On September 5, 2023, almost one year since its first flurry of similar Custody Rule actions, the SEC announced settlements with five SEC-registered investment advisers to private funds with respect to alleged violations of Rule 206(4)-2 under the Investment Advisers Act of 1940 (the Custody Rule) and related Form ADV violations. Specifically, these settlements primarily addressed the following types of violations: (i) the failure to have a private fund audited in accordance with the annual audit exemption under the Custody Rule and timely deliver the audited financials; (ii) the failure of a non-US firm to have the financials audited in accordance with US generally accepted auditing standards (GAAS); (iii) the failure to follow the alternativeCustody Rule requirements where the firm did not implement the audit exemption correctly; (iv) the failure to amend Form ADV, Part 1A, Schedule D, Section 7.B.23.(h) to reflect the receipt of the audit opinion following the annual amendment of the Form ADV; and (v) the failure of one firm to properly describe the status of its financial statement audits for multiple years in its Form ADV.
The SEC Division of Examinations had previously indicated that compliance with the annual audit exemption would continue to be an examination priority in 2023, just as it was in 2022. A summary of the enforcement actions is included in the table below.
SEC-registered private fund sponsors should review their compliance policies and procedures with respect to the Custody Rule to:
- Assess and address obligations under the Custody Rule. A private-fund sponsor must assess its obligations under the Custody Rule and make all necessary arrangements to meet them — i.e. (as applicable), (i) if relying on the audit exemption, select an appropriate auditor, provide all necessary information, ensure that the audit is conducted in accordance with the Custody Rule and distribute the audited financials to investors in a timely manner (as further described below); or (ii) otherwise meet the alternate Custody Rule requirements.
- Identify entities that need to be separately audited. Private-fund sponsors should consider policies and procedures to review which entities are required to be audited under the Custody Rule, including the various entities created below and above the main fund or funds (e.g., special-purpose vehicles formed to facilitate one or more investments, aggregators, feeder funds, or tax blockers). These entities may be created at the fund formation stage or at the investment stage (e.g., to facilitate one or more investments). As a general rule, a separate audit may be required if (i) the assets of the vehicle are not considered within the scope of the audit of another vehicle (e.g., the main fund), or if (ii) the vehicle has an owner that is not the (a) adviser, (b) its related persons, or (c) a pooled-investment-vehicle client that is controlled by the adviser or its related persons. For example, if a private-fund adviser forms a special-purpose vehicle that invests in a portfolio company and an unaffiliated third party co-invests in that special-purpose vehicle, that special-purpose vehicle likely requires a separate audit to comply with the Custody Rule, depending on the facts and circumstances. It is important in these circumstances to distinguish between an investment-oriented special-purpose vehicle (which may be a special-situation investment company) and a holding company of a portfolio company (i.e., the holding company is engaged in a noninvestment business directly or indirectly through its subsidiaries).
- Identify investors that need to receive the audited financials. The delivery requirement for the audited financial statements under the Custody Rule is not satisfied if the financial statements are sent solely to vehicles (e.g., limited partnerships, limited liability companies, or other pooled investment vehicles) that are related persons of the adviser. Rather, they must be sent to the beneficial owners (i.e., the investors). Therefore, in connection with the process for identifying which entities need to be separately audited, as discussed above, a private-fund sponsor should also determine to whom it is required to deliver the audited financial statements of the entity, which may include not only the entity's direct beneficial owners but also the beneficial owners of affiliated pooled-investment vehicles that invest in the entity.
- Ensure compliance with the privately offered securities exception. Private-fund sponsors should consider policies and procedures to ensure whether each pooled-investment vehicle that relies on the privately offered securities exception meets the conditions of the exemption, including the requirements that (i) the pooled-investment vehicle is audited and (ii) the audited financials are distributed in accordance with the Custody Rule.
- Ensure timely delivery of audited financial statements. A private-fund sponsor relying on the Custody Rule audit exemption is required to ensure that the audited financial statements are delivered within 120 days of the end of the fund's fiscal year, with an allowance for certain longer time periods for funds of funds. Private-fund sponsors should consider policies and procedures to (i) ensure the timely delivery of audited financial statements, (ii) identify circumstances where the audited financial statements may not be delivered in a timely fashion and attempt to mitigate any such delay, and (iii) after any failure to deliver the audited financial statements in a timely fashion, identify the reasons for such failure and take steps to reduce the likelihood of a similar failure in the future.
- Ensure the financial statements are audited in accordance with US GAAS and prepared in accordance with US generally accepted accounting principles (GAAP). SEC-registered advisers must provide audited financials prepared in accordance with US GAAP; however, for funds organized outside of the United States or with a general partner or a manager with a principal place of business outside the United States, financial statements may be prepared in accordance with accounting standards other than US GAAP so long as they contain information substantially similar to statements prepared in accordance with US GAAP. Any material differences with US GAAP must be reconciled. In any case, the financial statements must be audited in accordance with US GAAS.
- As needed, amend Form ADV after receipt of audit opinion. Question 23(h) of Section 7.B.(1) of Schedule D of Form ADV Part 1A requires a private-fund sponsor to report whether the auditor provided an unqualified opinion with respect to the private fund's audit. It has three options: "Yes," "No," and "Report Not Yet Received." The instructions require a private-fund sponsor that reports "Report Not Yet Received" to promptly file an amendment upon receipt of the audit opinion. A private-fund sponsor should consider policies and procedures to ensure that (i) Question 23(h) is appropriately answered at the time of the annual amendment and (ii) the answer to Question 23(h) is amended promptly, as needed, upon receipt of the audit opinion.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.