Proposed custody rule would hit small- and mid-market hardest

GPs’ costs would rise due to more assets falling under qualified custodians mandate.

A proposed revision to the custody rule by the Securities and Exchange Commission would have a significant impact on mid-market, experts say, as the regulator tries to solve what one lawyer calls a “non-existent problem” by requiring more private assets to be held by a qualified custodian.

Proposed last week, the rule would increase custody cost for private equity managers because it narrows the exceptions for what are private assets, requiring private equity firms to hold more assets with qualified custodians.

“Ultimately, at the end of the day this proposal will hurt investors because there will be fewer people entering the middle market PE industry, which will hurt potential portfolio companies who need capital, and will hurt the employees of those businesses,” said Yasho Lahiri, a partner at Kramer Levin.

If adopted as written, the definition of custodial assets would be expanded to include “funds, securities, or other positions held in a client’s accounts,” and expand the scope of the rules for some “privately offered securities.”

It also narrows the definition of “qualified custodian,” although more financial institutions would qualify, according to Lahiri. These would have to provide investment advisers reasonable assurances about the safety of the assets they hold. Becoming a qualified custodian would increase the liability for those institutions – from a “gross” to “ordinary” negligence standard – and would also result in greater liability for the actions of sub-custodians, noted Lahiri.

Under the proposal, custodians will have to indemnify fund managers and have a certain standard of safeguards in place for client assets.

Neel Maitra, a partner at Wilson, Sonsini, Goodrich & Rosati and former senior special counsel for Digital Assets & Blockchain Technology at the SEC, said there will be additional costs for qualified custodians to certify that they meet the custody requirements, and those costs will be passed on to the advisers.

Additionally, custodians will also have more reporting and other compliance complexities with respect to custodied assets, Lahiri said.

“The insurance costs to protect against the new liability and the cost of complying with the new requirements will be passed on to the funds and, ultimately, their investors,” Lahiri explained.

New rule

The SEC also proposed to expand the availability of the audit provision, in which an independent public accountant can verify client assets. But the new rule could also raise audit costs by requiring more assets to be custodied under a lower liability standard.

While the proposed rule would require all client assets to have a qualified custodian, not just funds and securities, there is a narrow exception for assets that cannot be held with a qualified custodian.

Chris Avellaneda, a partner with Schulte Roth & Zabel, explained that the exception for certain private securities will be changing under the proposal to also cover physical assets, such as real estate. Currently, a manager with the reasonable belief that a certain private security met the criteria for the exception wouldn’t have to keep the asset with a custodian. However, the proposal would narrow the exception to require a sponsor to believe that the asset couldn’t be held with a qualified custodian.

“The proposed rule will create challenges for PE firms in terms of deciding whether the exception from the qualified custodian requirement is available to them,” Avellaneda said. “PE Funds would need to take additional steps to use the exception than under the current rule, and even if they do, they would be subject to additional requirements than they are now, including having an auditor review private transactions.”

Although the rule will introduce higher custody costs and a greater compliance burden for private equity managers, Maitra said it will also provide needed clarity on which assets need to be custodied and which institutions would count as “qualified custodians,” which could allow managers to invest in newer types of assets because of the greater clarity the rule gives on what assets must be held with a qualified custodian.

“It takes a lot of the guesswork out of determining which assets have to be held with a custodian,” Maitra said. “And I think we will see more custodians available to hold assets, which would give managers more options for someone to hold the assets as required. This would allow managers to take advantage of different investment opportunities because the question of whether something would be a security and need to be held with a qualified custodian will be much clearer.”