Tag: IA-2968

More Information on the Custody Rule

With the removal of the 15 client rule exemption from registration with the SEC, many private funds are going to have to comply the custody rule Rule 206(4)-2. Private equity firms will have the most problems trying to meets the demands of the rule.

The SEC is trying to help. They updated the Staff Responses to Questions About the Custody Rule.

Apparently they have been getting lots of questions about how the surprise examination should work.

Question IV.4

Q: Is there an example of a report that may be issued by the independent public accountant performing a surprise examination of the adviser?

A: Yes. As stated within the Commission’s Guidance for Accountants (see Release No. IA 2969), the surprise examination is a compliance examination to be conducted in accordance with AICPA attestation standards. The AICPA has issued an illustrative surprise examination report to reflect the reporting specified in the Guidance for Accountants. The illustrative report is available on the AICPAs website at http://www.aicpa.org/InterestAreas/AccountingAndAuditing/Resources/
AudAttest/AudAttestGuidance/DownloadableDocuments/
FINAL_Surprise_Exam_Report_File_for_AICPA_org_REVISED_7.22.10.pdf.

Additionally, the AICPA published this illustrative surprise examination report in the May 2010 edition of the Audit and Accounting Guide — Investment Companies. (Posted September 9, 2010)

Question XIII.3

Q: Within the Guidance for Accountants contained in Release IA-2969, the Commission indicated that two types of reports issued under the AICPA professional standards (Type II SAS 70 or AT 601 compliance attestation) would be sufficient to satisfy the requirements of the internal control report. Are there other report formats that can be used to satisfy the Custody Rule?

A: Yes. The AICPA recently developed a report that under AT 101, Attest Engagements, of the AICPA’s professional standards that would be acceptable under the Custody Rule. An illustrative report is currently available on the AICPA’s website at http://www.aicpa.org/
InterestAreas/AccountingAndAuditing/Community/InvestmentCompanies/
DownloadableDocuments/Custody_report_September_1final.pdf. (Posted September 9, 2010)

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Private Equity and the Custody Rule

With the impending removal of the 15 Client Rule exemption from registration with the SEC, I was scratching my head trying to figure how to make the SEC’s new custody rule work for private equity.

The SEC recently updated its guidance on custody rule compliance truing to add clarity for advisers to pooled investment vehicles.

Here is one:

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients’ funds and securities. (Posted 2003.)

Actually that does not help. A private equity fund will hold interests in private companies. Those interests may be stock, LLC interests or partnership interests.  Just because the company is private, those interests may still be securities.

For real estate private equity, the deeds to the underlying property would fall outside the custody rule. The intermediate entities, REITs and joint ventures may not fall outside the custody rule.

§ 275.206(4)-2(b)(2) has an exemption for certain privately offered securities, if the securities are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;
(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client;
and
(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

This exemption is available only if the fund is audited, and the audited financial statements are distributed, as described in paragraph (b)(4) of this section.

The “uncertificated” requirement can be a problem. It is common practice for lenders relying on private company interests to require they be certificated to get better priority under the UCC.

The limits on transfer are a problem because as the holder of the interests, you want the flexibility to transfer interests.

The financial statements requirement is another extra burden, although may not be a problem for many funds. This requires:

  • annual audit
  • in accordance with GAAP
  • within 120 days of the end of the fiscal year
  • independent accountant registered and subject to inspection by PCAOB

(I’m not sure how quickly the SEC can change this rule if the Supreme Court rules PCAOB unconstitutional.)

In looking towards Capitol Hill, the Senate’s would exempt private equity firms from having to comply with the custody rule since they would not have to register. The House’s would not exempt private equity firms from registration and they would be subject to the custody rule.

One interesting aspect of the bills is that fund advisers that are currently registered because they have more than 15 clients/funds may no longer have to be registered if they fall under the venture capital fund advisers exemption or private equity fund advisers exemption. (Assuming those exemptions survive in the final bill.)

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Image of Old West Bank – It’s a beautiful bank is by oddsock

Custody of Funds or Securities of Clients by Investment Advisers

sec-seal

The SEC released the final version of its new custody rule (.pdf). The Commissioners had announced their approval of the rule on December 17 and then released the final text on December 30. The rule goes into effect 60 days after publication in the Federal Register.

The amendments are designed to provide additional safeguards under the Advisers Act when a registered adviser has custody of client funds or securities by requiring such an adviser, among other things: to undergo an annual surprise examination by an independent public accountant to verify client assets; to have the qualified custodian maintaining client funds and securities send account statements directly to the advisory clients; and unless client assets are maintained by an independent custodian (i.e., a custodian that is not the adviser itself or a related person), to obtain, or receive from a related person, a report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board. Finally, the amended custody rule and forms will provide the Commission and the public with better information about the custodial practices of registered investment advisers.

This new custody rule is designed to catch a Madoff fraud.

The rule is limited in scope. Only SEC-registered investment advisories that control custody of their client’s assets – as Madoff did — are subject to the rule. Independent RIAs with client assets in custody with unaffiliated third parties are exempt from the final version of the rule.

The difference is that the SEC exempted investment advisers who were deemed to have custody merely because they had the authority to deduct their advisory fees from client accounts from the surprise audit requirement. The SEC also exempted pooled investment vehicles from the requirement if they have an annual GAAP audit by an independent public accountant.

Between 1,500 and 1,900 SEC-registered investment advisories provide in-house custody of securities and most of these are either broker-dealer affiliates or alternative-investment managers. This leaves well over 9,000 SEC-regulated RIAs and at least that many state-registered investment adviser firms free from the burdens of the rule. The SEC estimates the annual cost of compliance at about $8,000 a year, but TD Ameritrade estimates the cost is closer to $25,000 per year.

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