News & Analysis

SEC sounds the alarm on custody rule

Registered private equity firms that fail to recognize they hold custody over client assets may significantly raise regulators' suspicions, according to legal sources.

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A risk alert sent out by the Securities and Exchange Commission (SEC) has highlighted that not all private equity firms are aware of their duty to comply with its custody rule.

The Madoff-inspired regulation provides a number of protections for investors who have securities held by GPs on their behalf. Among other requirements, the rule requires SEC registered private equity firms to use an independent accountant, if they have custody over clients’ assets.

The SEC said that it discovered a number of recently registered investment advisors failed to recognize that they had custody over client assets during examinations.

If you get sloppy on little things like custody then it is more likely that [the SEC believes] you will have big problems

“Essentially the way the SEC interprets custody is in the ability to obtain access to the assets. The GP of a fund has that ability because it controls the fund and generally the money and securities are held in an account for a fund and not in individual limited partner accounts,” O’Melveny & Myers lawyer, Kris Easter, told PE Manager.

One of the primary reasons why GPs have struggled with the rule is their lack of familiarity with the more technical aspects of registration, explain legal sources. Hundreds of private equity firms became registered just last March. 

A Ropes & Gray client memo suggests that the SEC will take a “rigorous and painstaking” approach to examinations, especially regarding technical custody rule violations.

“If you want minimize your regulatory exposure, one key step is spending a lot of time dotting all the i’s and crossing the t’s on the custody rule,” said Ropes & Gray lawyer George Raine.

“Your ability to show that you know how it works and have considered it will significantly increase the likelihood that you will come out of an SEC exam quickly and without incident.”

Raine believes 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.”