Some of the provisions in the Securities and Exchange Commission’s proposed Safeguarding Rule were sharply criticized by industry participants during the comment period that ended Monday. The Safeguarding Rule would expand the Custody Rule’s reach both to advisers engaging in discretionary trading and to all asset types.

The Investment Adviser Association, an industry group representing advisers, wrote in a comment letter to the SEC that requiring advisers to comply with custodial requirements for participating in discretionary trading is misguided.

Gail Bernstein, general counsel at the IAA, wrote in the letter that an adviser who has the authority to trade client assets without pre-approval does not have custody in the traditional sense because they cannot withdraw or redirect funds, and there is little risk of theft or loss.

Since many advisers have discretionary trading authority, many who are not currently subject to the Custody Rule would now be required to face annual surprise exams and to hire an independent accountant, among other requirements, according to Bernstein, who terms the requirements “very burdensome and very expensive.” Laura Grossman, the IAA’s associate general counsel, says approximately 5,000 registered advisers would have to comply with these rules for the first time, which is about one-third of all advisers.

In the eyes of Grossman and Bernstein, the SEC has not adequately explained what issues the proposal would solve or what the expected benefits would be. The IAA’s letter also said that the general pace of SEC rulemaking is too fast and difficult to keep up with.

The SEC received more than 100 comments concerning the proposal from registered investment advisers, law firms and auditors such as Deloitte & Touche LLP and PricewaterhouseCoopers LLP. Many commentators were seeking further clarity, changes or full pullback of the amendment.

Crypto, Too?

The IAA letter also stated its disapproval of expanding the Custody Rule to all asset classes, including digital assets, real estate and physical commodities. Bernstein explains that expanding the rule to all assets would impose a new regulatory regime on many previously uncovered asset classes and could “make those other assets difficult to transact in.” She describes this as “a huge sea change” for custodians, advisers and accountants.

The U.S. Small Business Administration expressed some of the same concerns in its letter, written in consultation with the IAA. The SBA says that defining discretionary trading as custody would have disproportionate effects on small advisers. Smaller advisers often do not hold or have access to client assets and do not have custody under the current regulations, according to the letter. This change would subject them to all the regulations and requirements of the Custody Rule.

Industry skepticism of the discretionary trading criteria could be facing headwinds from the SEC. William Birdthistle, the director of the SEC’s division of investment management, said during an open SEC meeting in February, when the proposal was formally offered, that discretionary trading is custody because it creates opportunities for loss if the adviser invests poorly. He repeated his support in March at an IAA conference, saying, “discretionary trading can create problems.”

And Don’t Forget Annuities

The Insured Retirement Institute, in its comment letter to the SEC, stated that the Safeguarding Rule would reduce access to certain annuities. The IRI noted that sometimes advisers have discretionary authority to move cash among investment options in a variable annuity contract, which would be covered by the safeguarding proposal.

The IRI referenced a no-action letter given to American Skandia Life Assurance Corp. in 2005, which permitted an adviser to withdraw assets from a client account for advisory fees without triggering the Custody Rule, and suggested making it universal for insurance firms. Many advisers dealing in insurance products have used this exemption so they can charge fees from clients’ accounts without having to keep those assets with a qualified custodian.

The IRI’s letter proposed that insurance companies be treated as qualified custodians for annuity contracts, since contracts provide strong legal protections and the adviser does not have actual custody of the assets at any point; custody is retained by the insurance company. Additionally, under state insurance laws, clients’ assets are segregated from the insurance company’s other assets, so they are protected in the case of bankruptcy, which is one of the objectives of the SEC’s proposal.

By universalizing the American Skandia no-action letter and treating insurance companies as a substitute for a qualified custodian, the SEC could avoid reducing access to annuity products, the letter argues.