Modernized Custody Rule Adopted:  Compliance Relief for Hedge Fund Managers

October 7, 2003

Securities and Exchange Commission (“SEC”) Rule 206(4)-2, the investment adviser custody rule, is being amended to, in the words of the SEC’s final rule release, “modernize the rule by conforming the rule to modern custodial practices.” Rule 206(4)-2 (the “Rule”) currently requires an investment adviser that has custody of client funds or securities (a “Custodial Adviser”) to (i) deposit client funds in bank accounts, (ii) segregate and identify client securities and hold them in safekeeping, (iii) send quarterly statements to clients whose assets are in the adviser’s custody, and (iv) have an independent public accountant conduct an annual surprise examination of those assets to verify the accuracy of client account statements.

The key provisions of the revised Rule that will affect all registered investment advisers will:

• require Custodial Advisers to maintain both client funds and client securities with “qualified custodians,”

• clarify the circumstances under which an adviser has custody of client assets,

• eliminate a Custodial Adviser’s obligations to send each of its clients a quarterly account statement and to undergo an annual surprise examination, if the qualified custodian sends quarterly account statements directly to the adviser’s clients, including each investor in an investment limited partnership, investment limited liability company or other type of pooled investment vehicle (all of which are referred to in this Advisory as “hedge funds”),

• require accountants to notify the SEC of any material discrepancies uncovered during annual surprise examinations of Custodial Advisers, and

• eliminate the requirement that Custodial Advisers include an audited balance sheet with Part II of Form ADV.

Another key provision of particular significance relates solely to hedge fund managers.  The SEC has generally taken the position that if an investment adviser or an affiliate of an investment adviser serves as the general partner of, or otherwise holds a managing position in a hedge fund, that investment adviser is a Custodial Adviser.  Nevertheless, the amended Rule will

• exempt advisers from the quarterly account statement and surprise examination provisions of the custody Rule with respect to a hedge fund’s assets if the hedge fund is audited at least annually and the audited financial statements are delivered to all investors in the hedge fund.

This audit-based exemption from the custody rule will have the effect of eliminating the need for independent representative/gatekeeper arrangements for most advisers of hedge funds.

Qualified Custodians

Currently, the Rule requires only that client funds be maintained with a bank, but is silent with respect to client securities.  The customary practice, of course, is for advisers that have custody of client securities to place them in accounts with a broker or a bank.  Because the SEC occasionally finds that an adviser keeps certificates in an office file or in a safe deposit box, the amended Rule requires advisers to maintain both client funds and securities with a qualified custodian.  The custodial account may be in the client’s name or in the adviser’s name as agent or trustee.

“Qualified custodians” include banks supervised by state or federal banking agencies, savings associations insured by the FDIC, and registered broker-dealers.  Registered futures commission merchants are also qualified custodians with respect to futures, including security futures, that are subject to Commodity Futures Trading Commission rules and with respect to securities held by the futures commission merchant incidental to client futures transactions.  All of these institutions are examined by regulators with respect to custodial services and are required to maintain fidelity bonds to cover possible losses caused by employee dishonesty.

The amended rule also includes as qualified custodians foreign financial institutions that customarily hold financial assets for their customers and agree to hold advisory client assets in customer accounts segregated from their proprietary assets.  However, an adviser’s retention of a foreign financial institution to hold client assets will be deemed to imply that the adviser has a reasonable basis for believing that the foreign institution will provide a level of safety for client assets similar to that which would be provided by a qualified custodian in the United States unless the adviser fully discloses to clients all material risks associated with the retention of the foreign custodian.  Thus, an adviser who places client assets in the custody of a foreign financial institution will face at least some exposure to liability should the institution fail to honor its obligations with respect to the custody arrangement.

Registered advisers that are banks or broker-dealers would themselves be qualified custodians under the proposed rule and permitted to maintain custody of their own clients’ assets, subject to the statement delivery requirements described below. Advisers can also maintain client assets with affiliates that are qualified custodians.

Exceptions. The amended Rule contains exceptions for mutual fund shares and privately issued securities.  When a client or an adviser purchases mutual fund shares directly from the fund’s transfer agent instead of from a broker-dealer and the transfer agent maintains the securities for the client on the mutual fund’s books, the adviser will be permitted to use the transfer agent in lieu of a qualified custodian with respect to those shares (subject to the transfer agent’s compliance with the Rule’s requirements for qualified custodians).

Maintaining privately-offered securities in accounts with qualified custodians poses difficulties because the client’s ownership of the security is often recorded only on the books of the issuer and only the client may receive copies of the subscription or partnership agreement.  Custodial Advisers are excepted from the Rule with respect to privately-offered uncertificated securities in their clients’ accounts if (i) ownership of the securities is recorded only on the books of the issuer or its transfer agent in the name of the client and (ii) transfer of ownership is subject to prior consent of the issuer or holders of the issuer’s outstanding securities.  However, these safeguards against the kinds of abuse the rule seeks to prevent may be ineffective when the privately held securities are owned by hedge funds and the adviser or an affiliate, acting for the partnership, has apparent authority to arrange transfers that would be recognized by the issuer.  Accordingly, an adviser may use the exception for private issues with respect to the account of a hedge fund only if the limited partnership is audited annually and the audited financial statements are distributed to all its investors as described below.

Custody

To date, “custody” has been defined only in the instructions to Form ADV.  That definition is being incorporated into the Rule, along with examples that illustrate the application of the definition and include within the Rule a limited exception for advisers that inadvertently receive client assets.

As defined, an adviser has custody of client assets when it holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them.  Accordingly, an adviser is subject to the Rule not only when the adviser holds client funds and securities but also when it has access to those assets.  The SEC’s theory is that clients are at risk that their assets may be lost, misused, misappropriated, or subject to the adviser’s financial reverses in either circumstance.  If an affiliate of an investment adviser holds assets of the adviser’s clients, the adviser may have custody of those client assets if the adviser has access to those assets through the affiliate.  The examples included in the definition illustrate circumstances under which an adviser has custody of client assets.

The first example clarifies that an adviser has custody when it has any possession or control of client funds or securities, even temporarily.  However, to avoid technical violations as a result of actions by third parties, the inadvertent receipt of client funds or securities is expressly excluded from the custody definition so long as the adviser returns them to the sender within three (3) business days of receiving them.  As proposed, the amended Rule permitted only one (1) business day for the return of inadvertently received items.  The final amended Rule retains, however, the requirement that the inadvertently received assets be returned to the sender.  Advisers will not be able to forward such assets to the intended third-party recipient, despite the delays inherent in returning the assets to the sender solely to be resent to the intended recipient.  Another clarification states that an adviser’s possession of a check drawn by the client and made payable to a third party is not considered to be possession of client funds equivalent to custody.

The second example explains that an adviser has custody if it has the authority to obtain possession of client assets, such as authority to withdraw funds or securities from a client’s account.  This includes any authority (such as a power of attorney) to sign checks on a client’s behalf, to withdraw funds or securities from a client’s account, or to dispose of client assets for any purpose other than authorized trading.  An adviser authorized to deduct advisory fees or other expenses directly from a client’s account also has access to, and custody of, the client funds and securities in that account.  The SEC declined to adopt the position that access to client assets solely for the purposes of fee deductions does not constitute custody.  However, the SEC has amended Form ADV so advisors who have custody solely because they deduct fees will not need to amend their registration statements.  See, “Form ADV” below.

Many advisers have in the past received payment of their fees from the client’s custodian out of the client’s assets under an approved procedure (see, e.g., Investment Counsel Association of America, Inc. (SEC staff letter available June 9, 1992)) in which (i) the client provides written authorization permitting the adviser’s fees to be paid directly from the client’s account held by an independent custodian; (ii) the adviser simultaneously sends to the client and the custodian a bill showing the amount of the fee, the value of the client’s assets on which the fee was based, and the specific manner in which the adviser’s fee was calculated; and (iii) the custodian agrees to send to the client a statement, at least quarterly, indicating all amounts disbursed from the account, including the amount of the advisory fees paid directly to the adviser.  As a result of the adoption of the amended Rule, the entire series of letters upon which this practice arose is being withdrawn and will no longer be available.  Accordingly, investment advisers will no longer be permitted to follow this procedure in the future.

The last example clarifies that an adviser has custody if it is the legal owner of the client assets or has access to those assets.  A typical scenario involves a firm that acts both as investment adviser and as general partner or similar official of a limited partnership or other type of hedge fund.  By virtue of its position, the adviser generally has authority to dispose of funds and securities in the hedge fund’s account and thus, according to the SEC, has custody of client assets.  The same principle applies when an adviser is the trustee of a trust that is a client and when such authority is indirect, such as when an investment adviser’s affiliate serves as the general partner of a hedge fund that is a client of the adviser.

The SEC has permitted investment advisers who are, or are affiliated with, hedge fund general partners, to avoid the application of the custody rule under another approved procedure (see, e.g., Bennett Management Co. (SEC staff letter available February 26, 1990) and PIMS Inc. (SEC staff letter available October 21, 1991)).  Under a “gatekeeper” arrangement such as the ones sanctioned by those staff letters, a hedge fund general partner (or similar official) enters into a contract with an independent representative and the fund’s custodian.  The contract calls for the independent representative to review and authorize the general partner’s payments and withdrawals of funds from the hedge fund’s accounts.  The staff letters approving this procedure are also being withdrawn.  As discussed below under “Exemptions,” however, in most instances such a procedure will no longer be necessary in any event.

Delivery of Account Statements to Clients

Instead of requiring a Custodial Adviser to send quarterly account statements to clients and to engage an independent public accountant to conduct an annual surprise examination of client assets in custody as a means to deter misuse of client assets, the SEC has adopted an approach that relies on qualified custodians to provide periodic disclosure of account information.  Thus, if the qualified custodian sends quarterly account statements directly (i.e., not through the adviser) to each advisory client, even a Custodial Adviser will be exempt from the requirement to send quarterly account statements and to undergo annual surprise examinations.  The direct transmittal of statements to clients by qualified custodians is designed to prevent erroneous or unauthorized transactions or withdrawals by an adviser from going unnoticed.  Because some clients may not wish to receive custodial reports, a client can choose to have an independent representative receive account statements on his or her behalf. [1]

For competitive reasons or otherwise, some advisers do not disclose to their custodians the identities of their clients, including hedge fund investors.  Those advisers will not be able to take advantage of the new approach. If any client does not receive account statements directly from the qualified custodian, the Rule requires a Custodial Adviser to continue sending quarterly account statements to each such client and to continue to undergo the annual surprise examination.  This is not a case of retaining the status quo, however.  A new provision in the Rule will require the examining accountant to send notice of any material discrepancies found during the examination directly to the SEC’s Office of Compliance Inspections and Examinations within one (1) business day of discovery of a basis for believing that a discrepancy exists.  In addition, the accountant must file a certificate on Form ADV-E with the SEC within 120 days of the start of his surprise examination.

A special provision applicable to hedge funds requires account statements (whether delivered by the qualified custodian or the adviser) to be sent directly to the investors in the hedge fund if its investment adviser also acts as its general partner or in a similar capacity and has custody of client assets.  This is most often the case.  This special provision avoids having the adviser be the sole recipient of account statements in its capacity as general partner, trustee, [2] managing member, etc.  Thus, account statements will have to be sent directly to each hedge fund investor or to his or her independent representative.

Exemptions

Most advisers will not need to comply with the quarterly account statement and surprise examination provisions of the amended rule with respect to hedge funds if they comply with the provisions of an exemption in the Rule.  Despite the fact that they are Custodial Advisers, the only conditions hedge fund advisors will have to satisfy in order to qualify for the new exception will be to insure that the hedge fund:

• is audited at least annually,

• has its audited financial statements prepared in accordance with generally accepted accounting principles, and

• distributes its audited financials to all its investors within one hundred twenty (120) days of the end of its fiscal year. [3]

This new exception will replace the awkward and expensive independent representative/gatekeeper arrangements that were previously necessary to avoid Custodial Adviser status under staff no-action or interpretive letters such as Bennett Management Co. and PIMS, Inc.  However, since such arrangements will no longer excuse a Custodial Adviser from the account statement and surprise examination requirements, compliance with the requirements of the new exception will be critically important.

Advisers to foreign pooled investment vehicles that prepare their financial statements in accordance with International Accounting Standards or other accounting standards different from generally accepted accounting principles in the United States (“U.S. GAAP”) may use such financial statements to qualify for this exception with respect to pools organized outside the U.S. or that have a general partner or other manager with a principal place of business outside the U.S. if they contain information similar to financial statements prepared in accordance with U.S. GAAP and they include a footnote reconciling any material variations between U.S. GAAP and the accounting standards employed.  However, all pooled investment vehicles’ financial statements must be audited in accordance with U.S. generally accepted auditing standards.

Also, advisers need not comply with the amended Rule with respect to clients that are registered investment companies because they must, in any event, comply with the strict requirements of Section 17(f) of the Investment Company Act of 1940 and the custody rules adopted under that section.
Finally, because broker-dealers are already required to send confirmations and account statements to their customers, including those that are advisory clients, the exemption from the rule for advisers that are also registered broker-dealers is eliminated. Most advisers that are also registered broker-dealers should be in compliance with the new Rule as it is and face no additional burdens.

Form ADV

The existing requirement that Custodial Advisers include an audited balance sheet in their disclosure statements (“brochures”) sent to clients (ordinarily, Part II of Form ADV) is being eliminated.  In eliminating this requirement, the SEC acknowledged that a balance sheet may give an imperfect picture of the financial health of an advisory firm (e.g., many advisers have few assets) and noted that Rule 206(4)-4 already requires advisers to disclose to their clients any financial condition that is reasonably likely to impair the adviser’s ability to meet its contractual commitments to its clients.  This impairment disclosure requirement did not exist when the audited balance sheet requirement was adopted.

In addition the instruction to Item 9 of Part 1A of Form ADV is being revised.  Item 9 asks whether the adviser has custody of client funds or securities.  Many advisers who deduct their fees directly from client accounts (and, accordingly, have custody), answer “no” anyway in reliance on the Bennett Management Co. and PIMS, Inc. line of no-action letters that are being withdrawn.  Rather than compel all those advisers to revise their answers, the instructions are being revised to provide that for advisers that have custody only because they deduct fees, “no” is the correct answer.

Effective Date

The effective date of the amended Rule is November 5, 2003, and all advisers must comply with the amended rule by April 1, 2004.  Thus, by April 1, 2004, [4] every investment adviser that deducts its fees directly from a client’s account or is a Custodial Adviser for any other reason (see, “Custody” above) must (a) ensure that all client funds and securities are kept in accounts with qualified custodians and (b) either (i) establish its reasonable belief that the qualified custodians holding client assets send quarterly account statements directly to the clients or to their independent representatives, or (ii) send quarterly statements to the clients itself and undergo an annual surprise examination.

Advisers to hedge funds that are not currently subject to annual audits must ensure that each hedge fund has become obligated to undergo an annual audit and that the audited financial statements are distributed to each investor in each hedge fund within 120 days after the hedge fund’s fiscal year if the adviser intends to rely on the exception described above. Advisers to hedge funds that are already subject to an annual audit may rely on this exception beginning November 5, 2003. In most cases, the partnership or operating agreement itself will contain an annual audit requirement. However, the commitment may appear in an ongoing letter of engagement with an independent public accountant, or in the disclosure statement investors receive.

State Registered Advisers

It is unclear at this time what impact, if any, the amended Rule will have on investment advisers registered with state securities regulators rather with the SEC.

As discussed above, in many instances, Custodial Advisers will be able to reduce their burdens under the amended custody Rule.  In addition to the demise of the balance sheet requirement, by arranging for a qualified custodian (typically a bank or a broker-dealer) to send quarterly statements directly to clients, an adviser will be able to avoid an annual surprise examination. Similarly, managers of hedge funds that are audited annually and promptly distribute their audited financials to their investors will be able to do away with the cumbersome gatekeeper arrangements to which they have been subject by reason of affiliation with a registered investment adviser. As such, for many advisers the amended Rule will provide substantial compliance relief without the assumption of any significant new regulatory burdens.

[1] An “independent representative” is a person that (i) acts as agent for an advisory client and by law or contract is obligated to act in the best interest of the advisory client; (ii) does not control, is not controlled by, and is not under common control with the adviser; and (iii) does not have, and has not had within the past two years a material business relationship with the adviser.

[2] The extent to which an adviser to a trust is subject to the hedge fund provision depends upon whether the adviser acts as trustee with legal ownership of the client assets and, thus, custody of such assets.

[3] The SEC proposed to require distribution of the audited financial statements within 90 days, but extended the period to 120 days so that funds of funds will have enough time to comply.

[4] Until April 1, 2004, advisers may continue to follow the client authorization procedure for the payment of advisory fees approved in the Investment Counsel Association of America, Inc. line of letters discussed above.

For additional information on this topic, you may contact Howard A. Neuman or Carol Spawn Desmond.