How Can Hedge Fund Managers Structure Managed Accounts to Remain Outside the Purview of the Amended Custody Rule’s Surprise Examination Requirement?

Under the amended custody rule, a registered hedge fund manager that has custody of client assets is required to undergo an annual surprise examination unless it is eligible for one or more of three exceptions from the surprise examination requirement.  Generally, an adviser is deemed to have custody under the amended rule in any of four circumstances: if (1) it maintains physical custody of client funds or securities; (2) it has the authority to obtain client funds or securities, for example, by deducting advisory fees from a client’s account or otherwise withdrawing funds from a client’s account; (3) it acts in a capacity that gives it legal ownership of or access to client funds or securities (for example, where it acts as general partner of a limited partnership); or (4) client funds or securities are held directly or indirectly by a “related person” of the adviser.  However, even if an adviser is deemed to have custody for any of the foregoing reasons, it would not be subject to the annual surprise examination requirement if it were eligible for any of the following three exceptions: (1) if it is deemed to have custody solely based on its fee deduction authority; (2) to the extent it advises pooled investment vehicles 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); or (3) if it is deemed to have custody solely based on custody by a “related person” and that related person is “operationally independent” of the adviser.  For a thoroughgoing discussion of the mechanics of the amended custody rule, see “How Does the Amended Custody Rule Change the Balance of Power Between Hedge Fund Managers and Accountants?,” Hedge Fund Law Report, Vol. 3, No. 4 (Jan. 27, 2010).  Accordingly, most registered hedge fund managers would not be subject to the surprise examination requirement, with respect to hedge funds under management, because they would be eligible for the “pooled investment vehicle” exception.  However, to the extent a hedge fund manager also manages managed accounts, the manager would not be eligible for the pooled investment vehicle exception with respect to those managed accounts.  There are at least two reasons for this: (1) the typical managed account only has one investor, and thus is not “pooled” within the meaning of the amended custody rule; and (2) generally, hedge fund managers do not distribute audited financial statements to managed account investors (though such investors often conduct their own audits of the account).  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).  Therefore, a hedge fund manager may only avoid the annual surprise examination requirement with respect to any managed accounts under management if: (1) it is not deemed to have custody of the funds or securities in the managed accounts; or (2) it is eligible for an exception from the surprise examination requirement other than the pooled investment vehicle exception.  The problem is, many managed accounts are structured and operated in ways that would cause their managers to be deemed to have custody and would render their managers ineligible for any exception.  For example, if a hedge fund manager has authority to deduct fees from the managed account and custodies the managed account assets at an affiliate of the manager that is not operationally independent of the manager, the manager would not be eligible for any exception.  See “SEC Adopts Investment Adviser Custody Rule Amendments,” Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).  Given the intrusiveness, expense and potential reputational harm arising out of surprise examinations, this article examines how managed accounts may be structured so that the manager will not be deemed to have custody of the assets in the account.  (The urgency of such avoidance is compounded by the growing chorus of calls from institutional investors for exposure to hedge fund strategies via managed accounts.)  In particular, the remainder of this article details: precisely what a managed account is (including the use of segregated portfolio companies in the Cayman Islands); the benefits of managed accounts; the drawbacks of managed accounts; how managed accounts can be structured and documented to avoid imputing custody of the assets in the account to the manager, or to ensure that the manager remains eligible for the fee deduction exception to the surprise examination requirement; the special case of private securities and illiquid assets; and special purpose vehicle considerations.

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