SEC provides Custody Rule guidance for private funds, SPVs and escrows
The US Securities and Exchange Commission has issued a new Guidance Update - “Private Funds and the Application of the Custody Rule to Special Purpose Vehicles and Escrows.”
According to Cordium, this regulatory update is relevant to certain registered investment advisers to private pooled investment vehicles using special purpose vehicles (SPVs) when making investments (investment SPVs) and to firms that use escrow accounts when selling interests in portfolio companies, in both cases typically private equity firms.
The Guidance Update discusses how advisers with Investment SPVs may comply with Investment Advisers Act of 1940 Rule 206(4)-2 (the “Custody Rule”), specifically with respect to the delivery of audited financial statements.
The Guidance Update also addresses how advisers using escrow accounts may comply with the Custody Rule’s requirement to maintain custodied funds and securities with a qualified custodian in separate accounts under each client’s name or in accounts containing only the adviser’s client’s funds and securities.
DIM determined to issue this Guidance Update in response to inquiries received by DIM and issues identified by the SEC Office of Compliance Inspections and Examinations (OCIE) in exams.
Investment SPVs – Advisers to private funds may have one or more of the funds they manage invest in certain securities through Investment SPVs which are generally controlled by the adviser or its related persons (i.e., persons, directly or indirectly, controlling or controlled by the adviser, or under common control with the adviser). In complying with the requirements under the Custody Rule regarding the delivery of audited financial statements to related persons, an adviser may treat the SPV as a separate client (i.e., the adviser has custody of the SPV’s assets) or treat the SPV’s assets as assets of the funds of which it has indirect custody. Under the Custody Rule, an adviser that relies on the audit provision (discussed further below) and treats the SPV as a separate client must distribute the SPV’s audited financial statements to the beneficial owners of the pools owning the SPV. An adviser relying on the audit provision that treats the SPV’s assets as assets of the funds of which it has indirect custody must include those assets in the funds’ financial statement audits.
The staff presents four scenarios related to Investment SPVs, along with DIM’s response to each. The assumption in each of the four scenarios is that the adviser has determined that the vehicle in question is an investment advisory client.
• Single purpose vehicles; multi-fund single purpose vehicles; multi-purpose vehicles. The first three scenarios relate to (i) a single purpose vehicle, where the adviser to a fund client uses a vehicle to purchase a single investment on behalf of the fund; (ii) a multi-fund single purpose vehicle, where the adviser uses a vehicle to purchase a single investment on behalf of multiple fund clients; and (iii) a multi-purpose vehicle, where the adviser uses a vehicle to purchase multiple investments on behalf of one or more fund clients. In response to each of these three scenarios, DIM advises that if (i) the assets of the vehicle are within the scope of the fund client(s)’ financial statement audit(s); and (ii) the vehicle has no owners other than the adviser, the adviser’s related persons or fund client(s) that are controlled by the adviser or the adviser’s related persons, then an adviser relying on the audit provision may treat the assets of those vehicles as assets of the fund client(s) of which the adviser or adviser’s related person(s) has indirect custody (and include the vehicles’ assets within the scope of the pooled vehicles’ financial statement audits).
• Investment funds. The fourth scenario presented is that of an “investment fund,” a vehicle which is used to purchase one or more investments on behalf of one or more fund clients and third party owners that are not the adviser, the adviser’s related persons or funds controlled by the adviser or its related persons. An adviser relying on the audit provision should treat the assets of such an investment fund as a separate client, and must comply separately with the Custody Rule’s audited financial statement distribution requirements with respect to that investment fund.
Escrow accounts – Advisers have asked DIM how the Custody Rule applies to escrow accounts used for a limited period of time in connection with the sale of a portfolio company owned by one or more pooled investment vehicles (escrows). These questions generally come up in the context of a sale (or merger) of a portfolio company owned by (a) one or more pooled investment vehicles (most frequently private equity funds) advised by a registered investment adviser, and (b) other persons that are not clients of the adviser. Often there is a sellers’ representative appointed to act on behalf of the adviser’s clients as well as on behalf of the non-client owners of the portfolio company with respect to a part of the sale proceeds held in Escrow following the closing. The reason such an account might be problematic is that the Custody Rule requires an adviser to keep funds and securities over which it has custody with a qualified custodian either in a separate account for each client or in accounts holding only the adviser’s clients’ funds and securities. Advisers have posited that the protections (and risks) of the joint Escrows for their clients are materially similar to the accounts required by the Custody Rule and that there would be significant costs to create separate Escrows, some of which the funds’ investors would be required to bear.
• Maintaining client funds in an Escrow with other client and non-client assets. As set out in the Guidance Update, an adviser could maintain client funds in such an Escrow if it meets the following six conditions:
◦ the client is a pooled investment vehicle that relies on the audit provision and includes the portion of the Escrow attributable to the pooled investment vehicle in its financial statements;
◦ the Escrow is in connection with the sale or merger of a portfolio company owned by the client (e.g., for indemnification or to adjust the purchase price);
◦ the Escrow contains an amount of money that is agreed upon as part of a bona fide negotiation between the buyer and the sellers;
◦ the Escrow exists for a set period of time similarly agreed upon in a bona fide negotiation;
◦ the Escrow is maintained at a qualified custodian; and
◦ the seller’s representative is contractually obligated to promptly distribute the funds remaining in the Escrow at the end of the escrow period on a predetermined formula to the sellers, including the pooled investment vehicle clients.
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