September 25, 2002
Mr. Jonathan G. Katz
Dear Mr. Katz:
This letter is submitted in response to the request of the Securities and Exchange Commission (the "Commission") for comment1 on proposed amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940, which is referred to as the "custody rule".
Seward & Kissel has a substantial number of registered investment adviser clients that act as the general partner, managing member or investment manager of pooled investment vehicles such as limited partnerships or limited liability companies ("private funds"). These clients currently rely on the procedures set forth in various staff no-action and interpretative letters in order that they are not deemed to have constructive custody of a private fund's assets. Many of our clients are considering the implications of the proposed custody rule amendments. The views we express in this letter, however, are our own and do not necessarily reflect those of our clients.
We commend the Commission's efforts in proposing amendments to modernize the custody rule and to clarify the circumstances under which a registered investment adviser has custody of client assets. We believe that the amendments will provide for greater understanding of the custody rule by registered advisers and generally will reduce unnecessary compliance burdens. However, we note that, in certain cases, a registered adviser acting as the general partner or investment manager to a private fund will be ineligible to take advantage of the exception in sub-section (b)(2) of the proposed amended rule. We believe that the ineligibility of such registered advisers is inconsistent with the purpose of the proposed rule amendments to reduce unnecessary regulatory burdens. Accordingly, we submit the following comments and urge the Commission to consider them before adopting the proposed rule amendments.
Sub-section (b)(2) of the proposed amended custody rule provides that a registered adviser is not required to comply with the other provisions of the rule with respect to the account of a limited partnership (or other type of pooled investment vehicle) that has its transactions and assets audited at least annually and distributes the entity's audited financial statements, prepared in accordance with generally accepted accounting principles ("GAAP"), to all limited partners (or other beneficial owners) within 90 days of the entity's fiscal year end. We note that many advisers of private funds will be ineligible for this exception because of (i) the 90 day delivery requirement and (ii) the requirement that audited financial statements be prepared in accordance with GAAP.
1. 90 Day Delivery Requirement Most private investment funds operating as fund-of-funds are unable to provide their investors with audited financial statements within 90 days of their fiscal year end. Because a fund-of-funds bases its audited financial statements on the audited financial statements of the underlying funds in which it invests, it must receive the underlying funds' financials before it can finalize its own audited financials. Often, a fund-of-funds must wait more than 90 days after its fiscal year end (commonly December 31) before it receives an underlying fund's audited financials. We understand that it is not unusual for a fund-of-funds to finalize its audited financials 5 to 6 months after its fiscal year end. Therefore, we recommend that the financial statement delivery requirement be revised so that it commences on the date that the auditors have signed the company's audit report rather than on the date of the company's fiscal year end. We believe that this change would allow more registered advisers to be eligible for the exception under sub-section (b)(2) without diminishing the level of protection afforded to their clients' assets.
2. GAAP Requirement The audited financial statements of private funds are generally prepared in accordance with GAAP. However, many private funds amortize their organizational expenses over a period of 60 months from the commencement of operations because it is believed such treatment is more equitable than expensing the entire amount of the organizational expenses in the first year, as is required by GAAP. Additionally, in an effort to protect the confidentiality of investment positions, many private funds do not disclose the specific securities held in their portfolio in audited financial statements, although disclosure is required for greater than 5% positions and industry weightings. Accordingly, the audited financial statements of private funds often contain a qualification indicating that they have been prepared in accordance with GAAP, except for the treatment of organizational expenses and/or disclosure of securities positions. We believe that there will be uncertainty as to whether an adviser is entitled to rely on the exception in sub-section (b)(2) of the proposed rule if a private fund for which it serves as general partner or manager has such a qualification in its audited financial statements. Therefore, we request that the Commission eliminate the requirement that the audited financial statements of private fund clients be prepared in accordance with GAAP or, alternatively, provide that such audited financial statements may contain GAAP qualifications for (i) amortization of organizational expenses over a time period exceeding one year and/or (ii) non-disclosure of investment positions. We do not believe that this modification would result in any less protection to a registered adviser's clients from a custody perspective.
We appreciate the opportunity to comment on the proposed amendments to Rule 206(4)-2. If you have any questions regarding this letter, please contact the undersigned at the telephone numbers indicated below.