Custody Rule Developments Affecting Private Funds

Philadelphia partner Josh Deringer and Chicago associate Andrew Raby published an article in The Investment Lawyer titled, “Custody Rule Developments Affecting Private Funds.”

Throughout 2013, the Securities and Exchange Commission (SEC) has emphasized time and again its increased focus on private fund managers and their compliance with SEC regulations. The SEC has also provided two significant releases this year related to SEC Rule 206(4)-2 (the Custody Rule) under the Investment Advisers Act of 1940, as amended (the Advisers Act). Managers of hedge funds, private equity funds and venture capital funds should take notice of the SEC’s recent Custody Rule guidance and prepare to demonstrate their compliance with the Custody Rule in SEC examinations.

In 2009, the SEC broadened the impact of the Custody Rule in response to several then recent investment frauds, most notably the Madoff P0nzi scheme. This revised Custody Rule increased ways an investment adviser could be deemed to have custody.

Specifically, the Custody Rule provides that an investment adviser has custody if it “holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them.” Advisers can therefore be found to have custody in situations beyond the obvious circumstances, such as where an adviser is also a broker-dealer and acts as broker-dealer for a client’s account. Private fund managers typically have custody of their fund’s assets because the Custody Rule specifically states that custody includes “any capacity that gives you or your supervised per- sons legal ownership or access to client funds or securities.” If an adviser determines that it has custody of client funds, there are several requirements under the Custody Rule.

The Custody Rule contains an exemption for “privately offered securities.” As drafted in 2009, this exemption was limited to uncertificated securities. Many private funds – primarily private equity and venture capital funds – held privately offered securities, but could not take advantage of the exemption because those privately offered securities were evidenced by stock certificates. Advisers to these private funds were therefore required to retain a qualified custodian to hold the fund’s stock certificates and other physical evidences of their investments.

Josh and Andrew conclude that while the SEC’s 2013 guidance on the Custody Rule has brought relief for some private fund advisers holding certificated private offerings, it should also cause all private fund advisers to consider whether their Custody Rule procedures are sufficient.

To view the article in The Investment Lawyer, click here.