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The SEC’s Division of Investment Management recently offered guidance on the custody of privately offered securities.  The SEC noted that 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.

The SEC noted that advisers assert that beyond the substantial investor protections provided by  financial statement audits, maintaining private stock certificates at a qualified custodian does not  provide meaningful protection to investors in pooled investment vehicles.  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,  including securities that are privately issued, regardless of whether the private stock certificates are held at a qualified custodian. Moreover, advisers have informed the Division that maintaining private stock certificates 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 of Investment Management advised it would not object if an adviser does not maintain private stock certificates with a qualified custodian, provided that:

  • 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;
  • 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 adviser and can be replaced upon loss or destruction.

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