New SEC Custody Rule has Little Impact on Hedge Funds
In an effort to beef up surveillance of financial firms that hold custody of client assets, the SEC passed a final rule at the end of 2009 which amended the existing Custody Rule (Rule 206(4)-2 under the Investment Advisers Act of 1940). When the amendment was put out for public comment, the additional rules were written so as to be applicable to hedge funds. However, after over a thousand comment letters were received, the final rule was passed with a provision to except out most hedge funds.
In summary, the new amendments provide that a registered adviser having custody of client funds or securities be required to undergo an annual surprise examination by an independent public accountant to verify client assets; to have the qualified custodian send account statements directly to the clients; and unless client assets are maintained by an independent custodian (i.e., a custodian that is not the adviser itself or a related person), to obtain a report of internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board (”PCAOB”).
Most hedge funds are exempt from these requirements as “pooled investment vehicles” that only meet the technical definition of “custody” because they can withdraw fees directly from client accounts. The Custody Rule calls for such pooled investment vehicles to be exempt from all requirements noted above if they obtain an annual audit from a PCAOB auditor within 120 days of their fiscal year end (180 days in the case of fund of funds) and distribute this audit to clients within that time frame. Assets still must be maintained at a qualified custodian. If the hedge fund does not meet these requirements, the adviser must indeed obtain an annual surprise examination and must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement of the pooled investment vehicle to its investors. The only portion of the new rules that do apply to hedge funds is the requirement to obtain the internal control report if the assets are held with an affiliated custodian.
The amendments to the Custody Rule are highly complex and the SEC’s release about them runs over 120 pages. The release can be viewed at http://sec.gov/rules/final/2009/ia-2968.pdf. We expect that this blog post will be used as a summary only and look forward to answering any questions from clients.
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