By Anne Sherry, J.D.
Via a no-action letter to the Investment Adviser Association, the SEC’s Division of Investment Management invited comments on questions that have arisen since the agency’s 2017 guidance update on the custody rule under the Investment Advisers Act. Some of the topics the staff is interested in exploring are issues relating to trading that is not settled on a delivery-versus-payment basis; the application of the custody rule to digital assets; and the advisability of revisions to the custody rule.
The letter explains that there is an increased risk of misappropriation or misuse of assets in the custody of investment advisers. The custody rule establishes requirements for advisers which have custody of client funds or securities; maintaining custody outside of those requirements is a fraudulent, deceptive or manipulative act, practice or course of business. “Custody” means any arrangement under which an adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian.
Non-DVP trading. In the 2003 adopting release for the amendments that established the definition of “custody,” the SEC explained that the rule does not apply to authorized training, and elaborated in a footnote. The footnote, however, does not address authorized trading of securities that do not settle on a delivery-versus-payment basis. SEC staff believes that the Commission should consider issues that have arisen since the 2003 amendments, including questions regarding so-called non-DVP trading.
IM staff is especially concerned about the risks of misappropriation inherent in non-DVP arrangements. Because there is no corresponding transfer into the custodial account, the custodian’s role as an independent safeguard is diminished. The letter also observes that investment advisers have an obligation to safeguard client assets independent of the custody rule, and this includes reviewing internal controls and addressing the risk of misappropriation or loss in compliance policies and procedures.
Digital assets. The no-action letter also invites engagement on issues relating to custody of digital assets. Staff and market participants have discussed whether and how certain aspects of digital assets implicate the custody rule. Some of these aspects include the use of digital ledger technology (DLT) to record ownership, the use of public and private keys to transfer digital assets, the “immutability” of blockchains, the inability to recover lost digital assets, anonymity of DLT transactions, and challenges posed to auditors.
Comments. The Division established a new email address to receive comments about the effect of the custody rule on non-DVP trading and/or digital assets. Commenters should email IMOCC@sec.gov and use “Custody Rule and Non-DVP Trading” or “Custody Rule and Digital Assets” in the subject line. The staff anticipates making submissions public, without redacting or editing personal identifying information.