In this post, we will discuss whether crypto assets are subject to Rule 206(4)-2 under the Investment Advisers Act—the so-called Custody Rule.

In our next post, we will discuss how an adviser would comply with the Custody Rule in connection with investing/trading in crypto assets on behalf of clients.

Background

The Custody Rule applies by its terms to registered investment advisers that have:

  • custody” over their clients’ 
  • funds or securities

“Custody” includes:

  • possession of client funds or securities (but not of checks drawn by clients and made payable to third parties) unless the adviser receives them inadvertently and returns them to the sender promptly but in any case within three business days of receiving them;
  • any arrangement (including a general power of attorney) under which the adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the adviser’s instruction to the custodian; and
  • any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives the adviser or a supervised person of the adviser legal ownership of or access to client funds or securities.

An investment adviser is deemed to have “custody” of client funds or securities if a “related person” of such adviser (as defined in Rule 206(4)-2(d)(7)) holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services such adviser provides to its clients.

These provisions can be more complicated in practice than they appear to be on paper, as evidenced by the SEC’s extensive FAQs on the definition of “custody” as contained in the Custody Rule, which can be found here.

A registered investment adviser that has custody of a client’s funds and/or securities must satisfy the following four requirements:

1. the adviser must maintain such funds and/or securities with a “qualified custodian” (the Qualified Custodian Requirement);

2. the adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to the client identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions in the account during that period (the Account Statement Requirement);

  • A bank as defined in Section 202(a)(2) of the IAA* or a savings association as defined in Section 3(b)(1) of the Federal Deposit Insurance Act that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act.
  • A broker-dealer registered as such with the SEC under Section 15(b)(1) of the Securities Exchange Act of 1934, holding the adviser’s clients’ assets in customer accounts.
  • A futures commission merchant registered as such with the CFTC under Section 4f(a) of the Commodity Exchange Act, holding the adviser’s clients’ assets in customer accounts, but only with respect to clients’ funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon.
  • A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the adviser’s clients’ assets in customer accounts segregated from its proprietary assets.

*Section 202(a)(2) of the IAA defines the term “bank” to mean (A) a banking institution organized under the laws of the United States or a Federal savings association, as defined in Section 2(5) of the Home Owners’ Loan Act, (B) a member bank of the Federal Reserve System, (C) any other banking institution, savings association, as defined in Section 2(4) of the Home Owners’ Loan Act, or trust company, whether incorporated or not, doing business under the laws of any State or of the United States, a substantial portion of the business of which consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks under the authority of the Comptroller of the Currency, and which is supervised and examined by State or Federal authority having supervision over banks or savings associations, and which is not operated for the purpose of evading the provisions of the IAA, and (D) a receiver, conservator, or other liquidating agent of any institution or firm included in clauses (A), (B), or (C) above.

An adviser has the option of sending its own account statement to its clients, in addition to (not in lieu of) those required to be sent by the qualified custodian.

3. the adviser must send a written notice to the client setting forth the qualified custodian’s name, address, and the manner in which the client’s funds and/or securities are maintained – promptly when the account is opened and following any changes to this information (the Custodial Notice Requirement); and

4. the adviser must enter into a written agreement with an independent public accountant in which the accountant agrees to verify the client’s funds and/or securities by actual examination at least once during each calendar year, at a time that is chosen by the accountant without prior notice or announcement to the adviser and that is irregular from year to year (the Surprise Examination Requirement).

These requirements (other than the Qualified Custodian Requirement) are subject to certain exceptions set forth in Rule 206(4)-2(b).

If the adviser or a “related person” (as defined in Rule 204(6)-4(d)(7)) is a general partner of a limited partnership (or managing member of a limited liability company, or holds a comparable position for another type of pooled investment vehicle), the account statements must be sent to each limited partner (or member or other beneficial owner), unless the exception from this requirement provided by Rule 206(4)-2(b)(4) (the so-called Audit Exception, discussed in detail below) applies.

Rule 206(4)-2(a)(6) imposes certain additional requirements that apply to surprise examinations where the adviser or a “related person” (as defined in Rule 206(4)-2(d)(7)) is a “qualified custodian” and the adviser or such “related person” has custody of the client’s funds and/or securities. (An adviser, however, is not required to comply with the Surprise Examination Requirement if: (i) such adviser is deemed to have custody of client funds and/or securities solely because a “related person” (as defined in Rule 206(4)-2(d)(7)) holds, directly or indirectly, such funds or securities, or has any authority to obtain possession of them, in connection with advisory services such adviser provides to its clients and (ii) such “related person” is “operationally independent” (as defined in Rule 206(4)-2(d)(5)) of such adviser.) 

A discussion of these additional requirements is beyond the scope of this blog.

One of the principal exceptions to compliance with the Account Statement Requirement, the Custodial Statement Requirement, and the Surprise Examination Requirement is the so-called Audit Exception provided by Rule 206(4)-2(b)(4).

Under the Audit Exception, an adviser that has custody of client funds and/or securities is not required to comply with the Account Statement Requirement, the Custodial Notice Requirement or the Surprise Examination Requirement (but is not relieved of the requirement to comply with the Qualified Custodian Requirement) with respect to the account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) if such vehicle:

  • is subject to audit (as defined in Rule 1-02(d) of SEC Regulation S-X) at least annually, and upon liquidation, by an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and
  • distributes its audited financial statements, prepared in accordance with generally accepted accounting principles, to all limited partners (or members or other beneficial owners) within 120 days (180 days if such vehicle is a “fund of funds”) of the end of its fiscal year, or promptly after the completion of the liquidation audit, as the case may be.

What Are Client “Funds or Securities?”

The Custody Rule applies to a registered investment adviser only to the extent it has “custody” over a client’s “funds or securities.”

So, even if we assume that a registered investment adviser has “custody” over a client’s crypto assets, this does not necessarily mean that the adviser must comply with the Custody Rule with respect to those assets.

Rather, compliance with the Custody Rule is required with respect to crypto assets only if such assets constitute “funds or securities.”

In Question II.3 of the SEC staff’s FAQs regarding the Custody Rule, the SEC staff asks:

“If an adviser manages client assets that are not funds or securities, does the… custody rule require the adviser to maintain these assets with a qualified custodian?”

The staff’s answer?

“No. Rule 206(4)-2 applies only to clients’ funds and securities.”

So, it is apparent that the staff believes that are certain types of client assets that are not “funds” or “securities” and therefore are outside the scope of the Custody Rule. 

A direct investment in real estate comes immediately to mind as an example.

So, to the extent that crypt assets are “securities” (which brings us back once again to the possible need to apply the “Howey test,” discussed in our post  “When Is a Crypto Asset a ‘Security,’ and Why Does That Matter? (Part I)”), they clearly are subject to the Custody Rule.

But what about crypto assets that are not securities (for example, Bitcoin and Ether)? 

Are they “funds?” 

If they are “funds,” they are subject to the Custody Rule. If not, they technically are not.

Legitimate arguments can be made that, to the extent crypto assets are not securities, they ordinarily would be commodities and therefore would not be subject to the Custody Rule.

This would mean, among other things, that an adviser who has custody over them is not required to maintain them with a qualified custodian or subject them to surprise examinations.

Whether the SEC will consider these arguments to be compelling in the specific context of crypto assets that are not securities remains to be seen.

Further, in situations where crypto assets are not “funds or securities,” a registered adviser still has a duty—stemming from its fiduciary duty of care—to take reasonable measures designed to ensure that such assets are protected from loss, destruction, and theft.

So, an adviser who has “custody” or crypto assets that are “securities” must maintain them with a “qualified custodian.” And, until the SEC issues guidance on the matter, it would be prudent for an adviser who has custody of crypto assets that are not securities to treat them as “funds” and, accordingly, to maintain them with a “qualified custodian.” Regardless of whether crypto assets are “funds” or “securities” for purposes of the Custody Rule, an adviser must take reasonable measures designed to ensure that such assets are protected from loss, destruction, and theft.

In our next post, we will discuss how an adviser would comply with the Custody Rule in connection with investing/trading in crypto assets on behalf of clients.