September 25, 2002
Mr. Jonathan G. Katz
Re:Comments on Proposed Rules Concerning Custody of Funds or Securities of Clients
Dear Mr. Katz:
The Financial Services Practice Group of Dechert is pleased to have this opportunity to comment on the Commission's proposed amendments to rule 206(4)-2 under the Investment Advisers Act of 1940 (the "Advisers Act") and to Part II of Form ADV, as set forth in Release No. IA-2044 dated July 18, 2002 (the "Proposing Release").
Dechert is an international law firm with a wide-ranging financial services practice that serves clients in the United States and worldwide. Among these are many US-registered investment advisers, including investment advisers that act as investment adviser, general partner or managing member to pooled investment vehicles ("Private Funds") that are not registered with the Commission under the Investment Company Act of 1940, as amended (the "1940 Act"). Private Funds may include entities commonly known as "hedge funds," "private equity funds," and "venture capital funds." The comments that follow reflect our own views and are in behalf of clients, but do not necessarily reflect the views of all clients of the firm.
In general, we commend the Commission's proposal to amend rule 206(4)-2 to reflect modern custody practices and to clarify the circumstances under which an investment adviser is deemed to have custody of client assets. As the Commission noted in the Proposing Release, custodial practices have changed significantly in the forty years since the adoption of rule 206(4)-2, and although the Commission's staff has attempted to reduce the compliance burdens on investment advisers by issuing numerous no-action letters with respect to the rule, the proposed amendments to the rule will clarify an investment adviser's duties with respect to clients' assets deemed to be in its custody. However, in certain respects, the amended rule would create additional compliance burdens with respect to Private Funds that we do not believe further investor protection.
Our specific comments on the proposed amendments to rule 206(4)-2 address the following matters: (1) the exemption from the rule applicable to client assets held in pooled investment vehicles; (2) the requirement that all client securities be maintained in an account with a qualified custodian; (3) the definition of "qualified custodian;" (4) the definition of an "independent representative" with respect to the delivery of account statements to pooled investment vehicles; and (5) the definition of "custody." We address these in turn below.
I. Exemption for Pooled Investment Vehicles
Amended rule 206(4)-2 would exempt advisers from the rule with respect to assets held in Private Funds if the Private Fund: (i) has its transactions and assets audited at least annually; and (ii) distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all investors within 90 days of the end of its fiscal year. We generally agree that the proposed exemption would apply to the advisers of most Private Funds, as most Private Funds of which we are aware undergo annual audits of their financial statements and send audited financial statements to all investors. However, we are concerned that, in certain instances, Private Funds that are otherwise operated in conformity with locally accepted principles of prudent management may not satisfy the technical requirements of the proposed exemption, and therefore their advisers would be subject to the rule, although no additional protection would be provided to investors as a result of the advisers being required to comply with the rule.
A. "Generally Accepted Accounting Principles"
Many Private Funds prepare their financial statements in accordance with generally accepted accounting principles of a jurisdiction other than the United States. This may be the case for a variety of reasons, including when the Private Fund is part of a "master/feeder" fund structure, and the master fund is organized outside of the United States, or when the Private Fund is subject to the jurisdiction of a non-U.S. regulator and that regulator requires financial statements to be prepared in accordance with different accounting principles than those applicable in the United States. The audit report on the financial statements, and the financial statements themselves, would normally disclose the applicable accounting principles under which the financial statements were prepared. Consequently, an investor will know the accounting principles that were used in preparing the financial statements.
Although the proposed exemption does not specify the meaning of "generally accepted accounting principles," we assume that this term refers to generally accepted accounting principles as applied in the United States ("U.S. GAAP").1 However, because the applicable accounting principles under which the financial statements are prepared will be disclosed in the financial statements (and referenced in the audit report), we believe that advisers to Private Funds utilizing generally accepted accounting principles other than U.S. GAAP should also be permitted to rely upon the exemption contained in amended rule 206(4)-2.
In addition, many Private Funds deviate in certain ways from applicable generally accepted accounting principles in the preparation of their financial statements. For example, U.S. GAAP requires that a Private Fund's organizational expenses be expensed in the period incurred. However, many Private Funds, in order to more equitably allocate the fund's organizational expenses among investors in the fund, choose to amortize organizational expenses over a five-year period. Similarly, many Private Funds deviate from U.S. GAAP by not including in their financial statements a schedule of each investment held by the Private Fund constituting more than five percent of the Private Funds' net assets. These accounting policies typically are disclosed in a Private Fund's offering memorandum as is the fact that these accounting policies may result in a qualified opinion being rendered on the fund's financial statements.2 Although each of these accounting practices deviates from U.S. GAAP, we believe that such deviations would not negatively affect the ability of the fund's investors to protect themselves from the misuse of the fund's assets. Moreover, typically a Private Fund's financial statements are audited in accordance with generally accepted auditing standards ("GAAS"), providing additional protection to the Private Fund and its investors.
We recommend that an adviser to a Private Fund be permitted to rely upon the exemption contained in amended rule 206(4)-2(b)(2) if: (i) the fund's financial statements are prepared in accordance with U.S. GAAP; (ii) the fund's financial statements are prepared in accordance with generally accepted accounting principles applicable in a non-U.S. jurisdiction in which the fund, or its manager, operates, is subject to regulation or is organized; or (iii) any deviations from U.S. GAAP, or other applicable generally accepted accounting principles, are clearly disclosed and the financial statements are audited in accordance with GAAS.
B. Timing of Delivery of Audited Financial Statements
Certain funds seek to achieve their investment objective by investing in other funds. These funds are typically referred to as "funds of funds." Private Funds that are funds of funds are unable to complete their annual audits until after the completion of the annual audits of the funds in which they invest. Moreover, certain Private Funds may invest in certain asset classes, such as private equity, that may raise difficult accounting or auditing issues, and may not complete their audit for several months after their fiscal year end. As a result, a Private Fund that is a fund of funds may have difficulty sending financial statements to its investors within 90 days of its fiscal year end. Consequently, many advisers to Private Funds that are funds of funds may not be permitted to rely on the exemption from the rule.
We believe that extending the time period by which a Private Fund that is a fund of funds must send its investors audited financial statements in order for its adviser to rely on the exemption from amended rule 206(4)-2 would enable an increased number of advisers to Private Funds to rely on the exemption and would not result in a significant reduction in the protection afforded to investors. It is noteworthy that the Commodity Futures Trading Commission has adopted a rule specifically permitting, under certain conditions, a fund of funds that is a commodity pool, an extension of time (of up to 60 days) to send annual reports to its investors.3 Therefore, we recommend that the proposed amended rule 206(4)-2(b)(2) be revised to exempt an adviser to a fund of funds from amended rule 206(4)-2 if the fund distributes its audited financial statements to its investors within 150 days of its fiscal year end.
II. Use of Qualified Custodians
Amended rule 206(4)-2, as proposed, would require that advisers maintain both client funds and securities with a qualified custodian (as defined in the rule) in an account either under the client's name or under the adviser's name as agent or trustee for its clients. Qualified custodians would include banks, savings associations, registered broker-dealers, and registered futures commission merchants.4 In contrast, the current rule requires only that client securities be held in a place reasonably free from risk of destruction or other loss.
A. Uncertificated Securities
Many securities held in a client's account are evidenced by a certificate issued in the name of the client or in the name of a nominee for a securities depository, such as The Depository Trust Company. These types of securities typically may be held through a qualified custodian. However, certain securities are not evidenced by a certificate ("uncertificated securities"). For example, securities issued by a Private Fund typically are not evidenced by certificates. The only record of the owners of uncertificated securities may be with the issuer's transfer agent or in the records of the issuer itself.
The Commission's staff has granted no-action relief under the 1940 Act to permit registered funds to invest in uncertificated securities of underlying funds.5 In each of these cases, the funds were permitted to maintain the uncertificated securities of the underlying funds in the book-entry system of the underlying funds' transfer agent. In addition, one of the conditions of the relief was that the funds would maintain a system reasonably designed to prevent unauthorized persons from giving instructions to the underlying funds' transfer agent. We believe that the relief granted in these no-action letters strikes an appropriate balance between protecting the funds' assets and permitting the funds to invest in uncertificated securities.
A fund may also invest in uncertificated securities of an issuer that does not have a registered transfer agent. For example, the beneficial interests in many Private Funds are maintained by an administrator engaged by the Private Fund or by the Private Fund itself. Similarly, a Private Fund that is a private equity fund or a venture capital fund may invest in uncertificated securities of private companies. In these cases, the Private Fund would not fall within the no-action relief described above, because the uncertificated securities of the underlying Private Funds would not be held in the book-entry system of a registered transfer agent. However, we believe that the most important factor in the protection of a fund's assets is whether a system is in place to prevent unauthorized transactions, rather than the identity of the entity maintaining the fund's interest. Moreover, the concern expressed in the Proposing Release, the risk that a client's securities certificates may be lost, stolen or destroyed, would be adequately addressed if such a system is in place.
Therefore, we recommend that the amended rule permit uncertificated securities of an issuer to be held in book-entry form with the entity that maintains the records of the issuer's security holders in the normal course of business (regardless of whether the entity is a qualified custodian), provided, however, that the adviser has implemented a system reasonably designed to prevent unauthorized persons from giving purchase, sale or delivery instructions to such entity.
B. Certificated Securities Issued in a Private Placement
A Private Fund, particularly a private equity fund or venture capital fund, may also invest in privately-placed securities of a company for which a certificate is issued. Typically, these securities would be subject to restrictions on transferability and the certificate would contain a legend noting that the security is subject to such restrictions. To require that these securities be held by a qualified custodian increases the cost associated with holding the securities while affording minimal protection to investors.
We believe that the Commission should continue to permit physical certificates of securities issued in a private placement, which are subject to restrictions on transferability, to be maintained by an adviser, so long as the securities are held in a place reasonably free from risk of destruction or other loss. Even if these securities were stolen, the restrictions on transfer would make it very difficult, if not impossible, for the person possessing them to dispose of them. Moreover, if the certificate was lost or destroyed, the issuer would typically issue a new certificate to replace the lost certificate if the client submits a lost certificate form and provides appropriate indemnification.6 Consequently, a client is exposed to very limited risk as a result of its adviser having custody of physical securities certificates.
Moreover, an adviser may have difficulty engaging a qualified custodian to maintain custody of physical securities certificates at a reasonable cost. As noted in the Proposing Release, most securities are now held through book-entry in custodians' accounts with securities depositories. Holding physical certificates would result in additional processing and administrative expenses for a custodian, which ultimately would be passed on to the client. We believe that the additional protection afforded to clients by having physical securities certificates held by a qualified custodian would be outweighed by the additional expenses incurred.
Therefore, we recommend that the amended rule permit an adviser to maintain custody of physical certificates of securities issued in a private placement, provided that (i) the securities are subject to restrictions on transferability and the certificate contains an appropriate legend to that effect and (ii) the securities are held in a place reasonably free from risk of destruction or other loss.
III. Definition of "Qualified Custodian"
Amended rule 206(4)-2(c)(3)(v) would include as a "qualified custodian," with respect to securities for which the primary market is a country other than the United States, and cash and cash equivalents reasonably necessary to effect transactions in those securities, a financial institution that customarily holds financial assets in that country and that holds client assets in customer accounts segregated from its proprietary assets.
The securities of certain funds may be held in a country other than the United States by a financial institution that would be considered a "qualified custodian" except that the primary market for the underlying security is not in that country. For example, a fund organized outside of the United States, and advised by an adviser registered under the Advisers Act, may invest in securities for which the primary market is in the United States. However, the fund's assets may be held by an offshore custodian, usually in the fund's domicile, for regulatory or other reasons. Similarly, the fund could invest in securities for which the primary market is in a non-U.S. country other than the country in which the custodian is located. In each of these circumstances, the fund's assets would not be deemed to be held by a "qualified custodian."
We believe that whether a particular financial institution is considered a qualified custodian should be based upon manner in which the assets are held and the regulatory scheme applicable to the activities of that financial institution rather than the location of the primary market for the securities being held. Accordingly, we recommend that rule 206(4)-2(c)(3)(v) be revised to include as a qualified custodian any financial institution that customarily holds financial assets in the country where it is located, that holds client assets in customer accounts segregated from its proprietary assets, and that is subject to a regulatory scheme with respect to these activities.
IV. Delivery of Account Statements to Clients - Independent Representatives
Amended rule 206(4)-2 would generally require advisers to send quarterly account statements to their clients and to undergo annual surprise examinations by an independent public accountant of client assets in the adviser's custody. However, an adviser would be exempt from these requirements if the qualified custodian sends monthly account statements directly to each client. In the case of an adviser acting as the general partner of a limited partnership (or acting in a comparable capacity with respect to a similar entity), the adviser or the qualified custodian, as applicable, would be required to deliver account statements to each investor in the limited partnership (or other similar entity) or to the investors' independent representative.
We do not believe that the delivery of account statements to investors is a viable alternative for many or even most advisers to Private Funds. In addition to the burden and cost of sending account statements to each investor in a Private Fund, the account statements are not likely to provide any meaningful information to an investor. Account statements contain a lengthy listing of all securities purchased and sold during the period. An investor is likely to be confused due to the amount of information contained in an account statement. Moreover, many Private Funds employ strategies that result in high turnover, resulting in an increased number of transactions in an account statement. Finally, the account statements may contain confidential information regarding the Private Fund's investment strategy, which could be useful to an adviser's competitors. Accordingly, we believe that most Private Funds that do not qualify for the exemption from the proposed amended rule will choose to send account statements to an independent representative.
The term "independent representative" is defined as a person that, among other things, "[a]cts as agent for limited partners of a limited partnership (or members of a limited liability company, or other beneficial owners of another type of pooled investment vehicle) and by law or contract is obliged to act in the best interest of the limited partners . . . ." In addition, the independent representative must not control, be controlled by or be under common control with, the adviser (i.e. it must not be a "control affiliate" of the adviser) and must not have, or had in the past two years, a material business relationship with the adviser.
In some instances, a Private Fund engages an administrator to perform certain administrative services on behalf of the Private Fund, including processing purchases and redemptions of interests in the Private Fund, fund accounting (including allocations of profits and losses to capital accounts) and calculating or confirming fees paid to the adviser.7 The administrator typically acts pursuant to a written agreement with the Private Fund. However, in most cases, the administrator is not obligated under its agreement with the Private Fund to act in the best interests of the Private Fund's investors and therefore would not qualify as an independent representative under amended rule 206(4)-2. As a result, in cases where a Private Fund has engaged an administrator, either the adviser or the qualified custodian would still be required to send the account statements to each investor of the Private Fund or the Private Fund would be required to engage an independent representative.
We believe that permitting an administrator or other service provider to a Private Fund to act as the "independent representative" would ease the burden and cost associated with sending account statements to each investor in the Private Fund, or the cost of engaging a separate independent representative for the sole purpose of receiving and reviewing account statements, while still providing adequate protection to investors. Although an administrator typically is not obligated by law or contract to act in the best interests of a Private Fund's investors, if the administrator is not a control affiliate of the adviser it should be sufficiently free of conflicts of interest to act as an "independent representative." Moreover, under the terms of the agreement with the Private Fund, an administrator or other service provider typically would be liable to the Private Fund if the administrator does not satisfy the requisite standard of care in the performance of its duties, giving investors a potential derivative claim. Accordingly, we recommend that the amended rule permit an administrator or other service provider to a Private Fund to act as the "independent representative" with respect to a Private Fund provided that (i) the administrator or other service provider is contractually obligated to calculate or confirm the calculation of the adviser's fee and allocations to the adviser's capital account and (ii) the administrator or service provider is not a control affiliate of the adviser.
V. Definition of "Custody"
Proposed rule 206(4)-2(c)(1) defines "custody" to include: (i) possession or control of client funds (except for checks drawn by clients and made payable to a third party) or securities, unless received by the adviser inadvertently and returned to the sender within one business day of receipt; and (ii) any arrangement (including a general power of attorney) under which the adviser is authorized or permitted to withdraw a client's funds or securities maintained with a custodian upon the adviser's instruction to the custodian.
Many advisers, as a service to their clients, may have the authority pursuant to a limited power of attorney to transfer funds or securities between a client's accounts, or between a client's accounts and a specified third party. For example, a client may wish to permit its adviser to transfer funds between the client's brokerage account and bank account, or to transfer funds from the client's brokerage or bank account to a specified third party. Where the adviser's authority is limited to transferring funds or securities to or from specified accounts (other than those in the name of the adviser), pursuant to a client's express standing instructions, the adviser should not be deemed to have custody of the client's funds or securities.8 In this situation, the adviser is simply acting as agent of the client by directing the disposition of a client's funds or securities pursuant to the pre-approved instructions of the client. Notably, the adviser does not have the authority to obtain possession of the client's funds or securities. The risk of misappropriation of the client's funds or securities is minimal because the adviser may only transfer the funds or securities to accounts specified by the client.
In order to permit advisers provide services as described above without being deemed to have custody of clients' funds or securities, we recommend that the definition of "custody" in the proposed rule be revised to permit an adviser to transfer clients' funds or securities to another account of the client, or to the account of a third party, as specified by the client, without the adviser being deemed to have custody of the clients funds or securities.
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We appreciate the opportunity to comment on the Commission's proposed amendments to the custody rules. If we can be of any further assistance in this regard, please do not hesitate to contact George J. Mazin at (212) 698-3570, David A. Vaughan at (202) 261-3355, Brian S. Vargo at (215) 994-2880 or J. Stephen King, Jr. at (949) 442-6040.