The staff of the SEC’s Division of Investment Management provided guidance allowing certain certificated privately offered securities held by private funds to be treated in the same manner as uncertificated privately offered securities they hold. The guidance describes conditions under which an adviser would not have to maintain with a qualified custodian an instrument evidencing ownership of a privately placed security (a “private stock certificate”) held by a pooled investment vehicle (a “pool”) in order to comply with Rule 206(4)-2 under the Investment Advisers Act of 1940 (generally referred to as the “custody rule”). As a general matter under the custody rule, an adviser that has custody (as defined by the rule) of a pool’s funds and securities must maintain them with a qualified custodian. However, if the pool meets the conditions described in paragraph (b)(4) of the rule regarding the distribution of its audited annual financial statements, the rule already provides an exception to the qualified custodian requirement with respect to certain uncertificated privately offered securities (“Exempt Privately Offered Securities”). The custody rule provides that to be an Exempt Privately Offered Security, the security must:
- be uncertificated;
- have been acquired from the issuer in a transaction or chain of transactions not involving a public offering;
- have its ownership recorded only on the books of the issuer or its transfer agent in the name of the pool; and
- be transferable only with the prior consent of the issuer or holders of the outstanding securities of the issuer.
The staff guidance responds to inquiries regarding the treatment under the custody rule of private stock certificates that, aside from the fact that they were certificated, share the essential characteristics of Exempt Privately Offered Securities. The guidance states that a private stock certificate held by a pool that distributes its audited annual financial statements in accordance with paragraph (b)(4) of the rule need not be maintained with a qualified custodian if:
- ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the pool;
- 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;
- the private stock certificate has a legend restricting transfer; and
- the private stock certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.
The guidance also states the staff’s position that a partnership agreement, subscription agreement or LLC agreement is not itself a certificate under paragraph (b)(2)(B) of the custody rule, and the securities these documents represent are Exempt Privately Offered Securities if they otherwise fall within the terms of that exception (as described above). In addition, the guidance notes that the staff considers securities that are evidenced by ISDA master agreements that cannot be assigned or transferred without the consent of the counterparty to be Exempt Privately Offered Securities.