Hedge Funds exempted from the new SEC Custody Rule

The Securities and Exchange Commission (SEC) has issued amendments to Rule 206(4)-2, the custody rule under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and related amendments to Form ADV Part 1 and Rule 204-2 on recordkeeping.

The purpose of the custody rule amendments is to impose additional controls on registered advisers that have access to client funds or securities. The primary tool for this is independent verification of the assets. The form of such verification varies depending on the nature of the adviser’s access to or control over the assets.

The custody rule will now require an adviser with custody:
• to undergo an annual surprise examination by an independent public accountant registered with the Public Accounting Oversight Board (PCAOB) to verify client assets;
• to have a reasonable belief after due inquiry that any qualified custodian maintaining client assets sends account statements directly to advisory clients; and
• if the adviser or a related person acts as “qualified custodian” of client assets, to obtain or receive from the related person, a report on internal controls relating to the custody of client assets prepared by an independent PCAOB-registered public accountant.
All SEC-registered investment advisers will be required to comply with the enhanced custody rules. The amendments will be effective March 12, 2010, and registered advisers must comply with the new rules as of that date, except in certain cases where other compliance dates are specified.

Unfortunately, every rule has its exemptions and hedge funds will likely be eligible for such exemption.

In fact, an investment adviser to a pooled investment vehicle that is subject to an annual financial statement audit and distributes the audited financial statements (prepared in accordance with U.S. GAAP) to the pool’s investors is deemed to have satisfied the annual surprise examination requirement. The audit must be performed by an independent PCAOB-registered accountant and the financial statements must be distributed to investors within 120 days of the end of the pooled investment vehicle’s fiscal year end (or 180 days for a fund of funds). In addition, if a pooled investment vehicle is liquidated, it must be audited upon liquidation and the audited financial statements distributed to all investors “promptly” after completion of the audit.

The SEC noted that under the amended rule, an adviser to a pooled investment vehicle that satisfies reporting obligations by delivering audited financial statements to investors is not required to have a reasonable belief that the qualified custodian delivers account statements to investors. The SEC has directed its staff to explore ways in which additional protections may be afforded to investors in such vehicles.

For further reading and sources, I recommend the bulletin on the subject published by Katten Muchin Rosenman. You can find the document at the following address:
http://www.kattenlaw.com/sec-adopts-custody-rule-changes/