Compliance Requirements of the SEC Custody Rule
Hedge fund managers are preparing to register as investment advisers with the SEC pursuant to the new Dodd-Frank registration requirements. One of the issues which managers will be dealing with during that process is the hedge fund custody rule (Rule 206(4)-2 under the Investment Advisers Act). In general this means that the SEC registered fund manager will need make sure that the fund (1) maintains its assets with a qualified custodian and (2) has an annual audit by a PCAOB Registered and Inspected audit firm.
Hedge Fund Managers Generally Have Custody
The requirements of the SEC Custody Rule are triggered when an investment adviser has “custody.” A fund manager is deemed to have “custody” of the fund's assets when it, or a related person, directly or indirectly has authority to obtain possession of” the fund's assets. The Rule specifically indicates that custody includes any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives the investment adviser or a related person “legal ownership of or access to client funds or securities.”
Because hedge funds are generally structured so that the manager or a related entity serves as the general partner, hedge fund managers will generally be deemed to have custody under the Rule. Managers who also provide advice through separate accounts would not be considered to have custody of those separate accounts unless they have authority to automatically deduct fees from the account (or have custody for some other reason). If a manager is deemed to have custody, the manager will generally need to follow certain safe-keeping requirements.
Qualified Custodian Requirement
The first safe-keeping requirement of the Rule is that a fund's cash and securities must be maintained at a qualified custodian in “a separate account for each [fund] under that [fund’s] name” or in an account under the name of the fund manager as agent for the fund. Under the Rule, “qualified custodians” include banks, registered broker-dealers, registered futures commission merchants, and foreign financial institutions that customarily hold financial assets for their customers. Hedge fund managers generally satisfy the qualified custodian requirement by holding funds’ cash and securities at a prime broker or other broker-dealer.
Managers of hedge funds are exempt from the Rule’s other safe-keeping requirements (or are deemed to comply with those requirements) if the fund has its financial statements audited annually and upon liquidation. The audited financial statements must be prepared in accordance with generally accepted accounting principles (GAAP) and the audit must be conducted by an “independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board [(PCAOB)] in accordance with its rules.” Care should be taken to ensure that any audit firm engaged by a fund is subject to regular inspection by the PCAOB.
The annually audited financial statements must be delivered to all limited partners within 120 days of the end of” a fund’s fiscal year.
Alternative to the Annual Audit Requirement
If a hedge fund manager does not qualify for the exemptions from other safe-keeping requirements by conducting an annual fund audit as discussed above, the other provisions to the Rule require that the manager to: (1) instruct the fund's qualified custodian(s) to send quarterly account statements directly to each limited partner, and (2) engage an independent public accountant to conduct an actual “surprise” examination of the funds’ cash and securities and file Form ADV-E with the SEC.
Because most funds will have an annual audit, the surprise examination alternative is rare.
Responses to Form ADV Questions Regarding Custody
In addition to satisfying the safe-keeping requirements of the Rule, hedge fund managers must make certain disclosures regarding custody on their Form ADV. Form ADV Part 1, Item 9.A requires managers to disclose the amount of funds and securities for which they have custody and Item 9.B requires the same disclosure for related persons of the manager. Additionally, Item 9.C requires managers to indicate whether they have engaged an accountant to conduct an annual audit of funds’ financial statements (and whether the managers use other means of satisfying the Rule’s safety requirements). The name and contact information of the accountant so engaged must be provided in Form ADV Schedule D, Section 9.C. Information provided on Form ADV Part 1, Item 9 (except the amount of funds and securities and number of clients for which the manager has custody) is considered material and must be updated promptly whenever there is a change.
Item 15 of Form ADV Part 2 (the Brochure) requires additional disclosures for those managers who have instructed qualified custodians to send account statements directly to the investors.
For most fund managers who will be going through the SEC registration process, complying with the custody rule will be a straight forward exercise. State-registered investment advisers are subject to the various custody rules of the states in which they are registered.
For more information, please also see SEC Responses to Custody Rule Questions.
Cole-Frieman & Mallon LLP provides investment adviser registration and compliance support to hedge fund managers. Bart Mallon can be reached directly at 415-868-5345. Karl Cole-Frieman can be reached at 415-352-2300.