Jack Katz (Global Leader; National Managing Partner, Financial Services ), Michael C. Patanella (National Asset Management Sector Leader, Audit Partner)
Oct. 30, 2013
Asset ManagementAdviser newsletter
New guidance from the SEC staff should help investment advisers of private equity and hedge funds keep costs down by reducing custodial expense for client securities. Under an IM Guidance Update from the commission’s Division of Investment Management, advisers are allowed to safeguard certain certificated, privately offered securities themselves, rather than pay financial institutions to do so.
The privately offered securities exemption
According to Rule 206(4)-2 of the Investment Advisers Act of 1940, known as the Custody Rule, advisers have to keep client cash and securities with “qualified custodians,” like banks and broker-dealers. But there is an exemption for “privately offered securities” when the fund client is a pooled investment vehicle (private equity, hedge fund) subject to audit under paragraph (b)(4) of the rule.1 Under the exemption, advisers can maintain these assets themselves if they are:
- securities acquired from an issuer in a transaction, or series of transactions, that does not involve a public offering;
- are uncertificated; and
- are transferable only with the prior consent of the issuer or the holders of the outstanding securities of the issuer.
Until now, nontransferable stock certificates or “certificated” LLC interests obtained in a private placement were not exempt from having to obtain a qualified custodian.
|Under the new guidance, the SEC will “not object if an adviser does not maintain private stock certificates with a qualified custodian."
According to the update, such “private stock certificates” will now be included under this definition if they meet the conditions listed in the Qualifying Conditions section below. They can therefore be maintained by advisers, reducing the substantial costs of asset custody that are ultimately borne by hedge fund and private equity investors. The SEC staff also stated that partnership, subscription and LLC agreements are not certificates, and the securities represented by these documents are privately offered securities if they meet the requirements of the exception.
The SEC staff’s reasoning
In expanding the exclusion to private stock certificates, SEC staff considered the following arguments made by advisers:
- The assets are similar in all material respects to a privately offered security, because the client’s ownership interest in the security is not affected by the existence (or lack thereof) of the certificate.
- Ownership of the securities is recorded on the books of the issuer or its transfer agent in the name of the pooled investment vehicle. The certificate cannot be used to effect a change in beneficial ownership of the security for which the private stock
certificate is issued.
- A private stock certificate can be replaced by the issuer if it’s lost or destroyed because ownership is recorded on the books of the issuer.
- Beyond the substantial investor protections provided by the financial statement audits, maintaining private stock certificates at a qualified custodian does not provide meaningful protection to investors in pooled investment vehicles.
- An auditor conducting an audit of a pooled investment vehicle’s financial statements in accordance with GAAP performs substantive procedures to verify the existence of the pool’s investments, including securities that are privately issued, regardless of whether the private stock certificates are held at a qualified custodian.
- Maintaining private stock certificates at a qualified custodian can add substantial costs, which are typically borne by investors in pooled investment vehicles as an expense paid by such vehicle.
Under the new guidance, the SEC will “not object if an adviser does not maintain private stock certificates with a qualified custodian,” provided:
- the client is a pooled investment vehicle that is subject to a financial statement audit in accordance with (b)(4) of the Custody Rule,
- the private stock certificate can only be used to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer,
- ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client, \
- the private stock certificate contains a legend restricting transfer, and
- the private stock certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.
Finally, it should be noted that an IM Guidance Update is not a rule, regulation or statement of the commission, and the commission has neither approved nor disapproved of it. If you have any questions about the update, please contact our professionals.
Download the full PDF.
1 The audit requirements are:
- the audited financial statements are prepared in accordance with U.S. GAAP;
- the audit occurs at least annually and the fund distributes its audited financial statements within 120 days of the end of its fiscal year;
- the audit is performed by an independent public accountant that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board; and
- the fund is subject to an audit upon liquidation.