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SEC Staff: Private Stock Certificates May Not Be Subject to Custody Rule

Posted in Investment Adviser Regulation

In a recent IM Guidance Update, the SEC’s Division of Investment Management said that it would not object if registered investment advisers (RIAs) to certain private funds do not maintain “private stock certificates” with a qualified custodian under certain circumstances.

The Guidance Update responds to inquiries from RIAs about whether Rule 206(4)-2 under the Investment Advisers Act (the “Custody Rule”) requires RIAs to audited private funds to maintain privately issued, non-transferable stock certificates with a qualified custodian.  The Custody Rule provides that “privately offered securities” do not have to be held at a qualified custodian, but private stock certificates do not technically meet the definition of “privately offered securities.”  The staff said that, nonetheless, they are similar in all material respects because, among other things, the existence (or lack of existence) of a certificate does not affect the ownership interest in the underlying security.

The staff also said that maintaining private stock certificates at a qualified custodian does not provide additional protection to fund investors, because auditors perform substantive procedures to verify fund investments (including privately issued securities) regardless of whether the private stock certificates are held at a qualified custodian.

Under the new guidance, RIAs to private funds will no longer be required to custody private stock certificates with a qualified custodian if:

• the client is a pooled investment vehicle that is subject to an annual audit as set forth in Rule 206(4)-2(b)(4);
• the private stock certificate can only be used to effect a transfer, or to otherwise facilitate a change in beneficial ownership, of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer;
• ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client;
• the private stock certificate contains a legend restricting transfer; and
• the private stock certificate is appropriately safeguarded by the RIA and can be replaced upon loss or destruction.

This Guidance Update is a small but significant step towards addressing some of the unintended consequences of the Dodd-Frank Act, which required some advisers to private funds to register with the SEC.  Many of these private funds hold assets that lack the characteristics of traditional securities typically held by a custodian.  We await further guidance on how the staff views similar situations involving custody of other non-traditional assets managed by RIAs.