SEC Issues Custody Rule Relief for Fund Managers

Earlier this year, the Securities and Exchange Commission (“SEC”)issued a no-action letter in response to a request by 16thAmendment Advisors LLC (“16th Amendment”) regarding the independent verification and financial statement provisions of Section 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-2 (the “Custody Rule”). For background on the Custody Rule, read our primer.

Under the Custody Rule, registered investment advisers that have custody of the assets of a pooled investment vehicle must either arrange for an annual surprise examination of the fund’s assets or an annual audit. The examination or audit must be conducted by an independent public accountant that is registered with, and subject to inspection by, the Public Company Accounting Oversight Board.

16th Amendment requested relief from these provisions of Custody Rule, asserting that an examination or audit is unnecessary when the client and investment adviser are the same. Specifically:

  • 16th Amendment’s principal owners, Messrs. Lamp, Lee, and McCarthy, together own a 91% interest in 16th They are listed as control persons on the firm’s Form ADV;
  • The remaining owner, Mr. Sen, owns 9% as a passive investor in 16th He is not invested in the fund but does have access to certain of 16th Amendment’s information as an owner;
  • Lamp, Lee and McCarthy own 100% of the fund and its general partner.

The SEC determined that it would not recommend enforcement action of the Custody Rule for advisers that do not comply with the examination or audit provisions in these circumstances, particularly that the only investors in the funds:

  • Are principals of the adviser, which the SEC defined as those (a) with plenary access to information concerning the management of the adviser, the funds and their general partners; (b) who are listed as “control persons” in Schedule A of the adviser’s Form ADV because of their status as officers or directors; and (c) who have material ownership in the adviser; and
  • Are the principals’ spouses and minor children, including investment vehicles established for their benefit.

While this relief means that advisers like 16th Amendment need not undergo costly audits, firms should carefully consider their circumstances and the criteria outlined above. Custody arrangements are a routine examination area (see the SEC’s Risk Alert for common pitfalls); firms wishing to take advantage of this relief should read the no-action letter in its entirety and consider documenting the basis of its analysis, including retaining all supporting information so it is available in an examination.  Any concerns about the applicability of this relief should be addressed to outside counsel and/or a firm’s compliance consulting firm.