When an investor directs money to a hedge fund, he expects those assets and his privacy to be protected. Custodian rules for hedge funds help to encourage these practices. Hedge funds are urged to place investor assets and securities with a reputable third-party custodian firm, which can be a bank or a broker-dealer, for instance, that is deemed qualified by regulators. The custodial responsibilities for hedge funds do not end there, however, as portfolio managers must remain actively engaged in the way that investor assets are handled.
The U.S. Securities and Exchange Commission updated certain custodial requirements for hedge funds following the financial crisis of 2008. The changes call for greater involvement of third-party service providers, including custodians and increased accountability on the part of hedge-fund managers. Fraud that occurred at broker-dealer firm Bernard L Madoff Investment Securities in 2008, a firm to which some hedge funds had direct exposure, spotlighted the risks associated with keeping custodial functions internal and caused the SEC to tighten rules.
Custodian firms are required to distribute quarterly statements to hedge-fund investors on account activity. However, this does not remove the burden from the hedge-fund manager, who is responsible for making a respectable effort to make sure that those documents were distributed, according to the SEC. Additionally, a hedge-fund manager who sends audited financial information to investors must urge those clients to compare the statements sent by a custodian with those of the fund manager for accountability purposes.
Hedge-fund managers may still opt to maintain custodial control over investors' assets. Managers with broad access to clients' money remain subject to unexpected accounting audits by an approved accountant each year, according to the SEC. The rule is designed to protect investors from any fraud as accountants are expected to respond to fund activity deemed questionable. According to the National Law Review website, an unexpected audit is likely to be expensive, and the cost burden is on the hedge fund.
Certain smaller hedge funds maintain custodial access over client accounts for the purpose of withdrawing fees. It may be too expensive for smaller funds to outsource these specific tasks to a third-party custodian. In response to feedback from the hedge-fund community, the SEC ultimately decided that hedge-fund managers who maintain custodial control strictly for deducting fees are not targets of unexpected yearly audits, according to the National Law Review. The SEC continues to monitor any effects of this allowance, however.
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