Advisor, industry groups blast SEC custody proposal

Organizations representing investment advisors and financial firms are warning the SEC that a proposal to overhaul custody rules would impose significant costs and regulatory burdens on investment advisors, while crimping their latitude to manage client accounts.

The proposal, which the Securities and Exchange Commission released in February and which runs 121 pages in the Federal Register, would extend custody obligations beyond securities and funds, which are covered by the current rule, and include all assets in a client’s portfolio. That would sweep in private securities, real estate, derivatives and other assets. It also would expand custody to crypto assets that are not securities.

Under the proposal, an advisor who can make trades on behalf of a client would be deemed to have custody of the client’s assets, according to an SEC fact sheet. The proposal also would require advisors to enter a written agreement with a qualified custodian to protect customer assets. Qualified custodians include banks, broker-dealers and trust companies, among other institutions.

SEC Chair Gary Gensler has said the first update to the custody rule in 14 years is necessary to ensure “advisers don’t inappropriately use, lose or abuse investors’ assets.”

Industry trade associations agreed in principle with that goal but pushed back hard on the way the SEC is proposing to do it. In comment letters that were due Monday, they questioned the justification for the rule and accused the SEC of regulatory overreach.

“The proposal would impose and shift substantial burdens and costs among advisers, their clients, and [qualified custodians] but without demonstrating that any marginal improvement in asset protection would justify such burdens and costs,” Kevin Carroll, deputy general counsel at the Securities Industry and Financial Markets Association, wrote in a comment letter Monday. “Unfortunately, it appears that the proposal’s biggest loser would be advisory clients due to fewer [qualified custodians] to provide services, reduced access to markets and products, and higher advisory and custodial fees.”

Expanding the definition of custody to include advisors who have latitude to make trades on behalf of customers drew criticism from the Investment Adviser Association.  

The provision “would make trading on behalf of clients impracticable,” Gail Bernstein and Laura Grossman, IAA general counsel and deputy general counsel, respectively, wrote in a May 8 comment letter. “It would be especially difficult for advisers to trade in asset classes that do not settle on a delivery versus payment basis. Ultimately, this recharacterization of custody would harm investors by limiting their investment universe and the number of investment advisers that can bear the burden of compliance with the rule.”

The Investment Company Institute, which represents mutual funds, said the provision would cause a “significant number of practical difficulties” for advisors.

“For example, equating discretionary trading with custody could cause advisers to be deemed to have custody over thousands of additional client accounts despite no change in the adviser’s relationship with the client,” Dorothy Donohue, ICI deputy general counsel, wrote in a May 8 comment letter.

The proposal also would place unwieldy requirements on advisors’ relationships with custodians, the IAA said.

“Many requirements of the proposed rule would compel the adviser to police commercial terms between clients and custodians on matters unrelated to the investment advice provided by the adviser,” the IAA’s Bernstein and Grossman wrote. “We believe that this type of ‘backdoor’ regulation is inappropriate, turns on its head the regulatory purpose of the custody rule, and imposes regulatory burdens unfairly, as we have noted in the similar context of the commission’s proposed rule on outsourcing by investment advisers.”

Public Citizen backed the SEC’s proposal, in part because it would place custody requirements around cryptocurrency assets.

“Currently, cryptocurrency trading takes place in a Wild West willfully flaunting the law and order,” Public Citizen wrote in a May 6 comment letter. “We heartily welcome the SEC’s effort to bring law and order to this so-called industry.”