How Will the Proposed Liquidation Audit Amendment to the Custody Rule Affect Hedge Funds?

The recent proposal to amend the Custody Rule has occasioned a flurry of comment letters from hedge fund industry participants, lawyers and other interested parties.  The amendments to the Custody Rule were proposed in part in response to recent fraudulent activities involving investment advisers and affiliated custodians.  While the amendments as a whole are intended to make it more difficult for registered investment advisers to misuse funds for which they serve as custodian, some portions of the amendments, according to various comment letters, would present difficulties in practice.  In particular, one aspect of the proposed amendments about which hedge fund managers have significant questions is the proposed requirement that hedge fund managers relying on the so-called audit approach that liquidate a hedge fund prior to the fund’s fiscal year end prepare audited financial statements upon liquidation.  The Securities and Exchange Commission (SEC) alleges that this “at liquidation” audit requirement is simply a “clarification” of standard practice, but practitioners interviewed by the Hedge Fund Law Report did not uniformly agree.  Further, there are questions regarding the timing of the liquidation audit and whether an audit upon liquidation should be required if it would occur close in time to when the hedge fund’s annual audit would be performed.  Finally, the liquidation audit requirement begs the question of what, in this context, constitutes a liquidation, and whether a hedge fund that is merged into another hedge fund will be considered to have liquidated and thus need to perform a liquidation audit.  This article addresses these and related issues.

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