686.4 hours13  Same as above 

 

 (32,177,44 + 

191,686.4) x $318 

= $71,169,621.12 

$11,162,54614 

RIAs (burden for Part 3)15 

No proposed changes  -- --  -- -- --381 

 

Current burden per RIA  

20 hours, 

amortized 

over three 

years = 

6.67 

hours16 

1.58 hours17  

$273 (blended rate for 

senior compliance 

examiner and 

compliance manager) 

$273 x (6.67 + 

1.58) = $2,249.52 

$2,433.74 per 

adviser18 

Total updated aggregate 

burden estimate 
 

70,646.67  

hours19 
15,646.74  hours20  

$318 (blended rate for 

senior compliance 

examiner and 

compliance manager  

$27,441,303.32 

($318 x 

(70,646.67 hours 

+ 15,646.74 

hours) 

$9,930,272.0821 

ERAs (burden for Part 1A, not including private fund reporting)22 

No proposed changes        

Current burden per ERA 

 

3.60 

hours23  

1.5 hours + final 

filings24 
 

$273 (blended rate for 

senior compliance 

examiner and 

compliance manager) 

 $0 

Total revised aggregate 

burden estimate 

 

1,245.6025 8,777.60 hours26  

$318 (blended rate for 

senior compliance 

examiner and 

compliance manager  

$3,187,377.60 

($318 x (1,245.6 + 

8,777.60 hours)) 

$0 

Private Fund Reporting27 

No proposed changes         

Current burden per 

adviser to private fund 

 

1 hour per 

private 

fund28  

N/A – included in 

the existing annual 

amendment 

burden 

 

$273 (blended rate for 

senior compliance 

examiner and 

compliance manager) 

 

Cost of 

$46,865.74 per 

fund, applied to 

6% of RIAs that 

report private 

funds29 

Total updated aggregate 

burden estimate 

 

1,150 

hours30 
N/A  

$318 (blended rate for 

senior compliance 

examiner and 

compliance manager)  

$5,173,478.40 

($318 x 16,26930 

hours)) 

$14,856,439.5831 

TOTAL ESTIMATED BURDENS, INCLUDING AMENDMENTS 

Current per adviser 

burden/external cost per 

adviser 

 

23.82 hours32 

23.82 hours x 

$273 = $6,502.86 

per adviser cost of 

the burden hour 

$77733 

Revised per adviser 

burden/external cost per 

adviser 

 

15.62 hours34 

15.62 hours x 

$318 = $4,966.43 

per adviser cost of 

the burden hour 

$1,669.0335 

Current aggregate burden 

estimates 

 

433,004 initial and amendment hours annually36 

433,004 x $273 = 

$118,210,092 

aggregate cost of 

the burden hour 

$14,125,08337 

Revised aggregate burden 

estimates 

 

336,389.4538 Initial and amendment hours annually 

336,389.45 x 

$318 = 

$106,971,844.04 

aggregate cost of 

the burden hour 

$35,949,257.6639 

Notes: 



382 

 

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. 

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 ¼ and ½ 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). 



383 

 

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).  

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 



384 

 

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 



385 

 

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? 



386 

 

 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.  



387 

 

Additionally, our analysis relies on the assumption that it will take 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 



388 

 

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? 



389 

 

 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 



390 

 

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 



391 

 

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 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). 



392 

 

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.  



393 

 

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, 



394 

 

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 



395 

 

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.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. 

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 

                                                                                                                                                                           

 
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. 



396 

 

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 

                                                                                                                                                                           

 
678  Advisers Act rule 0-7(a).  



397 

 

estimate that as of June 30, 2022, approximately 522 SEC-registered advisers are small entities 

under the RFA.679   

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   

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   

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 

                                                                                                                                                                           

 
679  Based on SEC-registered investment adviser responses to Items 5.F. and 12 of Form ADV.  

680  See supra note 553.   

681  See PRA discussion supra section IV. 



398 

 

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 small advisers associated with our proposed amendments to 

the safeguarding rule would be $5,371,008.684 

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 

                                                                                                                                                                           

 
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. 

684  13,632 aggregate small adviser hours x $394 (blended rate for a compliance manager ($361) and a 

compliance attorney ($426)) =$5,371,008. 



399 

 

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.  



400 

 

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.401 

 

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 



402 

 

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 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 



403 

 

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 



404 

 

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. 

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 

                                                                                                                                                                           

 
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).   



405 

 

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 

 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. 

 2.  Amend § 275.204-2 by: 

 a.  Removing and reserving paragraphs (a)(8) and (a)(17)(iii). 

 b.  Revising paragraph (b). 

 The revisions read as follows: 

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

* * * * * 



406 

 

(b) If an investment adviser subject to paragraph (a) of this section is subject to § 

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 § 

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, e-mail 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 § 275.223-1(d)(4) (Rule 223-

1(d)(4)) 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.  

(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 § 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 



407 

 

the reasonable assurances that the investment adviser obtains from the qualified custodian under 

§ 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 § 275.223-1(d)(8) (Rule 223-1(d)(8)) of such assets, as required under § 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 § 275.223-1(d)(3) (Rule 223-1(d)(3)) 

of the client’s assets (as defined by § 275.223-1(d)(1) (Rule 223-1(d)(1)), including whether a 

related person (as defined by § 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 § 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 § 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 § 

275.223-1(c) (Rule 223-1(c)). 

(v) Transaction and position information.   



408 

 

(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 § 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 § 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 § 275.223-1(b)(4) 

(Rule 223-1(b)(4)).  

(ii) A copy of any internal control report: 



409 

 

(A) Obtained by a qualified custodian and received by an investment adviser pursuant to 

§ 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. 

* * * * *  

§ 275.206(4)-2 [Removed] 

3.  Section 275.206(4)-2 is removed. 

4.  Section 275.223-1 is added to read as follows: 

§ 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;   



410 

 

(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 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 



411 

 

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. 



412 

 

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 



413 

 

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. 



414 

 

(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   

(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. 



415 

 

(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 



416 

 

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. 



417 

 

(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.  



418 

 

(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 advisory 

services you provide to clients. Custody includes: 



419 

 

(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. 



420 

 

(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;421 

 

(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; 



422 

 

(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 



423 

 

(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 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 

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. 

6.  Amend Form ADV (referenced in § 279.1) by: 

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; 

b.  In Glossary of Terms, revising the definitions of items 12 (Custody) and 13 

(Discretionary Authority or Discretionary Basis); 

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; 

d.  In Part 1A, revising Item 9; 

e.  In Schedule D, adding section 9.C.1; and revising section 9.C.3. 

The additions and revisions read as follows:    



424 

 

NOTE: The text of Form ADV does not, and this amendment will not, appear in the Code 

of Federal Regulations. 

FORM ADV (Paper Version) 

UNIFORM APPLICATION FOR INVESTMENT ADVISER REGISTRATION AND 

REPORT BY EXEMPT REPORTING ADVISERS 

Form ADV General Instructions 

* * * * * 

4. When am I required to update my Form ADV? 

* * * * * 

 Other-than-annual amendments: In addition to your annual updating amendment, 

o  If you are registered with the SEC or a state securities authority, you must amend 

Part 1A, 1B, 2A and 2B (as applicable) of your Form ADV, including 

corresponding sections of Schedules A, B, C, D, and R, by filing additional 

amendments (other-than-annual amendments) promptly, if: 

 you are adding or removing a relying adviser as part of your umbrella 

registration;  

 information you provided in response to Items 1 (except 1.O. and section 

1.F. of Schedule D), 3, 9 (except 9.A.(2) and 9.D.(2), unless your response 

to Item 9.D.(1) changed)), or 11 of Part 1A or Items 1, 2.A. through 2.F., 

or 2.I. of Part 1B or sections 1 or 3 of Schedule R becomes inaccurate in 

any way; 

* * * * * 

GLOSSARY OF TERMS 

* * * * * 



425 

 

Assets:  For purposes of Item 9 and related sections of Schedule D, has the same 

meaning as defined in Rule 223-1. 

* * * * * 

Custody:  Has the same meaning as in Rule 223-1. 

* * * * * 

Discretionary Authority, Discretionary Basis, or Discretionary Trading Authority: 

Your firm has discretionary authority or manages assets on a discretionary basis or has 

discretionary trading authority if it has the authority to decide which assets to purchase 

and sell for the client without consulting the client. Your firm also has discretionary 

authority if it has the authority to decide which investment advisers to retain on behalf of 

the client without consulting the client. 

* * * * * 

Operationally Independent:  For the purposes of Item 9 and related sections of 

Schedule D, has the same meaning as in Rule 223-1. 

* * * * * 

Qualified Custodian:  Has the same meaning as in Rule 223-1.   

* * * * * 

Standing Letter of Authorization:  Has the same meaning as in Rule 223-1. 

PART 1A  

* * * * * 

a. Item 9 Custody 

In this Item, we ask whether you or a related person has custody of client assets and about 

your custodial practices. 

 

A. (1) Do you have custody of client assets (excluding clients that are investment 

companies registered pursuant to the Investment Company Act of 1940 or 



426 

 

business development companies that elect to be regulated as such) either 

directly or because a related person has custody of client assets in connection 

with advisory services that you provide to the client: 

 

Yes 

No 

You must answer “yes” to Item 9.A.(1) if you reported discretionary RAUM in Item 

5.F.(2)(a); answered “yes” to Item 8.C.(1) indicating you have discretionary authority 

over client assets; or if you have the ability to deduct your advisory fee directly from 

client accounts.  If you answered “no” to Item 9.A.(1), do not complete the remainder of 

Item 9.   

 

(2) As of your most recent fiscal year end, what is the approximate amount of 

client assets (rounded to the nearest $1,000) of which you directly or a related 

person in connection with advisory services that you provide to the client have 

custody and for how many clients attributable to each of the following?  

 

Basis for Custody Direct Custody by Adviser Indirect Custody through a Related 

Person 

 (i) Approximate 

Amount of 

Client Assets 

(ii) Number of 

Clients 

(iii) Approximate 

Amount of Client 

Assets 

(iv) Number of 

Clients 

(a) Ability to 

deduct 

your advisory 

fees 

from client 

accounts 

    

(b) Discretionary 

Authority 

    

(c) Serving as a 

general partner, 

managing 

member, trustee 

(or equivalent) 

for clients that are 

private funds 

    

(d) Serving as 

a general partner, 

managing 

member, trustee 

(or equivalent) 

for clients that  

    



427 

 

are not private 

funds 

(e) Having 

general power  

of attorney  

or check-writing 

authority 

    

(f) Having a 

standing letter of 

authorization 

    

(g) Having 

physical 

possession of 

client assets 

    

(h) Acting as a 

qualified 

custodian 

    

(i) Through a 

related person 
that is 

operationally 
independent 

XXXXXX XXXXXX   

(j) Other     

(k) Total     

 

Because an adviser may have custody for more than one reason in the table above, the 

sum of (a) – (j) may not equal the amount in (k) Total. 

 

B.  (1) Are you relying on any of the exceptions in rule 223-1(b) to comply with rule 

223-1?  

 
Yes 

No 

(2) If you answered “yes” to Item 9.B.(1), on which exceptions in rule 223-1(b) 

are you relying (check all that apply).   

 

Shares of Mutual Funds (Rule 223-1(b)(1))

Certain Assets Unable to be Maintained with a Qualified Custodian (Rule 

223-1(b)(2)) 

If you checked the box above, list in section 9.C.(3) of Schedule D the accountants 

performing the verification required by Rule 223-1(b)(2)(iii)(A).



428 

 



Fee Deduction (Rule 223-1(b)(3)) 

Entities Subject to Annual Audit (Rule 223-1(b)(4)) 

If you checked the box above, list in section 9.C.(3) of Schedule D the accountants that 

performed the audit required by rule 223-1(b)(4).  You do not have to list independent 

public accountant information in section 9.C of Schedule D if you already provided this 

information with respect to the private funds you advise in section 7.B.(1) and that 

accountant only performs audits required by rule 223-1(b)(4) for those private funds. 


Certain Related Persons (Rule 223-1(b)(6)) 

Standing Letters of Authorization (Rule 223-1(b)(7)) 

Discretionary Authority (Rule 223-1(b)(8)) 

C. (1) Are any client assets of which you or a related person have custody 

maintained by a qualified custodian in accordance with rule 223-1 under the 

Advisers Act? 


Yes 

No 

If you answered “yes” to Item 9.C.(1) you must complete Section 9.C.(1) of Schedule D 

for each Qualified Custodian, including yourself or a related person, that maintains your 

client assets. 

 

D. (1) Are any client assets of which you or a related person have custody not 

maintained by a qualified custodian in accordance with rule 223-1 under the 

Advisers Act? 

 

Yes 

No 

(2) If you answered “yes” to item 9.D.(1), what are the number clients and 

approximate amount of client assets (rounded to the nearest $1,000) not 

maintained by a qualified custodian? 

 

(i) $   (ii) No. of clients:     

E. (1) Are you required to obtain a surprise examination in accordance with rule 

223-1(a)(4) under the Advisers Act? 

 



429 

 

Yes 

No 

If you are an adviser to pooled investment vehicle(s) or other entities relying on the audit 

provision under rule 223-1(b)(4) and do not otherwise need to obtain a surprise 

examination for other clients, indicate “No” in response to Item 9.E.(1).  If you 

responded “Yes” to Item 9.E.(1), list in Section 9.C.(3) of Schedule D the accountant 

engaged to perform the surprise examination required by rule 223-1(a)(4). 

 

* * * * * 

Schedule D 

* * * * * 

SECTION 9.C.(1) Qualified Custodian 

 

You must complete the following information for each qualified custodian that maintains 

your clients’ assets.  You must complete a separate Schedule D Section 9.C.(1) for each 

qualified custodian.  

 

Check only one box:  

 

 Add  Delete  Amend  

 

(1) Full legal name of the qualified custodian: ____________________________  

 

(2) The location of the qualified custodian’s office responsible for the services provided: 

________________________________________________________________________

______ (number and street) 

________________________________________________________________________

______ (city) (state/country) (zip+4/postal code) 

 

(3) Qualified custodian’s regulatory contact information: 

            

  

Name 

            

  

Telephone Number, including country code 

            

  

E-mail Address 

            

  



430 

 

Number and street (if different from above) 

            

  

City, state/country and zip+4/postal code (if different from above) 

 

(4) Type of entity: 

 

Broker/Dealer 

 SEC Registration Number:       

U.S. Bank or Savings Association

Futures Commission Merchant

Foreign Financial Institution 

  Primary Regulator/Country:       

 

(5) Legal Entity Identifier (if applicable):       

 

(6)  Number of clients and approximate amount of client assets (rounded to the nearest 

$1,000) held at the qualified custodian listed above: 

(i) Number of clients:       

(ii) Approximate amount of client assets: $      

 

(7) Is the qualified custodian listed above a related person?  Yes  No 

 

(i) If so, provide the following information about the independent public accountant 

that prepared the internal control report required by Rule 223-1(a)(1)(i)(C).  

 

(1) Name of the independent public accountant: ____________________________  

 

(2) The location of the independent public accountant’s office responsible for the services 

provided: 

________________________________________________________________________

______ (number and street) 

________________________________________________________________________

______ (city) (state/country) (zip+4/postal code) 

 

(3) Is the independent public accountant registered with the Public Company Accounting 

Oversight Board? 

 

Yes  No 

 

If “yes,” Public Company Accounting Oversight Board-Assigned Number:____________ 

 

(4) If “yes” to (3) above, is the independent public accountant subject to regular 

inspection by the Public Company Accounting Oversight Board in accordance with its 

rules? 

 



431 

 

Yes No 

 

(5) Did the internal control report prepared by the independent public accountant 

identified above contain an unqualified opinion?  

 

Yes No   Report Not Yet Received for Most Recent Fiscal Year End 

 

* * * * * 

SECTION 9.C.(3) Independent Public Accountants 

 

You must complete the following information for each independent public accountant 

engaged to perform a surprise examination, a financial statement audit of an entity whose 

assets you manage, or the verification of client assets required under rule 223-

1(b)(2)(iii)(A).  You must complete a separate Schedule D Section 9.C.(3) for each 

independent public accountant.  

 

Check only one box:  

 

 Add  Delete  Amend  

 

(1) Name of the independent public accountant: ____________________________  

 

(2) The location of the independent public accountant’s office responsible for the services 

provided: 

________________________________________________________________________

______ (number and street) 

________________________________________________________________________

______ (city) (state/country) (zip+4/postal code) 

 

(3) Is the independent public accountant registered with the Public Company Accounting 

Oversight Board? 

Yes  No 

If “yes,” Public Company Accounting Oversight Board-Assigned 

Number:____________ 

 

(4) If “yes” to (3) above, is the independent public accountant subject to regular 

inspection by the Public Company Accounting Oversight Board in accordance with its 

rules? 

Yes No 

 

(5) The independent public accountant is engaged to:  

A. perform a surprise examination  

B. perform an audit 

C. perform the verification required by Rule 223-1(b)(2)(iii)(A).  

 



432 

 

(6) Since the end of your most recent fiscal year, did all of the reports prepared by the 

independent public accountant identified above contain unqualified opinions?  

 

Yes  No Report Not Yet Received for Most Recent 

Fiscal Year End 

 

If you check “Report Not Yet Received for Most Recent Fiscal Year End,” you must 

promptly file an amendment to your Form ADV to update your response when the 

accountant’s report is available. 

 

* * * * *   

By the Commission. 

Dated:  February 15, 2023 

 

 

Vanessa A. Countryman, 

Secretary.