Articles Tagged with Custody

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While acknowledging the challenges in applying the securities laws to digital assets, the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA), in a joint statement on July 8, 2019, reaffirm that those rules equally apply to digital assets, and promise they will continue to engage the industry in finding solutions.

Read the full public statement HERE.

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On October 29, 2014, the Securities and Exchange Commission (“SEC”) announced an administrative enforcement action against an investment advisory firm and three top officials for violating rule 206(4)-2 under the Investment Advisers Act of 1940 (“Advisers Act”), the “custody rule,” that requires firms to follow certain procedures when they control or have (or are deemed to have) access to client money or securities.  This enforcement action follows closely on the heels of statements by SEC officials indicating that violations of the custody rule were a recurring theme during the “presence exams” of private equity fund advisers and other first time investment adviser registrants that have been conducted by the SEC staff over the last year and a half.

Advisory firms with custody of private fund assets can comply with the custody rule by distributing audited financial statements to fund investors within 120 days of the end of the fiscal year.  This provides investors with regular independent verification of their assets as a safeguard against misuse or theft.  The SEC’s Enforcement Division alleges that Sands Brothers Asset Management LLC has been repeatedly late in providing investors with audited financial statements of its private funds, and the firm’s co-founders along with its chief compliance officer and chief operating officer were responsible for the firm’s failures to comply with the custody rule.  As investment adviser registrants are painfully aware, chief compliance officers have personal liability for compliance failures under Advisers Act rule 206(4)-7.  This particular enforcement action was brought pursuant to section 203(f) of and rule 206(4)-2 under the Advisers Act.  It remains to be seen whether the SEC will bring a separate action against the Sands Brothers’ chief compliance officer under rule 206(4)-7.

Also nervously awaiting any further action by the SEC would be the accountants and lawyers that advised the Sands Brothers and their hedge funds with respect to the custody matter.  The accounting firm or firms that conducted the audit of the Sands Brothers hedge funds likely knew that the funds did not meet the requirements of the custody rule.  It is less certain whether the external lawyers knew or should have known about these violations.  However, if either the accountants or lawyers knew of these violations and advised that they were only technical in nature and immaterial or  unimportant, the SEC could take separate administrative action pursuant to SEC rule 102(e) to bar any such party from practicing before the SEC.  We previously wrote about the more aggressive posture that the SEC signaled with respect to service providers, specifically lawyers that assist or “aid and abet” violations of the securities laws.  The SEC has a fairly high standard to meet when bringing these types of cases, but that has not deterred the regulator from aggressively pursuing more accountants and lawyers in recent months.

According to the SEC’s order instituting the administrative proceeding, Sands Brothers was at least 40 days late in distributing audited financial statements to investors in 10 private funds for fiscal year 2010.  The next year, audited financial statements for those same funds were delivered anywhere from six months to eight months late.  The same materials for fiscal year 2012 were distributed to investors approximately three months late.  According to the SEC’s order, Sands Brothers and the two co-founders were previously sanctioned by the SEC in 2010 for custody rule violations.

If you have been late on the delivery of your audited financial statements and have not availed yourself of the “surprise audit” provision of the custody rule, or if you manage “side car” funds that have never been audited, you should immediately get in touch with your Pillsbury attorney contact.

 

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Written by: Ildiko Duckor

The California Commissioner of Business Oversight (“Commissioner”) recently amended California’s custody rule 10 C.C.R. Section 260.237 (the “New Custody Rule”).  The New Custody Rule will be effective on April 1, 2014.

All investment advisers licensed or required to be licensed in California must comply with the New Custody Rule.  California Exempt Reporting Advisers are not affected.

What is “having custody?”

Holding or having authority to obtain possession of client funds or securities, for example:

  • Possession of client funds or securities unless received inadvertently and returned to the sender promptly.
  • Any arrangement (such as a general power of attorney) that authorizes you to withdraw client funds or securities maintained with a custodian by instructing the custodian.
  • Any capacity with authority to access to client funds or securities (such as general partner of a limited partnership, managing member of a limited liability company or trustee of a trust).

If you “have custody” of assets.

  • Qualified Custodian.  You must maintain those assets with a “qualified custodian” such as a bank, trustee, or prime broker.
  • Notice on ADV.  You must notify the Commissioner on your ADV that you have or may have custody.
  • Notice to Clients*. You must notify your client in writing of the custodian’s name and address, and the manner in which the assets are maintained, and any changes to this information.
  • Quarterly Custodian’s Account Statement*.  You must reasonably ascertain that the custodian sends quarterly account statements with specific information to each client (for example, by being cc-d on electronic statements the custodian sends).
  • Surprise Exam*.  You must retain a CPA (by written agreement) to have an annual “surprise exam” of client assets, and report the examination and any resignation of the CPA on your ADV.
  • Internal Control Report.  If you or your affiliate serves as the qualified custodian:
    • The CPA firm conducting the surprise exam must be registered with and subject to examination by the PCAOB.
    • You must obtain an annual internal control report with specified content.
  • Exceptions.  There are certain exceptions from some of the New Custody Rule’s requirements for mutual fund shares, certain private securities, and for advisers that “have custody” only because they deduct fees (if certain conditions are also satisfied).

Fund Managers’ Obligations.

If you are a general partner of an investment limited partnership or a managing member of a limited liability company (or are in a similar position with respect to a pooled fund vehicle):

  • Quarterly Investor Account Statement.  You must send to all fund investors quarterly account statements showing:
    • the total amount of all additions to and withdrawals from the fund,
    • a listing of all additions to and withdrawals from the fund by an investor,
    • the opening and closing value of the fund at the end of the quarter,
    • the total value of an investor’s interest in the fund at the end of the quarter, and
    • a listing of securities positions on the closing date of the statement pursuant to FASB Accounting Standards Codification 946-210-50-4 through 6.
  • Independent Expense Verification*.  You must retain (by written agreement) an independent accountant or attorney obligated to act in your investors’ best interests and send him/her all invoices or receipts with details regarding calculations, so the independent person can:
    • review all fees, expenses and withdrawals from the fund,
    • determine that payments conform to the fund agreement, and
    • forward to the custodian approval for payments of the invoices.
  • Audited Fund Exceptions*.  You need not comply with the following requirements:  Notice to Clients, Quarterly Custodian’s Account Statement, Surprise Exam and Independent Expense Verification; if:
    • Your fund is audited annually, in accordance with GAAP, by an independent CPA registered with and subject to examination by the PCAOB.
    • The audited financials are distributed to all investors and the Commissioner within 120 days of the end of the fund’s fiscal year.
    • A final liquidation audit is performed, in accordance with GAAP, upon the fund’s liquidation, and the audited financials are distributed to investors and the Commissioner promptly upon completion of the audit.
    • The independent CPA is required by agreement to notify the Commissioner on Form ADV if it resigns or is terminated.
    • You notify the Commissioner that you intend to use the audit exception route.

For further details and interpretation of the intricacies of the New Custody Rule as they apply to you, please contact your Pillsbury Investment Funds and Investment Management team member.

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Written by:  Jay B. Gould and Jessica M. Brown

On October 28, 2013, the Securities and Exchange Commission (“SEC”)  brought enforcement actions and imposed sanctions on three different registered advisers and their principals for violations of Rule 206(4)-2 under the Investment Advisers Act of 1940 (the “Custody Rule”).  The circumstances that gave rise to each adviser being deemed to have custody differed, however, certain violations of the Custody Rule were present in each case.  These advisers were sanctioned for (i) incorrectly reporting their custody of client assets on their Form ADV, (ii) not conducting a surprise audit by an independent public accountant to verify client assets in custody, (iii) not having a reasonable belief that a qualified custodian was delivering account statements to fund investors at least every quarter, and (iv) a lack of properly written policies and procedures to protect client assets in custody.

This interest by SEC examination and enforcement staff should come as no surprise to investment advisers.  Each year, the SEC publishes a list of areas on which examiners will focus their efforts during the year.  The 2013 examination priority publication listed the Custody Rule as the first item on the priority list.  The SEC clearly stated to the industry that examinations of investment advisers would scrutinize the adviser’s (i) understanding of what constitutes custody, (ii) compliance with the “surprise exam” requirement of the Custody Rule, (iii) satisfaction of the “qualified custodian” provision and, (iv) if applicable, proper use of the exception for pooled investment vehicles.

Generally, any adviser that has access to a client’s account or assets, or has an arrangement in place that permits it to withdraw client assets, must comply with the Custody Rule.  An exception to the annual surprise audit and account statement delivery requirements are available for advisers that have custody of private fund or hedge fund assets, as long as certain conditions are met.

Because the definition of custody is both broad and somewhat convoluted, advisers should regularly review how client assets are maintained to determine if they have custody of client assets within the meaning of the Custody Rule and, if so, whether their compliance procedures, regulatory disclosures and marketing materials accurately reflect current business practice.  Investment advisers should always stay familiar with what the SEC has determined will be examination and enforcement priorities.

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Last week the SEC issued a Risk Alert and an Investor Bulletin on the Custody Rule after its National Examination Program (“NEP”) observed significant deficiencies in recent examinations involving custody and safety of client assets by registered investment advisers.  The stated purpose of the Risk Alert was to assist advisers with complying with the custody rule.  The Investor Bulletin was issued to explain the purpose and limitations of the custody rule to investors.  We encourage advisers and investors to review the Risk Alert and the Investor Bulletin, and remind advisers, particularly advisers to private equity funds,  fund of funds and funds that invest in illiquid assets that they may only self custody securities if they satisfy the requirements for “privately offered securities” (i.e., securities are (i) not acquired in any transaction involving a public offering, (ii) uncertificated, (iii) transferable only with the prior consent of the issuer and (iv) are held by a fund that is audited). Many advisers may not be in compliance with the custody rule because they self custody assets that do not satisfy the definition of privately offered securities.  Please feel free to contact us for more information on the Risk Alert, Investor Bulletin or the custody rule.

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On February 21, 2013, the Staff of the Securities and Exchange Commission (the “Staff” and the “SEC,” respectively) published its 2013 priorities for the National Examination Program (“NEP”) in order to provide registrants with the opportunity to bring their organizations into compliance with the areas that are perceived by the Staff to have heightened risk.  The NEP examines all regulated entities, such as investment advisers and investment companies, broker dealers, transfer agents and self-regulatory organizations, and exchanges.  This article will focus only on the NEP priorities pertaining to the investment advisers and investment companies program (“IA-ICs”)

As a general matter, the Staff is concerned with fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and the use and implications of technology.  The 2013 NEP priorities, viewed in tandem with the “Presence Exam” initiative that was announced by the SEC in October 2012, makes it abundantly clear that the Staff will focus on the approximately 2000 investment advisers that are newly registered as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”).

The Staff intends to focus its attention on the areas set forth below.   

New and Emerging Issues.

The Staff believes that new and emerging risks related to IA-ICs include the following:

  • New Registrants.  The vast majority of the approximately 2,000 new investment adviser registrants are advisers to hedge funds or private equity funds that have never been registered, regulated, or examined by the SEC.  The Presence Exam initiative, which is a coordinated national examination initiative, is designed to establish a meaningful “presence” with these newly registered advisers.  The Presence Exam initiative is expected to operate for approximately two years and consists of four phases: (i) engagement with the new registrants; (ii) examination of a substantial percentage of the new registrants; (iii) analysis of the examination findings; and (iv) preparation of a report to the industry on the findings.  The Presence Exam initiative will not preclude the SEC from bringing enforcement actions against newly registered advisers.  The Staff will give a higher priority to private fund advisers that it believes present a greater risk to investors relative to the rest of the registrant population or where there are indicia of fraud or other serious wrongdoing.  We expect to see the SEC bring enforcement actions against private equity and hedge fund managers for issues related to valuations, calculation of performance-related compensation and communications to investors that describe valuations and performance-related compensation.
  • Dually Registered IA/BD.  Due to the continued convergence in the investment adviser and broker-dealer industry, the Staff will continue to expand coordinated and joint examinations with the broker dealer examination program of dually registered firms and distinct broker-dealer and investment advisory businesses that share common financial professionals.  It is not uncommon for a financial professional to conduct a brokerage business through a registered broker-dealer that the financial professional does not own or control and to conduct investment advisory business through a registered investment adviser that the financial professional owns and controls, but that is not overseen by the broker-dealer.  This business model presents many potential conflicts of interest.  Among other things, the Staff will review how financial professionals and firms satisfy their suitability obligations when determining whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed.
  • “Alternative” Investment Companies.    The NEP will also focus on the growing use of alternative and hedge fund investment strategies in registered open-end funds, exchange-traded funds (“ETFs”), and variable annuity structures.  The Staff intends to assess whether: (i) leverage, liquidity and valuation policies and practices comply with regulations; (ii) boards, compliance personnel, and back-offices are staffed, funded, and empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.
  • Payments for Distribution In Disguise.    The Staff will also examine the wide variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same.  With respect to private funds, the Staff will examine payments to finders or other unregistered intermediaries that may be conducting a broker dealer business without being registered as such.  Payments made pursuant to the Cash Solicitation Rule will also be a focus of private fund payment arrangements.

Ongoing Risks.

The Staff anticipates that the ongoing risks selected as focus areas for IA-ICs in 2013 will include:

  • Safety of Assets.  The Staff has indicated that recent examinations of investment advisers have found a high frequency of issues regarding the custody and safety of client assets under the Investment Advisers Act of 1940 (“Advisers Act”) Rule 206(4)-2 (the “Custody Rule”).   The staff will focus on issues such as whether advisers are: (i) appropriately recognizing situations in which they have custody as defined in the Custody Rule; (ii) complying with the Custody Rule’s “surprise exam” requirement; (iii) satisfying the Custody Rule’s “qualified custodian” provision; and (iv) following the terms of the exception to the independent verification requirements for pooled investment vehicles.  Many private equity funds and fund of funds have been slow to adopt policies and procedures that comply with the Custody Rule.
  • Conflicts of Interest Related to Compensation Arrangements.  The Staff expects to review financial and other records to identify undisclosed compensation arrangements and the conflicts of interest that they present.  These activities may include undisclosed fee or solicitation arrangements, referral arrangements (particularly to affiliated entities), and receipt of payment for services allegedly provided to third parties. For example, some advisers that place client assets with particular funds or fund platforms are, in return, paid “client servicing fees” by such funds and fund platforms. Such arrangements present a material conflict of interest that must be fully and clearly disclosed to clients.  These types of compensation arrangements are commonplace among private equity fund advisers, many of which have just recently registered.  In fact, many private equity funds have compensation arrangements that the Staff believes requires broker dealer registration.  We believe that the Staff will make this point quite clearly by bringing enforcement actions against certain private equity fund general partners for engaging in unregistered broker dealer activity.  Enforcement actions are viewed as an effective way to get the message across to an industry that has long ignored this particular issue.
  • Marketing/Performance.  Marketing and performance advertising is viewed by the Staff as an inherently high-risk area, particularly among private funds that are not necessarily subject to an industry standard for the calculation of investment returns.  Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation procedures or practices.  The Staff will also focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized, and related disclosures and compliance with record keeping requirements.   The Staff is starting to think about how the anticipated changes in advertising practices related to the JOBS Act will affect their reviews regarding registrants’ use of general solicitations to promote private funds.  Whether private funds will be permitted to advertise performance under the JOBS Act rules remains to be seen.  Certainly, there have been loud and influential voices that advocated for the position that the SEC should continue to study performance advertising by private funds before allowing it in the adoption of the highly anticipated rules.
  • Conflicts of Interest Related to Allocation of Investment Opportunities.  Advisers managing accounts that do not pay performance fees (e.g., most mutual funds), side-by-side with accounts that pay performance-based fees (e.g., most hedge funds) face potential conflicts of interest.  The Staff will attempt to verify that the registrant has controls in place to monitor the side-by-side management of its performance-based fee accounts and non-performance-based fee accounts with similar investment objectives, especially if the same portfolio manager is responsible for making investment decisions for both kinds of client accounts or funds.  For certain types of strategies, such as credit strategies, where one fund may be permitted to invest in all securities in the capital structure, whereas other funds may be limited in what they can purchase by credit quality or otherwise, these potential conflicts of interest are particularly acute.  Fund managers must have policies in place that account for these potential conflicts, manage the conflicts and document the investment resolution.
  • Fund Governance.  The Staff will continue to focus on the “tone at the top” when assessing compliance programs.  The Staff will seek to confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability.  Chief Compliance Officers will want to make sure that those items that are required to be undertaken in the compliance manual actually occur as stated and scheduled.

Policy Topics.

The staff anticipates that the policy topics for IA-ICs will include:

  • Money Market Funds.  The SEC continues to delude itself regarding the regulation of money market funds.  This once sleepy and relatively benign product is now the pillar of the commercial paper market and functions like and deserves the regulation of a banking product.  But the SEC, and the mutual fund trade organization, are loathe to cede authority to banking regulators for this “dollar per share”  product.  Accordingly, the SEC will continue to try to find ways for thinly capitalized advisers to offer and manage  money market funds by requiring money market funds to periodically stress test their ability to maintain a stable share price based on hypothetical events, such as changes in short-term interest rates, increased redemptions, downgrades and defaults, and changes in spreads from selected benchmarks (i.e., basically, all of the market events that have proven fatal to money market funds in the past and which will be so again as long as these funds remain fundamentally flawed).
  • Compliance with Exemptive Orders.  The staff will focus on compliance with previously granted exemptive orders, such as those related to registered closed-end funds and managed distribution plans, employee securities companies, ETFs and the use of custom baskets, and those granted to fund advisers and their affiliates permitting them to engage in co-investment opportunities with the funds.  Exemptive orders are typically granted pursuant to a number of well-developed conditions with which the registrant promises to adhere.  The market timing and late trading scandals of 2003 illustrated that once a registrant has obtained an exemptive order, it may or may not abide by all of the conditions of that order.
  • Compliance with the Pay to Play Rule.  To prevent advisers from obtaining business from government entities in return for political “contributions” (i.e., engaging in pay to play practices), the SEC recently adopted and subsequently amended, a pay to play rule. The Staff will review for compliance in this area, as well as assess the practical application of the rule.  Advisers should be aware that most states have their own pay to play rules and many of them have penalties that are far more onerous than the SEC’s rule.

We will continue to monitor this and other new developments and provide our clients with up to date analysis of the rules and regulations that may affect their businesses.

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Written by Jay Gould and Peter Chess

In re-proposed custody rules, the California Department of Corporations (“DOC”) has reflected the most important aspects of the comment letter that Pillsbury provided on July 27, 2011, such that all transactions and short positions need not be disclosed in the quarterly account statements.  In general, the re-proposed custody rules define “custody,” and subject to certain limited exceptions, require that advisers with custody maintain the assets with a qualified custodian.  The re-proposed custody rules also specify details with regard to audits and require compliance by advisers with specific safeguards.   

The DOC also released proposed regulations that contain a successor to the private fund exemption, which are currently in the comment period.  Under the DOC’s proposed private adviser exemption, advisers would be eligible provided they: (i) have not violated securities laws; (ii) file periodic reports with the DOC; (iii) pay the existing investment adviser registration and renewal fees; and (iv) comply with additional safeguards when advising 3(c)(1) funds.  Additionally, under the proposed regulations, the exemption defines a private fund adviser as an investment adviser that provides advice only to qualifying private funds, which include 3(c)(1) and 3(c)(7) funds.  A grandfathering provision for private advisers is also included. 

The Massachusetts Securities Division released amendments similar to the DOC’s on January 18, 2012.  These amendments contain regulations that relate to the private fund exemption and custody requirements, among others.  The amendments, released after consideration of industry comments, make substantive changes to the definition of “institutional buyer,” re-propose a broadened private fund exemption that includes the introduction of a grandfathering provision, and propose requirements for advisers with discretion over, or custody of, client funds. 

The purpose of the Massachusetts amendments is to coordinate with the new rule adopted by the Securities and Exchange Commission under the Dodd-Frank Act.  Also included in the amendments is an exemption from state registration for advisers that provide advice solely to private funds that qualify as 3(c)(1) or 3(c)(7) funds.

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Written by Jay Gould

Pillsbury’s Investment Funds & Investment Management team has submitted a comment letter to the California Department of Corporations (the “DOC”) on behalf of the California Hedge Fund Association in connection with the DOC’s recently proposed amendments to the California custody rule.

In its letter to the Commissioner, Pillsbury requested that the DOC amend the California custody rule in a manner that balances investor protection and the need for fund managers to maintain confidentiality of certain portfolio positions.  Specifically, the letter requested  that the quarterly reports California-registered advisers to private funds are required to send to their investors be required to disclose only those positions that comprise more than 5% of the fund’s assets, and that the names of short positions not be disclosed at all, but be provided as an aggregate number.  “Implementing our suggestions would be consistent with the quarterly disclosure of schedule of investments based on the FASB’s U.S. financial reporting standards, and would also protect fund investors from short squeezes,” explained Jay Gould, head of the Pillsbury Investment Funds & Investment Management team.

The letter was provided in response to the  DOC Commissioner’s invitation for comment on the proposed changes to the California custody rule that will apply to California-registered investment advisers, including those investment managers that are currently either registered with the Securities and Exchange Commission or are not registered at all.  By February 15, 2012, investment advisers to private funds with less than $100 million under management will need to register with the DOC, if they have not already done so.

“The California Hedge Fund Association expects to provide comments to the DOC in connection with future rulemaking proposals and encourages California-based fund managers to become active in this process,” explains Chris Ainsworth, President of the Association.

A full text of the letter to the Commissioner is available here.

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The Dodd-Frank Wall Street Reform and Consumer Protection Act will significantly change the regulatory regime governing investment advisers, particularly investment advisers to private funds, such as hedge funds and private equity funds.  The primary purpose of the new rules and requirements is to “fill the regulatory gap,” by requiring advisers to private funds to register as investment advisers with the Securities and Exchange Commission or state securities regulators, unless an exemption applies, and provide information about their activities to the SEC. For a detailed discussion of the provisions of the Dodd-Frank Act applicable to advisers to private funds, please see our related Client Alert.