SEC Takes a Tough Stance on the Hedge Fund Exception to the Investment Adviser Custody Rule

December 19, 2005

On December 8, 2005, the Securities and Exchange Commission (“SEC”) issued a no-action letter interpreting Rule 206(4)-2 under the Investment Advisers Act, (known as the investment adviser custody rule), in a manner that will require many more hedge fund investment advisers to comply with the quarterly account statement and surprise examination provisions of the Rule with respect to a hedge fund’s assets.

Rule 206(4)-2 was amended in 2003, in the words of the SEC’s final rule release, to “modernize the rule by conforming the rule to modern custodial practices” (see our Hedge Fund and Investment Managers Advisory dated October 7, 2003).  Among the key provisions of the revised Rule 206(4)-2 was a change that made it possible for an investment adviser previously deemed to have custody of a hedge fund’s assets because the investment adviser or an affiliate of the investment adviser serves as the general partner of a hedge fund (or in a similar capacity), to treat itself as a non-custodial adviser.  An adviser deemed to be in custody of a client’s assets must send its clients quarterly account statements and undergo an annual surprise custody examination.  The ability to eliminate these obligations with respect to clients that are investment limited partnerships or limited liability companies or other types of pooled investment vehicles (collectively, “hedge funds”), is available to hedge funds fulfilling certain criteria that are audited at least annually and whose audited financial statements are delivered to all investors in the hedge fund. Among the requirements imposed on investment advisers to domestic hedge funds seeking to rely on this provision was a requirement that all such financial statements be prepared in accordance with U.S. generally accepted accounting principles (“GAAP”).

Since the American Institute of Certified Public Accountants issued Statement of Procedure (“SOP”) 98-5, the previously traditional practice of capitalizing and amortizing start-up costs (typically over five years) was replaced by a requirement that the full amount of these costs be treated as an expense item in the period in which they are incurred (see our Hedge Fund and Investment Managers Advisory dated July 27, 1998).  However, it remained customary for a hedge fund adviser to amortize the start-up costs advanced by the adviser in connection with a fund’s launch.  This spares investors the expense of repaying all of those costs in the first year of operations and benefits the adviser by keeping more investment capital in the fund.  Audit opinions for these funds will generally include a footnote to indicate this fact.  Thus, hedge funds that amortize these costs are not fully in compliance with GAAP. 

Recently, the Chair and Vice Chair of the Subcommittee on Private Investment Entities of the American Bar Association’s Section of Business Law wrote to the SEC’s Division of Investment Management asking for, among other things, assurance that a hedge fund adviser could still qualify for the exception despite this fairly common deviation from GAAP found in hedge fund financial statements.  The Division refused to provide such assurance.  As a result, investment advisers of hedge funds that amortize their start-up costs will have to comply with the quarterly account statement and surprise examination provisions of Rule 206(4)-2 with respect to a hedge fund’s assets. 

For additional information regarding Rule 206(4)-2, see our Hedge Fund and Investment Managers Advisory dated October 7, 2003, entitled “Modernized Custody Rule Adopted: Compliance Relief for Hedge Fund Managers” and our Hedge Fund and Investment Managers Advisory dated May 24, 2004, entitled “More About Account Statements Under the SEC’s New Custody Rule,” both of which may be found at http://www.ssbb.com or you may contact Howard A. Neuman or Carol Spawn Desmond.