Last year, the Securities and Exchange Commission put a new rule in place restricting an investment adviser’s ability to have custody of its clients’ assets. Given that many private fund managers are going to have to register as investment advisers they need to figure out how to comply with this rule.
The rule is the anti-Madoff rule. The SEC wants client assets separate from the manager’s control and for the manager to safeguards in place to prevent a manager from sending out false statements to investors. This includes having a third party custodian and having the custodian send statements directly to investors and subjecting the accounts to a surprise inspection by an auditor.
Rule 206(4)-2(a) If you are an investment adviser registered or required to be registered under section 203 of the Act, it is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Act for you to have custody of client funds or securities unless:
(1) A qualified custodian maintains those funds and securities:
(i) In a separate account for each client under that client’s name; or
(ii) In accounts that contain only your clients’ funds and securities, under your name as agent or trustee for the clients.
If your fund has securities, then you need a “qualified custodian” holding those securities. There is an exception for “privately offered securities” that will make life much easier for private equity funds and real estate funds.
Use of a Qualified Custodian
So who can you use as a “qualified custodian“?
(d)(6) Qualified custodian means:
(i) A bank as defined in section 202(a)(2) of the Advisers Act or a savings association as defined in section 3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act (12 U.S.C. 1811);
(ii) A broker-dealer registered under section 15(b)(1) of the Securities Exchange Act of 1934, holding the client assets in customer accounts;
(iii) A futures commission merchant registered under section 4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client assets in customer accounts, but only with respect to clients’ funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon; and
(iv) A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer accounts segregated from its proprietary assets.
Surprise audits and custodian statements
In addition to the requirement in (a)(1) that a qualified custodian hold the securities, there are addition requirements in (a)(2), (a)(3) and (a)(4) that you notify the client about the custodian, require separate statements be sent to the client and that the account be subject to surprise audits.
When investment funds are the clients these requirements make less sense, so (a)(5) requires funds to send the account statements to their limited partners.
There is an exception for pooled investment vehicles:
(b)(4) Limited Partnerships subject to annual audit. You are not required to comply with paragraphs (a)(2) and (a)(3) of this section and you shall be deemed to have complied with paragraph (a)(4) of this section with respect to the account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) that is subject to audit (as defined in rule 1-02(d) of Regulation S-X (17 CFR 210.1-02(d))):
(i) At least annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year;
(ii) By an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and
(iii) Upon liquidation and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) promptly after the completion of such audit.
If your auditor is not subject to inspection by PCAOB, you would have to switch auditing firms for your private fund to use this exception. You need to make sure your auditing firm has the horsepower to get the audited down in time for you to get financial statements out in within 120 days of fiscal year end.
Certain privately offered securities
There is a exception for having to deliver “privately offered securities” to the qualified custodian. Certain privately offered securities are:
(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;
(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and
(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.
Notes and Interests in Subsidiaries and Portfolio Companies
For real estate private equity, the problem will be notes. They may be considered securities. Notes won’t meet the definition of uncertificated and they are most likely transferable.
For entities and portfolio companies, the key will be to make sure the subsidiaries under the funds are not certificated and there is requirement for consent in order to transfer. I think fund managers are going to have to back and inventory their subsidiary entity documents.
Of course you may be able to make an argument that the interest in the subsidiary is not a security. If it’s wholly-owned you can make a strong argument that the ownership is not a security since you are not relying solely on the efforts of others. But if the subsidiary is corporation you may be stuck treating it as a security. It’s generally hard to argue that shares in a corporation are not a security.
In the SEC Q&A about the custody rule:
Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?
A: No. Rule 206(4)-2 applies only to clients’ funds and securities.
So you don’t need to deliver all of the fund assets to the custodian. Just those that are securities and cash. Presumably, fund managers are already keeping their funds’ cash in a bank account and not in a mattress. They just need to make sure that the cash accounts are in the fund names.
At first, I thought the limited partnership exception would allow private fund managers to completely avoid the burden of this rule. That was too broad. Now I think fund managers are stuck with hiring a qualified custodian if they register with the SEC. I would guess there will lots of private fund managers looking for custodians before they register.
- Rule 206(4)-2
- SEC Release No. IA-2968 – Custody of Funds or Securities of Clients by Investment Advisers (.pdf)
- SEC Staff Responses to Questions About the Custody Rule
- US SEC Amends Custody Rule for Registered Investment Advisers (.pdf) – Mayer Brown