Unusual SEC Case Proves Point

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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