Compliance March 17, 2023

Complying With the Custody Rule and the New Custody Proposal

Experts explained common compliance mistakes involving the custody rule and spoke to the new custody rule proposal.

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Compliance experts and officials from the Securities and Exchange Commission warned advisers that the SEC’s custody rule may apply even if an adviser does not intend to use it or is not aware of it.

Mukya Porter, the chief compliance officer at CIM Group, explained at the Investment Adviser Association’s Adviser Compliance Conference that anything in a client contract that grants “power of attorney” can bestow the obligations of the custody rule on an adviser.

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Among other things, the custody rule requires advisers to ensure assets in their custody are kept with a certified custodian and that the adviser submit to annual surprise SEC exams to verify the existence of those assets.

Natasha Greiner, a national associate director of the investment company examination program at the SEC, said the issues highlighted in a 2017 risk alert are still applicable today. The risk alert said that online access to a client’s assets, power of attorney or authorization to withdraw funds as payment can all impose custody obligations, but that many advisers examined by the SEC were unaware of this.

The alert also said many advisers who pay outside consultants to conduct a surprise exam are not actually surprised at all, because the exams had been planned or always happen on the same day each year but are presented as a “surprise” in the adviser’s compliance policies. In other cases, the third-party audits did not include a complete accounting of all of the assets in an adviser’s custody.

SEC regulatory guidance issued the same year also said advisers can become an unintentional custodian due to wording in their client agreements. Whenever an adviser can withdraw or transfer funds, it is considered a custodian, even if it has never actually used that power or intended to.

On February 15, the SEC proposed a new rule for adviser custody that would apply to all assets over which an adviser might acquire custody. The new rule requires that an adviser clearly segregate its assets from client assets so that the client’s assets are safe in the event that the adviser declares bankruptcy. These two provisions interact in an important way, because they prevent advisers from comingling their assets with their clients’ in previously uncovered asset classes, such as cryptocurrencies, which can leave investors stuck if their adviser goes bankrupt.

The new rule would also apply to agreements in which an adviser has discretionary trading authority, the ability to buy and sell clients’ assets without receiving client permission on a trade-by-trade basis.

William Birdthistle, the director for the investment management division at the SEC which drafted the new custody rule proposal, was especially enthusiastic about the provision that would apply custodial obligations onto discretionary trading agreements. He told the audience at the IAA Compliance Conference that “discretionary trading can create problems,” and updating the rule to include it is critical. It is unclear how this or other elements of the latest SEC custody proposal will end up in the final version of the rule.

The comment period for the new custody rule expires May 8, and directions on how to submit a comment can be found here.

Compliance March 16, 2023

Anti-ESG States Continue Organizing

Policy experts say that ESG policy is likely to be most active at the state level.

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A coalition of 19 states, led by Florida’s Republican Governor Ron DeSantis, signed an open letter declaring their opposition to the use of environmental, social and governance factors in government investing and outlined legislative priorities to that effect.

In addition to Florida, the alliance includes Alabama, Alaska, Arkansas, Georgia, Idaho, Iowa, Mississippi, Missouri, Montana, Nebraska, New Hampshire, North Dakota, Oklahoma, South Dakota, Tennessee, Utah, West Virginia and Wyoming.

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DeSantis is rumored to be seeking the Republican nomination for president.

The joint statement read that, “The proliferation of ESG throughout America is a direct threat to the American economy, individual economic freedom, and our way of life, putting investment decisions in the hands of the woke mob to bypass the ballot box and inject political ideology into investment decisions, corporate governance, and the everyday economy.”

The letter claims the Department of Labor’s recent final rule permitting the use of ESG factors when selecting retirement plan investments will cost Americans money by prioritizing a political agenda ahead of financial returns.

The coalition also identified some of its legislative priorities related to ESG, including a move to exclude ESG from government investing decisions at the state and local levels, specifically the management of state assets and the issuance of state and local bonds.

The letter also said the states intend to prohibit banks from establishing “social credit scores,” and discriminating against customers for religious and political beliefs, including those related to firearms, “securing the border” and “increasing our energy independence.”

Firearms manufacturers are often excluded from ESG funds due to the regulatory and reputational risks associated with the products they sell, and “increasing our energy independence” in this context means increased fossil fuel production. A social credit score is a reference to certain Chinese policies which can restrict access to various services, such as finance, based on one’s “social trustworthiness.” The imminent introduction of such scores in the United States is a conspiracy theory associated with the far-right.

A statement released by DeSantis affirms the same legislative agenda as laid out in the joint letter. The statement also mentions that Florida decided in August 2022 to only include “pecuniary factors” in the investment of state pensions, language that mirrors proposed legislation in Congress designed to roll back the DOL’s ESG rule and return to wording used by the department’s DOL regulations under President Donald Trump governing the consideration of ESG factors in the selection of retirement plan investments.

Lance Dial, a partner at the Morgan Lewis & Bockius law firm, said at the Investment Adviser Association’s 2023 Compliance Conference on Tuesday that most states passing anti-ESG legislation have carve-outs for business purposes, and the phrase “pecuniary factors” can be read this way as well. He says ESG funds should readily disclose and emphasize that they are using ESG for financial reasons, if that is indeed the case, and carefully explain that use. Clear disclosure could reduce their risk of running afoul of anti-ESG policies, he says.

Congress recently passed a resolution to overturn the DOL rule permitting ESG considerations in selecting retirement plan investments. The resolution was presented to President Joe Biden on March 9, and his veto is expected in the coming days, an outcome that the group’s joint letter anticipates and condemns.

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