If you are an adviser to a private fund (i.e. hedge fund or pooled investment vehicle), do you know if you are deemed to have custody? If so, is your Form ADV Part I completed correctly?
Since there is a significant increase in compliance responsibilities for firms that have custody of client funds and/or securities, it’s critical that you consider whether or not your firm will be deemed to have custody.
What is Custody?
Custody is defined in the Custody Rule as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” This is a very general, wide-ranging definition that extends beyond the standard meaning of direct control and includes authority that may be indirect and/or conditional.
Custody for Private Fund Advisers
The Custody Rule applies to private fund advisers who are registered as RIAs at the federal level and specifies a number of requirements that apply when a private fund adviser has custody of advisory client funds or securities.
While a private fund adviser generally does not directly hold client funds or securities, a private fund adviser is often deemed to have custody because: (i) it is party to an arrangement (such as an investment management agreement or advisory agreement) under which it has the authority to withdraw funds or securities from a client account (either as a general matter or to satisfy a management or performance fee payment obligation) or (ii) the adviser or a related person serves in a capacity, such as a general partner, managing member, or trustee, that gives it or its supervised persons legal ownership of or access to client funds or securities. For this purpose, pooled investment vehicles, such as private equity funds and other private investment funds, are considered to be clients of the private fund adviser, and the private fund adviser generally is deemed to have custody of the assets of those private funds.
Private fund advisers, however, need not comply with all of the requirements of the Custody Rule.
Key Requirements for Private Fund Advisers
Maintenance of Client Funds and Securities with a Qualified Custodian
All advisers, including private fund advisers, must maintain client funds and securities with a “qualified custodian” either: (i) in a separate account for each client in that client’s name or (ii) in accounts that contain only client assets and are titled in the name of the adviser as “agent” or “trustee” for the client. (Please see the Private Offering exception below.)
“Audit Exception” Requirements
If a client is a “pooled investment vehicle” and (i) it is subject to an annual audit by an independent public accountant registered with, and subject to inspection by, the Public Company Accounting Oversight Board (PCAOB); (ii) its audited financial statements are prepared in accordance with US GAAP provisions and are delivered to investors within 120 days of its fiscal year-end (funds of funds are subject to a different deadline of 180 days); and, (iii) it is subject to a final liquidation audit, with its audited financials being distributed to investors promptly after completion, then the private fund adviser is effectively exempt from complying with the notice, account statement delivery, and surprise examination requirements of the Custody Rule.
Requirements for Client Accounts of Advisers that Cannot Rely on the Audit Exception
For advisers that cannot satisfy the requirements of the audit exception with respect to certain clients (e.g., managed accounts), three additional requirements are imposed with respect to those clients:
- Notice to clients regarding accounts with qualified custodians. An adviser that opens an account with a qualified custodian on behalf of a client must provide written notification to the affected client (and to investors in any non-audit exception fund client) and include in that notice – and in any subsequent account statements sent by the adviser – a legend urging the client or investor to compare account statements received from the custodian with those sent by the adviser.
- Delivery of account statements. An adviser must have a reasonable belief, after due inquiry, that each qualified custodian is sending, at least quarterly, account statements directly to clients and investors.
- Annual surprise examination. An adviser must enter into a written agreement with an independent public accountant to conduct a surprise examination to verify client funds and securities at least once every calendar year.
Securities Obtained in a Private Offering
A private fund adviser is not required to maintain certificates evidencing securities obtained via a private offering with a qualified custodian, provided that:
- The client is a pooled investment vehicle that complies with the annual audit exception;
- The private stock certificate can only be used to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or other equity holders of the outstanding securities of the issuer (right of first refusal);
- Ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client;
- The private stock certificate contains a legend restricting transfer; and,
- The private stock certificate is appropriately safeguarded by the private fund adviser and can be replaced upon loss or destruction. Partnership agreements, subscription agreements, and LLC agreements are not certificates under this exception and the securities represented by such documents are privately offered securities provided they meet the other elements of the exception.
Partnership agreements, subscription agreements, and LLC agreements are not certificates under this exception, and the securities represented by such documents are privately offered securities provided they meet the other elements of the exception.
Exempt Reporting Adviser Requirements
It is important to note; the Custody Rule does not apply to exempt reporting advisers.
For many newly registered private fund advisers, the Custody Rule seems intimidating and overwhelming. However, the SEC views these rules as extremely important and are sure to be reviewed during a regulatory examination.