Sunday, August 25, 2013
SEC GUIDANCE ON PRIVATELY OFFERED SECURITIES UNDER THE INVESTMENT ADVISERS ACT CUSTODY RULE
The Securities and Exchange Commission (“SEC”) recently provided limited relief to investment advisers to audited pooled investment vehicles from certain requirements of Rule 206(4)-2 under the Investment Advisers Act of 1940 (the “Custody Rule”). The guidance addresses what many perceived to be an unnecessary burden imposed by the Custody Rule. Specifically, the guidance exempts some stock certificates and certificated LLC interests that would otherwise need to be maintained with an independent custodian.
The Custody Rule and the New Guidance
Rule 206(4)-2: The Custody Rule for Investment Advisers
The Custody Rule requires advisers having custody of client funds or securities to maintain those assets with a “qualified custodian,” typically a bank or broker-dealer. Under the Custody Rule, a general partner, managing member, or manager of a pooled investment vehicle is generally deemed to have custody of funds or securities held by the pooled investment vehicle. However, an important exception to this requirement exists for “privately offered securities” that:
- Are acquired from the issuer outside of a public offering;
- Are “uncertificated” (issued without a physical certificate) and have their ownership recorded only on the books of the issuer; and
- Are transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.
Critically, this exception is available to pooled investment vehicles only if they are audited in accordance with SEC regulations.
The New Guidance: An Exception for Certain Non-transferable Stock Certificates
The SEC’s guidance states that it would not object if an adviser does not maintain private stock certificates or certificated LLC interests with a qualified custodian if the following conditions are met:
- The securities are held by a pooled investment vehicle subject to audit in compliance with the Custody Rule;
- The certificate can only be used to effect or facilitate a transfer of beneficial ownership with the prior consent of the issuer or holders of the issuer’s outstanding securities;
- Ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client;
- The certificate contains a legend restricting transfer; and
- The certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.
These conditions allow an audited pooled investment vehicle to avoid an overly strict application of the Custody Rule merely because a security is “certificated.” This guidance might thus reduce the cost of compliance where a pooled investment vehicle holds private company stock certificates or certificated LLC interests, but would generally require a stockholders agreement or LLC agreement restricting transfer.
 The Custody Rule imposes additional requirements on advisers related to notice to clients, account statements, and independent verification of custody.
This Alert is for information purposes only, is general in nature and should not be construed as legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship.