SEC IM Staff Updates Custody Rule FAQs to Address Issues Arising in Connection with Surprise Examinations and Certain Certificated, Privately Offered Securities due to the COVID-19 Coronavirus
A registered investment adviser (RIA) that has “custody” of client funds or securities must comply with the provisions of Rule 206(4)-2 under the Investment Advisers Act of 1940 (Rule), including those related to the use of a qualified custodian to hold client assets and annual verification of client assets, absent certain exceptions. Recently, the Staff of the SEC’s Division of Investment Management (Staff) has entertained requests for guidance or relief when circumstances arising from the COVID-19 Coronavirus pandemic have resulted in RIAs being unable to meet certain of these requirements. This week, the Staff published two such FAQs:
Temporary Relief from Surprise Verification Requirement
RIAs that are deemed to have custody of client funds or securities for purposes of the Rule must, unless an exception is available, submit to an annual surprise verification (Verification) of those client funds or securities. The Verification must be performed pursuant to a written engagement between the RIA and an independent public accountant (Accountant), and must be performed on a date selected by the Accountant that is irregular from year to year. The RIA must complete Form ADV-E, and the Accountant must file the form, along with its report, through the IARD system within 120 days of the examination. In some cases, the RIA and/or the Accountant have experienced delays as a result of steps taken to mitigate the impacts of the COVID-19 Coronavirus.
On March 30, 2020, the Staff provided temporary no-action relief, in the form of an FAQ, in circumstances where “various logistical disruptions” due to COVID-19 Coronavirus causes a delay in the Verification or related filing. The relief is available if: (i) the RIA “reasonably believed” the Accountant would complete the Verification and filing; and (ii) the Accountant files Form ADV-E “as soon as practicable, but not later than 45 days after the original due date.”
Temporary Relief from Qualified Custodian Requirement for Certain Physical Securities
Under Section 206(4)-2(b)(2) of the Rule, certain privately offered securities are excepted from the requirement that a qualified custodian must maintain the securities, if the following conditions are met: (i) the securities are not acquired in a transaction involving a public offering; (ii) the securities are uncertificated; and (iii) 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.
On April 2, 2020, following discussions with Dechert regarding measures taken by DTCC and certain custodians to protect against the COVID-19 coronavirus by temporarily halting receipt of physical securities, the Staff provided temporary no-action relief, in the form of an FAQ, from the qualified custodian requirement for physical certificates that are unable to be placed with a custodian due to COVID-19 coronavirus-related closures. The relief is available if:
(1) the physical certificates can only be used to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer; (2) ownership of the security is recorded on the books of the issuer or its transfer agent (or person performing similar functions) in the name of the client; (3) the physical certificates contain a legend restricting transfer; (4) the physical certificates are appropriately safeguarded by the adviser and can be replaced upon loss or destruction; and (5) the adviser makes and keeps (in accordance with the terms of Advisers Act Rule 204-2) a record of the custodian’s closure.
