SEC Says CLO Managers Have Custody of Client Assets in Proposed Safeguarding Rule

Background

On February 15, 2023, the SEC released a proposed rule that would revise the existing Custody Rule¹ under the Investment Advisers Act of 1940 (the “Advisers Act”) and re-designate it as the “Safeguarding Rule” (the “Proposed Rule”).² The Custody Rule regulates the custodial practices of investment advisers (“advisers”) registered under the Advisers Act and is intended to “prevent client assets from being lost, misused, stolen or misappropriated.”³ Under the current Custody Rule, many advisers are able to comply by maintaining client assets with a “qualified custodian.”

The Proposed Rule would substantially overhaul the Custody Rule by, among other things, expanding the scope of “custody” to include the discretionary authority to decide which assets to purchase and sell for the client. As a result, advisers such as collateralized loan obligation (CLO) managers would for the first time be deemed to have “custody” of client assets.

Features of Proposed Rule and Impact on CLOs

The Proposed Rule would impose affirmative obligations on advisers to safeguard client assets of which they have custody. In the CLO context, the CLO manager is the adviser and the CLO issuer is its client. Because CLO managers have discretionary authority to trade assets on behalf of CLO issuers, CLO managers would be deemed to have custody of the CLO issuer’s assets and become directly subject to certain enumerated obligations set forth in the Proposed Rule. Among those obligations are:

• Written Agreement: The Proposed Rule would require the adviser to enter into a written agreement with a qualified custodian that maintains possession or control of the client’s assets. Such written agreement must include the following provisions, and the adviser must reasonably believe that such provisions have been implemented:
  • The qualified custodian will promptly, upon request, provide records relating to client assets to the SEC or to an independent public accountant;
  • The qualified custodian will send account statements, at least quarterly, to the client and the adviser;
  • The qualified custodian will obtain and provide to the adviser, at least annually, a written internal control report relating to custodial services and the safeguarding of client assets; and
  • The written agreement must specify the adviser’s agreed-upon level of authority to effect transactions in the account.
• Reasonable Assurances: Advisers would have to obtain reasonable assurances in writing from a qualified custodian, and have a reasonable belief that the qualified custodian will:
  • Exercise due care and implement appropriate measures to safeguard client assets.
  • Indemnify the client (or have insurance arrangements in place that will adequately protect the client) for losses caused by its negligence, recklessness or willful misconduct.
  • Not be excused from its obligations by other agreements (such as sub-custodian agreements).
  • Clearly identify and segregate client assets from the qualified custodian’s proprietary assets and liabilities.
  • Not subject client assets to any lien, security interest etc. in favor of the qualified custodian except as agreed in writing by the client.

Impact on CLOs:

• It is inconsistent with existing CLO market practice for a CLO manager to contract directly with a qualified custodian. Under the Proposed Rule, CLO managers would need to either (i) enter into new custody agreements with qualified custodians or (ii) become parties to the standard account control agreements that are traditionally bilateral agreements between a trustee affiliate and the CLO issuer. Either approach can be expected to result in additional costs for CLOs.
• The indemnification requirement is particularly concerning, as it could have a chilling effect on CLO formation if custodians become reticent to serve these functions for CLOs as a result.

• Surprise Examination or Audit: Under the Proposed Rule, client accounts would need to either (i) be subject to an annual audit meeting the requirements specified in the Proposed Rule or (ii) be subject to verification by an independent public accountant without prior notice to the adviser, at least once a year. Although there is an exception to the “surprise examination or audit” requirement for advisers whose custody is based solely on the discretionary authority to trade client assets, CLO managers are not expected to qualify because such exception is only available when such client assets are traded on a delivery versus payment (DVP) basis, and leveraged loans are not traded on a DVP basis.

Impact on CLOs:

• CLO managers would become directly subject to the surprise examination or audit requirement for the first time as a result of their being deemed to have custody of the CLO assets.

Conclusion

CLO managers and other industry participants will need to monitor developments in relation to the Proposed Rule, as with the SEC’s many other proposed or recently finalized rules, including the proposed private funds rule (see SEC Proposals for Private Fund Advisers Would Increase Costs for CLOs), marketing rule (see SEC’s Marketing Rule – Strategies for CLO Managers) and securitization conflicts of interest rule (see SEC Re-Proposes Rule to Prohibit Material Conflicts of Interest in Securitizations).⁴

¹Rule 206(4)-2 under the Advisers Act.

² The Proposed Rule is available online at Proposed rule: Safeguarding Advisory Client Assets (sec.gov).

³ Preamble to Proposed Rule at 7.

⁴ Comments on the Proposed Rule are due within 60 days after the Rule’s publication in the Federal Register. The SEC has proposed a one-year transition period to provide time for advisers to come into compliance. Therefore, the compliance date would be “one year following the rules’ effective dates which would be 60 days after the date of publication of the final rules in the Federal Register for advisers with more than $1 billion in regulatory assets under management” and 18 months for smaller advisers (see p.240 of preamble to Proposed Rule).