On February 15, 2023, the SEC proposed to amend and redesignate Rule 206(4)-2 (“Custody Rule”) under the Investment Advisers Act of 1940 (“Advisers Act”) to enhance investor protections relating to client assets of registered investment advisers.
Specifically, the proposal would: (i) expand the Custody Rule to cover a broader array of client assets and advisory activities; (ii) enhance the custodial protections that client assets receive under the Custody Rule; and (iii) update related recordkeeping and reporting requirements for advisers. Additionally, the amendments would redesignate the Custody Rule as new Rule 223-1 under the Advisers Act (“Safeguarding Rule”). Like the Custody Rule, the Safeguarding Rule would not apply to exempt reporting advisers.
The Safeguarding Rule would modernize and expand upon the Custody Rule’s original scope of assets and activities. Specifically, the Safeguarding Rule would require advisers to provide certain minimum protections, including the safeguards of a qualified custodian, for “substantially all types of client assets held in an advisory account,” by modifying the Custody Rule’s definition of “assets” to include “funds, securities, or other positions held in a client’s account.” The Safeguarding Rule would also explicitly include an adviser’s discretionary authority to trade client assets within the definition of custody. 
Similar to the Custody Rule, the Safeguarding Rule would require advisers with custody of client assets to maintain those assets with a qualified custodian in almost all cases. However, unlike the Custody Rule, the Safeguarding Rule would specify that a qualified custodian does not “maintain” a client asset if it does not have “possession or control” of that asset. The Safeguarding Rule would define “possession or control” in part as “holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets….”
Additionally, the Safeguarding Rule would require advisers to enter into written agreements with qualified custodians to ensure such custodians provide standard protections while maintaining client assets. Specifically, advisers’ agreements with custodians would be required to include provisions (i) mandating the custodian provide promptly, upon request, records relating to clients’ assets held in the account at the custodian to the SEC or to an independent public accountant engaged to audit the client or verify its assets and (ii) specifying the adviser’s agreed-upon level of authority to effect transactions in the account. The Safeguarding Rule would additionally enhance the Custody Rule’s requirements for qualified custodian agreements related to the sending of account statements and require the custodian to provide the adviser with an annual internal control report.
Under the Safeguarding Rule, advisers would also be required to obtain certain written assurances from qualified custodians, including that the custodian will: (i) exercise due care in accordance with reasonable commercial standards in discharging its duty as custodian and implement appropriate measures to safeguard client assets; (ii) indemnify the client (and have insurance in place protecting the client) against losses caused by the qualified custodian’s negligence, recklessness, or willful misconduct; (iii) not be excused from its obligations to the client as a result of any sub-custodial or other similar arrangements; (iv) clearly identify and segregate client assets from the custodian’s assets and liabilities; and (v) 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. The adviser must maintain an ongoing reasonable belief that the custodian is complying with the foregoing.
Exception to Qualified Custodian Requirement
The Safeguarding Rule would expand the Custody Rule’s current privately offered securities exception from the obligation to maintain client assets with a qualified custodian to also include certain physical assets such as real estate or physical commodities (e.g., wheat or lumber). Additionally, the proposal would modify the conditions for relying on this exception, limiting the exception’s availability to only “truly warrant[ed]” situations where ownership cannot otherwise be recorded and maintained with a qualified custodian. An adviser relying on this exception must reasonably safeguard the assets from loss, and must engage an independent public accountant to promptly verify any purchase, sale or other transfer of such assets. The adviser must notify the accountant within one business day of such a transfer, and the accountant is required to notify the SEC if it finds any material discrepancies during the course of its verification.
Segregation of Client Assets
The Safeguarding Rule would require that advisers with custody of client assets segregate those assets by (i) titling or registering the assets in the client’s name or otherwise holding the assets for the client’s benefit; (ii) not commingling the assets with the adviser’s or any of its related persons’ assets; and (iii) 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. These requirements would apply regardless of whether such assets were held with a qualified custodian.
The Safeguarding Rule would maintain the Custody Rule’s requirement for advisers to engage independent public accountants to conduct surprise examinations of client assets pursuant to a written agreement. However, the new rule would explicitly require that an adviser reasonably believe that the terms of the written agreement have been implemented.
Additionally, in response to the Safeguarding Rule’s expanded scope, and in an effort to balance the costs associated with obtaining a surprise examination with the investor protections such examinations offer, the Safeguarding Rule would (i) provide certain exceptions to the surprise examination requirement similar to those contained in the Custody Rule and (ii) expand the availability of the Custody Rule’s audit provision as a means of satisfying the surprise examination requirement to entities that are not pooled investment vehicles.
Notice to Clients
Similar to the Custody Rule, the Safeguarding Rule would require advisers to provide written notice to clients promptly upon opening an account with a qualified custodian on the client’s behalf. The Safeguarding Rule, however, would require that the notice include the custodial account number in addition to the currently required qualified custodian’s name and address.
Recordkeeping and Reporting Obligations
In conjunction with the aforementioned revisions, the proposal would also amend advisers’ (i) Advisers Act recordkeeping requirements and (ii) ADV reporting obligations in an effort to improve the level of detail and accuracy of custody-related information available to the SEC and the public.
Comments on the proposal are due on or before 60 days after publication of the proposal in the Federal Register.
 The SEC stated that the Safeguarding 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. “Assets” also would encompass 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 currently covered under the Custody Rule. Additionally, physical assets, including real estate or physical commodities (e.g., wheat or lumber), would be within the scope of the Safeguarding Rule. The current definition of “assets” under the Custody Rule only includes “funds and securities.”
 The Safeguarding Rule would define “custody” as holding, directly or indirectly, client assets, or having any authority to obtain possession of them. An adviser has 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 provided to clients. Custody includes: (i) possession of client assets (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, 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 its 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 the adviser or its supervised person legal ownership of or access to client assets.
 The Safeguarding Rule would provide an exception, and another means of compliance, for certain assets that are unable to be maintained with a qualified custodian. See “Exception to Qualified Custodian Requirement” below.
 Privately offered securities means securities: (i) acquired from the issuer in a transaction or chain of transactions not involving any public offering; (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 the adviser is 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.