SEC Issues Guidance on Application of Custody Rules to Special Purpose Vehicles and Escrows

by Ropes & Gray LLP
Contact

Introduction

The Division of Investment Management of the Securities and Exchange Commission (the SEC) recently released an IM Guidance Update with respect to the custody rule, Rule 206(4)-2 (the Custody Rule) under the Investment Advisers Act of 1940, as amended. Specifically, the SEC’s guidance focused on the application of the Custody Rule with respect to special purpose vehicles utilized for making investments (SPVs) and escrow accounts utilized when selling interests in portfolio companies. This guidance will be of interest to private equity fund managers, and other private fund managers that may periodically utilize SPVs in pursuing their investment programs, provided in each case that the manager is registered as an investment adviser with the SEC. 

The Custody Rule and Special Purpose Vehicles 

With respect to treatment of SPVs with respect to compliance with the Custody Rule, the SEC previously stated that an investment adviser could either (1) treat the SPV as a separate client (whereby the investment adviser would have custody of the assets of the SPV) or (2) rely on the audit exemption1 of the Custody Rule (the “audit exemption”) and treat the SPV’s assets as assets of the funds of which it has indirect custody. Generally, if an investment adviser opts to treat the SPV as a separate client, the Custody Rule requires that the investment adviser separately comply with the audited financial statements distribution requirements (i.e., by separately auditing the SPV and distributing the financial statements to fund investors). If an investment adviser opts to rely on the audit provision and treat the SPV’s assets as assets of a fund, such assets must be considered within the scope of such fund’s financial statement audit.

The SEC’s recent guidance focused on how an investment adviser that relies on the audit exemption can comply with the requirements of the Custody Rule in four common scenarios: (1) an SPV that holds one investment, whose sole beneficial owner is a single fund managed by the investment adviser; (2) an SPV that holds one investment, whose sole beneficial owners are multiple affiliated funds managed by the investment adviser; (3) an SPV that holds multiple investments, whose sole beneficial owners are multiple affiliated funds managed by the investment adviser; and (4) an SPV that holds one or more investments, whose beneficial owners include a fund managed by the investment adviser and other unaffiliated parties. 

The SEC clarified that if (a) an SPV is owned by one or more affiliated funds managed by the investment adviser and (b) the SPV is within the scope of the funds’ financial statement audit(s) (i.e., scenarios (1), (2) and (3) described above), then the investment adviser may treat the assets of the SPV as assets of the fund(s) to comply with the Custody Rule. However, with respect to an SPV owned by one fund managed by the investment adviser and unaffiliated third parties (i.e., scenario (4) described above), the SEC noted that an investment adviser relying on the audit exemption should treat the SPV as a separate client for purposes of the Custody Rule. As a result, in this scenario, the investment adviser must separately comply with the Custody Rule’s audited financial statement distribution requirements (among other requirements) with respect to such SPV. In light of this new guidance, we recommend that private fund managers reconsider whether separate audits should be obtained for one or more of the SPVs in which their funds hold interests.

The SEC’s guidance leaves unanswered several key questions with respect to SPVs that have often been raised by, and discussed with, the SEC during examinations, including:

  1. What does it mean for an SPV to be “within the scope of a fund’s audit”?
  2. Under what circumstances is an SPV a “client” of the investment adviser?2
  3. In a “club deal” among the funds of various advisers, which adviser must take responsibility for satisfying the Custody Rule?
  4. If an adviser does not rely on the audit exemption, how can that adviser comply with the Custody Rule with respect to the SPVs held by its funds? 
  5. Does the guidance in scenario (4) apply if a fund makes an investment through an alternative investment vehicle owned in whole or in part by some or all of the fund’s limited partners and/or the fund?

The Custody Rule and Escrow Accounts

In connection with the certain sales of portfolio companies by private equity funds, an escrow account is created to hold a portion of the proceeds of the sale, in case there is an indemnification claim or purchase price adjustment. The sellers (which may include both a fund advised by a registered adviser and unaffiliated sellers) appoint a “sellers’ representative” to act on their behalf with respect to the sale proceeds held in escrow. The custody rule requires a registered investment adviser to maintain funds and securities over which it has custody with a qualified custodian in a separate account for each client in the client’s name, or in accounts that contain only the adviser’s clients’ funds and securities that are maintained in the adviser’s name as agent or trustee for the clients. The funds in an escrow account often belong to both the adviser’s pooled investment vehicle clients and other sellers that are not advisory clients and are typically maintained in the name of the sellers’ representative. In its guidance, the SEC clarified that an investment adviser would be in compliance with the Custody Rule if the investment adviser maintained client funds in an escrow account with other client and non-client assets and the funds were held in the name of the sellers’ representative so long as:

  1. The client is a fund that relies on the audit exemption and includes the portion of the escrow account attributable to the fund in its financial statements;
  2. The escrow account is utilized in connection with the sale or merger of a portfolio company owned by the client (i.e., for indemnification or purchase price adjustment purposes);
  3. The escrow account contains an amount of money that is agreed upon as part of a bona fide negotiation between the buyer and sellers; 
  4. The escrow account exists for a period of time that is agreed upon as part of a bona fide negotiation between the buyer and the sellers;
  5. The escrow account is maintained at a qualified custodian; and
  6. The sellers’ representative is contractually obligated to promptly distribute the funds remaining in the escrow account at the end of the escrow period, based on a predetermined formula to the sellers (including the fund client). 

In light of this guidance, private equity firms will want to arrange the sales of their portfolio companies and related contractual provisions in a manner designed to satisfy the requirements of the new guidance.3

The full text of the IM Guidance Update is available here


1 If a fund is audited by an independent public accountant, the financial statements are distributed to investors and certain other requirements are met, the adviser is exempt from certain requirements of the Custody Rule, including the need to have a surprise exam to verify the proper custody of assets.

2 With respect to the second question, the SEC sidestepped this issue by noting that for purposes of its guidance, it was assuming that the SPV was a client (and whether an SPV is actually a client of the investment adviser is based on the facts and circumstances surrounding the SPV). 

3 In particular, firms will need to change the practice in certain jurisdictions of having non-qualified custodians (such as law firms) hold escrow proceeds. Also, while not specifically addressed in the guidance, we believe it is reasonable to take the position that the buyer of a portfolio company is not responsible for the custody of assets held in escrow. Finally, as above, the guidance does not address how advisers that do not rely on the audit exemption satisfy the Custody Rule in connection with an escrow. 

 

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.

© Ropes & Gray LLP | Attorney Advertising

Written by:

Ropes & Gray LLP
Contact
more
less

Ropes & Gray LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.