Staff Letter No-Action relief under Section 206(4) and Rule 206(4)-2 under the Investment Advisers Act of 1940
Dec. 20, 2018
Investment Advisers Act
December 20, 2018
Jay B. Gould
Michael G. Wu
Winston & Strawn LLP
200 Park Avenue
New York, NY 10166
Mr. Gould and Mr. Wu:
Your letter, dated December 17, 2018, requests our assurance that we would not recommend enforcement action to the Securities and Exchange Commission (“Commission” or “SEC”) under Section 206(4) of the Investment Advisers Act of 1940, as amended (“Advisers Act”), and Rule 206(4)-2 (“Custody Rule”) against Madison Capital Funding LLC (“Madison”), an SEC-registered investment adviser, in connection with administrative agent services it performs for its loan syndication business where it proposes not to comply with provisions (a)(1) and (a)(3) of the Custody Rule.
You provide the following background on loan syndicates and the role of administrative agents. You explain that, typically, non-bank lenders fund only a portion of their loans to middle-market companies and syndicate the remaining portion of the loans. In many cases, a portion of the loan will be sold to pooled investment vehicles or separately managed accounts that are managed by an SEC-registered investment adviser that is affiliated with the entity organizing the loan syndicate(s). You represent that the underlying investors in these pooled investment vehicles and separately managed accounts are commonly institutional and other sophisticated investors that seek the yields available on middle-market loans.
You explain that the non-bank lender (or an affiliate) will often also act as the administrative agent on behalf of the loan syndicate pursuant to terms set forth in the credit agreement. In this type of arrangement, each participating lender appoints the administrative agent to take action on its behalf pursuant to the credit agreement and to exercise powers that are delegated to it thereunder, together with other reasonably incidental powers.
You describe the administrative agent’s significant role in the relationship between the loan syndicate and the borrower, highlighting the primary functions of (i) serving as a conduit for most communications (whether ministerial or material) between the borrower and the loan syndicate, (ii) being the single point of contact for payment of principal and interest, as well as the receipt of loan proceeds, so that the borrower does not need to make or receive multiple wires, and (iii) allowing loans to be traded among lenders without disrupting the relationship with the borrower. You represent that, without an administrative agent, borrowers would need to interact with multiple lenders, risk making payments to the wrong lender (or to the correct lender but for the wrong amount) and, if a lender were to sell its loan to another lender, the borrower would need to comply with instructions from and make wire payments to that new lender – all of which would increase the burden, risk, complexity, and cost for the borrowers and the lenders.
Madison’s Loan Syndication Business
Madison is one of the largest non-bank lenders providing senior loans to middle-market companies. For a majority of such senior loans, Madison organizes a loan syndicate and serves as administrative agent to the loan syndicate (each loan syndicate organized by Madison, a “Loan Syndicate”). The participants in a Loan Syndicate (“Loan Syndicate Participants”) generally include Madison and its affiliates, other bank and non-bank lenders, and various institutional and sophisticated investors (either directly, through self-directed investments or separately managed accounts, or through pooled investment vehicles in which they invest). In addition to its business as a middle-market lender, loan syndicator and administrative agent, Madison provides investment advisory services to private investment funds and separately managed accounts for institutional investors (“Advisory Clients”). Loan Syndicate Participants may include Advisory Clients, and other individuals and/or entities that are not Advisory Clients, including Madison or an affiliate (collectively, “Third Parties”).
Each Loan Syndicate’s credit agreement requires Madison to follow negotiated guidelines or formulas regarding the movement of cash to and from the lenders and the borrower, as applicable, for the Loan Syndicate (i.e., the collection of loan proceeds from lenders and their disbursement to the borrower, as well as the use and distribution of payments received from the borrower). Madison, in its capacity as the administrative agent, applies the terms of each credit agreement and has no authority to determine how the cash is used, allocated or disbursed.
A single bank account (“Agency Account”), established by Madison and maintained by a U.S. bank that meets the definition of a “qualified custodian” under the Custody Rule, facilitates the movement of cash to and from the lenders and the borrowers, as applicable, for all of the Loan Syndicates. The Agency Account was opened by and in the name of Madison as agent for the Loan Syndicate Participants (i.e., the funds related to multiple Loan Syndicates are not held in separate accounts or sub-accounts for each Loan Syndicate Participant under the Loan Syndicate Participant’s name, but are commingled in the Agency Account).
As the administrative agent for the Loan Syndicates, Madison does not receive payments from the Loan Syndicate Participants or the underlying obligors in its personal capacity, but as agent for the Loan Syndicate Participants, and any such payments would not be a part of Madison’s estate in bankruptcy.
The Custody Rule is designed to protect client funds or securities from being lost, misused, misappropriated or subject to investment advisers’ financial reverses, including insolvency. The Custody Rule provides that it is a fraudulent, deceptive or manipulative act, practice or course of business within the meaning of Section 206(4) of the Advisers Act for an investment adviser that is registered or required to be registered under the Advisers Act to have “custody” of client funds or securities unless they are maintained in accordance with the requirements of the Custody Rule. Among other things, where an investment adviser has custody of client funds or securities: (1) a qualified custodian must maintain such funds or securities: (i) in a separate account for each client under that client’s name; or (ii) in accounts that contain only the investment adviser’s clients’ funds and securities, under the investment adviser’s name as agent or trustee for the clients and (2) the investment adviser must have reasonable basis, after due inquiry, for believing that the qualified custodian sends account statements to its clients at least quarterly.
Under the Custody Rule, an investment adviser has “custody” of client funds or securities where it or its related person “holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services [it] provide[s] to clients . . . .” Moreover, “custody” includes “[a]ny arrangement . . . under which [an investment adviser is] authorized or permitted to withdraw client funds or securities maintained with a custodian upon [its] instruction to the custodian . . . .”
You state that, in connection with Madison’s loan syndication business, it is likely that Madison would be deemed to have custody of the Advisory Client assets in the Agency Account because it serves as the administrative agent to the Loan Syndicates and has access to and authority to obtain the cash in the Agency Account, including those assets that belong to Advisory Clients. You note that, although Madison has no authority to determine how the cash is used, allocated or disbursed under the applicable credit agreements, nothing would prevent Madison from withdrawing cash held in the Agency Account, including for reasons unrelated to the Loan Syndicates, as Madison controls the Agency Account.
You indicate that because Advisory Clients’ Loan Syndication holdings are commingled in the Agency Account with Third Party Assets for the reasons described above, the requirements of Rule 206(4)-2(a)(1) are not met with respect to those client holdings. You state that Madison proposes to conduct its administrative agent services in the manner reflected below, which you assert would not materially affect the client protections of Rule 206(4)-2(a)(1). You assert that your proposed approach reflected below would provide at least as effective protections for Advisory Clients. You also indicate that, while it may be possible for the custodian of the Agency Account to send Loan Syndicate account statements at least quarterly in accordance with Rule 206(4)-2(a)(3) to Advisory Clients that do not qualify for the exception under Rule 206(4)-2(b)(4), the statements would not be very meaningful to those Advisory Clients (and could even be confusing) because the Loan Syndicate account contains assets belonging to Advisory Clients and assets belonging to Third Parties invested in multiple syndications; a client would be unable to identify its own holdings in these statements. You represent that Madison has a reasonable belief, upon due inquiry, in accordance with Rule 206(4)-2(a)(3), that each Advisory Client that does not qualify for the exception under Rule 206(4)-2(b)(4) currently receives, and would continue to receive, account statements from his, her, or its own qualified custodian(s) at least quarterly, and that these account statements provide each such Advisory Client information about his, her, or its individual portfolio holdings and cash, including individual interests in any Loan Syndicate and cash received therefrom. You maintain that these account statements provide such Advisory Clients meaningful information they need to monitor their assets. Accordingly, we would not recommend enforcement action to the Commission under Section 206(4) of, and Rule 206(4)-2(a)(1) or (3) under, the Advisers Act against Madison in the future for its dual activity as administrative agent and investment adviser, subject to the following conditions:
- The Agency Account will be maintained with a Qualified Custodian, as defined in the Custody Rule.
- Only the assets of Loan Syndicate Participants will be placed in the Agency Account.
- No cash will be deposited in or withdrawn from the Agency Account except pursuant to the credit agreements for the Loan Syndicates.
- Madison will receive payments from Loan Syndicate Participants or underlying obligors only as agent for the Loan Syndicate Participants (and such payments would not be a part of Madison’s estate in bankruptcy).
- In addition to disclosing on its Form ADV Part 1A the Advisory Client assets over which Madison has custody and each qualified custodian with which such assets are maintained, Madison will provide disclosure in its Form ADV Part 2A to reflect its custody of the assets in the Agency Account and that the account commingles Advisory Client and Third Party assets.
- Madison will develop and implement controls for its administrative agent services which include controls that are designed and implemented to ensure that: (i) the assets of the Loan Syndicate Participants are safeguarded from loss or misappropriation; (ii) the assets in the Agency Account are distributed in a timely manner, accurately and completely, and in accordance with the applicable credit agreements; and (iii) the administrative agent services are, and the Agency Account is being operated in a manner that is, consistent with the credit agreements for the relevant loans (“Control Objectives”).
- Madison will obtain a written internal control report (“Control Attestation”), no less frequently than once each calendar year, prepared by an independent public accountant (“Accountant”):
- The internal control report must include an opinion of the Accountant as to whether controls have been placed in operation as of a specific date, and are suitably designed and are operating effectively during the year to meet the Control Objectives;
- The Accountant must verify that the assets in the Agency account are reconciled to a custodian other than Madison or a related person; and
- The Accountant must be registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules.
- Madison will promptly seek to resolve any control activity exceptions identified in the Control Attestation on the part of Madison and/or its employees to comply with or fully implement the controls to meet the Control Objectives.
- Madison will include the annual Control Attestation, including any qualified opinion, as part of its books and records under Rule 204-2 under the Advisers Act.
- If the Accountant issues a qualified opinion with respect to any Control Attestation, Madison will promptly notify Advisory Clients that are Loan Syndicate Participants and inform them of the issue(s) that resulted in such qualified opinion and how such issue(s) will be avoided going forward.
- Madison will detail the controls developed and implemented to ensure that the Control Objectives are achieved, as well as the Control Attestation process, in its policies and procedures adopted, implemented, and subject to, annual review under Rule 206(4)-7 of the Advisers Act.
This conclusion is based on all of the facts and representations set forth in your letter. You should note that any different facts or representations might require a different conclusion. Further, this response expresses our position only with respect to enforcement action, and does not express any legal conclusion on the issues presented.
Aaron T. Gilbride
 You note that pursuant to Section 541(d) of the Bankruptcy Code (11 U.S.C. §541(d)), a bankruptcy estate does not include property in which the bankruptcy debtor holds only legal title and not an equitable interest. You contend that this bankruptcy statute applies to an administrative agent under a syndicated credit agreement just the same as any other fiduciary or agent.
 Adoption of Rule 206(4)-2 Under the Investment Advisers Act of 1940, Investment Advisers Act Release No. 123 (Feb. 27, 1962).
 Rule 206(4)-2.
 Rule 206(4)-2(a)(1). A qualified custodian is a broker-dealer, bank, savings association, futures commission merchant or foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer accounts segregated from its proprietary assets. See Rule 206(4)-2(d)(6).
 Rule 206(4)-2(a)(3).
 Rule 206(4)-2(d)(7) defines “related person” as “any person, directly or indirectly, controlling or controlled by [the investment adviser], and any person that is under common control with [the investment adviser].”
 Rule 206(4)-2(d)(2).
 Rule 206(4)-2(d)(2)(ii).
 The staff would view the use of a related person in these circumstances as imputing an investment adviser with custody. On the other hand, the staff believes that in connection with a loan syndicate, the use of an unaffiliated administrative agent in and of itself would not necessarily impute an investment adviser with custody. Such investment advisers should analyze whether the authority (if any) they have over such an unaffiliated administrative agent meets the definition of “custody” in the Custody Rule.
 You indicate that Madison also has custody of the assets of the Advisory Clients for which it or an affiliate serves as the general partner or managing member, and that Madison has custody of separately managed account Advisory Client assets where it has authority to withdraw Advisory Client funds. This letter does not provide relief with respect to Madison’s custody that results from activities other than those related to its role as administrative agent.
 You represent that any other Advisory Client funds or securities of which Madison has custody are and will be maintained as required by the Custody Rule.
 In this regard, you represent that Madison will comply with all of the other requirements of the Custody Rule applicable to the Agency Account, and that Madison will comply with all of the requirements of the Custody Rule applicable to the other accounts established by Madison’s Advisory Clients held at qualified custodians.
 The Division of Investment Management generally permits third parties to rely on no-action letters to the extent that the third party’s facts and circumstances are substantially similar to those described in the underlying request for a no-action letter. See Informal Guidance Program for Small Entities, Investment Company Act Release No. 22587 (Mar. 27, 1997), n.20. The staff is willing to entertain other no-action requests where investment advisers serving as administrative agents have similarly taken or propose to take steps to minimize the risk that client funds or securities could be lost or withdrawn or misappropriated by the investment adviser.