The SEC Custody Rule Implications and Solutions on the future industry structure

Transcription

1 The SEC Custody Rule Implications and Solutions on the future industry structure

2 Status Quo: Today s Private Securities Market Can we afford that lack of progress? Current State Little has changed over the last 80 years ownership of a private investment is still largely in the form of physical documents. Transaction processing, control and asset servicing of holdings are not automated. Transparency and reporting that currently exists is highly individualized compared to the public markets. Future State Holding private securities in electronic book entry registration is supportable now. Securities information can be standardized with universal identifiers for individual issues to support greater automation, improved audit trail and faster settlement. Creation of universal standards for data transfer, communication and reporting will enable better investment management outcomes.

3 Oversight Has Arrived The Playing Field Has Changed The Custody Rule is enacted requiring alternative investment firms doing business as registered advisors to hold their custodial holdings with a qualified custodian With the passage of the Dodd Frank Act, private equity and hedge fund firms became subject to increased regulatory oversight Further amendments to the Custody Rule subject these firms to: - annual surprise exams to verify assets, or - for privately offered securities, funds must be audited and issue financial statements SEC s National Examination Program issued a Risk Alert and announced that 1/3 of firms examined had custody rule deficiencies SEC issues additional guidance on how the Custody Rule applies to SPVs which still leaves many custody questions unanswered.

4 Growth in the Private Capital Markets The JOBS Act of 2012 liberalized and expanded private capital raising: - The new Reg A+, Reg CF (crowdfunding), Reg D (general solicitation provisions in 506(c)) raised the ceiling to 2,000 investors before requiring public registration - Created the funding portal designation and major support for equity crowdfunding

5 More firms stay private longer, fewer early stage firms go public

6 Crowdfunding makes progress , crowdfunding expanded at a 63% compound annual growth rate Globally, from its start in 2012, Crowdfunding raised $34B In 2015 and could surpass venture capital in 2016 Crowdfunding is projected to grow to over $300 billion by 2025.

7 Historical Shortcomings of Private Securities The Issues The asset is still issued in physical form/pdfs: not best practice book-entry Manual recordkeeping processes are non-standard and difficult to automate susceptible to errors in the recordkeeping processes Chain of custody is time consuming to trace Asset servicing is highly individualistic by firm and communication and reporting information is often untimely Records are maintained by multiple parties in multiple systems Verification of holdings/audit confirmations are time consuming, costly and manual and do not rely on validation controls For PE firms: The sheer number of related entities and complexity of deal structures are not easily understood, navigated, reported on or reconciled. The cost of this work has been absorbed by management companies rather than identifiably allocated to investors

8 How do we break free of our limitations and barriers to progress? Recommendations Register private securities with a transfer agent or qualified custodian at inception. Standardize transferability processes and language across all investors within an issue Use unique securities identifiers for the life of the instrument (e.g. LEI#, CUSIP#, ISIN, etc.) Use industry data standards and information utilities across all industry participants. Have issuers notify agents or qualified vendors of all beneficial owner directed information for all asset servicing data Obstacles Digital practices must be used at inception by attorneys, issuers, deal teams in offering documents, by-laws, etc. Need to overcome institutionalized resistance to standardize Getting all industry constituencies to agree that the benefits outweigh initial hurdles. An industry task force (portals, DTCC, transfer agents, BDs, etc.) should convene Issuer practices needs revision and maybe even regulation like public issuers report their notifications through the FINRA transparency facility for public securities

9 Benefits Safeguarding Investor Assets Third party Transfer Agency/Custody is a best practice : it provides strong governance, regulatory oversight and high transparency at relatively low cost All transactions and asset servicing postings are traceable from each issuer back to the investor level along with basic tax reporting services All distributions of income or principal could be announced and recorded by issuers/transfer agent to create a uniform source of data More comprehensive reporting information (authorized/issued/outstanding shares) can be provided to the market (ATS providers, DTC AIP) Allows reconciliation of accounting entries to a true custodial book of record. This model unambiguously meets the SEC s highest goals of safeguarding investor assets at its most basic level. It will also facilitate secondary market transactions for private securities

10 Benefits Governance, Oversight, Control, Transfer & Reconcilement Private and Public entities must meet recordkeeping auditable standards with the SEC s Guideline (# ) for custody confirmation in the post-madoff era. Insures that all holders of a security have transparency and standardized methodologies in obtaining information that is rightfully theirs to act on. Oversight and transparency over a vastly improved reconciled accounting, legal and tax structure satisfies both investor due diligence requirements and the SEC Sarbanes-Oxley certifications that public entities must meet today. Better control and management of records for entities such as SPVs, partnerships and other forms of ownership are now possible. More automated transfer/settlement of securities for secondary transactions.

11 Benefits Automation and Standard Data Transfers Allows the highly automated recordkeeping processes applied public securities to be applied to private securities electronically held and reconciled. Creates an audit trail of processes and structure that survives any one person who performs part of these processes internally, or an expensive outsource to outside counsel in some cases. Broker/dealers, fund managers, administrators and custodians become part of a community using a standard format (such as ILPA) where possible. Allows for standardized, highly controlled exchange of data and information amongst all industry participants. Can substantially reduce transaction processing time from the current lengthy span dictated by the use of physical ownership representations Provides a cost-effective way to manage and integrate disparate systems to aggregate and control these records.

12 Custody and Entity Management Approach Modernizing the custodial and asset servicing world Current State Manually maintained structure charts Future State Accounting runs separate portfolio platform Manual Ops with custodians PDFs are state-of-the-art Manual Enterprise Data Warehouse (integrated to custody) Enterprise Reconciliation Platforms (integrated to custody) Transfer Agency/ Custody

13 The Case for a Registered Transfer Agent/Custodian Maintains issuer / security holder records in electronic book-entry form Maintains and safeguard all data in a highly secure environment Uses standardized identifiers for private non-traded securities (e.g., CUSIPs) Supports and presents share / unit valuations for private non-traded securities Includes as of valuation date and explanation of calculation / price valuation Displayed on investor / employee web portal and participant statements (complies with FINRA Rule 15-02) Allows electronic issuer instruction for new issuances Fully transparent cap table / holder data and audit trail: All physical correspondence is scanned and imaged All transactions and maintenance is recorded electronically Supports private sale transactions (using issuer-provided valuations) Extensive reporting capability (PDF and.csv) Compliant with SEC regulations and mandated processing standards Supports compliance with state escheatment laws, IRS tax certification, OCC standards

14 Custody and Entity Management Approach Accounting and Investor Reporting: Integration of Fund Administrators Current State Manually maintained structure charts Future State Accounting runs separate portfolio platform Manual Ops with custodians PDFs are state-of-the-art Manual Enterprise Data Warehouse (integrated to custody) Enterprise Reconciliation Platforms (integrated to custody) Computershare Transfer Agency/ Custody

15 Multi-Entity Book-Entry Custody Process Flow

16 Custody and Entity Management Approach Legal, Tax and Governance tracking is driving new demands Current State Manually maintained structure charts Future State Accounting runs separate portfolio platform Manual Ops with custodians PDFs are state-of-the-art Manual Enterprise Data Warehouse (integrated to custody) Enterprise Reconciliation Platforms (integrated to custody) Computershare Transfer Agency/ Custody

17 Complex deals in Private Equity and even Venture Capital In large firms these number in the thousands Tax structures, Partnerships, SPVs and co-investments in PE and venture capital raise the complexity of deals. This level of automation and reconciliation is possible today. The need for automation and recordkeeping accuracy is expanding.

18 Data/Information Transfer Hub Is AIP a good start? Standardized Data/Information Transfer Allows the standardized exchange of information amongst all parties; Broker/dealers, fund managers, administrators and custodians. Automates the exchange of all pretrade, trade-related account information - subscription documentation through money settlement and post-trade reporting. Provides the industry with a streamlined, automated and centralized processing solution reducing the risks and time associated with paper-based processing. Alternative Investment Products (AIP) is a service offering of National Securities Clearing Corporation (NSCC), a wholly-owned DTCC subsidiary. This description is for informational purposes only. The Service is governed by applicable Rules, Procedures, and Service Guide for each DTCC subsidiary, which contain the full terms, conditions, and limitations applicable to this Service.

19 Next Steps Issuers Go to book-entry issuance and standardized asset transferability Adopt early standards and outsourcing of governance recordkeeping Protect and improve investor processes and transparency Standardize issuance announcements PE/Venture Funds Go to book-entry Custody and Issuance Move to standardized and outsourced governance recordkeeping Protect and improve investor processes and transparency Move to a reconciled recordkeeping approach such as CEMA Intermediaries Standardize book-entry custody and assets servicing processes Move to uniform data standards and data exchange processing utilities Harmonize public and private securities processing practices