New Guidance on the Custody Rule for SPVs and Escrows

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The Securities and Exchange Commission’s Division of Investment Management recently released updated guidance on the Custody Rule. Private funds, especially private equity funds, have been wrestling with the SEC’s Custody Rule. The rule clearly comes from the perspective of regulating retail investment advisers and hedge funds. It fails to deali n a useful manner with investments in assets that are not publicly traded. The SEC has been retreating from its latest version of the rule and trying to clarify its overly broad requirements.

The latest guidance (IM Guidance Update 2014-07) tries to add some clarity around the special purpose vehicles for investments and post-closing escrow accounts.

Last summer, the SEC tried to provide some clarity under the Custody Rule for private stock certificates, which was supposed to provide additional relief from the SEC’s overly narrow definition of “privately offered securities.” That guidance made it easier for private equity funds to comply with the Custody Rule without having to wastefully warehouse documents with banks to meet the strict boundaries of the rule.

But there is still lots of uncertainty around the Custody Rule. Compliance with custody is important. It’s a key control for consumers to make sure that their investment adviser is not stealing their money or investing it contrary to their requirements. Last year, the SEC announced that 1/3 of firms examined had custody rule problems.

For a private funds the question will arise as to who is the client for purposes of the Custody Rule when it comes to special purpose vehicles for investments. The new guidance answers questions using four scenarios where SPVs may be involved as fund subsidiaries.

The guidance provides that its okay to not treat the SPV as a separate client, but merely as an asset of the fund, as long as the fund or funds controlled by the same adviser are the owners of the SPV. The SEC states that an SPV owned by the fund and third parties would fall outside this. I’m a bit confused because I never thought an entity with multiple unrelated owners would be considered an SPV.

The guidance also tackles post-closing escrow accounts. The concern is that the escrow account would hold cash owed to the fund, as well as other sellers not related to the fund. The problem is that the Custody Rule requires the client’s assets to be in an account in the client’s name and contain only the client’s funds or securities. A mixed post-closing escrow would violate the rule.

In the Guidance, the SEC retreats from commingling requirement so long as:

the fund is audited
the commingled escrow is in connection with sale or merger of a portfolio company
the escrow is maintained by a qualified custodian

The Guidance fixes some problems and creates some more. The rule clearly states that commingling is never allowed. The guidance now says that commingling is allowed in certain circumstances. Good luck reading the published regulations.

The SEC has just laid down the law on how post-closing escrows are handled in private equity transactions. I can hear the screams now that the Guidance does not match up with how the deals are structured or how the escrow is designed. Of course for real estate fund managers, they are left scratching their heads trying to figure out how to make this exception work for them.

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