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Hedge Fund SEC Custody Rule Overview

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.

Audit Requirement

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.

Other Items

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.

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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.

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Proposed Amendments to the Investment Advisers Act: SEC Requests Feedback

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The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.

Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. The amendments are summarized in the bullet points below:

Rule 206(4)-2: All registered investment advisers:

  • must have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients
  • must undergo an annual surprise audit examination by an independent accountant
  • is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services
  • must obtain or receive an annual internal control report, if the adviser also acts as a qualified custodian over client assets
  • must inform the SEC within one business day of finding any material discrepancies during an audit examination

Rule 204-2: All registered investment advisers:

  • must maintain a copy of an internal control report for five years from the end of the fiscal year in which the internal control report is finalized

Form ADV:  All registered investment advisers:

  • must report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds
  • must report the dollar amount of client assets and the number of clients of which he/she has custody
  • must identify and provide detailed information regarding the accountants that perform the audits/examinations and prepare internal control reports

Form ADV-E: All PCAOB-registered accountants:

  • must file Form ADV-E with the SEC within 120 days of the completion of the audit examination
  • must submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes details of the resignation

All comments to the proposed amendments must be received by the SEC on or before July 28, 2009.  Please contact us if you have any questions on the above proposed amendments or would like to start a hedge fund.  Additionally, we will be submitting our comments to the SEC with regard to the proposed amendments and would like to know what you think as well – please comment below.

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For further information regarding the proposed amendments, please refer to the more detailed abstract below.  The full text of the proposed rules can be found here.

SEC Proposed Custody Amendments Abstract

The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms, with the intent to enhance the protections afforded to clients’ assets under the Advisers Act when an advisor has custody of client funds or securities. These amendments are proposed as a response to a number of recent enforcement actions against investment advisors alleging fraudulent conduct, including misappropriation or other misuse of investor assets.  Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.

Rule 206(4)-2, also known as the ‘custody rule’, seeks to protect clients’ funds and securities in the custody of registered advisers from misuse or misappropriation by requiring advisers to implement certain controls. The current rule requires registered advisers to maintain their clients’ assets in separate identifiable accounts with a qualified custodian, such as a broker-dealer or bank. Presently, advisors may comply with the rule by either a) having a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients or alternatively b) the advisor sending his/her own quarterly account statements to clients and undergoing an annual surprise audit examination by an independent public accountant. Similarly, an adviser to a pooled investment vehicle may currently comply with the rule by having the pool audited annually by an independent public accountant and distributing the audited financials to the investors in the pool within 120 days of the end of the pool’s fiscal year.

The proposed amendments to Rule 206(4)-2 aim to codify both of the above mentioned compliance alternatives by requiring  that all registered advisers having custody of client assets must a) have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients and b) undergo an annual surprise examination.  The amendments also explicitly state that an adviser is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services. The SEC additionally proposes that if an independent qualified custodian does maintain client assets, but rather the advisor or a related person him/herself serves as a qualified custodian for the client, then the advisor must obtain or receive from the related person an annual internal control report which would include a) an opinion from an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB), and b) a description of the relevant controls in place relating to custodial services and the objectives of these controls, as well as  the accountant’s tests of operating effectiveness and the test results. Lastly, the newly amended rule would also require the adviser and the accountant to inform the SEC within one business day of finding any material discrepancies during an examination that may assist in protecting advisory client assets. Together, these revisions to Rule 206(4)-2 are designed to strengthen the controls relating to the advisors’ custody of client assets and deter advisors from fraudulent activity.

Rule 204-2, governing record maintenance, presently requires that investment advisors obtain or receive a copy of an internal control report from its related person.  The proposed amendment to this rule would additionally require the advisor to maintain the copy for five years from the end of the fiscal year in which the internal control report is finalized. This amendment to Rule 204-2 is designed to further implement safeguards to protect clients’ assets and offset custody-related risks.

Form ADV, which outlines the data to be reported to the SEC by investment advisors, has also been amended to provide the SEC with additional data and more complete information from the perspective of the advisor. Currently, Item 7 of Part1A requires advisers to report on Schedule D of Form ADV each related person that is an investment adviser, and permits advisers to report the names of related person broker-dealers.  The new amendment modifies Item 7 to require an advisor to report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds. Similarly, Item 9 of Part1A currently requires advisers to report whether they or a related person have custody of client funds. The new amendment to Item 9 requires an adviser to report the dollar amount of client assets and the number of clients of which he/she has custody. Other reporting duties to be implemented under the new amendments include: a) whether a qualified custodian sends quarterly account statements to investors in pooled investment vehicles managed by the adviser, b) whether these account statements are audited, c) whether the adviser’s clients’ funds  are subject to a surprise examination and the month in which the last examination commenced, and d) whether an independent PCAOB-registered accountant prepare an internal control report when the adviser is also acting as a qualified custodian for the clients’ funds. Schedule D of Form ADV would also be amended to require additional reporting duties of the adviser, including: a) identifying the accountants that perform the audits/examinations and prepare internal control reports, b) providing information about the accountants including address, PCAOB registration, and inspection status, c) indicating the type of engagement (audit, examination, or internal control report), and d) indicating whether the accountant’s report was unqualified.  These proposed amendments to Form ADV are designed to allow the SEC to better monitor compliance with the requirements of Rules 206(4)-2 and 204-2 and better assess the compliance risks of an adviser.

Form ADV-E, which outlines the data to be reported to the SEC by designated accountants, has also been amended to provide the SEC with additional data and more complete information to the SEC from the perspective of the accountant. Currently, the rule requires this form to be filed within 30 days of the completion of the examination, accompanied by a certificate confirming that the accountant completed an examination of the funds and describing the nature and extent of the examination. The SEC proposes to amend this rule governing Forms ADV and ADV-E to extend the grace period within which the forms must be submitted to a period of 120 days from the time of the examination. Based on SEC observations, an adviser’s surprise examination may sometimes continue for an extended period of time, warranting this extension. Additionally, the amendment requires that the accountant submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes a) the date of such resignation, dismissal or termination, b) the accountant’s name, address and contact information, and c) an explanation of any problems relating to examination scope or procedure that contributed to such resignation, dismissal or termination. This proposed amendment to Form ADV-E is designed to provide the SEC with the information necessary to further evaluate the need for an examination to determine whether the clients’ assets are at risk.

The SEC strongly urges investment advisors, public auditors/accountants, and related professionals in the field of securities and investments to review the proposed amendments to the Advisers Act and submit relevant feedback that may assist the Commission in analyzing the effectiveness, efficiency, and feasibility of the proposed amendments as well as the possible impact of these new legislative measures on the global marketplace. While all proposed amendments are designed to provide additional safeguards to client funds or securities under adviser custody, the potential ramifications of their enforcement is currently being assessed. Comments may be submitted in electronically via the Commission’s internet comment form (http://www.sec.gov/rules/proposed.shtml), via e-mail to [email protected], or via the Federal eRulemaking Portal (http:/www.regulations.gov). Paper comments can be sent in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. All comments to the proposed amendments must be received by the SEC on or before July 28, 2009.  All submissions must refer to File Number S7-09-09, and will be made available to the public via the Commission’s Internet Website: http://www.sec.gov/rule/proposed.shtml.