The SEC’s Division of Investment Management recently released new guidance for private fund advisers regarding Custody Rule 206(4)-2 of the Advisers Act. This new guidance should come as a relief to the private fund industry.
Rule 206(4)-(2)(b)(2) is an exemption for private funds from maintaining the services of a qualified custodian for certain private fund securities if special conditions are met, one of which is that the securities be uncertificated. However, many private fund transactions, particularly private equity transactions, result in the issuance of paper stock certificates. In order to abide by the Custody Rule, private equity managers send the paper certificates to a qualified custodian for safekeeping.
The new guidance issued by the SEC will now allow paper stock certificates issued in private offering transactions to be exempt under Rule 206(4)-(2)(b)(2). This means that the paper stock certificates do NOT need to be held at a qualified custodian. Of course, certain conditions must be met and they include:
- The client (holding the certificate) is a pooled investment vehicle subject to the audit requirements under the Custody Rule
- Any transfer of ownership of the stock certificate must be done via prior consent of the issuer or holders of the outstanding securities of the issuer
- Ownership of the security must be recorded on the books of the issuer or its transfer agent- in the name of the client
- Certificates must contain a legend that restricts the transfer of ownership
- Certificates must be properly held by the adviser for safekeeping and must be replaceable if lost, stolen, destroyed, etc.
Another important consideration: if private fund advisers wish to continue holding the certificates at a qualified custodian, they must abide by the full Custody Rule. The important Rule requirements related to this issue are:
- The qualified custodian must maintain the certificates in a separate account for each fund/client under that fund/client’s name or in an account containing only the named client’s funds/securities and under the adviser’s name as trustee/agent. This means that certificates of one fund may not be commingled with certificates of another fund in the same fund custodial account.
- The qualified custodian must send out quarterly account statements to each client/fund verifying the certificates held.
Any private fund adviser that does not abide by the Custody Rule could find itself in violation of the Rule. This is a hot topic area for SEC examiners so the SEC will likely maintain its focus on custody issues when reviewing private fund advisers. In addition, dually registered advisers and advisers with affiliated broker-dealers that serve as custodians should be aware of the commingling considerations and make sure all custodial accounts are properly structured.