Jan 26, 2015
From the Financial Reporting Network
The SEC staff recently raised questions during the examination of certain registered investment advisors about their compliance with the Custody Rules of the Investment Advisers Act of 1940 when Real Estate Investment Trusts (REITs) are included in investment structures and the advisors have not obtained and distributed the REIT’s audited financial statements to the REIT’s shareholders (or obtained surprise security counts for the REIT’s investments).
Certain investment advisors include REIT subsidiaries in their pooled investment funds for tax and other purposes. To comply with the technical tax requirements of a REIT, the subsidiary REITs often will sell preferred shares to third-party shareholders that are not otherwise associated with the investment fund. The preferred shareholders often are entitled to receive only a fixed-preferred return with a liquidation preference. They do not receive redemption rights, have limited voting rights, and are not required to pay investment advisory fees. The investment advisor may not have considered the REIT’s preferred shareholders to be investment advisory clients and, therefore, the advisor may not have considered the implications of the Custody Rules for these preferred shareholders. However, the SEC staff has concluded in certain circumstances that the REIT’s preferred shareholders are advisory clients and the SEC staff directed certain investment advisors to the SEC staff’s Investment Management Guidance IM Guidance Update No. 2014-07 (previously announced in the July 3, 2014 edition of Weekly Review) to support the staff’s conclusion. Specifically, the guidance addresses when an advisor should treat the assets owned by a Special Purpose Vehicle (SPV) as assets of pooled investment vehicle clients of which the advisor has custody indirectly and, therefore, should include those assets within the scope of the financial statement audit of pooled investment vehicles. Although the Update uses the term SPV, the SEC staff has pointed to this guidance in its evaluation of REITs for certain investment structures.
Compliance with the Custody Rules including determining whether the REIT investors are investment advisory clients is a legal matter. Registered Investment Advisors with REITs within their investment structures should consult with their legal counsel about this matter and whether they are in compliance with the Custody Rules.