On November 19, 2015, the SEC announced the settlement of charges against an investment adviser, its co-founders, and a former CCO arising from alleged violations of the SEC's "custody rule" (Rule 206(4)-2 under the Investment Advisers Act of 1940). In particular, the SEC alleged the firm was repeatedly late in providing investors with audited financial statements of its private funds. The firm's co-founders will pay a $1,000,000 fine, will be suspended from raising money for one year, and will be overseen by a compliance monitor for three years. In addition, the former CCO will pay a $60,000 fine and will be suspended from acting as a CCO for one year.
Originally designed to prevent theft or other wrongdoing by investment advisers with custody of a client's funds or securities (e.g., stock certificates), the custody rule established reporting, independent verification, and other safeguards devised before the proliferation of today's complex investment vehicles and instruments. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) eliminated the exemption from registration previously relied upon by many investment advisers to private equity funds, hedge funds, and other pooled investment vehicles, thereby subjecting them to the custody rule for the first time.
Following Dodd-Frank, the application of the custody rule has become more complicated for many fund advisers. For example, as discussed in recent SEC guidance regarding the application of the custody rule to certain special-purpose vehicles (SPVs), to fully comply with the custody rule, such SPVs may be required to obtain an annual financial audit in addition to the annual audit of the fund or vehicle which invests in the SPV.
Custody rule compliance will continue to be an important consideration for investment advisers, particularly for those swept into the purview of the rule for the first time by Dodd-Frank. In the SEC's original announcement of the charges in the case referenced above, Andrew M. Calamari, Director of the SEC's New York Regional Office, stated that "[t]he custody rule is not a technicality. It is a critical investor protection provision designed to help ensure that investor assets are safe." Application of the custody rule to today's complex investment structures and instruments requires careful analysis to ensure compliance.