SEC Rule 206(4)-2

Rule 206(4)-2 is commonly called the Custody Rule. It sets detailed requirements for registered investment advisers who hold or control client money or securities. A registered investment adviser is a professional who manages money for clients and must register with the Securities and Exchange Commission (SEC). For hedge fund managers, this rule creates important operational and compliance duties. These requirements exist to protect investor assets from theft or misuse.

The SEC's Custody Rule applies to any registered adviser who exercises control over client assets. The rule defines "custody" broadly to cover several situations. An investment adviser has custody when they physically hold client assets, have the authority to access client assets, or are in a legal position that gives them control over those assets. An adviser also has custody when a related company—meaning any business directly or indirectly controlled by the adviser or under shared control—holds custody of client assets.

The Custody Rule identifies three main types of custody situations. An adviser has custody when they: (1) act as the general partner of a limited partnership, managing member of a limited liability company, or hold a similar leadership role with a pooled investment vehicleAn investment fund that combines capital from multiple investors to purchase and manage a diversified portfolio of securities, including hedge funds and private equity funds. or trust (this gives them legal ownership of or access to client money or securities); (2) physically possess client money or securities; or (3) have the ability to withdraw assets from a client's account, including direct authorization to debit advisory fees from the account.

Most hedge fund managers can use two important exceptions to avoid the strictest custody requirements: the pooled vehicle annual audit exceptionA regulatory exception under Rule 206(4)-2 allowing hedge fund managers to satisfy custody requirements by delivering audited financial statements to investors within 120 days of fiscal year-end, rather than providing quarterly account statements and annual surprise examinations. and the privately offered securities exceptionA regulatory exception under Rule 206(4)-2 that allows investment advisers to maintain custody of certain privately offered securities that are not easily transferable or traded without holding them through a qualified custodian.. The audit exception allows a hedge fund manager to skip the quarterly account statement and annual surprise examination requirements. To qualify, the manager must deliver audited financial statements to each investor within 120 days after the fund's fiscal year ends. For funds of funds, this deadline extends to 180 days. The manager must also conduct an audit and quickly distribute audited statements if the fund shuts down. This exception recognizes that audited fund financials give investors complete verification of their positions and transactions.

There is some flexibility with timing compliance. A hedge fund manager may still qualify for this exception even if they miss the 120-day deadline (or 180-day deadline for funds of funds). This flexibility applies when the manager reasonably believed at the time that they would meet the deadline but was prevented by unforeseen circumstances beyond their control.

When a registered investment adviser holds custody of client securities, the general rule requires that all securities be held by a "qualified custodian." A qualified custodian is typically a bank or broker-dealer that meets certain regulatory standards. The privately offered securities exception provides relief for certain securities that are not easily transferable or traded. SEC staff guidance has indicated that even registered or "certificated" securities may qualify for this exception under the right circumstances. However, a hedge fund manager who cannot meet the pooled vehicle annual audit exception cannot use the privately offered securities exception.

Hedge fund managers with related companies such as banks or broker dealers face potentially stricter requirements under the custody rule if fund assets are held with those entities. Managers who create special purpose vehicles for investment purposes must evaluate whether each vehicle counts as a separate advisory client. If so, each vehicle may need its own independent audit separate from the main fund's audit. This follows guidance the SEC staff provided in 2014.

In 2017, the SEC Division of Investment Management staff issued updated interpretive guidance addressing what the SEC called "inadvertent custodyA situation where an investment adviser unintentionally obtains custody over client money or securities through contractual arrangements that grant greater asset access than originally intended.." The guidance warned advisers about the possibility of unintentionally obtaining custody over client money and securities in separately managed accounts. This can happen through contractual arrangements—particularly custodial agreements between a client and custodian—that give an adviser access to client assets that goes beyond what the adviser's own client agreement allows. Advisers should carefully review all relevant agreements to identify provisions that could unintentionally create custody.

The Custody Rule recognizes that compliance with strict deadlines may prove impossible despite good faith efforts. A hedge fund manager may still be eligible for the pooled vehicle annual audit exception even when they fail to meet the specified delivery deadline for audited financial statements. This flexibility applies when the manager maintained reasonable confidence that the statements would be delivered on time and the failure resulted from circumstances the manager could not reasonably have anticipated or controlled.