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SEC Brings a BDC Custody Case
Background:
- On September 23, 2024, the Securities and Exchange Commission reached a settlement in an administrative proceeding involving a business development company (“BDC”) for failing to properly custody privately offered securities and loans (“uncertificated securities”) and violating its written policies and procedures.1
- In order to comply with Section 17(f) of the Investment Company Act (“Section 17(f)”), the BDC elected under its policies and procedures to have a qualified bank serve as its qualified custodian, however for an approximately three-year period the BDC held uncertificated securities with brokers, transfer agents, and in certain cases, even self-custodied. These non-custodian bank custody arrangements violated the custody- related provisions of Section 17(f).
Key Facts:
- Section 17(f): Section 17(f) requires that a registered investment company maintain its securities and similar investments with a custodial bank, a member of a national securities exchange, or self-custody subject to any rules prescribed by the Commission. While each of the three options are permissible, an investment company’s policies and procedures must accurately reflect the investment company’s custodial arrangement(s) and ratify such arrangement(s) with their board of directors at least annually.
Despite having a board-approved Custody Agreement in place with its Custodian Bank to hold all uncertificated securities at its bank, SEC examiners found that the BDC violated Section 17(f) by holding its uncertificated securities with brokers, transfer agents, and in self-custody. - Rule 38a-1: During the period that the BDC’s uncertificated securities were held by entities other than its Custodian Bank, the BDC failed to follow its board-approved policies which required that it periodically conduct sample tests to confirm compliance with its custody procedures, periodically reconcile custodial statements with internal records, and appropriately train its personnel. The SEC also cited the BDC for failing regulated as a BDC under the Investment Company Act. Given SuRo’s BDC election, the compliance and custody provisions of Section 17(f) apply to SuRo’s activities to implement policies and procedures reasonably designed to prevent violations of the securities laws as required under 38a-1.
Takeaways:
- Say What you Do and Do What You Say – The BDC had comprehensive, board-approved policies and procedures designed to comply with Section 17(f) and still missed numerous opportunities during its 38a-1 reviews to ensure that its custody policies and procedures were functioning effectively. Especially in higher-risk areas like custody, ensure that your personnel understand their obligations under your policies and test them regularly.
- Standalone Enforcement Case for a BDC – Outlier or the Beginning of a Trend? – This was a standalone enforcement case involving a BDC, which is rare as suing a BDC is often seen as punishing shareholders. As we have been noting for some time, we have been seeing significant registered/regulated investment company growth recently, with even more BDC, interval fund and tender offer fund launches in the pipeline. With growth often comes additional regulatory scrutiny. Given that growth, now is the time to take stock of your 38a-1 compliance programs.
1 The company, SuRo Capital Corp. (“SuRo”) is a publicly traded non-diversified closed-end fund which elected to be regulated as a BDC under the Investment Company Act. Given SuRo’s BDC election, the compliance and custody provisions of Section 17(f) apply to SuRo’s activities.