The Applicability of the SEC’s Proposed Custody Rule to Real Estate

May 22, 2023
27:27 minutes

The SEC has proposed sweeping changes to its custody rule that would impose new obligations on registered investment advisers with respect to physical assets such as real estate. On this Ropes & Gray podcast, regulatory partner Nicole Krea and real estate funds partner Matt Posthuma, both in the firm’s asset management practice, discuss how these requirements would affect investment advisers in their management of real estate assets.


Matt Posthuma: Hi, my name is Matt Posthuma. I’m a real estate funds partner in the asset management practice at Ropes & Gray. I’m here with Nicole Krea, a regulatory partner in the asset management practice here at Ropes. We wanted to talk about proposed changes to the SEC’s custody rule and how that would apply to real estate. Nicole, perhaps you can talk first about the rule at a high level, and then we can get into more detail about how it applies to real estate.

Nicole Krea: Thanks, Matt. In February of this year (2023), the SEC proposed significant amendments to the custody rule, which would actually be redesignated as the safeguarding rule. These requirements would have an impact on virtually all aspects of the custody rule that registered advisers are required to comply with today, including some pieces that are really very fundamental to the rule and how they interact with business of advisers managing real assets. But to be clear, the custody rule continues to apply only to SEC-registered investment advisers. So, for example, if an adviser isn’t registered, whether due to an exception or because, for example, it advises solely with respect to real estate and not with respect to securities, the rule still will not apply. To those SEC-registered advisers, this really—particularly if adopted as proposed—would have a sweeping impact on custody rule compliance and an impact more broadly on pieces of the business. So, Matt, as someone who spends quite a lot of time advising on real estate matters, before we start ticking through each piece of the new rule and its impact, presumably from your perspective the biggest piece for real estate managers here is that the custody rule now clearly applies to physical real estate assets. Am I right in thinking that?

Matt Posthuma: Yes, I think the new rule is pretty clear. And, as you said, RIAs (registered investment advisers), what do they do? They need to register when they advise in the purchase and sale of securities, but real estate is clearly not a security. In the past, we haven’t had to worry about the custody rule, but now, it seems, Nicole, that real estate is clearly a physical asset in that the SEC clearly wants to sweep real estate into this new rule. Although—Nicole, maybe you can get into this a little bit—even the rule itself seems to be a little bit talking out of both sides of their mouth in terms of how the rule would apply to real estate.

Nicole Krea: I agree—I think that that’s exactly right. To take a step back, currently, the rule applies to advisers with custody as a legal status set out in the rule, a client’s “funds and securities”—no concept of other assets, physical assets, or anything along those lines. Under the new rule, this is fundamentally changed—it applies more generally to client assets, and assets will be clearly inclusive of funds, securities, and other positions held in a client account. The commentary around the new rule, in connection with the new proposed rule—there is a proposing release, as there always is—made very explicitly clear that physical real estate would be included as a position held in a client’s account, and therefore, an asset, and they’re subject to the custody rule. And so, that inclusion of physical real estate really is a fundamental shift. Notably, and somewhat logically—and this gets to the point that Matt was noting—the rule, which still will require generally a qualified custodian when an adviser has custody with respect to client assets, base requirements still to be held by a qualified custodian. The rule would not require that physical assets like real estate be held by a qualified custodian—there is, of course, an acknowledgment that that’s not logical. There’s an exception for physical assets that can’t be held by a qualified custodian as well as an exception for privately offered securities.

We’ll get more into that exception in a moment, but the commentary around the rule really does introduce the open question as to: What about, for example, a deed to physical real estate? Sure, a physical building cannot be held by a qualified custodian—that’s very clear, both based on logic and based on the rule. The proposing release seems to acknowledge that—and I’m quoting from the proposing release here—“a deed or similar indicia of ownership that could be used to transfer beneficial ownership of a property wouldn’t qualify for the exception from the requirement to be held by a qualified custodian, but the physical buildings or land would qualify.” If, in fact, the proposed rule is bifurcating the asset and ownership of the asset, this could put you in a situation where you might be looking at a situation where a deed would need to be held by a qualified custodian. Notably, where assets are held by a qualified custodian, the new requirement actually imposes as proposed a requirement on advisers to maintain client assets with a qualified custodian that has possession or control of those client assets. So, we could be in a position where not only do you have a deed being held by a qualified custodian, but the qualified custodian needing to have possession or control, which means, under the new proposed rule, that the qualified custodian would be required to participate in any change in beneficial ownership of those assets, and that the qualified custodian’s participation would effectuate the transaction being involved in that change of beneficial ownership. That would be a rather notable change here.

Matt Posthuma: Yes, it’s very strange. As those of you in the real estate industry know, the way that title to real estate is transferred is that you have a deed that is given by the seller to the buyer, and then that deed is recorded with the county recorder of deeds—it’s that recording that’s the real evidence of ownership. What the rule seems to suggest is that title to the real estate as recorded in the county recorder would now need to be recorded in the name of a bank as qualified custodian. Obviously, this is a business that banks are not currently in, so there’s a question as to whether this is something that they would want to get into. I was trying to think of an analogue to it, and I was thinking about perhaps a context where you have a bank or trust company that holds title to a piece of real estate or a trust—that was the closet analogue to it, but query whether that’s a business now that banks want to get into with respect to this qualified custodian idea. Do they want to have the liability of an owner? Also, it strikes me that, again, for those of you who are involved in real estate industry, the title company is very involved in the transfer of the real estate—that’s where your real estate closings take place. The title company provides title insurance to the buyer or to a lender that’s getting a mortgage. And perhaps a title company actually might be a better entity in the real estate context to serve as a qualified custodian.

Nicole, maybe you can talk a little bit about the exemption side of this. As I mentioned before, it seems like the SEC wants the holders of real estate to qualify with the custody rule in the context of title, but then also, with respect to the land and building itself, wants the holders of real estate to comply with the requirements for the exemption. Can you talk about that a little bit—the reasonable safeguarding of assets?

Nicole Krea: Sure. That’s a great point, and what I would say is one of the oddities that we might see in the proposed rule. As we noted, and as Matt was describing, you might have a situation where we’re looking to comply with the various qualified custodian requirements with respect to evidence of ownership like a deed, but then, on top of that, there is a clear exemption built out in the proposed rule for privately offered securities and physical assets, so the physical land, real estate, and building would certainly qualify as a physical asset that doesn’t need to be held by a qualified custodian. But the inquiry, analysis, and compliance obligations really don’t end there. That’s another big shift, I will say, from the current rule, where there is summarily an exemption from the requirement to have privately offered securities held by a qualified custodian. Beyond that, there really isn’t a set of compliance obligations that come along with the manner in which those privately offered securities need to be held, at least from a rule perspective.

Now, they satisfied the exception from having physical assets held by a qualified custodian—there are a number of compliance obligations. To tick through them briefly, an adviser must:

  1. reasonably determine, based on a reasonable understanding of the relevant marketplace, that ownership cannot be recorded and maintained in a manner in which a qualified custodian can maintain possession or control of assets (with respect to physical real estate, it’s very clear that a qualified custodian cannot maintain possession or control of assets);
  2. reasonably safeguard the assets from loss theft, misuse, misappropriation, or financial reserves, including insolvency (we’ll get into that in a moment);
  3. have an independent public accountant verify any purchase, sale, or other transfer of beneficial ownership of the assets, and notify the SEC’s Division of Examinations within one business day upon finding any material discrepancy;
  4. have a notification requirement to notify the independent public accountant engaged to perform the verification of any purchase, sale, or other transfer of beneficial ownership of the assets within one business day; and
  5. have the accountant verify the existence and ownership of each of the client’s privately offered securities or physical assets that are not maintained with a qualified custodian during that annual independent verification.

For any of those listening who are familiar with the current custody rules surprise exam requirement, it feels like it almost imposes a surprise exam requirement on assets not held by a qualified custodian. So, this imposes a whole new set of compliance obligations onto assets that either, because they were not subject to the custody rule, like real estate assets, or were previously exempt and that was the end of the story, now we’ve got a whole five-prong set of compliance obligations.

I think perhaps most interesting, as Matt alluded to earlier, when we apply this to real estate assets, is this requirement for reasonable safeguarding, which just to say it, when we think about this in the examination context, really is ripe for being viewed with 20/20 hindsight if there were ever an issue. There’s an issue with security of the particular real estate asset when something happens that’s open for a question of whether or not it was reasonably safeguarded. The SEC includes a discussion about reasonable safeguarding with respect to physical assets in the proposing release to the rule. They do acknowledge that an adviser might reasonably safeguard those assets by looking to reasonable commercial standards in the applicable industry, and that those standards in those actions for reasonable safeguarding would be tailored to each particular physical asset, depending upon the standards in its market. I think nevertheless, notwithstanding that flexibility, the imposition of a reasonable safeguarding requirement under the custody rule—just from a fiduciary perspective with respect to any client assets—certainly imposes a new level of potential liability, and again, oversight and second guessing. For example, what insurance is in place? What controls are applicable at the particular real estate asset or at the particular property? It’s an entirely new lens through which to view those contexts.

Matt Posthuma: Yes, I totally agree with that, Nicole. Just taking apart the reasonable safeguarding, as I mentioned before, title to real estate can only be transferred using a title company and recording the change of title in the recorder of deeds. And as I mentioned, buyers and lenders, with respect to real estate, obtain title insurance from the title company. So, it would be very difficult for someone to steal real property or a building, but this misuse requirement is, as you said, very ripe for second guessing. In the institutional real estate market, it’s obviously very typical and common to obtain property and casualty insurance, but you could certainly second guess the amount of coverage. It’s also very common for institutional real estate managers to hire property managers who are often on site at the property and can inspect it from time to time. But the SEC really is getting into an area where it doesn’t have any experience, and it’s really problematic to have a regulator with no experience in the industry starting to supervise how managers are dealing with their real estate.

I want to talk a little bit about the verification requirement. Again, for those of you who may not be as familiar with how real property is transferred, you record the title transfer in the recorder of deeds, and, as you might imagine, this process varies quite a bit from county to county. Many of the larger counties, and I would say perhaps more well-off counties, do this now online where you can search title online, but they don’t all. You might think about, say, a warehouse or something that might be in a more rural location where it’s not that easy to check whether a title has been properly transferred, and it may not happen immediately upon recording—it may take some time for that to work through the system. So, it’s not like, say, perhaps with a public security where you can see that title change show up immediately. That whole process, I think, is ripe for foot faults as an auditor may need to check multiple times before it sees that the title has actually been transferred.

Nicole Krea: Another interesting point about that, Matt—and it was interesting to me because the SEC explicitly noted it in its proposing release—is that the adviser will have to pay the independent public accountant for those services, the cost of which might be passed on to clients or investors. The SEC acknowledges that verification costs are likely to vary across advisers depending upon the type of client assets and notes, in particular, that a transaction involving a real estate asset that requires independent public accountant verification is likely to be costlier to verify than a transaction that can be verified electronically or via telephone, for example, a public security. So, there’s a risk element, and also an increased burden and cost element that comes along here.

Matt Posthuma: Yes, this also seems like another task that might be better suited to a title company than an independent accounting firm. Most large institutional managers have a relationship with one, maybe two, national title companies, and that title company will be very familiar with the property recording processes in all the various counties and would be in a much better position to verify that title has been recorded and also when would be the right time to look to see that that title transfer has shown up.

Nicole, what else is changing in this rule? Are there any changes to the audit or surprise examination requirements?

Nicole Krea: Moving beyond the very notable changes to what needs to be held by a qualified custodian and the exceptions from that, there is some impact that I think is of particular relevance to real estate managers when it comes to audit requirements. Under the current custody rule, there’s a requirement as one method of complying with the custody rule to rely on what’s known as the “audit exemption,” which effectively states that for pooled investment vehicles, there’s no need to obtain a surprise examination—which could be more burdensome in some respects—so long as the pooled investment vehicle is audited at least annually, pursuant to certain established standards, and the audited financial statements are distributed to investors within a prescribed time period. It’s a very common method of compliance with the custody rule.

There are a few changes to those requirements now, and they are sometimes beneficial or sometimes less beneficial depending upon to whom they are applying. One is there’s expanded availability for use of this “audit compliance route,” from just pooled investment vehicles to any entities. So, an entity, not just a pooled investment vehicle, could be able to comply with the audit exemption. There are certain other changed requirements, but I think perhaps most notable here is that the SEC has very unhelpfully also stated that an adviser, in its guidance, would be required to treat an SPV, a restructuring vehicle held under the fund, as a separate client for purposes of this safeguarding rule, if the SPV has owners other than the adviser, the adviser’s related persons or pooled investment vehicles are controlled by the adviser or the adviser’s related persons. This is not welcome news in the proposing release. This is somewhat restating and modifying guidance that the SEC had previously given several years ago, often referred to as the “SPV’s custody guidance,” in which it acknowledged certain situations where an SPV (“special purpose vehicle”) below a fund would or would not need to obtain a separate audit. And as part of that guidance, which is heavily relied upon, there was the acknowledgment that inherent in any determination that a special purpose vehicle would need a separate audit was a threshold determination as to whether that special purpose vehicle was in fact a separate client under the rule, and that there are facts and circumstances that could be taken into account in determining whether or not they were separate clients.

So, this guidance that clearly picks up entities, not just pooled investment vehicles, makes clear that if we have any third parties coming into a special purpose vehicle below the fund, a separate audit would be needed, which is not really welcome news, particularly for real estate managers where we spend a lot of time thinking about application of the custody rule and the audit requirements to, say, a REIT subsidiary under a fund or a client largely being held by the client, but we might have 100 preferred shareholders for satisfaction of certain REIT requirements. This somewhat stricter guidance with respect to SPVs having owners other than the adviser or the adviser’s related persons or pooled investment vehicles controlled by the advisor would not apply favorably to that sort of situation.

Matt Posthuma: That’s right. For those of you who aren’t familiar with the use of private REIT subsidiaries, there is an IRS requirement that REITs have at least 100 shareholders, and that’s often satisfied in the private REIT subsidiary context by having 100-150 preferred shareholders who each buy one preferred share for $500-$1,000 apiece. So, the ownership of the REIT subsidiary is still 99.99% in favor of the fund or other pooled investment vehicle, and to start having independent audit requirements for each of these REIT subsidiaries could be quite burdensome. In the past, we were able to get out of that because the subsidiary of the fund was not a client in the same way that the fund was. Thinking about another context where this might come up would be in a situation where a fund is party to a joint venture—now, the joint venture would be swept into this requirement. And where you have institutional funds entering into joint ventures, usually those are with real estate operators who are not themselves registered investment advisers—again, because, as Nicole said before, they’re only dealing with investments in real estate, and so, don’t have the need to register. To start imposing these additional requirements on these unregistered real estate operators could also be seen as quite burdensome to those real estate operators.

Nicole, when are these changes scheduled to take effect?

Nicole Krea: It’s a great question and, I think, a really important point to keep in mind here, because right now it’s entirely unknown—these are all just proposed rules at this point. As I think that most can pick up from the content discussed in this discussion, and in a number of different places throughout the rest of the proposed rule, there are some aspects of this proposed rule that—we haven’t even touched on, including those that we have that are gathering a lot of industry comment—are going to, if adopted as proposed, be very problematic in a number of ways. This is just a proposed rule—it is subject to extensive comment. We are just nearing the end of the comment period. There will be some period of time—and it’s never quite known—between the end of the comment period for the SEC to consider what we are expecting to be very extensive industry comment, consider those comments, and then either come up with an adapted version of the rule or re-propose new changes depending upon what would change between the proposed rule and the adopted rule. And then, when we ultimately have an adopted rule, there will certainly be a transition period whereby registered advisers will be expected to prepare for and come into compliance with the new rule as adopted. So, I think that the hope is that there are some changes as between what is proposed here and what is ultimately adopted. We’ll need to see what’s ultimately adopted and then what the transition period will be once adopted.

A key point to keep in mind—which, again, could be subject to change to the extent we see movement as between the proposed rule and the adopted rule—is that in the current version of the proposed rule, there is no grandfathering. And what I mean by that is there is no exception from the application of these proposed requirements and changes to arrangements already in place with existing clients or existing custodians. So, if adopted as proposed, once we get through a transition period, the requirements would apply to existing arrangements and new arrangements. But, again, we’re expecting and are seeing extensive comment on all of this, so what’s ultimately adopted will very much remain to be seen.

Matt Posthuma: Yes, the lack of grandfathering would be quite burdensome to many existing large real estate funds. We think, in particular, about the large open-end funds that have hundreds of properties that they hold for many years—it would be a massive undertaking to have to transfer title to all those properties to a qualified custodian. Certainly, in this initial proposal there seems to be a lack of understanding in terms of how real estate is managed and how title is transferred, and hopefully through the comment process the SEC will get a little bit better idea as to how title and possession of real estate should be handled. And then, of course, we’ll need to figure out who actually is willing to serve as a qualified custodian and a verifier of title, assuming those requirements continue to apply. So, we look forward to seeing how that turns out.

Thank you to our listeners. And thank you, of course, to Nicole for speaking with me about this. For more information on the topics that we discussed, please visit our website at Of course, we can help you navigate any of the topics we discussed—please don’t hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple and Spotify. Thanks again for listening.

Subscribe to RopesTalk Podcast