• Last year, the SEC proposed an overhaul of custody requirement for registered investment advisers. The proposal relies heavily on Dodd-Frank granting new authority to take action.
• A new white paper from SIFMA and SIFMA AMG delves into the history and context behind Dodd-Frank language relating to SEC custody regulation for investment advisers.
• In short, Dodd-Frank affirmed and codified existing SEC authority, but it did not mandate that the SEC take action or expand SEC authority beyond its historical scope of funds and securities to all assets.
• Dodd-Frank also did not equate discretionary trading authority with adviser custody or authorize the SEC to indirectly regulate custodians.
• As the SEC continues to examine their approach to this rule proposal, the historical record of legislative history and SEC precedent must be taken into account.

Was Dodd-Frank a Grant of New Authority for the SEC to Regulate Investment Advisers?

Put simply, the answer is no.

While the SEC’s 2023 custody proposal relies heavily on Dodd-Frank text, a closer look shows that Congress did not intend the language as a mandate to take action or a grant of new SEC authority.

A SIFMA/SIFMA AMG white paper digs deeper into the history of Dodd-Frank and finds no foundation for a broader regulatory remit for the SEC. This challenges the perspective taken by the Commission in the proposal and echoed by Commission officials.

Any further consideration of investment adviser custody regulation by the Commission must acknowledge and remain consistent with its authority. The white paper’s goal is to contribute further knowledge and understanding of the historical landscape to better inform the Commission’s approach.

Background – The SEC Proposes Changes to the Adviser Custody Rule

Over a year has passed since the Securities and Exchange Commission released the “Safeguarding Advisory Client Assets” proposal. The proposal, if adopted, would amend and redesignate current Rule 206(4)-2 of the Investment Advisers Act of 1940 to new Rule 223-1 entitled “safeguarding client assets” and impose a wide range of new requirements on registered investment advisers.

The Proposal would also impact a wide range of other market participants, including clients, custodians, and broker-dealers. In comment letters to the Commission, SIFMA, SIFMA AMG, and others provided extensive feedback.

The Commission has long exercised authority to promulgate custody rules for investment advisers prior to Dodd-Frank, issuing custody regulations in 1962, 2003, and 2009 under Section 206(4) of the Advisers Act. The Commission adopted enhanced custody rules in December 2009 in response to several high-profile enforcement actions brought against investment advisers. The following July, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The Proposal relies heavily on authority the Commission references in the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 411 of Dodd-Frank amended the Advisers Act by adding new Section 223: ‘‘An investment adviser registered under this title shall take such steps to safeguard client assets over which such adviser has custody, including, without limitation, verification of such assets by an independent public accountant, as the Commission may, by rule, prescribe.”

Dodd-Frank Language Affirmed and Codified Existing SEC Authority

Why did Congress pass Section 411? As shown in several different contexts, the aim was to affirm existing authority rather than mandating new action or expanding authority.

Senate Banking Chair Dodd explained the reasoning behind the Senate bill’s custody language:

“[P]artly in response to the Madoff action, the SEC has already conducted rulemaking in this area. New rules governing the custody of client funds were adopted last December, and we think it would be appropriate to give these new rules a chance to actually work … before we direct the SEC to write some new ones. The Senate Bill requires investment advisers to follow the new SEC rules, and we believe that’s the best approach at this particular junction (emphasis added).

The Dodd-Frank Conference Report made no mention of granting additional powers under the Advisers Act. Instead, the Conference Report explained that Dodd-Frank “clarifies the SEC’s authority to make rules necessary for the exercise of the powers conferred upon the SEC by the IAA.”

A November 2010 Congressional Research Service report surveyed the rulemaking provisions contained in the Dodd-Frank Act. The report explicitly stated that Section 411 did not contemplate new authority or mandate a material reform of investment adviser custody regulation:

“Some sections of the Dodd-Frank Act provide financial regulatory agencies with new statutory authority to issue rules. Other sections, however, arguably provide rulemaking authority that the designated agency already possessed. For example, Section 411 of the act amended the Investment Advisers Act of 1940 (15 U.S.C. § 80b-1 et seq.) and states that a registered investment advisor ‘shall take such steps to safeguard client assets over which such advisor has custody…as the Commission may, by rule, prescribe.’ The SEC appears to have had this authority before the Dodd-Frank Act was enacted. Because the agency’s rulemaking authority in this area has not changed, the SEC may decide not to issue any new rules. On the other hand, the agency may decide to issue new rules in the context of the reforms enacted through the Dodd-Frank Act that are the same as, or similar to, rules that the agency would have issued even if the Dodd-Frank Act had not been enacted (emphasis added).

The Dodd-Frank language did not expand the SEC’s authority. It also was not a mandate for the SEC to take action, let alone take the specific measures contemplated by the 2023 proposal.

Dodd-Frank Did Not Expand SEC Authority Beyond Funds and Securities to All Assets

While the language of Dodd-Frank uses terminology of “assets” rather than the traditional “funds and securities” terminology from existing SEC rules, there is no evidence that Congress intended the choice of terminology to act as an expansion of SEC authority. Instead, the legislative history of Section 411 demonstrates that Congress intended to incorporate the SEC’s own understanding of term “assets,” which was expressly limited to “funds and securities.”

Like all Commission adviser custody rulemakings before it, the 2009 Custody Rule amendments governed an adviser’s custody of client “funds and securities.” In fact, the title of Rule 206(4)-2 and every SEC proposing and adopting release has referenced “funds or securities of clients” since the Rule’s inception in 1962. In the 2009 Rule’s adopting release, the Commission explicitly stated that:

“[w]e use the term ‘client assets’ solely for ease of reference in this Release; it does not modify the scope of client funds or securities subject to the rule” (emphasis added).

The Commission’s use of the term “client assets” as a shorthand reference to “funds and securities” in the 2009 Rule is significant because it sets the context within which Congress drafted Section 411. Upon advancing the final language of Section 411, the Senate Banking Committee issued a report referencing the 2009 Rule, stating “The SEC has recently adopted new rules imposing heightened standards for custody of client assets (emphasis added).” If the Committee held a more expansive view of “client assets” beyond funds and securities, this statement would be erroneous, as the 2009 Rule explicitly limited the scope of the term to “funds and securities.”

House and Senate legislative mechanics used the terms “funds and securities” and “client assets” interchangeably. The House Committee on Financial Services used the term “funds and securities” in its bill text but used the term “client assets” in the bill’s summary. As Senator Dodd explained, the intent was to give the SEC’s 2009 rules a chance to work – the same rules that had just been adopted six months earlier. There was no commentary or discussion of expanding the scope beyond funds and securities. If Congress had intended such a significant change, there would have been a trail of evidence left through the legislative process.

A single witness in a single hearing on private fund regulation made a comment to distinguish private funds from other Advisers Act rules, but did not testify in support of a proposal to overhaul investment adviser custody regulation or a proposal to expand the scope of regulation beyond funds and securities.

Dodd-Frank Did Not Equate Discretionary Trading Authority with Custody or Authorize the SEC to Indirectly Regulate Custodians

Though Section 411 authorized the Commission to promulgate rules to safeguard assets over which an adviser has custody (emphasis added), Congress likely contemplated the same understandings of custody that the Commission had historically held and which were memorialized in Rule 206(4)-2. There is no Dodd-Frank history that Congress intended otherwise. From the inception of adviser custody regulation, the Commission has always excluded discretionary trading from the definition of custody.

Similarly, the 2023 proposal would require investment advisers to enter into written agreements with custodians requiring custodians to meet certain standards of custodial practices. Though the Commission may issue new custody rules for investment advisers, such regulations must be within the scope of the authority granted under the Advisers Act. The Dodd-Frank language adds no new authority that would contemplate such measures extending to custodians.

Conclusion

The SEC’s 2023 custody proposal is far-reaching and has significant potential impacts on clients, advisers and other market participants. There is room for discussion about the design of investment adviser custody regulations, but the historical record of legislative history and SEC precedent dictates boundaries that must be taken into account.

Authors

Kevin Carroll is Deputy General Counsel, Litigation and Private Client (Legal) at SIFMA

Kevin Ehrlich is Managing Director and Associate General Counsel, Asset Management Group at SIFMA

Ray Mosca is Senior Associate, Asset Management Group at SIFMA

Related Resource

• White Paper

  The Dodd-Frank Underpinnings of the Securities and Exchange Commission’s Safeguarding Proposal