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SEC Provides Guidance on Use of SPVs and Custody Rule

July 7, 2014

In June 2014, the SEC’s Division of Investment Management released an IM Guidance Update (No. 2014-07) helping investment advisers who use special purpose vehicles, or SPVs, comply with the SEC’s Custody Rule.
 
The Custody Rule, Rule 206(4)-2 under the Investment Advisers Act of 1940, allows a registered investment adviser that manages a pooled investment vehicle, like a hedge fund, to comply with the Custody Rule by causing the fund to undergo a financial statement audit by a Public Company Accounting Oversight Board (PCAOB) accounting firm, annually and upon liquidation, and distribute such financial statements to fund investors within 120 days after the fund’s fiscal year end.
 
Background
 
The SEC recognized in the Custody Rule adopting release that, for various reasons, an investment adviser to one or more pooled investment vehicles may from time to time use SPVs to facilitate investments by pooled investment vehicles that such advisers manage.  The SEC further advised that, to comply with the then-new Section 206(4)-2(c) of the Custody Rule, the investment adviser could either (i) treat the SPV as a separate client, in which case the adviser will have custody of the SPV’s assets, or (ii) treat the SPV’s assets as assets of the pooled investment vehicles of which it has custody indirectly.
 
If the adviser is relying on the audit provision and treats the SPV as a separate client, the adviser must comply separately with the Custody Rule’s audited financial statement distribution requirements and distribute the audited financial statements of the SPV to the beneficial owners of the pooled investment vehicles that own the SPV.  Alternatively, if the adviser is relying on the audit provision and treats the SPV’s assets as assets of the pooled investment vehicles of which it has custody indirectly, such assets must be part of the pooled investment vehicles’ financial statement audit.
 
Guidance
 
The Guidance clarifies four scenarios in which an investment adviser to funds may rely on the Custody Rule’s audit provision.
 
  1. May the adviser relying on the audit provision choose to treat the assets of the SPV with a single investment, wholly-owned by a single fund managed by the adviser, as assets of the fund of which the adviser has custody?

    Yes, as long as the assets of the SPV are considered within the scope of the fund’s financial statement audit.

  2. May the adviser relying on the audit provision choose to treat the assets of the SPV with a single investment, wholly-owned by more than one fund managed by the adviser, as assets of the funds of which the adviser has custody.

    Yes, as long the assets of the SPV are considered within the scope of the funds’ financial statement audits.

  3. May the adviser relying on the audit provision choose to treat the assets of the SPV with multiple investments, wholly-owned by more than one fund managed by the adviser, as assets of the funds of which the adviser has custody?

    Yes, as long the assets of the SPV are considered within the scope of the funds’ financial statement audits.

  4. May the adviser relying on the audit provision choose to treat the assets of the SPV with one or more investments, less than wholly-owned by the adviser or a fund managed by the adviser, as assets of the fund of which the adviser has custody?

    No.  Because the SPV has owners other than the adviser or funds controlled by the adviser, such funds should be treated as a separate client for purposes of the Custody Rule and the adviser needs to comply separately with the Custody Rule’s audited financial statement requirements with respect to such fund. 
Regrettably the Guidance in this fourth scenario focused on the number of audited financial statements rather than the quality of the disclosure in such audited financial statements.  Hopefully, the staff will soon reconsider and also accept audited financial statements of one entity disclosing to the fund’s investors the custodial implications of co-investing through an SPV.
 
Summary
 
The Guidance, helpful to fund managers to meet their Custody Rule obligations, highlights that fund managers’ that co-invest through SPVs need to carefully consider the various audit requirements under the Custody Rule.

Should you have any questions, please feel free to contact us:
James G. Smith, Esq.
(212) 216-8060
jsmith@tarterkrinsky.com 
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