SEC Staff Provides Guidance on Custody Rule Compliance When Private Funds Use SPVs and Escrow Accounts

by Goodwin

The staff of the SEC’s Division of Investment Management issued IM Guidance Update No. 2014-7 (the “Guidance Update”) to provide guidance on how Rule 206(4)-2 under the Investment Advisers Act of 1940 (the “Custody Rule”) applies when private pooled investment vehicles (“private funds”) use special purpose vehicles (“SPVs”) to own one or more assets or use escrow accounts in connection with the sale of a portfolio company.

Four Scenarios for Special Purpose Vehicles

The Guidance Update elaborates on prior SEC statements regarding the alternatives available to an adviser delivering audited financial statements to private fund investors under the Custody rule (the “Audit Provision”) to either (1) treat an SPV as a separate fund client and comply with the audited financial statement requirements for the SPV separately from the owning private fund or (2) treat an SPV’s assets as assets of the owning private fund and include them within the scope of the owning private fund’s audit.  The Guidance Update addresses the following four scenarios:

  1. Single Purpose Vehicle:  a private fund client of the adviser invests in an SPV that makes a single investment.
  2. Multi-Fund, Single Purpose Vehicle:  two or more of the adviser’s private fund clients invest in an SPV that makes a single investment.
  3. Multi-Purpose Vehicle:  two or more of the adviser’s private fund clients invest in an SPV that makes more than one investment.

In these three scenarios, the staff advised that an audit of a private fund that includes the assets of the SPV will satisfy the Audit Provision as long as the SPV has no owners other than the adviser, the adviser’s related person(s) or private fund clients controlled by the adviser or the adviser’s related person(s).

  1. Investment Fund SPV:  one or more of an adviser’s private clients invest alongside third parties (such as pooled investment vehicles controlled by other advisers or persons that are not the adviser, the adviser’s related person(s) or pooled investment vehicles controlled by the adviser) in an SPV that makes one or more investments (an “Investment Fund SPV”).

In this scenario, the staff advised that the Investment Fund SPV should generally be treated as a separate client for purposes of the Custody Rule, which would mean, among other things, that the adviser would comply separately with the custody rule’s audited financial statement distribution requirements for the Investment Fund SPV.

Escrow Accounts

The staff noted that the sale of a portfolio company held by a private fund may involve the creation of an escrow account to serve certain limited purposes (such as to hold a percentage of sale proceeds for indemnification purposes or to provide for adjustments to the sale price of the portfolio company).  These accounts typically hold money that belongs to the adviser’s private fund client and to other sellers that are not clients of the adviser. In addition, these accounts are typically held in the name of a “seller’s representative” appointed by the sellers to act on their behalf with respect to the escrow.

The staff advised that it would not object if an adviser maintains client funds in an escrow account with other client and non-client assets, provided that: (1) the client is a private fund as to which the adviser relies on the Audit Provision, and the portion of the escrow attributable to the private fund is included in its financial statements; (2) the escrow is in connection with the sale or merger of a portfolio company owned by the client (i.e., for indemnification or to adjust the purchase price); (3) both the amount of money held in escrow and the length of time it is held are agreed upon as part of a bona fide negotiation between the buyer and the sellers; (4) the escrow is maintained at a qualified custodian; and (5) the seller’s representative is contractually obligated to promptly distribute, based on a predetermined formula, the money remaining in escrow at the end of the escrow period to the sellers, including the private fund clients.

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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