SEC Staff Issues No-Action Relief Under Custody Rule

The SEC staff has issued a no-action letter to Madison Capital Funding LLC, allowing the registered investment adviser to conduct certain loan syndication activities despite its inability to comply with certain requirements of Rule 206(4)-2 under the Investment Advisers Act. This rule, known as the custody rule, requires registered investment advisers to hold client funds or securities in accordance with certain conditions in order to protect client assets from misappropriation.

What the rule requires

The rule provides that client funds and securities must be maintained with an organization, such as a bank or a registered broker-dealer, that meets the definition of “qualified custodian.” The funds must be held either in a separate account for each client (under the client’s name) or in accounts that contain only the client’s funds and securities under the investment adviser’s name as agent or trustee. Additionally, the investment adviser must have a reasonable basis to believe the qualified custodian sends account statements to its clients at least quarterly.

Commercial practices involve commingling of assets

Representatives of Madison wrote to the SEC, noting that nonbank lenders typically fund only a portion of their loans to middle-market companies and syndicate the remaining portion. It is common for lenders to serve as administrative agents for the loan syndicate, thereby becoming the main point of contact for communication and payments.

In this context, Madison is a middle-market lender, loan syndicator and administrative agent that also provides investment advisory services to private investment funds and separately managed accounts. The investors in these funds and accounts are typically institutional investors, such as pension funds, insurance companies and other large organizations.

As required by the loan syndicate credit agreements, Madison follows negotiated guidelines and formulas when receiving or distributing money. In its capacity as administrative agent, it applies the terms of the credit agreements and, as noted by the SEC, “has no authority to determine how the cash is used, allocated or disbursed.”

To make and receive payments, Madison uses a single bank account maintained by a U.S. bank that meets the definition of a “qualified custodian” under the custody rule. In that account, funds from multiple loan syndicates are commingled instead of being held in separate accounts and subaccounts for each participant. However, Madison receives payments only in its capacity of agent for the loan syndicate participants, so none of these payments would be part of its estate in bankruptcy.

Why an exemption was needed

Even though Madison does not receive funds in its personal capacity and does not have authority to determine how the cash is used, it would likely still be considered to have custody of the client assets because it serves as administrative agent and has access to the cash in the account. Because of this, holding the funds in commingled accounts does not meet the requirements of the custody rule.

Madison proposed and the SEC staff accepted various conditions to protect the client funds and to preclude enforcement action. Here are some of the key conditions listed in the no-action letter:

• The agency account must continue to be maintained with a qualified custodian, and Madison must continue to receive payments only as agent for loan syndicate participants.
  
  
• The account must contain only the assets of the loan syndicate participants.
  
  
• Cash may be deposited or withdrawn from the account only in accordance with the credit agreements for the loan syndicates.
  
  
• Madison must implement controls to ensure the assets are protected from misappropriation and are distributed in a timely manner, consistent with the applicable credit agreements.

As a result of these conditions, Madison may continue to perform its dual role of administrative agent and investment adviser while using a single account with a qualified custodian. By facilitating compliance with the custody rule, the SEC’s guidance allows investors to continue to receive administrative services that reduce risk, complexity and costs.