I discovered some additional information about the SEC’s position on the application of the Custody Rule to the REIT subsidiaries of private real estate funds. A few months ago, a real estate fund was undergoing an SEC exam and the examiners focused on custody. The examiners used the June 2014 Guidance on SPVs to take the position that the fund must issue audited financial statements to the accommodation shareholders in the REIT subsidiaries.
I discovered that the SEC office involved in the exam was the Philadelphia office. So real estate funds in Delaware, Maryland, Pennsylvania, Virginia, West Virginia, and the District of Columbia should be especially focused on this issue.
Second, I discovered that the firm disagreed with the SEC’s position (obviously) and fought the deficiency through several rounds. Ultimately, the firm apparently decided to cede to the SEC’s position. I assume the firm decided the cost of obeying was less than the cost of fighting. Too bad.
The IM Guidance Update 2014-07 was a poorly put together document from the SEC. The key problem with the Guidance is Scenario 4 when a fund invests in another investment vehicle. Unlike the three previous scenarios in the Guidance, this clearly is not an SPV. The investment vehicle could be another fund, a joint venture or co-investment. The Guidance reaches the conclusion that the fund manager should get audited financial statements for the investment vehicle to comply with the custody rule because it is a separate advisory client.
Many people (and apparently SEC examiners) skip over footnote 10 that states that the SEC assumes that the SPVs in the four scenarios are investment advisory clients. But in many situations, that investment vehicle may not be an investment advisory client. The assumption in footnote 10 drives you directly to the conclusion in the Guidance
The Guidance also makes the mistake of stating that compliance with the Custody Rule can only be be achieved through providing audited financial statements. A fund manager can use the standard Custody Rule method of having information sent directly to investors by a third-party custodian and a surprise exam.
I don’t have the details on how that firm used REITs in its structure. The deficiency jumps right into the position that the REITs are advisory clients. But it also makes an overly broad statement:
“[T]his guidance indicates that Registrant must distribute the audited financial statements of all pass-through entities or special purpose vehicles that are controlled by Registrant or a related person and have outside investors to each such entity’s beneficial owners.”
That is not what the Custody Rule requires and it is not what the Guidance on the Custody Rule requires.
I would be interested to hear what other real estate fund managers are doing with their REIT subsidiaries for the Custody Rule. You can email me directly at my office or at [email protected].
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