In response to a slew of inquiries, the US Securities and Exchange Commission (SEC) clarified that its custody rule does not necessarily capture private stock certificates issued in a private placement.
The custody rule is designed to prevent investors’ assets becoming misappropriated, lost or misused.
SEC-registered private equity firms who have “custody” (or access to) fund assets must safe-keep them at an investment bank, broker-dealer or some other “qualified custodian”. GPs complain hiring a bank or broker-dealer to hold their non-transferable stock certificates or partnership agreements provides no additional investor protections and is a money waster.
The SEC seems to agree, stating in recent guidance it “would not object” if a GP maintained its private stock certificates or partnership agreements internally provided the fund was subject to a financial statement audit (most GPs are); transfer of the security could only take place with LP consent; and the stock certificate could be replaced upon loss or destruction, among some other technical criteria.
The guidance comes at a time when some registered investment advisers have struggled with the SEC’s custody rule. Some GPs are unaware their normal auditor can’t double as the auditor responsible for verifying custody of client assets. The custody rule also requires GPs to prepare their audited financial statements in accordance with US GAAP, which not every GP has been able to do without error.
Even with the welcomed guidance, one US-based chief compliance officer speaking with PE Managernoted it can be difficult to determine where within the fund structure ownership of a security should be attributed. Debevoise & Plimpton funds partner Ken Berman added funds that forgo an audit will not find relief from the guidance.
A Ropes & Gray client memo issued earlier this year suggested the SEC will take a “rigorous and painstaking” approach to examinations, especially regarding technical custody rule violations.
A separate private equity lawyer recently told PEM that the SEC views small infractions, like those involving custody, as a breeding ground for larger problems. “In the mind-set of the SEC exam staff if you get sloppy on little things like custody then it is more likely that you will have big problems.”