As a result of the Dodd-Frank Act, since 2012 investment advisers that operate pooled investment vehicles such as hedge funds and private equity funds with $150 million of assets under management became subject to the Investment Advisers Act of 1940 (the Act).1 An investment adviser that is required to register under the Act (RIA) becomes subject to the Act’s full panoply of rules, many of which are geared toward protecting clients’ highly liquid and easily transferable investments.
By failing to distinguish between hedge funds and private equity funds, the Dodd-Frank Act used a cleaver instead of a scalpel. Hedge funds engage in active trading of highly liquid publicly traded securities, which may involve hundreds of trades in any given month, have significant implications for the entire securities market and make it difficult for the SEC to recover assets in the event of fraud. On the other hand, private equity funds acquire controlling positions in a handful of privately held businesses whose securities do not trade. A private equity fund’s principal assets may be a dozen stock certificates, each representing a controlling interest in a privately held business and gathering dust in a safe deposit box for five or more years. Many of the Act’s rules impose costly burdens that, where the primary assets involved are illiquid investments, do not provide meaningful protection. The Custody Rule is one such rule.
An RIA that invests in private equity (Private Equity RIA) essentially has two kinds of clients: pooled investment vehicles such as a fund, and separately managed accounts for its clients with added leverage due to the amount of funds they invest. Separately managed accounts are often able to dictate more favorable investment terms than pooled investment funds can, including the safeguards to be employed to protect their investments. Pooled investment vehicles and separately managed accounts of a Private Equity RIA often invest together to acquire private businesses.
The Custody Rule
The Custody Rule was promulgated in 1962 to protect against an RIA’s misuse or misappropriation of a client’s assets by segregating and safeguarding the funds and securities over which an RIA had “custody” so that they would be “insulated from and not be jeopardized by financial reverses, including insolvency,” of the RIA.2
“Custody” is defined as the “holding, directly or indirectly, client funds or securities, or having the authority to obtain possession of them.” If an RIA has the authority to transfer its client’s funds or securities to a party other than its client, whether or not the exercise of that authority would be proper, the RIA has custody over those assets.
Since Private Equity RIAs and their affiliates serve as the general partners of their affiliated pooled investment funds, they possess the power to obtain access to and control the disposition and delivery of the cash and the securities of their fund clients and thereby have custody. In addition, Private Equity RIAs often have “discretionary authority” over their separately managed accounts, enabling them to obtain access to and control over the disposition and delivery of the clients’ separately managed funds and securities and thereby have custody.
The Custody Rule currently requires (1) the funds and securities over which an RIA has custody to be maintained in segregated and identified accounts (Segregation) by a “qualified custodian,” which is a bank or broker-dealer and certain other extensively regulated entities (Qualified Custodian); (2) that the RIA notify the client in writing of the name and address and other identifying information about the qualified custodian and any subsequent changes to any identifying information (and if the RIA sends account statements to the client, advise the client to reconcile those statements with the statements provided by the qualified custodian) (Notice); (3) that the RIA have reasonable basis, after due inquiry, for believing that the qualified custodian sends to the clients at least quarterly a statement with period-end positions and a listing of all transactions occurring during the period (Quarterly Statements); and (4) an annual surprise examination of the custodied funds and securities, done by an independent accountant (Annual Surprise Exam), who is then required to file a Form ADV-E with the SEC.3
Where a pooled investment vehicle, such as a private equity fund, provides its investors annual audited financial statements prepared in accordance with generally accepted accounting principles that have been prepared by an independent public accountant registered with Public Company Accounting Oversight Board (PCAOB) within 120 days of each of its fiscal year-ends, the RIA will be exempt from the requirements of the Custody Rule other than the segregation of the custodied assets and the use of a qualified custodian.4
Since the securities over which a Private Equity RIA maintains custody for its pooled investment funds and separately managed accounts are few in number, are held for many years and cannot be traded, it is difficult to see the benefit of requiring those securities to be held by a qualified custodian.
No Qualified Custodian Required for Uncertificated Private Securities
Furthermore, the Custody Rule contains a specific exemption from the qualified custodian requirement for privately placed securities that are not represented by physical stock certificates and that can be transferred only with the prior consent of the issuer or the holders of the outstanding securities (Uncertificated Private Securities).5 However, most private equity transactions involve the issuance of certificated securities.
No Qualified Custodian Required for Certificated Private Securities
In 2013 the SEC’s Division of Investment Management issued a Guidance Update (No. 2013-04 August 2013) permitting certificated private securities not to be custodied with a qualified custodian if (1) the client is a pooled investment vehicle that complies with the audit exception, (2) the prior consent of the issuer or its other holders is required to transfer ownership, (3) ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client, (4) the private stock certificate contains a restricted legend, and (5) the private stock certificate is appropriately safeguarded by the RIA and can be replaced upon loss or destruction (Certificated Private Securities). It is not clear why the SEC did not extend this relief to other clients of an RIA, such as a managed account. As a result, separately managed accounts of an RIA are not required to have a qualified custodian maintain uncertificated private securities but are required to have a qualified custodian maintain custody of certificated private securities.
Since the underlying premise for providing relief from the Custody Rule is that uncertificated private securities and certificated private securities cannot be easily transferred, protecting a Private Equity RIA’s clients—whether a pooled fund or a separately managed account—from the financial reverses, including insolvency of the Private Equity RIA, could be accomplished if all illiquid securities—whether certificated or uncertificated—were segregated and subject to an annual surprise examination by an independent accountant registered with PCAOB—whether or not the surprise examination was performed as part of a full audit.
Key Takeaways
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Private Equity RIAs should review their arrangements with their separately managed accounts and, if necessary, restructure the arrangement so that the Private Equity RIA does not maintain custody of their clients’ funds and securities. This can be accomplished by requiring an officer of the separately managed account to authorize the delivery of its funds and investment securities.
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Where a Private Equity RIA has custody over the investment securities of its separately managed accounts, the Private Equity RIA should consider holding those investment securities in uncertificated form.
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Instead of piecemeal remedies, the Private Equity community should lobby the SEC to make changes to the Custody Rule to better reflect the realities of the private equity business.
1 This is because the Dodd-Frank Act eliminated the “private adviser exemption,” which had been available to advisers that had fewer than 15 clients, with each pooled investment vehicle counting as a single client, and kept them from having to register under the Act.
2 Investment Advisers Act Release No. 123 (Feb. 27, 1962), 27 FR 2149 (Mar. 6, 1962).
3 If the qualified custodian is related to the RIA, the independent accountant performing the annual surprise examination must be registered with the Public Company Accounting Oversight Board, and the RIA must obtain an annual written internal control report of the related qualified custodian prepared by an independent public accountant who must also reconcile the funds and securities to a custodian other than the RIA or its related persons.
4 Most partnership agreements of pooled investment vehicles require their limited partner investors to be provided annual audited financial statements. Among the procedures performed by an independent accountant in auditing financial statements of a private equity fund is a surprise examination or third-party verification of the custodied assets.
5 In such a case, since a qualified custodian would not be required, it would follow that the notice and quarterly statement requirement would also not apply and the Custody Rule would require only segregation and an annual surprise exam.
