Last week the SEC announced an enforcement action against a mutual fund manager. That was not the unusual part. What makes this case unique was that this money manager was a small alternative manager of open alt-funds specializing in merger arbitrage. Also, the case was mainly about custody rule violations. It is rare indeed to see mutual funds violate the custody rule. Rule 17f-5 of the Investment Company Act is rather clear, especially for domestic funds with no sub-advisers.
So, how could a firm trip this up? In this case, the fund was holding its cash collateral for swap transactions with registered broker-dealers (oops). This may be okay in the Reg D, private fund world which is allowed to follow Rule 206(4)-2 (Advisers Act) for registered advisers, but its not okay for registered mutual funds. A registered fund must follow Rule 17f-5 of the Investment Company Act which has a specific clarification regarding the definition of a qualified custodian. A qualified custodian for a registered fund may be a bank and only a bank – no broker-dealers allowed.
So, what’s the lesson here? Make sure you know which rules apply to you and when.
View the SEC Administrative Proceeding
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