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News July 19, 2004 Issue

SEC Proposes to Fix Fund of Hedge Funds Custody Problem

Good news for advisers to funds of hedge funds worried about complying with the 120-day limit for distributing audited financials. The SEC has proposed to strike out that pesky "120" number and replace it with "180." The amendment to the Advisers Act custody rule was unexpectedly included in a package of proposed rulemakings requiring hedge fund managers to register as advisers.

As the custody rule now stands, a hedge fund can deliver financial statements to investors in lieu of account statements, provided the financials are delivered within 120 days of the end of the fund’s fiscal year. The financials must be audited and prepared in accordance with GAAP. For funds of hedge funds, this presents a logistical problem. A top-level fund has to wait for its underlying funds to complete their audits before it can finalize its own financials.

Over the past few months, the industry brought the issue to the attention of the SEC. The problem was addressed in a Q and A added to the staff’s Custody FAQ (see Question VI.8), in which the staff essentially granted a no-action position to funds of hedge funds that reasonably believed that they would be able to make the 120-day deadline, but then failed to do so.

What the industry really wanted was an extension. And now, it looks like they’ll get it. According to SEC assistant director Jennifer Sawin, the change was recommended in recognition that funds of hedge funds often cannot finish their own audits until the underlying funds have completed theirs.

But there’s a catch: the proposed change would make the 180-day period available to the underlying funds, as well. So, to reap the benefits of the extension, top-level funds will have to pressure their underlying funds to continue providing their audited financials within a shorter period (such as 120 days), rather than taking full advantage of the 180-day period.