On February 15, 2023 the U.S. Securities and Exchange Commission (SEC) proposed new rules and amendments to the Investment Advisors Act of 1940 directed at the current Custody Rule and designed to address how investment advisors safeguard client assets.

First and foremost, the Custody Rule as we know it under 206(4)-2 would be redesignated as a new rule, the Safeguarding Rule, under 223-1. From there, several amendments are being proposed to enhance investor protections. Corresponding amendments are also being proposed to the Recordkeeping Rule (204-2) and new amendments are being proposed to Form ADV.

The proposals are designed to modernize the scope of assets and activities that would initiate application of the rule, including discretionary authority to trade within the definition of custody. Additionally, the proposals further define what it means for qualified custodians to have possession or control and adds a requirement that an advisor enter into a written agreement with and receive certain assurances from qualified custodians. Further, the proposals offer several changes surrounding the privately offered securities exception. Next, the proposals go on to add provisions regarding segregation of client assets. Finally, the proposals offer some changes to the surprise examination requirements.

Each of the areas is discussed in more detail below.

Proposals Impacting the Scope of Assets and Activities

Scope of Rule

The proposed rule would change the current rule’s scope in two key aspects:

• The proposed rule would expand the current rule’s coverage beyond “funds and securities” to “client assets”
  • “Assets” would be defined as “funds, securities, or other positions held in a client’s account”
• The proposed rule makes explicit that custody includes discretionary authority

Takeaways

The proposed rule takes an expansive approach to the types of assets subject to the rule and is designed to remain ageless, encompassing new investment types as they continue to evolve and expand. The types of investments that may not have necessarily been included under the current rule that would now be subject to the Safeguarding Rule include, but are not limited to: short positions; written options; all crypto assets (even in instances where such assets are neither funds nor securities); financial contracts held for investment purposes; collateral posted in connection with a swap contract on behalf of the client; and physical assets, including but not limited to artwork, real estate, precious metals, or physical commodities (e.g. wheat or lumber).

Interestingly, the proposed rule goes on to indicate that the meaning of assets would also encompass investments that would be accounted for in the liabilities section of a balance sheet or represented as a financial obligation of the client. The SEC indicated it believes that the entirety of a client account’s positions, holdings, or investments should receive the protections of the proposed rule.

The proposed rule generally preserves the current rule’s definition of custody (i.e., possession of client funds or securities); however, one important clarification has been added – discretionary trading authority is an arrangement that triggers the rule. This is a major change from the prior rule because in connection with the current Custody Rule, the SEC stated that an advisor’s authority to issue instructions to a broker-dealer or a custodian to effect or to settle trades, or authorized trading, does not constitute custody.

There is some good news, though. If this discretionary authority (i.e., instructing the client’s qualified custodian to transact in assets that settle only on a delivery versus payment (DVP) basis) is the sole reason that an advisor is subject to the rule, then the advisor would be exempt from the surprise examination requirements. This is similar to the current exemption when the sole basis is automatic fee deduction. This and other exceptions are discussed in more detail in the “Exceptions from the Surprise Examination Requirement” section below.

Proposals Surrounding Qualified Custodians

Investment advisors with custody of client assets would still be required to maintain those assets with a qualified custodian, but the proposed rule adds several ways to strengthen that requirement.

Definition of Qualified Custodian

• The proposed rule requires banks and savings associations that act as qualified custodians to utilize accounts that are distinguishable from a general deposit accoun
  • The proposed rule also requires banks and savings associations to clarify the nature of the relationship between the account holder and the qualified custodian as a relationship account that protects client assets from creditors of the bank or savings association in the event of insolvency or failure
• Foreign Financial Institutions (FFIs) that act as qualified custodians must meet seven new conditions under the proposed rule to serve as a qualified custodian. They must:
  • Be incorporated or organized under the laws of a country or jurisdiction other than the United States, provided that the advisor and the SEC are able to enforce judgments
  • Be regulated by a foreign country’s government, an agency of a foreign country’s government, or a foreign financial regulatory authority as a banking institution, trust company, or other financial institution that holds financial assets for its customers
  • Be required by law to comply with anti-money laundering and related provisions
  • Hold financial assets for customers in an account designed to protect such assets from creditors of the FFI in the event of insolvency or failure
  • Have the financial strength to provide due care for client assets
  • Be required by law to implement practices, procedures, and internal controls designed to ensure the exercise of due care with respect to the safekeeping of client assets
  • Not be operated for the purpose of evading the provisions of the proposed rule

Takeaways

The proposed rule, like the current rule, continues to define the term “qualified custodian” to mean a bank or savings association, registered broker-dealer, registered futures merchant, or certain types of foreign financial institutions. Except for the changes above, the types of institutions that may serve as qualified custodians are not being changed. The SEC believes the change for banks and savings associations will improve the safeguarding of client assets by creating a fiduciary relationship rather than a debtor-creditor relationship.

The new requirements for FFIs are partly drawn from the SEC’s experience with the factors relevant to the safekeeping of foreign assets by the types of foreign entities that can act as eligible foreign custodians as defined in rule 17f-5 under the Investment Company Act. The SEC believes these requirements would help promote an FFI having generally similar protections as a U.S.-based qualified custodian.

Possession or Control

• The proposed rule would require the qualified custodian to have “possession or control” of client assets. Possession or control is defined as:
  • Holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets
  • The qualified custodian’s participation would effectuate the transaction involved in the change in beneficial ownership
  • The qualified custodian’s involvement is a condition precedent to the change in beneficial ownership

Takeaways

This is a crucial change from the current rule. The SEC has made it clear in the proposal that “accommodation reporting” does not constitute participation. Additionally, this could have far reaching aspects as it relates to crypto assets. Crypto asset trading volume often occurs on crypto asset trading platforms that directly settle the trades placed on their platforms. Due to the direct settlement, investors must pre-fund trades, whereby the investors transfer their crypto assets to the exchange prior to the execution of any trade. Since those trading platforms are generally not qualified custodians, and given the expanded definition of assets under the proposed rule, this practice would result in an advisor with custody of a crypto asset being in violation of the proposed rule, since the asset 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.

Minimum Custodial Protections

• The written agreement between the advisor and custodian (or the advisor and the client if the advisor serves as the qualified custodian) must contain the following contractual terms:
  • Requirement that the qualified custodian respond promptly to records requests from the SEC or independent public accountants engaged by an advisor for the purposes of complying with the proposed rule
  • Specification of the advisor’s agreed-upon level of authority to effect transactions in an account
  • Requirement that the qualified custodian deliver account statements to clients and to the advisor
    • Provision prohibiting the qualified custodian from identifying assets on account statements for which the qualified custodian lacks possession or control (i.e., accommodation reporting) unless requested by the client and, if so requested, must be clearly labeled as such
  • Requirement that the qualified custodian obtain a written internal control report that includes an opinion of an independent public accountant regarding the adequacy of the qualified custodian’s controls

• The proposed rule requires advisors to obtain reasonable assurances from a qualified custodian that include the following:
  • They will exercise due care
  • They will indemnify the client against losses caused by the qualified custodian’s negligence, recklessness, or willful misconduct
  • They will not be excused from obligations to the client as a result of any sub-custodial or other similar arrangements
  • They will clearly identify and segregate client assets from their own assets and liabilities
  • They will not subject client assets to any right, charge, security interest, lien, or claim in favor of the qualified custodian or its related person or creditors, except to the extent agreed to or authorized in writing by the client

Takeaways

Under existing market practices, advisors are generally not a party to the custodial agreement. Thus, the requirement for an advisor to enter into a written agreement with a qualified custodian will be a significant industry change. The good news is that it may alleviate certain concerns around inadvertent custody since the agreement will clearly define the advisor’s level of authority.

The proposed rules may also have a significant impact on custodians in terms of cost to provide these assurances and to satisfy these additional requests if they are not already providing them. For example, the change in the level of indemnification may create added insurance costs. Additionally, if a custodian is not currently receiving an internal control report, that may also add to the cost of compliance. The internal control requirement is not new, it was just previously only applicable when the advisor or one of its related persons served as a qualified custodian. This proposal expands that internal control requirement to all qualified custodians. Furthermore, in a change from the current rule which only requires statements be provided to clients, qualified custodians would now also be required to provide them to the advisor.

Proposals Affecting Privately Offered Securities (i.e., certain assets that are unable to be maintained with a qualified custodian)

The increased scope of the proposed rule to include all client assets (e.g., gold) required amendments to the privately offered securities aspects of the current rule. Additionally, the expansion of the amount and types of privately offered securities (e.g., private pooled investment vehicles) was cause for concern to the SEC. As such, the proposed rule is seeking to make changes in the following areas:

Privately Offered Securities Exception

• The proposed rule would provide an exception to the requirement to maintain client assets with a qualified custodian where an advisor has custody of privately offered securities or physical assets, provided it meets the following conditions:
  • The advisor reasonably determines and documents 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 transfers of beneficial ownership, of such assets
  • The advisor reasonably safeguards the assets from loss, theft, misuse, misappropriation, or the advisor’s financial reserves, including the advisor’s insolvency
  • An independent public accountant, pursuant to a written agreement between the advisor and the accountant:
    • Verifies any purchase, sale, or other transfer of beneficial ownership of such assets promptly upon receiving notice from the advisor of any purchase, sale, or other transfer of beneficial ownership of such assets
    • Notifies the Commission within one business day upon finding any material discrepancies during the course of performing its procedures
  • The advisor notifies the independent public accountant engaged to perform the verification of any purchase, sale, or other transfer of beneficial ownership of such assets within one business day
  • The existence and ownership of each of the client’s privately offered securities or physical assets that is not maintained with a qualified custodian are verified during the annual surprise examination or as part of a financial statement audit

Takeaways

These changes represent a significant departure from the current rule and put an added burden on advisors. This is particularly evident in that advisors will now need to have processes in place to provide notice to their independent public accountant within 24 hours of essentially any change to a privately offered security or physical asset. The independent public accountant would then have a record built to compare against during the annual surprise examination.

Think of it like this: the independent public accountant could theoretically see a transaction during the annual surprise examination that wasn’t reported to them within 24 hours of the date of the transaction. Then they themselves would have 24 hours from seeing that discrepancy to report the advisor for the material discrepancy of not reporting the transaction to the independent public accountant within 24 hours. Additionally, because of the increased scope, regardless of the exception, many physical assets that aren’t “audited” will still need to be verified during the annual surprise examination.

Definition of Privately Offered Securities and Physical Assets

• The proposed rule retains the elements of the current rule’s description that requires the securities to be acquired from the issuer in a transaction not involving any public offering
• The proposed rule retains the element of the current rule’s description that requires the securities to be transferable only with the prior consent of the issuer or holders
• The proposed rule also requires the securities to be uncertificated and recorded only on the books of the issuer or its transfer agent in the name of the client, with one key distinction:
  • The proposed rule would require that the securities be capable of only being recorded on the non-public books of the issuer or its transfer agent
• The SEC is not providing a definition of physical asset because it believes it to be self-evident

Takeaways

The tweak of the definition to require securities to be capable of only being recorded on the issuer’s non-public books will have an impact on crypto assets. Since such assets are often issued on public blockchains, they would not satisfy the conditions of privately offered securities under the proposed rule. Additionally, because the SEC chose not to define physical assets, it leaves some ambiguity in the rule. The SEC provided some examples:

• Real estate and physical commodities such as corn, oil, and lumber are physical assets
• Cash, stocks, bonds, options, futures, and funds are not (even if they provide exposure to physical assets)
• Physical ownership of non-physical assets (e.g., stock certificates, private keys, bearer and registered instruments) do not themselves qualify as physical assets
• Warehouse receipts for certain commodities would not qualify for the exception even though the commodities documented by the warehouse receipt may
• A deed for real estate would not qualify for the exception, but the physical buildings or land would qualify

Proposals Surrounding Segregation of Client Assets

Segregation of Client Assets

Advisors must attain reasonable assurance of segregation of client assets at a qualified custodian, but when an advisor has custody, the proposed rule would require such assets:

• Be titled or registered in the client’s name or otherwise held for the benefit of that client
• Not be commingled with the advisor’s assets or its related persons’ assets
• Not be subject to any right, charge, security interest, lien, or claim of any kind in favor of the advisor, its related persons, or its creditors, except to the extent agreed to or authorized in writing by the client

Takeaways

The SEC’s goals are to extend current custodial requirements to advisors who act as qualified custodians. In practice, most advisors who act as qualified custodians already have procedures in place to meet these requirements and the proposed changes should just serve as added clarity within the proposed rule. The SEC’s goal is not to prohibit operational practices that satisfy the requirements and not to prohibit client authorized actions (e.g., securities lending) that have been agreed to in writing.

Proposals Impacting the Surprise Examination Requirement

The proposed rule would expand the availability of the current rule’s audit provision, which should provide certain exceptions from the surprise examination as well as certain other exceptions:

Scope of the Audit Provision

Elements of the proposed rule’s audit provision are largely unchanged from the audit provision of the current rule, apart from the following:

• The proposed rule expands the availability from just limited partnerships, limited liability companies, and pooled investment vehicles to also include “any other entity”
• The proposed rule would require the financial statements of non-U.S. clients to contain information substantially like statements prepared in accordance with U.S. GAAP and material differences with U.S. GAAP to be reconciled
• The written agreement between the advisor or the entity and the auditor would require the auditor to notify the SEC upon the auditor’s termination or issuance of a modified opinion

Takeaways

The proposed rule expands the scope of entities that can utilize the audit provision exception while also delivering the SEC some information on private funds (e.g., modified opinions) that they may not have otherwise had the ability to see or didn’t necessarily receive as timely through advisor ADV reporting through the auditor notification requirement.

Exceptions from the Surprise Examination Requirement

• As noted above in the “Scope of Rule” section, the proposed rule would contain an exception from the surprise examination requirement for client assets if the advisor’s sole basis for having custody is discretionary authority with respect to those assets
  • This exception applies only for client assets that are maintained with a qualified custodian in accordance with the proposed rule
  • This exception applies only for accounts where the advisor’s discretionary authority is limited to instructing its client’s qualified custodian to transact in assets that settle exclusively on a DVP basis
  • Note that an advisor can rely on this exception if they also have custody for reasons that are subject to similar exceptions (e.g., sole basis is fee deduction, sole basis is related person custody, etc.)

• The proposed rule includes an exception from the surprise examination requirement if an advisor’s custody is solely because of standing letters of authorization (SLOAs)
  • SLOAs would be defined as an arrangement among the advisor, the client, and the client’s qualified custodian in which the advisor is authorized, in writing, to direct the qualified custodian to transfer assets to a third-party recipient on a specified schedule from time to time
    • The client’s qualified custodian cannot be an advisor’s related person
    • The authorization must include:
      • The client’s signature
      • The third-party recipients name
      • Either the third party’s address or the third party’s account number
      • A notation that the advisor has no ability or authority to designate or change any information about the recipient

Takeaways

Although the exceptions have been provided for, advisors will need to carefully evaluate their discretionary authority and SLOAs so ensure they conform to the new requirements. Otherwise, they may still find themselves subject to a surprise examination.

Other Proposals and Information

Investment Advisor Delivery of Notice to Clients

The proposed rule would continue to require an advisor to notify clients in writing promptly upon opening an account with a qualified custodian on its behalf

• The proposed rule would now explicitly require the notice to include the custodial account number

Amendments to the Investment Advisor Recordkeeping Rule

The proposed rule would add the following requirements:

• Maintain copies of all written notices to clients (e.g., notice to each client upon opening accounts at qualified custodians on the client’s behalf)
• Maintain six categories of records for each client:
  • Client account identification
  • Custodian identification
  • The basis for the advisor having custody of client assets in the account and whether a related person holds the advisor’s client assets
    • This includes whether the advisor has discretionary authority with respect to any client assets in the account.
    • This also includes whether the advisor has authority to deduct fees from the account
  • Any account statements received or sent by the advisor, including those delivered by the qualified custodian
  • Transaction and position information
  • Standing letters of authorization
• Maintain copies of all documents relating to independent public accountant engagements:
  • Audited financial statements
  • Internal control reports
  • Written agreements

Changes to Form ADV

• Item 9.A.(1) will be revised to require advisors to indicate whether they directly, or indirectly through related persons, have custody of client assets
  • This includes if that custody is solely due to an advisor’s ability to deduct fees or because the advisor has discretionary authority
• Item 9.A.(2) will be revised to require the number of clients and client assets falling into each of the following categories of having custody from:
  • The ability to deduct advisory fees
  • Having discretionary trading authority
  • Serving as general partner, managing member, trustee for clients that are private funds
  • Serving as general partner, managing member, trustee for clients that are not private funds
  • Having general power of attorney over client assets or check-writing authority
  • Having standing letters of authorization
  • Having physical possession of client assets
  • Acting as a qualified custodian
  • Having a related person with custody that is operationally independent
  • Any other reason
• A new Item 9.B will be added to require an advisor to indicate whether it is relying on any exceptions from the proposed rule
• Advisors will be required to include more detailed information about qualified custodians utilized
• Advisors will be required to include more detailed information about accountants completing surprise examinations, financial statement auditors, or verification of client assets under the proposed rule

Existing Staff No-Action Letters and Other Staff Statements

The SEC is reviewing certain no-action letters and other staff statements to determine whether any such letters, statements, or portions thereof, should be withdrawn in connection with the adoption of the proposed rule

Transition Period and Compliance Date

• Advisors with more than $1 billion in regulatory assets under management (RAUM) will have 12 months from the effective date (i.e., 60 days after public in the Federal Register of a final rule) to comply
• Advisors with up to $1 billion in RAUM will have 18 months
• Advisors should continue to comply with the current rule until the required compliance date
• Advisors can adopt prior to the required compliance date but must adopt all confirming amendments including those in the corrected rules

Summary and Takeaway

This SEC proposal comes just a year after it issued several 2022 proposals surrounding private fund transparency, cybersecurity risk management, and Form PF. Across the board, the proposed changes will rewrite the Custody Rule as we know it, rename it the Safeguarding Rule, and create additional requirements.

These proposed changes continue to extend the SEC’s reach into private offerings and more modern investments such as crypto. Advisors may need to lean on internal or external compliance to ensure that policy and procedure updates capture the necessary information and to make sure the new parts of the proposed rule are covered. Qualified custodians are not off the hook either, as the proposed rule puts additional burden on them as well.

Advisors should closely monitor evolving developments to ensure operational and compliance readiness. Comments and feedback on the proposal are due 60 days after publication in the Federal Register. The SEC is seeking feedback on 280 questions contained within the proposed rule.

We would be pleased to provide further information related to this subject. For more information, contract Craig B. Evans, Director, Audit & Accounting at cevans@kmco.com.

We recently held our annual investment industry update, which covered a host of topics including the latest updates on GIPS, the SEC Marketing Rule, fair value guidance, taxes, and compliance, as well as a discussion on valuation drivers in an investment firm.

During one of the sessions, John Canning, Director, Chenery Compliance Group provided an overview of the SEC rules becoming effective in the near future, a more detailed look at the private fund rulings, and a review of the rule relating to outsourcing services.

SEC Rules Becoming Effective in The Near Future

Some of the SEC’s rules that are on target to become effective within the next 12 months include:

• Cybersecurity Risk Governance Rule – This rule is related to cybersecurity risk management, reporting, and recordkeeping requirements for investment advisors and funds. The proposal would require firms to adopt and implement written policies and procedures that are reasonably designed to address cybersecurity risk. It would also require any significant cybersecurity incidents to be reported on a new form, ADV-C.
• Amendments to Form PF – Large private equity advisers and liquidity fund advisers will be required to file reports within one business day of events that would indicate significant stress at a fund that could harm investors or signal that there is a risk in the financial system.
• Money Market Fund Reforms – This rule would expand liquidity requirements, mandate swing policies for certain funds, amend fund disclosures, and eliminate provisions related to liquidity fees and redemption gates that were put in place in the earlier market rules.
• Private Fund Advisors – This rule would increase the regulation of private fund advisors. It includes accounting and auditing requirements and would require distributing quarterly statements to advisors that include a detailed explanation of all fees and expenses paid by the fund. Disclosure of the fund’s performance would also be required.
• Form PF – This rule would increase confidential reporting for private fund advisors, especially large hedge funds. It would also increase reporting for exposure on open positions and certain large positions.
• Prohibition Against Fraud, Manipulation, and Deception in Connection with Security-Based Swaps; Prohibition Against Undue Influence Over Chief Compliance Officers; and Disclosure of Security-Based Swap Positions – These proposals would require new disclosures for certain large swap positions. They would also institute new protections designed to prevent fraud and shield chief compliance officers from coercion and other improper influence.
• Investment Company Names – This proposal is designed to end funds’ use of misleading or deceptive names. Because fund names are usually the first piece of information potential investors see, the SEC believes that the names can have a large impact on whether an investor chooses to invest money in a particular fund.
• Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices – The proposal would require additional disclosures related to environmental, social, and governance (ESG) strategies in fund prospectuses, annual reports, and advisor brochures, including fund claims about whether it will achieve a certain ESG impact.
• Short Sale Disclosure Reforms – This proposed rule would require institutional investment managers to report monthly short sale information to the SEC.

Private Fund Advisors; Documentation of Registered Investment Advisor Compliance Reviews

The SEC proposed new rules and amendments under the Investment Advisers Act of 1940 to enhance the regulation of private fund advisors. The proposed rules would enact the following:

• Require private fund advisors registered with the Commission to provide investors with quarterly statements detailing information about private fund performance, fees, and expenses;
• Require registered private fund advisors to obtain an annual audit for each private fund and notify the SEC upon certain events;
• Require registered private fund advisors, in connection with an advisor-led secondary transaction, to distribute to investors a fairness opinion and a written summary of certain material business relationships between the advisor and the opinion provider;
• Prohibit all private fund advisors, including those that are not registered, from engaging in certain activities and practices that are contrary to the public interest and the protection of investors; and
• Prohibit all private fund advisors from providing certain types of preferential treatment that have a material negative effect on other investors, while also prohibiting all other types of preferential treatment unless disclosed to current and prospective investors.
• Additionally, the SEC is proposing to require all registered advisors, including those that do not advise private funds, to document the annual review of their compliance policies and procedures in writing.

Investment Advisor Outsourcing

The SEC proposed a new rule and related amendments to prohibit SEC-registered investment advisors from outsourcing certain services or functions to service providers without meeting minimum requirements. The proposal includes:

• New requirements for advisors to conduct due diligence before outsourcing and to periodically monitor service providers’ performance and reassess whether to retain them;
• Related requirements for advisors to make and/or keep books and records related to the due diligence and monitoring requirements;
• Amendments to the adviser registration form, Form ADV, to collect census-type information about advisors’ use of service providers; and
• A requirement for advisors to conduct due diligence and monitoring for third-party recordkeepers, along with a requirement to obtain reasonable assurances that the third-party will meet certain standards.

We will continue to monitor these SEC developments and keep you apprised of future updates. In the meantime, if you’d like to watch the rebroadcast of this presentation or any of the other presentations from our annual investment industry update, click here.

If you have any questions about this information or would like to discuss your firm’s needs, please contact Frank Varanavage, Manager, Investment Industry Group.

You may also like:

• Industry Leaders Discuss Questions Regarding the SEC Marketing Rule
• What Drives Value in an Investment Firm?
• Update on Accounting for Equity Securities with Contractual Sale Restrictions

Kreischer Miller recently held its annual investment industry update, which covered a host of topics including the latest updates on GIPS, the SEC Marketing Rule, fair value guidance, taxes, and compliance, as well as a discussion on valuation drivers in an investment firm.

During the event, Thomas Peters, Director of Kreischer Miller’s Investment Industry Group, moderated an SEC Marketing Rule panel discussion with Joshua Kramer, Manager in Kreischer Miller’s Investment Industry Group, John Canning, Director at Chenery Compliance Group, and Michael Beck, Performance Measurement Vice President at Glenmede Trust. The goal of the panel was to address various questions from the audience surrounding the new SEC Marketing Rule and to provide an update on any recent changes since Kreischer Miller’s previous panel on the Rule held last July. Below is a summary of the questions covered during the session and the panelists’ responses.

Question: Is it really a common practice to charge a model fee with the highest fee from the composite’s inception fee regarding the SEC Marketing Rule’s net of fee return requirement?

Response: Advisors have three general options when reporting net performance under the SEC Marketing Rule. They can use actual fees charged to the portfolios. Advisors can also use a model fee that results in performance results that are less than or equal to performance that would have been calculated had actual fees had actual fees been used.  The final option is using a model fee where the fee applied must be equal to the highest fee that would be charged to the intended investors. Panelists noted that the decision is highly dependent on the facts and circumstances of the advisor. However, the model fee approach will typically be easier to implement for larger firms due to the varied actual fees that may be charged to a large pool of investors.  When advisors are contemplating which option to employ, panelists stressed the importance of always keeping in mind the general prohibitions, which require that all advertisements are presented in a manner that is fair and balanced and not otherwise misleading.

Question: How does the SEC Marketing Rule relate to sub-portfolios, carveouts, and extracted performance included in composites?

Response: The main issue discussed by the panelists dealt with how advisors define what a portfolio is and how that definition is then applied to the definition of extracted performance provided in the SEC Marketing Rule.  In general, panelists explained that multi-strategy portfolios can either be identified as a single portfolio, inclusive of all the strategies, or as multiple portfolios segmented for each strategy.  The definition given to these portfolios by the advisor will then allow them to determine whether the or not they should be treated as extracted performance under the SEC Marketing Rule. In making these decisions, panelists offered various factors to consider including whether the strategies are managed with separate cash accounts, whether each strategy is managed under a separate investment management agreement, and whether the strategies are managed by investment teams at the advisor. The panel also referenced a recent SEC Marketing Compliance FAQ, which was updated January 11, 2023.

Question: Does net attribution and risk returns on data that is presented outside of the performance returns need to be shown?

Response: Panelists acknowledged that it has been standard industry practice to present attribution based on gross returns due to most internal systems applying fees at the total return level and not allocating the fee to individual sectors or asset classes. However, it should also be disclosed that the availability exists to calculate net returns.  While this has historically been the case, panelists raised concerns surrounding the recent FAQ published the SEC staff, which reiterated the need for advisors to show the net performance of a single investment or a group of investments when presenting the gross performance.  Panelists cautioned that additional information and clarity surrounding this FAQ may indicate a need for advisors to start presenting attribution on a net basis.

Question: What is considered a material fact that would need to be substantiated?

Response: Materiality consideration should be given to any advertising material, third party source, or performance claim that can be selected for substantiation by an auditor. The importance of backing up recordkeeping was also emphasized.

Question: What are considerations of material risks and material risk disclosures?

Response: The panelists advised leaning on investment professionals to identify and ensure that risks and potential benefits are being disclosed to potential investors.

Question: Should performance submitted to an online consultant database be considered an indirect advertisement subject to the SEC Marketing Rule?

Response: Performance submitted to an online database is subject to the SEC Marketing Rule if that performance will then be presented to a broader audience. Panelists discussed a rift among advisors and databases related to the information that some databases are accepting and the information that advisors are required to provide in order to comply with the SEC Marketing Rule.  This disconnect is causing advisors to make the difficult decision of whether to continue to provide databases with incomplete information under the SEC Marketing Rule, thereby incurring risk, or discontinue providing information to databases until the issue is resolved.

Question: Do advertisements that pre-date the SEC Marketing Rule need to be updated in order to be in compliance?

Response: It would depend on whether the advertisements are still being used and able to be viewed by potential investors. Advertisements that are still being used would need to be updated, while those that are no longer in use and are not viewed by potential investors would not need to be updated.

Question: Can a firm provide a link to a disclosure, testimonial, or endorsement?

Response: External links cannot be used for testimonials or endorsements; the source needs to be clear within the testimonial or endorsement. Other types of advertising disclosures can provide a link.

Question: What is considered hypothetical performance now for the SEC Marketing Rule?

Response: Hypothetical performance is considered to be any instance where performance is back/forward tested, projected, or calculated on hypothetical assets; availability restrictions on hypothetical performance were also emphasized by the panelists.

If you’d like to view the video of this panel discussion or any of the other presentations from our annual investment industry update, click here.

If you have any questions about the SEC Marketing Rule or would like to discuss your firm’s needs, please contact Kreischer Miller’s Investment Industry Group. 

You may also like:

• What Drives Value in an Investment Firm?
• Update on Accounting for Equity Securities with Contractual Sale Restrictions
• The Top 3 Custody Rule Pitfalls We’ve Observed

We recently held our annual investment industry update which covered a host of topics including the latest updates on GIPS, the SEC Marketing Rule, fair value guidance, taxes, and compliance. The event also included a discussion on valuation drivers in an investment firm. Jennifer Kreischer, M&A Advisory Consultant for Kreischer Miller’s Investment Industry Group, provided insights into the key levers that investment firms can use to drive value in their businesses.

Value determination is a critical aspect of any business, as it plays an essential role in making strategic decisions, be it in the context of a business transaction, succession planning, or growth financing. Understanding the value of a business is imperative for any owner or investor to make well-informed decisions and ensure that they are getting a fair deal.

In the context of business transactions, it is essential to be prepared for unsolicited offers, even if an owner is not actively planning to sell or buy the business. Having a well-established business value can help an owner be better prepared for negotiations. Value determination is also crucial in succession planning. Without proper planning, the options available for transitioning ownership of the business may be limited, and the value of those options may be lower. Understanding the value of the business can help the owner make more informed decisions about the best course of action for their business. Additionally, value determination is critical for growth financing, as banks and other financial institutions use it to assess the risk of lending to a business and to determine the loan amount they are willing to provide.

The main objective of value determination is to protect the interests of the business owners and help new investors to assess the opportunity to invest in the business. It also helps business owners evaluate whether they are ready to bring in new partners or promote team members to ownership positions. One way to think about it is that it helps potential partners determine whether they would be in a position to borrow money to buy into the firm and how long it would take them to pay back that loan based on the company’s cash flow.

The concept of the multiplier effect, which refers to the impact of certain value drivers on the value of a business, is also crucial. These value drivers can include factors such as revenue growth, profitability, and risk management. By understanding and focusing on these key value drivers, business owners can improve their options for succession and increase the value of their business. Earnings multiples are a better proxy for a discounted cash flow valuation. By increasing earnings and positioning the business to command multiples at the higher end of the range, the value of the business increases.

Value determination is a critical aspect of any business and plays a vital role in making strategic decisions. By understanding your business value, owners and investors can make more informed decisions and ensure that they are getting the best possible price for the business.

We invite you to watch the rebroadcast of Jennifer Kreischer’s full presentation here. If you have any questions about investment firm value drivers or would like to discuss your firm’s needs, please contact Kreischer Miller’s Investment Industry Group.

You may also like:

• Update on Accounting for Equity Securities with Contractual Sale Restrictions
• The Top 3 Custody Rule Pitfalls We’ve Observed
• SEC’s New Transparency Rules Target Private Fund Advisors

The Financial Accounting Standards Board (FASB) recently issued Accounting Standards Update (ASU) 2022-03, which amends Topic 820 (Fair Value Measurement) and helps clarify how entities should value and disclose investments in equity securities measured at fair value that are subject to a contractual sale restriction. This update did not change the principles of fair value measurement in ASC 820.

Prior to this ASU, there was conflicting guidance that resulted in a diversity in practice as to whether the effects of a contractual restriction that prohibits the sale of an equity security should be considered in measuring that equity security’s fair value.

The ASU helps clarify when a discount should be applied to the fair value of an equity security by understanding whether there is an entity specific restriction or an equity security with an asset specific restriction. If there is an entity specific restriction, this is a characteristic of the holder of the equity security rather than a characteristic of the equity security itself, and therefore, should not be considered in measuring the equity security’s fair value. If there is an equity security with an asset specific restriction, that restriction is included in the equity security’s unit of account and should be considered in the measurement of the fair market value.

The ASU also provided guidance on the following disclosures for equity securities subject to contractual sale restrictions that should be made:

• The fair value of equity securities subject to contractual sale restrictions reflected in the balance sheet
• The nature and remaining duration of the restriction(s)
• The circumstances that could cause a lapse in the restriction(s)

Equity securities restricted from sale because they are pledged as collateral and included in disclosures required by other topics should not be included in guidance for the ASU note above.

These clarifications resulting from the ASU should help entities understand when they are required to apply a discount on the fair values of equity securities and when it would not be needed.

The amendments in this update will be effective for public business entities for fiscal years beginning after December 15, 2023 and interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2024 and interim periods within those fiscal years. Early adoption will be permitted for both interim and annual financial statements that have not yet been issued or made available for issuance.

We would be pleased to provide further information related to this subject matter. For more information, contact Frank Varanavage, Manager, Investment Industry Group at fvaranavage@kmco.com.

You may also like:

• The Top 3 Custody Rule Pitfalls We’ve Observed
• SEC’s New Transparency Rules Target Private Fund Advisors
• Recent SEC Rule Proposal Changes and Additions

Rule 206(4)-2 of the Investment Advisers Act of 1940, known as the Custody Rule, can be extremely complex to apply. The Custody Rule was first adopted in 1962, and the current version follows amendments made by the SEC in 2009 as a response to Bernie Madoff’s Ponzi scheme. The Custody Rule requires four primary controls of investment advisers that have custody of client funds:

1. Client assets must generally be maintained with a qualified custodian. If the qualified custodian is a related person, an internal control report is also required.
2. Clients must be notified who the qualified custodian is, as well as when any changes are made to the custodial relationship.
3. Qualified custodians should send account statements directly to clients at least quarterly and advisers must have a reasonable belief that the qualified custodians are doing so.
4. Advisers must generally have an annual surprise examination by an independent public accountant.

For further background on the Custody Rule, the adopting release containing the latest amendments can be found here. The SEC has also posted several frequently asked questions, known as the Staff Responses, here.

Common Custody Rule Pitfalls

At times, an in-depth evaluation of individual circumstances may be required to determine whether an adviser has custody and should be subject to the requirements of the Custody Rule and an annual surprise examination. Based on years of performing such surprise examinations, our team has identified three common Custody Rule pitfalls. The SEC also identified some of these pitfalls as significant deficiencies in this 2013 risk alert as well as in this 2017 risk alert. We continue to see them today.

Pitfall #1: Client Checks

Rule 206(4)-2(d)(2)(i) specifically indicates that custody includes, “possession of client funds or securities (but not of checks drawn by clients and made payable to third parties) unless you receive them inadvertently and you return them to the sender promptly but in any case within three business days of receiving them.”

Based on that language, an adviser that has a client check or other assets in its possession, even momentarily, has custody. While Question II.1 of the Staff Responses indicate limited circumstances – such as receipt and forwarding of tax refunds from taxing authorities – do not constitute custody, as noted, the only way an adviser can normally alleviate itself of the requirements of having custody would be to return the client check to the sender within three business days of receipt. Thus, an adviser should have policies and procedures in place to address such situations.

We’ve often heard the argument from advisers that the purpose of the Custody Rule is to safeguard client assets and, therefore, routing a check back to the sender likely puts it in more danger of being lost than just forwarding it to the custodian on the client’s behalf. Such an argument may make a great point, but unfortunately the Custody Rule does not permit an adviser to forward client checks to the custodian. An adviser’s only option is to log the receipt of the check and promptly return the client check to the sender.

This type of situation could be a double whammy for an adviser. If it fails to return the client check, not only would that adviser have custody and be subject to all the other requirements of the Custody Rule, but it would likely also fail the requirement that client assets be maintained with a qualified custodian. That is unless the adviser is a qualified custodian.

Pitfall #2: Pooled Investment Vehicle Financial Statements

As noted above, the Custody Rule requires four primary controls of investment advisers that have custody of client funds. Advisers to pooled investment vehicles (e.g., hedge funds, private equity funds, etc.) generally have custody of the pooled investment vehicles they offer due to their role, or an affiliate’s role, as general partner. With that said, an adviser may be permitted to self-custody such assets rather than maintain them with a qualified custodian and would be exempt from the notice, account statement, and surprise examination requirements if the adviser relies on and complies with the audit exemption contained in Rules 206(4)-2(b)(2)(ii) and 206(4)-2(b)(4).

The most common pitfall we have come across when an adviser attempts to comply with the audit exemption is that it has not prepared the financial statements of the pooled investment vehicle in accordance with accounting principles generally accepted in the United States (U.S. GAAP). More specifically, advisers cannot comply with these provisions of the Custody Rule by providing financial statements prepared on the tax basis of accounting.

Additionally, advisers cannot apply U.S. GAAP on a selective basis. For instance, if U.S. GAAP requires all investments to be maintained at fair value, an adviser cannot value only those that are easy to value while leaving those that are more difficult, at cost.

Pitfall #3: Employees or Related Persons

Rule 206(4)-2(d)(7) defines a related person as “any person, directly or indirectly, controlling or controlled by you, and any person that is under common control with you.” Based on that description, an adviser is responsible for the actions of its employees and/or affiliated entities (e.g., any wholly owned subsidiary, etc.).

Taking that one step further, an adviser is responsible for the actions – at least as it relates to the Custody Rule – of employees of affiliated entities. Ultimately, an adviser is deemed to have custody and thus subject to the requirements of the Custody Rule if its employees or affiliated entities are deemed to have custody.

The most common pitfall we have come across is an adviser’s failure to identify that one of its employees serves as trustee to a firm client. This is the exact subject of Question II.2 of the Staff Responses. The SEC’s response is that, “The role of the supervised person as trustee is imputed to the advisory firm, thus causing the firm to have custody.” Consequently, an adviser should have policies and procedures in place that require all employees to identify any current or potential new situations where it is asked to serve as trustee. These policies should be in place prior to an employee officially agreeing to take on such a role.

Honorable Mentions

The following topics have also tripped up advisers when it comes to the Custody Rule:

• Bill-paying services: Due to this added service, an adviser can withdraw funds or securities and would thus be deemed to have custody.
• Online access: If an adviser has access to a client’s online account, including knowing the client’s username and password, and such access is not read-only, the adviser is deemed to have custody because of its ability to withdraw funds or securities.
• Inadvertent custody through custodial agreement language: An adviser’s investment management agreement does not overwrite language in a custodial agreement that provides the adviser access to client funds, even if the investment management agreement indicates the adviser will not take custody.
• SLOAs (Standing Letters of Authorization): While the SEC has issued a no-action letter for an adviser to avoid a surprise examination as long as it complies with certain criteria, advisers nevertheless have custody and must comply with all other aspects of the Custody Rule.
• Books and records to be maintained by investment advisers: Although not specifically under the Custody Rule, advisers that have custody or possession of funds and securities must also maintain certain documentation in accordance with Rule 204-2(b) (the Recordkeeping Rule). A qualified custodian’s maintenance of books and records for an adviser’s custody accounts, including trade confirmations, does not relieve the adviser from its requirement to maintain these records under the Recordkeeping Rule. Advisers should understand the retention policies of these records at custodians, especially if the adviser is not maintaining physical copies. This understanding should include the adviser’s ability to access the records in the event it is no longer the adviser or the custodian relationship has terminated.

If any of the above pitfalls impact your firm or you have another topic that might be subject to the intricacies of the Custody Rule, we’d be happy to have a conversation.

For more information, contact Craig Evans, Director, Audit & Accounting at cevans@kmco.com or Eric Sakelaridos, Director, Audit & Accounting at esakelaridos@kmco.com.