Oct. 30, 2023
To whom it may concern, I write to comment on ten issues pertaining to the proposed rule: 1. THE PROPOSED RULE RETROACTIVELY PUNISHES LAWFUL CONDUCT IN VIOLATION OF DUE PROCESS. The proposed amendments to the custody rule would retroactively impose significant new requirements on investment advisers who have lawfully relied on existing SEC guidance regarding the custody of digital assets. This retroactive punishment of prior lawful conduct violates due process protections under the Fifth Amendment. The Supreme Court has made clear that retroactive legislation presents problems of unfairness and requires a burden not imposed by legislation prospectively. Pension Benefit Guaranty Corp. v. R.A. Gray & Co., 467 U.S. 717, 728–30 (1984). A law may be impermissibly retroactive if it attaches new legal consequences to events completed before its enactment. Landgraf v. USI Film Prod., 511 U.S. 244, 269-70 (1994). Here, the proposed amendments seek to impose substantial new burdens on investment advisers who acted lawfully under existing SEC guidance regarding custody of digital assets. The SEC has not previously required advisers to maintain custody of digital assets with qualified custodians. And the SEC has not deemed digital assets to be "funds" or "securities" subject to the custody rule. Advisers thus reasonably relied on this guidance. Yet the proposed amendments would now attach new legal consequences to advisers' past decisions to custody digital assets in accordance with SEC guidance. Landgraf, 511 U.S. at 269-70. This fundamentally changes the rules after the fact and unfairly punishes reasonable, good faith conduct. As the Supreme Court has explained, elementary considerations of fairness dictate that individuals should have an opportunity to know what the law is and to conform their conduct accordingly. Landgraf, 511 U.S. at 265. The proposed retroactive application of the custody rule to digital assets denies advisers this basic due process protection. Courts have rejected similar instances of retroactive legislation on due process grounds. For example, in Eastern Enterprises v. Apfel, 524 U.S. 498 (1998), the Supreme Court invalidated retroactive legislation imposing substantial new financial burdens based on decades-old business conduct. As the Court explained, legislation might be unconstitutional if it imposes severe retroactive liability on a limited class of parties that could not have anticipated the liability. Id. at 528-29. The proposed custody rule amendments present precisely this sort of unconstitutional retroactivity vis-à-vis investment advisers' custody of digital assets. The SEC cannot impose substantial new regulatory burdens based on prior conduct that was lawful at the time. The proposed retroactive application of the custody rule to digital assets denies advisers fair notice and the opportunity to conform their business practices to legal requirements. This violates basic due process protections. The SEC should revise the proposed amendments to apply only prospectively. Retroactive application of the custody rule to lawful past conduct related to digital assets violates constitutional due process guarantees. 2. THE PROPOSED RULE PROVIDES INEFFECTIVE GRIEVANCE MECHANISMS. The proposed SEC rule regarding the safeguarding of advisory client assets lacks effective grievance mechanisms for clients and advisers to raise concerns about custodians. The rule mandates that advisers enter written agreements with qualified custodians that contain certain provisions, such as requiring custodians to exercise due care and properly segregate client assets. However, the rule does not provide a clear path for recourse if a custodian fails to uphold these standards. Without a formal grievance process, clients and advisers have no straightforward way to hold custodians accountable for negligence or misconduct. Filing a complaint with the SEC or pursuing legal action would be burdensome and inefficient compared to an internal grievance procedure. The SEC should revise the rule to require that custodians implement a transparent grievance process allowing advisers and clients to submit complaints and appeal decisions. At a minimum, this process should: Provide multiple channels for submitting grievances, including phone, email, web portal, and mail. Acknowledge receipt of complaints and provide expected timelines for resolution: -Conduct impartial investigations into grievances. -Allow clients and advisers to appeal grievance decisions. -Maintain records of grievances and their outcomes. -Periodically report metrics on grievance volume, resolution rates, and common issues to the SEC. Without effective grievance mechanisms, custodians lack proper oversight and accountability for safeguarding client assets. The SEC must address this oversight gap by mandating more robust complaint handling processes. Advisers and clients need clear recourse to raise concerns and resolve disputes with custodians. 3. LIMITED STAKEHOLDER ACCESS CAUSES CRYPTO CUSTODY CONCERNS. The SEC's proposed amendments to the custody rule, which would require RIAs to hold all client "crypto assets" with a qualified custodian, should be modified because the rulemaking process did not properly include or consider input from key stakeholders. While the SEC requested public comments after proposing the amendments, this process did not sufficiently incorporate perspectives from state trust companies, decentralized protocols, and other participants in the digital asset ecosystem. The Administrative Procedure Act requires agencies to consider and respond to significant comments, per the Supreme Court's decision in Perez v. Mortgage Bankers Association. The D.C. Circuit has also held that an agency acts arbitrarily and capriciously when it fails to respond to relevant and significant public comments, as in Carlson v. Postal Regulatory Commission. Here, by not directly engaging with affected stakeholders prior to the proposal, the SEC risks enacting overbroad regulations without fully understanding their consequences or considering alternatives. The SEC should conduct further outreach, through hearings, advisory committees, or other means, to gather input from state trust companies, decentralized protocols, investors, and other stakeholders before finalizing rules that will profoundly impact digital asset markets. 4. THE RULE CONTRIBUTES TO THE UNFAIR TREATMENT OF CRYPTO ASSETS. The proposed amendments to Rule 206(4)-2 unfairly target crypto assets and crypto asset service providers for more restrictive regulation compared to traditional custodians and assets. This differential treatment is not supported by empirical evidence of greater risks to investors and violates principles of technology neutrality in regulation. The proposed rule imposes additional burdens on custodians of crypto assets without a factual basis. The SEC justifies imposing additional obligations on custodians of crypto assets by referring vaguely to crypto's "specific characteristics" and the purported challenges of controlling crypto assets. However, the SEC fails to cite any data showing that qualified custodians of crypto assets have greater loss rates or fail to adequately safeguard assets compared to traditional custodians. Absent such data, there is no foundation for subjecting crypto custodians to more stringent requirements than traditional custodians under Rule 206(4)-2. Imposing unequal burdens without evidence of corresponding risk violates principles of fair regulation. See Business Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011) (vacating SEC rule for inadequately considering costs and benefits of regulation). 5. TECHNOLOGY NEUTRAL REGULATION IS NECESSARY FOR FAIR COMPETITION. By holding crypto custodians to higher standards than traditional custodians, the proposed rule disadvantages crypto-focused financial services providers relative to incumbents. However, if a custodian meets the baseline requirements to be considered a qualified custodian, any additional obligations should apply equally regardless of whether traditional or crypto assets are held. To do otherwise picks winners and losers. As SEC Commissioner Hester Peirce has argued, a technology-neutral approach to crypto regulation is required to foster responsible innovation. The proposed rule conflicts with principles of technology-neutrality and fair competition. Unequal treatment of custodians based solely on the digital nature of assets raises competitive fairness concerns. The SEC should regulate activities and risks, not technologies. Additional obligations are only warranted based on evidence of greater risks. 6. THE PROPOSED RULE RISKS CAUSING UNINTENDED CONSEQUENCES. The SEC's proposed amendments to the custody rule undoubtedly aim to enhance investor protection. However, the Proposal's prescriptive requirements risk stifling innovation in digital asset custody technology and driving activity offshore, ultimately harming U.S. leadership in this emerging space. The SEC should take a more principles-based approach focused on required outcomes rather than mandated means. The Proposal requires crypto custodians to demonstrate "exclusive" control and restricts certain custody models like sharding of private keys. However, technical exclusivity is an imperfect proxy for effective custody that may exclude compliant arrangements. The SEC should set standards for custody focused on preventing loss and misappropriation of assets rather than mandating specific technical implementations. Requiring specific technical means creates unintended consequences. For example, in NetCoalition v. SEC, 615 F.3d 525 (D.C. Cir. 2010), the D.C. Circuit struck down an SEC attempt to regulate based on similar technological assumptions. The court held that the Commission failed to properly consider the costs imposed upon petitioners and relied upon insufficient empirical data. Id. at 539, 547. The SEC risks repeating this mistake by mandating exclusivity without considering alternative custody arrangements that may prove equally or more protective. 7. PRESCRIBING QUALIFIED CUSTODIAN STATUS RISKS INNOVATION AND COMPETITIVENESS. By limiting qualified custodian status, the Proposal risks undermining U.S. leadership in digital asset technology. Rather than pre-judge, the SEC should adopt a functional approach considering whether a custodian effectively safeguards assets. Rigidly restricting qualified custodian status will push activity offshore to jurisdictions with more welcoming regulatory regimes. This will deprive U.S. investors of access to leading technologies and undermine U.S. competitiveness. The SEC should regulate based on desired outcomes not specific means. This regulatory humility will permit market solutions to emerge while ensuring investor protections remain paramount. 8. THE PROPOSED RULE PROVIDES DISPROPORTIONATE BURDENS RELATIVE TO BENEFITS. The SEC's proposed amendments to the custody rule under the Investment Advisers Act of 1940 go too far in regulating crypto assets and impose disproportionate burdens relative to the expected benefits. While the goal of enhanced investor protection is sound, the proposal's expansive approach to regulating crypto custody lacks nuance and proportionality. It would impose significant costs while offering limited additional protections beyond existing regulations. Less disruptive alternatives are available to achieve the SEC's stated goals. Several aspects of the proposal would impose disproportionate burdens on investment advisers and custodians relative to marginal investor protections gained: Expanding the custody rule to cover all crypto assets exceeds the SEC's authority under the Advisers Act. The Act's authority is limited to securities. Non-security crypto assets like Bitcoin and Ethereum do not implicate custody concerns, as acknowledged by former SEC Commissioner Peirce. Subjecting them to the custody rule lacks statutory basis. Requiring "exclusive possession or control" of crypto assets sets an impossible standard. Proving exclusive possession of crypto assets is technically infeasible, as private keys can be duplicated. Yet major custodians and auditors have developed methods to establish ownership and prevent misappropriation. Holding custodians to an unattainable standard disproportionately burdens compliant actors. Disqualifying existing crypto qualified custodians would cause significant disruption. Many RIAs currently rely on state-chartered trust companies that custody crypto. Forcing advisers to change custodians would impose transition costs and business risks exceeding investor benefits. Less disruptive alternatives like enhanced examinations of existing custodians are available. Limiting trading and staking would inhibit responsible crypto investing. Banning centralized exchange trading and limiting staking would prevent advisers from fully managing crypto assets in clients' best interests. These tools do not inherently create disproportionate custody risks when used properly. Bans impose costs exceeding benefits. More tailored crypto custody regulation based on asset characteristics, calibrated to risk, and recognizing existing protections would achieve the SEC's goals while avoiding disproportionate burdens. The SEC should utilize its broad exemptive authority under the Advisers Act to craft a more judicious final rule. 9. THE PROPOSED RULE INADEQUATELY EVALUATES THE IMPACT ON STATE-CHARTERED TRUST COMPANIES PROVIDING CRYPTO CUSTODY SERVICES. The SEC failed to adequately evaluate whether state-chartered trust companies currently providing crypto custody services could qualify as custodians under the proposed amendments to Rule 206(4)-2. While the proposal does not explicitly preclude state-chartered trusts from qualifying, statements by SEC leadership indicate a bias against these institutions without proper justification. The SEC should conduct a more thorough analysis of existing state regulations for crypto custodians and how they achieve the policy goals of investor protection underlying the custody rule. Failing to do so would ignore viable options for crypto custody and undermine state regulatory regimes without evidence of their inadequacy. Section 206 of the Investment Advisers Act prohibits fraudulent conduct by investment advisers. Rule 206(4)-2 implements this through requirements for custody of client assets. The SEC proposes amending the rule to cover crypto assets based on its broad authority under Section 206 to define fraud for advisers with custody. However, the SEC fails to properly evaluate whether state-chartered trusts with appropriate state regulation can act as qualified custodians under the amended rule. The definition of “qualified custodian” in proposed Rule 223-1 still includes banks under the Advisers Act definition. This encompasses state-chartered trust companies conducting substantial fiduciary business [Section 202(a)(2)]. Logically, well-regulated state institutions focused on crypto asset custody should not be precluded as qualified custodians purely because they deal with novel asset classes. The SEC itself acknowledges crypto custody is possible “in certain circumstances” [87 Fed. Reg. 1685]. It even notes some firms “may have developed custodial practices regarding digital assets” [87 Fed. Reg. 1687]. Yet statements by agency leadership indicate a bias against digital asset companies being deemed qualified custodians. This pre-judgment ignores the possibility of state oversight adequately ensuring critical custodial protections like asset segregation without federal regulation. Before determining no state regime can properly regulate crypto custodians, the SEC must actually evaluate existing state custody frameworks. The current proposal lacks any such analysis. This violates the Administrative Procedure Act requirement that an agency examine all important aspects of a problem before regulating See Motor Vehicle Mfrs. Ass'n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983). The SEC should remedy this failure by seriously evaluating state crypto custodial frameworks to determine if they meet the policy goals underlying the custody rule amendments. Only if state regulation is truly deficient should the agency consider prohibiting state-chartered institutions from qualifying as custodians. A demonstrated, evidence-based justification is needed to override states’ authority over corporate formation and supervision. The SEC has not provided such analysis here. For proper rulemaking, it must thoroughly assess whether its aims for investor protection can be achieved through enhanced state regulation rather than outright prohibiting state-chartered crypto custodians. 10. THE PROPOSED RULE OVEREMPHASIZES SHORT-TERM RESULTS AT THE EXPENSE OF LONG-TERM PROGRESS. The SEC's proposed amendments overemphasize short-term results at the expense of long-term progress in the digital asset industry. While the goal of enhanced investor protection is laudable, the proposal risks stifling innovation and growth in this nascent industry. The proposed requirements for "exclusive possession or control" of crypto assets set an unrealistically high bar that few, if any, existing crypto custodians can meet. As evidenced by the OCC's approval of crypto custody services at federally regulated banks, it is possible to safely custody crypto assets without having 100% exclusive possession of private keys. Imposing such an impractical standard would force advisers to avoid crypto assets entirely, depriving clients of exposure to a growing asset class. Likewise, the proposal's skepticism of state-chartered trusts' ability to serve as qualified custodians reflects a focus on short-term risks over long-term viability. Well-capitalized, regulated state trusts with robust custody protocols should not be categorically excluded as qualified custodians. While demanding stringent safeguards is prudent, the SEC should adopt a tailored, risk-based approach that accounts for providers' particular characteristics. An overly rigid stance will inhibit development of diverse, responsible crypto custodians. More broadly, the proposal conflicts with the SEC's historic role in facilitating capital formation while protecting investors. In United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975), the Supreme Court admonished that a security should not be defined so broadly that the mere purchase of assets with an expectation of profit becomes a federal security transaction. Similarly here, imposing overly blunt custody requirements in the name of safety risks severely limiting advisers' access to digital assets - thereby undermining the SEC's capital facilitation function. The SEC should promulgate a rule that recognizes both the risks posed by crypto assets and their enormous growth potential. While tight controls are needed, the Commission should craft a balanced framework that allows responsible crypto custody models to develop. With tailored standards that avoid a rigid, exclusionary approach, the U.S. can foster financial innovation while safeguarding investors' interests over the long haul. The current proposal falls short of that goal.