SEC Proposed Safeguarding Rule – Privately Offered Securities Exception
By Nina Iliushin, CPA, Assurance Manager, Alternative Investment Group
Amidst the rapidly evolving landscape of the financial industry, regulatory bodies like the U.S. Securities and Exchange Commission (SEC) are tasked with the challenge of keeping pace. Their goal? To ensure that new market innovations are complemented with robust guidelines that protect investors and maintain market integrity. On February 15, 2023, the SEC took a decisive step in this direction, unveiling a proposed Safeguarding Rule, which could be a game-changer for investment advisers and service providers of private funds. Yet, as with all sweeping regulatory changes, it hasn’t been without its share of controversy and critique.
Under the proposed rule, investment advisers registered under Section 203 of the Advisers Act must continue safeguarding all client assets for which they have custody using a qualified custodian, except for certain circumstances as clarified in Rule 223-1. Notably, the proposed rule provides an exception for privately offered securities, allowing investment advisers to self-custody under specific circumstances and conditions.
Privately Offered Securities Exception – Requirements and Costs vs. Benefits
Adviser’s Reasonable Determination
To qualify for this exception, an investment adviser must reasonably determine and document in writing that ownership cannot be recorded and maintained (book-entry, digital, or otherwise) in a manner in which a qualified custodian can maintain possession or control of such assets. This determination would require the investment adviser to understand the custodial services available in the marketplace and analyze each client asset for which it has custody. Although the proposed rule does not specify the frequency with which an investment adviser must update their understanding and analysis, a reasonable frequency for any determination would depend on the type of asset and the corresponding facts and circumstances of the marketplace. This requirement would benefit investors by limiting the scope of assets eligible for the exception and aims to ensure that any privately offered security for which a qualified custodian is available is held by such, providing enhanced protection of such assets to investors. In the SEC’s view, the extent of the benefit depends on the volume of advisers that currently would not otherwise maintain assets that they have control of with a qualified custodian despite the availability of custodial services for such assets. For instance, an adviser may currently self-custody due to the cost vs. benefit of maintaining an asset with a qualified custodian compared to internally safeguarding. Under the proposed rule, however, an adviser that maintains an asset internally due to the cost vs. benefit would not qualify for this exception. The SEC acknowledges that advisers may incur associated costs with this proposed reasonable determination requirement, which may be passed down to their clients through higher fees.
Adviser Reasonably Safeguards Assets
To qualify for this exception, an investment adviser must reasonably safeguard the assets not maintained with a qualified custodian from loss, theft, misuse, misappropriation, or financial reverses, including insolvency. Such protections may include enhanced recordkeeping, additional change of control terms in governance agreements, and designation of an agent required to be involved in transfers of beneficial ownership, among others. The proposed rule provides advisers flexibility to determine the specific measures it puts in place. Instead, the proposed rule would require advisers to develop enhanced safeguarding design and implementation policies and procedures for each asset consistent with the nature, facts, and circumstances. Advisers who do not already have practices in place to ensure consistent safeguarding of client assets will incur costs to develop and implement such procedures to comply with the proposed rule.
Notification and Prompt Independent Public Accountant Verification
To qualify for this exception, an investment adviser must enter into a written agreement with an independent public accountant whereby the accountant will verify any purchase, sale, or other transfer of beneficial ownership of such assets promptly upon receiving notice from the adviser of the transaction. The independent public accountant is required to notify the SEC within one business day upon finding any material discrepancies while performing its procedures. The SEC notes that this notification and verification requirement would benefit investors by reducing the risk that a loss, theft, misuse, or misappropriation of their assets goes undetected for a significant amount of time, which may mitigate losses associated with such events to be addressed in a timely manner. Although this requirement would likely result in initial costs to the adviser, the SEC believes that the ongoing costs of notifying the independent public accountant are likely to be small relative to the involved transaction costs associated with a change of ownership for privately offered securities. Additionally, those costs may be passed onto investors.
Surprise Examination or Audit
To qualify for this exception, an investment adviser must undergo an annual surprise examination, or financial statement audit, in which the existence and ownership of each of the client’s privately offered securities that are not maintained with a qualified custodian should be verified regardless of materiality thresholds. In other words, all privately offered securities not maintained with a qualified custodian must be verified rather than only a sample. The SEC notes that the proposed requirement would benefit investors by reducing the risk that the loss or theft of client assets is not detected when those assets are either not included in a surprise examination or audit sample due to materiality. This proposed requirement poses additional costs to advisers due to the increased scope of services to be provided by the independent public accountant.
The SEC highlights that the intention behind this exception and proposed requirements is to restrict its availability only to situations where it’s truly necessary.
Public Comments and Industry Reactions
The SEC received comments in response to the proposed safeguarding rule and the requirements under the privately offered securities exception, which generally express concerns about its practicality and potential impacts on investment advisers. Many commenters highlight the challenges in meeting the requirements of the privately offered securities exceptions, especially as it relates to “reasonable” determination, “reasonable” safeguard and notification, and prompt, independent public accountant verification. See below for a summary of key takeaways from the comments submitted to the SEC for the conditions primarily critiqued.
Adviser’s Reasonable Determination
Although the condition would only require a “reasonable” determination, the industry expresses concern that such determination will be evaluated with the benefit of hindsight and, as a result, expose advisers to regulatory risk for not having identified a properly qualified custodian in the moment.
Additionally, commenters note that the exception creates a challenging dilemma for investment advisers, forcing them to choose between adhering to fiduciary duties or complying with the exception requirements, and the practical implications of this requirement remain unclear to those in the industry. The industry is uncertain whether the exception applies regardless of the cost and their concerns about the competency or capacity of all available qualified custodians. There is concern about the undue costs or harm to their clients in a scenario where they choose a qualified custodian that potentially cannot properly maintain the assets.
Adviser Reasonably Safeguards Assets
While this condition is sensible, it remains unclear to investment advisers what exactly is required to satisfy this condition for specific assets. Since the exception relies on a “reasonableness” standard, it can be subjectively interpreted with perfect hindsight.
Notification and Prompt Independent Public Accountant Verification
Commenters believe that this condition requiring independent public accountants to promptly verify the purchase, sale, or transfer of beneficial ownership of assets is impractical, especially for private equity funds that frequently invest in privately offered securities. Like the challenges faced with securing qualified custodians for privately offered securities, there are concerns about the feasibility of advisers engaging independent public accountants for timely asset verification as it would require accountants to be on standby for prompt verifications.
Additionally, critics believe there is minimal risk of asset misuse or theft related to privately offered securities since private equity funds commonly hold them. As a result, there is a lack of justification to impose the verification requirements. Further, the condition lacks consideration of the various types of private equity fund investments that qualified custodians could not handle. As a result, commenters are concerned about the practicality and appropriateness of this condition.
Critics emphasize that the proposed rule may force investment advisers into less favorable investment structures, leading to additional costs and reduced investor returns. Moreover, they argue that the SEC did not adequately analyze the costs and benefits of these outcomes. Commenters requested a more risk-based approach, which the industry believes the risk for misappropriation of privately offered securities to be low.
The SEC’s endeavor to enhance investor protection with its proposed Safeguarding Rule has unquestionably stirred discussions, concerns, and debates across the financial industry. The critiques largely center on the practicality of implementing the rule and the potential ripple effects on investment firms, especially the smaller ones. While the emphasis on “reasonableness” offers flexibility, it also introduces ambiguity – a double-edged sword that could both allow for adaptive practices and poses challenges in consistent interpretation. The concerns raised by industry insiders point to a deeper underlying theme: the need for regulations that simultaneously ensure investor protection while considering the operational realities and diversity of investment advisers. As the financial community awaits the SEC’s next steps, there’s a collective hope for a balanced rule that safeguards interests without stifling market diversity and competition.
