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Private Fund Advisers Should Evaluate Compliance With Custody Rule

March 7, 2013

 

On March 4, 2013, the Securities and Exchange Commission (“SEC”) issued a Risk Alert and Investor Bulletin related to custody of client funds and securities by registered investment advisers. In the Risk Alert, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) identifies common deficiencies observed during examinations and reminds advisers of their obligations.[1] In the Investor Bulletin, the SEC’s Office of Investor Education and Advocacy (“OIEA”) instructs investors to discuss custody issues with their advisers and conduct their own due diligence.[2]

We summarize below issues raised in the Risk Alert of most relevance to private fund advisers.

The Custody Rule

Rule 206(4)-2 (the “Custody Rule”) under the Investment Advisers Act of 1940 (“Advisers Act”) requires registered investment advisers who have “custody” of client assets to take specific measures to protect those assets. An adviser has custody if the adviser holds or has the authority to obtain possession of client funds or securities. With limited exceptions, advisers with custody must satisfy all of the requirements under the Custody Rule.

Advisers that manage private funds or other pooled investment vehicles may rely on the “audit exemption” in the Custody Rule in lieu of satisfying all of the requirements of the Rule. Pursuant to the exemption, an adviser is deemed to comply with the surprise examination requirement and exempt from the notification and quarterly statement requirements with respect to the funds and securities of pooled investment vehicles provided: (i) the adviser obtains GAAP compliant audits of the pooled investment vehicles on an annual basis and distributes the audited financials to investors in the pooled vehicles within 120 days of the end of the pooled vehicle’s fiscal year (180 days for funds of funds), and (ii) obtains an audit upon liquidation of a pool and distributes the audited financial statements promptly after the completion of the audit.

OCIE Risk Alert

OCIE’s Risk Alert describes commonly observed deficiencies in compliance with the Custody Rule and suggests registered investment advisers reassess their policies and procedures. The Risk Alert identifies four categories of custody-related deficiencies as follows: (i) advisers did not recognize that they had “custody” for purposes of the Custody Rule; (ii) advisers did not fully satisfy the surprise examinations requirements; (iii) advisers did not comply fully with the qualified custodian provision; and (iv) advisers relied on the audit exemption in connection with the assets of pooled investment vehicles managed by the advisers but did not satisfy all conditions of the exemption. This Client Alert focuses on the observations related to (i), (iii) and (iv) of most relevance to advisers that rely on the audit exemption of the Custody Rule.[3]

Advisers Did Not Recognize That They Had “Custody”

The OCIE Risk Alert identifies circumstances in which advisers did not realize they had custody for purposes of the Custody Rule. Of particular relevance for advisers to private funds or other pooled investment vehicles, OCIE identified circumstances in which advisers serve as general partner of a limited partnership or hold a comparable position for a different type of pooled investment vehicle but have not complied with the Custody Rule, or the audit exemption, because the advisers did not realize they had custody for purposes of the Custody Rule.

Advisers Did Not Satisfy The Conditions of The Audit Exemption

OCIE’s Risk Alert notes that examiners identified lapses in compliance with the audit exemption by advisers to private funds or other pooled investment vehicles. The Risk Alert identifies the following deficiencies observed during SEC examinations:

  • The audited financial statements were not prepared in accordance with GAAP because: (i) organizational expenses of the fund were amortized rather than expensed as incurred; (ii) they were prepared on a federal income tax basis; or (iii) the accountant could not issue an unqualified opinion on the financial statements because the adviser could not substantiate fair valuations;
  • The accountant that conducted the audit was not “independent” under Regulation S-X;
  • The auditor was not registered with and subject to inspection by the PCAOB;
  • Advisers could not demonstrate that the audited financial statements were distributed to all fund investors and, in some instances, appeared to make the statements “available upon request” rather than distributing them;
  • The audited financial statements were not sent to investors within 120 days of the private funds’ fiscal year ends (or 180 days for fund of funds).

Fully satisfying the conditions of the audit exemption is particularly important where advisers custody privately offered securities owned by funds. The Custody Rule provides that privately offered securities do not have to be maintained by a qualified custodian and may be maintained by advisers. However, this exception is only available with respect to privately offered securities owned by private funds or other pooled investment vehicles if the adviser fully complies with the audit exemption.

Advisers Did Not Comply With The Qualified Custodian Provision

Advisers to private funds or other pooled investment vehicles that rely on the audit exemption must still maintain the funds’ or other vehicles’ funds and securities with a qualified custodian. The Risk Alert identified several deficiencies in compliance with the qualified custodian provision of the Custody Rule. The observation most relevant to private fund advisers found that advisers did not comply with the exception, mentioned above, to the qualified custodian requirement for privately offered securities. Privately offered securities are defined narrowly for purposes of the Custody Rule as those that are acquired from an issuer in a private offering and are uncertificated; ownership is recorded only on the books of the issuer or its transfer agent in the name of the client; and the securities are transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer. The staff found that advisers held the certificates of securities (i.e., securities not qualifying as privately offered securities) in safe deposit boxes controlled by the adviser instead of with a qualified custodian.

Advisers Subject to All Requirements of The Custody Rule if Fail to Satisfy Audit Exemption

If a private fund or other pooled investment vehicle managed by an adviser does not undergo an annual audit, or if an adviser does not fully satisfy all conditions of the audit exemption because the audited financials are not GAAP compliant, the adviser must comply with all of the requirements of the Custody Rule. This means that, in addition to maintaining assets with a qualified custodian, the adviser must:

  • Have a reasonable basis for believing the client receives quarterly account statements. The adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of the adviser’s clients for which it maintains funds or securities. Such quarterly account statements must include all transactions from the account during the applicable period.
  • Undergo an annual surprise examination. Client funds and securities for which the adviser has custody must be verified at least once during each calendar year by an independent public accountant, pursuant to a written agreement between the adviser and the accountant, and conducted without prior notice to the adviser of the timing of the examination and at times that are irregular from year to year.
  • Satisfy enhanced requirements if the qualified custodian is related to the adviser. If the adviser or a related person serves as qualified custodian, the adviser must satisfy the heightened requirements of the rule related to the annual surprise examinations and the additional requirement that the adviser obtain an annual report of internal controls relating to custody of client assets.

O’Melveny & Myers is available to advise registered investment advisers and exempt reporting advisers on their compliance obligations with respect to the Advisers Act. In particular, we are able to review and identify any concerns with an adviser’s compliance with the Custody Rule. For questions or additional information regarding such regulatory obligations, please contact Heather Traeger at (202) 383-5232, Kris Easter at (202) 383-5364, or Matthew Cohen at (202) 383-5179.

O’Melveny is broadly recognized for its strength in private equity. Recent accolades include being named “Law Firm of the Year (fund formation)” in Asia by Private Equity International (PEI) for the third consecutive year (March 2013) and being named “Private Equity Team of the Year” in London at the Legal Business Awards 2013 (February 2013). O’Melveny’s Hedge Funds Practice was also recognized at the 2012 HFMWeek US Hedge Fund Services Awards in the category “Best onshore law firm—hedge fund start-ups.” Out of all the US firms, O’Melveny came in second place for advice related to hedge fund start-ups.

[1] A copy of the Risk Alert can be found at http://www.sec.gov/about/offices/ocie/custody-risk-alert.pdf  
[2] The Investor Bulletin can be found at http://www.sec.gov/investor/alerts/bulletincustody.htm
[3] For a more fulsome discussion of the OCIE Risk Alert, the OIEA Investor Bulletin and the Custody Rule, see Advisers Should Evaluate Compliance with Custody Rule Following SEC Risk Alert and Investor Bulletin.


This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Heather Traeger, an O'Melveny partner licensed to practice law in the District of Columbia and Texas, Kris Easter, an O'Melveny counsel licensed to practice law in Texas, and Matthew Cohen, an O'Melveny associate licensed to practice law in the District of Columbia and California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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