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Private funds regulatory update: the Custody Rule still applies

COVID-19 has made an impact on all of our lives, and has changed what we have viewed as “the normal.” This includes our daily routines, where we spend our workdays and how businesses operate daily. The impact of working from home has been significantly assessed over the past few weeks. Some studies have shown that telecommuters are working more days per month than a standard office-based employee; however, some work-from-home inefficiencies pose challenges related to physical documentation.

While COVID-19 has created a new challenging work environment, regulatory requirements remain largely unchanged, and investment advisers must ensure they maintain compliance. A critical component of this is compliance with Rule 206(4)-2 (the Custody Rule), which was enacted to provide protection for client funds and securities against possible misappropriation.

Under the Custody Rule, an adviser must comply with the following key requirements in maintaining custody of client assets:

  1. A qualified custodian must maintain the funds and securities in a separate account under the client’s name, or in accounts that contain only the client’s funds and securities under the name of the investor adviser as an agent or trustee of the client.
  2. Clients are promptly notified in writing of the qualified custodian designated when an account is opened on their behalf and any changes are made to the above-referenced items.
  3. There is a reasonable basis for believing that the qualified custodian provides account statements (at least on a quarterly basis) to each of its clients.  
  4. An arrangement must be made with an independent public accountant to perform an annual surprise examination to assess noncompliance with the above items.

Compliance with all of the above requirements can become challenging during COVID-19. The Security and Exchange Commission’s (SEC) Division of Investment Management has released answers to frequently asked questions (FAQ) in both March and April in response to two key issues identified relating to operating within the challenges of a COVID-19 world: delays in completing surprise examinations and unintended possession of physical certificates.

Under the Custody Rule, an annual surprise examination by an independent public accountant is required for any adviser who has custody of client assets, except for those advisers who meet certain exceptions. Surprise examinations are required to be completed and Form ADV-E filed within 120 days after the surprise examination date, which is the date chosen by the independent public accountant. The FAQ update seeks to provide guidance on potential delays in this process.

While every effort should be made to comply with the 120-day due date, the FAQ notes that enforcement action would not be recommended against the adviser if the adviser reasonably believed that its independent public accountant would complete the exam and file prior to the 120-day timeline, but failed due to logistical disruptions. The surprise examination report must be filed as soon as practicable, and no later than 45 days after the initial 120-day timeline. If logistical claims cause this timeline disruption, advisers should be prepared to demonstrate this occurred. The SEC continues to enforce the original ruling over surprise audits, with the exception noted above.

The SEC also addressed considerations over privately issued securities, which are evidenced by physical certificates. These physical certificates are required to be held by a qualified custodian to satisfy the Custody Rule. While these physical certificates are typically vaulted by qualified custodians, disruptions and closures due to COVID-19 have meant this may not be immediately possible for new certificates. The FAQ guidance seeks to answer questions raised as to whether an exception would be made by the SEC for these situations. The guidance provided confirms that an exception would be made for the duration of the qualified custodian closure due to COVID-19, and until such time, the physical certificates could be placed with the qualified custodian. In these situations, enforcement would not be recommended, subject to the following being met:

  1. The physical certificates can only be used to effect a transfer or change in beneficial ownership with the consent of the issuer.
  2. The ownership of the security is recorded on the books of the issuer or its transfer agent, which is in the name of the client.
  3. The physical certificates contain a legend restricting a transfer.
  4. The physical certificates are appropriately safeguarded by the adviser and can be replaced upon any destruction or even loss.
  5. The adviser creates and maintains a record of the custodian’s closure.

The above FAQ responses by the staff of the SEC’s Division of Investment Management have indicated that although COVID-19 has disrupted the operation and ordinary course of business within private funds, delays are not to be expected or necessarily upheld. However, leniency has been given relating to enforcement action of the above items where significant challenges have been encountered relating to COVID-19. Those required to comply with the Custody Rule should remain diligent in ensuring compliance through this time. The SEC’s FAQ page relating to the Custody Rule can be found here.

For more information on this topic, or to learn how Baker Tilly asset management industry specialists can help, contact our team.

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