Compliance Avenue

On May 20, 2010, the staff of the SEC’s Division of Investment Management updated its responses to questions about Advisers Act Rule 206(4)-2 (the “Custody Rule), which was significantly amended by the SEC in December 2009.

The modified FAQs address (among other things) certain issues applicable to registered investment advisers of pooled investment vehicles (such as hedge funds, private equity funds and funds of funds). As discussed below, these FAQs underscore the importance for fund advisers to comply with the annual audit requirements in the Custody Rule, because the consequences of non-compliance would be quite severe.

Specifically, new FAQs VI.1 and VI.3 and modified FAQ VI.2 discuss the application of the Custody Rule’s requirements to an investment adviser of a pooled investment vehicle in the event that the investment adviser does not comply with the “annual audit” requirements, i.e., if the adviser does not distribute to investors in the fund, within 120 days (or 180 days for a fund of funds), annual financial statements prepared in accordance with GAAP (with no material qualifications), prepared by an independent auditor that is registered with, and subject to examination by, the Public Company Accounting Oversight Board.

As discussed below, these FAQs underscore the importance for fund advisers to comply with the annual audit requirements in the Custody Rule, because the consequences of non-compliance would be quite severe.

The Staff confirmed in FAQ VI.1 that if an adviser does not comply the “audit provision” requirements, the quarterly account statement exception would not be available to the adviser. As a consequence, the adviser, among other things, must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends quarterly account statements to each investor in the pool. Moreover, in modified FAQ VI.2 the Staff clarified that if an adviser does not comply the “audit provision” requirements, and thus is subject to the quarterly account statement requirement, the adviser would not be able to comply by simply sending each investor a statement of the investor’s ownership interest in the pool (e.g., the investor’s ending capital balance in a limited partnership).  Rather, each account statement must be a statement of funds and securities held by the pool and every transaction entered into by the pool (including purchases and sales of securities, payment of fees and expenses, receipt of new subscriptions and satisfaction of redemption requests, etc.  Thus, the adviser would essentially be required to provide each investor with complete and total transparency of the fund’s activities, not only at the portfolio level, but also at the fund level.

In FAQ VI-1 the Staff also confirmed that if an adviser does not comply with the audit provision requirements, the adviser must obtain an annual surprise examination with respect to the pool’s assets. Moreover, new FAQ VI.3 states that the accountant’s confirmation procedures for a surprise examination of a pooled investment vehicle must include confirmation with investors of the pool.  Specifically, the accountant must obtain confirmation from investors of (i) funds and securities held by the pooled investment vehicle as of the date of the examination and (ii) contributions and withdrawals of funds and securities to and from the pooled investment vehicle by the investor since the date of the last examination. The quarterly account statements required to be sent by the qualified custodian should provide investors with the information necessary to respond to the confirmation.

Finally, it should also be noted that if an adviser does not comply with the audit provision requirements, the adviser would be required to maintain any privately offered securities owned by the pool with a qualified custodian.  Generally advisers to pooled investment vehicles are exempt from the requirement to maintain private offered securities with a qualified custodian; however, this exemption is not available with respect to assets of an unaudited pool.

Thus, the modified FAQs made it very clear that an adviser to a pooled investment vehicle would be subject to significant and onerous requirements if the financial statements of the pool are not audited and distributed to investors in accordance with the Custody Rule’s audit requirements.