If you are an advisor to a private fund (i.e. hedge fund or pooled investment vehicle) do you know if you are deemed to have custody? If so, is your Form ADV Part I completed correctly?
According to SEC Rule 206(4)-2(c)(1)(iii), the definition of custody includes an investment advisor with “any capacity (such as a 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 you or your supervised person legal ownership of or access to client funds or securities.” In other words, if your investment advisor firm is the general partner (or similar status) of a hedge fund that it also manages, the advisor firm is deemed to have custody.
Investment advisor firms that fall under the definition of custody must meet a number of additional requirements. Under SEC Rule 206(4)-2, “it is a fraudulent, deceptive, or manipulative act, practice or course of business . . . for you to have custody of client funds or securities unless” the following are satisfied:
1. A qualified custodian maintains those funds and securities in a separate account for each client or in accounts that contain your clients’ funds and securities, under your name as agent or trustee for the clients;
2. You notify your clients in writing of the qualified custodian’s name, address, and the manner in which the funds or securities are maintained, when the account is opened and when any changes to this information occur;
3. You verify the delivery and accuracy of account statements prepared by the qualified custodian, or, if you send account statements to clients, an independent public accountant must conduct a surprise audit of those funds and securities at least once each calendar year (please keep in mind that account statements must be sent to each limited partner, member or other beneficial owner); and
4. A client may designate an independent representative to receive, on her behalf, notices and account statements.
The Rule 206(4)-2 does allow for some exceptions of “certain privately offered securities”. According to the Rule, advisors “are not required to comply with this section with respect to securities that are:
A. acquired from the issuer in a transaction or chain of transaction not involving any public offering;
B. uncertificated, and ownership thereof is recorded only on books of the issuer or its transfer agent in the name of the client; and
C. transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.
While these exceptions do provide some relief for advisors to hedge funds, they are only available if the advisor is audited at least annually and then distributes the audit findings to all limited partners, members, or beneficial owners. The audit findings must be distributed within 120 days (or 180 days in the case of an advisor to a fund of funds) of the advisor’s fiscal year end. In addition, an advisor may satisfy its obligation to deliver account information (as described under number three above) to investors by distributing the audited financial statements to investors.
Finally, advisors need to ensure their ADV Part I is completed correctly. Item 9.A. and 9.B. require advisors to disclose if they maintain custody of cash or bank accounts and securities.
For many newly registered advisor firms, the custody rules seem intimidating and overwhelming. However, the SEC views these rules as extremely important and are sure to be reviewed during a regulatory examination. If you have questions on how to meet these requirements or would like us to conduct a mock exam, please give us a call today.
Posted by Bryan Hill
Labels: Custody, Hedge Funds