A friend in the private fund compliance community just came up with another “gotcha” under the Custody Rule. His client used an auditor that was registered with PCAOB, but had not yet been inspected. He thought it was enough to be registered, while waiting for an inspection. An SEC examiner argued that the auditor needed to be inspected.
It turns out, neither one was right.
He and the examiner took a deep dive into the meaning of “subject to inspection” regarding the custody rule. Even thought the SEC used “subject to inspection” in the Custody Rule, it is not defined anywhere by the SEC. It turns out it was up to PCAOB to define “subject to inspection” in the PCAOB rules.
PCAOB says that you are an “inspected firm” if you have audited at least one issuer of public securities. Otherwise, PCAOB does not inspect that auditor. It is outside it’s statutory authority.
“The Sarbanes-Oxley Act authorizes the PCAOB to inspect registered firms for the purpose of assessing compliance with certain laws, rules, and professional standards in connection with a firm’s audit work for clients that are “issuers,” as that term is defined in the Act,* and (following amendments to the Act in 2010) a firm’s audit work for clients that are securities brokers or dealers. Many PCAOB-registered firms perform no such work, and the work they do perform is not within the scope of the PCAOB’s statutory responsibility and authority to assess. The PCAOB does not inspect those firms.”
The SEC takes that to mean that they are not therefore “subject to regular inspection”.
This is terrible result for private fund managers.
You can search for registered auditors on the PCAOB website. It shows the firm’s registration and which of the five categories the firm falls under. You need an “A” to see that the firm has audited at least one public company. A “C” audit of a broker-dealer will also work. It looks like a “B”, “D”, or “E” will be a problem.
This dovetails into the other technical issue I noted in the Custody Rule regarding “independence.” That definition also refers to the public company reporting side under Regulation S-X. That standard of independence is higher than the independence standard contractually required by investors under fund documents.
Unfortunately, this is a cautionary tale for a fund manager using a smaller auditor. The firm may be registered with PCAOB, but if its practice does not include public companies or broker/dealers, the firm may not meet the standards of the Custody Rule for audited financial statements. Check the PCAOB website.