The Securities and Exchange Commission on Thursday updated its custody rule FAQ guidance to reflect ongoing compliance concerns due to the coronavirus pandemic.
As the Investment Adviser Association explains, the updated FAQ issued by the agency’s Investment Management Division addresses delays in auditors’ completing surprise exams; delays in access to firm mail that may contain inadvertently received checks; and not being able to maintain physical certificates with a qualified custodian.
The law firm Dechert explains in a recent brief that under Question VII.4 of the FAQ certain privately offered securities are excepted from the requirement that a qualified custodian must maintain the securities, if the following conditions are met:
- the securities are not acquired in a transaction involving a public offering;
- the securities are uncertificated; and
- the securities are only transferable with the consent of the issuer or holders of the outstanding securities of the issuer. Funds can rely on this exception only if they are subject to a GAAP audit; such funds also can rely on staff relief for physical securities in some circumstances. However, if the privately owned securities fail any of the conditions (such as having a certificate), then a qualified custodian must maintain the securities, typically through physical possession of the certificate.
“Even before the COVID-19 crisis, fewer custodians were willing to accept physical certificates,” Norm Champ, a former IM director who’s now a partner at Kirkland & Ellis’ private funds group in New York, told ThinkAdvisor in a Monday email.
“Now even those custodians that do accept such certificates have had their operations impacted by the COVID-19 crisis. Many privately offered securities are exempt from the custody requirement. It is helpful that the Division of Investment Management has extended that exemption, subject to certain conditions, to physical certificates that may not qualify for the privately offered securities exemption during this crisis,” Champ said.
Michael Sherman, a partner at Dechert in Washington, explained in an email Monday that effectively, the IM update “broadens existing guidance allowing certain securities that have a physical form to be treated in the same manner that uncertificated securities are under the privately offered securities exception under the rule. Under that exception, a security that meets its terms need not be held by a qualified custodian (e.g., a bank or broker).”
The existing guidance, Sherman explained, “was available only to securities owned by private funds or similar vehicles that are subject to a GAAP audit. The FAQ lifts that limitation but, consistent with its particular intention to be a bridge while DTCC and some banks have closed off their ‘physicals window’ due to COVID-19 concerns, adds a requirement to document the custodian’s closure.”
The IM guidance also updates the agency’s stance on an advisor having custody if they inadvertently receive securities from a client.
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