Bloomberg Law
Feb. 27, 2023, 10:00 AM

SEC’s ‘Hammer’ Approach to Custody Revamp Worries Money Managers

Matthew Bultman
Matthew Bultman

The SEC’s proposal to strengthen safe-keeping of investors’ assets is partly a reaction to crypto concerns but has triggered industry worries that it would have an outsized effect on small money managers.

The Securities and Exchange Commission’s current “Custody Rule” requires investment advisers who are in custody of clients’ funds and securities to segregate and safely hold them with “qualified custodians,” such as banks.

The new proposal expands the rule to include all types of client assets held in advisory accounts—not just funds and securities but art, property, digital currencies, and more. Money managers making discretionary trades of client assets also would have to comply—a significant expansion.

The measure was targeted, at least in part, at the crypto market, which has been reeling from a broader regulatory crackdown. But it would have wide-ranging impacts on small money managers, who make up the largest segment of advisers registered with the SEC and may lack resources to comply with an expanded Custody Rule, investment adviser groups say.

“Crypto exposed ways in which the current rule either doesn’t work or is uncertain in how it applies,” Gavin Fearey of Winstead PC said. But “the application of the rule is going to be much broader than crypto.”

Along with broadening the scope of the Custody Rule, the proposal adds requirements. Investment firms would have to strike agreements with custodians on how to pay clients for certain losses. There would also be added record-keeping duties.

“A big part of the story here is not crypto,” said Gail Bernstein, general counsel for the Investment Adviser Association, a trade group representing fiduciary investment adviser firms. “A big part of the story is small business.”

Art, Real Estate, Wheat

The current Custody Rule was last revamped following the Bernie Madoff scandal. Among the rule’s requirements, advisers with custody can be required to submit to surprise exams from accountants.

As the SEC introduced revisions last week, much discussion, including from the agency’s commissioners, focused on what the changes would mean for crypto.

Crypto platforms holding digital assets owned by clients of hedge funds and other investment advisers would be subject to requirements. Investment advisers may also have to navigate additional hoops to invest in crypto.

As a result, some money managers may be discouraged from providing investment services for digital assets, attorneys said.

“I think the SEC misses the mark in important respects, and the safeguarding rule may chase advisers and potentially innovative custody solutions out of the crypto space,” Linklaters LLP attorney Oscar Saunders said.

The proposed changes are asset- and technology-neutral, the SEC says. The expanded sweep would catch assets such as real estate, artwork, jewelry, and wheat and other commodities that aren’t now subject to the Custody Rule.

Although traditional hedge funds might not get involved with these types of assets, many private funds have diversified their strategies, attorneys said. There are art investment funds, real estate funds, and others that focus on oil or natural gas.

“The private capital industry is very large and firm funds can invest in a variety of assets,” Schulte Roth & Zabel LLP attorney Christopher Avellaneda said. “One of the main developments in the past several years in the private funds industry is how diverse it has become.”

New Requirements

A proposed change that has drawn much investment industry attention is expanding the definition of “custody” to include discretionary authority to trade client assets.

Many advisers have discretionary authority, meaning they don’t need the client’s consent for each trade. Those activities would now be under the Custody Rule umbrella.

“That’s a big change from the current rule because it covers a lot more advisory activities,” said Laura Grossman, associate general counsel at IAA.

For advisers with custody of client assets, the new requirements would include getting a written agreement from the custodian, plus certain assurances. Those would include promises to segregate the client’s assets and indemnify the client against certain losses.

Banks are expected to push back on assuming such types of contractual obligations.

Segregation of assets has been a particular concern in crypto, with the implosion of firms like FTX revealing problems that arise from mixing customer funds with company assets. The SEC said in its rule proposal it believes that “segregation is a fundamental element of safeguarding client assets.”

Hammer Approach

Were the rule adopted as proposed, money managers would have to re-evaluate many custodial agreements. Investment firms would also have to wrestle with additional complexities around whether their arrangements comply with the expanded rule—something that can already be a sensitive judgment call.

“It’s not a simple matter of more paperwork,” Avellaneda said.

As proposed, the rule could have a “hugely detrimental impact” on firms with limited resources, Bernstein said.

Almost 90% of the investment advisers that are registered with the SEC have 50 or fewer employees and one or two offices, according to IAA statistics.

And although crypto’s expansion is helping drive the proposal, there’s no indication of widespread problems with safeguarding traditional funds and securities, the group said.

“We don’t see the problem that requires this kind of hammer approach, as opposed to a scalpel approach,” Bernstein said.

To contact the reporter on this story: Matthew Bultman in New York at

To contact the editor responsible for this story: Roger Yu at, Melissa B. Robinson at

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