Custody Rule SEC Exams and Enforcement Actions

Author

Vivek Pingili

Publish Date

Type

Article

Topics

  • Compliance

As noted in our recent blog, we have seen an intensified focus on private markets fund managers both from an examination and enforcement perspective.

Focus areas have covered a broad range of issues of substantive relevance to investors, such as fee and expense allocations (and the robustness of related disclosures), appropriateness of hedge clauses, and handling of conflicts of interest in general.

Additionally, we are seeing an increasing willingness from the Securities and Exchange Commission (SEC) staff to undertake deep dives into more technical (and often minute) aspects of the regulations that resemble the “broken windows” approach we saw in the early years of Dodd Frank. For example, we have seen SEC examiners find private markets fund managers (and their employees) deficient for failing to adequately comply with SEC guidance permitting carve-outs from personal trading reporting/pre-clearance requirements for employee personal accounts where discretion has been granted to a third-party investment manager or broker.

In this article, we shine a spotlight on the SEC’s renewed focus on custody rule compliance to illustrate these trends in examination and enforcement activities.

SEC Increases Enforcement Activity Relating to Custody Rule Compliance

This year alone, we have seen numerous enforcement actions involving custody rule violations in the private fund manager space. The frequency with which we have seen the SEC bring these enforcement actions is reminiscent of the custody rule enforcement actions we saw in the early years of Dodd Frank, when the SEC sought to send a clear message to the private fund manager community that custody rule violations would be prosecuted vigorously.

All of these enforcement actions involve failures to undertake annual or surprise audits of private funds (and/or a failure to retain Public Company Accounting Oversight Board (PCAOB)- registered auditors for annual audits), which are typically the most basic types of violations private markets fund managers commit in the custody rule space.

In one noteworthy enforcement action, a fund-of-funds manager was found deficient for failing to deliver the fund-of-funds audited financials to investors within 180 days. The failure was due to the manager not receiving K-1s on a timely basis from multiple underlying fund managers. In light of this enforcement action, fund-of-funds managers should realize that the SEC staff is unlikely to tolerate any attempts to passively point fingers at their underlying fund managers for such custody rule compliance failures. These managers need to actively monitor for these risks and proactively push their underlying fund managers to issue K-1s and/or audited/unaudited underlying fund financials sufficiently in advance to allow fund-of-funds audits to be completed and delivered to investors within 180 days.

In a significant number of these enforcement actions (as well as other types of enforcement actions), fund managers, as part of their respective settlements with the SEC, have had to undertake to retain an independent compliance consultant “not unacceptable” to the SEC staff, for periods ranging from six months to a few years, to assist with developing an action plan to address the types of deficiencies uncovered in these enforcement actions. The roles of these independent consultants have varied from assisting managers with enhancing their policies and procedures to remedying uncovered issues and/or testing managers’ implementation of such policies and procedures and issuing reports detailing these consultants’ findings.

Common Custody Rule Issues & Practical Tips to Avoid Deficiency Findings

In the context of SEC exams, beyond the most common types of custody rule violations described above, we are starting to see the SEC staff, with increasing consistency, expand their scrutiny to cover more complex and greyer areas of the custody rule. As our readers are well aware, despite prior guidance from the SEC aimed at private markets fund managers, the custody rule has always presented unique challenges for such managers.

We identify some of the recurring custody rule issues we have seen in the private market fund manager space (some of which have resulted in SEC exam deficiencies). Given the SEC’s increasing willingness to probe these often more complex areas, now is the time for private fund managers to comprehensively evaluate their custody rule compliance practices and address any relevant gaps.

  • Contractual Waivers
    We have increasingly seen private markets fund managers, via fund governing documents, negotiate waivers of annual fund audits. While this may work for un-registered fund managers (as they are not subject to the custody rule), it will not work for SEC-registered fund managers. The SEC has repeatedly noted, in multiple contexts, that managers cannot contract away specific obligations imposed by the Investment Advisers Act of 1940.1
  • Liquidation Vehicles
    In the context of fund wind-downs where liquidation trusts or other liquidation vehicles are organized to manage the liquidation of remaining assets post fund wind-down, we are noticing an increasing number of private fund managers fail to meet their custody rule obligations relating to these liquidation vehicles.

    In certain instances, custody rule obligations may not attach to liquidation vehicles (e.g., where a third-party is selected to serve as a trustee of a liquidation trust and handle administration aspects of the liquidation in accordance with a mutually agreed-upon liquidation plan and the private markets fund manager no longer has any investment advisory function to perform in this context).

    However, in numerous instances, the trustee/general partner (GP) (or equivalent thereof) of a liquidation vehicle may be the private markets fund manager (or an affiliate thereof), in which case the private markets fund manager will continue to have custody rule obligations in relation to such vehicle and, as such, will need to continue annual/surprise audits of the vehicle and ultimately undertake a liquidation audit.
  • When setting up a liquidation vehicle, do not assume your final custody rule obligation in this context is to undertake one last annual audit of the fund being wound-down. Instead, work closely with your regulatory counsel and/or compliance consultants to analyze whether custody rule obligations may extend to such a liquidation vehicle and, if so, coordinate with your fund auditors to develop a plan of action to meet such obligations.
  • Employee Funds and Co-Investment Vehicles
    With the exception of very limited relief granted by the SEC via no-action guidance, in the case of employee funds (which is more often too narrow in scope to be of assistance to most private markets fund managers), the SEC has repeatedly noted that the custody rule obligations (as well as other Investment Advisers Act obligations) apply to investment vehicles that do not pay management fees or carry.2

    Nevertheless, many private markets fund managers fail to audit employee/friends-and-family funds and co-investment vehicles that are offered on a no-fee and no-carry basis under the false belief that the custody rule obligations do not apply here, as well as out of a concern that investors in these funds may (and sometimes do) complain about the impact of audit fees on the funds’ profit and loss statement (P&L). We have repeatedly found the SEC to be unsympathethic to these positions and have noticed the staff increasingly cracking down on these practices during the course of exams.
    • Private markets fund managers should ensure that, absent the availability of no-action relief permitting otherwise, all of their client entities are annually audited.
  • Surprise Audits? Reconsider
    Private markets fund managers considering surprise audits (in lieu of annual audits), to save on auditor fees, should seriously reconsider such course of action. In our experience, various custody rule requirements that apply to private markets fund managers, taking the surprise audit route often present significant risks that may not justify any cost savings (e.g., the need to custody stock certificates for privately offered securities as well as original deal documents with a qualified custodian such as a fund’s bank (which can often be an expensive proposition as well as logistically challenging)); and the need to have the custodian independently send quarterly statements directly to limited partners (LPs) in the fund identifying all securities and other assets held in the fund, along with transactions the fund undertook during the applicable quarter (which statements can often be inaccurate due to the complex nature of private markets investments).

    The SEC has, during the course of examinations, started to take notice of these recurring deficiencies.
    • Before choosing to go down the surprise audit route for one or more vehicles, consider whether the regulatory compliance risks, related administrative burdens, and costs savings are worth it. In most cases, they are probably not. For one, often times when you factor in the fees charged by custodians to hold evidence of a fund’s ownership of portfolio companies (such as deal docs), the net cost savings by going the surprise audit route may significantly diminish.
    • If you still believe the surprise audit route may be worthwhile, develop a game plan both internally and with your custodian. First, it is imperative to have a centralized process for receiving and holding deal docs and privately offered share certificates. Having these documents loosely spread out between multiple deal counsels and investment professionals will not work. Once the control over these documents is centralized, the next step is to ensure having a process to get these deal docs to the custodian promptly (or have the docs sent directly to the custodian with copies to you). Finally, work with the custodian to reconcile any differences between the securities holdings and transactions listed on their independent quarterly account statements and your records.
  • Consolidated Audits - Pay Close Attention!
    Given the often-complex nature of private markets fund structures, consolidated fund audits are prone to recurring deficiencies whereby these audits, from time to time, do not capture all of the entities in a fund structure (such as AIVs, SPVs, holdcos and intermediate fund structures) through which money flows on its way to or from a portfolio company. Irrespective of generally accepted accounting practices (GAAP) requirements (which is what auditors primarily focus on), the SEC unequivocally requires that these entities either be audited separately or consolidated with the related fund’s audit.

    Especially in light of the complex instances of misappropriation of fund assets uncovered by the SEC in the private markets fund industry, incomplete consolidated audits have become a substantive issue for the SEC.
    • As a practical matter, it is easy for the SEC to uncover instances where a private markets fund manager has not in some form or shape had a vehicle in its fund structure audited because it is increasingly common for the SEC staff to ask for an inventory of all entities in a fund structure, an explanation of how the manager complied with the custody rule in relation to these entities, and where an entity was neither audited independently or via a consolidated Fund audit, the reason for such exclusion.

      Consequently, private markets fund managers should work closely with their fund auditors to pro-actively ensure their consolidated fund audits do not exclude any entities in a fund’s structure through which money flows.
  • Privately Offered Stock Certificates
    The SEC’s guidance relieving private fund managers (who undertake annual audits of their funds) from the obligation to custody stock certificates issued by their funds’ privately-held portfolio has a requirement that is often over-looked. These certificates must be appropriately safeguarded by managers who opt to take advantage of this relief. In many instances, these certificates are loosely held with multiple deal counsel and/or with multiple deal professionals at a private markets fund manager. There is often no centralized control over / inventorying of these documents.
    • While we have not seen the SEC focus on this area to-date, given the SEC’s increasing focus on compliance with technical aspects of custody rule compliance, now is the time to close any gaps in controls over privately offered stock certificates.
    • In at least a few instances, we have noticed portfolio companies issuing ownership certificates where there is no legitimate reason to do so (e.g., where the portfolio company is organized as a LLC, limited partnership or other unincorporated entity). In these instances, work actively with your portfolio companies to see if your funds’ respective ownership interests in these entities can be recorded exclusively on these entities’ books.
  • Stub Periods/Year-End Fund Launches
    We have seen private markets fund managers, in a commendable effort to save audit fees for their investors, either skip audits for stub period where they have launched funds towards the end of a fiscal year (e.g., a fund that closed in mid-December with a December 31 fiscal year end) or undertake audits covering periods in excess of one year (which include that initial stub period). While we are aware that in the latter situation some private markets fund managers have undergone SEC exams without the staff taking issue with this practice, especially in light of the SEC’s current intense focus on technical aspects of custody rule compliance, we caution fund managers against taking such liberties with the strict letter of the rule.
    • In the case of a fund launch towards the end of a fiscal year, if feasible, consider postponing your first capital call until January 1 of the following year. In this instance, you will not have custody of assets during that stub period and, as such, will not need to undertake any type of audit covering that stub period.

How we help

We have a variety of services to help private markets firms comply with the custody rule. Contact us if you have any questions about this article, or to find out more about our services.

Download our Private Markets Quarterly Update

This is just one of many insightful articles included in our Q4 2021 Private Markets Quarterly Update. Download the full newsletter to learn about:

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1 See footnote 30 and related discussion at: https://www.sec.gov/rules/interp/2019/ia-5248.pdf

2 See Q&A II.9. at: https://www.sec.gov/divisions/investment/custody_faq_030510.htm