The Securities and Exchange Commission, Division of Investment Management, recently issued an IM Guidance Update (the “Guidance Update”) setting forth new interpretative guidance under the Investment Advisers Act of 1940, as amended (the “Advisers Act) to registered investment advisers with respect to custody requirements for privately issued stock certificates. Subject to certain conditions set forth in the Guidance Update, the SEC has provided relief to private fund advisers that do not wish to engage a qualified custodian to custody certain privately-issued, non-transferrable stock certificates.
Rule 206(4)-2 of the Advisers Act (the “Custody Rule”) requires that a registered investment adviser that has custody of client funds or securities maintain such funds or securities with a qualified custodian (e.g., a bank, savings association, or registered broker-dealer). The Custody Rule also requires that a registered investment adviser with custody of private fund assets must either subject itself to a surprise annual examination by an independent public accountant (a “Surprise Examination”) or, alternatively, engage an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board to conduct an annual audit of the private fund and deliver audited financial statements to all limited partners or other beneficial owners within 120 days of the end of its fiscal year (or 180 days with respect to any "fund of funds") (an “Annual Audit”).
New SEC Guidance
Pursuant to the Guidance Update and subject to the conditions set forth therein, private fund advisers that use the Annual Audit approach are no longer required to engage a qualified custodian to hold privately issued, non-transferrable stock certificates, notwithstanding that such securities are not "uncertificated.” The Guidance Update sets forth the following five conditions to relying on the relief: (1) the client is a pooled investment vehicle that is subject to an Annual Audit; (2) the private stock certificate can only be used 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; (3) ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client; (4) the private stock certificate contains a legend restricting transfer; and (5) the private stock certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.
Advisers should carefully consider the five conditions set forth in the Guidance Update prior to terminating any existing custody arrangements with a qualified custodian.