On August 1, 2013, the Division of Investment Management of the Securities and Exchange Commission published an IM Guidance Update (the “Update”) regarding Rule 206(4)-2 (the “Custody Rule”) under the Investment Advisers Act of 1940, as amended.1 In response to requests from investment advisers, the Update provides that certain certificated, privately offered securities are no longer required to be maintained with a qualified custodian.
Under the Custody Rule, if a registered investment adviser has custody of client cash or securities,2 then it must maintain those client assets with a “qualified custodian,” subject to certain exceptions.3 The Custody Rule contains an exception for certain uncertificated, privately offered securities (the “Privately Offered Securities Exception”), which are not required to be held with a qualified custodian.4 The Privately Offered Securities Exception is limited specifically to uncertificated securities. Accordingly, prior to the Update, certificated, privately offered securities were required to be maintained with a qualified custodian, even if the certificate was non-transferrable.
The Update effectively expands the Privately Offered Securities Exception to include certain certificated, privately offered securities, provided that:
the adviser’s fund client is a pooled investment vehicle that is subject to audit in accordance with paragraph (b)(4) of the Custody Rule;5
the certificate can be used only to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer;
ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client;
the certificate contains a legend restricting transfer; and
the certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.
The Update clarifies that partnership agreements, subscription agreements and LLC agreements are not certificates and that the securities represented by such documents will be covered by the Privately Offered Securities Exception if they meet the requirements of the exception. The Update also clarifies that securities that (1) are evidenced by International Swaps and Derivatives Association master agreements and (2) cannot be assigned or transferred without the consent of the counterparty are covered by the Privately Offered Securities Exception.
1 The full text of the Update is available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-04.pdf.
2 “Custody” is defined as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them,” including having any access to client cash or securities. Rule 206(4)-2(d)(2). For more information on custody, please refer to our client mailing discussing the Risk Alert on the Custody Rule published by the SEC in March 2013, available at http://www.skadden.com/sites/default/files/publications/SEC_Recent_Developments.pdf, and our client mailing on the most recent amendments to the Custody Rule, available at http://www.skadden.com/sites/default/files/publications/Publications1988_0.pdf.
3 “Qualified custodians” include banks and registered broker-dealers. Rule 206(4)-2(d)(6).
4 To qualify for the exception, the fund client must be a pooled investment vehicle that is subject to audit in accordance with paragraph (b)(4) of the Custody Rule and the security must be: (i) acquired from the issuer in a transaction or chain of transactions not involving any public offering; (ii) uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and (iii) transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer. Rule 206(4)-2(b)(2).
5 Paragraph (b)(4) of the Custody Rule requires that the fund’s audit meet the following requirements: (i) the audited financial statements are prepared in accordance with U.S. GAAP; (ii) the audit occurs at least annually and the fund distributes its audited financial statements within 120 days of the end of its fiscal year; (iii) the audit is performed by an independent public accountant that is registered with, and subject to regular inspection by, the PCAOB; and (iv) the fund is subject to an audit upon liquidation. Rule 206(4)-2(b)(4).