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News March 2, 2015 Issue

Mutual Fund Cash Collateral Must Be Held at a Custodial Bank

Advisers to registered mutual funds must treat collateral cash the same as other securities when it comes to custody.

That’s one lesson from a settlement reached February 12 between the SEC and a New York-based adviser to several alternative mutual funds. The adviser, Water Island Capital, manages approximately $3.5 billion in assets, engages in specialized trading strategies, and employs equities and derivatives swaps to carry them out, according to the administrative order instituting the settlement.

The firm agreed to pay a penalty of $50,000 to settle charges that it improperly maintained custody of approximately $247 million in cash collateral related to the funds’ investments in specific total-return and portfolio-return swaps for approximately nine months. The collateral was maintained at broker-dealer counterparties rather than at a custodial bank, the agency said.

The alleged violations were uncovered during an SEC examination of the firm and its funds, the agency said. The SEC’s Office of Compliance Inspections and Examinations, in both its 2014 and 2015 lists of examination priorities, includes alternative funds as a concern, which may be one reason behind the SEC’s attention to the firm’s custody practices. "If you’re a hedge fund manager getting into the registered fund business, make sure you hire people who are steeped in the Investment Company Act," said Morgan Lewis partner John McGuire.

Custody and Section 17(f)(5)

The SEC charged the firm with violating Section 17(f)(5) of the Investment Company Act, which, according to the SEC, generally provides that if an investment company maintains its securities and similar investments in the custody of a qualified bank, the cash proceeds from the sales of the same securities and similar investments, as well as other cash assets of the fund, also must be kept in the custody of the bank. In addition, the agency noted, the funds’ own compliance procedures also required that each fund "shall maintain its securities and similar investments, the cash proceeds from the sale of such securities and similar investments and other cash assets … in the custody of a qualified bank."

Such was not the case, however. "From at least January to September 2012, … Water Island did not ensure that certain assets of the funds were maintained in the custody of the funds’ qualified bank. The funds’ broker-dealer counterparties instead held assets consisting of roughly $247 million in cash collateral. … Water Island did not ensure the transfer of these assets to the funds’ qualified bank as required by Section 17(f)(5) of the Investment Company Act and the funds’ policies and procedures."

"The principal question for an adviser to ask in deciding whether assets need to be held by a custodial bank should be, ‘Is the asset being posted the property of the fund?’" said

Perkins Coie partner Andrew Cross. If the answer is yes, then however the assets are described from a business or an accounting point of view – whether they are proceeds, collateral or simply securities – is irrelevant, he said. They all are fund property, meaning that custody must be maintained at a custodial bank.

A standard industry practice that would facilitate such an arrangement is a collateral account contract agreement, Cross said. The SEC, in fact, makes reference to such an agreement in one of the administrative order’s footnotes, which said, "The cash collateral could have, for example, been maintained with the funds’ custodian bank subject to a tripartite agreement, that is, a three-way agreement between the custodial bank, the counterparty, and the fund."

Other violations

Custody was not the only requirement that the SEC charged Water Island Capital with violating:

Failure to implement policies and procedures that would allow a specific kind of broker-dealer compensation. Investment Company Rule 12b-1(h) prohibits funds from compensating a broker-dealer for promoting or selling fund shares by directing brokerage transactions to that broker. But the Rule permits a fund to do so if the fund or adviser has implemented policies and procedures reasonably designed to, among other things, ensure that the selection of brokers for portfolio securities transactions "is not influenced by considerations about the sale of shares of that or any other fund," the SEC said. In this case, the funds’ policies and procedures "were not implemented following their adoption." Specifically, "Water Island failed to create and maintain an approved list of executing brokers for the funds … and also failed to maintain documentation reflecting monitoring the funds’ compliance with the Rule 12b-1(h) policies and procedures."

  • Violation of Investment Company Act Rule 38a-1, the Compliance Program Rule. The companion rule to Advisers Act Rule 206(4)-7, the Investment Company Act version requires much the same things, including the adoption and implementation of written compliance policies and procedures, and the review of those policies and procedures at least annually. Water Island Capital funds, as a result of their not meeting Section 17(f) requirements or their own policies and procedures regarding custody, as well as violating Rule 12(b)-1(h) in regard to broker-dealer compensation, violated the Compliance Program Rule.