The Division of Investment Management of the Securities and Exchange Commission (the “SEC”) provided an Investment Management Guidance Update (the “Update”) regarding the Custody Rule under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The Update focused on two issues that investment advisers regularly inquire about – the application of the custody rule with respect to (1) special purpose vehicles used when making investments and (2) escrow accounts when selling the interests in portfolio companies. Among other requirements, the Custody Rule obligates investment advisers to maintain client cash and securities with a qualified custodian. 

The SEC has received a number of inquiries regarding the application of the custody rule to special purpose vehicles (“SPVs”) created to facilitate investments on behalf of the advisers’ pooled investment vehicle clients. The SEC has previously provided guidance that, in such scenarios, advisers could either treat the SPV as a distinct client or it could treat the SPV’s assets as the assets of the client (the pooled investment vehicle). In either case, the adviser is deemed to have custody of the assets. If the adviser utilizes the audit provision of the custody rule, the adviser is required to:

  • where the SPV treated as a distinct client, distribute audited financials for the SPV; or
  • where the SPV’s assets are treated as assets of the pooled investment vehicle client, such assets must be included in the pooled investment vehicle’s audited financials.

The Update provided several scenarios that had been raised by investment advisers. For example: an adviser has several pooled investment vehicle clients and uses one SPV to make an investment. In turn, several clients invest in such SPV (but the SPV has no owners apart from the adviser, the adviser’s clients and related persons). The SEC affirmed that, under such facts, the adviser could treat the SPV’s assets as assets of the pooled investment vehicles clients. However, if third parties made investments in such SPV, the adviser should treat the SPV as a separate client. For the other scenarios addressed by the SEC, please find the full Update here.

The SEC also addressed the application of the Custody Rule to proceeds from sales held in escrow accounts; in particular, where the sale involves sellers who are not clients of the adviser and for which a “sellers’ representative” has been appointed to act on behalf of all sellers, including with respect to funds held in an escrow account. The SEC stated that it would not object to such a scenario under the Custody Rule so long as: (1) the adviser’s client is a pooled investment vehicle relying on the audit provision of the Custody Rule and the client’s share of the amounts held in escrow were accounted for in its financial statements; (2) the escrow was created in connection with the sale or merger of a portfolio company owned by the client; (3) the amount of money held in escrow and the escrow period was agreed upon through bona fide negotiations between the buyer and the sellers; (4) the escrow account is maintained with a qualified custodian; and (5) the sellers’ representative is contractually required to distribute the funds promptly following the end of the escrow period, based on a predetermined formula.