Safeguarding Proposal Remains Unpopular in Investment Industry

The re-opened comment period for the Securities and Exchange Commission’s safeguarding proposal closed on Monday. Industry opinion expressed in the comments remained much the same as it was during the original comment period that expired in May: The rule is too onerous and will hurt investors.

The safeguarding proposal would replace the old custody rule. Currently, advisers must keep assets with a qualified custodian if they have the right to obtain or control assets, including to draw from client assets to pay advisory fees. The custody rule applies to most securities besides registered funds.

The new proposal adds to these requirements. The first addition is requiring investment advisers to follow custody requirements if they have discretionary trading authority, even if they are not able to draw fees from the assets.

This element has been widely criticized as redefining custody and subsequently increasing cost for clients who want discretionary trading. The American Securities Association, for example, wrote that “discretion, generally, does not equal custody” and said investors “can benefit from discretionary investment management services. However, the Proposal generally increases the cost of providing discretionary advice.”

All Assets

Second, the proposal as it currently stands would include all assets under the custody rule, not just securities. That would include all manner of real assets and commodities, including real estate, art and precious metals.

This element has drawn criticism from Congressional Republicans, who noted that this encroaches on the authority of the Commodity Futures Trading Commission and that some assets cannot be easily custodied or audited. Further, some assets such as real estate are difficult to misappropriate.

Since the proposal would apply to all assets, it would also apply to cash. The most common objection to the proposal from investment industry groups is that it would require advisers to obtain assurances from custodians that cash will be kept segregated. Since many of the largest custodians are commercial banks, which lend cash deposits, these advisers would either have to find another custodian or pay much higher fees to those custodians.

The Insured Retirement Institute, the Investment Company Institute and many others objected to the proposal on that ground. HSBC noted this as well in a comment letter and added that it would make it particularly difficult to keep assets in foreign institutions, which would likewise be subject to the rule if interacting with registered advisers based in the U.S.

Audit Expansion

In expanding custody requirements to all assets, the safeguarding rule also expands the surprise audit requirement to all assets. Currently, advisers are subject to a surprise audit of custodied assets once per year to verify their existence and ownership, but only if those assets are part of a pooled investment vehicle.

Jay Gould, a special counsel with Baker Botts, says, “Advisers with custody or the ability to maintain and control client assets find portions of the rule burdensome and likely to increase costs, particularly expanding the audit provision to cover any other entity, in addition to pooled vehicles.”

Gould adds that “auditor oversight is something that the Commission believes is a significant investor protection feature. I would not expect the Staff to recommend that the Commission materially revise this requirement when they adopt the rule amendments.”

The SEC has not yet set a timetable to finalize the rule.