IM Guidance Update

AUGUST 2013 | No. 2013-04

US Securities and Exchange Commission

 Division of Investment Management

Privately Offered Securities under the Investment Advisers Act Custody Rule

T

he Dodd-Frank Act, which resulted in the registration of many investment advisers 

to hedge, private equity, and other private pooled investment vehicles, significantly 

increased the population of investment advisers to these vehicles registered with 

the Commission.1 The Division receives inquiries from advisers to pooled investment 

vehicles with respect to the Advisers Act custody rule, Rule 206(4)-2, regarding whether 

the rule requires advisers to audited pooled investment vehicles to maintain with a 

qualified custodian certain instruments evidencing the pool’s ownership of certain 

privately issued securities— namely, non-transferable stock certificates or “certificated” 

LLC interests2—that were obtained in a private placement (“private stock certificates”).3

The focus of these inquiries commonly involves whether these securities meet the 

custody rule’s definition of “privately offered security,” and therefore would not have 

to be held at a qualified custodian.4

Although a security evidenced by a private stock certificate does not technically meet 

the custody rule’s definition of “privately offered security” because of the existence of a 

“certificate,” advisers contend that such securities are similar in all material respects to 

a privately offered security because the client’s ownership interest in the security is not 

impacted by the existence (or lack thereof) of the certificate.5 In addition, advisers note 

that ownership of these securities is recorded on the books of the issuer or its transfer 

agent in the name of the pooled investment vehicle and the certificate cannot be used 

to effect a change in beneficial ownership of the security for which the private stock 

certificate is issued. Advisers also note that a private stock certificate can be replaced by 

the issuer if lost or destroyed because ownership is recorded on the books of the issuer. 

Advisers assert that beyond the substantial investor protections provided by the financial 

statement audits, maintaining private stock certificates at a qualified custodian does not 

provide meaningful protection to investors in pooled investment vehicles.6 An auditor 

conducting an audit of a pooled investment vehicle’s financial statements in accordance 

with generally accepted auditing standards performs substantive procedures to verify 

the existence of the pool’s investments,7 including securities that are privately issued, 

regardless of whether the private stock certificates are held at a qualified custodian.8 

Moreover, advisers have informed the Division that maintaining private stock certificates 
IM GUIDANCE UPDATE 2

at a qualified custodian can add substantial costs, which are typically borne by investors 

in pooled investment vehicles as an expense paid by such vehicles.

The Division would not object if an adviser does not maintain private stock certificates 

with a qualified custodian, provided that (1) the client is a pooled investment vehicle 

that is subject to a financial statement audit in accordance with paragraph (b)(4) of the 

custody rule;9 (2) 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; (3) ownership of the security is recorded on the books of the issuer or its transfer agent in the 

name of the client; (4) the private stock certificate contains a legend restricting transfer; 

and (5) the private stock certificate is appropriately safeguarded by the adviser and 

can be replaced upon loss or destruction.10

Endnotes

1 The Dodd-Frank Act eliminated the private adviser exemption from investment 

adviser registration, which was available to investment advisers that had fewer 

than 15 clients with each pooled investment vehicle counting as a single client.

2 Partnership agreements, subscription agreements and LLC agreements are not 

certificates under Rule 206(4)-2(b)(2)(B) and the securities represented by such 

documents are privately offered securities provided they meet the other elements 

of Rule 206(4)-2(b)(2). See Release No. IA-2176, Custody of Funds or Securities 

of Clients by Investment Advisers, Section II.B (September 25, 2003), available

at http://www.sec.gov/rules/final/ia-2176.htm. In addition, the Division considers 

securities that are evidenced by ISDA master agreements that cannot be assigned 

or transferred without the consent of the counterparty to be privately offered 

securities under Rule 206(4)-2(b)(2).

3 Paragraph (a)(1) of the custody rule states that it is a fraudulent, deceptive or 

manipulative act, practice or course of business for an adviser to have custody of 

client funds or securities unless a qualified custodian maintains those funds and 

securities in a separate account for each client under that client’s name or in 

accounts that contain only the adviser’s clients’ funds and securities, under the 

adviser’s name as agent or trustee for the clients. The rule defines “qualified 

custodian” as a bank or savings association, a registered broker-dealer, a registered 

futures commission merchant or a foreign financial institution that customarily 

holds financial assets for its customers. Rule 206(4)-2(d)(6). Typically, an adviser to 

a pooled investment vehicle has custody of the pool’s assets because the adviser 

or a related person serves as the general partner of a limited partnership or in a

comparable position of the pool. Under the rule, custody includes any capacity 

(such as general partner of a limited partnership, managing member of a limited 
IM GUIDANCE UPDATE 3

liability company or a comparable position for another type of pooled investment 

vehicle, or trustee of a trust) that gives the adviser or its supervised person legal 

ownership or access to client funds or securities. Rule 206(4)-2(d)(2)(iii). 

4 The custody rule provides an exception from the requirement to maintain securities 

at a qualified custodian for certain privately issued securities (“privately offered 

securities”) for an adviser to a pooled investment vehicle, provided the pool’s 

financial statements are audited by an independent public accountant that is 

registered with, and subject to regular inspection by, the Public Company Accounting 

Oversight Board (“PCAOB”). Rule 206(4)-(2)(b)(2). This exception for privately 

offered securities is not available to advisers to pooled investment vehicles that 

are not audited in accordance with paragraph (b)(4) of the custody rule. “Privately 

offered securities” are defined as securities that are: (A) acquired from the issuer 

in a transaction or chain of transactions not involving a public offering; (B) uncertificated, and ownership thereof is recorded only on the books of the issuer or its 

transfer agent in the name of the client; and (C) transferable only with the prior 

consent of the issuer or holders of the outstanding securities of the issuer.

5 Issuers provide “certificates” to investors, including private fund investors, for 

various reasons including state law requirements or investor demand.

6 Under the custody rule, investors in pooled investment vehicles are protected 

by controls that are designed to protect their assets from being lost, misused or 

misappropriated by either an annual audit of the pool’s financial statements (with 

delivery of financial statements to pool investors) or an annual surprise examination 

of the pool’s funds or securities (with delivery of the pool’s custodial account statements at least quarterly to pool investors). Rule 206(4)-2(b)(4); Rule 206(4)-2(a)(1).

7 In addition to verifying the existence of a pooled investment vehicle’s investments, 

the financial statement audit also addresses additional matters important to pool 

investors, such as tests of valuations of pool investments, income, operating 

expenses, and, if applicable, incentive fees and allocations that accrue to the adviser.

8 See, for example, AU-C Section 500, Audit Evidence and paragraph .21 of AU 

Section 332, Auditing Derivative Instruments, Hedging Activities, and Investments in 

Securities. If a qualified custodian does not hold a pool’s investments, examples of 

the types of substantive procedures an auditor may perform to verify the existence 

of a pool’s investments include, among others, confirmation with the issuer of a 

security or with the counterparty to a derivative, confirmation of settled transactions with a broker-dealer or counterparty, confirmation of unsettled transactions 

with a broker-dealer or counterparty, physical inspection of a security or derivative 

contract, reading executed partnership or similar agreements, inspecting underlying agreements and other forms of supporting documentation (e.g., for amounts 

reported, evidence that would preclude the sales treatment of a transfer, and 
IM GUIDANCE UPDATE 4

unrecorded repurchase agreements), inspecting supporting documentation for 

subsequent realization or settlement after the end of the reporting period, 

performing analytical procedures, etc.

9 Rule 206(4)-2(b)(4), the audit provision, requires the pooled investment vehicle 

to be subject to audit at least annually by a PCAOB-registered and subject to 

inspection independent public accountant, and for the audited financial statements 

to be distributed annually to all beneficial owners of the pool within 120 days of the 

end of the pool’s fiscal year. For unaudited pooled investment vehicles and other 

clients, a significant benefit of the requirement to maintain funds and securities 

with a qualified custodian is to allow the assets to be included on account statements 

that the qualified custodian provides to clients (or investors in the case of a pooled 

investment vehicle) so the clients (or investors) can monitor transactions and 

holdings in their (or the pool’s) account. Advisers relying on the audit provision 

of the custody rule for pooled investment vehicles, which provides alternative 

investor protections including, as discussed above, the audit’s substantive procedures 

regarding the existence and ownership of the pool’s securities, are not required to 

have a reasonable belief that the qualified custodian sends the pool’s account 

statements to investors. 

10 Registered investment advisers should have compliance policies and procedures 

reasonably designed to address the safeguarding of client assets from conversion 

or inappropriate use by advisory personnel. See Release No. IA-2204, Compliance 

Programs of Investment Companies and Investment Advisers (December 17, 2003), 

available at http://www.sec.gov/rules/final/ia-2204.htm. 

This IM Guidance Update summarizes the Commission staff’s views regarding various 

requirements of the Investment Company Act of 1940 and/or the Investment Advisers Act 

of 1940. Future changes in laws or regulations may supersede some of the discussion or 

issues raised herein. This IM Guidance Update is not a rule, regulation or statement of the 

Commission, and the Commission has neither approved nor disapproved of 

this IM Guidance Update.

The Investment Management Division works to:

s protect investors

s promote informed investment decisions and 

s facilitate appropriate innovation in investment products and services 

through regulating the asset management industry.

If you have any questions about this IM Guidance Update, please contact:

Investment Adviser Regulation Office

Phone: 202-551-6787

Email: IArules@sec.gov