March 2, 2023 - In a matter of immense importance to loan market advisers and custodians, the SEC proposed sweeping revisions to the Custody Rule (the “proposed rule”).  As noted by Sidley, if the rule is adopted as proposed, it “will have far-reaching effects on how registered investment advisers manage and safeguard client assets…”  As written, the proposed rule would impose significant burdens and costs on loan managers, including, at a minimum, a requirement to arrange for an annual surprise audit, and would completely alter their relationships with custodians.  Loan custodians would be required to accept significantly more liability, provide extensive written assurances to advisers and be subject to very prescriptive rules.  A worse outcome would require the manager to engage an independent accountant to, in effect, watch every trade and report discrepancies to the SEC in near-real time.

The Application of the Safeguarding Rule to CLOs and Loan Funds.  The proposed rule would apply to all client assets held in advisory accounts, not just funds and securities.  Moreover, an adviser’s discretionary authority to trade client assets, including loans, would now fall under the definition of custody. Bottom line: If you’re not a 40 Act Fund, you’re probably captured.

What does custody of client assets require?  Advisers would have to maintain client assets with a “qualified custodian”.  The qualified custodian must have “possession or control” of client assets and must participate in any change of beneficial ownership of client assets.  Whether loan custodians currently have such possession or control, and the implications if they do not, is of crucial importance and is discussed below.

Surprise Examinations.  The proposed rule would require managers who have discretion over client assets that are maintained by a qualified custodian but do not settle “delivery vs. payment” (DVP), like loans, to engage an auditor to verify the client’s assets by undertaking an annual surprise examination. This may be the best-case scenario.

Written Agreements with Qualified Custodians.  The proposed rule requires that qualified custodians enter into written agreements with advisers that include several safeguards that the adviser must “reasonably believe” have been implemented.  The proposed rule also requires advisers to obtain from qualified custodians written “reasonable assurances” that it will provide certain enumerated client safeguards, including, among others, the exercise of due care in performing its duties and indemnifying the client against the risk of loss as a result of the qualified custodian’s negligence.  It is likely that custodians will push back on these requirements.  If they do sign agreements, we anticipate that such arrangements will be very costly.

Do loan custodians have possession or control of client assets?  It is not yet settled whether current custody arrangements for loans would constitute “possession and control” of client assets. The proposed rule defines possession or control 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, and the qualified custodian’s involvement is a condition precedent to the change in beneficial ownership.”  While loan custodians are very integrated into the settlement and payment process, it is yet uncertain whether current procedures technically conform to the proposed rule’s definition and how the SEC would view those procedures.  The LSTA, working with managers, custodians, dealers and counsel are currently examining that question.

What if qualified custodians don’t have possession or control of client assets?  The proposed rule provides an exception to the requirement to maintain client assets with a qualified custodian provided that the adviser (i) reasonably determines that ownership cannot be maintained in a way a qualified custodian can maintain possession or control transfers of beneficial ownership of such assets and (ii) reasonably safeguards the assets from loss, theft, misuse, misappropriation, or the adviser’s financial reversals, including the adviser’s insolvency.  As Sidley notes, in order to rely on this exception, the adviser must engage and notify an independent accountant of any purchase, sale or transfer of beneficial ownership of any asset within one business day. The independent public accountant would be required to notify the SEC within one business day of finding any discrepancies and each loan would have to be verified in either a surprise examination or audit.  So, if current custodial arrangements are determined to fall short of constituting possession or control under the proposed rule, either changes to custodian arrangements would have to be made to come into compliance or loan advisers would have to rely on this very cumbersome and expensive exception arrangement.

Next steps.  The LSTA continues to analyze the proposed rule and is working with market participants to determine whether current custodial arrangements meet the SEC’s standards for possession or control.  We expect to submit a comment letter by the SEC’s deadline.

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