As part of our client update program, please find below a summary of what we believe to be the most relevant information on the SECs Examination Priorities for the Division of Examinations (Division) and the proposal of the new custody rule 223-1.
1. Examination Priorities 2023
The SEC announced its Examination Priorities for 2023.
New Investment Adviser and Investment Company Rules
The Division will focus on the new Marketing Rule (Advisers Act Rule 206(4)-1) and whether registered investment advisers (RIAs) have adopted and implemented written policies and procedures that are designed to prevent violations by the advisers and their supervised persons of the new rule, and whether RIAs have complied with the substantive requirements. The Division will also focus on new rules applicable to investment companies, including the Derivatives Rule (Investment Company Act Rule 18f-4) and Fair Valuation Rule (Investment Company Act Rule 2a-5).
RIAs to Private Funds
Examinations will review issues under the Advisers Act, including an adviser’s fiduciary duty, and will assess risks, with a focus on compliance programs, fees and expenses, custody, the new Marketing Rule, conflicts of interest, and the use of alternative data.
Environmental, Social, and Governance (ESG)
An increasingly hot topic, coming under growing scrutiny, the Division continues its focus on ESG-related advisory services and fund offerings, including whether funds are operating in the manner set out in their disclosures. The Division will assess whether ESG products are appropriately labeled and whether recommendations of such products for retail investors are made in the investors’ best interests. Fees and pricing will also receive close scrutiny.
Retail Investors and Working Families
The Division continues to address standards of conduct issues for RIAs to ensure that retail investors and working families are receiving recommendations and advice in their best interests. These examinations will focus on how registrants are satisfying their obligations under Regulation Best Interest and the Advisers Act fiduciary standard to act in the best interests of retail investors.
Information Security and Operational Resiliency
The Division will review RIAs’ and other registrants’ practices to prevent interruptions to mission-critical services and to protect investor information, records, and assets. Reviews will focus on the cybersecurity issues associated with the use of third-party vendors, including registrant visibility into the security and integrity of third-party products and services and whether there has been an unauthorized use of third-party providers.
Emerging Technologies and Crypto-Assets
The Division will conduct examinations of broker-dealers and RIAs that are using emerging financial technologies or employing new practices, including technological and online solutions to meet the demands of compliance and marketing and service investor accounts. Examinations of registrants will focus on the trading in crypto or crypto-related assets.
2. Proposal of the new custody rule 223-1 under the Advisers Act (“safeguarding rule”)
The SEC proposed an amendment of the rule 206(4)-2 under the Investment Advisers Act of 1940. The amendments would redesignate the current custody rule as new rule 223-1 under the Advisers Act (the “safeguarding rule”). The adoption of this rule would entail complementary changes to the Advisers Act books and records rule and Form ADV. SEC commissioners February 15 voted 4-1 to approve the proposal. This will mean real changes and action required from RIAs in Switzerland. The rule would still permit “Eligible Foreign” custodians provided they met several conditions, including being legally organized in a country and regulated by that country’s government.
Nevertheless, the proposed amendments would have significant consequences for advisers, custodians, accountants and clients.
The goals in brief:
- Expansion of the current custody rule to protect a broader range of clients assets and advisory activities to the rule’s protections,
- Enhancement of the custodial protections for clients assets,
- And update of related recordkeeping and reporting requirements for advisers.
The current custody rule 206(4)-2
The current custody rule requires investment advisers to safeguard client funds and securities in their possession or where they have authority to obtain possession of them. The rule is intended to protect the assets from the adviser’s insolvency or bankruptcy, and from being lost, stolen or misused.
The SEC acknowledges that today’s custodial environment may be “thin” in its ability to possess and control certain assets. The current rule includes an exception for certain pooled investment funds from having to maintain assets at a qualified custodian provided a surprise exam or financial audit occurs annually. The proposed rule would expand this “audit provision” to “other types” of private fund clients provided their assets could be audited.
One goal of the proposal is to address the numerous interpretive questions (e.g. what it means to have “custody”) and the changes in technology, advisory services and custodial practices that have developed since the last amendment of the rule in 2009.
Proposed amendments: new rule 223-1
The proposed rule 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.
The proposed rule’s enhanced protections require:
- Advisers to maintain client’s assets at a qualified custodian in a specified manner pursuant to a written contract that contains enumerated elements. A qualified custodian generally is a federal or state-chartered bank or savings association, certain trust companies or certain foreign financial institutions (“FFI”).Under the proposal, a qualified custodian would be required to have “possession or control” of advisory client assets. The proposal would require a more robust set of requirements for an institution to be an FFI that is eligible to serve as a qualified custodian. The proposal would further specify the manner in which qualified custodian banks and savings associations must hold client assets.
- Advisers must obtain a written assurance from a qualified custodian to ensure that the custodian will exercise due care over client’s assets and holding the custodians to certain duties, for example:
- Sending account statements to clients at least quarterly
- Sharing an annual written internal control report containing a public accountant’s view of the custodian’s controls and safeguarding of client assets
- Compensate 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 arrangements with regard to the client’s assets
- Clearly identify and segregate client assets
- Not subject client assets to any right, charge, security interest or claim in favor of the custodian or its related persons or creditors.
- Advisers that open an account with a qualified custodian on a client’s behalf must notify the client of the account details.
- Advisers to title or register client’s assets in the client’s name or hold assets for the benefit of that client and to hold free of any right, charge, security interest or claim in favor of the advisor and its related persons or creditors. The commingling of client assets with the adviser’s assets is prohibited.
- Advisers that maintain custody of client assets to be verified by an independent public accountant at least annually and to keep the SEC to a written agreement that provides for the filing of Form ADV-E.
- Advisers to keep additional, more detailed records of trade and transaction activity and position for each client account which it has custody (recordkeeping).
The proposal expands the scope of the current custody rule beyond client funds and securities to cover other assets that currently do not receive custodial protections – from physical coupon bonds, crypto assets, including tokens, real estate and art. The new rule would include an adviser’s discretionary authority to trade client assets within the definition of custody.
The rule includes some exceptions, for example certain “assets unable to be maintained with a qualified custodian”. Another exception would apply to advisers that have discretionary authority when clients assets “are maintained with a qualified custodian”. Banks, broker-dealers and certain foreign institutions are be defined as qualified custodians.
Changes to Books & Records rule
In the case of replacement of the current custody rule, the Advisers Act rule 204-2 (books and records) would be amended. Advisers would be required to keep additional, more detailed records of trade and transaction activity and position information for each client account of which it has custody.
Complementary changes to the Advisers Act books and records rule and Form ADV are designed to align reporting obligations with the new rule and to improve the accuracy of custody-related data available to the SEC, its staff and the public.
- The SEC cites that the overwhelming majority of securities are uncertified because private fund assets have vastly expanded in the recent years. The proposed rule aims to cover all assets.
- The SEC acknowledges that today’s custodial environment may be “thin” in its ability to “possess and control” certain assets.
- The SEC proposed the changes to ensure firms would have the records for examiners to judge their compliance with the safeguarding rule.
The comment period will be open for 60 days following the publication of the proposing release in the Federal Register.
Thank you for reading our newsletter on the SEC’s Examination Priorities for 2023. As always, we strive to keep you up-to-date on the latest developments in the financial industry, and we look forward to sharing more insights with you in the future. If you have any questions or would like to discuss these topics further, please don’t hesitate to reach out to us. Stay informed, stay ahead, and we’ll see you in the next edition of our newsletter.
Martin Straub, Michaela Portal, Christoph de Weck
Aviolo Compliance Solutions
Tel: +41 44 552 0387