New Custody Rule May Challenge Fund Managers
1. What does the new SEC Custody Rule say?
Rule 206(4)-2 (commonly known as the Custody Rule) is a provision of the United States Investment advisers act of 1940 (the act) that was amended by the us securities and Exchange Commission (SEC) on December 16, 2009, with the proposed effective date of March 12, 2010. This Rule pertains to any investment advisor who is required to register with the SEC under section 203 of the Act.
Typically, this means advisors at funds with more than $25 million under management and 15 or more investors. A fund counts as one investor. Investment fund advisors must comply with the Custody Rule, including requirements such as record-keeping, maintaining policies and procedures manuals, and a code of ethics. Space doesn’t allow for a full discussion of the Custody Rule in this article, and therefore advisors are strongly urged to consult with counsel
and other professional service providers.
Prior to the amendment, some advisors to funds did not have to register with the SEC, but those that did opted to comply with the Custody Rule by undergoing an independent audit. Of note to funds in the Cayman Islands, this meant using a local auditor that was approved by the Cayman Islands monetary authority (CIMA). Such audits did not have to be conducted by a Public Company accounting Oversight Board (PCAOB) registered advisor. As of January, only five Cayman entities (all affiliates of international firms) had registered with the PCAOB and none had been inspected.
2. What prompted the Custody Rule?
The well-publicised cases of fraud over the past 18 months clearly pushed the SEC to amend the Custody Rule, although this had been an SEC initiative for years. It previously mandated that all advisors to funds should register with the SEC, but that mandate was overturned in the Goldstein case, where it was asserted that as the act was a provision of us law, it could only be amended by Congress, with the ultimate approval of the President.
3. Why was it considered necessary?
As documented in the review of the fraud cases, custody of customer assets was not always maintained by a qualifi ed custodian. In the most famous case, the custodian was actually an entity controlled by the sub-advisor and the audit was performed by an unlicensed accounting firm. While the advisor to the funds may or may not have known about these relationships, custody was not maintained.
4. Is the new Rule a good thing, in your view?
The important thing to keep in mind is that well-regulated markets protect everyone: the investor primarily, but also the fund advisors and certainly the public as well. The Custody Rule codifies what is generally understood to have been proper procedure and most fund managers have maintained adequate controls all along. as with any situation where abuses have been identifi ed, there is a risk that the remedy can be too stringent or applied too broadly. Prudent behaviour, internal controls and well-considered investment strategies are what truly count the most.
5. What impact, if any, will the Custody Rule have on the Cayman Islands Monetary Authority (CIMA)?
CIMA has previously stated that it looks to use the work of others (auditors, attorneys, administrators and directors) to enhance its limited oversight capabilities. I would think the enforcement unit employed by the SEC would be looked at as another positive enhancement to its capabilities. my colleague, Ben Leung, partner in EisnerAmper (Cayman) informs me that the European union is also pressing Cayman to increase its oversight capabilities. some co-ordination of the various regulatory oversight boards will clearly have to be reached in the near future.
6. How will the Rule affect Cayman Islands funds directly?
Initially, a relatively small number of Cayman Islands funds may be impacted. Recall that many fund advisors are exempt from registration because their funds are only counted as one investor. If, for argument’s sake, a us-advisor manages a $1 billion fund in Cayman with 300 shareholders and nothing else, it is exempt. Looking forward, however, there is the likelihood that some form of fi nancial regulatory reform will come out of the us Congress.
On December 11, 2009, the US House of Representatives passed a bill promoting comprehensive financial regulatory reform. This bill includes a provision known as the Private Fund Investment advisers Registration act of 2009 (the Registration act). The reform is being debated in the US Senate, and President Obama has signalled his intent to sign a reconciled bill. as proposed, the Registration act would require advisors to private funds with more than $150 million of assets under management to register, with the number of investors no longer germane. It exempts advisors to venture capital funds, but does not exempt private equity funds, family offi ces or funds of funds, so clearly the potential impact to Cayman would be much more
substantial based upon the recent statistics from the Cayman Islands monetary authority.
7. How will the Rule affect non US-based fund managers—those not currently registered with the SEC?
Non us-based fund managers, including those that do not have a us place of business or that had fewer than 15 us clients during the previous 12 months, or that have assets under management of less than $25 million for us clients and that do not hold themselves out to the us public as an investment advisors, are not subject to us registration or the proposed Registration act.
8. How can an auditing firm assist with regulatory compliance?
Auditors are the final line of defence in the regulatory arena. Preparation and vigilance are key, so I urge clients to review their documents, marketing materials and websites carefully, and when in doubt, consult their independent counsel. as part of our planning meetings and audit work, we are continually keeping our clients aware of the issues as they develop.
9. Is the role of the fund manager changing and, if so, how?
The roles of all parties involved in fund management—advisors, directors, administrators, attorneys, auditors and the regulators— continue to evolve. The fund manager is the point person in managing all of these roles and in safekeeping the investors’ assets. Even if an advisor is not registered today, best practice is to track authorisations, valuations and record-keeping, and carefully manage potential clients. This will keep the advisor in line with new rules that may come out of the US, Europe, Asia or even Cayman.
10. What will these changes mean for your firm?
EisnerAmper is well positioned as a large regional firm in the US, with SEC, tax and fund expertise. We are registered with the PCAOB and we will register EisnerAmper (Cayman) when and if that is required. EisnerAmper LLP has the internal audit control capabilities required to handle the reporting requirements of the Custody Rule. In fact, we have already started to field enquiries. We have a newly formed back offi ce administration services group, which has state-of-the-art technology, dedicated staff and the ability to draw on other EisnerAmper service groups to surround a fund advisor with the services it needs to comply with the new Rule, and beyond.
11. What back office accounting services will be affected, and how does technology impact this service?
This will depend. If a client is using back offi ce services to comply with the record-keeping requirements of the act, the accounting services would potentially fall under the service provider rules and subject the services to being reviewed under sas 70. That said, technology moves markets, and it is imperative for us to keep current and employ the latest and most effective technologies available to us.
My partner, Anthony Deliso, of EisnerAmper Fund services, points out that we use software that allows us to deliver timely, cutting-edge alternatives to an internal accounting infrastructure and provides portfolio accounting, investor accounting, books and records, tax reporting and performance analysis. We have electronic interfaces with all major prime brokers and are able to produce and deliver financial information seamlessly through a secure website.
12. Where is your biggest client base?
By focusing on the New york capital markets, EisnerAmper’s traditional client base has ties to those markets and the other service providers in that market. The beauty of today’s technology is that you do not have to be next door to provide accounting services to a fund. accordingly, we have seen our client base expand throughout the global markets in recent years and look to continue that expansion as an independent member of Allinial Global, one of the largest networks of independent accounting firms in the world.
13. What differentiates you in the market?
Our track record. EisnerAmper’s 27 financial services partners serve more than 600 hedge funds, 200 private equity funds, 50 broker dealers. It is this depth of experience that has established EisnerAmper as an acknowledged leader in providing audit, accounting and tax services. We are recognised in particular for our expertise with start-up funds as witnessed by the recent vote of fund managers, published in Institutional Investor magazine, who selected EisnerAmper as the number one accounting service provider to funds with less than $1 billion of assets under management.