SEC staff provides relief from requirement to hold certain privately offered certificated securities with qualified custodians.

The Investment Management Division (the Division) of the Securities and Exchange Commission (SEC) has released new guidance under Rule 206(4)-2 (the Custody Rule) of the Investment Advisers Act of 1940 (the Advisers Act),1 providing that it “would not object” if an investment adviser did not maintain with a qualified custodian2 certain privately offered certificated securities held by a pooled investment vehicle (e.g., a private equity or hedge fund), provided that the following requirements were otherwise met:

  • The certificated interests are owned by a pooled investment vehicle that is subject to an audit which meets the requirements of the Custody Rule.
  • The private stock certificates cannot be transferred without the prior consent of the issuer or equity-holders of the issuer.
  • The issuer (or its transfer agent) records on its books the name of the pooled investment vehicle as an owner of the securities.
  • Each private stock certificate contains a legend restricting transfer.
  • The investment adviser “appropriately” safeguards the private stock certificates, and can replace them upon loss or destruction.3

Background: Custody Rule and the Privately Offered Securities Exemption

The Custody Rule generally requires registered investment advisers to hold the funds and securities of their advisory clients with “qualified custodians,” unless certain conditions are followed. For pooled investment vehicles that receive a generally accepted accounting principles (GAAP) audit and distribute financial statements to investors within 120 days of the vehicle’s fiscal year end, the adviser is not required to hold “privately offered securities” with a qualified custodian.4 However, the Custody Rule imposes a narrow definition of a “privately offered security.” To qualify, an instrument must be (a) acquired in a private offering, (b) uncertificated, and (c) transferable only with the prior consent of the issuer or owners of the issuer.5 As a result of this narrow definition, many securities that would be commonly understood to be “privately offered” by securities law practitioners and investment fund executives are nonetheless excluded from the benefits of this prong of the Custody Rule. Such securities instead must be held by a qualified custodian, at additional cost to the pooled investment vehicle and its registered investment adviser.

The new guidance regarding the Custody Rule provides greater flexibility in the treatment of the specified privately offered securities. The Division cited the comments it has received from the investment fund industry as a factor for issuing this new guidance. Commenters have observed that private stock certificates, although not meeting the narrow definition of “privately offered securities” under the Custody Rule, and thus not eligible to utilize the safe harbor, are materially equivalent to the range of private securities reasonably contemplated by the statute. Further, the Division took note of the investment fund industry’s view that the maintenance of these private stock certificates at a qualified custodian does not “provide meaningful protection to investors in pooled investment vehicles,” beyond that provided by the required qualifying audit, and generally the added administrative compliance expenses are borne by investors in the applicable pooled investment vehicle.6

Impact on Private Fund Advisers

The Division’s new guidance permits a notable expansion of registered investment advisers’ ability to comply with the Custody Rule through the privately offered securities safe harbor. We expect this treatment will be a welcome development for many advisers.

However, even with the new SEC guidance relaxing the non-certification requirement for defining securities as “privately offered” under the Custody Rule, an adviser must still consider whether the private stock certificate, partnership agreement, or other security at issue meets the other elements of the definition of a privately offered security. In particular, if the security is transferrable without the consent of the issuer, the security will not qualify as a “privately offered security” for purposes of the Custody Rule.