Advisers Act Custody Rule Dear CFO Letter

Foley & Lardner LLPOn October 23, 2020, the SEC Division of Investment Management’s Chief Accountant’s Office (“IMCAO”) issued three separate “Dear CFO” letters addressing (i) the determination of when a fund commences operations, (ii) financial statements included in the initial registration statement of a business development company, and (iii) compliance with the Advisers Act Custody Rule (206(4)-(2)) by means of combined financial statements. This note addressed the custody rule and ASC 310-1-55 (addressing the use of combined financial statements for entities under common management (the “common management basis”)). The IMCAO notes that common management is not enough in the context of “pooled investment vehicles” (“PIVs”) if the financial statements are to meet the requirements of the Custody Rule’s audit exception (e.g., to preclude the need for surprise audits, etc.). In this context, the IMCAO sets a high hurdle for the use of combined financial statements, as detailed below, suggesting that investment advisers and their auditors consult with the IMCAO when considering the use of combined financial statements for PIVs, unless the PIV in question meets the staff’s guidance as set out below.

2020-03
Combined Financial Statements for Compliance with Advisers Act Rule 206(4)-2

Dear CFO
(10/23/2020)

New

Rule 206(4)-2 [17 CFR § 275.206(4)-2] – Custody of Funds or Securities of Clients by Investment Advisers (the “Custody Rule”) of the Investment Advisers Act of 1940 requires investment advisers who have custody of funds or securities of clients, among other things, to maintain the funds and securities in an account with a qualified custodian (as defined in the Custody Rule) in each client’s name, or in an account in the adviser’s name for the benefit of its clients. Paragraph (b)(4) of the Custody Rule (“audit exception”) permits an adviser to comply with certain aspects1 of the Custody Rule if an account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) (collectively, “PIVs”) is subject to audit (as defined in rule 1-02(d) of Regulation S-X (17 CFR 210.1-02(d)). An investment adviser may wish to obtain audits of financial statements for multiple PIVs on a combined basis for operational purposes. ASC 810-10-55-1B states, in part, that “[t]here are circumstances, however, in which combined financial statements (as distinguished from consolidated financial statements) of commonly controlled entities are likely to be more meaningful than their separate financial statements. For example, combined financial statements would be useful if one individual owns a controlling financial interest in several entities that are related in their operations. Combined financial statements might also be used to present the financial position and results of operations of entities under common management.”

For purposes of compliance with the audit exception, however, we do not believe an investment adviser can prepare combined financial statements for multiple PIVs in reliance solely on the common management basis in ASC 810-10-55-1B. For example, in the staff’s view, if the economics of each PIV are different and not pro rata (e.g., certain PIVs only participate in certain investments or have differing fee arrangements or rights), the combined financial statements may provide less clarity about an investor’s ownership than if separate financial statements were provided to all limited partners (or members or other beneficial owners) in each PIV.

The staff believes that if an investment adviser uses combined financial statements to rely on the audit exception, the investment adviser should consider whether:

  • Each PIV has the same management;
  • There is clear evidence of legal ownership of each investment individually with each PIV or there are contractual agreements which clearly show the assignment of investments held on a combined basis to each PIV;
  • Investments and investment gains and losses, including income and expenses, are allocated pro rata to each PIV;
  • Each PIV has the same management fee and performance fee structure (e.g., allocations work on a combined basis, calculated based on one hurdle on the combined basis, including combined fair values and contributions/distributions);
  • The financial highlights are the same for each PIV; and
  • The combined financial statements will
    • Present a statement of changes for each PIV separately and a combined aggregate total; and
    • Provide clear disclosure of each PIV’s pro rata percentage ownership of the combined basis, total commitments of each PIV, and aggregated commitments on a combined basis.

It is the staff’s view that there may be additional considerations an investment adviser should evaluate when using combined financial statements to rely on the audit exception, including whether some limited partners (or members or other beneficial owners) have different rights over the life of each PIV that would impact the financial reporting presentation on a combined basis. The investment adviser should evaluate whether or not an individual investor could reasonably interpret the information presented on a combined basis to the investor’s ownership in a specific PIV. The SEC staff encourages investment advisers and their auditors to consult with the staff if their fact patterns raise additional concerns or questions about the ability to utilize audits of financial statements for multiples PIVs on a combined basis for purposes of satisfying the Custody Rule.

 

1 Paragraph (b)(4) notes that PIVs subject to the audit exception are not required to comply with paragraph (a)(2) and (a)(3) and such PIVs shall be deemed to have complied with paragraph (a)(4).

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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