The State Corporation Commission’s recent changes to the rules regarding custody of client funds and securities by Virginia-registered investment advisors will take effect on June 3, 2013. Virginia-registered investment advisors should be aware that Virginia has gone beyond the custody rules promulgated by the Securities and Exchange Commission (“SEC”) with respect to registered investment advisors (“RIAs”) managing private investment funds and other pooled investment vehicles (referred to in this alert as “private funds”). A few highlights of the new Virginia custody rules:
- Fund Auditor Must Now be PCAOB-Registered. As with the SEC custody rules, the new Virginia custody rules will require that, in order to qualify for the exemption from deemed custody for private funds and other private funds managed by the RIA, the private funds will need to be audited annually by an independent auditing firm which is itself registered with and subject to inspection by the Public Company Accounting Oversight Board (“PCAOB”) in accordance with its rules.
- The private fund will need to deliver its audited annual GAAP financial statements to its investors and the State Corporation Commission within 120 days after the end of the private fund’s fiscal year. This is a departure from the old Virginia custody rule only in the requirements that a private fund’s auditors be PCAOB-registered and that the private fund deliver a copy of its audited annual GAAP financial statements to the State Corporation Commission.
- If the private fund is not audited annually by a PCAOB-registered auditor, the RIA will need to arrange to be subject to surprise examination by a PCAOB-registered auditor to verify private fund securities and funds at least annually. Since the cost of the surprise examination could be comparable to or perhaps greater than the costs of obtaining regularly scheduled annual private fund audits, many RIAs will opt to engage PCAOB-registered auditors to provide regularly scheduled annual GAAP audits of the private funds that they manage.
- RIAs should also note that the new Virginia custody rules specify certain terms that must be contained in the engagement agreement with the private fund’s auditors and that a private fund must be audited on liquidation, with its final audited GAAP financial statements for the private fund distributed investors and the State Corporation Commission promptly after completion of this audit.
- New Fund “Gatekeeper” Requirement. In addition, the new Virginia custody rules will require the RIA to retain an independent fund administrator or other independent third-party “gatekeeper” for the fund.
- This gatekeeper (referred to as an “independent party” in the new rules) may not have any material business relationship with the RIA within the past two years (and may not have such a relationship for two years following the end of the gatekeeper’s engagement) and must be obliged (contractually or otherwise) to act in the best interests of the private fund’s investors.
- The RIA must send all invoices and receipts relating to the private fund to the gatekeeper for review, so that the gatekeeper can determine whether payment of the fees, expenses and withdrawals detailed in the invoices and receipts is consistent with the private fund’s governing documents.
- The gatekeeper (but not the RIA) may then direct the private fund’s custodian to pay these fees, expenses and capital withdrawals.
- This requirement was part of the old Virginia custody rules, but was waived so long as the private fund had an annual audit. Under the new Virginia custody rules, both the annual audit (or surprise examination) by a PCAOB-registered auditor and the gatekeeper role will be required.
- New Quarterly Report Requirement. Also in a departure from the old Virginia custody rules, to qualify for the exemption from deemed custody for private funds managed by the RIA, the RIA will be required to send each of the private fund’s investors a quarterly report showing total additions to, withdrawals from and opening and closing values for the private fund as a whole, as well as for the individual investor’s interest in the private fund, in each case as at the end of the quarter.
- Also, the report will be required to list all of the private fund’s long and short positions on the closing date of the report in accordance with Financial Accounting Standards Board rule Accounting Standards Codification (ASC) 946-210-50, including disclosure of individual long and short positions representing more than 5.0% of the private fund’s net assets.
- No deadline is established for delivery of this quarterly report, but best practices in the alternative investment industry would suggest this information should be delivered no later than 45 days after quarter’s end. The start date for this reporting also is not specified; it is assumed to begin with the quarter ending June 30, 2013. Oddly, the long and short position listing requirement applies regardless of whether the private fund is a hedge fund holding marketable securities or a real estate or private equity fund holding illiquid assets.
- Also, the new Virginia custody rules do not impose standards on how the RIA determines values for the private fund’s assets or the individual investor’s ownership interest in the private fund; it would be advisable for the RIA to confirm that the private fund’s governing documents contain a reasonable and well-described valuation policy and that this policy is applied consistently.
- If the RIA chooses not to send these quarterly reports, the RIA will not only be subject to annual surprise examination (regardless of whether regular annual audits of the RIA’s private funds are conducted by PCAOB-registered auditors), but will also need to ensure that each private fund investor receives from each custodian of the private fund a quarterly statement detailing the securities and other funds held in the private fund’s accounts with the custodian. For private equity and real estate funds that may not have brokerage accounts, at a minimum the bank statements for the private fund would need to be sent to investors
- Form ADV Disclosure. The new Virginia custody rules also emphasize the need for the RIA to disclose promptly in its Form ADV filed with the State Corporation Commission the fact that the RIA is deemed to have custody of the funds and securities held by its private funds, if not already disclosed in the RIA’s prior filings.
- Conforming Record-Keeping Changes. The State Corporation Commission also adopted changes to the investment advisor recordkeeping rules, including changes tied to the changes to the custody rules discussed above.
It is expected that the new Virginia custody rules could add significant expense to the cost of operating private funds for Virginia-registered investment advisors. Virginia RIAs managing private funds should consider promptly gathering pricing information for the gatekeeper services and quarterly reporting to investors required under the new rules and talking with their private fund investors about this added cost.
This publication is intended for general information purposes only and does not constitute legal advice. The reader should consult legal counsel to determine how laws apply to specific facts and situations.
Luis F. Ruiz