SEC Division of Investment Management Provides Guidance Regarding the Custody Rule and Privately Offered Securities

by Dechert LLP

The Division of Investment Management (Division) of the U.S. Securities and Exchange Commission (SEC) recently posted an IM Guidance Update that expands the applicability of an exception from the Custody Rule (as defined below) for certain privately offered securities held by certain private funds (Guidance).1  In 2013, the Division began posting IM Guidance Updates that summarize the SEC staff’s views regarding various requirements of the Investment Company Act of 1940 or the Investment Advisers Act of 1940 (Advisers Act). These Guidance Updates are not subject to SEC approval and do not have the force of a rule or regulation.

Rule 206(4)-2 (Custody Rule) under the Advisers Act generally requires that SEC-registered investment advisers that are deemed to have custody of client funds (i.e., cash) or securities maintain such funds or securities with a qualified custodian, as defined by the Custody Rule.  Non-U.S. investment advisers must comply with the Custody Rule with respect to their U.S. clients.2  Many advisers to private funds rely on an exemption available from certain Custody Rule requirements, including the requirements that (1) the adviser provide notice to clients regarding such custody arrangements, (2) the qualified custodian provide quarterly account statements directly to each client for which it maintains funds or securities and (3) the custodied assets are verified at least annually by an independent public accountant.  In order to take advantage of this exception, the adviser must annually distribute audited financial statements prepared by an independent public accountant, subject to certain conditions, to beneficial owners of the pooled investment vehicle.  Advisers may also be excepted from the requirement to maintain securities with a qualified custodian if such securities are: (1) acquired from the issuer in a transaction or chain of transactions not involving a public offering; (2) uncertificated,with ownership of the securities recorded only on the books of the issuer or its transfer agent in the name of the client; and (3) transferable only with the prior consent of the issuer or holders of the outstanding securities of the issuer.  An investment adviser may only avail itself of this exception with respect to securities held for the account of a limited partnership (or other pooled investment vehicle) if the pooled investment vehicle distributes to its investors, on an annual basis, audited financial statements prepared by an independent public accountant.

In the Guidance, the Division noted that the Dodd-Frank Wall Street Reform and Consumer Protection Act had resulted in the registration of many investment advisers that manage unregistered pooled investment vehicles.  In recent speeches, SEC officials have stated that the Division is reviewing Advisers Act rules for aspects that should be updated to address the business models of private fund advisers.  The Division stated that it has received inquiries from advisers to pooled investment vehicles regarding whether the Custody Rule “requires advisers to audited pooled investment vehicles to maintain with a qualified custodian certain instruments evidencing the pool’s ownership of certain privately issued securities – namely, non-transferable stock certificates or ‘certificated’ LLC interests – that were obtained in a private placement.”  The Guidance states that the Division would not object if an adviser does not maintain such “private stock certificates” with a qualified custodian, subject to the following conditions:

  1. The client must be a pooled investment vehicle subject to an annual financial statement audit (as described by the Custody Rule).

    For U.S. investment advisers, this audit must be conducted in accordance with U.S. Generally Accepted Accounting Principles (GAAP).  For non-U.S. investment advisers and non-U.S. funds, audits may be conducted in accordance with relevant local accounting principles, so long as the resulting statements contain information substantially similar to statements prepared in accordance with GAAP, the audit is conducted in accordance with U.S. Generally Accepted Accounting Standards (GAAS) and any material differences are reconciled.  Audited financial statements must generally be delivered to investors within 120 days of the end of the pooled investment vehicle’s fiscal year (with more time permitted for funds of funds and funds of funds of funds).4
  2. The certificate can only be used to effect transfers or changes in beneficial ownership with the prior consent of the issuer or holders of the outstanding securities of the issuer.
  3. Ownership of the security must be recorded on the issuer’s books or those of the transfer agent in the name of the client (i.e., the pooled investment vehicle).
  4. The certificate must include a legend that restricts the security’s transfer.
  5. The certificate must be appropriately safeguarded by the adviser and able to be replaced upon loss or destruction.

The Guidance provides clarity and relief for investment advisers that manage pooled investment vehicles that are subject to the requirements of the Custody Rule and hold securities such as certificated LLC interests and private stock certificates.4  This Guidance is especially helpful given that the term “uncertificated” is not defined in the Custody Rule and there is some confusion as to its precise meaning.

The Guidance also states that “In addition, the Division considers securities that are evidenced by ISDA master agreements that cannot be assigned or transferred without the consent of the counterparty to be privately offered securities under Rule 206(4)-2(b)(2).”  However, the Guidance does not address whether any particular ISDA master agreement represents a security.  Assets that are neither “funds” nor “securities” are outside the scope of the Custody Rule.


1. IM Guidance Update: Privately Offered Securities under the Investment Advisers Act Custody Rule (August 2013), available here (PDF).

2. Under SEC guidance, non-U.S. investment advisers are generally not required to comply with the substantive provisions of the Advisers Act (such as the Custody Rule) with respect to offshore funds.  ABA Subcommittee on Private Investment Entities, SEC No-Action Letter (Aug. 10, 2006). For these purposes, an offshore fund is a private fund organized and incorporated in a country other than the United States.

3. Neither the Custody Rule nor related SEC releases defines or explains what constitutes “uncertificated.” However, the Guidance does note that, “Partnership agreements, subscription agreements and LLC agreements are not certificates under Rule 206(4)-2(b)(2)(B) and the securities represented by such documents are privately offered securities provided they meet the other elements of Rule 206(4)-2(b)(2).”

4. See Question VI.5, Staff Responses to Questions About the Custody Rule, available here.

5. Although issued in connection with inquiries regarding these types of securities, the Guidance is not specifically limited to equity instruments.


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Dechert LLP

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