More guidance on custody rule offered

The US Securities and Exchange Commission (SEC) eased some concerns for registered investment advisors when it clarified that special purpose vehicles setup to acquire a portfolio company do not always require a separate financial statement audit and some relief on post-closing escrow accounts that may contain cash belonging to non-clients of the adviser under its custody rule.

With respect to SPVs, the guidance said a separate audit is not required so long as the SPV’s assets are treated as part of the fund, which is subject to its own audit, and that the SPV is fully owned by funds controlled by the adviser.

The guidance also addresses SPVs that are owned by persons other than the fund. In practice, one example where this might occur is in the context of a “club” deal in which the portfolio company is being acquired by a group of unaffiliated private fund sponsors said Debevoise & Plimpton investment management partner Ken Berman.

“In this context, the guidance suggests that the investment adviser or investment advisers that manage the SPV would be deemed to have custody of the SPV’s assets, should treat the SPV as a separate client and should arrange for a separate audit of the SPV (if the adviser is relying on the audit provision of the custody rule).”

An individual familiar with the matter also said the guidance means a SPV used to acquire a portfolio company that pulls cash from multiple funds managed by the same advisor would not need to undergo a separate audit so long that all the funds used underwent their own audit.

With respect to post-closing escrow accounts – which are sometimes used to hold sale proceeds until certain performance benchmarks are hit – the guidance said these accounts do not require separate escrow accounts so long that: (i) the fund is audited; (ii) the escrow is in connection with the sale or merger of a portfolio company; and (iii) the escrow is maintained at a qualified custodian.

Some compliance officers note that the guidance appears to contradict the custody rule when it suggests that it was possible to create a post-closing escrow account that held assets owned by someone who wasn’t a client of the manager or a “comingled account”.

Berman suggested that the SEC staff was taking a very practical view that while the funds were in the escrow account, they would be subject to appropriate safeguards (including the audit requirement), and that once the funds were released, the fund’s portion of the escrow would be distributed to investors.

The second source confirmed this interpretation, saying that while post-closing escrow accounts may hold cash that doesn’t technically belong to a client of the advisor (for example portfolio company management), it would “add unnecessary costs, often borne by investors” to require an advisor to create multiple escrow accounts in this scenario if the fund was already subject to its own audit.

The guidance is a follow-up to similar custody rule relief issued last August that said the rule does not necessarily cover private stock certificates issued in a private placement. In the guidance, the agency said it “would not object” if a GP maintained its private stock certificates or partnership agreements internally, provided that the fund was subject to a financial statement audit (as most GPs are); that transfer of the security could only take place with LP consent; and that the stock certificate could be replaced upon loss or destruction (along with some other technical criteria).