How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures in Light of Amendments to the Custody Rule?
Hedge Fund Law Report
On December 30, 2009, the Securities and Exchange Commission (SEC) published final amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940 (Advisers Act). The goal of the amendments, as stated by the SEC in its adopting release, is to strengthen controls over the custody of client assets and to “encourage custodians independent of the adviser to maintain client assets as a best practice whenever feasible.” The context of the amendments is a climate of heightened enforcement activity by the SEC against hedge fund managers and other investment advisers, and exposure of significant fraudulent activity during the recent economic downturn. The amendments generally require a registered investment adviser with custody of client assets to: (1) undergo an annual surprise examination conducted by an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB) (subject to a number of important exceptions outlined below); (2) if the adviser maintains physical custody of client assets or uses a related person as a qualified custodian, to obtain an annual report, prepared by an independent, PCAOB-registered accountant, on the internal controls of the adviser or related custodian; and (3) have a reasonable belief after due inquiry that a qualified custodian that maintains custody of client assets sends quarterly account statements directly to clients (rather than the adviser itself sending such account statements). The amendments contain three exceptions from the annual surprise examination requirement. Most importantly for hedge fund managers, the amendments provide that advisers to pooled investment vehicles (such as hedge fund managers) that deliver annual audited financial statements (prepared by an independent, PCAOB-registered accountant) to investors in the pool within 120 days of the end of the pool’s fiscal year (180 days for funds of funds) are deemed to have satisfied the surprise examination requirement. In addition, the custody rule amendments may have important implications for the design of compliance policies and procedures of hedge fund managers. Specifically, the SEC’s adopting release contains a variety of recommended compliance policies and procedures that registered investment advisers (RIAs) may implement to facilitate compliance with the custody rule amendments. As explained more fully in this article, while many hedge fund managers remain unregistered, a legal registration requirement is considered imminent by many practitioners, and in any case, compliance practices of RIAs are considered (by institutional investors and others) persuasive of best practices for unregistered advisers. This article analyzes the implications of the SEC’s compliance recommendations for hedge fund managers. The article begins by exploring the impact of the custody rule amendments for hedge fund managers, unregistered advisers and advisers to separately managed accounts, then details the SEC’s specific compliance recommendations. The article goes on to analyze whether the recommendations are mandatory or merely suggestive (legally and practically), and for some of the key recommendations, provides insight from leading practitioners on precisely how the recommendations can and should be implemented. Finally, after discussing the absence of public notice and comment on the compliance recommendations (which, in light of the nature of the recommendations, likely will not raise constitutional issues), the article explores the likelihood and necessity of adoption of the various recommendations by hedge fund managers.