How Does the Amended Custody Rule Change the Balance of Power Between Hedge Fund Managers and Accountants?

The bad news about the amended custody rule is the surprise examination requirement.  The good news, at least for many hedge fund managers, is the annual audit exception.  (That is, the amended custody rule contains an exception from the surprise examination requirement for advisers to pooled investment vehicles that are annually audited by a PCAOB-registered accountant and that distribute audited financial statements prepared in accordance with GAAP to fund investors within 120 days (180 days for funds of funds) of the fund’s fiscal year end.)  See “SEC Adopts Investment Adviser Custody Rule Amendments,” Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).  The qualified news is that while many hedge fund managers may avail themselves of the annual audit exception, an appreciable number may not.  For example, managers whose funds are audited by non-PCAOB-registered accountants, or that do not (or cannot) distribute audited financial statements to fund investors within 120 days of the fund’s fiscal year end, would not be eligible for the annual audit exception.  See “How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures in Light of Amendments to the Custody Rule?,” Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010).  For such “ineligible” hedge fund managers, the surprise examination requirement may complicate operations for at least two reasons.  First, it creates a de facto annual audit requirement.  The substance of a surprise examination – explained in the SEC’s adopting release and a related interpretive release providing specific guidance for accountants – closely resembles the substance of an annual audit.  (The substance of a surprise examination is discussed in more detail in this article.)  Moreover, as the SEC pointed out in the adopting release accompanying the custody rule amendments, a hedge fund manager’s inability to predict which transactions an auditor will test in the course of an annual audit is analogous to the “surprise” element of the examination requirement.  Second – and perhaps more controversially – the surprise examination requirement may complicate operations for hedge fund managers that are not eligible for the annual audit exception because of various SEC reporting requirements imposed on accountants that conduct surprise examinations.  Those reporting requirements are described in more detail in this article, but in pertinent part would require an accountant to file with the SEC, within four business days of resignation, dismissal or other termination from an engagement to provide surprise examinations, Form ADV-E, along with an explanation of any problems that contributed to such resignation, dismissal or other termination.  Importantly, Form ADV-E, along with the accompanying explanation, would be publicly available.  According to the adopting release, the policy rationale for such public availability is to enable current and potential clients of an adviser to assess for themselves the importance of the explanation provided by the accountant for its resignation, dismissal or other termination.  The concern haunting the subset of hedge fund managers that are (or are concerned about becoming) subject to the annual surprise examination requirement is that the Form ADV-E filing requirement may – in cases where reasonable minds can differ on close accounting and valuation calls – further enhance the leverage of accountants over managers.  In other words, the concern is that revised Form ADV-E may increase the volume and specificity of an accountant’s “noisy withdrawal,” and in recognition of that, may increase risk aversion on the part of hedge fund managers in dealings with accountants.  The rejoinder to this argument is that accountants already have considerable leverage over hedge fund managers, as evidenced most starkly by the consequences flowing from withholding of an unqualified audit opinion letter.  See, e.g., “Former CFO of Highbridge/Zwirn Special Opportunity Fund Sues Ex-Partner Daniel B. Zwirn for Defamation and Breach of Contract,” Hedge Fund Law Report, Vol. 2, No. 30 (Jul. 29, 2009).  In an effort to assess the extent to which the custody rule amendments may alter the balance of power between accountants and hedge fund managers, this article examines: how custody is defined in the amended custody rules (because custody is a condition precedent for application of the surprise examination requirement); the substance of the surprise examination requirement; the three exceptions from the surprise examination requirement; relevant SEC reporting requirements (on Form ADV-E); expert insight on whether and how the SEC reporting requirements may increase the leverage of accountants vis-à-vis hedge fund managers; existing accountant leverage (including a discussion of audit representation letters); who bears the cost of a surprise examination; and PCAOB resource limits.

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