On February 15, 2023, by a 4-1 vote, the SEC proposed new rules regarding an investment adviser’s obligation to custody assets. Unlike the existing rules, if adopted, the new rules would apply to all crypto assets.
Currently, Rule 206(4)-2 under the Investment Advisers Act imposes various conditions on the custody of client “funds and securities,” but does not cover crypto assets unless they are also securities. Under newly proposed Rule 233-1 (which would replace Rule 206(4)-2), the revised “safeguarding” rule would cover virtually all client assets, including crypto assets, irrespective of their status as securities. Rule 233-1, like its predecessor, would also limit the universe of qualified custodians to certain banks and savings associations, broker-dealers, registered futures commission merchants, and foreign financial institutions subject to regulation in their home jurisdictions.
In addition to imposing various new conditions on the activities of a qualified custodian, the new safeguarding rule would also require qualified custodians to maintain “possession or control” of custodied assets such that the qualified custodian is required to participate in any change in beneficial ownership of the asset. The SEC’s proposing release notes that while demonstrating a qualified custodian has exclusive possession or control of an asset would be one way to demonstrate that the qualified custodian is required to participate a change of beneficial ownership, it is not the only way. For example, the SEC posits that a qualified custodian would have possession or control of a crypto asset if it generates and maintains private keys for the wallets holding advisory client crypto assets in a manner such that an adviser is unable to change beneficial ownership of the crypto asset without the custodian’s involvement.
According to the SEC, in order to comply with the proposed rule, an adviser with custody of client crypto assets would generally need to ensure those assets are maintained with a qualified custodian that has possession or control of the assets at all times in which the adviser has custody. While this is true for most client assets over which an adviser has custody, it is particularly relevant with respect to crypto assets because, according to the SEC, much of the crypto asset trading volume occurs on crypto asset trading platforms that often directly settle the trades placed on their platforms. As a result, many crypto trading platforms require investors to pre-fund trades, a process in which investors transfer their crypto assets, including crypto asset securities, or fiat currency to such an exchange prior to the execution of any trade. The SEC noted that because most crypto assets, including crypto asset securities, trade on platforms that are not qualified custodians, this practice would generally result in an adviser with custody of a crypto asset security being in violation of the current custody rule because custody of the crypto asset security would not be maintained by a qualified custodian from the time the crypto asset security was moved to the trading platform through the settlement of the trade. Under the SEC proposal, this practice would also constitute a violation of the proposed rule for an adviser with custody of client crypto assets if the adviser trades those assets on a crypto asset trading platform that does not satisfy the definition of qualified custodian.
In her dissenting statement, Commissioner Hester Peirce identified what she believes to be a number of issues with the workability and effectiveness of the proposed rules. In particular, she expressed concern that the proposal would “expand the reach of the custody requirements to crypto assets while likely shrinking the ranks of qualified crypto custodians.” She also took issue with statements in the proposing release that could lead one to conclude it is “designed for immediate effect.” Specifically, she continued:
Specifically, the release states that some advisers “might take the position that crypto assets are not covered by the custody rule at all. This, however, is incorrect because most crypto assets are likely to be funds or crypto asset securities covered by the current rule.” The footnote to that statement explains that “The application of the current rule turns on whether a particular client investment is a fund or a security. To the extent there is a question as to whether a particular crypto asset is an investment contract that is a security, the analysis is governed by the test first articulated by the Supreme Court in SEC v. W.J. Howey . . . .” I disagree with the main premise that most crypto assets are securities and the sub-premise that crypto assets sold in a securities offering are necessarily themselves securities. Such sweeping statements in a rule proposal seem designed for immediate effect, a function proposing releases should not play. These statements encourage investment advisers to back away immediately from advising their clients with respect to crypto.
The SEC’s proposal is open for public comment until 60 days after publication in the Federal Register and is part of a growing movement to curtail perceived abuses in the crypto industry. The federal banking regulators, for example, recently issued a joint statement identifying crypto-asset risks to the banking system and have stepped up examination efforts on these topics. The SEC, CFTC and DOJ have increased the pace and frequency of crypto enforcement actions as well.